Description

US Foods Holdings Corp. (“US Foods” or the “Company”) is the second largest food broadline distributor in the United States. USFD supplies ~250,000 customers, has more than 400,000 SKUs and sources its products from more than 6,000 suppliers. USFD has been a constant number 2 in the market where M&A is the main driver of growth. After a failed merger in 2015 with Sysco (SYY) that was blocked by the FTC, the Company was taken public. As stand-alone operator, US Foods has maintained its 2^nd place position in the market, however Sysco has extended the gap, being almost twice as large, and Performance Food Group (PFGC), who was thought of as a far-out 3^rd player, has caught up and has almost the same market share as USFD.

An activist campaign in 2022 by Sachem Head focused on low shareholder returns vs. peers, management’s poor execution using the Sysco margin gap as an example and poor acquisitions. After threatening a proxy fight, Sachem Head got 3 seats on the board and Pietro Satriano stepped down from the Chairman and CEO position. Since this announcement in May 2022, USFD stock has risen 11% ahead of its closest peer Sysco declining -11%, and USFD has risen ~6% since the new CEO appointment in November 2022.

After Sachem Head’s proxy fight and a new management, the Street believes that the issues can be solved and that US Foods can catch up or at least be competitive with Sysco. Following my research, however, I believe that US Foods bull thesis is flawed as 1) the margin gap with Sysco can’t be closed in the timeframe expected: the majority of the improvements would have to come from the supply chain/operations side, and any impact there takes at least 3-5 years, 2) Independent restaurant penetration is key for growth and margin expansion: the majority of private label customers come from independent restaurant, which is the most competitive segment of them all and where large broadliners are not liked as a first option and 3) The cash & carry acquisition was not only poorly timed, but the business is not a great asset: USFD took a highly expensive financing from KKR to purchase what competitors consider a poor asset.

The Potential

As a perennial underperformer, US Foods has traded between 11.0x and 15.0x EV/EBIT, which historically has been ~3.0x-4.0x turns below its closest peer, Sysco. As the new CEO has not issued any new guidance, the Street still believes that USFD is going to have 3% EBIT margins in 2023, which is 50%+ what they did in 2022, and a number they have never achieved. Any adjustment from the Company in the next earnings call will probably lead to a rerating. In my base case, I expect USFD to still trade a few turns below its peers at and no major margin expansion as the Street implies for a downside of 31% as the stock rerates lower.

The Industry

The food distribution industry, as with any distribution business, is one where route density matters a lot. We can see examples in the uniform rental business, where Cintas, the number 1 player, has EBIT margins and ROICs that are double its competitors. This also happens in the waste management business, where Waste Management and Republic Services have margins that are almost double and an ROIC that is significantly higher than smaller players.

Therefore scale, represented by warehouse count, customer count and route density are major differentiators. In the food distribution industry, Sysco is the clear leader, followed by USFD and PFGC. The advantage of scale is evident in this industry as well, where Sysco has ROICs that are double those of its peers and its margins are constantly 2-3% higher throughout the years.

Independent Restaurant Opportunity: Despite still being a fragmented industry, where the top 3 players control ~35% of the market, many of the larger broadliners are looking into independent restaurants as the new engine of growth as the chains get saturated with competition. Independent restaurants are those single unit or few unit operators, while chains range from QSRs to restaurants like Outback, Olive Garden, etc.  In 2019, there were about 768,000 restaurants and bars in the US, post-covid that number dropped to 685,000, and is expected to grow back to 703,000 by 2025, still below the 2019 figure[1]. Within the major 3 players, independent restaurants represent an important part of their business. For Sysco it is estimated that it is about ~43%, for US Foods is about 35% and for PFGC is about 22%. Additionally, the independent channel is where most of the private label gets sold and is a key aspect of the margin expansion strategy. Sysco has about 37% of private label penetration, US Foods about 34% and Performance Food about 24%.

