Qualiport

Rentokil - The Final Countdown, Pt. 2
Tuesday, December 2, 1997

A Qualiport Investment Opinion by Bruce Jackson (TMFGoogly)

We're almost there. Today, we conclude the summary of Rentokil Initial, our first potential Qualiport buy. For those who missed it, here's a link to part 1 of the Final Countdown.

A ratio we didn't look at in our rundown of the company was price-to-sales ratio (PSR). It is calculated as:

   Market Capitalisation
---------------------------    
      Trailing Sales    

With a market cap of £7,167m and trailing sales of £2,819.6m (calculated using the same technique as EPS), Rentokil has a PSR of 2.54. If the PSR was calculated on 1996 full year sales of £2,339.7 it would be 3.06. This compares with Glaxo Wellcome's PSR of 5.4, Reuters 3.8, British Airways 0.70 and British Steel 0.45. The average FTSE 100 stock trades at about 1.6 times sales.

Another new concept is the enterprise value of the company. It simply takes the market capitalisation of the company, subtracts cash and adds debt. The enterprise value is effectively the price someone would have to pay to take-over the company. They would not only get the assets and brand names of the company they were acquiring, but also would get the cash and assume the debt.

At 31st December 1996, Rentokil Initial had debt of £699.7m and cash of £189.8m. Adding debt and subtracting cash to their current market capitalisation of £7,167m gives you an enterprise value of £7,676.9m. That gives them a 1996 enterprise value PSR of 3.28, and based on trailing sales it is 2.72. Because of their debt, the PSR based on enterprise value is higher, but still not excessive. Coca-Cola trades at a PSR of over 8 times sales and is the richest Dow Jones Industrial stock by this measure.

Margins: Because the BET take-over distorts the 1996 figures, we'll look at the 1997 interim report when calculating Rentokil's margins. Operating margins are calculated by dividing revenue by operating profits. For the 6 months ended 30th June 1997, this is 15.4%. Net profit margins arguably are the only ones that we should ultimately consider as they take into account the interest and taxation charges. Net profit margins are currently 9.9%.

These margins are nothing to write home about; however, net profit margins of 10% or more are often considered to be quite good. In the full year to 1996, operating margins were 14.9% and net margins 9.7%. As a comparison, Glaxo Wellcome has operating margins of 37.5%, Reuters 22.3%, Hays 14% and Marks & Spencer 13.2%.

In 1995, the last full year before the BET take-over, Rentokil's operating margins were 25.5%, up from 24.6% in 1994. Net margins were 16.5%, up from 15.9% in 1994. These are margins normally associated with a well managed company in a strong competitive position. I reckon by March next year when we finally see their results for 1997, Rentokil's net margins will be above that magical 10% figure.

Gearing: Gearing is a way of measuring a company's level of debt compared with total shareholder's funds. With 1996 gross debt of £699.7m and adding back the goodwill reserve to shareholder's funds, we get gross adjusted gearing of 30%. See Rentokil Initial, Part VI for this and the various other ways we can look at debt. With adjusted gearing at 30% and with their interest charged covered 8 times by earnings, Rentokil has a very manageable amount of borrowings. Strong operating cash flow is helping pay off that debt, reducing the interest charge and allowing them to continue with their small acquisitions.

Capital Allocation: Prior to the BET acquisition, Rentokil was a true service company, which largely had people as its assets and therefore had relatively little in the way of operating assets. The BET take-over changed that to some extent, especially as the Plant & Distribution division was concerned. In the 1996 fiscal year, excluding the actual BET acquisition, the company spent a net £163.9m on new capital. As we've said previously, we have to be sure that this expenditure is for actual expansion of the business, and not just replacing old clapped out assets. However, given Rentokil's exceptional record and its proven cash management expertise, this is not something to get too concerned about.

Like so many UK quality growth companies, Rentokil operates a progressive dividend policy whereby they increase dividends in line with the longer term underlying trend in earnings per share. As that rate has been 20% or more in the past 14 years and is expected to continue at that level, it is safe to assume that the dividend will also continue to rise at about 20% per annum. The trailing dividend for Rentokil Initial is 2.68p. At 250p, this gives a yield of 1.1%, which is quite low for a UK company. We're definitely looking for share price appreciation rather than relying on the dividend pay out for growth for Rentokil Initial.

Whilst their stated and very public aim of 20% per annum growth stays in place, Rentokil will probably look for another big acquisition in the next few years. There would appear to be at least 2 - 3 more years worth of 20% growth to be stretched out of the BET acquisition, if not more.

BET looks like it has turned out to be a perfect take-over target with lots of opportunities for rationalisation of existing business, the most obvious being the Initial brand. The danger with any acquisition is di-worse-ification. With no single UK based competitor standing out as a future possible take-over target, Rentokil may look abroad for a suitable company. Having six established divisions allows Rentokil to consider picking off smaller companies which will fit well within their existing businesses.

The Rentokil Initial Snapshot:

Recent Share Price: 250p    
    
Trailing 12 months sales: £2,819.6m    
Trailing 12 months net profits: £265.1m    
Trailing 12 months EPS: 9.37p    
    
1997 EPS estimates: 10.3p    
1998 EPS estimates: 12.2p    
    
Valuation:    
Enterprise value to sales: 2.72    
Current P/E: 26.7     
Forward P/E: 24 on 1997 estimates, 20 on 1998.    
Long-term expected growth rate: 20%    
Yield: 1.1%    

Conclusion: At 250p, Rentokil Initial is not cheap. As we have seen over the course of this epic, they are a very well managed company with an enviable track record. Fiscal 1997 is almost over, and you can bet your bottom dollar that Rentokil will at least meet the estimated EPS of 10.3p. This is one of the beauties of the company -- they're so consistent and predictable.

Once they hit their 1997 estimate, they will be trading at a forward p/e of 20, which exactly equals their growth rate and stated aim. Looking at the share price valuation in that light puts the rich p/e this quality growth company currently trades on into some sort of perspective.

Before we make the final decision about Rentokil Initial's potential entry into the Qualiport, I want to have a look at the risks and opportunities of investing in the company at this share price. Until then, I urge you to post your thoughts on whether we should be buying Rentokil Initial into the QualiPort message board.

Fooling,
Bruce Jackson (TMFGoogly)