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Rentokil's investment case is still intact

Rentokil is a good business with a good strategy for growth markets. This has served shareholders well in the past and looks likely to do so in the future.
Rentokil's investment case is still intact

Rentokil Initial’s (RTO) business strategy has done a great job for its investors over the past decade. It looks well placed to keep on doing so.

 

The business

Rentokil is the world’s leading pest control company trading under the Rentokil brand. The business is managed along the lines of local service teams largely located in urban areas and big cities. 

It offers pest removal and pest prevention services and removes pests such as rodents, insects, birds, snakes, termites and mosquitoes from commercial and residential properties. Around 80 per cent of the business is for commercial customers with a high level of contracted revenues. The business accounted for 64 per cent of total revenues and 68 per cent of operating profits in 2019.

The company’s Hygiene business trades under the Initial brand. It provides services to washrooms and buildings. It installs and services products such as soap and sanitiser dispensers, hand dryers, air purifiers, feminine hygiene units, toilet paper dispensers and floor protection mats. It also offers deep clean and disinfection services. Hygiene accounted for 20 per cent of Rentokil’s revenues and 21 per cent of operating profits in 2019.

Protect and Enhance supplies workwear and personal protection equipment (PPE) in France. It also has businesses specialising in plant displays in buildings and property maintenance services such as damp proofing, wood rot treatment and hazardous waste removal. This division accounted for 15 per cent of revenues and 10 per cent of operating profits in 2019.

Rentokil is very much a global business with nearly 90 per cent of its revenues generated outside the UK. The business is dominated by the US Pest Control division which accounts for just over 40 per cent of revenues. The company is trying to build up its exposure to emerging markets in Asia and Latin America.

 

 

Historic Business Performance

Rentokil looks to be a good business based on its financial performance ratios. The business has reasonably high operating margins and return on operating capital employed (ROOCE) while turning most of its profits into free cash flow. Combined with organic revenue growth and growth from acquisitions it has been able to deliver meaningful growth in profits for its investors.

Acquisitions are a key part of the company’s growth strategy. So much so that a significant chunk Rentokil’s invested capital is accounted for by the goodwill it has paid on those acquisitions. A pre Covid-19 ROCE of just over 11 per cent in 2019 suggests that the company is managing to make adequate returns for its investors on the money spent.

As an analysis point, Rentokil reports its adjusted operating profit before the amortisation of intangible assets apart from computer software. That’s not unusual in itself, but if you are using that profit number to calculate ROCE then it makes sense to add back the amortisation on intangible  assets such as customer lists and brands. This means that the profit and the capital employed number are both stated before amortisation which means you are comparing like with like. This has a big impact on Rentokil’s ROCE figure which would be just under 14 per cent in 2019 if this adjustment was not made.

These days I tend to look at ROOCE as the main measure of how good a business is. ROCE takes into account goodwill and shows whether a company may have paid too much for acquisitions and depressed returns in the process. Rentokil’s ROOCE has been at a very decent level.

The company has been carrying a reasonable amount of debt which spiked in the first half of 2020 as it borrowed money from the UK government’s covid corporate financing facility (CCFF) which it has now paid back. In 2019, total debt was just over five times annual free cash flow and had been on a downwards trend and not placing the company under financial stress.

 

Rentokil: Key financial performance numbers

£m

2015

2016

2017

2018

2019

LTM

Revenues

1,759

2,168.1

2,412.3

2,472.3

2,714.4

2,706.5

Op profit

232.9

284.4

314.5

329.3

365.4

352.2

Net profit

150.8

195.9

223.6

240.7

266.8

254.4

Free cash flow

149.1

164.3

189.6

190.7

263.1

279.3

Invested capital

2,075.4

2,411.5

2,969.4

2,939.5

3,266.4

3,466.8

Goodwill

597.3

736

972.2

1,156.8

1,342.5

1,433.2

Intangible amortisation add back (ex software)

434.6

470.9

507.5

581.1

631.2

674.2

Operating capital

1,478.1

1,675.5

1,997.2

1,782.7

1,923.9

2,033.6

Debt

1,198

1,337.8

1,234.9

1,238.3

1,360.6

2,016.3

Cash

102.6

160.2

310.1

129.8

309.6

973.6

       

