US Foods Stock: Same Story, Different Year (NYSE:USFD) (2024)

• US Foods (NYSE:USFD) is an American foodservice distributor operating solely in North America. The company has a decorated 150-year history and was the 10th largest private company in America until its IPO in 2016.
• US Foods prides itself on its mantra "Great food made easy" and generates more than $27 billion in revenue annually.
• The bulls behind US Foods believe that there is an opportunity for EBITDA margins to improve to levels similar to that enjoyed by US Foods' biggest competitor Sysco (SYY) warehouse .

US Foods has a mega operation that supplies approximately 300,000 customer locations nationwide, offering 400,000 fresh, frozen and dry food stock-keeping units (SKUs) sourced from 6,000 suppliers. The company has 3,000 sales associates, 70 distribution facilities, 80 cash and carry locations (discussed later) and a fleet of 6,500 trucks.

US Foods' 300,000 customer base includes independently owned restaurants, regional restaurant chains, national restaurant chains, hospitals, nursing homes, hotels and motels, country clubs, government and military organizations, colleges and universities, and retail locations. Sales to US Foods' top 50 customers represent 39% of revenue. The company's extensive network allows them to operate efficiently and provide high levels of customer service.

The crux of the investment thesis is that despite its large operational presence, US Foods lags its closest competitors in terms of margin performance. If US Foods were to close the gap and improve its operating margin through a number of synergies and cost cutting measures (which they have been promising since 2016), there is 50% upside to the stock. On page 12 I have included a "valuation matrix" which nicely demonstrates the impact of margin and growth on its fair value. The market is currently asking US Foods whether "it really is different" this time.

Food Service Industry

Foodservice distributors typically fall into three categories:

1. Broadline distributors - "broad line" of products and services.
2. System distributors - carry products specified for large chains.
3. Specialized distributors - focus on specific product categories (e.g. meat or produce).

US Foods is a broadline distributor offering a wide array of products which can be seen below.

The Total Addressable Market (TAM) is approximately $300 billion and the segment sizes are:

1. National Chain Restaurants - $78 billion
2. Independent restaurants - $71 billion
3. Retail - $34 billion
4. Other - $30 billion
5. Hospitality - $20 billion
6. Regional concepts - $16 billion
7. Healthcare - $15 billion
8. K-12 Education - $11 billion
9. Business & Industry - $9 billion
10. Education (Universities) - $9 billion

On page 6 there is a nice graphic that shows segment size, growth forecasts and segment emphasis on value added services (tech stack).

Currently the industry is at war over "Independent restaurants" as they offer the highest margins at 20%+ and represent a large part of the addressable market ($71 billion). Furthermore, Covid-19 provided a unique opportunity for the 3 major industry players (Sysco, US Foods and Performance Food Group (PFGC)) to acquire a larger share of the pie as many smaller foodservice distributors (whom supplied the independents) did not survive the pandemic when restaurant dining came to an abrupt halt. Independents are attractive not only from a margin perspective but also because the risk of a lost customer (restaurant) is spread out as opposed to the concentration of some of the larger national chains.

National chain restaurants have far lower margins at 10% due to mass scale discounts that they are able to negotiate with food service distributors. Though a chain will pay $5,000 per order at a 10% margin ($500 GP) compared with independents that will pay $1,000 per order at a 20% margin ($200 GP), therefore it may still be more profitable to service chains (depending on market share dynamics). This landscape is changing however as independents place a greater emphasis on value-added services such as compatible technology, which US Foods has an edge in providing. The numbers support this and US Foods has done a great job in penetrating this segment, growing its revenue from independents from 10% of total sales in 2016 to more than 30% in 2021.

Market Share

US Foods, Sysco and Performance Food Group represent about 35% of the market with the next biggest 7 only making up about 6% of the market. As discussed on the previous page, many smaller distributors did not survive the pandemic giving opportunity to the "big 3". Sysco is the industry leader with 16% market share followed by US Foods at 9% and Performance Food Group (PFG) at 8%.

US Foods operation - a closer look

1. Customer Mix

2. Margin analysis/breakdown

As mentioned earlier, the crux of the investment case behind US Foods is whether they can improve their margins to levels enjoyed by Sysco and PFG. Thus it is appropriate to get a better understanding of US Foods' cost structure. Let us walk through a $100 sale example for US foods.

