Sysco: Long-Term Investment, But Not Just Yet (NYSE:SYY)

Christel Deskins

I already covered Sysco (SYY) back in August 2019 and used the company as an example of how to screen for wide moat companies. Back then, I assumed that Sysco was rather overvalued as it was trading at around $70. And in retrospect, Sysco would not have been a good […]

I already covered Sysco (SYY) back in August 2019 and used the company as an example of how to screen for wide moat companies. Back then, I assumed that Sysco was rather overvalued as it was trading at around $70. And in retrospect, Sysco would not have been a good buy back then: When COVID-19 hit in February 2020, Sysco was among the companies hit hardest and the stock declined more than 60% within a few weeks. Since the lows in March 2020, the stock could increase more than 100%, but is still trading about 30% below the 52-week high of $85.98.

In this article, I will update my view on Sysco and start again with a short business description followed by asking the question once again if Sysco has an economic moat. And then I will also look at the safety of the dividend, the financial health and the effects of a potential second wave.

Business Description

Sysco was founded in March 1969 and became a public company only one year later. Sysco is a global leader in selling, marketing, and distributing food products to restaurants, healthcare and educational facilities, lodging establishments, and other customers who prepare meals away from home.

(Source: Sysco Factsheet)

Although most of the company’s revenue is generated in the United States, the company is also present in Canada, Mexico, Costa Rica, Bahamas and Panama as well as several European countries (France, Sweden, Ireland, Spain and Belgium). Today, Sysco has 326 distribution facilities all over the world, over 13,000 vehicles on the road and serves more than 625,000 customers. Aside from growing organically, Sysco also increased by mergers and acquisitions and the company admits that M&A is a key lever of its growth strategy.

(Source: Sysco Investor Presentation)

Sysco has been heavily affected by the pandemic resulting in horrible numbers for the fourth quarter of 2020 (April 2020 till June 2020). Sales in this quarter decreased 42.7% YoY, gross profit decreased 47.7% YoY and for the bottom line, the company had to report a loss of $0.29 per share. According to GAAP, earnings per share were even worse and decreased to a quarterly loss of $1.22.

When looking at the results for the full business year of 2020, the results look better, but sales still decreased 12.0% to $52.9 billion and gross profit decreased 13.2% to $9.9 billion. Adjusted earnings per share decreased 43.4% to $2.01 and earnings per share according to GAAP were only $0.42. Free cash flow also decreased from $1.7 billion in 2019 to $0.9 billion in 2020.

What about the moat?

My last article about Sysco was mostly focused on the question, if Sysco has an economic moat or not. And my conclusion was that Sysco definitely has a competitive advantage, but the company probably doesn’t rank among the best wide economic moat companies and only has a narrow moat.

Already by looking at the different numbers, we see that Sysco’s performance is not perfect. When looking for example at revenue, the performance is extremely impressive. Since 1980, Sysco could increase its revenue every single year aside from 2009 and 2020 and revenue grew with a CAGR of 9.93%, which is including the decline in 2020 and is still very impressive. However, when looking at net income, the picture is not so great – at least not in the recent past. From 1980 till 2005, net income could increase every single year, but between 2006 and 2015, the numbers fluctuated much more and the company had to report a decline in seven out of ten years and declined even five years in a row. Since 1980, net income could increase with a CAGR of only 6.07%, but if we leave out 2020 and only look at the growth between 1980 and 2019, we get a CAGR of 11.95%. While these are impressive average growth rates, the last two decades were not so great. Since 2000, revenue increased with a CAGR of 5.17% and net income increased with a CAGR of 7.11% (once again leaving out 2020). These are solid numbers, don’t get me wrong, but growth definitely slowed down.

(Source: Author’s own work based on numbers from Traderfox/FactSet)

While revenue is showing very high levels of stability, which is indicating a wide moat, the fluctuating net income is undermining that solid picture a bit. And the company’s margins are presenting a similar picture. Sysco has a very stable gross margin, which fluctuated in a narrow range between 17.6% and 19.1% during the last decade and even in 2020 the gross margin stayed at 18.7%. A stable gross margin is hinting that a company has pricing power, which is indicating a wide economic moat. But the operating margin is painting a different picture. From 2011 till 2019, the operating margin fluctuated between 2.5% and 4.9%, which is a lot considering that Sysco is operating in a low margin business. And in 2020, operating margin declined even to 1.4%.

And while operating margin fluctuated more than I would like to see for a wide moat company, return on invested capital was quite high. The average RoIC was 12.88% during the last ten years, which is including the horrible RoIC of 2020.

Overall, Sysco is presenting a mixed picture. Every company can have one or two horrible years (and even report a loss – especially when it is due to external factors that are very hard to control), but even before 2020 the picture was not perfect. Nevertheless, Sysco definitely has a competitive advantage and a narrow moat. In this context, the brand names are worth mentioning as brands often generate an economic moat around the business or might at least support an economic moat.

(Source: Sysco Investor Presentation)

But it is not so much the brand names that are generating the economic moat, but rather the cost advantages that result from Sysco’s distribution network and the company’s scale. Sysco is profiting from lower distribution costs compared to its competitors. Once a distribution network with distribution facilities and the vehicles with the distribution routes are in place, every additional customer is adding additional revenue, but only little additional costs, which is increasing margins, profitability and the bottom line. Especially for new competitors, it is therefore hard to match the prices Sysco can offer due to the lower costs Sysco has.

