Fund Stocks | 9 Mins Read | by AG Latto
The UK Buffettology Fund has bought into its second US-listed company with the addition of Rollins Inc (ROL). The pest control business is the market leader in North America where it operates under the trade name Orkin. The addition takes the total number of companies in the Buffettology fund to 31.
Rollins Inc share price $40.21 on 6 March 2019 close; market cap US$13.2 billion
- Revenue has increased from US$802m in 2005 to US$1.67bn in 2017 i.e. 6.5% a year. 80% of the group’s pest control revenue is recurring.
- The Rollins family control the majority of the company.
- The rolling 12-month forecast P/E ratio looks punchy at 50X earnings. The forecast P/E for 2020 is 45X.
CFP SDL UK Buffettology Fund remains a top performer with a return of 201.5% since launch in March 2011. This compares to a 70.68% return for the UK All Companies Investment Association sector.
The fund has delivered a return that is in line with the iShares S&P 500 ETF (CSP1) over the period. This is an impressive result given that the US equity market has been on a tear since 2009.
The Buffettology Fund has kept up with the iShares S&P 500 ETF
Source: SharePad
Rollins Inc was added to the Buffettology fund in February 2019. It is the second US-listed company added to the fund after Warren Buffett’s investment vehicle Berkshire Hathway.
The US equity market is the largest in the world and includes a number of high-quality businesses. It will be interesting to see if Rollins Inc marks a shift by the UK Buffettology fund towards stocks listed outside the UK.
The fund’s manager, Keith Ashworth-Lord stated in the March factsheet:
Rollins Inc., [is] the #1 pest control business in North America operating mainly under the trade name Orkin…Rollins' record is outstanding. Eighteen years' unbroken growth including making 2008 and 2009 look like a case of crisis, what crisis? Over the last ten years, the CAGRs are: Sales 6%, EPS 11% & DPS 20%. Return on equity is consistently around 30% with no gearing and free cash flow to earnings is consistently 115%. Capex and working capital requirements to cater for the growth are small with the result that the business is relatively asset light. Lastly, management does act with the owner's eye; the extended Rollins family retain 57% of the equity.
Rollins Inc appears to be a business that Mr Ashworth-Lord knows from personal interactions:
As someone with a home in Florida, I know that pest control in the States is not a discretionary spend. We are not talking about the odd rat in the kitchen or wasps' nests; we are talking about the need for regular treatment for a variety of infesting or destructive insects, and termites in wood frame houses.
That doesn’t sound great. So much for the dream of owning a home in Florida! Rollins Inc does have a very strong track record. The key question, in my view, is whether the shares are too expensive.
Some of the “popular pests” that Rollins Inc takes out
Source: Rollins
Rollins Inc’s valuation
Rollins Inc has a normal calendar year-end and has released results for the year to December 2018. One way to look at the valuation is to see how the shares trade against the last 12 months reported earnings.
This offers an insight into how the valuation multiple has changed and therefore how investor sentiment has changed. The historic valuation multiple that Rollins Inc has traded at has increased from 35X in 2005 to around 55X today.
Rollins Inc against P/E the last 12 months earnings
Source: SharePad
We get a similar picture if we look at the P/E ratio using the fiscal year-end share price. This was just over 35X for 2004 and then fell back to about 22X in 2009. The ratio for 2018 was a punchy 56.8X.
The forecast 12-month ahead P/E for Rollins at 50X is higher than the historic P/E that the shares traded on up until 2017. The forecast P/E for 2020 is currently 45X.
There appears to be no doubt that the valuation of Rollins Inc has increased relative to its historical valuation. This may reflect the general increase in the valuations of quality companies.
P/E ratio: share price at fiscal year-end
Source: SharePad
An additional valuation metric that we can use is enterprise value to turnover. This has increased from around 1.5X in 2004 to over 7X in 2008. Over the same period, the EBIT margin has increased from just over 6% to around 17%.
Can Rollins Inc justify its valuation?
1) Earnings per share convert into free cash flow
Rollins Inc stands out for converting all of its earnings into free cash flow per share. This is despite the group having delivered robust earnings growth since 2004.
This is the mark of a high-quality business: the ability to deliver growth in earnings per share and free cash flow per share.
It is also the mark of a capital-light business. Two companies that have achieved a similar feat in the UK are Rightmove and Hargreaves Lansdown.
While these sorts of companies trade on high P/E multiples the earnings are at least backed by cash. Companies on lower P/E multiples don't tend to convert all of their earnings into cash and/or are not able to deliver high-quality growth.
The below chart of strong earnings and free cash flow growth is a beautiful sight to see (for investors anyway).
Rollin’s Inc earnings per share and free cash flow per share
Source: SharePad
2) The return on capital and the cash return have improved since 2004
Companies that can generate and sustain a high return on capital are rare and valuable. Rollins Inc has seen its return on capital (ROCE) increase from around 22% in 2004 to just over 40% in 2018.
