|Shares Out. (in M):||36||P/E||0||0|
|Market Cap (in $M):||1,016||P/FCF||0||0|
|Net Debt (in $M):||276||EBIT||0||0|
FirstService (“FSV”) is the most compelling idea I have seen in some time. I believe it is conservatively worth $45 for a 60% increase on today’s price or $54 in 2018 + $7.70 in free cash flow for a total return of 118% and an IRR of over 25%. (CAD price today of $56, CAD total return $76.75)
It is one of the rare situations where I love the business, I love the management team, I love the price, and due to FSV’s long runway of organic and acquisitive growth, dominant competitive position, owner-operator management team, and essential service I believe FSV will compound earnings for a long-time passed 2018 making it unlikely I sell at either of the above prices. FSV just separated from its commercial real estate arm and one the reasons the Chairman gave is – “FSV is a business you can take to the bank” (the other often cited reason is “FSV is a free cash flow machine.”)
FSV currently trades 7.5x ex cash 2018 earnings
FSV operates in two segments: it is the largest US residential property manager and it is the master franchisor and operator of a variety of leading home service brands.
I believe there are five identifiable reasons for why this opportunity exists:
1. FSV was just spun off from its commercial real-estate arm Colliers - however no Form 10-12b was required - keeping it off the radar of traditional spin-off hunters
2. FSV is headquartered in Canada and primarily trades on the TSX (average volume of 75k shares vs 16k on NASDAQ) even though its business is almost entirely in the United States (reporting currency is USD)
3. Margins are temporarily depressed in their residential segment for two reasons:
a. FSV is in the 2nd of a 3 year information technology and brand integration
b. In conjunction with the brand integration, FSV rolled out a new health plan for all its employees and faced an unexpected surge in 2014 healthcare costs–the business has historically operated between 8-10% EBITDA margins but were 5% in 2014. HOWEVER as of 1Q15 management has re-affirmed guidance of 6.5 to 7% in 2015 as healthcare costs are passed through this year and further expansion as the IT integration winds down in 2015 with a 2018 margin goal of over 8%
4. Under appreciated growth opportunities and operating leverage in their Brands business
5. GAAP accounting obscures economic earnings
I will address each of these issues in the various sections to follow.
Management team & culture
FSV was founded by Jay Hennick whose track record of creating value is truly astounding (albeit never written up on VIC). FSV has generated a 20% compounded annual after-tax returns to investors for over 20 years, and Colliers International, the RemainCo from old FSV, further highlights this fact. In 2004, they bought Colliers Macauly Nicolls, the largest affiliate of the Colliers network and over the past 10 years have grown the business into the third largest provider of commercial real estate services. Revenue has grown from $280 million to over $1.7 billion and EBITDA has expanded from $18 million to $160 million in 2014. Their original Collier’s stake was purchased for under $80 million and today Colliers has a market capitalization of over $1.6 billion.
FSV has been involved in and exited numerous other business lines since Hennick took the company public.
1. Chemlawn Canada sold to ServiceMaster generated a 24% after-tax IRR from 1991 to 2004
2. From 1995 to 2006, they operated a business process outsourcing segment that at sale generated an 18% after tax IRR for shareholders
3. In 2008, they sold their integrated security division to ADT generating a 22% after tax IRR over 15 years
4. From 2007 to 2013 they generated a mid-teens IRR on their Field Asset Services business.
Part of the reason why this business has never been written up may have to do with the above. Over the last decade the consolidated business has been in-flux. Not until now has the market had to independently value its two most stable and what I consider its crown jewel asset: the residential management platform.
Management has significant skin in the game with Hennick owning over 10% and the remainder of the management team owning another 10%. In conjunction with the spin, Hennick became Chairman and long-time COO Scott Patterson took over as CEO (he owns and has options to over 1 million shares) and Jeremy Rakusin, former VP of Strategy & Corporate Development with background as head of M&A at Raymond James, became CFO.
FSV has a de-centralized culture where local managers operate autonomously and are incentivized by retaining a minority stake in their operation. Their culture and acquisition style is apparent in this quote from their 2008 purchase of GVA Williams, a NYC commercial real estate services firm:
“We met with one person, Jay Hennick. We walked in, we sat down with Jay and right away there was chemistry…Jay has an entrepreneurial spirit in running a public company. FirstService has maybe 12 people up there running this organization. Five hours later, we basically shook hands to go into the next stage of negotiations”
FSV does the same with local property managers. Every time FSV purchases a residential services firm the operating team keeps a piece of the business. This hands off headquarter style has enabled the team to complete scores of acquisitions over the years, while also motivating performance at the operating level. This strategy, a de-centralized operating culture and “skin in the game” may sound familiar as it is not only how Buffet operates, but he also recently shared his thoughts on it in his latest annual letter:
“Larry and his dad, Cecil, spent 62 years building the group, following a strategy that made owner-partners of all local managers. Creating this mutuality of interests proved over and over to be a winner. Van Tuyl is now the fifth-largest automotive group in the country, with per-dealership sales figures that are outstanding.”
This mutuality of interests has long been a core principle of FSV and has enabled them to grow property management revenue over 4x in the last 10 years. For years management has highlighted the “FSV Way” which gives more depth to how they pursue, value, consummate acquisitions and manage their business. I highly recommend you read it (page I12 prospectus or a lot of the old annual reports).
