Sysco Corp (SYY) — Q2 2018 Earnings Call Transcript

Thanks, Megan, and good morning, everyone. Welcome to Sysco's Second Quarter Fiscal 2018 Earnings Call. Joining me in Houston today are Tom Bené, our President and Chief Executive Officer; and Joel Grade, our Chief Financial Officer. Before we begin, please note that statements made during this presentation that state the company's or management's intentions, beliefs, expectations or predictions of the future are forward-looking statements within the meaning of the Private Securities Litigation Reform Act, and actual results could differ in a material manner. Additional information about factors that could cause results to differ from those in the forward-looking statements is contained in the company's SEC filings. This includes, but is not limited to risk factors contained in our Annual Report on Form 10-K for the year ended July 1, 2017; subsequent SEC filings; and in the news release issued earlier this morning. A copy of these materials can be found in the Investors section at sysco.com or via Sysco's IR app. Non-GAAP financial measures are included in our comments today and in our presentation slides. The reconciliation of these non-GAAP measures to the corresponding GAAP measures is included at the end of the presentation slides and can also be found in the Investors section of our website. To ensure that we have sufficient time to answer all questions, we'd like to ask each participant to limit their time today to one question and one follow-up. At this time, I'd like to turn the call over to our President and Chief Executive Officer, Tom Bené.

