Description

Rollins, Inc. (ROL) - Short

$51.09 / Share

Summary

Rollins trades at 47x 2018E EPS, an extremely rich price for a pest control business that will likely grow revenue at mid-single digits. There is a strong possibility that future financial results may be weaker than this as well. It is likely that there will be a management transition in the coming years, given that Chairman Randall Rollins is 86 and CEO Gary Rollins is 73. Additionally, there have been changes in competitive dynamics, as foreign competitors Rentokil and Anticimex have become more aggressive acquirers in the US. Shorting Rollins is compelling given its high valuation and limited risk of high revenue or EPS growth.

Business/Industry

Rollins is the largest pest and termite control service provider in North America with ~20% market share. Rollins provides these services through several subsidiaries, including Orkin, Western Pest Services, HomeTeam, Critter Control and others.

Rollins’ history dates back to 1901, when Otto Orkin founded Orkin. Mr. Orkin sold rat poison and later developed strategies on the timing and placement of the poisons in a customer’s home to maximize effectiveness, thus creating the “home visit” exterminator market. The Orkin name became known on a national level by World War II, when the company began servicing military facilities. In 1964, Wayne Rollins, founder of Rollins Broadcasting, learned that Orkin was for sale. After visiting Orkin, he decided to diversify from broadcasting into pest control. Rollins purchased Orkin for $62 million.

Over the coming years, Wayne and his children, Gary and Randall, built the business through re-deploying cash from operations (Rollins has rarely utilized debt, and only sparingly in the few cases when it has). At the time Wayne died in 1991 and Randall became CEO, Orkin was the dominant force in the pest control industry. However, competitors had been catching up to Orkin over this time period – others began to copy Orkin’s key strengths (clean trucks, regimented training and sophisticated marketing). At the same time, Randall and Gary may have been distracted with other ventures (Rollins had ancillary segments in plantscaping and security systems, and both brothers were involved as founding executives with RPC, Inc., an oilfield services company). By the mid-1990’s, Terminix had grown larger and become the market share leader, and thousands of local competitors had eaten away at Rollins’ market opportunity. Rollins’ sales stagnated, growing ~1% annually from 1995-1998. In 2000, Terminix had ~$730mm of revenue vs. ~$650mm at Rollins.

In 1997, the brothers began to re-focus and conduct a turnaround. They sold the (largely unprofitable) ancillary segments and focused on the core business. The company began to execute much better on sales in its Commercial division, and also began to invest more significantly in its training processes. The field management organization was restructured, new sales and marketing programs were put in place, and greater emphasis was put on quality control. Gary Rollins became CEO in 2001 and was broadly responsible for implementing these key strategic changes.

Another major change from this point forward was that Rollins became much more active in M&A. A closer look at the company’s filings shows that M&A was the driving force for the majority of the company’s growth from 2000-2010, and that organic growth was on average 2-3%. From 2011 onwards, on the other hand, organic growth has been more on the order of 4-5%. The acceleration of organic growth was likely driven by superior capabilities in digital marketing, branch operations, and general strong execution:

Terminix has also faced operational difficulties in recent years, primarily related to basic operational blocking and tackling (declines in technician and customer retention as well as inconsistent service). While this has allowed Rollins to take market share, Terminix is in the midst of a turnaround to improve its performance.

The outsourced market for residential and commercial termite and pest control represents an ~$8bn opportunity in the US. The market is quite fragmented outside of the top 4 players controlling ~50% of the market. Approximately 19,000 independent operators of various sizes control the rest. Rollins and Terminix each have ~20% share, UK-based Rentokil is in third place with ~9%, and Ecolab has ~5%. Of these 4 companies, Rollins is the only one focused solely on pest control.

The economics of pest control clearly favor developing scale within a given local market. Route density is a key determinant of profitability, as greater density raises margins by increasing technician utilization. This is the reason that national players use tuck-in M&A to increase density in certain markets. Benefits of scale appear less significant at a national level. However, there is an argument that national scale conveys increasingly important advantages in advertising/marketing, ability to use digital systems, and standardization of quality. Rollins appears to have taken advantage of some of these factors, particularly through use of sophisticated digital marketing (the company claims that for Google searches related to pest control, Rollins brands show up on average in the 1.6th position in the results list).

