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Netherlands-based supermarket group Ahold sold last year's e3 billion rescue rights issue to investors on a simple premise: its US food distribution arm, which had been hit by an accounting scandal, could be turned around and made to perform more like its great rival Sysco. This seemed a better option than a distressed sale of the business.
If Sysco's results were any guide, Ahold's investors could expect a juicy return on their rescue investment. After all, the US group's 5% operating profit margin is the envy of other food distributors. Based on it, Sysco's shares have commanded a high valuation, sometimes trading on a multiple of more than 30 times forecast earnings.
But Sysco's past results might be a less reliable guide to its prospects than Ahold's investors once thought. Sysco has been investing heavily in its supply chain to beef up distribution centres. There's nothing wrong with that. The catch is that Sysco seems to have accounted for this investment in a way that temporarily flatters its profits now – at the expense of profits in the future.
What are the warning signs? The main one is how much Sysco charges against earnings for depreciation. It doesn't state this number. However, it does give a total of depreciation and amortization (D&A). And since depreciation has historically accounted for more than 90% of this total, this number is a pretty good proxy.
It is interesting, moreover, because it has been growing much more slowly than the rest of the business. Sysco's sales rose 12% last year and net profits 17%. But D&A grew by less than 4%. This meant that accounting profits grew far faster than cashflow.
What's more, Sysco's depreciation isn't just lagging profits and sales. It is also lagging capital expenditure – itself generally a proxy for future depreciation. Capex was 87% higher than depreciation last year. That implies that depreciation should rise sharply in coming years.
It's not clear why there is such a mismatch. One possible explanation might be that Sysco has changed its accounting policies on depreciation – such as the number of years it considers its assets to be useful. But it insists it hasn't.
Capitalizing costs
Another possible explanation is that costs have been capitalized. Indeed, more than $150 million of costs related to the distribution centre initiative have been treated as an investment on the balance sheet, rather than an expense on the income statement. These assets aren't characterized as depreciation straightaway. But the costs will have to be incurred as new centres become operational starting this year and next. So Sysco's depreciation charge will rocket.
Moreover, $150 million of capitalized costs is not insignificant in the context of Sysco's operating profits, which grew by $217 million to $1.4 billion last year.
What impact could the unwinding of this timing mismatch have on Sysco's future profits? Normally, in a mature industry such as food distribution, depreciation should be in line with capex.
Take Sysco's profits for last year, and assume that this is the case. Then depreciation would be roughly double what it was last year. And that in turn would have cut Sysco's operating profit by some $250 million, slicing its operating margin from the reported 4.7% to just 4%.
This comparison is slightly unfair as it is based on static profits. But Sysco's investment in distribution centres should grow the business. So a higher future depreciation charge would be offset by higher profits. But the comparison does give an idea of what could happen to profits when depreciation goes up.
Sysco's own investors appear to have cottoned on to this. Its shares have come under pressure in recent weeks and the P/E ratio has fallen to 23.
So spare a thought for the investors that bailed out Ahold. This might still look like a better thing to have done than to have forced a distressed sale of the food distribution business. But what's happening at Sysco is bad for Ahold.
First, Sysco's expansion means it might be harder for Ahold to grow its own food business, or to jack up margins. What's more, the margin ambitions the Dutch group has for its US business – based on Sysco's performance – might have been built on the shaky foundations of a temporary accounting blip.
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