US Foods: Buying More Scale

Summary

• US Foods is making another sizable deal in an effort to build scale and drive synergies.
• I see the rationale behind the deal, yet pushing up leverage in such a potentially uncertain economic period could be questioned.
• Leverage will increase quite a bit as the question is how large the impact of the Coronavirus will be.
• Appeal seems to be on the increase, although high leverage is a small worry.
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US Foods (NYSE:USFD) is making a sizable move at a time when the general market is facing quite a bit of turmoil. The company is making a near billion acquisition for Smart Foodservice Warehouse Stores to further expand its empire. The rationale behind the deal is largely driven by greater scale and realization of potential synergies, yet this requires real integration as leverage will increase quite a bit in an uncertain economic environment.

Appeal is certainly on the increase given the recent share price decline, yet high leverage and a sell-off in the wider market is what prevents me from buying the current dip.

The Deal

US Foods has reached a deal with Apollo Global Management to acquire Smart Foodservice Warehouse in a $970 million cash deal. Smart Foodservice operates 70 small-format cash and carry stores in states like California, Washington, Oregon, Nevada, Utah, Montana and Idaho. Since 1955 these stores service restaurants and other food companies, with services provided by nearly a thousand employees.

The company generated about $1.1 billion in sales in 2019, indicating that about a 0.9 times sales multiple has been paid. With EBITDA seen at $85 million a year, margins on that metric approach 8% of sales and suggests that an 11.4 times multiple has been paid.

Rationale for the deal is undoubtedly scale, yet US Foods believes that the cash & carry business has good prospects with long-term growth seen at of 4-5% thanks to independent restaurants seeking cost effective and convenient solutions. The real kicker of course has to come from an anticipated $20 million in annual costs synergies (only fully achieved through 2024) thanks to purchasing efficiencies and expansion of private brands.

Leverage is set to increase to 4.0 times upon closure according to management, up a fraction from the 3.9 times leverage ratio reported for 2019. While shares of US Foods are down 4% in reaction to the news, I would not read too much into that price move as it is similar as the move shown by broad market indices. While one can argue that the food sector is a relative safe-haven given the threats of the Coronavirus, the counter argument could easily be made that as a supplier to restaurants among others, the company is not insulated from the current turmoil.

Pro-Forma Implications

In February, US Foods reported its 2019 results with sales up 7.3% to $25.9 billion, indicating that the latest deal adds about 4% to pro-forma sales. Growth has been split pretty evenly between impact from acquisitions as well as a 3.8% increase in organic sales. Much of this growth is the result of pricing with case volumes up 1.1%.

Earnings metrics reveal that adjusted EBITDA was up 8.3% to $1.19 billion, for margins equal to 4.7% of sales. This reveals that the latest acquisition will certainly be accretive to margins reported by the firm, even before accounting for anticipated synergies.

The company reported EBIT of $699 million which worked out to net earnings of $385 million, or $1.75 per share based on a share count of 219 million shares. Adjusted earnings came in at $2.38 per share with much of the discrepancy resulting from costs related to dealmaking, as well as $0.15 per share in stock-based compensation, which of course should not be adjusted for.

Net debt stood at $4.64 billion by year-end, for a 3.9 times leverage ratio based on $1.19 billion adjusted EBITDA. The 219 million shares currently represent a $6.8 billion valuation at $31 per share, for an enterprise valuation of $11.4 billion ahead of the latest deal. This values US Foods at nearly 0.5 times sales and around 9.5 times EBITDA. That means that the multiple paid for Smart Foodservice marks a big premium in terms of the sales multiple as a result of the differential margin profile, yet EBITDA multiples are largely similar, for the same reason of course.

I peg net debt increasing to about $5.7 billion following the deal without an equity issuance. At the same time, adjusted EBITDA will increase from $1.19 billion to about $1.28 billion, or $1.30 billion once synergies are included. That results in an increase in leverage from 3.9 to 4.4 times, not 4.0 times as suggested by management, as this marks somewhat of a discrepancy, unless shares will be issued.

Some Further Thoughts

To look at the true future impact, we have to look at the 2020 guidance and impact of this deal. For 2020 the company guided for solid growth thanks to acquisitions with case volume growth around 10% and a 12-15% increase in adjusted EBITDA which means that forward leverage ratios quickly come in around 4 times again.

Based on that guidance, adjusted EBITDA is seen around $1.35 billion, and with depreciation seen around $335 million, that results in adjusted EBIT of around a billion. Knowing that the latest deal will boost EBITDA by $85 million at the get go and assuming a 1.0-1.5% of sales D&A expense, I put the EBIT contribution at $70 million, resulting in a pro-forma adjusted EBIT number of $1.07 billion. The company guided for interest expenses of $215 million, and assuming a 5% cost of debt on the additional debt incurred, net interest costs might jump to $265 million, working down to a $800 million EBIT number.

With a tax rate around 25%, this results in net earnings of $600 million, for earnings just North of $2.70 per share, in line with the guidance. The reason why accretion is likely limited is that the majority of the incremental EBIT from the latest deal will be eaten by interest expenses, although modest accretion could reasonably be expected. Adjusting for some stock-based compensation expenses and structural components, earnings realistically come in around $2.50 per share, for a 12 to 13 times forward earnings multiple. While not very high, note that leverage certainly is high.

Final Take

My last article on this name dates back to summer of 2018 in an article called "Double Disappointment". The company cut the full-year sales guidance at the time and made an expensive acquisition causing shares to fall from $40 to $35 overnight. At $34, I found shares a bit expensive with adjusted earnings power at $1.70 per share, and note that these were adjusted earnings and leverage was high. Fast forward to today, we see earnings power notably higher and realistically at $2.50 per share currently already. While leverage is still high, the actual shares have only fallen further from $34 to $31 over the past one and a half year, while the broader market kept soaring.

Shares briefly rose to the high twenties later in 2018 and have ever since rose back to levels above the $40 mark this autumn, before dropping severely to $31 in recent weeks amidst the anticipated impact of the Coronavirus, which by the way poses real risk to the 2020 guidance. This uncertainty and the latest deal only adding to an already leveraged balance sheet are probably key reasons for the selloff as investors should reasonably expect some more volatility in the near term.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.