Emma Wall: Hello, and welcome to Morningstar. I'm Emma Wall and I'm joined today by Simon Murphy, Manager of the Old Mutual UK Equity Fund, to give his three stock picks.
Hi, Simon.
Simon Murphy: Good morning.
Wall: So, what's the first stock that you'd like to highlight today?
Murphy: One stock that I'm very keen on at the moment and have been for a while actually is Rentokil Initial (RTO). Rentokil, most people will be aware of for their pest control services and that is a big proportion of the business. They also do hygiene services and workwear rental services.
What's happened is, the new management team a couple of years ago have come in under Andy Ransom, the chief executive, and they've started to shift this portfolio away from some disappointing businesses, they've disposed of and focus more and more on this core pest control business. And pest control is a great business. It may not be very pleasant but it's a great business to be involved. It's very cash-generative. It's very profitable and it's pretty low cyclicality.
It's not really driven by the economic cycle. It's a very steady predictable business. And as the company has focused more and more on this side of the business, so the cash-generative nature of the company has improved, the returns to shareholders have improved. The shares, to be fair, have started to perform quite well, but I think there's still a long way to go in this transition to a pure pest and hygiene business.
Wall: It's not a very glamorous stock, but you don't invest to be glamorous. What are the risks with this stock? I mean, what's its market share? Are there any major competitors within the market?
Murphy: It's a very good question. I mean, they are global, but their biggest growth area is the United States. In the United States they are now number three. And there are only really three players that can offer pest control on a whole national basis across America, obviously a huge, huge country. So, the risk is that they are still a small number three to the two big players, Rollins, in particular, is the market leader. They are making rapid progress in terms of building scale.
But, yes, undoubtedly, if one of those two starts to get very, very aggressive competitively then that could be a threat. But it's such a nice industry and it's so local, what tends to happen is, you tend to have dominant market shares in particular geographies within the country and you sort of leave each other alone. So, it is a risk, but hopefully a manageable one.
Wall: And what's the second stock today?
Murphy: The second stock I'm really keen on at the moment is Tesco (TSCO).
Wall: Pretty controversial.
Murphy: Yeah, it's certainly, I'm sure, will raise some eyebrows, but actually I think over the last 18 months, again, under a new management team, Dave Lewis has come in and has really taken hold of Tesco and focused on rejuvenating the core business, which is the U.K. There are lots of other bits, but the U.K. is the dominant piece of the business. And after several years of having a vicious circle of declining volumes in particular, they have really set about just putting the basics right, putting the service right, putting the pricing right, getting the ranging right.
Wall: Coming back to the U.K.
Murphy: And just focusing much more on the U.K.; all the distractions of America have gone and so forth. And what we've seen now is for the first time in about six years we've seen some genuine volume growth coming through the business. And volume growth is so important for a food retailer because when you get volume growth, your suppliers are much happier because they are selling more to you, they give you better discounts and you can invest that in price to give the better offer the consumer and you can keep a bit for yourself and grow your profits and that is critical. And Tesco are still the dominant player in the U.K., 28% market share by a major factor. So, as they can get that volume growth wheel turning, they get backed away from a vicious circle to the virtuous circle and the business should start to see some really good profits growth.
Wall: And the accounting scandal and the threat of Aldi and Lidl, those things that you think actually are manageable?
Murphy: I think the accounting thing has been put to bed. That's one of the first things that Dave Lewis did when he joined the company. Aldi and Lidl, very, very important competitors, won't go away. They currently have about 10% market share in the U.K. and they will take more share, but Tesco have 28%. I would be much more worried for some of the other supermarkets in the U.K. than I would be for Tesco. Of course, you got to take them seriously as a competitor, which Tesco now are doing, but actually I think there is plenty of scope for them to thrive and the dominant market player to thrive as well.
Wall: And what's the third and final stock?
Murphy: The third stock is a company called Micro Focus (MCRO), which many people probably won't have heard of. They are a business that basically support software systems for companies and the systems that have been running for many, many years, legacy systems they are called that aren't necessarily being renewed now, but they are so complicated and so important to the infrastructure of the company that they still need them to run. So, Micro Focus tends to provide all the support for these big old mainframe systems for many, many companies around the globe. And what I like about that not dissimilar to Rentokil is it's a very steady predictable business.
Wall: Visibility on earnings.
Murphy: Good visibility, lots of repeat business, lots of subscription business. It's vital for the companies, they have to have these systems working and there aren't many people around still to support them. So, Micro Focus is doing a great job with their existing business and what they are also doing is buying other legacy software businesses. They are in the process of buying another one at the moment called Serena Software America which they then just add on to the platform, manage the declining asset very effectively, generate lots of cash flow and again keep returning that cash to shareholders. And it's been a great story over the few years and I think there are still many, many years for this business to go.
Wall: Simon, thank you very much.
Murphy: Pleasure. Thank you.
Wall: This is Emma Wall for Morningstar. Thank you for watching.
