The test of time is among the most powerful assessments a company can face. Few are truly able to survive and tell their tale. The few that do survive, all share attributes that have imparted such firms near invincibility in a spectrum of economic and industry-wide environments. Such attributes include:
The pest control and extermination industry is by no means the most "flashy" industry, however, it's great one nonetheless. The pest control services industry is expected to be a $28.85B industry by 2027, according to a new report by Future Market Insights. The report cites that robust CAGR of 5.1% will be driven by "growing urbanization and increasing consumer awareness about health and hygiene are factors expected to increase uptake of pest control services over the forecast period." Lastly, the report claims that "Conducive weather conditions for propagation of pests is leading to further increase in pest population across the globe." In all honesty, I do not think we needed a market research report to tells us all that. Rather it is safe to assume that we have already seen these market trends unfold before our very eyes.
Moreover, the industry does not seem to be overly affected by adverse macroeconomic scenarios given that the services being offered are vital no matter how the economy is performing. Such services are crucial to public health and well-being. I know that bed bugs, rats, termites, ants, and other pests will not disappear and will continue to evolve as will their methods to eliminate them.
Incorporated in 1948 in Delaware as Rollins Broadcasting, Inc. (NYSE:ROL), the company operates pest and termite control companies through its many subsidiaries to residential and commercial customers in North America, Australia, Europe. The company has international franchises in Central America, the Caribbean, Middle East, Asia, Mediterranean, Europe, Africa, Canada, Australia, and Mexico.
Rollins' wholly-owned subsidiaries include Orkin, Orkin Canada, HomeTeam Pest Defense, Western Pest Services, The Industrial Fumigant Company, Crane Pest Control, Waltham Services, Trutech, Permatreat, Rollins Australia, Critter Control, Safeguard Pest Control, and Northwest Exterminating.
The story behind Rollins Inc.'s flagship company Orkin dates back to 1901 when 14-year-old Otto Orkin, known as "The Rat Man," sold poison door-to-door. Eventually, Rollins purchased Orkin in 1964 for a mere $64M. Sounds like a pretty good deal now doesn't it... but of course, we would have to calculate the value of $64M in 1964 to today's money... oh wait I have. Today that investment would equate to over $518M as of 2018 figures.
Back to the story. It only takes four years for this new company to begin trading on the NYSE. Fast-forwarding to 1995, Rollins opened up their first Orkin franchise. Since then, Rollins has been on a shopping spree, compiling a portfolio of high-quality, brand name pest and termite control companies.
Since the very beginning, Rollins has prided itself on their family-oriented environment. The company exercises extra measures to ensure employees receive fair pay and benefits. Employee success drives a company's success. Without proper incentivization, employees do not have that urge to achieve better. Happy employees are great employees. There are several ways like generous 401(k) matching, stock purchase plans, etc. Rollins has a track record of taking care of their employees evidenced by the fact, several years ago the CEO of Rollins said that 70% of employees own stock in the company.
Furthermore, the company has spent years and an exceptional amount of effort to build high brand awareness. The "Orkin" man has a reported 70% brand awareness, which is remarkably high. The company spends around 5% of revenues annually to preserve and strengthen their brands. Orkin's "Pest Control Down to a Science" marketing campaign was a major boon for building brand strength and awareness. During that campaign, the company aired subtly funny commercials such as this, this, and this, among others.
Rollins operates with a basic structure, one reporting segment. Any guesses to the title? You guessed it. It is called the Pest and Control business. Although the company has one reporting segment, there is a little more to it than just that.
ROL's main business consists of operating the slew of pest and termite control companies as stated above. Rollins performs services to customers under contracts with pre-arranged pricing structures. Their portfolio of brand-name firms provides Rollins with a geographically diverse footprint. Because of the industry in which they operate, Rollins is capable of avoiding most economic turbulence. Such an attribute one might call refreshing in the current market we are witnessing.
