AGB 2021.12 - Rollins (ROL)
AGB 2021.12 - Rollins (ROL)
Conservative Growth, Process Discipline
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Rollins
“Pest control is a recession-resistant, but not recession-dependent business, representing a nondiscretionary purchase for commercial and most consumers.” – Chief Financial Officer Harry Cynkus on the F14Q3 Earnings Call
Rollins is the largest pest control company in the world with leading market share in the U.S. and Canada. The company operates under a family of brands including Orkin, HomeTeam, Northwest, Critter Control, Clark, Safeguard and others. Rollins started off in other lines of business (car dealerships, TV + radio stations, wallpaper distribution, maid service, etc.) but the core business as we know it today, Orkin, was acquired in 1964. Since then, the company has expanded the Orkin brand to over 400 branch locations globally and acquired many other pest control companies.
Rollins operates company owned pest control locations in the U.S., Canada, England and Australia. The company also franchises in these markets as well as in many other international markets such as Central America, the Caribbean, South America, Africa, Europe and Asia.
Certain details of the franchise program are somewhat limited, partially due to Rollins being a controlled company. Gary Rollins, Chairman and CEO, owns 51.5% of the shares outstanding. While there are many positives that come with this type of owner/operator leading the company, the disadvantages of this are: (1) the management team limits details about certain aspects of the business, usually citing competitive reasons, (2) fewer sell-side analysts cover the stock, and (3) management is conservative with company’s balance sheet.
Rollins started franchising in the U.S. in 1994 and internationally by 2000. The franchise program is primarily for smaller markets where it’s less economically efficient for the company to own a branch location and for newer markets, especially internationally, where the company is less knowledgeable or experienced in doing business. Franchisees are provided equipment, rights to a territory, customer contacts, branding, training and the benefit of national or regional advertising campaigns. In return, franchisees pay Rollins a percentage of revenues, which averages between 4%-7%. About 80% of franchisees are former Rollins employees, which should imply that the level of quality control is high.
Interestingly, at least for the domestic franchisees, there is a contractual buyback provision that allows Rollins to repurchase the franchise based on a predetermined multiple of revenues. As some of these smaller markets see increased demand and develop, Rollins may take that opportunity to repurchase these locations. International franchise agreements also have a buyback provision but the option lies with the franchisee. From the outside, it seems like the franchise agreement terms are heavily in Rollins favor, which could imply that the returns on capital are high (enough) for franchisees.
The company breaks out its business into three segments: residential, commercial and termite. Residential is almost half the business (45%) and customers typically seek out pest control services when there is some outbreak in their home. These customers are usually initially driven to Rollins by brand awareness and advertising (digital and traditional) and are less price sensitive, due to the urgency of their pest control needs. Rollins has taken 1%-2% annual price increases over the past 10 years, with the exception of 2020. Once a residential customer is “acquired” the technician and branch location can develop a recurring relationship with the customer if there are ongoing pest control maintenance services required.
Commercial represents 35% of the business and customers are looking for preventative pest control, which implies that commercial revenues are more recurring in nature. Commercial customers sign annual contracts and have technicians come in for service on a weekly or monthly basis, depending their needs. For Rollins, commercial customers are not profitable until the 3rd or 4th visit, due to the high cost of the initial visit (set-up, learning the customers needs, etc.), but the retention rate of these customers is very high.
Termite represents 20% of the business and is somewhat cyclical, due to the exposure to new home construction. Rollins has relationships with home builders that are (in some states) required to pre-treat a new home with termite protection. This can be done in a couple of ways, through a traditional liquid spray treatment or through baiting. Either way, the homeowner needs to follow-up with Rollins or another termite control company to retreat their homes or refill the bait stations to prevent termites in their homes.
Rollin’s largest competitor is Terminix, which was one of the business segments owned by Service Master. Terminix has a larger termite business but a lower exposure to commercial customers for general pest control. Service Master sold its lawncare, maid service and other businesses to private equity and spun out its home warranty company, American Home Shield (which is Frontdoor) in 2018. A new management team was put in place in 2017 and the company has regained focus on the pest control business.
When comparing the performance of the two companies over the past 6 years, Rollins has had much more success in its organic growth, beating Terminix by 3%. But the company lagged behind in its acquisition program due to a combination of being more disciplined on price and its unwillingness to take on significant amount of debt. Terminix has outgrown Rollins by almost 2% in growth via acquisitions over the same time period.