Operating margin

13.2%

13.1%

13.0%

13.3%

13.5%

13.0%

FCF margin

8.5%

7.6%

7.9%

7.7%

9.7%

10.3%

FCF conv

98.9%

83.9%

84.8%

79.2%

98.6%

109.8%

ROCE

11.2%

11.8%

10.6%

11.2%

11.2%

10.2%

ROOCE

15.8%

17.0%

15.7%

18.5%

19.0%

17.3%

Debt to FCF

8.0

8.1

6.5

6.5

5.2

7.2

Net debt to FCF

7.3

7.2

4.9

5.8

4.0

3.7

Source: Annual reports/Investors’ Chronicle Note: LTM invested capital has been adjusted for CCFF borrowing of £600m

 

Looking at the performance of the three main divisions shows that both Pest Control and Hygiene have been able to grow while maintaining high operating margins. Protect & Enhance has been struggling to grow profits and suffered a lot in 2020 due to workplace closures.

 

Rentokil: Revenues, profits and margins by division

Pest Control £m

2015

2016

2017

2018

2019

LTM

Sales

791

989

1,328

1,572

1,700

1,708

Op profit

151

184

240

277

305

294

Margin

19.1%

18.6%

18.1%

17.6%

18.0%

17.2%

       

Hygiene £m

2015

2016

2017

2018

2019

LTM

Sales

458

446

403

537

547

570

Op profit

90

86

71

90

97

101

Margin

19.7%

19.3%

17.7%

16.8%

17.8%

17.8%

       

Protect & enhance £m

2015

2016

2017

2018

2019

LTM

Sales

384

343

362

384

398

374

Op Profit

51

40

37

45

49

40

Margin

13.3%

11.6%

10.3%

11.7%

12.2%

10.7%

Source: Annual reports/Investors’ Chronicle

 

The Pest Control business has been reasonably resilient due to the high contracted nature of its revenues and its status as an essential activity. That said, the business has had to deal with higher costs to keep its workers safe and has seen bad debt provisions increase. This has been offset by some significant cost cutting.

Hygiene has benefitted from an increased focus on cleaning despite many workplaces being closed during 2020. The business has seen very high demand for cleaning and disinfection services which earn higher operating margins (similar to Pest Control) and should have seen profits grow in 2020.

Protect & Enhance has seen its profits hammered by lockdowns in France and the reduced demand for workwear that came with it. Demand for plant and property management services has also been subdued.

While acquisitions have been a big part of Rentokil’s revenue and profit growth, the company has proven that it has been capable of delivering reasonable rates of organic revenue growth which is prerequisite for any successful long-term investment. The key issue is whether it can continue in a more normal world.

 

 

Competitive positioning and growth outlook

Whether Rentokil stacks up as a decent investment at its current share price largely depends on the growth outlook for its Pest Control business and the company’s competitive strength to exploit it. In both cases there are reasons to be hopeful.

Demand for pest control services is expected to keep growing. As the global population has kept on growing and more people live in urban areas and big cities, pests have become a bigger problem and need dealing with. 

Rentokil looks very well placed to grab a decent slice of this growth. It has a long established and trusted global brand combined with the scale to offer great service to its customers around the world. It competes on service quality and product innovation.

The company has been good at introducing new types of pest control products that are chemical free and use non-hazardous biocides. Its LED-based insect catching products are a great example of a successful recent innovation that has gone down well with customers.

Rentokil has also invested extensively in the digitisation of its business which is benefitting both its customers and itself. Customers can now monitor pest threats around the clock and report issues back to Rentokil. Out in the field, Rentokil’s employees can log their work digitally while better monitoring of local areas can optimise the efficiency of local routes. 

Investment in product and service costs money which the bigger players such as Rentokil can more easily afford. This acts as a barrier to competition and should help more business flow its way as well as acting as a catalyst for further consolidation in a highly fragmented and large US pest control market.

There is still plenty of scope to hoover up smaller competitors by buying them out. This will also help with something called route density. This is where a pest control company is able to serve more customers in a particular postcode area and also sell more services to them. This will give rise to some positive operating leverage effects within the business and should help profit margins increase.

A significant source of future growth is in mosquito control. Mosquito-based infections are a growing threat to public health in the US and around the world. Rollins – one of Rentokil’s biggest competitors in the US – is currently seeing revenue growth rates of more than 30 per cent. Treating bed bugs and termites are also areas that offer high growth potential but Rentokil will have to beef up its offer to residential customers in order to exploit this fully.

