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UK business services conglomerate Rentokil Initial used to be the most reliable of companies. Under former chairman Sir Clive Thompson, it increased its earnings by 20% year on year for nearly two decades.
But now its reputation for quiet efficiency lies in tatters. Following a shock profit warning, Thompson has been kicked out and the business put under strategic review by new chairman Sir Brian McGowan.
What's the way forward? Two solutions have been widely touted. One is a management buy-out and another a break-up. Neither looks viable. But if the company can stabilize its falling margins, its high yield makes the stock look undervalued.
Rentokil's problems aren't really new. The company's operating profits peaked at £550 million ($990 million) in 1999. Since then, they have fallen by 20% and
margins have also declined. The shares have plummeted by more than 60% from their peak.
Part of the reason is that Thompson was more of a financial engineer than a business builder. His insight when he built Rentokil was that he could make lots of small acquisitions in the fragmented services sector at relatively low prices. The trick was that the earnings of the acquired businesses would then be revalued using the group's loftier multiple.
In recent years, the trick no longer worked, partly because Rentokil has become too big to play the same game. Competition has also intensified. The group has therefore been forced to use other expedients to hit its earnings per share target. These included massive share buybacks – £1.3 billion in 2000 alone – which have left it with substantial borrowings.
Potential solutions
The new management now has the task of turning around what is essentially a loosely related ragbag of businesses. Unfortunately, it's not easy to see a
quick fix.
It is hard to see a trade buyer for Rentokil emerging. There's only one FTSE 100 group that delivers packages, exterminates pests and waters office plants – and Rentokil cannot buy itself.
Philip Green's siege of retail group Marks and Spencer has raised hopes that a financial buyer might come forward to buy Rentokil. But this also looks unlikely. The group has £1.4 billion in net debt and little in the way of assets. In fact, it has negative net worth.
Furthermore, securitizing revenue flows from contracts might be difficult, as many can be quit at short notice. So the group cannot easily be leveraged up, reducing potential returns for any buyer. Rentokil is big too. If one paid a 30% premium for the equity and acquired outstanding debt the price would be £5 billion.
Not many bidders would want to shoulder that sort of investment. And the pest extermination business doesn't have an obvious Philip Green figure looming over it.
So what about a break-up? Most of Rentokil's businesses are the largest of their kind, so there are few natural buyers. Competitor PHS has said it is interested, but the snag is that there is little financial reason for a break-up. Using comparable companies and a sum-of-the parts valuation, the group trades at a slight premium to its break-up value, according to UBS.
Instead of quick answers, Rentokil investors need patience. There is no going back to growth through acquisitions given the group's leverage and its multiple of 10 times estimated 2004 earnings. So the only alternative is increasing the value of what they already have.
Management looks on the right track when it suggests increasing spending on measures such as hiring salespeople and spending more on centralized functions such as IT.
At worst, increasing spending should at least prevent further losses of important contracts such as that with supermarket chain Tesco. At this point, the most important thing for the company to do to preserve value is to stop the rot of its margins.
But the real challenge will be focusing the market on the reality that Rentokil is not, and hasn't been for some years, a high-growth company.
And the goal of every mature company is to do what Rentokil already does – throw off lots of cash. Rentokil's free cashflow was £269 million in 2003. Granted, higher costs will probably shrink free cashflow to around £200 million this year if management projections are believed. But even this reduced amount is about twice this year's payout. With the stock yielding 4.5%, the company could easily increase the dividend by say 50% and keep it there.
And if the company can deliver just 5% growth, the stock is looking way undervalued. Using a dividend discount model, predicated on a one-time 50% increase in dividend, 5% growth and a 9% cost of capital, the stock is currently trading at a 60% discount to its intrinsic value.
The real discount is probably smaller than that, but there is still plenty to shoot for.
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