Why is it a good business?
The pest control business is recurring in nature because pests come back after treatment. This is true for commercial and termite customers especially because most of the services are preventative and need to be recurring in nature. For Rollins, retention rates are 86%-90% for commercial customers and 86%-88% for termite. To put that into perspective, this is on par with some SaaS companies that target SMB customers. On the residential side, the business is not as recurring with retention rates at 74%-85%, but technicians tend to develop relationships with customers in a region over time, especially if the service is well received.
A small pest control company has very few competitive advantages because the commercial and termite businesses require relationships with large customers and home builders. And for a small pest control company, those relationships are difficult to establish, especially when larger and well-known companies are already in the mix. On the residential side, the efficiency of advertising dollars are much lower for smaller companies. Higher costs related to environmental compliance, wage increases, rising cost of healthcare for workers, all point to a more difficult time ahead for smaller pest control companies.
The market is fragmented with Rollins, Terminix, Rentokill, and Ecolab accounting for almost 40% global market share. Many of the larger companies have been consolidating the space due to scale advantages. Larger companies can source chemicals, supplies, vehicles, etc. at more competitive prices. Furthermore, as a pest control company increases its customer base within a local market, route density leads to increased efficiency for technicians that drive around town to get to their appointments. Advertising dollars go a lot further when the costs can be spread across more branch locations within a local market.
Specific to Rollins, the company has process power advantages. Whether it’s the outcome of a more focused company or because of the owner/operator mindset of the management team, the company seems to be ahead in gaining process efficiencies.
The company implemented an overhaul of their service and back office processes with a new CRM based system called BOSS (Branch Operations Support System) starting in late 2014. The goal was to digitize the entire process, including service tickets, notes, service history, payments, etc. The technicians now had the Orkin app on their smartphones, which was the central hub for communicating with the customer, completing service agreements, handling payments, etc. The initial goal was to realize a 200bps-300bps improvement in margins, but the company has exceeded those expectations at the branch locations where the BOSS implementation has reached maturity. BOSS was rolled out initially to the Orkin locations in the U.S. and this was completed in late 2017. Implementation was started in Canada by late 2018.
BOSS also helped reduce the time spent on administrative tasks at the branch location by 20%, which freed up time for back-office employees to concentrate more time on collections from customers (bad debt was reduced by more than 20%). Furthermore, because technicians were able to spend more time on the customer (instead of handling paperwork), retention rates increased by 7%.
In the next phase of process improvement, the company used software to improve their route management. Technicians were able to spend less time on the road (average of 5% fewer miles driven), which lowered the wear and tear on the vehicles and the associated fuel costs, driving time, and number of accidents.
Returns on capital?
Over the past 10 years, Rollins has spent 20% of its capital on capex and 80% on acquisitions. Capex is mostly for new branch locations that are being built out, but the company had elevated capex spend in 2014-2016 due to the BOSS implementation. Rollins pays for acquisitions with cash on hand and rarely uses debt to fund purchases. The company acquires companies as small as single locations and as large are regional players. The company does sell off branch locations and/or assets but they are minimal.
The largest acquisitions over the past 15 years are HomeTeam (2008), Critter Control (2015), Northwest (2017) and Clark (2019). As we would expect the smaller and earlier acquisitions were completed at lower multiples. Rollins has a range of multiples that it would like to pay for an acquisition between 1.25x-1.75x revenues. The company improves margins of the target by 400bps-500bps after an acquisition by stripping out costs and gaining efficiencies related to purchasing, back office, marketing and management structure.
HomeTeam was acquired for 1x revenues and at the time of acquisition was the 4th largest pest control company in the U.S. HomeTeam has a unique approach to pest control, leveraging its TAEXX prevention system, which are basically pipes that can be used to spray chemicals within the walls of the home. HomeTeam has partnerships with 23 of the top 25 homebuilders to install the pest control solution during home construction. The installation itself is unprofitable, but the company makes up for it from the recurring revenues from the homeowners, which average 8 years in lifetime value with an activation rate of 70%.
Northwest was acquired for a higher multiple at 2.8x revenues (on $50M TTM revenues) and Clark was acquired for 3x revenues (on $139M). At the time of acquisition, Clark was the 8th largest pest control company in the U.S. While the company does remain disciplined on price, Rollins had to pay up for these deals due to the larger size and higher average industry multiples. The company and Terminix have both said that Rentokil and Anticimex have been driving multiples higher.
