Description

Executive Summary

Despite its low margins, Sysco is a high quality, recession-proof business with a large moat. They’ve clearly been hit hard by the Covid pandemic, but I think they will show very little damage coming out of this and in fact will see improved growth prospects from the ability to steal share from smaller, less well-capitalized distributers which will inevitably struggle as the current environment goes on. The current environment probably adds some value to them long-term if pressures continue; otherwise, it will eventually be business as usual and you are getting the Sysco business at a Covid-discount. I see upside of ~50% over the next couple years as these points are factored into the share price. Had some formatting issues so please see here for a PDF.

Business

SYY is the largest global distributor of food and related products primarily to the foodservice or food-away-from-home industry, and over the years they’ve cultivated a dominant market position in the US. Their key end market breakdown has stayed fairly consistent over time: Restaurants (62% of FY2019 sales), Education/Gov (9%), Travel & Leisure (9%), Healthcare (8%), and Other (12%). Geographically, SYY is  80% US; they tried expanding internationally in 2016 through their $2.9bn acquisition of Brakes Group, but this has seen luke-warm results at best. The majority of value comes from US operations, with some future upside potential internationally if they can reach benefits of scale. 

Operating segments

• US Foodservice (69% of sales but 94% of EBIT): Primarily broadline distribution, with a full line of food products and a wide variety of non food to both traditional and chain restaurant customers, hospitals, schools, hotels, industrial caterers
• International (19% and 4%): Includes operations in the Americas and Europe, which distribute a full line of food products and a wide variety of non-food products
• Sygma (10% and 1%): Customized distribution subsidiary to certain chain restaurant accounts. Very low margins on account of customized nature, also known as a “systems distributor”

As US Foodservice is the majority of EBIT, we’ll focus our analysis here. Within US Foodservice, SYY has indicated that they are about evenly split between “local” customers and “national” customers. 

Local customers are primarily “street customers”, such as independent restaurants that do not have long-term contracts, or locally managed customers, such as local chain restaurants, while national customers are the multi-unit customers requiring national coverage from a customer centric view and are managed centrally from the Corporate office. Local allows for more favorable pricing and higher margins as a result. National customers benefit from purchasing power, as they are able to negotiate pricing agreements across multiple businesses. We’ll look at the Covid impacts on each in more detail subsequently. 

Industry

As can be seen below, the US foodservice market has grown steadily and is currently around $300bn. Sysco is the clear leader in the industry at 16%, double the next largest peer. As I’ll hit on below, Sysco’s large scale relative to peers give them many advantages that cannot be easily duplicated. (Note: There should be an industry graph to the left)

Business Quality

SYY displays several characteristics which I believe make it a very quality business with steady long-term cash flows, despite the industry within which it operates. These include:

1. Barriers to entry: High startup costs (need distribution centers, efficient network) make industry entry difficult, especially when there are such low margins on a business which already incorporates scale (Sysco). Makes it very difficult for smaller player to get to a point at which they can reach profitability. The idea of Amazon entering with their existing distribution facilities has been tossed around, but this is unlikely due to several reasons, among them the investment needed to efficiently handle food items as cheaply as broadline distributors and lack of an enhanced value proposition. Some of these arguments are laid out in a prior US Foods pitch here. 
2. Tremendous longer-term benefits to scale: Purchasing power leading to lower prices, increased density leading to lower cost per trip, and SG&A leverage are all key advantages that Sysco enjoys as the largest distributor. We can see just how much scale matters in their attempted 2014 acquisition of US Foods: synergies were equal to ~80% of US Foods EBITDA. This becomes a virtuous cycle as you are able to add additional features, like investing in more advanced tech and an ability to better assist customers.
3. Highly defensive, particularly in recessions: Historically the industry has been very steady, growing right below GDP + some additional price inflation. Even in the great recession the business was mostly stable, as seen below:

    

   

Obviously the situation today is unlike any recession we’ve had before, but the point is that this is in general a very strong business deserving of a premium multiple. 

Fortress Balance Sheet and Near Term Liquidity

The first and foremost consideration for Sysco is their financial positioning in this environment; how much of a hit is their business value likely to take, and how much of a cushion is there? At the end of Q4 2020 (June 30th) they had hit 10 consecutive weeks of positive FCF, and were FCF positive for H2 2020 as a whole (even when removing the inflows from NWC). In addition, they now have $8bn of cash and available liquidity. With the cost cuts that they have made and sales likely only going up from here, I don’t see them burning any meaningful cash. Even if they did, they have plenty of liquidity and reasonable leverage – there is $744mm coming due 2021 but their IG rating should make this easily refinanceable. SYY’s financial positioning has set them up extremely well to make moves toward improving their capabilities in order to steal share in the coming years. 

