Qualiport

Rentokil Initial -- Fool UK Buys
Friday, December 12, 1997

A Qualiport Investment Opinion by Bruce Jackson (TMFGoogly)

The aim of the Fool UK Qualiport is to have a fully accountable online portfolio that buys quality companies at reasonable prices. Our journey through Rentokil Initial has confirmed that this is in fact an excellently managed company with an enviable track record. In this last piece of the jigsaw, we shall look at the risks and opportunities of buying this company with a trailing price earnings (P/E) ratio of 27 and an expected long-term growth rate of 15%- 20%.

One of Warren Buffett's investing tenants is, when investing in a company, think like you are buying the whole thing, not just a small part ownership. Think big. If you could raise £7 billion, would you buy Rentokil Initial? If the answer is yes, the company is yours. You cannot sell it voluntarily, as there may never be a willing buyer. You have to be prepared to hang on to it for 5, 10 or more years. Buffett rarely sells.

Reality, of course, is different. If we wanted to, we could buy the shares on one day and sell them the next. The great thing about thinking really long term is that it allows us to move away from the accepted City practises of concentrating on earnings in 6 monthly blocks, in tune with when companies are required to report their figures. In the US, if a company were to miss its quarterly earnings figures by even a penny, shares in that company are often severely marked down. It doesn't happen to the same extent here in the UK, but it does and will happen.

Rentokil Initial has stated that its aim is to grow profits and earnings per share by at least 20%, "whilst not detracting from long term growth prospects." Although they've achieved this fantastic record for 14 years in a row, it would be foolish (small "f") of us to simply assume they will do it for the next 14 years. Even the next 5 years may be asking too much. No company can physically grow by 20% indefinitely.

The 1997 calendar year is almost over. I need not remind you that there are very few shopping days till Christmas. Rentokil Initial's 1997 fiscal year also ends on 31 December and current earnings per share (EPS) estimates are at 10.3p, giving them growth of 20.2% for the year. If that estimate is met or beaten, and there's no indication as to why it shouldn't be, Clive Thompson will be chalking up year number 15 in a row of 20%+ growth. It will take the accountants and auditors a couple of months to add up all the numbers, double and triple check them, and release them to the public. But, regardless of when Rentokil Initial actually reports their results, the numbers will be up to 31 December 1997. As our decision as to whether to buy them or not will be so close to that date, we will use 1 January 1998 as a base for our calculations when looking at the returns we can expect from holding the shares over the next 10 years.

We will assume base EPS of 10.3p, being the current 1997 estimate. If Rentokil Initial were to continue growing at 20% for the next 10 years, it would earn 63.8p in the year ended 31 December 2007. Over the past 5 years, Rentokil Initial has traded at P/E ratios of between 18 and 36. It is not realistic to think that the company will trade at a P/E of 36 ever again, so we won't even consider at what price the shares may trade at in 10 years time based on that P/E.

(I couldn't resist it. At 20% growth for 10 years and a P/E of 36, the shares would trade at 2297p for an annualised growth rate of 24.8%. Wow! Now that's impressive.)

Because of their fantastic growth record over the years, Rentokil's shares deservedly trade at a premium P/E. That premium is usually something in the order of 20% above their long-term growth rate. For example, at today's price of 250p, based on 1997 EPS of 10.3p, the shares trade on a P/E of 24, which is a 20% premium to their 20% growth rate.

The Conservative Valuation

Going forward, let's assume Rentokil can continue to grow EPS at 20% for the next 3 years. For the year 2000, that would give them EPS of 17.8p. After that, let's assume they reduce their stated growth aim to 15% and achieve that for the next 5 years. EPS in 2005 would be 35.8p. And then, shock of all shocks, they reduce their aim even further to 12%, and grow at that rate for the next 2 years. 2007 EPS would be 44.9p.

Although this is not the worst case scenario, it certainly isn't the best one. With their growth rate having slowed to 12% in 2007, it would be only fair to give the shares a multiple of 14.4, being 20% above their current growth rate. The shares would then trade at 647p (44.9p x 14.4), giving annualised growth over the 10 years of 10%. But what about the dividend? This forms part of the overall return. Over the years, Rentokil Initial has adopted a progressive dividend approach. They have raised their dividend by roughly the same percentage as the growth in their earnings. The 1996 full year dividend was 2.53p. We would expect this to increase by 20% in 1997, giving a starting point of 3.04p. At the same rate of growth as I've assumed for EPS, by 2007 the total dividends paid should total 82.03p.

The table below summarises.

   
Year Year  Market Growth  EPS   Div   P/E  Future
No.         Cap                            Price
    
0    1997   7,167   20%   10.3  3.04  24.0
1    1998   8,600   20%   12.4  3.64  24.0  297
2    1999  10,320   20%   14.8  4.37  24.0  356
3    2000  12,385   20%   17.8  5.25  24.0  427
4    2001  14,242   15%   20.5  6.03  18.0  368
5    2002  16,379   15%   23.5  6.94  18.0  424
6    2003  18,835   15%   27.1  7.98  18.0  487
7    2004  21,661   15%   31.1  9.18  18.0  560
8    2005  24,910   15%   35.8 10.55  14.4  516
9    2006  27,899   12%   40.1 11.82  14.4  577
10   2007  31,247   12%   44.9 13.24  14.4  647
    
Total Dividend -- 82.03

Adding the total dividends received of 82p to the 2007 share price of 647p gives a total return of 729p. For the share bought at 250p, that is a profit of 479p per share over the 10 years. The total annualised return is 11.3%, which is about the percentage the stock market as a whole has returned over the past 60 odd years. For comparison, the risk free rate of return for government bonds at the moment is around 6.5%.

