Big Question Marks in Sysco's $3.5B Acquisition of U.S. Foods

Updated from 1:55 p.m. ET to correct cash and stock component of transaction on page three.

NEW YORK (TheStreet) - Sysco's (SYY) $3.5 billion acquisition of U.S. Foods from private equity firms Clayton, Dubilier & Rice and Kohlberg Kravis Roberts (KKR) could go down as one of the more perplexing big M&A deals of 2013, even if the tie-up of the top two food services giants in the U.S. is a deal analysts have speculated about for nearly a decade.

Initial investor reaction indicated Sysco may have cut the deal of the year. At certain points in pre-market trading Monday, Sysco shares were nearly 40% higher than their Friday close, begging the question of whether U.S. Foods' private equity sellers had left some serious money on the table.

By the end of Monday's trading session, however, Sysco had lost most of its gains and closed up about 10%. As of Tuesday afternoon trading, Sysco shares are only up roughly 8% from their Friday close. Yes, Sysco's acquisition may be a good deal, but not as good as investors initially thought.

Sysco may be buying U.S. Foods at an opportunistic price, but also with the "buyer beware" caveat that any good management team is likely to weigh. Sysco, after all, has agreed to a $300 million termination fee that would represent 10% of the stock consideration of Monday's merger and a far larger percentage of the cash component.

The press release announcing Sysco's acquisition had a few eyebrow-raising details.

For one, CDR and KKR will be taking $3 billion of their deal proceeds in stock, giving both firms a total of 87 million Sysco shares, or roughly 13% of the company's outstanding stock. CDR and KKR also will have representatives join Sysco's board of directors. Nevertheless, neither private equity firm released a statement in Monday's deal announcement and both declined to comment when contacted by TheStreet.

U.S. Foods isn't likely to be a trophy investment for either CDR or KKR given that the firms bought the company in 2007 for $7.1 billion in cash and are now selling it to Sysco at an enterprise value of $8.2 billion. Still, depending on how Sysco's stock performs, it is conceivable U.S. Foods' former private equity sponsors could improve their investment returns.

Robert Kreidler, CFO of Sysco, indicated that CDR and KKR had considered an IPO, but instead chose a strategic exit and a minority investment in the acquirer.

"I think the owners have been analyzing their potential exit strategies. And prior to initiating something like an IPO or something like that, they wanted to talk about whether a strategic transaction would make some sense. And that's how the conversations began. I would say that they are very bullish on the combination, which is why they asked for, and they are getting stock in the company," Kreidler said.

CEO William J. DeLaney also confirmed on a call with analysts that Sysco had considered acquiring U.S. Foods before CDR and KKR made their 2007 buyout investment. However, it appears the Houston-based company balked at price.

"We looked at it, I guess, almost seven years, six and half years ago, when it was sold. I think the industry was different there in terms of where we saw growth and opportunity. Valuation was an issue at that point in time," DeLaney said. "I think we've got the best of both worlds here in terms of synergy opportunities, but also a mindset for continuous improvement," he added.

As CDR and KKR sought to exit the near 7-year old investment, one would assume Sysco had the best deal on the table, preferable to a drawn out IPO process. In that sense Sysco's patience appears to have paid off and at a time of pressure for the firm's profit margins.

Yet the merger of the two biggest food distributors in the U.S. raises some big risks for investors.

Analysts peppered Sysco's CEO DeLaney on a conference call about possible antitrust issues and the prospect that the Federal Trade Commission could ask for significant divestitures of Sysco and U.S. Foods' overlapping businesses.

Further, even if investors approve of Sysco's attempt to improve scale and cut costs across its businesses after multiple quarters of profit margin contraction, the merger may come with the poor optics of significant layoffs, office closures and customer defections.

On the antitrust side, DeLaney appeared to concede that divestitures could be a part of a FTC review, however, he stood by synergy forecasts Sysco laid out in its press release.

"[We] expect as we've signaled, that there will be a review process and it will take several months and we'll have some good discussions along those lines. So, there could very well be some divestitures. Our point I think is that, we've modeled what we can today, and even with some divestitures, we still see this as a very attractive deal," DeLaney said.

Varying Expectations

Sysco calculated that it will be buying US Foods at a multiple of just under 10 times the company's trailing 12-month adjusted EBITDA of $826 million. The transaction is expected to yield annual cost synergies of at least $600 million after three to four years, Sysco said, primarily from supply chain efficiencies, merchandising activities, and overlapping general and administrative functions.

DeLaney also confirmed Sysco's expectation that the combined company will control about a quarter of the U.S. foodservices market, while maintaining that the company believes it is an extremely fragmented and price-competitive industry.

"We think our market share is about 18% and they're about half our size. So, mathematically, you're talking, whatever, 25% give or take. With that said, the market's a very dynamic market. I mentioned before, there is 16,000, 15000, 16,000 distributors out there," DeLaney said.

