Compass Group: A Long Way To Go

Summary

• Compass Group continues to show signs of recovery, but progress in most divisions is slow.
• Its work on profitability is paying off, which should help cashflow too.
• However the recent share price run-up values it at 19x the likely earnings when demand recovery is complete, which looks overpriced to me.
• I don't think it's massively mispriced, but I do see it as overpriced for now, so switch my rating on it to bearish.

U.K.-based foodservice operator Compass Group (OTCPK:CMPGY) shares have gone up handily in recent months. However, the company is exposed to demand recovery in its markets which are largely outside its control. My investment thesis is that the brand name, experience and management mean that this is a solid long-term choice at the right price, as I outlined previously in Compass: Starting To Right Itself, but that for a company with no dividend and earnings recovery likely some years off, the shares look a bit overvalued right now.

Trading Remains Challenged but Profit Margins are Recovering

A trading update last month provided insight into how the business recovery is faring. I would say that the picture is not pretty. While the healthcare and seniors division is basically flat, other divisions continue to be hard hit by falls in demand. The drop off has not been as severe for the past couple of quarters as it was prior to that, but it is still significant.

While volumes remain hard hit, one bright spot is that operating margins are positive once more in all regions. This reflects actions the company took last year, including contract renegotiation and business resizing. The company expressed its confidence in its ability to move the underlying margin above 7%, even without a return to pre-COVID volumes. That is encouraging news.

Source: company trading update

The outlook is portrayed in fairly rosy terms and indeed Compass has excellent form in building a large business through contract wins as well as M&A. But demand is driven here largely by factors outside the company’s control. While its work on costs and margins is a credit to its management, there is not much the company can do to bring revenue back to former levels in many of its contracted locations like canteens or school refectories.

The Valuation Looks Somewhat Rich

The shares are currently trading at around 1,578p. That is below where they started last year pre-pandemic, but not much below – only around 17% down.

At the end of last month, the number of shares trading was 1,783,896,940, compared to 1,588,067,082 at the start of last year, which represents a dilution of around 12%. That reflects last year’s capital raise, which helped to shore up the balance sheet in a way which I see as positive for the company.

Nonetheless, putting together the effect of the share dilution and the share price recovery, the price today for a slice of Compass is within a few percentage points of what it would have been for an equivalent sized slice at the start of last year, before the pandemic started to affect the company.

That suggests that the market feels that the business prospects are roughly similar to what they were at the start of last year. That seems unduly optimistic to me in terms of valuing the company. While I regard it as well-run, the revenue figures above show that there remains a lot of work to be done. For example, sports and leisure revenue is down around three quarters – and it is hard to foresee substantial recovery in that division until the second half of this year at the earliest. Both business and industry and education potentially face more existential challenges. I do expect sports fans will come back when they can – Off the Ball on Radio Scotland each weekend contains legions of fans desperate to get back to a game, for example. But I don’t see education or business demand coming back to pre-pandemic levels any time soon. Many white collar jobs will return to a form of mixed working between office and home, in my view, reducing total demand for at work dining perhaps permanently. Education could go a similar way – while I think institutions will be keen to get students physically back on campus to assert more ownership of their value proposition (why pay $50,000 for online tuition when it’s free on Coursera?) I also expect some forms of blended learning involving remote learning is here to stay, for a couple of years at least.

If that analysis is correct – and no-one knows, is the truth at this point – then it suggests that total demand for Compass’ services will likely be down for at least several years to come. While the company’s moves to restore profitability are very welcome, it’s hard to see that a potentially smaller business is worth the same as the pre-pandemic one. Longer-term, I share the company’s stated optimism for “significant structural market opportunity globally” and ”a return to organic revenue growth” but I expect the benefits of these to show themselves in earnest at around 2023-24 at the earliest.

The dividend remains suspended. A pre-tax profit of around £1.5bn would match what the company achieved in the three years prior to the pandemic. Let’s say it does get back to that, albeit not for another two to three years. That would suggest EPS of 84p. Today’s share price therefore implies a prospective p/e of around 19x for earnings in 2023 at the earliest, with a lot of things needing to go right betwixt now and then in terms of demand recovery to enable those earnings.

I don’t think that offers good value and in fact think the shares look mildly overpriced. Compass deserves a premium for its market position, branding and proven management, but a prospective p/e in the low to mid teens would seem more reasonable to me. At the current price, I am bearish on the short-to medium-term prospects for the shares.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.