Despite the positive backdrop in the US, Rentokil is going to have to work hard to keep investors happy. It has set itself a target of having annual US revenues of $1,500m with profit margins of 18 per cent by the end of 2021. At current exchange rates of £1=$1.39, this would mean a business producing operating profits of £194m by the end of this year. In 2019, operating profits were £147.4m at a margin of 14.2 per cent.

Some City analysts are sceptical as to whether Rentokil can meet its US target. Covid-19 will not have helped and nor has the rising asking price for acquisition targets which will drag down the returns on them. However, the company has yet to moderate its ambition. 

One thing that could help them out is a return to pricing growth. The industry in general has not increased prices since Covid-19 came on the scene as they wished to be mindful of their customers’ ability to pay. Pest Control contracts usually track RPI inflation and it is likely that price increases will come back in 2021.

That said, pest control businesses have taken a hit from higher Covid related costs while bad debt provisions have also been increasing. If the US economy rebounds nicely when Covid abates then this will not be a worry but there is a risk that rising unemployment and subdued demand could slow down Rentokil’s rate of progress.

Another issue to consider is how easy it will be for Rentokil to scale its business in big cities in emerging economies. There is unlikely to be the same consolidation opportunities and the blot on benefits that come with them. This will mean high upfront investment costs and possibly lower initial returns on investment. The hope will be that higher growth will follow and that such investments will pay off handsomely.

Investment costs is a key issue within the Hygiene business’s growth strategy as well. Rentokil has exploited the surging demand for cleaning and disinfection services by launching Hygiene services in 20 new markets in 2020.

I think that it’s likely that the strong demand that was seen in 2020 will continue in 2021 and that this recent move will pay dividends in the short-term. The issue longer term is that Rentokil has not invested in the assets needed to create a growing business. 

At the moment, it is leveraging off its Pest Control infrastructure to provide cleaning services for Hygiene customers. This cannot continue for long and getting the balance right between money invested and the long-term revenue and profit opportunity for these new Hygiene markets post Covid is a challenge for management in my view.

 

An improving outlook for profits

After pulling its profit guidance for 2020 back in March due to Covid-19, the newsflow coming out of the company has been steadily getting better. The Hygiene division’s profits have been getting a nice – albeit temporary – boost while the Pest Control business has returned to growth. In January, Rentokil said that profits for 2020 would exceed current analysts’ expectations.

The company reports ist 2020 result on March 4th and it will be interesting to see if there is sufficient momentum in the business to raise guidance for 2021. What investors should see is that Rentokil will have proven to have been a very resilient business in 2020 with profits similar to 2019.

 

Rentokil forecasts

Year (£m)

2020

2021

2022

Turnover

2,812.70

3,002.50

3,126.50

Ebitda

590.7

654.8

709.3

Ebit

363.8

411.8

452.7

Pre-tax profit

339.9

380

427.9

Post-tax profit

258.7

295.4

334.6

EPS (p)

14

16.1

18

Dividend (p)

4.2

5.5

6.1

Capex

206

225.7

235.2

Free cash flow

250.9

288.1

313.6

Net borrowing

1,025.00

942.8

775.3

Source: SharePad

 

Analysts already assume that the company will resume its growth path again. Operating profits are expected to grow by 13 per cent in 2021 and by another 10 per cent in 2022. This assumption will be based on a reasonably significant amount of acquisition spend and that organic growth rates remain healthy. The big risk to these forecasts is the continued strength of sterling which is currently benefiting from its perceived Covid-19 vaccine status relative to other economies. Further strengthening from the current $1.39 level is likely to see forecasts come down.

But if they are achievable then there is a case for arguing that Rentokil shares are attractive to long term investors in a low interest rate and low inflation environment. There’s a lot to like about this business but unsurprisingly the stock market already knows this.

Pest Control and hygiene businesses currently command very high stock market valuations, especially in the US.

 

 

Rentokil peer group valuations
 

Price

Mkt cap (M)

PE (NTM)

Rentokil Initial

5.28

9,740

32.0

Terminix Global Holdings

$36.10

$4,769

37.4

Rollins

$27.14

$13,344

60.3

Ecolab

$158.77

$45,321

40.5

Source: FactSet

 

Just because a comparator company’s shares are expensive does not mean that Rentokil shares are cheaply valued. At 528p they trade on a PE of 32 times based on forecasts for the next year’s earnings per share (EPS). 

This kind of valuation is not unreasonable in current markets for good businesses that offer predictable and global growth. Rentokil fits this criteria and while its shares may not compound in value as they have over the last decade (total returns of 456 per cent) they could still do well for investors with a long-term and patient outlook.