A Possible Valuation

The above table awards Rentokil Initial a P/E of 14.4 in 2007, based on the company growing at 12% per annum at that time. We have optimistically looked at a valuation based on the company growing at 20% per annum for the next 10 years and being valued at a P/E of 36. That just won't happen. But it is conceivable that the company will keep on growing its profits and earnings by 20% for the next 10 years. It has done it for the last 14 years, so it's not inconceivable. If Rentokil were to succeed, their EPS would be 63.8p in 2007. Put a P/E of 24 on that and you've got a share price of 1531p. Add on the total dividend of 98p and that gives you a total return of 1629p and an annualised growth rate of 20.6%. Even if the shares were given a P/E of 20, the total return would be 1373p for an annualised growth rate of 18.56%.

The Risks

Rentokil Initial has grown over the years both organically and by acquisition. Before the big BET take-over, they only made relatively small niche acquisitions. BET was the first big, high profile acquisition and was done specifically to keep the 20% growth dream alive. It has and will hope to continue fulfilling this goal in the next few years. There should be a few more years of stretching those BET margins yet.

The 20% organic growth of the original Rentokil business is a thing of the past. The same will happen to the old BET businesses as the years roll by. As the company gets bigger and bigger, the organic growth becomes harder to generate. The solution to continued growth is to do so both organically and by acquisition. This is something Rentokil Initial have successfully achieved in the past and are doing now with BET. But, if they are to keep on growing at 20% per annum, the next take-over may need to be bigger still. And the bigger the acquisition, the harder it is to manage.

It has been rumoured recently that Rentokil Initial may be interested in taking over food services company Compass. The company would fit reasonably well into their Property Services division. This is only rumour, and Fools never buy or sell companies on rumour alone. Any acquisition is risky. They could be forced into overpaying or find the business doesn't quite fit as management expected. A company that relies on acquisitions for its growth can be a risky company.

Clive Thompson is one of the most respected Chief Executives around. His track record says it all. If he were to leave the company in the next 10 years, it would certainly have a detrimental affect on the share price. We would hope that any replacement would come from within the company, someone who is familiar with the Rentokil management culture. No-one is indispensable.

The above conservative valuation table has the share price remaining static between years 3 to 5. That's two years without any share price appreciation, caused by the P/E and growth rate contracting. The risk here is that investors may be tempted to sell the shares as they may become disillusioned with the lack of progress in the share price. This is something anyone who invests in such a high growth company must be prepared to accept.

The recent shenanigans in Asia may have an effect on the company's profitability. In 1996, 7% of Rentokil Initial's turnover and 17% of their profit came from the Asia Pacific and Africa.

And finally. When 1997 full year results are released in March next year, Rentokil Initial may miss their 20% growth target. Unlikely, but nevertheless possible. The shares would almost certainly lose a lot of their premium P/E rating. Another option is that they scrap their 20% growth aim sooner than we thought, which would certainly knock the shares down. Volatility is part and parcel of buying shares with a trailing P/E of 27.

The Decision

Fool UK buys £4,000 worth of Rentokil Initial shares! Welcome to the Qualiport. The founding share. A defining moment in UK Fooldom.

Over the past couple of months, we have dissected the company into as much detail as we possibly could. We know what they do, about their management and their record. We know the risks, and the potential rewards. We don't suggest for one minute that you go out and buy Rentokil Initial just because we have. We've done our homework and are comfortable purchasing a part ownership in this company at the current valuation.

We expect gains of between 11.3% and 20.6% a year over the next decade. Being conservative, we're taking the lower figure as our expected rate of return. However, if everything went to plan, we could expect returns of 18.5% to 20.6%.

Over the next 5 days, in accordance with the Fool's buying policy we will be buying 1600 shares in Rentokil Initial. With the share price currently standing at around 250p, this will cost us about £4,000 plus brokerage and stamp duty.

This is a real money portfolio. The Fools are stumping their own money to buy shares in this company. We will be riding the highs and cursing the lows, just as any investor would. We'll also be looking forward to those dividend cheques rolling in over the years. It won't be much money, but they will all be gratefully accepted.

The overall aim of the Qualiport is to produce a portfolio of about 5 shares and watch that produce market beating returns over the years. We will be putting a total of £20,000 into the portfolio, and we see Rentokil Initial as being the ideal first entrant. It serves the dual purpose of being a large capitalisation company and of also being a fast growing company. In the near future (once we've re-mortgaged Fool UK HQ) we aim to buy the four other companies that will make up the initial Qualiport. We will consider adding some medium and smaller sized companies, as they will make an ideal foil to our large capitalisation shares like Rentokil Initial.

Although the Qualiport is largely going to be using a buy and hold strategy, we won't be averse to selling shares. This will usually happen when something materially changes about the company we originally bought (for example, a loss of confidence in the management), or we find a better business in which to invest our money.

So that's it. Go Rentokil Initial -- here's to the next 10 years!

Bruce Jackson (TMFGoogly)