Description

Summary

With the market running at record levels following the AI-fueled boom, I am pitching a company that is trading at a historically low valuation. This is not a company prone to AI or other disruptions risks, in matter of fact this an industry that is almost certainly to be around and even growing for decades to come. Rentokil, the global leading pest control provider, is a well-run company operating in an attractive industry that is currently out of favour following one disappointing quarter. I believe this is an overblown reaction to some fixable issues. Rentokil has a long-tenured management team with a good track record and a history of always exceeding their guidance. Rentokil has been a consistent double-digit EPS grower with limited recession risk, which makes the current 2024 P/E of 17.5x an attractive entry point. If RTO hits their guidance and the multiple re-rates to 20-22x (still below the 10-year average of 24x) than I see a 30%+ IRR to the end of 2025.

Business overview

Rentokil Initial (RTO) is the world’s largest pest control service provider. It also offers hygiene services (installing hand dryers, hand sanitizers at facilities and refilling those on a recurring basis) and uniform rental in France (non-core and up for sale). Since pest control accounts for >80% of EBIT, I will focus only on this part of the business. As many are probably aware, pest control providers enjoy attractive economics. The market is growing at 4-6%, revenue is non-discretionary, high retention rates, capital-light and strong operating leverage. Over 70% of RTO’s revenue is recurring and the ‘non-recurring’ part is still very stable. When you have rats, cockroaches or termites, at least 9 out of 10 people will call a pest control provider regardless of the economic environment. This is also evident by Rollins (ROL) reporting positive organic growth during the GFC.

Barriers to entry are low, but barriers to scale are high. It’s not difficult to start a pest control business: apply for a license, buy/lease a van, procure chemicals & dispensing equipment, buy insurance and you are ready to go. The tougher part is to attract new customers, which is hard as no one knows you and you have zero reviews. The best way is to advertise is on digital channels, where you are probably going to be outbid by the incumbents (RTO and ROL), who are also deemed more ‘relevant’ by the likes of Google. We also see this back in market share dynamics, where RTO and ROL continue to gain share (partly due to M&A) and today account for 34% and 24% of the US pest control market respectively. Benefits from scale mainly come in the form of route density and branch consolidation (read margin expansion), which makes bolt-on acquisitions an attractive use of capital. Per RTO, branches that do >$8m in revenue have operating margins 1,000bps higher than those that do <$3m in revenue.

RTO used to be a poorly run business. This changed when Andy Ransom moved into the CEO role in 2013. He reorganized the business by disposing non-core assets (facility management, parcel delivery and interior services) and focused on building out the best segment, pest control. Pest control went from 20% of revenue in 2012 to 80% today. Since Andy took over in 2013, EPS grew in every year with a CAGR of >12%. He is still running the same playbook today, growing revenue at 9-10% (equally split between organic and bolt-ons) coupled with margin expansion.

Terminix merger

After years of acquiring small pest control providers (average deal size of <£10m revenue), RTO announced the acquisition of Terminix (TMX) in late 2021. The deal created the largest US pest control company. At announcement, the price totaled $6.7bn (80% with equity and 20% cash), which came down to 19x 2021 EBITDA and 13x (incl. initial synergies). The deal closed a year later, when RTO’s share price was 35% lower, lowering the price to ~$5bn and 2021 EBITDA multiple (incl. synergies) to ~10x. Management later raised the synergy target from $150m to $225m. Not a bad deal in hindsight.

The merger combines RTO’s expertise in the commercial sector with TMX’s expertise in residential and termite. The financial appeal is in the branch consolidation opportunity. RTO targets to move from over 600 branches in the US with an average revenue of $5m to around 400 larger branches with on average $8-10m in annual revenue. This will be a key driver of margin expansion in the coming years.

TMX used to be poorly run, as described in several of the ServiceMaster write-ups on VIC. TMX faced several issues: underinvestment into the business, high executive management turnover, low technician and customer retention rates and inconsistent service. Over FY14-22, US pest control organic revenue averaged only 2.2% for TMX versus 5.1% for RTO. Management believes they can pull this toward RTO levels by improving colleague retention and service levels. As both RTO and Rollins often point out, the key to this business is a high colleague retention rate, which translates into strong customer retention. So far the integration is going well. Legacy TMX’s colleague retention rate is already up 800bps to 69.7% (but still below RTO’s >80%), they already reduced the branch network by 100 properties and raised the net cost synergy target by 50%.

