When a stock holds enduring favor with a patient investor base and the stock is part of a sector that has enjoyed a big upswing in investor interest, that can be a powerful combination. That's about the only explanation that makes sense to me as to why Sysco (NYSE:SYY) shares are up more than 20% over the past year despite slowing sales and difficulties/delays in reducing operating costs. While Sysco remains a very good company, it's harder today for me to make the argument that it's an equally good stock.
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Another Sluggish Quarter
It has been a while now since Sysco has had a really strong quarter of growth, and this fiscal third quarter is one of the worst in recent memory. Revenue rose 4% as reported, but real sales were actually slightly negative as organic case volume declined by 0.2%.
Margins, too, continue to suffer. Gross margin fell 30bp this quarter, with about half of the decline coming from price competition and the rest from mix-shift. Operating income fell 12% this quarter, and operating margin fell 70bp, as Sysco continues to struggle to implement its SAP system and drive costs of its system.
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Sysco Is A Big Guy That Really Needs The Little Guy
Much is made of how big Sysco is – it's bigger than the next five competitors combined, and it holds roughly twice the market share of the #2 player (US Foods, formerly known as U.S. Foodservice). And yet, it's worth asking just how much that size is really worth to the company. After all, price competition was responsible for about half of the company's gross margin erosion this quarter, and you don't normally think of dominant companies as being subject to serious price competition.
Part of the problem for Sysco is how its business is actually run. Large institutions like schools, prisons, hotels, and healthcare facilities are consistent customers with extensive bargaining leverage, and they use that leverage to get price concessions from Sysco. Likewise for chain restaurants like McDonald's (NYSE:MCD) and Wendy's (NYSE:WEN) – they contribute large amounts of revenue each year, but it's not typically high-margin revenue.
Where Sysco makes up its margins is with smaller customers – the local brewpub that has great hamburgers or the local pizza chain that blows away the national chain. These are important customers for Sysco, not only because they have less bargaining power, but they often rely on Sysco for a lot of “off the invoice” advice and assistance (Sysco can work with restaurants to improve their menus and recipes, to offer better-tasting food that is also more profitable).
Unfortunately, the value-priced menus of McDonald's, Wendy's, Burger King (NYSE:BKW) and so on are hammering small restaurants. Likewise, high-end fast casual chains like Chipotle (NYSE:CMG) and Panera (Nasdaq:PNRA) are increasingly grabbing the lunch work traffic that has often been so important to small restaurants. Not only that, but the overall economic environment in the U.S. isn't helping – consumers are dining out less often during the week and are more often choosing to go with cheaper value deals from big chains, and business travel is likewise lower.
Are Cost Cut Delays Something To Worry About?
I can understand if investors are relatively patient and untroubled by the economic side of Sysco's business – Sysco has been through these ups and downs before, and the small restaurant business will recover someday. What's more problematic to me, though, is the lack of progress with cost-cutting.
The company's delays with its SAP/ERP rollout are becoming almost comical. Even outside of this implementation issue, though, there are other problems. A recent report from Meredith Adler at Barclays highlighted that perhaps as many as half of Sysco's SKUs are duplicates, but the company has to be very, very careful about reducing them – Sysco has multiple operating companies and “faces” to the customer, and changing around the SKUs can upset customers and push them to rivals. As a result, Sysco is hamstrung in cutting costs as far or as fast as it would like to – suggesting ongoing potential, perhaps, but also highlighting that ever-higher margins are not automatic.
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The Bottom Line
Consumer stocks have had a heck of a run, particularly in the food/beverage and restaurant space. Moreover, with investors now thinking that Berkshire Hathaway (NYSE:BRK.B) is a player in food after the announced deal for Heinz (NYSE:HNZ) (even though he rarely makes two major deals in an industry in quick succession), Sysco would make sense as “Buffett stock”.
I've said before that my only serious issue with Sysco stock is usually the multiple/valuation, and that's true again today. Even double-digit free cash flow growth isn't enough to generate a fair value beyond the low $30s, and today's price seems to more than account for the eventual recovery in the smaller restaurant market. I certainly wouldn't sell Sysco just because it's a little pricey today, but I think investors buying in today are looking at underwhelming total returns.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.