Investor Update

Sep 13, 2018

Slides

Welcome to Compass Group's IFRS 15 conference call. Hosting today's call is Laura Carr, Group Financial Controller, and Sandra Mora, Head of Investor Relations and Corporate Affairs. A link to the slides related to this call can be found on the investor relations section of our website, www.compassgroup.com. Following the presentation, you will have the opportunity to ask questions. If you'd like to ask a question, please press star one on your touch-tone telephone. If you are using a speakerphone, please release the mute function to allow the signal to reach our equipment. Today's call is being recorded. I will now turn the call over to Laura Carr. Please go ahead. Thank you. Good afternoon, everyone. Thank you very much for dialing in today to hear about how the adoption of the new revenue standard, IFRS 15, will have a very minimal impact on Compass Group. My name is Laura Carr, and I am the Group Financial Controller here at Compass. We plan to give you a brief overview of the expected impact of the new standard, and then open the call for any questions that you may have. Before we get into the new standard, we thought it may be helpful to go back to basics and remind you of our business model and how we generate revenue. Compass is primarily a food service provider. We generate revenue by providing food service to our clients. Additionally, we provide cleaning and other soft support services. Revenue is recognized when the service is performed or when the goods, i.e., food, drinks, or meals, are sold to either the client or directly to the consumer. We've given a couple of examples here in the slide. When we perform food services for our client, we typically bill them on a monthly basis. In a fixed price contract, revenue is calculated as the number of meals served that month times the agreed fixed price of a meal. In a management fee contract, we would invoice them the value of the cost incurred that month, plus an agreed management fee. We also generate revenue directly from consumers. We may have a P&L contract with a local hospital where we operate a coffee shop. In this example, the revenue is generated as we sell food and drink to the consumers at the coffee shop. It is important to note that we do not have any long-term contract accounting. We do not make any judgments or estimates regarding the level of completion of a service in order to recognize revenue. Compass makes investments in clients where the returns are attractive. These investments are typically capitalized and amortized over the life of the client contract. Some examples of client investments include purchasing equipment to enable us to provide our services at the client site, such as ovens or catering equipment in the kitchen. We may pay a client to gain exclusive access to their consumers, for example, at a sports stadium. Sometimes we pay a client a signing-on bonus to secure a contract. Currently, client investments are reported as either property, plant, and equipment, PP&E, contract intangibles, or prepayments, depending on their nature. As you'll see from the slides that follow, under IFRS 15, Compass will make some balance sheet reclassifications of client investments to provide more meaningful disclosure of the investments that we make. The new revenue standard, IFRS 15, will apply to Compass for the FY 2019 financial year. In summary, IFRS 15 will not have a significant impact on the timing and recognition of revenue for Compass. Given that we have a simple business model, we already follow simple revenue recognition principles, and we do not use long-term contract accounting. We will discuss the impact on each line item on the next couple of slides, but the key headlines are that we expect absolute revenue will be reduced by less than 0.5%. Absolute profit will be increased by a minor amount, and therefore, margin will increase modestly. When we release the financials on an IFRS 15 basis in FY 2019, we will restate the comparatives for FY 2018, and therefore, as a result, there will be no impact on our key performance indicators of organic revenue growth and margin progression, assuming all other things remain equal. Our guidance and outlook remain unchanged by IFRS 15. As already mentioned, we will also reclassify some of our client investments on the balance sheet. This mainly relates to the creation of a new balance sheet category called contract fulfillment assets. Finally, given that this is an accounting change only, there is no impact on net cash or free cash flow. We will now run through the line items where IFRS 15 has an impact on the financial statements. Firstly, please note that these numbers are FY 2018 estimates and have not been finalized, nor have they been audited. We will report the final numbers in our interim results next year. Looking at the income statement, revenue will be very slightly reduced. We estimate by less than 0.5%, as some amounts that were previously treated as an expense will now be deducted from revenue. Operating profit will increase slightly by circa 0.3% as we will now be required by IFRS 15 to capitalize sales force commissions. The P&L impact will be the timing difference between the previous practice of expensing these costs as incurred, compared to capitalizing and amortizing them over the life of the contract. As a result of these small changes to revenue and