Financial Reporting thoughts on Aramark (ARMK US)
I think it could be a nice short, if someone believes populism in the US will push for an increase in minimum wage …
Price fore perfection.. at a aP/E of x20 and EV/EBITDA x11.6
Although balance sheet remains weak, highly leveraged with razor-thin margins
Financial Reporting thoughts on Aramark (ARMK US)
Debt: Aramark’s Q2 results for the quarter ending 1/4/16 show Net Debt remains elevated
Net Debt increased 2% QoQ at USD 5,261m and Net Debt to Equity currently stands at x2.47 times and x4.4 times last year’s EBITDA (FY15 EBITDA USD 1,188.4m). Aramark used receivables factoring to raise USD 350m, repayable in May ’17. Credit market appears to shrug off concerns about high leverage, on Dec ’15 the company issued USD 400m notes due in 2024 at 5.125%, currently these notes trade at 103.5, Moody’s rated them B2e. Current debt to EBITDA covenant stands at x5.125 times, if breached all debt becomes immediately repayable.
Operating leases: total future commitments from operating leases amount to USD 533m, with only 41% of this balance being due in less than a year. Management makes heavy use of operating leases avoiding finance leases, which amount to only USD 56m. An operating lease is expensed on the P&L without reporting a balance sheet asset and finance liability, allowing for a more favorable leverage ratios.
Hedging: the company applies a ‘cashflow hedging’ policy with interest rate swaps to fix interest rates. Designating a hedging derivative as a ‘cashflow hedge’ allows management to report profit and loss on derivatives directly in equity, without showing the fluctuations in fair value on the P&L Consequently USD 41.4m of unrealized losses are not reported on the P&L but are deducted from shareholders’ equity through ‘Other Comprehensive Income’. Interestingly their hedging is for a notional amount of USD 2.6b, leaving a large part of the USD 5.3b debt unhedged.
Oil derivative: Management tried to limit the risk of oil price fluctuations, entering a pay fixed/receive floating swap for the notional amount of 34.7m gallons. Management didn’t classify this transaction as a cashflow hedge and in recent results (FY16 Q2) a loss of USD 1.9m was reported on the P&L. There is no disclosure as to why this hedge wasn’t effective and didn’t protect shareholders from higher oil prices.
Share buy backs: Despite the high leverage, management spent USD 28.4m buying back shares.
Weak balance sheet: Aramark’s business is food and facilities management services. However, property plant and equipment makes only 13% of Aramark’s long term assets as Goodwill and Other Intangible Assets make 87% of the balance (peers Sodexo and Compass show a higher % of tangible assets). Goodwill and Other Intangible assets account for x3.4 times the equity book value. If a slow-down in economy reduces the operating cashflows in Aramark’s underlying business, an impairment on Goodwill and Other Intangibles will be required, but that could trigger a rights issue to rebuild the balance sheet. Assuming a slowdown in economy triggers an impairment of say 15%, it could halve shareholder’s equity, costing USD1b. Of course impairment of goodwill is a ‘non-cash-item’, as the cash was paid in the past, but Net Debt to Equity could double from current x2.57 times, triggering a rights issue.
Slower Depreciation and Amortisation: Q2 results show depreciation and amortization expense decreased 3.8% yoy which contradicts the higher balance in long term assets (increased 1%) and property plant and equipment (increased 3%). A possible explanation for lower depreciation charge although net assets increase could be either a change in depreciation policy or a change in the assumptions about assets useful life. Similarly, amortisation of intangibles also slowed down 19% yoy in H1 (from USD 68m to USD 54.7m), saving the company USD13.3m and improving profits by the same amount.
Borrowed to pay dividend: Aramark increased dividend 12.5% yoy for the half to 1/1/16. However dividend was paid with borrowed cash as operating cashflow (USD 209.8m) was used in CAPEX (USD 237.8m and acquisitions (USD 58m)
India: Q2 FY15 completed the sale of Aramark India Private Limited, resulting in a pretax loss of USD 4.3m, “the company did not receive any proceeds from the sale of its India subsidiary”. This implies either management disposed-off India business for free and or the buyer assumed some undisclosed liability.
Pension plan in FY 15 took a hit of an USD 40.6m adjustment, after that current pension deficit was reduced to USD 13.1m
Share-based compensation: Cost in Q1 FY16 came at USD 14.1m (v 15.7m last year), accounts for 18% of income. Although a material cost, management adjusts EBITDA to exclude this cost (even though this cost comes out of shareholder’s pocket). Outstanding share based awards account for 9m shares (3.7% of share count) which are granted and an additional 8.6m shares (3.5% of share count) which are not yet granted because the performance targets were not met (the latter is excluded from calculating diluted EPS).
Potential liability: Guaranteed residual value on leases could cost the group an additional USD 121m
Critical supplier: 60% of Aramark’s products are delivered with Sysco (SSY US), a 20+ year relationship. Current agreement with Sysco is terminable by either party with 180 days notice
Severance payments : Aramark has an accrual of USD 21.5m related to unpaid obligations
Expense Capitalisation: Aramark capitalizes expenses to serve client contracts when these cash payments help finance ‘improvement or renovation at the facility from which the Company operates’, these amounts are amortised over the contract period ‘If a contract is terminated prior to its maturity date, the company is generally reimbursed for the un-amortised client contract investment amount’. These capitalized costs appear under ‘Other Assets’ and amount to USD 815m The net amount of capitalized expenses increased +4%yoy (or by USD 67m, 42% of H1 net Income), although revenue declined marginally.
Japan Investment: Invested in Japanese food and support services company ‘AIM Services Co’, which owns 50%. Disclosed under ‘Other Assets’ for USD 164.8m, uses the equity method (if it was a 51% subsidiary, would had to consolidate debt as well). I think they lack discipline in capital allocation, as a result Aramark’s Return on Assets (ROA) is just 2%. Interestingly the Japanese entity has capitalized the cost of a Golf Membership (JPY 143m)
Not a cost-plus contractor: 73% of Aramarks’ contracts are ‘P&L contracts’. These contracts shift some risk to Aramark requiring higher capex than cost-plus contracts, but could result in better margins. In some cases, Aramark would have limited flexibility in controlling certain operational variables in cost and pricing. For example could have limited ability in passing through a potential increase in minimum wage cost as pricing at corporate cafeterias is fixed.
Governance, segregation of duties: CFO Stephen Bramlage (appointed April ’15, joined from Owens-Illinois), assumes also the duties of principal accounting officer, due to an extended medial leave by the company’s controller and chief accounting officer.