This article was written by Peter Shearlock and published in The IRS Report in June 2011.

Compass to convert cash flow into dividend growth

There is an old saying that "cash never lies". Free cash flow (FCF) remains one of the best gauges of the true health of any business. Stated profit can be massaged in a variety of ways, despite the best efforts of the accountancy standard-setters over several decades. But the amount of cash a business generates out of operating profit after funding the capital expenditure needed to keep it in business is hard to fudge.

Where FCF is running at levels sufficient to pay down debt in a year or two were the directors not to make any acquisitions or buy back shares, there is a good case for putting the shares on one's watch list. Right now, there is no better example of that than contract caterer and support services business Compass Group. The business is generating cash at an annualised rate of over £700m, which compares with borrowings of £671m at the last count.

Compass is the world's largest food services business with revenues of around £16bn. It is positively humming at the moment, as recent half-year figures showed. What is particularly exciting is the rate at which the dividend is being lifted - and the possibility of a one-off special payment to shareholders.

Last year, Compass lifted its dividend by a third, taking it to a new base level of 17.5p a share. This was described as "a reward to shareholders". Last month, it followed this by raising the interim payment by a further 30%. Given the expected ratio between the interim and final dividend payments, that suggests a 20p total for the year. That still only puts the shares on a yield of 3.4%, but, as my colleague Douglas Moffitt stresses here regularly, a steadily rising dividend is one of the keys to investment success.

Cousins has also hinted that Compass may make a one-off move to gear up the balance sheet. In each of the last two profit statements he has said the board is keeping the balance sheet under review. Effectively, Compass is generating more cash than it needs. A special pay-out to shareholders would be one way of dealing with this issue - and would doubtless go down well in the market.

Compass has been transformed since Cousins came in almost exactly five years ago. The former chief executive of plasterboard producer BPB Industries prior to its takeover by the French company, St Gobain, Cousins worships at the altar of efficiency. Compass had been an underachiever inthe five years before he arrived, winning plenty of new business but failing to convert it into profit. Cousins embarked on a host of disposals and tidied up the balance sheet. Then he introduced his MAP (management and performance) system. A key element of that is to take cost out of the business and drive up margins.

He has been very successful. Since 2006, margins have been pushed up from 4.4% to 7.2%. Earnings per share, which had been static for so long, have nearly doubled. The business now does a lot more than catering. "Soft support" services - housekeeping management, vending services, even the management of a museum - are an increasing element of the total.

There is no sign of the momentum slowing. The recent half-year figures to end-March showed operating profit up nearly 12% - this despite the negative impact of the Japanese tsunami. The pipeline of new business is said to be strong.

Progress in the second half may be more muted as Compass enjoyed a particularly strong second half last year and the aftermath of the Japanese disaster is expected to cost a further £20m. Nonetheless, broker Evolution Securities is still forecasting a rise in profit before tax from £922m to £1.01bn, with £1.1bn to follow in 2012.

Compass has earmarked around £300m for acquisitions thisyear, and much of the spending will be aimed at expanding the presence in emerging markets. At present, North America and Europe dominate revenues with 44% and 24% of the total respectively. Cousins reckons the emerging markets businesses have the potential to generate double-digit growth rates.

There are two big challenges for Compass. One comes from mounting food price inflation - though the firm has shown itself adept at re-working menus and using techniques such as regional buying. The other is government cut-backs, which might be expected to squeeze a supplier such as Compass. In practice, those same cuts are prompting more organisations to outsource their catering in order to find cost savings.

The worldwide food service market is put at £200bn. Just under half of that is currently outsourced - so there is still plenty of room for growth.

Compass is well run, producing high returns on capital employed and impressive cash generation. Its shares are not as highly rated as those of its biggest global competito, the French company Sodexo. With a commitment to dividend growth and an under-geared balance sheet, Compass has much to commend it to value-conscious investors.