Sysco Corp. (SYY) is the largest food service distributor in the United States with an approximately 17% market share of this highly fragmented industry. Founded in 1969 and headquartered in Houston, Texas, Sysco went public in 1970 with a base of $115 million in combined sales from its originating nine small food distributors with the dream of creating a national food service distribution organization. By year-end 2010, and 150 acquisitions later, Sysco’s sales have ballooned to over $37 billion in its core markets, the United States and Canada. Approximately $33 billion in sales are from the United States and the other $4 billion are generated in Canada. This leaves ample room for growth since the total size of its core market is in excess of $210 billion.
The following logarithmic F.A.S.T. Graphs™ plots Sysco’s earnings growth since 1992. Even though this high quality consistent earnings generator has achieved a long-term above average earnings growth rate of 11.5%, it's clear from the graph below that earnings growth has flattened since fiscal 2006. On the other hand, it should also be clear that the company has remained profitable right through the great recession of 2008 which brought with it a high unemployment rate. In other words, even though the rate of earnings growth did slow during these weak economic times, this well managed industry leader was able to run this large industry-leading business profitably.
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Our next graph looks at the company's earnings growth since calendar year 2006. Here we discover that even though the earnings growth rate of 4.1% was significantly below historical norms, the fact that Sysco was able to grow earnings at all through these troubled economic times speaks volumes to the strength and quality of their business. Later in this document we will discuss additional reasons beyond the weak economy that have caused Sysco’s earnings to flatten. But most importantly, we will offer a thesis that implies that this recent weakness was partially driven by affirmative action that the company has taken to strengthen and increase long-term profitability.
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The following F.A.S.T. Graphs, presented at normal scale, reviews Sysco’s earnings and dividends since 1997. The orange line represents the calculated earnings justified valuation with a PE multiple of 15. The green shaded area represents total earnings, and the light blue shaded area shows the amount of dividends paid out of those earnings. This provides a graphic illustration of how both earnings and dividends have grown over the years.
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The next graph adds two lines that provide an important perspective regarding how the market has traditionally valued this high-quality company. The black jagged line plots monthly closing stock prices since 1992. The royal blue line with asterisks plots the historical normal PE ratio that the market has traditionally capitalized Sysco’s earnings at. Here we can clearly see that the market has historically priced Sysco’s shares at a premium up to and through calendar year 2006. But now that Sysco’s shares are priced more in line with earnings justified levels, the current dividend yield of approximately 3.6% is greater than what can be earned by investing in a 10 year treasury bond. We believe that this is both atypical and attractive, assuming that the dividend continues to grow.
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The performance results associated with the above graph illustrate two very important investor/shareholder benefits that Sysco has provided. The first shareholder benefit is a strong and consistently growing dividend. The second shareholder benefit is a capital appreciation reward (closing annualized ROR) that is more than twice the S&P 500. Add the two together, and we find that even at today's historically low valuation, long-term shareholder returns from owning this quality dividend growth company have been strongly above average.
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The following estimated earnings and return calculator based on the consensus five-year earnings growth rate of 12 analysts reporting to FirstCall indicate an attractive future opportunity. As an interesting aside, according to MSN, nine analysts reporting to Zacks expect even higher five-year earnings growth of 11.5%. In either case, if these estimates prove reasonably accurate, then Sysco would, as the title of this article suggests, represent a gourmet company at a fast food price.
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Thesis for Growth
The remainder of this article will present reasons why we believe that Sysco represents an attractive long-term opportunity at today's valuation. This view is based on several initiatives that Sysco has taken which we believe does, and will, provide them a competitive advantage in their highly fragmented industry. Primary among these are the expansion of their distribution platform in order to increase efficiency and lower distribution costs, an investment in software and technology to improve supply-chain efficiency and a commitment to customer service via increasing the size, scope and efficiency of their sales force.
Sysco has labeled their current initiatives as their Business Transformation Project, which at the core starts with developing and implementing an integrated software system designed to streamline operations. This enterprise resource planning (ERP) initiative has been substantially completed and is currently being tested with encouraging results. The company is implementing this ERP initiative in the first locations in 2011, and anticipates the majority of the capital expenditures this year will be related to their Business Transformation Project. Although the cost of this project will most likely exceed benefits during these early stages of implementation, longer-term we expect it to enhance profitability.
One of the key advantages of this ERP initiative will be the freeing up of their marketing associates from mundane tasks associated with paperwork and reporting, thus allowing them to spend more time and focus on their customers and their needs. This should potentially solidify relationships and improve sales. There are numerous other benefits to include inventory control, routing and many other factors that should reduce costs and potentially bring the opportunity to win new customers. This should add to the huge moat that their extensive distribution network already provides.
