2023-09-03 21:14:59 ET
Summary
- Rentokil Initial offers integrated service solutions for pest control, hygiene services, and workwear solutions. The company has grown at a CAGR of 11%, with strong organic growth and consistent acquisitions.
- RTO has a fantastic business model, with a leading position in numerous segments and deep expertise, allowing for 4-6% organic growth in a mature industry.
- The company has consistently improved FCF, with scope for further margin improvement as it optimizes acquired entities. This will be a key value lever in the coming years.
- In conjunction with strong fundamentals (& M&A), RTO is benefiting from industry tailwinds, as infrastructure spending and economic development globally drive demand.
Investment thesis
Our current investment thesis is Rentokil Initial plc ( RTO ) (RKLIF) is an incredibly attractive business, with a market-leading position in various essential services segments globally. This is developed through scale and deep expertise, allowing the company to create long-term relationships with clients.
The company's strategy of bolt-on M&A has accelerated what is already an impressive organic growth trajectory, with a strong track record of successful acquisitions and integrations.
We are expecting a continuation of its current trajectory, with strong growth and incremental margin improvement. This will support the distribution capacity of the company and allow it to maintain its financial advantage relative to its peers.
Industry tailwinds include economic development, a fragmented industry, and greater infrastructure spending.
Company description
Rentokil Initial is a global provider of essential services, specializing in hygiene, pest control, and interior landscaping. Headquartered in the United Kingdom (and listed on the FTSE 100), the company operates across various sectors and industries, offering a range of solutions to enhance health and safety standards for businesses and individuals.
Share price
RTO's share price performance during the last decade has been impressive, with more than double the returns of the S&P. This is a reflection of the company's business model improvement, contributing to greater financial returns for shareholders.
Financial analysis
Presented above are RTO's financial results .
Revenue & Commercial Factors
RTO's revenue growth has been an impressive 11% during the last decade, with strong consistency following FY14.
Business Model
RTO offers a range of integrated service solutions aimed at creating safe, clean, and hygienic environments for businesses and individuals. These services include pest control, hygiene services (e.g., hand hygiene, restroom care), and workwear solutions. RTO is the premier company within this space and the leader in commercial pest control. Its integrated solutions approach has allowed the company to develop deep types with multinational clients.
Pest Control is the largest segment of the business, comprising 80% of its H1'23 revenue. This said, the company is growing other parts of the business well, reducing reliance on Pest Control (the Terminix transaction discussed below is distorting the development of other segments).
Further, the company operates in over 80 countries worldwide, providing its services to a diverse range of industries, including healthcare, food processing, hospitality, and more. RTO's revenue is primarily from North America (62%) but is truly global in its reach with good diversification.
This diversification in geography and services provided has been incredibly lucrative for the business, giving it an ever-growing total addressable market and a smoother upward revenue trajectory.
RTO's services require specialized expertise in pest management, hygiene, and safety regulations, with Management acquiring or developing this over an extended period. Through this, the company has evolved a range of brands that are globally recognized for their expertise and reliability, giving existing and future clients trust that the business is able to deliver a high-quality service. From a competitive standpoint, the company scale in conjunction with this gives it an unrivaled ability to provide a leading offering at scale.
The company's business model emphasizes a proactive and preventive approach to addressing pest control and hygiene challenges. This approach helps businesses avoid costly disruptions caused by infestations or hygiene issues. This involves offering a comprehensive customer support packaging, alongside education on hygiene and pest management practices. This approach to servicing clients is optimal in our view, as it develops a deeper relationship with its clients with ongoing monitoring and support. Many of these services operate on a subscription or contract basis, which is extremely attractive due to the recurring revenue profile and greater stability over cash flows.
RTO utilizes digital technology and data analytics to enhance its services, improve customer experiences, and optimize its operations. Despite the company's substantial size, mature industry, and heritage, Management must be credited for how the business is operated. RTO is continually investing in incremental operational and commercial improvements, with a strong culture of innovative improvements.
Underpinning the company's impressive business model is Management's approach to M&A. The company utilizes strategic acquisitions (primarily bolt-ons) to expand its service portfolio and global reach, contributing to strong growth. The largest transaction in recent years was Terminix, which was valued at slightly over $6.5bn. This has significantly expanded the company's Pest Control capabilities, improving its monopolistic position within the industry, with scope for synergies and long-term value enhancement. Beyond this, the company has acquired a further 24 businesses in H1'23m with a total consideration of £202m (aligning to its bolt-on focus). Management's track record with M&A is unquestionable and the fragmented nature of essential service provision globally (management estimates over 30k companies globally - source: investor pack ) implies a broad target market to approach.
Essential Services Industry
The fundamental nature of Essential Services is attractive, namely due to the very thing in its name... essential. Businesses across the globe, in increasing numbers as economies develop, are legally required to meet certain standards at their locations, forcing them to use Essential Services businesses.
This creates long-term relationships with service providers, particularly when service delivery is efficient, high quality, cost-effective, and with minimal disruption. As previously discussed, RTO's brands are market leaders in this space and have developed a superior offering, allowing it to win and retain customers.
This creates a resilient industry that is broadly unaffected by economic conditions and near-term changes in economic development.
We consider the following to be key value drivers that will support healthy organic growth in the coming years:
- Economic development globally increasing RTO's TAM.
