Description

Summary: Aramark (ARMK) is a short because its underlying profitability is lower than management would lead you to believe, its actions towards its US mid-level managerial workforce with regard to FY2018 bonuses are unethical at best and will likely be disruptive and kill morale in what is a people business and a tight labor market, and its plan to provide a “one-time” U.S. reinvestment plan in FY2019 funded from the proceeds of a tax reform refund it received last year is a thinly-veiled attempt to make right on arbitrarily cutting bonuses for thousands of workers despite them meeting in-unit profit goals. The fact that this FY2019 payout, which will be backed out of FY2019 EPS results because it is “one-time”, is set to be paid in the same timeframe these managers were expected to be paid their FY2018 bonuses suggests earnings management which allowed executives to (1) declare “mission accomplished” on achieving its 3-yr, 100bps margin expansion target in 4Q2018 - a key area of focus for the investment community, (2) exceed its long-term incentive comp target that was predicated on adjusted EPS targets which was further aided by tax reform, and (3) still purport to be able to deliver the double-digit earnings growth algorithm it has highlighted since its IPO in 2013. Aramark has also had two key executives announce their departure from the company - their Chief Accounting Officer on Jan 9th (effective Feb 8th) and their General Counsel on Jan 31st (effective Apr 1) - which adds to our concerns over the quality of the reported financials. 

It is difficult to quantify the impact of the incentive comp cut as management is not providing any details but our best guess is it being in the ballpark of what they are spending on their one-time reinvestment, i.e. $80mn, which would translate into ~$0.24 of EPS, or almost all of the earnings growth last year in a year the company was a huge beneficiary of tax reform. 

Note: Our firm is long only and we previously were shareholders. However, as news highlighted below came to light we no longer felt comfortable with our position and sold shares. I am now short shares personally via options and believe the catalyst will be further scrutiny on the timing and nature of the 1x reinvestment in its US food workforce and the potential for regulatory and/or political scrutiny. Absent additional scrutiny, however, I do believe shares will be pressured as it gets clear the earnings hurdle in 4Q is too high and estimates come down, and thus see reasonable base case downside and limited risk to the upside based on earnings beats. 

Sequence of events:

• On November 13th, ARMK reported strong 4Q results that beat expectations, and the highlight was a 165bps YoY increase in adjusted operating margins which enabled the company to declare “mission accomplished” on its 3-yr, 100bps operating margin expansion target set in Dec 2015, with 2018 margins excluding M&A, catastrophes, and FX hitting 7.2%. On the call, during the CFO's comments management attributed margin expansion to continued focus on driving net in-unit food and labor productivity improvements, along with lower SG&A and incentive compensation expense. So to be fair, they did reference incentive comp but only 1 time vs. 11 mentions of productivity on the call. You can see which narrative they want to promote.

• In its 10K filed November 21st (day before Thanksgiving), ARMK attributed margin improvement in its US Foodservice business to “$92.1mn of profit growth within our businesses, primarily from a reduction in personnel costs, including employee incentive expenses, and profit from the Avendra acquisition. The 10Qs filed prior to this had no mention of employee incentive expenses, implying that the incentive comp accrual was drastically changed in 4Q, providing a big boost to profits. Also note that the 10-K refers to GAAP operating profits. Since Avendra had numerous integration costs which would have been included in their GAAP profits, it is likely that incentive expenses delivered the lion's share of the $92mn improvement (we just ballpark $80mn because it lines up well with the company's 1x reinvestment plan). 

• On December 11th, ARMK held its 2nd analyst day since returning to the public markets and shares fell $4 as investors were blindsided by lowered organic growth targets, the lack of a follow-on margin improvement target, and confusion related to the outlook for organic adjusted operating profit growth in FY2019. Management’s outlook was in stark contrast to its bullish commentary one month earlier but makes more sense after going through the 10K (conveniently filed on the busiest travel day of the year).

• On January 15th, ARMK filed an 8-K noting that its Chief Accounting officer resigned effective Feb 8th, noting that he took a similar role at another company. The outgoing CAO did not sign the FY1Q 10Q.

• On January 30th, an article on philly.com (https://www.philly.com/business/aramark-management-bonuses-delayed-k-match-cut-20190130.html) noted that, in early December, ARMK notified its employees that it was cutting 401K matches and that annual incentive bonus payments would be delayed from its normal December timeframe to some point in February. This was unusual but the company noted it had until mid-March to make its payments. What is interesting is that the books on FY2018 were already closed - ARMK knew it was planning to stiff its workforce but chose to wait to deliver the bad news.

• On February 5th (same day as ARMK’s call), the writer on Philly.com published a follow-up piece (https://www.philly.com/business/aramark-foss-bonus-cancellation-20190205.html) noting that despite comments from the CFO on the call that suggested earned FY2018 bonuses were paid out, the paper had gotten a copy of an internal communication from Feb 1st noting that FY2018 bonuses for all managers in tiers 5-8 in the US Foodservice business were cancelled. In this same email, an employee that did not receive an incentive bonus was also made aware that he/she was entitled to a “Special Recognition Award. ” The Special Recognition Award was a component of managements "1x reinvestment in its US employee workforce" in FY2019 which it announced on its 1Q2019 call. The reinvestment totalled $90mn to be funded from its $100mn US tax refund on account of tax reform, and included targeted wage increases, special recognition awards, 1x funding contributions for retirement accounts, and scholarship funding. In the email it noted that the award would be paid on February 15th - suspiciously close to the time when FY2018 bonuses were supposed to be paid.
  
