Qualiport

[ February 4, 2000 ]

Dumping Rentokil

By Bruce Jackson (TMFGoogly)

Fitzrovia, London -- As the Motley Fool grows, one of our challenges is to keep the static content on the site up to date. For example, and for a bit of a laugh, take a look at the ten ideal criteria of a Qualiport company, especially point one. In it, I praise the leadership at Marks & Spencer (LSE: MKS) and Rentokil Initial (LSE: RTO), and slam that of Psion (LSE: PON). I also said that ex-M&S boss Sir Richard Greenbury was not autocratic. Talk about getting things wrong! You do live and learn, especially from your mistakes. By the way, I will soon be updating the Qualiport criteria, and not because I feel a need to erase my past mistakes. Things do move on. We are always learning about individual companies and the art of investment. If Warren Buffett is still learning, so too are we.

On that note...

Rentokil Out

Today the Qualiport is announcing its intention to sell its whole holding in Rentokil Initial. Sometime in the next 5 trading days, in accordance with the Fool's trading rules, we will sell 783 shares. With the shares hovering around 240p, that will realise just short of £1900.

Why sell?

In the 2 years and 7 weeks since we've held Rentokil Initial, the company has changed. In that time, I've also learned a lot more about the company, and about investing and especially my philosophy. The Qualiport's aim is to buy and hold the best of the best. We're looking for growing companies, with a sustainable competitive advantage, and are looking to buy them at attractive valuations.

Putting the valuation to one side, Rentokil is no longer a growing company. It didn't stop growing when it suddenly, but not unsurprisingly, dropped its 20% earnings growth target back in August last year. They actually went ex-growth in the second half of 1997 -- aeons ago! That slow-down was actually masked by the fact that sales for the whole of 1997 grew by 23%. The second half numbers, in isolation, are rarely highlighted by the company. That's not Rentokil's fault, yet they were there for all to calculate.

I can't see any identifiable future growth prospects for Rentokil. In fact, they are a shrinking company. A disposal programme is already underway as they look to dump under-performing assets. There's rumours of special dividends and share buy backs, both measures effectively returning money to shareholders. In the past, Rentokil have grown largely by acquisition. They look to snap up underperforming businesses, assimilate them into the company, and then stretch their operating margins. Rentokil have effectively bought their sales, and worked on making those sales more profitable, rather than generating organic sales growth. If and when they stopped acquiring sales growth, the company was always going to be struggling. That's the point at which we currently find Rentokil.

If Rentokil's business plan had such an obvious flaw, why didn't I recognise that back in December 1997 before I bought the shares? Isn't hindsight a wonderful thing? It was very easy to be blinded by Rentokil's great past growth record, a record which until this day, to my knowledge, is unsurpassed in the UK -- 15 years in a row of earnings growth of at least 20% per annum is a fantastic feat. But, that was then and this is now.

Rentokil's new aim is to "substantially outperform the support services sector (as measured by total shareholder return) over the next five years." Will they achieve that feat? If they do, it will not be a surprise to me, as in the past they've delivered on their promises. But, the stated target is a little woolly. For example, what is their definition of the support services sector? And, they could achieve their target by underperforming the market if the support sector as a whole does the same. Should that be viewed as successful?

As for valuation, Rentokil has a forecast forward price-to-earnings ratio (P/E) of 17.7 for an earnings yield (1/17.7) of 5.65%. On the face of it, that's neither dear nor cheap. I prefer to look at their cash flow. There's been a continual increase in working capital requirements over the past 3 years. The level of capital expenditure is putting a strain on their ability to generate free cashflow, and that in term adversely affects their ability to enhance shareholder value through acquisitions, share buy-backs and special dividends.

Rentokil Initial is a low-growth company, without any obviously identifiable future growth prospects. Its current valuation is fair, but we're looking for more than that. Whilst we haven't got any definite plans to replace them in the Qualiport, we do have a couple of ideas, some of which may be existing Qualiport companies. Anyway, I believe buy and sell decisions should be made in isolation, and I believe the time is right for Rentokil to be sold. Arguably it should have been done last August, because nothing more has changed about the company since then. Put it down to denial and inertia on my behalf.

Finally, for those people who may be thinking the Fool has aborted its long-term buy and hold mantra, nothing could be further than the truth. Our idea holding period is still forever. It's just that most companies are not good enough to be held forever. Unfortunately, Rentokil is one of them.

Related links
• Time to dump Mr 20%
• More Trading Thoughts
• Rentokil Message Board
• Rentokil buy report

Emap Bombs

At 9.32am this morning, Maynard potentially ruined my day. Staring blankly at the Bloomberg screen, he rather matter-of-factly said "trading statement from Emap (LSE: EMA)". Knowing that unexpected trading statements rarely bring good news, I quickly skimmed the text, but what I really wanted to see was the immediate reaction to the share price. Now, I know that as long-term investors we shouldn't really be bothered too much about looking at share prices on a daily basis, but like many, I just can't help it.

And what I saw wasn't nice. An initial 150p fall was bad enough, but when I next looked, the shares had lost 284p. I've seen and experienced profit warnings which have knocked 50% from a company's market capitalisation in one fell swoop. Luckily I had to leave the office for the morning just after the trading statement, so couldn't distract myself into checking the Emap share price every 2 minutes.

As I left the office, I was thinking the worse in terms of short-term share price damage. But, then I came to my senses. The news that Emap's 3rd quarter USA advertising revenues were down 7% surely didn't signal that the company was in dire long-term straits. The US Petersen acquisition is taking a little longer to bed in than Emap originally thought, but most big mergers usually go through some teething problems. Emap are continuing to invest for the future, as demonstrated by this -- USA "launch costs for FHM will have a material impact on profitability in the next financial year".

I also reminded myself that Emap's shares stood at 730p in only last October. They began 2000 at 1280p. One month into the new year, the shares have actually gained 4.4% whilst the FTSE 100 has slumped 10.75%. The fact that the shares were standing above 1773p just a few days ago should be neither here nor there. This is a long-term game, the winner of which will have a successful business. A short-term share price winner is not necessarily a long-term business winner. The Emap share price fall, rise and fall in the last 3 months is a case in hand. In that time the business has remained largely unchanged.

Continuing on that theme, and on Emap, the share price initially shot up on the back of the excitement surrounding the AOL Time Warner merger. Content was again seen as king, and Emap have plenty to offer in that respect. Also, the market suddenly got excited about their Internet potential, sending the shares into orbit. However, as we have seen today, and will see even more in the future, having a company with 'Internet potential' means nothing unless it has or will have a sustainable long-term competitive advantage. Remember -- on the Internet, your competitors are always only one click away.

Retailing is an extremely competitive environment, as I found to my cost when the Qualiport held Marks & Spencer. There are however some competitive barriers, none the least being location, location, location. But on the Internet, the barriers to switching companies are virtually zero. Whilst the market loves marking up the shares of just about any dot com (or dot co dot UK) business, it isn't yet taking into account the quality of those businesses, and especially their competitive advantage. But it will!

Related links
• Emap news summary
• Emap message board

Thanks

Finally, a big thank you to US-based techie geek Dagwood Gardner, who is responsible for the great new look and feel of the Qualiport numbers. It certainly makes my life a lot easier, not to mention a huge improvement to their presentation. Perhaps I can also seek his assistance in making the portfolio returns look a little better!

Have a great weekend, and see you on the Qualiport message board.