Sysco Corp (SYY): A Future Dividend King Worth Reviewing

Dividend investing has proven to the be an effective way for investors to compound their wealth and income over time.

 

And when it comes to dividend growth stocks, they don’t get much more consistent than the dividend aristocrats and dividend kings, groups of companies that have raised their dividends for at least 25 and 50 consecutive years, respectively.

 

Let’s take a closer look at Sysco Corporation (SYY), which is a dividend aristocrat and, thanks to 48 consecutive years of dividend growth, is just two years away from becoming a dividend king.

 

More importantly, learn if Sysco seems likely to reward dividend investors with many more years of income growth and if today’s valuation appears to be reasonable.

 

Business Overview

Founded in 1969 in Houston, Texas, Sysco is one of the world’s largest food distributors, essentially acting as a middleman between food producers and retail consumers.

 

Sysco’s 65,000 employees serve half a million customers in 13 countries, although the U.S. is its most important region by far.

 

 

Sysco’s client base includes everything from restaurants, hotels, and hospitals to government agencies and schools. The products it sells are diversified as well.

 

 

Business Analysis

A company’s ability to steadily grow its dividend for decades usually depends on two key factors.

 

First, the business model needs to be stable, providing consistent and recurring cash flows from which to reward income investors. The second is a competitive advantage or moat of some kind in order to preserve, and hopefully grow, its margins and returns on shareholder capital over time.

 

Sysco Corp enjoys both of these attributes. That’s because even during economic downturns people still need to eat (sales declined just 2% in 2009), and the company’s highly diversified customer base somewhat insulates it from industry downturns, such as those that occur with restaurants during a recession. As a result, Sysco generates highly consistent cash flow.

 

Wholesale food distribution is a simple business as well, which is likely one reason why Warren Buffett bought into the industry in 2003 when he acquired McLane Company from Wal-Mart for $1.45 billion.

 

The industry’s pace of change is very slow, and new innovations seem unlikely to pose any material threat to the way the wholefood distribution space operates. At the end of the day, food manufacturers need a cost-efficient way to get their products to retailers and consumers.

 

The best operators offer prompt and accurate delivery of orders, a broad assortment of products, and competitive pricing. Since distributors are middlemen, their margins are very low (Sysco’s operating margin has averaged less than 5% over the last decade) and players must either establish themselves as price or niche leaders in a given region.

 

Not surprisingly, Sysco’s scale plays a big advantage and forms a moat. Since its formation nearly 50 years ago, Sysco has grown from $115 million to more than $50 billion in annual sales, driven by a long history of well-executed acquisitions in this highly capital intensive industry.

 

 

 

Sysco benefits from having the industry’s best economies of scale, and few companies have the capital and supply chain network and expertise to match Sysco’s inventory assortment.

 

When combined with Sysco’s wide network of warehouses and distribution systems, the company enjoys an advantage in serving national accounts and can offer daily delivery to most of its customers. Thanks to its dense delivery network around its warehouses, Sysco can offer lower pricing than most other distributors in its geographic regions, too.

 

The company’s latest acquisition, Sysco’s $3.1 billion purchase of European food distributor Brakes Group in 2016, gives the business a solid foothold into international expansion, which is necessary because the opportunity for needle-moving growth in the mature U.S. market is narrowing.

 

Specifically, that’s due to Sysco’s large market share (revenue and operating income are two and three times the size of its nearest competitor, according to Morningstar), which is one main reason why the Justice Department decided to block the company’s $8.2 billion attempted buyout of America’s second largest food distributor, U.S. Foods, due to antitrust concerns.

 

As a result, Sysco has turned to global industry consolidation to fuel steady (but slow) growth in both its top and bottom line. You can see that Sysco’s annual revenue has pretty consistently grown at a mid-single-digit rate over the past decade.

 

 

That being said, Sysco’s profitability and returns on shareholder capital have shown signs of deterioration, due to the incredibly fragmented industry (Sysco’s market share in the countries it operates in is about 16%) that provides for limited pricing power. Combined with high fixed operating costs, this explains why Sysco’s margins are razor-thin.

 

 

Then again, thank’s to its large economies of scale and ongoing cost-cutting efforts, Sysco still boasts industry-leading profitability and impressive returns on investor capital.

 

 

Management is laser-focused on maximizing cost cutting in the coming years as well. That’s partially thanks to activist investor Nelson Peltz, who took a 7% stake in the company in 2015 promising to make the company much leaner and has a seat on the company’s board of directors.

 

In fact, thanks to efficiency improvements Sysco expects that it can grow its operating income by $600 million to $650 million between 2016 and 2018. That would represent a 33% increase in profitability, with operating income growing at an impressive 10.2% annual rate.

 

In addition, management believes it can achieve a long-term return on invested capital (ROIC) of 15%, which would be highly impressive in this low-margin industry.

 

 

While such cost control efforts are far from guaranteed to succeed, if management can deliver on its plan, this bodes very well for Sysco’s future dividend growth prospects.

 

Key Risks

There are several main risks to consider before investing in Sysco.

 

First is the highly competitive and mature nature of the food distribution business. Sysco competes with tens of thousands of domestic U.S. rivals, and smaller specialty distributors have taken some market share in the higher-margin restaurant business in recent years. This makes the industry highly commoditized, meaning that maintaining industry-leading profitability can be a challenge over the long term.

 

Sysco is working to combat these challenges by expanding internationally, gaining greater scale, and offering a more localized approach to many of its customers. For example, the company offers locally produced foods and ingredients targeted more specifically at certain demographics. Sysco can also use its size to acquire some of the local and regional niche distributors to protect its business, if necessary.

