Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Our discussion below of our results includes certain non-GAAP financial measures that we believe provide important perspective with respect to underlying business trends and results and provides meaningful supplemental information to both management and investors that is indicative of the performance of the company’s underlying operations and facilitates comparison on a year-over-year basis.  Other than free cash flow, any non-GAAP financial measures will be denoted as adjusted measures and exclude the impact from multiemployer pension withdrawal charges, severance charges, integration planning, litigation costs and termination costs in connection with the merger that had been proposed with U.S. Foods, Inc. (US Foods), facility closure charges and US Foods related financing costs. Additional items in fiscal 2014 include a change in estimate of self-insurance, and charges from a contingency accrual. These fiscal 2015 and 2014 items are collectively referred to as (Certain Items).  Our US Foods financing costs include the write off of unamortized debt issuance costs when our bridge acquisition facility was terminated upon the issuance of our senior notes in October 2014 and interest expense on those senior notes.  In fiscal 2014 , costs from executive

retirement plans restructuring were included within Certain Items; however, because these costs in fiscal 2015 are comparable to fiscal 2014 , these were not included in the Certain Items definition for the comparison of adjusted results for fiscal 2015 to fiscal 2014 . This continues to be presented as a Certain Item in the comparison of adjusted results for fiscal 2014 to fiscal 2013 . More information on the rationale for the use of these measures and reconciliations to GAAP numbers can be found under “Non-GAAP Reconciliations” and "Liquidity and Capital Resources."

 

Overview

 

Sysco distributes food and related products to restaurants, healthcare and educational facilities, lodging establishments and other foodservice customers.  Our primary operations are located throughout the United States (U.S.), Bahamas, Canada, Costa Rica, Ireland and Mexico and include broadline companies, SYGMA (our chain restaurant distribution subsidiary), specialty produce companies, custom-cut meat companies, hotel supply operations, a company that distributes specialty imported products, a company that distributes to international customers and our Sysco Ventures platform, which includes our suite of technology solutions that help support the business needs of our customers.

 

We consider our primary market to be the foodservice market in the U.S., Canada and Ireland and estimate that we serve about 17.7% of this approximately $264 billion annual market based on a measurement as of the end of calendar 2014 .  We use industry data obtained from various sources including Technomic, Inc., the Canadian Restaurant and Foodservices Association and the Irish Food Board to calculate this measurement.  According to industry sources, the foodservice, or food-away-from-home, market represents approximately 48% of the total dollars spent on food purchases made at the consumer level in the U.S. as of the end of calendar 2014 .

 

Industry sources estimate the total foodservice market in the U.S. experienced a real sales increase of approximately 0.7% in calendar year 2014 and  1.1% in calendar year 2013 .  Real sales changes do not include the impact of inflation or deflation.

 

Highlights

The foodservice industry performance in fiscal 2015 was generally improved. Consumer confidence and the outlook of foodservice operators are at high levels, but have decreased slightly in the summer months of 2015 . Fuel prices declined during fiscal 2015 and are currently at lower levels, as compared to recent years, that may support higher consumer spending in the future. Spending at restaurants is generally improved, but customer traffic levels are generally unchanged. Overall, the market environment appears to be modestly improved as compared to the prior two years; however, uncertainty in industry growth remains for fiscal 2016 . Amid these conditions, we provided our customers with excellent service, growing our business with both our locally and corporate managed customers and stabilizing our gross margins by successfully implementing several value-added commercial initiatives. We improved our expense management performance as the year progressed, achieving greater success managing expenses in the second half of the year as compared to the first half.  The impact of Certain Items contributed to lower earnings in fiscal 2015 as compared to fiscal 2014 , primarily from the costs associated with the merger that had been proposed with US Foods.   

 

Comparison of results from fiscal 2015 to fiscal 2014 :

 

See “Non-GAAP Reconciliations” for an explanation of these non-GAAP financial measures.

Business Transformation

 

In fiscal 2015 , we completed the three-year financial objectives of our Business Transformation. These financial objectives were largely designed to lower our product cost and lower our operating cost structure. We implemented a category management

program to leverage our scale and develop deeper, more strategic relationships with our suppliers to drive growth and innovation. We also implemented multiple initiatives to lower our operating cost structure including a more streamlined and standard approach to the management of fleet, labor, maintenance, procurement and supplies. Our goal for the project was to generate approximately $550 million to $650 million in annual benefits to be achieved by fiscal 2015 . We exceeded our final three-year target for annualized benefits.

