Narrow-Moat Sysco's Recipe for Growth Is Cooking up Improved Performance | SYY Message Board Posts


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Msg  30 of 30  at  8/12/2021 8:28:31 PM  by

jerrykrause


Narrow-Moat Sysco's Recipe for Growth Is Cooking up Improved Performance

 Morningstar Investment Research Center
 
 
 
Narrow-Moat Sysco's Recipe for Growth Is Cooking up Improved Performance 
 
 

Rebecca Scheuneman
Equity Analyst
 
 
Business Strategy and Outlook | by Rebecca Scheuneman Updated Aug 12, 2021

We believe Sysco possesses a narrow moat, rooted in its cost advantages. We surmise the firm benefits from lower distribution cost given its closer proximity to customers, complemented by scale-enabled cost advantages such as purchasing power and resources to provide value-added services to its customers. While COVID-19 created a very challenging environment, the food-service market has nearly fully recovered, with sales at 95% of prepandemic levels as of the summer of 2021, and Sysco has emerged as a stronger player, with $2 billion in new national account contracts (3% of prepandemic sales) and 13,000 new independent restaurant customers.

In May, Sysco laid out its three-year road map, termed "recipe for growth" which will be funded by the elimination of $750 million in operating expenses. The plan should allow Sysco to grow 1.5 times faster than the overall food-service market by fiscal 2024. Sysco is investing to eliminate customer pain points by removing customer minimum order sizes while maintaining delivery frequency and lengthening payment terms. It improved its CRM tool, which now uses data analytics to enhance prospecting, rolled out new sales incentives and sales leadership, and is launching an automated pricing tool, which should sharpen its competitive pricing while freeing up time for sales reps to pursue more value-added activities, such as securing new business. Sysco is also developing the industry’s first customized marketing tool, harnessing its significant customer data to generate tailored messaging that should resonate with each customer. In pilots, this practice increased Sysco’s share of wallet. Further, Sysco has switched to a team-based sales approach, with product specialists that should help drive increased adoption of Sysco’s specialized product categories such as produce, fresh meats, and seafood. Lastly, Sysco is launching teams that specialize in various cuisines (Italian, Asian, Mexican) that should drive market share gains in ethnic restaurants. Looking abroad, Sysco has a new leadership team in place for its international operations, increasing our confidence that execution will improve.

Economic Moat | by Rebecca Scheuneman Updated Aug 12, 2021

We believe that Sysco possesses a narrow moat anchored in its cost advantages, underpinned by both its closer proximity to customers, which lowers distribution cost, and its scale, which provides the firm with superior purchasing power as well as resources to provide clients value-added benefits such as technology tools, consultancy, and a high level of service.

In our view, Sysco’s vast and unmatched distribution network of 172 U.S. distribution facilities places it in closer proximity to its customers, providing it with a distribution cost advantage. This compares with 72 facilities for no-moat US Foods, Sysco's nearest competitor. Supporting our contention, over the past three years, Sysco’s distribution expense averaged 5.8% of revenue compared with 6.9% for US Foods. No-moat Performance Food Group is another sizable distributor, with 74 food-service distribution facilities. Its distribution cost has averaged just 4.8% of sales the last three years, but this metric skews lower due to PFG's high mix of national accounts.

We believe Sysco’s purchasing power also provides an advantage, as Sysco’s fiscal 2021 U.S. revenue was $42.9 billion (16% market share), in comparison to US Foods’ $25.9 billion (10% share) and the $21.0 billion (8%) we expect from PFG's food-service segment over the same period. Even the largest restaurants can’t match this purchasing power; only the top U.S. restaurant, wide-moat McDonald's, is in the ballpark, with $40.5 billion in 2020 U.S. systemwide sales. Thereafter, revenue falls off steeply, with number two Starbucks reporting $18.5 billion and number three Chick-Fil-A booking $13.7 billion. While Sysco hasn’t always leveraged its purchasing power scale (historically, each distribution center operated independently), in 2014 it began an effort to consolidate purchases, which drove a 200-basis-point improvement to gross margins. While we acknowledge that US Foods has also realized margin improvement from consolidating purchases, we do not believe it realized the same degree of benefits as Sysco, given its smaller size and as evidenced by gross margins that lag Sysco's U.S. broadline margins by about 200 basis points.

