ServiceMaster spun-off their home warranty segment, principally the American Home Shield brand, under the new corporate guise “frontdoor, inc.” back in October of 2018. This spin did not garner a lot of attention from the value investing community as both the RemainCo (SERV) and the NewCo (FTDR) were easily discernible high-quality businesses and both parts were going to be about the same size business at about $1.5 - $2 billion in revenue. In other words, not particularly fertile grounds for a mispricing and not what most event-driven value investors look for. Now that we’re about 7 months post-spin, with both entities trading at high-teens EBITDA multiples, they both appear fully valued by my eye. There was quite a bit of volatility in between, as Q4 proved to be a particularly hostile environment for spin-offs of all shapes and sizes so it was possible to pick both up at bargain prices (for the quality of the businesses) if you were paying close enough attention - not so much at today’s prices.
So Why Am I Looking?
Despite ServiceMaster and frontdoor not appearing quantitatively cheap on valuation metrics, the reason I think it’s worth studying up on both companies is fairly simple. Both, at first glance, appear to be extremely attractive companies as they each dominate their respective markets and possess especially compelling corporate-level economics. I’ll go over the multitude of reasons it appears to me ServiceMaster is an above-average business in this write-up. Furthermore, it certainly does not take neck-breaking, earth-shattering primary analysis to ascertain that we’re in the late stages of the current cycle. As such, now seems as good a time as any to be adding quality-type businesses trading at quality-type business prices in order to capture the opportunity if a broader market sell-off emerges. As such, let’s start with ServiceMaster.
Overview - The Company Has Been Around A Long, Long Time
ServiceMaster has been around since the late 1930s. Granted, this is somewhat in name only as the company has acquired and divested many businesses over the ensuing decades; although, the business has always operated in the cleaning residential services industry. The company was originally founded as a mothproofing business by Marion Wade - a minor league baseball player at the time. The company quickly switched gears and got into the carpet cleaning business in the 1930s. ServiceMaster experienced a good deal of success throughout that decade and began franchising its brand in the 1940s for residential and on-site carpet cleaning. Throughout the 1960s and 1970s - the era which the ServiceMaster brand really become a household name - ServiceMaster expanded into hospital maintenance. By the mid-1970s ServiceMaster had sold in excess of 1,000 franchise licenses in its consumer cleaning division, and the Company’s health care division had won cleaning contracts with more than 460 hospitals and was growing rapidly. By the mid-1980s with hospitals reducing their budgets to implement cost controls as well as government regulations making it a continually less appealing market to operate in, ServiceMaster’s main source of growth and earnings, the health care sector, began to suffer. This coincided with a change in management which ultimately led to a deterioration of the Company’s core tenets of management such as fiscal responsibility.
Post-1980s as the Company saw the writing on the wall with their main operations facing secular headwinds, the new Management began empire building. As the original management team eschewed financial leverage and preferred a conservatively financed enterprise, new management used leverage liberally to acquire unrelated businesses in different markets to “diversify” themselves. Many of these acquisitions made little sense as they ranged from a company that marketed office machines and financial services to doctors and dentists, to a cafeteria business serving educational facilities. This seemingly random use of shareholder capital for new acquisitions would continue into the 90s. However, one acquisition would prove to stand out from among the rest as ServiceMaster announced in November of 1986 that they had agreed to acquire the country’s second largest pest control business, Terminix International. With 165 company-owned locations in addition to 150 franchisee branches, Terminix had approximately $150 million in revenue. ServiceMaster made the acquisition for $165 million.
The Company would continue to make more acquisitions and take on more debt to finance them straight through the end of the millennium. However, by the turn of the century the struggles the company faced as it had the unenviable task of incorporating its hodgepodge of unrelated businesses became evident. Profits fell and the stock tanked. They eventually sold themselves to a private equity firm in 2007 for $4.7 billion (12x EBITDA). ServiceMaster became public again in 2014 at ~$17/share with about 4.5 turns of EBITDA in debt (note: don’t run away yet - they’ve paid down a lot of it) and the PE firm has fully exited the position.
ServiceMaster has two main businesses:
1) Terminix; which specializes in termite prevention & pest control. They provide their pest control services to both households and businesses. Additionally, about 5% of this segment’s revenue comes from selling physical pest control products. The Terminix brand represents 87% of total revenue.
2) ServiceMaster Brands (previously known as Franchise Brands); which are the Company’s cleaning and restoration brands. As you can tell from the former name of this segment, these brands are ServiceMaster’s franchise brands - making up the remaining 13% of revenue.
ServiceMaster has 8,000 company-owned locations (310 of which are allocated to Terminix), 10,700 company associates, 34,000 employees under their licensed franchisees and earned 97% of revenue from within the United States. On net, I believe the evidence depicts ServiceMaster to be a company that is recession-resistant, highly cash generative, and is poised to continue growing both organically and by further consolidating their industry. But before we talk about the quality of the businesses, we have to first dissect ServiceMaster further - as there are a lot of moving parts here.