Another, yet small aspect of their business shares similarities to fast-food behemoth McDonald's (MCD). Just like McDonald's, ROL also utilizes a franchise business model, but in a minimalist way. Currently, Rollins has franchises for their Orkin, Critter Control, and Rollins Australia which consists of Murray Pest Control and Scientific Pest Management. Pertaining only to the Orkin franchises, the company cites in their FY'17 10-K that franchises are used in "smaller markets where it is currently not economically feasible to locate a conventional Orkin branch." Domestic franchisees are subject to a buyout provision at Orkin's option, while International franchisees have a buyout option at their discretion. For Orkin, the ability to have that clause allows them to capitalize on strong franchisees by taking over that franchize and building that cash flow, rather than collecting royalties and licensing fees. It provides more upside for them.
As a whole, the select franchise path is seen by management as a way to grow the company, and by doing so Rollins is not forced to dish out capital nor take the risk to create operations where it does not feel the risk-reward ratio is favorable. On the contrary, the company is paid royalties and licensing fees.
As you will understand momentarily, Rollins has performed superbly for a long time. A major reason for that success is the training that employees go through.
Orkin Learning Center in Atlanta, which provides a complete training experience with the latest technologies and settings. Orkin’s Commercial pest specialists face “real life” pest control scenarios in a 13,000-square-foot space that includes model rooms in restaurants, hospitals, hotels, and commercial kitchens."
Furthermore, Orkin also employs "Orkin TV," a web-based training platform to help train over 8,000 employees. The company goes through extensive measures to ensure that its employees are properly suited to handle a wide spectrum of pest encounters that may arise. Such attention has resulted in strong customer happiness with their services.
There are not many companies that carry themselves as financially responsible as Rollins, which is sort of an unfortunate thing to admit. The company exemplifies the characteristics of what an investor desires in a 30-year investment, which will be explained in depth momentarily. Key to Rollins strong performance is attributable to their meticulous attention to the customer and solving their problem rather than overpricing or misaligned interests. So without further ado, let us delve into the firm's financials.
I am not a man of many words to be brutally honest, the hardest part about writing articles, well writing, in general, is putting thoughts to paper (or internet) and elaborate on my thoughts. Visualizing things such as graphs is an integral part of how I understand things. In my opinion, there is no better way to understand and analyze financials than lots of graphs and elaborating on them, so that's what I shall do. For this article, I have compiled a decent amount of data, into my Financial Analysis spreadsheet via excel, which I shall attach right below, in an effort to utilize my own graphs.
When an investor is looking to invest in a company, one looks at companies who have a record of consistent top-line growth rather than remarkably high clips which quickly diminish too much slower growth rates. Essentially, lower volatility is much desired. A company able to attain such a feat speaks to the quality of the product/service, pricing power, and market power among other reasons.
Data per 10-Ks; Excel
Regarding Rollins, they have a remarkable track record of growth across the board. I am not sure which was most recent, a WWII or a year with lower revenue than the previous year. Management raises prices for their services every year, and routinely comment on how the increase in rates equates to less than 2% of the revenue, which is pretty impressive. Put another way, the customers are not overly price sensitive to rate increases, but the increases are not much.
Furthermore, they are able to grow their customer base as well. As you can see via the graph, dating back all the way to 1999, the company has grown revenue every single year, and I know it is longer, but I just went back to 1999. There is only so much that can be said for a company that continually performs and have no doubt that that chart speaks leaps and bounds about how this company has withstood, and well prospered through recessions.
It does not matter what the economic climate is, if there are termites or pests, they can hurt businesses more than the already tough economic times. Putting it off may hurt their brand equities or destroy their reputations. Also, homeowners, I highly doubt you will put off getting your house fumigated, getting rid of pests, very long because well no matter what you probably want them eradicated, just as I would.
Not doing so poses health and property risks. Scenarios like this are a prime example of how ROL revenue streams are highly reliable, where 80% is recurring. Customers sign an initial one-year agreement where services occur monthly, bimonthly or quarterly basis.