Sysco also uses its scale to differentiate itself from smaller regional and local players by offering clients products and services that smaller distributors cannot offer, such as technology tools that help their customers better manage their businesses. These systems provide restauranteurs with integrated systems that help them manage their point-of-sale transactions, control inventory, calculate menu profitability, facilitate online orders and reservations, and schedule employees. In addition, these systems allow clients to input their own orders, freeing up significant time for Sysco’s salesforce so the reps can engage in more value-added activities, such as consultative selling to increase penetration of existing accounts or following leads to secure new business. Sysco’s clients have embraced online ordering, as 70% of the firm’s orders are placed online. Sysco has said that for clients who use these tools, the distributor gains a higher share of wallet and it also improves client retention (without quantifying), which in our view, suggests that these tools enhance Sysco's competitive advantage.

Sysco also seeks to differentiate itself from smaller distributors by offering independent restaurants consultancy services. Sysco offers operations consultants that advise clients on improving operations and profitability, chefs that advise on menu selections, and graphic designers to design menus and marketing campaigns. The team offers clients a complete review of their operations and makes personalized recommendations to the entrepreneur. Sysco completes 50,000 such reviews each year, which it reports are in high demand. These services are provided free of charge, as a benefit of partnering with the firm. Smaller distributors have not been able to replicate this specialized service, and as such, we think it contributes toward Sysco’s competitive edge. Even though UniPro Foodservice, a distributor cooperative with over 400 members that collectively generate $120 billion in revenue, does offer its members information on consumer and menu trends, as well as tips to help restauranteurs improve their marketing, in our view, this does not compare with Sysco’s thorough and personalized business review services.

We think Sysco’s scale also provides the firm with the resources to invest in its business to ensure that it is able to deliver a very high level of service. This includes forecasting tools to ensure that the right product is on hand, the fleet to ensure the trucks are running on time, technology to efficiently route the fleet, and financial systems to ensure orders are processed and billed correctly. As a result, excluding 2021 when labor and product shortages were common, Sysco averages a 98.5% service level, the percent of orders delivered with the requested product (no substitutions), within the designated delivery window, and billed accurately. From our vantage point, these service levels are likely aiding the firm’s ability to gain market share over time. While others, including US Foods, have failed to disclose this metric, we suspect competitors are unable to match these high service levels, given Sysco's industry-leading net promoter score, a metric of customer satisfaction.

Sysco also uses its scale to offer clients their own lines of private label products. While there is evidence that these products enhance distributor margins, we do not contend that these offerings enhance the distributors’ competitive advantage, as they are ultimately replicable. The most popular private label offerings are relatively easy to duplicate, as they are commodity-like items such as cuts of meat, minimally processed produce, and dairy products. We acknowledge that private label brands have become a significant portion of distributors’ businesses, composing 45% of Sysco’s restaurant cases in fiscal 2021. However, we attribute that to a push from the distributor to enhance its margins, as opposed to gaining a competitive edge. Sysco prefers these products as they have twice the margin of nationally branded product, and the distributors incentivize their sales reps to promote these items to clients.

In addition to other distributors, food-service clients can also source their food and supply needs from cash and carry locations such as Costco, Sam’s Club, and specialized restaurant supply stores such as Restaurant Depot. Technomic estimates that these stores combined maintain about 10% market share of the food-service supply industry. While these stores don’t offer the convenience of delivery, do not have the same breadth of product, and may not consistently carry the same items, they offer appealing prices on many products that food-service operators regularly use. This channel is particularly compelling during periods of uncertainty, when food-service operators are most cost sensitive. For example, according to Sysco, during the 2008-09 recession, cash-and-carry share gains accelerated. Similarly, US Foods disclosed that its cash-and-carry outlets proved more resilient than delivery services during the pandemic. While Sysco notes that the channel’s market share has been stable excluding periods of significant disruption, we believe the channel represents a viable competitive threat to distributors. Sysco is currently testing a cash-and-carry concept in Latin America, although it has not announced plans to open stores in the U.S.

