Description

Investment Thesis

We believe that shares of ARAMARK (NYSE: ARMK) offer a compelling investment proposition as benefits from a company turnaround are currently hidden behind the difficult, but improving, operating environment.  The company’s new strategic direction that was implemented just prior to the pandemic and is setting the stage for increased organic growth and margins in order to bring the company in-line with major global competitors such as Compass and Sodexho (which have historically traded at higher multiples). We see the company’s financials “normalizing” (back to pre-COVID-19 levels) by FY2023 and that the company is trading at reasonable multiples of 9x EBITDA and 14x EPS on those numbers. However, from that point that we expect to see a company re-rating due to the fruition of current investments leading to faster organic growth and higher operating margins. At the end of the day, our belief is this is a high-quality business that was mismanaged but is now led by an impressive CEO that has a history of turnaround results.       

In mid-2019, after years of underperformance, Mantle Ridge took a 20% activist stake in the company to demand changes to the company’s leadership and strategy.  Aramark quickly came to an agreement with the activist investor and board representation was granted. Change did not take much time as the former CEO soon retired (i.e. pushed out) and a new CEO was brought in within a few months. The new CEO, John Zillmer, was an Aramark veteran (23 years) but had also helped lead turnarounds of CSX Corp, Univar, and Allied Waste. Zillmer immediately sought out to change the culture towards a focus on organic growth driven by increased investments and customer service. These investments included adding additional sales infrastructure and product enhancement through increased technological investments to improve productivity and increase customer retention. Zillmer made it clear that this program would be focused on the longer-term and that margins, in the near-term, could take a hit until the benefits flow through. It is important to note that the company’s strategy prior to Mantle Ridge’s engagement was almost solely focused on near-term cash flow and margin improvement through cost-cutting. Aramark’s business model historically produced significant free cash flow and it has been subject to management buyouts multiple times during its history. The lack of investments leading up to Mantle Ridge’s engagement ended up backfiring as it resulted in anemic organic growth and margins that did not improve much.  The stage was finally set for a turn-around entering 2020 and then COVID-19 hit. 

ARMK was hit particularly hard by the pandemic due to many of its end-markets driven by in-person attendance (whether at school, sports stadiums, business offices, etc.). At its worst, revenue was down by ~50% yoy in Q3FY20. The larger worry became the company’s balance sheet which was/is heavily levered. It was feared that debt covenants would trip and the company could be at risk of a restructuring.  However, this fear was alleviated as the company received debt covenant waivers in order to get through the worst of the pandemic and we see reasonable, but still high, leverage levels returning in the next year. There is no doubt that the current leverage levels (9.5x ND/TTM depressed covenant Adj EBITDA) scare off many investors but see a path to get these levels down to a reasonable, for this type of business, 4-4.5x in the next year or so with significant free cash flow on the horizon.  The company does have significant liquidity availability ($2.6bn of liquidity including $1.4bn of cash on the balance sheet), no significant debt repayments until 2024, and has started to paydown some debt (including $500mm recently) in order to decrease interest expense.   

As of the most recent quarter, Q2FY21, revenue was still down to ~70% of pre-COVID levels with adjusted EBIT levels slightly positive. However, due to the recent relaxation of isolation mandates and the current economic rebound, we see a sharp acceleration of revenue over the next few quarters leading to a return to pre-COVID revenue levels by sometime in FY2022. While we do think the stock has priced in a good deal of the economic recovery (as witnessed in its sharp share rebound over the past year), we do not think the operational improvements are priced in and could lead to substantial upside over the next few years.    

