A Formidable Force in Food

09/17/2009 11:06 am EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst Michelle Chang say giant food-service distributor Sysco is a strong competitor with steady profits.

Sysco (NYSE: SYY) operates as the largest food-service distributor in North America, controlling about 15% of the market. The firm distributes more than 300,000 food and nonfood products to 400,000 diverse customers, including restaurants, health-care and educational facilities, and lodging establishments.

From its founding in 1969 through the end of its 2008 fiscal year, Sysco has acquired around 145 companies or divisions of companies to expand its footprint. Sysco is not immune to the barrage of challenges created by food inflation and deteriorating economic conditions, but we believe the firm will weather the current storm better than its competitors due to its unparalleled scale, the breadth of its products and services, and its continued focus on reducing costs.

While food distributing is generally a low-margin, capital-intensive business, Sysco’s economies of scale have allowed it to consistently post returns on invested capital well beyond our estimate of the firm’s cost of capital.

Sysco has built a wide economic moat primarily resulting from the economies of scale inherent in its expansive distribution network. Another source of Sysco’s moat is its extensive portfolio of more than 40,000 higher-margin, private-label and specialty product offerings designed to meet the industry’s growing need for reasonably priced, quality products.

Despite its positioning as a low-cost provider, Sysco is keenly focused on trimming additional costs from its already lean operating structure. For instance, Sysco is working to reduce the complexity of its supply chain by more efficiently routing its deliveries, as well as building several redistribution centers. The firm is already realizing some initial benefits from these efforts.

Despite these competitive advantages, it is not all wine and roses for Sysco. As price-conscious consumers rein in their spending in this difficult macroeconomic environment, volumes will suffer. Further, food costs will remain elevated for the foreseeable future.

Sysco faces some major head winds in the near term, but we believe the firm’s expansive distribution network and its leading market position will enable it to continue generating strong cash flows and outsize returns for shareholders.

Our fair value estimate is $35 per share. (It closed below $26 Wednesday—Editor.) We expect economic conditions will weigh on the firm’s near-term sales, as food inflation is countered by volume declines. We believe sales growth will slow to around 3% annually over the next two years before returning to 5% annual growth longer term.

We do not expect Sysco’s consistent profit generation will significantly falter; Sysco should continue delivering operating margins of around 5% of total sales over the next five years. We have not forecast any acquisitions (despite the firm’s acquisitive nature in the past), even though we anticipate that Sysco will make some smaller bolt-on acquisitions from time to time that should not move the needle.

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