Compass Group PLC (CPG) Earnings Call Transcript & Summary

Welcome to Compass Group's Third Quarter Trading Update Call. Hosting today's call will be Dominic Blakemore, group Chief Executive Officer. My name is Suzanne, and I will be your coordinator for today's event. Please note, this call is being recorded. [Operator Instructions] I will now hand over to your host, Dominic Blakemore, to begin today's conference. Thank you.

Thank you, and good morning, everyone. As usual, I'm here with Palmer, our CFO. We're delighted with our third quarter performance. Growth further accelerated in the quarter to 43% from 38% in the first half. This was due to positive contributions from all drivers of growth. Most critically, net new business accelerated to 9% or 7% on a like basis with 2019 compared to a historical 3%. Pricing stepped up and volumes continued to recover strongly. Pleasingly, all sectors and regions are now above 2019 levels, including B&I, which was 97% in the quarter and above 100% on a run rate basis. As we expected, new business and a change in mix in B&I is now offsetting any hybrid office risk. In addition, we continue to see a very strong new business pipeline, and it's clear that the complex market conditions and high levels of inflation are contributing to this. Margins improved by 40 basis points in the quarter to 6.2%, and we're confirming our full year guidance of margin above 6%. We now expect Q4 margin to moderate slightly to around 6.7% to 6.8% as we mobilize double-digit new business. Taking advantage of the growth opportunities, they're #1 priority. And whilst investment in mobilization costs make slower margin recovery in the short-term, it's driving more profits to the bottom line and is better for the long-term health of the business. Let's move now to Q&A.

First question comes from the line of Jamie Rollo from Morgan Stanley.

Three questions really on margins, please. First of all, just in terms of that moderating margin momentum, perhaps Dominic or Palmer, if you could break it down between the impact of sort of mobile edition costs on the net new wins versus the underlying sort of cost inflation. Secondly, if you could quantify that cost inflation, please, in the main buckets and talk perhaps specifically about the supply chain on the food side and what it means for GPO purchasing. And then finally, I think you said 6.7% to 6.8% in Q4. What's the implication for fiscal '23 margins then? And when do you think you might get back to 2019 margins?

Jamie, let me just take margin in overview and then maybe hand over to Palmer for some detailed color on your 3 points. I think, first of all, if we take a step back, we just want to remember the journey we've been on from 4.5% in 2021 to now over 6% in 2022. So we've made significant progress in the recovery and will again make significant progress in 2023 on a full year basis. We see no structural impediment to restoring 2019 margin either from COVID or inflation. But in the short term, the recovery may slow from the impact of the exceptional growth that we're seeing and reporting today and also if inflation is sustained at these higher levels for longer. Again, important to remember both market conditions and inflation are creating the great growth opportunities that we talked about and will bias to growth in the short term. Palmer, on the detail on 3 points.

Sure. In terms of impacts on the margin between the new business and inflation, it's some and some. When you look at it, certainly, the inflation is helping to contribute to the new business just as Dominic mentioned. But inflation at these high levels does have a drag, which we need time to offset between mitigation and pricing. So there is a drag effect to that, and as you know, the drag effect in new business, both from mobilization which is expensed when incurred, as well as lower margins that progress over the life cycle of a contract. So as growth is increasing, you will have this bit of margin drag this there. In terms of the rates, labor inflation has remained fairly consistent at 6% to 7% between Q2 and Q3. Food inflation has accelerated. It's now about 10% overall. That's really blended across the entirety of our portfolio, some pockets, the U.S., the U.K., Europe would be a bit more, LatAm would be in there as well, a bit more than perhaps APAC and some others. As it impacts on our business, and specifically, Jamie, you referenced the GPO aspect of it, similar to our new business wins within core Compass, it actually helps us on the third-party business side of things as well. So certainly, the same challenges that are prevalent for our clients -- potential clients where self-operated are the same for other potential clients on the GPO side. However, I'll say that there's still supply chain disruption that is happening. So within the U.S., for instance, substitution rates are still in the 7% to 8% range. That's never been more than 2% historically. That is impacting really the value proposition that we're able to immediately deliver right now, not only to our sales, but the third parties. It's helping us to get products, certainly our size and our scale and our growth, but we're not fully optimized at the moment. And then looking into '23, Dominic referenced it a second ago. The reality is with growth rates this high and inflation this high, it's going to be difficult to progress the margin much from where we're exiting the year. That's not to say that it won't progress over time. And certainly, of either of those 2 moderates a bit, you should expect to see more margin progression from us. But the reality is that it will be slow as long as those 2 elements are as high as they are. And again, they have a direct correlation with each other. We think the best indicator of the health of the business is profit. And that's what you're seeing some nice strength all across the board.

