- Step change in organic growth
- Margin recovery story
Compass Group (CPG) plates up 5.5bn meals every year. Despite its colossal reach, however, it is one of the lesser-known constituents of the FTSE 100. More’s the pity. Contract catering has boomed since the pandemic, and there could be plenty more growth to come.
The world’s three biggest catering companies – Compass, Sodexo (FR:SW) and Aramark (US:ARMK) – increased their market share from 19 per cent to 21 per cent between 2019 and 2023. In the same period, regional players lost ground and the decline of self-operators accelerated.
The driving force behind this change has been financial. Smaller caterers have struggled with wage hikes and food inflation, and the same pressures have prompted organisations with in-house canteens to seek external help for the first time. There are other challenges too, however, including health and safety and allergens.
“These could open employers up to potential lawsuits if managed incorrectly,” analysts at HSBC pointed out.
These push factors have turbocharged demand at the big listed groups. Compass achieved a net new business growth rate of 4.6 per cent in 2023, well above its historic level of 3 per cent (although behind the previous year's 7.5 per cent), and first-time outsourcing accounted for half of new wins. Organic growth remained high in the first quarter of FY2024 at 11.7 per cent, and management is forecasting “high single-digit” organic revenue growth and “ongoing margin progression” for the year ahead.
Aramark and Sodexo have also made some big steps forward. The former achieved organic revenue growth of 13 per cent between October and December, and has upgraded its full-year profit forecasts, while the food services arm of Sodexo banked like-for-like sales growth of 10 per cent. Like Compass, they expect growth to moderate in the coming months, but to remain above historic levels.
Jefferies – which upgraded the whole sector to a ‘buy’ late last year – thinks these tailwinds could persist for a decade. “Organic revenue growth is likely to be considerably higher this cycle because industry outsourcing momentum has doubled post Covid,” the broker concluded.
Profits also look well protected. During lockdown, the industry quickly migrated to a “cost-plus” contract model. Under these agreements, clients cover all allowed expenses plus an additional payment, which represents the profit margin. This is low-risk, but analysts feared it would also be low-margin.
However, Compass challenged this view in 2021, when management asserted that cost-plus contracts, combined with a regular retainer, were delivering a 7.5 per cent Ebita margin. Since then, profit margins have continued to climb, helped by a shift back to the P&L model, which allows caterers to operate on commercial terms within a client’s premises and charge diners as much as they want.
Cost pressures are also easing. Aramark said this month that lower inflation had “provided a tailwind to profitability during the quarter”. This chimes with research by Fidelity which found, for the time since the pandemic, more of its analysts thought companies’ cost inflation would fall rather than rise in the year ahead.
Picking a winner
The catering giants are not interchangeable, however. For starters, Compass is by far the biggest: its global food service revenue is as large as that of Sodexo and Aramark combined. This is partly because Compass has outperformed its peers over the past decade.
Compass’s organic revenue almost doubled between FY2010 and FY2023 versus a 57 per cent increase at Aramark and a 41 per cent increase at Sodexo. The latter has historically struggled to increase volumes, with new wins offset by client attrition, while Aramark’s former chief executive was pressured out by activist investors in 2019 due to disappointing progress.
Looking ahead, Compass’s growth prospects still look stronger. Analysts at Jefferies believe that Compass could deliver organic revenue growth of 8-9 per cent over the next two years. Sodexo is only expected to grow by 6-7 per cent and Aramark by 6-6.5 per cent. Meanwhile, Compass still enjoys significantly higher margins.
At Aramark, there is also the issue of debt. The group’s net debt-to-adjusted Ebitda ratio currently sits at a whopping 3.9 times and it paid $451mn in interest last year, against adjusted Ebitda of $1.6bn. Deleveraging efforts are ongoing, but this will drag on cash flow and things could head south if demand doesn’t increase as expected.
The groups’ respective valuations reflect these differences. Compass is the most expensive, with a forward price/earnings ratio of 21.7 times, compared with Sodexo’s 15.2 times and Aramark’s 18.2 times. There is a chance the valuation gap will narrow. Analysts at HSBC, for example, noted that Sodexo “appears to be gaining ground”.
“We don’t read this as a growing competitive threat – there seems to be plenty to go for in first-time outsourcing... However, this does open up a viable alternative investment for those looking for growth exposure in this sector.”
For now, though, Compass is the obvious quality candidate – particularly as it sets its sights on European expansion.
