SYSCO Corporation (NYSE:SYY) is a holding in our Conservative Retirees dividend portfolio. The company is a dividend aristocrat that has paid dividends since 1970 and appears to offer a very safe 3% yield today.
While SYY’s growth rate is very moderate, the company’s durability has been noteworthy. The pace of change in the food service distribution industry is really slow, and SYY derives several benefits from being the largest player in the market.
Despite several years of sluggish growth and some pricing pressures, we believe SYY will keep plodding forward as it executes on its cost improvement plan and becomes even more competitive. A well-known activist investor also purchased 7% of the company in August 2015 and could help the company unlock additional value.
Among the funds tracked by Insider Monkey, 30 investors held shares of SYSCO at the end of September, reporting positions with a total value of $3.45 billion, equal to roughly 15% of the company. This compares with 29 funds holding $2.21 billion worth of stock a quarter earlier. Nelson Peltz of Trian Partners is one of the most bullish investors, holding around 42.68 million shares, according to one of Trian’s latest SEC filings.
Business Overview
SYY was founded in 1969 and is the largest distributor of food products in the country. It basically acts as the middleman between food producers and retail consumers.
Restaurants are its biggest customers at about 64% of total sales, followed by healthcare cafeterias (9%), schools (8%), hotels (8%), and other facilities (11%). Overall, SYY sells to about 425,000 customers.
SYY’s product mix is fairly well diversified. Some of its biggest segments are fresh and frozen meats (21% of sales); canned and dry products (16%); frozen fruits, vegetables, and bakery products (13%); dairy products (11%); and poultry (11%).
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 $1.45 billion.
The pace of change is very slow, and new innovations (even drones!) 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 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 (SYY’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, SYY’s scale plays a big advantage. Since its formation nearly 50 years ago, SYY has grown from $115 million to nearly $49 billion in annual sales (acquisitions have been a significant growth driver).
As the largest food products distributor in North America, SYY 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 SYY’s assortment. For these reasons, SYY is one of a handful of players that can serve national accounts.
Furthermore, SYY’s wide network of warehouses and distribution systems allows it to offer daily delivery to most of its customers and provide competitive rates. With a dense delivery network around its warehouses, SYY 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 SYY 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. As the largest player, SYY is especially challenged to grow. The company had historically increased in size by acquiring market share, but there are few big enough deals left to really move the needle.
Most notably, SYY 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 SYY 25% share of the national market but was blocked by the U.S. government, requiring SYY 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 heled positions in Kraft, Wendy’s Pepsi, Mondelez, and several others.
SYY’s new three-year plan calls for stricter cost management, smaller acquisitions, and better sales efforts to improve operating income by $400 million and deliver a 15% return on invested capital by 2018. The company is also focusing on updating its product offerings and technology to better compete with smaller rivals that have more organic products and online ordering.
While the future will be much different without U.S. Foods under its belt, we think SYY will continue squeezing out modest profit growth over time and remain a force in the $265 billion foodservice market for years to come.
