Featuring Jay Van Sciver
Published on: April 11th, 2019 • Duration: 12 minutes • Asset Class: Equities • Topic: Trading, ValuationJay Van Sciver, sector head of industrials & materials at Hedgeye, makes his Real Vision debut on “Trade Ideas.” Sciver highlights one particular short idea: Rollins, the pest control company. He analyzes the bear case, notes the deteriorating fundamentals and discusses how to take advantage of the opportunity in this interview with Jake Merl. Filmed on April 10, 2019.
JAKE MERL: Welcome to Trade Ideas. I'm Jake Merl sitting down with Jay Van Sciver, sector head of industrials and materials at Hedgeye. Jay, great to have you on the show.
JAY VAN SCIVER: Great. Thank you so much for having me today.
JAKE MERL: So this is your first Real Vision interview. And we've actually had both Keith McCullough and Howard Penny of Hedgeye on before. So it's great to finally sit down with you. We've been trying to get you on the show for quite some time.
And today, before we actually get into your trade, can you please go over your background, who you are, and what you do?
JAY VAN SCIVER: Sure, yeah, I'm the industrials and materials sector head at Hedgeye. I am a longtime buy-sider. I come from a long-only, long-short proprietary trading background. It's only time I've ever been on the sell side.
I cover industrials and materials, which includes Caterpillar, Deere, Air Products, names like that. We are on the both long and short sides. So we have best ideas on both sides of the book. And I think we are unique in that we're independent. We really try and generate alpha. We're extremely data-oriented. We focus a lot on developing our own data and staying within our own process.
JAKE MERL: So Jay, you must be a pretty humble guy, because you forgot to mention that you're one of the most well-known Tesla bears out there. You've done a lot of work on the company. But we're going to save that segment for next week. And today, we're going to be talking about a different short idea, and that's Rollins. Can you please talk about Rollins, what the company does, who they are, and then why you're going short?
JAY VAN SCIVER: Sure. So Rollins is the Orkin man. They compete with Terminix, Rentokil, some other large pest control providers. And the reason that we're bearish on it is that it is a severely overvalued stock that embeds very high earnings growth expectations. So basically there's an expectation that margins are going to expand for a very long time at Rollins. And the reality is that they are benefiting from a couple of anomalies.
One, after the financial crisis, they were underpricing. They did a great Boston Consulting Group study that you can find on the BCG website that shows that they basically ratcheted price up for the next five, six years. And that allowed them to expand margins. But you don't get to raise prices in perpetuity. You can adjust from below market to what we think is now actually really extreme above market pricing.
And we have some evidence for that. For example, the customer growth, if you actually look at their own disclosures that they don't put out too clearly, but they do, in their presentations, say how many customers they have, they have actually not grown their customer base in the last, say, four or five years, despite doing a number of acquisitions. So they're basically acquiring customers as they overprice and generate churn on the existing customer side.
So when you look at, for example, where Lyft is trading at about 5 and 1/2 times next year's sales and you look at where Rollins is trading, which is of at over 6 times next year's estimated sales, it's pretty clear that there's some extreme growth baked in there. And you really need that perpetual margin expansion, which we don't think will recur.
JAKE MERL: So you're saying they're running out of runway here?
JAY VAN SCIVER: Yeah. And they actually ran out of runway, from what we can, tell a bit earlier. But they've benefited from abnormally warm weather the last couple of years, particularly in the Southeast, where they have their strongest franchise.
JAKE MERL: So when did you first come across this name? And what were some of the major red flags that you first noticed?
JAY VAN SCIVER: Well, I've covered the space for a long time. I was actually at Servicemaster, which owns Terminix, back before it went private in the early aughts, not to date myself. But the reality is that it's just something we launched on in December of last year. So it's a relatively new idea.
One thing we do try and do is we try to be a little early in our timing to give our clients the ability to actually act on what we put out. Like, if I added it as a best idea or whatever on the all-time high, that doesn't really get us anywhere. We try and be a little early to anticipate what's next. And as we go through this year, this will be the first time you've had an abnormally cold winter in the Southeast. You had snow in Louisiana, Atlanta, places like that.
It is also a year where you're going to have an increased push from a new competitor in this industry, which is Rentokil. So increasingly, we're seeing competitive entry into the business. And we think this is the year that has the toughest comps. So earnings growth is going to slow for Rollins this year. It almost has to, because the comps are so difficult.
JAKE MERL: So even though you first recommended it in December, you think now would be a good time to get involved?
JAY VAN SCIVER: Yeah, so we had it is a best idea. And it promptly collapsed. So one problem with this job is you end up pounding the table on all the stuff that makes you look bad. So we don't make a big deal, or we try not to make a big deal to our institutional clients, wave our arms around when things actually go down. But when they pop back up, like Rollins just did, this is something that we then come out and present. We did it at a shorts conference hosted by Hedgeye, The Analyst, and some other firms last week.