Expansion into complementary businesses: In addition, several food distributors have expanded into the cash & carry business as a complimentary business. For some, like Gordon Food Service, it has become an important part of their business, while for others is a minor part. It is an overall good business with 7%-8% EBIT margins and a positive growth outlook. As a constant acquirer USFD felt it fell behind on this business and acquired a large cash & carry business in 2020, right before the pandemic, for what people in the industry considered to be a rich price.

The idea behind the business is that it complements but also attracts a new customer base to the distribution business. However, it is estimated that only 20% of people that shop at cash & carry businesses become distribution customers and that many of the customers that shop at cash & carry will never be big enough to join the distribution business. Additionally, in this segment they are now competing with Costco, Sam’s Club and other big warehouse grocers.

Key Thesis Points

The Margin Gap With Sysco Can’t Be Closed Within 1 to 2 Years

The market has always looked at closing the margin gap with Sysco as the main goal of the business, and thus previous management pursued it without any success. One of the issues with this goal is that it is a moving goal post. As Sysco grows it becomes more efficient thus the margin gap increases unless USFD can execute and deliver, which has not been the case historically. Still, based on conversations with people in the industry, it is estimated that the average 2% gap between both can be split 1% in COGS and 1% in SG&A/operating expenses. Still, the advantage on the COGS side comes from private label penetration in independent restaurants (further discussed in the report later) as they both carry the same product mix and a very similar customer mix, while the opex difference comes from logistics. Historically, Sysco has spent 6% of its revenue on shipping and handling vs. 7% of US Foods. Though there are some levers that can be pulled to close this, Sysco’s scale (300+ warehouses vs. 170 for USFD) give it a massive advantage that is hard to replicate. Thus, leaving US Foods to focus on improvements in operations that industry experts estimate would take at least 3 to 5 years to be implemented and not 1 to 2 years as the Street estimates based on their immediate margin improvement.

