Business Breakdowns
· Asif Jeevanjee, Matt Reustle
[00:00:00] S1: Food is very much a local business. It's done at the country level. Having been very big in Germany is not going to help you in France in terms of buying food. So you really need to be big at the country level. Compass really found it challenging in some markets to get big, either because of local competition or because of the structure of the market. So they've really said goodbye to some markets that you would think might be potentially one day very big, but they've actually struggled to scale up in, and have concentrated on markets where they already have scale and where they're going to get much bigger. And with that, I think, comes long term improvements in profitability. [00:00:00] S0: It's interesting to pair that where you're actively managing the portfolio of brands and assets that you have, not just in buying, but in also selling. On the buying and the acquisitive front. I want to pair this with the valuation storyline because I am sure if Compass is to acquire a local player, there are going to be cost synergies that can be realized which are going to make it potentially accretive. But is there a pretty attractive valuation arb that they can play when buying these businesses as well? And can you tap into some of the valuation framework that you would generally use for this type of business and how the market perceives it?
· Asif Jeevanjee, Matt Reustle
[00:00:00] S1: I don't think there's a major valuation arb to play where the acquired cash flows are sort of re-rated within Compass because Compass is by and large acquiring very high quality assets, rather than fixer uppers. And it's not using its balance sheet to make these acquisitions. In terms of the way we think about value and Compass, what we try and do is nail down what is the free cash flow so that we've got a good idea of what the free cash flow yield is. And we think that's currently around 5%. We then marry that with organic sales growth, which conservatively we think can be 5% over the medium term. That alone gets you to have a double digit type return. If we stack on top of that other elements of per share free cash flow growth over the medium term, whether it's margin increases or accretion from the use of cash on acquisitions or repurchases, then you can start to have line of sight towards low teens type returns, medium term. [00:00:00] S0: On that free cash flow generation and how that gets allocated. Sometimes when you see, as you mentioned, potentially shrinking the portfolio or the geographical reach that could be associated with returning capital to shareholders, whether it's buybacks, whether it's dividends, is that something that they actively do? What's their methodology just in terms of capital allocation?
· Asif Jeevanjee
[00:00:00] S1: Compass has a simple, clear, and consistent capital allocation framework. Priority one is to reinvest into the business, which given the attractive returns, is something we're happy to see them do. Capex to sales runs at about 3.5%. This can be on a variety of things, such as cafeteria refits, particularly on new contracts. But increasingly, it's devoted to technology. This is both hardware and software. And one of the reasons this is happening is that Compass has a lot of data. Across its supply chain, on consumers, on labor, and it's investing to be able to collect that data, analyze it and use it to the benefit of their customers. The second use of cash is, as we've discussed, on acquisitions. Naturally the spend here is quite episodic, but generally speaking, they're buying medium sized businesses. After that they have an ordinary dividend payout of about 50% of earnings. But to come back to your question, as a very cash generative business, they still have surplus cash beyond that. And in the last few years what they've been doing with that is to repurchase shares. If there's a slight blemish on an otherwise spotless record, you could point to the fact that they issued equity during the pandemic to shore up the balance sheet and now they're buying back shares at a much higher price. But assuming there's no more pandemic-like surprises, I think the visibility around capital allocation is pretty clear and it's all being carried out within a nicely conservative leverage corridor of about one to one and a half times net debt to EBITDA.
· Matt Reustle
[00:00:00] S0: Is there anything else that stands out from a risk perspective for Compass that maybe we didn't tap into or is worth digging into further?
· Asif Jeevanjee
[00:00:00] S1: One issue worth pondering is whether there might be a risk to volumes across Compass's business. It does seem like the administrative layer across all sorts of organizations is under assault currently. This is most prominently seen in the US in the federal government. Now luckily Compass doesn't have too much direct impact because they don't do much work with the federal government, but there is a possibility that something similar could occur in other parts of the economy. So we've heard many large corporates, for example, talk about thinning the ranks of middle management. This would impact, within B&I, attendance rates in the cafeterias. In higher education, the ratio of non-teaching staff to faculty and students has increased dramatically over the last 30 years. Ultimately, students are picking up the tab for that through higher tuition costs which they're borrowing the money to pay. Is this sustainable? If not, administrative staff levels might be reviewed or enrollments will drop. Either way it could harm attendance rates on campus cafeterias. A similar phenomenon is playing out, I think in healthcare, where healthcare costs are quite high relative to GDP in many countries. And if I look at the UK, where healthcare is predominantly provided by the state, and it's free at the point of use. The quality of care is deteriorating, but the cost of providing it is rising. And one way this is starting to be addressed is by reducing non-medical staff in the system. That ultimately will also cause attendance rates to drop. Now, this sounds very pessimistic, but there is a silver lining here for Compass. Which is, it is exactly these sorts of pressures and stresses on systems that can catalyze an outsourcing decision. Ultimately, if it does play out, it might actually supercharge Compass's net new business growth.
· Matt Reustle
[00:00:00] S0: Well, this has been a fascinating deep dive and primer on food services as a whole and then Compass fitting into that equation. We end these conversations with the key lessons that you can pull away from this business and potentially apply elsewhere. What stands out to you in terms of key lessons from Compass that maybe are applicable in other investing research?