Business Analysis: Compass struggling to win back City confidence

Back to basics on new executive incentive scheme
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The Independent Online

Compass set out to win back investors' confidence yesterday by overhauling its executive incentive plan two months after a devastating profits warning wiped £1.7bn off its value.

Compass set out to win back investors' confidence yesterday by overhauling its executive incentive plan two months after a devastating profits warning wiped £1.7bn off its value.

The new bonus scheme will require the group's management team to knuckle down and hit the two targets that obsess the City when it comes to this most aggressive of catering giants: free cash flow generation and return on invested capital.

In future, two-thirds of all executive bonuses, including that of the chief executive Mike Bailey, will depend on whether the company "breaks the cost of capital", as he puts it. Previous incentive schemes have been heavily weighted towards increasing earnings per share and underlying profits.

"That's a significant move, and one we've not done before," Mr Bailey said.

Shaking up the incentive plan gets to the crux of the problem that has dogged the acquisitive catering company over the past few years: had it just been buying growth?

A multiple warning in September about profits, cash flow and misjudged contracts to feed schoolchildren reignited shareholders' fears that Compass was incapable of growing its £12bn business without swallowing more companies. Although the warning knocked just 4 per cent off the company's operating profit this year, it sliced 25 per cent off its market valuation. More worrying still, it dished up an unexpected £200m outflow of cash. And this from a company that has never demonstrated the benefit of its complex demerger from Granada nearly four years ago.

Kevin Lapwood, a support services analyst at ING Financial Markets, said overhauling the incentive scheme was "absolutely crucial" because "either the management receives no bonus or it will achieve a better free cash flow and return on capital. That will be a stabilising influence, there's no question." He added: "Incentivising the management on earnings growth was like saying, 'you may use our balance sheet capacity to increase your bonus'."

Analysts at Dresdner Kleinwort Wasserstein concurred, saying: "The rapid realignment of incentive schemes highlights the board's responsiveness and this strategy is far more in synch with the demands of large, sophisticated investors."

Last year, in a shareholder revolt at Mr Bailey's £1.6m bonus, which took his total pay package close to £4m, one-quarter of investors voted against the group's remuneration report at its annual meeting.

Mr Bailey unveiled the company's plans to change its incentive scheme alongside preliminary results that missed even analysts' downgraded forecasts. Operating profit before goodwill amortisation at the group fell 3 per cent to £775m, although reduced one-off charges helped pre-tax profits rise to £370m from £358m. Shares in the group fell 5 per cent to 229.25p, just off the 213p low they touched in the wake of September's warning, as analysts trimmed their numbers for next year.

Robert Morton, at Investec Securities, said: "The underlying model is intact. But what isn't satisfactory is that the numbers are coming down again. They should have got all that out of the way in September."

The company's closely watched free cash flow figure fell 41 per cent last year to £246m after it was forced to inject an extra £100m of working capital in growing its defence, offshore and remote site business (which saw like-for-like turnover soar 35 per cent last year). It did, however, stick to its projections that free cash flow would recover to between £350m and £370m in the current year.

Analysts applauded the level of detail provided in yesterday's briefing (all 70 pages of its slide presentation), which they ascribed to the new finance director Andrew Martin's bid for transparency. Analysts at DKW upgraded their stock recommendation to buy.

That the group took an axe to its UK profit margin, which has long been way out of kilter with rival contract caterers, also pleased analysts.

That said, some major worries still dog Compass. For starters, can the group, which has pledged to stay off the acquisition trail, hit its targeted 6 per cent organic sales growth without the need to dish out another massive slug of working capital?

Mr Lapwood said: "There are still questions over whether Compass will need to put an increasing amount of capital in to achieve that growth. They say not, but that's the bit that people don't trust them on. I'm a bull. I think there is probably good growth in the business. But the nature of contract catering is changing. It is becoming a much more capital intensive business."

While Mr Martin frets about just what return on capital the group can achieve - it manages 7 to 8 per cent now, slightly less than it spends - Compass shareholders can take heart that some of its strategies are yielding the goods.

The group announced yesterday that Marks & Spencer had approved the opening of another six Simply Food stores at its Moto motorway service stations, extending a franchise partnership that has focused on railway stations. It has also opened two Simply Food stores at Heathrow and Manchester airports.