While the term “outsiders” gets thrown around a lot recently – these guys, in the truest sense, embody those qualities and I am not sure one could partner with a better management team.
What they do
FSV Residential is “a manager of private residential communities in North America. Private residential communities include condominiums, cooperatives, homeowner associations… and a variety of other residential developments governed by common interest…(collectively referred to as "community associations"). Residents of community associations appoint or elect volunteer homeowner board members to oversee the operations of the community associations. The board may choose to hire a professional property manager like FirstService. In total, [they] manage over 1.6 million residential units in more than 7,000 community associations in 22 American states and 3 Canadian provinces”
FSV receives a management fee for “handling administrative property management functions on behalf of their community association clients, such as advising homeowner boards on matters relating to the operation of their communities, collecting monthly maintenance fees, sourcing and paying suppliers, preparing financial statements and contracting out support services” and receives additional fees for ancillary services “[such as] facility maintenance, janitorial, front-desk, swimming pool management, heating and air conditioning, energy advisory, commercial association management, concierge services, resale processing, sales, leasing, landscaping and pest control. In most markets [they] provide financial services (cash management and other transaction-related services, collections, specialized property insurance brokerage and energy retrofit financing) utilizing the scale of our operations to economically benefit clients.”
This is just an absolutely wonderful business. It is an essential service – I am as sure as I am of anything that my building will have a property manager over the next 10 years. 90% of the revenue is contractual and they have a 95% client retention rate. Furthermore, they are in an enviable position as the largest player in their industry, with a strengthening moat, and they require no capital to grow.
In FSV Brands, they operate two models. They are the master franchisor for 7 leading brands: Paul Davis Restoration, California Closets, CertaPro Painters, Service America, College Pro Painters, and Pillar to Post, and Floor Coverings International.
These cover a diverse range of property services. Paul Davis, with 370 franchisees, provides commercial restoration for the insurance industry; California Closets, has 86 franchisees, and delivers custom designed closet and home storage solutions; CertaPro Painters, with 350 franchisees, offers residential and commercial painting.
There are over 1,900 franchisees that generated in excess of $1.3 billion in system wide sales and $90 million in recurring franchise system royalties. 90% of revenues come from three mature systems – Paul Davis which does close to $700 million in system wide sales, CertaPro Painters which does over $300 million and California Closets which is around $300 million.
They also own & operate 11 California Closet “branchises” and the entire ServiceAmerica system. The ability to own & operate compliments their franchise operation as it allows them to develop best practices and selectively deploy capital at high returns by buying out under-performing locations.
Franchise models are well appreciated by the market and are historically good businesses. For FSV, each franchise brand is ranked #1 or #2 in its respective market, the franchise business requires minimal capital, has strong incremental margins, and is diversified across a number of end markets. There are a good set of public market comps for these business that trade around 14-17x EBITDA and 25x+ forward earnings (spoiler alert all of these comps are significantly more mature with less top-line growth and less room for margin expansion).
In residential services, FSV has a tremendous long-term opportunity that should enable the firm to grow revenue 10+% for a long-time. FSV is the largest residential property manager by a factor of three, yet they only have a 5% market share managing 1.6 of the estimated 36 million community association units. The number of units is growing at approximately 2% per year, while 30-40% of communities are still internally managed with a steady movement towards outsourcing.
As said on a recent conference call: “with Residential, [the] key component of our organic growth is contract wins from new development, from self-managed communities that are transitioning to professional management and market share gains. That will be in the high-single-digit range. It has been for several years. We expect that to continue.”
FSV’s moat is getting wider as they benefit from a reinforcing process where increases in scale drive cost savings they can deliver to their customers. Simply, the larger operating budget they control the greater purchasing power they have over their suppliers, which enables them to deliver lower costs to their clients which drives new client and market-share wins. As Hennick has said:
“But in general, we continue to win market share in that business. We're the largest by a factor of three, relative to our nearest competitor. And we're able to leverage that scale to save our clients money. And it's a compelling differentiator, and we will continue to win business as a result.” (2Q13 conference call)
90% of FSV’s revenue is the contractual management fee and the majority of these typically renew annually at a 95% rate. FSV has historically been able to adjust their contracts with CPI and pricing adds 1-2% of growth but is not historically used as growth mechanism but just to maintain margins. However, this should provide comfort that if there is inflation that it can be passed through.
The remainder of their revenue is ancillary services. FSV is currently only responsible for 10-15% of their clients annual $7 billion + spend. To understand what the opportunities are here you simply need to walk through a property’s operating budget. FSV helps provides staff for certain properties, underwrites insurance for over 3,000 communities, manages over $2.5 billion in average daily client deposits, facilitated over $3 billion in client loan transactions and has rolled out energy procurement solutions to over 600 high rise buildings. They operate the largest commercial swimming pool and recreational facility management business and recently launched a new service line focused on amenity management.
An important thing to note is that a very small part of their business is facilities management (a fancy word for hiring janitorial and front desk staff). I want to stress this is NOT a facilities management business for which there are many public competitors. Facility management is a major component of a property’s spend and provides a long growth runway for FSV but it is historically a much more competitive and lower margin business.
These are just some of the organic opportunities.
