Buy, Sell or Hold: Is Sysco Eating Up the Competition?

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You call to make reservations at that new and trendy restaurant.  Can you guess who the restaurant called prior to opening its doors?  Chances are the first call it made was to Sysco Corporation (NYSE: SYY).

Sysco's by far and away the leading provider of food to the restaurant industry. The company has an 18% share in a $235 billion dollar industry in the U.S., Canada and Ireland.

Sysco provides the restaurateur everything he needs - from high-quality chef ingredients to Styrofoam cups. It serves more than 400,000 customers and has over 180 distribution centers.

Shareholders have been rewarded by Sysco's fine execution of its business plan as it breaks above new multi-year highs.

However, there is something strange afoot.

Independent restaurant operators who account for 63% of Sysco's customers are seeing a slowdown in foot traffic. Even Sysco CEO, William DeLaney, did not hide the fact during the most recent company conference call.

"Many of our restaurant customers struggled to grow during the quarter," Delaney stated. "Specifically, sales dollar growth with our street customers, who are largely independent restaurant operators, was soft for the quarter."

Allow me to lay out the Sysco pros and cons before deciding whether the share price is justified.

One note first...

Before disqualifying this article because you have read headlines elsewhere that the restaurant industry is experiencing solid growth, it is important to distinguish the niche Sysco is embroiled in.

It is true that restaurant sales have increased when you include the quick-serve restaurants like Burger King (NYSE: BKW).

However, large chain restaurants use their own distribution channels and don't have a need for Sysco's services. Sysco accommodates the smaller local restaurants and chains. It is this niche that is suffering through some difficult economic times.

Pros

  1. Growth through acquisition - Sysco is aggressively expanding. Just this year alone it has completed 11 acquisitions that will bring an estimated $1 billion in annual revenues.  These acquisitions are in addition to the 25 made from 2008 to 2012.

    As mentioned above, Sysco has an 18% share of the industry. That's double to its closest competitor - US Foods. The industry is very fragmented with a lot of smaller players.

    Sysco believes in growth through acquisition by "gobbling up" these smaller rivals. In the last quarter, sales grew by 4% which can be partly attributed to the effect of those acquisitions.

  1. Strong results from other business segments - Independent restaurants do count for a majority of Sysco's business but the other areas are doing quite well.

    These areas include hotels, motels, hospitals and schools.  Not only do they provide food, but also a host of products such as fine linens for 5-star hotels.

    An interesting side note: Sysco bids on (and gets awarded) government contracts as well. Sysco was recently granted a $67.5 million contract from the Department of Defense where it will provide food services to customers in Virginia, Honduras and Guantanamo Bay, Cuba.

  1. Sysco is cutting costs - The company is in the midst of a large technological overhaul that will bring standardization and centralization to a myriad of business processes.

    Even the customer will see the benefits from of Sysco's new web-based solutions. It already gets high marks in customer satisfaction and it continues to find avenues of further improvement.

    The bottom line results of optimizing its business procedures are estimated to show annual cost savings of $600 million by 2015.

  1. Dividend - Sysco pays shareholders a healthy 3.3% dividend yield. It has raised its dividend each year for more than 10 years. Some may quibble with the fact that dividend increases are dropping percentage-wise each year - bringing into question if the dividend is sustainable.

    With sales growth continuing and the ability to generate strong cash flows I don't see that as being much of an issue.

Cons

  1. The starving customer - People are not frequenting restaurants for a sit down meal as often as they once did.  Headlines across the business pages continually read of slow job growth, low wages etc. - take your pick.

    Suffice it to say people are doing a little more dining at home or pulling up to the drive-thru windows for their 'value' meals. Again the vast majority of Sysco's revenue is derived from the restaurant patron - obviously this will have a direct impact on its fiscal results.

  1. Oil prices - With crude oil prices breaking above $100 per barrel mark, they will have a spill-over effect into Sysco's costs. Moving a product from point A to point B will cost more.

    Plus, while food inflation has been tame over the past year, it is only a matter of time before it rears its ugly head. Higher oil prices will only exacerbate the problem.

    Sysco is showing signs of this already.  Sales for the most recent quarter were $10.9 billion - partly due (along with new acquisition sales) to a 2.4% food cost increase in produce and poultry. Clearly, that's not the way you want sales to grow.

  1. Weak earnings - Sysco has seen a decline in earnings over the last few years. In the most recently reported quarter, earnings per share were down 23% to $0.34 from the prior year period.

    While it is true that there were some one-time expense items that negatively impacted earnings, the long term slowdown has me concerned.

  1. Share price - Sysco's share price is at multi-year highs.  It is at a delicate point that with some type of catalyst it could break-out even further to the upside. What that catalyst will be is unclear.  Perhaps more quantitative easing from the Fed?

    Sysco Corporation

    The share price has been attempting to break-out in recent weeks, but is not quite getting there. If I were to put on my chartist hat, my guess is that the share price is going to consolidate between $32 and $36 for a while.  

When weighing the pros and cons one thing seems clear - The pros all stem from the internal positives going on within the business of Sysco, while the cons are external in nature and out of the company's control.

Unfortunately, this scenario is the case for many corporations today, but it is especially true of Sysco.

If (and it's a big 'if') the economy were to recover and 'fine dining' is back in vogue then Sysco should prosper handsomely. However, this is not currently the case and investors should take solace in the 'fine dividend' while they wait.

That's why I rate Sysco a HOLD.

[Editor's Note: If you have a stock you would like to see us analyze in a future issue, leave us a note in the comments below and we'll add it to our list.]

About the Author: David Mamos brings nearly 15 years of analytical experience to the table with a background ranging from big-picture fundamental analysis to highly technical trading decisions. He began his career working as a financial advisor with Royal Alliance in 2001 and helped clients with portfolio management as well as buy-sell decisions before transitioning to the development, implementation and execution of trading strategies for aggressive investors.