With a global economic downturn likely on the horizon, we are undertaking an investment review of defensive industries like pest control. The industry is undergoing its most dramatic shake-up in decades. Rentokil (LSE:RTO), the UK-based powerhouse in pest control, is acquiring Terminix (NYSE:TMX), the second-largest pest control firm in the US. The acquisition has widespread implications, as reviewed in this report.
The transaction immediately forms a new largest pest control player in the US. We are bullish on the combination of the two firms. Management expects $150 million of corporate synergies from the transaction. This is too conservative. We expect $300 million (5% of combined revenues). Our variant view stems from our optimism surrounding tighter route density, operational improvements (expertise in commercial and national accounts coverage, hygiene capabilities, internal software upgrades), and cost improvements (removing duplicate corporate structures, natural attrition).
Terminix is the ideal turnaround candidate. It has the strongest brand name in US pest control, but is suffering from years of operational mismanagement and chronic underinvestment. Gross margins lag the industry average by ~10 percentage points. While operations are improving under Brett Ponton's leadership, Rentokil brings the operational excellence and scale required to effect transformational change.
Competitors, such as Rollins (NYSE:ROL), will benefit from the merger. Competitors will jump at the opportunity to seize any customers or technicians that churn from Rentokil/Terminix. Inevitably, this churn will occur as Rentokil re-routes and re-aligns.
The M&A market will become more attractive for Rollins and the PE-backed players, as Rentokil (one of the most aggressive acquirors) becomes less active in M&A processes for the next 2-3 years. Rollins is well-positioned as the buyer-of-choice for mom & pop pest control firms, given its strong ties to the industry (relationships spanning decades) and its family-owned business culture.
Rollins, in particular, will benefit as the number of commercial providers able to service national accounts (one of the most lucrative activities in the value chain) shrinks from four to three, creating a comfortable oligopoly at the national level.
Overall, we recommend accumulating shares in both Rentokil and Rollins. With a bullish view on near-term synergies, Rentokil offers a favorable risk/reward over the next 3 years. Meanwhile, Rollins provides a safe, attractive return on investment with favorable organic growth and M&A tailwinds.
The global pest control market is a $20bn industry with expected organic growth of 4-5%+ per annum. The US market (the focus of this report) is the largest geographic market, representing $12bn in annual sales and offering a similar organic growth rate. The industry is highly fragmented, with 40,000 operators globally, including 20,000 operators in the US.
While fragmented industries are generally unattractive market structures, pest control is an exception. Three firms control over 40% of the US market, with the balance held by two private equity-backed players (Massey and Arrow), Ecolab, and mom & pop shops.
The industry has low barriers to entry and low barriers to exit. Economies of scale are substantial, with the largest firms benefiting from centralized fixed costs (routing and billing software), strong brand names (facilitated by large marketing budgets and storied histories) and, most importantly, tight route density (the ability to visit several houses and businesses within the same neighborhoods or regions within the same day).
While industry organic growth is in the low-to-mid single digits, the largest players typically achieve top-line growth of ~9-10% through bolt-on acquisitions. There is no shortage of players to acquire and the benefits of an acquisition are quite lucrative. The largest players spread ‘shared costs’ across a large asset base, most evident in marketing and back-office functions (KPI tracking, routing software, corporate functions).
The benefits of scale are substantial. While financial information is scarce for privately held pest control companies, we received a brief glimpse into Clark Pest Control’s financials in 2018 during its acquisition by Rollins. Keep in mind, at the time of acquisition, Clark was the 8th largest pest control firm in the US. Rollins and Clark both generated 52% gross margins. However, Rollins enjoyed an 18% operating margin, while Clark operated near break-even at a 2% operating margin. The difference lies in Rollins’ ability to spread its fixed costs over 800 locations, while Clark spread its fixed costs over only 26 branches.