Just to push you a little bit, if we try and maybe quantify the mobilization versus the cost inflation or at least sort of compare the 2 in terms of quantum, is it -- I'm guessing it's much more of the inflation side of it than the mobilization side of it. But if you can help a little bit more on that, please.

Yes, it's not something we want to not necessarily get into quantifying specifically. And in all fairness, is quite difficult to do because of in a relationship between the 2. But it's certainly some and some. Inflation at these levels is certainly weighing a bit.

[Operator Instructions] The next question comes from the line of Harry Martin from Bernstein.

I'll ask 3 questions as well if that's okay. The first one really is what was the main driver of the improvement in new business wins getting that so much better than the guidance that you gave at Q2, where the real surprise is for you? The second one is really on the momentum and price inflation and how that's contributing to the revenue uplift. Where are we today compared to the 5% in H1? Do you expect that to be in Q4? And then can we sort of extrapolate that at least into H1 next year regardless of what the macro does? And then the final question, on my math, I think if you give credit for around sort of 5.5% net new as a percentage of 2019, add in 6% pricing, you can reach the 35% organic growth guidance with volume versus 2019 still down sort of 15% which is kind of what you suggested you were running out at H1. Is that the way that you're thinking about internally still a lot of volume recovery potentially to come back next year or where about do you think we are on that volume recovery?

Thanks, Harry. Let me take the first question and ask Palmer to take the question on price and the quarter 4 run rate. I think in terms of the new business wins, I mean, look, we saw record levels of new business wins that we reported at the full year last year and at the half year. We've perhaps seen those mobilize more quickly and with higher initial volumes than we anticipated, which I think is a theme, also the volume recovery in Palmer will come on to talk to where we are today with volumes versus '19 compared to the half year. So I think that higher volume contribution from the initial mobilization phase has been positive. The new business wins are across the piece. They're across all sectors. They're also strong in B&I, which has helped us with the recovery in volume of B&I and they're strong across the regions as well. So it's a very positive outlook. And yes, I mean, we're now running a couple of points stronger than we were at the half.

Just a bit more within that. If you're getting into the net new aspect of it, Harry, the retention piece is a big driver as well. So it's not only in the new business side, but the retention, which in fairness is probably a bigger contributor if you're looking at it on a net new. That has been improving pretty much across the board. We've seen a step change of that over the last 12 to 18 months within Europe, which we're excited about. And we think there's further opportunity both on the new business and on the retention side. In terms of pricing, we're a little bit above the 5% pricing level that we discussed at the half year. Frankly, it needs to be at that level and then some dealing with inflation at the rates we are. Keep in mind, too, though, it's not just a pricing strategy, if you will. We've got to mitigate. It actually starts with mitigation. And if we're not mitigating for our clients, even on the cost plus contracts, if we're not mitigating with -- for our clients, we're not doing our job, and they're going to ask us where is the value proposition. So it's a combination between the 2. And then in fairness, with inflation at these levels, it's a bit of operational leverage that's being used as well. So they're all contributing to how we're dealing with inflation at the moment. When you look at the revenue guidance going forward, first of all, in Q3, we're about at 109% of 2019 revenues overall. And as you heard from Dominic, at the beginning, we're now above 100% in all regions and on a run rate basis in all sectors. So B&I was 97% in the quarter and now above 100% as you look ahead. When you do the math, just like you've done, Harry, to get to the 35% on the dot, it actually equates to 109% of 2019 revenue as well, which what we have in the quarter is a step change both in B&I, which we think can be recurring, but certainly in the Sports & Leisure and we've got the benefit of some scheduling some timing aspects which are one-offs that will not be repeated in the quarter. So we've got -- that element is there. It's hard to say what the recovery will be. We saw a big acceleration of that base volume recovery occur in Q3. At the half year, we were right. We thought -- you were right, we thought we had about 15% of base volumes yet to recover. We think that number is somewhere around 8% now. So a nice pickup there in Q3, which really accelerated and brought forward some of that recovery, we expect it to occur into '23, is actually happening a bit earlier than expected. So that's the way we sort of see the revenue taking place for the rest of the year.

