Description

Summary

Servicemaster Global Holdings (SERV) is a compelling long investment opportunity with a potential for multiple catalysts over the next 6-12 months that should unlock meaningful value for shareholders.  Servicemaster is selling its Brands business to become a pure-play pest control business, paying down debt to create a clean, unlevered balance sheet, searching for a permanent CEO, and looking to improve core operations so that results more closely match peers.  As these proceed, either a new management team or potentially a new owner can realize significant value inherent in the business.  

Background

Servicemaster is a blast from the near and distant past for VIC readers.  SERV most recently was written up in 2016 by smash432 and also in 2015 by lalex180 in 2015.  I was beaten to the punch by one of those writeups, and SERV performed extremely well over the last few years from the change in management and spin of frontdoor (FTDR).  The strong performance at SERV came to a halt in late 2019, and the situation has changed sufficiently, so I will add my 2 cents now as the opportunity is once again compelling.

Background

I will not go into much background given the prior writeups on this platform, but VIC readers should know that SERV spun off its former American Home Shield division as FTDR in late 2018 to become a more pure play pest control business.  SERV performed well through 2018 and 2019 until the October announcement of Q3 2019 results.  The strong performance until then was due to a continued very strong industry backdrop and SERV’s improving performance (a long-term industry laggard on growth and execution).  The pest control business continues to be highly fragmented, stable (grew even in 2009), recurring (pests come back every year), low capital requirement (negative working capital and capex < 2% of sales), with continued pricing power (lsd annual pricing) and strong margins (20%+ EBITDA margins).

New Liability 

In October 2019, Servicemaster pre-announced an earnings revision that included slower organic revenue growth and higher cost than expected which reduced EBITDA by $10m versus prior guidance on a base of $440m.  More importantly, Servicemaster announced an adjustment to prior damage claims for termite treatment which caused another $10m adjustment to 2019 earnings estimates.  The $20m of combined reduction dropped the stock from ~$55/share to ~$35/share which equated to approximately $2.5b+ of lower EV on the ~140m shares outstanding.  Investors were frustrated with operational execution issues at SERV (again), as this has been a recurring issue with performance perennially trailing that of Rollins (ROL) and new entrant Rentokil (RTO.LN).  

But what truly worried investors was the new disclosure on liabilities stemming from elevated Formosan termite claims.  Formosan termites are a special kind of super termite that had been found in select locations in the US, but were not common outside of the southeast.  The Formosan claims were driving termite damage claims to 7-8% of revenue up from 4-5% historically and above those of peers which ran in the 1-2% of revenue range.  The new claims were coming from Mobile, Alabama, a region that represented 2% of termite revenue.  There was a fear that damage claim liabilities would grow meaningfully in the other 98% of the termite business.  However, Formosan termites were not found in most of the rest of the country served by Terminix.  Also, Alabamans suffering termite damage to their homes had a unique opportunity - they could not only receive damage repairs paid on a claim (typically a few hundred to a few thousand dollars), but they could also get damage awards for the pain and suffering of having to endure termite damage to their home (hundreds of thousands up to a few million dollars per claim).  Worried investors extrapolated this to other areas outside of Alabama despite the fact that Formosan termites were rare and despite the fact that the ability to receive pain and suffering claims was unique to that state.  The market took $2.5+ billion of enterprise and equity value out of Servicemaster on this news.

Liability Sized

In response to the investor concern, and to fully understand for itself the liability, SERV hired a third party actuarial firm to size the termite damage liability.  The results of this analysis was given with the Q4 2019 earnings.  The result showed that rather than $2.5+ billion, the company had approximately $130-150 million in additional above normal claims to be paid out over the next 5-10 years.  These elevated claims would be run through reported EBITDA on a forward basis, as they had been historically as well.  Thus, the market had overestimated the liability by approximately $2.2 billion, or $16/share or ~50% of the then share price of SERV of $34/share.  In a normal world, SERV stock would have surged.  In fact, SERV finished up 11% the day this was reported on February 27, 2020.  The market sank 4.5% that day on increasing COVID fears.  And then over the next 3 weeks of March 2020, we all know what happened.  The SERV liability mispricing was quickly forgotten and lost in the chaos of wild share moves everywhere.  (https://investors.servicemaster.com/sites/servicemaster.investorhq.businesswire.com/files/event/additional/Q4_2019_Webcast_Presentation_vFINAL.pdf for good summary of details on the liablity)

Servicemaster Strategic Changes

In January 2020, just prior to releasing the Q4 liability update, SERV also announced that its CEO was being replaced.  The chairman of the board was taking the interim CEO position while a new CEO search was initiated and to be completed over the next 6 months.  SERV also announced that it was seeking strategic alternatives for its Servicemaster Brands franchise business unit.  This is a franchisor for disaster restoration and general cleaning services primarily for commercial businesses.  Servicemaster indicated it would use proceeds of the Brands process to delever the balance sheet.  When Q4 earnings were reported in February, SERV moved Brands to discontinued operations held for sale.  The rationale for the sale of Brands could be debated especially in a post-COVID world where demand for commercial cleaning would appear to be materially higher than anytime in history.  But the decision to delever the balance sheet made little sense.  SERV had historically operated with material leverage, had been through an LBO at 8x leverage just prior to the 2008 financial crisis and survived and in fact grew organically through the crisis, and had minimal capital expenditure needs and negative working capital.  

