Compass: Meals for the Masses - [Business Breakdowns, EP.211]

29:04I want to get into the M &A point a little bit more, but before we move on, on terms of the market size and growth, is there a way to measure how much the market is growing organically each year? I can understand there's going to be contracts that are moving from one provider to the next, but is there some sense in terms of what organic growth is for the market as a whole, whether you break that down geographically or at the world level? It's tricky to do that because you've got to assess what is the market, but if I look at compass specifically, we can tease out what are the elements of growth.

29:39There are several elements to their organic growth. One is volume growth. It's pretty hard to eke out more than a few basis points really a year from that because the biggest way you can grow there is to convince people who may be on using their cafeteria every day of the week to use it more often. So that's a very small contributor to growth, but it has been a positive one. The second one is pricing. Compass generally is passing on pricing to the consumer that's broad in line with inflation. They're certainly not trying to use pricing as an important lever because actually what they really want to do is to try and reduce costs so that they don't have to do that.

30:21But they're able to pass on inflation at costs to the consumer and you've seen that, particularly in the last years when you had quite high food inflation and high labor inflation, they were able to pass that on. Over time, that's been sort of around the 2 % type level. The really big driver of organic growth has been what they call net new business wins. I mentioned earlier that retention is around 96%. Compass has been growing net new business at around 4%. So that requires a growth swing greater of about 8%, which is on that sales base absolutely enormous. and they've been doing that to end up at a net and you've got four.

31:00Mid to high single digit organic growth is certainly possible for a very long time for Compass. I want to get into the financial dynamics because I think that will instruct some of the M &A conversation as well. You gave a good sense of the top line growth there. One of the benefits of a large player in this market should be the cost structure being more efficient. What does it actually look like in terms of the margin profile of this business? And however you might categorize how compass performs, how the industry performs, and the most important metrics associated with the margin profile? So the typical margin in the food service sector is around 6%.

31:41Aramot makes about 6%. Sedexo a little bit under that, but that's partly because of the the value to the effect of its facilities management business. Compass outside North America also makes about a 6 % margin. But in North America, they make a more than 8 % margin. And what explains this 200 base point spread? There are several contributing factors that key one is scale. We've got a fixed managerial cost and technological infrastructure cost. and the more revenue you layer on top of that, the higher your margin is going to go. In addition, Compass has embedded within it an economy scale shared type of model within the procurement side of the business.

32:31And I think that partly also explains the margin differential, although it mainly explains the ability to grow the business and that drive scale and that drives margin. Just to delve into that, in the early 2000s, Compass acquired a small food procurement technology business called FoodBuy, and that is formed the bedrock of Compass's GPO or General Purchasing Organization. And the way this works is that most of the ingredients purchased by the Compass chefs are bought through FoodBuy via approved vendors. And as you can imagine, that by itself is a lot of volume. But in addition, Compass invited third parties, these could be cafes, restaurants, hotels, etc., to also procure through food by.

33:19Today, in total, food by does about $40 billion of volume, 60 % of that coming from third parties, and that enables Compass to secure better prices and better payment terms from their suppliers. As an aside, Compass charges third parties a very small fee fee using food by which I like to think is a slightly Costco -S touch. And it's a really compelling win -win for everyone involved. Compass attains lower procurement costs which help them win more business, further driving up scale. Third parties can access Compass's buying power and reduce their cost of goods sold in a way they couldn't have done otherwise.

34:01The consumer enjoys a lower else equal the client will be happy. Even the suppliers content with this arrangement because although they might sell at lower prices, they also have certainty about demand, which is particularly important when you're dealing with perishables. And this model is very difficult for other players to compete with or to replicate. And now Compass is ramping up food by in Europe. And this dovetails really nicely with the acquisition strategy that that will bring scale in core markets like the UK, Germany, France, the Nordics, etc. That will enhance procurement volume in each of those countries, this ought to lead to more growth which will drive up the European margin in the direction of the North American level over time.

34:56It's impressive to see we always use the AWS example in terms of something you need for yourself and eventually being able to sell it elsewhere. but interesting to hear and why that would be so attractive as an added model to the system and to the business profile. On the cost point, you mentioned something there around food buying, purchasing, in terms of inventory risk. This is always something I walk through a grocery store and I just think to myself, all of this produce. It's perishable, how do they possibly model out inventory management? And I never spend enough time to understand the real ins and outs of it, but it just weighs on me.

35:34How does that come into play if at all for Compass? That's a really great point and one of the things I think Compass is slightly advantage -drawn is the way their model works versus say a restaurant A restaurant is a spot business, but Compass is a contractual business Compass is able to menu plan. Let's say for the week ahead and then all of their chefs at the site level will order from food by The inventory turns are quite high inventory represents less than 2 % of sales. It's not going to be sitting within the business very long. It's mainly perishable. There might be some food that sits in the fridge for a while, but it's going to be used according to the menu that's already been planned out.

