Compass：为大众提供餐食——[Business Breakdowns，第211期]

All right, Geoff, I am excited to dive into the world of food today, particularly the business of food and an interesting business that sits in that world with Compass Group. To start us off, I don't think too much of our audience will be familiar with Compass Group. Maybe you could start with a simple explanation of who they are and how a listener might interact with the business in their day-to-day life.

Well, it's great to be here. Compass is a food service company, a contract caterer. They're a UK company, but their biggest business is by far in North America.

They operate in a very large market. The best way to understand the business is to think about how many of your listeners will have used a corporate cafeteria if they've worked for a large company. The cafeteria will have a kitchen and seating area, and will probably provide hot and cold meals and beverages.

The operation of that cafeteria, which sits within the client's location—your employer—is provided by companies like Compass. The important point is that it is on-site, so you don't have to leave the building to enjoy your meal.

Can you share some general context on the size of this market? I know 2 players at this point, but how big is it, and what other context would you put on the market as a whole in terms of its health or anything else you would use to describe it?

It is a massive market. It's very hard to size it accurately if you're looking at the global market, but if we use numbers that Compass provides—and they're in about 30 countries—they think that the food service market is about $320 billion.

That is really just for the food service part of their business. They have another part of their business, which is support services. This is the provision of certain add-on services, like reception and cleaning, which account for about 14% of their revenue.

Some of the big players in this market are Sodexo and Aramark, but it is otherwise quite a fragmented market, with a number of independent regional players as well as—and this is a really important part of the market—in-house operations. One of the exciting areas of Compass is tapping into that and driving outsourcing over time.

It's interesting to hear that market size. That $320 billion is a staggering number. I can remember looking at the advertising industry a few years ago, when it was something like $700 billion. You think about how much that market drives so many different businesses, and this is essentially half of that but still substantial.

When you mention the fragmentation and those large players, are there any with sizable market shares? Do they break out what Compass Group has in terms of market share, whether by market or anything else, and some of the other big players you referenced? What does a dominant market share look like in this industry?

Compass is the 800-pound gorilla in this industry. They have about an 11% to 12% market share of that market. If you were to take the next 2 biggest players, Sodexo and Aramark, and add them together, their revenues would just about equal those of Compass.

In the case of Sodexo and Aramark, a much bigger share of their business is in facilities management. Within food, Compass is by far and away the biggest player.

That's a good opportunity to give a little bit of an understanding of what these things mean in terms of food versus facilities services. I think I have the broader picture, but can you talk a little bit about how the money moves through the system?

I assume that Compass isn't growing and producing all of this food themselves, but what does it entail to be the food services provider for a large corporation? How do the dollars move through the system, thinking about their suppliers and then how they supply to the customers?

If you look down at the food on your plate, there are a number of participants in the ecosystem that will have made that possible. Compass procures food from producers, farmers, and other suppliers. The food is then transported from the supplier to a Compass-operated client location by food distributors like Sysco and US Foods.

On the client site, the food is prepared by Compass chefs and served to the consumer. When you look at the money flows, they're pretty much in the opposite direction. The consumer purchases meals on-site, and Compass then pays distributors and suppliers.

There can be some balancing flows between Compass and the client, depending on the contract type, the level of any subsidy, and performance against service-level agreements.

It's a good opportunity to talk about what contracts look like in the space, whether it's the term of the contract, how they're priced and structured, or anything else you can share about standard contracts, to the extent that there are standard contracts in food services.

Contracts are typically 3 to 5 years, but there are exceptions where they can be longer, particularly in the sports and leisure area and in education, where contracts can run up to 8 years. There are some historical B&I contracts—business and industry contracts—where the terms have been longer still.

There are 3 types of contracts. There's something known as fixed-price contracts, where the client will agree with Compass to a fixed price per meal, and then it's up to Compass to figure out how to manage its costs to make sure it makes a profit.

There's another contract type, which is cost-plus, where Compass will simply pass on whatever costs are incurred in making the food, plus a small management fee. Then there are P&L contracts, where Compass and the client will agree to share the profits earned from the operation.

From an investor's perspective, and even from the business's perspective, is there a contract type of those 3 that is most preferred, that results in the highest margins, or something that you see a transition toward more and more?

