Description

Investment Thesis: ServiceMaster (SERV) is a compelling long with 50% potential upside. SERV is an acyclical, asset-light business that generates recurring cash flow and operating leverage – yet there are several misperceptions that cause SERV to trade at a wide discount relative to its true comps. First, the market is unduly worried about a flattish contracted customer count at Terminix, rather than focusing on faster growth in total volume driven by uncontracted jobs. Second, investors seem skeptical of the home warranty business, as AHS has no clear comps and recently completed a business model shift going direct-to-consumer (DTC). Although the Company’s elevated leverage may have unduly put it in the penalty box with some investors, the low economic sensitivity and high free cash flow conversion will accelerate SERV’s recently announced share repurchase program in addition to providing flexibility for continued M&A and a potential issuance of a dividend. Finally, the stock has sold off significantly since the Q2’16 call, reflecting  

Recent Events:

• Q2’16 Earnings: SERV lowers guidance of top-line revenue to $2.73B-$2.76 from >2.75B in Q4’15.

• Q1’15:SERV provides lower 2016 EBITDA guidance of $675-$690M after raising guidance to >$685M in Q4’15

• Q4’15 Earnings: SERV provided 2016 guidance of “at least” $2.75B in revenue and “at least” $685M (implying 40% incremental margins).  

• -   Announced a $300M repurchase over three years (allocated 1/3 of FCF).

• -   Announced that Q4’15 will be the last time management discloses the “customer count” metric for Terminix.

• Announced its NOL has been exhausted and will be a cash tax payer in 2016.

• 3/29/16: US Virgin Island / DOJ - Terminix enters plea agreement in DOJ investigation of methyl bromide use.

• 11/11/15: Terminix acquires Alterra (pest control) for what is a purported to be a $75M in top line revenue.

Catalyst Path / Timing:

• 2017 Potential Dividend Announcement: during Q4’15 earnings call, management essentially said a dividend program would be strongly considered once they reached a targeted long-term leverage of 2.5x-3x. According to management, there are no plans to pay down debt until potentially 2018 when $80M in notes will be due.

Brief Business Description: ServiceMaster provides pest control services under the Terminix brand and home warranties through American Home Shield (AHS), with a smaller presence in cleaning services as a franchisor.

o   Terminix (56% of sales / 56% of EBITDA): Terminix is the largest player in the U.S. termite and pest control market. Customers typically sign multi-year contracts for preventive services, which creates high-visibility recurring revenue. The termite business has particularly long contracts, sometimes as long as ten years, as Terminix installs traps that technicians return to monitor several times per year. These long-term contracts have price escalators, which drive steady price gains in the termite business. In pest control, volume and price should both continue to grow as Terminix expands the range of services it offers. Terminix has focused historically on the residential market, but recent moves to reorient towards commercial customers have boosted growth.

o   American Home Shield (35% of sales / 33% of EBITDA): AHS operates in the home warranty industry, a niche market at an interesting inflection point. A home warranty is an annual contract covering repairs and replacements for home systems such as HVAC or plumbing and appliances. The customer pays an annual fee (~$600) for coverage and an incidental fee (~$75) for each claim. When a customer needs a repair, he submits a request to AHS, which assigns the job to a local contractor.

o   Franchise Services Group (9% of sales / 12% of EBITDA): Third and smallest segment, franchising, collects royalties from a variety of cleaning related franchisees. This royalty stream is high-margin and annuity-like, but has limited growth prospects.

Why the Opportunity Exists:

The primary driver of my variant perception comes from my assessment of the growth potential of AHS and Terminix, in that order. With AHS, there is a wider divergence between my view versus the market as investors debate AHS’s business quality, long-term earnings potential, and the DTC channel opportunity. Investors focus on the risks of DTC, despite AHS’s nearly ten years in this channel, rather than the strong competitive advantages AHS brings to this open-ended growth opportunity. With Terminix, investors have myopically focused on contracted customer count, a metric so irrelevant that its closest peer, Rollins, does not even disclose it. Within Terminix, the company is using its pricing power, new product offerings, and IT investment to pursue non-contractual, high margin business within its pest customer base, a strategy that has been yielding positive returns.

SERV also falls into the category of an “orphaned” stock, with sell-side analysts who cover the company also covering a wide range of unrelated companies and even fewer analysts comping SERV to relevant metrics that highlight the free cash flow generation of this business (i.e. utilizing P/E vs. FCF yield).

