2023-09-06 03:57:34 ET
Summary
- Rollins is a leading pest control company, one of only two global players in the industry.
- The pest control market is highly fragmented, making it difficult for small players to survive.
- Rollins has a stable business model with high recurring revenues and expanding profit margins.
Rollins ( ROL ) is a leading pest control company servicing both residential and commercial customers primarily in the United States. There are only two main global and scaled pest control companies in the world: Rollins and Rentokil Initial ( RTO ). The entire pest control industry is highly fragmented, and Rollins has consistently been acquiring regional small players. The pest control business is known for its stability. It is a high-quality company worthy of a spot on the watchlist.
Fragmented Pest Control Market
Setting up a pest control company may seem straightforward: hiring skilled workers and obtaining several trucks. However, scaling it up and achieving decent profit margins can be challenging. To become a successful pest control company, it's essential to offer digital platforms to customers and attract enough clients to ensure efficiency and profitability through route density. I would argue that it's not easy for a small player to survive in such a market. That's why Rollins has consistently been acquiring small and mid-sized players to further consolidate the fragmented markets.
Globally, only Rollins and Rentokil Initial have reached a certain scale in the pest control market. They earn more than 18% in operating margins and generate quite decent cash flows.
High Recurring Business in Nature
The pest control market demonstrates remarkable resilience in various macro environments. In 2009, Rollins still achieved a 5.2% revenue growth. When residential or commercial buildings have pest issues, property owners must seek pest control services, which are typically non-deferrable. Additionally, for many commercial customers, pest control services are mandatory to comply with legal requirements.
Therefore, I prefer Rollins's business model, which operates as a stable franchise. As illustrated in the chart below, Rollins has consistently expanded its business during various economic cycles, including the 2009 Recession, Industrial Recession, and the Covid-19 Pandemic. Rollins has disclosed that 80% of their revenues are recurring.
High Margin Business
Rollins has consistently expanded its margins over the decades. I believe their margin expansion can be attributed to the following factors:
Pricing Power : Thanks to their market-leading position, Rollins can gradually increase their service prices. Pest control services are essential for both commercial and residential customers, making it possible to pass on price increases that can effectively cover labor cost inflation.
Operating Leverage : Rollins is achieving high-single-digit organic growth. Simultaneously, their operating expenses do not need to increase at the same high-single-digit rate. This discrepancy contributes to operating leverage, which bolsters their profit margins.
Tuck-In Acquisitions : When Rollins acquires small players, the integration process is relatively straightforward due to their existing infrastructure and digital platforms. There are numerous synergies to be realized when acquiring these smaller pest control companies. As more companies are integrated into a single platform, Rollins can benefit from increased route density for their workers. In other words, workers can spend less time on the road, creating opportunities for margin expansion at Rollins.
Recent Financial Results and Outlook
Rollins successfully completed the acquisition of Fox Pest Control in April 2023, marking the second-largest deal in Rollins's history. In Q2 FY23 , the management reported that the integration process with Fox is progressing smoothly. I have confidence in Rollins's ability to integrate Fox effectively.
During Q2 FY23 , Rollins achieved an impressive 7.7% organic revenue growth. This growth was evident across all three segments: Commercial pest control increased by approximately 11%, residential saw an increase of over 18%, and termite control rose by approximately 14%.
On the balance sheet, they successfully refinanced their credit revolver, increasing it from $175 million across two banks to $1 billion involving eight banks. Rollins had a very strong balance sheet in the past, with a gross debt leverage of less than half a percent. Their robust free cash flow generation is ample to support tuck-in acquisitions, dividend payments, and modest stock buybacks.
I anticipate that Rollins can achieve 8% organic revenue growth in FY23, with acquisitions contributing an additional 3% to their top-line growth.
Valuations
In my DCF model, I have assumed a 7% normalized organic revenue growth rate and a 2.7% growth rate from acquisitions. I have also factored in increasing depreciation and amortization expenses when calculating their operating margin. Based on my estimates, the operating margin is projected to reach 23.1% in FY32. Additionally, the model indicates that free cash flow is expected to reach 22.6% in FY32.
The model is using 10% of WACC, 4% of terminal growth rate, and 26% of tax rate. Discounting all the free cash flow from the firm, the total equity value is calculated to be $16 billion in total, as such the fair value is estimated to be $33 per share as per my estimate.
Key Risks
Acquisition Integration : Given that acquisitions are a key component of Rollins' growth strategy, it's reasonable to acknowledge potential M&A integration risks. For instance, the recent Fox acquisition, being their second largest deal, might encounter some challenges in the future. Rollins has invested $1.2 billion in acquisitions over the past decade, out of the combined $2.9 billion in cash generated from operations. This percentage allocated to M&A is relatively high compared to other companies. However, it's worth noting that Rollins predominantly focuses on small and mid-sized tuck-in deals, and they have a well-established track record of successful business integration.
Labor Shortage and Cost Inflation : As of December 31, 2022, Rollins employed 15,800 individuals in the United States. Labor shortage and inflation could potentially have a significant impact on their growth and margins. It's worth mentioning that pest control workers are generally compensated well compared to other industries, and as previously discussed, Rollins' pricing strategies are positioned to offset cost inflation throughout various economic cycles.
To Summarize All Together
Rollins is a highly recurring and high-quality growth company. I firmly believe that they have the capacity to sustain growth across various economic cycles. With their organic revenue growth and strategic tuck-in acquisitions, I anticipate they will deliver double-digit earnings growth over the next decade. For potential investors, I recommend considering accumulation of the stock when its price drops to around $33 and holding it for the long term.
For further details see:
Rollins: High Recurring Pest Control Franchise In A Fragmented Market