Philippine Markets Daily

Distributors are often low-margin businesses, but this firm bucks that trend thanks to its massive scale, delivering Uniform ROAs of 10%+ as a result

March 25, 2021

In a typical supply chain, distributors act as middlemen, matching manufacturers (sellers) with retailers (buyers). In this business, there’s not a lot of room for product differentiation, and customer switching costs are relatively low.

Distributors therefore have to compete on price—offering as low a price as they can go. This means that they are usually low-margin businesses. However, this food distributor is not only competing on price, but also on scale.

While as-reported metrics show that this strategy didn’t make much of a difference relative to other low-margin distributors, Uniform Accounting reveals that competing on scale has helped it buck the low-margin expectations.

Also below, Uniform Accounting Embedded Expectations Analysis and the Uniform Accounting Performance and Valuation Tearsheet for the company.

Philippine Markets Daily:
Thursday Uniform Earnings Tearsheets – Global Focus
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When we talk about efficiency, we often think about it as doing x amount of work using as little resource as needed by cutting out the non-essentials. In that context, would having a distributor be inefficient management for the supply chain?

The typical supply chain consists of manufacturers, distributors, retailers, and the consumers. Distributors act as the middlemen between manufacturers and retailers—they purchase the products from manufacturers and sell them to the retailers.

However, to be more efficient, would it make sense to just do away with distributors and have retailers connect directly with manufacturers? The answer is no. Distributors actually provide a vital role in the supply chain.

Instead of having to go to multiple suppliers, distributors essentially act as one-stop shops for retailers. For example, supermarkets, restaurants, and hotels would find it much easier to have their food supply come from one place (the distributor) as opposed to individual suppliers for meat, vegetables, and other products.

So, contrary to expectations, having distributors as middlemen does in fact improve the efficiency of the supply chain. Although, even with their importance, distributors aren’t stellar businesses themselves.

Other than the quality of products and the amount that they carry, there’s not much room for product differentiation. This means that there’s high incentive for one customer to switch from one distributor to another.

This also means that distributors largely compete on price, offering as low as they can go, which is what makes them low-margin businesses.

Still, Sysco Corporation (SYY), a food distributor and consistent Fortune 500 company, manages to be successful. It’s because it competes not only on price, but on scale as well through the expansion of its distribution network.

To do this, Sysco developed the fold-out strategy to establish distribution centers in entirely new markets in order to take as much market share as possible. It has also acquired a number of companies in the foodservice industry to expand its products and services, as well as its market share.

In fact, when Sysco tried to dominate the market by acquiring its closest competitor, U.S. Foods (USFD), the Federal Trade Commission had to block the deal due to anti-competition concerns—Sysco would have simply been too powerful.

Instead, the company diverted its excess funds towards the acquisition of Brake Bros., a leading foodservice company in the UK, France, and Sweden. While this didn’t help Sysco take control of the U.S. foodservice market, it helped expand its international footprint, in addition to other international acquisitions such as SERCA Foodservices, Asian Foods, and Pallas Foods.

Sysco now has 326 distribution facilities worldwide and a market share of 16%, a lot more than U.S. Foods’ 70 distribution facilities and a market share of about 8%.

The company’s goal of growing its scale domestically and internationally through the expansion of its distribution network seemed to have been a success, although as-reported return on assets (ROA) of sub-10% levels doesn’t make it seem that way.

In reality, Uniform return on assets of 10%+ show that Sysco’s strategy of taking market share through scale expansion has helped it become more profitable.

The distortion between Uniform and as-reported ROAs comes from as-reported metrics failing to consider the amount of goodwill on Sysco’s balance sheet. In recent years, goodwill sits close to $4 billion, about two-thirds of its total long-term assets, stemming from the company’s acquisitions to expand its footprint.

Goodwill is an intangible asset that is purely accounting-based and unrepresentative of the company’s actual operating performance. When as-reported accounting includes this in a company’s balance sheet, it creates an artificially inflated asset base.

As a result, as-reported ROAs are not capturing the strength of Sysco’s earning power. Adjusting for goodwill, we can see that the company isn’t actually performing poorly. In fact, it has been the opposite, with returns that are nearly 2x greater.

