[00:00:11] Greg Denewiler
This is Greg Denewiler, and you are listening to another episode of the Dividend Mailbox, a monthly podcast about dividend growth. Our goal is to stuff your mailbox full of dividend checks. When they grow over time, a funny thing happens—you create wealth.
Welcome to the Express Mail edition of the Dividend Mailbox. We've done a few of 'em in the past. These are situations that come up that we think warrant an update on something that's going on. And what has prompted this one, an episode that we did about a year ago—Episode 47 in May—was on Sysco, the food distributor.
Yesterday, they announced an acquisition, and it's a major one for 'em. It's gonna grow their business by more than 20%. The stock was trading up around 80, 81, and the market was nervous about this acquisition. It sold off more than $10, and it actually went below our price of 70. Usually, the acquirer gets penalized and the company being acquired gets the benefit, but.
Who Sysco is purchasing is Restaurant Depot. They're a private company. They're in the same line of business. However, they are going after, for all intents and purposes, an entirely different niche. The total purchase price was $29 billion. It's going to basically take the revenue of the company from $80 billion up to $100 billion.
As you should be aware, if you've listened to very many of these podcasts, most of the time we are not fans of acquisitions. So we did a quick back-of-the-envelope to decide, is this maybe bringing up an opportunity or, you know, here we go, like we've went through on Clorox—we're not very excited about it.
They probably paid too much. It's gonna dilute shareholder value. In this case, it actually has created an interesting scenario. First of all, just a little background. So if you're a pizza shop or a single restaurant owner or just a small operator, you won't meet the minimum delivery requirements for Sysco.
So Restaurant Depot—basically smaller restaurants, if they need product, they just come in and buy it. It's very similar to Costco. It's basically a Costco model. The advantage to Restaurant Depot is they are supposed to be about 20% cheaper because they are not doing a distribution model and going through the cost of delivery.
Another advantage is even a larger chain, if you run out of something—because these delivery companies, a lot of times you'll be on their route once a week, twice a week—if you need something, then you can go in there and buy it. So they appeal to a different customer, which is one of the things that makes this a little more interesting.
They're really not cannibalizing either one of the businesses, and you kind of can see where there's potential synergies. A smaller operator gets to a point where they can start meeting the minimum delivery requirements, and they no longer want to go out, take the time to go out and buy their inventory.
Then it's a natural fit. It does make some sense. Another interesting thing is this has been owned by the same family, I think, since it was started. There are a couple of other minority shareholders, but as it was presented, this company went to Sysco and said, we would like to create some liquidity, but we still wanna run the business.
It's gonna be operated completely on its own—same management, same guy who owns it is now gonna own about 20% of Sysco because they're gonna issue 91 million shares, and it's mostly all going to the family. But normally these businesses are bought at relatively substantial premiums.
When we look at something, if we've got cash flow coming out of the business and the market cap, we're getting north of 5%, ideally 6% or 7%. We consider it a reasonable buy. Well, this was sold at basically 7% of their free cash flow, so they really didn't pay what you would consider a big premium, or much of a premium at all, from a standpoint of how these things are usually priced.
Because the company did not shop it, they went straight to—this was kind of similar to a lot of times how transactions are done with Berkshire Hathaway. People wanna sell to Berkshire, they go there, and they understand how their business is gonna be treated going forward. That supposedly was the theory on Restaurant Depot. So that brings up an interesting scenario.
The acquisition seems to kind of make sense, and this is just a quick overview, but how does it affect dividend growth? Because that's our key, and it's hit 70, which is what we were really interested in buying, putting more of it into our portfolios. We do have accounts that own it, but it is not in a model portfolio.
So now the question is, are we gonna put it in the model portfolio? Well, the dividend yield's up to 3.1%. Okay. Sysco is a Dividend Aristocrat. They have been raising the dividend at least 25 years. It's got the long-term dividend growth story. In 2015, it was $1.19, and now it's up to $2.16, so it's virtually doubled the dividend in 10 years.
Going forward, Value Line had an estimate of 5% dividend growth. Earnings growth is 7%, so it was potentially gonna fit our dividend growth story going forward. The story gets more complicated because they're gonna issue 91 million shares, which is gonna take the number of shares outstanding up to 566 million.
But more importantly, currently Sysco has $12 billion of debt. They're gonna issue $21 billion for this acquisition, which takes it up to $33 billion. The first simple observation is if your cost of debt—which, if you look at where bonds trade for Sysco, the bonds out in 2035 traded at a 5.4% yield—if you can borrow money at 5.4% and you bought the thing at a free cash flow yield of 7%, that really implies that this thing is immediately accretive.
But one of the problems that starts to come into this: Sysco has BBB-rated debt. The normal measure for credit quality is times interest earned based on earnings before interest and taxes, and the low end of the BBB scale is four times what their annual interest cost is.