Gross margin is 15-25%

• So COGS is 75% which is the cost to purchase the food and the expense to get it to US Foods' warehouses. COGS is really the "landed cost" to buy the food and get it to your warehouse.
• $20 profit remaining

Costs after gross margin are operational specific and this is where future cost savings are expected to stem from (GP margin improvement comes from a higher independent mix). Percentages here are quoted as percentage of what is left after the gross margin is taken into account.

G&A

• This is between 5% and 8% and is the overhead cost at individual warehouse (salaries of staff to run the warehouse, etc.).
• $18.5 profit remaining

Distribution related costs

• Fleet up-keep costs are around 8%-9%. This is the maintenance (and depreciation) on transport trucks, tractors, trailers and tires.
• Selling & distribution costs (including the sales force) are around 50% and are a huge (operational) expense. This is the cost of the delivery driver moving the product from Point A to Point B and not just the delivery (including fuel which is highly variable) but it also may include the unloading at the customers' facility.
• $6.6 profit remaining

Warehouse costs

• This is up to 15% and relates to depreciations costs on warehouses and storage costs. "Pick and Pack" costs, once a product makes it to US Foods warehouse, the inclusive costs of storing it.
• $3.6 profit remaining

Other costs

• These include interest expense on debt, asset impairment charges, restructuring costs and other losses for a total of 8%.
• $2 profit remaining

Thus, on a $100 sale US Foods will make a $2 operating profit which translates to a 2% operating profit margin. Now that we have a better understanding of the cost structure, let us have a look some of US Foods' competitors.

So the million dollar question - why is it that US Foods has a margin lower than many competitors given the size and scale of its operation? [Refer to Appendix 4 for historical EBITDA margin comparisons.]

Having pored through earnings transcripts and the experts' networks there are a few factors that contribute to the weaker operating margin.

1. It appears that US Foods has the approach of "don't let any meaningful business escape". A lot of US Foods value-added technology offerings comes at a cost to the business and at the end of the day, restaurants make decisions primarily around the price of food. This has been a great initiative in an attempt to steal market share but restaurants often say to US Foods "but Sysco charges $2 less for that item?" so US Foods will match them on the price, taking a hit on margin.
2. Distribution costs are higher than the industry standard, partly due to the use of third-party trucks. Freight costs are high and this is an area that US Foods plans to give much attention to.
3. Warehousing costs are higher than the industry standard. US Foods maintains the view that there are duplication of activities in their warehouses and that there can be large reductions in personnel in corporate and back-office positions which will drive operational efficiency

US Foods management are of the opinion that they can close the 2%+ EBITDA gap between themselves and Sysco through:

• Improved customer mix (greater emphasis on independents)
• Increased private label penetration
• Improved logistics network
• Warehouse assortment optimization

The jury is still out on whether this is achievable, but first let's turn to what the market is saying, both the bulls and the bears.

What are the BULLS saying?

1. The world is shifting towards eating out more

Food-away-from-home (FAFH) expenditure as a % of total food expenditure has steadily risen since 1975 and now represents 50%+ of total food expenditures vs 36% in 1975. This bodes well for foodservice distributors as it points to growing demand for foodservice products and services. This makes the food distribution market attractive for players like US Foods as the market is growing faster than GDP growth due to a penetration opportunity at play.

2. US Foods will continue to steal market share from the smaller players

The technology (omni-channel and value-added services) as well as the reliability of bigger players like US Foods, especially off the backdrop of Covid, makes it likely for US Foods to continue stealing market share. Customers are able to track their trucks and understand where their order is and when their order will arrive. This greatly assists restaurants in planning their labor and their inventory.

US Foods has an edge in the technology offering, which is also expected to drive better margins in the future as fewer sales reps are needed for online ordering (through US Foods developed software). Though, there is an argument that this may have a negative impact on personal relationships that US Foods has with their customers and could impact sales growth. However so far so good and US Foods e-commerce accounts for 70% of total sales.

Food Safety is becoming increasingly important and with larger players you have traceability of the product not only from the distributor to the supplier, but from the supplier to the source (i.e. the farmer). Smaller players (distributors) lack a compatible technology stack which restaurants have been placing increased importance on in recent years.

