In this episode of Industry Focus: Consumer Goods, Vincent Shen recruits Fool.com senior contributor Asit Sharma to help him field listener questions.
First, Ben wants to know how to evaluate goodwill as an investor, especially when it makes up a significant portion of assets as is the case with investment research and data company FactSet (NYSE:FDS). Then, they turn to a question from David regarding the two largest food distributors in the country -- US Foods (NYSE:USFD) and Sysco (NYSE:SYY).
A full transcript follows the video.
This video was recorded on March 21, 2017.
Vincent Shen: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. I'm your host, Vincent Shen, and it's Tuesday, March 21st. We will be turning to our mailbag for this episode. Asit Sharma is joining me via Skype to cover some of the questions from our Foolish listeners. Hey Asit, great to have you back!
Asit Sharma: Great to be here, Vince!
Shen: As I mentioned, we have a few questions here from our listeners, and I think we should move on to our first note because we have a lot to cover. This is coming from Ben. This is a two-part question, and we'll try to juggle these one at a time.
Ben wrote, "I was wondering if you could give your thoughts on goodwill, especially when it's over 40% of assets on a common size balance sheet. FactSet is a very interesting company, but I am of the belief that goodwill is a filler on the balance sheet, so whenever I see it this massive, I question it."
FactSet would traditionally fall under the purview of Gaby and the Financials segment of Industry Focus, but I think the topic of goodwill is a very important one to cover for the consumer retail industry. We can also talk a little bit about FactSet as a company as well, it's a very interesting business. Let's start with, for goodwill overall, Asit, can you give me a rundown of what Ben is referring to here, and just how to look at it?
Sharma: Sure. Goodwill represents the excess of fair value in an acquisition. We typically think of goodwill when one company acquires another. I'll give a really simple example between myself and Vince. Vince has a frisbee to sell me, and I decide that I really like this frisbee because I play ultimate frisbee. It's a red frisbee with golden trim, and it's selling for $2 on the market. But I really like this frisbee. And Vince knows that I really like it. And he and I agree that I'm going to buy it for $10. So, once the transaction takes place, I go home and sit down and do my accounting. I record that there was an outlay of $10 cash. That's one side of the ledger, $10 goes out. Then, what do you think I record the frisbee value at? Do I record it at $10 or $2? Vince, what do you say?
Shen: Well, the frisbee value, according to the purchase accounting method, for the frisbee itself, would be recorded at $2.
Sharma: Absolutely. So, I put the asset on my books at $2, and there's an $8 hole to fill on my balance sheet, and I book that to an intangible asset called goodwill. Two ways you can look at that $8: either it represents something that, in the future, I can get value out of, I have this knowledge that someone else is going to want that frisbee for even more, because they recognize the same things I do. You can also look at it like, "Asit, why did you pay $8 for a frisbee which had a fair market value of $2?" And this gets to the heart of a lot of questions about goodwill. Whenever you see a company acquiring another company, you're curious: Has a fair purchase price been paid? Or has one company overpaid for another?
Shen: I think that's a really nice, simple example to present it. Ultimately, the question becomes, what does that goodwill represent in a lot of cases for these bigger, complicated M&A deals between companies? For the frisbee, maybe it's because it happens to be the frisbee that was played in a winning championship ultimate frisbee game, so it has that extra good luck juju, and that's why you're willing to pay the extra $8 for that goodwill. But for actual acquisitions, it might be things like brand power, top-tier management or employees, a loyal customer base -- things that just don't end up being reflected when you add up all the hard assets like factories or inventories or patents, cash balances, on the buyout target, but they still have excess value that needs to be reported in some way in the books, and as you described, Asit, that's where it goes to goodwill.
A big example beyond FactSet, I want to anchor it to the consumer retail space, one of the bigger deals in recent memory was the Kraft-Heinz deal. For accounting purposes, Heinz was identified as the acquiring company. They paid $53 billion in total consideration for Kraft. But the identifiable stuff that they mentioned -- and you can find all of this in their 10-Q and 10-K filings -- they have $314 million in cash, they have about $4 billion in property, plant, and equipment, and intangible assets of about $48 billion. But when you take out the liabilities, because this is supposed to be the net assets, you take out things like payables, long-term debt, then in all, the identifiable assets less liabilities they acquired came out to just $22 billion. So, the rest of that consideration they paid, which amounted to over $50 billion, that difference is our goodwill.
