Rentokil Earmarks Extra Sales and Marketing Spending to Remedy Weak Organic Growth in North America

Senior Equity Analyst

Grant Slade

Rentokil Initial's strategy is sharply focused on the attainment and maintenance of market share leadership in the highly localised pest-control and hygiene-service markets it competes in. The strategy aims to benefit from ever-improving unit costs offered by economies of density in each localised geography in which Rentokil Initial operates via organic growth and a strong acquisition impetus aimed at rolling up the pest-control and hygiene-service markets, which remain substantially fragmented. To this end, Rentokil Initial has completed over 200 acquisitions since 2015—and has spent an average of GBP 300 million on tuck-in mergers and acquisitions annually over 2018-23 (excluding Terminix)—focusing on acquisition targets that build geographic density of its customers. The late 2022 acquisition of Terminix Global Holdings was a transformative and moat-reinforcing deal, creating a new U.S. market share leader. Pest-control targets remain Rentokil's top M&A priority, but tuck-in candidates for the hygiene segment are now also set to become a focus. The successful execution of the strategy has delivered a durable cost advantage for the pest-control business—the source of our wide economic moat rating for Rentokil Initial.

While offering the promise of a strengthened cost position, M&A also attracts risk. Financial prudence will be paramount for the economies-of-scale benefits offered by the M&A programme to ultimately prove shareholder value is accretive. Still, we remain in favour of Rentokil Initial's acquisition bias, noting risk also exists in failing to further participate in the ongoing global industry roll-up. With a number of other multinational players also actively acquiring pest-control targets to amass scale, Rentokil Initial's M&A programme reinforces its superior cost position. The company has an opportunity to fortify its economic moat through the ongoing digital transformation of the pest-control business. The rollout of this digital service should reinforce the cost position of the business while lifting service standards for customers in tandem, supporting our expectation for organic market share gains on top of acquisition-led growth.

Business Strategy & Outlook

We assign Rentokil Initial a wide moat rating owing to the superior cost position of its global industry-leading pest-control franchise. Rentokil is the world's largest commercial pest-control business, boasting leading market shares in the vast majority of the 87 countries in which it operates. This has been achieved in large part via vigorous tuck-in acquisition activity aimed at reaping the cost benefits, which accrue to a route-based business like pest control as density of service provision increases. To this end, the late 2022 acquisition of the Terminix Global Holdings pest-control franchise, which elevated Rentokil to a market share leader position in the U.S., has strengthened the cost-led economic moat surrounding its global pest-control franchise. 

Rentokil Initial's business model augments the scale advantages of its pest-control business. The model aims to unlock further economies of scope-related cost benefits by organising its regional operations under a single-country management team. In turn, regional management teams lead multiple localised operations spanning across Rentokil's two major service categories of pest control and hygiene and wellbeing. The closer integration of otherwise disparate services operations, supported by combined back-office functions, IT systems, warehousing and logistics costs and property expenses, aims to deliver better unit costs than would be possible with siloed category operations.

Economies of scale prevail typically in business operations, which are characterised by high fixed costs. Fixed costs emanate from an inability to scale certain production costs below some minimum level when demand is low. As a result, certain categories of production costs aren't fully variable, meaning a business must bear its fixed costs in full regardless of whether demand is high or low. Pest-control and hygiene-service operations are a prime example of an inability to scale production costs to precisely align with prevailing market demand. Fixed and step-fixed—part fixed and part variable—costs account for an approximate 75% of Rentokil Initial's cash operating costs. As a scale player in the majority of localised markets in which it operates, Rentokil Initial benefits from a maintainable cost advantage as its fixed and step-fixed costs are better fractionalised across its larger revenue base relative to players with inferior local market share. Most significant among these largely invisible production cost categories is labour, which has constituted an average of 55% of total cash operating costs over 2016-21. Further sources of cost indivisibility stem from Rentokil Initial's fleet of service vehicles, property expenses and other fixed costs, which contribute a further 6%, 2%, and 7%, respectively.

The economics of route-based businesses—such as pest control and hygiene services—are overwhelmingly localised. Increased local market share—that is, scale—translates into better unit costs and therefore widened operating margin. As market share increases, the use of routing optimisation tools, density planning, and smart scheduling for Rentokil Initial's service personnel unlock the density benefits from ongoing consolidation of localised pest-control and hygiene-service markets.