3. Independent restaurants are growing in the US

Technology is making it easier for independents to get higher up the funnel in a consumer's purchase through platforms such as Uber Eats. I would remind you that the market is excited about independents due to them being a far higher margin customer. Technology continues to assist independent restaurants. Value-added services also make it easier for restaurants to run their businesses and drive stickiness to US Foods. The below graphic nicely depicts the size of the segments and which segments place greater emphasis on value added services. Independents are on the right of the graphic, with the most emphasis on value-added services, which US Foods has an edge in providing.

US foods has rapidly acquired market share in the independents segment and there is still a long-runway for growth ahead. This contributes to the margin expansion story and is probably the most credible thesis for US Foods to close the margin gap between themselves and their competitors such as Sysco. Importantly, US Foods has been growing its market share within Independents faster than its two main competitors, Performance Foods and Sysco. There are 449K independent restaurants that fall within US Foods target market, currently US Foods only services 80K of them.

4. Cost saving synergies could reach $150 million by 2023.

US Foods has been promising cost savings for some time. It is "expected" that $65M cost savings synergies will come from the Food Group acquisition and $20M will come from Smart & Final acquisition. US Foods believes that there are a number of corporate and back-office positions that are redundant and reductions could increase the operational efficiency (the balance).

What are the BEARS saying?

1. Inability to integrate tuck-in-acquisitions

US Foods routinely acquires smaller companies as part of its strategy to grow. The business barely grows organically and most of its growth comes from these acquisitions. Many investors have questioned the ability of US Foods to seamlessly integrate all of these systems post acquisition. Investors have questioned whether this contributes to the higher cost structure and whether it is possible to eliminate these inefficiencies. For reference, the below graphic shows the extent of acquisition activity of US Foods since 2010.

2. US Foods has a huge debt burden

US Foods has razor thin margins which creates little room in terms of profitability. Low return ratios and a considerable debt load puts pressure on the balance sheet. There is little visibility into how US Foods will pay down this debt without continuously rolling it and consequently continue to pay a higher interest charge.

3. Is the recovery play still here?

Many investors took advantage of the recovery play. US Foods fell nearly 60% in March 2020. The business was severely impacted by the pandemic, which can be seen in FY20's results (annual sales declined 12% and net income declined 160%). However, markets are forward looking and in FY21 US Foods is back to operating at levels it was pre-pandemic. With a 5-year view, the pandemic was a hiccup. US Foods share price had fully recovered by April 2021, a little over 1 year post crash. The graphic below on the left shows how the Food-Away-From-Home is close to levels it was pre-pandemic and the graphic to the right shows how sharply volumes grew in early 2021 (off a slumped base) to somewhat normalize towards the end of 2021.

4. Continued Pressure on US Foods margins

A number of macro conditions have put increased pressure on US Foods margins. To name a few, spiking protein prices, labor shortages/wages increase and increasing freight costs are putting pressure on margins. There is still an ongoing debate over whether these conditions are transitory or the new normal. Depending on whether these conditions are permanent or transitory matters to US Foods. For example, inflation is only automatically passed through to 65% of its customers. Many clients have a "fixed fee markup" which maintains gross profit dollars but can compress the margin. The below graphic shows US non-farm payroll data relating to food services including restaurants, etc. It shows that the labor market is still weak in the food service segment

5. Food distributors are on the other side of the restaurants negative working capital cycle

Independent restaurants (and the focus of the industry) often sell their food within a few days of taking delivery but often pay for the food 30+ days after selling it. This put's pressure on US Foods cash flow and as independents continue to make up a greater proportion of US Foods business, US Foods will have greater exposure to this negative working capital cycle.

6. GPOs (group purchasing organizations) are a challenge to the industry

A GPO is basically a "legal entity" of higher margin clients, such as mom-and-pops or independent restaurants that have "grouped" together to bring scale benefits to their orders by negotiating discounts and reducing costs. Thus, GPOs cut into the margins of food distributors immensely. What used to be a 25% margin customer is now a 10% margin customer. This can translate significantly into a reduction in margin/earnings. For example, GPO members account for approximately 21% of US Foods' sales. Assuming that 21% of these customers are independents that would have used US Foods before joining a GPO, the margin differential is 14% (25% - 11%). This translates to a $800 million gross margin impact if we use 2021 revenue figures. Though, one could argue that US Foods may not have made the sale if it were not for the GPO (which brings together the needs of multiple smaller customers).