Excel; Data per 10-Ks
First, we looked at the top line, but there is still more to look at to determine the long-term viability of a company. That is where Operating Income and Net Income come into play. In all honesty, there might not be a prettier chart that exists than of Rollins' Operating and Net Income. Since 1999, ROL has seen an 18.93% CAGR Operating Income; on the other side, the company has seen a 6.38% CAGR of Net Income for the same time period. Both figures are ridiculous! The ability to maintain this level of growth is truly remarkable.
The company has and is still able to achieve such financial success has to do with their model. A majority of their Operating Expenses are SG&A. The company does not report Gross Profit, as they include COGS in the Costs and Expenses portion of the Income Statement. If you consider them both as expenses incurred for operations, they are near all the expenses.
Additionally, the company, let's call it "outsources" much of its R&D to "unaffiliated universities and companies." The company considers that "outsourcing" R&D may yield better results, but more importantly, significantly reduces costs. Obviously, by the looks of it, management has done a wonderful job controlling costs, not letting them spiral out of control.
The root of Rollins' long-term financials gains is due to margin expansion. As you can see above, since FY'99, ROL has done a wonderful job expanding the operating margin from 2% to a much more formidable 17%. As for the company's net margin, excluding the high margin in 1999, it has grown from below 2% all the way to almost 13%. Bear in mind that since 1999, the company has invested over $800M in acquisitions in an effort to expand their business offerings domestically, as well as in Canada, the U.K., and Australia.
To invest that much money and continually improve margins speaks leaps and bounds as to management's ability to identify, execute, and integrate companies into the Rollins umbrella that will create significant synergistic opportunities with their existing operations. It is quite obvious based on the numbers that this is the case as they have been able to reduce overhead through these acquisitions and other costs.
Yes, I am very well aware that I have talked a lot about the Income Statement. Before I move on, I would like to look at a couple of ratios, Return on Equity (ROE) and Return on Assets (ROA), that further demonstrate how well the company generates profits
A company's ROE is presented as a percentage which demonstrates how efficiently management generates profit per dollar of shareholders' equity. A higher ROE is most desirable and it can be a strong indicator of what Warren Buffett refers to as a "Durable Competitive Advantage" (DCA). The presence of DCA tells you the company has a moat versus competitors. As you can see above, ROL has an ROE of 33% and change. This means, that for every dollar of equity, Rollins generates $0.33 in profit.
That is pretty high, regardless of industry. The impressive thing is that the company has consistently maintained a high ROE, which leads me to believe that the company possesses the highly sought after DCA as it tells me that management has a great understanding of how to create shareholder value through maximizing equity to generate strong profits. To put this into perspective, Mr. Warren Buffett is known for investing in companies that have an ROE of at least 12%. Anything below that, one can argue that management is not using equity efficiently to generate returns for their shareholders.
Lastly, we shall look at the company's Return on Assets. Return on Assets, reveals how much profit is generated for every dollar of asset owned by the firm. In essence, it shows how efficiently a company utilizes its assets to generate a profit. With ROA, just like with ROE, an investor desires a higher ratio as it signifies higher efficiency. Rollins generates 21.4 cents for every dollar of assets owned. Once again, this is an above average figure and has continued to increase over time. For the company to continually grow its ROA demonstrates managements knowledge of its asset base and how to maximize it to produce above-average returns.
Moving on to the Balance Sheet, Rollins exemplifies financial responsibility. The company does not rely on debt to fund their operations, as you will see in the next section. The company is able to fund to fund their operations internally, which has allowed the company to preserve a pristine Balance Sheet. Without levering up the balance sheet, Rollins has been able to expand their assets, $1.094B as of the latest report, which in turn allows for higher returns as interest expense is not as prevalent to siphon out some of the initial return.