The professional pest-control industry provides services to suppress pest prevalence and maintain the hygiene of physical locations of commercial, public sector and residential customers. Interventions carried out by the industry suppress pests that could otherwise damage commercial interests or endanger public health, including rodents, cockroaches, bed bugs, ants, wasps, termites, birds, snakes, and fleas. Provision of services to the commercial segment of pest-control global markets accounts for 80% of pest-control category revenue. Accordingly, Rentokil is less exposed to the residential segment of the pest-control market, which accounts for the remaining 20% of pest-control revenue. The lion's share of pest-control revenue from residential customers are derived from the U.S. and Australia, owing to their termite-prone timber-frame housing stocks. Agricultural, marine, and large-scale vector control are niche segments of the pest-control market in which Rentokil Initial does not participate.

Rentokil's superior scale in the vast majority of pest-control markets in which it operates drives a maintainable cost advantage. The group's ongoing roll-up of still highly fragmented pest-control markets has yielded leading market share in 56 of the 87 countries where the Rentokil franchise competes. With superior market share comes superior route density, spreading the fixed costs associated with the delivery of pest-control services over a larger revenue base than is possible for smaller competitors in what are still highly fragmented markets. Rentokil Initial estimates there are an approximate 40,000 pest-control service operators globally, with an estimated 20,000 in North America, the largest of these regionally distinct markets.

Rentokil's superior scale has yielded higher average EBIT margins over the preceding five years relative to other large-scale internationally active players. These key internationally active competitors—which include Orkin (Rollins), Anticimex, and Ecolab—are also actively engaged in the ongoing roll-up of the global industry. With Rentokil enjoying better margins than its largest competitors—which also benefit from EBIT margin-widening scale economies—we infer the cost advantage which Rentokil maintains over the highly fragmented tail end of the market is meaningful. We note the similar historical EBIT margin performance of Orkin. We understand Orkin also enjoys very good economies of density in many of the regions it competes in, particularly in the U.S.

Rentokil Initial is reinforcing the moat it has built around its global pest-control business via a continued focus on bolt-on pest-control acquisitions aimed at increasing the density of customers serviced by its existing pest-control branches. While Rentokil has completed a sizable 228 acquisitions—predominantly in pest control—since 2016, pest-control acquisitions remain a focus. Increased localised market share allows for better route optimisation for technicians, with the increased density of service provision yielding further labour and vehicle cost efficiencies. The late 2022 acquisition of Terminix Global Holdings substantially bolsters the cost-advantaged position of Rentokil in North America, with cost synergies identified as part of the deal to widen Rentokil's EBIT margin progressively over 2023-25. The deal cements Rentokil as the new market share leader in the U.S., where we estimate the enlarged pest-control franchise commands a 30% share of the addressable market.

The widespread rollout of digitally enabled pest-control devices to its commercial customers over the coming decade will act to further reinforce its economic moat. Following years of product development, Rentokil will now embark on a digital transformation of its commercial pest-control business. In doing so, Rentokil aims to lead the industry toward pest prevention from its present, predigital state of reactive pest control and shore up its cost-advantaged position in the process. PestConnect is Rentokil's proprietary digital ecosystem, which utilises digitally connected pest-control devices—in place of traditional bait boxes with mechanical traps and poisons—to transmit data in real time to a central command system, allowing for pest monitoring to take place 24 hours a day. Valuable data is also generated, with pest activity tracked by site area and benchmarked against industry averages. This contrasts with traditional pest-control visit cycles, which are typically six to eight weeks, allowing for pest infestations to go unchecked for multiple weeks before detection. As a result, the digitisation of the industry is leading to improved service delivery for customers. This improved service, which features digital around-the-clock site monitoring, occurs while routine visits to sites from technicians are reduced. In the case of Rentokil, a PestConnect installation reduces technician visits to an average of four visits annually, down from a prior average of eight. Therefore, for pest-control players like Rentokil that have the regional scale to justify investing in such an Internet of Things network, the scale economies that are available to large players such as Rentokil are heightened. By contrast, small pest-control operators who cannot justify the capital investment and overheads associated with running their own Internet of Things pest-device network cannot benefit from the route optimisation and lower labour costs offered by a digitally enabled device rollout. 

Rentokil Initial's stable of hygiene and wellbeing businesses are also route-based businesses, which benefit from the same economies of scale that come with increasing density of service provision. However, we do not think the stable of hygiene and wellbeing businesses have been densified sufficiently to dig an economic moat around this business. Nonetheless, we do see potential for future prolonged economic profit generation as organic growth and greater attention to densifying bolt-on M&As for the segment slowly improve the relative cost position of the hygiene business. 