And the company specifically states in its filing that "The 2015 merger resulted in $30.5 billion of non tax-deductible goodwill, relating principally to synergies expected to be achieved from the combined operations and planned growth in new markets." Just an example there specific to the consumer retail sector for a very big deal that has happened in the past couple years. What else, Asit, do you think people need to know in terms of, specific to Ben's question, when it becomes a larger and larger part of a company's assets on its balance sheet? Are there concerns there? How should investors think about that?
Sharma: Good question. It really depends on the industry that you're looking at. When goodwill reaches 40% on a common size balance sheet, that means that it represents 40% of total assets. That could be a lot of goodwill for no good purpose, especially if the company generates return off of its fixed assets, tangible assets. So, if you look at a company like Caterpillar, which makes most of its money off of heavy, earth-moving equipment, you wouldn't want to see an extraneous amount of goodwill there, because they're in the business of buying equipment, selling that equipment at a reasonable profit, reinvesting those profits, and generating cash flow, etc.
Once you start moving down the spectrum to more and more intangible types of revenue, goodwill starts to make a little bit more sense. If you're in the business of selling an intangible -- let's say you're Microsoft and you're selling software -- it might make sense for you to purchase lots of intangible assets. One thing that our listeners should consider if you do indeed go look at some of these annual reports is, there are actually two items that make up intangible assets on a balance sheet. One is goodwill, as we're talking about. The other is called exactly that -- intangible assets. Whenever a company can identify when it purchases another company the very things that Vince mentioned, such as copyrights, trademarks, patents, software, content, types of technology, to the extent that management can identify a value for each of those items, it books those to intangible assets. What it really can't assign a certain value to, and it becomes subjective, is goodwill. Investors should be aware that there are actually two items to look at on those balance sheets. Sometimes, the goodwill balance is small, but the intangible assets value is quite big. You have to make sure you look at both of those.
Shen: Yeah, that's a really good point, Asit. And that actually comes up in terms of some of the specific items that you mentioned. Software technology, for example, that actually comes up with FactSet. Let's shift gears a little bit and put things into context a little bit for this company. Can you give us a quick rundown of what we're looking at, in terms of FactSet and their situation in terms of their goodwill balance?
Sharma: Sure. FactSet provides market information content to the investment community. It's grown its goodwill balance through a series of small acquisitions. It's constantly looking to stay up-to-date with its competitors, who are also in the marketplace to buy information. So, when it acquires a company, it's not really acquiring fixed assets so much as it's acquiring intangible assets that, down the road, can parlay into more revenue. So, what an investor needs to understand is, if you have not looked at FactSet's balance sheet before this conversation, you have an expectation that maybe it's bigger, the goodwill balance plus the intangible assets, relative to a company which is dealing in hard assets, as we've talked about before.
I want to read from FactSet's most recent annual report to give you an idea of how intangible their revenue base is. "FactSet is a leading provider of integrated financial information, and big data analytical applications to the global investment community. We deliver insight and information to investment professionals through our analytics, service, content, and technology." Now, that asset base, if you were an accountant, auditor, showing up once a year at FactSet's premises, you wouldn't be counting boats, you would not be looking at mechanical things. You would be looking at software and trying to determine, what's the value of this software? What will this mean for revenue down the road? And this is what's important to understand about this company -- it is dealing in intangibles.
Shen: The example I pulled up, this was a big jump in terms of their goodwill balance, specifically toward the end of 2015 -- the company's balance sheet has goodwill currently of $508 million, just shy of half the total assets of the company at $1.05 billion. In the fourth quarter of 2015, the goodwill balance jumped from $308 million to almost $500 million, and that specifically was the result of the acquisition of a privately held company called Portware. The purchase price was just shy of $264 million.
