EUR 850.00 For Business Accounts Only

Morningstar | US Foods Beefs Up Geographic Reach With SGA Deal Amid Intense Competition; Shares Still Rich

No-moat US Foods' hunger for acquisitions is evident in the company's $1.8 billion all-cash deal for SGA's Food Group of Companies. We view the price as fair at 12.5 times estimated fiscal 2018 adjusted EBITDA, but just 8.6 times after incorporating anticipated cash tax benefits and $55 million in targeted synergies related to distribution, procurement, and overhead; this generally aligns with past industry transactions. The strategic rationale is clear, as the purchase stands to build out US Foods' scale, enhancing its geographic footprint in the Northwest and expanding its base of private-label offerings. While the deal will push pro forma net leverage to around 4 times, we expect US Foods will delay share repurchases and direct free cash flow to pay down debt, targeting 3 times by fiscal 2020, which we think is attainable. We are holding the line on our Standard stewardship rating.

US Foods also reported second-quarter results, which included a contraction in case volume (150 basis points on an organic basis) despite modest margins gains, with adjusted gross margins up 30 basis points to 17.9%. While a portion of the volume retreat was intentional--the company terminated relationships with certain lower-margin customers--executional stumbles, including the transition to centralized replenishment, persisted. In light of recent results, management tempered its full-year expectations for case volume growth to approach flat (from 1% prior) and sales growth of 1%-2% (from 3% prior), but it maintained its outlook for adjusted earnings per share of $2.00-$2.10. After incorporating the impact of the SGA deal and recent results, we don’t intend to alter our $29.50 fair value estimate materially, outside the time value of money. Even after accounting for the midteens decline in the share price after these announcements, we think US Foods' valuation looks a little inflated and would suggest investors remain on the sidelines.

Intense competition abounds in this fragmented, mature space, with a number of foes, including narrow-moat Sysco, vying for share gains. We believe US Foods is taking appropriate steps to withstand industry headwinds. We think efforts to extract excess costs from its operations, centering on its supply chain and distribution, should help offset the onslaught from inflation and competition that is unlikely to materially abate. Further, we view favorably US Foods’ strategic intent to scale back its exposure to national chain restaurants (lower-margin contracts where price competition is intense). We think initiatives related to building out e-commerce capabilities and leveraging data analytics can increase the stickiness of customer relationships and help US Foods retain customers, as we don’t believe smaller operators can replicate these offerings. As such, we aren’t wavering on our long-term outlook for annual sales growth of nearly 4% (more than 1% benefit from case growth, nearly 2% from inflation, and 70 basis points due to acquisitions) and operating margins around 3%.