Sysco - 10-Q quarterly report FY

 

(Mark One)

(Exact name of registrant as specified in its charter)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.)

619,315,728 shares of common stock were outstanding as of January 28, 2006.

SYSCO CORPORATION and its Consolidated Subsidiaries
CONSOLIDATED BALANCE SHEETS
(In Thousands Except for Share Data)

Note: The July 2, 2005 balance sheet has been derived from the audited financial statements at that date.
See Notes to Consolidated Financial Statements

SYSCO CORPORATION and its Consolidated Subsidiaries
CONSOLIDATED RESULTS OF OPERATIONS (Unaudited)
(In Thousands Except for Share and Per Share Data)

See Notes to Consolidated Financial Statements

SYSCO CORPORATION and its Consolidated Subsidiaries
CONSOLIDATED CASH FLOWS (Unaudited)
(In Thousands)

See Notes to Consolidated Financial Statements

SYSCO CORPORATION and its Consolidated Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

The consolidated financial statements have been prepared by the company, without audit, with the exception of the July 2, 2005 consolidated balance sheet which was taken from the audited financial statements included in the company’s Fiscal 2005 Annual Report on Form 10-K. The financial statements include consolidated balance sheets, consolidated results of operations and consolidated cash flows. Certain amounts in the prior periods presented have been reclassified to conform to the fiscal 2006 presentation. In the opinion of management, all adjustments, which consist of normal recurring adjustments, necessary to present fairly the financial position, results of operations and cash flows for all periods presented have been made.

These financial statements should be read in conjunction with the audited financial statements and notes thereto included in the company’s Fiscal 2005 Annual Report on Form 10-K.

A review of the financial information herein has been made by Ernst & Young LLP, independent auditors, in accordance with established professional standards and procedures for such a review. A report from Ernst & Young LLP concerning their review is included as Exhibit 15(a).

Beginning in fiscal 2006, SYSCO changed the measurement date for the pension and other postretirement benefit plans from fiscal year-end to May 31^st, which represents a change in accounting. The one-month acceleration of the measurement date will allow additional time for management to evaluate and report the actuarial pension measurements in the year-end financial statements and disclosures within the accelerated filing deadlines of the Securities and Exchange Commission. The cumulative effect of this change in accounting resulted in an increase to earnings in the first quarter of fiscal 2006 of $9,285,000, net of tax.

Pro forma net earnings and earnings per share adjusted for the effect of retroactive application of the change in measurement date on net pension costs, net of tax, are as follows:

The following table sets forth the computation of basic and diluted earnings per share:

The net reduction in average shares outstanding is primarily due to share repurchases. The net reduction in diluted shares outstanding is primarily due to share repurchases, the exclusion of certain options from the diluted share calculation due to their anti-dilutive effect and a modification of the treasury stock method calculation utilized to compute the dilutive effect of stock options as a result of the adoption of SFAS 123(R). This modification results in lower diluted shares outstanding than would have been calculated had compensation cost not been recorded for stock options and stock issuances under the Employees’ Stock Purchase Plan.

The number of options that were not included in the diluted earnings per share calculation because the effect would have been anti-dilutive was approximately 23,000,000 and 29,000,000 for the first 26 weeks and second quarter of fiscal 2006, respectively. The number of options that were not included in the diluted earnings per share calculation for the comparable periods of fiscal 2005 was insignificant.

Prior to July 3, 2005, SYSCO accounted for its stock option plans and its Employees’ Stock Purchase Plan using the intrinsic value method of accounting provided under APB Opinion No. 25, “Accounting for Stock Issued to Employees,” (APB 25) and related interpretations, as permitted by FASB Statement No. 123, “Accounting for Stock-Based Compensation,” (SFAS 123) under which no compensation expense was recognized for stock option grants and issuances of stock pursuant to the Employees’ Stock Purchase Plan. However, share-based compensation expense was recognized in periods prior to fiscal 2006 (and continues to be recognized) for stock issuances pursuant to the Management Incentive Plan and stock grants to non-employee directors. Share-based compensation was a pro forma disclosure in the financial statement footnotes and continues to be provided for periods prior to fiscal 2006.

