Description

Sysco – SYY   SHORT       $34.43                                                                                                                   7/24/2013

Short idea:  Sysco, the large food distributor, is trading too rich.  At 19x EPS with flat EBITDA for years (despite acquisitions and significant accounting hijinx), SYY is undeserving of a market premium.

Executive summary  

• SYY has several secular/competitive headwinds and is up 12% YTD and trading at 18x FY ‘14 P/E. Earnings estimates have been revised downwards (FY ’14 has gone from $2.16 to $1.98), so it has all been multiple expansion
• Over the last few years the stock has traded from 11-12x at its trough to today’s 18x. I would argue is a low quality/low growth business and should get a below market multiple, but even if you take 14-15x it's tough to lose
• They have a June FY end and report on 8/13. Sell-side is generally bearish on the name, and for good reason.
• Admittedly, it is 14 days to cover (SI has been building) but borrow is available at GC rates.

Business has been suffering – growth is anemic and margins under pressure 

• Dining trends are poor – their biggest customer set is small mom and pop casual restaurants, who are losing market share to larger chains. Also, they are more exposed to traditional casual dining vs the faster growth ‘fast casual’, which is typically a chain concept like NDLS or DIN’s Applebee’s. They have started to chase some chain business, but that is lower margin and weighing on their mix. Moreover, we’ve seen McDonalds and Panera report disappointing SSS #s so far this earnings season, and given all the pressure on the average consumer, simple intuition there would be some incremental cyclical pressure here too.

• Food inflation – they can’t really pass thru food inflation – and though the increases have moderated they are still up YoY. The industry is very fragmented / low barrier to entry, and other guys are willing to pass thru less inflation to take market share.  They have a low margin structure (~18% GM / 4% Op Margin) so the many vacillations that nearly all businesses face with multiple items having impacts of, say even 30 bps, is a major problem at SYY.

These margin headwinds and poor organic growth have led to EPS being down YoY for the last 6 quarters.  However, consensus has that turning around starting in the Sept Q, yet we haven’t seen anything to suggest the business has inflected.  Volumes have been growing 2-3% in the last few quarters and that includes some small acquisitions.  Ex-acquisitions, we estimate volumes were flat on an organic basis in the March quarter.

Their operational turnaround has been a flop so far and is causing business disruption 

• The company is really 85 or so regional Opcos – several years ago, they started to migrate to a SAP to help ‘consolidate the company’ but it continues to be severely behind schedule and over budget. They’ve had issues with making on time deliveries and were upsetting customers. They’ve actually frozen the implementation of additional SAP rollouts until they can figure it out, so you have some incremental expenses but w/o any benefit yet

• Category management – in an attempt to rationalize their assortment and get better volume discounts, they decided to cut 5% of their SKUs last year and another 5% this year.  This sounds good on paper, but the reason a restaurant goes with a guy like SYY is to get whatever they really need for their restaurant. Being able to offer more diversified SKU offerings and local products that restaurants want was one of their competitive advantages over the smaller guys. Apparently they’ve had to pass thru the volume discounts to their customers to keep them from leaving.

• Sales force reductions – company is cutting back on the number of salespersons they have out there on the streets, so more accounts per salesperson, which means less visits and less interface with the customers, and gives competitors the opportunity to pick off customers

Accounting Hijinx

• Accounting can be an art rather than a science, and they have been accused of obfuscation of all sorts.  Grievances include boosting cash flow by creating an internal Co-Op, Deferring $1B of taxes that the IRS later deemed inappropriate, Boosting operating results with non-operating investments, lengthening depreciation schedules  and useful lives of equipment to the point where they can add ~$1B of assets without an increase in depreciation expense, etc.
• A particularly pernicious one has been their botched ERP System installation that has faced continuing delays (some might say on purpose).   Their filings state, “certain labor costs, which would have been expensed absent this project, are being capitalized as software costs as a result of this project.”  So basically they are capitalizing the labor portion of the ever-ongoing installation to have it circumvent the P&L to the tune of hundreds of millions.  Estimates will be cut by up to 40c (recurring) if they ever finish the install and start counting ALL the people on the payroll.

Despite all these issues, valuation is getting stretched 

• $20.4B mkt cap on 593.5m shs out, $2.8B debt, $332m cash… EV = $22.9B
• Trades at 19.5x FY ’13 and 18x FY ’14 EPS, which may have some earnings revision downside – they guided to $2.50-2.70 in FY ’15 EPS but that seems implausible, so they’ll have to cut that too
• They probably can get to ~$2 and the stock is trading at $34 which is 17x… a pretty rich valuation for a low margin, low growth business with weak prospects.  The stock should probably be ten dollars lower at 12x.
• Helping them is a 3% dividend yield – must have helped the stock this year… though they are at a 60% payout ratio and at 56% on the $2 figure despite at stated goal of 40 to 50%.  Also they have no exposure to Europe/China which has likely been a plus in 2013. 

Catalyst

• Fessing up to more problems on the call
• Losing the expense shield by finally installing the ERP System, and other accounting hijinx coming home to roost
• Realization of weak organic growth
• Estimate cuts