Again, in FactSet's 10-Q, you can find a section called "Business Combination", if you want to look this up. The company specifies what assets it acquired, and how they value out. So, the company got in terms of tangible assets -- again, this company being much more in the intangible space -- those only amounted to $9.7 million worth of tangible assets. But then, things like the software technology, client relationships, came out to around $75.5 million. Deducting those liabilities again, assets acquired amounted to $76.2 million. So, that difference between the $76 million and the $260-some million they paid gives us the goodwill increase of about $187 million, which is what increased the balance toward the end of 2015.
Anything else, Asit, that you wanted to add, in terms of, specifically, FactSet? Do you have a concern here based on the rather acquisitive business model, and the way they have competed in the market, where they're trying to find other services to differentiate it in the financial service community, in terms of offering this research? I used this myself when I was still in banking, and FactSet was a very powerful and important tool for us on a day-to-day basis. It seems like they're branching out, Portware giving them things like automated trading. Any last thoughts?
Sharma: Sure. I do have a slight concern when you see that balance creeping up in that you do want a company to be able to innovate internally as it goes along, and not just always acquire the technology that's going to turn into revenue later on. I actually went back really briefly and looked at 2012's numbers. Goodwill to total assets was about 35%. So, it had a balance approaching at 40% that our listener, Ben, is concerned about. Its operating profit margin, FactSet's operating profit before taxes and interest, was about 34%. Now, fast forward to this year, goodwill to total assets is 41.4%, and the operating profit margin is 31%.
And that actually made me feel a little bit more comfortable. Yes, the goodwill balance crept up, but the operating margin has largely stayed the same. It's decreased a bit. And that's what you want to look at, when you see that year after year, a company is going out and acquiring these other companies -- look at that relative trend of goodwill to total assets, but also look at net income, because it might mean that acquisitions are sustaining stable profit, which is what you see in this case. Last point, in 2016, FactSet was able to sell one of its divisions for $112 million, which made up about a third of net income for the year. So, it's actually taking some of that intellectual property, repackaging it down the road, and selling it for a profit. That's also a positive sign. To me, bottom line, I'm not that worried about the goodwill balance here, but that's a really great question from Ben. You should always be skeptical of those large balances, and you should investigate.
Shen: Thank you, Asit, that's an awesome takeaway. For me, the way I look at it is, this isn't really something that you can necessarily evaluate in a vacuum. You need to look at some of those other metrics, like you mentioned, to see how they're impacting things on the bottom line, profitability, as some of these companies like FactSet have a more acquisitive business model.
The one thing I do want to add, in terms of how goodwill can change and how it's evaluated on an annual basis is, ultimately, these companies that carry these goodwill balances, they need to evaluate them each year to see if they have maintained at least that value that they paid for it. If not, then they can take an impairment charge. There's been some very famous, almost infamous examples of these goodwill writedowns, I think the most famous being the AOL-Time Warner deal from the early 2000s. They had to suffer a goodwill writedown of over $50 billion. In some cases, this can be an example of a company overpaying, but otherwise, something you need to look at more holistically.
For question No. 2, Asit, David wrote in asking, "I would love to see a comparison between SYY and USFD," that's Sysco and US Foods, "specifically, revenue versus market cap and revenue versus net income, and how important those numbers are in establishing the appropriate value."
Sysco and US Foods, these are the two largest food distributors in the country in an otherwise very fragmented industry. When you think about restaurants, hotels, schools, hospitals, various places that prepare or serve food, those places need to get their supplies -- their produce, their meat, and other products -- supplied from somewhere. That's where these companies come in. Huge industry. I think industry research puts this sector at around $300 billion annually, in terms of supplying all these different restaurants and other food service businesses. What do you think?
Sharma: It's a great question that David has, but my first thought is, why do you want to invest in this industry? [laughs] The profit margins are very low. Everyone knows that. Grocery stores have low profit margins, traditionally. Maybe a Whole Foods has higher margins because it sells specialty products. But if you think of the companies which supply food to institutions, etc, those margins are even lower, 1% to 2% in a year. So, that's my first thought.
