Qualiport

Rentokil -- Gearing Up For A Decision
Friday, November 21, 1997

A Qualiport Investment Opinion by Bruce Jackson (TMFGoogly)

The sixth in the Rentokil Initial Series.

As at 30th December 1996, Rentokil Initial had net debt of £509.9m. This can be broken down into cash of £189.8m and borrowings of £699.7m. Gross debt is the £699.7m.

Gearing, or leverage as it is known in the US, is a way of measuring a company's level of debt in comparison to total shareholder's funds, or capital employed. It is most commonly calculated as:

                      Debt
Gearing =  ---------------------------
             Equity Shareholders Funds

This is also known as Debt-to-Equity.

In the case of Rentokil, as at 31st December 1996, they had negative shareholder's equity of £130.3m. Luckily for us, that doesn't mean that shareholders owe the company money. Here in the UK, when a company makes an acquisition, all sorts of techniques are used to account for that acquisition. Without getting into too much detail, the thing we need to know is that of the £2,221.7m total consideration paid by Rentokil to acquire BET, a whopping £2,132.9m was considered goodwill. Under UK GAAP (Generally Accepted Accounting Principles) this amount may be deducted from shareholder's equity, hence the negative £130.3m on Rentokil's balance sheet. In the US, the goodwill cost of the acquisition would be shown in the assets section of the balance sheet, under intangible assets.

To calculate a meaningful gearing figure, we first need to add back the total goodwill reserve to shareholder's funds. As at 31st December 1996:

                   £699.7m
Gearing =  -----------------------
             (£130.3m) + £2,459.2m

         =  30%

The same calculation, using net debt of £509.9m as the numerator, gives net gearing of 21.9%. Neither of these numbers seems too demanding.

Another popular measure of debt is Debt-to-Capitalisation. This is calculated as:

                Debt
     -----------------------------
      Market Capitalisation + Debt

Where market capitalisation = shares outstanding * share price

For Rentokil, it is:

               £699.7
     ---------------------------
     (2,857m * £2.40) + £699.7m

     = 9.26%

The percentage is getting lower all the time!

The last ratio we will look at is Debt-to-Revenues. This is the ratio that they (meaning Randy and Jeff) prefer to use over in the States at the Motley Fool. Its attractiveness stems from the fact that sales are completely independent of external factors like a share's current market capitalisation and the way a company deals with intangible assets such as purchased goodwill. It's a great ratio for company to company comparisons. It is calculated very simply as:

      Debt
     -------
      Sales

For Rentokil, the ratio is £699.7m / £2,270m = 30.8%. Uncannily, this is very close to the first number we calculated, gearing. In comparison, pub operator Regent Inns has a debt-to-revenue ratio of 46%, and acquisitive transport company Stagecoach's ratio is a whopping 79%. I would have calculated the ratio on more suitable companies, like Glaxo Wellcome or Hays, but I haven't got their annual reports on hand, and I can't get the information off the Internet. Perhaps we'll get there one day!

A Debt-to-Sales ratio of 30.8% is nothing to get too concerned about, especially as we have seen that Rentokil are reducing their debt level, whilst increasing sales. Doing a bit of guesswork about their gross debt as at 30th June 1997, I calculate their debt-to-sales ratio to be about 22.8%. I'd expect it to be even lower at the end of this year.

I think we've now covered Rentokil's debt. Basically, they are in debt, but not excessively. They can easily cover their interest payments, and their overall level of gearing is acceptable.

Just before leaving cash, I'd like to touch on something I spotted in the company's cash flow statement that gave me reason for a little concern. Capital expenditure is exceeding depreciation in 1996 and the first 6 months of 1997. I'd like to make sure that the capital expenditure is not all spent on replacing old assets, but some is being spent on genuine expansion. There's a big difference between the two. If it's the former, the company may be using a lot of cash just to keep going. Spending cash on new plant & equipment that will increase profits over a period of time is a more preferable use of the money as far as shareholders are concerned.

Next article, I promise, we will look at the share price and its valuation. At 240p, Rentokil Initial trades at a trailing p/e of 25.6. The company hopes to grow at 20% per annum.

Bruce Jackson (TMFGoogly)