March 14, 2017

RSG, WM, and WCN – Uniform Accounting Uncovers Trash Stocks with Treasure Valuations


  • Republic Services, Waste Management, and Waste Connections are all trading at premium valuations to both peers and fair valuations given their profitability
  • After significant gains in share prices in 2016, these firms are also trading at valuations in excess of levels ever before seen, and corresponding market expectations are far too aggressive
  • Had these companies seen 0% gains in share price in 2016, this may have been warranted, and unless investors believe fundamentals improved by 30-70% as well, downside is likely justified

 

Several weeks ago, we detailed one of our screening processes in our article on the Retail industry. Specifically, we focused on how investors can look at the relationship between quality (in terms of profitability) and valuations, and use this relationship to find interesting potential long and short ideas. Generally we find that the most interesting names are outliers in the market and within their own sector or industry, and it is rare to find entire sections of the market over or undervalued given the “wisdom of crowds”. However, as highlighted in that Retail article, there are times when entire industries can be overvalued, and once again it is apparent that the market is too bullish on a niche in the market.

 

A number of companies in the waste management industry, and specifically the three largest players by market cap in the solid waste and recycling business: Republic Services (RSG), Waste Management (WM), and Waste Connections (WCN), all appear overvalued, both compared to peers, and compared to their own historical profitability.

 

Given their end markets, these companies have profitability that is tied to the health of the economy, and specifically health of housing markets, industrial markets, and energy end markets, and as such have seen their share prices improve dramatically since the Great Recession, and even further in the past year up 30%+ as markets have grown significantly more optimistic about their outlook. However, fundamentals have not actually improved that significantly, and have been relatively stagnant this past year, and valuations have become absurd as a result.

 

Analysis of an Industry – The Quality vs. Valuation Scatter Can Highlight Relatively Expensive Names

 

Looking across industries, markets, and time, there has been a very strong relationship between a company’s Uniform Adjusted ROA (ROA’) relative to the corporate average (6%) ROA’, and the multiple the market will pay above the value of the company’s UAFRS-based Asset (Asset’) base, in terms of a cleaned-up P/B multiple (V/A’). A company that generates a 6% ROA’ will tend to trade at a 1.0x V/A’, and a company that generates an 18% ROA’ will trade at a 3.0x V/A’, etc., within a growing band of variance. This heteroscedastic pattern is a result of higher ROA’ firms having more variables (including growth rates) that can affect valuations relative to low ROA’ firms.

 

It is also important to note that there is a very clear spline at one point of this scatter in which this relationship does not hold: firms generating returns below the cost of capital. These firms often trade on much different factors, generally things such as the recovery value of assets and the risk of default, but generally trade at a V/A’ below 1.0x.

 

This phenomenon is depicted visually in the chart below:

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Below, we have included a scatter chart that plots all companies in the Environmental and Facilities Services sub-industry, located in the US or Canada with a market capitalization of $500mn or above. To conduct similar analysis, you can follow this link to the scatter chart for WCN.

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It is also important to note that there is a very clear spline at one point of this scatter in which this relationship does not hold: firms generating returns below the cost of capital. These firms often trade on much different factors, generally things such as the recovery value of assets and the risk of default, but generally trade at a V/A’ below 1.0x.

 

This phenomenon is depicted visually in the chart below:

Below, we have included a scatter chart that plots all companies in the Environmental and Facilities Services sub-industry, located in the US or Canada with a market capitalization of $500mn or above. To conduct similar analysis, you can follow this link to the scatter chart for WCN.

 

It is initially apparent that there are a number of companies that are trading at valuations greater than may be warranted, and specifically, RSG, WM, and WCN all warrant further investigation as potentially expensive names.

 

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historical economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

 

Garbage Stocks – WM, RSG and WCN are interesting short ideas

Upon further analysis, not only are these names likely overvalued relative to peers and the overall market, but compared to their own historical profitability, the market must be expecting a significant change in the operations of each company to warrant current valuations.

 

WM

Historically, WM has seen consistently weak, somewhat cyclical profitability, with ROA’ slightly below cost-of-capital levels in most years. From 2000-2003 ROA’ declined from 11% to 3%, before stabilizing at 4% levels from 2004-2008. While the Great Recession drove ROA’ to -1% in 2009, it subsequently rebounded to 5% levels from 2010-2012, before falling to 2% in 2013. However, since then ROA’ has stabilized at 6% levels. Meanwhile, Asset’ growth, which from 2000-2004 consistently ranged from 6%-8%, has become increasingly volatile, ranging from -8% to 16% since 2005.

 

WM is currently trading at a 1.9x V/A’, which is historically high, and until recently, the firm had not traded at a V/A’ north of 1.6x since 2000-2001. For reference, the last time valuations were even close to current levels, the firm had just generated 2x cost of capital profitability, and was not actively shrinking Assets’. At these levels, the market is pricing in expectations for the firm to completely buck the trend it has seen since the early-2000s and see ROA’ jump to 13%+ levels going forward, with minimal Asset’ shrinkage compared to recent levels.