But, let's read part of his question again. "I want to see a comparison, specifically revenue versus market cap." Let's pause right there. This is a nice question because in many cases of investing, there's not a really good relationship between revenue and market cap, meaning, what a company sells in a year and what its total value is on the stock market. But with these particular companies, it's actually significant, it makes a difference, the reason being, when you're running at a 1% to 2% margin a year, let's say you're selling $13 billion, $20 billion worth of food, but you only take home that 1% to 2%, then the amount that you sell suddenly becomes important. Both Sysco and US Foods are serial acquirers of business. Going back to our first question of the day, they do a ton of acquisitions. The reason is, that's the best way to grow sales. It's hard in this industry to go out institution by institution, hospital to university, etc, and spread your wares, versus buying up the smaller companies. So, when you're selling at these margins, and you're acquiring more companies, it becomes important to see what an investor will pay for your sales.
This is really the crux of David's question. He's asking about the revenue that these guys have, versus how it's valued in the market. I have some numbers to see how they stack up. Sysco -- listeners, this is not to be confused with Cisco the tech company -- has a market cap currently of about $28 billion. And its trailing 12-month revenue is about $54 billion. If you take that market capitalization, that stock market value, divide it by the revenue, you get 0.52. So, we think of that market cap to revenue multiple of being 0.5. Now, US Foods is a much smaller company, as Vince said. It's also giant, but relatively speaking. It has a market cap of just under $6 billion, and it has trailing 12-months revenue of about $23 billion. That's a capitalization to revenue of 0.25. In the screens that you'll encounter when you research your investments. You'll see this more commonly expressed as price to sales. So then you have the price to sales of Sysco as 0.5, and the price to US Foods as 0.25, a half versus a quarter. I'm going to throw it back to Vince and ask him to interpret these numbers for us, and we'll move on from there.
Shen: It's really interesting to see, I think, especially when you look at some other sectors. If you're listening to Dylan's show, for example, and looking at some of the really hot tech companies that come out, in terms of things like price to sales, or some of the multiples that you see, they'll be much more generous than this, and I think, again, it comes down to some of the great points that you made, Asit, in terms of this being an industry where, Sysco's bottom line net margin is around 2%, US Foods is around 1%, really tight here, just like if you think about your local supermarket. I think that when you are in this business, the way the companies in this space compete, I can tell you, having worked in the restaurant industry for many years with my family's business, customers, ultimately, want a large variety of items to choose from, they want deliveries that are on time, they want good, consistent quality. And, of course, they want all of that at low, competitive prices.
As Asit mentioned, the scale is really important here, because, for example, the more foods Sysco can procure from their own suppliers -- and they work with thousands of companies procuring different items -- they're able to win those volume savings, and they can translate that to more competitive pricing for the customers. Then, you combine that with some of the incredibly complex logistics of having to store inventory safely, being able to deliver it all over the country to these various establishments, and there's a lot of efficiencies and savings that can be sought out in operations, as well. Overall, I think, for these two companies here, you're definitely just looking at the numbers between Sysco and US Foods, even though US Foods, in terms of their top line, only generates half of what Sysco does -- about $54 billion of revenue for Sysco versus $23 billion for US Foods. That ratio there, 0.5 to 0.25, I would generally interpret US Foods, just on that metric, as being the better value, arguably.
Sharma: Yeah, I agree. This is where we need more nuance to make a determination if you're comparing the two companies. The second part of David's question helps us with that. Let me read, again, the second part of his question, which is, revenue versus net income. How important is this in establishing a base value? Let's read these figures as well. Sysco's trailing 12-month revenue is $54 billion. It made net income of $1 billion. That's about a 2% net profit margin. US Foods had, as Vince was saying, about $23 billion in revenue. It made a profit of $210 million. That's approximately a 1% net profit margin. Again, this goes back to my first question -- why do you want to buy these businesses? But, I do see, especially with US Foods, it's much smaller and it's mostly domestic, so there's probably some growth opportunity there.
