Brand Value and a Never Ending Supply of Future Business...
One of the greatest investors in living memory, Peter Lynch, extolled the virtues of investing in what you know. He also discussed how investors might find promising opportunities in some very dull areas or might just discover a business with intrinsically attractive economics hiding in plain sight. In an earlier article, I discussed the Chemed Corporation (CHE) and my interest in its subsidiary - Roto-Rooter. Roto-Rooter is great in my mind because of the fact that no matter what - tree roots are going to still grow into pipes and clog them. Relying on nature to provide an inevitable revenue stream is a great way to find a margin of safety. I believe that Rollins, Inc (ROL) is one such business that has and will continue to profit from another force of nature...Pests!
Through its subsidiaries, Rollins is engaged in pest, termite control and extermination services for residential and commercial real-estate. In addition to having one of the strongest brands in the business, Orkin, a household name in termite and pest control - Rollins also enjoys worldwide exposure through franchises and subsidiaries including Western Pest Services, The Industrial Fumigant Company and HomeTeam Pest Defense.
Why Pest Control is a Great Business: Let's Talk Termites
For someone who owns his or her home, there are few things more hazardous to your investment than termite infestation. A social insect, termites can colonize and eventually destroy structures built from wood - undermining the very foundations of the structure and in many cases forcing the building to be condemned for safety reasons as it is often economically unfeasible or otherwise impractical to carry out extensive repairs of a house subjected to prolonged termite infestation.
Descended from wood-eating cockroaches, termites are thought to have evolved into a distinct species during the early Cretaceous period (145 M.Y.A). Adapted to consume wood and other cellulose containing products (such as paper) which are then metabolize into energy through a symbiotic relationship with their gut flora, for termites anything that is made of wood in your house is on the menu.
Once a house has been infested, termites can spread to neighboring houses in the neighborhood if their population is left unchecked and the queen is not destroyed, she will produce new queens which will then disperse from the colony - begetting the cycle anew next door or in another part of town.
In the Southwestern United States alone, termites are estimated to be responsible for $1.5 Billion dollars of property damage annually. Termites, with very few exceptions (including extremely cold and hot climates), are one of the most evolutionarily successful of all insects - enjoying a global distribution. Bad for homeowners - good for Rollins. Great for shareholders.
From a damage control standpoint, I believe that this discussion makes it abundantly clear that Rollins is provided with an almost inexhaustible source of future business. In addition, the insect extermination and control business is recession-proof - given huge potential costs of an unchecked infestation, the minor annual outlay for a contract with Orkin and the specialized knowledge, techniques and chemicals required to exterminate termites effectively.
From a cash-flow standpoint, the company enjoys a considerable position of strength. Rollins services are performed through a contract - providing recurring cash flow that is stable and predictable. Large commercial entities, homebuilders, real estate holding companies and individuals have a vested interest in maintaining coverage against termite and other insect infestation.
The Numbers on Rollins
Because the company operates as a franchise model, Rollins, Inc itself is a lean enterprise - shifting the costs of capital intensive aspects of the business (such as vehicles, personnel and chemicals) to the owner-operators. The balance sheet of the company reflects this fact - as it has no debt - a book value of $2.63 and cash per share of $.63 against a price of $25.76 per share. The business is also family run and is majority owned by insiders, standing at 56% currently. The company currently yields 1.4% - and the dividend has been increased by the company by more than 10% for 11 consecutive years.
Future Growth Potential: Franchise Expansion and Global Potential
Wherever there are termites and people living together, there is a need for pest-control. In 2012 - Rollins further expanded its franchises into the China, Chile and Mexico, which I believe will provide healthy growth in the future. The company currently operates 22 Orkin franchises overseas and 57 domestically.
The company has also made acquisitions to expand its service coverage ecosystem, recently acquiring Trutech, an animal and insect control company in the United States and No Fly Zone, a company engaged in bird control and exclusion. In addition, the company is poised to benefit from a housing recovery through its subsidiary HomeTeam - which has relationships with Toll Brothers, Pulte, D.R Horton and Lennar, offering "built-in" pest protection services for new homes.
The Battle of Brands: Orkin vs. Terminix
Two of the most popular names in the pest control market are Orkin and Terminix. Orkin has a history of over one hundred years as an independent company. Terminix is the largest company in the space, however it is a subsidiary of the privately held ServiceMaster corporation. I believe that this is a classic "Coke vs. Pepsi" situation, however for investors seeking exposure in this space the choice has already been made for them by virtue of the fact that Rollins is publicly traded.
Given the hazardous chemicals used to exterminate termites, and the hardiness of the creatures themselves, the company does face a potential for lawsuits seeking damages for incomplete rendering of services or unintended effects of chemicals on the inhabitants of the buildings subject to extermination treatments.
Evolution is also something to be aware of, and while I believe that it is a very slow process - there is a potential for termite populations to build resistances to conventionally used insecticides (as has been seen with microorganisms and anti-bacterial soap as well as antibiotic resistant pathogens), forcing the company to develop new methods of pest control that could cause margins to compress or additional regulatory involvement.
Seasonality also has an effect on the business, with termite life cycles being governed by temperature. A period of cooling over several years could produce a decline in revenue growth, however given the contract model in place I believe that revenues from existing clients would not be jeopardized. In addition, termites dislike extreme weather and need moisture in order to thrive, consequently prolonged periods of drought will have an impact on revenue in the short term.
The final area of risk that I have identified is related to the stock price. As the company's business model is able to generate large streams of cash with minimal expenditures in addition to producing robust dividend growth - this stock commands a handsome premium to the assets held on its balance sheet. Though I believe that this premium is justified, it is important for investors to carefully assess the price of the stock and to employ dollar cost averaging over the long haul in order to reduce the risk of overpaying.
Thoughts on the Recent Price Action
Even though Rollins, Inc is a small company that has prospered in obscurity - its virtues are reflected in its phenomenal performance over the past several decades. This company is far from the classic Grahamian "Cigar-Butt" stock - instead it is much more closely aligned with Buffett's "Wonderful Business for a Fair Price," and consequently, investors will have to pay a premium for the company's assets. Due to the fact that there is such a wide disparity between hard assets (Book Value and Cash) and the intangibles of the company (such as the Orkin brand, security of dependable cash flows etc...) I believe that this stock is susceptible to heavy selling pressure if the company fails to meet earnings projections and I believe that investors seeking to make a long-term commitment to the company should welcome these events in the near term and employ dollar cost averaging due to the underlying strength of Rollins' cash flows and the constant source of demand for its services.
I believe that Rollins provides investors with a very attractive investment opportunity - the company has grown its dividend considerably over the past decade in addition to enjoying above-average growth prospects as a result of acquisitions and international expansion. The company also has an extremely strong household brand name and an almost inexhaustible source of recession-proof future business.