Sysco Muddling Through

By Stephen D. Simpson, CFA | August 13, 2012 AAA

The tough times for the restaurant industry continue. Once solid quick-service restaurants like McDonald's (NYSE:MCD) and Chipotle Mexican Grill (NYSE:CMG) have seen softer traffic patterns lately, and big food service equipment companies like Middleby (Nasdaq:MIDD) and Illinois Tool Works (NYSE:ITW) continue to report soft spending from restaurants. Sysco (NYSE:SYY) has been losing some of its shine in recent quarters, as the company struggles to leverage its much-heralded market share and infrastructure into real profit growth. Unfortunately for shareholders, not only does the near-term environment still look tough, but the share price may not yet fully account for that.

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A Little Optimism to Close the Fiscal Year
Sysco's final fiscal quarter looked reasonably good on paper, though investors should keep their enthusiasm reined in a bit.

Revenue rose 6% as reported, with real sales growth of 2.5%. That marks a sequential improvement from 1.6% real growth in the fiscal third quarter. Food inflation came in a little over 3%, while case volume increased 3.3%. Not only was this also better on a sequential basis (case volume rose 2.3% in the fiscal Q3), but it was better than the slightly negative overall restaurant comp decline for the Q2 (about 0.2% according to Knapp Track).

Profitability remains pressured, even if slightly less so than analysts feared. Gross margin fell about half a point from last year, while rising almost as much sequentially. Operating income fell 4% (though operating margin improved sequentially) and EBITDA declined for the third straight quarter.

SEE: Everything Investors Need To Know About Earnings

Droughts Don't Help Stability
Sysco management has spoken before of its desire for a relatively stable level of food price inflation, but that looks like it may not materialize in 2013. With the U.S. drought spiking corn prices, there are real worries about the degree of price increases that protein producers like Tyson (NYSE:TSN), Smithfield (NYSE:SFD) and Pilgrim's Pride (NYSE:PPC), and dairy producers like Dean Foods (NYSE:DF), will be contemplating next year.

It's hard to see how this doesn't hurt Sysco one way or another. Either the company will have to absorb some of the inflation (hurting margins), or it will see a mixed shift to lower-cost products (hurting margins) and/or lower overall order volumes (hurting margins).

SEE: A Look At Corporate Profit Margins

Long-Term Inevitability Versus Expectation
By no means do I think Sysco has any meaningful long-term problems with its business or its business model. Americans will continue to dine out, and Sysco's sheer operating scale gives it a real advantage over rivals. In other words, I think Sysco can see not only a growing addressable market, but continue to increase its share of that market.

SEE: "Healthyfying" The Fast Food Market

The Bottom Line
That said, I really don't see how the shares are undervalued today. Even if Sysco can add 50 basis points of free cash flow yield over the next five or so years (a lot for a company like this) and keep revenue growing at a 5% clip, it takes a low discount rate (8.5% or so) to generate a fair value of $35 - and even that isn't really compelling undervaluation. Although it's not at all uncommon to see high-quality companies sport healthy valuations, particularly when there are sizable barriers to entry, and today's environment really doesn't show what the company can do, it still seems like Sysco stock could find slow going for the foreseeable future.

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

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