Contracts are evenly split across the business among those 3 types, and that hasn't changed very much over time. We don't have enough information to discern different levels of profitability by contract type, and the contract structure that's adopted is largely down to the circumstances of the client.

Some clients prefer a fixed-price contract because it gives them certainty about what the outlay is each month in a subsidized cafeteria. Other clients may want to share in the upside potential and elect a P&L contract.

Whichever structure is written into the RFP, Compass will factor that into its bid terms to ensure that the structure is commercially attractive to it, both from a margin point of view and from a risk point of view.

On that point, in terms of retention, I'm trying to get some appreciation for how sticky these contracts might be. You are on the corporation's premises and within its facilities. I imagine there is some ability to switch, and it's not going to be a complete overhaul.

What does retention tend to look like for the industry, and are there things that can make these contracts stickier? Good service and steady performance are certainly going to be part of that, but are there hidden things that impact the retention rate and stickiness of these contracts?

There are switching costs involved. The retention rate for Compass is 96%, which is industry-leading. That is very, very high.

When you think about the scale of the business—$42 billion of revenue—if you're hitting a 96% retention rate, that means you're losing 4% every year, which is a lot of business that they then have to replace. To tread water, they've got to win, let's call it, $1.5 billion a year. To grow as they have, they've got to do that again.

Retention is really important. I like to think of it as, in investing, Warren Buffett's rule is, "Don't lose money." I think in contract catering, it's, "Do not lose a contract that you've won."

This is really the secret sauce to Compass's ability to grow: they've excelled not only at winning business but at hanging on to the business they've won.

That 96% tells me that there's something very sticky about their business, and I appreciate that you mentioned it still requires them to replace $1.5 billion of revenue each year just to tread water.

What would you point to in terms of competitive advantage that they might have versus their peers, and anything else on the switching costs associated with it? If I can comprehend what that would look like, it would be helpful as an example. What would it entail to move from one provider to the next? Beyond, “We have this crew that’s shown up and served the food out of here on Friday; on Monday, it’s going to be this group.” What else goes into it that makes it more complex?

Contracts do move around. Every time you win a contract from another provider, there are bid costs involved, and there are mobilization costs involved, which can be quite high. So those are the switching costs, but also, the incumbent operator is going to know how the operation works and what the needs of the client are. So there is an advantage to the incumbent.

But I think Compass’s industry-leading retention is really down to making a science out of sales and retention. They keep a very close eye on what it is that the customer wants. And when I say “the customer,” one of the things that makes this industry quite unusual is that there are 2 customer groups: there’s the client and there’s the consumer.

Whether it’s through surveys or through technology and data, Compass has a very, very good idea if either the client or the consumer is not happy. They will work very hard to fix that long before the contract comes up for renewal. So by the time it’s coming to the renewal point, they’re in a really good position to hang on to it.

It’s also important to point out that it’s going to be very difficult to achieve 100% retention because, for example, a client might change its factory footprint and close a factory, or consolidate offices, and therefore a site will disappear, which is out of Compass’s control. So there’ll always be some contract loss.

Yeah, I can imagine scenarios to your earlier point. The incumbent understands the operation very well. They can probably price the contract to that specific setup, while new bidders might not appreciate it, might come in with a lower price, and it might not be bad business to lose in that sense if what is required is going to undercut you on pricing to the extent that that happens. I could certainly see it.

What else goes into their model in terms of, as you mentioned, being the 800-pound gorilla? Maybe we should go back in time and cover some of the history and build up to it. That might be a good place to start, because I want to work toward how they’ve gotten to this place. What is the origin story of Compass? Can you bring us back to the beginning and the formation of this company? How far does it go back, and then we can work our way forward?

It’s a really interesting history—fascinating, because there have been so many plot twists along the way. But also, I think it’s a marvelous story of resilience, because Compass has faced a number of challenges over its more than 80-year history. Every time, it’s come out stronger.

The origin story really begins in World War II. The Churchill government in Britain at the time passed legislation that said any large munitions factory had to start operating a clean and safe canteen and produce nutritious food for the employees in the factory. This was important because, up until then, many of those workers would have been subsisting on meager rations. It was important for their productivity and contribution to the war effort that they were well-fed.

