Sysco Can't Fight A Low Tide

By Stephen D. Simpson, CFA | November 05, 2012 AAA

Without going a little too far with the nautical analogies, Sysco (NYSE:SYY) continues to look like a very tight ship, but one that can't change the tides. With established restaurants such as McDonald's (NYSE:MCD) and growth chains like Chipotle (NYSE:CMG) all seeing weaker traffic, there's not a lot that Sysco can do to goose organic volume growth. Although Sysco's margins softened a bit this quarter, this remains a top-notch company for the long-term, albeit one that is not especially cheap.

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A Sluggish Start to the Fiscal Year
Sysco didn't get its fiscal year off to a roaring start, but its financial performance also wasn't that different than sell-side expectations.

Revenue rose about 5%, as reported, with real sales up 2.3% on case volume growth of 2.6%. Acquisitions continue to be a meaningful part of the company's long-term growth plan, as Sysco has made six acquisitions in its first four months of this fiscal year. Food inflation was up about 2.2% this quarter, but Sysco seems to be having a somewhat more challenging time fully passing on those costs (due in part to more aggressive competition).

With that more limited ability to pass on costs, gross margin did fall about 30 basis points from last year. Operating income fell 5%, as the company absorbed not only the gross margin hit, but also higher payroll costs and ongoing "business transformation" costs.

SEE: Everything Investors Need To Know About Earnings

Don't Wait for a Sharp Rebound
Between the comments from Sysco's management and other restaurant operators like McDonald's and Brinker (NYSE:EAT), there would seem to be little reason to expect a sharp turnaround in Sysco's underlying case volumes. The restaurant industry as a whole continues to see traffic weaken; Sysco saw volumes soften as the quarter progressed, and that has continued into October.

Although a few restaurant chains/concepts are doing alright (Yum Brands' (NYSE:YUM) Taco Bell, for instance), at least some of this is due to menu changes, and even then those traffic improvements seem to be petering out a bit. Even with reported payroll numbers improving (more people getting jobs), the lack of wage growth isn't helping consumer confidence any, and that seems to be filtering into discretionary spending like dining out.

With Sysco holding close to 20% share of the restaurant market, there's not much they can do to spur growth significantly beyond the underlying industry traffic trends. Yes, Sysco can continue to gain share and/or acquire businesses, but as restaurants go, so goes Sysco.

SEE: The Impact Of Recession On Businesses

Improvement Is a Process, Not a Destination
Sysco also continues to implement various business improvement initiatives, including new systemwide ERP software. These moves cost money in the near-term, but should eventually allow an already very efficient company to streamline even further down the road.

While the nuts and bolts of cost-efficient operations are frankly quite boring to most investors, they are nonetheless critical for a company like Sysco. This is a business with exceptionally thin margins and even small improvements in free cash flow conversion (say, from more effective working capital management turnover on better inventory management) make a huge difference in the company's projected long-term free cash flow growth rate and, by extension, the fair value.

SEE: Working Capital Works

The Bottom Line
As I said in the opening paragraph and, frankly, almost every time I've written on Sysco, the worst thing about this story is that it's well-known and appreciated on Wall Street. What Sysco has achieved over the years is remarkable and the end result is that the stock is seldom cheap.

Even if I project low-teens free cash flow growth (predicated on mid-single digit revenue growth and the remainder from improving free cash flow generation), the stock is still not all that cheap. I see fair value in the low-to-mid $30s right now, suggesting maybe 10 to 15% upside. Conservative investors might feel that Sysco's dependability (and 3.5% dividend yield) is a good enough offset to that upside, but for now I'm keeping this stock on my watch list, and not on my buy list.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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