7. Can US Foods really improve its operating margin to levels enjoyed by competitors?

This is the million-dollar question. Management has been singing the same song of "margin improvement" since 2016. US Foods has been promising (without any meaningful success) to close the margin gap between themselves and Sysco for years. Is a 2% improvement to operating margin as easy as updating an excel valuation sheet? Certainly not. While a 2% higher operating margin increases the fair value from $34 to $59, the path to get there is not clear.

I have poured through the experts' network and earnings transcripts to get a better sense of whether this margin improvement is as easily achievable as management makes it appear in the investor presentations. However, concerningly I have heard from experts and ex-employees of US Foods that there are structural differences between Sysco and US Foods and the gap on margins will be very difficult to close. For example, Dmitri (who spent 10 years with US Foods - 7 of which he was a director) says that these structural differences include the fact that Sysco has bigger warehouses and a denser network that US Foods. Dmitri believes that "yes, some smaller inefficiencies can be worked out by management, but overall it is probably not possible".

My view

Point 7 above describes my concluding view on the investment case behind US Foods. While I think the downside is limited, US Foods probably trades within a 10% range of where it should be. The "blue sky" scenario with this business is the promised improvement to operating margin, which in itself is not clear to me. Where the path to margin improvement is clear with an investment case like Rakuten, with US Foods it is not. If you bought US Foods on its IPO at $25 a share in 2016 and you bought into the idea of this promised margin improvement, 6 years later you would be sitting on a 30% return. During that same period the S&P 500 has delivered a 110% return.

My research indicates that on a balance of probabilities, it is definitely tilted against US Foods in being able to achieve this margin improvement. US Foods' operation is enormous and entrenched. If the business were smaller and nimbler, perhaps the case would be clearer. For context, a 2% operating margin improvement translates to more than $600 million in absolute values. That is a lot of personnel to fire, a lot of freight cost improvement and many independent restaurants to win etcetera.

SWOT

Strengths

• Leader in Technology. US Foods is a Leader in Technology amongst the foodservice distributors. They offer a very large range of value-added technological solutions to their customers, and place a large focus on innovation and technology. US Foods' independent restaurant customers that use e-commerce to place orders have over a 5% higher retention rate than those customers that don't and have over 5% higher purchase volumes than those customers that don't use e-commerce.
• Focus on winning independents. Independent restaurants are US Foods' most profitable customer while national chains have dropped to the least profitable customer (dollar-per-case contribution margin is four times higher than for national chain customers). US Foods aims to build their independent restaurant business at double the market-growth rate in order to optimize their sales mix and allow them to become more profitable. Currently their independent restaurant case growth is growing faster than any of their other segments.
• US Foods scale. US Foods' size allows them to them to use economies of scale to keep costs low whilst remaining competitive. This places US Foods in a position to grow organically and inorganically (through acquisitions) which will result in increased market share.

Opportunities

• Margin improvement. As mentioned throughout this report, US Foods' margins are lower than its peers. This is largely due to a poorer product and customer mix and a number of operational inefficiencies. US Foods has undertaken a number of initiatives to margins. These include CookBook pricing optimization, strategic vendor management, centralized replenishment, improving customer and product mix, improving the corporate model, indirect spend centralization and sales force productivity.
• Product Sales Mix. US Foods currently trails its peers by as much as 400 bps on the percentage of goods sold that are private label. Driving sales of these items is a key lever to improving gross profit as the margins on these private label items are higher. This creates an opportunity for US Foods to move their product mix towards the optimal mix thereby improving profits in the short to medium term.
• Customer mix. US Foods' independent restaurant customer mix is approximately 30% compared to 45% at Sysco. This provides an opportunity for US Foods to improve their customer mix by increasing the independent restaurant customers who generally purchase higher margin products.
• Cash and carry. This is a fairly new initiative of US Foods. US Foods acquired a business called Smart Foodservice Warehouse Stores which is rebranded to CHEF'STORE effective March 1, 2021. The newly opened CHEF'STOREs will act as a one-stop shop for restaurant operators and food industry professionals, featuring thousands of food products from fresh produce to fresh meat, as well as restaurant-grade equipment and supplies. The stores will be open to the public with no membership required. This model is cheaper (as distribution is only to these stores opposed to customers directly) and enjoys higher margins. US foods expects $20 million of run-rate savings by the end of FY24 from this. US Foods has EBITDA margins double that of other segments of the business and currently accounts for less than 10% of sales.