FSV Residential has also served as a platform to acquire local and regional property managers. There are over 8,000 local and regional firms, and due to their scale and M&A core competency they have been able to execute scores of tuck-ins. As individual owners of local and regional firms look to take capital out of their business they have a standing buyer in FSV. This Buffet-esque situation providers for fantastic returns on invested capital. The brand and IT integration to be discussed in the “Margin section” will further highlight how investment’s over last few years will enable them to accelerate their pace of acquisitions as they grow. Management believes acquisitive growth will be driven by volume as there are just not that many needle moving acquisitions relative to their current size. For example, management estimates that the second largest property manager is Associa based in North Texas with estimated revenues around $200 million and after them there is a significant drop-off.
When one add this up it is obvious to see how they have a tremendous runway for growth. For the last decade, they have talked about how they can grow 10+% organically and guess what? That’s what they have done – revenues in this segment have grown from just above $200 million in 2004 to a run-rate of $1 billion today. As far as the future growth they are saying the exact same thing:
“In our Residential Real Estate Services segment, revenues are expected to grow at a low double digit percentage rate in 2015 from continuing new business wins, strong client retention and the full year impact of acquisitions completed during 2014” (prospectus page K33)
Of all the companies I own, I am most confident that their service will be required and their moat will be larger 5, 10, 20 years from now.
The Brands group has an equally strong opportunity for organic growth. Paul Davis, CertaPro, and California Closets compete in respectively $60, $40, and $4 billion markets where they are either the number 1 or 2 player but have a market share on average of 1% (4% in California Closets).
For a long time Brands was the third child of old FSV and until 2012 was managed somewhat autonomously. They had contemplated exiting this business but decided to re-focus management’s attention to it and bought out the old management’s team non-controlling interest. Now as a core part of new FSV it will have the appropriate resources behind it.
Looking at the franchise group on a consolidated basis is slightly misleading – there is basically a portfolio of mature and scaled businesses: Paul Davis, California Closets, and CertaPro Painters and two more immature brands in Pillar to Post and Floor Coverings International. Across all systems management has aggressively invested to drive franchise level productivity through the implementation of Net Promoter Scores and other best practices. In conversations with management they have touted how they have been able to almost double a lot of CertaPro franchisees same store sales from about $700k to $1.3 million and believe they can drive this number significantly higher. Pillar to Post and Floor Coverings will also continue to grow through increases in franchisees. Royalty revenue has grown sharply in the last two years up 8% in 2013 and 15% in 2014 but this also understates the performance as they began in-sourcing certain California Closets in 2013.
However, the major and unappreciated growth runway comes from the opportunity for FSV to in-source select franchisees and become more owned & operated.
Over the last two years, management has already begun buying in strategic or underperforming California Closet franchisees and as we will review below the results are impressive.
Management believes there is an opportunity to purchase another $30-40 million of EBITDA with another $15-20 million of EBITDA from their California Closets franchisees and $20 million of EBITDA from Paul Davis. If you read the 1Q15 call closely you will see management mention the Paul Davis opportunity for the first time. There is a strong strategic rationale to own select Paul Davis franchisees in order to offer insurance company customers one point of contact for national restoration work.
While the franchise business is excellent and requires minimal capital – the rationale for in-sourcing is as follows:
So, over the next couple of years we're going to continue to drive our existing brands. We may look to add more company-owned operations strategically in a couple of different areas, which is in effect built-in growth. When you have a franchise system of size with a strong brand, it's a national brand, you are in a special situation and you have a special opportunity to go through – to add company owned operations and do it in a way that generates a high return on invested capital. In terms of acquisition growth, I'd say that most of the acquisitions that we're looking at in this segment right now are internally – internal type acquisitions like acquiring the significant franchise in an existing region that we think we can double or triple. And so, famous last words, I don't see us adding another franchise brand but I do add – I do see us becoming much more company owned oriented over the next two, three years.” (Hennick, 1Q13 Conference Call)
In 2014, they bought back two California Closets, and management had the following to say in third quarter 2014 about their owned & operated segment:
“They are outperforming the system in general. And in 2013 we started to invest in our company-owned operations more aggressively to ensure that we were setting the tone for the brand and ensure that we were employing all of the proven best practices across the system, including the style, size and set-up of the showrooms, the product security, the approach to customer service and so on. We have years and years of data to know what works. We've implemented it now in all of our operations and it's showing, the growth of the company-owned has outpaced the franchise system really all year.”
These results have continued into the seasonally weak 1Q. The brands segment grew revenue over 15% and over 10% organically but the excellence is even slightly misleading as Paul Davis their largest system was actually down due to a tough year over year comp (very harsh 2014 winter drove a strong 1Q14, but management hinted at a very strong2 Q15) while California Closets and CertaPro grew over 20%.
It is worth repeating how large of an opportunity this is. In 2014 their owned & operated did $12 million of EBITDA – but $4 million of this is from ServiceAmerica – which means $8 million from California Closets. Over the next few years there is the potential to acquire 5x this amount of EBITDA.
Margins and GAAP Accounting
Over the last two years the residential management business looks like it is under significant margin pressure – coming from 9.5% EBITDA margins in 2009 to 5% in 2014. However, looking under the hood and talking to management has given me confidence in their guidance toward 2018 EBITDA margins of at least 8%.
This margin degradation has been the result of three themes.
1. Brand integration
2. IT integration
3. Elevated 2014 medical costs due to change in medical plan, which as of 1Q15 management has stated is firmly behind them
The expenses from the brand integration are fairly straight-forward, one-time costs and backing those out from their 2013 results gets the company back to mid-8% EBITDA margins.