And then just to clarify on that, would you expect Q4 to be a little bit better than 109% or quite similar?

That's what we're showing right now is our forecast and our guidance. I think the wildcard is just as you mentioned, on the base volume recovery to see what that does.

The next question comes from the line of Vicki Stern from Barclays.

Just firstly, on the signings and retention piece, I think at the first half stage, you were running at an exit rate based on signings and retention then of around 6%. Now the retention just got a ton better. And you mentioned, Dominic, that the pipeline looks very good. So just really your views now on the sustainability of that higher run rate on both signings and on retention as we sort of try to frame the right view on the future net new business growth for the company. Secondly, just on competition, what are you seeing around you? And I'm particularly interested in the smaller operators. Any incremental signs of share gains, disruption amongst those operated? And would that sort of trigger any potential desire to do more M&A? I think last time you spoke, you were a little bit more cautious on sort of overloading the teams with a lot more M&A in coming months. And then just finally on CapEx, are you seeing the same sort of trend there on the CapEx side that even though you're seeing this faster net new, you're not actually seeing that come along with a higher than 3.5% CapEx to sales ratio?

Again, I'll take the first question, pass the next 2 over to Palmer on competition and CapEx. Really, just on our outlook on net new. If you recall, we kind of said, as a consequence of COVID, now as a consequence of inflation, we are seeing a significant first-time outsourcing opportunity. The share of first-time outsourcing in the pie of new signings is increasing significantly. We're very, very focused on how we sustain that. We also obviously talked to some of the more technical challenges now, which is accelerating first-time outsourcing. They persist and increase around data, allergens and so forth. So we do feel that the marketplace is exciting. It does feel that these levels of inflation, smaller players have less levers to pull than we do. And therefore, it's also creating opportunity for share. So it is an attractive marketplace. I think we have to remind ourselves that the levels of net new we're reporting now close to 7% are twice as big and some than our historical run rates. So it's a very, very significant acceleration that we're seeing. Again, when we came into this, we thought if we could improve the structural net new growth rate of the business by 1 to 2 points from that 3 to 4 to 5, then all things being equal and normalized pricing, that could look like a 6% to 8% growth rate. I think right now, clearly, we're outperforming that. Our ambition and our strategy is to do everything we can to sustain it. But the acceleration we talked about of 1 to 2 points on a sustainable basis would be a very attractive step change for our business model. And of course, that's being achieved with record retention. That's also been judicious use of CapEx, and I think very, very good relationships through COVID and beyond. We need to ensure that we are sustaining that as well because that's the first lever to pull in an improved net new performance. So I mean, look, we're absolutely delighted with where we are. We should never underestimate the scale of our performance against relative history. I think a little bit of that was starting before COVID. A lot of it is also down to self-help in terms of the quality and discipline around sales and retention processes and execution, particularly outside North America. So we're optimistic about what we can achieve, but we would also be cautious about sustaining at these levels for the medium-term.

