This Food Distributor Is a Good Company in a Bad Industry

Doing an analysis of the food-distribution industry will paint a pretty grim picture. Suppliers, the big branded-food manufacturers, have strong bargaining power, as they are large and concentrated relative to a more fragmented supplier base. The threat of new entrants is also high, given the low capital intensity of distributors. The competitive rivalry with the industry is very intense, especially since most of the players compete on price.

Notwithstanding these difficulties, Sysco , the market leader in the food-service supply market, has an impeccable financial track record. It has been profitable and free-cash-flow positive in every single year for the past decade. Over the same period, it has maintained its gross margin within a narrow 17%-19% range. The reasons for Sysco's consistent profitability in a difficult industry are examined below.

Weakening supplier bargaining power
In a 2009 conference call, Sysco communicated to analysts that it was putting a strong emphasis on Sysco-branded products with its sales force. Based on research done by Value Line in 2010, Sysco derives about half of its revenue from private-label products. In the event that any supplier raises prices, Sysco has the choice of either lowering the price of its private-label products relative to its branded counterparts or simply dropping the manufacturer's products in favor of its in-house brands.

Another way of reducing supplier bargaining power in the industry is to increase the market concentration of food distributors relative to its suppliers. Sysco currently has an 18% share of the food-service industry and it obviously thinks a greater market share will further enhance its bargaining power. In December, Sysco announced a proposed merger with its largest rival, US Foods. A large part of the estimated annual synergies of at least $600 million is likely to be derived from the increased buying power of the combined entity.

Increase capital intensity
Distributors, by nature, are more asset light and less capital intensive compared to manufacturers with their factories and restaurants with their locations. Sysco has invested heavily in technology to drive costs down as part of its business transformation project, where Enterprise Resource Planning (ERP) will be put in place to manage most of its processes. It expects to realize annual cost savings of about $300 million by fiscal 2015.

Sysco's actions send a strong signal to new entrants. Companies entering the food-distribution industry will be expected to either to match Sysco's investments to achieve a similar cost structure or be severely disadvantaged in terms of pricing.

Similarly, United Natural Foods , the largest organic and natural foods retailer in the U.S., has spent about $225 million in the past five years to optimize its distribution network. In June 2013, United Natural Foods started a new 540,000 square feet distribution center in Aurora, CO. In July 2013, it bought land in Montgomery, NY to construct a new distribution center to service the New York metropolitan market, which is expected to be up and running by fiscal 2015. These are all part of United Natural Foods' plans to derive greater cost efficiencies in distribution.

Potential new entrants will have to replicate both companies' investments in technology and distribution before they can even compete on an equal footing.

Avoiding destructive price competition
Given the commoditized nature of most food products, food distributors tend to compete on price. Sysco is slowly transitioning itself from a pure distributor to a provider of valued customer solutions. In May 2013, Sysco officially launched its new solutions and services business, with the aim of helping food-service operators increase foot traffic and lower labor and food costs.

For example, its web-based eNutrition tool assists restaurants in analyzing the nutritional content of its foods so that it can tailor its menus to appeal to health-conscious consumers. Another solution offered by Sysco is iCare, which helps restaurant owners link up with the right vendors in areas such as promotion and marketing and repair and maintenance. By embedding its solutions and services deeper into its customers' operations, Sysco is better positioned to maintain long- term sustainable customer relationships.

The Chefs' Warehouse , a specialty-food-products distributor, also doesn't compete on price, unlike most of its broad-line food-service distribution peers. As its customers are typically either menu-driven independent restaurants or fine-dining destinations, it places a higher demand on sales-force quality and product range.

More than half of The Chefs' Warehouse's sales force is culinary-trained; and it also has more than 14 times the number of stock keeping units (SKUs) than an average specialty-food distributor. Given that it has successfully differentiated itself from its competitors, The Chefs' Warehouse has managed to keep its gross margin stable at 26% from 2009 to 2012.

While Sysco and The Chefs' Warehouse differ in terms of their strategies and customer focus, both have successfully avoided price competition.

Foolish final thoughts
Industry structure doesn't have the final word on company profitability. Companies like Sysco have proven that a superior strategy allows for a greater share of the industry profits, notwithstanding the profitability of the industry as a whole. Sysco, through a series of strategic choices, has increased its bargaining power with suppliers, competed on non-price factors, and raised the barriers to entry.

Retire in style with these three stocks
It's no secret that investors tend to be impatient with the market, but the best investment strategy is to buy shares in solid businesses and keep them for the long term. In the special free report, "3 Stocks That Will Help You Retire Rich," The Motley Fool shares investment ideas and strategies that could help you build wealth for years to come. Click here to grab your free copy today.

The article This Food Distributor Is a Good Company in a Bad Industry originally appeared on Fool.com.

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends Sysco. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.