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Rentokil Initial: significant changes, but still looks like it will deliver for shareholders

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Rentokil (LSE:RTO) has undergone significant changes over the last couple of years. The pandemic forced the pest control and hygiene business to adapt to fluctuating demand for corporate sanitation services and respond to new demands in pest control from an increasing stay-at-home workforce.

Rentokil has also seen structural change too, with the transformational acquisition of Terminix, a US-based termite protection provider, and an internal restructure to streamline the business into two operating units, reducing from the three prior reporting segments of Pest Control, Hygiene and Protect and Enhance.

Despite these ongoing changes, Rentokil continues to deliver for shareholders. A recent trading update in April suggested that revenues in Q1 2022 grew at 8% on an organic basis (when removing the results from Covid-19 impacted disinfection sales). Rentokil’s Pest Control business, which accounts for over two thirds of its sales, has continued to post resilient results, with organic growth of 5.5% and total growth of 11.2% when factoring acquisitions.

With the return of many companies and employees to office locations, Rentokil’s Hygiene business ‘Initial’, which provides washroom services, has continued to bounce back, producing organic growth of 12.9% during the period and total revenue growth of 14.2%.

Given the current inflationary environment, Rentokil provided positive commentary on costs and pricing; although Rentokil is seeing inflation across much of its input base, it has managed to protect margins with price increases, and in the first quarter, price increases entirely offset the impact of inflation. Confidence in pricing can also be found, with pest control competitor Rollins suggesting it has been aggressive with price increases in the US, which is also Rentokil’s largest market.

Terminix acquisition going to plan

With lots of moving parts to the Rentokil investment case, investors should be pleased that the acquisition of the US leader in termite control Terminix is going to plan. In the latest update, Rentokil explained that the deal had now satisfied US competition requirements and the integration was on track and scheduled to close in the third quarter of 2022. Rentokil agreed to pay $6.7 billion for Terminix in December 2021, issuing 643 million shares (approximately 35% of Rentokil’s share capital) to undertake the acquisition.

With its sights set on US expansion, Rentokil paid a significant premium, offering a price 47% higher than Terminix’s shares were valued to close the deal. Despite the premium, management suggests that bringing Terminix under the Rentokil umbrella will drive efficiencies and result in a cheaper valuation than the headline figures after cost synergies are found. Speaking on the deal, CFO Stuart Ingall-Tombs outlined the valuation features below:

“We expect it to be value accretive, with the transaction valuing Terminix at approximately 19.3x 2021E consensus EBITDA pre synergies and approximately 13.9x 2021E consensus EBITDA pro forma for aggregate cost synergies across the Combined Group of $150m.”

Restructure commercial business units

Looking inwards, to the recent restructure of Rentokil’s commercial business units, the prior divisions of Pest Control, Hygiene and Protect and Enhance are to be simplified to two divisions, Pest Control and Hygiene and Wellness. This change has effectively dissolved the Protect and Enhance business unit, which had the lowest profit margin of the group at 11%, and moved the individual operations (Ambius, French Workwear, Dental Services and Property Services) into the two aforementioned units.

In its annual report, Rentokil commented that its French Workwear business, which contributed 50% of the now dissolved Protect and Enhance business unit, will exist as a separate entity outside of the two managed divisions. It is plausible this move paves the way for a spin-off of Rentokil’s Workwear operations. Such a move would increase profit margins across the group and provide capital for further purchases of small pest control outfits.

Rentokil’s efforts to restructure the business should be seen in a positive light, as the company still lags its closest peer, Rollins, in terms of profitability. Rentokil has made some improvements over the last few years, primarily driven by better performance in its Hygiene segment, which has now become a higher margin business than the Pest Control division, showcased in the graph below.

Rentokil Initial: Divisional Profit Margins

Now, with a reshaped business post the acquisition of Terminix, 75% of revenues will be derived from Pest Control, with a large weighting to business in North America. This doubling down of bug-bashing capabilities should provide future resilience and keep top-line growth ticking over at mid-single digits, as secular tailwinds, such as increased population density and global warming, increases the demand for critter call-out services from Rentokil.

The attractive tailwinds of the pest control industry haven’t gone unnoticed. Fundsmith, the UK investment house behind the popular Fundsmith Equity and Smithson Trust, added Rollins, the US pest control company, to the Smithson portfolio in 2021. Commenting on the sector in Smithson’s 2021 annual report, fund manager Simon Barnard noted the following:

“Unlike in the UK, houses and businesses in many parts of the world require frequent attendance by pest control professionals to keep them comfortable, and in some cases, habitable. This leads to highly repeatable revenue, as many customers pay for the services on a monthly subscription basis.”

Investors with a keen eye for a bargain might be put off Rentokil’s current valuation of 28x forecast earnings in 2022, however, when compared to its US peer Rollins, which trades on a forward P/E of 46, Rentokil’s valuation looks fairly reasonable. With potential upside from the acquisition of Terminix yet to be realised and the opportunity to create further value from restructuring, Rentokil’s prospects look bright.

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This article does not constitute investment advice. Make sure you do your own research or consult a professional advisor.

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