Paul Giannamore: When you look across the spectrum, all assets have dramatically inflated. In 2008, in response to the great financial crisis, the Federal Reserve embarked on an extremely unorthodox financial experiment, quantitative easing. They wanted to reflate the housing market, goose the stock market, and wanted Americans to feel wealthier. If Americans feel wealthier, they'll spend more. If they spend more, they would rev up the economy.
Quantitative easing is a perverse form of government interference. It creates a tremendous amount of distortions in the market that started the stock market on a tear to where we've ended up at a 5,000 year high, not only a sovereign bond bubble but also a stock market bubble. In the pest control industry, we have benefited tremendously from that bubble that's blown.
What is a bubble? It's a fantastic story in a boatload of liquidity. We got liquidity from the courtesy of the Federal Reserve and the US Department of the Treasury, the government putting everything on a credit card. Of course, we've got the great story. Pest control is recession-resilient, desirable, central, and all those sorts of things. Here we have it.
During COVID, these governments overcooked it. They created a spectacular amount of money. They created a tremendous fiscal impulse to pay people to sit at home smoking pot, playing video games, buying Bitcoin, buying AMC, buying luxury watches, buying jewelry, and buying houses. We saw the Federal Reserve buying billions upon billions of dollars in mortgage-backed securities. That's when things started to go crazy. In November of 2021, we saw transaction multiples eclipse 30 times in nominal EBITDA and north of five times revenue. Effectively, we printed money in Q4 of 2021 exactly what we said would happen in Supernova.
Patrick Baldwin: I want to welcome you to Bubble Trouble: M&A in the Year of FED Tightening. I'm here with my longtime friend and adviser, Paul Giannamore.
Paul Giannamore: Thank you, Patrick.
Patrick Baldwin: Paul, welcome to The Boardroom.
Paul Giannamore: I appreciate it.
Patrick Baldwin: I want to know, what's different? What's new? Why are we going from M&A in the late stages of the pest control consolidation boom to now, Bubble Trouble?
Paul Giannamore: Patrick, a ton has happened since Supernova. We did it in June 2021. We had that massive spike between the middle of the year till the end of the year. The reason why we're doing Bubble Trouble is a little bit different. We are in a very different time than we were shy of a year ago. I'm going to give this talk. It's a discussion and it's more somebody as a fellow investor than an M&A adviser.
Like you, my primary focus is protecting my family's financial future. That's number one. All business owners think about it that way. Number two, I need to make sure that I provide my clients the absolute best advice that I can. In order to do that, I toil in the M&A vineyards every day. I'm a student of financial history.
One of the things that we're going to talk about is framing up how 2022 is almost a mirror opposite in a lot of ways where we were in 2021. In 2021, we are in a speculative frenzy. Now, in 2022, we've reversed that. Everything that took place over the last several years from an asset price perspective, government policymakers supporting asset prices has been flipped on its head. Now more than ever, you as a business owner need to be vigilant of that.
This is the discussion that I want to have with you. First off, I come into this space not as a pest control guy. Sometimes I wish I was because I got a nasty app problem that I haven't been able to eradicate in the pest control services myself. I tried everything from baiting to sprays, you name it. I can't get the job done. I come into this with an investment banking background. I started my career in the early ‘90s out in Silicon Valley. I sat across the table from Michael Dell and Steve Jobs. Granted, I was carrying books and grabbing coffee.
That's where I started my career, and then I went into private equity. I worked for the largest publicly traded private equity firm in the world at the time. I focused on a lot of roll up activities similar to what Anticimex does in the market, similar to what Thompson Street Capital Partners does. That's the frame that I come from.
My thought process today is to not try to predict anything per se. I'm not going to predict stock market crashes, and so on and so forth. I want to talk to you about how I believe that you should be thinking about these current events. I know that a lot of you aren't thinking too much about it. I know that because I talk to you every day.
We're going to go through a lot of different data. We're going to lay out a couple of different theses. We've got some great guests that will be joining us on the second half of this program. One of the things that I want you to think about is if you own a pest control business or whether it's a pest control business or a publicly traded equity, you own a claim on future cashflows. Your wealth is future cashflows. The value of your business is nothing more than the current price. It's the current price of that future cashflow.
Just like the stock market goes up and down every day, the market can dramatically underprice your asset or overprice your asset. Your wealth is the current price of that future cashflow. We've lived in an era where policymakers have done everything in their power to not only create the wealth effect by juicing up the stock market, reflating the real estate market. They've also tried pretty hard to create inflation. As we can see in 2022, they're finally successful.
As I think back, everything that policymakers have done has been extremely bullish for risk assets. Meaning they propped up valuations and we've ended up with a stock market bubble, a sovereign bond bubble. We now have real estate eclipsing pricing that we saw prior to the great financial crisis. We're starting to enter a period of a great reversal.
When you look at the last 40 years or so, the Federal Reserve was able to backstop the market. Every time there was a wobble, they could step in. In the last several years, bad news was good news. Every time something bad happened, every time we got a COVID spike, the stock market went up. Every time there was a crisis, we had some crisis in the treasury market, the repo market, the Fed stepped in, and the stock market went up.
Now we finally are having a great reversal, where bad news will be bad news and good news will be good news. The Fed finds themselves in a significant box now because they can't support the market like they did historically because we find ourselves in an environment with tremendous price inflation. Last time we saw this, I was literally on the floor eating playdough.
It makes it very difficult to support financial assets when we've got to fight inflation. If you look at the Rasmussen poll, the largest issue on American’s minds, about 75% said, “Inflation is the key issue that we're dealing with right now.” If you go to the pump, you get beat up. If you go to the grocery store, you get beat up. Prices of cars, homes, we're seeing it across the board.
Now that we've entered into 2022, the new paradigm is that line item on the household, P&L, interest expense, that's starting to ramp up. We didn't see that in 2020 and 2021, but now this year, 2022, we're seeing a dramatic pickup in interest. There's a lot of pressure. Because it's a political issue, the Fed can afford to support asset prices. The Fed is going to have to step in and create demand destruction.
If you listen to what the Federal Reserve is saying, if you listen to Dudley and former heads, what they tell you now is that pushing stock prices down, decreasing valuations is a Fed policy. Whereas throughout my entire life, it's always been a Fed policy to increase valuations. This is the first time in my working career where I have a Fed that steps up and says, “It is our policy to push the market down.”
They're going to do that because the extreme majority of Americans do not own financial assets. These people get up every morning, work their ass off, getting kicked to shit out of the grocery store and at the pump. It's become a serious political issue. The Fed is going to have to push down. If you watched Supernova, you can understand what has taken place and how that can potentially impact asset prices. Before we get started, we're going to talk a lot about interest rates. We're going to talk a lot about the bond market and the stock market. I tend to think about interest a little bit differently than a lot of people do. Patrick, if I asked you, what's interest?
Patrick Baldwin: I think of interest rates in the simplest form, cost to borrow someone else's money.
Paul Giannamore: In this simplest form, it is but if you think back, if you go back through the millennia, there was a time when markets set interest rates. We don't live in that environment anymore. Largely, central banks are setting interest rates. If you look back over the millennia, interest rates are a ratio of time preference. All humans prefer consumption in the present. If you want a Tesla, you want it now. You don't want to wait ten years for it. If you want to take that trip to Patagonia, you want to do it now, not when you're 89. There's a lot of time preference.
When you look across societies, across histories, wealthier countries tend to have lower interest rates. They tend to have their daily needs taken care of and can push capital aside and invest in the future. Less wealthy economies tend to have higher interest rates because there's more time preference. What we've seen almost exclusively over the last fifteen years or so is the central bank's repressing and suppressing interest rates to below the natural rate and it has caused a lot of weird things to happen.
This is the first time in history that we've seen negative nominal and real interest rates on sovereign debt. If you think about it, we had $17.5 trillion in bonds yielding a negative interest rate. Meaning, if you invest in it, you are guaranteed to lose money. By manipulating these interest rates, we've pulled consumption and we've pulled financial returns from the future to the present.
As we go through here, this is the framework that we're going to be looking at. The first one that we're going to look at is the S&P 500. Before I tap into the S&P 500, I wanted to say one thing. Throughout my twenty-some odd years of doing what I do, I've been involved in a variety of different roll ups in different industries. We're going to focus largely on macro events and we're going to tie it specifically to the pest control industry because the extreme majority of the asset price inflation, we see in pest control.
These consolidation booms, Rentokil buying Terminix, take place because of what's going on in the macro financial environment, not only at the industry level. If I go back to the year 2000, you couldn't sell a government contractor for four times EBITDA. Fast forward to 2003 and 2004, these things were selling at nosebleed multiples, not because of the macro environment necessarily but because of the Iraq War, 9/11, the amount of spending that took place.
