ISS A/S (QJQ.F) Earnings Call Transcript & Summary

Welcome to the ISS Trading Update for Q3 2022. [Operator Instructions]. This call is being recorded. Today, I'm pleased to present Jacob Aarup-Andersen, Group CEO; and Kasper Fangel, Group CFO. Speakers, please begin.

Good morning, ladies and gentlemen, and welcome to this call covering ISS Q3 2022 Trading Update. My name is Jacob Johansen. I'm Head of Investor Relations, and I'm here at our global headquarters in Søborg, Copenhagen. In the room with me for this call is our group CEO, Jacob Aarup-Andersen; Group CFO, Kasper Fangel, and Christian from the IR team. Before we begin the presentation, I will ask all of you to pay close attention to the disclaimer on Slide 24. With this, I will hand over the word to Jacob and Slide #3, please.

Thank you very much, Jacob, and good morning, everyone. So let's start here on Slide 3 for some opening remarks. Today marks an important point in our OneISS journey as we have formally reached our financial turnaround targets that we laid out in December 2020. Reflecting on the 2 years that are passed, I'm proud of how the organization has developed but also grown stronger during challenging times. ISS was in a deep crisis in 2020, and it's the passionate work of more than 360,000 place makers that has taken us to a very different situation today. The financial health has strengthened significantly, and we've enhanced the operating model for long-term performance. As such, we are now ready to look beyond 2022. Therefore, we are excited to present the next stage of the OneISS strategy at our 2022 Capital Markets Day on this coming Monday at Canary Wharf in London. We will leave all comments about the future to that day. Today, we'll focus on current performance. In Q3, the growth momentum continued to be very solid. The work with our customers is supporting strong portfolio growth and is also impacted by historically high customer retention level. Our operating margin is also developing in line with plan, and we're updating our financial outlook today more on that later. So please turn to Slide #5. Throughout the quarter, we focused on the execution of our strategic priorities in a volatile and unpredictable macro environment. Our operating model is the foundation for managing the main challenges that we face today. That's inflationary cost pressure, it's tight labor markets, and it's our customers focused on attracting employees back to the office. These challenges are putting our model to the test and so far with encouraging results. Our investments in the commercial model continues and is yielding results. We win the right contracts and are expanding the business with our current customers. As announced on October 28, we've also acquired a business in Switzerland, Livit FM. The acquisition plays right into the OneISS strategy and the strength of our delivery model. Livit will add around 0.5% to our revenue and the asset is financially attractive. It's a low-risk, highly synergistic, bolt-on acquisition in a country where we have an experienced ISS management team and a strong operational track record. We'll provide more details on that on Monday. Then let's go to Slide #7. The commercial momentum in Q3 remained solid. And in October, we were awarded a new key account contract with a U.S.-based pharmaceutical customer. Since our Q2 announcement, we've extended 6 major key account contracts. We now only have one remaining contract that's expiring in 2022. This contract represents less than 1% of group revenue. The pipeline of new business is still attractive within our prioritized segments. Our commercial processes are developing positively, but they are longer and more complex than before the pandemic. Many new factors are included in the decision process, such as ESG, technology, workplace design and much more. At the same time, we are laser-focused on keeping the strong discipline in the pricing and risk reviews, and we do not accept any uncapped inflation risk. Please turn to Slide 8. So it's probably not a surprise that management of the inflationary cost pressure is a top priority in all of our markets. Managing inflation has been a core part of our business model for more than 100 years. And in 2022, we further sharpened and improved our processes. The majority of our cost base is staff costs, which are mainly adjusted through collective agreements. That creates predictability, and it enables thorough planning and execution. But managing the operating margin on the heavy inflationary environment is, of course, challenging full stock. We've been successful so far, supporting growth at unaffected margins, but not without tough negotiations with suppliers and challenging ongoing conversations with our customers. High inflation will not disappear anytime soon. We will continue to rigorously manage potential negative implications, but we will also exploit the opportunities that it creates. Higher outsourcing rates will lead to new business potential and ongoing discussions with current customers enable reshaping and adjustment of scope for improved long-term performance. Please go to Slide #9. The recovery of revenue compared to pre-COVID-19 levels continued in Q3. Our revenue, excluding FX and M&A, is now 1% above the level from Q3 2019. This represents a sequential underlying improvement compared to Q2 as revenue from the Deutsche Telekom contract is now included in the comparison base. The positive trend in food continued and is now at Index 90.That is despite customers not being back to the offices to the same degree, but both technical services and cleaning services are already above pre-COVID-19 levels. Similar to the reporting on our underperforming areas, we are also expecting that this quarter will be the last quarter with COVID-19 reporting. Today, growth is mainly driven by new business rather than recovery of lost business. As such, this reporting is getting less meaningful going forward. That concludes the first part of my presentation, and I hand over the word to Kasper and the numbers. And let's get to Slide 11, please.