On the competition front, as it's leading into new business wins and then potential M&A, Dominic mentioned it there a second ago. We're seeing a slight uptick in the share gains from competition. In fairness is -- it's not near the uptick that we're seeing from first-time outsourcing. That's been the biggest driver within the new business side of things. We're seeing a slight uptick from the share gains and the smaller players. That's not to say that it's not impacting the smaller players. The way we look at things is challenges and complexities in the market, we think, ultimately play to our favor. And as we discuss internally, if the operating environment is challenging for us, it's going to be every bit as challenging and then some for others and frankly, brutal for the self-ops. So everyone is feeling it. They'll probably feel it perhaps a bit more as we look ahead. But it's playing out to some degree in the share gains and probably more so within their current operations. On the M&A side of things, you're right, Vicki, it's something that we want to do. We've always been disciplined, but we think we need to be especially disciplined in this environment. Our operators have full loads on their plate now. We don't want to distract them. It needs to be a fairly compelling proposition for us to take M&A. That said, we did do some small infills in the quarter. We did about $65 million or so of new deals in the quarter. Most of those were within the U.S., but we're looking at M&A opportunities in every region right now. It does need proposition. We would need to look at what the business looks like, their sector split, their contract structures, really what brings us, how does it help us grow going forward. We think of M&A as certainly core to our overall strategy, but we do need to be disciplined, especially in this environment. And then, Vicki, your last question on CapEx. We're still seeing the same algorithm of the 3.5% of revenues right now. That's not to say that we wouldn't potentially invest more to continue these high levels of growth. But that's not what we're experiencing at the moment. We're still seeing a continuation of our same algorithm and expect that to be somewhere around the 3.5% for the year.

And sorry, just 1 follow-up back on the retention. So I think your retention rate, the exit rate is sort of well above 96%. I think Compass Group used to talk about 96% as a sort of sensible ceiling for where retention could get to. But yes, so how sustainable is retention at these high levels from here?

Yes. I mean we've -- look, in North America, we've sustained retention above 96% for some time and continue to improve. This business is all about marginal gains. I think as we start to get to new thresholds, we'll set ourselves new targets. The biggest single shift in retention right now is our European and U.K. businesses. So if we can sustain retention at those levels, then there's every reason why we can expect to sustain retention at these higher levels and continue to push on from there. We'll be all about the marginal gains as we go forward from here.

Next question comes from the line of Jaafar Mestari from BNP Paribas.

I've got a couple, if that's okay. Firstly, on medium-term guidance, you've updated for your '22 guidance, started giving some direction on for your '23. So you obviously have working functions for higher inflation...

Jaafar, sorry to interrupt you. We're struggling a little bit to hear you clearly.

I'm sorry, if that's better, I'll continue; otherwise I will just..... Is that better?

If you try again.

Sorry, sorry. Yes, I was just wondering whether you could update your more medium-term indications to take into account what is now known in terms of higher inflation and better new business. You were talking about full year '24 revenue that could be 120% or 125% of '19. That was a while ago with more inflation, more new business if you run an updated scenario there. And then separately on U.S. education, specifically, you made some comments on generic competition and retention trends, that's the market that feels interesting. I think we're nearing the end of the renewal season there. So just curious how it played out for you. Are you coming out with good begins of your own university contracts? Have you been able to win some from competitors and on the more long-term university first-time outsourcing has seen some of the big prices to come from helping this year?

Thank you, Jaafar. Thank you. I think we've followed those questions. If I take the sort of the medium-term guidance, I'll turn to Palmer so he can talk to U.S. health care. Just on the medium-term, I think the first thing to say is it's clearly very, very difficult for us to look into current circumstances and form a view as to what medium-term growth trends could look like. I mean, clearly, pricing in particular, will play into that very significantly as well the net new performance. And as we look at '23, what we do know is that there is a momentum that we've got in the second half of '22 which will run into '23. So we still expect to see very healthy levels of growth next year as we have the annualization of the volume recovery, the strong pricing and the strong net new trends that we are experiencing today. What does that mean broadly? I think we could be at a full year '24 ambition in full year '23. As we look beyond that, I think we need to understand what the inflation and pricing environment looks like. But as I said earlier, the sort of structural base case for us would be a 1 to 2-point improvement in net new and then continuing to be successful with pricing if inflation moderates, I'm sure it will be above the historical levels that we experienced for quite some time yet for a while. So in aggregate, that would suggest when volumes are stabilized, I think medium-term growth rates that are ahead of what we enjoyed pre-COVID.