We can look at IT staffing, those bubbles back in the ‘90s. There's been a variety of consolidation booms, but the overarching ingredients for this is we need an accommodative macro-policy. From 2012 to 2022, we can see the breathtaking multiple expansion in the S&P 500. The S&P 500 is an important benchmark index in the United States. We talked about it extensively on Supernova.
If I look at the kickoff to this thing being around 2012 after the great financial crisis when quantitative easing was in full force, we can see multiple expansion in the S&P 500. What we hear a lot in the pest control echo chamber, “It's a great industry. It's fantastic. It's the best industry on the planet. We're so happy. We're so fortunate.” It is a great industry, but we would be saying a lot of the same things if we were in the healthcare services or the food services space. We can make those arguments about any industry. We're seeing the same.
In certain industries, it’s substantially higher asset price inflation in pest control. This gives you an idea of the top 500 large cap firms in the United States that used to trade at 1.1 times revenue and now eclipsed 3.1 times revenue in late 2021, so that shows you. The higher the price on an asset, the lower the implied forward returns.
Think about it, if you buy an apartment, the more money you pay for that apartment, the lower the return you're going to get on that rent if all else being equal, if that fixed stream of cashflow is the same. The same thing for the stock market. The stock market has repriced over the decade. A lot of you don't pay attention to historical norms, and we can go back over 100 years.
If we look back over the last 30 years or so, it captures the great financial crisis, the dot-com boom, the Tequila Crisis, the Russian ruble crisis in the late ‘90s, and the bond rout of 1994. If we go back to 1992 on an equal weighted basis, which means each 500 companies represented equally and it's not market cap weighted, the median revenue multiple, even including where we are today, is 0.9 times revenue.
The largest companies in the United States, Rollins is in that index, Google, Microsoft, a lot of big financial institutions, a lot of big industrial companies are in that index. Over the last 30 years or so, it traded roughly at one times revenue. That gives you a historical perspective of how far this whole thing is run.
We all looked at Rollins back in Supernova. This is one that might be familiar to some of you. Rollins is the bellwether in the industry. We went back 30 years, but we could have gone back 50. Rollins spent the majority of its existence trading between 0.6 and 2.5 times revenue. There hasn't been a tremendous amount of technological advancement in the pest control industry over the last 40 or 50 years, if we're all honest with ourselves.
Sure, we had a lot more baseboard jockeys back in the day, we're doing IPM now, and everyone's blowing a lot of smoke but at the end of the day, the industry hasn't changed a whole lot. We've seen other players get into this space. We've seen the M&A market get a little bit more competitive. If we push all that aside and only look at the equity markets, only look at Rollins, we see that this is a business that spent literally half a century trading somewhere around dollar for dollar.
In November 2021, it was almost at nine times revenue. It is spectacular for a pest control company to be trading at 25, 30, 40 times EBITDA. There’s an era of financial repression. There’s an era of central banks forcing interest rates into the floor, converting treasury bonds into base money and making investors extremely uncomfortable with 1% yields on treasuries and looking into other markets.
When you think about Rollins, in my mind, it trades like a bond. The interest rate environment that we have been in over the last ten years or so is quite a bit different than other companies that are in service industries similar to Rollins. There's a variety of reasons for that. Rollins has a very narrow public flow. The Rollins family and trusts own the simple majority of that business, so it's not extremely actively traded as much as other companies would be.
It's been a steady performer. Quarter over quarter every year, this business kicks out a dividend. It is not in a technologically disruptive industry. It's got high visibility on cashflow. It's capital light. In a lot of ways, this trades like a bond in my mind. You're going to see the ten-year US Treasury yield back over the last 30 years or so and we see Rollins.
I'm using enterprise value to revenue or price to sales as a proxy for us because I wanted to remove some of the quarter-by-quarter variance that we see in earnings. I'm not using PE. I'm not using EBITA. I'm not using EBITDA. I’m just using enterprise value to revenue. You've got a 40-year trendline and that's where prevailing ten-year interest rates have gone in the United States. We've been in a 40-plus year bull market and fixed income or bonds.
Finally in 2022, with the Fed having only hiked interest rates once, 25 basis points, we now have broken the 30-plus year trendline in ten-year treasury yields. The other thing that you could notice is there is some direct correlation in my mind as to the yield on the ten-year and how Rollins trades. As the yield continues to fall, Rollins trades at a higher multiple.
There are other things going on behind the scenes there. We'll get into that. For now, in very simple terms, Rollins trades inversely to the yield. We've had 40 years of declining yields and we finally are in a position where the fed funds future market is priced in at least ten hikes in 2022 alone. We're getting ready for the great reversal.
I'm not going to dwell very much on quantitative easing. We talked a lot about it on Supernova. We talk a lot about financial repression and quantitative easing, what it is and how it works on The Buzz. In fact, if you're on our distribution list, we got a 25 or 30-page commentary that goes into the details of what quantitative easing is and how it specifically impacts the public equities in this space.
We've got a twenty-year history in the Federal Reserve balance sheet. It wasn't until 2008 where they started increasing the balance sheet. They started to build up the balance sheet, buy treasuries, buy mortgage-backed securities, and convert that into base money. Of course, the COVID crisis continued to substantially increase that in 2020 and 2021. Now we've got a massive balance sheet that the Fed is going to unwind.
I introduce, into the concept of Rollins’ EV/Revenue, another one of our friends in the industry, Rentokil. Rentokil trades at a discount to Rollins and has attempted for a long time now to narrow the gap, as Terminix. Congratulations, you are the negative yield generation. You have now seen with your own eyes over $17 trillion in negative yielding sovereign debt.
I hate to draw direct causality because this is a system. The results of forcing interest rates through the floor, both nominally and in real terms, causes dramatic run ups specifically for assets that are extremely rate sensitive like Rollins. For me, the most important thing is not Rollins and Rentokil. We've gone from over $17 trillion in negative yielding bonds to about $2.5 trillion today. We saw the most dramatic reprise repricing of the bond market in US history.
I wasn't able to find a quicker repricing of the bond market that is still in process today. After we talk a little bit more about valuations, we're going to get into bond yields and we're going to get into the repricing of both the equity as well as the fixed income market. For now, here's the fun stuff. This is what all you guys care about. You're like, “I don't care about Rollins. At the end of the day, what I care about is private market multiples.”
There is a direct impact from the public equity markets to the private market. When I go to Stockholm and I sit in EQT's office, the owner of Anticimex, and I look at their valuation model, what do I look at? I see Rollins’ trading statistics, I see Rentokil’s trading statistics, and I see Anticimex imputing an exit multiple for their business based upon where Rentokil and Rollins drive that EQT/Anticimex model. On occasion, Ecolab, and I have yet to see Terminix in that mix. It's extremely important.
I used to make private equity models and go out and acquire businesses for the largest publicly traded private equity firm in the world at the time. We were doing internal rates of return analyses and a variety of different things, but I didn't care a whole lot about interest rates. That's not what I was focused on. What I was focused on is what are my exit multiples because that's how I'm going to impute my return.
Where do I get my exit multiples? I don't pull them out of my ass. I go to the public equity markets to determine what those are. Every acquirer out there is benchmarking from an equity perspective to Rollins. Rollins underpins that complex. The private equity firms, companies like Anticimex, are looking at Rollins because this is what they aspire to. If they increase cashflow, they increase growth rates. If they look more like Rollins, they get the Rollins multiple and that's how exit multiples are determined.
This is a little bit different from what we have on Supernova. We've put the upper bound of private market transactions and we've gone back twenty years. I'm not going to rehash all of Supernova. If you want to look at that, we went individual transaction by transaction and gave you some color on it. Suffice it to say, for half of the last twenty years, these were dollar for dollar deals. If you've been in the industry long enough, that's what you heard. In fact, there's a lot of guys out there that still think dollar for dollar sleeping under the rock.
It wasn't until around 2011 and 2012 that we saw this dramatic uptick in transaction multiples. In 2021, we did Supernova. Patrick, I didn't answer your question. You said, “What's changed in Supernova?” Supernova was easy. We have an extremely accommodative fiscal monetary policy in the United States. Going into 2019, things started to get tightened. Market started to roll over. I said, “This might be the top of it.”
In 2018, 2019, I saw Rollins roll over. I’m like, “Things might cool off.” We've got a repo market issue, we got a US Treasury issue, the Fed steps in, more quantitative easing, and market spikes again. Now, we get to COVID. In the COVID era, we saw what the Federal Reserve Bank did with its balance sheet. It created a phenomenal amount of fiscal and monetary stimulus that jacked things up.
Every one of you sitting here knows that 2020 and particularly 2021, around the time we did Supernova, had all of the hallmarks of a speculative frenzy. We had AMC. We had Bitcoin. I use a Terminix franchise here in Puerto Rico. I have the best technician. I love the guy. He used to work in New Jersey. He's Puerto Rican. He comes to my house.