Sysco has also been actively investing in capital improvements. They have been modernizing and constructing new distribution facilities which are expected to increase distribution efficiencies and reduce costs. They continue to focus on modernizing their fleets with more fuel-efficient vehicles and with flexible freezer and refrigeration options. These and other cost saving initiatives serve as examples of how Sysco’s management has positioned the company as the low-cost operator in this more than $210 billion industry. Their commitment to controlling costs without sacrificing efficiency or customer service is a major differentiator for this leading food service distributor in the United States and Canada. With an estimated 16,500 competitors, we believe Sysco stands out as one of only a few companies with the size and scale to effectively operate and compete in the current challenging economic environment.
The food service industry and the restaurant industry respectively have faced numerous challenges in the last few years. First the recession hurt these businesses, and then rising commodity costs including an increase in fuel costs have greatly impacted growth. However, Sysco’s management has indicated that they're seeing an improvement in restaurant sales which represent over 60 % of their total sales. On the other hand, Sysco's management has also indicated real year-over-year market growth for the food service industry in the U.S. to be mildly positive but low through 2015 which will challenge growth. As the only major publicly traded food service distribution company in the U. S. market, these economic challenges have hurt Sysco’s share price, especially since the recession of 2008.
On the other hand, we believe that the current weakness in this industry could represent a long-term opportunity for Sysco to expand market share and re-accelerate their earnings growth rate. As previously discussed, Sysco's competitive landscape is comprised of more than 16,500 distributors operating in this $210 billion market. Sysco, with $37 billion in sales, commands a 17% market share; U.S. Foodservice with $19 billion in sales holds a 9% share; and Performance Food Group with $10 billion in sales holds a 5% share. There are an additional top 10 regional broadline distributors that collectively generate $23 billion in sales and hold an 11% market share. The remaining, approximately $121 billion of sales, representing 58% of the total market, is shared amongst the remaining 16,490 smaller firms.
The food distribution service industry is generally a low margin; capital intensive business that we believe favors Sysco due to its large scale and deep pockets. Sysco has already reported that they feel that the current M&A opportunities are the best they have seen in quite a while. Additionally, Sysco has a long legacy of consistently growing market share over the years at an average of one half-point share gain per year since 1972. Sysco has also grown sales at approximately twice the rate of the growth of the industry in general. Consequently, we believe that Sysco, with its numerous competitive advantages, is poised to exploit the numerous opportunities in front of them. There are challenges to be sure, but we believe the opportunities greatly favor this high-quality company with its strong balance sheet and A+ corporate rating.
Cash Flow Is Key
One concern that we believe has weighed on Sysco's stock price has been a sharp reduction in cash flow from operations reported fiscal year 2010. However, closer scrutiny reflects the effects of a $528 million payment related to its IRS settlement and an additional $140 million in early pension contributions. As these are both nonrecurring drains on cash flow, we believe that concerns regarding their cash flow generation capabilities are overblown.
Management has recently guided that they expect to generate significant cash flow over the next five years. Including the remaining IRS payments, which will expire in 2012, Sysco anticipates generating between $8 and $10 billion of operating cash flow over the timeframe fiscal year 2011 through fiscal year 2015. This should provide sufficient cash flow available for acquisitions, dividends, share repurchases and continued reinvestment towards improving their business.
Sysco’s Opportunity in a Nutshell
The following three slides excerpted from a presentation Sysco made to the Consumer Analyst Group of New York (CAGNY) on February 23, 2011 summarize the opportunity that Sysco sees before them:
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Sysco represents an A+ rated company with a history of operating excellence since its inception in 1969. In response to the recent weaknesses in its core markets as a result of the great recession of 2008, Sysco’s management team responded by aggressively investing in its business infrastructure and marketing staff in order to better prepare the company to operate profitably over the long term. They are the leader in a highly fragmented market which presents many opportunities for growth in excess of the industry. The company generates high returns on equity, has a strong balance sheet and is expected to generate improving cash flow from operations going forward.
Therefore, we believe that their dividend which has increased in each of their 40 years as a public company is well covered and should continue to grow. The current yield of approximately 3.6% is reflective of the fact that their stock currently trades at a discount to their historically normal price earnings multiple. Sysco has announced that they will webcast their third quarter fiscal 2011 conference call on Monday, May 9, at 10 AM ET. Consequently, prospective investors seeking an attractive dividend yield from an A+ rated company with a historically low valuation have a decision to make. Do they wait until earnings are announced in a few days, or consider building a position in advance of the pending release. On the other hand, those with a more jaundiced view of this company and industry in general may want to avoid investing altogether. The choice is yours.