Thank you, Jacob, and good morning from me as well. In Q3, the strong growth momentum continued and organic growth was 8.1%. This was driven by price and scope increases as customers are investing in the workplace post COVID-19. Return to office trends are still contributing positively, but with a lower effect as the reopening after COVID-19 started to have effect in Q3 2021. This led to an organic growth in the portfolio business up 10%. The Projects and above base revenue was flat in the quarter and stronger than expected. Non-portfolio revenue accounted for 17% of group revenue and remained above the pre-pandemic level. Please turn to Slide 12 for a look at the regional development. All regions continued to deliver solid organic growth in Q3, and it's pleasing to see how all regions are contributing to our growth. The strongest growth was achieved in the Americas region, where food and new contract wins generated strong growth. In both Southern and Central Europe and Asia and Pacific, organic growth accelerated compared to Q2. In Southern and Central Europe, Turkey was the main driver of the positive development due to both price increases and underlying volume growth. All countries in the Asia Pacific region delivered solid positive organic growth, driven by increased activity level, especially as COVID-19 restrictions reduced compared to H1. The organic growth in Northern Europe was lower than in Q2, driven by the Danish Defense contract that was exited in May and low growth in the U.K. as expected. As Jacob mentioned, today marks an important point in our OneISS journey. We have achieved our financial turnaround target of a run rate margin above 4%. Therefore, this will also be the last time that we will show this slide. The continued improvement of the underperforming countries and contracts had a positive effect, and the 4 hotspots have in total reached the financial turnaround target. The U.K. reached the target already in Q1. France will end the year behind target and Deutsche Telekom is on track to deliver breakeven at the end of this year. In summary, this has been a long and tough journey as part of our financial turnaround, but we are satisfied with our progress and we're looking forward to present the future performance drivers at our Capital Markets Day. Please turn to the next slide for the 2022 outlook. Based on the performance in the first 9 months, we are, today, updating the 2022 outlook for all financial KPIs. Organic growth is now expected to be around 6.5% compared to above 5% previously. This is driven by continued solid return to office trends and workplace investments. It implies organic growth of 4% to 5% in Q4, and I will come back to that shortly. Operating margin is now expected to be around 3.8%. The positive margin effect from higher revenue is expected to be roughly offset by negative margin factors such as additional hiring and mobilization costs. The margin improvement in 2022 is mainly driven by Europe, where performance of the hotspots are contributing. Free cash flow is expected to be around DKK 1.5 billion. The expectation for operating profit is roughly unchanged, but we no longer expect an inflow from working capital as a result of the higher growth. Please turn to Slide #15 for a closer look at the drivers behind organic growth. We expect a decline in organic growth in Q4 compared to the first 9 months. And it relates to nonrecurring factors, including a more challenging comparison. The main driver expected to decrease is non-portfolio work. The revenue from non-portfolio was all-time high in Q4 2021, and we do not expect that again this year. Needless to say that non-portfolio work is difficult to forecast, especially in these uncertain times. The second driver is that the return to office contribution is reducing as return to office was already material in Q4 last year. In total, that gives us expected growth of 4% to 5% in Q4 and around 6.5% for the full year. In line with previous quarters, we show 4 main building blocks behind the 2022 organic growth development. I will not go through each of them as it is quite self-explanatory on the slide. Please turn to Slide 16 for a deep dive on free cash flow. The outlook for free cash flow is updated and is expected to be around DKK 1.5 billion. The expectation for operating profit is basically unchanged, and we now expect a roughly neutral effect from working capital for the full year. Payments of restructuring booked in 2020 are still expected to reduce this year's free cash flow with DKK 0.5 billion. And therefore, we expect underlying free cash flow to be around EUR 2 billion. With that, I conclude the financial part of the presentation, and I will hand the word back to Jacob for some additional remarks and Slide 17, please.

