Wednesday, January 28, 2015

Sysco (SYY) Belongs On the Dividend Investor’s Watch List

It has an attractive dividend history

It will benefit from low energy prices

It is emerging from the cloud of merger uncertainty

Earnings need to improve in order to justify current stock prices

Its US focus is attractive and could offer portfolio benefits

As one of the dividend aristocrats, Sysco is, or has been, in the portfolio of many dividend- growth investors.  The company’s failures to produce earnings growth as well as high price earnings ratio have probably taken it off the radar of many dividend-growth investors.  However, there are reasons to keep the stock on one's watch list.

An article on SeekingAlpha entitled “Sysco: Plunging Gas Prices, US Foods Merger Will Benefit The Company” illustrates the issue.  It points out the benefit that Sysco could derive from lower energy costs and its merger with US Food.  However, it goes on to point out that by many metrics Sysco's stock is overpriced.  Looking just at those factors, the merger with US Food would have to be a significant catalyst for improvement before the stock would become appealing.  That certainly is a possibility, but without some evidence that it is occurring, it alone is not a convincing investment thesis.  It justifies watching the company's performance but not necessarily purchasing a significant position in the stock.

However, there are other reasons to consider Sysco.  The SeekingAlpha article focused on the benefit plunging oil prices would provide as a result of Sysco’s energy consumption.  That reduced cost to the company could improve profits and margins.  There is another impact that the market may be overlooking.  That is the influence of energy on the demand for Sysco's services.

Food away from home, the source of demand for Sysco’s services, is influenced by energy prices in two ways.  Reduced gas prices lower the cost to the consumer of going out.  The cutback in driving associated with high energy prices usually focuses on long trips, but it probably also influences local discretionary driving such as going out to eat.  Lower gasoline prices would reverse that impact.  Second, the US consumer is a major beneficiary of reduced energy costs.  As a discretionary purchase, food away from home will be a beneficiary of the increase in discretionary income of consumers.  A previous posting entitled “Markets in Motion” expressed some skepticism about analysts’ estimates of the impact of oil prices on earnings.  Specifically it stated: “While the energy sector’s earnings will be reduced, earnings in some other sectors will benefit.”  Sysco is an example of the company that could be a beneficiary.

The current raft of earnings reports where negative currency translations have resulted in earnings that disappointed investors has probably provided an investor with an intuitive understanding of what generalized foreign currency exposure means.  For anyone who still does not understand why foreign currency exposure is important, a quick reading of two recent WALL STREET JOURNAL articles should help.  “Swiss Franc’s Leap Lifts Some FX Brokers on Monday, January 26 and “Currency-Trading Volumes Jump” on January 28 both make mention of the amount of money involved in currency trades.  When more than $4 trillion (note that's trillion with the t) is flowing in a single day, it will easily overwhelm any actions taken by the management of any corporation.  Sysco's US focus means it is not as exposed to currency risk as many other corporations.

At the same time, there is a potential benefit to Sysco from the strong dollar.  A strong dollar will reduce the price of imports.  Consumers of imports, US citizens for short, will be beneficiaries of those lower import prices.  That will increase their discretionary income which could benefit Sysco if it results in increased demand for food away from home.

Reduced cost as a result of lower energy prices, reduced risk as a result of its US focus, and the economic tailwinds that could result in an increase in demand for Sysco's services, are all factors that will take time to have any impact on Sysco's profitability.  So, it would be a bit naïve to expect them to have their major impact on the upcoming earnings report.  They might, but waiting for the earnings report and carefully examining it for any indication that these factors are starting to show is a viable strategy.  There is a difference between operating in an economically beneficial environment and actually benefiting from it.  The latter requires that management capitalize on the beneficial economic environment. 

Despite the cautions above, I have initiated a position in Sysco due to portfolio considerations. A previous posting entitled “Rebalancing and Risk” discussed why an investor might want to reduce his or her exposure to generalized tail risk. It focused on mutual fund holdings and on tail risk.  However, even without tail risk, many investors, especially those seeking dividend growth, may have significant exposure to a large number of multinationals.  As a consequence, they may have taken on a substantial amount of generalized foreign exchange exposure.  That would not be the case if one is loaded up on REITs, pipelines, US banks and utilities.

However, a previous posting, “The Widows’ andOrphans’ Portfolio and US Banks,” presented a core portfolio for a buy-and-hold investor.  With the exception of Verizon, all of the holdings are multinational.  As a core portfolio, many of the stocks have been held for a long time (decades) and represent significant portions of the total portfolio.  Also, the posting suggested that an investor, at least this investor, might want to avoid regulatory risk.  It is difficult to find utilities and banks where the regulatory risk is acceptable.  Even pipelines and some REITs have regulatory risk. As consequence, many of the non-core holdings are similar to those discussed in the posting.

Investors can find themselves in a position of searching for domestic exposure that is relatively “regulatory risk free."  Sysco is such an investment.  There is no magic formula that can tell the investor how much of their portfolio to shield from foreign exchange fluctuations or, for that matter, regulatory risk.  With only 10% of my portfolio distributed across seven stocks that are primarily domestic in their orientation (NNN, GAS, HCN, WTR, WFC, TRP, VZ) Sysco is appealing from a portfolio perspective.

Given that conclusion, two issues remain: what role will it play in the portfolio, and when and how should it be acquired.  Regarding the first issue, a SeekingAlpha article entitled “Modern Graham Quarterly Valuation Of Sysco Corporation” provides pretty good guidance on what role it should play.  It will not be a core holding, but it is not totally a speculation.

Timing the acquisition of any stock is always an issue.  A good stock at a bad price is not a formula for success.  Thus, acquiring some of the intended position ahead of earnings may work for some investors, but given the economic tailwinds that could benefit Sysco, putting it on a watch list and examining its earnings release closely is a justified use of time for many investors.  The company has become very interesting again.

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