Thank you, Neil, and good morning, everyone. Our second quarter results represent continued momentum in the business, most notably in the top line fundamentals, driven primarily by solid case growth. The quarterly results also include some circumstances that created gross profit and expense challenges, as well as some tax-related impacts that Joel will describe in a few minutes. Nonetheless, our strategy of delivering disciplined profitable growth remains our focus, and we are confident in our ability to deliver on our full year fiscal 2018 financial targets. Our results for the second quarter include: a sales increase of 7.1% to $14.4 billion, driven by U.S. Broadline local case growth of nearly 5%; gross profit growth of 5%; and adjusted operating expense growth of 5.3%, which delivered an adjusted operating income increase of 3.9% to $579 million; and an adjusted EPS increase of 34% to $0.78. Further adjusting to remove the beneficial change in our statutory tax rate, adjusted earnings per share grew 13.8% to $0.66. Joel will take you through the details in a few minutes. We achieved these results in a favorable macroeconomic environment propelled by steady spending from businesses and households in the United States. Market conditions in the U.S. for foodservice operators remained somewhat favorable as sales at restaurants continue to rise, offsetting somewhat lower traffic counts. Economic growth in the international markets in which we operate is mostly positive, including modest growth in the foodservice sector. However, significant food cost inflation in our UK business, driven by a combination of both product cost increases along with less favorable currency translation, impacted both our volume growth and gross margins. Transitioning to our quarterly results by business segment, beginning with U.S. Foodservice Operations. Sales grew 6.6% for the quarter, gross profit grew 5.1%, operating expenses grew 5.9%, and operating income grew 3.6%. For the quarter, local case growth in our U.S. Broadline business was very strong at 4.8% and has now grown for 15 consecutive quarters. Local case growth, excluding acquisitions, was also strong at 4%. Cases grew by nearly 2% with national customers, driving overall case growth to a healthy 3.5%. The national customer case growth is the result of recently added new customers, and we will continue to look for opportunities to grow in this segment in a disciplined and profitable manner. While we are pleased with the gross profit growth we delivered this quarter, we continue to face challenges from escalating inbound freight costs, which have provided headwinds to our gross profit dollar growth. The industry is facing driver availability challenges, which is leading to increased lane rates for many carriers. As a result, our cost to move products has increased, and we've had to utilize more spot loads to transport goods. We are actively working to mitigate these risks and continue to ensure that Sysco remains a preferred customer with various carriers we work with. From a product perspective, Sysco Brand continues to grow with local customers, making up almost 46% of cases purchased, which is up 37 basis points for the quarter versus the prior year. The consistent success we've seen is driven by a few factors, including the breadth of products that are offered across multiple categories and tiers, along with continued progress from our brand revitalization work and new innovation concepts. Some examples of this work include products that offer our customers unique value through labor savings, as well as on-trend products that fulfill specific customer needs. Our e-commerce ordering utilization continues to grow, and early indicators tell us Sysco customers who shop via digital platforms have higher penetration numbers versus customers who do not. We are pleased to see increased utilization. However, we continue to believe that providing choice to our customers in how they want to interact with us is the right strategy to ensure the best possible customer experience. Turning our attention to cost in our U.S. Foodservice Operations. Our operating expense growth for the quarter was roughly 6%, driven by volume-based supply chain costs, startup costs related to some new national account business recently signed, continued investment in our selling organization, and increased fuel prices. In supply chain, some of these costs are offset by improvements in productivity that are the result of reengineering the delivery process to be more efficient while also providing higher service levels. In the selling organization, we are once again adding marketing associates in an effort to accelerate our local sales and are doing so through a targeted insights-based approach where we have the greatest opportunities for growth. We continue to believe that our consultative approach to selling is the key driver for local case growth, and we believe these efforts will continue to enrich our customers' experience of doing business with Sysco. Moving on to International Foodservice Operations. We had mixed results for the quarter with sales growing 9.3%, gross profit growing 4.1%, adjusted operating expenses growing 11.9%, and adjusted operating income declining 28.8%, driven by the reporting change from a calendar year to a fiscal year, investments in our supply chain transformation, and new change initiatives targeted to grow local customers all within our European business. Additionally, we had transition costs associated with the acquisition of a large customer in Mexico. Our business in Canada had a strong quarter, with gross profit dollar growth of more than 4% and an operating leverage gap of nearly 2 points. This led to strong operating income growth, driven by an improving macroeconomic environment, increased restaurant traffic, and improved execution of our customer-centric strategy. Our business results across Europe were mixed. Looking at overall product costs, the UK continued to experience acute inflation of about 6% during the second quarter, driven by a combination of Eurozone sourcing and the relative impact of the pound sterling versus the euro. Also in the UK, we continue to invest in the supply chain transformation to multi-temperature facilities and fleet, as well as new initiatives such as technology solutions that are being implemented to enrich the customer experience, which will ultimately lead to improved loyalty and local case growth. Outside of the UK business, France and Ireland are performing well. France is driving solid top-line growth while recently completing key IT milestones that will help us to integrate the Davigel and Brake France businesses. This is another important step to build on our position as a leading European foodservice provider. In Ireland, we are ahead of expectations in cost synergies from the merging of Brakes Ireland and Pallas Foods. And finally, in Sweden, we recently acquired a small produce company that has broadened the range of fresh fruit and vegetable products offered to our customers and we are seeing positive trends as a result. As for our business in Latin America, we continue to be excited about the growth opportunities in this region. In Costa Rica, we continue to see solid growth and have continued our expansion of Cash & Carry locations to complement our Broadline footprint. In Mexico, we're absorbing the costs of adding a new customer and are due to annualize that addition next quarter. We remain confident in the performance of Mexico and expect continued growth in the future. Our SYGMA segment continues to grow and performed well this quarter, producing high single-digit growth in sales and gross profit while expanding gross margins by 6 basis points. Operating income grew approximately 6%, and we are focused on continuing to improve operational performance that will contribute to long-term operating income growth. And lastly, our Guest Supply entity continues to be a great business model, serving our hotel customers with various products and services, which help them to be successful. Although their overall results were slightly down for the quarter, we are confident in their ability to deliver growth in fiscal year 2018 and remain excited about the long-term potential for this business. In summary, we feel good about the fundamentals of our business and about the trajectory we're on for fiscal 2018 to close out our initial 3-year plan. Despite the inbound freight and unique expense challenges we experienced in the second quarter, we continue to make progress on our customer and operational strategies to improve our customers' experience. One example of this is Sysco's redesigned website sysco.com, which we'll be launching this week. This site will be enhanced to further enrich our customers' overall experience of partnering with Sysco and to provide all those looking to engage with Sysco a clear understanding of the company's differentiated position within the foodservice industry. Showcasing Sysco's breadth of industry-leading innovative solutions, including products, services, and customer-facing technology, the updated site will reinforce Sysco's brand and recent positioning at the heart of food and service. With that, now I'll turn the call over to Joel Grade, our Chief Financial Officer.

