The thesis is simple:
- Trough volumes
- Trough pricing
- Close to trough valuation
It is rare to get all the ducks aligned; I think they are currently. In my opinion, an investment in waste today has some similarities to an investment in railroads or airlines in late '09. I am referring specifically to the timing of the inflection point in volume growth and pricing.
Why the stock is mis-priced:
- This is a boring business literally at the bottom of its respective cycle. Investors are extrapoliating the very low growth the business has been experiencing in recent years.
- Pricing power has been below normal in recent quarters due to a depressed CPI (which lags economic growth) and underpriced constracts, which roll off July 1.
About the business:
- Waste is a stable business with good cash flows that grows approximately in line with GDP. Drivers of growth--volume and price--are bottoming currently and are set to inflect positively for the first time this cycle (Q3'11).
- RSG is the second largest solid waste company in the US (after WM). Together, the two companies control the majority of landfills in the US. Landfills are irreplaceable assets with high barriers to entry and have pricing power as a result.
- This industry has been consolidating for 20 years. During the last business cycle, the large players who control the majority of major markets found pricing religion for the first time. Despite a low double digit decline in volumes over the past few years due to the recession, pricing has continued to rise, albeit more slowly than when the economy was growing last business cycle. The only industrial industries I am aware of that continued raising prices despite declining volumes through the downturn are railroads and aggregates--both of which have also consolidated and become more rational over a similar time period.
- Approximately half of the business is tied to index-based pricing, which lags the CPI by 6-12 months. I believe the CPI will begin rising this year due to higher oil and food prices as well as rising rents et al. RSG's price guidance this year is 1-1.5% but the important part to note is that 2H pricing will be significantly higher than 1H as negative pricing contracts (-40bps) roll off July 1. We should see pricing inflect positively in Q3'11. This will likely be a key inflection point for investor psychology, which has been negative for a few years.
- Volumes are tied to the economy overall and tend to ramp very late in the economic cycle. Construction represents <10% of the business but is more cyclical and is down ~50% from the peak. Guidance this year is for 0-1% volume growth. Volume growth should accelerate this year from the GDP growth that occured in 2010 and that which is occuring in 2011. The duration and magnitude of the volume recovery will be a function of the economy. Any rebound in construction is an added kicker.
- We project FCF/share of about $2.65 in 2012. At $30.50, this means the stock trades at 11.5x. I think this is cheap relative to 1) earnings growth outlook coming off the bottom of an extended downturn, 2) remaining untapped pricing power, 3) stable earnings stream and 4) high barriers to entry. The business is probably worth 16x normal FCF and should grow at an accelerated rate over the next couple of years until we see volumes return to more normal levels. If I assume 16x 2012 FCF (still below normal), the stock should trade at $42.50, +40% from today in 6 months.
- For context, during the last period of economic growth, the business was valued at a peak of about 21x FCF and a trough of about 15x. This occured when investors first realized the industry had pricing power.
- On an EBITDA basis, the enterprise is valued at about 7.3x trailing versus a low over the past 2 years of 7x and an average over the past 5 years of 8.4x. In other words, the business is being valued near a trough multiple on trough earnings (relative to the past 2 years) whereas in reality it probably should be valued at an above average multiple at this point in the cycle. For context, during the last period of economic growth, the business was valued at a peak of almost 10x trailing EBITDA and a trough of 8.2x. If I assume just an average multiple of 8.4x depressed 2011 EBITDA, the stock will be $39.50 in 6 months from now, or +30% from today.
- Downside potential is low in my opinion. The low downside potential is as importnat as the upside potential in making RSG an attractive investment. I think the probability this stock is below $30 at the end of this year is low. If we enter a recession, I think there is downside risk to about $26.5, or 13% from here. This would assume 6.5x 2011 EBITDA (trough on trough). In this scenaro, the market is likely down more than RSG.
In less than 3 months, RSG should be experiencing a positive inflection in both volume and pricing growth for the first time this cycle leading to accelerating earnings growth.
Investors will stop extrapolatinng recent below normal growth and begin extrapolating a trajectory of earnings recovery over the next 2-3 years. Multiple expansion will result.