Zillmer has made it clear that the business downturn has not paused the company’s restructuring efforts and that the benefits will only become clear when the industry environment starts to normalize.  Here is Zillmer responding to a question regarding how the company has handled investments in the strategic turn around during the pandemic at the BofA conference in March this year:

• “…a couple of the fundamental things that we believe were necessary, the investment in sales infrastructure and sales resources. So we have we talked about taking resources from what had been the center-led sales organization and putting them back into the field back into the specific business units, and then adding resources to go ahead and create a much more efficient and focused sales organization, all that work has been done. It was begun pre pandemic and has been accelerated during the pandemic. So we've got that infrastructure in place. We've got the number of salespeople increased in uniform services, for example, we added 150 sales managers last year, we're adding another 100 this year, really closing the resource gap between us and our other competitors in that industry.” 

The obvious question is what we expect to see from the company when the industry normalizes from the COVID-19 impact.  Zillmer has repeatedly stated that he expects “normalized” organic growth of at least ~5%, which may not sound off the charts but is significantly better than ARMK’s historical organic growth rates from 2014-2019 averaging closer to 0% (excluding acquisitions). For comparison, in 2019 Compass Group grew organically by ~6.4% with operating margins of 7.4% vs. ARMK at 3.6% and 6.7%, respectively. Zillmer is confident that Aramark will move closer to the past results of peers like Compass Group after restructuring is complete. The future increase in organic growth is likely to be fueled by an increased sales team that is seeking out customer wins at facilities that are currently self-operated. There is a strong economic incentive for many of these companies to outsource services like food and beverage and increased new customer engagement should be able to accomplish this transition. As the investments made for this transition start to wind down, Zillmer also expects margins to exceed past levels due to operational leverage.

In terms of the operating environment, end markets are rapidly normalizing as in-person attendance ramps at sports stadiums, schools, offices, and other locations that Aramark serves. Using professional sports as an example, the company is lapping a year with zero attendance in most sports stadiums. As of the company’s last earnings report, in May, baseball stadiums were still only at ~33% capacity. This is rapidly moving to 100%.  Also, NFL stadiums are preparing to be at 100% capacity in the fall. The company’s financials have yet to see much benefit from this and the next few quarters should see large step-ups in revenue. This is happening in other end-markets, such as education, where in-person learning seems to be set to fully return this fall.  A fair pushback on these trends is that infection rates seem to be climbing again due to issues such as lower than expected vaccination rates and COVID variants (including the Delta variant) that appear to be easier to transmit. We clearly see this risk but think this could result in increased mask mandates vs. massive social distancing orders, which have been incredibly unpopular and devastating to the economy.  

It has been speculated that the company may look at strategic options for the Uniforms business as they would likely receive a much higher multiple for that business than the overall companies. At and Oppenheimer conference in just stated:

• “As we’ve said repeatedly, we’d be fools to not think about and hear what folks have said about the Uniform business and does it fit? And is it the right thing to have it part of Aramark? We hear it and John and I certainly understand the viewpoint. And would certainly open to conversations about it and wouldn't turn away anything that -- any conversations that did happen. But that said, it's a great business. Back to the M&A strategy, if you've got a good management team, you've got a high-growth opportunity marketplace like Uniforms, you've got margin enhancement opportunities, it sort of ticks all the boxes of a business you want to be in. So we'll continue to move that business forward, create value, the implementation of the ABS route accountability system is an example of continuing to invest. As I mentioned before, 300, 350-plus new sales folks invested -- we've invested in the Uniform business. So I think we've taken the tack that putting a for-sale sign in front of a business isn't particularly motivational. So we don't want to do that at all. We want to continue to drive the business, drive the results, support the team. And if something comes up, certainly we'll take a look. But in the meantime, a lot of value to create.”

Our base case does not include a Uniform divestiture, but this does present potential upside in the future.   

Company Overview:

Aramark is a global provider of food & facilities management services and uniform rental services to various industries.  The company breaks down its operations into three distinct units:  US Food and Support Services (FSS), International FSS, and Uniform. 

