Deal's End Doesn't Change Sysco's Moat

After a month of deliberations, a judge upheld the Federal Trade Commission's challenge to

Despite the improved purchasing power and enhanced scale we expected from the proposed tie-up between these two industry cohorts, which was announced in December 2013, we're standing by our narrow economic moat rating for Sysco, which reflects our view that the profit deterioration that has plagued the firm in the past few years is unlikely to abate, given intense competitive pressures, volatile commodity costs, and soft consumer spending. However, we still believe Sysco's vast distribution scale, with sales more than 2 times its next-largest competitor and operating margins about 3 times other industry heavyweights, is an advantage in an industry plagued by high fixed costs.

In our view, food-service distribution is a locally competitive market in which Sysco is not 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. In that light, we doubt that Sysco's penchant for pursuing deals and extending its geographic reach has waned. As such, we expect Sysco to remain a consolidator in this highly fragmented space, seeking out smaller bolt-on deals to build out its footprint and ultimately enhance its scale edge.

Intense competition combined with a customer mix shift toward larger chain restaurants, which are inherently lower-margin sales, could constrain profits over a longer time frame. But Sysco's efforts to improve its supply chain by more efficiently routing deliveries and optimizing product sourcing and supplier relationships are likely to resume in earnest before long and should offset some of these pressures. We also think the potential for higher customer retention, the ability to better serve customers, and improved reporting stand to prop up revenue and limit unnecessary expenses when this effort has been fully launched across the firm's operating network.

Profits Could Stay Constrained, but Narrow Moat Maintained Despite the improved purchasing power and enhanced scale we expected from the proposed tie-up with US Foods, we contend that Sysco still possesses a narrow moat. Sysco operates as the undisputed leading food-service distributor in the United States and Canada, with about 18% share of the $255 billion market in which it plays (which also includes its presence in Ireland). In an effort to increase the stickiness of its customer relationships, Sysco has made it a priority to consult with clients on how they can drive sales and minimize costs--an advantageous undertaking, given that about 80% of its sales are derived from smaller customers. From our vantage point, Sysco's vast distribution scale is an advantage in an industry plagued by high fixed costs, but we recognize that profits could remain constrained by intense competitive pressures, soft consumer spending, and volatile input costs for some time.

This scale, together with a focus on realizing further efficiencies, has driven returns on invested capital that have consistently exceeded our 8.4% cost of capital estimate. We forecast that returns on invested capital (including goodwill) will expand to 17% by fiscal 2019, reflecting modest profit expansion, with operating margins approaching 5% versus 3.4% reported in 2014, as the firm finally starts to leverage the scale and purchasing power that a multi-billion-dollar organization should have. However, given that restructuring efforts have been ongoing for several years, combined with the fact that profits have been constrained by competitive pressures that are unlikely to abate, we possess less confidence in the firm's ability to generate excess profits over the very long term, warranting our narrow instead of wide moat rating.

Competition and Customer Attrition Are Risks Sysco is undergoing a major technology upgrade, which has proved to be its Achilles' heel. Further, management is working to streamline its product assortment in select categories where the breadth of the offering set hasn't provided added value to the customer or its own operations. Customer attrition, which can prove costly, may also surface if customers balk at a consolidating supplier base and instead seek out more options. Fragile consumer spending may also make restaurants, which drive about 60% of Sysco's sales, reluctant to raise prices. As such, Sysco may be forced to bear the brunt of any pronounced upticks in food costs, which have been more material in the meat, dairy, and seafood categories over the recent past and account for about one third of the firm's annual spending.

The food-service distribution landscape strikes us as quite competitive, which could keep a lid on industry profits. Besides the 16,000 food-service distributors that operate throughout the country, the competitive picture is even more diverse, as it includes member-only cash-and-carry locations (like Jetro and Restaurant Depot, which exclusively cater to food-service and nonprofit operators with more than 100 locations in the aggregate throughout the United States); club and wholesale stores such as Costco and Sam's Club; and online delivery sources like AmazonFresh and Peapod. In fact, industry research firm Technomic estimates that many food-service operators purchase from up to 12 different suppliers, including broad-line firms and specialty companies, as well as through other unconventional outlets. Further supporting our stance that the competitive landscape is quite varied, Sysco management has historically estimated that although it is the leading industry player, it fulfills only 30%-40% of its customers' spending, indicating that its clients are purchasing through multiple sources. In this vein, Sysco is likely to pursue further tie-ups down the road.

We believe the biggest risk to our valuation is whether the firm can offset the impact of rising input costs, particularly amid an intensely competitive operating landscape, while also wringing additional costs from its already lean operating structure. As such, we assign the firm a medium fair value uncertainty rating.