The IT integration has been long and complex. In the company’s words:
“FirstService Residential decided in 2013 to implement a specific initiative to centralize and enhance the efficiencies of certain back-office functions to reduce redundant costs and drive operating margin expansion. Targeted areas of improvement in our business processes and customer experience include: (i) consolidation of selected back office activities across the entire platform into regional shared centers; (ii) consolidation of information technology, data and telephony systems and our customer care operations into two call centers; (iii) increased automation of client accounting system components; (iv) consolidation to one corporate accounting system; (v) consolidation and outsourcing of certain human resource functions and other vendor relationships; and (vi) automation and cost optimization of our home resales and mailings business through an outsourced third-party on-line service which benefits our clients. This effort is an ongoing, multi-year initiative which, while negatively impacting our operating margins in 2014 and creating headwinds in 2015, will result in longer-term efficiencies. Our success with these initiatives has led to further advances in the way we operate which will reinforce our service excellence with clients, generate new business and enhance our profitability.” (Prospectus page I-17)
To understand the extent of the IT integration it is important to review the scope of their operations. As FSV grew through acquisitions each local management team kept their operation intact. If you lived in New York you might have been familiar with Cooper Square Realty or Continental Group in Florida. In total, the company operated under 18 regionally branded firms. Within each brand they would oversee hundreds of properties. Each property has a manager, who is supported by a team that collects the property’s rents, pays its bills, creates its financial statements, and everything else required to keep the property in order. They had over 100 groups operating different bill pay and accounting software systems around the country. They have yet to actually remove any of the old processes and so current run rate margins of 7% account for the on-going investments and the additional personnel expenses.
Management has been very clear about the cost and time associated with the process saying on the fourth quarter 2013 conference call:
Q - Stephen D. MacLeod>: Yeah, okay. Great. And then on the FirstService Residential business, so – you
mentioned that you're sort of looking for a flat margin for 2014, almost 7.4% actually within the cost. What – how do you get back to the 9% sort of margin profile that you had on a relatively consistent basis over in the mid-2000s?
: The 2013, 2014, 2015 are going to be different years in the sense that while we will continue to add contracts and drive operating leverage, at the same time, we are investing to really support the brand, and the biggest area is in IT, and shared services infrastructure. There are certain back-office functions and administrative functions that are – are or were being done in 20 different locations. And there are opportunities to create efficiencies and service improvements by regionalizing or centralizing these functions, and – but we have to create capability and invest in the infrastructure to do that. Customer care centers are one example. That was a 2013 initiative. There are many others that we will be working on in 2014 and 2015. We will balance the investment carefully with the organic growth and our expectation is flat to slightly up in 2014. And then, incremental margin improvement from there. And we certainly expect that to get back to 9%, and expect to – the goal is to drive to 10% over the next several years.
A year later they were just as clear:
“Do you have a specific target as to when you think you can get back to the sort of historical levels of 9%, 10% in that business?
: It's going to take some years. Next year, we're targeting between 7% and 7.5%, but we'll
add to that clarity in our year-end call. Our long-term goal is still marching towards 10%, and the key for us really is to get through our systems implementations and infrastructure build around our shared service centers, so that we're able to regionalize and centralize many of the functions that are, in some cases, taking place in over 100 locations right now. There are significant efficiencies available to us, but we need to get through these systems implementations, which will take us through 2015. So, we're a few years out, but we're confident in our direction. But it will take some time.” (3Q14 conference call)
I am confident in management not only because they appear to be extremely talented; but also, they have been through a very similar experience in their commercial real estate segment. As they built their commercial real estate operation, they acquired local and regional firms in a variety of service lines. In 2010 they launched “Project Fusion” to re-brand all of their firms as Colliers International and get EBITDA margins to 10% by 2016. They practically got to 10% in 2014 – 2 years ahead of schedule.
Finally in 2014, they were hit with a surge in medical costs. As part of the rebrand they consolidated all of their employees who had been operating under regional plans to one plan. Their cost experience deviated significantly from actuarial projections. They have made it clear that these new costs will be passed on to clients in 2015:
“The second issue relates to the cost of health coverage provided to our associates. During 2013, in an initiative aligned with our rebranding and also to comply with U.S. Healthcare Reform, we consolidated 16 different benefit plans to create a national self-funded medical plan across FirstService Residential. Year-to-date, and particularly in the second quarter, our utilization experience and actual costs have risen more quickly than expected based on our previous experience in industry actuarial tables. These increases will be passed on to clients as contracts renew.” (2Q14 conference call)
Absent these costs margins would have been 6% in 2014. As of 1Q 2015 management had this to say about the situation:
“Last year, our margin was negatively impacted by escalated employee health costs. We can say after Q1 that we are comfortable that redesigned medical plans and increased sharing with associates and customers has reset the cost that we will bear this year, and we are on track to increase our emergence to the 6.5% to 7% range for the full year.”
Adding it all together, management historically talked about 10% margins in the residential segment (they operated near this range during middle of decade) and until recently that was their highlighted target. They recently brought this down to 8% with the language that they have a clear line of sight to 8% and then can get to 10% with some good performance in ancillary lines. I believe as new company they are being thoughtful about having achievable guidance and setting a hurdle they can easily clear.
Regardless, the price target above does not give them credit for additional margin expansion in the Residential segment.
