Spruce Point Capital Management Announces Investment Opinion: Releases Report and Strong Sell Research Opinion on Rollins Inc. (NYSE: ROL)
NOTE TO EDITORS: The Following is an Investment Opinion Issued by Spruce Point Capital Management
Finds That Changing Industry Dynamics Are Causing Increased Pressures Such as Rising Customer Churn and Acquisition Costs, Auto Accident Claims, and Consumer Resistance to Recent Price Increases
Warns That Nearly 40% of Rollins’ Annual Revenue Growth Has Come From Its Acquisition Strategy and a Flood of New Private Equity Money Backing Pest Control Acquisition Platforms is Causing Growth Challenges
Warns That Rollins Recently Settled Improper Earnings Management Charges With the SEC and Questions Rollins’ Recent Claims That Gross Margins Are Improving Organically Absent Its Levered Acquisition of Fox Pest Control
Believes That Rollins Faces Long-Term Pressures From Declining Insect Populations Due to Global Warming and Other Factors
Finds that the Rollins Family is Accelerating Stock Sales While the Company Increases Leverage to Repurchase Shares
Given Multiple Pressures And That Rollins’ Valuation Is Among The Highest In The Residential And Commercial Services Sector, Sees 30% to 40% Long-Term Downside Risk to Rollins’ Share Price and Urges Investors to Visit www.SprucePointCap.com and Follow @SprucePointCap on Twitter for the Latest on $ROL
October 04, 2023 09:00 AM Eastern Daylight Time
NEW YORK--(BUSINESS WIRE)--Spruce Point Capital Management, LLC (“Spruce Point” or “we” or “us”), a New York-based investment management firm that focuses on forensic research and short-selling, today issued a detailed report entitled “Cockroach Theory of Investing” that outlines why we believe shares of Rollins Inc. (NYSE: ROL) ("Rollins" or the "Company") face up to 30% to 40% long-term downside risk, or $21.75 – $25.40 per share. Download or view the report by visiting www.SprucePointCap.com and follow us on Twitter @SprucePointCap for additional information and exclusive updates.
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Spruce Point Report Overview
Rollins, an S&P 500 index component, is the second largest pest control service provider in the U.S. and operates under a variety of brands such as Orkin, HomeTeam Pest Defense, Critter Control, Fox Pest Control and Western Pest Services. The Company services more than two million customers, with approximately 45% and 35% of sales to residential and commercial customers. Approximately 93% of sales are in the U.S., with the remaining 7% coming from international sales. While historically the pest control industry has exhibited healthy margins and is viewed as recession-resistant due to recurring revenues and services that were deemed essential during COVID-19, there are multiple growing long-term macroeconomic and microeconomic issues that have been identified, which are likely to pressure Rollins’ historical growth and margins.
The concerns we outline in our report include:
- Industry competition is increasing with the recent merger of Rentokil and Terminix, the rise of door-to-door sales, a flood of new private equity backed platforms, and bundled home services. In October 2022, Rentokil completed its acquisition of Terminix to become the largest pest control company in the U.S. and globally. Our research indicates that the combined company is increasing its marketing intensity, which is ultimately pressuring Rollins’ customer churn and acquisition cost. In addition, because digital marketing costs have increased, the pest control industry has seen a resurgence of door-to-door marketing companies, a sales practice that Rollins has historically not fully embraced until recently. Furthermore, realizing that home services, and pest control specifically, is an attractive business, new entrants have entered the space. Beyond the shift to door-to-door sales and the growing competition, we believe the biggest threat to Rollins is by far the emergence of private equity. Today, there are at least 20 private equity firms managing a combined $300 billion in assets under management that have made acquisitions in the pest control industry, with some backing platforms designed to rapidly scale through organic and acquisition growth. Others have used ancillary home services, such as gutter cleaning or lawn care, to offer discounted bundled offerings in pest control.
- Rollins has depended heavily on M&A to grow, but there is evidence of new challenges with this strategy. Just in the past five and half years, Rollins has deployed $1.25 billion to acquire 184 pest control companies, with the two largest being Clark Pest Control (2018) and Fox Pest Control (2023). On average, approximately 40% of total revenue growth per annum has been from acquisitions. Given the rise of private equity competition, industry experts claim that at least 50 to 65 potential financial buyers have emerged at recent auctions and that Rollins has generally been conservative in its acquisition strategy and unwilling to pay rising valuation multiples to remain competitive in the M&A market. As a result, we seriously question the quality of the recent acquisitions completed by Rollins. For example, Rollins recently acquired Fox Pest Control (“Fox”) in April 2023, which has grown rapidly in door-to-door marketing and has averaged approximately 47% annual revenue growth in the past four years. However, Rollins is implicitly guiding that Fox’s revenue growth will be (0.2%) to 11.0% in 2023. In addition, we estimate that its sales per employee is projected to decline to multi-year lows. Beyond larger acquisitions, Rollins also frequently conducts smaller “tuck-in” acquisitions. However, by adjusting its recent reporting for the contribution of Fox, we find that revenue from tuck-in acquisitions has declined double digits for three quarters in a row.