Effective July 3, 2005, SYSCO adopted the fair value recognition provisions of FASB Statement No. 123(R), “Share-Based Payment,” (SFAS 123(R)) using the modified-prospective transition method. Under this transition method, compensation cost recognized in fiscal 2006 includes: a) compensation cost for all share-based payments granted through July 2, 2005, but for which the requisite service period had not been completed as of July 2, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and b) compensation cost for all share-based payments granted subsequent to July 2, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). Results for prior periods have not been restated.

As a result of adopting SFAS 123(R) on July 3, 2005, SYSCO’s earnings before income taxes and net earnings for the 26-week period ended December 31, 2005 were $64,810,000 and $56,949,000 lower, respectively, than if the company had continued to account for share-based compensation under APB 25. Basic and diluted earnings before the cumulative effect of the accounting change per share for the 26-week period ended December 31, 2005 would have been $0.74 and $0.73, respectively, if the company had not adopted SFAS 123(R), compared to reported basic and diluted earnings before the cumulative effect of the accounting change per share of $0.65 and $0.64, respectively.

As a result of adopting SFAS 123(R) on July 3, 2005, SYSCO’s earnings before income taxes and net earnings for the 13-week period ended December 31, 2005 were $29,338,000 and $25,299,000 lower, respectively, than if the company had continued to

account for share-based compensation under APB 25. Basic and diluted earnings before the cumulative effect of the accounting change per share for the 13-week period ended December 31, 2005 would have each been $0.37 if the company had not adopted SFAS 123(R), compared to reported basic and diluted earnings before the cumulative effect of the accounting change per share of $0.33 each.

The adoption of SFAS 123(R) results in lower diluted shares outstanding than would have been calculated had compensation cost not been recorded for stock options and stock issuances under the Employees’ Stock Purchase Plan. This is due to a modification required by SFAS 123(R) of the treasury stock method calculation utilized to compute the dilutive effect of stock options.

Prior to the adoption of SFAS 123(R), the company presented all tax benefits of deductions resulting from the exercise of options as operating cash flows in the Consolidated Cash Flow statement. SFAS 123(R) requires the cash flows resulting from tax deductions in excess of the compensation cost recognized for those options (excess tax benefits) to be classified as financing cash flows. The $3,080,000 excess tax benefit classified as a financing cash inflow for the 26-week period ended December 31, 2005 would have been classified as an operating cash inflow if the Company had not adopted SFAS 123(R).

SYSCO provides compensation benefits to employees and non-employee directors under several share-based payment arrangements including various employee stock option plans, the Employees’ Stock Purchase Plan, the Management Incentive Plan and the 2005 Non-Employee Directors Stock Plan.

SYSCO’s 2004 Stock Option Plan was adopted in fiscal 2005 and reserves 23,500,000 shares of SYSCO common stock for grants of options and dividend equivalents to directors, officers and other employees of the company and its subsidiaries at the market price at the date of grant. This plan provides for the issuance of options qualified as incentive stock options under the Internal Revenue Code of 1986, options which are non-qualified, and dividend equivalents. To date, SYSCO has only issued options under this plan. Vesting requirements for awards under this plan will vary by individual grant and may include either time-based vesting or time-based vesting subject to acceleration based on performance criteria. The contractual life of all options granted under this plan will be no greater than seven years.

SYSCO has also granted employee options under several previous employee stock option plans for which previously granted options remain outstanding at December 31, 2005. No new options will be issued under any of the prior plans, as future grants to employees will be made through the 2004 Stock Option Plan. Vesting requirements for awards under these plans vary by individual grant and include either time-based vesting or time-based vesting subject to acceleration based on performance criteria. The contractual life of all options granted under these plans through July 3, 2004 is 10 years; options granted after July 3, 2004 have a contractual life of seven years.

