Sysco Still On Simmer

By Stephen D. Simpson, CFA | November 09, 2010 AAA

From an operational standpoint, the restaurant industry seems to be on the road to recovery. Companies like McDonald's (NYSE: MCD), Yum! Brands (NYSE: YUM) and Chipotle Mexican Grill (NYSE: CMG) are all seeing better traffic and lofty stock prices. The question, though, is whether food supply giant Sysco (NYSE: SYY) gets to share in the happy feelings.

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A Dog's Breakfast In The First Quarter
Sysco's fiscal first quarter report does not really seem good enough for a company whose stock is near a 52-week high. Revenue rose more than 7% to $9.8 billion, and it did beat the consensus estimate, but the quality of the beat may be a worry to some. Food cost inflation was 3.3% in the quarter, and acquisitions and forex chipped in another 1.1% of the revenue growth. Volume growth, then, was on the order of 3% - not bad, but probably not enough to really get investors or analysts excited.

Concerns about the company's margin performance are also likely. Gross margin has been a concern for some time, as the company has battled a tough pricing environment on both sides of its business. For this quarter, gross margin dropped 40 basis points to 18.8% - a number that is not likely to thrill those worried about this issue. A little further down the line, operating income growth of 2% is likewise not a real cause for celebration.

The Road Ahead
At this point, it is hard to find any real threat to Sysco beyond sustained mediocrity in growth. The company serves 40% of the U.S. food service industry, has more share than its next five competitors combined, and still has opportunity for expansion in both products and customers.

On the other hand, Sysco suffers from a long-term case of "It is what it is." YUM can carpet the developing world with its quick-service restaurants, and smaller chains like Chipotle and Buffalo Wild Wings (Nasdaq: BWLD) can deliver impressive growth by exploiting new niches in the restaurant market. Sysco simply cannot grow as fast and does not have the same sort of expansion options. There is no reason that Sysco cannot grow overseas, but it takes time and money to build the networks and relationships.

The Bottom Line
Sysco is not a bad company; far from it, in fact. A double-digit return on invested capital and a commanding share in a growth industry are two of the best indicators of good companies over the long term. That said, investors have to buy this stock right, because there is no falling back on good growth and earnings momentum to ease that mistake. (For more, see The Characteristics Of A Successful Company.)

To that end, Sysco just does not look compelling today. The company has a consistent record of mid-single-digit growth and low/mid-single-digit cash flow margins. It is hard to see what the company could, or would, do to change that. The best guess here is that there will be some consistent improvement in cash flow generation, but not enough to fuel a dynamic price target. Accordingly, it would seem that a pullback of at least 10% would be in order before the stock would be intriguing. (For more, see The Value Investor's Handbook.)

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