Description

US Foods (USFD) – Long Equity (10/20/17)

Thesis Summary

USFD represents an opportunity to buy a market leader in a recession-resistant/steady-growth industry, at an inflection point in its product’s value proposition to customers.  The company also trades at a discounted valuation given misplaced Amazon and restaurant slowdown concerns.  Price Target is ~$50 (i.e., +82%) in ~2 years.

1. Company is trading at its lowest valuation relative-to-market due to a few key misunderstandings, including:

• Amazon risk – limited ability to improve the mousetrap; distribution network would need to be built or acquired; foodservice distribution does not further Amazon’s goal of increasing share of consumer wallet

• Restaurant (end-customer) slowdown – share gain of independents is not appreciated; short-term fluctuates, but long-term growth driven by disposable income

2. Market leaders and share gainers in a stable and growing industry

• Scale within a consolidated industry drives USFD’s competitive advantage, enabling the company to gain market share over time

• Fragmented industry with ~15,000 players, with the top 3 only controlling ~29% share of the US market

• Steady long term growth of ~4%, in-line with disposable income growth, which at its most was down -0.5% in the Great Financial Crisis, and never down in any prior recession

3. Foodservice distributors are at an inflection point in their growth trend due to industry changes

• Temporary headwinds abating, and tailwinds beginning

• Independents growing and gaining share

• Tech solutions making distributors a more value-added partner, enabling them to gain greater share and maintain stickier customer relationships

4. Pathway to improved shareholder returns

• Company is nearing it’s 3.0x leverage target, at which point share buybacks or other more accretive uses of capital become likely

Business

Operations

Foodservice distributors leverage their wholesale distribution facilities and vehicle fleets to transport food items in bulk quantities.  Both suppliers (i.e., food manufacturers) and customers (i.e., restaurants, healthcare institutions, hospitality institutions, etc) are fragmented, and rely on distributors’ purchasing scale and fixed cost leveragability to ship large containers cost-effectively.  Industry sales total ~$280bn1.

The primary types of distributors include (1) broadline distributors, (2) systems distributors, (3) specialty distributors, and (4) cash-and-carry retailers.  Broadliners, as their name suggests, carry a broad line of product SKUs (e.g., USFD carry ~400,000) for either regional or national distribution to business customers willing to abide by some minimum order size (typically ~$500 per case). Systems distributors move boxes exclusively for large national chains, with customers negotiating product prices directly with manufacturers and simply paying the distributor a logistics fee.  Systems businesses are lower value add and lower margin.  Specialty distributors will carry a lower assortment of product types, but more SKUs per product in which the distributor specializes.

Specialty distributors are largely local, and usually in products like meat and dairy.  They can carve out a niche versus broadliners, despite their limited scale, because part of broadliners’ efficiencies come from consolidating SKU count to gain leverage over suppliers, leaving the “long-tail” of certain product categories to specialty distributors.  Cash-and-carry stores include retailers like Restaurant Depot and Costco, and provide items in bulk that the customer can pick-up themselves, typically for last-minute fill in items or for smaller customers that can’t meet the broadliner’s minimum orders.  Given the more limited selection, requirement to pick up items yourself, inability due to food safety regulations to self-transport temperature controlled products legally and more limited service (i.e., no sales rep relationship) cash-and-carry competitors are not a perfect substitute for broadliners.

Broadliners use their scale to purchase food typically at a ~1% to 2% discount, receiving “slotting fees” or rebates (a contra to cost of sales) from suppliers for their volume purchases.  Suppliers are 90% domestic for the large US broadliners, and the distributor typically adds no preparation work to the food.  The types of food distributed include a mix of fresh and frozen meats, canned and dry products, frozen fruits and vegetables, dairy products, poultry, etc (see chart on product breakout).  The broadliner ships the food to its distribution facilities (typically ~200,000 sq. ft. in size), which are purpose-built for bulk food storage and are relatively labor intensive.  The distributor ships ordered food through their owned fleet, typically within a ~200 mile radius of the facility.