36:17And because you have a mainly captive customer base, you sort of know what your covers are going to be if you like, the equivalent in a restaurant business. So it's a very different business from that point of view. But I think inventory isn't really a huge part of the story from a working capital point of view though what's interesting and again difference with the restaurant industries that working capital is negative for companies so effectively they're able to pay suppliers later than they're collecting from the clients and consumers and that's really a very attractive feature of the business particularly as it seems to continue to grow and grow every business lover loves a good negative working capital story I think that like sends off the trigger in the brain.

36:57So that's a favorite. On the other cost buckets, thinking about labor, I saw some staggering statistic in terms of the employee base. Can you map out what that entails in terms of labor and is the right understanding that they have a workforce that is essentially contracted out to the corporation or whoever the end customer is in order to work the cafeteria or whatever site it might be? No, so actually the employees on site are compass employees. If compass takes over a contract from an in -house operation, they will usually take over most of the employees as well. As you said, it is a staggeringly big business from a point of view of how many people they employ.

37:41It's nearly 600 ,000, which makes it one of the largest private sector employees in the world outside of retail and managing that labor force is challenging but also I think one of the skill sets companies has. They have a few advantages here versus I think their peers and also other restaurants. One is they've invested a lot in technology and what they call labor scheduling and technology. What the employees can do is input into an app the hours that they'd like to work, the shifts they'd like to work, which days they'd like to work. So there's a lot more flexibility for employees versus let's say a restaurant.

38:21And then they can use the algorithm to match up where demand supply for labor is. So you might have one particular cafeteria in a location that based on demand would be overstaffed and another that is understaffed and they can actually move people across locations. But the other thing is that flexibility is a huge advantage in terms of recruitment. If you think about a typical high -end restaurant, It's a very high stress environment. The hours tend to be pretty antisocial. When your biggest day part is lunch for a typical cafeteria I think that makes for much more sociable working hours and one of the ways that this actually plays out is in the gender balance of the compass employee base Which is much more balanced than the restaurant sector.

39:05So they have a slight edge I think in managing labor which is their biggest cost by far and And I think they generally have pretty good labor relations. These people in their labor force act as extensions of other companies, so it's important to get that right and higher high quality. So interesting to hear those dynamics and how they play a role. When you think about the volatility of the financials and particularly the income statement, I think you referenced COVID, a 40 % decline. That probably isn't the right historical period to use as a model. But if you go back over previous recessionary periods or previous moments of macro sensitivity, how is the business performed both from a top line perspective and then from margins and the operating leverage that sits in the system?

39:55Compass is a cyclical business. The main element of cyclicality comes from the volume in the actual canteen. And that's going to be a function, for example within B &I of employment levels. If you look back at the biggest shock to employment we've had in let's say the last 20 years, it was during the financial crisis and there you did see volume decline a little bit, but you didn't see organic growth go below zero during that period because what happened is Compass won a lot of new business as well. I think there's a sort of natural edge there because in stressed macro environments, I I think there's an even bigger propensity for self -operated or in -house operations to actually looked out source because their own cost structure will become problematic with a drop in volume, complexity is rising.

40:48So this is actually something I'm a bit nervous about in the future, but I think the offset will be net new business growth. in terms of the lingering effects of COVID where we went from five days in office to zero days in office to return to office and still seeing that be figured out from a lot of corporations and I think we see five days a week, we see some four, we see some three, there is definitely a return to office as the standard but what that looks like is kind of up for debate still it seems like, how has their own business recovered from that? Understanding they've won a lot of net new, which is a good thing, but is that legacy business still impaired in a material way from the lingering impact of COVID?

41:35There's no question that pandemic era working practices were really rough for the contract catering industry. If the standard working week was five days in the office before the pandemic and that goes down to four days, that's 20 % off your revenue scone straight away. If it goes down to two or three days in the office, that's brutal. The pandemic taught us all that work from home is possible and it could be that attendance levels in offices never quite returns to pre -pandemic levels. But the good news is there has been the steady recovery in return to office. But all that being said, I think it's a common misconception about Compass that they really only do office catering.

42:21And I think that's partly because for many investors, their own office cafeteria is the primary frame of reference when they're visualizing what Compass does. But actually the exposure to the office is much less than one would imagine. And understanding this actually created quite a major buying opportunity in the stock during the pandemic. If you look at B &I, it's about 38 % of revenues. So this is their biggest sector and yes, that is very important. But it's not the be all and handle of that 60 % is in business. So that's where the office is sit. the other 40 % the INB and I is things like industrial plants and manufacturing facilities where the reality is work from home is not really possible and in fact that part of the business was not really impact during the pandemic.

43:15So in reality the office part of what Compass does is in the low 20s percent of the group and then if you go through the other sectors well healthcare actually grew during the pandemic and that's the second most important sector. Sports and leisure was very, very impacted. It was hit hard because almost overnight, sports fixtures and concerts were just cancelled. But the minute there was reopening, people were really eager to get back to those events. And that business recovered very, very fast. And similarly, in higher education, it's pretty difficult to keep fee -paying students away from campus.