In 2021, he was demonstrating to me how I could become very wealthy trading cryptocurrency and buying call equity options on the S&P and the Nasdaq in 2021. We had all the hallmarks. Everyone's getting rich with Bitcoin, all this jazz. The equity markets were on a tear. In addition to the public equity markets, SPACs, and all the frenzied activity in the private pest control market, it was around the time that we did Supernova where I said, “We could literally sell anything.” I could literally take a deli and put a pest control company on it, and somebody would come in and buy this thing. It was in the second half of 2021 that things started to ramp up. Dylan, I'm wondering if you've got a clip from Supernova.
“The problem that we have right now is the Federal Reserve's buying treasuries and effectively converting that into non-interest-bearing base money. We're monetizing the debt and we're starting to see the inflation in the market today. That will have a dramatic impact on risk assets going forward. The most important thing for you to know from this presentation is we are at the highest point we have been from a valuation perspective in pest control. It will continue to ramp up in 2021. All of the government fiscal spending in monetary policy is extremely bullish for risk assets, but we're coming towards the end here. We're coming to risky times based on what we're seeing.”
That's what we said in June of 2021. We were watching it in real time. If you talk to any acquirer out there, they’re like, “Holy crap. Things went crazy.” We did Supernova and wanted everyone to know exactly where we were. It's almost impossible to time markets. One thing that you can do is realize, if you try to take a logical and unemotional approach to things, when you're in the center of a speculative frenzy or bubble. That's what we did.
If you fast forward a little bit to August 2021, for the first time in my twenty years or so in the pest control industry, I sent out what we call the Sell Now email to our clients. I focused on our clients that were the ones that were on the fence trying to determine what they wanted to do. I literally said, “Sell now.” August, in my mind, was the absolute epicenter of this frenzied storm in 2021.
From June to December/January 2022, private pest control transactions priced at the highest that ever priced at any point in history both in the United States and in certain international jurisdictions. The stock market peaked. The Nasdaq, the S&P 500, and the DAO peaked in November 2021. That's where some things started to get interesting.
Before we talk about peaking and the impact on pest control multiples, we're going to stick with asset prices in general. We're going to come back to that because I'm going to have some things to say about where we are in 2022 and what I think is going on in the market. This is the Case-Shiller national top ten metro areas. You can look back from 1987 to present. You see the housing bubble, and then you see the home price appreciation. You see the home price appreciation that took place in 2020, 2021.
Now in 2022, by rate of change basis, that is starting to roll over. It showed you the most spectacular and rapid increase in mortgage rates. From the end of 2021 until present, mortgage rates long term 30-year fixed went from literally around 2.9%, 3% to 5.4% or 5.5%. In November of 2021, if you could afford $400,000, you can only afford a $300,000 home today. It impacted the affordability of housing by 25%.
People look at that and they think about it. You got to remember, monetary fiscal policy, all of these things take anywhere between 6 and 24 months, sometimes longer to impact the economy. When we did the fiscal spend in 2020 and 2021, I almost looked at it like a boa constrictor eating a pig. It's in there but it takes a while to work through the system. It's got to come out.
The way that the federal government handles this is they try to react to it. They're always looking through the rearview mirror. They're always overshooting things. They've overcooked this thing. They've done a tremendous amount of fiscal spend, forced interest rates for the floor, and all of a sudden, the Fed wakes up and says, “We've got to slam on the brakes.”
It's almost like when I go to a hotel with my wife and it's a little chilly. Instead of turning it from 68 degrees to 70, she strolls in and cranks it up to 90. For a while, you feel okay. You lay down, you go to sleep, and then you wake up at 3:00 AM and you're sweating to death because she overcooked it, she cranked it up. That's exactly how these central banks deal with it.
You saw that in the housing boom and bust. You saw that in the tech boom and bust. It's cranking things down and cranking things up. We are back to our favorite ten-year Treasury yield. I've got fed funds rate. One of the things that I find interesting is we've got the fed funds rate at the upper bound of about 50 basis point. We've done one hike.
If you look at the yield, just the talk and job owning of financial tightening has caused the ten-year Treasury yield now to eclipse 3%. The Fed says that they're going to do many more of these. In fact, the fed fund future market was pricing in 10.13 more hikes. We've got a rapidly moving freight train. We've got super low, but increasing interest rates. We've got a ton of financial stimulus that was done. This train is moving along. Now we've got this high inflation and all of a sudden, they're going to hit the brakes.
It is now a policy of the Federal Reserve Bank to lower stock prices for the first time in my career. What does this mean? We've got a bubble in everything. Go look at house prices and look at stock market prices. People sell their businesses and say, “I don't even know where to put my money because everything's overpriced.” We are off to the worst start of the year ever in the global bond market.
If you go back to 1990, we can chart out the returns every year to the global bond market. This is $65 trillion in global bonds. It's the Bloomberg Global Aggregate total return index. As prevailing interest rates increase, the Fed can't control the long-end of the curve unless they do yield curve control, so that moves. As interest rates have spiked dramatically, bond markets have sold off. They're entirely repricing. We have more and more positive yielding bonds because bonds are getting cheaper.
That also has impacted the public equity markets. You hear about the 60/40 portfolio. I used banks like JP Morgan and Goldman Sachs. I talk to a lot of portfolio managers and I still hear a lot about the 60/40 portfolio. In fact, I've heard folks in the pest control industry financial advisors talking about the 60/40 portfolio. What the hell does that mean? That means a portfolio of roughly 60% bonds, 40% equities.
I've been particularly concerned about the 60/40 portfolio for a couple of years, especially when I saw stocks and bonds falling in tandem during the COVID crisis, which was extremely rare. I mentioned it at the PCT M&A seminar a few years ago when we got there. I felt like there would come a time when stocks and bonds fall in tandem, the purpose of the 60/40 portfolio is when stocks fall, bonds go up and when bonds fall, stocks go up. You have a levered bond portfolio and that risk parity balances out your risk.
Since November 2021, we've lost 24% on the Nasdaq, 15% on the S&P 500, and 12% on the bond fund. There's nowhere to run, nowhere to hide. Everything's falling. We're in a position where the Fed is trying to stop this freight train and they're going to use everything at their disposal to do it. This is the havoc that’s wreaking on the market because the market hasn't had to worry about this for many years and all of a sudden, it matters.
We have the 30-year mortgage index. That's why homes are 25% less affordable than they were 4 or 5 months ago. Negative yielding bonds decrease simultaneously at the spike in interest rates. There's no direct correlation between mortgage rates and negative yielding bonds. It's all a system that plays together. Yields up and these sorts of fixed income assets clearly down.
The extreme majority of the carnage, we see the interest rates on the 30-year mortgage going up, 2% or 200 basis points just 2022 alone. The negative yielding debt went from $11.5 million at the beginning of 2022 to $2 million and change. Seismic moves. We've got some inflation. The reason why I want to start to tie some of these macro things together for you is that pest control owners are a very optimistic bunch. It has served many of you very well.
I've got one of the most optimistic pest control owners on the planet, Mr. James McHale, who will certainly delight us and entertain us. Guys like him are entrepreneurs, are going to run through walls, and are going to get it done. Jim’s a young dude. He certainly wasn't operating in a high inflation environment. We are all in a very different environment right now.
Every single day when I have conversations with pest control operators, they say, “Paul, I need six more months.” “I need twelve more months because things are going gangbusters and demand has never been higher. I'm just having a hard time finding people. If this keeps going, I’ll have a business that's 50% bigger in two years when multiples hold up.”
For me, this discussion is about asset prices but it's also about the real economy. We talked about the inflationary pressures that the Fed is going to have to focus on. We need to think about where a lot of this inflationary pressure came from and why there's going to be a big fiscal drag or gap in growth, and why you're seeing all these Q2 earnings downside surprises.
You can't compare Q2 this year to Q2 last year because we had the COVID bounce and we had all this fiscal spend. This is going to cause a tremendous amount of drag. If you look at the PCE, the personal consumption expenditures, and the consumer's contribution to GDP in 2021, it was spectacular. I will tell you a little bit more of the types of things that I look at when I'm trying to manage my own portfolio. We have the US government's social spending outlays. The government has spent a ton of money, fiscal spending. We all know that $1.9 trillion and $1,400 checks went out the door, PPP loans, all these sorts of things.
We can see in the numbers. If you look at 2020 and ‘21, the Q1 of 2021 says $1.7 trillion. Here is what we're experiencing in Q2 of 2022. We have crossed over the threshold. That's the fiscal gap. At the beginning of April, we crossed over the one-year mark. That stuff is going to start to cycle through the economy and there's a $1.7 trillion hole. It's an important hole because we're effectively in a high inflation environment. The economy is beginning to roll over, decelerate. We're moving into the beginning of a Fed tightening cycle.
When you look at those fiscal gaps and you look at what was spent in 2021, where did it end up going? If I look at the last few years of inflation and I break it down, I like to understand what are the components of inflation. It's pretty clear to see that during COVID, a lot of the folks that work in factories were at home. You had healthcare workers, essential folks, pest control people out doing their job.
