Compass’s rehabilitation has been fuelled by recovering sales at businesses, sporting events and schools as pandemic restrictions have eased over the past two years. But the next catalyst for the catering giant’s shares is harder to identify in the face of recession across global economies and optimistic revenue expectations baked into market consensus.
Sales are now back above pre-pandemic levels, at 105 per cent of the 2019 level over the 12 months to the end of September. That rose to 116 per cent during the final quarter of the period. Sales of £25.8 billion were also ahead of market expectations and almost 38 per cent higher than the prior year at constant currency rates. After a recovery in cash generation management declared another £250 million share buyback. That’s the good news.
Compass has long been valued at a premium, in recognition of the group’s scale, exposure to defensive markets like healthcare and public sector contracts and the benefits to be reaped from a shift towards outsourcing catering by large businesses and other organisations.
But guidance for elevated organic revenue growth this year has not been matched by a fatter earnings multiple, with the shares trading at just under 21 times forward earnings. That compares with a ratio of 28 at the start of the year and is nearer pre-pandemic norms. Higher inflation and shift away from pricier stocks is one reason for the de-rating in the shares. But investors are also justified in being reluctant to buy into the promise of superior sales growth. Management reckons it can notch-up an annual rate of 15 per cent organic growth this year, lower than the jump recorded last year, but still ahead of a pre-pandemic range of between 4 and 6 per cent. Why so confident? A higher rate of winning new business, almost half of which has come from clients outsourcing catering for the first time. Net new business added 7.5 per cent to organic revenue last year, ahead of a historical norm of 3 per cent, and was 5.7 per cent ahead of 2019 levels.
New business, higher volumes from existing clients and pricing typically contribute equally to organic sales growth. So guidance for 15 per cent organic growth this year implies price rises remain intact; the rate of new business wins remains elevated and growth in sales from contracts at existing sites is ahead of pre-pandemic norms.
Double-digit inflation makes the above first in that list seem likely. Higher costs for public sector organisations and businesses might also make the scale benefits that a company of Compass’s heft can secure also more alluring. Whether growth in sales volumes at sites where Compass is already operating remains elevated is more questionable as some of its global markets enter recession.
The company has managed to stomach the pressures of rising food and labour bills. But guidance of an underlying operating margin of above 6.5 per cent this year was lighter than the 6.9 per cent analysts had forecast and means there is still further to go to attain the 7 per cent margin recorded prior to the pandemic. The start-up costs associated with new contracts could be one trade-off this year, as could inflation rising unexpectedly higher. Between a quarter and a third of Compass’s contracts are fixed price, which would require renegotiation.
Liquidity is not an issue for Compass, which has £3.7 billion in cash and undrawn debt. Net debt is in the middle of a target range of between 1 and 1.5 times adjusted earnings before taxes and other charges. Yet convincing investors the shares deserve a higher price over the next year is going to be tough.
ADVICE Hold
WHY The shares may tread water in the face of a downturn in large global economies
Diploma
The immediate risks to earnings for the distribution company Diploma are inescapable, namely elevated inflation and weaker demand curtailing spending by its industrial clientele. The longer-term potential of the FTSE 250 constituent’s expansion in the US and Europe is more interesting.
Against said macroeconomic pressures, Diploma has earned itself a lead. Revenue over the 12 months to the end of September rose by 29 per cent and 15 per cent on an organic basis, ahead of market expectations. More than half of that organic growth was generated by higher volumes rather than just price inflation.
That level of growth, boosted by businesses seeking to buy more products ahead of time to navigate supply chain disruption, won’t be sustained. Organic growth is guided at 5 per cent this financial year. Even so, analysts upgraded profit forecasts for this year, with RBC Capital raising its earnings number to 116.6p a share, also higher than the 107.5p recorded last year.
The industrial seals, gaskets, specialist wiring and cabling that the group sources and supplies are critical to its customers’ operations, which means that they are accounted for in operational rather than capital expenditure budgets, which are less likely to be cut in a downturn. Providing services such as technical support and training means the group has a pricing power that has imbued it with superior margins to other middlemen.
Diploma requires a low level of capital to sustain its operations, which makes the business highly cash generative. Net debt is roughly 1.4 times adjusted earnings before tax and other charges, easily below a target ceiling for a multiple of two. That leaves room for more deals.
Only half the group’s debt is fixed, which means finance costs should increase again this year. But that burden on the bottom line should be offset by the benefit of the stronger dollar since Diploma generates a good proportion of its sales in the US, if the dollar maintains its value against the pound. The gap between return on capital employed last year, which stood at just over 17 per cent, and a 3 per cent cost of debt should also give investors comfort.
ADVICE Buy
WHY Shares have potential for long-term compound growth
