Decent Underlying Trends As US Foods Starts A New Era

A long stretch of underperformance and a bruising battle with an investor have ultimately led US Foods (NYSE:USFD) to an interesting place early in 2023 – case volumes with more profitable customers are fairly strong, there have been some operating improvements, and the company has a new CEO with a clear mandate to close the performance gap with Sysco (SYY) without compromising growth.

My issue with US Foods roughly a year ago was that while the company had the potential to do a lot better, it wasn’t clear that it had the capability. The shares are up about 7% since then, outperforming the market and Sysco, but underperforming Performance Food Group (PFGC) on what I believe is optimism that the new CEO will make a stronger push for real change. I’m not going to suggest that change will be easy from here, but I think the management change will be a positive driver and I don’t think USFD stock's valuation is all that demanding now.

Fourth Quarter Earnings Show Some Positive Momentum

Although US Foods did lower guidance for 2023, I would still say that fourth quarter results show some momentum going into the year. The impact of deflation is still a big unknown, but I think underlying case volume and some ongoing operating leverage are both positive takeaways.

Revenue rose more than 11% in the quarter, a trivial miss relative to sell-side expectations. Revenue was driven principally by ongoing food cost inflation (up over 8%), while case volume grew 2.6%, including a 100bp headwind from strategic business exits and 5.8% growth at independents. Overall volumes weren’t bad next to Sysco (up 3.2%) and Performance (flat), with independent case volume growth strongest at US Foods this quarter (Performance was second with 4.3% growth). Sysco reported similar inflation, while Performance was at around 10%.

Adjusted gross margin improved 60bp yoy and 70bp qoq to 17.1%. Adjusted EBITDA rose 34%, with margin up 70bp yoy and 20bp qoq to 4.1%, beating by 5%. Adjusted operating income rose 50%, with margin up 80bp yoy and about 5bp qoq to 2.9%. While operating income was a slight miss relative to the Street estimate, I know some analysts add back amortization in their estimates and it’s not clear to me whether the reported “consensus” number was with amortization or not.

Initial guidance for 2023 was soft, with a midpoint about 4% below the prior sell-side average estimate, but it seemed as though more than a few sell-side analysts expected a below-consensus guide, so it wasn’t really a thesis-changing development.

2023 Will Have Some Interesting Currents To Navigate

Inflation continues to play a big role in reported revenue growth for the food distributors, as it’s largely a pass-through business. I say “largely”, though, because inflationary periods are typically good for distributors and their margins.

That makes the outlook for food inflation/deflation in 2023 more relevant, but it’s a tricky analysis. The CPI for food still showed 10%-plus year-over-year inflation in January, but the pace has been slowing. Further complicating matters, distributors typically see a roughly six-month lag in their numbers, so while deflation could well show up before year-end (and could be priced in by the market), I’d still expect to see roughly mid-single-digit growth from inflation in US Foods’ numbers for 2023.

While inflation does whatever it does, US Foods should see some improvement in labor. Wage inflation is still a significant issue, but also seems to be easing and availability is improving. At the same time, there has been progress with improved routing/route density, and warehouse automation efforts seem to be filtering through into better operating leverage.

As far as underlying demand goes, I’m generally positive on dining trends. Traffic has improved a bit of late, though it’s still not that strong, and there has been some growth in restaurant unit volumes. Unfortunately for US Foods, the strongest growth is in areas like fast food chains and fast casual chains (Chipotle (CMG), Panera (PNRA), Portillo's (PTLO), Shake Shack (SHAK), et al) and not in independent casual or fine dining where US Foods generates more profitable case volumes.

How Long Will Investors Need To Wait For Change?

At this point, US Foods’ new CEO, hired after a settlement with an activist investor that included the removal of the prior CEO, has said relatively little about what he intends to do differently to drive better results. Given his short time on the job, that’s not unexpected, and the plan for the immediate future seems to be to follow the current plan but look to drive acceleration where possible.

There’s a good core to build on here. US Foods has good share with its core independent restaurant customers, and the company has a number of initiatives in place to drive more profitable, stickier relationships, including an e-commerce/online ordering platform, dynamic pricing, and services meant to help customers gauge and maximize the profitability of menu items. The company also has its cash-and-carry Chef’s Store concept, which has been driving growth in small-ticket purchases without any meaningful cannibalization.

There are also issues, though. US Foods has lagged Sysco’s margins for years and the distribution system just isn’t as good. That’s a liability in a business where profitability is driven by running ever-higher volumes through highly efficient distribution channels. There has been some progress here already, including improved routing and leverage from past automation efforts, but I believe a more comprehensive restructuring/improvement of the distribution system may be needed to really close that gap with Sysco.

The new CEO is a veteran of distribution businesses, including running Performance Food Group’s foodservice operations a few years back. I believe he’s well aware of the circumstances that led to his hiring (two board members nominated by the activist investor were part of the search committee) and understands the mandate to drive improved operational performance. With that, I think investors can reasonably expect to hear a plan that goes beyond “more of the same, only better” within the next year.

The Outlook

Modeling improvement at US Foods is challenging without clearer guidance on exactly what the new CEO intends to do differently, what it will cost, and when the results can be expected to start showing up. As I said, I don’t believe the CEO was hired simply to steward the current plan, but modeling anything especially dramatic at this point largely just becomes an exercise in what I might want to see or do in that position.

I still expect US Foods to generate long-term revenue growth of around 4% and I’m looking for a little more than a half-point of improvement in EBITDA margin across the next two years. Longer-term, I think a full point of improvement in free cash flow margin is possible over the next decade, driving double-digit FCF growth. That’s not a conservative estimate relative to the company’s past performance, but I don’t think it’s out of reach either.

If those cash flow margin improvement assumptions are viable, US Foods can trade into the high-$40s on a discounted cash flow valuation approach. A margin/return-driven EV/EBITDA approach is less generous (using a forward multiple of 9.75x), but then that doesn’t reward the longer-term improvements I expect from the business, so it’s not unreasonable that it would drive a lower short-term fair value. Even so, the $43 I get that way still offers double-digit upside.

The Bottom Line

I believe the bear-case scenario here is basically that the new CEO can’t drive meaningful improvement and the business continues to muddle through. A “more of the same” model with no FCF margin improvement would mean meaningful downside from here, but less downside relative to the upside I see if the company can reach that one-point improvement threshold over time. I’d like to hear more specifics on the plan before getting more bullish, but I do think the risk/reward skews more favorably than not at this point, even allowing for challenges like deflation in 2023.