Customers typically have ~2+ broadliners and ~3 to 4 specialty distributors from whom they purchase, though this has somewhat consolidated over time.  Customers can order food either online or through their merchandise associate (MA) (i.e., sales rep), typically 2 to 3 times a week for delivery ~ next day.  Delivered packages are dropped off in a location designated by the store owner, but service is not fully white-glove (i.e., individual items are not stocked in different locations within the restaurant).  Customers are either contracted (60% to 65% of sales) or non-contracted (~35% to 40% of sales).  Contracted customers include larger restaurant chains and hospital/hospitality institutions, and contracts are for ~3 years and require that 80%+ of your food purchases are from the distributor.  Typically, ~50% of contracts are on a % markup basis (i.e., the broadliner receives some fixed % of the food $’s purchased by the customer), and ~50% of contracts are priced at a fixed $ per case, with this fixed $ received by the broadliner typically increasing at inflation.  Non-contracted customers include independent restaurants, and they only require some set $ minimum of purchases by the consumer.  Pricing for non-contracted independents is independently set by the sales rep that is responsible for that customer relationship, and is constantly adjusted (weekly, or even more frequently) for food inflation.  The sales rep for non-contracted customers are 100% compensated on a commission based on gross profit per customer.  The parent broadliner sets guardrails within which the sales rep must price.  Returns are allowed for all customers.

Broadliners’ product offering is evolving to include more value-added services.  Historically, the distributor’s sales rep would visit the independent restaurant multiple times per week, and spend ~90% of their time taking orders verbally from the customer.  Only recently (~2014 to 2015) have customers begun ordering more online, using the distributor’s web-based portal.  USFD has largely led this initiative, resulting in fewer sales people per customer, but more time per sales person allocated to higher value-add services for the customer.  Customers now receive consultations from the distributor (starting ~2016) in how to optimize their menu, cost-effectively use ingredients for menu items, improve floor space, and manage labor.  In addition, the sales rep and web portal push innovative private label products that the customer can use to lower costs (e.g., products that require less labor to turn into a final dish) or differentiate themselves (e.g., better tasting dishes or more ethnic/unique dishes).  Large distributors have invested in tech systems and-value added services to partner with independent restaurants, supporting their core businesses, versus simply taking orders.

While the industry is often described as fragmented, that’s partially due to the high number of specialty distributors, which operate a somewhat distinct “concept” from broadliners given their SKU count differences.  The last few decades have seen meaningful consolidation.  Broadliners as a category have generally gained share of the total distribution pie, going from 45% to 61% of the market over the last 20 years at the expense of specialty distribution.

US Foods (USFD) is the 2nd largest broadliner, with ~$23bn in total sales and ~16% market share.  The company has fleet of 6,000 vehicles across 75 warehouse facilities, serving 250,000 customers with 400,000 SKUs from a base of 5,000 suppliers.  USFD was IPO’d in May 2016, after having been owned by private equity (KKR/CD&R) starting in ’07.  Previously, USFD was owned by Royal Ahold from ’00 to ’07.

Quality

Competitive advantage is driven by scale.  Scale benefits include (1) purchasing cost advantages, (2) increased density through your network, which lowers costs per trip, offset by the fact that route density efficiencies are determined on a regional basis (3) increased share of each restaurant pushes up drop size making them more cost competitive and (4) leveraging general and administrative costs.  Amongst the publicly traded companies, we can observe the benefits of scale as the larger the player, the greater the EBITDA margin (even after adjusting for differences in customer and business mix).  Increasingly, scale enables a greater fixed investment in higher value-add tech solutions (discussed above), which enable large players to further differentiate themselves.

Barriers to entry for the large broadliners include (1) the high fixed cost investment necessary to recreate the single-purpose distribution network and tech solution platforms, (2) the low margins on a business that already has scale advantages which makes it difficult for new entrants to operate economically, (3) challenges in gaining share given tech solutions and other value-added services are creating stickier customer relationships, and (4) multi-year contracts on a majority of the business.  It’s important to differentiate between the barriers to entry in becoming a broadliner versus a specialty distributor.  Anyone with a truck, small warehouse, local relationships with restaurants, and willingness to accept low-single-digit EBITDA margins can compete in specialty distribution.  This is because they are covering SKUs that broadliners don’t provide because it’s more beneficial for the broadliners to concentrate their purchasing power in fewer products.  However, given they offer different product sets, specialty distributors are not direct substitutes for broadliners, and thus the low barrier to entry in becoming a specialty distributor does not suggest there are low barriers to entry in becoming a broadliner.  However, specialty has been losing share of the distribution market over time despite the low barriers to entry to new entrants in this space, perhaps indicating that the advantages that the broadliners derive from concentrating their purchasing and driving lower prices has been more important than breadth of product selection over time.

