Compass Group Momentum Carrying Through Into 2024

Strategist

Michael Field

Compass Group is the largest food-service provider internationally and one of the most entrenched. Its extensive footprint serves a diversified mix of sectors and geographies, providing the foundation for a narrow economic moat that generates consistent revenue streams and healthy cash flow. Combining this dynamic with an asset-light operating structure leads to strong returns on invested capital. Demand for Compass' services is moderately tied to both consumer and enterprise-level discretionary spending, which adds some cyclicality. Nevertheless, Compass appears well positioned to grow as enterprise-level outsourcing gains traction for the longer term.

The majority of Compass' revenue comes from the business and industry division, which manages corporate cafeterias. Employee food service is not an absolute necessity for most companies, but Compass has plenty of cost levers to pull when facing lagging sales or service cutbacks. This can be seen in slow but steady margin expansion during the most recent U.S. and European economic downturns. Compass has also been active in the last decade in diversifying into other areas such as healthcare, education, and sports and leisure, which now constitute a material chunk of revenue. 

In the longer term, food service remains a large fragmented global industry that offers Compass ample room to grow. The firm's global reach makes it one of the few vendors that can efficiently fulfil the needs of multinational companies with diverse locations. There is also opportunity to expand in the stable healthcare and education sectors, which maintain a high percentage of self-operated cafeterias. As costs and complexity continue to rise in these sectors, we expect more institutions will recognise the savings potential of outsourcing the food-service function. We also believe emerging markets with economies tied to energy and commodity extraction typically require higher-margin remote and offshore services, and thus offer good longer-term growth opportunities.

Business Strategy & Outlook

Compass Group’s narrow moat comes from two primary sources: switching costs and cost advantage. Switching costs form a large part of Compass’ narrow moat. Contracts in food service vary in length but are generally between three and five years. These multiyear contracts, combined with material fit-out costs, dissuade clients from switching providers, as does the potential disruption to service, particularly in sensitive areas such as hospital catering. This is evidenced by contract retention rates averaging 95% over the past decade. Another reason for this high level of retention is strong relationship management. Compass establishes two points of contact with each client to ensure the highest level of communication exists. For the most part, once a good working relationship has been established and pricing is competitive, clients generally have little motivation to switch providers and hence opt to renew existing contracts. This is particularly true with clients that Compass services on a regional or global basis. As the firm is the largest of only three food-service companies with global capabilities, clients have little option but to choose Compass, unless they want the additional inconvenience of dealing with multiple operators across their networks.

In an asset-light industry, in which the majority of costs stem from food produce and labour, a cost advantage is a rarity. However, through Foodbuy (a U.S.-based subsidiary procurement company), Compass has managed to materially lower its input costs. Foodbuy not only purchases for Compass’ U.S. business but also aggregates purchases for the wider industry, including hotels, airlines, and restaurants, purchasing around $23 billion in food produce annually, making it the largest food-service procurer in the United States. Bulk purchasing on this level secures material discounts to prices at which competitors can procure food produce. While this method of procurement currently exists only in the U.S., this concept is beginning to be rolled out in other regions such as the United Kingdom. Compass’ cost advantage is illustrated by the firm’s continually widening operating margins, which at 7.5% before COVID-19 were the highest in the sector.

Narrow

Economic Moat

Compass Group PLC

Compass Group Plc engages in the provision of food service and support services. It caters the sectors of business and industry, healthcare and seniors, education, defense, offshore and remote, sports and leisure, and vending. It operates through the following geographical segments: North America, Europe, Rest of the World, and Central Activities. The company was founded in 1941 and is headquartered in Chertsey, the United Kingdom.

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Compass Group has been on the up ever since the pandemic and it will be a major shock if the caterer is anything but upbeat with its first quarter update next week. In-fill acquisitions such as gym and leisure centre caterer CH&CO for £475m, announced in January, look set to be the way forward and should keep up the momentum.

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Compass Group PLC (OTCPK:CMPGF) Q4 2023 Results Conference Call November 20, 2023 4:00 AM ET Company Participants Dominic Blakemore - Group CEO Palmer Brown - Group CFO Conference Call Participants Jamie Rollo - Morgan Stanley Simona Sarli - Bank of America Vicki Stern - Barclays Leo Carrington - Citi Harry Martin - Bernstein Jarrod Castle - UBS Andre Juillard - Deutsche Bank Dominic Blakemore Good morning, and thank you for joining us today. 2023 was an excellent year for Compass.

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Compass has recovered well from previous challenges and is performing strongly with organic revenue growth in all regions. The company expects mid-to-high single-digit organic growth in the long term and aims to achieve historical profit margins. Despite its competitive advantage and growth potential, the current valuation is considered too high, leading to a "sell" rating.

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Contract caterer Compass Group has come storming back following the end of the pandemic and as people have returned to offices, gyms, hospitality venues and other workspaces. Organic growth from the FTSE 100-listed group hit 24% in the three months to end December and more of the same is expected when it updates this coming Wednesday.

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