Similarly, Rentokil shows its ability to double branch-level operating margins of its bolt-on acquisition targets. Rentokil achieves 20-30% branch-level operating margins through greater density (excluding the benefits of SG&A synergies and drag of corporate expenses). In addition to shared costs, Rentokil is able to accelerate organic growth by investing in commercial sales reps and up-selling/cross-selling services.
The residential market has low barriers to entry and represents two-thirds of the $12bn pest control market. Price is generally a secondary consideration. Customers typically don’t spend too much time shopping around. When they call, they want the pests gone as soon as possible. Brand recognition is important since it indicates quality (an important qualitative factor when customers are letting someone into their home). Strong brand recognition increases the likelihood of being among the customer’s first calls. The largest players spread fixed marketing costs (social media, billboards, radio ads) over a larger customer base, lowering customer acquisition costs.
Due to the high upfront costs (~$80-200 CAC) customer retention becomes the most important metric for high IRRs. To illustrate this point, a typical residential pest control firm generates $125/quarter of revenue per customer. Assume $80-200 of fixed marketing costs, $40/visit to rig a truck, and $20-40/visit of technician costs. The unit economics suggest residential pest control gross margins of 40-50% with a payback of 1.0-1.5 years on initial marketing spend. While these exact numbers can vary based on provider and regional pricing schedules, the math highlights the importance of retaining customers for as long as possible (especially in the first year).
Rollins and Terminix differ significantly in their ability to retain customers. Rollins has about a 10-15% annual customer churn, while Terminix suffers from 25% annual churn. To put this into perspective, Terminix’s salesforce starts the year knowing they will lose 25% of their customer base. It’s a steep treadmill.
Some of these wounds are self-inflicted. In 2019, Terminix closed its call center in Memphis and opened up a call center in the Philippines. Applying an offshore solution to regionally specific problems created headaches for customers and the sales and marketing team. This was further compounded by language barriers. This is an easily solvable issue through re-shoring and/or leveraging Rentokil’s existing call centers.
Technician turnover inextricably links to customer churn. As technicians become familiar with their customers and the pest control issues they face, it becomes easier to provide treatments in the future. Customer satisfaction understandably drops if a customer must re-explain the issue to a different technician each treatment. Again, Rollins has the advantage. Technician turnover is substantially lower at Rollins, with some technicians staying for decades. It’s viewed as a favorable place to work, with a tremendous amount of training and upfront investment in technicians along with materially higher wages than those offered by Terminix and Rentokil. Meanwhile, Terminix suffers from technician turnover in excess of 100% per year, which in effect flows through to customer churn.
The commercial market is more attractive than the residential market. One of the most lucrative opportunities within this segment stems from national accounts. Large QSRs (McDonald’s, Burger King, Starbucks), hotels (Hilton, Hyatt, Marriott), and big-box stores (Walgreens, Walmart, Dollar General) have contracts in-place with the largest pest control companies. To service these contracts, pest control providers must have national footprints and 24/7 availability. Only four firms (Rollins, Terminix, Rentokil, and Ecolab) can compete for these national contracts.
Commercial pest control is a necessity. Regulators require firms to have pest control in-place and the potential fallout from a customer discovering a pest, termite, or cockroach in a place of business is damaging to a firm’s brand image. This necessity creates demand inelasticity, providing pest control firms with incredible pricing power. Indeed, the contracts are lucrative. For example, one large hotel (1,700 rooms) paid Rollins $35,000/month for its services, spending $15,000/month on pest control and $20,0000/month on bed bug services. With one or two technicians assigned to this project and minimal travel costs, the result is a high return on capital.
Assuming the Terminix acquisition clears without any significant antitrust hurdles, the number of national pest control firms will shrink down to three (Rentokil, Rollins, Ecolab). The remaining competitors will benefit from strong pricing power and potentially increased customer retention rates (as a result of fewer viable alternatives).
The competitive dynamics may also change. For instance, Ecolab wins certain contracts because they can attach hygiene to pest control services. Rollins and Terminix don’t have this capability, but Rentokil does. The growth in Rentokil, a formidable competitor at the national level, may cause Ecolab to lose certain commercial contracts upon renewal because Rentokil will be able to service contracts involving hygiene on a pro forma basis.
