A Good Company in a Poor Industry

Even though management is crucial for the success of a company, the type of industry and business it is in is also very important. Warren Buffett once said that he prefers to buy companies that are so easy to run that they can be operated by a fool, "because someday a fool will". He also said that "when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact".

Why am I saying this? Well, because I think I've found a great company with great management but in an industry with relatively poor economics. And I'm not talking about airlines.

Consider SYSCO (SYY), a food distributor company. SYSCO sells prepared and raw food and food-related products to restaurants, healthcare and educational facilities, lodging establishments and other food service customers.

SYSCO's results over years have been pretty good. In the last 10 years SYSCO has:
  • Increased its dividend by an annualized 17%.
  • Increased earnings-per-share by an annualized 13%.
  • Reduced outstanding shares to 600 million from 670 million.
  • Had an average ROE of 31.9% (with an average leverage of 2.91).
  • Grown sales an annualized 8%.
  • Grown free cash flow by an annualized 14.6%.
A pretty impressive achievement for a company of its size, $12 billion market cap.

On the other hand, consider the difficulty of achieving these results. This company depends heavily on commodity prices (fuel and food), has limited pricing power, achieves only minimal differentiation from competitors based on services since its products are very similar to those of competitors, and is highly dependent on the North American market for the bulk of its earnings.

Food Prices and Pricing Power.
SYSCO buys food to sell to customers. Therefore it's exposed to food prices. In its most recent 10Q report, they say "Sysco attempts to pass increased costs to its customers; however, because of contractual and competitive reasons, we are not able to pass along all of the product cost increases immediately".

Considering that their products are similar to that of the competition, they must compete on higher-quality services and price. Therefore, the economics of this type of industry are not great. Compare that with products such as J&J's Band-aid, P&G's Gillette razors, WD-40 and Coca-cola. No one will choose a cheaper brand, even if the difference in price is 10, 20 or 30%. But customers of SYSCO do care if prices are 5 or 10% lower, especially if the product is very similar.

Fuel Costs. SYSCO is also exposed to fuel costs, since they deliver the food using their own trucks. SYSCO attempts to hedge fuel costs by entering forward diesel contracts. About 70% of their fuel expenses are on the basis of fixed-price agreements. However, this means they need to make bets on the direction of oil prices. In 2008, the company entered forward-contracts when oil prices were high and thus had to pay higher prices for diesel than spot market prices during the year. Management says
We periodically enter into forward purchase commitments for a portion of our projected monthly diesel fuel requirements to lessen the volatility of our fuel costs due to changes in the price of diesel. In the first 39 weeks and third quarter of fiscal 2009, our forward purchase commitments resulted in an estimated $50,000,000 and $22,000,000, respectively, of additional fuel costs as the fixed price contracts were higher than market prices for the contracted volumes.
(emphasis mine).

On the flip side, now that oil has dropped form last year's peak, SYSCO is enjoying lower fuel costs and is thus immune to increases for the duration of the current contracts. Over the long run, I expect such agreements to have no positive effect on earnings, as the ups and downs in the price of the contracts serve only to smooth volatility in fuel costs, but does not reduce fuel costs (to understand why, just think of the investor on the other end of these contracts).

Hence, SYSCO is squeezed between higher food prices that can't be passed on to customers automatically and higher fuel costs that are hard and expensive to manage. This means an investment in SYSCO is probably a bad hedge against inflation.

In fact, management recognizes this much: "Prolonged periods of high inflation, such as those we have recently experienced, have a negative impact on our customers, as high food costs and fuel costs can reduce consumer spending in the food-prepared-away-from home market".

SYSCO's net earnings as a percentage of sales has recently been in the 2.6 to 2.8% range. Compare that with Coca-cola's 18% and J&J's 23%.

Conclusion. SYSCO is a well-run company, in a stable and somewhat profitable market with large and stable demand. The company has a 16% share of a $231 billion a year market. However, the economics of this industry are not appealing and a fool could not run this company successfully for very long. Therefore, investing in SYSCO is making a bet in its management and in a deflationary to mild-inflationary times ahead.

At reasonable prices, SYSCO is an appealing buy. But it's a company one needs to watch the fundamentals very closely and be ready to sell when fundamentals deteriorate.

Disclosures: I own SYSCO at the time of writing.

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