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: Buy, Sell, or Hold: Analyst:
Sysco Corp SYY 01/04/2011 $29.66 $38.75 $31.00 3.5% 15.2 Buy Thomas Kennedy
Thesis: As the largest distributor to the foodservice industry, Sysco benefits from economies of scale and economies of scope not experienced by its smaller competitors. Because of the large number of deliveries performed each day, Sysco is able to route orders in a way that better utilizes trucks and warehouses, allowing the company to deliver more cases per trip and lower the cost of each delivery. Sysco also benefits from economies of scope where its industry leading selection of products makes it possible to satisfy more of a customer s needs, giving Sysco a higher percentage of each customer s purchases. Recent projects, such as the addition of regional distribution centers and the adoption of a company-wide Enterprise Resource Planning system, should add to earnings while continuing to improve the company s low cost advantage. This defensible competitive position has allowed Sysco sustain a high return on equity throughout the business cycle despite the heavy competition and capital intensive nature of the foodservice distribution industry. The foodservice industry has experienced significant growth over the last 40 years, driven by food inflation, population growth and consumers eating a greater percentage of meals away from the home. Inflation and population growth are likely to be the primary drivers of future industry growth as the market share for foodservice and grocery will likely remain at the stable level experienced between 1998 and 1999. Inflation has a positive impact on revenue and has added significantly to past growth as contracts automatically pass on increases in food prices to customers. This property makes Sysco a fair, yet imperfect, inflation hedge as rising food prices can cause consumers to shift more food purchases to the grocery segment to save money, lowing foodservice volumes. In the past, Sysco has been able to outpace the overall growth of the foodservice industry (See Fig. 1) with a number of acquisitions bolstering its organic growth. With only 17% market share and a strong balance sheet, Sysco has the financial wherewithal and expansion potential to continue outgrowing the market for years to come. After years of earnings growth without a meaningful increase in share price, Sysco appears attractive relative to both historic valuations (see Fig. 2 for graph of price/share vs. earnings per share)
and an estimate of its fair value. Sysco s price to earnings ratios (P/E ratio) and price to book ratios (P/B ratio) since 2008 have been below the ratios seen earlier in the decade, with recent dividend yields showing a corresponding increase. A relatively lower valuation is fair considering the slower growth prospects projected over the next few years, but the current price seems overly pessimistic. A discounted cash flow model gives a fair value of $38.75 (see Valuation section below for assumptions used) and a suggested purchase price of $31.00. The suggested purchase price implies a price to next year s earnings of 16, a price to book under 5, and a dividend yield of 3.4%. With Sysco priced below its suggested purchase price and trading around a 25% discount to fair value it represents a strong candidate for a long term investment. Industry Analysis: Food purchases in the US and Canada are divided relatively evenly between foodservice and grocery, with an estimated $210 billion spent in the foodservice segment annually. Over the last 40 years an increasing number of meals have been eaten outside of the home, with foodservice growing from 37% to nearly 50% of total food purchases during the period from 1972 to 1998. This split had remained relatively stable until 2009 when foodservice market share declined to 47% in tandem with the general decline in consumer spending. From 1973 to 1980, the industry grew over 10% annually (See Fig. 3), with high inflation during the period adding meaningfully to results (See Fig. 4). Growth averaged between 4.7% and 5.6% annually from 1980 through 2007 due to moderate inflation and the foodservice segment gaining market share from grocery. During the recessionary period from 2007 to 2009 growth slowed to 1.3% with negative real growth for both 2008 and 2009 (See Fig. 5). Real growth through 2015 is projected to be below 1% annually due to continued economic weakness. A major distinction is made between chain restaurants and other customers as the bargaining power of larger chains has a meaningful, negative impact on a distributor s margins. This is easily seen by comparing Sysco s SYGMA segment, which serves chain restaurants, with the rest of their operations which had operating margins of roughly 1% and 7%, respectively, during 2010. Although restaurants are the largest segment of the foodservice industry, there are a number of retailers competing within the space. Sysco s customer base provides a good sample of foodservice customers with 62% of the company s revenue coming from restaurants, with the remainder from hospitals and nursing homes, hotels and motels, schools and other customers which provide 11%, 6%, 5% and 16% of