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A Spicy Outlook for Sysco

By Joseph Agnese Though its name sounds exactly like that of a certain computer-networking giant, Sysco (SYY) has made its mark in a decidedly different business: It's the largest marketer and distributor of food-service products in North America. We at Standard & Poor's recently raised our 12-month target price on Sysco to $38, from $34, as we see it benefiting from continued growth in the so-called food-away-from-home industry, a weakened major competitor, and continued gains in operating efficiency. The stock carries our highest investment recommendation of 5 STARS (buy).

Since the company's formation in 1970, when shareholders of nine companies exchanged their stock for Sysco shares, it has grown dramatically, with sales climbing from $115 million to over $26 billion in fiscal 2003 (ended June). Growth has come from both expansion of its existing businesses and acquisitions of other foodservice outfits, with around 100 such deals completed since its founding.

Operating from nearly 147 distribution facilities and self-serve centers throughout the continental U.S., Alaska, and parts of Canada, Sysco holds a 13% share of the foodservice industry in the U.S. and Canada. The company provides products and services to approximately 415,000 restaurants, hotels, schools, hospitals, retirement homes, and other food-service operations -- nearly anywhere a meal is prepared away from home.

DISTRIBUTION LOCK. The majority of sales are generated from chain-restaurant customers (63% of the total in fiscal 2002), including regional pizza and national hamburger, chicken, and steak outlets. The company also supplies hospitals and nursing homes (10%), schools and colleges (6%), hotels and motels (6%), and other businesses (15%). Sysco's largest customer, Wendy's (WEN), accounted for just over 5% of total fiscal 2002 sales.

We project sales to grow approximately 8% to 10% in fiscal 2004, spurred by modest food-cost inflation and further expansion of its business units serving larger dining chains and independent restaurant operators.

The company typically locks customers into distribution contracts for one-week to one-month periods, which may temporarily pressure gross margins during periods of quickly rising inflation. In many cases, those contracts will commit the customer to purchase products at a stated percentage rate above Sysco's cost. For example, as the rate of wholesale inflation quickened in the first half of 2003, Sysco's margins were pressured as it absorbed increased product costs.

MARGIN BOOST. However, as we expect inflation to moderate in fiscal 2004, customer contracts should allow Sysco to maintain its gross margin while, more importantly, reaping a higher overall gross profit. In the company's view, a 1% to 2% inflation rate is optimal for maximizing profitability. In all, we expect gross margins to widen slightly in fiscal 2004, aided by increased sales to independent restaurants, which offer wider margins than provided by Sysco's chain restaurant business. Gross margins should also benefit from an increased proportion of sales of private-label products.

Meanwhile, we see operating margins continuing to benefit from productivity improvements resulting from a company-wide information-systems implementation. Partially offsetting these improvements, Sysco anticipates incurring expenses related to the construction of redistribution centers as part of a supply-chain project.

Still, those expenditures should help boost efficiency down the road, in our view, as the project is expected to create a more effective supply-chain infrastructure. The first such center, serving the northeastern U.S., is expected to be operational in the summer of 2004. As it ramps up business, we do not expect it to benefit operational profits until 2005.

All told, we see the company reaching its 27th consecutive year of earnings growth, and estimate fiscal 2004 earnings per share of $1.36, up 15% from the $1.18 posted in fiscal 2003.

SHOPPING AROUND. Sysco expects growth in real sales (adjusted for acquisitions and food cost inflation or deflation) of 5% to 7% and net sales (unadjusted) of 9% to 12%, reflecting food cost inflation of 1% to 2% and acquisition benefits of 3%. We believe these goals are attainable as the company has achieved a compounded annual growth rate over 10% in the past 5- and 10-year periods, respectively.

To achieve these goals, Sysco is focused on developing its customer relationships and expanding the percentage of products its customers buy from the company (currently 35%). Additionally, it is building its sales force with attention on adding employees who will focus on value-added, higher-margin sales to independent restaurants. To supplement this growth, Sysco continually looks for acquisitions that will open new markets or add to its product portfolio.

The company has consistently improved margins throughout its history. We see plenty of reasons why this trend should continue. As Sysco expands, it attains an increasing amount of leverage with its suppliers. We believe this will allow it to progressively achieve lower costs and improve gross margins. Additionally, its strategy of increasing branded product sales, building its independent restaurant business, and completing complementary acquisitions has created more value for its customers, in our view, while allowing Sysco to expand margins.

EARNINGS FORECAST. We believe the company is operating within a favorable environment, with growth of the food-away-from-home market continuing to expand and given the public disclosure of financial troubles at major competitor U.S. Foodservice, a unit of Ahold (AHO). Additionally, with its major competitor having financial difficulty, we contend that risks of pricing competition have eased. Reflecting our expectations for solid revenue growth and continued margin expansion, we believe EPS growth at a percentage rate in the mid-teens is certainly attainable.

On a per-share basis, we project Standard & Poor's Core Earnings of $1.30 in fiscal 2004, after adjusting for 6 cents of stock-based compensation expense. This represents a difference of 4.4% from our operating EPS estimate for the year.

Our valuation of Sysco shares is based on a combination of two metrics: price-to-earnings and

discounted cash flow. Based on our fiscal 2004 EPS estimate of $1.36, the shares recently traded at a p-e of about 22.5. With positive industry conditions, improving industry fundamentals, and a favorable long-term outlook, we believe the shares are undervalued at this level. Assuming the stock returns to its five-year average p-e level of 28, we arrive at a share price of $38.

RISKS AND POSSIBILITIES. Assuming Sysco can achieve its long-term revenue and earnings goals, as we outlined earlier, and with our expectation for capital expenditures as a percentage of sales to remain stable, we derive an intrinsic value, based on our discounted cash-flow analysis, of $37. That figure suggests that the stock was recently trading at a discount of 17% to fair value.

Blending our two valuation methods, we arrive at a 12-month target price of $38. That represents appreciation of about 24% from the stock's recent level.

There are some risks to our earnings estimates and target price for Sysco. They include: competitive pricing pressures, an unexpected rise in fuel or other transportation related costs, and the inability to acquire adequate supplies of its food-service products as a result of job-action strikes by employees of suppliers. Other potential risks include adverse weather or crop conditions, natural disasters or other catastrophic events, a failure to effectively negotiate labor union contracts, and an inability to integrate acquired businesses successfully. Analyst Agnese follows food-retailing and foodservice stocks for Standard & Poor's

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