What is notable is that the return on capital held up well during the global financial crisis. Pest control, as Mr Ashworth-Lord states, is clearly not a discretionary item in the United States.
The driver of the improved return on capital has been an increase in the EBIT profit margin. Further improvements in the profit margin will have a leveraged impact on the bottom line.
Rollins Inc return drivers
Source: SharePad
What is also remarkable is that the cash flow return on capital employed (CROCI) has increased to almost 35%. The figure did not dip not decline during the global financial crisis.
Rollins Inc stated in its 2017 annual report that:
“Approximately 80% of the Company’s pest control revenue was recurring in 2017 as well as 2016.”
Rollins Inc ROCE and CROCI
Source: SharePad
3) Historic and forecast growth
Rollins Inc has increased revenue from US$802 million in 2005 to US$1.82 billion in 2018. This works out as a 6.5% annualized increase.
Organic revenue growth, excluding acquisitions, was 4.5% in fiscal 2017. The group undertook the largest acquisition since 2008 during the year.
Revenue is forecast to increase to US$2.25 billion in fiscal 2021, which works out as a 7.3% annualized increase.
The EBIT margin for the business is also expected to improve from 17.1% in 2018 to 18.1% in 2020.
If the group can continue to improve its margin it would have a significant impact on the bottom line.
If the 2018 margin was improved from 17.1% to 26.7% we would see profits increase by 50%. Whether this is realistic is difficult to judge.
Rollins Inc on a roll
Source: SharePad
Rollins Inc EBIT margin
Source: SharePad
4) Long-term growth potential
Rollins operates in 53 countries but generated 92.1% of its revenue from the United States in 2018. Mr Ashworth-Lord doesn’t touch on the long-term growth potential for Rollins Inc in his comments.
In my view, the company needs to generate reasonable long-term growth to justify its current valuation.
The key near-term growth drivers will be the increase in commercial and residential buildings in the United States. Acquisitions could be another source of growth but this is less attractive than organic growth.
International markets may be a source of long-term growth. It is not clear, though, how Rollins will be able to take market share from rivals outside the US.
Rollins Inc revenue breakdown in 2018
Source: SharePad
Rollins Inc's growth has been largely organic to date. The group didn't have any goodwill on the balance sheet until 2002.
The below chart suggests that the only significant takeovers to date were in 2006, in 2008 and in 2017. Goodwill is the difference between the purchase price for a business and its tangible assets. Its presence on the balance sheet indicates, therefore, prior acquisitions.
Rollins Inc turnover and goodwill
Source: SharePad
5) Free cash flow yield: historic and forecast
Free cash flow valuations tend to deliver better results than earnings-based valuations. This is because high-quality businesses like Rolins Inc achieve stronger results on free cash flow valuation metrics.
The free cash flow yield available on Rollins Inc has declined from around 4.5% in 2004 to 2% in 2018. It is expected to increase to 2.3% in 2019 and then reach 2.6% in 2021.
Rollins historic free cash flow yield
Source: SharePad
6) Dividend growth
A cash generative business like Rollins Inc can pay out generous dividends as it grows. Dividend cover is expected to decline from 1.8X in 2018 to 1.3X in 2020 with the dividend increasing from 38.5 US cents to 69.7 US cents over the period.
The forecast dividend yield, though, is modest at 1.2% in 2019 and 1.7% in 2020.
Rollins Inc's dividend growth: bug busting bounty
Source: SharePad
Summary
Rollins Inc is clearly a high-quality business with profits holding up during the financial crisis. The forecast P/E ratio, though, is pretty demanding at 50X earnings even if cash flow is robust.
The valuation multiple has also increased in recent years and may not have much scope to move higher from here. The share price is therefore likely to move in-line with earnings per share in the best case scenario.
Revenue growth is expected to come in at a compound annual rate of 7.3% over the next three years. Earnings per share growth are expected to be 11.3% in 2019 and 12.7% in 2020.
Rollins Inc is growing at a reasonable pace but is also trading at a very high multiple. Without a better understanding of the long-term growth potential, and the scope for margin improvements, there doesn’t appear to be significant upside.
A company like Facebook (US$172) appears to offer a better combination of quality/growth against the current valuation. Facebook has a forecast free cash flow yield of 4.9% in 2021 versus 2.6% for Rollins Inc.
Rollins Inc is clearly just one position in a 31 stock fund. The valuation at which Rollins Inc has been bought, though, does make me more cautious towards the Buffettology fund. Quality stocks do tend to outperform over the long-term. But it helps to buy them at an attractive valuation.
I have no doubt that Mr Ashworth-Lord's Florida home will remain pest free. I am less certain that Rollins Inc will outperform the S&P 500 over the medium-term.
Rollins Inc and the S&P 500 total return index
Source: SharePad