Q3 report

In the first year after the merger closed everything went smoothly with above average growth, medium-term target upgrades and synergy execution running ahead of schedule. This changed when they released their Q3 report in October 2023, causing the shares to drop 40% peak-to-through. The report wasn’t that bad in my opinion with +4.3% organic growth. However, the US pest control business (60% of EBIT) slowed down to +2.3%. They further commented that they now expect US organic growth to be below expectations for FY23 with margins of 18.5-19% (vs. previous target of 19.5%). This was all made worse by a very poorly conducted call, where management couldn’t clearly explain the reason of the slowdown. This raised concerns that pest control industry may have a slight cyclical element and potential integration issues with TMX. The final blow was delivered by Rollins, who a week later reported strong organic growth.

After months of pessimism, RTO reported a better than expected Q4, but more importantly addressed what went wrong in H2 and an action plan to fix it. The main challenge was lower acquisition of new residential, termite and SME customers with in-bound sales leads down 2-3%. This is a combination of the TMX merger (integration planning), a change in RTO's marketing and sales leadership, flat sales colleague retention (60% at TMX and 77% at RTO), impact from branch closure and increased digital marketing spend by competitors. These don’t seem like structural issues and management laid down a detailed plan in their FY23 presentation on how to fix it. Key points: improving colleague retention (mainly legacy TMX), improving pricing (they were always less aggressive than ROL), improve cross-selling from technicians (only 50% of US technicians engage in cross-selling vs. 88% in their UK business). This commentary coupled with another synergy target raise and reiteration of the medium-term targets pushed the shares up 20%. The shares have already come down a bit ahead of the Q1 trading update (18 April).

Valuation

Management guides for at least 5% organic revenue growth and 8-10% total revenue growth. Margins are guided to reach >19% by 2026 (vs. 16.7% today). This is driven by synergy execution (still 2/3% of the $225m to go) and operating leverage (30% incremental operating margin). If RTO hits these targets, this would result in a £0.34 EPS in 2026. Note that the current management team has always exceeded their guidance since they started providing it in 2014. RTO currently trades at 17.5x 2024 P/E, which is significantly below its 5-year and 10-year average of 28.5x and 24x. If RTO executes on the above, I assume the multiple to move closer towards its historical levels. Using a 20-22x multiple on 2026, gives 53-68% upside, a 30%+ IRR. There may even be upside to this multiple as service providers with resilient and structural growth general fetch high valuations (e.g. ROL 43x NTM P/E, WM 30x, WCN 35x, RSG 31x, Cintas 41x, Chemed 26x).

For the downside case one needs to assume a structural slowdown in the US, management being unable to improve TMX’s performance (putting pest control organic revenue growth to 0% over 2024-2026), no further synergy capture, no further margin expansion and a mid-teens EPS multiple (versus mid-twenties historically). This would lower 2026 EPS to £0.26, which at a 15x P/E gives a price of £3.95 (10% downside minus a 2% annual dividend yield). Based on the Q3/Q4 results and related commentary, there is no information that points toward these conclusions. In short, I believe that the risk/reward is very positively skewed.

The main risk is a poor integration of TMX. RTO has a good track record of integrating bolt-ons, but the size of this deal makes this completely different. The merger result in a significant branch consolidation wave and a large rebranding with all TMX commercial business being rebranded to ‘Rentokil’ and their own residential & termite to ‘Terminix’. Moreover, there seems to be a US/UK culture switch. For example, TMX employees will move from their largely variable to a largely fixed salary. The integration went well up to now, but it’s not unthinkable that there will be some stumbles along the way.

Catalyst

• RTO showing in the upcoming quarters, starting with Q1 on 18 April, that growth is not structurally lowered.
• Further progress on the TMX integration.
• A listing in the US. There have been multiple UK companies that pursued a listing in the US in recent years. Following the TMX merger, the US accounts for >60% of revenue/EBIT. To be clear, management didn’t share any intentions of following this route, but it would make sense (better executive compensation and likely a higher valuation).