Pest control services are sold on a contractual basis, whereby Rollins visits the location on a periodic basis (typically monthly or quarterly). Across its business, Rollins has ~80% recurring revenue.

Rollins’ mix of business is 41% Residential pest control, 41% Commercial pest control, 17% Termite control, and 1% other. Rollins is over-indexed to commercial business relative to Terminix. Commercial business is slightly lower margin, given negotiating dynamics; however, the commercial side has larger award sizes per contract, and is generally stickier business (given that contract lengths are 2-5 years with an annual price escalator, as opposed to 1-year contracts as in residential). Customer retention annually is 88-90% for Commercial, 76-85% for Residential, and 85% for Termite. When comparing these retention rates to other home-based subscription services, such as cable, these are indeed quite impressive. Over the years, growth rates for the residential and commercial businesses have switched back and forth in terms of which is higher – currently, the residential business is outperforming (likely due to Rollins’ advantages in digital marketing, which is less of a needle-mover in commercial).

Pest plans are designed to rid a building of rodents, ants, cockroaches, spiders, bed bugs or other pests, in order to prevent disease or damage. Pest plans generally have no upfront fees but cost an average of ~$115 per quarter for continuous inspection and protection on residential properties and an average of ~$250 per quarter for commercial properties (there is a large range of pricing based on provider or customer need).

Termite services are principally provided to residential customers. Rollins is the second largest player in this market, behind Terminix. Rollins has had difficulty in the past with liability risk from damage claims, and thus has tended to take a more cautious approach to the termite market. The termite business has therefore been a slower growing segment for the Company. Approximately 50% of termite services revenue is recurring. (This lower level of recurring revenue is due in part to the Company having “solved” many customers’ termite problem). A typical termite service agreement is a 10-year contract (guaranteed against termite damage), with a large (~$1,000-$1,500) payment due in year 1 for initial eradication and ~$200 due in each of the out years for on-going control and prevention.

Rollins charges slightly higher prices than competitors, but only within reason. Rollins also likely benefits from having more advanced pricing analytics capabilities, such as the ability to run pricing studies in different markets. Our pricing checks revealed that Orkin generally charges the most expensive rates in the market. Additionally, Orkin, more than other companies, employs the most high-pressure sales tactics, including calling back 10 minutes after the initial call to offer a 10% discount.

It is reasonable to expect that in the US, the pest control industry will grow 2-3% annually on a go-forward basis (industry sources such as IBIS estimate 2.6%). The National Pest Management Association (NPMA) found in a 2012 survey that only a third of U.S. households use professional exterminators, implying that the market could represent a larger chunk of the population over time. However, such changes in consumer behavior are slow to take hold. The industry is only marginally economically sensitive (note Rollins grew organically 1.2% in 2009) and is also helped by increased residential construction. Another driver for pest control’s slightly above-GDP growth is the ability to provide more and more services over time. As an example, treatments for bed bugs have been a key growth driver for the industry over recent years, as their occurrence has spread markedly in the past decade. However, despite this ability to offer more ancillary services around the edges over time, we do not anticipate any game-changing service dramatically increase industry growth rates.

The emergence of Rentokil as the number 3 market share player in the US (with 9% share) has caused an important change in competitive dynamics over the past several years. Rentokil, which was founded in London in 1925, has long been the leading pest control company in the UK, but had only a minimal (less than 0.5%) market share in the US by the mid-2000’s. Through a series of acquisitions (most notably Ehrlich for $142mm in 2006 and Steritech in 2015 for $425mm), Rentokil has become an important player in the US market. Rentokil and others (such as Sweden’s Anticimex) have pushed M&A multiples higher over time. The Steritech acquisition was carried out at ~3x revenues and ~15x forward operating income (including synergies), more than double historical precedent transaction multiples.

Changes at Terminix’s parent company ServiceMaster are also currently impacting competitive dynamics in the industry. In mid-2017, ServiceMaster hired a new CEO (Nik Varty, previously VP at Wabco) and announced its intent to spin off the American Home Shield home warranty business. Terminix is now executing on a number of changes to improve customer experience and retention. While these changes are ongoing, they could very well result in a more-focused and better-run Terminix that competes more effectively with Rollins.