Thank you, Tom. Good morning, everyone. As Tom mentioned earlier, we are pleased with the top-line fundamental results for the second quarter. Our earnings growth reflects strong sales and case growth, partially offset by challenges from inbound freight, increased investment in our sales force, and national customer startup costs in our U.S. operations. In addition, our continued transformation investments and integration costs in Europe, as well as the reporting change from a calendar year to fiscal year impacted our performance for the quarter. This morning, I'll start with our quarterly results. For the quarter, sales grew 7.1%. gross profit grew 5% while adjusted operating expenses grew 5.3%, which resulted in adjusted operating income growth of 3.9% and adjusted earnings per share growth of 34.5% to $0.78 per share. As Tom mentioned, when further adjusting for the tax benefit, our adjusted earnings per share grew 13.8% to $0.66. This further adjustment assumes a consistent statutory tax rate to the previous year and provides a better apples-to-apples comparison of performance on an EPS basis. For the second quarter of fiscal 2018, we saw a foreign exchange benefit to sales of approximately 1%. Sysco experienced inflation across all of our segments in the second quarter. In our U.S. Broadline business, we experienced 3.3% inflation, driven by a few categories including meat, dairy, and produce. The pace of inflation increases in some of these categories was rapid, ultimately driving overall inflation. Within our international business, inflation was a combination of both product costs increasing along with currency translation in the UK. During the quarter, we had gross profit growth of 5%, driven by overall volume growth and improved Sysco Brand penetration. As Tom mentioned earlier, the increased inbound freight expense is a headwind for gross profit dollars as both the product cost and associated inbound freight both reside in our gross profit line. Adjusted operating expenses grew 5.3% for the quarter. The increase in expense is largely due to overall volume growth, new customer startup costs, increased investments in our sales force, and increased fuel prices in our domestic business, as well as investments in our transformation and integration costs in our international business. As a result, we did not leverage operating expense growth to gross profit dollar growth in the way that we would have liked to. However, we expect to improve this trend in the third quarter and for the remainder of the fiscal year. As it relates to taxes, our results for the second quarter were impacted by excess tax benefits from stock option exercises and additional tax credits. In addition, per the new tax reform legislation, we incurred a provisional estimated charge of $115 million for our one-time transition tax on unrepatriated foreign earnings. And we incurred a provisional estimated benefit of $15 million related to the remeasurement of our accrued income taxes and deferred tax assets and liabilities due to the change in our U.S. tax rate. Because we are halfway through our fiscal year, our U.S. statutory tax rate is prorated to 28%, retroactive to the beginning of our fiscal year. Our second quarter income tax expense included a tax benefit of approximately $64 million related to applying the lower rate to year-to-date earnings. Our U.S. statutory tax rate will change to 21% in fiscal year 2019. Cash flow from operations was $933 million for the first half of fiscal 2018. Net CapEx for the first half of the year was $255 million or about 1% of sales, which was roughly flat to last year. Free cash flow for the first half of fiscal 2018 was $679 million, which is $313 million higher compared to the same period last year. The significant improvement in free cash flow is largely driven by cash taxes that were not paid in the second quarter due to flood relief associated with Hurricane Harvey. We continue to expect strong cash flow for the full fiscal year 2018. Now I'd like to transition to three business updates: first, regarding second half expectations. We still expect to see a stronger second half of the year, including the international segment, as we align the Brakes Group calendar year to our fiscal year. Second, regarding U.S. tax reform. We currently estimate $200 million to $300 million in annual savings from lower taxes as a result of the Tax Act. We will continue to evaluate our options with regard to how to best utilize these savings and will do so consistent with our capital allocation priorities. Finally, as a financial update, we expect our earnings per share for the second half of fiscal 2018 to be positively impacted by $0.09 to $0.13 as a result of tax reform changes related to the ongoing effective tax rate. In summary, I remain confident that we're on track to achieve our three-year plan financial objectives, including the high end of the $600 million to $650 million range of improved adjusted operating income comparing fiscal 2018 to fiscal 2015, excluding Brakes. The fundamentals of our business remained strong as we expect to deliver solid local case growth and good gross profit dollar growth along with improved cost management. Operator, we're now ready for Q&A.