Thesis point (Variant View): AHS is a high-growth gem that provides plenty of runway for growth in a nascent, under-penetrated market.

SERV’s AHS has been a strong HSD/LDD  grower with incremental margins in the high 20%-low 30% range, benefiting from steady/growing renewal rates (75% and growing) and HSD customer count growth. The sheer magnitude in potential of this business is completely underappreciated by the market. Per below, AHS has been a steady grower – even during the macro softness in 2008 and 2009 – and given the leveragability of the business, high incremental margins are yielding significant EBITDA margin expansion.

The scale of AHS is a key competitive advantage of AHS that investors continue to underappreciate. Management noted that their leading market share gives them an ability to negotiate with contractors that competitors cannot. Most notably, SERV provides contractors with a guaranteed number of jobs, not leads, and that some of their contractor relationships are 40 years in length. This bargaining lever of jobs allows SERV to demand a high level of service for its AHS customers from the best contractors at prices that the individual cannot obtain. A few anecdotes from IR:

• AHS handles three million claims per year and, as a testament to the density of AHS’ contractor network, these jobs are assigned within 15 minutes 90% of the time.

• Competitors suggest that AHS uses this volume to drive discounts of up to 50% versus retail contractor rates, savings that significantly exceed those achieved by competitors.

• At the national level, as one of the nation’s largest buyers of HVAC parts and appliances, AHS uses its purchasing scale to negotiate better prices directly with manufacturers. These savings can be as high as 40%.

The Direct-to-Consumer Opportunity. Although AHS already benefits from its scale, it also helps that its closest competitors have a minimal presence in the DTC market. These companies offer home warranties primarily to support their core title insurance businesses, and although I have only had a brief conversation with First American’s IR and sell-side on HSV, they are not focused on investing the time and money to grow DTC. As one analyst noted, “Homeserve has no interest in providing more general Home Warranty coverage through chosen franchised service partners… it is more economical to focus on heating/boiler/water/plumbing coverage and to concentrate resources in this area. It would be dilutive to returns to start adding on new units.” If competitors eventually do push harder into DTC, they will begin from a scale disadvantage and need time to develop an offering.

Some analysts, most notably Baird, speak to the “adverse selection” of the DTC market – attracting only customers who already have broken items. Based on my calculations, I believe that a cohort of DTC customers actually has a higher lifetime value than a similar cohort of real estate customers. In year one, DTC customers are slightly unprofitable, as they average one extra claim and have a higher cost to acquire. Despite these differences in year one profitability, the higher retention rate for DTC customers means higher lifetime value; year one retention for DTC customers is ~75% compared to ~25% for real estate customers. After year one, the persistency of customers acquired through the two channels converges.

Long runway in large TAM. Although management speaks to how underpenetrated the market is at currently 5% of all households that own a home (an assumption First American underwrote in their May 2015 Investor Day), few on the sell-side have actually gone through the exercise of quantifying what the addressable market could be and what that may mean for AHS, which currently has 42% market share. Per below, I calculate ~80M households that own their home – a number that resonates with public sources. Now, the few sell-side analysts that do attempt to frame the market are all over the map – dicing the market by all demographics and income brackets. That being said, I conservatively apply a few assumptions:

• The vast majority of AHS’s customer base lies within the $50K-$150K income demographic and will pursue this constituency going forward.

• Assume that 1 in 5 households will ultimately pursue a home warranty

• AHS maintains its market share of 42%

• By applying this simple math below and assuming AHS’s contract revenue/customer is where it stands today ($600/customer) – AHS has the potential to grow its revenue base by ~2.5x.

Thesis point (Part II): Street underappreciates this potential, modeling rapid deceleration of AHS’s top line revenue through the near term.

Street analysts have been honed in on the recent Q4’15 “blip” in AHS, in which claims costs were $19M, resulting in a fairly sizeable segment EBITDA miss although revenues were above estimates. In reality, this was not a byproduct of growing the direct-to-consumer channel too aggressively, but a renewed focus on improving service levels by temporarily using out of network contractors during a recent negotiation with in-network contractors. What matters is that there is plenty of runway and a strong glide-path toward continual long-term growth, which is something consensus is clearly discounting. Sell-side estimates are implying massive deceleration from 2015 to 2017 in top line growth, and from the few initial estimates for 2018, look downright anemic.