US Foods Merger Termination

 

We sought to merge with US Foods, a leading foodservice distributor in the U.S. The merger was reviewed by the Federal Trade Commission (FTC) and in February 2015, the FTC commissioners voted 3 to 2 to authorize the FTC staff to seek a preliminary injunction from the U.S. District Court for the District of Columbia preventing the parties from closing the merger. In June 2015, the preliminary injunction was granted. Shortly thereafter, the parties involved agreed to terminate the merger agreement, as a result of which Sysco was obligated to pay $300 million to the owners of US Foods. During the review period with the FTC, Sysco created a divestiture package, comprised of the sale of 11 US Foods facilities to Performance Food Group (PFG), which was contingent on the closing of the merger. This divestiture agreement entitled PFG to receive a $25 million termination fee if the sale of the divestiture package was terminated before July 6, 2015, with each of Sysco and US Foods responsible for one half of the applicable fee. Sysco accrued for termination payments totaling $312.5 million in fiscal 2015 and paid these amounts in fiscal 2016 .

The following tables outline our expenses attributable to our integration planning, litigation and termination costs and financing activities, for the periods presented:

  

Fiscal 2015 Acquisitions

Mayca Distribuidores

In the first quarter of fiscal 2015 , we acquired a 50% interest in Mayca Distribuidores (Mayca) of Costa Rica and three other affiliates. Mayca, which has been in business since 1995, is a leading food distributor across Costa Rica. In addition to its distribution business, Mayca has a retail cash-and-carry affiliate with multiple locations, a cold-storage company and a truck-leasing company.

Pacific Star Foodservice

In the fourth quarter of fiscal 2015 , we acquired a 50% interest in Pacific Star Foodservice, a leading foodservice distributor in Mexico. Pacific Star has operated since 1989 with distribution centers servicing Mexico City, Guadalajara, Monterrey and Tijuana and primarily services chain restaurants, including fast food and casual dining restaurants, casinos, theme parks, movie theaters and hotels throughout Mexico.

Tannis Foodservice

In the fourth quarter of fiscal 2015 , we acquired Tannis Trading, Inc., a broadline foodservice distributor in Ottawa, Ontario. Tannis has a 75-year history of providing quality service to customers in Ottawa, Canada's fourth-largest metropolitan market, and the surrounding areas.

 

Trends and Strategy

 

Trends

 

General economic conditions can affect the frequency of purchases and amounts spent by consumers for food-away-from-home and, in turn, can impact our customers and our sales.  Consumer confidence and employment metrics, such as

unemployment rates, have shown some signs of improvement during fiscal 2015 ; however, consumer spending has been cautious. Fuel prices are currently at lower levels, as compared to recent years, that may support higher consumer spending in the future. Overall, the market environment appears to be modestly improved as compared to the prior two years; however, uncertainty in industry growth remains for fiscal 2016. One industry resource, Technomic, Inc., has projected roughly 2% real growth annually. Real growth excludes the impact of inflation or deflation.

Our sales and gross profit performance can be influenced by multiple factors including price, volume and product mix. The modest level of growth in the foodservice market has created additional competitive pricing pressures, which is, in turn, negatively impacting sales and gross profits. Case growth with our locally-managed Broadline business is an important contributor to gross profit dollar growth. Our locally-managed customers, including independent restaurant customers, comprise a significant portion of our overall volumes and an even greater percentage of profitability due to the high level of value added services we typically provide to this customer group. Through focused efforts, our locally-managed case volume growth has accelerated over the past three years. Our sales to corporate-managed customers, including chain restaurants and multi-locational restaurants, also comprise a significant portion of our overall volumes. Gross margin on sales to our corporate-managed customers is generally lower than sales to other types of customers due to the higher volumes we sell to these customers. Case growth for our corporate-managed customers remained strong, but competitive pricing pressure has constrained our gross margins. Inflation is a factor that contributes to the level of sales and gross profit growth and can be a factor that contributes to gross margin pressure. Food cost inflation in fiscal 2015 was 3.7% , an increase from 2.1% experienced in fiscal 2014 . Our inflation rates were higher in the first half of fiscal 2015 , reaching levels of 6.0% at the mid-point of the fiscal year and dropping to 0.1% by the end of the fiscal year. While we cannot predict whether inflation will continue at current levels, periods of high inflation, either overall or in certain product categories, can have a negative effect on us and our customers. High food costs can be difficult to pass on to our customers. In addition, rapid declines in prices can make it challenging to leverage our fixed costs. Our category management initiative has helped us to manage our gross margin performance in response to several of these factors. Lastly, changes in foreign exchange rates are having a larger impact on our sales as compared to recent fiscal years. The strengthening U.S. dollar is depressing our foreign sales as we convert them to U.S. dollars. The impact of foreign exchange rates for fiscal 2015 was a 1.0% year-over-year decrease to sales growth. This impact has typically been in the range of 0% to 0.5% .