Typically, when we look at net profit and want to talk about valuation, we consider earnings. Usually, that's just net income divided by total number of shares outstanding, you get earnings per share. Personally, I love the forward P/E ratio, the forward price to earnings ratio. Whenever I'm looking at an industry for the first time, or two companies for the first time, I'd like to know, based on what these companies are projected to make over the next year in earnings per share, how is the stock price in relation to those projected earnings? Many people prefer the trailing 12-month P/E ratio, which is a look backward. I like to look forward.
The other thing that I'm very keen on doing, I don't have a lot of depth in the foodservice industry, but I do in the grocery industry, and they're very similar -- as a whole, if you take all the companies that are in this basket, on average, so, think of companies like Aramark, which is a competitor to each of these two companies, what is the price to earnings forward ratio in the industry as a whole? I looked this up for food service just now in the S&P 500. The forward P/E ratio is about 19.6 times. So, we get down to, what is the forward P/E ratio of US Foods and Sysco? What are these ratios versus the industry? And according to Yardeni Research, that industry P/E ratio of 19.6 times, here's how it stacks up: Sysco trades at a forward P/E ratio of 21 times earnings, and US Foods trades at a forward ratio of 20 times earnings.
So, these companies are both priced right at the market within their industry. They're not too high, they're not too low. Which then throws more emphasis on that first measure we looked at, and as Vince was saying, "Hey, US Foods looks like it's comparatively undervalued versus its bigger competitor." This next step we've taken, David's second question, shows us that may be what we have to go on here, because neither one of these companies has tremendous operating leverage. I would go back, if I was interested in US Foods versus Sysco, I would read the management's discussion and analysis part of their 10-K annual report and see what the strategy is for the next year, see if there's operating leverage that they can then turn into higher earnings and move that forward P/E ratio a bit up.
Shen: Thanks, Asit. Something that you brought up, in terms of how similar this industry can be to the supermarkets that we have previously discussed on the show before, just an example of something these companies are trying to do to boost profitability, for example, when the margins are so tight -- both companies are developing in-house private brands with better margins that they can offer to customers. For US Foods, their private brands make up 33% of their organic sales from 2016.
Overall, looking at these two companies, things to watch, something to keep in mind for Sysco, for example, is, they actually recently had a pretty big deal, I think it was about $3 billion or so, for moving into the European market. Already the leader, I think, the market share numbers that I could find between Sysco and US Foods, about 16% and 8%, respectively for the North American markets. So, Sysco trying to branch out. So, there's big growth opportunity there for them. Also, on the Sysco side, after its acquisition of Brakes -- Sysco is a dividend aristocrat, they pay a 2.5% dividend yield, and have been paying that for over 30 years at this point, giving them that dividend aristocrat status. So, those are some other things to keep in mind. Otherwise, this is definitely what could be considered a more stable industry, the idea that you're always going to need food service distributors, companies like these, to supply the restaurants that we go to, to supply the leisure industry, the hotel industry. But finding the differences between them, that scale makes a big difference. Any other final thoughts from you, Asit, before we wrap up?
Sharma: Just one last thought. I love that you brought up the Brakes acquisition. If you're interested in Sysco, they have done a really good job in this first update of peeling back the Brakes numbers, so, you can see how the rest of the business is doing. It's made a fairly big impact on the profit and loss statement. Quarter by quarter, make sure you see how the U.S. business is still growing. It's still pretty slow, but you commend management for showing you the two different numbers in a clear fashion.
Shen: Thanks again, Asit, for joining us today. Fools, you can always reach out to us and the rest of the IF crew via Twitter @MFIndustryFocus, or you can send us any questions to firstname.lastname@example.org. Don't forget to check out podcasts.fool.com for more content. People on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear during the program. Thanks for listening and Fool on!
John Mackey, CEO of Whole Foods Market, is a member of The Motley Fool’s board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool’s board of directors. LinkedIn is owned by Microsoft. Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends FactSet Research Systems and Whole Foods Market. The Motley Fool recommends Cisco Systems and Time Warner. The Motley Fool has a disclosure policy.