the company s revenue, respectively. Foodservice retail is highly fragmented with a large number of individually owned and franchised locations, nationwide and regional restaurant and hotel chains, and a number of government owned locations (ex. public schools). The distribution network for the foodservice industry is similarly divided, often adding complexity to restaurant operations as numerous distributors will often serve each location. A retailer will choose between a small number of national or regional distributors, a greater number of local and regional distributors and other niche distributors (ex. a franchisee being served by their franchisor). Even as the market leader, Sysco only served 17% of the market. The other two national providers and the top ten regional competitors control a combined 14% and 11% market share, respectively, leaving almost 60% of the market split between more than 16,000 smaller companies (see Fig. 6). Distributors
sell both branded and private label products, but when retailers sell items to the public they will often be unbranded or take on a label given by the restaurant (ex. Big Mac) although select items will retain the manufacturer s brand. The source of supply for most items is fragmented with a large number of international corporations and regional processors supplying each product. Competition is fierce amongst foodservice distributors, as new competitors have minimal barriers to entry and customers will often have no switching costs to keep them loyal to a distributor. Because the industry has low operating margins and high capital investment needs (for trucks, warehouses, etc.), foodservice distribution is generally an unattractive business. The price distributors charge customers is commonly based on the cost of food with either a percentage markup or additional fees for each case delivered. This practice helps shield these companies from swings in food commodity pricing and helps to keep gross margins stable. Without any pricing power the only way a distributor can earn a higher return on investment is to operate more efficiently, by either lowering expenses or gaining a greater utilization of assets. Larger competitors, such as Sysco, US Foodservice and Performance Food Group, have scale advantages over their smaller competitors which has enabled them to earn satisfactory returns on equity. These advantages have led to considerable consolidation amongst midsize and large players in the industry. This consolidation is likely to continue although the pace is likely to slow down because of the lower number of meaningful acquisition targets. Company Analysis: Since its founding Sysco has experienced steady growth and the last 10 years are no exception; from 2000 through 2010 revenue, earnings and earnings per share have had a compounded annual growth rate(CAGR) of 6.8%, 10.0% and 11.4%, respectively (see Figure 7). During this period revenue growth was caused by industry growth, inflation, and expansion of market share from 11% to 17% (see Fig. 1). Sysco was able to grow earnings faster than revenue through expansion of operating and net margins. Net margins went from 2.4% in 2000 to 3.2% in 2010 with fairly flat gross margins (see Fig. 8), showing that margin growth was accomplished through efficiency improvements. This is further evidenced by 69% growth in revenue per employee from 2000 through 2010, from $477,804 to $809,641. This measurement takes into account both organizational improvements and the impact of food inflation. A good way to measure changes in efficiency without the impact of inflation is looking at the average number of cases delivered per trip (CPT) which grew 24% over this period, going from 585 CPT in 2000 to 725 CPT in 2010 (see Fig. 9). These changes to Sysco s net margin have had a direct impact to return on equity as shown by the DuPont formula (which states that the ROE is equal to the product of its net margin, its Revenue/Asset ratio and its Asset/Equity ratio). The benefit from a higher net margin was partially offset by lower Revenue/Assets (see Fig. 10) as goodwill increased as a percentage of assets. Sysco s net margin has the ability to expand further with the addition of new regional distribution centers (RDC) and the implementation of a companywide Enterprise Resource Planning (ERP) system. Any added improvement to margins helps to entrench Sysco s low cost advantage and
will add further to its ROE. The ERP software has other potential benefits beyond margin expansion, as it gives management and salespeople more accurate and timely information which should improve decision making throughout the organization. These investments aren t without risks, however. The significant capital investment required in building these RDCs and implementing an ERP system requires substantial savings in order to earn a fair return on investment. If the ERP system runs into any scheduling delays or operating difficulties, or if these projects experience cost overages, it could disrupt business operations or impair profitability. Management has managed these risks through the phased implementation of ERP changes and the building of a few RDCs at a time, but the ultimate benefits of these projects