Whether or not antitrust regulators agree with DeLaney and Sysco's industry assessment is another story.

"[We] believe the anti-trust/regulatory review could prove to be a lengthy and difficult process. As regional/local market share information on the food-services industry is not readily available from third parties, it is not easy for outsiders to assess market share concentration," Jefferies analysts pointed out in a Monday client note.

"From a broader industry perspective, SYSCO's 18% share, joining with US Foods 9% share doesn't sound overly concentrated, but with #1 joining with #2, there is a chance that some adjustments or market divestitures could be required by regulators," they concluded.

It seems like there is the expectation that an antitrust review could yield some divestitures in some overlapping regions. However, Sysco's talk of significant cost synergy could be a big red flag for an activist FTC, especially in an economic environment where stable working class jobs are scarce.

Currently, the Obama administration is engaging with discussions on trying to improve middle- and lower-tier worker standards through a possible increase to the minimum wage. A synergistic merger, as is contemplated in Sysco's acquisition of U.S. Foods, could prove a lightning rod for criticism.

Some large 2013 private equity transactions have already faced significant scrutiny. Heinz, after being acquired by private equity 3G Capital and Berkshire Hathaway was criticized for closing plants in South Carolina, Idaho and Canada, costing 1,350 total jobs. That raised the ire of economists and some legislators.

Sysco and U.S. Foods employees are likely assessing the writing on the wall after Monday's merger announcement. Sysco CEO DeLaney indicated that there could be redundancy across the combined company's operations, even if it was less than what a stock analyst might model for.

"I'd say that there is some overlap and that overlap is both from a distribution standpoint as well as from a sales associate and marketing, associate territory standpoint, but maybe not as much as you might think. And so, from our standpoint, our goal obviously going into this thing is to retain every customer and to grow the business," DeLaney said.

For perspective, Jefferies analysts calculated that most synergy from the merger will come from distribution and logistics cost savings, lower procurement costs, and layoffs. Overall, they expected up to $800 million in merger integration costs, mostly attributable to severance costs and consulting fees.

That's probably the last thing Sysco or U.S. Foods workers would want to hear. Sysco's Teamster workers are already wondering how Monday's deal will impact their jobs, especially for those with unionized contracts that expire in the next year, the Albany Times Union reported.

Still, the U.S. Foods deal may be a good merger, from a strategic standpoint. Both firms have struggled with falling pricing in the food services industry and poor gross margins in recent quarters. A merged company may be less vulnerable to the discounting that is plaguing the food services industry.

"With SYY and US Foods more focused on cost savings, we believe the likelihood of SYY pursuing discounting to drive case volumes likely falls. The weak restaurant backdrop has contributed to an atmosphere of competitive discounting and we believe the company has been particularly focused on improving its case volumes. Gross margin declines of 66 and 68bps over the last two quarters underscore the level of margin sacrifice," Jefferies wrote.

The deal might result in painful layoffs, but that may simply be the economic reality of a consolidating and cost-burdened food services industry.

When combined with U.S. Foods, Sysco expects to have about $65 billion in annual sales and operating cash flow of $2 billion, the company said. Of that, it appears U.S. Food's $22 billion in annual sales will contribute about one-third of the group's combined revenue.

Sysco will pay $3 billion in stock and $500 million in cash for U.S. Foods and also has agreed to refinance the company's approximately $4.7 billion in outstanding debt. When counting debt, Sysco's total acquisition comes in at $8.2 billion. Sysco said in a press release it has secured fully committed bridge financing for the deal and expects to issue permanent financing prior to closing.

Sysco said it expects to maintain an investment-grade credit rating as part of the acquisition. The company also expects the deal will immediately benefit its earnings, upon closing.

Prior to Monday trading, Sysco's 8% year-to-date gain had significantly underperformed the S&P 500 Index.

Goldman, Sachs is serving as financial adviser to Sysco and Wachtell, Lipton, Rosen & Katz and Arnall, Golden & Gregory are serving as its legal advisers. Simpson Thacher & Bartlett and Debevoise & Plimpton are serving as US Foods' legal advisers.

-- Written by Antoine Gara in New York.

Follow @antoineGara

More from Mergers and Acquisitions

10 Questions for PayPal Ahead of Its Big Investor Day

10 Questions for PayPal Ahead of Its Big Investor Day

Congress May Have Just Set in Motion a Huge Banking Industry Merger Wave

Congress May Have Just Set in Motion a Huge Banking Industry Merger Wave

Attention 60 Minutes: Google Isn't the Only Big-Tech Monopoly

Attention 60 Minutes: Google Isn't the Only Big-Tech Monopoly

Apple Buys Tesla? Amazon Buys Sears? 3 Dream Mergers That Just Make Sense

Apple Buys Tesla? Amazon Buys Sears? 3 Dream Mergers That Just Make Sense

Square Shares Shake Off Concerns About PayPal's Deal for iZettle

Square Shares Shake Off Concerns About PayPal's Deal for iZettle