Rentokil Initial: can the pest control pioneer return to growth?

Rentokil Initial (LON:RTO) has a long track record of growth and is the market leader in the pest control sector. However, it’s struggling to integrate a big US acquisition and is facing sluggish demand in North America, which now accounts for half the group’s revenue.

The resulting profit warnings have seen the stock fall by around 40% since June 2023. However, Rentokil remains a highly respected brand, while growing long-term demand for pest control services seems assured.

I think the business could be worth a closer look at this point, ahead of a potential recovery.

Summary

Pros:

• World’s largest pest control business, US market leader

• Strong brands and long track record of growth

• Shares are trading at a discount to historic valuation and US peers

Cons:

• Terminix acquisition is proving difficult and expensive to integrate

• Not clear if Rentokil can continue to gain market share given its size and maturity

• Net debt is relatively high, adding to finance costs

Profile

About the stock

Rentokil Initial is a pest control and hygiene company operating in markets including the UK, Europe and North America. It’s listed in the Professional & Commercial Services industry group within the Industrials sector.

Although the core operations within the group were founded more than 100 years ago, Rentokil Initial in its current form was created in 1996.

Today the company is a FTSE 100 member with a market cap of £10.2bn and a recent share price of 404p.

Rentokil’s acquisition of US firm Terminix in 2022 has coincided with some weakness in market US demand. Performance has been disappointing over the last couple of years and the StockRanks reflect this.

Rentokil scores well for quality, but is weaker in value and momentum:

About the opportunity

In 2022 Rentokil Initial completed the acquisition of a major US competitor, Terminix Global Holdings, for $6.7bn. The deal was funded with $1.3bn in cash and the remainder in stock. This valued Terminix at a steep 19x 2021 EBITDA, prior to cost savings.

The combined business became the largest US pest control contractor, with North American revenue now accounting for more than half Rentokil’s business.

However, both Rentokil and Terminix have hundreds of US depots. Integrating these to achieve the hoped-for $150m of cost synergies has been slow. Completion is now not expected until 2026.

Business performance has not been helped by a sluggish US market, either. North America revenue rose by just 3% in 2023, with a similar figure expected in 2024.

Rentokil reported a “weaker termite season” earlier this year and warned that the business had been over-resourced for peak trading, resulting in some additional costs.

However, I think signs of stabilisation may be emerging. In its October update the company maintained the reduced guidance issued at the time of September’s profit warning.

The market has also taken some comfort from the news that activist investor Nelson Peltz’s Trian Partners has taken a 2.3% holding in the business and appointed a director to Rentokil’s board.

Slashed earnings forecasts have left Rentokil Initial shares trading on a forecast P/E of 18, despite share price falls:

While this may not seem especially cheap, I think it may be worth noting that US-listed rival Rollins (NYQ:ROL) currently trades on a rolling forecast P/E of 45!

Granted, Rollins has stronger growth and profitability than Rentokil. But if the UK-based firm can complete the Terminix integration, reinvigorate growth and lift margins, I think it’s fair to suggest that Rentokil’s valuation could move closer to that of its rival.

After all, Rentokil has traded at significantly higher multiples in the recent past:

I think Rentokil shares may currently offer an opportunity to benefit from a recovery and re-rating of the business, if it can return to growth successfully.

Business & Model

What is the company’s history and what does it do?

The Rentokil pest control business was founded in 1925, selling treatments for woodworm (‘Ento Kill’).

In 1957, Rentokil was acquired by British Ratin, a business whose roots providing effective rat poison could be traced back to 1906.

The combined business quickly expanded and was listed on the London Stock Exchange in 1969.

The Initial brand was added in 1996, when Rentokil acquired the British Electric Traction conglomerate. This included the Initial hygiene and workwear business, whose history stretches back to 1903.

Pest Control

Rentokil Initial is market leader by revenue in all of its global markets:

High-profile acquisitions have shaped the group’s listed identity, but a lot of Rentokil’s pest control growth has been driven by smaller and more easily absorbed bolt-on acquisitions.

In 2023, for example, the group made 34 acquisitions delivering £76m of incremental revenue.

This strategy has helped to create a pest control business operating in 90 countries with an attractive record of growth and high-teens operating margins:

Note - even without Terminix, Rentokil’s revenue and adjusted profits have grown at a CAGR of >10% since 2015. Restoring this record (if possible) could justify a higher valuation, in my view.

Hygiene & Workwear

Arguably, the Initial arm of the business has little in common with Rentokil’s pest control operations. Initial services washrooms and provides laundry and workwear services to sectors including hospitality, education, offices and industry.