SYSCO’s 2005 Non-Employee Directors Stock Plan was adopted in fiscal 2006 and reserves 550,000 shares of common stock for grants to non-employee directors in the form of options, stock grants, restricted stock units and dividend equivalents. In addition, options and unvested common shares also remained outstanding as of December 31, 2005 under previous non-employee director stock plans. No further grants will be made under

these plans, as all future grants to non-employee directors will be made through the 2005 Non-Employee Directors Stock Plan. Vesting requirements for awards under these plans vary by individual grant and include either time-based vesting or time-based vesting subject to acceleration based on performance criteria. The contractual life of all options granted under these plans through July 3, 2004 is 10 years; options granted after July 3, 2004 have a contractual life of seven years.

Certain of SYSCO’s option awards are generally subject to graded vesting over a service period. In those cases, SYSCO recognizes compensation cost on a straight-line basis over the requisite service period for the entire award. In other cases, certain of SYSCO’s option awards provide for graded vesting over a service period but include a performance-based provision allowing for accelerated vesting. In these cases, if it is probable that the performance condition will be met, SYSCO recognizes compensation cost on a straight-line basis over the shorter performance period; otherwise, it will recognize compensation cost over the longer service period.

In addition, certain of SYSCO’s options provide that if the optionee retires and meets certain age and years of service thresholds, the options continue to vest as if the optionee continued to be an employee. In these cases, for awards granted through July 2, 2005, SYSCO will recognize the compensation cost for such awards over the service period and accelerate any remaining unrecognized compensation cost when the employee retires. For awards granted subsequent to July 2, 2005, SYSCO will recognize compensation cost for such awards over the period from the grant date to the date the employee first becomes eligible to retire with the options continuing to vest after retirement.

The fair value of each option award is estimated as of the date of grant using a Black-Scholes option pricing model. The weighted average assumptions for the periods indicated are noted in the following table. Expected volatility is based on historical volatility of SYSCO’s stock, implied volatilities from traded options on SYSCO’s stock and other factors. SYSCO utilizes historical data to estimate option exercise and employee termination behavior within the valuation model; separate groups of employees that have similar historical exercise behavior are considered separately for valuation purposes. The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.

The following summary presents information regarding outstanding options as of December 31, 2005 and changes during the 26-week period then ended with regard to options under all stock option plans:

The weighted average grant-date fair value of options granted during the 26-week period ended December 31, 2005 and fiscal year 2005 was $7.83 and $7.12, respectively. The total intrinsic value of options exercised during the 26 weeks ended December 31, 2005 and fiscal year 2005 was $29,114,000 and $81,220,000, respectively.

SYSCO has an Employees’ Stock Purchase Plan which permits employees to invest by means of periodic payroll deductions in SYSCO common stock at 85% of the closing price on the last business day of each calendar quarter. The total number of shares which may be sold pursuant to the plan may not exceed 68,000,000 shares, of which 5,824,489 remained available at December 31, 2005.

During the 26 weeks ended December 31, 2005, 910,623 shares of SYSCO common stock were purchased by plan participants. During fiscal 2005, 1,712,244 shares of SYSCO common stock were purchased by plan participants.

The weighted average fair value of employee stock purchase rights issued pursuant to the Employees’ Stock Purchase Plan was $5.03 during the 26-week period ended December 31, 2005 and $5.19 during fiscal 2005. The fair value of the stock purchase rights was calculated as the difference between the stock price and the employee purchase price.

SYSCO has a Management Incentive Plan that compensates key management personnel for specific performance achievements. The bonuses earned and expensed under this plan during a fiscal year are paid in the following fiscal year in both cash and stock, and a portion of the bonus may be deferred for payment in future years at the election of each participant. The stock awards under this plan immediately vest upon issuance; however, participants are restricted from selling, transferring, giving or otherwise conveying the shares for a period of two years from the date of issuance of such shares. The fair value of the stock issued under the Management Incentive Plan was based on the stock price less a 12% discount for post-vesting restrictions. The discount for post-vesting restrictions was estimated based on restricted stock studies and by calculating the cost of a hypothetical protective put option over the restriction period.