Terminix

Thesis Point. Terminix is a predictable, FCF generative business that is unfairly scrutinized for declining customer counts rather than being rewarded for total volume driven in uncontracted jobs.

Terminix generates steady recurring revenue through the economic cycle. Over the last fifteen years, Terminix’s worst growth occurred in 2009, when revenue slipped less than 1% compared to a 4% industry decline. More recently, management expanded Terminix’s scope to cover new pests, such as bedbugs, mosquitos and wildlife. Previously, the company actually turned away homeowners looking for help with these problems. These new services, combined with Terminix’s greater focus on the commercial end market, have led to solid recent growth.  

However, sell-side analysts have been consumed by the declining customer counts, most notably for Pest Control, unfairly taking mindshare over what is a very stable, GDP+ growing business with enviable pricing power and incremental margins. In particular, the Street completely ignores the fact that in Q3’15, Pest Control had actually grown 4.7% organically (most likely 3% on an organic volume basis) in spite of the -2% contraction in customer count and grew 3.9% in Q4’15.

Likewise, in the commercial market, pricing power is even stronger. For these customers, choosing the cut-rate provider is seldom worthwhile. Historically, Terminix focused on the residential market, but management recently revamped the commercial salesforce, driving 10%+ revenue growth Q3’15 and 6% in Q4’15. This could be an excellent opportunity if it can emulate Rollin’s growth trajectory.     

In terms of M&A, Terminix regularly buys mom-and-pop operations that can often be integrated into existing routes. Terminix typically pays 1.0-1.5x revenue, which translates to ~5x EBITDA at overall Terminix EBITDA margins and ~3x at Terminix gross margins (assuming Terminix can eliminate SG&A at targets as they speak to on earnings calls). These acquisitions help Terminix further increase its route density, boosting productivity and increasing margins. Most notably, Terminix just bought Alterra, which should generate about $75M in incremental revenue. Surprisingly the incremental $67M of acquired revenue from this acquisition ($8M already recognized in Q4), implies 2.3% of organic growth which is lower than 2015 organic growth of 3% for the segment.  

Thesis Point: SERV is in the final innings of its deleveraging cycle and is in a strong position to significantly return capital to shareholders through multiple channels.

SERV has massively de-levered from over 9x when it was an LBO candidate to near 3.9x 2015 EBITDA. With the stated long-term goal of reaching 2.5x-3.0x targeted net debt/EBITDA, management has already announced a $300M buyback (1/3 of FCF over three years) in addition to opportunistic tuck-in M&A. Given management’s forecast of ~$685M EBITDA for 2016, SERV will already be near <3.5x levered and will be in that targeted zone by 2017. Although SERV currently does not have a dividend policy, management seemed fairly constructive on instituting a dividend on the Q4’15 earnings call and will contemplate such a decision when the leverage levels get closer to those targets.

Please see below the deleveraging scenario at 12x EBITDA (to be discussed in the valuation section) which assumes a more aggressive share buyback program of deploying $300M in 2016 and 2017 and implies a 2.0% dividend yield by 2017.

The levered FCF characteristics of this business are enviable and generate nearly ~$2.90/share in LFCF or ~$750M in cumulative LFCF over the 2016-2017 period, which even after $300M in buyback over two years (vs. three years which management guided toward), leaves plenty of dry powder toward accretive M&A and issuing a dividend.

Valuation

Due to the fairly disparate businesses within ServiceMaster, I have utilized a few different frameworks to triangulate around valuation, including relative valuation and sum-of-the-parts. Please review the comps table included below. Summary points are as follows:

“True” Comparables:

• Rollins. ROL is only true comp to Terminix and is the darling of many investors. The Company skews toward commercial customers (stickier but lower margin) while focusing more on pest control (85% of business) vs. termite. ROL is in a net cash position with a management team that has delivered nearly double-digit EPS growth for a decade. For obvious reasons, ROL trades at a premium valuation of ~18x 2016 EBITDA, but the near 8x valuation gap is surprisingly wide. I am applying a 13x EBITDA – not necessarily splitting the difference between where SERV (consolidated) trades but giving credit toward a re-rate.

• If I were to apply ROL’s 18x EBITDA to the Terminix business, we would effectively get the AHS and FSG business for free.

