Description

Executive summary and valuation

US Foods (“USFD”) is the 2nd largest foodservice distributor in the US behind Sysco. It was part of Royal Ahold until it was carved-out by private equity (CD&R and KKR) in 2006. During private equity ownership, Sysco attempted to purchase the Company in 2014 in a deal that was blocked by the FTC.  In that deal synergies were equal to ~80% of USFD EBITDA which shows how much scale matters in the industry. After the failed merger with Sysco, USFD IPO’d in 2016 and completed two large acquisitions Food Services of America (“FSA”) and Smart Foodservice Warehouse Stores (“Smart Foodservice”) building its footprint in the Northwest.

Historically the foodservice business has been highly defensive. EBITDA at Sysco and USFD was flattish during the GFC, driven by a highly diverse customer base and variable cost structure which was adjusted quickly to declining volume trends. As a result, Sysco’s valuation bottomed ~13x PE during and the industry was trading at 10-13x EBITDA and 16-20x PE for the few years prior to COVID-19.

The current situation created a once in a generation negative situation for the foodservice industry which we believe is short lived. With a significant portion of its customer base made up of restaurants (50%) and hotels & leisure (15%), USFD’s customer base has been significantly impaired since the shutdown began in March. To make things worse, USFD signed ~1bn deal in early March to purchase a chain of cash and carry value based stores servicing independent restaurants in the Northwest. Although a nice to have asset, management made a critically bad decision going ahead with this deal as it raised leverage to 4.0x (on old EBITDA estimates) in a time of crisis. This deal created liquidity concerns among investors and forced the company to raise a PIPE from KKR (conversion price $21.50) and additional debt to fortify its balance sheet.

With its recent transactions, liquidity is not an issue. On USFD’s recent credit investor call, USFD said they have enough liquidity to last through the end of 2021, at current trends of volume -50%. With liquidity now not an issue, our focus turns to what a recovery could look like in the new normal. Based on our estimates of EBITDA and EPS we believe the stock is worth mid $30s on recovery (2021 or 2022) estimates. Should the industry fail to rebound completely, or if valuation multiples were to not recover, we believe KKR could look to take the business private once the dust settles. We believe this can help protect our downside

Industry Overview / Outlook

The food distribution business is highly fragmented with the top 3 players controlling only 40%+ of the overall market. The industry topline grows slightly below GDP with the largest players continuing to take share. EBITDA has been growing 5%+ as the larger players have pushed private label and independent restaurant penetration, both of which are higher margin vs. the overall business.

Over the past 20 years, we have seen a slow and steady climb in % of food eaten away from home. The recent trend was driven by enhanced dining options (not just eat-in), more dual income families and overall convenience. The COVID-19 virus will reverse some of this trend but we believe on the margin. Should food away from home massively decline, the current supply chain would need additional support and we believe this could create opportunity for USFD to gain share in the grocery business (happening currently). We believe dine-in is most at risk and some of the loss will be made up by delivery, drive-thru and takeaway.

Business Mix / Profitability & Current Trends

USFD has a diverse customer base and is exposed to a variety of end markets. Its biggest and most profitable segment is independent restaurants at ~33% of volume, with total restaurant exposure ~50%. We believe independent restaurant gross profit / case is 3-4x national chains and close to 2x the company average.

USFD and PFGC recently updated the market on current trends and reported trough volume declines of ~50% during late March and early April when most of the country was under lockdown. Below is our estimate (not confirmed) of early April volume trends. We believe these results are very temporary and the PFGC and USFD have already confirmed they are seeing improved trends as states being to reopen. In addition, schools have been mostly shut but will reopen at some point adding MSD volume back to the business.

We believe the worst is behind us and will address future outlook below

Cost Structure

There are two main reportable segments within the USFD cost structures.

1.     COGS: mainly a pass thru on % or $ mark-up basis. COGS are ~82% of revenue but fully tied to volumes so we will not see deleveraging. We will likely have negative mix shift based on customer mix and product type sold (addressed later)

2.     SG&A: 13% of revenue and 75% of gross profit. This part of the cost structure is fully under control of management and is where significant cuts are being made

Per management ~50%+ of USFD’s SG&A structure is highly variable which includes distribution center (“DC”) hourly wages, truck driver wages, sales commissions (plus some headcount). IR has mentioned there is another 10-15% of SG&A that includes marketing, consulting services, tradeshows, etc. that can be easily cut in a downturn. 

On its recent debt raise call, USFD said variable expenses were ~50% of SG&A and have now been cut in-line with volume. They also mentioned that ~20% of its fixed cost base has been rationalized and could be cut further should it be necessary. Overall 60% of the cost base has been removed as we believe the company is managing for a more moderate decline vs. the 50% they are currently experiencing. We also don’t think all of the variable and fixed costs that were cut need to be added back should the business fully recovery.