• US Food and Support Services

• LTM revenue of $5.5bn and an Adj EBIT loss of $75mm.  This compares to FY2019 numbers of $9.9bn and $740mm (7.5% margin), respectively – equal to ~61% of the company’s revenue

• This segment is primarily known for its food & beverage services where it provides outsourced catering services (think school cafeterias and concession stands at sports stadiums). The segment also provides services such as plant maintenance, custodial services, energy management, grounds keeping, and project management.

• Within this segment end-markets were broken down as follows in FY2019:

• Education – 32.6% of segment revenue

• Sports, Leisure & Corrections – 25.8% of revenue

• Facilities & Other – 16% of revenue

• Business & Industry – 16% of revenue

• Healthcare – 9.4% of revenue

• International Food and Support Services

• LTM revenue of $2.5bn and an Adj EBIT loss of $82mm. This compares to FY2019 numbers of $3.74bn and $175mm (4.7% margin), respectively – equal to 23% of company revenue.

• This segment performs the same functions as the US FSS segment in 18 countries outside the US with Europe accounting for ~54% of segment revenue and Canada being the largest individual market

• The company does not breakdown the end markets in terms of industry

• Uniform

• LTM revenue of $2.4bn and adj EBIT of $146mm (6.1% margin). This compares to FY 2019 numbers of $2.59bn and $269mm (10.4% margin), respectively – equal to 16% of company revenue.

• This segment provides uniform delivery and cleaning services along with bathroom non-garment items such as mats and towels.

• End markets include manufacturing, construction, transportation, restaurant, and healthcare industries.

• This is the #2 uniform player, behind Cintas, in North America with additional sales in Canada and Japan

• As can be seen in the segment financials, this segment held up relatively well compared to FSS. This was due to the fact that the company also supplies personal protective equipment (“PPE”) that was obviously in high demand over the past year.

Across all segments, the company usually enters into longer term contracts due to the fact that an up-front investment in facilities and personnel is needed. The vast majority of contracts in FSS exceed 1 year and contracts for education and sports & leisure services can typically have terms of 5-15 years due to the larger upfront capital investments. These contracts manage downside and upside through mechanisms to pass along food, beverage, and merchandise costs (relevant to today’s higher inflationary environment).  Contracts in Uniform typically have terms of between 3 and 5 years.  Across the company, they have been successful in customer retention (historical retention rates have been in the mid-90% and Zillmer believes this can be improved by a couple of % points, which is meaningful when looking at future growth).     

Financials and Valuation

We are modeling a significant recovery in revenue over the next 3-4 quarters and that the company should be close to annualizing FY2019 levels in FY2022 with similar margins prior to the pandemic (~6.5% adj EBIT).  FY2023 is when we expect to see the fruits of the company’s restructuring.  We model organic growth of 5% and adj EBIT margins of 7% (still below historic peer levels – we are being conservative due to the timeframe but believe there is clearly upside to these numbers when looking at peers).  Please note that Adj EBIT is used primarily due to a large amortization charge backed out.  Significant free cash flow should be produced in FY2022 and FY2023 leading to a rapid de-levering of the balance sheet.  Here are our assumptions on financials for the next few years:

In terms of valuation, we look toward FY2023 as we believe this will likely be the year that investors start to re-rate the company as they start to show restructuring benefits and a continued roadmap for increased growth and margins.   These contract services companies have historically (pre-COVID-19) traded between 10-12x EBITDA (ARMK on the low end and Compass Group on the higher end). If ARMK trades at its historical levels (~10x EBITDA), we see a bit of upside to the stock with a re-rating to the top-end (12x – which we think is extremely likely if company execution is close to what we think it will be) leading to significant upside (~50% over the next year or two).  Here is our valuation framework:

Major Risks

• COVID infection rates continue to climb, and government social distancing mandates are re-instituted

• Inflationary pressures start to hit margins and the ability to pass along price increases to end-customers.  The majority of the company’s contracts allow them to raise prices, but lower demand could be the obvious result.  

Catalyst

- Continued acceleration in the recovery from COVID-19 impacts

- Potential sale of uniform business