Furthermore, the lack of debt has allowed Rollins to maintain additional flexibility with their pricing for services. This is because interest and principal payments are not as worrisome so the company does not have the headache of having to generate higher levels of cash flow to support those payments. The lack of this phenomena can be seen as how the company has grown Cash Flows and the top and bottom lines over time as Rollins ability in having pricing power has permitted them to offer lower prices while keeping their high-quality and customer first model intact. In essence, pricing power has allowed Rollins to significantly expand their customer base.
There is a third metric that I included in the graphic above, Book Value, or Shareholders' Equity. This is found by calculating the difference between Assets and Liabilities. Rollins has held Liabilities relatively flat, when in comparison to the growth of Liabilities, which has turbocharged the growth of the company's BV. The growth of Shareholders' Equity can be interpreted as yet another positive sign that shows how management has shareholders in mind when going about their business decisions.
Those of you who have read my prior pieces know how much I love Cash Flow. Maybe it is because I never get tired of hearing Kevin O'Leary talk about Cash Flow. Say it with me "CASH FLOW" (in Kevin O'Leary's voice). All I know is that a company's ability to generate Cash Flow can mean the difference between life and death. I say this because a company can be unprofitable but still generate strong cash flow and still perform well. Here is why: the Income Statement is based on Accrual-based accounting methods vs. Cash Flow, which is a Cash-based method.
Cash Flow tracks the cash inflows and outflows of a business over a specific period of time. Generating strong cash flow permits an entity to invest in itself, through innovation and M&A, as well as spoil shareholders. I am for spoiling the living bejeebers out of the shareholders... as long as there is plenty of capital to reinvest back into the business. That being said, if you can still generate cash to pay the bills and you are not profitable, you can survive, but not forever. As we have firmly established, profitability at Rollins is nothing to worry about, which is why I am very excited to discuss their Cash Flow.
Well, that is enough on the beauty of CASH FLOW, so let's get started on the beauty of Rollins cash flow. When I say beautiful, I mean it. I mean like Jennifer Aniston... you get the picture. Below is a colorful graph I have composed of the firm's cash flow since FY'99. For the sake of all the cash flow talk, I have color coded it. Anything in "Salmon" is Operating Cash Flow; anything in "Green" - because money is green- is Free Cash Flow. These colors will remain the same for this entire section.
Rollins has a very long history of growing Operating Cash Flow - just like every other metric - which has been paramount to the company's financial success. Although the company has grown cash flow at strong clips, how can you tell if it is "strong" cash flow? Look at conversion rates. Briefly, I will dip to the graph below, the "salmony" part. The company consistently converts over 100% of their Net Income to OCF which tells us a lot about the strength of their operations.
The ability to convert over 100% signals that a company is "strongly" able to internally fund its operations from cash flow. A phenomenon like this is much desired in the business world and is frankly a mere "pipe-dream" for most. This is further illustrated by the fact that the company has not loaded up their balance sheet with mountains, not even one mountain, of long-term debt.
Historically speaking, Rollins has converted around 130% of Net Income to CFO. Over the last few years, ROL has experienced lightened CFO/Net Income margins. This effect has weighed on the potential for high cash flow, however, their OCF has still been flying high. This noteworthy growth is attributable to higher Net Income which, as we established is evidenced by net margin expansion and top-line growth. The slightly lighter margin has been pressured from elevated levels of "Trade Account Receivables."
This effect was especially prevalent in 2012 and was further enhanced by an above-average hit from "Long-Term Accrued Liabilities." I do foresee the trend of the 130% ratio to become more of the norm rather than the previous days when Rollins was converting between 150%-190% of Net Income. Although the company might not be back in that range, there is some room for the company to expand that margin beyond the 130% point.
As for the company's Free Cash Flow, it has grown hand in hand with OCF. Throughout Rollins' positive FCF generation era, they have essentially maintained their conversion rate of OCF to FCF relatively constant. I am not saying it is a good nor a bad sign. You can make arguments for both angles. What I will say is that the company's model does not call for a lot of CAPEX; thus, they are able to generate fat levels of free cash flow.
