Description

Important Disclosures: Certain funds and accounts managed by us and our affiliates are currently long USFD.  We may buy and/or sell shares of USFD in the future for the funds and accounts managed by us without notice, and we are under no obligation or agreement to take, or not take, any action or restrict our actions in any manner.  This is not a recommendation to buy or sell shares.  Our views are subject to change without notice and we may trade in any manner, whether consistent or inconsistent with this investment thesis.  The information below is from public sources.  We have not independently verified this information and we make no representations as to the accuracy or correctness of any such information.  We undertake no obligation to update any information below.

SUMMARY

We believe US Foods is an undervalued stock given the demonstrated stability of the company’s cash flows, their wide competitive moat and distinctive position to increase market share.  It is trading at a discount to Sysco and Performance Food Group on a free cash flow and EV/EBITDA basis using 2017 consensus estimates.  We estimate US Foods could generate close to $2.00 per share of FCF in 2019 based on a projected $1.2 bn of EBITDA and a 39% tax rate.  If the market re-rates USFD to a SYY and PFGC multiple, we believe USFD could be up to a $38 stock in 18 months, in which caser it has potential to yield ~40% upside to the current stock price.

BRIEF COMPANY HISTORY & SELECT HISTORICAL FINANCIALS

US Foods was created via the consolidation of multiple food service companies over the last 150 years.  In 2007, Royal Ahold sold the company to CD&R and KKR in a $7 bn transaction.  After a failed proposed merger with Sysco in 2015, the company IPO’d in May of 2016.  CD&R and KKR continue to own approximately 28% of the float.

STRONG POSITION IN A GROWING, FRAGMENTED INDUSTRY

The restaurant industry and the foodservice distributors have been benefitting from a long-term trend of consumers eating outside the home.  US Foods is specifically focused on servicing the higher-growth customer types, including independent restaurants, hospitality and healthcare companies.  Customer mix helps inform management’s medium-term goals to grow volumes in the 2-4% range each year.

The industry’s highly fragmented structure provides the two largest incumbents with a long runway for future potential growth.  Sysco and US Foods are the only two operators with nationwide footprints, yet only have 17% and 9% market share, respectively.  US Foods is roughly 50% larger than Performance Foods, the third largest player.  Beyond the top three players, which collectively generate only one-third of the industry’s sales, the rest of the market is comprised of an estimated 15,000 smaller distributors.      

US Foods estimates that they command the #1 or #2 market share position in over two-thirds of their local markets.  We believe scale is important as it enables the large incumbents to offer more products and services at lower prices to their customers.  Our view is that these self-enforcing competitive advantages over the long tail of smaller industry participants will only grow stronger with time. 

1)      Product Breadth and Availability

Restaurants, Healthcare and Hospitality Customers, Educational and Government Institutions can go to the larger foodservice distributors for a wider variety of SKUs.  These range from canned goods, dairy, meats, seafood, and produce to janitorial supplies and cleaning equipment.  Customers are able to aggregate purchases into a fewer number of orders to lower costs and improve efficiency. 

Note the relative size of USFD and SYY’s distribution centers and the number of SKUs offered.  There are simply no other companies in the industry that can match the size and breadth of their product offerings.

2)      Flexible and Lower Cost Delivery

Customers rely on the foodservice distributors for on-time delivery and high service levels.  The largest food distribution companies are not only able to offer next-day delivery services but can leverage their denser route networks to lower per unit delivery costs.  This fortifies the companies’ moats by enabling them to offer more to their customers at a lower price.

3)      Products: Lower Cost Sourcing, Private Label and Consistency

Larger distributors can flex their purchasing power to source SKUs for lower costs, which can then be passed onto their consumers.  The larger distributors can also offer higher-margin, but generally lower cost private label products to end customers.  Finally, national and regional chains are able to sleep better at night, knowing that there is consistency of product across their menus and across their locations by employing one of the two national distributors.

RESILIENT HISTORICAL FINANCIAL PERFORMANCE

The US foodservice distribution industry has historically been characterized by relatively stable growth and macroeconomic resiliency, which has translated into consistent financial results for the two largest, publicly-traded food distributors, Sysco and US Foods.  Both companies were able to either maintain or grow EBITDA through the Great Recession.

Note: On December 2013, SYY and USFD announced an agreement to merge.  The Federal Trade Commission voted to block the deal on February 2015, and both companies blame the drawn out approval process for the relatively poor EBITDA performance between 2014 and 2015.

TECHNOLOGY MAY DRIVE INCREMENTAL MARKET SHARE GAINS

We believe US Foods will be a market share winner as the company has aggressively invested in IT infrastructure and e-commerce initiatives, embedding their technology in their customers’ business processes and increasing customer retention.  E-commerce represented 68% of US Food’s net sales in FY16 compared to less than 10% at Sysco.  Examples of e-commerce capabilities include online ordering, clean invoice and proof of delivery, and auto-payments and re-ordering.  These tools allow the salesforce to spend their time upselling private label brands, which we believe can generate up to 2x the margins of manufactured product, and offering restaurant consulting solutions, rather than merely fulfilling orders. The company intends to leverage its technology platform and innovate product offerings to increase their share with existing and new customers, grow share in higher-margin center-of-plate proteins and produce, and expand their private brand programs.

CERTAIN RISKS

The risks we have identified in connection with an investment in USFD include, among others:

1)      Food Price Deflation

As a pure-play distributor, food price deflation has a negative impact to operating profit dollars.  We refrain from making any bold predictions about the future direction of commodity prices, but we are encouraged by the company’s ability to grow EBITDA in the face of declining beef and cattle prices during 2015 and 2016.  More recently, the data shows a bottoming out of prices and perhaps even slight upticks.  The charts below illustrate Bloomberg-sourced prices for USDA Boxed Beef Prices and Live Cattle Futures. 

Chart 1: 90% Fresh Beef Box, Chart 2: 50% Fresh Beef Box, Chart 3: Live Cattle Futures

2)      Spiking Fuel Prices

Spiking fuel prices will be a headwind to profitability to the extent US Foods is unable to pass these along to customers expediently. 

3)      Independent Restaurant Case Growth is Lower than Expected

Foodservice distributors generally generate higher margins from sales to independent restaurants vs. national and regional chains.  If profitability and/or traffic trends at independent restaurants come under pressure, then US Foods will not grow as quickly.

4)      Poor Acquisition Integration and/or Purchase Prices

In order to hit the high end of their medium term guidance of 7-10% EBITDA Growth, US Foods must make acquisitions.  Integration problems and/or inflated purchase prices will negatively affect financial results.

CONCLUSION

The stability of USFD’s end markets, fragmented industry landscape, investments in technology and cost cutting plan, underpin our confidence in management’s publicly stated strategy to grow volumes 2-4%, EBITDA 7-10% and earnings in the mid-teens.  US Foods trades at a discount to SYY and PFGC on a FCF and EV/EBITDA basis.  We believe USFD could be up to a $38 stock in approximately 18 months if the market ascribes a SYY and PFGC free cash flow multiple on our projected $2.00/share of 2019 FCF estimate in that timeframe.

Catalyst

Secondary offerings to increase stock liquidity, potential acquisitions, potential return to food price inflation