In terms of U.S. education, it's certainly a business that we continue to be excited about. We think it's done quite well, certainly over the last year when you look at the base recovery of the new business wins, the strong retention. That's continuing. You're right that the selling season. The traditional selling season, sort of coming to an end. Although we'll say that we're seeing a bit more expansion of the selling season because of the various pressures that are there. So it's still very much pronounced within the spring, but that's expanded out to be on that just a bit. We're seeing gains on both the first-time outsourcing and share gains as well. And really, when you break it down the K-12, the public higher ed, the private higher ed, the independent schools and the support services aspects of it, they're all performing nicely. They're doing a bit differently than some of them have different contract structures. You look at the higher ed piece and the support services tends to have more fixed price components within that K-12 would be an element of that as well. Within the education business, retail and catering is still depressed a bit from historical levels. So we think we're still about 25% down on the volumes, the base volumes versus historical levels. But you're right, all of those pressures that we're dealing with there, everyone else is facing and the self ops are as well. So it's certainly helping to drive sources of revenue. We're excited about that as we look forward. There's still a massive structural growth opportunity in that environment. And with the macroeconomic pressures that everyone is increasingly keeping an eye on. Education performs very well in downturns. It actually tends to grow a bit during downturn. So it has an insulation effect there as well.

Next question comes from Leo Carrington from Citi.

A couple of follow-ups on net new business, please. Firstly, in terms of helping our modeling really of the ramp-up of net new business, the net new business KPI, am I correct in saying that mechanism behind your disclosure here means that it would be fair to assume that the current levels of net new business, in absolute times, say, continues for at least the next 3 quarters as the current contracts go through that first year? And then secondly, in terms of the volumes that you're seeing on mobilization, are your new contracts tending to be near 100% of the expected total volumes or should we allow for a little extra tailwind in the second year as footfall and volumes recover to what might be a normal level?

With respect to the net new as we look ahead, that 6.9%, 7% in the quarter certainly it's higher than we actually expected. Look, we knew the forward-looking indicators were strong. And we looked at the new business wins and the forward-looking retention. We knew those numbers were strong coming in. But to actually see the growth that strong within the quarter surprised us a bit. I think it speaks to the strength of the opening and the ramp-up that's occurred there. As we look ahead, we expect to still see that number be strong. We think the 6.9% is pretty exceptional and probably should be treated as exceptional. When you look at it, the 5.2% is a year-to-date figure, and that's probably something that's closer to what we would expect going forward. Also keep in mind the lapping effect, the comps that come into play as we go forward. We had a big step-up in Q4 last year. 77% of 2019 revenues in Q3 of last year, up to 88% in Q4. So certainly, all those factor in and contribute. And then in terms of the ramping up of the volume on new business, you're right, there's a gradual ramp-up. We've been the beneficiary of that over the course of this year, certainly when you had mobilizations occur last year, but not fully optimized. That's getting back to at least closer to what we expected. There will be a bit more to come. You're right, it usually doesn't fully optimize into the second year. And especially if you have the larger deals. So think of a large health care system, a large senior living system, something like that, where there's a ramp-up that occurs over 3, 6, potentially more months, obviously, you'll get a rolling effect of that.

[Operator Instructions] The next question comes from the line of Neil Tyler from Redburn.

A couple left, please. Sticking with the topic of margins, actually. You've been clear that the inflation effect this year at least isn't just a mechanical percentage, but obviously, there will be a sort of a profit drag. Would you anticipate being able to recover that absolute profit delta over the course of FY '23, assuming, of course, the cost inflation itself normalizes? And then longer term, the sort of 6% growth algorithm that you framed, does that still allow that level of net new that's incorporated within that? Does that still allow operating leverage to deliver perhaps 10, 20, 30 basis points of margin improvement? Or at 6%, do you effectively sort of run at sort of static margins as those components combine? And then more specifically, going to the topic of new wins and in B&I., I'm just quite interested if you wouldn't mind describing a little bit the unit margin comparison of the new business wins there? Because it strikes me that there's probably a difference in the cost structure in quite a lot of the new business that you're winning as you expand that market yourself.

