Sysco's Benefit Of The Doubt Looking A Little Fuzzy

By Stephen D. Simpson, CFA | August 12, 2013 AAA

Like a bag of produce left in the back of the fridge too long, the argument for Sysco (NYSE:SYY) being a dependable year-in/year-out performer is looking fuzzy and pretty unappetizing. I don't argue that Sysco remains the go-to name when it comes to supplying restaurants and all manner of food-serving institutions, but I do argue that that dominance isn't worth quite as much in terms of margin leverage as long believed. Still, this company reliably churns out free cash flow and that ought to keep the shares from getting all that cheap.SEE: Earnings: Quality Means Everything Another Soft QuarterFiscal fourth quarter results didn't show much of any improvement for business at Sysco. In fact, core volume and margin trends continue to be weak relative to Street expectations, and it's unclear to me that management has the ability to drive significant near-term changes. Revenue rose 5% for the quarter, but underlying performance was quite a bit softer than that. Case volume did grow nearly 1% on an organic basis, about 1% better than the fiscal third quarter. Still, excluding food cost inflation (up 2%) and acquired revenue (up 2% net of forex), core growth was quite weak. Margins were even more concerning to me. Gross margin fell 60bp from last year, marking the 13th straight quarter of year-on-year declines and carving out new lows. Operating income declined 11%, as the company not only couldn't reclaim the lost gross margin leverage, but saw ongoing pressures like a shortage of truck drivers. If you exclude the business transformation expenses, operating income was down only 7%, but I think investors should not exclude these – unless management is prepared to report margins in the future net of the benefits of these “transformation” activities.SEE: Food Plays That Look Savory No Joy In Food ServiceSysco is a very strong company in the food distribution space, but there's only so much they can do about a challenge market backdrop. Companies like McDonald's (NYSE:MCD) and Subway continue to take share in the restaurant industry, particularly with value menus that offer relatively adverse margins to a company like Sysco. At the same time, the restaurant industry continues to see those businesses struggle that have traditionally provided Sysco with better margins (small, locally-owned restaurants). Can Sysco Afford To Accommodate Customers?I'm increasingly wondering whether or not Sysco can afford to hold back on some of its margin improvement opportunities. In particular, it seems that roughly half of the company's SKUs are duplicates (a legacy of the growth-by-acquisition model) and there are inherent inefficiencies in running so much duplicate effort. In the past, Sysco has held off on “de-duplicating” its SKU base for fear that it would alienate customers and lead to lost sales (“Brand A” tomato sauce may be identical to “Brand B”, but if customers have used Brand A for years, they may not appreciate a forced switch to Brand B). While I trust management to have run the numbers and calculated the net trade-off between lost sales and improved margins, I wonder just how much lower Sysco management will let gross margin go before taking more aggressive action. Just Not The Play In Food Or Restaurants Right NowMaybe this is the bottom for Sysco, but it's clear that this stock has not been the way to play restaurants or food service. Middleby (Nasdaq:MIDD), a provider of food service equipment with a large exposure to chain restaurants, has continued to report torrid revenue growth through value-additive acquisitions, organic product introductions, and market share gains. At the same time, even Manitowoc (NYSE:MTW) and Illinois Tool Works (NYSE:ITW) seem to be able to extract more growth from the restaurant and institutional food space with their equipment sales. Likewise, a variety of food stocks have outperformed Sysco. Tyson (NYSE:TSN) and Pilgrim's Pride (NYSE:PPC) have both done particularly well in the protein space, and even often-lowly Dean Foods (NYSE:DF) has logged a good trailing 12 months in the market. The Bottom LineWhile Sysco's fourth quarter was uninspiring in terms of revenue and operating performance, the company did exceed most expectations when it came to free cash flow, and I don't think this is a point to overlook. Although Sysco may not be quite as strong or dependable as previously believed, the company has long been a reliable producer of positive free cash flow. Even so, I'm in no hurry to jump into the shares today. If Sysco can maintain its historical revenue growth rate (around 4.7%) and boost the free cash flow growth rate to 8% (by ultimately posting a free cash flow margin 50% higher than its historical average), it's still only worth $30 to $35 and that's only if you exclude the net debt on the balance sheet. Should the “but it's a great company” premium erode, I might reconsider the shares, but for now they continue to look like an iffy capital gains proposition. Disclosure – At the time of writing, the author did not own a position in any of the companies mentioned in this article.

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