A total of 617,637 shares and 1,001,624 shares at a fair value of $36.25 and $34.80 were issued pursuant to this plan during the first quarter of fiscal 2006 and fiscal 2005, respectively, for bonuses earned in the preceding fiscal years.

Each newly elected director is granted a one-time retainer award of 6,000 shares of SYSCO common stock under the 2005 Non-Employee Directors Stock Plan. These shares vest one-third every two years during a six-year period based on increases in earnings per share. In addition, there are one-time retainer awards outstanding under the Non-Employee Directors Stock Plan, which was replaced by the 2005 Non-Employee Directors Stock Plan. The total amount of unvested shares related to the one-time retainer awards as of December 31, 2005 and July 2, 2005 was not significant.

The 2005 Non-Employee Directors Stock Plan provides for the issuance of restricted stock. During the first 26 weeks of fiscal 2006, 27,000 shares of restricted stock were granted to non-employee directors. These shares will vest ratably over a three-year period.

The total share-based compensation cost that has been recognized in results of operations was $74,168,000 and $11,697,000 for the first 26 weeks of fiscal 2006 and fiscal 2005, respectively. The total income tax benefit recognized in results of operations for share-based compensation arrangements was $11,370,000 and $4,416,000 for the first 26 weeks of fiscal 2006 and fiscal 2005, respectively.

The total share-based compensation cost that has been recognized in results of operations was $32,888,000 and $3,691,000 for the second quarter of fiscal 2006 and fiscal 2005, respectively. The total income tax benefit recognized in results of operations for share-based compensation arrangements was $5,370,000 and $1,393,000 for the second quarter of fiscal 2006 and fiscal 2005, respectively.

As of December 31, 2005, there was $161,988,000 of total unrecognized compensation cost related to share-based compensation arrangements. That cost is expected to be recognized over a weighted-average period of 2.80 years.

Cash received from option exercises was $52,530,000 and $48,570,000 during the first 26 weeks of fiscal 2006 and fiscal 2005, respectively. The actual tax benefit realized for the tax deductions from option exercises totaled $7,207,000 and $6,635,000 during the first 26 weeks of fiscal 2006 and fiscal 2005, respectively.

The following table provides pro forma net earnings and earnings per share had SYSCO applied the fair value method of SFAS 123 for the 26- and 13-week periods ended January 1, 2005:

The pro forma presentation includes only options granted after 1995. The pro forma effects for the periods presented are not necessarily indicative of the pro forma effects in future years.

The components of net benefit cost for the 26-week periods presented are as follows:

The components of net benefit cost for the 13-week periods presented are as follows:

SYSCO’s contributions to its defined benefit plans were $69,117,000 and $83,048,000 during the 26-week periods ended December 31, 2005 and January 1, 2005, respectively.

Although contributions to its qualified pension plan (Retirement Plan) are not required to meet ERISA minimum funding requirements, the company made a voluntary contribution of approximately $66,000,000 in the second quarter of fiscal 2006. The company does not anticipate making additional contributions to the Retirement Plan during the remainder of the fiscal year. The company’s contributions to the Supplemental Executive Retirement Plan (SERP) and other post-retirement plans are made in the amounts needed to fund current year benefit payments. The estimated fiscal 2006 contributions to fund benefit payments for the SERP and other post-retirement plans are $7,659,000 and $338,000, respectively.

SYSCO is required by its insurers to collateralize a part of the self-insured portion of its workers’ compensation and liability claims. SYSCO has chosen to satisfy these collateral requirements by depositing funds in insurance trusts.

In addition, for certain acquisitions, SYSCO has placed funds into escrow to be disbursed to the sellers in the event that specified operating results are attained or contingencies are resolved. There were no escrowed funds released to sellers during the first 26 weeks of fiscal 2006.

A summary of restricted cash balances appears below:

In September 2005, SYSCO issued 5.375% senior notes totaling $500,000,000 under its April 2005 shelf registration, due on September 21, 2035. These notes, which were priced at 99.911% of par, are unsecured, are not subject to any sinking fund requirement and include a redemption provision which allows SYSCO to retire the notes at any time prior to maturity at the greater of par plus accrued interest or an amount designed to ensure that

the noteholders are not penalized by the early redemption. Proceeds from the notes were utilized to retire outstanding commercial paper issuances.

