Performance Food Group (PFGC) Stock: Margins Need To Get Better

Distribution is a tough business, but one that rewards scale and particularly scale combined with efficiency. This is something that giant food distributor Sysco (SYY) understands well, but that other rivals like Performance Food Group (NYSE:PFGC) and US Foods (USFD) have struggled to match. While there are still opportunities to benefit from share gain and share-of-wallet gain across the large food service and convenience store markets, I need to see more evidence from Performance that it can really drive attractive leverage from the business.

Performance Food has been doing well with respect to reported versus expected earnings, with a multi-quarter run of better-than-expected EBITDA results, including a sizable beat-and-raise in the fiscal first quarter (the calendar third quarter). Still, this looks like a situation where meaningful long-term margin improvement is already in the stock and management will have to continue beat-and-raise performances to drive further outperformance.

Restaurants Have Come Back, But 2023 Could See A Shift In Consumer Behavior

The restaurant industry has been recovering from the impact of the pandemic and after units dropped 7% in 2020, they rose more than 2% in 2021 and look poised to grow around 2% again for 2022. If that holds true, restaurant counts will still be about 3% below pre-pandemic levels overall. Not surprisingly, national and regional chains have fared better, likely to end 2022 around 1% below pre-pandemic levels.

A stronger recovery in national/regional chains is a mixed blessing for Performance Food. While this segment generates a larger percentage of sales for Performance than for its largest rivals, it is lower-margin revenue.

I do expect ongoing recovery in restaurant unit counts, but the recovery in the independent channel (which tends to be more lucrative for distributors) is a harder call for the next couple of years. With higher rates in place, it’s more expensive to finance a new restaurant, and I also expect to see a downturn in consumer spending in 2023. While the longer-term trend of eating more meals prepared outside of the home will likely continue, independents skew higher than national/regional chains in terms of ticket size, and if/when consumers look to stretch their budgets, I expect there may be a shift toward cheaper options (as well as some shift away from eating out).

While not tied to consumer behavior, there is another aspect to Performance Group’s customer/end-market exposures that I think is worth mentioning. Performance has long prioritized and focused on the independent pizzeria category, and this focus has been rewarded in exceptional market share – while Performance enjoys around 9% national foodservice distribution share (against 17% for Sysco and 11% for US Foods), its share in the independent pizzeria category is closer to 25%. The problem? Sysco has been targeting this space more aggressively, and when the 800lb gorilla is interested in what you have, it’s a threat.

Looking For Positive Operating Shifts

Inflationary environments are usually pretty good for distributors, as they typically enjoy more pricing power and that benefits margins. Reported inflation has been running at a double-digit rate for several quarters, and is helping drive some margin improvement.

I’d like to see more, though, and I think there are still a lot of areas where Performance could improve its operational performance.

Performance has done well with its private label business, with a high-40%’s percentage of its case volumes to independents coming from private label versus a mid-40%’s percentage at Sysco and a mid-30%’s percentage at US Foods. Gross profits for private label products can be as much as double that of branded products at the case level, and even a few tenths of a percent of gross margin improvement can be significant with this sort of business model.

I do want to see Performance do more with core “back-office” and distribution efficiency. Relative to Sysco and US Foods, Performance has been slower to adopt technologies like online/automated ordering, and US Foods has managed to win/hold some share on the back of offerings that dynamically price for customers (driving more cross-selling and customer retention) and offer customers insight into menu costs and operational productivity.

I likewise want to see more efficient fulfilment, and particularly in the convenience store space. Performance acquired its way into a major presence in this market (rivaling Berkshire Hathaway’s (BRK.A) McLane) by buying Eby-Brown and Core-Mark, but the c-store distribution business has even worse margins than the core foodservice operations. While there are cross-selling opportunities here (including private label offerings and leveraging Vistar in areas like snacks, candies, and beverages), optimizing routes and density along those routes is a major opportunity, but one that takes time and resources to build.

The Outlook

The recent move into 3% EBITDA margins for the foodservice business is encouraging. It’s still a good distance behind the nearly 5% margin at Sysco, but it is at least trending in the right direction. If the company can improve its back-office efficiency (more digitalization), continue to grow its private label business, and improve route density for both the foodservice and c-store operations, I do see a path to better cashflows and a higher multiple.

As is, I’m expecting around mid-single-digit long-term revenue growth. I’m not expecting double-digit inflation to become any sort of new normal for the business, but I also see opportunities for the big players to continue to take share from smaller, inefficient regional and local distributors.

The margin modeling is the tricky part here, and not just because this is the sort of model where a modest change in gross margin or operating costs (tenths of a percent) can have pretty significant bottom-line impacts. I am expecting modest improvement in EBITDA margin over the next few years of around 20bp/year. I do think more is possible, but making significant back-office or distribution changes is expensive, disruptive, and time-consuming, so I think it’s more reasonable to expect/model more gradual change over time.

I don’t believe that Performance is likely to ever reach (or at least hold on a year-to-year basis) a free cash flow margin of 2%, but I do nevertheless expect modest improvement in keeping with EBITDA/operating margin improvements. I do see some risk of the company choosing to invest more resources into capex to drive more automation and digitalization, but I believe such investments would likely more than earn their cost over time.

The Bottom Line

I don’t find Performance all that undervalued on a short-term multiples-based valuation approach, which shouldn’t be so surprising given the significant move in the shares over the last year (up 40%). On a discounted cash flow model, though, I do see more worthwhile upside here, and I could see a high single-digit annualized return if the company can hit my targets.

All told, this isn’t a high-priority idea for me. I think the near-term upswing in the performance of the business is reflected in the share price, and while I do see a path to better long-term performance, I’d like to see/hear management more actively and aggressively address these opportunities.