Food Wholesalers On A Diet

• Brad Kelly
• On 6:02 pm EDT, Friday August 28, 2009

U.S. health officials scramble during tainted-food emergencies such as last year's peanut products recall or the spinach E. coli crisis of 2006.

In both cases, government agencies sought the assistance of tech-savvy Sysco (NYSE:SYY - News), the nation's largest food distributor, which ships more than 21 million tons of produce, meats, prepared meals and food-related products each year.

In the peanuts case, the Houston food distributor quickly identified six operating companies that potentially carried the salmonella-contaminated peanut products made by Peanut Corp. of America.

Sysco also used its tracking software to help the Food and Drug Administration pinpoint 20he source of the contamination by triangulating information about its shipments, eateries that reported outbreaks and the suspected ingredients.

Its sophisticated technology will be key to surviving unparalleled head winds -- slumping restaurant sales and traffic, declining volume and weak pricing -- over the next year, says Mark Wiltamuth, an analyst with Morgan Stanley.

Sysco's sales dropped 1.8% in the June-ended fiscal year and are expected to fall an additional 1% in 2010. In past recessions, sales growth merely slowed, never declined, Wiltamuth says.

"This is unchartered waters for Sysco," he said. "But Sysco is a well-run company and if it can pare labor and other operating expenses, it could offset the sales slowdown."

1. Business

Food distributors are middlemen. They buy products from vendors -- everything from produce and meats to coffee beans -- and supply those goods to customers across the U.S. and Canada.

They use rail and trucks to haul products to and from their distribution centers (DCs), which can ring up a hefty gas bill. That means food distribution tends to be a regional business.

Distributors try to achieve two types of scales: a large network of DCs and large-volume shipments from each facility, says Andrew Wolf, an analyst at BB&T Capital Markets.

"(DCs) carry big, fixed costs, so a low-cost, efficient infrastructure is imperative," he said. "And a large-scale enterprise of DCs gives them buying power with their vendors."

Sysco is one example of how size plays a role in this sector. With more than 180 DCs across the U.S., Alaska and Canada, Sysco is the largest food service distributor in the North America by a long shot. Its sales hit $36.9 billion in fiscal 2009, which ended in June, by suppling food to more than 400,000 customers.

United Natural Foods (NasdaqGS:UNFI - News) is the nation's largest supplier of natural food and related products with a coast-to-coast network of 20 DCs. It ships more than 60,000 natural, organic and specialty food products to 17,000 customers.

Dominating the supply channels to convenience stores is Core-Mark (NasdaqGS:CORE - News), the second-largest distributor to general stores. From its 26 DCs, it ships cigarettes, tobacco, candy, snacks, groceries and other products to 24,000 locations in all 50 U.S. states, though its strength lies on the West Coast.

Coffee suppliers make up another segment of the food wholesale group. Green Mountain Coffee is a wholesaler and direct seller of 100 varieties of coffee sold under its own, Newman's Own Organics and Tully's brands.

It also owns Keurig, which makes gourmet, single-cup brewing systems, and employs a razor-blade model by selling the K-Cups separately from the brewers. In the single-cup segment, Keurig is the clear leader with 60% market share.

The other coffee players in this group are Diedrich Coffee , which franchises 118 coffee shops in 30 states and sells coffee wholesale, and Coffee Holding , which generates 30% of its coffee bean sales from Green Mountain.

Some companies in the group, including United Natural Foods, Weston George , Nash Finch (NasdaqGS:NAFC - News) and Amcon Distributing , own and operate grocery, health food or convenience stores.

As of Friday, the Food Wholesale-Retail group ranked No. 42 among IBD's 197 industry groups, down from No. 4 just three weeks ago.

Name Of The Game: Grow sales by improving operations and technology to ensure that food and related products are efficiently and safely shipped to the right venue at the right time.

2. Market

Distributors serve supermarkets, organic and natural food grocery stores, restaurants, coffee shops, hotels, hospitals, convenience stores, sports stadiums and school cafeterias. Some of the customers are chains, but the majority are independently run.