Hygiene: washroom operations have also provided solid growth at good margins over the years, albeit at a more sedate rate:

France Workwear: in its 2023 results, the company said that its French workwear division “is now a ‘standalone’ business”, except for some shared IT. I wonder if this smaller, regional business could be spun-out from the group at some point, given that it’s arguably sub-scale and not a great strategic fit:iThe sale of the workwear business could generate some cash to reduce debt, which would be beneficial in my view.

How does the business model work?

Rentokil’s businesses operate under multiple brands. Its offerings target a full range of clients, from multinationals to individual residential customers.

All of the group’s business lines are based on the idea of providing route-based services where central marketing and strong branding are used to help create dense and profitable routes.

Markets & Competition

What is the size and state of the company’s market?

Pest control: Rentokil’s 2023 results presentation quoted industry forecasts suggesting that the global pest control market could grow at 5%-6% annually to c.$33bn between 2023 and 2028.

This implies the 2023 market size might have been around $25bn in 2023.

Rentokil’s pest control revenue was around $5.6bn last year, suggesting the company has a market share of over 20%, globally. In some markets – notably North America – this share is significantly higher.

Demand for pest control seems likely to continue expanding due to the ever-increasing size and population density of towns and cities globally. But with such a high market share already, I wonder if gaining further market share could become more difficult for Rentokil.

Hygiene & Wellbeing: the company estimated the 2023 size of this market at $55bn, with growth expected at 4%-5% CAGR between 2023 and 2028.

Rentokil’s 2023 revenue of c.$1.1bn in this category suggests a market share of about 2%, leaving significant room for expansion. This might also suggest there’s an opportunity for an industry rival to consolidate its market share through the acquisition of the Initial business.

How does Rentokil derive its competitive advantage?

Intangible assets: For businesses, pest control is an issue that can lead to significant reputational and financial risks.

For households, pest problems are highly emotive, can lead to significant damage to property, and may pose health risks.

For these reasons, I believe the company’s ownership of well-known and trusted brands in its largest market is likely to provide a significant competitive advantage in terms of marketing and customer retention.

The Initial brand should benefit from similar advantages, albeit perhaps less wide-reaching.

Switching costs: changing to another pest control or washroom service supplier is not necessarily a prohibitive burden, but there is a certain level of switching cost, particularly for business customers.

For example, pest control technicians will carry out surveys and become familiar with properties before installing equipment on customer sites.

Initial hygiene services are often also linked to onsite equipment and regular servicing requirements.

Barring a problem with service quality or pricing, I would guess that customers are unlikely to want to switch suppliers very often.

Cost advantages & greater scale: Rentokil Initial’s focus on creating dense, profitable routes for its technicians should help the company to provide competitive pricing and a responsive service while maintaining attractive margins.

Gaining more customers should add to economies of scale as technicians spend more time on paid work and less time travelling between customers.

Other advantages may also result from dense local coverage, such as greater familiarity with local conditions and more proactive, responsive service.

Is the competitive advantage durable?

This business seems unlikely to be disrupted by new technology or automation.

Smaller competitors are likely to struggle to replicate Rentokil Initial’s comprehensive geographic networks and trusted brands, which have been built over many years.

I think Rentokil’s competitive advantages are likely to remain durable for the foreseeable future, assuming the business avoids any major reputational issues.

Financials & Ownership

What is the record of growth & profitability?

Both revenue and profits rose fairly steadily over the last decade, before taking a step higher when the Terminix acquisition was incorporated into the business in 2022/23:

Of course, acquiring Terminix entailed significant share issuance. So earnings per share have not increased in line with operating profit.

Indeed, this Stockopedia chart from the Income tab of the StockReport suggest statutory earnings have been rangebound for many years (ignore the 2017/18 spike, which relates to pension accounting, not trading):

Progress on profitability has also left something to be desired over the last decade.

While operating margins (blue) have been broadly stable, Rentokil’s typical range of 10%-12% is not especially exciting. It’s also some way below the statutory figure of c.18% achieved by US pest control rival Rollins, which I mentioned earlier.

Return on capital employed (orange) has also drifted lower since 2020. This reflects lower operating profit margins and rising goodwill in recent years.

My reading of the accounts suggests either that pricing power has not kept pace with costs, or that the company has started to pay a higher price for acquisitions. Or possibly both.

In fairness, margins and ROCE may improve when the Terminix integration finally completes and as intangible assets associated with the deal are amortised (reducing capital employed).

However, as things stand, I would argue that the current level of profitability may be an obstacle to Rentokil stock earning a higher valuation.

Although the company’s QualityRank remains relatively high at 85, Rentokil’s individual quality metrics are respectable rather than outstanding:

Is the balance sheet in good health?

