Clean up with Rentokil

As the world’s leading commercial pest control company, Rentokil Initial (RTO) is never going to be crowned the most glamorous business listed in London. But its non-discretionary services, high levels of contracted revenue and enduring demand trends offer investors a defensive, predictable and long-term growth opportunity.

Fund managers have certainly taken note. Jamie Forbes-Wilson, co-manager of the AXA Framlington Managed Balanced Fund (GB0003509659), points to “the security and stability of its earnings, the international opportunity and M&A optionality”. He says that the company “plays into a lot of themes around population growth, urbanisation, and clearly, within the past 12 months, a greater degree of focus on cleanliness and sanitation”.

Leading the rat race

Rentokil derives almost two-thirds of its revenue from pest control and is the number one player in 54 of its 82 markets. Tapping into a global market estimated to be worth $21bn (£15bn), it caters to both commercial and residential properties, dealing with everything from rats and moles, to mosquitoes and termites.

Commercial customers account for 80 per cent of the group’s pest control sales, and thanks to its scale Rentokil is able to serve both national and global accounts. Around 75 per cent of revenue comes from subscriptions and its client retention rate was 84 per cent last year.

As well as its large footprint, product innovation also provides a competitive edge. Moving beyond the basic bait box to hi-tech pest control solutions, the group’s PestConnect system uses infrared beams to sense rodent activity, activate traps and update its technicians in real-time. Its installed base of such connected devices more than doubled to 150,000 last year, and it is hoping to reach up to 300,000 in 2021.

Because pest removal and prevention are essential services, this provides some protection from economic downturns. Rentokil’s pest control revenue was largely flat in 2020 as the closure of offices and hospitality businesses was offset by higher demand from pharmaceutical and residential customers.

“Whether you're going through leaner times or not, if you have a pest problem, you're going to pay to have it sorted out,” says Forbes-Wilson. “So, the consistency of earnings generation through the cycle is one of the appealing parts of the business.”

Demand for pest control is also underpinned by numerous structural growth drivers, including rising urbanisation, increasing workplace and food regulations, and climate change creating favourable conditions for unwanted critters to thrive.

Pest control has traditionally been Rentokil’s engine room for growth and what it is best known for. Indeed, prior to the pandemic, Mike Fox, manager of the Royal London Sustainable Leaders Trust (GB00B7V23Z99) – which has the group as a top 10 holding – was focused on the appeal of the pest control market, telling Investors' Chronicle that Rentokil is “an exceptional business in an exceptional industry”. Now, though, he says the group is “play[ing] into one of the biggest drivers of the post pandemic world: hygiene”.

Supplying items such as soap dispensers and air purifiers for businesses, hygiene activities account for just over a quarter of Rentokil’s total sales. Revenue from ‘core’ hygiene services dipped by 5 per cent last year, reflecting the closure of schools, offices and hospitality locations, but amid soaring demand for disinfection services overall hygiene revenue surged by 37 per cent.

The group rapidly adapted to the pandemic, training 7,000 people in less than a month to provide its deep cleaning solutions and launched its hygiene services in 20 new markets, including North America.

The question is, how much of this demand will persist beyond the Covid-19 crisis? Rentokil anticipates disinfection volumes and prices will "significantly unwind” as the pandemic abates, but it believes there will be an increased focus on hand, surface and air hygiene as part of the ‘new normal’. As such, it now expects 4 to 6 per cent organic revenue growth from hygiene services in the medium term, up from previous expectations of 2 to 3 per cent growth.

The least attractive part of Rentokil’s business is its ‘protect and enhance’ division, which provides plant displays for commercial settings, property care services in the UK and workwear in France. It has struggled to grow revenue and profits over the past few years and has been hit hardest by the pandemic due to its high exposure to the hospitality sector – the segment’s adjusted operating profit plunged by 30 per cent last year to £33m.

David Greenall, an analyst at Davy Research, suggests the protect and enhance division should be sold and the capital reinvested into pest control and hygiene. He estimates the business could be worth around £400m.

Chief executive Andy Ransom isn’t ruling out a disposal, saying that “if there is an opportunity where we can create value for shareholders and look at a potential exit down the road, then we will”.