Weaknesses

• Low margin business. The Food distribution industry is a low margin business and profitability is affected by deflation and inflation depending on whether US Foods is able to pass price increases onto consumers. This is not always the case and it varies across the business. US Foods' profitability is highly susceptible to small changes in their costs. Furthermore, US Foods' margins are lower than its peers due to various reasons such as execution difficulties and poor negotiating with customers. The looming question has always been whether they will be able to improve these margins.
• Highly leveraged. US Foods is a highly leveraged business that operates with a high level of debt which adds to the riskiness of the business. Furthermore some of US Foods' debt facilities contain covenants which restricts their ability to dispose of certain assets (as substantially all of the Company's assets are pledged under various debt agreements), restricts the paying of dividends, and a repayment default could trigger all debt to become due and payable.

Threats

• Disruption. Following Amazon's (AMZN) acquisition of Wholefoods there is an increased risk of competition and disruption in the foodservices industry. It could be a logical next step for Amazon to begin a selling and distribution platform to independent restaurants whether through building or buying a foodservice distributor, however - whether Amazon will pivot their focus on the at-home consumer and include independent restaurants in their customer set is still an uncertainty.
• Independent restaurant growth may be difficult to achieve as Sysco, US Foods and PFG have all indicated their intentions to focus on growth in this high margin segment. There is a risk that there is not enough growth among independents to sustain independent growth among all peers.
• Freight costs. US Foods has experienced operational issues regarding freight costs which have impacted their margins. These headwinds are largely from third party carriers that US Foods makes use of. When demand exceeds capacity for freight services, spot prices increase suddenly which impacts US Foods. They do currently have some mitigating strategies in place such working with vendors to negotiate allowances and optimizing freight lanes. Furthermore, the impact on rising fuel costs will also impact freight costs and there could be a timing lag before this cost is passed on to customers. Rising fuel costs not only impacts margins, but may also negatively affect consumer spending as households' disposable income decreases.
• Highly competitive industry. US Foods operates in a highly competitive industry with a large number of local and regional distributors. Since there are generally no specific sales agreements in place, customers are able to switch suppliers to the cheapest option relatively easily. Furthermore, customers generally purchase their goods from more than one distributor which makes it even easier for them to adjust their buying mix depending on which supplier is cheapest. Adjacent competition such as cash and carry operations, commercial wholesale outlets and grocery stores continue to serve the commercial foodservice market - however US Foods are managing to capture some of this market through its Chef'stores.

Investment Thesis

The investment thesis for US Foods is the following:

1. A leader in technology amongst the foodservice distributors.

2. Increasing market share of independents restaurants.

3. If US Foods can improve its operating margins from 2% to 5% and enjoy an operating margin closer to that of Sysco's - there is 50%+ upside.

I believe closing this gap will be extremely challenging and investors have already been waiting around for 6+ years for this story to play out (as I have pointed out numerous times throughout this report).

We value US Foods using a normalized EBITA multiple. We apply a country-specific multiple of 16 for the US. This takes into account the country's nominal inflation, nominal risk-free rate, real return and its equity risk premium. This translates to a discount rate of 9.2%. I apply no premium to the developed multiple of 16 given US Foods' low operating margins, high levels of debt and poor execution.

Valuation Cover Sheet

Target price: My FV is $39.8. At the time of this writing US Foods currently trades at $37, implying 7.5% upside to my target FV.

Opposed to doing a bull and bear case scenario, I decided I would rather include a "Valuation Matrix". This might be useful for future reports considering that growth and margins are the main drivers behind our fair values. We can quite quickly get a sense of where the fair value lies under a number of scenarios.

Conclusion

US Foods requires a great deal of execution to improve its margins to levels that have been promised since 2016. My research and discussions with ex-employees indicate that this margin expansion story is a very challenging one given the structural differences between US Foods and Sysco. Management has shown poor execution since 2016 and many investors have been waiting around for years underperforming their benchmarks off the hopes of this story playing out. I believe US Foods' fair value is something within a 10% range higher or lower than the prevailing share price and is thus close to its fair value.

JJ Brink, CA, CFA