Sysco Corporation: the Emporor Has No Clothes
Lots of smart folks have historically liked Sysco Corporation as an investment.* I don’t get it. I mean, I get it, but I don’t “GET” it. What I get is this: Sysco is the dominant food service distributor in the U.S. It’s huge. It has economies of scale. It has a terrific dividend of 3.72% as of this writing, with a sustainable payout ratio of only 53%, and has become a dividend aristocrat. It is not going anywhere. As companies go, it is about as close as you get to “safe.” Unsurprisingly, it strongly outperformed the market during the crash year of 2008.** But it’s not for me, because it seems actually to be declining, and in my view it just does not generate enough free cash flow to justify even its apparently cheap valuation today.***
First of all, looked at over the past ten years to April 2002, Sysco has underperfomed the S&P price index by 25%, and when compared to the S&P total return index (which includes reinvestment of dividends), it has underperfomed that index by OVER 52% looking back 10 years from today. Ouch. (Note that that chart uses only Sysco’s price, without dividend-reinvestment, but this is only responsible for part of the underperformance.)
More importantly, this underperformance does not appear to have been driven merely by a significant prior overvaluation of SYY stock relative to the index. (For a totally contrasting example, look up Microsoft’s charts and earnings/FCF growth.) To be blunt about it, Sysco has had no significant and sustainable free cash flow growth at all in the last decade. (More on that below.) Relatedly, its asset turnover, return on assets, gross margin, and operating margins, are all at or near decade lows. See here for the key ratios, to see that I am not making this stuff stuff up.
According to my free cash flow spreadsheet here, wherein I use among other things an average of the past ten years cash flow, it’s hard for me to construct a scenario I am pleased with in which Sysco is fairly valued, let alone undervalued. And that’s using an extremely friendly WACC of 7.1%, the most friendly to Sysco that I could find, as the discount rate. (If you use a 10% discount rate, or more…, “fuggetaboudit.”)
Here is the bottom line: you need to assume 10 years of 7.5% annualized FCF growth, plus 2% perpetuity, just to be able to tell yourself you are getting Sysco for fair value. And you have to be able to assume greater than 10.5% annualized FCF growth for the entire next decade to think you are gettting it at a 20% discount to fair value, assuming Friday’s closing price of $29.03/share. You you can count on some extra pop in that number over time, because Sysco has been reducing its share count modestly, but these numbers, particularly the latter growth number, just do not seem realistic at all.
Now let’s talk a little more about FCF in more detail. In four of the past eight years, dear reader, free cash flow at Sysco has been less than what it was in 2002. In two years, 2008 and 2009, Sysco had vastly higher free cash flow than in any other years this past decade. The big question for an investor regarding free cash flow, and Sysco, is this: were the very high 2008 and 2009 FCF figures an aberration from Sysco’s “low-to-no” FCF growth trend? Or did they mark the start of a new ”growthier” trend, which would make the very low FCF of the 2010 and 2011 accounting years an aberration from that new trend?
I don’t have a final answer on that. But there are clues. Note there was zero FCF growth at Sysco from 2002 to 2006. Nadisimo! ничто! Look at the most recent few years of cash flow statements here. Notice first that in 2009 there were $325 million in income taxes payable included in the operating cash flows. That’s a pretty classic questionable cash flow source, and without it, FCF would only have been $793 million, still high, but much more in line with the prior low-to-no growth trend. And if you take out the positive $122 million in “other working capital” for that year — the only year in the last five where that has been positive, then you fall down to a normal level for Sysco of $671 million in FCF. (Also, 2009 showed exceedingly low investments in property, likely for reasons of fear, and if you up that by $100 million then you are down closer to the past two years’ lower-than-normal levels.)
As for 2008, that cash flow statement is not as blatantly unusual-looking to me. I note that investments in property also seem lower-than-trend by around $100 million. Note too the massive portions of both 2007 and 2008 operating cash flows ($643 million in 2008) that were actually comprised of “deferred income taxes.” That amount reflects a deduction that had to be made for balance sheet purposes (and is added back on the cash flow sheet), to reflect that income had been earned that year but because of tax law, the company did not have to pay taxes on the income in the same year it earned it. So this is essentially a “drawing forward” of some future operating cash flows into 2007 and 2008. That is because the company will have to pay the taxes later, at which point they will reduce net income, and free cash flow.
In short, I’m just not that into Sysco. I don’t think its sustainable future free cash flows remotely justify a “margin of safety” buy at today’s price. In fact even to make the stock ”fairly valued” at today’s price, you have to assume growth in the next ten years that it simply has not even come close to achieving in the past ten. Assuming a company can continue its prior growth, even at a slowed pace, is one thing. It’s still problematic, even though all FCF analyses are based on it. But assuming a company will show way more growth than it has apparently (unless I’m wrong about my parsing of the cash flow sheets) shown in the last ten years? No thanks. Not for me. I don’t care how high the dividend is, or how low the beta is.****
What am I missing here?
* Among others, Josh Peters, Morningstar’s long-time dividend-stock guru, focused on it positively in his 2006 book on dividend-investing, The Ultimate Dividend Playbook (See pages 52-55.) Morningstar currently gives it a 4-star buy rating as of the date of this blog post. Eddy Elfenbein of Crossing Wall Street, whose buy list has outperformed the SYP for each of the last five years from 2006, has had Sysco on that list each of the six years including this one. The only two years it individually outperformed the market were 2006, and (predictably) 2008.
** I would speculate that this is why Eddy owns and recommends the stock, nd why it’s on the lists of many a dividend investor. It pays you today, and it’s a hedge against black swans and general market dives, in such adverse scenarios it is virtually assured of outperforming the indexes, if only for a short time.
*** I’m not an expert. I’m not a trained financial analyst. To the extent I am trained or have any expertise at all, I am entirely self-taught. I’m human and I make mistakes. (All too many mistakes…sigh.) This post is not a recommendation to buy or sell Sysco or any other stock. For my full disclaimer see here. I welcome any criticism or suggestions.
**** Note at least one cash flow analysis, performed in a different manner than my own, shows SYY to be a strong buy. This analysis assumes annualized 3% growth in revenue and that FCF will comprise a set percent of that. I’m not sold.
UPDATE: 4/23 — yes, I realize I mis-spelled “emperor”.