Opportunities across the pond

More than 90 per cent of Rentokil’s revenue comes from outside of the UK, and North America is its largest operating region. It also happens to be the world’s biggest pest control market. While Rentokil is the global leader in pest control services, it is the number three player in the US, behind Rollins (US:ROL) and Terminix (US:TMX). But these top players have still only captured a combined 43 per cent of the market, leaving plenty of scope for consolidation.

Rentokil had been aiming to generate $1.5bn (£1.1bn) of revenue in North America by the end of 2020, and it surpassed this target by delivering just under $1.6bn last year. Its other main objective for the region is to reach an adjusted operating profit margin of 18 per cent.

The margin increased by 3.1 percentage points in 2020 to 17.3 per cent, thanks to cost savings and demand for higher-margin disinfection services. It is expected to fall back to between 16.5 to 17 per cent this year as the appetite for disinfection normalises and acquisitions dilute margins in the short term. But the group is confident it can hit 18 per cent by the end of 2022 as its big IT platform upgrade is completed.

As well as North America, the group is also looking to push into emerging markets, where spending per capita on pest control is comparatively low. While $24 is spent on pest control per person in North America, in Asia it is just $0.56.

Acquisitions galore

Rentokil has a good track record of cash generation. Lower capital expenditure and tight control of working capital boosted free cash flow by over a third in 2020, to £337m. This enabled net debt to come down by 7 per cent to £994m, equivalent to 1.6 times cash profits (Ebitda). The group therefore has sufficient balance sheet firepower to make acquisitions to supplement its organic revenue momentum.

Rentokil has bought over 200 businesses since 2015, spending on average £330m per year. It typically scoops up smaller, independent companies in order to increase the density of its customers. This improves the productivity of its technicians, who can visit more locations per day, feeding through to higher margins.

The group spent more than £200m on 23 acquisitions last year and anticipates it will spend around £400m in 2021. It purchased Environmental Pest Services for an undisclosed sum in January, the 15th largest pest control business in the US. The acquisition has expanded the group’s presence in the south east of the country, notably the lucrative Florida market where Jefferies reckons Rentokil has now become the leading player.

Rentokil beat analyst expectations with its 2020 results – its adjusted operating profit rose by 5 per cent to £384m, coming in 4 per cent ahead of consensus forecasts. Brokers have been getting more bullish on the group’s prospects over the past year and there could be further upgrades to come following its capital markets day in September, which will focus on the future of the hygiene division.

While most analysts view Rentokil in a positive light, Berenberg has assigned it a ‘sell’ rating, highlighting pest control competition in the US from “new kid on the block” Anticimex. The Swedish company – which is currently owned by private equity – is rumoured to be mulling an IPO later this year and currently has a 2 per cent market share in the US, versus Rentokil’s 9 per cent. Rentokil doesn’t seem too concerned by its rival, however, and Ransom says, “just because they are coming to market... I would not really see that as a signal of any great change in strategy or particularly in impact.”

Worth the price tag?

Having gathered momentum post-‘Corona crunch’, Rentokil’s shares reached an all-time high of 579p in November. They have since dropped back to 500p, equivalent to around 28 times consensus 2022 earnings. That’s not exactly cheap, but competitors Rollins and Terminix’s forward price/earnings (PE) ratios currently stand at 53 and 31, respectively.

“With the end markets being so consistent – and consistently growing – the impact on the company is that you get a compounding of growth over time,” says Forbes-Wilson. “That has manifested itself in the stock markets’ enthusiasm for the company and the valuation that it enjoys.”

But despite the premium price tag, he believes Rentokil’s quality is worth paying up for: “That's why we back it and continue to hold it. Over the course of time, good quality companies demonstrate their value, and it is recognised eventually by the markets.”

Some prospective investors may be put off by recent director share sales, which include North American managing director John Myers, who offloaded 250,000 shares last month for £1.2m, and chief financial officer Stuart Ingall-Tombs, who sold around £92,000-worth of shares he received under a performance share plan for tax purposes.

While it’s never ideal to see management selling shares, we’re inclined to look past this as Rentokil’s long-term growth prospects remain intact. The structural demand drivers and international expansion opportunities mean the shares likely have further to run.

Last IC View: Buy, 492p, 30 Mar 2021