Back in August I wrote a moderately optimistic article on Sysco (SYY) suggesting that the company would be able to complete its transformation project and restore margins to their historical average levels. The stock spiked vigorously on the announcement of the planned acquisition of US Foods, a large, privately held competitor. As the stock surged as high at $43, I closed my position at a profit, and do not plan to reopen it, in spite of the fact that shares are now trading in the $36 area. Here's why.
As a rule of thumb, it's advisable to avoid a company making an acquisition that is more than 25% of its own size. I forget where I picked it up, but it makes a lot of sense.
Sysco's TTM sales are $45 billion. The combined entity is expected to have sales of $65 billion. Doing the math, US Foods is over 40% the size of Sysco.
Prior Acquisitions Not Fully Integrated
The extensive delay on completing the transformation plan, originally announced in 2009 and still ongoing, highlights the fact that Sysco didn't properly integrate acquisitions. The interminable rollout of ERP from SAP was probably slowed by the differing needs of various business units.
Ongoing efforts to rationalize the supply chain and increase the efficiency of deliveries have not increased margins: to the contrary, margins have deteriorated. Synergies expected from prior acquisitions have not materialized: otherwise, margins would be better.
Serial Acquirers Sometimes Overreach
Acquisitions have been ongoing. There is no year in the past ten that the company did not record acquisition expense. It's questionable whether Sysco has the capacity to grow organically.
Sysco's Total Debt/Equity is 62.1%, higher than I prefer. Buying US Foods from a private equity firm, Sysco will assume the debt. Private Equity firms frequently extract income by overloading their possessions with debt that will be difficult to repay. Then they sell.
Harry Domash puts it well:
Most firms grow by developing new products, opening new stores and so forth. However, some resort to an acquisition strategy to maintain growth after they've saturated their original markets. Early successes implementing this strategy lead to overconfidence. Eventually the company makes a bad acquisition, its results fall sort of expectations, and the shortfall sinks its share price. Since it was issuing shares to pay for the acquisitions, the lower stock price devalues its acquisition currency, further slowing growth which puts more pressure on the share price.
What About the Dividend?
Sysco has a long history of dividend increases. However, in recent years they have been token, amounting to a penny each. I correctly surmised that the dividend would be increased by that amount, to keep the streak going.
But when the acquisition has been completed, there will be a fabulous amount of pressure to reduce debt. It is entirely possible that the dividend will be frozen, reduced or eliminated.
Mr. Market Got It Wrong
The initial market reaction to the acquisition announcement was just plain wrong. Share prices have since sagged back to a level closer to where they were before the news hit.
I sense a desperate Hail Mary by management that hasn't been able to create value by improving operations and organic growth.
This will take a long time to play out. I would avoid the stock until questions about the ongoing transformation project have been answered, and results from the operations of the combined entity are available for review.