Description

Recently IPOed, SSP is a high-quality business led by a proven and incentivized new CEO that can grow EPS at a >40% CAGR for the next few years and trades at just 11.5x our 2017 earnings estimate.

If you have been employing a long-short strategy in Europe at some point during the past 10 years, you have probably heard the WH Smith short pitch at least once.  In fact, it has been written up on VIC twice in just the past couple years.  The argument is nearly always the same.  WH Smith, a High Street and Travel retailer of predominately analog media – books, newspapers, stationary, etc., will finally succumb to headwinds from digital disintermediation as cost rationalization opportunities cannot continue forever and the treadmill isn’t slowing down.

We are not pitching WH Smith as a long – nor would we short the stock without figuring out a way to externally validate the exhaustion of cost-savings opportunities (we have yet to see a short case actually offer value added research to substantiate the same valid, but tired claims).  Instead, we are pitching a much better business behind the former CEO, Kate Swann, an anathema to short-sellers, who tripled margins and more than quintupled the share price during her 10 years at the helm.  On our estimates, we think SSP offers over 50% upside over the next 18 months, driven by new CEO Kate Swann executing the same fine-tuned playbook employed at WH Smith. 

We will now outline the thesis with some historical context, discuss new CEO Kate Swann’s track record from WH Smith, describe the business, compare SSP versus peers and then analyze the market dislocation by bridging current margins to our 2017 expectations.  

Thesis and Background

We think that through several initiatives, proven CEO Kate Swann can take EBITDA margins from ~9% to 12%, having already increased margins by ~100 basis points from when she joined a year ago.  During her 10 years as CEO of WH Smith, Kate Swann was able to generate tremendous returns despite massive industry headwinds. 

The now former CEO of SSP was previously CFO of Compass Group – before Richard Cousins took the helm.  He along with his CEO partner, oversaw five years of tremendous margin pressure at Compass culminating in 350bps of lower EBITDA margins and 36% lower EPS.  This is despite 16% sales growth over that time frame.  For reference, Compass is the UK based contract catering businesses that has witnessed a tremendous turnaround over the past 9 years. In fact, in the five years after the former CEO of SSP left Compass, CEO Richard Cousins REGAINED that lost margin, grew sales by 50% and the stock was up about 200% - 10x the gain of the FTSE 100. 

To bring the story full-circle, Compass sold SSP to private equity firm EQT in 2007 and the old CFO of Compass was hired as SSP’s CEO.  Over the next six years, margins declined by over 200 basis points at SSP, well below its two biggest rivals who we do not believe are structurally superior.

Here are a few quotes from former SSP employees:

·         “[He] was a financial driven CFO – who didn’t really understand the operations as well”

·         “Not very rigorous on costs – was prob a missed opportunity.”

·         “Many geographies were less analytical – more of a pioneering spirit”

·         “After Kate took over, she brought a totally new approach to the business.  She was much more cost focused and many positions were combined/replaced”

·         “I would average close to 200 flights per year and now this is done via videoconference”

CEO Track Record and Incentive

We could write paragraphs on the hundreds of individual operational initiatives that created value at WH Smith, but at the risk of being overly concise, we would recommend speaking with anybody at WH Smith past or present or any sell-side analyst that has covered the company for several years.  Here are just the highlights:

·      Kate formerly led WH Smith, a UK literature and stationary retailer, where she nearly tripled margins, resulting in a 5 bagger during her decade at the company. 

·        Equally impressive she took fully-loaded ROIC from <10% to >60% during her tenure. 

·       WH Smith is akin to a Barnes and Nobles in the US, but also with 1/3 of its sales through airport and rail kiosks – think Hudson News

·        She has a history of under-promising and over-delivering. A study of her time at WH Smith showed that she delivered nearly 2x each of her cost savings targets. 

·       She accomplished this through dozens of initiatives from closing regional head offices to optimizing labor efficiency

·        The overall result was lower employee costs on a gross basis despite nearly doubling the location base during her 10 years there.  Lease costs were only up ~30% over this time.

·      Kate has historically bene incredibly shareholder friendly.  In addition to healthy regular and special dividends, she also employed opportunistic buybacks, reducing the share count by 25% in her last four years alone.

·       Kate is significantly aligned at SSP.  Kate owns >$20M of stock through common and an LTIP (LTIP based on EPS and TSR growth).

Business Description

SSP operates Airport and Railway food and beverage outlets across more than 600 sites and 2,000 outlets around the world.  They expect to generate low-to-mid single digit same store sales growth plus 100-200bps from new contract wins per annum.   We assume 4% revenue growth on a constant currency basis versus a 5% CAGR over the past 5 years. This is a good business for a number of reasons.

·         First, SSP operates under long-term contracts with very limited customer concentration

·         Second, travelers have few alternatives, creating pricing power for SSP (think about what you pay for a “Value Meal” at a QSR at an airport versus a motorway)

·         Third, this is a very cash generative business. With free cash flow typically converting at more than 100% of net income due to sustainable negative working capital dynamics (A/P days > A/R) 

·         Fourth, SSP benefits from the long-term secular growth in air and rail travel. 

o   Airline capacity grows at 1.5-2x GDP

o   It has been very resilient even during times of crisis – for example in 2008/2009, global passenger growth was roughly flat

o   The rise of LCCs and airlines cutting back on serving food also helps the cause

o   Lower fuel prices should provide another near-term boost to demand

Peer Comparison

Now let’s compare SSP versus its peers – HMS Host and Elior.  SSP’s margins are ~9%, Autogrill’s HMS asset is targeting 12% and Elior’s concession asset is a hair over 10%.  We believe SSP should be at least as profitable as HMS and more so than Elior.