For the most part, factory workers had a tough time. We were making stuff. Supply chains, we were able to shift stuff. Consumer preferences shifted from services. It shifted away from hospitality to goods. This is exactly what happens. It doesn't take a rocket scientist to see the change in behavior. The government is sending out these checks and now we have inflation in goods. Of course, energy has ramped up. It was disinflationary and now it's inflationary.
I did a little bit of research as I was thinking about fiscal gaps because I'm trying to think about how I'm going to position my portfolio. In 2021, as the industries began to roll over, I needed to get positioned for 2022. We talked a lot about this on The Buzz, Patrick. I've been net short in the market since December. I have been a seller of equities in the market since December.
One of the things I did when I was doing some research is I got on the Congressional Budget Office and I saw the US fiscal spending. We've got a $1.3 trillion hole equivalent to 6% of GDP. When you start to get those sorts of holes, what ends up happening is growth accelerates, GDP turns over. If we look at the ISM services index, we are starting to decelerate. We haven't started the hiking cycle yet. We're decelerating there.
The ISM manufacturing index is losing steam. We are now at the lowest point we've been since May of 2020. We all know where consumer confidence is. I'm saying all these things because it's important to not take historical facts. Financial advisors always say, past performance doesn't guarantee future performance. What's gone on in ‘21, ‘20, and ‘19 does not mean it's going to continue to go on going forward.
I'm putting my money where my mouth is, and I'm betting that it won't. I'm betting that the Federal Reserve, at least in the near term, will dramatically impact not only asset prices, but also the greater economy. We've already got a quarter over quarter negative GDP print. We're barely out of this COVID thing. We've spent trillions of dollars and we're already printing negative GDP.
Why are we boxed in? The Fed could pull the Volcker playbook and jack up interest rates to 18%, control the M1 money supply, and do all the things that the monetarists did back in the 1970s and 1980s. The big problem with that is back in the 1970s, the US was a manufacturing superpower. It was roughly 1/3 of the global economy. It was debt to GDP at 35%. Even during the great financial crisis, debt to GDP was at 60%.
We eclipsed 130% in 2021 and we're at 125% now. There's not a lot of room to maneuver. Every 100 basis points and interest rate increases cost the US Federal Government about $350 billion in interest expense. I am betting on some rate increases in the near term. I'm thinking ultimately that the US will have to capitulate. If they do capitulate, probably at some point, is this six months off? Is this two years off? Is this five years off?
Where I will ultimately end up putting my money is the US will do what Japan is doing today, which is yield curve control. They are trying to control the longer end of their bond curve. They went out and said, “We are going to buy an unlimited amount of JGB ten-year bonds. We're going to print an endless amount of money to buy these bonds because we want to keep the yields at or below 25 basis points.” That is exactly what happens. That's the currency. That's the Japanese yen versus the dollar.
They lost 12% to 13% in a matter of a few months, which is a seismic generational shift for Japan. Japan's an importer of most things. It is going to have a dramatic impact on their cost of living over there. That is the price of yield curve control because you can either control the currency or you can control interest rates. You can't do both. Patrick, before we get deeper into some pest control stuff, what's on your mind over here?
Patrick Baldwin: I've got a few questions. I know how to operate a business. It's made a lot of rich rednecks in the pest control industry. I’ve got to love it. As I put on the investor mindset in 2021, I got to figure out, “What do I do with my money?” I'm wondering for those that are reading right now, it's better the devil they know than the devil they don't know. If they were to sell the pest control business, is there a place for them to put their money?
Paul Giannamore: You're saying you're in the process of trying to determine where you want to put your cash. I'm going to move us a little bit forward here. We're going to go back to Japan. When I think about market cycles, I think about where we are right now not only in global equities, but also on pest control. I think about the fact that a lot of folks take the buy and hold approach, which is a great approach to take. It's great if you're buying at the front end of a cycle when prices are low. It's great if you've got a 20 to 50-year time horizon.
It's not good if you went out in 1990 and said, “I'm going to buy the Japanese Nikkei,” and it peaked in 1989. If you waited until it sold off 25%, effectively what the Nasdaq has now done since its peak in November, you would still be underwater today. From 1990 to present, in real terms, you would still not have recoup your losses.
Had you bought the market index in 1929, bought the DAO, you would have been underwater until around 1954 in real terms. If you bought companies like Microsoft, parts of the Nasdaq in 2000, it would have taken you 30 years to get up. The wealthiest investors in the world over history have managed the market cycle.
If you think about Bernard Baruch, I read a biography of him over the Christmas holiday. It was fascinating because he was originally called the Lone Wolf of Wall Street in the 1920s. He was an advisor of President Roosevelt and a handful of presidents. He was one of the most wealthy Americans and he made a tremendous amount of money in the run up to the great crash in 1929. He sold out in 1927 and 1928. They were interviewing him some years later. They asked, “What has been the secret to your success?” He said, “I've always sold too early.”
My message to pest control operators is there's clearly the devil that you know and the devil that you don't know. I'm not suggesting that you run out and sell your business. Some of you guys should never sell your business. You're emotionally attached to it. It's part of who you are. The heart wants what the heart wants. That's it. Keep it.
If you're a sophisticated investor, you need to look at this data and think about where we are in the market cycle. There are lags and there's delays. One of the good things is we haven't seen the deterioration. We saw market multiples on the private side spike in 2021. We saw a straight line, so to speak, and a spike and it came back to trend. It hasn't rolled over. The market is buoyant.
My opinion is in the minority. Most pest control operators think that the stock market will continue to go up this 2022. They believe that pest control multiples are bare minimum, not decline because they've been up so long and this is the new normal. When you talk to some of the sophisticated acquirers, they will tell you things like, “Pest control companies always have to make acquisitions.”
I don't know why it's any different now than it was 10 or 15 years ago. You'll hear companies like AX, “We got big plans. We want to get to $1 billion in private equity firms,” and so on and so forth. Terminix is going to be gone so they're not there to buy anything. For me, history tells me to look at the macro environment and let that govern it. The micro environment is a small aspect of it. I'm focusing my attention on huge prevailing interest rate moves in equity markets.
I’m not saying the floor is falling out tomorrow. I'm just saying when I think about risk versus uncertainty, I can quantify and I can put odds to risk. I know what the risk of the roulette wheel spin is. When I start getting into uncertainty, I can't ascribe a risk to it. It's almost like saying, “What's the chance of Italy pulling out of the euro?” If I say 10%, I would have to act as though I make investment decisions based on me believing that, but I can't believe it because it's uncertain.
We live in an uncertain period but it's pretty easy for folks to look back over history and look at the yield curve inversions, look at fed tightenings. Go back 50 or 100 years and look when we have inflationary regimes and we have fed tightening. Show me indications where stock markets don't sell off 25% to 80% or 90% around the world. A pest control business is illiquid. It takes you 3 to 6 months to sell it. You know this. You started in March and when did we get out? Within August?
Patrick Baldwin: Yeah.
Paul Giannamore: You've got a very illiquid asset. Even publicly traded stocks in a market panic are extremely illiquid. Not only do I want to own them. That's why I use asymmetrical bets like options. To own a privately held business, when the jig is up, the jig is up. Having the optionality of cash to buy things when it rolls over puts you in a good stead. I told you before, “After you sold that business, don't rush into the market. Watch what you're buying. We're super high. Wait for a discount.” “Paul, inflation.” I'd rather 8% of my cash disintegrate than losing 50% in the Nasdaq rolling over because that's almost a sure thing.
Patrick Baldwin: That brings me to another question. I've heard you say mean revert and I question you, “Are you serious? This is going back dollar to dollar?”
Paul Giannamore: It wasn't too long ago where these things were dollar for dollar. I call the mean somewhere between 1 and 1.5 times revenue or somewhere in the 5 to 8 times EBITDA reach. For me personally, there is zero doubt in my mind that pest control will go back to that point. Hundreds of years of financial history shows mean reversion. Things shoot above trend and they go back.
I can't imagine being in 2009 and 2010 doing what I'm doing today, anything selling for the prices that they're selling now. If this Fed is even halfway successful in what they're doing, I'm not saying you're going to have twelve months to force it to the mean. I'm just saying we're in a market right now where we are guaranteed that multiples will go down. I don't know if they'll mean revert now, but they will at some point.
They're definitely going down. They're not staying the same. They're definitely not appreciating when we are in an environment where things are beginning to roll over. We're seeing it. There's a lag. The good news, private market illiquid, takes a long time to figure things out. This thing is still going. We're seeing a lot of support in the market today. I truly believe and I am prepared for things to change here.
Patrick Baldwin: 2021 was a perfect storm. You leaned on your timing saying, “Supernova, now's the time. Behind the Supernova, we're going through black bear.” Now I see this house of cards. Is there one more card that's going to make this whole thing top when the economy falls apart?