What was interesting is that some entrepreneurs saw this legislation and decided to start a catering business to help these factories meet their obligations. Two of the companies that were started at that time were Bateman Catering and Midland Catering. I’ll come back to those companies.

Interestingly, after the war, the catering business basically continued to flourish because employees quite liked the idea of meals being provided by their employer. Some of the more paternalistic employers quite liked the idea of looking after their employees and looking after their health and well-being. Also, there were more and more women starting to enter the workforce. In peacetime, the industry continued to grow and grow.

In the 1960s, a British conglomerate called Grand Metropolitan acquired Bateman Catering, and Midland Catering merged with it to form effectively what is Compass today. The business continued to flourish, and in the 1980s, the management of the division within Grand Met did a huge management buyout of what is effectively Compass. A year later, they took it public.

Compass grew and grew through the 1980s and 1990s. It became known as the quintessential defensive growth stock, probably what today would be called a quality compounder. The trajectory came to an abrupt end, though, in 2000, when another conglomerate called Granada effectively bought Compass.

There was really very little overlap between the 2 businesses. But the industrial logic was that Granada wanted to put its hospitality assets into Compass so that it could become a pure-play media company in a red-hot TMT market. So the 2 companies, a year later, demerged, and Compass emerged as this sort of hospitality company saddled with hotel assets, service stations, roadside eateries, and so on.

That then led to a few years where Compass’s performance wasn’t quite as good as it had been. It was less focused. That really changed in 2006, when a new board put in place a new CEO, a guy called Richard Cousins.

Richard Cousins had come from outside the industry. He was a breath of fresh air. He looked at this business and said, “This is a good business. We’ve actually done well on the top line. We can do better, but we’ve done well. But we need to introduce more financial discipline, more rigor, and more accountability.”

He developed a framework called the MAP framework, which goes very well with Compass, and that stands for “management and performance.” It had 5 elements to it, which were about winning and retaining business, winning with the consumer, and managing costs. Those are food costs, labor costs, and out-of-unit costs.

What it was was a tool to help people across Compass talk about the business in terms that really affect the value drivers of Compass. It became a common reporting tool, and it became a tool to hold people to account. It is still used in the business today.

Richard Cousins tragically died in an aviation accident in 2018, just months before his planned retirement. Luckily, his successor had already been announced, Dominic Blakemore, and he’s led the business since 2018 very successfully, albeit with a huge challenge in the middle, which was the pandemic.

Probably the hardest challenge that Compass has faced in its history: at one point, revenues were down 40%, something the business had never seen before. Amazingly, the business has emerged stronger from it, with a bigger revenue base today than it had before the pandemic.

Very interesting history. I did not appreciate that it was really born out of a war environment, and I think we’ve seen quite a few businesses that at least have their ties to that.

It sounds like, over the history—and let’s remove COVID from the situation, since that was certainly a unique environment—this has been a market that has just grown substantially over time. Even some of those pivots that they’ve had to make were either associated with some less-than-attractive combinations and a lack of focus on this core business around the dot-com boom, or, even with the changing of the guard in the late 2000s, that sounds like it was more focused on the cost side of the equation, not on the top line.

So has this just been a very healthy, steadily growing market over history that has offered a lot of runway for them to capture? Is that a fair way to categorize it?

I think you’re right. It has been a healthy market, but I think it’s really important to give Compass credit for some of the moves they made to really capture more than their fair share.

One thing I really missed out of the history of Compass is what they did in the mid-1990s, which was to really launch in the US. Compass was predominantly a UK business up until then. They realized that the US was really exploding due to a wave of outsourcing that had been taking place since the 1980s, and they sent some executives over from the UK.

One of them was a guy called Gary Green, who went on to run Compass in North America and ended up doing so for 30 years. He just retired last year after 40 years at Compass.

They did a number of things that were really, really smart. Compass was not very well-known in the US at that point, obviously. They were starting from scratch, and so they went out and bought a business. They bought a business called Canteen, which offered food services and vending. This was in 1994. It was quite a big business, about $1 billion in revenue.

Perhaps on the back of that, they won a massive contract the following year with IBM, probably one of the biggest food service contracts awarded up until that point. I think what happened then is that gave them confidence and cash flow to go out and buy other businesses.