• No advantage in purchasing at this scale: despite being the #2 player, USFD is still a massive player with over $34bn in sales, so they have massive purchasing power with its suppliers. However, they have reached such a scale that any advantage Sysco might have on this is minimal or non-existent.
  • Senior executive at privately owned food distributor: “For example, we are part of the buying group that is larger than Sysco overall. Still, I believe that at that scale, purchasing power becomes somewhat irrelevant. Probably the same happens between US Foods and Sysco.”
  • C-Level Executive at large privately owned food distributor: “US Foods has no opportunity in COGS due to scale, they should get the same advantage at Sysco, they are big enough.”
• Over indexation into a 7-day trail plan: within operating expenses the major expense comes from shipping and handling, which represents 47% of total operating expenses for US Foods. From Wall Street, there has been an over indexation to the 7-day plan that the Company disclosed in its latest earnings call. However, several contacts in the industry with operations backgrounds and customers don’t see much value in it.
  • Logistics Mid-Level Executive at Publicly Traded Food Distributor: “We have facilities that go 6 days a week to be more efficient. However, the days a facility operates is all market dependent.”
  • Regional Leader at Publicly Traded Food Distributor: “We have a 6 day delivery model, as it is a way to have more operating leverage over our existing base. Maybe one day customers will want an extra day. We saw that US Foods started a test in 3 markets (didn’t disclose the markets) but haven’t heard anything beyond that.  From our side we haven’t seen any major demand for an extra day. This is all anecdotal. Still, if there is customer demand for it, we would consider it.”
  • Operations Senior Executive at Privately Held Distributor: “There is some effectiveness to it. It helps for those one-off stops that don’t fit into predetermined schedule. Most of the industry is on 6 days schedules, there are some markets can do 7 days, but is all driven by markets. There are things like city ordinances, service areas, route density that also affect scheduling days. So, I think this will be more of a market by market rather than a national/all industry impact.”
  • C-Level Executive at multi restaurant group: “We get deliveries about 6 days a week and try to do less days as every time we get one delivery is disruptive for the restaurant operator... If we can get delivery days down to 5 it would be ideal. For example, we don’t want to be taking deliveries on Sundays as it is a busy day, but if we run out of stuff on a Saturday it is nice to be able to get some stuff delivered on Sunday.”
• Despite labor issues easing a bit, it remains an issue across the industry: labor issues impacted all distributors during the pandemic when they were unable to fill out selector (people who work in the warehouses and select the merchandise for each customer) and driver openings. Though there has been a decline in these issues, specially on the selector segment, there is still a large truck driver shortage in the US (estimated to be of over 100,000 drivers), making retention the most immediate driver of margin growth. Drivers and fuel make about 50% of the shipping costs, and 20% of that is fuel, which you can’t control. Despite this, the new CEO’s priorities in logistics don’t include any improvement in driver retention or transportation improvements. When discussing with industry contacts, the majority said they would spend their marginal dollar on improving its transportation and reducing driver turnover as it is the most expensive part of the supply chain:
  • Regional leader at publicly traded food distributor: “…Additionally, there is the staffing issue. You have to manage employee productivity and employee training. At our company we opened a training academy a year ago for drivers and selectors, something that I believe competitors don’t have…Driving is the most expensive part... If I had a marginal dollar I would drop it to driving. So, more efficiency in transportation”
  • Logistics Mid-Level Executive at Publicly Traded Distributor: “The overall shortage is starting to slow down. However, there are some markets that are still struggling. What was curious is that during covid staffing warehouses was harder than drivers, which had never been the case. Warehouse labor was $13 per hour then, now you have to pay them $18 an hour to compete with Amazon, Walmart, etc. In terms of trucking there is over a 100,000 driver shortage. This is the most challenging thing for someone in the industry.”
  • Operations Senior Executive at private competitor: “If I had to spend a marginal dollar to improve my operations I would spend it in retention in all lines, warehouse, loaders, drivers. As the experience of employees increases the efficiency of the overall business goes up.”
• Beyond any improvements, the issues at US Foods seem to be cultural: based on conversations with previous employees, there seems to be a disconnect in understanding that foodservice is more of a logistics business than a sales business and the main reason US Foods has struggled is due to lack of integration and constant acquisitions:
  • Former Logistics Senior Executive at US Foods: “USFD is a great company in ensuring that they have the best customer experience. The problem at the Company is that they are constantly chasing that next mousetrap that sometimes can get in the way. It would be great to have one year to focus on running the business instead of chasing the next mousetrap.”
  • Former Logistics Senior Executive at US Foods: “The advantage that Sysco has is that lot of their leadership has come from the supply chain, which is helpful, specially in a business like this where the supply chain is the key, this is a supply chain business. They embrace being a supply chain company and that is a differentiator. While US Foods is more a sales based organization. At USFD they are great marketers, great at selling, but they lack on the supply chain execution.”

Independent Restaurant Penetration Is Key For Growth and Margin Expansion

As the largest segment in the restaurant industry, all food distributors are looking into this segment for growth. Not only for its size, but most importantly as they are the biggest users of private label products. Private label products margins are higher than regular products and estimates of the gross margin of private label range from 20% higher to 2x higher than regular products. There is value in it as once a customer is hooked to a distributor’s private label it is very hard for them to switch, thus turning this into a retention tool.

Key to success in this segment is route density, but it is hard to combine with customer service. Also, based on my contacts many independent restaurants use local distributors as they get better product selection, reliability and customer service and switching providers is extremely easy and not sticky at all.

