Investment Highlights
• Merger with U.S. Foods makes Sysco by far the largest distributor in the industry and could boost margins significantly
• Restructuring should help bring expenses in line with longer-term average and increase earnings
• Management has maintained the dividend yield even in light of the higher share price
Sysco Corporation (SYY) is the country’s largest distributor of food and foodservice products with 60% of sales coming from restaurants. Nursing homes, schools and corporate cafeterias account for most of the remaining sales. Nearly all (88%) of sales are from the U.S. market with another 11% from Canadian customers.
Sysco was able to meet Wall Street expectations for $0.50 per share earnings in the fourth quarter when it reported last month, despite higher costs from commodities prices. Earnings increased 6.4% over the year on an increase of 5.9% in sales to $12.3 billion. Prices of meat and dairy products drove costs up 4.1% in the quarter with competitors also calling out the steep rise in dairy prices as a problem.
Food processors and distributors have not been able to pass along higher food costs to consumers yet due to weak employment and wage growth. This might be ready to change as the unemployment rate drops and businesses start raising wages. Besides the boost in sales with a slight increase to prices, Sysco could see some strong competitive advantages if it can finalize its deal to acquire rival U.S. Foods. The $3.5 billion merger was announced in December but has raised anti-trust issues since it will create the largest food distributor in the United States and likely control at least 25% of the market.
Even though a combined Sysco-U.S. Foods would be much larger the next largest competitor, the distributor industry is still fragmented with more than 16,000 companies. I doubt the merger will be blocked by anti-trust issues and the new company should immediately see benefits to lower costs.
Fundamentals
Sales growth has been consistent with the market for food distribution relatively mature. The company’s size advantage over competitors helps it increase sales at a faster pace. Operating expenses have grown at a 6.9% rate over the last three years, well above the 5.7% growth in sales and have caused profitability to slip. Growth in expenses over the longer 10-year period is lower at 4.9% and the company is undergoing a major restructuring to bring expenses down to the long-term trend.
Despite the weaker operations over the last few years, the company still has an extremely strong balance sheet. Current assets cover near-term liabilities by more than 150% and the company only uses debt sparingly in the capital structure. With rock-bottom interest rates, I would actually like to see more debt used by Sysco to boost profits.
In light of weaker cash flow, management has decreased its spending on capital investments over the past few years to protect free cash flow. Capital expenditures have come down to $523 million a year, down from $785 million in 2012, but still around the company’s long-term average. Sysco posted $970 million in free cash flow last year, more than enough to cover the $667 million in dividends and $76 million in net shares repurchased.
Dividends and Growth
Shares pay a yield of 3.1%, just under the 3.5% average over the last year but the company has still managed to keep its yield high against a strong increase in the share price. This is something that many other S&P Dividend Aristocrats have not managed, instead letting their yields fall below 2% over the last year.
To support the yield, the company has had to increase the payout ratio to 73% of earnings, above the 60% average payout ratio over the last five years. Dividends have grown at a 3.74% pace over the last three years and have been paid since 1970. Management has increased the dividend for the last 37 consecutive years.
Besides a commitment to cash return through dividends, the company regularly buys back shares with $342 million in net repurchases over the last three years.
Valuation
Shares are trading around the industry average at 24.0 times earnings over the last four quarters. This is well above the company’s five-year average of 16.8 times earnings and seems a little pricey. Shares jumped 12% in December when the U.S. Foods merger was announced but have traded sideways this year. While the shares may seem a little expensive on current fundamentals, the merger should create immediate benefits that could increase earnings significantly and bring the price multiple back down to a reasonable range. I doubt the merger will be blocked so am comfortable with the current premium on the share price.
Sysco has a commanding lead in the food distribution business and could grab a significant advantage if it is allowed to merge with U.S. Foods. The combined company will have unrivaled pricing power in the industry and margins could jump. Even if the merger is denied, a possible but not probable event, the company has a strong track record of shareholder cash returns and share price appreciation.