The hygiene and wellbeing businesses are complementary to commercial pest-control services, servicing the same customer types and sharing country management, technology and back-office services. Likewise, hygiene is a route-based service business, which benefits from economies of density. Washroom services are fulfilled by Initial’s pool of service personnel on a fixed schedule basis. Service frequency ranges from daily visits to up to eight weeks depending on the frequency which service is needed. The preplanning of washroom servicing allows for daily service routes to be optimised to garner the maximum benefits offered by density economies.

Rentokil Initial's global hygiene business has a more than 100-year heritage in washroom services, with its genesis as Initial Towel Supply; it entered the London washroom hygiene market in 1903. As legislation has evolved over time to boost hygiene standards in commercial and public settings, the business has expanded its scope, offering integrated solutions to commercial customers who seek to outsource the hygiene management of their public or shared washroom facilities. Via its leading market brand, Initial, Rentokil Initial provides hand, surface, air, washroom hygiene and waste management solutions, including the provision of feminine hygiene and nappy waste management, provision and servicing of dispensing systems and associated supply of consumables for toilet tissue, surface sanitiser, hand soap, hand drying, air fragrancing and purification and washroom vending units. While Initial offers a comprehensive suite of solutions for the washroom environment, it is not a cleaning company and does not offer washroom cleaning services.

Initial's expertise extends across food processing, office, education, hotel, retail, health service, manufacturing and restaurant industries, helping commercial clients keep their facilities hygienically safe for personnel and customers and in certain instances, compliant with hygiene laws and regulations. Initial has leading share in 22 of the 45 markets it operates in and it's in the top 3 in 38 of these markets. Of note, the business is significantly underweight in North America with no core washroom service business addressing the U.S. market and no current plans to build one out, given the norm of bundled hygiene and janitor services in the region. As a result, just 12% of category revenue is derived from the region.

The category also incorporates Rentokil Initial's more niche premises hygiene and enhanced environments businesses. The premises hygiene business provides specialist hygiene and clinical waste management services to the dental and clean-room segment of the hygiene market. Under the Ambius brand, the enhanced environments business delivers interior plants, biophilic design and air scenting and quality services to commercial customers. The premises hygiene and enhanced environments businesses accounted for a cumulative 26% of Rentokil Initial's hygiene and wellbeing category revenue in 2019 (that is precoronavirus). With operating margins are appreciably lower for these niche categories, their contribution to category operating profit is significantly lower than its revenue contribution. 

While the core washroom hygiene franchise boasts a number of leading market share positions, the business operates in highly fragmented markets populated by incumbents with the same operating model as Initial as well as facilities management and janitorial businesses, which also offer bundled cleaning and hygiene services. This disparate segment makes the assessment of the cost curve positioning of the Initial business somewhat challenging. Nonetheless, comparisons of the Initial business' historical operating margins with that of large European hygiene players with similar operating models—including PHS—is instructive. Given the hygiene business' relative operating margin performance, we surmise Initial is yet to move sufficiently down the industry cost curve in enough of its geographies to warrant an economic moat designation. Greater acquisition activity on the part of Rentokil—aimed at amassing greater market share and density benefits—would lower the hygiene business' cost-curve position while steepening the industry cost curve.

Wide

Economic Moat

Rentokil Initial PLC

Rentokil Initial Plc engages in the provision of business support services. Its products and services protect people from the pest-borne disease and the risks of poor hygiene. It operates through the following geographical segments: France, Benelux, Germany, Southern Europe, and Latin America. The firm focuses on route-based services, predominately in pest control and hygiene as well as other smaller services including plants, medical, property care. The company was founded by Harold Maxwell-Lefroy in 1925 and is headquartered in Camberley, the United Kingdom.

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Rentokil Initial Plc engages in the provision of business support services. The firm's products and services protect people from pest-borne disease and the risks of poor hygiene. It operates through the following geographical segments: North America, Europe, UK and Sub-Saharan Africa, Asia and MENAT, and Pacific. The company was founded by Harold Maxwell-Lefroy on September 24, 1924 and is headquartered in Crawley, the United Kingdom.

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Rentokil is a market leader in the pest control industry, controlling 21% of the global market. The pest control market is expected to reach $42.5 billion by 2032, with high margins. Rentokil has faced challenges following its acquisition of Terminix, but long-term investors should take note of its potential for growth.

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Rentokil Initial plc (RTO) Q1 2024 Sales/Trading Statement Call Transcript

Rentokil Initial PLC (LSE:RTO)'s revenues were up 4.9% in the first quarter, or 3.1% on an organic basis when stripping out the impact of acquisitions including HiCare in India. North American growth “stabilised” in the quarter, the FTSE 100-listed group said, with organic revenues up 1.5% in the region.

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