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Stock Strategist

Sysco's Moat Narrows

But the US Foods deal would cement the food distributor's leading competitive edge.

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Since  Sysco's (SYY) bid to acquire US Foods--which would combine the number-one and -two domestic food-service distribution players--was announced in December 2013, there has been a heated debate about the degree to which competition could be stifled. A Wall Street Journal article questioned whether the Federal Trade Commission could block the deal; we think asset sales are more likely. Even though the combined firm would control about one fourth of the North American market, food-service distribution is a locally competitive market in which neither Sysco nor US Foods is always the leader. Besides the tens of thousands of domestic food-service distributors, the competitive picture has expanded, as struggling restaurants have also looked to club and wholesale stores to fulfill their needs. As such, we think the actual share held by a combined Sysco-US Foods could be less than 25% when considering the number of alternative outlets operators have to service their product needs. However, improved purchasing power and enhanced scale are potential benefits to joining these two cohorts; Sysco targets $600 million in synergies from the tie-up three to four years after the close. We ultimately believe the combined operation would amass more competitive clout than each independently.

We've long thought that Sysco maintained solid competitive positioning through economies-of-scale cost advantages that far surpass those of its peers. As evidence, its sales base is more than twice that of its next largest competitor, and operating margins are about 3 times the level of other industry heavyweights. However, given the erosion in profits realized in the past several years, combined with our expectation that material profit expansion is unlikely to come to fruition over the near term, we recently lowered the firm's Morningstar Economic Moat Rating to narrow from wide. Sysco's restructuring efforts have been ongoing for several years, and profits have also been constrained by competitive pressures that are unlikely to abate. Therefore, we possess less confidence in the firm's ability to generate excess profits over the very long term.

Erin Lash does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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