The easy gains are behind Compass. The powerhouse catering group has generated extraordinary revenue growth over the past two years as workers returned to the office, events restarted and schools reopened. Elevated price inflation was another boon.
Now it needs to show that it can resist the downturn across the broader economy and the risk of staff cutbacks. In the longer term, Compass needs to convince investors that there is a sustainable structural shift towards outsourcing catering and that it can take market share.
Organic revenue growth this year has been suggested at somewhere in the high single digits, a slowdown from the 19 per cent increase last year because of flat volumes and lower prices inflation. The post-Covid bounceback, which pushed underlying sales volumes at Compass 7 per cent higher last year, has played out. Price inflation is likely to slow from 7 per cent to 5 per cent this year.
The rate at which the FTSE 100 company wins new business is expected to be the only constant, at 4 per cent to 5 per cent. Net new contract growth slowed from 4.8 per cent in the third quarter to 4 per cent in the fourth. Its biggest market is business and industry accounts, which make up about 35 per cent of sales, although that is a lower proportion than before the financial crisis in 2008. The less cyclical sectors of healthcare and education account for a combined 45 per cent.
The shares have rebounded past the pre-pandemic level and trade at 20 times forward earnings. That is in line with the 15-year average. Guidance for mid-to-high-single-digit organic revenue growth over the longer term is not dissimilar to the rates before the pandemic. Analysts have forecast another fall in revenue growth, to 7 per cent, from 9 per cent this year. Margins are yet to fully recover, not helped by cost inflation and the expense of getting new contracts up and running.
Higher bond yields have penalised highly valued stocks. Compass’s scale has earned it a reputation as a defensive company, deserving a premium, but justifying a higher valuation will hinge in part on the rate at which it wins new contracts. That is still ahead of the historic norm. Catering in just over half of the education and healthcare sectors is handled in-house, which leaves plenty for Compass to go for, Dominic Blakemore, the chief executive, believes.
Broader factors helped to push the public and private sectors to outsource catering. The high rate of inflation was one. Food shortages have been another, along with a tight labour market. Compass’s scale has helped it to navigate all three more easily than individual customers. Whether that advantage will hold up, now that the former two factors are falling away, is up for question.
Achieving profit ambitions might earn the group more credit. Compass hopes to lift profits ahead of revenue over the longer term. The size of its catering operation brings natural margin benefits. Margins should improve as long as the group can achieve mid-to-high-single-digit revenue growth while cost growth reverts roughly in line with white-collar wage inflation of 4 per cent to 5 per cent. There are also potential benefits from continuing to cut back its footprint. Twenty of its 35 geographic markets generate 95 per cent of revenue. The plan is to deploy more of its capital in its core markets of America and Europe.
Net debt stands at about 1.2 times adjusted earnings. Debt is set to increase this year, partly owing to higher capital expenditure, which means that guidance for interest payments was higher than analysts had expected.
Without signs that the catering industry has fundamentally changed, though, Compass could be left searching for catalysts.
ADVICE Hold
WHY Organic sales growth will not be as easy
Diploma
Consistency has earned Diploma a premium valuation and beating profit expectations again is more proof that the industrial distribution specialist deserves its place in the FTSE 100.
The strength of Diploma’s business model lies in its ability to inflate margins by pushing sales growth ahead of costs. Last year, its adjusted operating margin rose to 19.7 per cent, from 18.9 per cent.
The group, which distributes industrial seals, gaskets, specialist wiring and cabling, has defied concerns of a fall in demand from its industrial customers. Supplying smaller-ticket products that are accounted for out of customer’s operating, rather than capital, expenditure is a help. Over the past decade, adjusted earnings have grown at a compound annual rate of nearly 14 per cent.
Organic revenue slowed to 8 per cent last year as the post-Covid bounce eased and is set to relax this year to 5 per cent. The group is not relying on prices inflation, either. Fourth-quarter organic revenue growth of 7 per cent was comprised of five percentage points of volumes and two percentage points of inflation. The shares trade at 24 times forward earnings, not cheap by conventional London market standards but in line with the long-running average. Diploma’s record of buying well might convince investors that it has the potential to continue inflating its margins in future. Acquisitions typically account for half total revenue growth.
Ten bolt-on purchases were completed last year, which generated a 20 per cent return on capital employed. Two larger deals, including the £170 million takeover of a European fluid power company, will take a couple of years longer to meet that returns threshold.
Strong free cashflow, together with a £235 million equity-raising in March, has helped to cut net debt to a ratio of 0.9 times adjusted earnings before interest, taxes and other items, a way below a target ceiling multiple of two. Diploma’s cost of capital doubled to 5.6 per cent last year, but was far exceeded by an average return on capital employed of 18.1 per cent. If it can maintain that record, it should convince the market it deserves a higher price.
ADVICE Buy
WHY There is potential for more margin growth