Neil, I'll just take the sort of growth versus margin point and then ask Palmer to deal with the sort of profit drag and the unit margin on new business. On that first point, look, I think when we were in pre-COVID, old world, old money, we had a growth range of 4% to 6%. And we always said at the high end of that, we'd expect less or little margin progression as we enjoy that higher level of growth. I think it's quite difficult right now for us to be precise. There are a lot of moving parts in the margin equation. We've obviously got the operational leverage recovery as volumes come back. We've got the impact of cost inflation, the timing of pricing and when pricing recovers the lag. And then we've got these exceptional levels of net new growth. All of those are going on simultaneously. In that context, we've made significant progress year-over-year and expect to make significant progress again. The path back to pre-COVID margin will take a wee while, but we expect all of those levers to be positive. But if we would continue to grow, let's say, we talk about net new business at 5%, and that means the pricing being the same as pre-COVID, we're growing at 8%, we would expect that to put some pressure on the margin journey until that growth moderates. So I think there's a lot going on right now. I think the right thing to take away is we're very excited about the growth potential of the business. We think we can now grow at above historic levels and pricing would also contribute to that. And we do believe that we'll recover pre-COVID margin. I think those are the 2 takeaways. The balance of how those play out over time, we'll have to go on that journey with you as we plan to forecast within the business.

In terms of margins and the inflationary pressures being a profit drag, we actually would probably look at it a little differently. If you look at margins from the headwind perspective, I certainly see what you're saying. But we see it has a drag on the margins, but it's contributing to the top line growth, which ultimately, we think, has a net benefit to profit. So we think the best way to judge performance in these kind of environments when inflation can be a tailwind and a headwind is actually the improvement in the growth on profit. So that's the way we look at it. In terms of the recovery aspect, which is, I think, the essence of what you're asking there. Dominic referenced it. We fully anticipate continued progression on the margin. We're not going to put a timetable on it. We're going to go for the growth opportunity this there, but we'll get the operational leverage as it comes through all things being equal. In terms of the B&I new business, -- from a -- just from a margin contribution, a unit margin contribution, we don't expect there to be a significant change out of the gate. We're seeing a bit more free food offers, a bit more commissary delivered in, a bit more micro market and pantry type of offers there. Some of those are scale gains. So if you think of the central kitchens to the extent we can utilize our current infrastructure, whether they're units out of other units or centralized kitchens and utilize more scale, we should get a bit more margin drop through over time. But we're not necessarily seeing any real margin impacts within B&I right now. And frankly, we expect to see pretty consistent and healthy margins in B&I as we go forward.

The next question comes from the line of Estelle Weingrod from JPMorgan.

Just 1 question from my side. Just coming back to your organic growth momentum into next year. I understand there are a lot of moving parts, of course, in the current environment. But is there a scenario whereby we can be in mid-teens growth territory?

I think we need to -- we'll come back to you at the end of the year. Right now, as you've seen, the growth in quarter 4 is going to be in the 20%-plus range. we're going to enter next year with that momentum. We've got very strong net new. The pricing momentum will continue. So look, I think the prospects for growth in the first half are very strong. The second half is a little more unclear. We'll need to see how we continue to trend on net new, though, as you've heard us say today, we feel positive about both retention and the gross pipeline of new business opportunities. I think we also need to see where pricing shakes out and where inflation shakes out as we start to lap the annual impacts, although again, we do expect it to continue to trend high -- so I think all the ingredients are there for positive growth next year. I think putting a range on it right now is tough. But we exit this year with very strong momentum.

This now concludes our question-and-answer session. I will now hand back to Dominic Blakemore for final remarks.

Just to say thank you all for joining us today. We'd like to wish you a restful and enjoyable summer holidays, and look forward to speaking to you later in the year. Thank you again.