43:55So that business also recovered very quickly. Another theme that I was curious about is the general corporate office, which again, I'm doing exactly what you mentioned, just picturing compass through the slence of the corporate cafeteria. But I am sure it extends elsewhere a bit into the rest of their business, but seeing businesses rather than having one single hub, maybe move towards having several more spokes, splitting offices, you see the we work model and some of the other sharing models come into play. Are those negatives, do they have a material impact on the business, thinking about that theme and somewhat of a shift away from the large corporate headquarters, which I think particularly 30 to 40 years ago were the standard default.

44:42The office model is always evolving and I think it will continue to do so. I think Compass is also demonstrated an ability to evolve with it. Just one example of that is during the pandemic they started from scratch a delivery business which actually became quite significant over time to serve certain clients whose employees were working from home. You're right that flexible office solution model has grown meaningfully in the last few years and generally speaking they tend to serve small head count firms. And the reality is that those kind of businesses would not have been compass clients anyway.

45:26When you start to transition in terms of seeing the earnings translate to free cash flow, thinking about the capital intensity of this business, what does that look like? The negative working capital of always a very interesting theme for a business, is there a significant capital intensity in this business? Where would that come from if it does exist? And anything else in terms of thinking about the cash flow profile of Compass. It is a very cash -generative business and it's also a fairly asset -like business as well. Compass doesn't need to have a fleet of trucks to move food around that's handled by the distributors.

46:02As I said before, they have negative work in capital, but then the real kicker is the fact that they don't actually own the sites, those belong to the client. If you compare that with a restaurant business which actually has to own or lease the sites they operate out of, that's a really big difference. And one of the ways that this lens quite a competitive advantage to Compass is that whilst high street players or main street restaurants, sandwich chains, etc, are going to see their cost increase partly from increasing lease rates, Compass isn't seeing that because they're not paying any rent on their premises.

46:41That's causing the pricing gap to emerge and get bigger between what you'd pay to get a sandwich outside versus eating in the compass cafeteria. And I think that is a building competitive advantage. And particularly at the time when consumers are struggling with their budgets, I think that's going to drive potentially more volume back to the cafeteria. When you pair it with something like mid to high single -digit margins, those don't scream for new competition to come into the market. They don't attract major new upstart investment necessarily. But in some ways, the success of Compass, to me, would point to the opportunity for some of those larger players to maybe go out and look at a same positive growth strategy to roll up the market.

47:32Another theme that people love is industries right for roll up. Is that something that you have seen happening or what has stopped competitors from maybe going out and trying to become a more formidable force against Compass over time? What would make that challenging is that in North America Compass bought most of the best businesses. There isn't a lot left to buy. It was rumored last year that Cedexo would buy Aramark, which would create another 800 pound gorilla, or be it not as big in food as compass, but I think culturally that would be quite an interesting combination. We'd see how it would work out.

48:09So I think it would be challenging. And this is a really interesting aspect of compasses, strategies. They have been exiting whole countries, pre -pandemic, they were in about 50 countries, and now they're down to 30, and I think they'll go a little bit lower than that this year. Why are they doing that? Many years ago, part of the strategy was to be a massive global player and begin emerging markets, which we're going to grow, but actually it doesn't quite work because scale is only relevant at the local level. So what you really want to do is to be big in a particular country. Some of the countries where compasses existed, they've sold to some of their competitors.

48:49So it could be that those players get very big and successful in those countries we'll see. But I think Compass has exactly the right approach, which is to try and get big in the UK and in Germany and so on. Which is mirroring the exact approach they took in the US. The limitations of the benefit on scale, does that cap out at the country level? Is it more regional? And I know this is more art than science, but where would you say the benefits of scale cap out when thinking about your point on region geography? food is very much a local business done at the country level. Having being very big in Germany is not going to help you in France in terms of buying food.

49:30So 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 struggle to scale up and, and if concentrated 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. 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 also selling.

50:06Under 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 a creative. But is there a pretty attractive valuation or that they can play when buying these businesses as well? 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? I don't think there's a major valuation 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.

50:53In terms of the way we think about value and Compass, what we've tried to 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 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.

51:37On that, free cash flow generation and how they get allocated. Sometimes when you see, as you mentioned, potentially shrinking the portfolio or the geographical reach, that can be associated with returning capital to share older or whether it's five acts, whether it's dividends. Is that something that they actively do? What's their methodology just in terms of capital allocation? 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. CapEx2Sales runs at about 3 .5%.

52:17This 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 customs. The second use of cash is, as we've discussed, is 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 to pay out of about 50 % of earnings.

53:01But 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 another wise 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 high price. But assuming there's no more pandemic like surprises, I think the visibility around caplocation is pretty clear. And it's all being carried out with a nicely conservative leverage corridor of about one to one and a half times net -tap tweeter.

53:43Is 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? 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 assaults currently. This is most prominently seen in the US and 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.

54:21So 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 none 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.

55:11And if I look at the UK where health care 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 compasses net new business growth.

55:53This has been 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? 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.

56:39And that's been particularly true under the excellent leadership of Donut Blatemort. There are food service sectors where campus 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 judged 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.

57:22And 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. I love that. One of my favorite themes is 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. I'll break down today. It's been great to be here. Thank you. To find more episodes of breakdowns ranging from Costco to Visa to Moderna or to sign up for our weekly summary, check out JoinKalases .com.

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