Sysco Not Exactly Feasting

By Stephen D. Simpson, CFA | February 09, 2012 AAA

It's a little scary when even some of the most efficient operators have difficulties cutting their costs enough to keep growing. That would seem to be the case today with Sysco (NYSE:SYY). It seems odd to read analysts criticizing Sysco's cost structure, but the reality is that growth has become more challenging for this proven dividend champion.

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Costs Chewing into Profits
Sysco posted revenue growth of over 9%, but that number is a little misleading. Two-thirds of the company's growth was a byproduct of food cost inflation and actual case volume growth was more on the order of 3% with real organic growth closer to 2%. (For related reading, see What You Should Know About Inflation.)

Unfortunately, Sysco struggled to pass those costs on to its customers. As a result, gross margin slid about 80 basis points from the year-ago level. Sysco was also not able to trim its operating costs enough to compensate for its aggressive pricing. Operating income dropped about 2% as operating margin contracted 50 basis points.

Finding the Balance Between Price and Volume
Listening to management talk about the quarter, it looks like the company was willing to be more aggressive on pricing to drive volume. At the same time, investors shouldn't kid themselves about the pricing environment. Tyson Foods (NYSE:TSN) recently reported earnings where there were double-digit price increases across the protein spectrum and protein is close to 25% of Sysco's sales base. It's not just Tyson either, as most food companies are reporting price growth in the mid-single digits (at a minimum).

How Efficient Can Sysco Be?
Sysco has been relentless over the years when it comes to driving costs of its system. Now, though, investors are lamenting the company's cost structure and blaming that for the company's fiscal second quarter performance. This raises the question of what more the company can do. It's true that there's a decentralized structure at Sysco, but doesn't a national distribution business have to be decentralized to some extent?

There aren't many public companies that do what Sysco does, so comps are hard to come by. Nevertheless, Sysco does do better than United Natural Foods (Nasdaq:UNFI) and SuperValu (NYSE:SVU) when it comes to margins and returns, so it's worth asking just how much more Sysco can do to streamline its already-lean operations.

Stuck in the Middle
It's also worth noting that Sysco can only push customers so far in the present environment. Restaurant sales are about two-thirds of the company's customer base and people just aren't eating out as regularly as before the recession. What's more, when people do eat out, they are tending to go more to chain restaurants (25% of Sysco's customer base) that have value-priced or promotional meal deals.

What that means, then, is that Sysco has to press on companies like McDonald's (NYSE:MCD), Yum Brands (NYSE:YUM) or Ruby Tuesday (NYSE:RT) to drive better margins. With all of these companies likewise working to preserve their own margins, there just isn't that much slack left in the system. (For related reading, see How To Analyze Restaurant Stocks.)

The Bottom Line
Sysco is rarely ever cheap, as it is practically a permanent fixture in lists of blue-chip dividend stocks. Right now, the stock seems a little below fair value, but not to such an extent that's really exciting or interesting. Sysco remains a worthwhile holding for conservative income-oriented portfolios, but it's not an especially interesting stock today from a capital gains perspective.

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

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