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Dividend Aristocrat Sysco (SYY) disappointed on FY13 earnings, a miss and a withdrawal of prior goals for 2015 EPS. Shares were pummeled, prompting me to update my analysis. Declining margins and slow progress on corrective action raise questions about valuation and the sustainability of dividend increases. I regard the problems as soluble.

Overview

The company describes itself as follows:

Sysco is the global leader in selling, marketing and distributing food products to restaurants, healthcare and educational facilities, lodging establishments and other customers who prepare meals away from home. Its family of products also includes equipment and supplies for the foodservice and hospitality industries. The company operates 193 distribution facilities serving approximately 425,000 customers. For Fiscal Year 2013 that ended June 29, 2013, the company generated sales of more than $44 billion.

Declining Margins

Distributors frequently exhibit very low margins. As a result, small changes in margin can have outsize effects on EPS. For eight of the past ten years, net income as a percentage of sales has generally been in the area of 3%. However, over the past two, this has declined to 2.6% and then 2.2%.

While revenue, fueled in part by a strong history of fold-in or bolt-on acquisitions, has displayed a 3.4% CAGR for the past five years, this has not been sufficient to maintain EPS growth.

Causation

Management attributes part of this to industry conditions, which are competitive. At the same time, they acknowledge that a planned transformation, which includes the roll-out of ERP from SAP, has not been proceeding at an optimal pace.

They expect to realize savings through advanced IT, streamlining sales and administration, supply chain consolidation and improved delivery efficiencies.

It is tempting to speculate that this serial acquirer did not fully integrate all acquisitions, and that this industry leader by revenue has not taken appropriate advantage of economies of scale.

Transformation

In fiscal 2009, the company started a three part Business Transformation Project:

  • the design and deployment of an Enterprise Resource Planning (ERP) system
  • a cost transformation initiative to lower cost structure by $300 million to $350 million annually by fiscal 2015.
  • a product cost reduction initiative designed to lower total product costs by $250 million to $300 million annually by fiscal 2015

The costs exceeded the benefits in fiscal 2012 and 2013. A project of this magnitude presents operational risks.

Valuation

Sysco presents nonGAAP financial information, which is reconciled to GAAP in the usual way. This provides insight into transformation costs and normalized earnings.

The company had previously stated an expectation or goal of $2.50 to $2.75 EPS in fiscal 2015. That guidance has been withdrawn.

A successful outcome may be estimated by applying the company's five year CAGR for revenue (3.4%) to develop an estimate for 2015, and then assuming they can return to their previous 3% net income as a percentage of revenue. It works out to $2.40 per share.

Applying a P/E of 17 yields a conditional price target of $41 by the end of fiscal 2015; the condition being, that the transformation is successful, creating an industry leader that is applying superior technology and economies of scale to gradually grow market share.

The Dividend

Sysco is a Dividend Aristocrat, and recent presentations highlight the long history of increasing the dividend.

As a matter of cash deployment policy, the company prioritizes investments necessary for future growth and profitability, and sets a payout range of 40% to 50%. The current dividend of $1.12 represents 67% of GAAP earnings for 2013.

Cash flow continues strong, and my best guess is that the board will increase the quarterly dividend by 1 cent, to keep the streak going. By 2015 the outcome of the transformation will be clear, as will the sustainability of the dividend increase history.

Capex vs. Depreciation

Capex has generally been well in excess of depreciation. The data supports the conclusion that the company's fleet and facilities are up-to-date and suitable for what they're doing.

Investment Implications

I'm investing on the basis that the transformation will ultimately permit a return to prior margins. From recent prices in the $33 area, an increase to the $41 conditional target for 2015 would provide a return of 14.5% annualized, including the dividend.

While it may be surprising at this point in time to see a major player that has not taken full advantage of information technology and economies of scale, Sysco is not alone in that regard. In March 2011, I noted similar issues for Procter & Gamble (PG). Such issues were considerations when Ralph Whitworth of Relational Investments took a position in Illinois Tool Works (ITW). He was looking for the company to centralize procurement and logistics.

Sysco has the necessary financial and management resources to bring the process to a successful conclusion. As such, the normative analytical process calls for a reputable assumption that management will get the job done.

By way of estimating risk, a mediocre outcome might result in EPS of $2.00 for 2015, at a P/E of 15, or $30 per share. In the meantime, the dividend yields 3.38% and may be regarded as secure, due to the strong cash flow.

Quarterly earnings and conference calls should be monitored, with particular attention to progress on the transformation project.

Source: Sysco: Transformation Project May Improve Declining Margins