Compass Group finals

Provides contract food, catering and support services to a wide range of commercial businesses and government departments operating in over 50 countries.  I have a holding in my income portfolio (epic code: CPG).

Compass Group announced their full year numbers yesterday and underlying results were as indicated in their trading statement, commented on here, on 26 September 2013.

Briefly - revenue grew by 3.9% to £17,557m and 4.3% on an organic basis.  Underlying operating margins improved by 20 bps to a record 7.1% and underlying pre-tax profits grew by 9.2% to £1,188m.

Underlying EPS grew 12.5% to 47.7p and a final dividend of 16p was proposed - an increase of 13.5%, bringing the full year dividend to 24p up 12.7%.  

On the surface, this looks to be a good set of results, but there were some weak areas:

Although underlying EPS grew by 12.5%, reported EPS declined 26.6% to 23.4p, due mainly to a £377m goodwill impairment charge.  This is an increase on goodwill impairment, relating to the Granada merger in 2001, as a result of increases in the UK gilt yield that is part of the calculation in valuing expected cash flows from a business unit.  Put simply too high a price was paid by Compass in merging with Granada back then and, future profits and hence the net book value of the company are depleted. 

Europe & Japan continue to suffer and revenue fell by 3% on an organic basis to £6,039m, this had the effect of decreasing profits by £60m although this was offset by productivity improvements that produced a 60bps increase in operating margins.  Consequently operating profits from this division increased by £23m to £420m, this must be considered a good outcome in difficult markets.

The largest region North America continues to perform well and grew revenue on an organic basis by 8% to £8,150m, while improving operating margins by 10bps; all of which had the effect of increasing operating profits by £59m to £657m.

The Fast Growing & Emerging regions grew revenue organically by 10.2% to £3,368m, although operating margins fell by 30bps due to exiting some non-core contracts and implementing a new regional management structure, so operating profits increased by just £7m to £242m.

Financially Compass is in a strong position, net debt is just 0.8 of EBITDA and operating cash flow is  89% of net debt.  Free cash flow (FCF) was £681m for the year, similar to last year and gearing just 45%, with interest covered over 10 times.  Compass returned 19% on their average capital employed in the business a good margin over my estimate of their WACC of 8.3%.

Owners' earnings (dividends plus growth in NBV) have increased by a CAGR of 16% over the past 5 years and FCF has returned 19.5% over the same period. 

The increase in the dividend was by my reckoning the 12th successive year and has grown by a CAGR over that period of 12.7% pa.  This is an impressive record, more so since recent increases have not faltered, with the full year dividend for the period just ended having doubled over 5 years.  For those that are concerned with the 0.98 dividend cover from earnings for this year, dividends declared over the last three years have represented 63% of FCF (covered 1.6x), as FCF can move around from one year to the next, it is more meaningful to view it over an extended period such as three years.  This is both generous to shareholders, but comfortable for the company. 

At today's closing price of 922p Compass is fully valued at 17.9x this year's expected earnings and with a forward yield of 2.77% offers a below average income.  Some may argue that with these growth rates in the pay-out this may be a price worth paying, but there is little in the way of a margin for safety and remember it will take almost 5 years to catch up and replace the lost alternative dividend with say a 4% yielding stock with little or no growth.  Although having stated that, I currently have no intention of selling, but would not add to my position with any spare funds.

On a discounted cash flow basis I have calculated an intrinsic value of 925p per share for Compass.  This assumes that this year's FCF grows by 10% pa for the next 10 years, in perpetuity for 2.5% pa and I have used a cost of equity of 9.8% as the discount rate.

This note would not be complete without some comment on the new share repurchase plan announced of £500m, this follows on from two previous repurchase plans totalling £900m.  At a P/NBV of almost 6 this is value destroying for shareholders; companies should only repurchase their own shares when they are considered to be well below their intrinsic value.