In September 2005, in conjunction with the issuance of the 5.375% senior notes, SYSCO settled a $350,000,000 notional amount forward-starting interest rate swap which was designated as a cash flow hedge of the variability in the cash outflows of interest payments on the debt issuance due to changes in the benchmark interest rate. See Note 9 for further discussion.

In November 2005, SYSCO and one of its subsidiaries, SYSCO International, Co., entered into a new revolving credit facility to support the company’s U.S. and Canadian commercial paper programs. The $500,000,000 facility, which may be increased up to $1,000,000,000 at the option of the company, terminates on November 4, 2010, subject to extension. The new facility replaces the $450,000,000 (U.S. dollar) and $100,000,000 (Canadian dollar) revolving credit agreements in the U.S. and Canada, respectively, both of which were terminated. Since this long-term facility supports the company’s commercial paper programs, up to $500,000,000 of commercial paper issuances outstanding are classified as long-term debt.

As of December 31, 2005, SYSCO had uncommitted bank lines of credit which provide for unsecured borrowings for working capital of up to $145,000,000. There were no outstanding borrowings on these lines of credit as of December 31, 2005.

As of December 31, 2005, SYSCO’s outstanding borrowings under its commercial paper programs were $530,875,000. During the 26-week period ended December 31, 2005, commercial paper and short-term bank borrowings ranged from approximately $126,846,000 to $696,950,000.

Included in current maturities of long-term debt at December 31, 2005 are the 7.0% Senior Notes due May 2006 totaling $200,000,000. It is the company’s intention to fund the repayment of these notes at maturity through issuances of commercial paper, senior notes or a combination thereof.

During the first 26 weeks of fiscal 2006, the company issued 24,527 shares with a value of $700,000 for contingent consideration related to operations acquired in previous fiscal years.

Acquisitions of businesses are accounted for using the purchase method of accounting and the financial statements of SYSCO include the results of the acquired companies from the respective dates they joined SYSCO. Acquisitions in the periods presented were immaterial, individually and in the aggregate, to the consolidated financial statements.

The purchase price of the acquired operations is allocated to the net assets acquired and liabilities assumed based on the estimated fair value at the dates of acquisition, with any excess of cost over the fair value of net assets acquired, including intangibles, recognized as goodwill. The balances included in the Consolidated Balance Sheets related to recent acquisitions are based upon preliminary information and are subject to change when final asset and liability valuations are obtained. Material changes to the preliminary allocations are not anticipated by management.

Certain acquisitions involve contingent consideration typically payable only in the event that specified operating results are attained. Aggregate contingent consideration amounts outstanding as of December 31, 2005 included approximately 1,035,000 shares and $119,850,000 in cash, which, if distributed, could result in recording up to $141,110,000 in additional goodwill. Such amounts typically are to be paid out over periods of up to five years from the date of acquisition.

In September 2005, in conjunction with the issuance of the 5.375% senior notes, SYSCO settled a $350,000,000 notional amount forward-starting interest rate swap which was designated as a cash flow hedge of the variability in the cash outflows of interest payments on the debt issuance due to changes in the benchmark interest rate. Upon settlement, SYSCO paid cash of $21,196,000, which represented the fair value of the swap agreement at the time of settlement. This amount will be amortized as interest expense over the 30-year term of the debt, and the unamortized balance is reflected as a loss, net of tax, in Other comprehensive income.

Reflected in the changes in the net deferred tax liability and prepaid/accrued income tax balances from July 2, 2005 to December 31, 2005 is the reclassification of deferred tax liabilities related to supply chain distributions to accrued income taxes. This reclassification reflects the tax payments to be made during the next twelve months related to previously deferred supply chain distributions.