In general, you want to short things that are up if you can, particularly if they have a little bit of short interest in them already. Short squeezes is the strategy we actually use in Tesla. Rollins is less crowded, but it is a name where there is some short interest. So you want to take advantage of abnormal upside volatility.
JAKE MERL: What is the short interest? What does that look like?
JAY VAN SCIVER: It's around 10% of the float, but about half the float is controlled by the Rollins family. In general, from a valuation standpoint, the fact that about half the company is controlled-- the company itself is controlled by the Rollins family would be a reason for it to have a discount. That isn't something that would typically result in a 60X earnings multiple.
It has a board, the composition of which, great governance is not made. It is a very inside board. They're on all these other boards together. It also looks a little bit like a retirement community. They're all over 70, 75 years old. In general, when you look at the short interest, the DES on Bloomberg, you're going to see 10%. But just keep in mind, that's a mid-single digit percent of the total float or of the total share count.
JAKE MERL: So how much downside do you actually see for the stock?
JAY VAN SCIVER: Our time horizon is about a year out, as they go through difficult comps. And the key metric is organic growth slowing and earnings growth slowing. Usually the stocks follow earnings growth, second derivative, right? The downside, if you DCF it, so Rollins is the big boy in the industry. It's unlikely to be a strategic acquisition. It trades at 60X, so it's probably not going private with debt. That would be a good way to create some negative value.
So basically, if you go through in the DCF, which I think is the right valuation approach for that company, you get something between 15 and 22 on a stock that's trading around 40. Does it have to trade my fair value? No, but it is, at 60X, ludicrously overvalued. At 25X, you could argue it's overvalued. But we certainly wouldn't be interested there.
JAKE MERL: And you're not worried it could get more overvalued? Would you have a stop loss for this trade?
JAY VAN SCIVER: Well, we don't have a position. So I don't have a stop. I haven't checked how active the options market is. But the reality is that there's always risk in shorting. We could certainly be wrong. But from a macro perspective, we're in a decelerating growth environment. So we're seeing GDP comp not necessarily down, but it's just decelerating.
So one thing we do at Hedgeye, I think, really well and we've gotten better at is tracking real time data, things that allow us to tell, in real time, whether we're falling out of bed. So we can track things like weather trends, web traffic, some other things in Rollins that tell us basically it's having a difficult quarter. It's not necessarily blowing up.
They also missed last quarter. So estimates were too high last quarter. People say it's because they report quality earnings or something like that. But, OK, they missed, right? So I think we're in a situation in which his company is already starting to stumble and disappoint.
A lot of the metrics we track in real time suggest that's going to continue. One of the difficulties would be, I guess, is if our metrics were telling us that it weren't going to be off or disappointing. But currently, everything seems to be tracking in line with what we expect.
JAKE MERL: So if that were to happen, you would reassess your thesis?
JAY VAN SCIVER: Yeah, we would get out of the way. So for example, on Tesla, we track test drives. We track used prices. We track new prices. We track inventories. We track a lot of things in real time that allow us to tell if we're on the right track. And we do some very similar stuff for Rollins.
JAKE MERL: So Jay, I know you're bearish on this stock. But what about the overall industry? What are you seeing there?
JAY VAN SCIVER: So what we're seeing is competitive intensity increase. And what's interesting about this industry is, aside for the fact that it's almost nothing. It doesn't really grow. And it's pest control. Is that it does have a history of doing this exact thing it's doing now, where margins increase, competitors are attracted, because there's basically no barrier to entry, at least not much of a capital barrier to entry.
So one of the digs we hear back is that, well, Rollins has very high return on capital. And it's like, well, so does a lawyer. It's not a capital intensive business. It's a guy going around spraying your house.
And if we look back to the '70s in this industry, we actually show Rollins margins going back to the '60s and '70s. It's been around for a long time. The industry had very high margins. And it attracted competitors, Waste Management being the most well known. Margins subsequently fall quite a bit. Waste Management runs away.
And when we look at Rentokil being attracted to the North American market, because it's structurally more favorable, there's an element to that that's a little bit ridiculous. The other thing we hear a lot from longs is that people are in it because of climate change, that they think that as the planet gets warmer, there are going to be more pests and therefore, we're going to have more need for pest control, which is interesting, because it's like the contrapositive of a Trump tweet saying it's cold outside.
Global warming isn't going to work on first quarter earnings, most likely. That is possible, I guess. I'm not a climate change expert. But it seems a little bit far-fetched, given the state of the science. And the other problem with that thesis is that mostly, climate change is bad for life on the planet, in so far as you are not a global warming skeptic. I'm not. But if we look at flying insect populations, mostly they're decreased not increased in the face of sort of environmental degradation.
JAKE MERL: Well, Jay, that was great. Thanks so much for joining us.
JAY VAN SCIVER: Great. Thank you for having me.
JAKE MERL: So Jay is bearish on Rollins. Specifically, he likes shorting ticker symbol ROL at current levels and thinks the stock could reach as low as $20 over the next eight months. That was Jay Van Sciver of Hedgeye. And for RealVision, I'm Jake Merl.