Sysco Corp: A Great Company, an Inflated Price

A simple valuation procedure

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Aug 29, 2016
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Sysco (SYY, Financial) is by far the biggest and best marketer and distributor of food, food products and related equipment and supplies to the U.S., Canadian and international foodservice industry.

The company distributes fresh and frozen meats, prepared entrées, vegetables, canned and dried foods, dairy products, beverages and produce as well as paper products. It also distributes restaurant equipment, supplies and cleaning products. The company is a key supplier for many bulk purchasers and retail chains, including not only restaurants but hotel chains and lodges as well. It is also an active supplier to the hospital and education industries.

Restaurants account for about 60% of sales with hospitals and nursing homes accounting for another 10%. Sales to universities and the hospitality industry account for about 6% of sales with the “other” category making up the remainder.

Sysco has one of the best distribution networks with a delivery fleet operating almost everywhere in the world. This distributional advantage is critical for maintaining its cost advantage over competitors as it is a tight margin industry.

Many of you are probably not aware, but a lot of the food you’re consuming in restaurants is coming directly from Sysco-distributed outlets.

Sysco has retained its leadership position in the North American market for over 30 years with about 19% of revenues generated from meat sales, 18% canned/dry food sales, 13% frozen food sales, 11% dairy sales and 10% poultry sales.

Key purchase considerations

Sysco continues to be the most dominant player in the industry, and we expect this dominance to continue to grow in the future. It serves a customer base with an ongoing perpetual need. While industry growth isn’t terribly strong, and margins in the industry can be expected to remain tight, the company has achieved near operational excellence.

The restaurant environment will improve as employment and income levels continue to grow. The transition in many emerging market economies toward more service-based activities will bode well for Sysco. We also like management’s obsession with cost controls, which will hopefully result in further savings. We expect largely stable margins moving forward over the next few years.

Overall, this is a steady and safe company with a great track record of revenue preservation and cash flow generation.

Estimating sales growth

When assessing the competitive strength and investment merit of any firm, the first thing we like to do is to look at what’s going on with sales — that’s really the first level of inquiry that any investor should undertake.

Ideally, we are looking to invest in companies whose sales are strong, consistent and generally growing faster than nominal gross domestic product (GDP) growth (that is, real GDP growth and inflation combined). Based on Sysco’s historical sales data, you can see that things look pretty good. The 10-year sales growth has been 4% per year. This compares to nominal GDP growth of 3% per year over the same period, which is perfectly acceptable for a firm of its size.

In '09 and ’10, Sysco faced a bit of a downturn due to the financial crisis and economic recession, but since 2011 it's certainly been doing quite well. Sysco’s sales growth has been 5% per year over the last five years and 4% per year over the last three years. Sysco's three-year revenue growth is ranked higher than 51% of the 318 companies in the Global Food Distribution industry. Overall, we can see that Sysco has an appealing revenue profile and has done a superb job of generating strong, stable and growing revenues.

Figure 1: Revenues and growth

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The second thing we like to do when assessing sales is to look at consensus market estimates. As reported in Yahoo! Finance, the market is projecting 10% annual growth for this year and 4% for next year. These estimates are drawn from the projections of 12 analysts. The sales estimate is $54.73 billion for 2017, which compares to the year ago estimate of $50.37 billion. Note that the company does not provide any revenue guidance.

A third thing we like to do when assessing sales is to compute the firm's sustainable growth rate. The sustainable growth rate reflects the rate of growth in sales that a firm can support given its existing earnings power, capital resources and dividend payout policy. In any given year, a firm's sustainable growth rate is calculated by multiplying its return on equity (ROE) by its retention rate. Rather than rely on data from only one year, however, we calculate sustainable growth by using the firm's three-year average ROE and three-year average retention rate. Sysco's ROE averaged 18% over the last three years while its retention rate averaged 16%, giving the firm a sustainable growth rate of 3% per year.

Let's recap briefly what the sales data is showing us. From what we can tell, it is not unreasonable to estimate that sales over the next five years could grow at a rate of somewhere between 0% and 7%.

Table 1: Choices for possible growth rates

Growth Rate (%) Rationale
4 The three-year growth gate
5 The five-year growth gate
4 The 10-year growth gate
7 The two-year average consensus growth estimate
0 The firm's guided growth rate
3 The sustainable growth rate

We're going to select a rate of 3%. With $50.367 billion in sales generated last year, this means sales will continue to grow in the future and will reach about $59.603 billion in five years. This estimate reflects our understanding of the firm's historical results, the intensity of competition within the industry, changes in buyer preferences and new product/service launches.

Estimating earnings per share

Now that we have generated our sales estimates, we’re going to estimate growth in earnings per share. This method applied below takes the sales growth projection — in this case, 3% a year — and subtracts the expenses and taxes. What we're left with is the earnings. Then we divide by the projected number of diluted shares outstanding to determine the earnings per share (see table below).