The effective tax rate for the first 26 weeks of fiscal 2006 was 39.95%, an increase from the effective tax rate of 38.25% for the first 26 weeks of fiscal 2005. The effective tax rate for the second quarter of fiscal 2006 was 39.56%, an increase from the effective tax rate of 38.25% for the second quarter of fiscal 2005. The increase in the effective tax rate was primarily due to the adoption of SFAS 123(R) which is discussed in Note 4. SYSCO recorded a tax benefit of $11,370,000, or 15.3% of the total $74,168,000 in share-based compensation expense recorded in the 26-week period ended December 31, 2005. SYSCO recorded a tax benefit of $5,370,000, or 16.3% of the total $32,888,000 in share-based compensation expense recorded in the 13-week period ended December 31, 2005.

SYSCO’s option grants include options which qualify as incentive stock options for income tax purposes. The treatment of the potential tax deduction, if any, related to incentive stock options is the primary reason for the company’s increased effective tax rate in fiscal 2006 and may cause variability in the company’s effective tax rate in future periods. In the period the compensation cost related to incentive stock options is recorded, a corresponding tax benefit is not recorded as it is assumed that the company will not receive a tax deduction upon the sale of such incentive stock options. The company may be eligible for tax deductions in subsequent periods to the extent that there is a disqualifying disposition of the incentive stock option. In such cases, the company would record a tax benefit related to the tax deduction in an amount not to exceed the corresponding cumulative compensation cost recorded in the financial statements on the particular options multiplied by the statutory tax rate.

The determination of the company’s overall effective tax rate requires the use of estimates. The effective tax rate reflects a combination of income earned and taxed in the various U.S. federal and state, as well as Canadian federal and provincial, jurisdictions. Jurisdictional tax law changes, increases/decreases in permanent differences between book

and tax items, tax credits and the company’s change in earnings from these taxing jurisdictions all affect the overall effective tax rate.

Comprehensive income is net earnings plus certain other items that are recorded directly to shareholders’ equity. The following table provides a summary of the components of other comprehensive income for the periods presented:

SYSCO is engaged in various legal proceedings which have arisen but have not been fully adjudicated. These proceedings, in the opinion of management, will not have a material adverse effect upon the consolidated financial statements of the company when ultimately concluded.

The company has aggregated its operating companies into a number of segments, of which only Broadline and SYGMA are reportable segments as defined in SFAS No. 131, “Disclosures about Segments of an Enterprise and Related Information.” Broadline operating companies distribute a full line of food products and a wide variety of non-food products to both traditional and chain restaurant customers. SYGMA operating companies distribute a full line of food products and a wide variety of non-food products to some of the chain restaurant customer locations. “Other” financial information is attributable to the company’s other segments, including the company’s specialty produce, custom-cut meat, and lodging industry products segments. The Asian cuisine foodservice operations, previously classified in “Other,” have been moved to the Broadline segment beginning with the fiscal quarter ended December 31, 2005. All corresponding items in prior periods have been restated to reflect this change. The company’s Canadian operations are not significant for geographical disclosure purposes.

Intersegment sales represent specialty produce and meat company products distributed by the Broadline and SYGMA operating companies. The segment results include allocation of centrally incurred costs for shared services that eliminate upon consolidation. Centrally incurred costs are allocated based upon the relative level of service used by each operating company.

The company does not allocate share-based compensation related to stock option grants, issuances of stock pursuant to the Employees’ Stock Purchase Plan and stock grants to non-employee directors and corporate officers. The increase in unallocated corporate expenses in fiscal 2006 over fiscal 2005 is primarily attributable to these items. See further discussion of Share-Based Compensation in Note 4.

SYSCO International, Co. is an unlimited liability company organized under the laws of the Province of Nova Scotia, Canada and is a wholly-owned subsidiary of SYSCO. In May 2002, SYSCO International, Co. issued $200,000,000 of 6.10% notes due in 2012. These notes are fully and unconditionally guaranteed by SYSCO.

The following condensed consolidating financial statements present separately the financial position, results of operations and cash flows of the parent guarantor (SYSCO), the subsidiary issuer (SYSCO International) and all other non-guarantor subsidiaries of SYSCO (Other Non-Guarantor Subsidiaries) on a combined basis and eliminating entries.