What are we reading?

  1. Flawed thinking about buybacks (here)
  2. Cultivating the state of flow (here)
  3. DJCO 2019 Key Notes (here)
  4. Warren Buffet Feb 25th full interview transcript (here)

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Sysco and the hubris of buy backs

From Google finance:

Sysco Corporation (Sysco) along with its subsidiaries and divisions, is a North American distributor of food and related products primarily to the foodservice or food-away-from-home industry. The Company provides products and related services to approximately 425,000 customers, including restaurants, healthcare and educational facilities, lodging establishments and other foodservice customers. Sysco provides food and related products to the foodservice or food-away-from-home industry. The Company has aggregated its operating companies into a number of segments, of which only Broadline and SYGMA are the main segments. Broadline operating companies distribute a line of food products and a variety of non-food products to their customers. SYGMA operating companies distribute a line of food products and a variety of non-food products to chain restaurant customer locations. The Company’s other segments include its specialty produce, custom-cut meat and lodging industry products segments

Sysco was recently in the news for terminating the merger deal with US foods (link here). At the same time they announced that they would be buying back stock of about $3B from the market.

  • Total market cap of Sysco is around $22B
  • At the last close price it is trading at a PE of 25; earnings yield is 4%
  • Net margin for the business is 1.79% for TTM
  • Debt/equity for the business is at 1.44
  • ROE for the business is at 16.3% for TTM
  • FCF for the business is $868M
  • Shares outstanding for the business is 599M

Let us see what happens as a result of this buyback. For the sake of simplicity, let us assume that Sysco can buyback the stock without significantly influencing the price.

Sysco current price 37.54
Oustanding shares 599
Buyback ($M) 3000
Shares to be repurchased 79.91476
After buyback outstanding shares 519.0852
Net Income 868
EPS before buy back 1.449082
EPS after buy back 1.672172
% EPS Growth 15.4%

So far so good. Current investors can spend $3B at current prices and get a 15% bump on EPS.

Any company can spend the money it generates in four ways

  1. Dividends to shareholders
  2. Buybacks to return money to shareholders
  3. Inorganic growth through  acquisitions
  4. Fund internal programs

At any given point, the CEO, whose prime job is capital allocation, is deciding where to allocate the money.

The current ROE of Sysco is 16%. Let us explore option 4 and see what happens if Sysco is able to generate half the ROE that it generates with the new programs on which it would spend the $3B on without diluting shares by using internal cash generation and debt to generate an incremental ROE of 8%.

To be invested in additional internal project ($M) 3000
ROE 8%
Additional to FCF and Net Income / year (simplified to assume the same number for both) ($M) 240
Net Income after re-investment ($M) 1108
EPS 1.84975

The EPS growth in this case is 27% significantly higher than the buyback scenario. The ROE of internal projects needs to be 4.4% for the buyback option to make sense over the re-investment scenario which is also a possibility and we can assume that the CEO has done his due diligence.

The questions that begs to be asked are as follows:

  • What is a stock doing trading at 25 times PE when it cannot find re-investment projects at one-fourth of the ROE that the company generates today?
  • Is the management being prudent is buying back stock at 25 times earnings? Even at 20 times, the EPS growth generated will not be as lucrative as the re-investment option.
  • Is the CEO doing his job of optimal capital allocation?
  • Is the market rational and efficient when it either rewards a stock that cannot find a project at 4% ROE or is taking sub-optimal capital allocation decisions?

Not all buybacks are created equal. A conservative investor needs to be cautious before rewarding businesses blindly that buyback shares in the name of shareholder value creation.

Bed Bath and Beyond (BBBY)

  • Revenue per share is up $33/share in 2011 to $63/share in 2015
  • ROE is up from 20.85% to 28%
  • Gross Margins are down from 41% to 38%
  • EPS is up from 3.07 to 5.07
  • BBBY has been gobbling up its own shares reducing shares outstanding by 70M shares from 2011 to 2015 reducing shares outstanding from 258M to 188M
  • $6.3B shares re-purchased in last five years
  • Shares are trading at an earnings yield of 7%
  • Company does not give guidance
  • Strong cash position of $875M and net debt of $650M
  • FCF of $4.5B in last five years and $900M in last 12 months
  • Strong management team with share holder orientation

The most important question under the circumstances to ask is: what’s the catch? What can go wrong?

2010 2011 2012 2013 2014
EPS 3.07 4.06 4.56 4.79 5.07
EPS Growth 32.2% 12.3% 5.0% 5.8%
Shares Outstanding 258 244 228 213 189
% Change -5.4% -6.6% -6.6% -11.3%

If you look carefully at the above table, one can spot a potential problem. EPS growth is lower than the rate at which the shares outstanding have been declining. While it is great that the company is returning money back to the shareholders, the underlying business is losing it strength. Over the last 2 years, while shares outstanding have declined 6.6% and 11.3% and net income has risen only 5.0% and 5.8%.

To understand this better, look the below chart to see what happens to EPS when shares outstanding change.

2010 2011 2012 2013 2014
Theoretical shares outstanding 100 94.6 88.4 82.6 73.3
Net Income 100 100 100 100 100
EPS 1.00 1.06 1.13 1.21 1.37
EPS Growth 5.7% 7.0% 7.0% 12.7%

Essentially the underlying EPS growth on the base business has been trending negative for the last 24 months and essentially one is buying a negative EPS growth business goosed up by buybacks at 13 times earnings when one buys BBBY. The primary reason can be attributed to the high gross margins that the company makes at 38% in 2014 as against its chief competition online where it is significantly lower. As the online business for BBBY grows and due to competition, one can expect the underlying EPS to come further down over the next few years. While the strong cash generation and the buyback will probably put a floor on the stock and goose up EPS further, it might be worthwhile to look at it from the sidelines and participate with long term compounding machines instead unless it gets very cheap from here.

Disclosure: No position