For more than a year, Sysco Corporation (NYSE:SYY) has tried to absorb archrival US Foods in what has been called "a transformative acquisition." But last week, the U.S. Federal Trade Commission decided it likes things just fine the way they are, thank you very much.
In a contentious meeting, the FTC on Thursday voted 3-2 in favor of seeking a preliminary injunction against Sysco's planned merger with private equity-owned US Foods.
A story of he said...
Responding to the news in a press release, Sysco emphasized the "slim margin" by which the decision was taken, saying it "demonstrates a lack of consensus within the Commission that the proposed merger could be viewed as harmful to competition under the law" -- and rightly so, as Sysco argues that "the FTC's decision is based on an erroneous view of the competitive dynamics of the foodservice distribution industry."
... FTC said
For its part, the FTC argued that a merged Sysco-US Foods operation would control 75% of the "national broadline market" for foodstuffs and related supplies distributed to restaurants, hospitals, schools, and similar cafeteria operators around the country. Such market concentration, in the government's view, would harm competition in at least 32 local markets.
What's at stake
Sysco sells everything from frozen food to canned, dry goods, disposable paper plates, napkins, forks, and also more durable silverware, cookware, and serving dishes. The company also does business in cleaning supplies. US Foods operates a similar but smaller business, with its 9% national market share being half the 18% that Sysco controls.
Both companies compete with smaller operators, most of which lack the business scale to provide the kind of "one-stop-shopping" that Sysco and US Foods offer. Their customers include pretty much every civilian enterprise you can think of that runs a cafeteria operation. Moreover, Sysco and US Foods are both major contractors to the Pentagon, and are regularly tapped to perform multiyear contracts for millions of dollars for the U.S. Army, Navy, Air Force, and Marine Corps.
The prospect of owning just one company that dominates all these markets sent Sysco shares flying when the merger was announced in 2013. Investors didn't even balk at the price tag -- a reported $3.5 billion in cash and stock, plus assumption of $4.7 billion in debt from US Foods. Nor are they backing off much now that the deal looks to be on the rocks. To the contrary, after losing 3.4% of their value in the wake of the FTC news, Sysco shares have gained back all but 0.8% of that slip.
But what if they're wrong?
The risk for investors
If Sysco loses its grip on US Foods through FTC "meddling," shareholders will still own stock in the nation's leading foodstuffs distributor, bar none. These shares will, however, cost 27 times trailing earnings, and nearly 0.5 times annual sales (versus a valuation of just 0.36 times the $65 billion in annual sales a combined Sysco-US Foods was expected to produce).
They'll still own a stock that pays a 3% dividend yield. But profit growth, absent the infusion of new business from US Foods, will remain stuck at an anemic 7% annually (according to S&P Capital IQ estimates). That seems a bit slow to support the 27 times earnings valuation that Sysco shares have climbed to since the merger was announced.
Long story short? Sysco shares, which have lagged the market even with the prospect of a transformative merger to support them, will probably suffer even more pain if the merger falls apart. If that's how things play out, this is one "falling knife" you will not want to catch.