Paul Giannamore: Back after the financial crisis, I was at a hedge fund event in London and there was a guy who was speaking there. He’s a hedge fund manager. You hear one thing and it changes your whole outlook on investing. He was talking and said, “At the end of the day, nothing matters until the market cares about something. You don't have to predict the future. You don't have to predict the weather. You just walk outside and determine if it's raining.”
In 2007, the money markets were seizing up. We had some problems in the repo markets. The S&P was making new highs. The financial plumbing of the system was on the fritz and the market is making new highs because the market didn't care. Once the market did care, it was 2008. Guys are always looking through the rearview mirror at past and then seeses stuff. For me, it's not saying what's going to happen 3 months from now, 6 months from now, 12 months from now. I don't know if there'll be a catalyst. The Fed is going to increase rates until something breaks. We don't know what it is.
In the ‘90s, it was the Tequila Crisis and the Asian crisis. In ’94, Kidder, Peabody went bust. We had the Lehman incident. There's going to be something that breaks. I don't know what that is. All I know is I don't need to predict the future. I just need to look at what's happening today in this market. I don't think much of this stuff is priced in. Why do I think that? Because there's no way these markets could still be trading both the debt market as well as the equity markets with what they're going to need to do to try to get this inflation genie back in the old bottle.
Patrick Baldwin: It talks a lot about the macro economy. Drill in a little bit. Terminix and Rentokil are on everyone's mind. That's potentially one less acquirer, maybe two less for the near term. What's going on? What impact has that had and what will it have?
Paul Giannamore: I wake up in the morning and I don't even think about Terminix other than the European disposition projects that we're working on for the merger. Other than that, I wish all my friends at Terminix well. I don't think Terminix is a buyer. Terminix is looking at acquisition opportunities. Terminix is a buyer in certain circumstances.
I don't care about the number of buyers out in the market. I am watching what's going on in the debt markets. I'm watching what's going on with the high yield market and credit cycle. That's the 1 million-ton Freightliner coming down the rails, this big stuff. What Terminix is doing impacts things on the margin. I always say to clients that it's these big things that are going on. This is what matters.
Patrick Baldwin: We are live. I've got one more question. You touched on European. You were named as the advisor on the deal to divest. Terminix is a European portfolio. Can you give me a comment?
Paul Giannamore: No comment, Patrick. I've been warned. What I’m going to do is I'm going to play a clip from a friend of mine named David Clark. He was a client who sold his business in December of 2021. It's an Anticimex portfolio company in North Carolina, South Carolina, and Georgia. It’s a $20 million some-odd firm. David and Dawn, his wife, were down here. We went to Dorado. We spent some time out there. We're at my house on our way out to the country club and Dawn grabbed the camera and we got a clip of David. We're going to play that and then I'll be back momentarily with Dave and Jim. Send your questions.
Paul Giannamore: We're like Neapolitan out here. Jim did wear his baby blues. You don't look like Easter eggs.
David Billingsly: I'm rocking the pink, for sure.
Jim McHale: It takes a special man.
David Billingsly: I am special.
Paul Giannamore: Welcome back to the island, David Billingsly. Jim McHale, it’s your first time down in Puerto Rico.
Jim McHale: It’s a beautiful place.
Paul Giannamore: How are you enjoying it?
Jim McHale: I love it. I love the culture. I love the food. It's been wonderful.
Paul Giannamore: The Mexican trained you well.
Jim McHale: Yes.
Paul Giannamore: We've got Jim and David. Both of these guys have been on The Buzz. I've heard many people tell me that both Jim's episode and David's episode are their favorites. Some people thought Jim's was a favorite. You've got the halo effect from Jarl because you were on the front end of Jarl’s.
David Billingsly: I’ll take all that I can get because I need plenty of it. I preempt you.
Jim McHale: You probably have.
David Billingsly: Thanks, everybody.
Paul Giannamore: Here's why we got these guys on The Bubble Trouble. First off, I like to hang out with them. I've been talking to Jim in Puerto Rico for a long time. Jim, we didn't get to golf this time around but next time we will when Jen comes down.
Jim McHale: That's fine.
Paul Giannamore: You’re an Anticimex man, JP McHale. David, you were the head of the West Coast for Anticimex. Now, you have come down here and contributed to an already high level of unemployment on the island. You raised the rate today.
David Billingsly: I did because I am gainfully unemployed. I spent two fine months. My wife's probably not happy about it.
Paul Giannamore: There's been a lot of changes at Anticimex. You departed. Jarl left. Axelrod is gone. A lot of changes. You guys are here on behalf of yourselves as individuals. I want to start with Jim. Jim, when I think about this Bubble Trouble event and a lot of the things that are on the minds of owners that are contemplating selling their business. One of the main things that I hear is, “I've been at this for 30 years. I love these people. I love this office. This is a great place to hide from my wife. I want the money.”
David Billingsly: She’s watching, right?
Paul Giannamore: Of course, she is. Other people said that. He didn’t say that. In his household, she's the one that boots him out.
David Billingsly: Jen, he loves you.
Paul Giannamore: What do you tell a guy? In some ways, you were able to have your cake and eat it too. Amazon warehouse workers are paying him $22 an hour down the street from you. Still, you stayed at Anticimex. Tell us about that.
Jim McHale: This was probably one of the most emotional and hardest things I've ever done in my life. This was my baby. This was my identity. We built this thing from the ground up. We didn't do any acquisitions. It was all organic growth. It took a lot of servant leadership and a lot of focus on the client experience to differentiate ourselves from the marketplace. As you know, we've approached that topic probably 2 or 3 times. I couldn't pull the trigger because of the emotional attachment I had to the business and the people that I worked with.
Paul Giannamore: Didn’t you throw up once many years ago? We were going through a process. You got close to it.
Jim McHale: I was physically ill before I had to make a decision not to sell the company prior to selling to Anticimex on May 1st of 2019. I did come to a crossroads. At some point, you have to say to yourself, “What's best for my family?” All our eggs were in one basket. Everything I owned and every asset I had was in this business. We had a lot of nieces, nephews, and cousins who may be thinking about coming into the business.
We all know that from the 1st generation and 2nd generation, it's a 50% success. The 2nd to 3rd is a lot less than that. I had to make a decision that was best for my family, best for my brothers. Ultimately, I came across and met with Mikael Vinje and yourself in White Plains, New York several years ago. They talked about the decentralized business model and the fact that my brand would remain and I would be still running my business. The opportunities that I was presented to implement a lot of the strategic concepts that I always wanted to do was exciting to me.
Towards the end of the JP McHale era, I was trying to initiate concepts and push through ideas and initiatives. We didn't have the people. We didn't have the infrastructure. AX has presented me with the infrastructure, the resources, and a tremendous amount of technology. Our CEO, Bill Talon, said at a meeting, “We're an IT company now, too. We’re not just a pest control company but we're a technology company.” There's a lot of truth to that.
For those of you that are out there, it's emotional, I get it. At some point, you have to make a business decision. Work on your business and not on your business so to speak. AX, we're not heavy-handed. The integration process is exceptionally soft. We slowly and surely learn what made that company successful. We don't make heavy-handed changes. We don't screw around with the brand initially.
We've been confronted with all kinds of challenges. In one particular acquisition we did, the team members were on production pay. That's a sensitive situation. The worst thing you can do is have the technicians leave and the clients leave after you buy these companies with the multiples that we're paying. We had to be careful and strategic about how we wove those pay scales into our pay plans. All these companies are fragmented industries, highly niched, and have distinct cultures. The integration part is where we execute best.
Paul Giannamore: David, you and Jim are cut from a slightly different cloth.
David Billingsly: I'm an employee, or at least was.
Paul Giannamore: Jim didn't come from the trailer.
David Billingsly: I grew up with small beginnings in Florida. A lot of people have heard that story. I grew up on a double-wide trailer, me and my cousin, Skeeter. It was small beginnings. I was super humbled to be in the position that I was in with Anticimex. Make no bones, Anticimex changed my life. It put my wife and me in a position where we have the ability to make some decisions. It would have probably been different if Matt would have sold to one of the other larger acquirers.
Paul Giannamore: You're so rich now. You feel comfortable wearing a pink sport coat. You got to have money to pull that off. You can’t do that if you’re poor.
David Billingsly: Jim is rich.
Jim McHale: I wouldn't say that.
Paul Giannamore: David, when you and I got to know each other, you were at the helm of Americans. The Nixon family sold that business. You were running an American Pest in the mid-Atlantic. You and I talk every single week because you're killing it one deal after another. You then went out and you ran the West Coast for Anticimex for less than a year.
David Billingsly: It was quite over. It’s fourteen months-ish.
Paul Giannamore: What changes have you seen in the industry? This is not necessarily about Anticimex. I want to understand, what have you seen over the course of your career in this industry, at least from an M&A perspective?
