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Sysco's (NYSE:SYY) acquisition of the Brakes Group is a strategic move to gain an additional source of revenue and to provide a foundation for growth in Europe. Both companies are leaders in the food service industry in their respective regions. Sysco and the Brakes Group supply food and related items to restaurants, hotels, hospitals, schools, nursing homes, and sports/leisure facilities.
Since the Brakes Group is experiencing noteworthy growth (6.5% increase in revenue in 2015 over 2014), this acquisition will help Sysco increase its revenue growth. Sysco is expecting to grow revenue at 3.6% for FY16 (consensus), so Brakes represents a more robust source of revenue growth.
Sysco is getting a good deal with the acquisition from my perspective. Sysco is paying $3.1 billion for Brakes, which generated $5 billion in revenue in 2015. That represents 10% of Sysco's expected FY16 revenue of $50 billion. Therefore, the combined companies are likely to generate at least $55 billion in FY17 as the deal is expected to close by the end of this fiscal year.
I think the price that Sysco paid for Brakes is fair. Sysco is getting Brakes for a price that equals 62% of the $5 billion in annual revenue that Brakes earned in 2015. Brakes' price to sales ratio of 0.62 is slightly higher than Sysco's price to sales ratio of 0.58. The price that Sysco paid for Brakes will be worth it in my opinion since Brakes is growing revenue at a higher pace. Furthermore, Sysco will have a better ability to expand into Europe through Brakes' growth.
The Brakes Group is based in London and operates food service in the United Kingdom, Ireland, France, Sweden, Spain, Belgium, and Luxembourg. Since Brakes has a similar food supply business to Sysco's business, the acquisition fits well for both companies.
Brakes will continue to operate as it currently does after the acquisition. The company will be owned by Sysco, but still operate under the Brakes and its other brand names and maintain its leadership structure. So, there won't be much disruption to the Brakes operation.
The acquisition is likely to be beneficial to both companies. Of course, Sysco will gain a new source of revenue. Sysco will also be able to expand its footprint in Europe over time. Brakes will likely benefit from Sysco's expertise in operating strong distribution networks. Sysco operates 197 distribution centers in the United States, Canada, the Bahamas, and Ireland. Therefore, Brakes will gain from Sysco's distribution expertise, while Sysco gains from Brakes' business knowledge of the European market.
The acquisition fits into Sysco's strategy to grow in established markets and to expand into new regions. Ireland is an established market that Sysco already operates in. Brakes provides Sysco with six new European countries to add to its business. Both companies will help each other to grow going forward as they draw on each other's regional expertise.
Sysco also has a strategy in place to achieve $400 million in annual operating income growth and 15% ROI by fiscal 2018. The company's Q3 results show that Sysco is effective in contributing to these goals through the 3.6% increase in case growth and 35 basis-point increase in gross margin. Sysco is also contributing to its goals for operating income and ROI by reducing costs. The company implemented a workforce reduction plan to eliminate 1,200 positions, while still effectively providing strong service to customers.
Sysco is on target to hit its goal of $1 billion in free cash flow for the fiscal year. The company brought in $627 million in free cash flow for the first three quarters. So, Sysco just needs $373 million more in FCF in Q4 to hit its goal. Free cash flow generation will be important for Sysco to pay its 2.5% dividend. The company's payout ratio is high at 88.5%. So, driving down the payout ratio by producing more FCF will allow the company to effectively pay and increase the dividend and to do share repurchases.
Valuation on the High Side, But Justified
Sysco is priced at a premium to the broader market with a forward P/E of 22 as compared to the S&P 500's forward P/E of 17. However, Sysco is the leader in the wholesale food industry with a large geographic presence and market cap of $28 billion.
Sysco is valued below competitor, Core-Mark Holding (NASDAQ:CORE) which is trading at 24X next year's expected earnings (consensus). However, competitor Hain Celestial Group (NASDAQ:HAIN) is trading at a discount to Sysco with a forward P/E of 21.
Sysco's stock is probably getting an above market average valuation for its dividend. HAIN doesn't pay a dividend, so it won't attract income-seeking investors. CORE's dividend yields less than 1%, so its stock is probably not attracting income-seeking investors either. However, CORE is expected to grow earnings at a higher rate over the next 2 years according to consensus (over 20% annual EPS growth) than Sysco (10% average annual EPS growth) and HAIN (9% average annual EPS growth). Therefore, CORE is getting the higher valuation as investors anticipate strong earnings to drive the stock price.
Overall, Sysco offers a good combination of dividend payments and stock appreciation potential driven by consistent earnings growth. Therefore, its valuation is justified in my opinion.
Sysco is likely to get a long-term boost from the Brakes acquisition. Brakes will help Sysco expand its global presence and grow revenue and earnings going forward.
One key risk for Sysco is that the acquisition has not closed yet. If it does not receive approval for the acquisition due to antitrust concerns, then Sysco will not reap the expected growth benefits from Brakes. I do think that the acquisition is likely to close successfully, but the risk of an unexpected non-approval is still on the table.
Sysco has solid strategies in place to achieve earnings growth that is likely to exceed the broader market. The company's 10% expected annual earnings growth is likely to allow the stock to outperform the S&P 500, which is expected to average about 6% to 7% EPS growth annually over the next two years. Therefore, I would expect Sysco's stock to edge higher than the S&P 500 over at least the next 2 years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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