They bought many of the very best independent regional businesses in the industry. They bought Restaurant Associates. They bought Bon Appétit. They bought Morrison Healthcare. They bought Flik. This gave them some of the leading brands in the industry. It brought in a lot of talent because these were entrepreneurial businesses that had been very successful, and they retained many of the management teams.

What’s really interesting is they didn’t then just plaster those businesses with the Compass brand. They retained those brands, which were known to American purchasing managers, and then they did something really smart, which was to sectorize the business.

Restaurant Associates, let’s say, is very strong within B&I. Morrison is very strong within the healthcare industry. Let’s operate along those lines, because we recognize that what a hospital system wants from its contract is going to be very different from what a university campus wants, or what an office tower wants.

That sectorization approach has been incredibly successful. Interestingly, the competitors have not adopted it. Sodexo, for example, their next-biggest competitor, is a French company that has really gone out with the Sodexo brand. I've often wondered whether this is out of a Napoleonic desire to centralize, or because they thought it would be more efficient—which, in some ways, it has been—but it has also not been as effective in the marketplace.

This approach of sectorizing, keeping these well-known brands, and being quite aggressive about scaling up the business through acquisition was remarkably successful. From a standing start, they've built the U.S. business—or North American business, I should say—into a huge business. So, if I look at Compass's revenue today, about $42 billion, more than 2/3 of that is coming from North America. In fact, because it's a more profitable business because of its scale, more than 3/4 of Compass's profits come from North America.

It's really interesting, especially your point on the decision to keep independent brands operating within their sectors. I find this to be an interesting dynamic across the business universe, when companies decide to consolidate and have one enterprise brand that really operates across the system versus having independent brands with their sector specialties. I certainly wouldn't want to be getting the hospital food if I'm at the B&I.

There are certain dynamics that make a lot of sense, but it also offers some theoretical expertise, or gives the idea that there is expertise in terms of operating those systems relative to some of the competitors. It's an interesting one that stands out to me, and one of those themes that you see across the business universe. It's fun to hear about.

That's right. Sectorization is a really interesting approach, and it enables a number of benefits. One is the ability to use reference contracts in a pitch more effectively. If a potential client is, say, a hospital system, Compass can show them what they've accomplished in another hospital system of a similar size, maybe in the same state, and that's much more persuasive than showing something generic or from a different sector. Down to the site level, contracts are very bespoke, and Compass's brand and sectorization approach has really helped with that.

In fact, it has been so effective that Compass has taken things to the next level and subsectorized the business. Today, Compass operates along 27 subsectoral lines. I've got a fun story to illustrate that this really is how Compass functions.

During the pandemic, Compass, along with the rest of the sector, was under intense pressure due to the lockdowns. I had a hunch that if Compass were feeling the heat, then the self-op part of the market was going to be feeling it even more keenly, and that this might actually drive more outsourcing. To test the theory, I commissioned a survey asking various organizations whether or not they currently outsourced their catering and, if not, whether they planned to do so. If they did plan to outsource, who were they considering partnering with? Was it Compass, Aramark, Sodexo, or someone else?

When the results of the survey came back, they did indeed show that many organizations were contemplating subcontracting out their currently in-house operations, but Compass hardly came up as a choice. This was a bit of a head-scratcher. Then it hit me that, whilst we investors know who Compass is, the decision-makers at the client organizations don't necessarily know the name Compass. They deal at the subsector level, with brands like Bon Appétit, Crothall, Morrison, Chartwells, and so on. A revised questionnaire did bear this out. So, that was quite a nice proof point about sectorization.

On the point of market penetration, the adoption of food services—whether it's versus the alternative of providing in-house services or just not having any services at all—do you have any sense of where that stands today in terms of market penetration and how that might be measured?

If we focus first on the North American market, as I said, one of the things that drove Compass to really launch in North America was recognizing that the market was outsourcing, but that was really focused on B&I. You can imagine companies in the '80s and '90s saying, “Why are we doing this in-house? We should really outsource this. We'll save money, and it's really not core to our business.” That sort of wave of outsourcing has pretty much happened, and today almost 100% of the B&I marketplace is fully outsourced.