 

Unless the firm is able to overhaul and improve its current business model, and drive significant profitability improvements, significant downside would be warranted.

 

To see WM’s full Performance and Valuation Prime and other insights on Valens Research, click here.

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Impact of Adjustments

This analysis uses Uniform Adjusted Financial Reporting Standards (UAFRS) metrics, or adjusted metrics, which remove accounting distortions found in GAAP and IFRS to reveal the true economic profitability of a firm. This allows us to better understand the real historic economic profitability of a firm as well as allows for better comparability between peers. To better understand UAFRS, please refer to our explanation here.

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Above, we have included a common size balance sheet and income statement, highlighting the impact of all of the UAFRS adjustments made to Net Income to get to the Adjusted Earnings number, and all of the parts included in the UAFRS-based Net Assets number.

 

Note above, one of the more material adjustments to WM’s Adjusted Net Asset base comes from UAFRS capitalization of operating leases. WM’s operating lease expense is material. However, the decision management makes between investing in capex and investing in a lease is not a decision between an expense and an investment, but rather a decision in how management wants to finance their investments. If they would rather spend cash upfront for the asset, they will spend capex. However, if they want to spread the cost of the asset over several years, they will instead choose to lease the asset. That said, as-reported accounting statements treat one as an investment, and the other as an expense that does not impact the balance sheet. WM spends materially on operating leases, as-reported metrics like Total Assets and ROA materially overstate the firm’s true profitability and capital efficiency versus UAFRS metrics.

 

RSG

 

Historically, RSG has seen overall declining, somewhat cyclical profitability. Leading into the Great Recession, ROA’ declined from a high of 17% in 2000 to 9% levels from 2004-2010. Then, ROA’ resumed declines once more in 2011, falling each year through 2014, to just 6%, before rebounding slightly, to 7% in 2015. Meanwhile, Adjusted Asset growth has been fairly consistent, positive in fourteen of the past sixteen years, while ranging from 1%-20%, excluding 192% growth in 2008 attributable to the firm’s acquisition of Allied Waste.

 

At a current 30.0x V/E’, and 2.5x V/A’ (both historically high), the market is pricing in expectations for a material turnaround at RSG. As opposed to pricing in expectations for declines to continue, the market is currently pricing in expectations for ROA’ to reach 14%, with Asset’ growth consistent with recent 3% levels going forward.

 

Again, unless the firm is able to realize material near-term improvements in its business, equity downside would likely be warranted.

To see RSG’s full Performance and Valuation Prime and other insights on Valens Research, click here.

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Impact of Adjustments

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Once again, the waterfall chart above highlights the impact UAFRS adjustments have on RSG’s asset base and earnings. Similar to WM, UAFRS capitalization of operating leases can have a somewhat important impact on RSG’s Adjusted Net Asset base.

 

WCN

From 2000 through 2008, WCN saw Adjusted ROA consistently decline each year, from 14% to 9%, before seeing a substantial compression to 3% in 2009. In 2010, profitability immediately rebounded, with Adjusted ROA reaching 10%, and remaining in the 7%-12% range until reaching a record high 15% in 2015. Adjusted Asset growth has been more cyclical in nature. From 2000-2002, Adjusted Asset growth expanded from 19% to 26%, before fading to a low of 8% in 2004. Growth then increased every year until reaching a peak of 19% in 2008, after which it has subsequently faded every year to 7% in 2015, not inclusive of the 46% growth in 2012 due to the acquisition of R3 Treatment.

 

After seeing its share price run nearly 70% since the end of 2015, WCN is now trading at a V/A’ nearly double historical averages, and over 60% greater than previous historical highs. At these levels the market is pricing in expectations for the firm to build on 2015 ROA’ improvements, and drive ROA’ to 26%, with Asset’ growth in line with 7% levels since 2013.

 

However, analysts have more bearish expectations for 2016, and unless this is an anomaly WCN will likely struggle to meet market expectations going forward, warranting significant equity downside.
To see WCN’s full Performance and Valuation Prime and other insights on Valens Research, click here.

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Impact of Adjustments

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Once again, the chart above highlights that WCN has operating lease expenses that, prior to being capitalized, cause an overstatement of the firm’s true profitability. Furthermore, capitalizing all operating leases for all three companies allows for greater comparability; none of the firms has the advantage of treating a greater proportion of their leases as an expense rather than an investment. Thus, it is easier to determine the true asset efficiency of each company.

 

Valuations may have been fair once, but no longer

 

If RSG, WM, and WCN had seen share prices remain largely stagnant over the last year, based on historical profitability this would have likely been warranted, and the shares would likely still be around fair value. However, since the beginning of 2016, WM and RSG shares have gained 30%+ while WCN shares have jumped nearly 70%.

 

As such, unless fundamentals are expected to improve at a similar rate (which would be highly difficult given each of the firm’s operations and business models), valuations have run much too far, and any further fundamentally-driven upside is likely limited. Moreover, should the firms fail to meet lofty expectations, warranted downside would be significant.

 

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is regarded around the world for his expertise in forensic accounting and “forensic fundamental” analysis, particularly in corporate performance and valuation.