Large foodservice distributors’ after-tax ROIC % tend to be ~ mid-teens %.

Growth

The foodservice distribution industry grows volume at ~2% and price at ~2%.

• Volume is driven largely by food-away-from-home (FAFH) $ growth, which itself is largely driven by disposable income $ growth.

• US consumers tend to dine-out (i.e., FAFH) about 20% of the time, but this spend represents ~45% of their meal purchases given dining-out is more expensive than eating-in.

• FAFH has grown share over time versus food-at-home (FAH), as more families have become dual income, and disposable income has steadily grown.

• Over time, FAFH spending has remained a constant ~5% of disposable income, showing how as disposable income grows, people keep their dining-out spend consistent with this growth, taking spend away from FAH.

Recently, independents have begun to grow faster than overall FAFH growth due to the internet lowering consumers’ discovery costs for less well known restaurants, increased home delivery options and a recovery in traffic trends overall from the Great Financial Crisis.  Given the distributors make higher margins with independent restaurants than chains, this mix shift will benefit profitability growth.

Thesis

1. Company is trading at their lowest valuations relative-to-market due to a few key misunderstandings, including Amazon risk and restaurant (end-customer) slowdown.

Amazon risk

• Amazon concerns, which heightened when Amazon announced it would buy Whole Foods on 6/16/17, have helped compress USFD’s P/E (NTM) from 20.6x to 16.8x.  USFD now trades at all-time low valuations relative to the market.

• I believe this multiple compression is over-done for the following reasons:

• No opportunity for Amazon to improve the mousetrap, unlike other industries in which Amazon has taken share

• Historically, Amazon has competed in products in which the company could improve the service or solve some customer pain point.  Whether simply shipping the product to the customer instead of requiring the customer to drive to a store, or offering a long tail of products to increase the value of its network, Amazon has always offered a better value proposition to the customer in order to take share.

• With foodservice distribution, there is very little that Amazon can do to improve the service.  Products are shipped directly to the customer.  Customers have access to 400,000 SKUs on an online marketplace.  Value added systems like inventory management and new product introductions are incorporated into the system.

• The only ways in which the service can theoretically be improved is through (1) more frequent ordering allowances, (2) full price transparency and (3) cutting out the sales rep.  However, each of these items would lead to either Amazon needing to charge more than USFD because it would add costs to the system, or is something that USFD could do itself with little impact to earnings.

• More frequent ordering allowances – currently, customers can order ~2 to 3 times per week.  Amazon could allow for ordering at all times as a way to try to take share.  However, if this were to occur, it would simply increase the cost of service.  Amazon would know that USFD could offer this as well with little difficulty, so all Amazon would effectively do is lower the margin structure for the entire industry without achieving any advantage with which to gain share. This lowering margin structure would be especially difficult for Amazon if early-on they don’t have the scale.

• Full price transparency – each independent customer currently receives prices set by their sales rep within certain guidelines set by corporate.  Therefore, neighboring restaurants can pay two different prices for a specific product without knowing it.  Amazon could post the same prices for everyone online, gaining customers who currently pay above average.  Possibly during the early years, this would cause pricing pressure (similar to what happened with Restaurant Depot) as smaller customers who historically received higher prices would now have a benchmark price to use in negotiations with USFD.  However, this would just effectively be a price cut, not an improvement to the mousetrap, given these small price declines could easily be matched.  This wouldn’t result in Amazon gaining share long term, and in the near term would put Amazon at even more of a disadvantage given Amazon wouldn’t yet have scale.

• Cutting out the sales rep – the large distributors are already moving into the direction of cutting the sales rep in favor of tech solutions.  However, surveys show that customers would need a 13% cut in prices to incentivize them to work without a sales rep.  Given the business operates on ~5% or less EBITDA margins, this suggests that completely eliminating the sales rep would make no sense.