Rollins will benefit from the merger since they can promote the stability of their business to national account customers. They will benefit from a lower level of competition at the national level and competitors distracted while integrating their merger.
Unfortunately, the reduced number of national pest firms may draw the ire of the DOJ. There is a possibility that Rentokil will need to divest Terminix’s commercial operations, because of antitrust concerns. Rollins and Ecolab cannot acquire the commercial arm, meaning Anticimex (a European strategic) or the regional, private-equity backed players (Massey, Arrow) could enter the segment. These firms lack national infrastructure to service the accounts on a stand-alone basis, so a few of them would need to form a consortium to service these accounts.
Comparison of the 3 largest players
Terminix has one of the strongest brand names in pest control. Yet, the company is a mess. Organic growth has been a paltry 2-3% per annum over the past three years, with a growth rate less than half of Rollins. The industry standard is to operate with 50%+ gross margins. Anything less is trouble. Terminix is operating on 42% gross margins. While part of the underperformance is attributable to specific factors, such as Termite damage claims (~200bps of headwind), much of the operational underperformance is attributable to turnover at the leadership level, an unprofessional commercial offering, and a poor company culture.
ServiceMaster, its former parent, chronically under-invested in the business. This underinvestment culminated in future issues, similar to a house with a weak foundation (or worse, termites). For instance, ServiceMaster failed to invest in adequate training and billing software, which resulted in Terminix losing a major contract with Walgreens within eight months of signing. Terminix did not get paid since they failed to meet basic service-level requirements (e.g., technicians not showing up on time, technicians not checking in, and major billing issues).
After the separation from ServiceMaster, Terminix’s leadership team was effectively a revolving door, with various executives trying to improve the business to meet industry standards. Most of these attempts failed, for various reasons. Some executives refused to move to Memphis (where the company is headquartered) and failed to steer the business remotely. Others lacked expertise in commercial pest control (Terminix’s main area of weakness), while others lacked expertise in pest control (the commercial folks brought over from Waste Management and such). Ultimately, these failed efforts resulted in employees defaulting to the status quo. For example, Terminix is still operating on a DOS system (an old-school software with green font and a black background) and many workflows are reportedly still done with pen-and-paper.
Under Brett Ponton’s leadership, the company is tackling some of these issues, recently working through a technician shortage, reducing technician turnover through more intense training, and restructuring commercial compensation to align with recurring contracts (instead of one-time sales). Terminix’ back office is already working with Rentokil on pre-integration, which will make the transition a bit easier. While an integration and successful turnaround will not be easy, the benefits of success will be tremendous.
In the late-2000’s, Rentokil set out to become the largest global player in pest control. To achieve this, they would need to capture a large share in the US (the world’s largest market). Rentokil, led by Andy Ransom (who has been described by former employees as an ‘M&A cowboy’), set out on an ambitious acquisition strategy. They began rolling up regional players and paying robust multiples (sometimes twice as much as Rollins and Terminix were willing to pay). The land grab was ultimately successful, creating the third-largest player in the market.
Rentokil has a strong brand name in the UK., with brand recognition on par with Coca-Cola and a storied history with over 100 years of service. The company has achieved mid-to-high single-digit organic revenue growth, with the balance coming from M&A. Rentokil targets 4.5-6.5% organic growth and 12-15%+ IRRs within its pest control business, 4-6% organic growth and 15-20% IRRs within its hygiene business, and 3-4% organic growth and 20%+ IRRs from workwear. The company operates in over 80 countries through a partially decentralized model (single-country management teams) with combined back-office functions (underpinning common systems and processes such as route optimization and customer satisfaction surveys).
