We Do Not Report Adjusted Anything

A close look at Sysco’s (SYY) conspicuously complex non-GAAP adjustments

Sep 12

This report is about Sysco (SYY)-so don’t be confused that it starts with a discussion of Fastenal (FAST).

If you have never taken in one of FAST’s conference calls, we highly recommend you check one out. In a world full of hype and self-promoting companies, CEO Daniel Florness is a candid breath of fresh air. He knows his business and focuses on executing it as well as possible. He isn’t afraid to call it like he sees it, and he doesn’t try to make the business of distributing fasteners out to be anything more than it is.

It is therefore not surprising that FAST is one of the very few companies left that have not wandered into the murky world of non-GAAP earnings. We will always remember a comment Mr. Florness made in a conference call after the company took an $8 million writedown to the value of inventory during the pandemic which it did not add back to non-GAAP results.

“I have to say, earlier this morning, I chuckled while reading through, I think, at the moment, Dave Manthey sent out reports early this morning and I really had a kick out of Dave Manthey. I believe it was bullet number 3, where he commented, while FAST does not report adjusted anything, core gross margin, he went on to explain the impact of the $8 million. You are absolutely correct, we do not report adjusted anything. We are not an acquisitive company, we’re not a manufacturer that’s leveraging and talking about EBITDA. We’re a distributor and I don’t think distributors in our position should be doing that.”

Now back to Sysco (SYY). It is a distributor too. It may distribute chicken breasts and frozen peas rather than screws and hook fasteners, but it is still a mature distributor. However, in stark contrast to Fastenal, SYY has one of the longest running and most colorful sets of non-GAAP reconciliations of any company we have ever followed. We highlighted in a review from January how the company’s earnings presentation slides featured not just two, but three different sets of earnings from which to choose: GAAP earnings, non-GAAP earnings, and non-GAAP earnings with another layer of adjustments. The third level of adjustments disappeared after that quarter.

We function in a market where beating or missing EPS targets can result in significant stock price moves. Despite SYY topping earnings expectations in the 6/22 quarter by 4 cps, the stock was still punished by weaker-than-expected guidance for the second half. We believe it is safe to say the decline would have been worse if the company had missed expectations and the fact that the quarter once again featured questionable adjustments which exceeded the beat by a considerable amount makes us question the quality of that beat.

We will look at a couple of those below.

Lower Adjusted Provision Expense Added 2.5 CPS

We explained in our earlier report on SYY how the company ramped up its provision for bad debts when the pandemic hit in 2020. The company discusses this in its 10-Ks:

“In the third and fourth quarters of fiscal 2020, the company experienced an increase in past due receivables and recognized additional bad debt charges on its trade receivables that were outstanding at the time the pandemic caused closures among our customers in mid-March 2020. These receivables were all created in fiscal 2020 and are referred to as pre-pandemic receivables.”

At the time, the company added back the incremental provision expense related to the “pre-pandemic receivables” to its non-GAAP earnings in the 3/20 and 6/20 quarters. We do not like the practice of ignoring every expense deemed to be “higher than normal”, but at least the unusual jump in provision expense was related to a once-in-a-century pandemic that was completely unexpected.

However, in the 9/20 quarter, the company began collecting on some of these “pre-pandemic receivables” and reduced its allowances as a result. It began to take the gains from the reduction in reserves against these receivables out of its non-GAAP results in the 9/20 quarter.

This all seems reasonable enough. However, the problem is that the company extended receivables to sales made after the pandemic began which it determined was mid-March of 2020. The reserves on these receivables were higher than normal which reflected the increased risk of collection at the time. Like the pre-pandemic receivables, they also began experiencing better than expected collections, but the impact of reversing those reserves was not being removed from non-GAAP results.

The following table shows the GAAP provision/(credit) for bad debts, the related non-GAAP adjustments, and the implied non-GAAP provision expense for the last twelve quarters:

In 2021, the non-GAAP provision expense was running much lower than the comparable 2020 periods. We estimate that the lower provision expense as a percentage of sales was adding 2-4 cps to EPS growth during those quarters. Remember, the non-GAAP provision expense adjusts out the benefits of better collections on receivables generated before the pandemic began, but not those generated after the beginning of the pandemic. It is the writing back of the reserves on the latter receivables that is driving the decline in non-GAAP provision expense.

In the 3/22 quarter, non-GAAP provision expense was $4.8 million compared to a credit of $10 million in the year-ago quarter which led to an approximate 2.9 cps headwind for EPS. We would have expected to see non-GAAP provision expense in the 6/22 quarter be at least flat with last year’s second quarter. However, we see above that the company took a GAAP credit of $16 million in the 6/22 quarter, but only adjusted $8.8 million of the credit out, leaving a $7.3 million credit in the calculation of non-GAAP earnings. We estimate if the adjusted provision expense had remained constant with the year-ago quarter it would have shaved about 2.5 cps off EPS in the June quarter.

More Restructuring Charges Added Back to Non-GAAP EPS

We pointed out above that FAST manages to never report adjustments to its GAAP EPS. However, SYY can’t seem to live without them, especially restructuring costs. The following table shows the company’s Restructuring and Transformational Project Costs it has added back relative to non-GAAP EPS for the last twelve quarters:

SYY added back 7.7 cps of Restructuring and Transformational Project Costs in the most recent June quarter, up from 3.7 cps in the previous quarter.

In addition to the costs it adds back to non-GAAP results, management presents other costs related to productivity investments in its quarterly slide presentations that it calls out as temporary. The following table shows these costs broken down into various categories for the last few quarters:

“Snap Back” costs were first called out in the 10/21 quarter and labeled as “Short-Term Transitory Expenses Associated with Business Recovery”. That quarter, the company even added these costs back to a second layer of earnings adjustments on top of the first layer of non-GAAP adjustments in its earnings presentation. This practice disappeared after that quarter we don’t know why. The Snap Back costs relate to expenses such as replacing all the employees it laid off during the pandemic.

“Transformation Costs” relate to the company’s “Recipe for Growth” strategy to improve its IT capacity and other enhancements to its business. We observe that we typically see costs such as these trend down steadily over time whereas they are increasing for SYY. Meanwhile, the “Productivity Costs” line appeared in the 4/22 earnings call slides and retroactively included the $40 million in the 1/22 quarter which was not present on that quarter’s slide deck. These amounts represent more investments in the company’s business model.

To be clear, only the “Restructuring and Transformational Project Costs” line is added back to non-GAAP earnings and those amounts likely include spending that is included somewhere in the three above categories. However, we find it interesting that the non-GAAP add-backs do not seem to be very correlated to the total spending in those three categories, and we are unclear as to what qualifies an expense to be ignored by non-GAAP results.

We understand that that company is investing heavily in its business now and the overall level of spending could come down to the benefit of fiscal 2023’s earnings. But here’s what we see as the big problem- SYY’s restructuring charges added back to adjusted results long predate any of these categories listed above and extend back years before the pandemic. Every quarter for the last five years has featured a restructuring charge with an average amount of 11 cps. To be clear, the charges extend much further back than five years, that’s just as far as we cared to document for this writeup. We follow few companies with a track record for material charges that are that predictable. So, calling out these charges as “one-time” or implying they are not operational does not make sense to us.

All of the above makes us question the quality of a 4 cps beat when the company ignored almost 8 cps of restructuring expenses in the quarter versus 4 cps in the quarter before.

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