Description

Compass Group is the global leader in the contract caterer / food and support outsourcing services industry. Compass was reintroduced to the UK market in 2001 after being de-merged from Granada Compass. It operates in two main business areas: contract catering (~85% of sales) and multi-services (~15%). Its activities can be divided into a number of segments: business & industry, education, sports & leisure, healthcare as well as defense, offshore & remote. North America accounts for over 60% of group sales while Europe is close to 25%, with RoW ~15%.

Historically, contract catering has been a high quality industry with consistent top line growth and EBITDA margins.  Compass has best in class operator with leading top line growth in the industry of 4-6% (vs. Sodexo @ 2-3% and Aramark at ~3-4%).  Client retention rate at Compass has also been the highest in the industry at ~95% - given complexity in terms of logistics and set up for large events, reputation and brand is of utmost importance.  Scale is of upmost importance in the industry given purchasing power leading to margin differentiation in the industry – Compass is the biggest Group Purchasing Organization (GPO) in the industry leading to lower purchase costs.  Combination of the above (high win rate and retention rate + scale benefits) has resulted in Compass becoming the biggest and most profitable player in the market (EBITDA margin of ~8%).

Another positive aspect of the story is that Compass can continue to outgrow its competitors driven by large market share gains of outsourcing in the US.  Outsourcing penetration in the US market has historically been under 40% vs. 50-60% in various parts of Europe.  The trend was changing pre-Covid and we believe that post-Covid, the pace of increased outsourcing will increase with Compass garnering a larger share of that growth.  Between 2014 and 2019, Compass’s market share in North America outsourcing market grew from 17% to 22% while the shares of its largest competitors remained stagnant (Sodexo at ~11%) or declined (Aramark 13% to 10%).

Driven by the above fundamentals, stock has compounded at ~19% since over the 10-yr period between 2009-2019 vs. the S&P’s 14.5%.  Since 2020 driven by Covid, the stock is down more than -20% while the S&P is up +23%.  The two major parts of the business that have been most impacted by Covid is the sports & leisure (~13% of revenues), education (~18% of revenues) and business and industry (~40% of revenues).  A bullish thesis on Compass in essence relies on the fact that most of these business impacts are cyclical in nature and not structural in nature.  We think the education and sports & leisure businesses are temporary in nature (i.e. schools/colleges will reopen and sporting events will come back – we can argue the timeline but we don’t think these are impaired businesses).  The biggest question mark is the business and industry segment which we’ve taken a conservative view as to how this recovers.  The biggest impact this segment is the WFH phenomenon - ~60% of the B&I exposure is to white collar type of jobs.  Based on some data we have gathered, in the UK for example, ~40% of workers surveyed were already working from home with large part already averaging <1 days pre-Covid.  We believe the share has flipped with over 65% working from home. For our forecasts, we have increase the share of people WFH >2 days over the long term.  The ultimate impact to Compass at the company level is a deceleration in revenue and ultimately margin compression.

We still believe on a normalized basis that Compass can achieve an EBITDA margin of ~6.4% by 2023 which would be below the 7.4% achieved in 2019.  Compass's superior historical margin performance has been helped by two key factors (i) as mentioned earlier, scale as the largest single-service caterer globally; and (2) strong management execution and cost management.  Given the new normal, we expect the past benefits will take time to build back up, due to a slow and highly uncertain volume recovery which will act as a 60bps drag on the FY19 level until volumes return to former levels ultimately impacting margins by ~1%. We believe this will be offset by new business wins– this is driven by the growth of outsourcing market (as highlighted earlier) as well as taking advantage of its strong balance sheet to take business from smaller distressed competitors. Another area of potential upside is that management is currently going through unit-level contract re-negotiations.  From a balance sheet perspective, Compass is well positioned as it has £4bn in available liquidity and £1.5bn in cash; it has revolver capacity of £2.8 bn that expires in 2024.  Total net debt to EBITDA is at less than 2x. 

From a valuation point of view, Compass has traded at ~13x EBITDAx / 20x P/E on average historically.  From an EV/rev basis, it was trading at 1.5x. Today, on our normalized 2023 numbers, Compass is trading at 1.2x revenue and 17x P/E. Given the low downside risk from both a balance sheet and business quality front, we believe a 30% potential upside is attractive for Compass.

Catalyst

Pandemic provides opportunity to buy one quality business undergoing temporary headwinds at an attractive valuation