The Terminix acquisition caught many UK-based institutional investors off-guard. Investors grew accustomed to Rentokil’s traditional formula of achieving stable results through a mix of bolt-on acquisitions and organic growth. However, the transaction has likely been simmering for several years. It wasn’t until Terminix’s share price sold-off in late-November/early-December when Rentokil finally had the opportunity to achieve its U.S. ambitions at a reasonable price.
The combination of Terminix and Rentokil will be formidable. Rentokil can address the operational deficiencies at Terminix and flex its commercial strength. The leader of Rentokil North America, John Myers, has been with Rentokil since 2008, providing the stability Terminix needs. Rentokil can provide the polish and professionalism Terminix lacks with its approach to commercial accounts.
Rentokil has accelerated their M&A strategy, front-end loading what would have been well over a decade of bolt-on M&A activity. The headline purchase price of 3.6x revenue and 19x EBITDA seem rich, but the EBITDA multiple comes down to 13x EBITDA after accounting for the announced $150mm of announced synergies (7% of target revenues). The transaction is beneficial to Rentokil, enabling scale and density in one fell swoop.
The most relevant comparable transaction is Rollins’ acquisition of Clark Pest Control for $354mm in January 2019 (excluding the value of the real estate portfolio, which was later divested). Rollins paid 2.6x LTM revenue and 100x LTM P/E. However, we saw earlier that Clark Pest Control was burdened by large fixed costs and was only earning a 2% operating margin. If we assume that Rollins was (reasonably) able to increase profitability to 18% operating margin (consistent with its achieved results), they paid an effective 14.5x EBIT. Not bad considering Rollins trades for 42x NOPAT.
Viewed through the lens of precedent transactions and publicly-traded comparables, the multiples paid for Terminix seem quite attractive. While M&A multiples in the pest industry have crept up over the past few years, with the U.S. & European strategics and private equity players consolidating the space, 19x EBITDA should be the new public benchmark for the industry and may set a ceiling for multiples in the near-term.
Rentokil has a tremendous opportunity ahead of them. Terminix is the ideal turnaround candidate. It has a great brand name, but is suffering from years of operational mismanagement. There is a 10 percentage point gross margin differential between Rollins (52% GM) and Terminix (42% GM). Putting aside some of the structural differences (Rollins has a higher commercial mix & Terminix is dealing with termite claims resulting in 200bps margin headwind), the opportunity for gross margin improvement at Terminix is surely substantial.
Rentokil’s margins vary significantly by region, with 12% operating margins in the Southeast and Western states, to software-like operating margins of 22% in the Northeast.
The Northeast is the most mature market in the US and is generally more densely populated than the Southeast and Western markets. Rentokil was able to build its density through its $142mm acquisition of Ehrlich in 2006 (1.1x revenue; 7x EBITDA).
Terminix has a large presence in North Carolina (51 branches), Texas (36 branches), California (34 branches), South Carolina (33 branches), and Florida (31 branches), providing an opportunity for Rentokil to improve margins in the Southeast and Western territories with increased route density.
The combined company will certainly face competition in these regions. Rollins is particularly strong in the Southeast/California and Massey is well-fortified in Florida. However, Rentokil’s achieved results in the U.S. NE provides a promising data point, with the potential for 10 percentage points of operating margin improvement in a blue-sky scenario.
For comparative purposes, Cintas' $2.2bn acquisition of G&K was a slow and steady process. They were very careful to rebrand and re-route, but they were able to close branches over time and extract immense value. The acquisition raised gross margins by 300 basis points from rerouting and operational improvements. The benefits of integrating corporate infrastructure lowered G&A as a percentage of sales, resulting in another EBITDA margin uplift of 200-300bps. Net-net, Cintas was able to achieve a 500-600bps advantage relative to competitors from the size and density benefits. Rentokil’s leadership recognizes this.