• Increasing private label penetration might be harder than expected: USFD claims that 34% of its sales from private label, while Sysco is at 38%, which doesn’t seem much of a difference and a gap that could be closed. Additionally, based on the evolution on private label % for US Foods, it has been very stable over the past few years, indicating that there might be a limit for further penetration without angering current suppliers. Also, based on my conversations, Sysco is extremely aggressive in maintaining its private label presence in independents, which is estimated to be 50%+ of independent sales.
  • Equity research analyst: “Overall Sysco a scale advantage and has an edge on private label. They will force private label on customers. Which in turn helps retention as customers get used to Sysco private label.”
  • C-Level Executive at large privately owned food distributor: “USFD might have opportunity in private label, a private label case makes $2 to $3 more than a regular one. Penetration in the independents is at 55% for Sysco and USFD is nowhere close to that. In terms of margins for private label, are about 20% better, not double. Private label is also useful for retention as your customers get used to your products, so helps reduce churn.”
  • C-Level Executive at privately held distributor: “When you are distributor, you are at an interesting spot to balance supplier and private label. So, it is important to be sure you don’t cut out too much of your supplier’s business. For example, if we distribute Hostess, and then you create a competing private label product, Hostess is going to ask why did your orders dropped from 100 to 80 suddenly.”
  • Senior executive at privately held food distributor: “Yes, we have private label. It has been great as we get better margins, but it varies a lot from products. For example, the margins might be better in a product, but the volume from that one is not great, so it is better sometimes to just sell something that sells at a higher volume but lower pricing that is not private label.”
  • C-Level Executive of multi restaurant group: “We don’t actually use private label. Lets use Baldor as an example as we use them a lot in NYC. What Baldor does, which Sysco does in some places, is selling chopped onions vs. full onions. So, value added products that can help us save on labor is pretty useful for us. For example, in terms of ketchup we go with what is the cheapest.”
• Independent restaurants are not very fond of major broadliners and there is no customer stickiness: even though broadliners have been able to penetrate the independents market, based on my conversations there are several reasons why many don’t use them, or the ones that do are not very happy. As smaller operations, these restaurants care about reliability, customer service and product selection, making price the last consideration, which is where most broadliners would have a major advantage.
  • C-Level Executive of multi restaurant group: “In the end we care about price and then reliability on delivery. If you can promise to be the first person on the route it would be great and that puts you in front. However, as a smaller restaurant chain it is hard to be the priority. On the broadliners side, they are struggling with drivers and their reliability is half what they used to be. That is one of our biggest concerns is that we are making sure we get the deliveries.”
  • C-Level Executive of a multi restaurant group: “Look we are set up like most people (Sysco, US Foods, Baldor) we sign up with everyone in case one fails. It wouldn’t be irregular to switch every other order. If someone became really unreliable we stop ordering immediately and have an immediate back up.”
  • Sous chef at independent restaurant: “In our case as we are a small restaurant and we don’t have an assigned sales rep from our largest supplier. However, the smaller suppliers we have assigned sales rep, they do have someone who visits every 2 weeks to show us new products.”
  • Sous chef at independent restaurant: “We pick it based on product selection, consistent arrival and then pricing. For example, we use Baldor as they are very well positioned in NYC. They do a good job with great products, service and prices. Another supplier we use is Natoora. They are focused more on organic fruits and vegetables. So, they are more expensive but their products are great. We are seeing a trend towards this in our world. Also, it is important to consider that in this business larger restaurants get priority. For example, a restaurant like Balthazar in NYC has its own account manager at its distributors, while we just manage our orders online.”
  • Sous chef at independent restaurant: “In terms of switching it is pretty easy. You just need to create a profile on their websites and start ordering. Still, we don’t plan to change suppliers as we are very happy with our current base. It is not like we are going to change to USFD or Sysco if they help me save $1 per pound of tomatoes. There are other things more important than price.”
  • Former Logistics Senior Executive at US Foods: “Companies that are regional are more effective. That have the ability to be more flexible and have more turnkey solutions. Those who have committed to the supply chain. The ones that come to mind are the regionals such as Gordon, Cheney Bros, etc.”
• Competitors have started specific programs for independent restaurants while USFD has not: Sysco Your Way is a program focused on dense neighborhoods where Sysco can take advantage of the density of independent restaurants in a certain neighborhood by using the same delivery, sales person, etc. and at the same time offer its customers no order minimums, late night ordering until 11:45pm and delivery options 7 days a week. Since its implementation, Sysco has seen double-digit growth in both top and bottom line with this initiative. Additionally, Sysco recently changed its comp structure for salesforce from commission based to salary based, which can be an indication of aggressive growth as management has growth targets of 1.5x the market. On the other side you also have PFGC pushing private label hard in its latest conference call, the CEO mentioned “We just finished a month where it was 51.9% of our independent business. And it's just not a number that, quite frankly, I expected us to get to. So it's been really good. And almost -- I mean, really close to all of our branded business goes to independent restaurateurs. So we're really focused on that. It's doing well. Customers seem to receive it well.”

