Sysco Initiated at Neutral

We are initiating coverage on Sysco Corp. (SYY) with a Neutral recommendation, as the company has been posting positive surprise in the last four quarters on the back of strong inorganic growth, making up for the weak economic environment.

Why Neutral?

On Nov 4, Sysco delivered first quarter fiscal 2014 results beating the Zacks Consensus Estimate for both earnings and revenues. Earnings of 56 cents however declined 3.4% from the prior-year quarter due to weak restaurant traffic led by lower consumer spending.

Sysco's sales grew 5.7% on a year-over-year basis to $11.7 billion in the first quarter of fiscal 2014, driven by 3.0% volume growth (including acquisitions). Acquisitions contributed 2.3% to sales growth, while currency translation decreased sales by 0.5%.

Gross profit improved only by 1.8% to $2.1 billion in the quarter due to ongoing competitive pressure and unfavorable shift in customer mix. Gross margin declined 68 basis points (bps) to 17.63%. Adjusted operating income declined 2.7% in the quarter to $478.0 million due to higher adjusted operating expenses.

Overall, we appreciate the company’s growth strategy and its efforts to reduce costs and improve efficiency. The company has employed different initiatives to reduce costs under its Business Transformation Project. The company’s goal for this project is to generate approximately $550 million to $650 million in annual benefits to be achieved by fiscal 2015. In fiscal 2013, the company realized approximately 25% of the total benefit, while in fiscal 2014 the company expects to achieve approximately 50% to 70% of the total targeted benefit.

Sysco operates in a highly fragmented industry. Therefore, it believes in growing through acquisitions to expand its distribution network and customer base and boost long-term growth. During fiscal 2013, the company acquired 14 companies, which represent annualized sales in excess of $1 billion.

Sysco expects to achieve 0.5%–1% sales growth through acquisitions in the long term. Other than sales growth, these acquisitions will also enhance its presence in the international market.

However, Sysco has been witnessing declining gross margins since the last two fiscal years due to multiple factors. The slow rate of recovery in the foodservice market has created competitive pricing pressure for its products, which in turn is negatively impacting gross profit. Sales from the locally-managed business, including independent restaurant customers, have not grown at the same rate as sales to regional and national customers.

However, the gross margin rate from regional and national customers is generally lower than other types of customers. This unfavorable mix of consumers is hurting margins. We are also concerned about rising costs, which may hurt margins in future quarters.

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