It has yet to happen within 2 very important markets, which are healthcare and education. In North America, probably about half the market is outsourced. That's what's continuing to drive Compass's quite high rate of new business wins. Increasingly, and particularly after the pandemic, those clients are saying, “We really need to outsource this.”

One of the things driving that decision is cost. Compass's scale in procurement is so big that they're always going to be able to deliver food more cheaply than an in-house operation. The other factor is just rising complexity. Consumers are getting more demanding. They want to know more about the food they're putting in their bodies. They have nutritional demands, whether it's around vegan or gluten-free food. They want to see labeling around allergens, and that's particularly important in the healthcare and education spaces.

It's quite hard to deliver on that. You need to have a very good eye on your supply chain, a lot of data, and a lot of technology. It's becoming more and more difficult for a single-site operator or even a small regional player to really compete. So, that's driving a second wave of outsourcing now in healthcare and education in North America.

What's really interesting, though, at the moment is that, for many, many years, continental Europe was quite reluctant to outsource. It did happen to quite an extent within B&I, but certainly not in the other sectors so much, and that is now changing. Compass recognized that, and they've been investing very heavily in Europe, in acquisitions in particular, replicating the successful strategy that they executed in the '90s and 2000s in the U.S.

What you're starting to see is really an acceleration in organic growth to levels that we've almost never seen in Europe. I think that's really a repeat of the strategy that's already played out in the U.S.

It's interesting when you talk about acquisitive DNA. To go from a period where that seemed to be a theme in the '90s—I'm sure there was some M&A over the years in between now and then—but to go back to that time period and have a precedent like that, it's a little bit further back in time than most companies would point to in terms of executing a strategy. It seems like a lot of the DNA is still in place.

I want to get into the M&A point a little bit more, but before we move on, in 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 are going to be contracts moving from one provider to the next, but is there some sense 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 the market is.

If I look at Compass specifically, we can tease out what the elements of growth are. There 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 maybe aren't 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 broadly in line with inflation. They're certainly not trying to use pricing as an important lever, because what they really want to do is try and reduce costs so that they don't have to do that. But they're able to pass on inflationary costs to the consumer. You've seen that particularly in the last few 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% 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 gross win rate of about 8%, which is, on that sales base, absolutely enormous, and they've been doing that to end up at a net of about 4%. Mid- 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 inform 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 a more efficient cost structure. 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?

The typical margin in the food service sector is around 6%. Aramark makes about 6%. Sodexo is a little bit under that, but that's partly because of the dilutive effect of its facilities management business. Compass outside North America also makes about a 6% margin. But in North America, they make more than an 8% margin.

What explains this 200-basis-point spread? There are several contributing factors. The key one is scale. We've got fixed managerial costs and technological infrastructure costs. 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-of-scale, shared-services-type model within the procurement side of the business.

And I think that partly also explains the margin differential, although it mainly explains the ability to grow the business, and that drives scale, which drives margin.

Just to delve into that, in the early 2000s, Compass acquired a small food procurement technology business called Foodbuy. That has formed the bedrock of Compass’s GPO, or group purchasing organization. The way this works is that most of the ingredients purchased by Compass’s chefs are bought through Foodbuy via approved vendors. As you can imagine, that by itself is a lot of volume. But in addition, Compass invited third parties—these could be cafés, restaurants, hotels, et cetera—to also procure through Foodbuy.

Today, Foodbuy does about $40 billion of volume, 60% of that coming from third parties. That enables Compass to secure better prices and better payment terms from its suppliers. As an aside, Compass charges third parties a very small fee for using Foodbuy, which I like to think is a slightly Costco-esque 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. The consumer enjoys a lower-price meal, and if they’re happy, then, all else equal, the client will be happy. Even the supplier is 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.

This model is very difficult for other players to compete with or replicate. Now Compass is ramping up Foodbuy in Europe, and this dovetails really nicely with the acquisition strategy that will bring scale in core markets like the UK, Germany, France, the Nordics, et cetera. 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.

It’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 it’s interesting to hear 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 Foodbuy 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? I never spend enough time to understand the real ins and outs of it, but it just weighs on me. How does that come into play, if at all, for Compass?