Let’s compare scale, channel mix, geographic exposure and brand mix.

·         In terms of scale, SSP is the largest in terms of revenue at 1.4x HMS and 1.7x Elior, which improves purchasing power.

·         In terms of channel mix, HMS is nearly 100% air; where SSP is 51% air, 42% rail with the balance motorway and other.  Elior is 38% air, 36% rail and 26% motorway and other.

o   As the former CEO of HMS confirmed, Air and Rail should be the highest margin businesses driven by captive customers and higher customer density.

o   Rail traffic grows a little less, but is more stable than air

·         From a geographic perspective, Europe represents over 80% of sales for SSP and Elior.  HMS is nearly entirely US.

o   HMS gets the edge in that US labor flexibility, but Elior is nearly entirely France, Germany and the Benelux.  France is likely the lowest margin market due to a weak consumer and rigid labor costs.  By comparison Asia, for example, offers the highest margins for SSP due to lower and more flexible labor costs. 

o   Air travel growth is projected to be higher in Europe than in N America with Europe acting as a global hub for international travel and Europeans just seem to like to travel more.

·         Now for brand mix.  This is where it gets interesting.  Elior’s mix is similar to SSP’s, which is around 50% national and 50% local and proprietary brands.  HMS is nearly entirely national brands.

o   HMS pays higher licensing fees to run a Starbucks or McDonald’s, but has higher density (and revenues) vs a local concept

o   Local airports, especially in the US, are pushing to showcase local restaurants, like Shake Shack.  SSP focuses on local brands is well-positioned to take share, driving faster growth vs HMS.  In the US, SSP is growing double digits while HMS is just over flat.

With superior scale, channel and geographic mix, SSP should be able to surpass Elior’s low 10% margins and at least approach HMS.  Above that, we believe that Kate is worth at least 100-200bps of margins versus peers given her track record of pushing the envelope on cost reduction initiatives.

Margin Bridge

To reiterate, we are betting that Kate can take margins from 9% to 12%.  We expect 45bps to come from food, 225bps to come from labor (net of rental increases) and 30bps to come from Overhead.  As mentioned, from speaking with a number of former senior employees, the old CEO ran the business without a heavy focus on analytics or cost controls, which is what created the opportunity for Kate to come in and turn the business around.

·      Food Costs, represent 34% of sales.  Management has indicated that they can achieve at least 10bps of improvement per year from less waste/unit (shrinking the size of baguettes, tracking inventory better, etc.).  Calls with former employees suggest that purchasing was done at the local level, even on condiments and other standard products.  SSP has the highest scale in the industry yet also the highest food costs as a percentage of sales.  She cut 15bps already in 2014 and most of the actual improvements from those initiatives will begin to annualize in 2015. We expect 15bps per year of improvement going forward. 

·      Labor costs, we expect 75bps of annual improvement.  This represents a reduction of 8% in employee labor hours from now to 2017.  In her last four years at WH Smith alone, she reduced employees per stores by 30%.  During her 10 years at WH Smith, employees per store declined by 59%. This was largely accomplished by matching peak labor hours with peak demand as opposed to having significant labor overcapacity during hours of low demand.  In her first year at SSP, she saved 94 basis points on labor and most of these savings are yet to be annualized.  Additionally, the staffing management system she used at WH Smith has not yet been fully implemented across the businesses.  For example, in much of Northern Europe, which accounts for 39% of sales, local management has not begun utilizing this labor efficiency system.   

·       Rental costs: We assume a 25 basis point headwind per year from higher concession fee/rental costs, which is in-line with management and entirely offsets our operating leverage from the 4% constant currency revenue growth.  This is the biggest risk to overall margin improvement and the expense line that requires the most focus.  Most contracts are 5-10 years and given that airports seem to prioritize historical relationships, local content and perceived ability to sell (lease cost is directly tied to sales), we think this risk is manageable.  Additionally, external checks suggest that SSP was the “bad actor” in certain geographies.  Given that this is really a three player market (plus a number of tiny players), Kate’s arrival at SSP may help reverse this industry trend, but that is not part of our thesis…

·        Overhead: This one is the hardest to identify.  We assume 10bps of annual improvement.  This would include utilities, uniforms, waste, etc.  Kate is a master at cutting the odds and ends, which are similar in virtually every way to what she faced at WH Smith (replacing light bulbs with LEDs and auto switchers, procuring private label goods consumed internally vs. branded, employing practices to track waste, printing only in black and white vs. color, using cash counting registers to reduce shrinkage, etc.).  Much of this will come from more efficient usage and central procurement when possible.  We would be disappointed if she did not surprise to the upside on this line.

In conclusion, we are betting on a proven and highly incentivized CEO delivering a fraction of the improvement she accomplished at WH Smith, a far inferior business.  We know that the business is mismanaged given the margin differential with competitors despite some clear structural advantages.  This margin opportunity was externally validated from multiple conversations with former employees and competitors.  If our margin bridge is correct, SSP will generate 25p of EPS in 2017 versus consensus at 16p.  Cash flow will be slightly higher than earnings due to working capital, but even at 17x our 2017 EPS number, a discount to where comparable assets trade, we get over 50% upside over the next 18 months (before regular dividends). 

We think the biggest risks to our investment case are “key-woman” risk and anything that could structurally impair air or rail travel – acts of terrorism, pandemics, etc.  Outside of such exogenous risks and a dramatic change in the competitive landscape, we think the downside is quite limited here.

Catalyst

Earnings announcements, increased sell-side coverage, capital structure announcements, etc.