Despite financing the majority of the Terminix acquisition with new shares, Rentokil needed to take out a new $2.7bn bridging facility to fund the cash element of the deal and related costs.

Net debt rose from a relatively comfortable $1.2bn to $3.2bn as a result. So far, the company has not made much progress in reducing this figure. The half-year results reported a net debt/EBITDA ratio of 2.8x, which is a little above my preferred maximum of 2.0-2.5x.

Balance sheet liquidity metrics such as the current ratio do not look especially strong, either:

In this context, I’d argue that the decision to increase the 2023 dividend by 15% and then increase the 2024 interim payout by a further 15% made little sense and was arguably a little rash.

I’d prefer to have seen the dividend held with any additional free cash flow used to repay debt.

Fortunately, cash conversion does seem to have remained fairly healthy. My sums suggest 2023 free cash flow of £406m (excluding acquisitions), giving >100% conversion from reported net profit of £381m.

With the dividend running at c.£200m, I’d hope that Rentokil will soon be able to start applying surplus cash to debt reduction.

I think it may also be worth noting that consensus forecasts suggest a slowdown in dividend growth, perhaps suggesting some recognition that the historic rate of growth has become unsustainable:

On balance, Rentokil’s balance sheet is not as strong as it might be. However, I expect debt levels to remain manageable and gradually fall. I don’t see the balance sheet as a dealbreaker here, given the group’s size and relatively stable cash flows.

Is there evidence of historic share dilution?

Rentokil Initial’s share count had been largely flat for many years, prior to the acquisition of Terminix in 2022. A total of 643m new shares were issued to help fund this deal, resulting in a c.30% increase in the combined group’s share count.

I don’t think the Terminix acquisition has yet demonstrated good value for money. But I’m reassured that the remainder of the company’s growth over the last decade has been achieved without any dilution.

What is the ownership of the company? Does management have stakes?

Rentokil’s shares are mostly held by large institutions, including Singapore’s sovereign wealth fund.

As I mentioned earlier, the other institutional shareholding of note is activist investor Nelson Peltz’s fund Trian Partners, which has a 2.3% stake and has secured a seat on the board.

Management: according to the 2023 annual report, chief executive Andy Ransom owned 1.2m shares at the end of 2023, worth around £5m today. His total remuneration for 2023 was £3.3m.

However, last year’s annual report suggests that Mr Ransom may have disposed of at least c.445k shares during the year, potentially at prices 50% higher than the current share price.

Valuation

How does the relative valuation compare versus industry and sector?

Rentokil shares do not look obviously cheap relative to the wider UK industrial sector:

However, a comparison against the Professional & Commercial Services industry group suggests the business may be more reasonably valued, assuming the company can rebuild earnings growth:

Rentokil also trades at a notable discount to US-listed peers Rollins and Ecolab (NYQ:ECL), whose business includes hygiene, water treatment and pest control.

However, I think it’s worth considering the possibility that like so many big cap US stocks at the moment, Rollins and Ecolab are quite expensive.

What’s the stock’s intrinsic valuation?

Analysts seem to be taking a more cautious view on the outlook for Rentokil than they did prior to the Terminix acquisition.

Writing in November 2024, Stockopedia shows an average price target of 446p, based on a long-term growth rate of just 2.5%.

Stockopedia’s history function allows us to see that on 29 November 2021, the equivalent consensus price target was 600p, with a long-term growth rate of 11.2%:

(This was just before the Terminix deal was announced in December 2021)

I can see the problem. Rentokil is already the largest pest control business in the world. The company’s own forecasts suggest mid-single digit annual revenue growth for the foreseeable future.

The acquisition of Terminix has led to extra costs and has not yet delivered any improvement in growth or profitability.

On this basis, I also find it hard to get a target price that’s much above the current share price, even if I factor in some cost savings and a recovery in operating margins.

However, if the final stage of the Terminix integration plan is successful, then I can see a route to a higher valuation.

Once the branch integration is complete in 2026, the company is hoping to achieve an organic growth rate that’s 50% higher than the market growth rate in North America:

Industry data cited in the 2023 results presentation suggested the US market is growing at a CAGR of 5%. If Rentokil can truly achieve a 7.5% organic growth in North American pest control, then my sums suggest a fair value for the stock could be closer to 600p.

I think there’s a fair amount of risk attached to this, though. So far, the Terminix acquisition has been a costly millstone around the company’s neck rather than a source of stronger organic growth.

The integration has gone poorly so far and completion has already been pushed back from 2025 to 2026. I would not want to bet against further delays in what appears to be a complicated integration, merging two mature workforces and branch networks.