profit, our absolute margin will increase by around four basis points. I would just like to reiterate again that when we report under IFRS 15, the comparatives will also be adjusted in the same way. We do not expect any impact to our key KPIs of organic revenue growth or margin progression if other things are equal. Finally, EBITDA will also increase slightly as the sales commissions are no longer expensed, and EBITDA will not include the amortization charge from those commissions. Moving on to the balance sheet. The main change under IFRS 15 will be a reclassification of client investments and the creation of a new category called contract fulfillment assets. We estimate this reclassification will move approximately GBP 800 million out of intangibles and into contract fulfillment assets. The prior year balance sheet will also be reclassified to enable comparability. There will be a new contract-related asset on the balance sheet, as we are required to capitalize sales force commissions. These costs were previously expensed as incurred. We estimate this brought forward asset to be approximately GBP 40 million, and the related deferred tax liability to be around GBP 10 million. As a result of the capitalization of these sales commissions, we expect overall net assets to increase by less than 2%. Finally, we expect that IFRS 15 will have a less than 10 basis point impact on our return on capital employed measure. This is due to a slight increase in NOPAT and a small increase in average capital employed, both as a result of the capitalization of sales commissions. As the comparative will also be restated, there will be no impact to ROCE progression. To clarify the timeline for the implementation of the new standard, we will apply IFRS 15 for our year ending 30th of September 2019, we will then restate our FY 2018 results retrospectively to provide comparable data. We will not restate any prior history. When we report our full year results for FY 2018 this November, the financial statements and investor presentation will include an updated quantification of the expected impact of IFRS 15 on FY 2018. In May next year at our FY 2019 interim results, the accounts will be presented on an IFRS 15 basis for the first time with the restated comparatives for 2018. In November 2019, when we present our full year results, again, those will be on an IFRS 15 basis with the FY 2018 comparatives restated. Hopefully that very brief overview has clarified that IFRS 15 will not have a material impact on Compass. We look forward to giving you more details in the FY 2018 financial results in November, but in the meantime, we'd like to open the call now for any questions that you may have. Thank you. We'll now take a question from Jamie Rollo of Morgan Stanley. Please go ahead. Yeah. Hi there. Afternoon, everyone. I'm just wondering, as you say, it's not really important, this. There's no impact on cash. Why are you going to the trouble of reclassifying these intangible assets then? Because IFRS 15 has the ability to allow you to capitalize assets related to a contract, it just makes sense to us to use that categorization. Nothing's changed fundamentally, as you said, but it is an appropriate category for us. Contract fulfillment assets really defines exactly what those assets are. Okay. You could have reclassified them before. It's not like you were prevented from doing that before IFRS 15, were you? Well, no, it's not. There's no change ultimately. It's just that IFRS 15 has specifically got the wording which says that you can capitalize costs incurred to fulfill a contract. We think that those particular words are very applicable to us. You're right, it doesn't change the balance sheet. It's just a categorization. Okay. Well, obviously, it would have quite a big EBITDA impact, not that that matters so much. You're not concerned about the potential impact that it would have had to EBITDA then? Well, no, I don't think it would have any impact to EBITDA. Okay. It's just a balance sheet classification between intangibles and contract fulfillment assets. Right. I'm just thinking because other companies that have done this have generally moved. At the moment, there's an amortization charge of those intangibles, but the standard is suggesting that comes off revenues. I think it would have been an EBITDA impact, but obviously no EBIT or earnings impact. Okay. Yes. Okay. The other thing is. The point is. Sorry. The point is, Jamie, that IFRS 15 is not changing our view that the monies that we invest in our clients are investments and therefore should be amortized and expensed. It's not a deduction of revenue. That's quite a key point. Okay. Just the other question is, this is obviously a slightly sort of arcane area, I or our accounting expert read the rules to suggest that you could only separate out that benefit, i.e., the client investment, if it was sufficiently separable from the actual vendor product itself, the contract. That in reality, you wouldn't pay an upfront bonus, for example, if you didn't expect to get economics from the contract with the customer. How can these be separated into a separate category if essentially they are part of the contract? They're part of the same thing. They wouldn't be done if there weren't a fee to be received on the contract. To your point, a contract fulfillment asset may be specifically for us to refurbish a restaurant