If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale.
With every company in our coverage universe, we rate them on 13 unique measures. To get started, we show Republic Services’s below:
Republic Services earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. We expect the firm’s return on invested capital (excluding goodwill) to expand to 21.3% from 20.2% during the next two years.
Within the collection line of a waste hauler’s business (typically 60-70% of revenue; about 75%-plus in Republic’s case), residential services provided to municipalities and individual households are on a service-based model (not-volume based) and can largely be viewed as insulated from economic pressures. Such a constant revenue stream helps to mitigate cyclical pressures in a trash taker’s commercial collection and industrial roll-off lines, which also fall into the overall waste-collection category.
Cell-by-cell landfill build-out provides additional flexibility with respect to capital outlays, as haulers can scale back expenditures during troubled economic times. Republic’s free cash flow margin will likely return to double-digit levels this year following its acquisition of Allied Waste a few years ago.
Transfer and disposal (typically 20%-30% of revenue; about 18% of revenue in Republic’s case) is the most lucrative revenue stream in the waste business. Landfill ownership can largely be viewed as the primary competitive advantage for a solid-waste operator. Though anyone that can finance a truck can bid on collection routes (service is undifferentiated), new entrants are at a significant disadvantage for disposal.
The firm sports a very nice dividend yield of 3.1%. We expect Republic to pay out less than half of next year’s earnings to shareholders as dividends. We include Republic Services in the portfolio of our market-beating Best Ideas Newsletter, as one of our favorite yield ideas.
Economic Profit Analysis
The best measure of a firm’s ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm’s economic profit spread. Republic Services ‘s 3-year historical return on invested capital (without goodwill) is 16.6%, which is above the estimate of its cost of capital of 8.1%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
We think Republic is worth $ 37 per share, which represents a price-to-earnings (P/E) ratio of about 28.1 times last year’s earnings and an implied EV/EBITDA multiple of about 8.7 times last year’s EBITDA. Our model reflects a compound annual revenue growth rate of 1.2% during the next five years, a pace that is lower than the firm’s 3-year historical compound annual growth rate of 36.7% (which includes the Allied acquisition).
Our model reflects a 5-year projected average operating margin of 22.9%, which is above Republic Services’ trailing 3-year average thanks to improvement in pricing. Beyond year 5, our valuation model assumes free cash flow will grow at an annual rate of 1.5% for the next 15 years and 3% in perpetuity. We employ an 8.1% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm’s fair value at about $ 37 per share, every company has a range of probable fair values that are created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn’t see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock.
In the graph below, we show this probable range of fair values for Republic Services . We think the firm is attractive below $ 28 per share (the green line), but quite expensive above $ 46 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Republic Services’s fair value at this point in time to be about $ 37 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm’s current share price with the path of Republic Services’s expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm’s shares three years hence.
This range of potential outcomes is also subject to change over time, should our views on the firm’s future cash flow potential change. The expected fair value of $ 47 per share in Year 3 represents our existing fair value per share of $ 37 increased at an annual rate of the firm’s cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements