|Shares Out. (in M):||46||P/E||20.1||17.9|
|Market Cap (in $M):||1,487||P/FCF||14.9||0|
|Net Debt (in $M):||313||EBIT||117||0|
|TEV (in $M):||1,800||TEV/EBIT||15.4||0|
|Borrow Cost:||General Collateral|
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I am recommending a short of Core-Mark (“Core” or the “Company”). As will be described more below, my current target return is relatively modest as the stock has declined significantly (by almost 20%) during the time I’ve been preparing to share this short idea with the VIC community. However, since it is probable that a higher level to short this stock will materialize, I share my research accordingly to evaluate the opportunity now and also at a potentially higher level.
Core-Mark is one of the largest wholesale distributors to the convenience retail industry in North America. In 2018, the Company provided its distribution services of almost 60,000 SKUs through thirty-two distribution centers to ~43,000 customer locations in all fifty states plus five Canadian provinces and one Canadian territory. It is notable that total customers being served by the Company is relatively the same as it was in 2016 despite CORE having acquired another distributor in 2017 with nearly 6,000 customers. Approximately 70% of CORE’s customer locations are traditional convenience stores and the remainder includes Wal-Mart, Rite-Aid, and numerous schools.
The industry generates a high volume of sales but at a low profit margin. During 2018, CORE’s sales were $16.4B and EBITDA margin was just 1%, resulting in EBITDA of $164.7M. Although CORE’s sales grew by almost $1.9B from 2016-2018, EBITDA increased by just $12M. Management’s guidance for 2019 is sales of $16.8-17.0B, EBITDA of $176-182M, and ~$100M of FCF. The Company generated only $70M in aggregate FCF during the preceding three years and has averaged $23M since 2011 which includes two years of negative FCF. During 2018, CORE generated a ROIC of 5.4% and has averaged 7% during the past five years. The Company’s tangible book value is $10 per share.
Based on management’s guidance, CORE is currently trading at ~10x EBITDA and ~6.7% FCF yield. Based on consensus EPS estimates, CORE is currently trading at ~20x 2019E EPS and ~18x 2020E EPS. Management is targeting 8-10% earnings growth over the next several years. Note that from 2014-2018, CORE’s EPS CAGR was less than 1.9%. Given the variability of earnings growth as evidenced by the Company’s recent past, I think Mr. Market is being generous with an earnings multiple that is twice management’s targeted earnings growth.
The emphasis of my short thesis is predicated on the source of the Company’s recent growth and the vulnerability of that growth driver to sustain a pace that is consistent with high expectations coupled with the premium valuation.
According to the National Association of Convenience Stores (“NACS”), the number of convenience store locations in the U.S. totaled ~153,000 in 2018, down by 1.1% from 2017. A key trend within the C-store industry has been consolidation and this trend is likely to continue with the top ten participants controlling only ~27% of all stores.
Nearly 80% of the industry’s stores sell motor fuel. According to the NACS, nearly 40M Americans go to fuel their car each day. Eighty percent of such activity occurs within the C-store channel where 44% of customers fueling their car also come inside the store. This includes individuals who have no choice but to pay for their fuel with cash. Not surprisingly, customers choose a specific venue to fuel their car based on lower prices and that percentage has increased substantially from 47% in 2016 to 59% in 2019. The percentage of customers who choose a specific venue based on the quality of items inside the store is 18%, up from 12% in 2016. In-store sales comprise approximately two-thirds of a store’s overall profits so the importance of customers buying something besides low-margin fuel cannot be understated.
As defined by having ten or fewer stores, approximately two-thirds of stores in the U.S. are characterized as being “independently-owned”. In Canada, management estimates there are ~27,000 stores. CORE’s customer mix is ~55% chains and ~45% independents. Management aims to increase its mix of business with independents.
CORE’s customers include Murphy USA, Circle K, 7-Eleven, Wal-Mart, FAS GAS, AM PM, Rite Aid, MAPCO, Mac’s, Speedway, Shell, and Market Basket. Top ten customers accounted for over 39% of net sales in 2018 including CORE’s largest customer—Murphy USA—at almost 12%. A substantial amount of sales is made under purchase orders and short-term contracts. The larger customer contracts are typically no more than three years and renewals are bid out in a highly competitive market. At the end of last year, management did renew its contract with Mapco, one of CORE’s larger customers. The Company remains vulnerable to losing customers in these bidding contests but also could benefit from winning new business although in a highly competitive market, there is some concern about the “winner’s curse.” In the recent past, when business was lost, the Company has experienced some off-boarding challenges, and also some on-boarding challenges with new business. This was the case with 7-Eleven which CORE began servicing 900 stores in its western region in October 2016.
In regards to Wal-Mart, in May 2017, CORE began service of a three-year supply agreement with 530 Walmart stores in five western states which grew to 560 stores by year-end 2017. The supply agreement encompassed the distribution of candy, tobacco, and certain snack foods and health food items but candy comprised the largest product category under the agreement. During 2018, candy sales to Walmart represented 34% of CORE’s total sales for its candy category.
The Company depends on relatively few suppliers for a large portion of its products. During 2018, CORE purchased ~80% of its products from its top twenty suppliers among the ~5,800 from where it sources its ~60,000 SKUs. The largest two suppliers were Altria and R.J. Reynolds, accounting for ~33% and 23% of its purchases, respectively.
The Company is one of two national distributors to the convenience store industry; the other is McLane which was acquired by Berkshire Hathaway from Wal-Mart in 2003 for $1.45B for ~6.6x EBIT. For context, CORE is currently valued by the public market at ~15.5x forecasted EBIT. As described in Berkshire’s 2018 10K, “McLane’s grocery distribution unit, based in Temple, Texas, maintains a dominant market share within the convenience store industry and serves most of the national convenience store chains and major oil company retail outlets.” Although there are numerous differences between McLane and CORE, the following is noted in Berkshire’s last 10K, “We expect the current unfavorable operating conditions will continue in 2019.” In Berkshire’s most recent 10Q, the following is noted, “McLane continues to operate in an intensely competitive business environment, which is negatively affecting its current operating results and contributing to low operating margin rates. We expect these operating conditions will continue over the remainder of 2019.” McLane’s EBITDA has declined by almost 25% during the past two calendar years versus 8% growth at CORE during the same period but CORE’s growth includes the benefit of its acquisition of Farner-Bocken. During that same period, EBIT at McLane declined by ~43% which compared to a decline of 20% at CORE.
All other competitors can be characterized as being more regional. Two large companies—H.T. Hackney and Eby Brown--cover the eastern half of the U.S. Eby-Brown was recently acquired by Performance Food Group (“PFGC”) which could be demonstrative of PFGC’s intent to become more of a national distributor as well. During their most recent earnings call, management at PFGC noted an intent to expand distribution at Eby-Brown with two facilities in the next eighteen months. PFGC paid $150.6M, inclusive of contingent consideration, for Eby-Brown. This represents just .03x Eby-Brown sales during 2018 (versus CORE now valued at .11x FY18 sales) and an estimated EBITDA multiple, assuming a margin of .9%, of just 3.2x (versus CORE now valued at ~11x FY18 EBITDA). Based on primary research, I understand the low valuation is likely ascribed to the looming risk pertaining to Eby-Brown’s large mix of business associated with Speedway and the potential that the Speedway contract, which was renewed at the beginning of 2016, might not be renewed again. The fifth largest distributor is Imperial Trading which combined with S. Abraham & Sons last year. The closest “pure play” publicly-traded peer is AMCON Distributing Company (“DIT”) which ranked as the eighth largest convenience store distributor in the U.S. based on sales, according to Convenience Store News. DIT’s primary business is as a distributor but it also owns a small (and unprofitable) health and natural food retail business. DIT’s stock is very illiquid and so the relevance of its valuation should be taken in that context but DIT was recently trading at 6.6x EBITDA (~35% discount to CORE’s multiple) and less than TBV at 0.8x (~75% discount to CORE’s multiple at 3.2x). In Canada, Wallace & Carey has national distribution capabilities and Sobey is a large national convenience store and grocery wholesaler.
Some larger convenience store chains self-distribute based on the geographic density of their stores. The ongoing trend of store consolidation is an ongoing structural risk to CORE as the increased density being sought by the consolidators is prompting more considerations to self-distribute as part of the envisioned synergies. If business is not being eliminated by self-distribution, then CORE is also at risk as the balance of power improves across the larger customer footprint. It is therefore not surprising that CORE’s management is focused on increasing its mix of independents but those independents might be vulnerable as the industry further consolidates and the regionals/nationals improve their positioning relative to the independents. As an industry insider said, “There are two ways to make money: increase prices or reduce expenses, so naturally there’s a push to look at reducing distribution costs at a time when consumers are increasingly price-sensitive.”
The Company’s vulnerability to a loss of a significant customer, whether from a customer moving to self-distribute or incurring a loss to a competitor, cannot be understated. During August of 2016, it was announced that Core-Mark would lose distribution services to more than 2,000 stores as Circle K parent Couche-Tard, the industry’s second largest C-store operator, awarded McLane its supply chain services business in the eastern and midwestern U.S while also extending a multi-year agreement with McLane to continue servicing the almost 1,400 former Pantry-acquired locations in the Southeast. CORE’s stock price declined by nearly 18% on the day the news was released and would be marked down by a total of 22% fifteen days later. CORE continues to work with Couche-Tard though, providing management services for Couche’s owned distribution centers in both Arizona and Texas as well as providing distribution services for stores owned by Couche in Western and Central Canada plus stores in their Rocky Mountain and West coast divisions. To the extent Couche-Tard were to decide to bolster its self-distribution further, this remains a risk to Core-Mark.