Terminix currently serves approximately 2.8 million customers nationwide. As such, Terminix is one of the main competitors in the nation. There are three ways we can further break Terminix down. How to think about the Terminix business is by the three end markets they serve: Residential Pest Control, Commercial Pest Control, and Termite & Home Services (which also has a commercial and residential side of operations). Think of the Pest control side as the segment that deals with bedbugs, mosquitoes, cockroaches, wood-destroying ants, etc. while the Termite segment deals with, you guessed it, termites. The share of revenue is broken down as follows:
● Residential & Commercial Pest Control: 59%
● Termite and Home Services: 36%
● Other (selling products, etc.): 5%
Residential consists of serving family households and stands at 67% of the Pest segment revenue while Commercial serves businesses and brought in 33% of the Pest segment revenue in 2018. Close to 95% of Termite and Home Services revenue was earned from Residential, while the remaining minority was attributable to Commercial. Residential Termite is their flagship business as they, in the past, mainly focused on serving this sector. ServiceMaster’s historical focus on the rural market is demonstrated by the fact that they are #1 in the residential sector and #4 commercially, as determined by customer-level revenue.
The Termite segment maintains an especially robust retention rate of customers, as contracts are generally signed in excess of one year. The contracts are multi-year in nature as the Company is installing various traps and other deterrents in order to kill/exterminate wildlife. Further, an additional part of their termite services includes insulation services and crawlspace encapsulation. The annual report describes the process as “installation of a protective liquid barrier or bait stations surrounding the home.” The pricing of the Termite products is in such a way that customers pay substantially more in the first year then they do in the years following. In large part, this is because in the first year ServiceMaster has to incur substantial costs when first setting the equipment in place whereas in following years the team only has to maintain routine check-ups. Approximately 80% of the Termite Segment’s revenue came solely from these renewal-option contracts. This gives the company an incredibly stable base of recurring revenue as well as multi-year top-line revenue visibility. Despite being the flagship business, the Termite Segment, as of late, has been the sole underperforming segment. Of the three segments within Terminix, Termite is the only one which has seen declining growth rates. Gross margins for the entire segment typically run in the 45% range while EBITDA margins come to 20%.
Very little of ServiceMaster’s value comes from this segment. As I’ve already said, this segment contributes around 13% of total revenue. The brands that make up this segment are: ServiceMaster Restore (restoration), ServiceMaster Clean (commercial cleaning), Merry Maids (residential cleaning), Furniture Medic (cabinet and furniture repair) and AmeriSpec (home inspection). All seem to do fine in their respective industries. Together, these brands brought in revenue of $244 million and EBITDA of $89 million in 2018. Despite being small and offering zero growth, this is an appealing source of earnings for the company. Revenue earned are in large part royalty fees paid to ServiceMaster by the franchisees. The dynamics of the relationship are typical: ServiceMaster provides the infrastructure and brand name while the franchisees run the actual business. This translates to recurring high-margin revenue for ServiceMaster. EBITDA margins remain resilient at the high-30s level.
“What I’ve found here is that through the downturn in the economy … basically the team was able to hold revenue constant and improve earnings and cash flow in a very challenging environment. … If we lose a customer it’s because we made a mistake. It’s not the economy. It’s not the weather. It’s that we didn’t deliver on our promise. We didn’t meet our expectation. The economy has not hurt us dramatically.” - Hank Mullany (former CEO of ServiceMaster as quoted in February 2011)
ServiceMaster is a company with meaningful pricing power .
Above I’ve highlighted two extremely attractive aspects inherent with ServiceMaster’s business model. The first is that the business appears to be extremely recession resistant. Throughout the Great Financial Crisis, the Company’s revenue remained relatively flat - only decreasing <1% in 2009 from its 2008 level. In addition to the company not shrinking its top line, EBITDA only fell 5% year over year in 2009, only to get back above the 2008 level in 2010. Conceptually, this makes a lot of sense. Given the nature of the Terminix business model, it doesn’t appear to me that this would be a highly discretionary product. Coupled with extremely high retention rates (disclosed in prior years 85%+) and the corporate-level results match any reasonable intuition of the product-level economics.
Furthermore, SERV maintains a dominant market position in an otherwise fragmented market. In an industry with >20,000 companies, Terminix captures over 21% of the market as measured by customer-level revenue. Terminix’s only true competitors at Rollins at 19% market share, Rentokil with 7%, and Ecolab maintaining a 5% position. While the case can be made that Terminix has seen stiffer competition in recent years as peers have been able to achieve higher organic growth rates, it’s important to realize just how sticky a customer is once they have chosen a pest control company. In 2018, under new management, Terminix reached out to former customers that had left them to find out why they had left. Of those who left, an incredibly small minority did so because of price (see chart above). When you add the qualitative aspects described herein with respect to both pricing power and the business being recession-resistant, you would expect to find evidence of this quantitatively in the financial statements. And that’s exactly what we do find with SERV.
Per the 2018 10-K, ServiceMaster had $5 billion in assets and $2.2 billion in equity. Now, both of these are misleading as the vast majority of ServiceMaster’s book value comes from intangibles assets like goodwill and various other intangibles. These items might be important to us if we’re trying to gage how well management has been allocating capital, but these are largely irrelevant to you and me right now.
Let’s look at Invested Capital (or Net Tangible Assets, if you will).
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