UK Foodservice King a Cash Machine

06/10/2011 9:30 am EST

Focus: GLOBAL

Peter Shearlock

Editor, Growth Company Investor

After tightening up its balance sheet, Compass Group has begun to steadily increase its dividend...and is expanding its lucrative operations into emerging markets, writes Peter Shearlock of The IRS Report.

There is an old saying that "cash never lies.” And in fact, free cash flow (FCF) remains one of the best gauges of the true health of any business.

Profit can be massaged in a variety of ways. But the amount of cash a business generates out of operating profit, after funding the capital expenditure needed to keep it in business, is hard to fudge.

Where FCF is running at levels sufficient to pay down debt in a year or two, as long as directors don’t make any acquisitions or buy back shares, there is a good case for putting the stock on one's watch list.

Right now, there is no better example of that than Compass Group (London: CPG). The catering and support-services business is generating cash at an annualized rate of over £700 million ($1.15 billion), which compares with borrowings of £671 million.

Compass is the world's largest foodservice business, with revenues of around £16 billion ($26.2 billion).

What is particularly exciting is the rate at which the dividend is being lifted—and the possibility of a one-time special payment to shareholders.

Last year, Compass lifted its dividend by a third, taking it to a new base level of 17.5 pence (28.6 cents) a share. This was described as "a reward to shareholders.”

Last month, it followed this by raising the interim payment by a further 30%. Given the expected ratio between the interim and final dividend payments, that suggests a 20p total dividend for the year.

That still only puts the shares at a yield of 3.4%, but a steadily rising dividend is one of the keys to investment success.

A Special Dividend in the Cards
Effectively, Compass is generating more cash than it needs. A special payout to shareholders would be one way of dealing with this issue—and would doubtless go down well in the market.

Compass has been transformed since Richard Cousins came in almost exactly five years ago. Compass had been an underachiever in the five years before he arrived, winning plenty of new business but failing to convert it into profit. Cousins, who worships at the altar of efficiency, quickly tidied up the balance sheet.

Then he introduced his MAP (management and performance) system. A key element of that is to take cost out of the business and drive up margins.

He has been very successful. Since 2006, margins have been pushed up from 4.4% to 7.2%. Earnings per share, which had been static for so long, have nearly doubled.

The business now does a lot more than catering. "Soft support" services—housekeeping management, vending services, even the management of a museum—are an increasing element of the total.

And there is no sign of the momentum slowing. Operating profit was up nearly 12% through the end of March—this despite the negative impact of the Japanese tsunami. The pipeline of new business is also said to be strong.

Progress in the second half may be more muted, as Compass enjoyed a particularly strong second half last year, and the aftermath of the Japanese disaster will cost a bit of revenue. Nonetheless, broker Evolution Securities is still forecasting a rise in profit before tax from £922 million ($1.51 billion) to £1.01 billion ($1.65 billion), with £1.1 billion ($1.8 billion) to follow in 2012.

Earnings per share should rise from 35.5p to 38.5p, with 41p possible for 2012. [London shares closed at 598.50p on Thursday—Editor.]

Compass has earmarked around £300 million ($491 million) for acquisitions this year. Much of the spending will be aimed at expanding the company’s presence in emerging markets.

At present, North America and Europe dominate revenues, with 44% and 24% of the total, respectively. Cousins reckons emerging markets have the potential to generate double-digit growth rates.

Big Challenges...And Even Bigger Opportunities
There are two big challenges for Compass. One comes from mounting food-price inflation—though the firm has shown itself adept at reworking menus and using techniques such as regional buying.

The other is government cutbacks, which might be expected to squeeze a supplier such as Compass. In practice, those same cuts are prompting more organizations to outsource their catering, in search of cost savings.

With a commitment to dividend growth and a trim balance sheet, Compass has much to commend it to value-conscious investors.

Subscribe to The IRS Report here...

Related Articles on GLOBAL