There are a couple important things to understand about the Brands’ segment margins. First, the business can be thought of as mature and immature systems. From conversations with management, the mature systems, Paul Davis, California Closets, and CertaPro have 30-40% EBITDA margins, which leads me to believe the immature systems with strong growth potential are probably at best breaking even today. As these continue to grow and reach profitability this should provide a nice boost to consolidated margins. One can see the type of margins achievable if you look at ServiceMaster. They have a segment called Franchise Services Group that is broadly similar to the Brands segment. 50% of revenue is from royalty agreements, 25% from company owned branches and the rest from janitorial and products. They do $236 million in revenue and $78 in adjusted EBITDA for 33% segment margin.
They also break out their revenue and earnings from franchise fees (royalty + initial fees) (this includes franchise operations outside the franchise group) and in 2015 they did $146 million in revenue and $71 in EBITDA or 48% margins. These numbers should seem directionally reasonable to where FSV could get to over-time.
The major factor in whether they drive toward these margins will be the degree to which they in-source various franchisees. If they in-source slowly operating leverage should pick-up dramatically in the franchise group. In the scenario where they aggressively in-source (my base case) total franchise EBITDA will likely increase slightly as immature systems move to profitability and system sales and margins stay flat in their mature systems, but there will be a large increase of sales and total EBITDA in their owned & operated segment albeit at lower margin.
Also consolidated Brand margins are further impacted by ServiceAmerica which is their owned & operated HVAC unit in Florida. This business has been under a bit of pressure recently but does about $50 million in revenue and $4 million of EBITDA. Today if one were to separate out owned & operated from franchise in the consolidated Brands segment the resulting numbers are slightly misleading because today they only have $70 million of owned & operated California Closet sales vs $50 million of ServiceAmerica sales. This makes current owned & operated margins look significantly lower than they are.
Management has guided to 14% owned and operated EBITDA margins up from 11% run rate today. There will be incremental operating leverage from adding additional sales on their platform but most significantly management is rolling out 2 manufacturing hubs for their California Closet board-cutting operations. Historically each operation has been responsible for their COGS and these two hubs in Phoenix and Grand Rapids Michigan will help drive an improvement in gross margin for all operations. Their Phoenix hub opens in the next month or so and should have a significant impact and this is why they are currently most focused on adding West Coast branchises to their owned and operated network.
Due to the partnership philosophy discussed earlier each segment has a non-controlling interest “NCI”. This is the value of the stake held by the local operating team. The value of this NCI is usually valued at a 5x multiple of average 2 year trailing earnings. The local team retains put and FSV has call provisions. Management prefers not to call them, however if there is sustained poor operating performance or succession issues management will at time call the NCI.
This is a very real charge and management views it as such. There is another charge, which is non-controlling interest redemption increment. This is change in the value of their NCI. As the business grows or shrinks they re-value the NCI and this flows through the income statement. At old FSV, Colliers due to its cyclicality often had large swings in the value of the NCI which would often obscure the performance of their operations. This is not a real economic charge. The re-valuation of the NCI will be impacted then by the share of earnings the business takes in the following year.
Going forward, management from my conversations has guided to 15-20% NCI. There was actually a question on this in last conference call where John Fredrichsen the CFO who is going to Colliers said 20% but from my conversations that seems to be on the high-side. Over last two years it has been significantly lower (6-11% range).
In the base case of my model, I reset the NCI at 15% and I assume it continues to grow at 10% but shrinks as a % of total income which will happen if they execute on their M&A strategy.
Management does periodically buy-back parts of the NCI and this should provide a future tailwind to EPS as there is a multiple arbitrage between where they can buy the NCI and the likely market multiple.
I also want to note that management has guided to and gets compensated on Adjusted EPS where they deduct the current non-controlling interest but ignore the redemption increment.
This being a very undervalued investment hinges on the simple assumption that margins begin to normalize in their residential segment – management has already made clear this has happened.
However, being thoughtful about the significant changes in normalized earnings as residential gets to its targeted margins and the scope of the M&A opportunity in the Brands segment, I think the most prudent thing to do is look at the valuation prospectively on an absolute basis with a simple DCF.
Modeling out to 2018 and putting a 20x multiple on adjusted EPS which would give an owner a 15% forward free cash flow yield gets me to a targeted 2018 price of $54. The business should generate approximately $7.70 in free cash flow over this period for a total return over $61. I assume that all this cash is just returned and not used for accretive share repurchases. Discounting this back at 10% gets me a price today of $45.
I think a 15% forward free cash flow yield – 10% growth and 5% free cash flow yield from a business that can compound for a very long-time is more than reasonable (their closest competitors discussed more below have all traded in excess of 25x LTM earnings on average over the last 10 years and today trade over 23x expected 2017 earnings). This base case assumes they execute on the above mentioned M&A strategy.
In my bear case in which they do not execute meaningfully on M&A but continue to benefit from strong organic growth, operating leverage, and use excess credit capacity to drive equity returns I get a target price today of $38 or a total return of $48 by 2018. Putting a 20x multiple on 2018 EPS of $2 gets a target share price of $40 with free cash flow of $6 and incremental capital (assumed just returned as dividend instead of accretive share repurchases) of $2.20 by bringing net debt to EBITDA of 2x.