David Billingsly: Matt sold in 2016. I started at American in 2006. We didn't do any M&A. I didn't know what M&A was. When Anticimex came in and Mikael Vinje came in and did his presentation, after he left, I looked around the room and I was like, “Did anybody understand half of what the hell he showed us?”
Paul Giannamore: It wasn't the language.
David Billingsly: I didn't know what EBITDA was and all of these fancy things. Probably, fourteen-ish, we started noticing some of the consolidations in the DC area. Connor’s sold to Rentokil and some of the businesses we traded against. It was a good competition. It began to sell. That's when we started to see things begin to progress for us. In September 2016, they were sold. They give me the keys of the kingdom. I got a PhD and five years from Anticimex. We did twelve deals at American. I did twenty deals total before I left. The consolidation is happening, there's no doubt about that.
For some of your audience that has those smaller businesses, $1 million to $3 million businesses, you've got these large players in the market and they're consolidating. They're buying the American Pest and the JP McHale of the world. There's a huge opportunity for those businesses to gain market share, the DC market, New York City, New Jersey, Florida, or whatever it may be, to build and grow those businesses. The customers want that local business. The bottom line is, as much as I wanted American to be the local business, we were something larger now.
Paul Giannamore: David, I'm on the sell-side.
David Billingsly: You made me pay.
Paul Giannamore: You're on the buy-side. Would you disagree with anything that I said about the speculative frenzy that took place in 2021 in the pest control M&A market?
David Billingsly: I agree. It was nuts. Generally, businesses would not have commanded the multiples. It's supply and demand. Once again, small beginnings, cousin Skeeter, and trailer. I'm not a smart guy. It's supply and demand. The good companies, the McHale's of the world, those got snatched up. Those should still continue to demand high levels of multiples.
It was the other ones that you'd look at them and you'd be like, “3 or 4 years ago, I would have said, ‘I'm not interested in that past.’” All of a sudden, you guys are coming to us or we're self-sourcing deals and we're finding things. We were working. You see these businesses and you're like, “I would have paid $1.5 X for it 3 or 4 years ago.” All of a sudden, Franco’s saying, “Billingsly, at 4X, get the deal.”
Paul Giannamore: Jim, since you sold Anticimex, you have done some deals yourself. You've probably done 5 or 6 of them. What is the JP McHale platform? The day it sold, it was 25 or 26, in that area. What is it now?
Jim McHale: We've doubled the revenue model. We did see the peak multiples in the back half of ‘21. There's still room. We have an aggressive M&A protocol. We're looking for strategic companies in high-value areas, strategic tuck-ins, and quality companies that we can open up new geographical footprints. There's an M&A market.
We can all agree that the peak was probably the back half of 2021. The markets got a little more competitive with some private equity firms but it's leveling off. We're going to be much more selective in the companies that we take. We’re going to have to check certain boxes in regards to tech utilization, density plays, and new geographical footprints.
David Billingsly: I heard you're going to Buffalo.
Jim McHale: If you get the right company and the right platform with the right people. One of the most positive things we get from these acquisitions is we get talent. If you can get the right people on board through these acquisitions, the sky's the limit. It's a talent-starved industry. It's great when you get people that are passionate about the industry and are open to learning and growing.
Paul Giannamore: Let me ask you both. This is the same question for the two of you. We didn't prepare for this. You guys are operators. You know so much more about pest control and operations than I'll ever know. Someone asked you an unfair question. I tend to think, at some point in time, and that time is closer, that transaction multiples will mean revert to where they were for the majority of your existence in the pest control industries. Being not finance guys focused on that, what's your initial gut reaction to that?
David Billingsly: I would agree.
Jim McHale: I would agree. I don't know if they'll go back to historic low multiples. The new PE players that are involved will prop up some of the multiples for the time being. Whether they stay in the market and how long they stay in the market or if they flip these companies, that's going to be a determining factor as to how these multiples are going to play out at the end of the day.
Like the stock market, when you're playing stocks, a lot of times they go on a run. When they come back down, they break through a ceiling, then there's a new ceiling, and there's a new low watermark so to speak. There might be a new low watermark at some point. I believe that these PE players and these new entries into the marketplace are going to shed light on how this thing unfolds.
David Billingsly: They're filling the void with the whole Rentokil and Terminix stuff. There's no doubt that some of that has cooled off. They're still doing some deals here and there. The PE firms, the Thompson Streets, and the Certus’s of the world, they're filling those gaps and holes for the time being. If you have a quality company, high recurring revenue, good profitability, and good people, and the talent acquisition piece of this, those are going to command high multiples. The other businesses that are 50% or 60% recurring and probably need to be developed need to be able to get that business ready to sell so they can get the full max value out of that. Because multiples in 2021 were so high, these people that weren't ready to sell were like, “I could get what?”
Paul Giannamore: You both were on Supernova.
David Billingsly: We’re super pissed at what it did to the multiples. All your clients were super happy. We were like, “What is Giannamore doing?”
Paul Giannamore: I doubled down.
David Billingsly: I do think they're going to come down some. The PE is going to fill some of that gap for now. Rentokil and Terminix, whenever this thing closes and they figure out what they're going to do with that business, they’ll jump in with both feet and that's probably going to hit the market up again.
Paul Giannamore: I have some questions for you guys. You two are sexy beasts and you have a lot of fans out there, especially amongst the ladies. We got some questions. I like it. There are some good questions here. Keep them coming. I like them. Question number one, is Jim McHale single?
Jim McHale: No. My wife and my sister-in-law are on this. I'm married to both of them. That doesn’t happen to Italian families.
Paul Giannamore: You are married. Jim is taken. I didn’t see, “Is Billingsly single?”
David Billingsly: That’s because I'm poor.
Paul Giannamore: You got a pink coat.
David Billingsly: I’m poor and I don't have a job.
Paul Giannamore: You’re like that Seinfeld episode, unemployed, living with my parents, the opposite. What do you think the time horizon is for a sale, assuming we close? As soon as we choose to hold through the impending recession, would you predict it is 3 years, 5 years, or 10 years before we see a recovery? For me, my days are trying to predict things. If I answer this question, my days trying to predict things are entirely over.
I never expected what would happen during COVID, all of that stuff. It's impossible to say. On the one hand, from a valuation perspective, there is a chance. I look at it and I say, “You've got so much underinvestment due to ESG like petroleum products and all those upstream and downstream aspects of the energy industry.”
At some point, I talked to Fidelity, Intero, Price, and all the portfolio managers and these are the guys that own significant chunks of Rentokil, Terminix, and Orkin. All of these guys are trying to deploy capital. One of the things that we have to always keep in mind is that investors’ preferences change. There are different investment opportunities. There’s tag, there's no tag, there's this, and there's that. It's hard to say. I wish I could answer that question. How long does a recession take? I don't know.
David Billingsly: Does a recession hurt the value of pest control companies?
Paul Giannamore: Why wouldn't it?
David Billingsly: We're about as recession-proof business as we can get.
Paul Giannamore: There are always two variables. If you're recession resilient, there's the stream of cashflow. Let's go with it and say, “David is right.” Not only is it easier to hire people but the business didn't trail off. The fundamentals of the industry are strong. That's one leg. The other leg though is the current pricing of the asset. If the Fed hikes or the bond market doesn't believe the Fed and it does it on its own.
David Billingsly: Money gets more expensive. The multiples should have to come down.
Paul Giannamore: That's the problem. How much does business market location affect multiples when selling? Which markets are the hottest? David, you are a transnational dude. What do they think?
David Billingsly: From a market standpoint, you can get strategic. It has nothing to do with Franco because he sucks at life. We went out to California. I say we. Anticimex is still in the blood. I still bleed blue. We got out there and there were certain markets that we wanted to get into. You guys knew that. Consequently, it was going to demand a higher multiple. The same thing.
Jim has probably got some targets up in the Long Island, New York City area and some of those are going to fill a need, whether it's because of route density or maybe this team has got a great leadership team and he needs some more leadership in those areas. Markets can drive multiples. It depends. You guys do a good job of this. You know which markets the acquirers are going into. When you do get an asset like that, you know how to price it appropriately and get full value at it.
Jim McHale: I might add that high-value locations filling whitespace for us, that's a huge priority. If you have the right business with a certain amount of recurring revenue and a certain amount of EBITDA, we'd be interested in speaking to them. Also, the verticals that are not affected by COVID. If you serve verticals that are unaffected by COVID, that's another high-value play.
Paul Giannamore: You guys are coming up with great questions. We did nine Supernovas in 2021, which was a ridiculously dumb idea in retrospect. It sounded great. You were in New York. You were in California. We brought on different people from different acquirers and we did them by region because every region is different. Take a lot of the Midwestern markets. Rollins, for example, has focused on the Midwest acquisitions. You guys had no platform out there. You weren't going to buy a $3 million business in Missouri or Illinois.
