Self-inflicted problems took their toll on US Foods (NYSE:USFD) in 2018, but it looks like those service issues (which impacted fill rates and on-time performance) are behind the company, and it likewise looks as though customer volumes are willing to give the company another chance. Add in ongoing opportunities to drive share-of-wallet with existing customers, penetrate further into the independent restaurant market, and drive more private label adoption, and there’s still a credible case for above-average revenue and profit growth here.
Slightly Better Results To Start FY 2019
US Foods earnings reports are a pain because of the LIFO/FIFO differences, various sundry add-backs, and so on, so I can fully understand why at least some investors don’t want to bother with the hassle of figuring out what this foodservice distributor actually earned in a quarter. In any case, dealing with that hassle is kind of why I’m here.
Revenue rose more than 3% as reported, beating expectations by about 1%, as US Foods saw a healthy 1.4% organic case volume growth. Growth within the independent restaurant business was particularly strong, up 5.5%, while healthcare and hospitality was up 1%, coming off a four-quarter stretch of basically no growth. Within the mix, private label increased another 100bp to 35%.
Gross margin was basically stable on an adjusted basis (at 17.4%), while adjusted EBITDA rose almost 4%, matching expectations but missing slightly on a margin basis. Adjusted operating income was up about 4% as well.
Looking at US Foods’ peers, Sysco (SYY) reported “local cases” up more than 2%, which is a reasonable enough substitute for US Foods’ independent cases metric. Performance Food Group (PFGC), a closer peer in terms of overall size, reported 3.4% organic growth with 5.4% growth in independent cases and a similar 2% food cost inflation.
Driving Independent Case Growth Remains Key
The key driver for US Foods remains the performance of the company with independent restaurants (basically local operators and small regional chains). Independents are roughly the same size in total as the national chains (larger if you lump regionals in with them), but they are faster-growing as a category and they offer better margins to distributors like US Foods – as you might imagine McDonald's (MCD), Panera (PNRA), et al, have considerable bargaining power when it comes to dealing with outside distributors (as well as internal capabilities in at least some cases) and they’re not shy about using it.
US Foods has around 10% share in the independent category, meaning the company punches slightly above its overall weight in the foodservice space (it has around 8% to 9% share versus mid-teens share for Sysco). Even so, US Foods’ clients typically only do around 20% to 30% of their total business with US Foods, meaning there are still opportunities to increase the share of wallet with those customers.
Beyond expanding past that 10% share (more new customers) and increased share-of-wallet (more business with existing customers), I see at least two other significant ongoing drivers for US Foods. First is private-label offerings. These are higher-margin sales for US Foods (a 1% increase in private label mix should be worth around 0.1% GM all things equal) and they represent savings to the customer as well, so it’s a “win-win.” US Foods also still has opportunities to improve the performance of its underperforming accounts, mostly through increased sales detailing and working to shift more of that business to the e-commerce platform, where US Foods still has an edge over Sysco and Performance Food in terms of sales penetration. Those customers who do use US Foods’ e-commerce platform tend to order more and stick around longer (higher retention), and they’re cheaper to service.
A Premium-Priced Acquisition
US Foods is still working to close its acquisition of SGA, a deal first announced about a year ago. The FTC review process has dragged on a bit, and US Foods may have to agree to some divestitures to get the deal done, but management won’t talk in detail about that. While SGA is a top-10 player in foodservice distribution (#6, I believe), it has less than 2% national share, which speaks to how fragmented this industry remains even after Sysco’s seemingly endless process of consolidation. SGA will bring US Foods improved exposure to the Pacific Northwest, but at a healthy low-teens premium even after figuring in the NOLs.
The Outlook
I do still have some concerns about risks like freight costs, as recruiting/retaining drivers remains challenging in the trucking market. What’s more, there’s not a lot of room to maneuver if fuel costs spike; this is a low-margin business so all costs matter. On the other hand, management seems to be back on track with case growth, and increased share-of-wallet with customers can drive improved operating efficiencies.
I value US Foods on the assumption of 4% long-term revenue growth and about 130bp of long-term improvement in FCF margins from increased gross margins and improved operating efficiency. In addition to discounted cash flow, I use the margin/return-driven EV/EBITDA approach as a secondary method.
Both approaches suggest a high-$30s share price is fair.
The Bottom Line
While “fairly valued” relative to its risks, US Foods is still priced for a high single-digit annualized return to shareholders, which is not bad for a company with fairly modest economic cycle sensitivity. For investors who want a more consumer-driven story, but one that has self-help potential as well, US Foods still has some moderate appeal.