This bear case can also be thought of more simply by just looking out to 2016 – so no increase in residential margins, no M&A, and barely any change in Franchise operating margin and say 14x EBITDA which is 2-4x turns below comps gets one to a $41 in 2016.
Or you could perhaps look at this on sum of parts – if you think Franchise is worth 1x EV to system wide sales then it is worth more than current enterprise value of the firm and I consider Residential to be the crown jewel of the operation.
While there is no perfect comp for the entire business there are decent ones for parts of the business and by reviewing a set of potential competitors one can gain confidence in the large margin of safety and potential for valuation multiples in-excess of the ones used in the DCF.
The consolidated model is built from each underlying segment. We will walk through it piece by piece and then at end comment on general corporate assumptions.
|Cost of revenues||658,568||731,204||800,046|
|Selling, general, and administrative||203,758||229,829||258,678|
|Amortization of intangible assets||10,160||12,422||8,744|
|Acquisition related items||166||655||1,183|
|Other (income) expense, net||(245)||20||255|
|Earnings before income tax||43,487||24,237||38,434||59,838||79,616||105,642||134,403|
|Income tax expense||12,722||5,785||12,242||17,951||23,885||31,693||40,321|
|Non-controlling interest share of earnings||4,746||1,253||3,105||6,500||7,150||7,865||8,652|
|Non-controlling interest redemption increment|
|Net income attributable to Company||35,387||48,581||66,084||85,430|
|Amortization per share||0.27||0.26||0.31||0.35|
|Depreciation & Amotization||23,851||28,132||26,474||27,782||32,328||38,595||44,927|
|Tax rate (%)||29.25%||23.87%||31.85%||30%||30%||30%||30%|
|Interest rate (%)||2.91%||4%||4%||5%||5%|
|NCI share of net income||15.43%||6.79%||11.85%||15.52%||12.83%||10.64%||9.20%|
|Gross beginning debt||238,000||238,000||263,000||313,000||363,000|
|Gross ending debt||238,000||263,000||313,000||363,000||413,000|
|Gross debt to EBITDA||2.73||2.54||2.25||2.08|
|Corporate expense growth rate||5%||5%||5%|
|As a % of sales||1.40%||1.53%||1.58%||1.65%|
I have built the model up from each of the individual segments. The Residential segment is pretty straight-forward:
|Residential cost of goods sold||602,126||665,205||728,537||799,085||878,993||966,892||1,063,582|
|Residential gross profits||166,868||179,747||191,008||212,415||233,656||257,022||282,724|
|Residential depreciation & amortization||18,530||30,655||19,644||20,230||22,253||24,478||26,926|
|Residential operating earnings||39,748||23,869||26,991||45,517||55,632||73,435||87,510|
|Residential operating metrics|
|Gross profit margin (%)||21.70%||21.27%||20.77%|
|Operating earnings (%)||5.17%||2.82%||2.94%|
|EBITDA margin (%)||7.58%||6.45%||5.07%||6.50%||7.00%||8.00%||8.50%|
|Organic growth (%)||8%||8%||8%||8%|
|Acquired growth (%)||2%||2%||2%||2%|
|Gross margin (%)||21%||21%||21%||21%|
I think this model is conservative - management re-affirmed their 6.5 to 7% target for 2015 as they now can see that healthcare costs have been passed through and we are keeping them at the low end of their target. I assume by 2018 they are only operating at 8.5%. Ultimately if they are able to get back to mid-decade margins would be an absolute home-run.
The Brands model is a little more complicated because of the scope of the M&A opportunity.
Filings do not break out their owned & operated business but they break out the entire Brands segment and also disclose Franchise numbers which allow us to back into it.
|FS Property Services revenue||170,827||193,135||212,457||266,291||376,324||492,473||616,752|
|FS Property Services cost of goods sold||71,509||71,509||71,509|
|FS Property Services gross margin||99,318||121,626||140,948|
|FS Property Service sg&a||72,365||89,868||103,655|
|Property Services depreciation and amortization||5,155||8,557||6,734||7,552||10,075||14,117||18,001|
|Property Services operating earnings||21,798||23,201||30,559||35,088||48,103||62,337||80,184|
|Property services operating metrics|
|Gross profit margin (%)||58.14%||62.97%||66.34%|
|Operating earnings (%)||12.76%||12.01%||14.38%|
|EBITDA margin (%)||15.78%||16.44%||17.55%||16.01%||15.46%||15.52%||15.92%|
We also have the Franchise business metrics:
|Franchisor cost of goods sold||3,751||4,023||4,534|
|Franchisor gross profits||71,274||76,428||86,150|
|Franchisor depreciation and amortization||3,477||6,641||3,252|
|Franchisor operating earnings||16,801||19,435||22,071|
|Gross franchise revenue||75,025||80,450||90,684|
|Franchise operating metrics|
|Gross profit margin (%)||95.00%||95.00%||95.00%|
|Operating earnings (%)||22.39%||24.16%||24.34%|
|EBITDA margin (%)||27.03%||32.41%||27.92%|
Making the assumption of ServiceAmerica at $50 million of revenue and $4 million of EBITDA and 45% gross margins in owned & operated we can back into their results:
|Owned & Operated Revenue||95,802||112,685||121,773|
|Owned & Operated "Branchises" Revenue||45,802||62,685||71,773|
|Owned & Operated D&A||1,678||1,916||3,482|
|Owned & Operated EBIT||4,997||3,766||8,488|
|ServiceAmerica D&A (3% of sales)||1,500||1,500||1,500|
|Owned & Operated "Branchises" D&A||178||416||1,982|
|Owned & Operated "Branchises" EBIT||2,497||1,266||5,988|
|Owned & Operated "Branchises" EBITDA||2,675||1,682||7,970|
|Owned & Operated "Branchises" Revenue||45,802||62,685||71,773|
|Owned & Operated "Branchises" COGS||25,191||34,477||39,475|
|Owned & Operated Branchises Gross Profits||20,611||28,208||32,298|
From here we can show the effect of the M&A strategy on system wide sales and royalty revenue. I have system wide sales growing at 7% per year. Due the factors mentioned above management believes they can grow these sales organically at high single digits, and looking at the change in royalty revenue over last 2 years we can see that they grew at 8% in 2013 and 14% in 2014. In the 1Q15 consolidated sales were up 10% organically (15% including acquisitions), which understates how good the business is doing as Paul Davis was flat and accounts for about half of system wide sales as 1Q was a very tough comp after tough winter weather in 2014. CertaPro Painters and California Closets were both up over 20% YoY.
