Rentokil Initial (LSE:RTO) issued a disappointing trading update earlier this month. But I think the FTSE 100 stock falling over 20% as a result’s an overreaction. 

As a result, I’ve been buying the stock for my portfolio. Here’s why I think the latest drop’s a buying opportunity as the market’s underestimating the company’s long-term prospects.

What’s the problem?

The biggest issue with Rentokil’s latest update is the performance of its North America business. The company’s expecting organic sales growth of just 1% during the second half of the year.

Sometimes, slow revenue growth can be explained by a difficult trading environment. But not in this case – competitor Rollins (NYSE:ROL) has been growing its top line at 7.7%. 

Rentokil’s made some other unforced errors. Taking on more staff in anticipation of increased seasonal demand’s proved to be a mistake that’s going to weigh on margins for the year.

I’m not saying investors shouldn’t be disappointed by the company’s latest update – they should. But I don’t think things are as bad as the current share price is making out. 

Valuation

In 2023, Rollins generated $3.1bn in revenues, which translated into $496m in free cash. At the moment, the company has a market cap of $24.7bn – almost 50 times free cash flow.

During the same period, Rentokil’s revenues were $6.8bn and free cash flow was $704m. And the UK firm’s market-cap’s currently $12.22bn – around 17 times free cash flow.

In other words, Rentokil generated more than twice as much in sales as Rollins and almost double the free cash, but it trades at half the price. That’s a big difference.

There are some important differences between the two businesses. But I ultimately don’t think these justify such a big difference in valuation.

Balance sheet

The biggest difference between Rentokil and Rollins is in the balance sheet. As a result of acquiring Terminix in 2022, the FTSE 100 firm’s net debt is around 2.8 times its cash earnings. 

With Rollins, this metric’s below 1. The US firm’s been looking to expand through acquisitions, but it’s focused its attention on smaller targets that have been easier to integrate. 

Other things being equal, that’s a clear reason to prefer Rollins over Rentokil from an investment perspective. But other things aren’t equal – the UK stock’s much cheaper. 

There might be some uncertainty about the benefits of the company’s big acquisition might show up. But the Rentokil share price currently looks like investors shouldn’t expect anything at all.

A buying opportunity

In my view, it’s far too soon to be writing off the Terminix acquisition as a complete failure, but that’s what the market seems to be doing. I think this has created an attractive opportunity.

That’s why I’ve been buying the stock for my own portfolio. Generating twice the sales of its nearest US competitor while trading at half the price, I think the stock looks like a bargain.

Over the long term, I expect the market for pest control to keep growing. And I think it’s highly likely Rentokil will be able to provide a decent return on an investment at today’s prices.