• Amazon can’t compete in foodservice distribution without building or buying a foodservice distribution network to compete

• Amazon’s distribution network of fulfillment centers and FedEx/UPS trucks can’t handle bulky food  items as cost efficiently as broadliners.  The broadliner network requires different equipment within the warehouse and a different labor force.  In addition, they cannot leverage FedEx/UPS to deliver the last mile for refrigerated/frozen food items. This would require Amazon to separate trips and further reduce the drop size, making this uneconomic unless it can be done with three temperature trucks.  This means Amazon would need to either build or buy a new national foodservice network to compete.

• One way to confirm this network difference is to actually order bulky non-food products on Amazon versus USFD.  For approximately the same all-in cost, you can have bulky items delivered on Amazon for shipment times of 10 to 20 days, versus next day delivery for USFD items at their warehouse.

• Historically, Amazon could leverage its existing network to compete in new consumer products.  Amazon would not be able to leverage its network for food distribution.

• This is a corollary of the points that the food distribution network is single-purpose, and that Amazon wouldn’t be able to improve the mousetrap.  Amazon can’t leverage its existing network to compete more cost effectively.

• Given the cost to build a full national network, and given Amazon wouldn’t be fundamentally changing the value proposition and thus likely would start with very low share, Amazon’s ROIC from entering this market would likely be relatively low.

• No synergies with Amazon’s goal of increasing penetration of consumer spend

• Amazon’s goal is to sell everything to everyone, and is focused on increasing penetration to the consumer at home.  Its Amazon Prime strategy with free 2 day delivery has the goal of increasing its share of household purchases further increasing density and drop there making it more economic to deliver more frequently.  Foodservice distribution to restaurants and institutions doesn’t help with this goal.

• Amazon does attempt to sell to businesses through Amazon Business.  However, it is for prices that are the same as provided on Amazon.com.  Over time, as Amazon matures in its current customer strategy (a long way off), Amazon may need to turn to business sales for growth.  However, given the low ROIC Amazon would face by entering this market, it’s unclear why they would turn to foodservice distribution because they would effectively just be buying growth as opposed to innovating to growth.

Restaurant Slowdown

• Restaurant demand seemingly turned negative in late ’16, however USFD was able to grow gross profit/earnings in the period.  The disconnect between restaurant data and USFD’s actual performance is that:

• The restaurant data that captures total $ spend (i.e., SpendTrend) exhibited only temporary weakness before trending back positive.  We did see some slowdown in Q4 ’16 for broadliners before accelerating in Q1 ’17, in-line with the SpendTrend results.

• Most of Wall St pays attention only to the comp store sales of national chains (e.g., MillerPulse or the compilation of publicly traded comps shown below), which does not take into account that (1) independents are taking share from national chains and (2) units are growing ~2% to 3%, offsetting the comp sales declines.  For broadline distributors selling into restaurants, the only metric that matters is total restaurant $ sales growth.

• Independents are taking share due to (1) the trend towards local/fresh foods, (2) online reviews better enabling smaller restaurants to be discovered, and (3) increased penetration of delivery.

2. Market leaders and share gainers in a stable and growing industry

• During the 2008-2009 recession, USFD’s earnings were ~flat.  The food supply chain is largely recession resistant.

• USFD has a cost savings plan, driven by centralized purchasing and other gross profit initiatives, in addition to opex savings such as sales force productivity and indirect spend centralization.

• Secular drivers were discussed in the business section, but include:

• Food-away-from-home mix benefit

• Independent customer mix benefit

• Private label mix benefit

• Private label is ~2x as profitable as 3rd party purchases.

• Less sales staff as technology platform grows

• Improved network density as volume grows

• Share gains from applying their scale advantage against a fragmented competitor base

3. Foodservice distributors are at an inflection point in their growth trend due to industry changes

• The industry is moving beyond a few industry headwinds over the last ~5 years, which should enable multiple expansion.  Here is a discussion of each of the factors, and what is changing:

• Cash-and-carry

• Cash-and-carry operators like Restaurant Depot began to compress broadline distributors’ margins starting in 2011.  The impact was less on volume share, and more on pricing, given Restaurant Depot essentially created local price transparency.  As the cash-and-carry operator opened a store in a new town, the local broadline distributor witnessed near term pricing declines.