|M&A System Wide Sales Build||2012||2013||2014||2015||2016||2017||2018|
|Beginning System Wide Sales||1,278,227||1,317,703||1,309,942||1,301,638|
|System Wide Sales Growth %||7%||7%||7%||7%|
|Ending System Wide Sales||1,317,703||1,309,942||1,301,638||1,292,753|
|Average System Wide Sales||1,297,965||1,313,822||1,305,790||1,297,195|
|Franchise Royalty Revenue||82,341||83,347||82,837||82,292|
Again this probably overly conservative because the underlying dynamic is that you have the mature system sales staying flat and the immature systems should at least become break-even. Assuming the mature systems have 36 % EBITDA margins today you can see how these numbers are achievable without major contribution from the immature systems. I am omitting this simple reconciliation in interest of space and flow but happy to get deeper into it in Q&A.
If they execute on the M&A strategy discussed above – management has a pretty strict criteria of not paying more than 5x EBITDA. I have them acquiring $5 million of EBITDA at 10% margins so $50 million of sales in 2015 and $10 million annually from 2016 to 2018. This will ultimately be lumpy and neither I nor management knows when they will be able to complete these transactions but the opportunity is present and management is working on it.
|Owned & Operated Sales Build||2012||2013||2014||2015||2016||2017||2018|
|Beginning Owned & Operated Sales||71,773||128,950||237,977||354,635|
|System Wide Sales Growth %||10%||7%||7%||7%|
|Ending Year Same Sales||78,950||137,977||254,635||379,460|
|Owned & Operated Revenue||128,950||237,977||354,635||479,460|
Again I think this is very conservative as talked about above sales are materially growing faster. Furthermore they believe they can either accelerate sales because some of the branchises are under-performing or they can drive more operating improvements and best practices. Can go back to quote above and see that historically their owned stores have outpaced the systems in general.
We get total Owned & Operated Sales by adding back the ServiceAmerica business which I have constant at $50 million in sales and $4 million in EBITDA.
As a consolidated segment, management has talked about getting Brands to 18% EBITDA margins in conjunction with acquiring the $35 million of EBITDA from the model below you can see this is very reasonable and if achieved would mean a more than doubling of Brands EBITDA from 2014 to 2018.
If you look back above you will see consolidated EBITDA margin of almost 16%. This is actually 200 bps under managements expectations. I think a fair amount of this has to do with the impact of the immature sales systems, but it also gives me confidence in the conservatism of the model.
There are a few other important pieces that I have not presented here, but will briefly describe and am happy to share or elaborate on in Q&A but take up a fair amount of space. The acquisition opportunity should also give rise to a fairly significant intangible asset. I assume 75% of the purchase prices is attributed to the intangible asset and is amortized over 12 years – this will ultimately get added back to derive adjusted EPS.
I have the NCI starting at 15%. Assuming they execute on the M&A strategy this should decrease as a % of net income, but I have it continuing to grow at 10% in-line with the general top-line growth of the business.
I have corporate expenses starting at run-rate $12 million which is $4 million above guidance and growing 5% per year. I have interest expense starting at 3.5% slightly over their current rate and growing to 5% by 2018. Depreciation expense will run about 1.5% of sales which is a good measure of cap-ex going forward so adjusted EPS is a good proxy for free cash flow.
My bear case model basically has no M&A opportunity
There is no change to the residential segment. As system wide sales grow 7% annually with 60% incremental margins I get them to $40 million in Franchise EBITDA at 36% margins. Again I think this is low as immature system sales inflect has a big impact. I have their owned and operated business growing 7% top-line with and getting to $12 million of EBITDA so ex-ServiceAmerica I have the Brands segment doing $52 million of EBITDA in 2018. I have the NCI staying at a constant 15% of sales. I have amortization staying flat at $8.5 million. I have debt increasing $19 million per year until they get to 2x net debt to gross EBITDA with assumption cash is dividend out to shareholders.
