Compass off course

Three profits warnings in 12 months, a UN investigation, takeover rumours, an earful from Jamie Oliver over school meals, a boardroom revolving door and the dismissal of its UK boss - by any stretch of the imagination these are not happy times for Compass.

With full-year results due next Tuesday (29 November) even Compass predicts pre-tax profits will be about £580m, well below original market expectations. With shares at a 10-year low, the pressure on incoming chairman Roy Gardner is unlikely to lift any time soon.

So how did Compass, still the world's biggest contract caterer with 400,000 employees worldwide, get to this point, and can it dig itself out?

The first sign that all was not well came in September last year with the first profits warning. Subsequently, UK boss Don Davenport was replaced last summer by Peter Harris (of whom more later). Chairman Sir Francis Mackay and chief executive Mike Bailey are also both departing the business. New chairman Sir Roy Gardner, currently chief executive of energy firm Centrica, is expected to join "sometime in 2006" but cannot take up his position until a replacement at Centrica is found.

Into this febrile atmosphere have come rumours of takeover interest, with American equity group Clayton, Dubilier & Rice, owner of food supplier Brakes, mooted as a possible buyer.

Then, to top it all, there has been the embarrassment of the United Nations investigation. This is looking into alleged irregularities surrounding the awarding of a 35.3m food and water contract in Liberia to Compass's Eurest Support Services (ESS) division. On 3 November this affair claimed its first scalps with the departures of Harris and mid-ranking ESS executive Andrew Seiwert, who had been associated with the UN contracting at the division.

The first thing to understand about all this, argue both City and industry observers, is that the UN investigation is completely separate from Compass's trading woes. Yes, it's very serious and potentially damaging to the company, but in pure financial terms it's more a distraction than anything else. Compass's UN supply operations account for just £35m of its near-£12b turnover. "The scandal couldn't have come at a worse time but the direct financial consequences won't be massive," agrees Karl Green, City analyst at Dresdner Kleinwort Wasserstein.

Of greater concern are Compass's underlying trading difficulties. These can be whittled down to four key areas, argue industry observers: its growth model, its cash-flow, its relationships with suppliers and, in the longer term, its pension deficit.

Dealing with the growth model and cash-flow issue first, Compass has over the years followed a very acquisitive, turnover-led growth model. This has helped turn it into the world's largest contract caterer but has also stored up problems that now appear to be coming home to roost.

"They've chased high-capital-intensive business, which has raised their margin but damaged their cash-flow and return-on-investment," explains Green. "They got too aggressive on their purchasing but I think they won't be so margin-obsessed now and will go for contracts where there's less capital input involved but accept lower margins in return. They'll be more financially disciplined," he predicts.

May's half-year figures highlighted the weakness of the current financial model, showing a 5.9% increase in turnover against a 14.5% decline in pre-tax profits. Then there's the company's cash-flow, which has been severely squeezed by a combination of a decline in profits in the UK, a £40m one-off charge in the Middle East on top of a £30m reduction in profits there, and changes in payment terms to suppliers.

Borrowings rose by £270m last year with, according to some analysts, the increase in turnover reported at the half-year largely the result of underbidding in order to win or retain contracts.

This, in turn, brings us to Compass's relationship with its suppliers. Suppliers have in the past complained - some direct to Caterer - about the length of time it has taken them to get paid. Compass moved to address these complaints in September last year, when, at its final results, it announced it had shortened the amount of time it took to pay from 70 days to 58 days and would be monitoring the situation on a monthly basis. Yet, while this may have mollified some suppliers, the change has also inevitably had a knock-on adverse effect on cash-flow, at least in the short term, the company has admitted.

One difficulty Compass has faced here, argues Chris Stern of the Stern Consultancy, is that clients have got better at driving a hard bargain, meaning there's less wriggle room for caterers and suppliers alike.

