Dividend Aristocrats Part 16 Of 52: SYSCO Corporation (SYY) by Ben Reynolds, Sure Dividend

Sysco (SYY) is the largest food distributor in world.  The company distributes food products to restaurants and stores throughout the US (including Alaska), Canada, Ireland, and Puerto Rico.

Sysco has a long corporate history.  The company was founded in 1969 and has increased its dividend payments for 44 consecutive years.

Trian Fund Management recently became the largest shareholder of Sysco.  Trian now owns 7.1% of Sysco.  Here’s what Trian CEO (and famous activist investor) Nelson Peltz had to say about his stake in Sysco after gaining a seat on the company’s board:

“Sysco is a leader in its business, and we believe it is undervalued and has tremendous long-term potential. As Sysco’s largest shareholder with an approximate 7.1 percent ownership position, we welcome the opportunity to work constructively with the Board and management.”

Declining Competitive Advantage

There’s no question Sysco is in need of a managerial talent infusion.  The company’s operating margins have been declining since 2010:

  • Fiscal 2010 operating margin of 6.4%
  • Fiscal 2011 operating margin of 5.9%
  • Fiscal 2012 operating margin of 5.4%
  • Fiscal 2013 operating margin of 4.9%
  • Fiscal 2014 operating margin of 4.6%
  • Fiscal 2015 operating margin of 4.8%

Operating margins grew 0.2 percentage points in fiscal 2015.  Prior to fiscal 2015, operating margin declined every year since 2010.

Falling margins are a sign of a declining competitive advantage.  It is likely that recent margin improvements are a result of sinking gas prices rather than structural improvements.  Low gas prices mean lower transportation costs for Sysco – which raises margins.

The food distribution industry is slow changing.  Restaurants will always need food supplies, after all.  Due to the commoditized nature of Sysco’s services, competition is fierce.  Sysco’s declining margins show strong competition in the food distribution industry.

The US Foods Merger

Sysco planned to return to growth and strengthen its competitive advantage by acquiring its largest rival – US Foods.  Here’s what I wrote about the proposed transaction when I last covered Sysco:

“In late 2013, Sysco announced plans to merge with its largest competitor, US Foods…  US Foods is the second largest food distribution company in the US.  As a result, the combined company will have significantly more pricing power than either business had on its own.  The combined business will also have a more robust supply chain, further enforcing Sysco’s current competitive advantages.  The strategic rationale behind the acquisition is to give the combined business enough scale advantage to negate the negative trend in operating margin through economies of scale and return the company to margin expansion.  The deal is a net positive for shareholders; there is one catch, the deal is facing regulatory scrutiny.”

Unfortunately for Sysco, the proposed merger did not go through.  The Federal Trade Commission blocked the merger on the basis that the combined company would have too much market share in specific regions.  Sysco now has to pay a total of $315 million in break-up fees since the merger was not completed.

Enter the Peltz Plan

Since Peltz’ announcement of his large stake in Sysco, the company’s stock price has risen from around $36 a share to around $41 a share – a roughly 14% increase.

Despite a run up in the company’s stock price, Sysco has announced it will engage in large share repurchases. The company is planning on repurchasing $3 billion in shares over the next two years.  This comes to 12% of the company’s market cap at current prices.

Sysco is attempting to boost its earnings-per-share through debt-fueled share repurchases.  The company recently raised $2 billion from issuing debt.  Sysco will use $1.5 billion of these funds for its previously announced share repurchases.

Share repurchases can be beneficial for shareholders, but they are not always beneficial.  When shares are repurchased when a stock is trading above fair value, share repurchases destroy shareholder value in the same way that paying $1.00 for three quarters destroys value.

Sysco Valuation

Sysco had adjusted earnings-per-share of $1.84 in its fiscal 2015.  The company is currently trading at a price-to-earnings ratio of around 22.5.

For a company to be fairly valued at a price-to-earnings ratio of 22.5, it needs to have a strong and durable competitive advantage, a shareholder friendly management, and excellent growth prospects.

Sysco’s competitive advantage has been in decline over the last 5 years.  While it certainly still has a competitive advantage thanks to its industry leading size and scale, the company is less secure than many other Dividend Aristocrats.

Sysco does have a very shareholder friendly management with a long history of dividend increases as well as a commitment to repurchase shares.

The company’s growth prospects are mediocre at best, unfortunately.  Earnings-per-share have grown at just 3.4% a year over the last decade.  The company has seen sales grow at 4.5% a year over the same time period.  These are not numbers that justify a 22.5 price-to-earnings ratio.

Over the last decade, Sysco has traded for an average price-to-earnings ratio of around 18.  The company appears to be overvalued at current prices.

As a result of its current high valuation, I believe Sysco’s management should forego share repurchases until the stock’s price-to-earnings ratio falls at or below 18.

Recession Performance

Sysco managed the Great Recession of 2007 to 2009 well and saw only modest earnings-per-share declines.

The company saw declines in restaurant orders as consumers eat out less during recessions which in turn reduces demand for Sysco’s restaurant products.

Despite this, earnings-per-share did not fall significantly.  The company’s earnings-per-share from 2007 to 2010 are shown below to show how the company handled the Great Recessions and subsequent recovery:

  • 2007 earnings-per-share of $1.60
  • 2008 earnings-per-share of $1.81
  • 2009 earnings-per-share of $1.77
  • 2010 earnings-per-share of $1.99

Final Thoughts

Sysco may very well improve its margins in the short-run. In the long-run, the company’s slowly declining competitive advantage in a highly competitive industry does not bode particularly well for shareholders.

Nelson Peltz is one of the best practicing activist investors today. I certainly wouldn’t bet against him. At the same time, Sysco shares have already seen a substantial price run up. As Warren Buffett says:

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

To be fair, Sysco’s industry isn’t terrible – but it is highly competitive and has very low margins.  Additionally, it is very difficult for businesses to differentiate each other in the food distribution industry.

Instead of Sysco, dividend growth investors should consider this recent Nelson Peltz investment.

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