There is ample quantitative evidence of Sysco’s competitive edge. Sysco has reported organic market share gains, operating margins superior to its direct peers, and steady economic profits. Over the five years preceding the pandemic (calendar 2015-19), Sysco’s U.S. food-service segment average annual organic revenue growth rate was 3.3%, modestly ahead of the 3.1% average annual industry growth rate over the same period, according to Euromonitor. Similarly, during the pandemic, Sysco secured $2 billion in net new national account business and about 13,000 new independent restaurant partnerships, despite a contracting industry. Together, we think the firm’s cost advantages, underpinned by closer proximity to customers and its scale, facilitate market share gains by allowing the firm to offer customers similar products and services at a lower price, or offer customers superior products and services at a comparable price. Sysco also maintains higher operating margins than its direct peers. For 2017-19, Sysco reported an average adjusted operating margin of 4.4%, compared with number two US Foods’ 3.1% and number three Performance Food Group’s 1.6%. Finally, Sysco consistently reports ROICs far in excess of our 8% estimate of the firm’s cost of capital. Over the past 10 years, the firm’s ROICs including goodwill have ranged from 10% (due to the pandemic) to 17%. Our forecast calls for continued economic profits, with ROICs ranging from 17% to 26% over the next 10 years.

We assign the firm a narrow moat rating, as we believe the firm will maintain this advantage for at least the next 10 years. However, we do not have the visibility or conviction that Sysco can maintain its advantage for at least 20 years, required for a wide moat rating, due to the evolving competitive environment, with consolidating direct competitors, the firm’s lack of pricing power and related gross margin volatility, the growth of restaurant group purchasing organizations (GPOs), and the growth of cash-and-carry alternatives, such as Costco, Sam’s Club, Restaurant Depot, and US Foods' Chef'store.

Fair Value and Profit Drivers | by Rebecca Scheuneman Updated Aug 12, 2021

After Sysco’s fiscal 2021 results came in better than we expected, we are lifting our fair value estimate to $71 from $65. The food-service market is recovering from the pandemic much faster than we expected, and Sysco has gained material market share, causing us to increase our fiscal 2022 sales forecast for Sysco to $62.5 billion from $60.0 billion previously. Our valuation implies a fiscal 2022 price/adjusted earnings of 21 times and enterprise value/adjusted EBITDA of 13 times.

For its U.S. food-service segment (70% of fiscal 2021 revenue), we expect fiscal 2022 sales will rebound 23%, (after dipping 3% in 2020 and 11% in 2019), as traffic patterns recover from the pandemic and Sysco onboards the 13,000 new independent restaurants secured during the crisis, in addition to the $2 billion in new national contracts. In 2023 and beyond, we expect just over 5% annual sales growth, driven by 4.5% annual organic growth, (outpacing the 3.5% growth of the market) and 0.75% from acquisitions. For Sysco's international business (16% of sales), we expect sales to rebound 29% and 13% in fiscals 2022 and 2023 (after falling 16% and 14% the past two years), normalizing at 4% thereafter. For SYGMA (13% of sales), we expect 7% growth in 2021, due to $2 billion in contract wins, with 3% growth thereafter. In aggregate, we forecast a 23% recovery in 2022, and 5% long-term annual revenue growth.

Given the highly competitive nature of the food-service distribution industry combined with the fact that we don’t posit Sysco (or its peers) possess much in the way of pricing power, we expect Sysco‘s gross margins will continue to hover around 19% long term, after recovering from the pandemic-driven dip to 18.2% in 2021. Sysco cut $350 million in operating expenses in 2021, and plans another $400 million between 2022 and 2024, although a portion will be reinvested in its growth initiatives, such as an expanded salesforce, the elimination of minimum order sizes, increased delivery flexibility, and investments in digital tools. The combination of this underlays our forecast for operating margins to improve to 5.4% by 2028 from 2.8% in 2021. Our model accounts for Morningstar’s probability-weighted house expectation of an increase in the U.S. statutory rate to 26% beginning in 2022, lifting Sysco's consolidated tax rate to 29% in fiscal 2023 and beyond.

Risk and Uncertainty | by Rebecca Scheuneman Updated Aug 12, 2021

Although the U.S. has been steadily recovering from the pandemic, variant strains of the virus can cause disruption, and international markets continue to see a high number of cases. Even so, we think Sysco's solid balance sheet, significant new business wins, channel diversity, the widespread adoption of carryout, and the eventual containment of the coronavirus (with vaccines becoming increasingly available), will return Sysco's sales to the prepandemic level by fiscal 2022.

