Though we'll likely raise our fair value estimate by a dollar or two on the narrow-moat firm, we don't view the risk/reward opportunity as attractive.
Erin Lash, CFA
03:21 PM | Email Article
Profit improvement persisted for narrow-moat Sysco
in the second quarter, as adjusted gross margins increased 55 basis points to 18.3% and adjusted operating margins edged up 47 basis points to nearly 4.1%. In light of this performance and the gains realized through the first half of a three-year cost-restructuring plan, which is slated to be completed by the end of fiscal 2018, management ticked up its operating income improvement target to $600 million-$650 million from at least $500 million previously.
Erin Lash, CFA, is a director of consumer sector equity research for Morningstar.
While we intend to review the assumptions underlying our discounted cash flow model, incorporating the updated profit targets will marginally boost our long-term margin forecast beyond the 5% operating margins we had previously expected, which was about 100 basis points above the level generated in fiscal 2016, and probably likely bolster our $46 fair value estimate by $1-$2 per share. Even though the shares fell at a mid-single-digit rate after the earnings release, we don’t view the risk/reward opportunity as attractive, with Sysco still trading at a 10% premium to our valuation.
Despite the profit gains, top-line growth slipped 0.2% on an organic basis, constrained by intense competition in an environment of languishing restaurant traffic trends. While deflationary trends persist, with management calling out 1.8% food cost deflation in its U.S. broadline business, we believe this pressure could become more pronounced if food cost inflation emerges, particularly in the dairy, protein, and produce categories. We think Sysco would be forced to bear the brunt of any pronounced upticks in costs, hampering profits, or risk losing share. However, we're holding the line on our narrow moat rating, which is based on the firm’s expansive distribution scale (with sales more than 2 times its next-largest competitor), which enables it to leverage the high level of fixed costs that plague the industry.
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