Every market is different. The West Coast has been different from the East Coast. That was a great answer. In today's market, what is a reasonable multiple for a sale, a 30-year history at about $1.2 million in revenue? It's impossible for me to answer that question because a company that does $1.2 million in a pureplay-recurring commercial that's priced above the median to the market is going to be a lot different than $1.2 million with 300,000 residential recurring low prices and a bunch of one-times. It's difficult to answer that question.
Jim McHale: We'd have to look at all the recurring revenue, EBITDA, route density, tech utilization, what service lines they have, and what verticals they serve. It's a complex model.
David Billingsly: It's the portfolio business. That’s recurring revenue.
Paul Giannamore: Jim will look at the numbers. For David, you would want to send in a photo. If you have a photograph, we do want to send that in.
David Billingsly: Drawing stick figures, that's helpful for me. I like pictures.
Paul Giannamore: If the valuation declines to 1 to 1.5 times, will it go back to three times revenue? If so, what is your best guess for when that happens?
Jim McHale: Being the elder statesman of the group, I've seen a couple of cycles. When I first got into the business, the waste management rolled up. It was another 15 or 20 years. I'm old, unfortunately. Everything's cyclical. I don't think we can time it but it will come back. If you're in the business right now and growing it and you're in your 20s, you've got a good opportunity to maybe take another bite in twenty years.
Paul Giannamore: If you want to do this, look at market cycles. Put the S&P 500 up. You can use those as proxies for valuations. At the end of the day, that governs. All you have to do is look back. You can pull that up from 100 years. Get online. You'll see that these market cycles tend to range from a few years all the way up to about 30 years with the median being 10 to 15 years, these market cycles. We're in the Great Moderation. The crises that we're having are more violent and dramatic but they tend to be more dispersed.
We've had a 6 or 7-year run. If they mean revert, you probably got 10 to 15 years. The good news is there are a lot of guys out there that are in their 30s and they've got twenty-year horizons. They can live that out. My clients that are the slowest in moving things along tend to be the guys that are 60 to 80. They're the at-risk population for a lot of things. They have heart attacks. They’re dropping dead. Also, they’re missing the boat on this. Those are the guys that won't get another chance if this thing rolls over.
Jim McHale: Especially in today's environment, we're facing things that are unprecedented like interdicted supply chains and spiking fuel. We had spiking fuel in some of the cycles I've seen.
Paul Giannamore: ‘14 and ‘08.
Jim McHale: We got through it. This business is recession-resistant. During the downturns, the residential side always spikes. The commercial side is tempered. It's a grind.
David Billingsly: If you want that valuation, I still firmly believe that if you've got a quality business that's built right, high recurring, high profitability, good people, those are going to continue to command high valuations. I'm not so much about missing the boat. It's more make sure that you've got your business built the right way for the acquirers. There are some smart folks that have done that with their businesses and they've commanded high values for those. It’s got to be built the right way.
Jim McHale: My relationship with Paul spans over fifteen years. We get together every couple of years. We talked about my numbers and what we needed to do to optimize the valuation. I've met with the big three multiple times over the course of my career and they shaped how we grew the business. It's smart to benchmark and to speak with people who have the intellectual property and can help you with the acumen. This industry has been good to me. People are always willing to share information. It was a great industry. It’s a small industry. I've made connections across the country. It's been fantastic. Those of you that are young, 20 or 25 years old, it's all out there for you. You have to seize the moment.
David Billingsly: I'll give The Boardroom Buzz a shameless plug here. Throughout this journey, if you go through those episodes, there's some good quality stuff in there on how to build your business the proper way. All you’ve got to do is subscribe to The Buzz.
Jim McHale: I wish this was around when I first came into the industry. It would have been fantastic.
David Billingsly: You guys didn’t even have TV back then.
Jim McHale: They didn't have face masks on football helmets when I started.
David Billingsly: You guys used to crowd on the radio.
Paul Giannamore: You had all those dudes at Western that looked out for you.
Jim McHale: I had some great mentors, Tony Fortunato, Tony Ramirez, and the guys at Western.
Paul Giannamore: You missed Tony by a month. He was down here.
Jim McHale: He told me. Franco sent me photos of him and Tony at the beach. He’s been a good friend for a long time.
Paul Giannamore: It’s weird. He's down here with his wife but then I see the pictures and it's him and Franco, the Mexican, laying on the beach. I was like, “Okay.” I’ve got more questions. This is an interesting one. It's not relevant to you guys. Do you have any comments specifically directed toward the Canadian pest control market? You guys aren't in Canada. Vinje used to look at a few things in Canada.
David Billingsly: That's a good Givlin question.
Paul Giannamore: We are going to take this question and we're going to send it to Givlin. We are going to get back to it. The pest control market in Canada is similar to the US market. To me, all of Canada is like the West Coast of the United States. When I look at the East Coast, it's old firms, it’s developed, American, JP McHale, all the old school developed firms. California is the Wild West with lower recurring revenue. There are a lot of rat cities out there. Canada's like that. You tend to have lower recurring revenue. Obviously, the weather's adverse.
David Billingsly: Huge termite market there. I’m joking.
Paul Giannamore: Will the Mex be making an appearance?
David Billingsly: I hope not.
Paul Giannamore: I don't know about that.
Jim McHale: He’s got to face the radio.
Paul Giannamore: Do we have any more questions coming through here?
David Billingsly: How many folks do we have online? If the Mex shows up, they're going to all leave immediately.
Paul Giannamore: The questions are being brought over. We're not going to bring the Mex online.
David Billingsly: It's good. He probably got a stupid swim trunks on or something like that. He has his sunglasses and his hair blowing in the breeze.
Paul Giannamore: Is there a correlation between gross profit versus EBITDA revenue to a company valuation? I’ve got some opinions but I want to start with you. Is there a correlation?
Jim McHale: We love to look at gross margin, that's one of the leading indicators for us to say, “This is a great business.” Anything north of 58% on the gross margin is attractive.
David Billingsly: I agree wholeheartedly. There should be unless your indirect costs are out of control so that's going to affect EBITDA. You want to have that higher gross margin business. It usually means that you're priced properly. It usually means that you're routed properly so you're efficient. It usually means that your wages aren't crazy high as well. When you see that high gross margin business, it usually points to all of those things. EBITDA should come through. Even if EBITDA doesn't, those indirect pieces are much easier to control. If you've got a wage issue, that's hard to undo. That's tough.
Paul Giannamore: I have now gone through and looked at the internal business cases. I've been doing this long enough. Your friends at Anticimex sent me a business case inadvertently on accident. I've seen them all and they're all similar. You guys are looking at historical financials. You're projecting them to the future. You're trying to quantify synergies. You're making your business case as to why you guys should do the deal and how you're valuing it as such.
Inevitably, over time, if you take a business like Anticimex being a private equity roll-up, you have the platform, JP McHale or American, for example. If I run in JP McHale, $50 million in revenue, I find a $5 million business, correct me if I'm wrong, you would first be looking at top-line revenue, understanding the quality of that revenue, and looking at the gross margin because that's the big picture there. You're thinking, “Who's staying? Who's going? How can I get some back off as a field to finish efficiencies?”
What I've noticed lacking from almost every business case that an acquirer has done is the field efficiency analysis, meaning they talk about technicians but they don't route it. That's like the gravy. We're taking that gravy there but it's not going in the business case. You guys make reference to it. It always exists. You being the president of American overtime and you being a former seller, are there things that you learn or anything that surprised you being part of a big company when you look at acquisitions? You probably learned a lot,I would imagine.
Jim McHale: Absolutely. I've learned a tremendous amount since I joined AX in regards to KPIs, dashboards, transparency, and accountability. Pricing is an art. We want to make sure that people are doing regular price increases. One of the big initiatives that Jarl made before the inflation started was, “We need to adjust our pricing. We need to get ahead of this.” He called it the 800-pound elephant in the room. We had to stay ahead of the inflationary headwinds. We looked for regular price increases when we're at a company, tech utilization with the routes are valued at, the general overall efficiency of the company, vehicles, and all the direct stuff.
Paul Giannamore: I'm going to ask you, Jim. The final time we went through a real process and you met with Jarl and all these guys and we went over to Stockholm and you had Jen over in Stockholm, which is fantastic.
Jim McHale: In the hotel where Stockholm syndrome was invented.
Paul Giannamore: I remember that distinctly.
Jim McHale: Nice bar though.
Paul Giannamore: It's a fantastic bar.
David Billingsly: Paul loves Stockholm. He may or may not have missed a flight occasionally. I wouldn't know anything about that trip.
Paul Giannamore: I had been there over 30 times over the past several years with everything that was going on over there. I love Stockholm. When you finally got serious, you looked at transaction multiples, you looked at the family dynamics, and you said, “I've got all these nephews. I got to get my ducks in a row and I’ve got to figure this out.” You look at strategics. Between John Wilson and Orkin and Freeman, you know all these guys. It was a super easy conversation.
