Consider Buying This Distributor

We have nearly 90 stock analysts on staff here at Morningstar, and recently we had a powwow of nearly 30 of them who cover a wide variety of industries. The topic? Distributors--trying to figure out what makes a distributor attractive or unattractive.

A select few distributors, such as  Sysco (SYY) and  Fastenal (FAST), have a wide economic moat, while the vast majority have utterly no moat whatsoever. I own food distributor Sysco in StockInvestor's Tortoise Portfolio, so I came out of our powwow feeling quite confident about Sysco and its moat. Here are some of the key insights from our meeting and on how Sysco stacks up:

For Distributors, Slower-Growth Industries Are Actually More Attractive
While growth is usually a good thing in the realm of investing, we decided that when it comes to distributors' moats, it can be more of a curse. This is because when a distributor operates in a hyper-growth industry, there are always new opportunities opening up that may allow a new competitor to enter the game.

On the other hand, when a distributor operates in an industry that is more stable and slower growing, the existing distributors tend to be much more entrenched with their existing relationships and relatively low costs. A new distributor in a stable industry will be forced to pry away customers from existing distributors. This is much harder to do than fighting for a new customer that may not have previously existed in a market that may not have previously existed. In other words, the barriers to entry for distributors in any given market are inversely related to the growth of the market.

Although the small, independent restaurants Sysco serves are constantly opening and closing, the food distribution market remains relatively stable on balance, a good thing for the stability of Sysco's moat.

Economies of Scale Are Key
Distributors usually operate with extremely thin profit margins, so those that can cut costs through economies of scale are usually at an advantage. Sysco's net profit margins have been near 3% of sales the past couple of years, while most of its competitors have struggled to get to 1%--that is, if these competitors were even profitable at all.

Undoubtedly part of the reason Sysco's profit margins are far better than its competition is the economies of scale Sysco enjoys. Consider that Sysco is roughly 50% larger than its next-largest competitor, U.S. Foodservice. (It is also worth noting that Foodservice's parent company--Koninklijke Ahold AHO--has been embroiled in controversy, with some giving it the nickname "the Enron of the Netherlands.") Sysco is also approximately 5 times larger than the industry's third-largest player.

The Greater the Product Scope Offered, the Better
Scale helps in moving products from point A to point B more cheaply than the competition, but having the widest selection of products is important in pleasing and retaining customers. All else being equal, a distributor that can act as a "one-stop shop" for its customers is going to have a leg up over those distributors that have a less comprehensive offering.

Sysco also scores quite well on this front, having more than 300,000 products on the menu, including nearly 40,000 private-label and specialty products for its customers to choose from. (Private-label products also tend to carry higher profit margins.)

The More Fragmented the Markets Being Served, the Better
In his breakthrough work, Competitive Strategy, Harvard professor Michael Porter described how one could ascertain the competitiveness of a business by looking at "five forces." We decided at our powwow that two of those forces--supplier power and buyer power--can greatly differ between distributors in different industries.

In general, the greater the fragmentation of the markets a distributor is serving, the more power the distributor will have in negotiating terms and prices. In looking at the relationships Sysco has with both its suppliers and its customers, it is positioned quite well. Many of the products it distributes are either commodities or have many substitutes, so the power of Sysco's suppliers is limited. Meanwhile, Sysco has more than 390,000 customers, the vast majority of which are small operations that have essentially no power to bully Sysco or its peers.

Given the factors cited here, I think it is plainly evident Sysco has a wide economic moat that is in no danger of being breached at any time in the foreseeable future. Just think, Sysco became the largest food distributor in North America in 1977, and concrete evidence of its moat comes in the form of the strong double-digit returns on capital it has earned for the vast majority of the time since then. I was delighted to have the opportunity to increase our ownership position earlier this year below $30, and with the stock still within pocket change of its "consider buy" price, it's well worth thinking about today.