We have experienced higher operating expenses in fiscal 2015 as compared to fiscal 2014 , primarily from increased payroll costs and integration planning, litigation and termination costs in connection with the merger that had been proposed with US Foods. We anticipate a low level of operating expenses attributable to the merger termination in the first quarter of fiscal 2016 . Our payroll costs have been influenced by higher pay in our sales organization as a result of higher gross profits, investment in new administrative support capabilities, higher management incentive accruals due to improved performance against our incentive targets and companies acquired within the last 12 months. Sales and gross profit growth partially contributed to an increase in sales pay-related expenses due to increases in sales commissions and bonuses. In addition, we have increased our marketing associate headcount in certain markets in order to invest in future sales growth.

In October 2014 , we secured long-term financing for the proposed merger with US Foods; therefore, interest expense increased in fiscal 2015 as compared to fiscal 2014 . The October 2014 senior notes contained mandatory redemption features providing that, if the merger agreement were terminated on or prior to October 8, 2015 , we were required to redeem all of the senior notes at a redemption price equal to 101% of the principal of the senior notes plus accrued interest. In June 2015 , we terminated the merger agreement and redeemed the senior notes in July 2015 using cash on hand and the proceeds from borrowings under our commercial paper facility. In fiscal 2016 , we will recognize several charges from the redemption of these senior notes including $50.0 million in premium fees, $29 million in unamortized debt issuance costs and $18.0 million in unamortized bond discounts each of which had resulted from the issuance of the senior notes in October 2014 . We had hedged $1.25 billion of this debt by swapping the fixed rates to floating rates with the goal of reducing overall borrowing cost.  We terminated these swaps in July 2015 and will recognize a gain of $10.0 million from the fair value adjustment that had been recorded on the underlying debt. Our interest expense on the notes was treated as a Certain Item in fiscal 2015 , since the proposed merger had not closed. Similarly, these charges and gain associated with the repayment of these notes will be presented as Certain Items in fiscal 2016 . As discussed in Note 9, “Derivative Financial Instruments,” two forward starting swap agreements used to hedge interest rate risk exposure on our October 2014 senior notes issuance were previously terminated and were paid in the amount of $188.8 million . The resulting amounts recorded as a loss are currently amortizing into interest expense at a rate of $2.5 million per quarter for the next 9 years and $1.1 million per quarter thereafter for another 19 years .  These amounts will continue to amortize into interest expense as the amount hedged is anticipated to remain within our capital structure. 

Following the termination of the merger agreement, we announced a $3 billion , two -year share repurchase program. We intend to execute the first half of this program through an accelerated repurchase program near the end of first quarter of fiscal 2016 . We expect to issue $2.0 billion of debt at approximately the same time and we intend to use a majority of the proceeds to fund these repurchases. These actions will lower our basic and diluted shares outstanding providing an expected earnings per share benefit of approximately $0.03 to $0.04 per share. This estimate includes a 4% to 5% reduction in average shares outstanding,

partially offset by higher interest expense from the new debt issuance. Because the share repurchase will take place near the end of the first quarter of fiscal 2016, we will not realize a full-year's benefit from the reduction in shares in fiscal 2016; however, the full-year benefit will be realized in fiscal 2017.

Sysco’s fiscal year ends on the Saturday nearest to June 30 ^th .  We will have a 53-week year ending July 2, 2016 for fiscal 2016 , and this additional week will be presented as a Certain Item in fiscal 2016 .

 Strategy

 

We are focused on optimizing our core broadline business in the U.S., Bahamas, Canada, Costa Rica, Ireland and Mexico, while continuing to explore appropriate opportunities to profitably grow our market share and create shareholder value by expanding beyond our core business.  Day-to-day, our business decisions are driven by our mission to market and deliver great products to our customers with exceptional service, with the aspirational vision of becoming each of our customers’ most valued and trusted business partner.  We have identified five components of our strategy to help us achieve our mission and vision as follows:

In fiscal 2016 , to further our strategy, we see opportunities to further accelerate case growth, especially with our locally-managed sales customers through improved product and service differentiation combined with enhanced sales and technology capabilities. We will continue to build on our success in stabilizing gross margin through enhanced product innovation, growing privately-branded product sales and improving pricing analytics and support. There continues to be opportunity to improve our productivity and reduce overhead costs in our supply chain organization and administrative areas of our business. We will continue to invest in our business to fully realize the benefits and improve our return on invested capital.