Trends & Catalysts?

Short-term demand may be uncertain due to seasonal fluctuations in demand. But on a medium-term view, trends towards greater urbanisation, regulation and population density seem likely to increase demand for pest control and hygiene services.

Similarly, climate change is expected to increase the incidence of pest-related problems in many regions of the world.

Are there any catalysts that could drive a re-rating in the medium term?

Completion of the Terminix integration and delivery of planned cost savings may act as a near-term catalyst for the valuation.

Another event that might generate value for equity holders would be the sale of the workwear business. The proceeds could be used to reduce debt, cutting the group’s interest bill and strengthening the balance sheet.

Looking further ahead, one potential long-term catalyst might be that the majority of US homes don’t currently use a pest control service. Increasing the proportion of the market that’s served by companies such as Rentokil could drive stronger than expected growth over the coming years:

Risks

For me, the biggest risk by far with Rentokil is simply that the integration of Terminix will prove to be harder and more costly than expected. This could act as a drag on performance for some time yet to come.

Stock market history is littered with examples of big acquisitions that failed to create value for shareholders.

On paper, Rentokil and Terminix’s North American operations appear to overlap nicely and offer considerable cost synergies.

But my impression is that at ground level, there are significant differences in areas such as employee pay and conditions, and the average size and revenue of each branch.

The company’s ambition to combine the two branch networks (Rentokil c.400 & Terminix c.200) is ambitious and suggests to me that many staff could see changes to their location and team structures, in addition to new IT and work practices:

One of the priorities that’s mentioned repeatedly in the integration plan is improving staff and customer retention.

If the service quality of the combined business suffers during the integration progress, a recovery in growth could take longer than expected as competitors capitalise on the situation.

Recent trading & news

17 Oct 2024 - Q3 trading update: the company’s third-quarter update presented a mixed picture, in my view.

Group revenue for the quarter rose by 3.6% at constant exchange rates, including organic growth of 2.6%.

North America organic revenue rose by 1.4% as previously guided, reflecting “lower volumes than planned”. To address this the company cut c.250 jobs in addition to normal seasonal adjustments, generating annualised savings of $22m.

The Terminix integration continued in Q3 with a pilot of new pay plans and branch structures. To assess the success of these plans the integration programme will then be reviewed early in 2025, resulting in a c.3 month delay to further progress. This seems prudent but also suggests a lack of confidence in the current plan, in my view. I would not be surprised to see further delays or changes announced following this review.

Outlook: on a more positive note, the revised 2024 guidance provided with September’s profit warning was unchanged:

• Revenue and margin expectations unchanged

• Group adjusted pre-tax profit of c.£700m;

• Net debt to EBITDA leverage unchanged at 2.8x.

Sentiment & Outlook

What do brokers currently think and are they upgrading estimates?

Analysts covering Rentokil shares have not started to upgrade estimates. But they have stopped cutting their forecasts after a year of declines:

Consensus estimates suggest adjusted earnings of 21p per share for 2024, rising by 6.7% to 22.4p per share in 2025.

Oddly, the dividend is expected to be held at 8.7p per share in 2024 despite the increase to the interim payout. This would imply a cut to the final dividend, which seems unlikely to me given that the payout remains covered 2.4x by forecast earnings.

What would the person selling to us be thinking and who are they?

I imagine a seller would be concerned about the continued execution risks of the Terminix acquisition and the risk that the combined business will be sluggish and slower growing than hoped for.

As discussed, I think the shares could already be fairly priced unless Rentokil can continue to gain market share.

Another possibility is that after the recent share price recovery from sub-350p, traders might want to lock in gains ahead of any further newsflow from the company.

Conclusions

Rentokil Initial is a market-leading business with strong brands and a leading share in key markets, notably North America.

However, the company faces significant challenges integrating Terminix and has not yet demonstrated that this deal can deliver the profitability and market share growth needed to justify the c.$6bn price tag.

In addition, Rentokil’s debt burden is becoming relatively expensive, placing a drag on equity returns unless earnings growth accelerates.

At c.400p, I don’t see any clear evidence of the kind of margin of safety I would prefer for a new investment. With a P/E of 18 and a 2.3% dividend yield, Rentokil’s steady-state valuation is not obviously appealing, in my view.

On the other hand, if Rentokil can achieve its target of continuing to gain market share in North America, profitability could improve markedly. This could justify a significantly higher share price.

An investor believing the company can deliver the necessary improvement in performance might be tempted by the potential for Rentokil shares to re-rate to a similar level as US peers. This could deliver significant returns from current levels.

More conservative investors might want to wait for updated 2025 guidance and the outcome of the Terminix integration review early next year.