Note that 8% of Rollins’ revenue is from international sources. The company owns facilities in Canada, Australia, and Europe, and has a network of 81 international franchises in 45 countries (Central America, Asia, Europe, Africa, and Australia). The international business is more heavily skewed towards commercial work than the US business. Theoretically, the global pest control market should grow faster than the US pest control market. However, international represents a small portion of Rollins’ overall revenue.

Management/Capital Allocation

Over 50% of the shares outstanding are owned by the Rollins family, primarily through a family trust company. The founder’s sons Gary Rollins (CEO) and his older brother Randall (Chairman of the Board) hold the top posts. With average tenure of 35 years, Rollins’ management is amongst the most experienced in the sector.

CEO Gary Rollins (age 73) has long emphasized Orkin’s training program, and he was also responsible for driving Rollins’ sales program in the commercial market in the early 2000’s. More recently, management initiatives at Rollins have focused on digital marketing and the use of software to streamline branch operations (through route optimization, communications/CRM, etc.).

John Wilson (age 60) is president and chief operating officer of Rollins, and the presumptive successor for the CEO role. John oversees the field operations of Orkin and the Rollins Independent Brands. Before assuming this role in January 2013, John served as president of Orkin USA. Since joining Orkin in 1996, John has served in a variety of positions, including service technician, sales inspector, branch manager, central commercial region manager, Atlantic division vice president and Southeast division president. He attended the University of Tennessee and completed the Executive Program at the University of Virginia’s Darden School of Business.

Eddie Northen (age 52) joined Rollins in 2015 as CFO and Treasurer. Eddie joined UPS in 1985, and most recently served as Vice President of International Finance & Accounting – Global Business Services. Previously, he was CFO of UPS' Asia Pacific Region based in Hong Kong, and he served as Vice President of Finance in the company's Pacific and West Regions.

Succession and ongoing ownership for the Rollins family are key questions given Randall’s and Gary’s ages. None of the brothers’ nine children are involved in the business, and control of the family trust has been the subject of a lawsuit between Gary and his children. It is unclear what the ongoing ownership by the family will be beyond Gary’s and Randall’s lifetimes.

On capital allocation, the dividend payout ratio has steadily crept up over time, from 25% in 2002 to just over 50% today. Beyond the dividend, management has generally skewed towards using ~2/3 of remaining FCF for acquisitions, and ~1/3 for repurchases. Acquisitions are management’s preferred use of capital – the company made 34 acquisitions in 2016 alone. These acquisitions are small in scale, given that the targets are generally local players. There are signs that finding acquisition targets has been difficult for the company in recent years, and spend on M&A is slightly lower now than it has been in the past relative to the company’s size.

Valuation

Rollins currently trades at an extremely high multiple: 47x 2018 P/E. The company trades at a 2% FCF yield. Meanwhile, the closest peers (ServiceMaster, Rentokil, and Ecolab) trade at a 25x P/E on average. Shorting the stock is compelling based on valuation alone. Results of shorting ROL could be even better if competitive dynamics intensify, if Rollins faces operational difficulties related to a management transition, or if industry profitability declines due to labor costs, price competition, or any other reason. And should the business performance suffer, even temporarily, we will likely make good money on our short as the multiple may contract significantly and quickly.

Risks

• Plague of locusts, or any other major pest epidemic. A tremendous increase in the population of pests would obviously be positive for Rollins. Greater pesticide resistance through natural selection, global warming, or other long-term ecological changes could influence this. It is unlikely that such changes would take place during our investment horizon.
• Sale of the business given unclear desire by the Rollins grandchildren to maintain ownership. This risk is somewhat limited given the already high valuation and the fact there is no natural buyer in the pest control industry, and that beyond $6mm in Gary and Randall’s annual compensation there are no large, obvious areas to cut costs.
• Smart capital allocation or M&A. This risk is somewhat limited given increasingly elevated acquisition multiples in the pest control space.
• Persistent Rollins advantage in digital marketing or tech-enabled branch operations. We believe that Rollins’ advantage here is likely to recede over time. Platforms like Thumbtack, Yelp, and HomeAdvisor can increasingly be used to compare pricing and reviews for specialist services such as pest control. More generally, given the low barriers to entry, any lapse in Rollins’ execution should allow competitors to catch up over time.

Catalyst

• Intensifying competitive pressure as Rentokil expands and Terminix executes turnaround plan
• Wage, gas price, and other cost inflation
• Consecutive seasons of cold weather could negatively impact the business
• Potential disruption from management transition