• AHS. HomeServe is one of the few comps to AHS, but is not necessarily a good one. HSV is based in the UK, with revenue predominantly from the UK, France, and Spain which are more regulated geographies. HSV is reliant on long-term affinity relationships with utility companies and appliance manufacturers, and delivers policies to customers under their brands, which tends to cut into margin (hence the 500bps spread between AHS and HSV’s EBITDA margins). In addition, HSV has been hampered for 3 years by an investigation conducted by UK’s Financial Conduct Authority over marketing compliance, which had let to £47 mn of exceptional costs and £12 mn of provision movements in FY14 alone.

• Apply an 11x EBITDA multiple to AHS, which is anchored to HSV. Given AHS’s market share, competitive positioning in the US, and superior margin structure, I believe this is incredibly conservative.

• FSG. Small driver of value. Some sell-side analysts are comping this business to other franchise-only businesses that trade at 12x+ EBITDA. I conservatively apply an 8x business that is a steady-eddy business with 35% EBITDA margins.

• Management has not spoken to this, but FSG is a non-core asset that should be monetized – generating nearly $600M in proceeds (need to understand tax-leakage, if any) that could be utilized for a more aggressive buyback.

Relative Value

o   Across nearly all valuation metrics, including EV/EBITDA, P/E, and FCF yield, SERV trades at a fairly wide discount although its growth algorithm and margin profile, not to mention its recession-resistance profile, all prove to be superior (in many cases, wildly superior).

• Historical / forecasted growth and margin profile is superior to nearly all relevant comps. SERV compares favorably to nearly all the comps, which include true comps (Rollins and Homeserv for pest control and home warranty, respectively), facility service companies, and a few CPG companies that demonstrate similar revenue growth, margin, capital structure and FCF conversion. This is readily apparent on the comps table in green.  

• Recession-resistant. The vast majority within this comp universe show severe revenue contraction during the recession, with only a notable few. AHS actually grew 7% during the recession while its closest comp, HomeServe, actually declined 18%. Furthermore, most facility service businesses, in addition to most branded CPG companies, all demonstrated inferior growth. For Terminix, the business was essentially flat during this time while Rollins showed healthy top line growth.

• Floor Valuation: SERV trades at $32/share. From the comps shown, the “lowest common denominator” trades near 10x EBITDA (Aramark, ABM and Rentokil), which I consider a fair floor valuation for SERV given the superior profile across all metrics. At this valuation, SERV would be a $32 stock, which would imply an 8.2% FCF yield. For comparison, see below on the ~10x EBITDA businesses.

• (1)   ARMK – elevated leverage, un-even top line growth, and vastly inferior margin structure.

• (2)   Rentokil – choppy top line growth, inferior geographic exposure, government contractual work.

• (3)   ABM Industries – vastly lower margin profile.

Management Team:

While PE owned, SERV went through three CEOs from 2010 to the time of the IPO in 2014. CEO Rob Gillette took over in 2013, and while his brief stint at First Solar was at first blush a cause for pause (to follow up), my understanding is that Gillette receives high marks for operational execution. His experience as CEO and President of Honeywell Aerospace / Transportation (13 years at HON) clearly can play to executing SERV’s ongoing strategy of cutting costs and investing in IT. Furthermore, SERV is deploying a CRM IT platform to improve cross-selling between Terminix and AHS, which seems to be virtually non-existed today despite the overlapping target base.

Risks:

1.      High financial leverage

• While leverage is still elevated, SERV’s high recurring revenue stream and free cash flow generation should provide plenty of cushion to meet its debt payments (~$54M of principal cash payments) + interest of ~$150M.

• Interest rate sensitivity: each 1% change in interest rates would result in an approximate $17 million change in the annual interest expense on our Term Facility (after considering the impact of the effective interest rate swaps).

2.      Limited tenure of senior management

• Although it is true that management are not seasoned pest control/home warranty authorities, Rob Gillette has gotten high marks for execution (implementing a more rigorous marketing strategy and investment in technology) which are bearing fruit in driving EBITDA margin expansion.

3.      Impact of adverse weather on demand

• Both termite and pest activity are affected by weather (most notably warmer weather, which is beneficial for “swarm activity). This can However, the high proportion of termite and pest control services which are contracted and recurring, as well as the high renewal rates for those services, limit the effect of weather anomalies on the termite and pest control industry in any given yea             

Catalyst

• 2017 Potential Dividend Announcement: during Q4’15 earnings call, management essentially said a dividend program would be strongly considered once they reached a targeted long-term leverage of 2.5x-3x. According to management, there are no plans to pay down debt until potentially 2018 when $80M in notes will be due.