The returns on these acquisitions are unclear as the company and its competition don’t really discuss deal multiples based on EBITDA. While paying 1.25x-1.75x revenues with 400bps-500bps margin improvement probably indicate better than 15% return on capital, we can’t say for certain. Terminix does talk about 30% incremental margins on organic revenue growth, but doesn’t concretely talk about returns on M&A.
We estimate that Rollins has returned between 25%-30% on its incremental capital over the past 5 years. The consistency of the returns year after year at Rollins is impressive.
Reinvestment potential?
The global pest control market is $18B annually of which $9B is from North America. Rollins estimates that its TAM is $12B, given that the company owned branches are mostly in the U.S. and Canada and the franchises have small exposure across multiple international markets.
Pest control is a larger market in North America vs. the rest of the world on a per capita basis, which makes sense given the suburban layout of the U.S. and warmer climate than many other developed countries. It’s estimated that spend per capita is $18 in North America vs. $7 in Europe, $5 in Asia, and $3 in Latin America. The International market is expected to grow faster than in North America as GDP and middle class wealth continues to rise. According to Rentokil/Allied Market Research, India is expected to grow +12% annually from 2017 to 2023, China +10% and other Asian countries +8%.
The reinvestment opportunity for Rollins are threefold. First is acquiring established pest control companies in regions where Rollins doesn’t have a large presence. For example, the company didn’t have much of a presence in the west until it acquired Clark, which at the time was the #1 pest control company in California. Second is building out new branch locations in the U.S. and Canada in regions where it can increase local density. This will lead to efficiency gains as explained above.
The third is to expand internationally through its franchise program. This is more dependent on the demand for pest control in the different international markets and there being franchisees willing to participate in the program. For Rollins, the buyback provision is always an option for the company if a market opportunity gets large enough. The company has been buying back franchise locations in Australia.
And in a similar vein, the company can acquire locations from its Critter Control franchisees. Rollins acquired Critter Control back in 2015 and has been slowly buying back franchise locations every year. The wildlife control market opportunity in North America is estimated to be $500M and Critter Control is the #1 player. What the company likes about this market is that it’s a natural extension from pest control and the growth of the market has been higher. Furthermore, there aren’t many other bidders for wildlife control branch locations, and so the returns on capital are higher for the company.
With a reinvestment rate between 35%-45%, we estimate that Rollin’s intrinsic value has increased 9%-11% annually over the past 5 years. The reinvestment rate has increased over the past couple of years due to the Clark acquisition for which the company had to take on debt. This likely has improved growth in intrinsic value as capital has been more efficiently deployed.
What else is important?
Aversion to debt
Rollins has historically taken on very little debt to fund its acquisitions and new branch locations builds. Only when the company acquired Clark in 2019 has there been debt on the balance sheet, but even then the cash generated in 2020 was partially used to pay down that debt. Management’s philosophy, while not explicitly stated, has been to be conservative with its balance sheet to withstand any pullbacks in market demand.
While this may have been warranted years ago when the company was a lot smaller, given the size of the company now and the predictability of the underlying business (which is also recession resistant), it would help increase the returns of the company (and the stock) to take on debt to fund acquisitions. Rollins has a net debt/EBITDA ratio of 0.2x, while Terminix has a ratio of 1.3x (also probably too low for the industry).
Covid impact
Rollins was open for most of the pandemic related lockdowns of 2020, with pest control being classified as an essential business. Demand from residential customers actually increased as more people were staying in their homes. However, the commercial business was hit as offices and retail establishments closed. Commercial customers for the most part didn’t cancel their agreements, but asked to delay the frequency of visits from Rollins, leading to flat y/y revenues for that segment.
The company underwent furloughs, layoffs and eliminated most travel. Capex was postponed until there was more visibility in the 2nd half of 2020 and management took a temporary salary reduction. Rollins also reduced the dividend from 12c to 8c. The company does pay out a special dividend almost every year and did so in November of 2020.
Optionality
Aside from large acquisitions like Clark, the company has the option to enter new international markets if they becoming attractive enough. Rollins has visibility into demand and returns from its franchisees and due to the buyback provision, can elect to enter these markets at a good price. Rollins should continue to develop the franchise side of the business to create a pipeline of potential high returning acquisitions.
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