The company isn't known for spoiling shareholders with fat dividends, though they do pay a dividend. The company's preferred method of spoilage is more indirect. Free cash flow is directly responsible for how the company continually reaches new heights. Rollins prefers utilizing such capital to reinvest and grow their business which is quite apparent. Such growth has translated to hefty capital gains for shareholders over the past 10 years, to use as the benchmark. The only thing upsetting long-term shareholders of the company are the taxes they have or will pay on it. *Yikes*
On another note regarding Free Cash Flow, another method to analyze the metric would be utilizing what is called the Free Cash Flow Margin. The FCF Margin tells investors how much every dollar in sales is converted to free cash flow. According to this metric, that company has encountered consistent expansion, allowing the company to convert and retain more and more of every dollar in sales, providing the company with ample capital.
If someone had to write a book about the story of Rollins' story and success, the title would be... okay let's not make me come up with a book title. You get the point. Just as I previously noted, just look at the balance sheet, how much long-term debt do you see? Hint: Right now, you will not find any. Their acquisitive endeavors and organic growth has been subsidized - I really don't like that word, but it fits - by the firm's ability to generate strong cash flow.
Lastly, not having to fund operations through debt also allows the company more flexibility on pricing as they do not have to worry about outrageous interest expense or other principal payments. In turn, this enables for a highly competitive pricing environment, one where Rollins is capable of offering better services at lower prices than rivals.
This is my favorite part about investing and writing, financial modeling and forecasting. You cannot tell me that Discounting Cash Flows or Dividend Discount models or historical data analysis and finding patterns and applying statistics to the past to try to forecast the future, is not fun. Although sometimes it can be a grueling and tedious pain in the royal heinie, it is nonetheless fun and challenging.
The hardest companies to forecast are the ones that are, historically, all over the bloody place with their financials. I am referring to companies that grow by 75%, then 90% then 45% to 35% to 50% then to 25% to 15% and so on. On the contrary, the easiest, okay well not as grueling, companies to forecast are companies just like Rollins. Firms that have a long history of consistent growth and growth rates. Firms that show consistent margin improvement. Even then, it still is not the easiest, because you have to figure out what method you want to use, among other things.
Regarding Rollins, I took a very statistical-based approach. I knew using a Discounted Cash Flow model was in order, the one that I have created and used in past pieces. *FYI the spreadsheet with all this data is above at the beginning of the "Financials" section. Everything is in there*. The model is a six-year forecast plus a terminal value. All forecasts are discounted by the WACC, which is calculated using my WACC calculator (also my own). Furthermore, the model takes into account cash and debt to create a Fair Value. The forecasts or Free Cash Flow is the dependent variable. On the flip side, the independent variable, the variable I am manipulating, is the Delta or the YoY change.
As for the numbers themselves that would be inputted into the model itself, that was the challenging aspect. First, I ran a correlation test to determine the best accurate method to calculate OCF and then subsequently FCF. The most accurate method was using an OCF margin, the percentage of each dollar converted sales to Cash Flow from Operations - whose correlation was 0.9969 versus the 0.9126 for the OCF/Net Income method. Subsequently, the best method to calculate Free Cash Flow was then to utilize the FCF/OCF ratio - with a correlation of 0.9959.
Other methods tested were the FCF margin (0.9034). Following that, I applied a trendline to the "Revenue" graph that I presented above, attempting to find the best fit line. That line was the polynomial line with an R2 of 0.9961, implying that the fitted regression line nearly fits the data. Using the formula showed, I moved it over to the newly created "Projections" sheet. On this sheet, I created a blank Income Statement, also including CFO and FCF at the bottom. I coded the entire sheet to have each metric react to certain inputs that I control or are already inputted.