Sysco operates in a highly competitive market. Although we believe Sysco has cost advantages compared with its smaller peers, pricing power remains elusive, given the vast number of alternatives through which they can purchase supplies. Sysco estimates independent operators use five to six food-service delivery services, with the leading service averaging 30% to 40% of wallet share, so it is typical for customers to shift purchases to another distributor if a lower price is found. Promotional pressures can arise, and Sysco has shown a willingness to respond in the past as a means to forgo the more material cost of winning back customers.

Sysco also faces erratic changes in food inflation. While about 50% of Sysco’s business operates under a cost-plus contract, and therefore faces no margin risk, the remaining 50% uses negotiated spot prices. Sysco can generally pass through food inflation that ranges from 1% to 3%, but when inflation exceeds this level, Sysco can typically not pass it through all at once and will likely take a loss on the item. Prices are typically reset every two weeks, and depending on the magnitude of the inflation, it can take several weeks to fully pass the inflation through, which can lead to prolonged periods of margin compression.

We do not think environmental, social, and governance issues represent a significant area of risk for Sysco. While carbon emissions can be material, it works diligently to optimize routes and reduce mileage, and is testing electronic vehicles.

Capital Allocation | by Rebecca Scheuneman Updated Aug 12, 2021

We rate Sysco's capital allocation actions as standard under the current leadership team. In February 2020, Kevin Hourican stepped in as CEO, replacing Tom Bené, who had been at the helm since 2017. Hourican most recently served as president of CVS' $85 billion retail division and prior to that held various roles in supply chain and logistics at Macy's and Sears. We think Hourican has done a great job of leading Sysco through the pandemic while simultaneously implementing his strategy, which we think will allow the firm to more consistently leverage its scale-based cost advantage, translating into more steady share gains. Sysco is investing to eliminate customer pain points by removing customer minimum order sizes while maintaining delivery frequency and lengthening payment terms. It improved its CRM tool, which now uses data analytics to enhance prospecting, rolled out new sales incentives and sales leadership, and is launching an automated pricing tool, which should sharpen its competitive pricing while freeing up time for sales reps to pursue more value-added activities, such as securing new business. Further, Sysco has switched to a team-based sales approach, with product specialists that should help drive increased adoption of Sysco’s specialized product categories such as produce, fresh meats, and seafood. Lastly, Sysco is launching teams that specialize in various cuisines (Italian, Asian, Mexican) that should drive market share gains in ethnic restaurants. Fruits of these efforts (and food-service operators' migration to distributors with strong balance sheets) have manifested in Sysco securing $2 billion in new national restaurant and healthcare contracts since the beginning of the pandemic (3% of fiscal prepandemic sales), in addition to the onboarding of 13,000 new local restaurants.

We believe Sysco has been a disciplined acquirer, as the firm continues to report robust ROICs including goodwill and the firm has refrained from engaging in transactions at times management believed valuations were not attractive. While the U.S. food-service industry is highly fragmented, Sysco's position as the largest U.S. distributor limits its ability to make large, transformative acquisitions. In late 2013, Sysco attempted to acquire US Foods, but the Federal Trade Commission blocked the deal in 2015, forcing Sysco to walk away. As such, Sysco opts to return cash to shareholders via a dividend, unlike peers US Foods and Performance Food Group, which direct a higher portion of free cash flow toward acquisitions. Over the long term, we expect Sysco to pay 50%-60% of earnings as dividends. Share repurchases should be a less significant use of cash, and we expect Sysco to repurchase about 1% of shares annually over our 10-year forecast.

In general, we think the firm has been a good steward of capital, appropriately investing in growing the business and building the firm’s capabilities, while maintaining a sound balance sheet. However, Sysco has not always capitalized on the benefits of its scale. Prior to 2014, Sysco operated as a decentralized organization, with each distribution center essentially operating independently. But over the past few years, the firm centralized purchasing (and realized 200 basis points in gross margin improvements as a result), and we think this newly found purchasing power is one of the major facets of Sysco’s cost-advantaged moat.

 
 
 
 
 


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