Hi. Good morning. Was hoping you could just help us understand the components of the pressures on the margin, the inbound freight, the investments in the sales force, and the startup costs. Can you quantify those? And just particularly on the inbound freight costs, how are you thinking about passing those along if those continue? And what is the mechanism to pass those on, on the local side and the multiunit side?

Good morning, Kelly. Let me take a shot at that and then give Joel an opportunity as well. Let's start with the freight and the margin side. So inbound freight obviously does impact our gross margins. As everyone is fairly aware, there have been significant increases, specifically in spot loads in the marketplace, driven by carrier challenges with drivers primarily. A lot of this started with some of the recent storm activity in our first quarter and has continued, impacting our business. We're able to pass on some of that certainly to our contract customers, and we are doing everything we can to try to move that along as quickly as possible. But on our local customers, it's a little more sensitive. We're having to deal with both product inflation and the cost of that inbound freight. It's just a balancing act of how much of that you can move through at any point in time with those local customers. We continue to work on that. We are doing as good a job as we can, leveraging some of those tools we've built in our past regarding revenue management. The fact remains that the rates that are increasing in some of those spot loads are dramatic, and we are struggling to pass all that along. That's one of the primary drivers of the margin impact. Regarding cost, you'd asked about cost, a couple of comments there. The investment in the sales force, we are adding additional marketing associates. We believe that we're at a point where we can leverage data and analytics to target those resources. We're at a place where we believe that we can add effectively. Even though we're getting some leverage with e-commerce, we feel there are enough opportunities, and we know where those opportunities are that we're now adding marketing associates again. We feel really good about that and believe these efforts will continue to enrich our customers' experience of doing business with Sysco. So those are a couple of the headlines. Joel, do you want to add anything?

Yeah, I think the only other thing I'd add is that as mentioned earlier, we have incurred some startup costs associated with taking on some additional multiunit business. While we certainly have taken a disciplined approach to growing our business, these costs are something we expect to get benefits from over time.

Okay, that's helpful. And then just another one on the local case growth, obviously very strong, ahead of your target for the next couple of years, I think the strongest growth on the local side in several years. But just curious if you feel that was market share gains on the local side or if the local customer in general is improving? I know it’s hard to pinpoint, but what’s your sense just from talking to your customers?

I think, Kelly, it's a combination of both. We're certainly having success gaining some share in certain markets. I think we feel pretty good about that local or independent customer, particularly their ability to continue growing in the local marketplace. So, I think it's a combination of both.

Hey great, good morning guys. Thanks very much for taking my questions. So just to go back, I know the big question on folks' minds, of course, is around the margins. As you had mentioned in the past, in an inflationary environment, should we basically think of it as obviously the dollar's going up, the percentage going down? But I guess more of my question is, as we move into the second half of the year when you're starting to go against compares that are less increases from last year, should we have any thoughts on how you see that in the back half of this year for folks?

So again, Vinnie, good morning. I think you got it right. Obviously, as inflation increases, margin dollars are going to go up generally, but the percentages are going to be pressured a bit. We are seeing that. Our gross profit per case has actually gone up in the second quarter, so we feel good about that. Remember though, that the inbound freight issue is going to impact our gross profit line as well, so you have to keep that in mind. Not knowing exactly how inflation is going to play out, you should probably expect continued pressure on the gross margin percentage. But we should be continuing to be able to grow our gross profit dollars at the rates we've talked about, and we anticipate favorable trends for case gross profit as well.

