This Food Supplier Is Still in the Early Innings of Growth

The most profitable investment opportunities are found with companies in the process of developing their competitive advantage, as opposed to those that have already developed theirs. This is because the stock market tends to factor in the positives for the latter group into stock prices.

The Chefs' Warehouse (NASDAQ: CHEF  ) , a premier distributor of specialty-food products to restaurants -- with a specific focus on menu-driven independent restaurants -- belongs to the former category. It is currently increasing its customer base and route density to take advantage of economies of scale.

Economies of scale in distribution
All distribution businesses are about economies of scale, particularly with respect to increasing route density. When a delivery van transports goods from one point to another, most of the costs associated with one round trip are largely fixed. These include depreciation or leasing expenses for the vehicles, wages for the driver, and fuel costs.

If Chefs' is able to secure more business and achieve more stops per route, every additional dollar of revenue flows straight to the bottom line after covering fixed costs. The same operating-leverage effect comes into play if each customer orders a larger quantity of products from Chefs'.

As of the end of 2012, Chefs' served more than 12,500customer locations in the U.S. with significant potential for expansion in the fragmented specialty-food- distribution industry. In contrast, Sysco (NYSE: SYY  ) , the largest food-products supplier, claims to serve about 425,000customers.

Customer price sensitivity
Comparing the financial performance of Chefs' and Sysco for the past four years, Chefs' has consistently delivered higher gross profit margins of 26%. In contrast, Sysco achieved comparatively lower gross margins of 17%-19%. I believe that the relatively lower price sensitivity of Chefs' customers holds the key to its superior profitability.

Firstly, Chefs' enjoys a significant edge over the competition, allowing it to charge a price premium. Broad-line food-service distributors are generally unable to serve the needs of their customers very well because of their diversified clientele comprising restaurants, hotels, schools, and hospitals. In contrast, Chefs' has a more focused customer base of high-end restaurants and has in place a team of dedicated sales professionals with culinary experience to meet their needs.

Small independent specialty distributors are also not able to match up to Chefs' in terms of the depth of its specialty-products offerings. As a comparison, Chefs' boasts of close to about 15 times the number of stock-keeping units (SKUs) that a typical specialty distributor offers. In a bid to get the exotic spices needed for their masterpiece offerings, chefs are willingly to pay more for Chefs' products.

Secondly, quality matters more than price for Chefs' customers, who have a high proportion of independent restaurants as opposed to restaurant chains. The restaurant business is highly competitive and there is a limited number of ways to build strong customer loyalty. In addition to factors such as exceptional customer service and choice locations, the quality of food is the key to drawing customers into their restaurants and converting them into repeat customers.

Future outlook
For the second quarter of fiscal 2013, Chefs' grew organic revenue and pro forma diluted earnings per share by 8.5% and 13%, respectively, to $9.8 million and $0.26, respectively. On the back of expected synergies from its May acquisition of Qzina Specialty Foods, a supplier of gourmet chocolate, dessert, and pastry products, Chefs' is guiding for a 15% increase in pro forma diluted EPS based on the lower end of its forecasts.

Going forward, Chefs' is targeting to increase both existing customer penetration and the number of new customers. As it grows, Chefs' is poised to see significant margin expansion with the realization of economies of scale.

Apart from organic growth, acquisitions also help Chefs' to achieve its targets. For example, its recent acquisition of Qzina allowed it to realize cost synergies through the consolidation of delivery logistics.

Peer comparison
Chefs' peers include Sysco and Core-Mark (NASDAQ: CORE  ) .

Sysco is the largest food-service distributor in the U.S. with about 18% of market share. It has a diversified customer base, with non-restaurant customers such as hotels, hospitals, and schools representing about 40% of its revenue. In the fourth quarter of fiscal 2013, Sysco increased quarterly revenue by 5% but saw the gross margin compress by about 60 basis points.

I am of the opinion that the decline in Sysco's gross margin is partly attributable to competition from players such as Amazon Fresh and group-purchasing organizations. I also believe that Chefs' is relatively more shielded from such competitive pressures because of its niche focus on high-end independent restaurants and its culinary-trained staff who can relate better to the customers.

Core-Mark is U.S.' largest distributor of fresh products to convenience stores. It grew net sales by 10% for the second quarter of fiscal 2013. Notwithstanding the broad decline in cigarette sales, its top line actually increased 14%. It is a beneficiary of the increased focus on fresh food and growth in single convenience stores.

Core-Mark's main customers are single convenience stores, which are not sufficiently large to leverage economies of scale from direct sourcing. Over the 12-year period through 2012, single convenience stores grew twice as fast as the entire convenience-retail industry and now account for 62% of all U.S. convenience stores compared with half of the industry in 2010.

Conclusion
Chefs' trades at a premium to its closest comparable, Sysco, with a forward P/E of 20. In comparison, Sysco is valued by the market at 16 times forward P/E. However, I believe that Chefs' valuation premium is justified, given its superior profitability in terms of its gross margin. Furthermore, it has the ability to increase its market share in the fragmented specialty-food-distribution industry by virtue of its broad product range.

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