Right now, Sysco is up at 5.5 times, so they're roughly towards the middle of the BBB scale. They've got Restaurant Depot—they're buying $2 billion of operating income. The combined earnings before interest and taxes of the two companies should be around $5.5 billion on $33 billion of debt.
Currently, Sysco has current interest cost on the $12 billion of $583 million. With the additional debt costs on this acquisition, it's going to add probably about $1.1 billion of interest cost a year. If you consider that they borrow money at 5.4% and they're borrowing $21 billion, the additional $1.1 billion—it's gonna bring the thing up to a little below $1.7.
They think there's gonna be, you know, $250 million of savings from larger purchases and utilizing distribution, et cetera. And I think they're relatively conservative on that. They're not factoring in really any cross-selling or anything. But to keep things simple here, it's gonna bring it down to $1.5 billion of interest costs.
Well, the problem is that's a little bit below four. It's bringing the total interest coverage down potentially below BBB. So that's the first kind of red flag here.
They say that in the first year, they think they can get it up to 4.5. Not totally sure how that's gonna happen, but there's a little bit of an issue there. And now we're gonna look at, okay, what's supposed to happen over the next two years?
What their goal is, is to get the coverage in two years back to 5.5. That implies that they're gonna have to buy back $4 billion of debt a year. Well, Restaurant Depot has a little bit faster growth than what Sysco has. Sysco has been down around 3% or 4%, so it actually may help that a little bit.
But if you use 6% growth, in two years that earnings before interest and taxes should grow from $5.5 to $6.2 billion. The current dividend's $1.2. CapEx is about $1. So $4 billion of debt plus $1 billion of CapEx plus $1.2 billion of dividend gets you to $6.2.
So basically, they can do it. They can get the debt down, get the credit quality up a little bit, keep the BBB in place, create a little liquidity in the balance sheet to do something else in the future if they choose to.
But here comes the big dilemma. They've openly stated they're gonna stop share buybacks. They intend to maintain their Dividend Aristocrat standing, which means you can read between the lines with their debt reduction mandate that they're putting in—they really don't have much room to raise the dividend.
And it's potentially gonna be one-penny raises just to maintain the record of showing dividend growth. We don't want 1%. We really want 7%.
The story gets even more complicated because after two years, Sysco should be in a situation to get back to a relatively aggressive dividend grower again—probably easily hit back to the 6%, 7% number. We've got two years here that maybe not a whole lot happens. Is 3.2% on the dividend enough to compensate us for not getting any dividend bumps?
Well, it gets even a little more complicated. Can we keep our overall portfolio growing in our model portfolio? We've got Williams-Sonoma in there that yields half of what Sysco does at 3.2%, so we could pick up dividend growth from that—moving a lower-yielding asset to a higher-yielding asset.
But Sysco is really in a gray area. I don't think it really yields quite enough. So we're really kicking into: is it gonna play catch-up down the road?
The issue here is it's trading way below a market multiple. It's trading down around 15 times earnings. It is a very consistent business. Even with the restaurant shutdown in 2020, Sysco still grew their dividend and they still had positive earnings.
Even in an extremely challenging environment, you could easily say this is a high-quality company that, once they show some execution on this acquisition, the P/E quite likely is going to expand. The total return on this thing actually looks pretty good.
And the one thing I have to say is there are a few companies—Accenture's one of 'em—that have shown a fairly successful track record of making acquisitions and tucking 'em in and keeping the business profitable. Sysco is really the same story.
They've got experience doing a lot of small acquisitions, and Sysco has a track record of executing. So if you think maybe we are contradicting ourselves or being a little hypocritical here, every situation's different, and you have to look at it and determine, you know, where do you think the risk is and is it an opportunity?
Having said all of that, we are really trying to figure out whether we want this in a model portfolio or not because it checks a lot of boxes, but it doesn't check the 7% box for the next two years. That's a big part of our story.
The biggest part of this story—this thing probably does have the total return. In fact, it may actually do better than double over the next decade because you're buying it fairly cheap now.
So with that, I leave you with the dilemma of managing dividend growth but also balancing total return. Looking at, okay, how are you going to apply your discipline, and what is your end game?
We are not totally sure of how we're gonna treat this yet, but we've talked about we own things that don't fit the dividend growth model. What we will do is probably put it in more portfolios, but just thought we would give you an update because the situation has changed.
Hope you enjoyed our Express Mail. I hope this helps you with the dividend growth story.
If you enjoyed today's podcast, please leave us a review and subscribe if you would like more information regarding dividend growth or our investment strategy. Please visit growmydollar.com. There you'll find previous episodes and also our monthly newsletter.
If you have any questions or anything to add to today's episode, please email ethan@growmydollar.com.
Past performance does not guarantee future results. Every investor should consider whether an investment strategy is right for them and all the risk involved. Stocks, including dividend stocks, are volatile and can lose money. Denewiler Capital Management may or may not have positions in the publicly traded companies mentioned herein.