Similarly, Waste Connections’ $4bn acquisition of Progressive is an encouraging datapoint. Progressive was an operational mess with high turnover, poor safety, and a growth-at-any-cost mindset. Within the first year, WCN cut unsafe routes, pruned unprofitable contracts, raised prices, and reinvested in trucks and maintenance. This boosted driver morale, reduced turnover, and resulted in higher productivity and uptime. Within the first year, the low-single digit EBITDA margins of some markets were brought up to 18%-21%. Even as WCN purposefully shrank Progressive’s revenue from ~$2bn to $1.8bn, they lifted EBITDA from $480mn to $600mn and doubled free cash flow.
Rentokil has the opportunity to introduce stability at the leadership-level. Even a mediocre leader can be fine as long as it introduces stability and employees know what to expect. While John Myers views himself as an operator, the reality is that he is more capable at M&A and merger-integration. His skills will be useful as Rentokil integrates Terminix over the next three years. John is likely entering the final stages of his career, so after the acquisition is done, Rentokil will likely look for another CEO to lead the combined company. Eric Rimiller, the COO of Rentokil North America, is likely next in line. However, it is possible that a leader from Terminix could take the helm. None of these outcomes are particularly inspiring. While John is the right person to lead the merger integration, Rentokil will need a transformational leader with a very strong operational and commercial background in pest control. Either way, the decision is several years away. The onus is on Rentokil’s leadership team to execute the merger integration and ensure they don’t get distracted.
Rollins is generally viewed as the best operator out of the three publicly listed companies. The company benefits from stable leadership at the top, with minimal executive churn, and a large backlog of new executives to promote from within. Rollins is well known for its comprehensive training. They have a training center in Atlanta, where they built a full house with the walls exposed and let termites infest the house, providing real-world training for technicians. Comprehensive training also manifests into more efficient sales and service teams, flowing through to sales and cost efficiencies.
The reason Rollins will win over its competitors is due to extensive background checks, training, education, reputation, and having a dozen entomologists on staff. If a technician can't solve an issue, they will say: "Okay, we sealed up holes, we've done everything that we can do, why is this still a rat infestation here, what is happening." And then Rollins will bring in the scientists. And they come in, they spend a week there, and they do a complete analysis of the property and figure it out, and then basically solve it. And that's done for them at no charge.
While all these ‘soft’ qualitative issues seem relatively insignificant, when combined they create a superior customer value proposition. Operational excellence is baked into Rollins’ culture. While culture is a very difficult thing to change, Rentokil can act as a change agent to implement a lot of these qualitative factors at Terminix after the merger integration to transform the company from good to great.
State of the industry
The two biggest cost inputs for pest control firms are labor and fuel. Both are increasing due to supply-side inflationary pressures and the war in Ukraine. While high inflation will persist over the next few years, its intensity may decrease over the next 18 months as supply-chain issues subside and the Federal Reserve raises interest rates.
With labor forces of +10,000 employees, wage inflation will certainly hit the P&L of the largest pest control firms this year and erode operating leverage. The industry is facing labor shortages stemming from a tight labor market. Rentokil and Terminix typically pay less than Rollins, so they will likely need to increase wages to attract and retain technicians. Terminix is feeling the brunt of this, with labor shortages as earlier as Q3 2021, although they are taking steps to combat the shortage. Pest control firms look to hire laborers away from the construction industry during a downturn. These are high-quality workers with a strong work ethic. Although early, we are seeing preliminary signs of a slowdown in the US housing market, which may help pest control firms to attract new talent.
Fuel cost, while important, is a lesser concern. Fuel accounts for a smaller portion of overall costs (around 10% of total). The industry is focusing on route optimization to combat rising gasoline prices. Some firms, such as Terminix, hedge out their fuel exposure, making it relatively a non-issue (aside from hedges rolling at a higher rate).
Counterintuitively, the fact that the prices of raw materials go up or down does not affect an industry’s margins in the long-term. Of course, factors such as inflation and fuel expense matter for near-term profitability. However, if barriers to entry remain unchanged, long-term industry margins will remain intact. No matter how much costs fluctuate, prices simply reflect the new level of costs.