- Increased infrastructure spending in the West supporting demand from core markets.
- General developments in living standards and thus legislation to support increased requirements.
- A fragmented industry where RTO can consistently acquire global businesses to strategically develop its position.
This suggests RTO is an incredibly attractive business, with a monopolistic position (particularly in Pest Control). The combination of its business model, a resilient industry, and strong pricing power will allow the business to achieve strong growth going forward. It is key that investors do not look at this business as purely a consolidator.
Margins
RTO's EBITDA-M has softened over the historical period, with its NIM understandably noisy due to acquisitions. Although this may look concerning, the company's FCF has soured, allowing RTO to invest more in growth.
Underpinning this current position is regular M&A, which restricts the ability to optimize the business wholly. For this reason, there is long-term scope for further value extraction through synergies and operational improvement undisrupted over time.
H1 results
Presented above is RTO's H1 results .
The company has once again achieved impressive results. The key takeaways are:
- Pest Control:
- Organic growth of +5.6%, in line with Management's medium-term target. Adj. OPM up to 19.2% (+1.3ppts).
- RTO continues to develop its market-leading position, with innovation driving new customer wins. Unit growth of "PestConnect" (premium IoT service) is at a CAGR of 20%, further enhancing Subscription revenue.
- Hygiene and Wellbeing:
- Organic growth of +5.2%, in line with the targeted level. Adj. OPM at 16.4%, with H2 expected to exceed 19%.
- Industry growth is expected to be strong, with RTO well positioned and seeking to improve exposure. Investment is being made to improve its products/services.
- Workwear:
- Organic growth of +16.3%, significantly exceeding expectations as the segment continues to grow well post-pandemic. Adj. OPM of 16.9%, up 2.2ppts.
- High customer retention, with investment into operational aspects of the business to enhance value.
Overall, we are incredibly impressed with RTO's H1. The business has shown its immense resilience in the face of weakening economic conditions, owing to its bullet-proof business model. At an organic growth rate of 4-6% and incremental margin improvement, the business is incredibly attractive in our view.
Balance sheet & Cash Flows
RTO's balance sheet is relatively clear. The company has partially utilized debt to maintain its capital allocation strategy, contributing to an ND/EBITDA ratio of 3.3x. This is approaching a healthy maximum but we must acknowledge that EBITDA is expected to grow substantially in the coming year, bringing this ratio back to an expansionary level. Similar to other factors, this is a reflection of a well-managed business.
Distributions thus far have been quite mild, as a FCF margin >10% implies both dividends and buybacks are sustainable. This is due to the capital allocated to M&A. We are not overly concerned by this, as the acquisitions have shown themselves to be highly accretive. There is scope in the future for an acceleration should Management shift toward distributions.
Outlook
Presented above is Wall Street's consensus view on the coming 5 years.
Analysts are forecasting a continuation of its current growth trajectory, with margins incrementally improving over the coming years. This appears to be a reasonable assessment, as Management continues to execute bolt-on acquisitions alongside healthy organic growth, while operational improvements over time (with operating cost leverage) drive an uptick in margins.
Industry analysis
Presented above is a comparison of RTO's growth and profitability to the average of its industry, as defined by Seeking Alpha (18 companies).
RTO performs well relative to its peers. The company's growth is broadly above the average, particularly in profitability, illustrating the accretive returns of its revenue growth. Terminix is the reason for the outperformance in the go-forward period.
RTO's clear advantage is its margins, with superiority across most metrics. Our expectation is for further improvement in the coming years, contributing to a widening delta. The biggest positive, and the reason a larger premium to the trading multiple is warranted, is due to the degree to which RTO's FCF is larger.
Valuation
RTO is currently trading at 20x LTM EBITDA and 14x NTM EBITDA. This is a premium to its historical average.
A premium to RTO's historical average is warranted in our view, as the company's strategic execution, financial development (namely FCF), and increased scale (both M&A and Organic), have allowed RTO to become a better and more defensible business.
Further, RTO's premium to its peer group is also warranted, primarily due to its superior profitability and superior strategy. Many of these peers also have strong moats (in other similar industries) so this is less of a factor.
The discount to RTO's historical average, particularly on a NTM basis, looks attractive we feel. This is less so relative to peers, given the c.20-30% premium on an EBITDA basis. This premium only widens on an FCF basis. What cements this view for us is the discount compared to RTO's NTM FCF yield.
Key risks with our thesis
The risks to our current thesis are:
- M&A execution. As a business conducting regular M&A, with occasional large deals, there continues to be execution risk with incorporation and synergy realization. RTO's track record implies low risk.
- FX. As RTO continues to develop globally, the business faces risks associated with the conversion of earnings, potentially distorting its underlying performance.
Final thoughts
Rentokil Initial is truly a fantastic business with very few limitations. The company operates a range of market-leading brands, is built on deep expertise, and is incredibly well-run. From an industry perspective, there is a broad tailwind benefiting the industry underpinned by improving demand, with increased subscription-based revenue potential.
We believe Management's target of 4-6% organic growth is reasonable, purely on pricing power, with room for margin improvement also. RTO's valuation is certainly on the top end but continued improvement in economics should mean upside in the coming years. Investors shouldn't forget that Dividends and Buybacks have been scarce. Eventually, RTO will transition toward these.
For further details see:
Rentokil Initial: Thriving Compounder In A Market Leading Position