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Morningstar | US Foods’ Hunger for Deals Unlikely to Result in Sufficient Scale to Warrant a Competitive Edge

US Foods is the second-largest U.S. food-service distributor after narrow-moat Sysco. While we believe Sysco has a cost-advantaged edge, we have not found evidence of a competitive advantage at US Foods, and as such, do not grant it a moat. The firm has not demonstrated a distribution cost advantage, organic market share gains, consistent economic returns, or superior profits (even compared with some smaller regional distributors). We expect the firm will remain a consolidator and have a favorable view of its pending $1.8 billion tie-up with Service Group of America, an operator in the West and Midwest. SGA strikes us as a well-run organization, with EBITDA margins of 3.8%, not far off US Foods’ 4.0%. Beyond the enhanced scale, we expect that opportunities to sell US Foods’ value-added services (innovative technology platform and consultative services) to SGA’s clientele are tangible. However, while the transaction could increase the firm’s market share to 10% from 9%, this still materially lags Sysco’s 16%, failing to evidence a sustainable competitive edge for the combined business. In its legacy operations, we think US Foods’ growth has been stymied by cost-cutting efforts. US Foods has improved profits the last five years, as gross margins increased from 16.8% to 17.8%, operating margins from 2.0% to 3.1%, and ROICs from 6.2% to 7.8%. We attribute this to an improvement in customer mix (both to more profitable segments and more selective customer contracts within segments), more effective data-driven pricing, the centralization of purchasing and administrative functions, and a reduction of the salesforce, facilitated by productivity-enhancing tools. But despite the added profits, we believe the reduction in the salesforce hampered organic market share gains. Over the past four years, US Foods’ compound annual revenue growth rate was 1.2% (excluding acquisitions and the intentional termination of unprofitable accounts), more muted than the 2.2% industry growth. The lack of organic share gains impairs the firm’s ability to leverage its scale and progress toward a scale-based cost advantage.