Qualiport

Rentokil Initial's BET Debt
Monday, November 17, 1997

A Qualiport Investment Opinion by Bruce Jackson (TMFGoogly)

The fifth in the Rentokil Initial Series.

As of 31st December 1997, Rentokil Initial PLC's net debt was £509.9m. The year before, they had a net cash position of £97m. The 29th April 1996 acquisition of BET PLC for a total consideration of £2,221.7m, of which £568.5m was satisfied in cash, had a considerable impact on the new company. By 30th June 1997, the date of that last published set of Rentokil initial accounts, their net debt had reduced to £454.2m.

A householder when buying a new dwelling takes on a certain level of debt. Mortgage companies allow a family to borrow up to a certain limit based on the income of the family members. This is often something like 2 1/2 times combined salaries. The reason the lender sets this limit is so that they can be sure the family has sufficient income to pay them back the principal and interest thereon.

With a company, the principle of borrowing is very similar. It's up to the company's bankers and its management to decide what level of debt is manageable. The challenge for investors also is to assess that level of debt in relation to a company's ability to pay interest on it and capacity for paying it back to the bank.

One way to assess a company's level of debt is by its interest cover. This is a measure of how many times a company can pay its interest charge out of its profits. The calculation is:

                  Pre Tax Profit plus
                  Gross Interest Expense
Interest Cover = --------------------------
                  Gross Interest Expense

The higher the ratio, the more times the company can pay its interest bill. For a company with little debt in comparison to its profits, the interest cover number will be very high and the company will usually be in a sound financial position. Conversely, a company that finds most of its profits eaten up by a high interest charge will have low interest cover. Such a company will often be in financial difficulties. A classic example is Eurotunnel, whose net interest paid in 1996 was £645m on turnover of £448m and pre tax losses of £685m. No wonder that most of the 225 banks that financed the project have already written off their investment in Eurotunnel. As for an absolute number that investors would feel comfortable with, there is no set rule. However, I personally wouldn't feel comfortable investing in a company whose interest cover was much below 2.

Luckily for me, this isn't the case with Rentokil. Taking their full year 1996 numbers we get:

Pre Tax Profit      £318.0m
Gross Interest       £43.7m

                  318.0 + 43.7
Interest Cover = ----------------
                       43.7

               =    8.28 times

Rentokil have covered their interest bill over 8 times by profits. It would take a huge rise in interest rates coupled with a big deterioration in their profits for them to have any major problem meeting their interest charges.

Because UK companies don't have to produce a comprehensive set of accounts at the interim stage, it's impossible to exactly calculate the interest cover for the 6 months ended 30th June 1997. We are given the net interest payable of £16.3m, but this is not broken down into interest paid and interest received. Making an educated guess, I'll say that interest received is about £12m and interest paid £28.3m. With pre tax profits of £193.9, that gives Rentokil interest cover for the first 6 months of the financial year of 7.85 times. This is little changed from 31st December 1996 and still at a very comfortable level.

More important, however, is that the level of net debt has decreased in the 6 months to 30th June 1997 from £509.9m to £454.2m, indicating the company is generating sufficient actual cash to help pay off its borrowings. This is important because accountants, legitimately using non-cash charges, can to some extent manipulate profit levels of a company. But cash is cash is cash, and a company cannot vary its cash balances from what is actually in the bank or owed to the bank.

In the next installment of Rentokil Initial, I'll take a look at another measure of a company's level of debt -- its gearing. As usual, I'll finish this round up with a couple of questions.

Who are Rentokil Initial's competitors? Rentokil is a somewhat unique company in that they probably have lots of competitors in each of their 6 different divisions. Chief Fool US analyst Randy Befumo, looking for just one company, suggested ServiceMaster of the US, which is owned by none other than investment guru Warren Buffet.

Will the currency and stock market turmoil of the Far East affect Rentokil Initial's growth prospects?

Answers and comments to the QualiPort message board.

Bruce Jackson (TMFGoogly)