Based on the company’s comments + our view of negative gross margin shift in this environment, we believe the company can be EBITDA positive with volume declines of 35-40%. We believe USFD should be fast approaching and exceeding these levels as the US begins to open.

Liquidity currently and coming out of COVID

As the shutdown began, investors were solely worried about liquidity. USFD recently completed a variety refinancing transactions that helped complete the Smart Foodservice deal (85m of EBITDA pre COVID) and to solidify the balance sheet to weather a prolonged crisis:

1.     Raised 500m in preferred equity from KKR at $21.50 strike and 7% PIK/cash coupon (~10% dilutive)

2.     Raised 1bn in public notes at 6.25% (raised target from $800m during marketing process)

3.     Raised ~300m in private term loan (terms unknown)

4.     Consolidated its ABS/ABL into once security

The company currently has ~1.6-1.7bn of gross cash on the balance sheet and another 300m+ of liquidity under its ABL facility. On its lender call, USFD discussed its liquidity needs in detail. Based on its additional $200m bond raise, we believe at current trends of volume -50%, USFD has liquidity to last the next 7 quarters. This math would imply USFD is burning 250-300m of cash flow at late March / early April levels. As we discussed earlier, we believe the company can be EBITDA positive at volume declines -35 to -40% and FCF positive around -30% vs. 2019 (pre working capital with severe cuts to capex)

With ample liquidity outstanding and our view that over 1 to 1.5 years the company will burn little to no net cash, the KKR permanent equity raise was unnecessary. That being said, there is one big positive which is having KKR, who previously owned the company, on the Board and overseeing major capital allocation decisions. Given management’s poor track record of capital allocation we believe this is a BIG positive. KKR’s 10% investment also provide a natural take private scenario in 2021-23 should the public market not value USFD appropriately.

Range of Recovery Outcomes

The timing of a recovery is uncertain but we do believe once we have a vaccine for the virus eating out will become a core part of our everyday lives. Here is what believe is a realistic / conservative case on recovery:

1.     Independent restaurants will suffer and close (10%+ closed in 2019)

2.     Chain restaurants will pick up a lot of the share lost through delivery / share gains

3.     Healthcare, Government and School will remain healthy

4.     Hospitality will continue to suffer with volumes down significantly vs. 2019

5.     No market share gains (although this is highly likely to occur)

6.     Result: volume down 5-10% with LSD-MSD negative mix shift impact

Investors are overly focused on the negative gross margin mix shift as independent volume shifts to chains. This will likely be worse than the GFC but the companies were easily able to manage this shift when 10%+ of independents went out of business in 2009/10.

Our math assumes a HSD volume decline in our recovery base case and a LDD gross profit decline with no additional private label penetration or $ per case gross profit gains (have experienced every year). This assumes independent restaurants and hospitality are both down 20% vs. 2019.

What some investors miss is the ability of foodservice companies to more than offset gross profit declines with cuts to the supply chain in a normal downturn (i.e. the recovery scenario). We believe USFD will have more visibility as the recovery begins and will not need to add back all of the costs it just cut and can make routes more efficient with larger drops to chain restaurants as they take share

We believe recovery EBITDA should be down 10-15% vs. 2019 PF levels with a decent probability of a sharper recovery and market share gains. We also think EBITDA growth for a few years after the recovery will be above the historical 5-8% range as the health of the end customer improves

Price Target

As the economy begins to recover and people’s live return to normal we believe USFD will be in a prime position to capitalize on market share gains and additional tuck-in M&A. A combination of a strong competitive position and above trend growth in 2023+, we thinks USFD will trade at or above historical levels. At 11-12x recovery EBITDA (or 18x EPS) with EBITDA down 10-15% vs. 2019, the stock is worth mid to high $30s from a current share price of ~21.

In addition, the company will have ~1.5bn of excess cash on the balance sheet that it can use to buy distressed distributors at accretive valuations. In our EPS case, we remove the excess interest expense for gross cash on the balance sheet, but believe tuck-in M&A can create earnings figures above the stated estimates.

If we are wrong and EBITDA declines 20-25% and signs of a future recovery are not evident we believe the stock could trade to 8-9x EBITDA or an average of $16 per share. At these levels we believe USFD could become an attractive candidate for KKR to look at a buyout or for additional large scale M&A to be retried in the sector.

Overall we believe your risk / reward skew is very positive at current levels given liquidity is now not a concern 

Key Risks

·   COVID-19 creates long-term structural headwind to eating out

·   Chains push back on foodservice margins in difficult environment (already low)

·   Cost structure proves not as flexible on the recovery as we expect

·   Leverage will still be high even on a normalized recovery

·   Mix shift from independents to chains is worse than we anticipate

·   Cash burn is worse over 1-2 years than we anticipate

Catalyst

Catalysts will be the fundamental recovery of the US economy and improvement in underying trends. Upon full recovery we expect USFD to used its high cash balance to make tuck-in strategic acquisitions that will be highly accretive