Sysco is actually more robust than you think it is

As-reported metrics distort the market’s perception of the firm’s recent profitability. If you were to just look at as-reported ROA, you would think the company is a much weaker business than real economic metrics highlight.

Sysco’s Uniform ROA has actually been higher than its as-reported ROA in the past sixteen years. For example, as-reported ROA was 5% in 2020, but its Uniform ROA was actually 2x higher at 10%.

Specifically, Sysco’s Uniform ROA has ranged from 10% to 22% in the past sixteen years while as-reported ROA ranged only from 5% to 12% in the same timeframe. Uniform ROA slowly compressed from 20% in 2005 to 11% in 2015, before rebounding to a peak of 22% in 2019. It has since fallen to 10% in 2020 due to pandemic headwinds.

Sysco’s Uniform earnings margin is weaker than you think, but its Uniform asset turns make up for it

Uniform ROAs have been driven by trends in both Uniform earnings margin and Uniform asset turns.

Uniform margins have generally been stable, sustaining 3%-4% levels from 2005 to 2019, before falling to 2% in 2020. Meanwhile, Uniform asset turns have followed the same trends, maintaining 4.2x-5.7x levels through 2020.

At current valuations, the market is pricing in expectations for Uniform margins and Uniform turns to rebound from current levels.

SUMMARY and Sysco Corporation Tearsheet

As the Uniform Accounting tearsheet for Sysco Corporation (SYY:USA) highlights, the Uniform P/E trades at 35.7x, which is above the global corporate average of 25.2x and its historical Uniform P/E of 31.3x.

High P/Es require high EPS growth to sustain them. In the case of Sysco, the company has recently shown a 56% decline in Uniform EPS.

Wall Street analysts provide stock and valuation recommendations that provide very poor guidance or insight in general. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Sysco’s Wall Street analyst-driven forecast is a 10% EPS shrinkage in 2021, followed by a 85% EPS growth in 2022.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Sysco’s $80 stock price. These are often referred to as market embedded expectations.

The company is currently being valued as if Uniform earnings were to grow by 18% per year over the next three years. What Wall Street analysts expect for Sysco’s earnings growth is below what the current stock market valuation requires in 2021, but above its requirement in 2022.

Furthermore, the company’s earning power is twice the corporate average. Also, cash flows and cash on hand are nearly 2x higher than its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low dividend and credit risk.

To conclude, Sysco’s Uniform earnings growth is below its peer averages, but the company is trading above its average peer valuations.

About the Philippine Market Daily
“Thursday Uniform Earnings Tearsheets – Global Focus”

Some of the world’s greatest investors learned from the Father of Value Investing or have learned to follow his investment philosophy very closely. That pioneer of value investing is Professor Benjamin Graham. His followers:

Warren Buffett and Charles Munger of Berkshire Hathaway; Shelby C. Davis of Davis Funds; Marty Whitman of Third Avenue Value Fund; Jean-Marie Eveillard of First Eagle; Mitch Julis of Canyon Capital; just to name a few.

Each of these great investors studied security analysis and valuation, applying this methodology to manage their multi-billion dollar portfolios. They did this without relying on as-reported numbers.

Uniform Adjusted Financial Reporting Standards (UAFRS or Uniform Accounting) is an answer to the many inconsistencies present in GAAP and IFRS, as well as in PFRS.

Under UAFRS, each company’s financial statements are rebuilt under a consistent set of rules, resulting in an apples-to-apples comparison. Resulting UAFRS-based earnings, assets, debts, cash flows from operations, investing, and financing, and other key elements become the basis for more reliable financial statement analysis.

Every Thursday, we focus on one multinational company that’s particularly interesting from a UAFRS vs as-reported standpoint. We highlight one adjustment that illustrates why the as-reported numbers are unreliable.

This way, we gain a better understanding of the factors driving a particular stock’s returns, and whether or not the firm’s true profitability is reflected in its current valuations.

Hope you’ve found this week’s Uniform earnings tearsheet on a multinational company interesting and insightful.

Stay tuned for next week’s multinational company highlight!

Regards,

Angelica Lim
Research Director
Philippine Markets Daily
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