The Cash & Carry Acquisition Was Not Only Poorly Timed, But The Business Is Not A Great Asset

In early 2020, USFD entered into an acquisition agreement with Apollo Global Management to acquire Smart Foodservice Warehouse Stores, a group of cash & carry stores in the West Coast for $970mm. Unfortunately, the acquisition was announced days before the pandemic started and thus USFD encountered itself without financing to close the deal. Instead of walking away from the deal, the Company took a very expensive financing from KKR (its previous owner) to close the acquisition. Additionally, all the assets of this business were in the West Coast, a market that USFD had just entered the year before through its acquisition of SGA. Based on conversations with people in the industry, it seems that USFD overpaid for this asset and that the cash & carry stores are in terrible locations, which might force them to relocate them to be competitive.

• The Company overpaid for what it seems to be a poor asset:
  • C-Level Executive at privately held competitor: “We have 200 stores. Cash & carry is a great part of our business... It is about time for USFD to get into the business. We looked at the business they acquired but we passed. However, the business they bought is not great (the locations are poor). They will end up having to relocate stores. I would assume a new cash & carry store would cost around $6mm to $8mm.”
  • C-Level Executive at competitor: “Again, this acquisition from USFD is more confusion. Cash & carry make more sense for a player like PFG as they serve usually lower end restaurants that don’t value their time as an asset, which are the big users of this business. For example, Restaurant Depot is an amazing company, but here it looks like another one-half assed attempt by USFD.”
  • Equity research analyst: “Overpaid, wasn’t the best use of capital at the time.”

Besides the above, since the Company’s new CEO came in, they stopped announcing every cash & carry store opening through press releases.  Though it might mean nothing, as a new CEO, David Flitman might be looking to start with a clean slate and a potential sale of the business might be in order. If that is the case, the sale of this business would imply a ~$1.3bn loss in revenue, ~$100mm in EBITDA and a potential impairment of $40mm, providing further downside kicker in of $0.35 earnings per share. (Based on an estimated 2023 EBITDA of $103mm for the cash & carry business and a 9.0x multiple. This is 2.0x turns below what Restaurant Depot, the market leader, is valued at).

Lastly, as part of this deal, the KKR financing was not only extremely expensive, but also very restrictive. US Foods not only gave KKR 10% of the Company for ~$500mm with 7% rate and a low conversion price of $21.5, but also gave KKR a board seat and USFD can’t raise any capital senior to the preferred without KKR’s approval, basically putting its entire financing strategy on KKR!

Valuation

As the new management has decided not to change guidance in its during its initial months, the Street estimates are still fixed on previous goals, which based on my research seem hard to attain. Thus, any new guidance given by management in the next earnings call or event, will force Wall Street to adjust estimates to more realistic figures.

In my base case I assume that US Foods can grow its revenue at 1.3x the restaurant market vs. its goal of 1.5x as every player in the segment is targeting the independent restaurant business as a growth driver and USFD has also to battle local players which are very entrenched in the independent restaurant segment. Then expect some gross margin recovery as inflation eases, but then assume that shipping & handling and sales & marketing costs remain high as staffing issues remain and as US Foods must spend more on marketing to keep its growth rate and battle strong competition. Therefore, I don’t see 2024 EBIT margins hitting the ~3.4% rate consensus estimates, specially as USFD has never had those margins in its history.

USFD has historically traded 3.0x-4.0x turns below Sysco, due to being the perennial underperformer. Overall, I believe that this issue will remain over the next two years as any potential changes will take longer than expected, therefore valuing USFD at 11.0x FW EV/EBIT vs. Sysco’s 14.0x.

Catalyst

New guidance released by new management next earnings call might lower Street expectations