Trashy Can Be Classy
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As proof that you can't assume that companies stay the same, you only need to look at the waste removal industry. The two largest players, Republic Services (NYSE: RSG) and Waste Management (NYSE: WM) dominate the industry. I've compared the two in the past, and at the time it seemed like Republic Services was a better deal. However, because of the companies higher yield, in my real life portfolio, I actually purchased Waste Management. I've subsequently sold that investment because I realized that I overestimated the company's growth capabilities. Based on the two companies performances, it seems I should've stuck with my original research. Republic Services recent earnings report just seems to reinforce the point that this company is the better buy.
Republic Services reported revenue down 1.25% and earnings-per-share jumped 20.41%. While the company's divisions didn't show impressive revenue growth, what's really exciting is their ability to squeeze cash flow out of even small revenue growth. Republic Services has been increasing its cash flow and decreasing its share count at the same time. In the most recent quarter, the company's adjusted operating cash flow increased almost 18%, if you strip out asset and liability changes. Over the last year, the company has also retired almost 3% of their diluted shares. Last but not least, the company's adjusted free cash flow more than covers their dividend with a 73.13% payout ratio. Some might wonder, with relatively lackluster revenue growth, why would they choose Republic Services over other investments?
There are several reasons to favor waste removal companies and specifically Republic Services. First, you couldn't ask for a more consistent industry. Even as more consumers move towards recycling rather than just trash removal, Republic benefits as someone has to haul away these recyclables. Second, analysts that follow Republic see the company's revenue growth picking up slightly over the next few years. While it might not sound like much, the average analyst expects revenue growth of about 1% for 2012 and 2.6% for 2013. If Republic was able to generate 18% more operating cash flow out of sub-1% revenue growth this year, what could the company do with 2.6% growth? A third and compelling reason to consider Republic Services is, the company's relative value compared to their competition.
Waste Management is the largest player in the field, but the company has been hit recently with concerns about their growth. Analysts have taken note of these issues and cut their 2012 and 2013 EPS projections. These same analysts have also cut Waste Management's expected EPS growth rate from about 10% to 4% over the last few months. Even though Waste Management pays a respectable 4.3% dividend, if the company only produces 4% EPS growth, this gives investors a combined 8.3% total return at best.
Another player in this field is Waste Connections (NYSE: WCN). There are two problems I have recommending Waste Connections versus either of their larger competitors. The company is expected to show about 7% EPS growth, but the market has the stock priced like a fast-growth darling at about 22 times forward estimates. Second, Waste Connections yield is just over 1% versus 3% and 4% at Republic Services and Waste Management. Using the combined total return method, even Waste Connections doesn't look that good at just 8%. With both of Republic's major competitors showing total expected returns of about 8%, what can investors expect from the company?
Republic Services offers the lowest valuation of the three companies at about 15 times forward earnings estimates. The company also has the highest projected growth rate at nearly 10%. This alone would make the stock worth considering, but when you add in the company's 3.3% yield, the deal looks even better. If investors have a choice between a better than 13% combined total return or about 8%, the numbers seem to clearly favor Republic.
When it comes to one of the most basic measures of efficiency, gross margin, Republic does well here also. While Waste Connections gross margin is over 40%, we've already seen the valuation issues with that company. Looking at Republic versus Waste Management, the gross margin battle isn't close. In their most recent quarters, Republic's gross margin was 39.77% versus 34.66% at Waste Management. This better efficiency is just another reason to favor Republic Services.
In my original comparison, I favored Republic largely because the company's combined return was over 3% higher. Today the company's expected total return is almost 5% higher than Waste Management or Waste Connections. With a stable business model, and the best combination of growth and income, Republic Services shows that being trashy could be a classy investment.
MHenage has no positions in the stocks mentioned above. The Motley Fool owns shares of Waste Management. Motley Fool newsletter services recommend Republic Services and Waste Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.