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Rick Konrad on Sysco

(Guest Commentary by Rick Konrad – April 24, 2008)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month.

In this commentary, Rick will be offering his thoughts on the well-known food service distribution company Sysco, a company (even though it is already the market leader in food distribution) that still has a lot of room to grow in terms of market share.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Recurring Revenues and Industrial Distribution” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

A lot of people that I know view buying stocks much as they would buying a lottery ticket or with spending a weekend at the table at a Las Vegas or Atlantic City casino. Their stock selection odds resemble those of a lottery ticket…there is an infinitesimal chance of a huge payoff and a high probability of loss. Market corrections, though they feel like Mr. Market is dragging your guts through the gravel enjoy one huge plus…the opportunity to buy great quality names that you had dreamed of owning but couldn't afford into a buying range. It's as if your local Lexus dealer was offering 20% off of your dream car. Most of us would turn down an offer to buy a rusty, broken down Pinto even at 50% off.

Applying the same sort of reasoning that you would use at the car dealership should apply to your investing. This correction has provided us a very decent sale where we can afford to buy tremendous quality at reasonable prices. As Benjamin Graham wrote some 70 years ago, Investing is most intelligent when it is most businesslike.” In an uncertain market, we continue to find decent recurring revenue kinds of companies at reasonable prices. I have coveted companies like these for some time, yet found them too expensive through most of the last few years. SYSCO is one of those names. It has a number of competitive advantages that offer an excellent wide moat. Its returns for what is a rather mundane, low margin business are spectacular, in my opinion. Finally, it is available at a decent discount to its intrinsic value which I would estimate to be in the $40-$50 range.

SYSCO (SYY) is North America's dominant market leader in food service distribution. Sysco distributes more than 300,000 products to 400,000 restaurants, schools, hotels, health-care institutions, and other food-service customers. Restaurants account for two thirds of Sysco's annual sales, with independents contributing 55% of restaurant sales and chains making up the rest. Because Sysco generates roughly 15% of its total sales from restaurant chains, which are much more price-sensitive and prefer to lock in prices with long-term contracts, it has more pricing flexibility.

Historically, the company largely has grown along with the industry and through acquisition, and developed scale and operational efficiencies as acquired companies were integrated in its network. More recently, SYSCO has shifted its focus to more organic growth by investing in pricing and superior service levels. Supply chain initiatives are funding investments and creating some sustainable competitive advantages.

The company has historically demonstrated great consistency of earnings. But SYY has treaded water in the market for the last five years, trading between the upper $20s and the mid-$30s during this period.  The company has been stuck at the low end of this range recently, largely due to macro factors of a slowdown in consumer spending and its impact on the company's primary customer base, casual dining and white tablecloth restaurants.

The company seems to enjoy several competitive advantages that have afforded it a significant moat. First of all, its larger competitors are facing some potential financing pressures which should improve the competitive climate. Its major competitors, US Foodservice and Performance Food Group, having undergone (or about to undergo) LBOs in the past year and will have a difficult time re-investing in the business to drive market share.

Though the food service distribution industry is still largely mom and pop, SYY is the dominant company in terms of its share. SYSCO enjoys about a 15% market share compared to US Food Service's 10% and Performance's 3%. I suspect that we will continue to see further consolidation in this industry.

The company generates impressive returns in what has traditionally been a low-margin business through its substantial economies of scale, investments in technology which mom and pops cannot provide, and competent sales force and support staff of more than 14,000 associates. Investments in technology and its distribution network have also allowed Sysco to lower its procurement and logistics costs. Consequently, the company is regarded as the low cost provider in the industry.

The closeness of the relationship with customers is described in the 10-K:

“Through our more than 14,400 sales and marketing representatives and support staff of SYSCO and our operating companies, we stay informed of the needs of our customers and acquaint them with new products and services. Our operating companies also provide ancillary services relating to foodservice distribution, such as providing customers with product usage reports and other data, menu-planning advice, food safety training and assistance in inventory control, as well as access to various third party services designed to add value to our customers' businesses.”

The operating environment itself offers numerous challenges; customers are affected by the highest level of food inflation in twenty years, by high energy prices, by consumer behavior being impacted by mortgage issues, etc. Even supermarkets now offer many more alternatives to dining out that are quite value-oriented.

SYSCO is not standing still on scale alone. The company is implementing its National Supply Chain project. This project is intended to increase profitability by lowering aggregate inventory levels, operating costs, and future facility expansion needs at its broadline operating companies while providing greater value to SYY's suppliers and customers.

The National Supply Chain project has three major supply chain initiatives actively underway. The first initiative involves the construction and operation of regional distribution centers which will aggregate inventory demand to optimize the supply chain activities for certain products for all SYSCO broadline operating companies in the region. It is expected that five to seven redistribution centers (RDCs) will be built. The first of these RDCs opened in 2005 and the second one should open later this year. As of June 30, 2007, the company operated 177 distribution facilities of much more modest size throughout the United States and Canada.