You wanted to explore private equity and that was the beginning of private equity looking in the industry. When we compared enterprise value between what the strategics could do and what private equity could do, there was a big enough delta. A little bit more context for the readers, Jim had two brothers in the business. You wanted to stay and you were happy to roll all of your equity but we needed to make sure we got them out at a fair price. They weren't going to be like, “I'll take a discount.”
Jim McHale: That's why AX was the perfect model because they were a strategic yet also private equity. They had the best of both worlds.
Paul Giannamore: You're part of AX. Do you think about what it would be like? What thoughts do you have for guys that are your age even exploring the private equity route? You haven't gone through it?
Jim McHale: Talking with all those private equity companies, we interviewed Morgan Stanley. I have tons of them and we talked to them all. At the end of the day, we didn't have the infrastructure to optimize the value for those private equity firms. It would have been a risky situation for us to roll our equity in without the infrastructure.
The fact that AX was strategic, they were in our space already. They understood the model. They said to us, “Once you're on board and when your brothers have retired, you need to build out a leadership team and build this infrastructure out.” Their guidance was instrumental. Guys that are talking about a private equity firm, you need to make sure you have the proper infrastructure when you merge with those so you can hit the ground running and get your second bite of the apple in a fruitful way.
Paul Giannamore: We have a lot of interesting questions. Speaking of private equity, how has PE affected the current acquisition market? How will it affect the future acquisition market? Which macroeconomic factors have impacted PE companies in the pest face? I can answer that to a certain degree. As I've said on The Buzz, if we have 20 bidders in a process, 15 of them are private equity firms. I'm getting on a plane leaving Puerto Rico. I am sitting down with a client and a $6 billion private equity firm that is about to enter into the pest control space. They're moving in.
On Supernova, there was a clip of me talking about how private equity always tends to enter the party late. I can say that because we used to. I used to be at American Pest. We would go out and we would look for these opportunities. We would enter late because we always wanted to find something that was proven. We didn't want to be the pioneers. We wanted to go out and try to find an industry. In the world that we live in right now, there are private equity firms that have started groups called the Residential Services groups within XYZ capital to go out and buy plumbing, HVAC, and all of this stuff.
To answer some of the questions, has PE affected the current acquisition market? In the second half of 2021, there were many instances where PE was solely responsible for pushing up valuations above historical limits. It was private equity betters doing this. How will it affect the future acquisition market? Private equity, when they model these things, model it based upon exit. David, you guys know this. I'm not going to ask you to give away the secret sauce. When you look at Anticimex's valuation, it's a PE model. What did they do? They take Rentokil. They take Rollins. They tie it right to those multiples at an impute enterprise value. That's how you’re stocked. You guys roll equity and that's how it's valued.
David Billingsly: For me, that second bit of apple was great.
Paul Giannamore: I can see it. You had a lot of second apples.
David Billingsly: I’m down fifteen pounds.
Paul Giannamore: You look great, though. You did lose some weight. It'll continue to support the market. What macroeconomic factors impact PE companies? The biggest. In 2021, PE firms were putting upwards of seven times EBITDA leverage on businesses. Think about that. Seven times EBITDA was the debt. Something anyone can look at is if you type into Google Ticker HYG, that's the high yield ETF. It's a simple way to monitor the credit cycle. As the dollar increases the way it has been, as interest rates go up, it's hard on high yield credit.
The number one impact on private equity is credit. The number two impact is where the publicly traded companies are focused. When you talk to private equity firms and I meet with them every week, most of the guys are younger than me. Most of them are in their early to mid-30s. They have never lived through like 2008, 2000, or 2001. None of these guys have any idea how to navigate this and they're all extremely bullish, which is good for you, the seller. You want them to be bullish and you should be happy that this is an intimate discussion with our brethren in the industry.
All these private equity firms were booted. We don't want them here. The private equity firms on this. This is straight-up pest control talk. At the end of the day, these guys are bullish about this industry. They look and they have the ability to do some consolidation. Private equity firms have to commit capital. They have a ton of proverbial dry powder.
The last thing I'll say about private equity is if you think about it, how do private equity firms get paid? They get paid because it might be 2% and 10%. It might be a 2% management fee or 1% management fee and then they get 20% of the upside. If you're a private equity firm and you go out and you get a massive return, you get a massive payday, if you bust out, you don't lose money. You're sharing in the upside. You might have a hard time raising capital going forward but we go through these cycles and financial investors have short memories.
I love some private equity in the late stage because these guys are always looking at the back end. The good thing about private equity in the late stage is that the principals there can't lose money. They're losing their investors’ money. For me, I say double down on this. It's a transfer of wealth from pension funds, from everyone else that's investing in these private equity firms into your own pocket. It’s nice to take advantage of it. That's what I pushed in 2021, big time.
Jim McHale: If I might add, you talked about the dry powder. In my circles, every private equity person I speak to, not ones I'm doing business with but in passing, their biggest problem is finding a deal. That's something you could leverage if you're a seller. They have a tremendous amount of cash and they are looking for deals and dry powder.
Paul Giannamore: Now that you are unemployed, how can you help my business, David?
David Billingsly: I don't know. I've got sixteen years of experience. If you're interested in long-term and selling, you're not ready to sell now. You want to be able to take your business from that 50% or 60% recurring. How do you get that? I've got some experience in being able to do that. I certainly can do some of that. I'm accepting all calls and entertaining all offers right now. I've been off for over two months. It's been good. The break was much needed. Eventually, I'll get back into the game in some way shape, or how. I've been saying this for years.
For folks that have known me through Copesan and through Associated, there's a significant void for mid-level management training here in our industry. I'm sure nobody reading has ever done this. Jimmy, your best technician always makes your best service manager. How many times have we taken the best technician and made them a service manager because you're growing your business?
The bottom line is, as leaders, part of our job, and Matt was great at this, is supporting us to give us the right tools that we needed to be successful. As leaders, part of our jobs is to make sure that we are giving our future leaders the right tools for them to be successful to be able to do that. I've been able to do that over a sixteen-year career in the pest control industry. I'd be interested in that. I'm a sports guy. I always said that I wanted to be a football coach. Now I can be a business coach. Who knows?
Paul Giannamore: There's good news and bad news. The good news is we've got a ton more questions. The bad news is I have been commanded to wrap this up at the end of the hour. I'm going to thank my fine guests for coming down, suffering the Mexican, and enjoying the beautiful weather in Puerto Rico.
David Billingsly: This is horrible.
Paul Giannamore: I appreciate the two of you guys.
Jim McHale: Thanks for having us. It’s a pleasure being here.
Paul Giannamore: I appreciate everyone here in San Juan, Puerto Rico. Jim and David, thank you for joining us. In closing, I'm going to talk a little bit about some key takeaways for you. First off, you learned from some folks on the buy-side as well as me on the sell-side that there was a speculative frenzy in 2021, especially the back half of the year, which is why we did Supernova. The transaction multiple is here in 2022. The good news is the market is still resilient. There is a lag between what goes on in the public equity markets and the private markets.
You haven't missed the boat. There's an opportunity to get out the door. The main folks that are at risk here are the old timers that are thinking, “I want to do this for another 6 to 12 months, grow this business, and then ultimately try to sell it a year from now.” You might be okay but there's a significant risk that you are going to miss the boat. I'm not talking about missing the boat and multiples mean revert to 1 or 1.5 times revenue. The real risk is falling off 30% or 40%. Think about it, if you own a $10 million business, 30% to 40% is $3 million to $4 million. That's real money. It's something that you need to be cognizant of.
The good news is we're out here, we're Potomac, and we can help you. We make it easy to work with us. In a lot of ways, we're waiving upfront fees for folks to come on in. We'll bring a preliminary evaluation at a table and you'll be one of the first guys to get the email that says, “Sell now,” which most of our clients benefited from in 2021 when we had the most spectacular year from a valuation perspective in the industry. Before I leave, I'm going to introduce my colleague, Jessica. She's going to give you a number and you can track us down. Jess, what's our number?
Jessica Scogin: Those of you who want to reach Potomac, you can reach us at 267-242-8132 or send us an email at Pest@PotomacCompany.com. I look forward to hearing from you.
Paul Giannamore: Thank you so much for joining us. You'll be getting a commentary from me. I'll have charts from the show because I know everyone's going to ask me for them. Hold your horses, you’ll get the charts. We're going to be doing the drawing and Patrick will be announcing the winner is on the trip to Puerto Rico on The Boardroom Buzz. Thank you.
Thompson Street Capital Partners
David Billingsly - LinkedIn
Jim – EP 25 – Anticimex Acquisition Bellwether JP McHale PEST CEO Jim McHale
David – Bonus Buzz – Anticimex Enters California, Acquiring Pro Pacific Pest