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Sysco Corporation (SYY)

Founded in 1969, Sysco (SYY) is the largest global distributor of food, essentially acting as a middleman between food producers and retail consumers. The company provides food products and related services to more than 500,000 customer locations, including restaurants (61% of sales), healthcare facilities (9%), schools and governments (9%), hotels and travel companies (9%), and other foodservice customers (12%).

The products Sysco sells are diversified as well and include fresh and frozen meats (19% of revenue), canned and dry products (16%), frozen fruits, vegetables, and bakery items (15%), poultry (11%), dairy products (11%), fresh produce (8%), paper products (6%), seafood (6%), beverages (4%), janitorial products (2%), equipment (1%), and medical supplies (1%).

While Sysco has a presence in more than 80 countries, the U.S. is its most important region by far, accounting for more than 70% of total revenue. The company organizes itself into four business segments:
Source: Sysco Investor Presentation

Business Analysis

Wholesale food distribution is a simple business. That is likely one reason why Warren Buffett bought into the industry in 2003 when he acquired McLane Company from Wal-Mart for $1.5 billion.

The pace of change is very slow, and new innovations seem to pose little threat to the way the industry operates. At the end of the day, food manufacturers need a cost-efficient way to get their products to retailers, restaurants, and consumers.

The best operators offer prompt and accurate delivery of orders, a broad assortment of products, and competitive pricing. Since distributors are middlemen, their margins are very low (Sysco's operating margin has averaged less than 5% over the last decade), and players must either establish themselves as price or niche leaders in a given region.

Not surprisingly, Sysco’s scale plays a big advantage. Since its formation nearly 50 years ago, Sysco has grown its annual revenue from $115 million to more than $55 billion (acquisitions have been a significant growth driver).

As the largest food products distributor in North America with approximately 16% share of the $280 billion foodservice market in the U.S., Sysco works with thousands of suppliers to offer the broadest assortment of products (over 400,000) on favorable terms. 

Few companies have the capital and supply chain network and expertise to match Sysco’s assortment. For these reasons, Sysco is one of a handful of players that can serve national accounts. 

Furthermore, Sysco's wide network of warehouses (over 300 facilities with 48.7 million square feet) and distribution systems (more than 13,000 delivery vehicles) allow it to offer daily delivery to most of its customers and provide very competitive rates. 

With a dense delivery network around its warehouses (thanks to serving 500,000 customer locations), Sysco can offer lower pricing than other distributors that attempt to play in its geographic regions.

In addition to economies of scale, high capital costs, and product assortment, new entrants are also challenged by supply contracts Sysco has with many of its customers.

While the food distribution business has several favorable characteristics that seem to ensure its durability, it is a very mature market. Research firm Technomic projects the $400 billion foodservice market to experience just 1.6% real annual growth from 2017 through 2022.
Source: Sysco, Technomic

As the largest player, Sysco is especially challenged to grow. The company has historically increased in size by acquiring market share, but there are few big enough deals left to really move the needle.

Most notably, Sysco made an offer to acquire the number two player in its market, U.S. Foods, for $8.2 billion in December 2013. The acquisition would have given Sysco 25% share of the national market but was blocked by the U.S. government, requiring Sysco to significantly alter its core strategic plan and pay hundreds of millions of dollars in breakup fees to U.S. Foods.

Less than two months after the merger was terminated, activist investor Nelson Peltz took a 7% stake in the company and secured two seats on the board of directors. Peltz brings meaningful experience in the food industry and has previously held positions in Kraft, Wendy’s Pepsi, Mondelez, and several others.

Sysco ultimately turned more of its attention overseas, agreeing to acquire European food distributor Brakes Group for $3.1 billion in 2016, less than one year after its bid for U.S. Foods was shot down. This acquisition gave Sysco a solid foothold into Europe (especially the United Kingdom, France, and Sweden), which is necessary because the opportunity for needle-moving growth in the mature U.S. market is narrowing.

As part of its strategy, Sysco had put together a three-year plan in 2015 that called for stricter cost management, smaller acquisitions, and better sales efforts to improve operating income by $600 million to $650 million and deliver a 15% return on invested capital by 2018. The company also focused on updating its product offerings and technology to better compete with smaller rivals that have more organic products and online ordering.

As you can see below, through the first 10 quarters of Sysco's initial three-year plan, the company has done an excellent job delivering on its objectives.
Source: Sysco Investor Presentation

Going forward, Sysco's upcoming three-year plan calls for somewhat faster local case growth and continued working capital improvements, which will further boost free cash flow. The company plans to continue being generous with capital returns to shareholders as well, targeting a payout ratio between 50% and 60% over time which should allow for mid-single-digit dividend growth.
Source: Sysco Investor Presentation
Overall, Sysco seems likely to continue squeezing out modest profit growth over time and remain a force in the large and fragmented foodservice market for years to come.

Key Risks

There are several main risks to consider before investing in Sysco.

First is the highly competitive and mature nature of the food distribution business. Sysco competes with tens of thousands of domestic U.S. rivals, and smaller specialty distributors have taken some market share in the higher-margin restaurant business in recent years. The industry's competitive intensity means that maintaining industry-leading profitability could prove to be a struggle for the company over the long term.

Sysco is working to combat these challenges by expanding internationally, gaining greater scale, and offering a more localized approach to many of its customers. For example, the company offers locally produced foods and ingredients targeted more specifically at certain demographics. Sysco can also use its size to acquire some of the local and regional niche distributors to protect its business, if necessary.

Amazon could also affect the industry’s dynamics in the future, especially after news of its acquisition of Whole Foods in 2017. Amazon is the expert in warehousing, inventory management, and delivery capabilities, but it would be surprising if they went after Sysco’s core business.

Establishing all of the necessary supplier and restaurant relationships would require a lot of work, and Sysco’s margins are already quite thin. The inventory and delivery mechanisms needed for wholesale food are also quite different.

Perhaps the bigger risk would be if large national accounts or food producers decided to enter the distribution business themselves and cut out the middleman. However, this doesn’t seem to be happening today – probably because of the industry’s capital intensity and low value-add.

But consumer eating habits are evolving. A decline in consuming food away from home, or a shift in preferences toward restaurants that are not Sysco's customers could lower demand for the company's products. As consumers increasingly opt for organic and locally grown products, Sysco may have to more aggressively shift the mix of its product portfolio to stay on trend, potentially incurring higher costs. 

Another risk to consider is that in order to acquire Brakes Group, as well as steadily buy back shares over time, Sysco has had to take on a large amount of debt in recent years. As a result, the company’s ability to further grow through consolidation may decline somewhat in a rising interest rate environment, although Sysco does still maintain a healthy investment grade credit rating.

Finally, it’s worth mentioning that swings in commodity prices (e.g. fuel, food prices) and consumer spending patterns (Sysco obtains the majority of its revenue from the cyclical restaurant industry) can impact Sysco’s results from time to time. However, these factors seem unlikely to have an impact on the company’s long-term earnings potential.

Closing Thoughts on Sysco

While Sysco may not be a high-flying growth stock, the company has certainly proven its ability to help shareholders grow their income over time. In fact, Sysco has paid higher dividends each year since its founding nearly 50 years ago.

 Sysco is a simple, boring business, and its time-tested operations, well-known brand, economies of scale, defensive profile, and dependable cash flow generation make it a very reliable dividend aristocrat.

The food distribution industry is very competitive and must continuously adapt to changing consumer tastes. However, it also provides essential services that are unlikely to go away anytime soon. 

All things considered, Sysco seems likely to remain an appealing long-term investment for conservative investors seeking sources of safe dividend income. 

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