• Pre-Restaurant Depot, independent restaurants had no pricing benchmark to consult when negotiating prices with their sales rep except for other distributors.  Restaurant Depot gave customers a point of comparison that enabled them to successfully argue for lower pricing given their pricing was lower due to its lower service, lower cost delivery model.

• Cash-and-carry industry statistics have been difficult to find, but based on our calls we believe that the headwind is largely behind distributors for a number of reasons.

• Restaurant Depot has grown to 122 locations covering most of the major metropolitan areas.  These are large stores (70-75k square feet) with large trading areas.

• Cash-and-carry is not a substitute product versus a broadliner, given the need to pick up the items yourself and more limited selection.  For example, the average broadline purchase is $2,200, versus cash-and-carry at only $410.  Therefore, cash-and-carry’s threat was largely just the fact that it broadcast pricing on certain items, which is largely a 1x headwind.  Now that cash-and-carry is in 80-90% of states, we believe that the cash-and-carry headwinds have subsided.

• Decentralized pricing

• The headwinds from cash-and-carry were enhanced by the fact that sales reps historically had full pricing control.  This led to a lack of pricing discipline when faced with disruptive competitive pressures like cash-and-carry.

• Starting in ’14, large broadliners began pilot testing revenue management software that would institute top-down pricing discipline on sales reps.  The system was fully deployed by the end of FY ’16.  The results were apparent as the industry began talking about some larger customers they dropped because they didn’t meet their profitability standards.  This was a big change from before.

• USFD also has centralized pricing, as the sales reps pricing decisions are kept within a band that is dictated by corporate.

• This pricing technology has been made easier with the sales tech platforms in which USFDhas invested, given pricing by item can be pushed to the sales rep real time, and based on a deeper understanding of product cost.

• GPOs

• GPOs began targeting foodservice operators in 2010, pooling together restaurant buyers in order to negotiate prices directly with manufacturers to lower prices.  This essentially led to pricing and margin pressure for distributors.

• The challenge for GPOs in expanding into foodservice categories is that the GPO is only able to negotiate lower prices for products that are purchased across the entirety of their customer base, that did not have much diversity and for which the customers didn’t feel strongly on which product was used, otherwise the GPO can’t get enough scale to be effective.  This means that GPOs re-negotiated prices on a limited set of products.

• The net result was that GPOs only impacted a limited SKU count but each in a significant way as it reduced pricing on the customer that had the highest pricing.  Much of this impact was felt in 2010-2012.  The distributors also responded with category management which concentrated their buying power into single manufacturers who committed to not buying from the GPO.  The impact of GPOs is already in the current net pricing, and is not an ongoing headwind.

• Restaurant chains mix shift

• Restaurant chains have steadily gained share for, as successful restaurant concepts have steadily opened new units in their niche.  In 1955, McDonald’s only had 10 stores, and Subway sandwiches didn’t exist until 1965.  Applebees began in 1980 and Chipotle in 1993.  These chains took share from some subset of independent restaurants for decades, and they typically do not use broadliners as they mature because they hire a systems distributor.

• Since ’15, restaurant chains as a category have actually begun losing share to independent restaurants.  We believe this this is due to a combination of chains having already grown so much to fill most product niches, independents increasing awareness due to the internet and further delivery options connecting more restaurants to the end customer.  Independent restaurant reviews are now posted on Yelp.com and other websites, which is especially helpful to travelers in a new town for the first time looking for a restaurant.  Independents also were hit harder in the GFC and have taken longer to recover as traffic was slow to rebound.

• Restaurant chains represent significantly lower margins for broadline distributors (typically, ~50% of the margin of independent restaurants), and so the reversal of this mix a tailwind.

• Failed merger attempt

• Sysco (SYY) attempted to purchase USFD on 12/9/13, and the merger process was open through 6/30/15 before ultimately being denied by the FTC on grounds that SYY/USFD would be the only national broadline distributors for large national restaurant chains.

• The failed merger discussions led to USFD losing market share to SYY, given customers shifted with the belief that they were going to be SYY customers anyway post-merger.