at a client site. It's pretty separable, and we feel that that asset then will allow us to generate the revenues from the contract over the period of the life. That's why we feel that we can capitalize it, and then we spread those costs over the life of the contract. Using that example, you wouldn't do the refurbishment and spend the money if you weren't going to get a return back on that, and therefore, it's inseparable from the contract itself, isn't it? Else you wouldn't be spending the money to begin with. Yeah. I think the accounting is that we invest it, and then it generates revenues throughout the life of the contract. It feels appropriate then to capitalize it. It'll be clearly visible on the balance sheet as a contract fulfillment asset, and then that will be amortized over the life of the contract while we generate the return. Okay. Thank you very much. Thanks, Jamie. Again, ladies and gentlemen, if you wish to ask a question, please press star one on your touch tone keypad. We will now take another question. We will take a question from Tim Ramskill from Credit Suisse. Please go ahead. Thanks. Good afternoon. Just one question from me, really. Again, on the same topic of client investments, as Jamie mentioned, there's other companies dealing with this in a different way, including Sodexo, your closest peer. Just to be clear, did you have any choice in how you go about accounting for it? Could you have taken that write-off, effectively that D&A charge to that client investment as a deduction to revenues, or did you feel that wasn't a possible option for you? Hi, Tim. I think the IFRS 15 for us hasn't changed the way that we view our accounting, I think that's the key message that we're trying to bring today. It's not a question of choice. We feel that we're creating an asset when we invest in our clients, they were capitalized today on a non-IFRS 15 basis and will continue the same treatment in the future on an IFRS 15 basis. I appreciate your referencing differences to our competitors, but I think we're different today, we're very comfortable with our view today that we are creating an asset that should be amortized over the life of the contract. Does that answer your question? I think so, yeah. I guess if my understanding is correct, the way that they account for it does a couple of things. One, it means that the CapEx to sales numbers that they tend to quote are understated relative to yourselves, which I think is misunderstood by a lot of investors. It's an important consideration. They do ultimately capitalize it, but the amortization of that asset, or the depreciation, if you like, of that asset, is taken as a deduction to revenues. You just end up with a situation where we've got some different treatment going on by two otherwise very similar companies. Yeah. Obviously we wouldn't comment on their accounting policy. The purpose of this call is to really reassure you that our treatment is consistent with how we do things. Obviously, if we did do what you were just referring to, we'd have a lower revenue number and our absolute margin- Yeah percentage would be higher. Yeah. I think we're really comfortable with how we do it today. The good news for us is as we've done a very deep dive in IFRS 15 and reviewed everything, that all the current treatments remain valid. The only real change in policy is the capitalization of sales force commissions, which is not a choice under IFRS 15. Okay. Fine. Then, sorry, just one very quick one. I suspect the answer is no, but in terms of H1, H2, is there anything within any of what you've unearthed thus far that suggests that there's a seasonality to any of these effects that mean that we might see a modest impact on a full year basis, but there might be a skew in terms of H1? There's nothing that I know at the moment. As soon as if we did think that there was some impact, we'd get back to you. That'll probably be in November. I don't think there should be. Okay, fair enough. Great. Thank you. Thank you. We'll now take another question from Jaafar Mestari from Exane. Hi, good afternoon. Just have a quick question on that total GBP 800 million of asset reclassification. Could you maybe talk to the geographical breakdown of those assets and, as a separate point, the end market breakdown, whether some of your verticals are particularly subject to that? I'm thinking about sports and leisure in particular. Thank you. Yes. Just as you can see in our segmental analysis that we already provide, a big chunk of that GBP 800 million will obviously be in North America, where the sort of contract structures that we have do lend themselves to client investments. In terms of sectors, I don't think we give that breakdown, but obviously there are higher sort of CapEx investments in healthcare and education, as you'd probably imagine. Thank you. Sports and leisure. Thanks. Thanks. We'll now take another question from Najet El Kassir from Berenberg Bank. Good afternoon, everyone. Just regarding the equity, would this change in accounting impact your equity or not really? No, not really. Only the sales force commission piece. The net assets change is less than 2%, but it's a very minor amount. Okay. Thank you very much. Thank you. We'll now take another question from Jarrod Castle from UBS. Thanks. Just on the contract assets, the circa GBP 40 million, on average, what will the amortization period