"A thriving independent sector in all three markets is vital to distributors, who make more money because independent stores have less buying leverage than chains," Wolf said.

But the 11 companies within IBD's Food/Wholesale-Retail group don't battle each other. Instead, competition stems entirely from smaller, private companies.

The addressable restaurant market is roughly $215 billion. The convenience store market is nearly $66 billion, while the natural and organic food segment tops $40 billion, according to BB&T Capital Markets' estimates.

Nearly two-thirds of Sysco's sales come from restaurants. Its 17% market share is equal to its next five biggest competitors combined.

United Natural has about a fifth of the natural and organic market and could become a powerhouse if it decides to buy its top rival, Tree of Life, barring any antitrust issues.

"We continue to take opportunities to grow our market share," the company's CFO, Mark Shamber, told IBD. "We'll see if it's a strategic fit, but we can't make a call until we see their books."

A highly fragmented market has created acquisition opportunities in the past for distributors looking to add new product lines or expand their distribution footprint.

United Natural and Sysco have successfully grown through consolidations, but analysts expect few mergers in the near term.

3. Climate

Since distributors supply products that are ultimately bought by consumers, today's environment is tough. Cash-strapped consumers long ago cut discretionary spending, such as eating out and buying expensive organic food.

Sales in the food service distribution industry will suffer as a result. If cost cutting doesn't work, the downturn could be worse, Wiltamuth said.

United Natural's third-quarter revenue came in flat at $889.5 million. That's because a third of its sales are tied to Whole Food Markets , which has watched sales recede as consumers swap out pricey options for more value.

Restaurant same-store sales and traffic are down amid the worst postwar slump. Sysco anticipates that 3% of the roughly 15,000 to 17,000 U.S. restaurants could close this year, placing severe stress on its core business.

Some analysts see home brewing gaining ground in a weak economy as coffee drinkers eschew pricey coffee chains. That bodes well for Green Mountain.

Distributors welcome food inflation because it yields higher sales. But inflation is cooling, and some analysts fear prices could swing into deflation. Higher fuel costs, scarce acquisition targets and declining volume exacerbate the problem.

4. Technology

Sysco's complex network of software, databases, scanning systems and robotics would impress even Silicon Valley.

Customized technology tools are used at Sysco's DCs to create a logistical plan every day and execute it. That way, an elementary school doesn't end up with meals meant for an assisted-living facility.

Each truck driver is outfitted with a wireless scanner and a hip-mounted printer with exact instructions on what to load on the forklift. The company's software calculates exactly how each pallet should be arranged.

United Natural has not been as tech-savvy in the past, but it has upgraded its systems to limit errors and redundancies.

Four of its DCs use pick-to-light technology, which illuminates bar codes on the shelves where products are stacked, showing the correct quantities to ship in a delivery. Other distributors use off-the-shelf inventory management software.

"In order to save free cash flow, (distributors) must focus on improving efficiencies and investing in new technologies at existing DCs," says Scott Mushkin, an analyst at Jefferies & Co.

Distributors also make improvements unrelated to new technology, such as arranging facilities so that employees work methodically in one direction and aisles are organized according to weight and temperature.

5. Outlook

Economists expect a slow and protracted recovery as consumers continue to ration spending, which will yield weak sales.

Reducing labor and operating expenses amid tepid sales is imperative for food service distributors.

They must continue to invest in sophisticated software and smart supply-chain logistics to keep expenses low and improve service, analysts say.

But if smaller competitors start to fail as a result of a sluggish economy, it could mean more gains in market share for the bigger players in this group.

"Dominant market share, a large network of DCs, a healthy balance sheet and continued ability to grow free cash flow will guide distributors through the choppy waters," Wolf said. "And those that create leaner businesses will be well-positioned for positive growth once sales trends recover."

Upside: Technology, software and efficient supply-chain logistics are helping food distributors to cut waste. And as smaller independent distributors fail, the bigger public companies will pick up new business and face fewer competitors.

Risks: Growing sales is vital in a low-margin business, but industry head winds will make it a difficult task in the near term.

Buzz up!