  We spoke with management about the timing of the two payments, and they told us that the desire on the timing was to mix the bad news (no bonus) with the good news (bonus). That doesn’t sound like an awful idea in and of itself, but it does lend credence to the view that expenses were shifted out of FY2018 and into FY2019.

Key Points:

• Profitability - Management paints a great picture of a company that under-invested while private that has demonstrated a track record of sustainable improvements in its cost structure driven by prudent reinvestment of productivity savings into systems and processes designed to standardize procedures, share best practices, and capitalize on its scale. Despite significant progress since its IPO, management continues to suggest their are plenty of opportunities to grow margins via productivity initiatives even after delivering good improvement since its 2013 IPO, but based on our read of the Proxy, which includes an adjusted operating profit calculation that excludes the impact of lower incentive comp accruals (this calculation was necessary for determining whether management hit is AOI short-term incentive compensation target) and an adjusted sales number, core ARMK adjusted operating margins were just 6.4%, well below the 7.2% target management claimed it hit on the 4Q conference call and ~20bps below the prior year results. For a business with low margins and relatively high leverage, this is a big difference.

  ARMK wants to be compared to industry leader Compass, which lacks the higher margin uniform business that ARMK but still delivers mid-7% margins and 2-3x faster organic growth, but the reality is Compass is in a different league than its competitors. On the uniform side you could argue the same about Cintas. This matters because the multiple expansion/SOTP story for ARMK is much worse if you substitute weaker peers Sodexo & Elior (~8.8x EV/EBITDA) for Compass (~13x) on the Food side and Unifirst (~8.7x) for Cintas (~14.5x) on the Uniform side.

• Bonus compensation antics - Based on our conversations with employees, historically, mid-level manager incentive comp (~20% of total comp) was based on in-unit performance vs. goal, so managers had a good sense for what their compensation would amount to assuming the historical practice held, and they likely spent accordingly during the holiday season. Management confirmed as much to us but noted that it had been trying to evolve the payment of bonsues more towards firm profitability targets. This seems reasonable for higher level executives or in periods of extreme financial stress, but makes less sense for people that manage high school cafeterias in a year where the business delivered record results. Even if it were ok to do this, the company should at least signal as much to its employees rather ahead of time rather than hanging them out to dry well past when full year results were already finalized.  In this type of populist political environment heading into an election cycle, these types of stories present a significant business risk, particularly to a company with government contracts as there are number of presidential hopefuls that would love to skewer a greedy management team catering to bigwigs on wall street and screwing their middle-class workers.  
  
  The other challenge to this whole ploy from an operational perspective is that the "1x reinvestment," in addition to looking a lot like earnings managment, is likely to be even more disruptive to morale. Based on our read of the emails sent to employees, it appears that the "Special Recognition Award" paid out the same amount for all the managers within each tier, regardless of how their units performed. So now you have company where talented managers now think their own unit's performance has nothing to do with their bonus and the best performers within each tier are effectively subsidizing the weakest performers. Not exactly a recipe for inspiring hard work and dedication going forward and we would not be surprised to see attrition pick up given how tight the labor market is currently. 

• Earnings management - we have been told the impact of the bonus cuts in the US foodservice business impacted anywhere from 'several thousand' to 'twenty thousand' and that the range of bonus expected was $9K to as high as $60K for certain individuals (likely an outlier). We also heard from an employee that noted the lower tiers (i.e. more senior employees) also had their bonuses drastically reduced. Whatever the total impact was, clearly, this was a material cut to boost 4Q2018 earnings and enable the company to hit stated margin targets and its FY2015-2018 long-term incentive compensation targets (management needed to deliver $2 in adjusted EPS in FY2018 to hit its targeted comp and reported $2.41 in the Proxy. We estimate tax reform was a ~$0.25 benefit and incentive compensation added an additional ~$0.25).  Management would have also reported almost no growth in adjusted EPS in FY2018 despite being a significant beneficiary of tax reform, which is in stark contrast to the story of it being a steady double-digit earnings grower. 
  
  On a go forward basis, the cut to incentive comp in 4Q2018 presents a risk to FY2019 EPS growth targets. Already the company has guided to flat EPS growth in 4Q, but if the hurdle is as high as we think it is (~$80mn), ARMK will need to print its best quarter ever to overcome that headwind and that may be tough with all its good mid-level managers busy looking for jobs. So risk is to the downside for forward estimates. 

Stock Price Risk: ARMK is trading at $31.50, ~13.5x FY2019 EPS. Multiplying our estimate of earnings that were manufactured last year (~$0.24) at today's multiple implies ~$3 of downside. But if we assume organic growth remains challenged and the margin story starts to erode, each additional turn of P/E multiple compression = ~$2.50 of stock price. Our best guess is $5-7 of downside from current levels, but where it would get really interesing is if negative press intensifies and the company attracts regulatory or political scrutiny, at which point there is potentially significant downside. Based on the damage they have done to their employee base and the challenges they have to meet full year guidance just from a quantitative standpoint, we don't see a ton of upside risk from EPS beats, though it is fair to say the company is cheap relative to history and could benefit from sector-wide revaluation.  

Catalyst

Further scrutiny on the timing of bonus payments from investors causes management to shed further light on how material this was to results .

Potential regulatory or political scrutiny weighing on the multiple

Earnings guidance is walked down to the extent organic growth remains lumpy at best and the 4Q incentive comp hurdle is too high.