Yes. And I would just add, I think when you look at the overall components, our Sysco Brand percentage continues to perform well. We continue to benefit from category management. There are some put and takes on this, and while we have some headwinds, there are certainly good things happening as well.

Okay, all right. That's helpful. And then maybe just a quick follow-up. Can you give us an update on the UK business? Obviously, we know that you've got inflation and some currency effects going on there. But could you provide more on the fundamental investments you've been making? I know you said we're making these now for the longer term. How should we think about that?

The UK is unique. We are experiencing inflation driven by the Brexit impacts as we source a lot of products for the UK from other parts of Europe. The inflation we have to pass along is quite high. We discussed the impact on our gross profit and volume in that market. Some of that is driven by competitiveness, and some is by consumer confidence not being as strong compared to the U.S. We continue to invest in supply chain transformation and technology solutions to enrich the customer experience, which will lead to improved loyalty and local case growth. However, we still have a year of investments to make.

Additionally, in the UK, we have ongoing operational investments in how we go to market, and while there are some accretive costs here, we feel they are necessary for the long-term position.

Yes, okay. That's helpful color. Thanks very much, guys. Good luck.

Thanks.

Thanks.

So a couple of things. Let me start with, is inflation continuing to run here in this quarter kind of in that 3% range? And with respect to, have you seen any change in pricing, right? Because you look at the pickup in local case growth, I assume that had very little to do with any change in pricing on your end, so the price environment remains rational, is that fair?

Yes, John. Inflation, yes, we expect it to continue at the same pace. In terms of pricing, we didn't really see any major changes or impacts, and we aren't investing in price currently. So that shouldn't be an issue going forward aside from normal competitive environments.

And if I look in the U.S. business, the margin pressure this quarter, do you think was that evenly split between inbound freight and the impact of inflation? And how do you see those components contributing?

I don't want to get too specific on that. We feel good about the gross profit increase this quarter. We're up 5% in the U.S. So, yes, all those things are impacting that number, including an increase in the CMU business. Those all impact the gross margin number.

I would say, John, there was probably a little more impact from inflation than inbound freight, just a high-level overview.

All right. And then lastly, if you think about getting to $650 million for the year, your target pre-Brakes, U.S. EBIT probably has to step up from where it is, 300 basis points or 400 basis points in terms of growth. What’s the biggest thing that changes? Is it more on the SG&A line?

Yes, it's on the SG&A line clearly. You saw the numbers. We feel really good about where we're at from the top line and gross profit perspective, but we had some cost challenges that we're dealing with.

Thank you. I just wanted to start with the inbound freight. Is that a structural thing that you can fix by increasing contracting or hauling it yourself, or is that something you're stuck with and it’s going to have to pass through as the market allows?

I think we're doing everything we can to try to mitigate the impact. The issue with the driver shortage has led carriers to choose which products to haul and which customers to prioritize based on the rates they're able to get. As a business, it's crucial we maintain availability for our customers, which could mean increased rates to ensure we can fulfill orders efficiently. While we’re focusing on managing this, there are challenges we expect to continue facing.

Do you have any sense that this is related to issues we’ve seen on the retail side of food where they have been shorted or penalizing vendors?

It's hard to say for sure without data. What we do know is that some storm activity previously affected carriers' focus on hauling products. There have been additional pressures on the trucking industry, but I can't confirm if it's directly related to retail operations.

Thank you. And just related to tax reform, do you have a sense of how much it'll impact your cash flow and the reinvestment decisions?

I would say the final calculations are somewhat complicated. We're evaluating ways to optimize these tax benefits, which will influence our capital allocation decisions moving forward.

Thank you. Good morning and thanks for taking my question. Just wanted to touch back on the expense outlook for the second half. You called out a number of factors that impacted your second quarter customer startup costs, fuel costs, increased investments in international. How much of those do you expect to persist into the back half of the year? And which of those would actually alleviate and help you to get that better back half performance?

Thanks, Marisa. I think startup costs will certainly decrease in the third quarter and beyond. The investment in the selling organization will continue, but that also is intended to drive growth. The calendar move was a one-time issue related to our European business, but fuel costs may persist for another quarter.