I applied that formula for Revenue, inserting the year (starting with 21, as it would be the 21st year in the graph) in for x, and dragging that out to year 26 or 2024. Those numbers would be the basis for the OCF figures. However, one must determine the OCF margin, which I graphed the historical percentages for the OCF margin conversion and found the best fit line's equation. The best fit line gave me the equation of 0.0437ln(X)+0.0091. After inserting the x's, you get the percentages. Then I repeated that same process for the FCF/OCF margin and plugged those in as well to the sheet
Once I received those free cash flow figures, then I plowed them into the DCF model. Next step was calculating the Weighted Average Cost of Capital (WACC), which is easier said than done because the required market return can have a sizeable bearing on a company's WACC via manipulating the Cost of Equity. A lower market return deflates WACC, making it more aggressive; while a higher market return inflates WACC, making it more conservative.
Excel; Data per 10-Ks and analytics
At current prices, I think the market is not applying a high enough discount rate to the company's present value [discounted value] of the future cash flows. I can just hear my FINC300 and now my FINC365 professor saying it now. The company's WACC is subject to larger swings due to the required market return, due to the other factors in the calculation. Using a required return of 7%, we get a WACC of 5.48%, keeping all else equal, which would inflate the fair value.
On the flip side, when the required return is inflated 8%, the WACC comes out to 6.07%, which deflates the fair value. I implied the desired market return of 7.5%, which seems appropriate given the extraordinary volatility being endured. Plugging in that figure to the calculator and we receive a WACC of 5.75%. Using that rate as the discount rate, keeping all else equal, and we assume a Fair Value per share of ~$35.02, or 7.35% below the current price of $37.86.
For starters, there are some inaccuracies with this calculation, as with any forecast. Bear in mind that the accuracy of generating the formulas for the lines may be skewed a little as the data for Q4 is not present, thus there is a level of inaccuracy incurred in this model. The Q4'18 estimate of CFO was low at a mere $50M, while FCF was a very low figure at $30 which would impact the OCF margin, impacting the FCF/CFO ratio.
Those figures impact the ratios in the graph, thus the lines may not be as best fitted as they could be. When making estimates, I prefer to err on the conservative side. However, I do believe that this model does represent and provide a relatively accurate fair value of what Rollins should be trading around.
At current prices, I do think the company is overvalued. A more sensible price would be in the $35 range, at the most. Based on many valuation metrics, even at $35, that would be considered "richly valued," but my response is cash flows don't lie. For the long term, I do foresee the company being able to generate ~10% returns annually when factoring in the dividend and capital appreciation due to the extraordinary and continued growth of the firm.
As I said earlier, the company pays a dividend, but it is nothing to write home about. With a mere 0.98% yield, the company definitely is not trying to win the Best High-Yielder award. However, I do think the company is a solid investment for DGI investors. The chart below illustrates that the company has kickstarted its dividend growth in the last couple of years.
Furthermore, the company boasts a payout ratio of sub 40%. When you couple those two figures together, you get a company that has significant room to the upside to grow that dividend. Keep in mind that ROL is, in fact, growing their Net Income at nice rates, thus, they can still have their profit outgrow their dividend growth, keeping their payout ratio lower. This would allow the company to abide by their recipe for success of retaining FCF to reinvest rather than issuing massive dividends. Rollins aims to give investors just a taste as the real gains are via capital appreciation.
Few companies are able to withstand the test of time. Rollins is one of them, and it is quite obvious why the company has been able to. The company has done an excellent job of not growing the company too fast, "biting off what they can chew." This method, in turn, has allowed ROL to become a self-funded company that generates fat OCF and Free Cash Flow. The amount of cash flow generated has also permitted the company to fulfill its inorganic expansion desires via M&A.
Rollins has been built for the long term and that philosophy is still well intact and foresees much more gains when looking 20-30 years out. While companies may not survive the next recession, I am confident that ROL will survive and be prosperous. Through all of my research and analysis of Rollins' financials, and everything else I do foresee this company being able to deliver ~10% annual returns to shareholders.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.