• The impact ended up being negative for both USFD and SYY, given USFD lowered pricing in an attempt to protect against business losses.

• In addition, other players like Performance Food Group and the larger regionals took advantage of the merger disruption to take share from both entities.

• This headwind was temporary given the merger’s termination in mid ’15.

• Normalizing inflation

• The ideal inflation environment for distributors is ~2%, given this level of pricing can be passed through to customers while maintaining the gross margin.  Deflation leads to lower gross profit $ per unit as the size of the total basket declines.  Food cost inflation that is much above 2% typically can’t be fully passed through to customers all at once, leading to gross profit pressure.

• Starting in FY ’16, the overall food basket began to deflate in price, driven by “center of the plate” (i.e., proteins like beef) prices.  This acted as a headwind for USFD, but prices have since recovered and starting mid to late ’17, the expectation is that YoY inflation will return.

• We have more history from SYY, and over long periods of time inflation has averaged ~2%.  For example, between ’05 and ’15, inflation was 2%+ except for 2 years (’06 was only 0.6% and ’10 was -1.5%).  Therefore, it’s the exception rather than the norm for the deflation we saw in 2016.

• Large distributors are differentiating themselves by offering higher value-added tech solutions, evolving beyond simply moving boxes.  The result is (1) further consolidation of market share amongst the market leaders that can afford these investments, (2) more disciplined industry pricing and (3) stickier customer relationships.

• Starting in 2014, USFD led a push to increase online ordering and the sale of value-added services to customers which only became possible once the sales rep’s time was freed up from simply taking orders.  Between menu optimization, innovative food product explanations, inventory management tools, labor management tools, and on site business consultants, the distributors are finding ways to create stickier customer relationships and increase their value-add.

• The net benefits of this transition towards higher value-added products are:

• Further consolidation of market share

• Customers are consolidating their distributors, moving from 2-3 broadliners to 1-2.  This transition has been attributed to the tech platforms, and could possibly be because the larger players’ (especially USFDs) tech solutions are so differentiated. These tech platforms give powerful tools to market items which they do not already provide to the end customer to pick up share within the restaurant.  USFD has said that their customers who use their eCommerce platform order 5% more.

• Smaller players are becoming less competitive given their inability to invest in a similar technology platform.

• Distributors’ new technology lower sales rep cost, providing an even greater cost advantage.  USFD’s sales associates between ’13 and ’16 declined from 5,000 to 4,000, despite customers increasing from 200,000 to 250,000.

• More disciplined pricing

• As discussed above, greater technology allows pricing decisions to be centralized and more accurately based on product cost.

• Stickier customer relationships

• Overall, USFD has found that retention is 5% higher for eCommerce customers vs non-eCommerce customers.  Reasons for the stickier customer relationships include:

• Sales rep can focus on providing more value-added services

• The eCommerce platform can pick up and alert the sales rep to changes in order patterns if it looks like they could be losing share which gives them a chance to address any problems and try to retain the business

• Inventory management and other services integrated into customers’ business processes

4. Pathway to improved shareholder returns

• Company is nearing it’s 3.0x leverage target by ‘18, at which point share buybacks or other more accretive uses of capital become likely

• FCF % yield in high-single-digits, enabling meaningful shareholder return

Risks

1. Restaurants could come under pressure as their pricing becomes unattractive leading to declining visits and volumes for foodservice distributors.  Food-away-from-home food inflation has outpaced Food-at-home inflation, which could eventually lead to consumers increasing eating at home causing share shift to FAFH to slow down or even reverse.  In addition, restaurants may have to increase pricing even more aggressively as product deflation swings to inflation and labor costs rise due to minimum wage increases rolling in over the next 1-2 years.

• Mitigating factor: food-away-from-home grows in-line with disposable income, despite pricing deltas between food-at-home and food-away-from-home.  As long as disposable income continues growing at MSD%, food-away-from-home should continue to grow.

1. Abrupt food inflation

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1 The industry is ~$230bn if you include only restaurants, healthcare, hospitality, education and business (i.e., excluding retail & other), which is the way the market may be defined by some sources given the target markets for large distributors.

Catalyst

Transition of capital uses to shareholder returns, once leverage target is met