April 25, 2017

Uniform Accounting highlights RSG’s Adjusted EPS is weak, and valuations are even more aggressive than as-reported metrics suggest


  • RSG’s traditional EPS is materially distorted by the age of their assets and the resultant depreciation charges
  • After making the appropriate UAFRS adjustments, EPS’ was significantly lower than as-reported EPS last year, and will continue to be lower going forward
  • At current valuations, RSG is not undervalued with a 0.87x PEG that as-reported metrics suggest, but instead a 3x PEG, a very premium valuation that may not be justified

 

Republic Services, Inc. (RSG) is expected to release Q1 2017 as-reported earnings of $0.52 per share on 4/27, representing significant 16% growth from $0.45 levels during the same period last year. Full-year EPS expectations are as aggressive and are for growth from $1.78 last year to $2.33.  As such, markets have rewarded the firm for a continued positive outlook, and RSG has rallied over 45% since the beginning of 2016, and although UAFRS-based P/E (Fwd V/E’) has reached 27x, the firm initially appears cheap when considering its projected 30%+ growth.

However, after making appropriate adjustments under Uniform Accounting Financial Reporting Standards (UAFRS), it is apparent that profitability is actually much weaker and growing more slowly, and valuations are more aggressive, indicating the recent run in RSG share prices are unwarranted, supporting longer-term underperformance.

Specifically, under UAFRS, Adjusted EPS (EPS’) is only expected to grow by 16% in Q1, from $0.30 to $0.37 and by 10% over the full-year 2017, from $1.52 to $1.68. As the chart below highlights, EPS’ is also significantly below as-reported EPS, with EPS’ expected to remain over 25% lower than as-reported EPS suggests, a continuation of trends seen historically, indicating investors may not realize the weakness in RSG’s profitability.  Lower EPS’ also implies valuations are more aggressive than as-reported metrics suggest, indicating that not only is growth slower than reported, but valuations are far too aggressive when considering the firm’s economic outlook.

rsg1-20170425

The quarterly results show a similar trend, with EPS’ remaining well below traditional EPS in each quarter.  Given weaker-than-reported profitability trends, valuations may not be warranted, and investors may not realize the scope of weakness in RSG profitability.

rsg2-20170425

UAFRS, Uniform Adjusted Financial Reporting Standards, call for the removal of distortions from issues like the treatment of excessively aged, or relatively long-lived assets. Once removed, it is apparent that EPS’ has been weaker, and will likely continue to be weaker than traditional EPS suggests.

UAFRS vs. As-Reported EPS

Investors make major decisions about which companies to own based on quarterly company earnings, the most common metric mentioned in traditional corporate investment analysis.

However, more often than not, the earnings that companies report in any given quarter can swing wildly and lead investors to completely wrong conclusions, because GAAP and IFRS rules force management to report results in ways that are not representative of the real operating performance of the business.

While there is a case to be made that some management teams can use “creative accounting” to adjust numbers, the research would show that more often than not, the real problem is with the accounting rules themselves, not management’s use of them.

Impact of Adjustments from GAAP to UAFRS

There are several adjustments required to make earnings representative of a firm’s true cash flows. For RSG, the most material is related to adjusting for true depreciation of the firm’s assets.

RSG has not actively invested in its business over the last several years, leading to its asset base aging considerably over this time frame.  Generally, companies with older assets tend to have lower cash flows than they would have otherwise, once they have to spend more on maintenance capex.  However, RSG has been milking their asset base, allowing assets to depreciate until they approach fully depreciated levels on their balance sheet.  Once assets are fully depreciated but continue to be used, the depreciation expense associated with those assets disappear and as-reported net income will appear improved as the company has the same earnings power, but no depreciation expense on the assets generating that revenue.  This continues to be true until management does spend on maintenance capex.  Since RSG has been milking their asset base, their depreciation expense, a proxy for maintenance capex, is being understated currently.

Moreover, given the long-lived nature of the firm’s assets, the true maintenance capex costs related to their assets is much higher than depreciation, which is reflective of the cost of those assets when the company bought them, which happened almost 20 years ago for many of RSG’s assets.   As such, nominal asset values should be restated into constant-currency values to improve the reliability of business performance metrics, and the related depreciation (maintenance capex) expense should then be calculated off of the value of the Adjusted Asset base.

UAFRS-reporting adjusts for these traditional accounting distortions by estimating the age of assets and using a GDP deflator to adjust the asset value and associated depreciation expense into the values reflective of what replacement cost would be in the current year being measured. This calculation removes a tremendous amount of accounting noise related to investment activities and improves investors understanding of the operating earnings of a business.

Weaker than reported earnings mean valuations are actually more expensive than they appear

Using traditional metrics would suggest the firm is still undervalued even after the recent stock price run, with a 0.87x PEG ratio; however, this is directly contrary to the actual potential of the firm. Once accounting distortions are removed, it is apparent that RSG is not trading at reasonable valuations with a 27x P/E and 31% projected growth next year, but instead, a 30x UAFRS-based P/E (Fwd V/E’), with only 10% projected growth in UAFRS EPS’, implying a PEG of 3x.

At current prices, investors are not realizing the weakness in RSG’s profitability outlook, and it is apparent that when looking at valuations and EPS’ that longer-term underperformance is warranted.

By using Uniform Adjusted Financial Reporting Standards (UAFRS), investors see a cleaner picture that distorted GAAP and IFRS metrics cannot show. By standardizing financial reporting consistently across time and across companies, corporate performance and valuation metrics improve dramatically. Comparability of a company’s earnings over time, trends in corporate profitability and comparability in earnings power and earnings growth across close competitors and different sectors becomes far more relevant and reliable.

To find out more about Republic Services, Inc. and how their performance and market expectations compare to peers, click here to access the open beta of the Valens Research database.

Our Chief Investment Strategist, Joel Litman, chairs the Valens Equities and Credit Research Committees, which are responsible for this article. Professor Litman is a recognized global expert in advanced financial statement analysis, corporate performance, and valuation.