Description

Quick Thesis: 

When examining the opportunity set of companies that have been most dislocated by the Coronavirus shutdown, Aramark stands out as one of the best positioned to navigate through the crises and will be one of the first to recover once the economy begins to re-open. Aramark trades at just 10x our Sept-2022 earnings, suggesting 45% return over the next 12-18 months for a superior business with a great new CEO and further potential upside from operational improvements. Despite this near-term disruption, we believe the company’s longer-term earnings power is virtually unaffected. Aramark has contract-driven recurring revenue and retention rates in the mid-90s that facilitate a stable and predictable business model, even in recessionary environments. The company has a high level of variable costs and institutional expertise in rapidly scaling up and down operations, which will allow the company to navigate the Coronavirus disruption while still remaining FCF positive. 

Company Overview:

·         Aramark benefits from a scale based competitive advantage in the fragmented food, facilities and uniform services industry

·         Aramark’s Food and Support Services (FSS) business (84% of revenue) hires and trains employees who order, prepare and serve food and beverages at client locations

·         Aramark’s FSS segment also provides facilities services including maintenance, custodial, energy management and groundskeeping

·         Aramark’s Uniforms segment provides uniform rental and cleaning services for clients

·         Aramark estimates that it operates in a ~$900bn market across its business and that only ~10% of this market is addressed by large scale providers

·         The global food service market is highly fragmented with Aramark constituting only ~3% of the total market but has 20% market share among larger outsourced providers

How does ARMK make money?

·         Aramark typically signs 3-5-year contracts with clients where Aramark assumes all risk to the P&L and pays the client a fixed or variable percentage of revenue

·         Aramark also signs some Client Interest Contracts, under which the clients reimburse Aramark’s operating costs and pay a management fee to operate food or other services

·         Under Aramark’s P&L contracts, Aramark hires employees, purchases the food and operates all aspects of the food services operation

·         Aramark will spend capex dollars for food facility build outs or improvements; typically 3-4% of revenue

·         As a result of modest working capital and capex needs, FCF generation is solid with 80-100% cash flow productivity

Thesis: 

        1) Aramark is a high-quality company that will navigate the current disruption without impairment of the longer-term earnings power of the business

·         Aramark provides mission critical services for clients and benefits from significant scale advantages that results in sustainable competitive advantages 

·         While the current shutdown is resulting in a 50% decline to total revenue (see more detail below), the variable cost nature of the business model will allow the company to remain FCF positive through a worst-case 6-month shutdown

·         Management released an 8-K on 3/19 confirming that the company expects to have 15-20% decremental margins on lost revenue

·         Our VAR corroborates management’s decremental margin guidance. For example, we learned that ~80% of labor costs are hourly workers and food and other COGS are purely variable

·         Aramark’s customers are not going anywhere (colleges, large businesses, hospitals and stadiums) and will be the first to re-open once the shutdown ends

·        We believe the medium-term earnings power will be unaffected as these customers return to normal after the disruption

·        Even if you assume some destruction of earnings power due to a ‘new normal’ (WFH, virtual classrooms, fewer full stadiums), the valuation discount today offers a margin of safety  

        2) Aramark has a strong new CEO who is the well-equipped to lead the business through the Coronavirus disruption

·         John Zillmer worked at Aramark for 18 years before executing two successful turnarounds as the CEO at Allied Waste and Univar

·         Zillmer has intimate knowledge of Aramark’s business, which will suit him well in the current situation

·         Our work on Zillmer gives us conviction that he has the right combination of expertise in food services, leadership qualities and experience to lead Aramark through the disruption 

      3) Current situation has created an extremely compelling entry point for a 2-3 year investment horizon

·         Since the beginning of the Coronavirus-related selloff, ARMK has underperformed the broader market by >20%

·         Conservatively assuming ~$1.75 in earnings power in 2021 (~30% below pre-Corona consensus), ARMK share shares are trading at 13x EPS and a 7% FCF yield –below historical lows for any company in the food service industry

Modeling Assumptions

·        Given the Coronavirus shutdown and its implications on Aramark’s business, we have worked to assess the financial impact by forecasting the impact on each of Aramark’s end markets, detailed below

·         Business & Industry: We are expecting a 70% drop in B&I revenue for the fiscal 3Q’20 period and assumes the shutdown lasts until June. When businesses open, the cafeterias will be the first areas to become operational. We assume a slower ramp in 2021 and 2022 as businesses may have less employees and more employees working from home. Thus, we assume 2021 and 2022 revenue gets to 83% and 87% of 2019 levels

·         Education: We are expecting a 85% drop in Education revenue as a vast majority of this revenue is higher education. The non- higher education piece is still operating in some instances providing take-away lunches in public K-12 schools. We assume the education revenue gets back to 87% and 92% of 2019 levels in 2021 and 2022

·         Healthcare: We assume healthcare revenue grows LSD in the current environment and grows from 2020 levels in out years

·         Sports, Leisure & Corrections: Sports is roughly half of this segment and is the lowest margin end market for ARMK, thus only accounts for ~5% of total company operating income. We are assuming an 80% drop in revenue during the shutdown and returns to ~90% of 2019 levels in 2021 and 2022

·         Uniforms: Given the contractual nature of the uniform business and the mission critical nature of the service, we are assuming a 40% reduction in uniform revenue for the 3Q’20 period. We assume uniform revenue returns to 92% and 97% of 2019 levels in 2021 and 2022

·         Facilities & other: We are assuming a 20% drop in facilities revenue for the Q3’20 period with a relatively quick return to normal revenue levels given the importance of facility cleanliness. We assume revenue returns to 97% and 99% of 2019 levels in 2021 and 2022

Key Risks:

·         Full Coronavirus shutdown lasts much longer than six months 

·         Decremental margins are worse than management projections 

Catalyst

Once we get clarity on the timing of our economy re-opening, we believe Aramark shares will re-rate. Further, after the re-opening, we believe Aramark's new CEO will drive operational improvements over the next 2-3 years.