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Morningstar | Sysco Delivers Solid Sales Growth and Modest Margin Gains in 2Q, but Shares Still Rich

We believe narrow-moat Sysco’s second-quarter results (2.5% reported sales growth, 4 basis points of gross margins expansion to 18.77%, and 9 basis points of adjusted operating margin gains to 4.09%) highlight that the firm is withstanding intense competitive and macro headwinds well. However, after accounting for the mid-single-digit uptick in shares, the valuation looks inflated to us, at a nearly 15% premium to our view of its intrinsic value. Results through the first half are tracking our full-year estimates for 4%-5% reported sales growth and 20 basis points of operating margin gains, to 4.5%. As such, we see little to warrant altering our $58 fair value estimate or long-term outlook (3%-4% sales growth and 80 basis points of operating margin improvement to just north of 5% over the next decade).

In our view, the firm’s national scale enables it to bring value-added services (data, trends, and consulting) to smaller restaurant chains, which helps foster long-standing and profitable partnerships. As evidence, within its U.S. foodservice operations (more than two thirds of sales) in the quarter, case volume growth was solid, totaling around 3% (or 2% on an organic basis), while food-cost inflation approximated 1.4% in the quarter (concentrated within frozen potatoes, meat, paper, and produce). And we don’t think the firm is content with the status quo, completing two acquisitions over the past two months (Classic Drinks in Ireland and Waugh Foods in central Illinois). Neither will move the needle on our valuation, but they should enhance its footprint and capabilities at home and abroad. Over the long term, we forecast food-cost inflation of just about 1.5%, generally in line with the historical average, case volume growth of 1.5%-2% (just below management's 2%-3% target, but more in line with the past couple of years), and a 50- to 100-basis-point benefit from acquisitions, which in aggregate underlies our 3%-4% annual top-line growth forecast.

Even in the face of challenges resulting from the competitive landscape and cost inflation (both as it relates to food costs and transportation), Sysco maintains a stringent eye on costs, with plans in place to boost operating income by $650 million to $700 million by fiscal 2020, which we view as achievable. The success of these efforts is evident in the fact that gross profit dollars continue to outgrow operating expenses (to the tune of a 60-basis-point differential in the quarter, in line with the average over the past six quarters). Building on these initiatives, Sysco announced that it has cut its salaried corporate support staff by 10% (which should reduce layers of management and spans of control, not in areas that maintain direct relationships with customers and ultimately support growth). Beyond this, we continue to believe the firm will look for opportunities to enhance its supply chain capabilities and more efficiently use technology across the organization. However, we don’t think the entirety of any savings will drop to the bottom line but rather will be funneled back into the business to offset intense competition.