Next time you order milk at a restaurant, imagine the journey it took to get to you. The cow it came from was likely milked by a machine, then the milk stored in large vats. From there, it goes to a lab to get tested. Once it passes inspection, it is then pasteurized, homogenized, and separated. After that, it is packaged, and takes a journey -- sometimes long, sometimes short -- to your restaurant of choice.
By ordering the milk, you inherently trust that it is safe to drink. But would you feel the same way if you knew that -- during the journey to the restaurant -- it sat for hours in an unregulated storage locker, with temperatures allegedly up to 105 degrees Fahrenheit?
Stomach-turning as it sounds, those are the accusations that Sysco (NYSE:SYY) confirmed earlier this month. These revelations are important for investors both in terms of how the company is run, and what ramifications it might have to face for its questionable practices.
It all started in San Francisco
In early July, NBC's San Francisco affiliate filmed Sysco trucks storing "meat, dairy, and fresh produce [where it was] being kept for hours in those public storage lockers where you might put your old furniture. They're outdoors, they're hot, and they're certainly not approved to store things like raw chicken or milk."
At first, Sysco only admitted that this was a practice common at its 14 Bay Area "drop sites". But by September, the NBC affiliate had uncovered similar practices in 10 other states, the District of Columbia, and Canada.
The other shoe finally dropped on Sept. 6, when company CEO Bill DeLaney issued a press release stating that the company has "discontinued operation of all drop sites across Sysco."
Not only is this serious because the company reportedly was knowingly keeping these drop sites out of health inspectors' purview by not registering them with California but according to Dr. John Ryan -- a food safety expert focusing on safe food supply chains -- "as soon as the food gets over a 41 degree level, bacteria is going to double every few minutes," Ryan told NBC Bay Area.
How this could damage shareholders
As far as I can tell, there are three distinct threats the company faces as these revelations become known. The first is in the form of fines. In California those fines could be up to $1,000 for each and every violation.
With the practice allegedly having taken place for up to a decade, and 21 drop sites reported in California, the fines could be steep. Add in the fact that Canadian authorities are now investigating, and that 10 other states and the District of Columbia could get involved, and the pain could go well beyond what's happening in California.
The second threat comes in the form of margin compression. Renting out a storage locker is no doubt much cheaper than buying a fleet of refrigerated delivery vans for dropping off perishable foods. As the company is forced to either dump the smaller clients served by the drop sites or purchase expensive equipment to ensure safe delivery, there's less money that will make it from the top down to the bottom-line profit.
Where the real damage could be done
Over time, the previous two concerns shouldn't cause the company or investors to hit the panic button. Sysco had $44.4 billion in sales last year, with $992 million in profit. Though fines could be hefty, they will be a one-off event. And though purchasing new equipment might be expensive, it's definitely the right long-term move for the company.
Instead, the real damage could be to Sysco's image, and clients deciding to bring their business elsewhere.
Here's what the makeup of Sysco's clients looked like during the last fiscal year:
Obviously, all of these organizations are interested in ensuring their food is healthy. But for restaurants, cases of food poisoning can be a kiss of death. Unlike schools or hospitals -- which are going to be serving food to people no matter what -- restaurants don't have a guaranteed client base that will continue to return if their food is bad.
Currently, Sysco estimates that it controls about 18% of the U.S. and Canadian food service market. As most of the competition is in the form of regional distributors, Sysco holds a big advantage in providing a national framework for countrywide restaurant chains.
Though that's certainly not a competitive advantage to take lightly, it's also not a guarantee that the company can escape any indiscretions unscathed. Indeed, the company readily admits in its annual report that, "Non-traditional competitors are becoming more of a factor in terms of competition within our industry, and consumer spending trends are gradually shifting more to fresh, natural and sustainably produced products."
United Natural Foods (NASDAQ:UNFI) could represent a threat with such a focus. Currently, the company is focused on delivering fresh and organic goods to supermarkets -- and counts Whole Foods as one customer that represents a whopping 36% of all revenue.
If United Natural wanted to diversify its revenue base to include restaurants, not only are industry trends swinging in the company's favor, but the latest snafu from Sysco would provide ample motivation for such a move. And because United Natural has a nationwide distribution chain, it is one of the few competitors that could challenge Sysco.
Fool contributor Brian Stoffel owns shares of Whole Foods Market. The Motley Fool recommends Sysco and Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.