 

Amazon could also affect the industry’s dynamics in the future, especially after news of its acquisition of Whole Foods. Amazon is the expert in warehousing, inventory management, and delivery capabilities, but I would be surprised if they went after Sysco’s business.

 

Establishing all of the necessary supplier and restaurant relationships would require a lot of work, and Sysco’s margins are already quite thin. The inventory and delivery mechanisms needed for wholesale food are also quite different.

 

Perhaps the bigger risk would be if large national accounts or food producers decided to enter the distribution business themselves and cut out the middleman. However, this doesn’t seem to be happening today – probably because of the industry’s capital intensity and low value-add.

 

The second risk is that in order to acquire Brakes Group, as well as steadily buy back shares over time (at a pace of 1.8% of shares annually over the last decade), Sysco has had to take on a large amount of debt in recent years. As a result, the company’s ability to further grow through consolidation may decline somewhat in a rising interest rate environment.

 

 

Finally, be aware that due to Sysco obtaining the majority of its business from the cyclical restaurant industry, its results can be a bit lumpy depending on the health of the economy. For example, during the Great Recession sales growth fell from 7% in 2008 to -2% in 2009.

 

While that performance was better than most companies’ results, it’s worth being aware of the unpredictable short-term trends that can affect results. Volatile commodity prices (e.g. fuel) and consumer spending patterns (e.g. grocery vs. restaurants) are two examples. However, neither of these issues should affect Sysco’s long-term earnings potential.

 

Sysco’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Sysco has a dividend Safety Score of 97, indicating that its dividend appears to be among the safest and most dependable on Wall Street. That’s not a surprise given that Sysco has grown its dividend every year since its founding.

 

 

This impressive track record is courtesy of the company’s highly predictable cash flow and management’s disciplined approach to maintaining a safe payout ratio.

 

As a result, Sysco’s dividend is backed by plenty of cash flow to act as a buffer during times of economic distress, making it an ideal candidate for low risk investors. You can see that Sysco’s free cash flow payout ratio has remains between 40% and 70% most years, which is a healthy level for such a defensive company.

 

 

It’s also interesting to note that Sysco’s free cash flow meaningfully increased during the recession. This is because the company does not have to build up as much inventory and working capital when demand falls, allowing it to sell its existing inventory and raise more cash.

 

 

In addition, despite its increased use of debt in recent years, Sysco’s balance sheet remains sound. As a result, management has the flexibility to keep investing in future growth without having to sacrifice the annual dividend growth that investors have come to expect.

 

For example, while Sysco does has a large amount of debt, we can’t forget that this highly capital intensive industry is also marked by highly consistent and stable cash flow.

 

 

And when we compare Sysco’s relative debt metrics to its peers, we can see that, while slightly higher than average, the company’s debt burden is far from alarming.

 

In fact, the strong interest coverage and current ratios (short-term assets/short-term liabilities) give Sysco an investment-grade credit rating. This means that Sysco is likely to continue to have strong access to low cost debt, a major competitive advantage in a capital intensive industry and during a period of rising interest rates.

 

 

While Sysco does have a somewhat high payout ratio near 70% and a lot of debt, the stability of its business and the strong free cash flow it generates each year make the company’s dividend payment very safe.

 

Sysco’s Dividend Growth 

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

 

Sysco’s dividend Growth Score of 43 indicates that investors can expect slightly below average dividend growth going forward compared to the broader market of dividend-paying stocks. This isn’t surprising given the slow-growth nature of the industry and Sysco’s lower payout growth rate in recent years.

 

You can see that Sysco’s annualized dividend growth rate has declined from 6.2% over the past decade to 3.5% over the last three years.

 

 

Of course that doesn’t mean that Sysco won’t still grow the dividend faster than inflation. After all, analysts expect Sysco to generate 3% to 4% annual sales growth, 0.5% to 1.0% of which will likely come from ongoing acquisitions.

 

That, combined with around 2% annual share repurchases, plus growing margins from its ongoing cost cutting efforts, should allow the company’s free cash flow per share to grow at around 5% to 8% annually.

 

Given that the company’s FCF payout ratio will probably remain stable, it seems likely that Sysco’s long-term payout growth will also come in at a mid-single-digit rate.

 

Valuation

Over the past year Sysco has about matched the market’s total return of about 20%. However, the stock’s current valuation is looking a bit rich.

 

For example, the company’s forward P/E of 20.3 is rather high given its slow growth profile and is slightly above its 13-year median of 19.5. It’s also higher than the S&P 500’s forward PE  of 17.8.

 

Sysco’s current 2.4% dividend yield is also much lower than the stock’s 13-year median yield of 3.2%. From a historical P/E ratio and yield perspective, investors might be better off waiting for a more attractive entry point.

 

That being said, even at today’s somewhat inflated valuation, investors can likely expect around 7.4% to 10.4% annual total returns (2.4% dividend yield + 5% to 8% annual earnings growth). For such a high-quality and low risk dividend growth stock, that’s not a bad potential return; especially when you take into account the fact that Sysco’s stock has historically been much less volatile than the S&P 500.

 

In other words, while buying Sysco today may not represent an ideal situation, there doesn’t seem to be a strong valuation case to sell the stock either, especially since it makes a reasonable holding as part of a low risk, diversified dividend growth portfolio.

 

Conclusion

While Sysco may not be a high-flying growth stock, that doesn’t mean that it can’t help you steadily grow your income and wealth over time. Sysco is a simple, boring business, and its time-tested operations, economic moat, and dependable cash flow generation make it a very reliable dividend aristocrat.

 

Sysco’s current valuation doesn’t look that appealing for new investors today, making it a good watch list candidate, but I continue to believe Sysco remains a reasonable long-term hold for conservative investors seeking sources of safe dividend income. Investors looking for higher yields but still focusing on safety can review some of the best high dividend stocks here, too.