Dividend

Considering the ongoing pandemic and the big impact it has on Sysco’s business, we also have to look at aspects like financial health, the impact of a potential second wave as well as the consequences of the first wave and the safety of the dividend.

We start with the dividend, which is playing an important role for Sysco investors as the company has not only been paying a dividend for 51 consecutive years, but also increased the dividend every single year. This makes Sysco a dividend king, but it will probably lose the status again as management already indicated that it is unable to increase the dividend. During the last earnings call, management stated:

Regarding Sysco’s dividend, we remain committed to returning substantial value to our shareholders through our dividend payments. We are unable to grow our dividend due to an amendment restriction as previously communicated. However, we are committed to the long-term growth of the dividend.

Right now, Sysco is paying a quarterly dividend of $0.45 resulting in a dividend yield of 3% and while a dividend increase in the foreseeable future seems to be off the table, a dividend cut is also not unrealistic. A company that increased the dividend for more than 50 years and is committed to the long-term growth of the dividend will avoid a dividend cut as long as possible. But when looking at the annual dividend of $1.80 and the adjusted EPS of $2.01, we get a payout ratio close to 90%, which is not sustainable. When considering GAAP results (EPS of $0.42), the company is actually paying out more than four times earnings in dividends.

Financial Health

To get a clearer picture, if the dividend is sustainable, we have to look at the financial health of the business. Similar to many other companies, Sysco also tried to improve its liquidity and increase its cash position as soon as it became obvious that COVID-19 is actually a bigger deal. As a consequence, cash and cash equivalents increased from about $500 million a year before to more than $6 billion. But not only the asset side increased – liabilities also increased and long-term debt increased from $8.1 billion a year ago to $12.9 billion right now. Additionally, Sysco has $1,542 million in short-term debt. Right now, the company has only $1,158 million in shareholders equity resulting in a debt-equity ratio of 12.5. But we also have to keep in mind that Sysco has almost $10 billion in treasury stock on its balance sheet. In the last few years (before COVID-19), the company generated about $2.3 billion in operating income and it would therefore take Sysco more than six years to repay the debt. This is an extremely high ratio, but on the positive side, we have to keep the $6 billion cash in mind, while on the negative side we have to point out that the company probably won’t generate $2.3 billion in operating income in 2021 (and maybe also not in 2022). Overall, I am not worried about Sysco’s financial health, but the balance sheet could be better.

Second Wave

The final and probably decisive question is, what will happen in the months to come. Like many other companies, Sysco could report weekly improving numbers since the low at the end of March and beginning of April. At the end of June, weekly sales were about 30% below previous levels and during the earnings call management stated the sales stagnated during July.

(Source: Sysco Bernstein Strategy Presentation)

Management also stated that it was already profitable again at the end of June and expecting better sales for the fiscal year 2021 than for the months of June or May 2020, which should result in a profit in the coming quarters.

But high risks remain for the business. As we can see in the chart above, 7% of Sysco’s business is stemming from travel & leisure, which hasn’t recovered yet. Analysts also estimate that about 15% of restaurants could close permanently and restaurants are responsible for 62% of Sysco’s sales, which would be a big hit. Reservation data from Open Table is also showing that we are still far away from pre-crisis levels (despite a continuous improvement).

(Source: Open Table)

And the biggest problem is that we still don’t know what the next few months will bring. On the one hand, we are learning to leave with the virus and companies as well as politicians are putting protocols in place in order to go back to normal. Politicians in various countries are also stating that there won’t be another lockdown. On the other hand, the number of daily new cases globally in still at a high level (around 300k) and especially many European countries, which had the virus more or less under control see rapidly rising case numbers again and Spain or France for example are reporting higher daily numbers than in March and April and in South France, the ICUs are in short supply already. And despite political rhetoric, it seems extremely unlikely that a safe and effective vaccine will be available in 2020. We have to expect that the next few months when it is getting colder again and the flu season is starting will get tough. The fact that the virus has been spread widely due to tourist is also not helping. All in all, we must not rule out another decline for businesses like Sysco.

Intrinsic Value Calculation

In my last article, I was rather cautious and assumed only moderate growth rates of 4%, which led to a rather low intrinsic value. However, when looking at the performance in the last four decades, I would be a little more optimistic – despite growth slowing down over the last few years. For the fiscal year 2021, I assume free cash flow being similar as in 2020 as I don’t see a quick recovery for Sysco right away. For 2022, I assume 50% growth compared to 2021 and in 2023 I assume free cash flow is the same again as before the crisis. For the years following 2023, I would assume 6% growth till the end of the first decade and following that 5% growth till perpetuity. During the crisis, Sysco was trying to cut its costs even further and removed about $350 million in annual costs permanently, which should increase its bottom line as well as the free cash flow permanently. This leads to an intrinsic value of $62.19 making Sysco more or less fairly valued at this point.

Conclusion

Although Sysco is not a wide moat company, it definitely has a competitive advantage and a narrow moat in my opinion. And although the company might cut its dividend, it is still interesting for dividend investors as management is still committed to growing the dividend over the long run. The permanent closure of a large part of restaurants and the potential of a second wave hitting in the fall and winter should make us cautious about investing in Sysco right now as we might see lower stock prices in the coming months. But when considering Sysco as a potential long-term investment, the stock might be fairly valued at this point when considering similar growth rates as in the past.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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