That’s a really great point. One of the things I think Compass is slightly advantaged on is the way its 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 its chefs at the site level will order from Foodbuy.

The inventory turns are quite high. Inventory represents less than 2% of sales. It’s not going to be sitting within the business for 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.

And 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, a difference with the restaurant industry—is that working capital is negative for Compass. So effectively, they’re able to pay suppliers later than they’re collecting from clients and consumers. 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 sends off the trigger in the brain, so 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, it 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. It’s nearly 600,000, which makes it one of the largest private-sector employers in the world outside of retail. Managing that labor force is challenging, but also, I think, one of the skill sets Compass 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 in what they call labor scheduling 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, and which days they’d like to work. So there’s a lot more flexibility for employees versus, let’s say, a restaurant. And then they can use the algorithm to match up where demand and 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 daypart is lunch, as it is for a typical cafeteria, I think that makes for much more sociable working hours.

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. So they have a slight edge, I think, in managing labor, which is their biggest cost by far, 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 hire 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 has the business performed both from a top-line perspective and then from margins and the operating leverage that sits in the system?

Compass 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 we 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. 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 hedge there because, in stressed macro environments, I think there’s an even bigger propensity for self-operated or in-house operations to actually look to outsource, because their own cost structure will become problematic with a drop in volume. Complexity is rising, so 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, we went from 5 days in the office to 0 days in the office to returning to the office, and we’re still seeing that be figured out by a lot of corporations. I think we see 5 days a week, we see some 4, we see some 3. There is definitely a return to office as the standard, but what that looks like is still up for debate, 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?

There’s no question that pandemic-era working practices were really rough for the contract catering industry. If the standard working week was 5 days in the office before the pandemic and that goes down to 4 days, that’s 20% off your revenue gone straight away. If it goes down to 2 or 3 days in the office, that’s brutal.

The pandemic taught us all that working from home is possible. And it could be that attendance levels in offices never quite return to pre-pandemic levels. But the good news is there has been this 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. And 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 end-all. Of that, 60% is in business. So that’s where the offices sit. The other 40%, the I in B&I, is things like industrial plants and manufacturing facilities, where the reality is working from home is not really possible. And in fact, that part of the business was not really impacted during the pandemic.

So 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, health care actually grew during the pandemic, and that’s the second most important sector.

Sports and leisure was very heavily impacted. It was hit hard because almost overnight, sports fixtures and concerts were just canceled. But the minute there was reopening, people were really eager to get back to those events, and that business recovered very quickly. Similarly, in higher education, it's pretty difficult to keep fee-paying students away from campus, so that business also recovered very quickly.

Another theme that I was curious about is the general corporate office. I'm doing exactly what you mentioned, just picturing Compass through the lens of the corporate cafeteria, but I'm sure it extends elsewhere into the rest of their business. Rather than having one single hub, businesses may move toward having several more spokes and splitting offices, with the WeWork model and some of the other sharing models coming into play.

Are those negatives? Do they have a material impact on the business? I'm 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.

The office model is always evolving, and I think it will continue to do so. I think Compass has also demonstrated an ability to evolve with it. Just one example of that is that during the pandemic, they started a delivery business from scratch, which actually became quite significant over time to serve certain clients whose employees were working from home.

You're right that the flexible office solutions model has grown meaningfully in the last few years. Generally speaking, those businesses tend to serve smaller-headcount firms, and the reality is that those kinds of businesses would not have been Compass clients anyway.

When you start to transition into seeing the earnings translate to free cash flow, thinking about the capital intensity of this business, what does that look like? Negative working capital is always a very interesting theme for a business. Is there significant capital intensity in this business? Where would that come from if it does exist? And is there anything else to consider in terms of the cash flow profile of Compass?

It is a very cash-generative business, and it's also a fairly asset-light business. Compass doesn't need to have a fleet of trucks to move food around; that's handled by the distributors. As I said before, they have negative working capital. But 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 it operates out of, that's a really big difference. One of the ways that this lends a competitive advantage to Compass is that while high-street players or main-street restaurants, sandwich chains, and so on are going to see their costs increase partly from increasing lease rates, Compass isn't seeing that because it's not paying any rent on its premises.