A projected growth rate of 3% will result in almost $59.603 billion in sales five years out. Now we need to take a look at the firm's pretax profit margin (what’s left over after expenses but before taxes are subtracted). In Figure 2 below, we can see that Sysco has been doing a decent job maintaining its profit margin — 3% in 2013, 3% in 2014, 2% in 2015 and 3% in 2016. The average for the last five years has been 3%, and the average for the last 10 years has been 4%. We believe that Sysco's margins will revert to its near term mean of 3%. At this rate, projected pretax profits on $59.603 billion in sales would be just over $1.788 billion. This means expenses would amount to $57.815 billion.

Figure 2: Pretax profit margins

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The next step in our estimation process is to establish the tax rate that will be paid on the company's profits. The most recent year’s rate was 34%. Normally we wouldn't play with that number too significantly because in general, it shouldn't change much from year to year.

The only time we would make major changes to this number would be in instances where maybe the current rate differed significantly from that of the past or if we had some knowledge about which rate was likely going to persist in the future, perhaps because the company is going to get some preferential tax treatment on operations abroad. For Sysco over the last 10 years, the company's tax rate has been as low as 32% and as high as 40%. Tax rates for most U.S. companies will fluctuate between 35% and 40%. We're going to select a rate of 37%, representing the average rate of the last 10 years, excluding the influence of nonrepresentative years. This would result in a tax expense of $662 million from pretax profits of $1.788 million in five years. This would leave us with $1.126 million in projected earnings five years from now.

Our next main consideration is a matter of determining the number diluted shares that will be outstanding in five years. Sysco has significantly decreased the number of shares outstanding over the last decade. There were 626 million shares outstanding in 2007, then the number of shares went down to 589 million in 2011 and 577 million in 2016. Currently there are 568 million shares outstanding.

This data suggests the company has been repurchasing about 6 million shares per year. We're going to rely on the company's historical share repurchase activities to guide our estimation process. That is, we project share repurchases of 6 million per year over the next five years.

With shares estimated at 539 million in five years, EPS is expected to grow at a compound rate of 5% over the period. This is slightly higher than our projected five-year revenue growth rate. Note that it doesn't always work out this way. Based on this EPS growth forecast, we are expecting EPS of $2 five years out. Results of our forecasting procedure are summarized in the table below.

Table 2: Path from projected sales to projected earnings

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Forecasting a target P/E multiple

Now we need to take a look at the price history of the company's stock. From Figure 3, we can see that the spread between the high and low stock prices has been holding steady. We have a current price of $52.12, with a high in the past 10 years of $53 and a low of about $19. We want to keep this steady variability in mind when establishing our upper and lower valuation range. Specifically, given the firm's historical stock price behaviour, we should expect the stock to fluctuate by about $6.45 over the course of a year.

Figure 3: Stock Price History: Close, High, Low

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Sysco’s stock has traded at moderately consistent price-to-earnings (P/E) multiples over the last decade, averaging 20 over the last 10 years, 24 over the last five years and 29 over the last three years. Currently the firm is trading at 32 times trailing 12-month earnings per share and 22 times expected future earnings.

For determining an estimated target P/E multiple, the first thing we like to do is eliminate any outliers from the historical data series. This includes abnormal P/Es that are not reflective of the normal operations of the firm, and this could be the result of abnormal growth or significant one-time nonrecurring charges/gains. In the case of Sysco, we are going to keep the historical series intact. The next thing we like to do is to run an optimization procedure that reveals what P/E multiple yielded the best forecasting accuracy over the evaluation period. If in our judgment this multiple continues to accurately portray the earnings and cash generating power of the company as well as the growth and risk characteristics of the firm, then we will use this multiple as our target multiple. If not, we will adjust the multiple upward or downward accordingly.

The figure below presents the historical P/E profile for Sysco. We will utilize a target P/E multiple of 20x that reasonably characterizes the risk-return attributes of the company's stock. This multiple represents a contraction of 37% relative to the current multiple. It also represents a contraction of 10%, 23% and 36% relative to the three-year, five-year and 10-year average P/E multiples.

Figure 4: Historical P/E multiple and target point of reversion

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Setting a target price and valuation range

We selected a target P/E multiple of 20x. To determine a price target five years out, we then multiply this by our EPS estimate. EPS are estimated to reach $2.09 in five years giving us a target price of $41.79. Now, this price is significantly lower than the current price. It’s more in line with where the stock traded two to three years ago. Nonetheless, to properly judge the extent to which the stock may be under or overvalued, we need to determine a fair value range within which we expect the stock to trade. To do this we rely on the average annual trading range for the stock, which from the analysis above we know is $6.45. This means that, given our target price estimate, we expect the stock to trade naturally, and fairly, between $39 and $45. The result of this is that when the stock is trading below $39 it is in the Buy Zone and when the stock trades above $45 it is in the Sell Zone.

Conclusion

So what return can we expect for holding Sysco's stock? Well, we now know we can expect stock price appreciation of 20%. We can also expect to earn dividend income of about $6 over the evaluation period. Added to our price estimate, this means we could earn a compound annual rate of return of 2%, provided our estimates prove accurate. All in all, we are happy with this company but are not happy with the return potential it offers. Keep this company on your watchlist and consider a purchase if its stock price falls below $38.56.

Disclosure:Ă‚ We do not hold any positions in Sysco.

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