Strategic Interest?

A possible explanation for the actions above is that SERV was preparing to sell itself.  It hired a third party firm to do due diligence on the liability for potential buyers, it announced the sale of a non-core business leaving it as a pure play pest control business, it cleaned up the balance sheet to eliminate debt, and it removed the permanent CEO.  SERV however has not said this, but potential buyers may view the moves this way.  Rollins (ROL), Rentokil (RTO.LN), and Ecolab (ECL) all have enterprise value >2x that of SERV (and even more upon the potential sale of Brands).  They are all growing in pest control and continually looking to consolidate the pest control market.  Anticimex, a portfolio company of EQT Group, could also be involved.  It has an enterprise value of approximately $4 billion after its 20% ownership sale to GIC in November 2019.  EQT said at the time of the GIC investment that it had received takeover proposals for all of Anticimex from other private equity firms and from strategic parties, and that it would consider those offers or an IPO “when the time is right”.  Interestingly, despite COVID and the overall equity market collapse of 2020, ROL, RTO.LN, and ECL are all at or near all time highs and at all time high valuations as investors continue to reward high-performing, recurring businesses in stable industries. SERV stock meanwhile is languishing as it is under-reporting recurring EPS, EBIT, and EBITDA as it addresses one-time Formosan issues in Alabama, but is still one of the largest players in a very solid industry.

The Opportunity from Here

SERV reported its Q1 2020 results on May 7, 2020, and to no surprise COVID had some near term issues on the business due to inability to access customer premises.  Some one-time COVID costs and near term lost sales opportunities from COVID hurt near term revenue and EBITDA outlook, as the interim CEO may not have been as focused on operations (ROL and RTO.LN did not seem to have the same issues). The company indicated that it was still in process to sell the Brands business (though it is still not clear whether this is a good decision given the potential for COVID related demand to meaningfully improve the prospects of the commercial cleaning and restoration business).  The stock strangely fell >20% on the near term operating disappointments and then recovered approximately 20% the following day.  

From here, investors should be able to recoup some of the lost value from the overestimate of termite liability (the company recovered approximately $3.50/share of $16/share on the day reported in February). This issue got lost in the chaos of the market unwinds, but patients investors should recover this in due course.

A sale of the Brands would likely be a material positive event, if it happened.  The closest comparison to Brands is SERVPRO, a franchisor purchased by Blackstone for $1 billion in March 2019 for approximately 6x revenue and about 15-20x EBITDA (estimates based on limited public financial disclosure).  Applying similar valuation framework implies a value for Brands of $1.5-2.0 billion.  This compares to net debt as of Q1 2020 of approximately $1.6 billion.  Therefore, the after tax proceeds to SERV of a sale of Brands, should it happen would create a debt-free or near debt-free balance sheet for SERV - a company whose competitors maintain 2x+ of leverage and who has in its own history easily carried 4-5x of leverage.  This would provide a substantial $800-1,500+ million of capital (20-40+% of current share price) to use in a shareholder friendly way as this business model is cash generative and requires minimal capital.  Also, should a Brands sale not proceed, this may actually be an even better outcome for existing shareholders if COVID-driven cleaning service business truly accelerate.  It would be another growth angle to a very profitable franchise model.  Time will tell.

Finally, SERV may choose to combine with another strategic as mentioned above rather than finding another management team to try to execute its operational improvement plan. I would assume this drives upsides for shareholders in excess of the numbers above, but will not speculate on the magnitude of upside from synergies or premium.

Valuation and Upside

Below are assumptions for where SERV can go.  I do not assume any use of proceeds or re-leveraging of the balance sheet in case Brands is sold which again is an additional 20-40% of the current price.  In the low case, I assume below low end of trading multiple and no sale of Brands.  In a base scenario, I use historical multiples for SERV and no use of proceeds for Brands, which I assume to occur at the low end of range based on SERVPRO.  In the upside case, I use the higher end estimate for Brands sale multiple, normal trading multiple for SERV, and no use of proceeds or releveraging post a sale of Brands.  Therefore, I believe that there is ~30% more upside than the numbers below indicate, but these are attractive enough.

Catalyst

Sale of Brands?

Strategic interest?