Dividend Aristocrats In Focus Part 31: Sysco

Author's Avatar
Oct 29, 2014
Article's Main Image

In part 31 of the 54 part Dividend Aristocrats In Focus series, I take a look at the competitive advantage and future growth prospects of Houston-based food distributor Sysco (SYY, Financial). Sysco is the largest food distributor in the U.S. with a market cap of $22 billion. The company has increased its dividend payments for 44 consecutive years. Sysco operates in the slow changing and low margin food distribution industry. The company’s operations are analyzed below.

Business Overview

Sysco distributes food products to restaurants and stores throughout the U.S. (including Alaska), Canada, Ireland, and Puerto Rico. The company has over 400,000 customers and delivers more than 1 billion cases of food each year. Sysco is the largest food distributor by market share. The company currently controls about 18% of the highly fragmented food distribution market in the U.S. The top 5 competitors make up less than 40% of the food distribution market.

Competitive Advantage

Sysco’s competitive advantage comes from its size advantage over its rivals. The company can put pricing pressure on suppliers that smaller competitors cannot due to its larger size. In addition, Sysco also has a competitive advantage in the U.S. from its strong distribution network which has been formed over the last four decades. The image below shows the locations of the company’s facilities which build the backbone of its supply chain:

03May20171316211493835381.jpg
Source: 2014 Investor Factsheet

Despite its larger scale, Sysco’s operating margins have been falling for the last several years. Operating margins have fallen from a high of 6.4% in 2010 to just 4.6% in 2014. As a result, the company’s EPS have contracted from a high of $1.99 in 2010 to $1.58 in 2014. Sysco is not resting on its laurels while its margins contract. The company has plans to return to EPS growth going forward.

Growth Prospects

In late 2013, Sysco announced plans to merge with its largest competitor, U.S. Foods. The deal would give Sysco shareholders approximately 87% of the new company, with U.S. Foods owning 13% of the merged business. The merger would be immediately beneficial for shareholders of Sysco, as it would nearly double the EBITDA of the company. The merger is expected to close in the third or fourth quarters of 2015.

US Foods is the second largest food distribution company in the U.S. As a result, the combined company will have significantly more pricing power than either business had on its own. The combined business will also have a more robust supply chain, further enforcing Sysco’s current competitive advantages. The strategic rationale behind the acquisition is to give the combined business enough scale advantage to negate the negative trend in operating margin through economies of scale and return the company to margin expansion. The deal is a net positive for shareholders, though there is one catch: the deal is facing regulatory scrutiny. Sysco’s management reported favorable progress with regulatory agencies in its most recent quarterly release. The deal is still on track to close by the third or fourth quarter of 2015.

In addition to Sysco’s proposed US Foods merger, the company is also attempting to boost margins by becoming more efficient. To this end, the company is upgrading its facilities to the SAP management program. The move should increase efficiency for Sysco and result in a small boost to operating margin. Overall, Sysco has grown revenue per share by about 4.8% over the last decade, while EPS has grown at just 0.8% per year in the same time period due to the aforementioned margin contraction. Going forward, I believe Sysco can increase its operating margins back to the 6% range and grow revenue per share in line with its historical average of around 5%.

Dividend Analysis

Sysco currently has a dividend yield of 3% and a payout ratio of 70%. The company’s high payout ratio means dividends will likely grow at or below the company’s long-term growth rate of about 5%. Shares of Sysco may appeal to income-oriented investors looking for some future growth potential. If margins expand from the SAP integration and US Foods acquisition, Sysco may be able to grow its dividend payments substantially faster in the next three years.

Recession Performance

Sysco managed the Great Recession of 2007 to 2009 well and saw only modest EPS declines. The company saw declines in restaurant orders as consumers eat out less during recessions, which in turn reduces demand for Sysco’s restaurant products. Despite this, EPS did not fall significantly. The company’s EPS from 2007 to 2009 are shown below to show how the company handled the Great Recessions:

  • 2007 EPS of $1.60
  • 2008 EPS of $1.81
  • 2009 EPS of $1.77

Valuation

Sysco is currently trading at a PE multiple of about 23, well above the S&P 500’s PE ratio of about 19. Historically, Sysco has traded at about a 1.1x premium to the S&P 500’s PE ratio. At current market levels, Sysco should trade at a PE ratio of about 21 including its premium multiplier. In my opinion, Sysco should not trade at a premium to the overall market due to its multi-year operating margin slide. The company needs to prove it can reverse its margin trend before it deserves a premium multiple to the S&P 500. The company further has a lackluster long-term growth rate which should also discount from its premium multiplier. At current prices, I believe Sysco to be somewhat overvalued.

Final Thoughts

Sysco is attempting to consolidate the slow-changing US food distribution industry. The company’s long-term growth rate is fairly low, and it has suffered margin contraction in recent years as it struggles to pass along inflationary price rises to its customers. The company appears somewhat overvalued at this time. Due to its high payout ratio and slow growth rate, Sysco is not ranked highly using the 8 Rules of Dividend Investing. At current levels it is not a buy.