It goes without saying that food is big business. In fact, it's a $235 billion industry, and distributor Sysco (NYSE:SYY) is a major player. It serves about 18% of the market, but at the same time, Sysco's profits have stagnated over the past five years.
In a clear attempt to move the profit needle in a big way, Sysco will acquire US Foods for $3.5 billion in stock and cash, according to a recent announcement. This will create a food-industry conglomerate with annual sales of $65 billion.
At first glance, some may be tempted to view this as yet another example of corporate empire-building foolishness. However, an analysis of Sysco's recent past reveals that the company needed to make a significant move to grow in 2014 and beyond.
Food-industry growth is slowing
Any company that engages in providing consumers with a necessity of life stands to do well. Sysco operates a large and highly profitable business, but there's no denying that growth has slowed. This is due to a number of factors, including rising costs and intense competitive pressures. Sysco admits that the food industry has not fully participated in the overall economic recovery due to consumers tightening their spending on food away from home.
Consider that Sysco's profits have actually fallen since fiscal 2009, even while the broader economy steadily recovers from the recession. Sysco earned more than $1 billion in fiscal 2009, but its profits clocked in at just $992 million in fiscal 2013. The company's sales grew in the past five years, but costs are rising even faster.
Another factor weighing on the industry is the sheer amount of competition in the space. Food is a hugely saturated industry. Sysco itself notes in its 2012 annual report that there are more than 15,000 companies engaged in food distribution. Sysco also sees threats from customers who choose to purchase directly from the company's suppliers. With this kind of competition, it's tough for any business to get ahead, even for a well-run company like Sysco.
Just the right catalyst
Sysco needed something to move the needle. Food-industry woes persist, even though it's been years since the financial crisis. There are several reasons that this deal makes sense for the company.
First, Sysco is no stranger to making acquisitions. As part of its recently initiated business transformation project, Sysco is determined to get profits going in the right direction again. Part of that is to obtain growth through acquisition. Sysco acquired 14 companies during fiscal 2013, which it estimates will add $1 billion in annual sales going forward.
In addition, the deal is expected to generate significant cost synergies, since Sysco and US Foods are direct competitors with complementary products. In the next three to four years, Sysco expects to realize at least $600 million in annual savings. Moreover, it's not as if it overpaid for US Foods. Investors would be absolutely right to criticize Sysco if it paid an absurd premium for the acquisition, but that's not the case.
Consider that although Sysco's direct competitors aren't traded publicly, food companies ConAgra Foods and Hormel Foods enjoy much higher multiples than what Sysco paid for US Foods. ConAgra trades for 20 times trailing earnings and 12 times enterprise value to earnings before interest, taxes, depreciation, and amortization. Hormel, meanwhile,changes hands for 24 times earnings per share and 13 times enterprise value to EBITDA. Sysco paid 8.8 times enterprise value to EBITDA for US Foods. This is a fairly conservative valuation considering how some other food companies trade.
Bottom line: The US Foods acquisition makes sense
Sysco, and the food industry more broadly, struggles to restore profit growth, even five years removed from the 2008 recession. Consumers continue to withhold spending, and competitive pressures persist. Sysco needed to take a drastic step to reengineer growth and did just that by purchasing its major competitor.
The deal to acquire US Foods makes both strategic and financial sense. As a result, investors should view the buyout positively, and hold Sysco with confidence.
Fool contributor Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Sysco. 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.