That'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. I think that is a building competitive advantage, and particularly at a time when consumers are struggling with their budgets, I think that's going to potentially drive 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 start-up investment necessarily. But in some ways, the success of Compass, to me, would point to the opportunity for some of those larger players to go out and look at an acquisitive growth strategy to roll up the market.

Another theme that people love is industries ripe for roll-up. Is that something that you have seen happening, or what has stopped competitors from 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 Sodexo would buy Aramark, which would create another 800-pound gorilla, albeit 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, but I think it would be challenging.

This is a really interesting aspect of Compass's strategy: They have been exiting whole countries. Pre-pandemic, they were in about 50 countries, and now they're down to 30. 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 in emerging markets that were going to grow. But it doesn't quite work because scale is only relevant at the local level. What you really want to do is be big in a particular country.

Some of the countries where Compass has exited, they've sold to some of their competitors. So 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 to get big in the UK and in Germany and so on, mirroring the exact approach they took in the US.

The limitation of the benefit of scale: Does that cap out at the country level? Is it more regional? 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 regional geography?

Food is very much a local business, done at the country level. Being very big in Germany is not going to help you in France in terms of buying food, so you really need to be big at the country level.

Compass 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 said goodbye to some markets that you would think might potentially one day be very big, but where they've actually struggled to scale up. They've concentrated on markets where they already have scale and where they're going to get much bigger. With that, I think comes long-term improvements in profitability.

It's interesting to pair that with the fact that you're actively managing the portfolio of brands and assets that you have, not just in buying but also in selling. On the buying and acquisitive front, I want to pair this with the valuation storyline because I'm sure that 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 accretive.

But is there a pretty attractive valuation arb that they can play when buying these businesses as well? And 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 arb to play, where the acquired cash flows are rerated 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.

In terms of the way we think about value and Compass, what we try to do is nail down the free cash flow so that we've got a good idea of what the free cash flow yield is. 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 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 a line of sight toward low-teens-type returns over the medium term from that free cash flow generation and how that gets allocated.

As you mentioned, potentially shrinking the portfolio or the geographical reach could be associated with returning capital to shareholders, whether it's buybacks or dividends. Is that something that they actively do? What's their methodology in terms of capital allocation?

Compass has a simple, clear, and consistent capital allocation framework. Priority 1 is to reinvest into the business, which, given the attractive returns, is something we're happy to see them do.

Capex to sales runs at about 3.5%. This 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. One of the reasons this is happening is that Compass has a lot of data across its supply chain, on consumers, and on labor, and it's investing to be able to collect that data, analyze it, and use it to the benefit of its customers.

The second use of cash, as we've discussed, is acquisitions. Naturally, the spending here is quite episodic, but generally speaking, they're buying medium-sized businesses. After that, they have an ordinary dividend payout of about 50% of earnings.

To come back to your question, as a very cash-generative business, they still have surplus cash beyond that. In the last few years, what they've been doing with that is repurchasing shares. If there's a slight blemish on an otherwise 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 higher price.

But assuming there are no more pandemic-like surprises, I think the visibility around capital allocation is pretty clear, and it's all being carried out within a nicely conservative leverage corridor of about 1 to 1.5 times net debt to EBITDA.

Is 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 assault currently. This is most prominently seen in the US in the federal government.

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. We've heard many large corporates, for example, talk about thinning the ranks of middle management. This would impact attendance rates within B&I cafeterias.

In higher education, the ratio of non-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 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. If I look at the UK, where healthcare is predominantly provided by the state and is free at the point of use, the quality of care is deteriorating, but the cost of providing it is rising. One way this is starting to be addressed is by reducing non-medical staff in the system, which ultimately will also cause attendance rates to drop.

Now, this sounds very pessimistic, but there is a silver lining here for Compass, which is that 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 Compass's net new business growth.

This has been a fascinating deep dive and primer on foodservice 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 may be 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. Whilst acquisitions have served Compass well, they've also been willing to do something else, which is to shrink to grow. That's been particularly true under the excellent leadership of Dominic Blakemore.

There are foodservice sectors where Compass 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. They judged that the risk was too high, the opportunity not so attractive, or the capital required to get to scale 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 that Compass is opting to play games they know they can win. 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. It's one of my favorite themes from the U.S. 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.