Compass Group CPG LN
October 29, 2018 - 12:05pm EST by
ElCid
2018 2019
Price: 15.54 EPS 0 0
Shares Out. (in M): 1,584 P/E 0 0
Market Cap (in $M): 24,616 P/FCF 0 0
Net Debt (in $M): 3,658 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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Description

Thesis Summary
Compass Group (CPG LN) is a recession-resistant, MSD% revenue compounder that is competitively advantaged given its scale and brands. Recently, valuation has meaningfully compressed due to misunderstandings surrounding a recent customer loss, in addition to temporary labor inflation headwinds.
Business
Compass Group is the global leader in food and support outsourcing services. As a food outsourcer, or contract caterer, Compass serves food to a captive audience.  Corporations, hospitals and schools hire Compass, who in turn hires service and meal‐preparation staff, manages the food supply chain, furnishes and maintains the serving area/kitchen, and invests in light equipment (cookware, utensils). The Company operates a "sectorization" strategy where they manage multiple brands, each targeting a specific end market / customer, which serves as a differentiator and competitive advantage vs peers. For example, the Bon Appetite, Eurest and Flik brands cater towards the Business & Industry end markets, while Chartwells focuses on the Education customer and the Levy brand serves Sport & Entertainment clients. 
Compass also operates a GPO called FoodBuy, which is the largest foodservice GPO in North America, managing more than 650 contracts that represent over $20B of food & beverage purchase power. FoodBuy's purchasing power is much greater than competitors' GPOs and provides a ~7% food & beverage cost advantage relative to smaller peers. This purchasing advantage is significant and allows Compass to bid more aggressively on contracts and to reinvest into the business. 
Thesis
  1. Leading player in the outsourced catering space with clear competitive advantages that have driven share gains over a decade and supports continued HSD% revenue growth in North America
    • Scale
      • Compass has a ~7% cost advantage on food purchases relative to smaller competitors like Elior
      • Compass is the largest North American caterer and owns the largest food buying GPO, FoodBuy 
    • Multi Branded "sectorization" approach
      • Compass utilizes multiple brands, most of which were acquired, and have been maintained and fostered as stand‐alone businesses
      • This contrasts to peers, which have rolled up acquisitions under a single global brand
      • Competitors can't replicate Compass' strategy because they historically have invested all brand equity into the corporate brands
    • Strong brand / reputation 
      • Compass is known for its ability to handle large, complex projects
      • Compass is known for its focus on foodservices vs peers Sodexo (provides facility management services) and Aramark (provides uniform rental services)
  2. Secular growth in North America contract catering supported by increased outsourcing
    • There is a large runway for growth and opportunity for large contract caterers to continue to gain share from self-operated clients and regional players. The US is currently only 36% outsourced vs more mature European countries like Spain, UK and Italy which are 46%, 54% and 65% outsourced, respectively.
    • From an end markets perspective, healthcare and education have been slow to transition towards outsourcing due to less of a focus on cost controls. However, this is starting to change as both sectors are under budget pressures.
    • The current wage inflation environment today may serve as a catalyst to encourage more businesses across sectors to outsource to contract caterers. 
    • Compass has been able to win 70% of all new dollars going to outsourced catering in North America
  3. Recession resistant business model
    • The large public caterers grew both revenue and EBITDA organically during the Great Financial Crisis
  4. Compelling valuation given recent concerns that we believe are all temporary/non-structural, including: potential margin headwinds from wage inflation (headlined by AMZN’s decision to raise wages to $15/hr for their warehouse workers) and the loss of a major customer at FoodBuy
    • The stock currently trades at 18.3x forward PE (vs historically at 20x-22x). This is an attractive opportunity to purchase a recession resistant business with secular growth headwinds that can consistently grow earnings
    • Compass should be able to pass through labor inflation (40% of COGS for Compass)
      • The Company’s contracts have price escalators in place to pass through food and labor inflation
      • Only about 1/3 of all contracts are fixed and an even smaller percentage of contracts are fixed in the US
      • Compass has been operating in an inflationary environment for multiple years now and EBITDA margins have expanded each year for the last 6 years
      • The Company views a rising wage environment as a positive catalyst for more employers to outsource their cafeterias and as a bigger headwind for smaller competitors who may not be able to pass on the costs
    • FoodBuy's purchasing advantage should not change after the loss of Dining Alliance and the Company has already filled some of the lost volume with new members
      • This customer loss lowers FoodBuy's total purchasing volume to ~$20B and increases Entegra's total volume to $18B, which brings the gap in volumes to just $2B vs ~$10B prior
      • Optically, these volume figures would suggest Entegra should now have a similar cost buying advantage vs FoodBuy, however compliance rates are key (not volume) and FoodBuy has a much higher compliance
        1. Compliance within a GPO just means that the members of the GPO all agree to use the same GPO contract and purchase the same types of product for optimal cost savings
        2. Dining Alliance is a high-volume client, but very low compliance since members are mostly chain restaurant who need proprietary ingredients that GPOs can’t contract
      • We believe that weighted for compliance, Foodbuy has 2x Entegra’s purchasing power
  5. Management structure and incentives are aligned with shareholders, which is not the case at competitors
    • Compass has a traditional management comp package with the LTIP based on ROIC, total shareholder return and adjusted free cash flow. The Company's structure is decentralized which allows each brand to focus on their specific niche markets and run as a separate unit with centralized support. In contrast, Sodexo is run from its corporate HQ in Paris, which results in a disconnected management team. Entire verticals are run globally (for example K through 12 Education -- schools in the US are very different vs Europe), which leads to management being out of touch with local trends and relationships (based on expert calls). 
    • Sodexo is controlled by the Bellon Family (40% ownership), who is supposedly only concerned about their dividend and less interested in investing in the business and innovation.
    • Additionally, Sodexo, similar to other competitors like Aramark and Elior, runs business units that are not related to the core contract catering business vs Compass who is focused on contract catering. Sodexo has a voucher business that represents 22% of operating income, Aramark has a uniform rentals business that is 18% of operating income and Elior runs a concession business (i.e. running shops at airports and roadways) that is 37% of EBITDA.
  6. Unique combination of growth and yield due to limited incremental investment required to drive growth in the business 
    • Consistent earnings growth between 9% ‐ 10% and 5% FCF yield resulting in mid-teens compounder
    • CPG has grown EPS at a CAGR of 11% from 2010 – 2017 while paying a ~4% dividend yield on an annual basis including ordinary and special dividends
    • Business is negative working capital and low capex, so it can grow without much incremental investment
Investment Risks
  • Sustainability of Compass growth rate in North America as they become an even larger share of the market
    • Compass currently is garnering 70% of all industry growth. As they become larger, they will need to garner above 90% of market growth to maintain current growth rates
      • Mitigants:
        • Compass has continued to increase their share of market growth as they have grown over time. Their advantages are only becoming greater with further scale.
        • Businesses like Education have very long‐term contracts (10‐20 years) where Compass hasn’t had the opportunity to win these since they have developed their competitive moat. These are more likely to provide wins and share gains going forwards
          • Most recently, Compass was awarded the Northwestern University contract (~$30m), beating Sodexo the incumbent
  • FX Risks
    • Compass has exposure to business in a variety of different currencies
      • Mitigant:
        • ~60% of group profit comes from North America and should increase closer to ~70% which makes the bulk of the business a US dollar investment
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

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