Food Distribution Performance Under Covid

For Sysco, we saw Q4 case volume declines of 38.7% in the local category and 41.5% overall. However, the exit rate of the quarter was closer to a 30% decline, which I believe is a good near-term downside indicator. At that mark, Sysco is profitable thanks to their 70/30 variable vs fixed SGA costs. 

Data from US Foods paints a rosier picture: 

“At the end of June, our sales to independent restaurants in markets that opened the earliest, shown by the green line, were only off 10% to 12% versus prior year, and this is packed despite the fact that restaurants still had seating restrictions in many areas. This compares to markets in later phases, shown in blue and red, whose variance to prior year was greater anywhere from 20% to 30% at the end of June. Again, this shows us that once consumers feel safe, they will return to restaurants, and it's what gives us the confidence that when markets do fully reopen, we will see a recovery in volume close to pre-COVID levels”

Clearly, this is positive for the long-term outlook in contrast to the fears that the pandemic will fundamentally change eat-away-from-home demand. Once customers are able to go out and eat, they are generally willing to do so.

Market Share Opportunity

The most important part of Sysco’s current dominant position is that it allows them to gain share from struggling industry participants. Smaller independent restaurants are really feeling a lot of pain right now – UBS estimated permanent closures will be at 20% (although industry participants see this as highly overstated – permanent closure figures today are in low single digits). But regardless, the point is smaller/regional distributors are under a lot of financial strain. We expect scaled distributors to see outsized gains in market share as many independent distributors struggle in this reduced-volume environment, eventually losing their customers’ confidence. 

There will be a timing gap caused by the churn of restaurants that exit permanently and then those that will actually get back into this business after they've cleared their bankruptcy, and those that fill in the empty space. I’ve reflected this in the model assumptions

New Wins

The current strain is also translating to larger chains, where confidence in the distributor is absolutely critical. Sysco has already won $1bn in new business since the pandemic began, and that is mostly national business. $500mm of that was announced on their Q3 call, where they said they had had the opportunity to purchase the distributor pre-Covid, but were able to instead essentially end up stealing that business. The most impressive part is they brought on that business in less than 7 days.

Another example of distributor business being scooper up here: https://www.pentallect.com/pandemic-catalyzes-a-foodservice-distribution-mutation/

In addition, as the recovery accelerates, its increasingly difficult for these smaller player to ramp back up their inventory levels as quickly as they need to. Customers have confidence that a player like Sysco will have access to product, including fresh product, and be able to ship exactly on time. 

Sysco Partnership Capability

Another quick point on Sysco’s ability to provide customers with superior service: they’ve been able to provide value by (1) helping with alternative reopening plans like outdoor dining options (2) providing customers with technological support to start a website for those which didn’t have one (3) helped narrow menus to maintain profitability. This has led to an increase in net promoter score of 900 bps over the last several months.

Future Rebound and Valuation

Revenue Build

I estimate that the exit rate of down 30% from pre-covid levels for US Foodservice is maintained throughout 2021, with a slight uptick at year end leading to revenue that is 71.7% of pre-Covid revenue. We then see a turnaround in 2022, getting to 90% of pre-covid revenue, before eventually getting back past 100% with accelerating growth in 2023.

Mix Shift

I see the mix as shifting slightly toward chain/national accounts over the next 2 years as independents shut down (and hence some GM pressure), but expect that independents eventually will pop back up to replace those that have been shuttered. General industry consensus is some of the “permanent closure” numbers are highly overstated, especially when considering longer-term replacements. Total case vol actually dropped more than local (41.5% vs 38.7%) in Q4 which isn’t quite what you’d expect. - it shows that overall the two categories are performing similarly. But on the margin independent customers have less financial wherewithal, so you eventually more of these in permanently closed category. However, most of restaurants are pretty much single-purpose buildings, and will likely end up being refilled. 

Costs

The company has taken steps on the cost side to remove $500mm of OpEx, 300mm of which is permanent and management recently updated this to $350mm. Reflected in lower SGA margin going forward (2023E uses implied 2019 SGA margin with $350mm less costs). 

Historically, the business has traded at 11-15x EBITDA. I think they should be trading at the higher end of this range in 2022 when it is closer to a normal environment, given all of the positive business qualities mentioned previously. In addition, they will likely be in a more dominant position than before due to incremental share gains, leading to marginally faster future growth. Valuation below: 

Catalyst

--Recovery faster than expected

--Continued wins of incremental market share