Some other operational investments in Europe are ongoing as well, but we feel good about the potential for alleviation of expenses going forward as we head into the second half.

Got it. And then just quickly to follow-up on the MA sales force expansion. Do you expect that to continue in the second half? Or was that more of a one-time step-up in 2Q?

The addition of resources now will continue. The costs will persist but we don't see further significant acceleration in hiring beyond that.

Got it. That's very helpful. Thank you so much.

Yeah. Thanks, and good morning. Thanks for taking the questions. Just circling back on the previous question. What was your productivity for the U.S. marketing associates during the quarter? Should we expect it to decline slightly as you increase investments in the selling organization?

We don’t typically disclose specific productivity metrics for our selling organization. However, we're seeing good productivity and leverage from the current organization. Our targeted resource allocation will support further local sales growth moving forward.

Also worth mentioning, we are now able to roll out new sales associates with larger territories, leading to quicker productivity. Even newer team members are becoming productive faster.

Great, I appreciate the color. Just a question on the lower corporate tax rates. Do you see any advantage against smaller private distributors?

While it's speculative, we have observed that smaller distributors often seek to minimize taxes. Given our profits, we will see benefits from the lower rates, which may not apply similarly to family-owned businesses.

Thanks.

Hi. Thank you. First, just a question on international. We’ve talked about the fiscal calendar shifts a couple of times. Did you quantify how that impacted the second quarter and how it may help in the third?

We have not quantified that specifically but have mentioned that we would see a negative impact this quarter, and that impact will pick up in the second half.

Okay. But that amount wasn’t adjusted out of operating income for the international segment, correct?

That is correct. We did not provide any adjustments for that.

Got it, thank you just for clarifying that. And regarding your growth, do you see international being flat this year? I wonder how big of a ramp we should expect in the back half, considering the calendar change.

I can't provide specific guidance on that number, but there will be some level of pickup in the second half. Investments for long-term benefits in multi-temp growth have required significant capital in this area.

Can I clarify guidance? You're still talking about the upper end of the $600 million to $650 million, excluding Brakes. What should we think about for Brakes at this point?

We will give an update on that in our Q3 call. It will likely be slightly less than flat, but we need to quantify that better before presenting it.

Is it possible for international to be flat this year?

I don't want to be non-responsive, but we haven't guided that number yet. However, we do expect some recovery in the second half.

Okay. To follow-up on tax reform, how are you considering reinvestment? How much are you keeping versus putting back into the business?

We are optimistic about several investments in our business that align with our capital allocation priorities, meaning investing back into assets and technology to drive long-term value is the focus.

Hi. Good morning. I had a question on just the currency impact. Can you confirm what the currency impact was in Q2 on a consolidated basis?

The currency impact for the top-line was just a little over 1%. It had some effects on gross profit and expenses but washed out for operating income.

Okay. That's helpful. So there’s no significant flow through to earnings from currency?

Correct. There was no significant impact found there.

I wanted to ask about the consumer-related impact. Is there any discernible impact on restaurant spending in general?

Broadly speaking, anything positive for the consumer is good for our industry. It's varied across restaurant types, but we believe any increase in consumer confidence could lead to more spending in restaurants over time.

We know currently that consumer confidence is an important driver, and we've seen good data regarding same-store sales and restaurant dynamics.

Okay. Thank you.

When you look at prior instances of consumer tax relief, have you seen any discernible change in trend within restaurants and your business?

We haven't specifically researched that. It may be worthwhile for us to do so. Generally speaking, increased consumer confidence usually aids the industry overall.

On the incremental hiring of salespeople, am I interpreting that correctly? It seems a little different than how you’ve been talking previously. What’s driving this change?

You are interpreting it correctly. We stabilized our selling organization previously and focused on building out a consultative model. Now we see specific areas of opportunity where we can add resources effectively, which is prompting this increase.

Okay, great. Thank you.

Thank you.

Thanks.