|Cost of revenues||658,568||731,204||800,046|
|Selling, general, and administrative||203,758||229,829||258,678|
|Amortization of intangible assets||10,160||12,422||8,744|
|Acquisition related items||166||655||1,183|
|Other (income) expense, net||(245)||20||255|
|Earnings before income tax||43,487||24,237||38,434||57,719||70,612||90,561||109,606|
|Income tax expense||12,722||5,785||12,242||17,316||21,183||27,168||32,882|
|Non-controlling interest share of earnings||4,746||1,253||3,105||6,500||7,414||9,509||11,509|
|Non-controlling interest redemption increment|
|Net income attributable to Company||23,087||33,904||42,014||53,884||65,215|
|Amortization per share||0.23||0.23||0.23||0.23||0.23|
|Depreciation & Amotization||23,851||28,132||26,474|
|Tax rate (%)||29.25%||23.87%||31.85%||30%||30%||30%||30%|
|Interest rate (%)||2.91%||3%||4%||5%||5%|
|NCI share of net income||15.43%||6.79%||11.85%||15%||15%||15%||15%|
To build some comfort around these numbers and because ultimately this will be compared by sell-side analysts to other business we can look at some businesses that people might use as their competitors and think about how they have been historically and are currently valued in the market.
There really is no good or proper comp to the residential management business. If you put a gun to my head and made me pick one – I would probably say Healthcare Services Group “HCSG”. This was written-up by Maggie as a short in August 2014 primarily because it trades 25x LTM EBITDA and 40x LTM earnings. This is really more of a facilities management company – similar to Aramark, ISS, ABM, etc. except that the market it’s operating in allows it to grow top-line at FSV like 10+% numbers and has FSV –ish 7+% EBITDA margins. Sell-side likes this business because of its high re-occurring cash flows, 85% customer renewals.
Bloomberg consensus has this at 32x 2016 earnings or 24x 2017 and 18x forward EBITDA and 14x 2017 EBITDA. I don’t have a view on the company or the price, but it should be noted that it over the last 9 years the average multiple is probably above 30x earnings (all numbers from Bloomberg).
Average P/E multiple over the last 9 years
The best comps for the Brands business are probably ServiceMaster, Rollins, Choice Hotels, and MTY Foods.
ServiceMaster and Rollins primarily operate and franchise termite and pest control businesses (Terminix and Orkin). Both of these businesses are significantly more mature, with more defined market shares, and lower organic growth. ServiceMaster also operates and franchises the largest home warranty business and franchises ServiceMaster Restore, ServiceMaster Clean and Merry Maid business. ServiceMaster Restore is broadly similar to Paul Davis Restoration and Clean and Merry Maid are franchised cleaning operations. Home service owned & operated business such as Rollins and Service Master have mid-teens to low twenties EBITDA margins.
ServiceMaster and Rollins are not the best comps today but if First Service executes on their business plan will be more apparent as majority of Brands EBITDA moves from 2/3 Franchise to 2/3 Owner and Operated. MTY Foods or Choice Hotels are a reasonable comp for the franchise side of the business.
MTY Foods is pretty nice comp for a few reasons. It’s based in Canada and does about same amount of EBITDA as Brands business - $43 million EBITDA in 2014 vs $37 million for FSV. It is heavily weighted toward franchised vs owned & operated. However, I think the service provided by FSV is substantially more resilient than MTY. MTY trades 15.5x EBITDA and over 23x earnings.
ServiceMaster does not have a lot of recent public market history as it was taken private by CD&R in 2007 and IPO’ed a year ago. It is 5x levered and trades 22x forward earnings. It is growing in the low to mid single digits.
Rollins on the whole is more similar to a comp on the owned & operated business, and also runs with a net cash position - but with better margins and trades 20x EBITDA and 39x earnings although it is only growing low to mid single digits as well. Rollins has been public for a long time and here is the average P/E multiple looking over a 10 year period.
Again I think looking at these competitors highlights the high multiple these businesses are given THROUGH THE CYCLE on normalized earnings. These businesses get these multiples because they have reasonable organic growth and are considered “essential services”. As we have talked about earlier the residential property management business grew through the last recession, and is growing significantly faster than these competitors. On the residential side, I am not sure there is a more stable and essential businesses.
Here are the implied multiples for the comps current share price. The way to read this is - today HCSG is trading 23x 2017 earnings, and ROL is trading 15.9x 2017 EBITDA, etc.
If FSV were to trade at similar multiples its price today would be any of the corresponding prices. I would put more weight on the 2017 prices due to large change in margins but hopefully this shows how a lot of the above valuation work is quite conservative.
|FSV Equivalent Price Today|
At these implied multiples can get a sense for where FSV should trade TODAY based on its future earnings and EBITDA. So if you thought FSV should trade 23x 2017 earnings its price today should be $49.96
If FSV is ultimately compared to these business then it’s reasonable for it to trade at multiples in excess of the ones for their competitors because it has SIGNIFICANTLY HIGHER implied growth rates:
|Growth Rate (YoY)|
|FSV earnings Implied||28.15%||33.42%|
|FSV EBITDA Implied||28.09%||30.51%|
If you think ultimately this gets a HCSG type multiple in 2018, for example historically has traded around 30x last twelve months earnings then2018 target would be $81. That would be my “upside case”.
I want to note that there is a change of control agreement. Hennick is entitled to a payment of about 10% of the total market capitalization of the company if it were sold. I hope this management team does not sell this business for a long-time and we get to enjoy the compounding. However if they sell 5, 10+ years from now and the price is diluted by 10% to account for the payment I think it’s inconsequential
1. General market awareness of the business post-spin
2. Market appreciation for margin reset in Residential
3. M&A in brands