The second initiative is the national transportation management initiative, which provides the capability to view and manage all of SYSCO's inbound freight, both to RDCs and the operating companies, as a network and not as individual locations. As of June 2007, all inbound freight to United States broadline operating companies is managed centrally.

Finally, the third initiative is the national implementation of demand planning and inventory management software. This project is strategically important in that it creates the foundation to effectively execute new supply chain processes, including redistribution, as well as efficiently manage its inventory assets. With 300,000 products getting out to 400,000 customers, one can imagine the great value and savings in managing those inventories and procuring supplies on a national basis.

As the scale of these initiatives implies, the company has been investing in capex fairly heavily. During fiscal 2007, 2006 and 2005, approximately $603,242,000, $513,934,000 and $390,026,000, respectively, were invested in facility expansions, fleet additions and other capital asset enhancements. The company estimates its capital expenditures in fiscal 2008 should be in the range of $625,000,000 to $650,000,000. To put this into perspective, this represents about 1.7 times depreciation or about 1.6% of revenues.

The company may well have hidden asset value in its real estate.  To quote the 10-K:

We own approximately 480,861,000 cubic feet of our distribution facilities and self-serve centers (or 81.0% of the total cubic feet), and the remainder is occupied under leases expiring at various dates from fiscal 2008 to fiscal 2041, exclusive of renewal options. Certain of the facilities owned by the company are either subject to mortgage indebtedness or industrial revenue bond financing arrangements totaling $17,727,000 as of June 30, 2007. Such mortgage indebtedness and industrial revenue bond financing arrangements mature at various dates through fiscal 2026.”

As well, the company owns its 325,000 square foot headquarters in Houston. As well, SYY owns 87% of its fleet of 9,300 refrigerated delivery vehicles which range from tractor trailers to panel trucks.

The operating model has shown very consistent gross margins in the 20-20.5% range for the last five years.  Selling, general & admin expense similarly has represented about 14-15% over that period of time. The difference or operating cushion is small, generally between 5-5.5%.

Historically, SYY has managed to pass through food price inflation costs to its customers. Again, quoting from the most recent 10-K:

“Estimated product cost increases, an internal measure of inflation, were 3.4% for fiscal 2007. The rate of product cost rose throughout the year, ending at an estimated 6.1% for the fourth quarter. Product cost increases result in reduced gross margins as a percentage of sales when compared to the prior year, as gross profit dollars are earned on a higher sales dollars base. However, the company was able to manage this inflationary environment well resulting in gross profit dollars increasing 7.4% for the year.”

From a working capital perspective, the firm has a cash cycle of only about 18 days, remarkable given that so many of its customers are small restaurants.

Recent results have held up very well, despite the economic scenario with SYY sales and margins have sustained at a relatively healthy level when compared with the overall restaurant landscape. Margins have held steady or improved in seven consecutive quarters, indicating SYY management is likely navigating the treacherous currents well.

Here is a spreadsheet of relevant ratios as per Reuters:

As you can see, the firm trades at an EV/EBITDA of less than 9 times and has a high ROIC for a relatively low operating margin distribution business of almost 17%. Given the leverage, ROE is above 30%.

There is some leverage on this balance sheet but interest coverage by EBITDA is very, very comfortable at 19.6 times. As the company explains:

“Our share repurchase program is used primarily to offset shares issued under various employee benefit and compensation plans, to reduce shares outstanding (which may have the net effect of increasing earnings per share) and to aid in managing the ratio of long-term debt to total capitalization. We target a long-term debt to total capitalization ratio between 35% and 40%. The ratio may exceed the target  range  from time to time, due to borrowings incurred in order to fund acquisitions and internal growth opportunities, and due to fluctuations in the timing and amount of share repurchases. The ratio also may fall below the target range due to strong cash flow from operations and fluctuations in the timing and amount of share repurchases. This ratio was 35.0% and 36.2% as of June 30, 2007 and July 1, 2006, respectively.  For purposes of calculating this ratio, long-term debt includes both the current maturities and long-term portion.”

Here is a look at cash flows since 2000. As you can see, the business has generated free cash flow through the piece. Please check:

Since 2000, SYSCO has generated about $9 billion on cash flow from operations. Almost $4 billion has been returned to shareholders through buybacks, almost $3 billion of it net of share issuance.  Another $2.3 billion was returned to shareholders through dividends. The five year growth rate of dividends has been 18%.

Relative to its own history, the stock is cheap on a P/E basis as well:












28.9 X











In my view, this high quality growth company may well surprise us positively over the next several years as its competitors struggle with their LBO debt, and as SYY's restructuring and streamlining takes hold.  Many investors, fearful of food inflation and fearful of consumer weakness have taken this stock down to a very reasonable multiple at a time that the company could well be a year away from accelerating growth.

Disclaimer: I. my family, or clients have a current long position in SYSCO.

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