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US Foods Holding (NYSE:USFD) is the second-largest foodservice company, next to Sysco Corporation (NYSE:SYY). Many remember Sysco’s attempt to acquire US Foods, which did not pass regulatory hurdles. Soon after the deal was off, US Foods decided to go the IPO route as a public company.
My initial interest in US Foods was the company’s growth potential over the long term, combined with the opportunity for margin expansion resulting from consolidation and restructuring of the company’s operations. I had modeled US Foods over the long term providing investors with a double-digit return at the right stock price.
Today’s fourth quarter and fiscal year-end results were strong for the company. Net sales improved to $22.9 billion for the year and $5.7 billion in the fourth quarter. Investors should note that 2015’s numbers included a 53-week period versus the 52-week period during 2016. Apples-to-apples, net sales were up. Net sales were driven by three percent growth in total case volume, led by 6.6 percent growth in independent restaurant case volume.
More importantly, US Foods realized cost savings for cost of sales and operations. This translated to a 30-basis point (bps) improvement for gross margin and a 100-bps improvement for operating margin. On an adjusted basis, this led to a 130-bps improvement for diluted earnings per share (NYSEARCA:EPS). Profit margin on an adjusted basis came in at 1.4 percent, only 60-bps shy of the all-important two percent focal point.
In addition to the company’s net sales and profit margin, adjusted EBITDA improved by 12.5 percent. The company has continued to guide for adjusted EBITDA to grow over the mid-term by seven to 10 percent, but 2016’s performance exceeded these expectations. US Foods’ return on equity increased dramatically to 13 percent. Debt is now four times EBITDA on a gross basis, which is lower than Sysco and well on track to meet the three times goal in the near term.
Lastly, free cash flow came in strong for 2016 at approximately $400 million leading to a seven percent free cash flow yield for the stock price. Investors will remember that US Foods does not pay a dividend like some of its peers. But the company’s strong cash flows should allow for stock repurchases to improve adjusted diluted EPS growth. And a dividend may be on the horizon at some point in the near term.
As stated, my target for US Foods to be a solid long-term holding is for the company to attain a two percent profit margin. Ideally, this would occur on a GAAP basis, but the company’s calculation for adjusted net income has provided an adequate non-GAAP metric which still would provide investors with strong investment potential at a two percent margin.
US Foods computes its adjusted net income by first calculating EBITDA by adding interest expenses, income taxes and depreciation and amortization to GAAP net income. From this point, the company adds a variety of other line items including restructuring and impairments, share-based compensation, reserve charges, among others, to get an adjusted EBITDA. From here, the company simply subtracts out the previous EBITDA items for adjusted net income.
Source: US Foods, Q4 and Full Year 2016 Results, February 15, 2017
US Foods has provided analysts and investors slide 16 from the Q4 and full year 2016 results earnings call, which is an important one to model financial expectations. These expectations are what helps us to form an opinion regarding the stock’s valuation level for potential growth.
The problem is that US Foods earned $1.57 per share on an adjusted basis during 2016. For 2017, the company has provided a range of $1.26 to $1.40 per share. By considering growth expectations for net sales, adjusted EBITDA and net income, there are clearly no red flags as to the company’s core growth.
This is confusing as there is a precedent regarding US Foods’ adjusted EBITDA numbers being the last step before subtracting depreciation and amortization, interest expenses and income taxes to get adjusted net income and diluted EPS. If we work out the math from these assumptions, we get an adjusted dilut ed EPS number much higher than the range provided at approximately $1.85 per share.
If US Foods adjusted EBITDA were to grow at the midpoint of 8.5 percent for 2017, this would be applied to the $972 million generated in 2016, or $1.05 billion. Share dilution is not something that would appear to be on the horizon based upon the company’s strong cash flow. But investors will remember that a prospectus had been filed with the Securities and Exchange Commission (SEC) regarding a secondary public offering of another 36 million shares by Clayton, Dubilier & Rice, LLC ((CD&R)) and Kohlberg Kravis Roberts & Co. (NYSE:KKR), as selling shareholders.
Within this prospectus, the common stock outstanding as of December 31, 2016, was listed at 220.8 million shares. In addition to the original 36 million shares being sold, an additional 5.4 million shares were available for sale. On January 31, 2017, US Foods announced that the closing of the underwritten second ary public offering did indeed include the 41.4 million share total for CD&R and KKR as the selling shareholders. Based on this information, US Foods could have a significant increase in diluted shares for 2017. Just totaling the shares outstanding at year-end 2016, and the new total has increased to 262.2 million, a 19 percent increase in dilution.
When considering this number of shares outstanding, we get a number much closer to US Foods’ provided adjusted diluted EPS range at $1.50 per share US Foods did beat analyst estimates for the fourth quarter by $0.07 per share, so the company could very likely be providing conservative guidance.
Aside from the share dilution from the secondary public offering, US Foods’ growth projections for 2017 would generate a 30-bps improvement from the 1.4 percent profit margin to 1.7 percent on an adjusted basis.
When looking at US Foods’ current valuation level, the stock is trading 17.3 times adjusted earnings an d 9.5 times adjusted EBITDA, with a seven percent free cash flow yield. On a forward basis, US Foods is trading 18 and 15.4 times 2017 and 2018 adjusted earnings.
Sysco is trading 23 times adjusted earnings and 13.7 times EBITDA with a five percent free cash flow yield. On a forward basis, Sysco is trading 21.3 and 19.2 times 2017 and 2018 adjusted earnings. Both companies are witnessing expanding profit margins on an adjusted basis.
The share dilution does hurt US Foods, especially if the stock trades with a P/E multiple at 17 or 18 times adjusted earnings. Hopefully the market can get focused on US Foods now that CD&R and KKR have received a cool $1.7 billion in dividends and the secondary offering. In an economic growth cycle, I do believe that investors will be willing to pay over 20 times earnings. Sysco will likely continue to trade at a premium above US Foods.
As US Foods continues to approach a two percent profit margin, the company should se e an expansion for the P/E multiple. I do expect US Foods to eventually pay a dividend in the future. When this occurs, the stock may also see a higher valuation multiple.
For the time being, I expect US Foods to be range-bound somewhere between $26 to $27.50 per share. Over the next couple of years, if the company can meet its mid-term projections, a stock price approaching $35 per share is not unreasonable with a P/E at 20 times earnings. This target price provides the potential for 30 percent upside from today’s price level.
Over the long term, if US Foods can attain a P/E multiple at 20 times earnings, investors could expect to see annual stock price returns approaching 10 percent. This valuation level is not unreasonable, especially as Sysco has traded between 23 and 25 times earnings during the recent growth cycle. As the market continues to attempt to figure out US Foods, investors may look to enter or add to positions near the $26 per share level or low er to lower near-term market risk.
Disclosure: I am/we are long USFD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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