Aramark reported their 1Q18 results beating on top and bottom line and raising guidance. Increased outlook was based primarily on taxes, currency and acquisitions. No change to outlook of legacy business. They saw broad based growth across all lines of business and all geographies. Seeing a strong pipeline of new business opportunities. They did have some margin compression, driving operating income down 3%, which was more than offset by the lower tax rate, driving the EPS beat. Costs associated with the onboarding of new customers, weaker uniform margins and technology investments (kiosk and mobile ordering) contributed to the operating profit decline. They expect margins to improve in the back half of the year as onboarding costs abate and as labor productivity initiatives are implemented. They booked a $184m gain on re-measurement of deferred tax liability on the lower tax rate.
Thesis intact, key takeaways:
Strong organic growth was a key positive in the quarter:
- Organic revenue growth was a nice improvement from their Q4 results where they missed organic growth targets.
- Revenues were up 6% on 5% organic growth and 1% currency.
- Organic growth driven by volumes, price increases (to offset labor and food inflation), and improving retention rates.
- International had particular strength in Europe and emerging markets.
Inflation and margin compression are concerns:
- They are expecting 3% inflation in their business, but feel they are well positioned to recover rising costs.
- Though wage inflation is fairly broad based they did say it varies across regions in the US.
- They have labor productivity initiates (centralized hiring and demand driven scheduling) aimed at offsetting wage increases.
- They also have some shielding to inflation because of about 1/3 of contracts have a pass-through mechanism (cost plus, escalators) and another 1/3 with renegotiation rights.
- There is some concern around potential competitive pricing actions given a tax windfall, as low margin businesses, where competition is high, are more likely to have tax benefits competed away though pricing.
- This dynamic could be offset by their historically higher tax rate than peers – management said it may be more of a level playing field for them going forward.
Recent acquisition integration:
Avendra and AmeriPride both closed within the last couple months.
- Expect the acquisitions to be earnings dilutive in 2018, but FCF accretive.
- Interest expense increased to $350m.
- Leverage ratio is up, but they extended their debt maturities and now have so significant maturities for 7 years. Will use FCF and tax benefit to de-lever.
Outlook raised:
- Increased outlook based primarily on taxes and currency. No change to outlook of legacy business.
- They expect 3% organic revenue growth and a 1-2% currency benefit.
- 2018 EPS guidance of $2.15-$2.30. This was raised from the EPS guidance they gave last quarter of $2.10 to $2.20.
- Capex at 3.5% of sales – this is line with historical level.
- FCF outlook of at least $400m maintained despite raise in EPS outlook- not yet updated to reflect the benefits of tax reform and the acquisitions, so this number is likely to go up. Street numbers were closer to $500m.
- Expected tax rate of 26% is a 700bps improvement.
- Will use tax savings to decrease leverage ratio which climbed up with acquisitions. Aiming to get below 4.5x by year end.
The Thesis on Aramark:
- ARMK is an industry leader in the food, facilities, and uniform outsourcing market. The market is large and growing supported by favorable outsourcing trends.
- Aramark has an opportunity to continue expanding margins driven by productivity initiatives and operating leverage.
- The stock currently trades at a trough multiple vs. the market and at a discount to peers which I expect to mean revert thanks to low double digit EPS growth for the next few years driven by margin improvement, deleveraging, and improving top line.
- ARMK is well positioned to weather economic cycles due to a diversified customer base and greater than half of their revenues coming from non-cyclical industries.
- As deleveraging continues shareholder returns should increase via dividend growth and buybacks.