Indeed, the industry is pushing through its most aggressive price hikes in years as a direct response to inflationary pressures. The PCO M&A Specialists Pest Index, a proxy for small cap pest control firms, has registered double digit gains of 20% y/y in February and 13% y/y in March as several firms pushed through above-average price increases in Q1. We also saw larger firms such as Rollins push through early and more-aggressive price than normal in Q1 (vs. usual Q2).
A helpful exercise is to predict where we expect these businesses will be in 18 months. While most forecasts prove hopelessly incorrect (ours included), the exercise is helpful in valuing the business as they will be, not as they are today. We will then track the results to see how close the reality is to our prediction.
Our 18-month prediction is as follows:
Rollins continues to execute and raise prices. They pick up +50-100bps of incremental organic growth by acquiring some of Rentokil/Terminix’s customers.
Rentokil will have closed the Terminix merger with ~12 months of integration underway. While the merger clears antitrust hurdles, there is a possibility the DOJ raises concerns about Terminix’s commercial business and forces Rentokil to find an alternate buyer.
Rentokil will almost certainly find some skeletons in the closet at Terminix, which will result in a few messy quarters (reorganization and restructuring charges) but the corporate synergies will begin to accelerate growth. Terminix will be merging into Rentokil as a relatively healthier company (stemming from changes currently underway), with headwinds from the termite damage claims easing.
Merger integration and international growth will be the focus of quarterly earnings calls. The stock may not initially find a natural buyer, with conservative UK investors taking a wait-and-see approach and US-focused funds shying away (given its a UK-based company with international operations). However, with operating margins improving, Rentokil will begin to screen attractively and attract investors looking for the next compounder.
We see Rollins delivering a 6-8% IRR over the next 3-5 years, driven by 6-7% organic revenue growth and an additional 2-3% inorganic revenue growth stemming from M&A activity, 50% near-term gross margins scaling up to 52% gross margins over the next decade. While the IRR is low, this is commensurate with a bond-like risk profile (significantly less risky than the market).
We see Rentokil delivering a 10-15% IRR over the next 3-5 years, driven by 4-5% organic revenue growth and an additional 6-8% of inorganic revenue growth stemming from the acquisition of Terminix and small bolt-on acquisitions, and operating margin expansion to 20% assisted by higher regional density and positive mix shift. This is an attractive IRR with low commensurate risk (albeit, higher risk than Rollins as a result of merger integration risk).
Multiple compression: The multiples for high-quality (high ROIC) firms have expanded rapidly over the past decade, assisted by ultra-loose monetary policy. Rollins trades at a lofty 42x NOPAT multiple. There is a risk that trading multiples for high-quality businesses continue to compress as the Federal Reserve raises interest rates. We believe the defensive characteristics of Rollins business model and predictability of growth (especially through recessionary periods) will allow it to retain its premium valuation.
Merger integration risk: The biggest risk associated with the Terminix acquisition, or any large acquisition, is the risk of a failed integration or recurring cash restructuring costs that eat away at operating income. We believe this risk is largely mitigated by Rentokil’s expertise in integrating US M&A targets over the past two decades. In particular, the leadership team (Andy Ransom and John Myers) are well-seasoned executives with respect to M&A integration.
Regulatory risk: The transaction may attract the ire of the DOJ, especially at the national accounts level. If the regulators were to block the deal or otherwise force Rentokil to walk away, a lot of the positive tailwinds discussed in this report would dissipate. Despite increasing rhetoric from regulators surrounding tackling market concentration, we believe they have much bigger fish to fry (e.g., Big Tech, Big Box Retailers) that will be more politically favorable to tackle than the boring pest industry.
The information contained in this report is provided for informational purposes only and is not intended as an offer or solicitation of an offer for the purchase or sale of any security and should not be relied upon in evaluating the merits of investing in any securities. The author has compiled data from publicly available sources believed to be accurate but makes no representations or warranties to the completeness or accuracy of this data and is under no obligation to update these materials after such date. These materials are not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use is contrary to local law or regulation.