Thank you, Kasper. Let me be brief. We have achieved what we committed to back in December 2020, and ISS has regained its financial strength. We reached our operating margin target. We have generated significant cash, more than DKK 3 billion in '21 and '22, and we have taken our financial leverage to below 3x EBITDA. As such, ISS is now in a strong position to look forward. Please go to Slide 18. We are excited to welcome all of you to the 2022 Capital Markets Day on Monday, November the 7th at Canary Wharf in London. We will present the improved and enhanced operating model as well as the opportunities that it brings to the business. ISS will be represented by selected leaders of the executive group management who will present and deep dive into key topics of the future. This should give all of you the opportunity to gain unique insights into the core of our business. We will also announce new financial targets, including our future approach to capital structure and capital allocation. With that, I will now open up for a Q&A session. Questions related to the future will be referred to Monday's presentation. As such, we expect today's Q&A to be relatively short. Operator, please?

[Operator Instructions]. The first question is from the line of Michael Rasmussen from Danske Bank.

Yes. And well done, once again, guys. So obviously, not asking beyond Q4 is probably going to be a slightly different -- difficult task here, but I'll do my best. First of all, on Deutsche Telekom, you wrote in the report that you have ongoing contractual disagreements that the parties are trying to resolve. I think the wording on that, I haven't seen exactly in the past reports from you. And I guess, obviously, it's nothing new that the contract is difficult. But if you could just add a little bit of thought on that. And then, Kasper, on the working capital guidance, I just wanted to make absolutely sure that you're not just growing faster because you're offering better credit terms or anything else here. So if you could just confirm that terms are unchanged. And I'll leave the next question because I'm running out of Q4 questions here. So just 2 questions from my side.

Thank you, Michael, and thanks for the restraint. We can hear that you're struggling with it, but you will get your questions on Monday. Don't worry. Listen, let me start on the Deutsche Telekom question, and then Kasper will speak to working capital. Listen, we're continuing to progress on the comprehensive gap closing plan on Deutsche Telekom. And I'm very pleased to say that we will deliver on our run rate breakeven at the end of the year, as we have promised you for the last 2 years. We will deliver on that, and we're very pleased to be able to say that. It doesn't change the fact that this is a complex contract and to get it to clearly stronger margin levels in the future, we need to continue our hard work on the improvement program. As part of our work, we are in constructive dialogue with the customer on certain we say, interpretations of aspects of the contract. And that is completely natural given the size and complexity of the contract. So that's a natural part of the next phase of this, which is to take the contract to clearly stronger margins than where we are at the moment. Over to you, Kasper.

Thank you, Jacob. And Michael, you -- I can indeed confirm what you said. I mean the free cash flow and the working capital is purely impacted by the stronger-than-expected growth that temporarily will impact the level of receivables. And whereas we before expected an inflow from working capital, we now expect the working capital to have a neutral effect this year. So there's nothing to do with us that provided for us unfavorable payment terms with customers, purely related to the strong growth that we've seen this year.

Great. Okay. Thanks for that both of you and look forward to be able to dive into the next couple of years on Monday.

The next question is from the line of Maddie Jobber from Morgan Stanley.

Again, trying to keep it to just the report today and Q4 without going further. Just one question for me in that case. Would you be able to talk us through the loss of the Ministry of Defense contract in Singapore that I noticed. Was there sort of key drivers that we should be aware of for that? Or was this just sort of a regular course of business?

Thanks, Maddie. Let me take that. There's actually not a lot to add. You almost answered yourself. It's ordinary course of business. So no specifics there. We will not go into specific contracts and what the terms were and who wanted what aspects of a contract, et cetera. What we can say is that we will, of course, expect once in a while to lose a contract. That's just a fact of life with 40,000 customers. We are reporting a retention rate that is now above 93%, which is the highest we've reported historically. So it's a very strong retention. But still, of course, there will once in a while be contracts that leaves us. But nothing extraordinary to report on this one. So I think we'll leave it at that.

Of course. And can I just double check? Is that -- would that be classed as a key account that contract there to be above EUR 200 million annually?

So it's a key account. That means it's above EUR 100 million.

The next question is from the line of Peter Sehested from ABG.

Congratulations on the results. I have a couple of them, let's say, boring housekeeping questions. First question is, could you just give the figure for the impact of the U.S. food business in Q3 isolated? And after that, I have a couple more questions.

Peter?

Yes. Can you hear me?

Yes, sorry. So your question was basically the growth in the food business in Americas.

Yes. Actually, the impact on your group organic growth from the U.S. food business. And after that question, I have a couple of more, if I may.

Yes. So the food business grew in Q3 with approximately 30% in Americas.

And can -- could you just translate it into a component or contribution to the organic growth in Q3?

Peter, I think we are going to quite narrow details here. If it's okay with you, I think we will take it offline afterwards. Is that okay with you?