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Morningstar | Sysco's Sales and Profits Truck Ahead in 3Q, but Shares Fail to Offer Any Bargain

We don’t anticipate a change in narrow-moat Sysco’s $58 fair value estimate following third-quarter results (2% sales growth and a 52-basis-point gain in adjusted operating margins to 4.2%). However, we don’t believe the stock should whet investors’ appetites, with shares trading at a 25% premium to our valuation. While we view Sysco’s strategic course to bolster profits and stabilize sales favorably, we think the market is largely disregarding the plethora of headwinds that may dislodge Sysco from its current trajectory, including competitive and inflationary pressures at home and abroad.

Management emphasized pronounced sales volatility over the quarter, partly due to the inclement weather that impacted much of the U.S. in February. We estimate U.S. foodservice underlying sales (nearly 70% of its total base) ticked up just 2%-3% in the first three months of the year, as 2.3% food cost inflation (concentrated within meat and poultry) combined with just 1% organic case volume growth. Despite this more muted growth, over the longer term, we posit the firm’s national scale should position it to offer value added services (data, trends, and consulting) to smaller restaurant chains as a means to foster long-standing and profitable partnerships (resulting in nearly 2% annual case growth through fiscal 2028).

Even as restaurant traffic cyclicality persists, we think efforts to boost operating income by $650 million to $700 million by fiscal 2020 are prudent. As evidence, gross profit dollars outpaced operating expenses (a 330-basis-point differential in the quarter, outpacing the 100-basis-point average over the last seven quarters). While we expect the magnitude of this gap is poised to compress, we don’t believe the firm will abandon efforts to drive efficiencies, boosting operating margins to 5% long term, up from 4.3% in fiscal 2018. However, we don’t expect much profit expansion beyond this level, as it opts to fuel investments behind its competitive edge.

From a capital allocation perspective, we continue to expect Sysco will acquire smaller rivals to enhance its scale and product assortment. In this vein, Sysco inked two deals in the quarter (J&M Wholesale Meat and Imperio), but financial terms were not disclosed. Management suggested these additions stand to bolster its reach within the Hispanic customer segment (given the positioning within central California), and we suspect Sysco will continue to prudently allocate capital to consolidating the market when opportunities to enhance its capabilities and reach arise. As such, we continue to believe that its top line will be bolstered by about 50-100 basis points annually to reflect its appetite for deals (aligning with Sysco’s historical bent).