be? Just secondly, on sales force commissions, in absolute terms, how stable is that amount, and how much will you be capitalizing each year? Thanks. Thanks. I think the GBP 40 million should be capitalized over our average contract length, which I think we say is about three to five years. It's a relatively stable number, and it's obviously very small as we're highlighting today. The brought-forward net book value is GBP 40 million. Relative to that amortization, so let's say at four years, GBP 10 million. In terms of further sales force commissions, is that roughly the run rate? Should we expect that number's pretty stable after amortization or moves around a lot? It should be relatively stable. Don't forget, the timing difference in the P&L on adoption is actually the difference between expensing and capitalizing and amortizing. The P&L impact on transition is smaller than the ongoing amortization rate. Okay. Thank you. Thank you. We'll now take another question from Jamie Rollo from Morgan Stanley. Please go ahead. Yes. Thanks. One more if I may. The GBP 800 million, again, back on that, what's the P&L amortization charge associated with that, please? I'm just trying to think. The total amortization, I think, of all contract intangibles was about GBP 193 million last year, off the top of my head. It's a big chunk of that, I think. I'll have to get back to you, Jamie, on the exact number. Sorry. It's not changing, though? Yeah. Sorry. Oh, no. No change, sorry. There's no change to how we amortize them. It's just literally a balance sheet categorization change. Okay. If I look at that GBP 800 million number, which I think is equivalent to the, I think it was GBP 900 a year ago in the 2017 accounts, that's the sort of other client contracts intangibles, i.e., not the ones arising acquisition. The historic cost of that was about GBP 1.6 billion. Yeah. As you say, the amortization charge, I think, was GBP a couple of hundred million. That's for eight-year useful economic life. That is longer than the 3-5 years average contract length. Can you just talk a bit about how that works? Obviously, you're signing up pretty long-term contracts with higher ed and sports and leisure, but to get the average of eight years, that just seems quite on the high side, doesn't it? Yeah. No, you're right. I think the three to five is sort of the global average of contracts. You're exactly right that as we invest in the areas, particularly in North America, in those higher ed and education contracts, they are longer, and therefore that's where the CapEx is. The average useful economic life is higher in those investments. Okay. To get to an average of eight, you're obviously signing some at 15, 20 years. Exactly, yeah. Okay. Thank you. You can see from the North American wins that we announced, that they are very big contracts and very Yeah. Thank you. Great. Thanks. We will now take another question from Richard Clarke of Bernstein. Please go ahead. Hi. Good afternoon. Just on the sales force commissions. GBP 40 million capitalized, we're talking roughly GBP 10 million a year, maybe slightly more. That's about 0.5% of your new business wins per year. Is that a good way to think about it? Is that sort of the run rate of commissions you're paying? The variability by geographies where you've said the U.S. has a slightly bigger margin impact, is that because you pay more commissions in the U.S. than you do in other geographies? I think the overall picture is a very small number. They do tend to skew towards the U.S. I haven't really thought about it on a new business percentage win. Yeah, if it's GBP 10 million a year, it's a very small number. Remember, there's an element of sales force commissions that's paid in year two or year three, depending on the performance of the contracts. Okay. Thanks. Again, ladies and gentlemen, if you wish to ask a question at this time, please press *1 on your telephone keypad. We will now take another question from Tim Barrett from Numis. Oh, hi there. Sorry if I missed this, did you say exactly what you're netting off revenue now? What that 50 basis points reduction in revenue relates to? Thanks. I don't think you did miss it. We're saying it's up to about 50 basis points. Fundamentally, nothing's changed under IFRS 15. As we've done a very detailed review through the adoption process, building up contract by contract, there are some payments to clients that we feel we do not receive a distinct good or service in return. Under IFRS 15, we've cleaned that up, and they'll now be a deduction off revenue. Okay. That's about GBP 100 million. It's definitely less than 0.5%. I'm giving myself a bit of wiggle room till November, it's going to be less than that. Okay. You said that's stuff you didn't feel you were getting a return on? No, not a return. It's just that if you look at the IFRS 15 lens, you have to be very clear that you'll receive a distinct good or service in return for that payment. I think there's some areas that we just wanted to be very prudent. We've taken the decision to deduct them from revenue. It's very minor if you think about the size of our revenues. Sure. All right. Thanks. There are no more questions in the telephone queue at this time. Okay. Thanks very much. If anyone else has any further questions, just give us a ring. Thanks for joining. Thank you. Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.