US Foods’ (USFD) IPO: Fine Dining or Junk Food?

In what shapes up to be perhaps the busiest week for the IPO market in 2016, with as many as seven deals pricing, there is one that stands out due to the size of the offering. That IPO is US Foods (USFD), which is expected to raise about $1.0 billion in gross proceeds, should its 44.4 million share IPO price in line with the $21-$24 projected price range. That would put it second only to MGM Growth Properties (MGP) this year, which generated $1.05 billion in proceeds on April 19.

USFD’s IPO, led by tier one firms Goldman Sachs, Morgan Stanley, and JP Morgan, is expected to price on Wednesday May 25 and open for trading the next morning.

Typically, the week heading into Memorial Day weekend is slower, with less volume and volatility. That would be a positive factor for USFD. However, we are not exactly dealing with typical conditions. The broader markets have struggled to gain traction all year and investors have been skittish, operating with a risk-averse mindset. Even seemingly benign news – such as comments from a Federal Reserve voting member – have the ability to shake the markets.

With that said, USFD has an advantage relative to other companies who recently sought to go public. It’s a very stable business with predictable revenue that generates a lot of cash flow. In a volatile market, stability can be a very attractive quality.

However, I do feel that USFD is lacking any real catalysts, and, the fact that it isn’t offering a dividend is certainly a disappointment.

A Look Back

About one year ago, US Foods' (USFD) future path changed rather dramatically when a federal judge ruled that Sysco's (SYY) proposed acquisition of USFD would be a competitive threat and ruled against the merger. In a highly fragmented industry, in which about 77% of sales are derived from local and regional distributors, the prospect of a single, large national distributor would pose too much of a risk to the food industry, and ultimately the consumer, in the opinion of the judge.

Consequently, USFD is forging its own path forward once again, after struggling through a difficult period when the proposed merger was being examined. During that time, potential customers hesitated to switch business to USFD, due to the uncertainty hanging over the transaction.

Still, the pick-up in revenue growth so far in 2016 has been minimal, as shown in the financial table below. However, USFD is decidedly not a top-line growth story, and won't be viewed as such. The food distribution industry is generally a stable one, but, not a high growth one.

Second Largest National Food Distributor

USFD is second only to Sysco (SYY) in the foodservice distribution industry in the U.S., in terms of revenue. It estimates its market share to be about 9%, which might seem low for the nation's second largest company. But, again, it is a highly fragmented industry with many regional players, each claiming a small percentage of the market.

The company supplies approximately 250,000 customer locations, including single and multi-unit restaurants, regional and national restaurant chains, hospitals, nursing homes, hotels, government and military organizations, and universities. It provides over 400,000 fresh, frozen, and dry food SKUs, in addition to non-food items.

The customer base is very diverse, but, it does focus more intently on a couple distinct markets -- namely, independent, small chain, and regional chain restaurants, and healthcare and hospitality customers. These customers accounted for 66% of net sales in FY15, up a tick from 65% in 2014.

USFD says that its nationwide reach means that it can serve large regional or multi-regional customers who want a more seamless experience across the geographies they serve. This scale provides several advantages over local distributors as USFD achieves volume savings across the board. It also benefits from greater efficiencies of scale for many functions, like accounting, payroll, and taxes, resulting in lower unit costs.

Financial Review

Figure_1.jpg

For investors looking for an exciting revenue growth story, USFD is going to come up woefully short. The "strongest" revenue growth over the past few years was FY14's +3.2%. And, given its huge revenue base and the dynamics of the food distribution industry, its revenue growth rate isn't going to dramatically improve (unless it comes from un-organic means).

What USFD lacks in growth, it makes up for in predictability and cash flow generation. While revenue is not likely to pick-up a ton of steam, it is also highly unlikely to fall off a cliff due to its scope and because its customers aren't likely to change a food supplier that they have become accustomed to working with. Also, as a consumer staple, its business is not as cyclical.

As the table above shows, USFD's free cash flow has been increasing at a rapid pace over the past few years. That's the good news. The not-so-good news is that its operating income is trending in the other direction, lower on a year/year basis for the past three years. While gross margin has remained pretty steady, operating expenses have been growing at a faster clip than revenue, driving operating income lower.

Another blemish is the massive amount of debt on its books, standing at a staggering $5.0 billion as of April 2, 2016. This, of course, is resulting in huge interest payments. Last year alone, it shelled out $285 million to service that debt. The primary source of this debt burden stems from it being purchased by private equity firms CD&R and KKR in a leveraged buy-out in 2007.

Conclusion

All in all, my sentiment on USFD isn't overly positive, although, I do feel there are a couple good attributes. Its best fundamental quality is its cash flow generation and the general stability of its business. In this volatile market in which many investors are seeking some security and a sense of safety, USFD may look like an attractive opportunity.

What is particularly disappointing about USFD is that it is not offering a dividend. For a low-growth company that generates plenty of cash, one would probably expect a dividend to compensate for the more limited upside potential in the stock. After all, close peer Sysco (SYY) is paying a dividend that is yielding 2.5%.

Another issue -- or, better said, risk -- is that there are two private equity firms hanging onto a massive amount of stock after the completion of this IPO (98.5% of shares prior to this offering). Therefore, investors can expect a secondary offering somewhere down the road as those firms look to cash in on their investment.

To sum up, my sense is that USFD could see decent interest due to the strong underwriting team behind it, its size and scope, and its cash flow generation capability. However, my enthusiasm is quite muted because it is neither a compelling growth story, nor is it an income-generating asset.


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