Business Breakdowns
· 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?
· Asif Jeevanjee, Matt Reustle
[00:00:00] S1: One lesson is that, while generally acquisitions have a bad rap, Compass has shown that, executed well and within a coherent strategy, they can create a tremendous amount of value. And whilst acquisitions have served Compass well, they've also been willing to do something else, which is to shrink to grow. And that's been particularly true under the excellent leadership of Dominic Blakemore. There are food service sectors where Compass has elected not to play. There are some where they're quietly retreating. And counterintuitively, they've divested from operations in entire countries, including some large population ones. There they judge the risk was too high, the opportunity not so attractive, or the capital required to get to scale just simply too large. Instead, they've redeployed those resources into doubling down where they're already strong, and where they see a big runway. One way to think about this is Compass are opting to play games they know they can win. And this goes against the grain of so many companies that by nature are expansionist. I think shrinking to grow is a high density signal of quality amongst the noise, and well worth looking out for in other companies and other industries. [00:00:00] S0: I love that. One of my favorite themes from the US railroads and their incredible performance dating back to the early 2000s and for a decade plus thereafter. I love that theme and think it's laid out very interestingly here. Asif, thank you very much for joining us on Breakdowns today. [00:00:00] S1: It's been great to be here. Thank you Matt.