Sysco (SYY) is a holding in our Conservative Retirees dividend portfolio. The company is a dividend aristocrat that has paid dividends since 1970 and appears to offer a very safe 3% yield today.
While SYY’s growth rate is very moderate, the company’s durability has been noteworthy. The pace of change in the foodservice distribution industry is really slow, and SYY derives several benefits from being the largest player in the market.
Despite several years of sluggish growth and some pricing pressures, we believe SYY will keep plodding forward as it executes on its cost improvement plan and becomes even more competitive. A well-known activist investor also purchased 7% of the company in August 2015 and could help the company unlock additional value.
SYY was founded in 1969 and is the largest distributor of food products in the country. It basically acts as the middleman between food producers and retail consumers.
Restaurants are its biggest customers at about 64% of total sales, followed by healthcare cafeterias (9%), schools (8%), hotels (8%), and other facilities (11%). Overall, SYY sells to about 425,000 customers.
SYY’s product mix is fairly well diversified. Some of its biggest segments are fresh and frozen meats (21% of sales); canned and dry products (16%); frozen fruits, vegetables, and bakery products (13%); dairy products (11%); and poultry (11%).
Wholesale food distribution is a simple business. That 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 pace of change is very slow, and new innovations (even drones!) seem to pose little threat to the way the industry 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 (SYY’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, SYY’s scale plays a big advantage. Since its formation nearly 50 years ago, SYY has grown from $115 million to nearly $49 billion in annual sales (acquisitions have been a significant growth driver).
As the largest food products distributor in North America, SYY works with thousands of suppliers to offer the broadest assortment of products (over 400,000) on favorable terms. Few companies have the capital and supply chain network and expertise to match SYY’s assortment. For these reasons, SYY is one of a handful of players that can serve national accounts.
Furthermore, SYY’s wide network of warehouses and distribution systems allows it to offer daily delivery to most of its customers and provide competitive rates. With a dense delivery network around its warehouses, SYY can offer lower pricing than other distributors that attempt to play in its geographic regions.
In addition to economies of scale, high capital costs, and product assortment, new entrants are also challenged by supply contracts SYY has with many of its customers.
While the food distribution business has several favorable characteristics that seem to ensure its durability, it is a very mature market. As the largest player, SYY is especially challenged to grow. The company had historically increased in size by acquiring market share, but there are few big enough deals left to really move the needle.
Most notably, SYY made an offer to acquire the number two player in its market, U.S. Foods, for $8.2 billion in December 2013. The acquisition would have given SYY 25% share of the national market but was blocked by the U.S. government, requiring SYY to significantly alter its core strategic plan and pay hundreds of millions of dollars in breakup fees to U.S. Foods.
Less than two months after the merger was terminated, activist investor Nelson Peltz took a 7% stake in the company and secured two seats on the board of directors. Peltz brings meaningful experience in the food industry and has previously heled positions in Kraft, Wendy’s Pepsi, Mondelez, and several others.
SYY’s new three-year plan calls for stricter cost management, smaller acquisitions, and better sales efforts to improve operating income by $400 million and deliver a 15% return on invested capital by 2018. The company is also focusing on updating its product offerings and technology to better compete with smaller rivals that have more organic products and online ordering.
While the future will be much different without U.S. Foods under its belt, we think SYY will continue squeezing out modest profit growth over time and remain a force in the $265 billion foodservice market for years to come.
As we mentioned earlier, the wholesale food distribution market is very mature. With SYY’s planned takeover of U.S. Foods getting rejected by the FTC, meaningful growth will be even harder to come by.
Smaller specialty distributors have also taken away some higher-margin restaurant business from SYY, and the sluggish economy has resulted in generally softer restaurant sales over the last few years. These factors have created some price pressure and suppressed SYY’s margins.
SYY is taking action to combat these factors by offering a more localized approach to many of its customers. This includes offering locally produced foods and ingredients targeted more specifically at particular demographics. We expect SYY to also be more acquisitive of these local and regional niche distributors.
Otherwise, it seems like Amazon is worth mentioning as their reach continues to extend into many different markets. They specialize in warehousing, inventory management, and delivery capabilities, but it seems like more of a stretch for them to establish all of the supplier relationships that SYY has. The inventory and delivery mechanisms for wholesale food are also very 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 its capital intensity and low value-add.
Finally, it’s worth mentioning that swings in commodity prices (e.g. fuel) and consumer spending patterns (e.g. grocery vs. restaurants) can impact SYY’s results from time to time. However, we don’t believe these factors have an impact on the company’s long-term earnings potential.
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. SYY’s long-term dividend and fundamental data charts can all be seen by clicking here.
Dividend Safety Score
Our Safety Score answers the question, “Is the current dividend payment safe?” We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
SYY’s dividend is very secure with a Safety Score of 93. We can see that the company’s payout ratios have increased over the past decade to about 70% today. While that is on the higher side of what we like to see, it is a reasonable level for SYY because the business is so steady. However, it does suggest that future dividend growth will need to more closely align with the company’s earnings growth.
A high payout ratio can be dangerous if a company’s earnings are cyclical. However, SYY is a very stable business. As seen below, the company’s sales dipped by just 2% in fiscal year 2009. While less people eat out at restaurants during difficult economic times, they still need to consume food. SYY’s stock fell 23% in 2008 but outperformed the S&P 500 by nearly 15%.
Despite its low margins, we can see that SYY has generated a solid return on invested capital over most of the past decade. Returns have decreased a bit in recent years, but it otherwise looks like a company that has a bit of an economic moat.
SYY has also generated free cash flow ever year. It’s interesting to note that 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.
If it weren’t for SYY’s reliable cash flows, its balance sheet would be somewhat concerning. The company has a lot of debt relative to cash on hand, but its debt burden is reasonable compared to its free cash flow generation. S&P has also given the company an A- credit rating.
While SYY has somewhat high payout ratios and a lot of debt, the consistency of its business and the strong free cash flow it generates each year make its dividend payment very safe.
Dividend Growth Score
Our 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.
SYY’s dividend Growth Score is 40, suggesting that the company’s dividend growth potential is below average. This shouldn’t come as a surprise given the mature state of the foodservice distribution industry, the company’s large size, and its above-average payout ratios.
Despite its lower growth profile, SYY is a member of the S&P Dividend Aristocrats Index and has paid a dividend since 1970. The company most recently increased its dividend by about 3% in late 2015, and we expect continued dividend growth in the range of 2-4% per year (the company is using most of its cash left from the failed U.S. Foods acquisition to repurchase shares).
SYY trades at 21x forward earnings and offers a dividend yield of 3.0%, which is lower than its five year average dividend yield of 3.25%. Looking only at the earnings multiple, SYY appears to be somewhat highly valued given its lower earnings growth profile.
With that said, if the company can deliver mid-single digit earnings growth under its new three-year plan, its total return potential would appear to be around 8% per year.
With an extremely safe dividend payment, low business volatility, and activist involvement behind the stock, SYY is potentially an appealing stock for investors living off dividends in retirement. However, it looks like more of a long-term hold than a new buy today.
SYY is about as boring of a business as they come, but its time-tested operations, well-known brand, economic moat, and strong cash flow generation certainly qualify it as a blue chip dividend stock.
The stock’s price does not look cheap today, but we believe SYY remains a quality long-term hold for conservative investors seeking sources of safe dividend income.
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