While Compass does benefit from economies of scale, the demands and expectations from the City and shareholders alike have been pushing it into an ever more impossible corner. "There are only certain levels of profit you can expect in this business. Either customers pay more or caterers have to understand that they cannot make the levels of profit they expect," explains Stern. "The problem is not school meals, it's the market. Compass will drive its profits back up again but in the long term that may cause damage within the company. There's no easy answer unless it can better educate the City."

As the company has grown, there have also been particular management challenges, suggests Jonathan Doughty, group managing director of consultancy Coverpoint. While Compass has diversified from its origins as a staff canteen caterer into markets such as event catering, motorway services areas and travel and leisure concessions, its management mentality has remained, at heart, that of a contract caterer rather than a specialist in all the areas in which it operates, he argues.

The people in charge of any particular division need to have the "operating DNA" to run their area. "There has to be a brand centre, but each individual business has to be its own business," says Doughty, who cites clothing retail giant Arcadia as a good example of a business that lets its brands have their head.

"Compass Group's senior management team have been phenomenally successful in what they've done. But the food service market is moving so quickly that they do need new blood. When you're the biggest and the best you can find your market eroded by a lot of small niche players. Compass has lost the art of being a niche player," Doughty claims.

Compass disputes this picture. Sources close to the company have argued strongly that, while it's a diverse and complicated operation, each division is run by a specialist team that knows its sector inside out.

Finally, there's the question of the pensions black hole. Analysts have suggested the company's pension liabilities, put at some £420m, could act as a "poison pill" to any potential buyer and become a significant long-term financial drag.

Yet industry and City observers are not writing it off just yet. It's still a hugely powerful, dominant business. While there will always be takeover speculation when a company is publicly struggling, there's a sense that a turnaround is possible. At the May interims, for instance, Bailey made it clear he recognised the company was struggling. "I'm not happy with our recent performance," he said candidly. "We need to respond more rapidly than we have to the changes taking place in our market."

Many in the City are pinning their hopes on chief finance director Andrew Martin, who joined Compass in March last year from First Choice Holidays and so is relatively unscathed by the recent problems.

Compass's decision to sell its travel concession Select Service Partners to focus on the core contract catering businesses has also won plaudits in the City.

On top of any financial and structural changes the company needs to make, one of the biggest challenges will be motivating its people, argues Doughty. "How do they feel at the moment? The operations manager, say, who has delivered day in and day out for the organisation and is now seeing the company ripped to shreds by the press. There may be people who feel alienated, uncertain and exposed," he says. "Having said that, Compass is and will remain a significant player."

"I think it will be a supertanker effect," concludes Green. "It could take a very long time for the new management to bed down, perhaps two to three years."

Whether shareholders and investors will be prepared to wait that long is the £580m question.

Compass in brief
Turnover, pre-tax profit (full-year, 2004): £11.78b, £370m
Employees: 400,000
Number of countries operating in: 90

Sectors and key brands

• Business and industry (Eurest, Baxter & Platts, Everson Hewett)
• Fine dining (Restaurant Associates, Patina Group, Flik)
• Defence, offshore (ESS)
• Education (Scolarest, Chartwells)
• Healthcare, seniors (Medirest, Morrison, Crothall)
• Travel and leisure (Select Service Partners, Moto, Levy Restaurants, All Leisure)
• Vending (Canteen, Selecta)

Timeline

• September 2004 Trading statement reveals operating profit will be down £30m on forecasts, blamed on difficulties in UK and Europe.
• November 2004 Full-year results report slight rise in pre-tax profit (to £370m) but, as expected, a decline in operating profit.
• March 2005 Trading statement warns of £9m hit from rationalising UK back office and management teams, plus £15m reduction in profits in Middle East operations.
• September 2005 Chief executive Mike Bailey says he will step down "some time in 2006".
• September 2005 Trading statement warns of profits squeeze in UK and continuing difficulties in Europe and Middle East. Overall full-year profits will be about £580m (against forecasts of about £620m). Shares fall to 10-year low.
• October 2005 UN suspends ESS as a registered vendor and an investigation begins over £35.3m food and water contract in Liberia
• November 2005 UK boss Peter Harris and ESS executive Andrew Seiwert dismissed over UN investigation.