- COVID-19 was a boon for the pest control industry, but now multiple tailwinds are becoming headwinds to Rollins. COVID-19 benefitted the pest control industry for a variety of factors: 1) it was deemed an essential service during the pandemic, 2) people were staying (and investing) in their homes at that time, and 3) many individuals migrated from cities to the suburbs and sought out pest control services. More recently, inflation allowed pest control companies to raise prices by 4% per annum over the past two years, well ahead of the typical 1% - 2% per annum historical price increase. Based on management’s recent tone, we believe Rollins is telegraphing that its customers are now resisting price increases, which could manifest in higher customer churn. In addition, a tight labor market for drivers and a recent rise in auto accident claims and insurance rates look to be pressuring Rollins and we do not believe this will be a temporary issue. Furthermore, Rollins depends heavily on vehicle leases, and given that approximately 20% of its fleet turns over annually and lease costs are rising, we expect its lease expense to pressure earnings. Lastly, our research indicates that Rollins has underinvested in its business infrastructure and technology in favor of capital allocation toward M&A and dividends. In fact, Rollins’ recent investor presentation does not even mention the word technology when discussing its focus on modernization. In contrast, we find that many of Rollins’ competitors are finding creative ways to deploy various technologies to better service customers and that new (and free) software offerings targeted to small and medium-sized pest control operators and designed to improve operations and customer service could be leveling the playing field.
- Rollins was recently charged by the SEC for improper earnings management and also changed auditors, which introduces financial restatement risk. In April 2022, Rollins and its former CFO were charged by the SEC with improper earnings management.1 We believe Rollins’ financial reporting has historically been opaque as evidenced by its inability to provide quarterly customer count reporting and churn. We find concerning evidence of historical revenue claims not reconciling with reported results. Furthermore, we find that Rollins does not provide complete reporting of quantitative factors affecting its gross margin. Management recently claimed that gross margin improved by 40 basis points year-over-year and cited improving factors across all its brands as a driver of results. However, based on commentary from an industry expert, door-to-door sales operations, such as Fox, carry gross margins 10%-15% higher than traditional pest control operators. If we remove the estimated contribution of Fox from recent results, we find that 40 basis points or more of gross profit contribution is attributable to Fox. This implies that, in contrast to Rollins’ claim, its underlying business may be suffering, not improving.
- Multiple new scientific research studies conclude that insect populations are declining globally. Rollins’ services are highly dependent on customers perceiving there to be value in preventive and maintenance treatment against many types of insects. However, there are multiple growing bodies of research that conclude that insect populations are declining. For example, even NASA, which studies global climate change, has models that shed light on how insect populations may respond to climate change. In a study recently published in Nature Climate Change, scientists found that 65% of the insect populations they examined could go extinct over the next century.2 Beyond climate change, the root causes are believed to be pollution, deforestation, urbanization and the use of pesticides. Moreover, another long-term risk to Rollins and other pest control companies is the increasing adoption and funding for sterile insect techniques (SIT). These techniques are perceived to be an environmentally friendly alternative to pesticides and involve the mass-rearing and sterilization of male insects so that when they mate they produce no offspring. One of Rollins’ core pest control offerings is termite protection and ancillary services, which are approximately 20% of sales. According to Rollins’ reporting, annual termite damage appears to have declined in the past ten years. This revenue source could be at risk if consumers perceive termite protection services are not worth purchasing.
- The Rollins family and management are accelerating stock sales while it commands a rich valuation premium. We see 30% - 40% downside risk. The Rollins family and related entities filed a registration to sell up to 249 million shares and recently completed an offering of 44.5 million shares at $35 per share to realize $1.5 billion in proceeds. In addition, members of the management team recently disclosed 10b5-1 stock sale programs. Concurrent with the share offering, Rollins repurchased $300 million of stock which we estimate required additional borrowing to finance. While Chairman Gary W. Rollins, now 78 years old, may be selling shares for estate-planning purposes, the timing of the stock sales should also be analyzed. Based on our research, rising competitive pressures from the Terminix / Rentokil merger, a deluge of private equity money entering the market, signs that Rollins is acquiring lower-quality companies, rising auto accident claims, a change in auditor, and frothy valuation of the stock all bolster our view that now is an appropriate time to liquidate stock. In fact, at 6x and 27x 2023E sales and EBITDA, we believe Rollins is one of the most richly valued residential and commercial services companies in the North American public markets. To put Rollins’ $20 billion enterprise value in context, it has approximately 12% of the global pest control industry sales but its enterprise value accounts for nearly 85% of the global annual market turnover. If Rollins’ valuation multiple normalized to reflect our findings that its industry position is weakening, we estimate there is 30% to 40% downside risk to its share price and its stock would be valued at $21.75 - $25.40 per share.
The research note can be found at www.sprucepointcap.com and updates will be posted on twitter @sprucepointcap.