remain uncertain. The largest opportunities for Sysco include continuing to grow market share within current markets and expanding into a new geography. On top of stable organic growth and smaller acquisitions management has stated they were open to an acquisition of a larger regional competitor or an acquisition to enter a new market. Sysco s strong balance sheet makes any of the larger regional distributors a reasonable takeover target and could add as much as 20% to sales. An acquisition outside of the US and Canada markets would present a new platform for future organic growth and additional acquisitions. These purchases would carry the typical risks of paying too high a price or having difficulties in integrating an acquired business, but a history of over 100 successful acquisitions should help mitigate a portion of this risk. Valuation: Some of the best methods to arrive at Sysco s fair value include price to earnings and price to book values, dividend yield and a discounted future cash flow model. The price to earnings ratio (P/E ratio) is an effective method of valuation because of the company s earnings stability. The current P/E ratio of 15.2 is within the 11-19 range experienced over the last 3 years but is below the historic values from 2000 to 2007 which were as low as 17 and as high as 40. Sysco s earnings yield, which is simply the inverse of the P/E ratio, currently sits at 6.6%. With Sysco s free cash flow mirroring its earnings, the earnings yield shows what the company could potentially return to shareholders each year. This value compares favorably to bonds and other fixed income investments even before considering the potential for growth. Out of Sysco s 6.6% earnings yield the company pays out a 3.5% dividend. Since 2000 Sysco s dividend has grown faster than its earnings commensurate with an increase in payout ratio from 35% to 50%. Management intends to maintain the current payout ratio, which should give sufficient capital to reinvest into the business, giving shareholders a reasonable dividend yield which should increase over time. Sysco s price to book value of 4.6 is toward the middle of the 3.5-6 range seen over the last 3 years but below the book values from 5-12 experienced between 2000 and 2007. One way to put the price to book ratio in context is to compare it to the company s return on equity (ROE) as the product of the ROE and the price to book value gives the company s price to earnings ratio. Since 2000 Sysco s ROE has went from a low of 25.8% in 2000 to a high of 35.4% in 2003 and 2004 (see Fig. 11). Over the last 3 years the ROE has remained between 30.6% and 32.4% which is toward the middle of this historic range. Sysco s ability to generate above average returns over a long period of time shows evidence validating
the existence of competitive advantages. A price to book ratio of 4.6 seems reasonable considering Sysco s ability to profitably grow while increasing its ROE. A fair value estimate of Sysco s cash flows puts the price per share around $38.75. This assumes a reduction in cash flows from 2011 to 2013 from tax settlements, the building of regional distribution centers and the implementation of ERP software. By 2015 free cash flows will grow to $1,675,000 from reduced expenditure requirements, revenue growth around 4% and net margin expansion of roughly 0.4%. After 2005, free cash flows will grow by 5% through 2020 with industry growth and slight market share gains generating the majority of growth. Perpetuity growth is estimated at 3.75% with inflation and industry-wide volume growth contributing 2.5% and 1.25% to this amount, respectively. A 9.5% discount rate was used to find Sysco s fair value because of the relative stability of consumer demand within the foodservice industry and the competitive advantages which help protect the company s profitability. Even with Sysco s low profit margins there is below average uncertainty in estimating cash flows because its revenues are so closely tied to costs. These factors make Sysco a safe purchase with a moderate, 20%, discount to fair value. At this suggested purchase price of $31.00 investors would receive a fair return even if Sysco experiences only half of the expected benefits from efficiency improvements and growth from 2005 into perpetuity averages 3%. The biggest risks in estimating cash flows involve the possibility of deflation or the loss of market share to the grocery segment, which could lead to stagnant or negative revenue and earnings growth. Because of the related uncertainties around timing, price and size, acquisitions weren t factored into the model and could lead to positive or negative revisions to fair value. Summary: Below the suggested purchase price of $31.00, Sysco is a strong, low risk candidate for long term investment. The dividend payout, inflation protection and risk profile make the company a good addition for those seeking income or a core position within a portfolio.
Price per share in blue, earnings per share in red
Industry Growth vs. Sysco s growth
Real Industry Growth Rate (ex. Inflation)
Foodservice Market Share
Cases per trip
Graphical Depiction of DuPont formula
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