PierreDesrosiers/iStock via Getty Images
I've been lukewarm on US Foods (NYSE:USFD) for a while, as I feel stuck between valuing the company on the basis of what it could (and arguably, should) achieve in terms of organic growth and margin leverage and the reality that management hasn't been delivering on that potential in a meaningful way. Now there's a proxy fight for control of the board, with investor Sachem Head looking to take over and presumably put the company on the "right path".
These shares are up about 7% since my last update, beating the S&P 500, but largely tracking with food distribution peers Sysco (SYY) and Performance Food Group (PFGC). These shares do still look undervalued, but I see risks around the proxy fight - if management wins, I'm concerned that investors may see more of the same underwhelming results, but I haven't seen a compelling plan from the other side either, and I worry about the risks of a hack-and-slash approach to cost-cutting.
Looking For Progress On Value Drivers
One of the frustrating things for me in analyzing US Foods is that I don't see a lot of progress or leverage from what should be value drivers for the business.
The company's private label business generates significantly higher profits (around 2x gross profit per case), but private label sales have been stuck at around 34% to 36% of sales since 2017. Yes, the pandemic did impact the business, but the lack of momentum here is concerning, particularly as the company has invested resources in expanding and promoting the assortment. Penetration did improve by more than 100bp in the last quarter, so that is at least moving in a good direction now.
I'm also frustrated by the company's share of wallet with existing restaurant customers. US Foods has a roughly one-third share of wallet with its restaurant customers, and my understanding is that this metric, too, has been relatively flat for a while. If anything, the pandemic should have encouraged more consolidation, particularly with smaller distributors having more issues with stocking and labor, and the fact that the company can't capture more business with existing customers does concern me.
I don't know if this is an opportunity to engage more directly with customers ("why aren't you doing more business with us?") or get more creative on pricing, but this seems like important low-hanging fruit to me. If nothing else, US Foods trucks are already driving to these locations, so selling more at each stop would be a meaningful margin leverage opportunity.
Last and not least is the digital strategy. Relative to its large peers (not to mention the smaller independent distributors out there), US Foods was an early mover in digitalization, and it generates a substantial percentage of its sales through e-commerce channels, with good penetration across its customer base. Sysco, by comparison, has lagged far behind (but is stepping up recently), but it doesn't seem to be driving any meaningful share of wallet growth, private label sales momentum, or margin leverage for US Foods.
Operational Challenges Remain, But Are Harder To Visualize
US Foods doesn't report enough detail to really go into depth as to how/why Sysco outperforms them consistently and significantly on margins (around 200bp, which is significant for a company with operating margin around 200bp), but there is enough information to suggest that US Foods has higher distribution and fulfillment costs.
US Foods has been addressing this by targeting improved routing and warehouse automation, as well as more vendor management and smarter/dynamic pricing. All of that makes sense, but execution is crucial. Investors have been hearing various iterations of management pledging improvement, but those improvements have not really shown up. As the name would suggest, success in distribution absolutely depends on being able to cost-effectively distribute products and this is an area where both Sysco and Performance Food have established records of superior performance.
The Outlook
In part to sway the proxy battle, management issued a three-year plan with fourth quarter results that calls for ongoing improvement in the business. Management is targeting $1.7B in FY'24 EBITDA, but that's not all that much better than what the Street was already expecting. Moreover, if my revenue estimates for the next couple of years prove accurate, that $1.7B in '24 EBITDA will still only be barely above the pre-pandemic EBITDA margin level of 4.6%.
So, in essence, management is looking to generate overall growth about 30% above the underlying market growth rate (with 1.5x growth in the restaurant channel), and still only get back to where margins were before the pandemic? Adding to my concern, organic case growth targets have been hit-or-miss with management, and I'm not sure that US Foods' core independent restaurant channel is well-placed to outgrow national chains that picked up business through the pandemic on the strength of their drive-thru/takeout/delivery capabilities.
That's not to say that these targets can't be met, or even beaten. Given the higher distribution costs here versus peers, there should be meaningful cost-reduction opportunities. Moreover, improved share-of-wallet and private label penetration would absolutely help drive above-market revenue growth.
My revenue estimates are higher now than at my last update, but that's all due to higher-than-expected inflation. My underlying core volume growth assumptions have not improved, and I'm not expecting inflation to hang around forever. As is, I'm looking for around 5% long-term revenue growth, but I won't be surprised if there's a downward reset at some point on lower inflation/deflation.
I do expect US Foods to get to a 5% EBITDA margin in FY'25, but that's not much out of line with the consensus opinion today. Long term, I'm looking for FCF margin to improve to 3% versus around 2% in the years before the pandemic, and that may well be too bullish unless management can improve its execution on margin improvement initiatives.
The Bottom Line
Between discounted cash flow and margin/ROIC-driven EV/EBITDA, I believe that US Foods is around 10% to 20% undervalued today and priced for a long-term annualized total return in the high single-digits. That's fairly attractive, and there could be even more upside if the company can execute on organic revenue growth and margin improvement initiatives.
I don't have a dog in the proxy fight, but I do think it's reasonable for investors to hold management accountable for the frustrating lack of progress here. I believe this business can do better than it has, and while I think there's upside potential here, I would personally rather wait for more clarity on who will be running this business and how they plan to drive those needed improvements before investing my own money.