Given the ongoing consolidation trend among its customers, CORE management recognizes a need to bolster its own footprint and has therefore pursued a strategy that includes tuck-in acquisitions. Between 2010-2018, the Company completed six acquisitions and added three primary distribution centers.
Industry trade publication Convenience Store Newsrecently issued its 2019 industry report and there are a variety of relevant industry issues they highlight that I describe below:
· The C-store industry completed another strong year in sales and profit growth, “but trouble lurks behind the scenes.”
· In-store sales, an important barometer of the health of the convenience store industry, were up “a paltry 1.6% in 2018, as both in-store and motor fuel transactions were down for the second year in a row.”
· The number of in-store transactions per week declined by 1.4% and motor fuel transactions declined by 1%.
· More consumers are doing their shopping over the internet or using delivery services. And greater fuel efficiency due to tougher fuel emission standards is resulting in fewer trips to the pump. Gallons sold last year were down 0.1% and this is largely ascribed to better fuel economy vehicles coupled with ride-sharing.
· Cigarette sales in the channel fell in 2018, by an average of 2.3% per store, but electronic cigarettes “hit it out of the park,” with the average sales per store growing by almost 180% to $26,613.
· Electronic cigarettes beat out cigars to be the second other tobacco product (“OTP”) to smokeless tobacco which remains the top other tobacco product type at $48,629 per store but grew at a more modest 2.8%.
· Resulting from the “astounding” growth of electronic cigarettes, 2018 was the high point for OTP growth across convenience stores in a five-year period, rising from a low of 4.3% growth in 2014 to 23.5% in 2018.
During CORE’s first quarter earnings call, CORE’s CEO characterized the industry in his following prepared remarks, “…a few reflections coming out of the recent NACS State of the Industry Summit. The headlines for 2018 focused on continued sales growth driven by food and alternative nicotine with headwinds coming from store count and store visits.”
Cigarette products, which are the number one product sold in convenience stores, comprise an average 28.5% of in-store sales at U.S. convenience stores, and were ~67% of the Company’s net sales in 2018 and 26% of its total gross profit. Although cigarettes are a lower margin category, the sales do generate attractive gross profit per cubic foot. Moreover, according to an examination of retail POS data by Management Science Associates, 49% of cigarette transactions included other items as well. The cigarette product category does not include “other tobacco products or alternative nicotine products.” Other tobacco products (“OTP”) represented another 8.5% of CORE’s net sales in 2018. Alternative nicotine products are not disaggregated in a transparent manner but included in the Company’s “health, beauty & general” product category which represented 4.3% of CORE’s net sales in 2018 and grew by almost 60% from 2016-2018. Alternative nicotine products include the highly controversial e-cigarettes which is also sometimes called vaping products.
It is notable that McLane describes e-cigarettes within its cigarettes/OTP section on its website. Through primary research, I confirmed that McLane does indeed track e-cigarettes as being among their “other tobacco products.” I confirmed this with the largest convenience store operator 7-Eleven as well. As described also by Convenience Store News, when mentioning electronic cigarettes, such is characterized as “other tobacco products.” However, this is inconsistent with CORE’s approach which suggests to me that CORE management might be trying to mask the significant magnitude of e-cigarettes to its growth profile by integrating this controversial set of products within the health, beauty & general category.
Given the well-documented decline in the consumption of cigarettes, it should come as little surprise that CORE witnessed a decrease in carton sales during 2018. Excluding an acquisition, carton sales decreased by 6.7% compared to 2017 although the decline in volume was partially offset by a 4.7% increase in the average sales price per carton. Management anticipates overall cigarette consumption will continue to decline but expects to offset the decline through continued growth in non-cigarette categories including alternative nicotine products and OTP. Altria recently communicated their expectation for an acceleration of decline in carton volume.
It is notable that from 2016-2018, the Company’s cigarette product category grew net sales by ~6% while OTP grew by ~22% and the health, beauty & general category grew by almost 60%. Although management doesn’t provide specific clarity for the magnitude of the growth ascribed to alternative nicotine products, they have acknowledged it being a significant majority of that 60% growth. For additional context, OTP increased by 9% from 2017; the health, beauty & general category increased by ~39% which was “driven primarily by the increasing popularity of alternative nicotine products.” It is this area of growth, from which the Company has accrued recent benefits, that I think is vulnerable for several reasons and that risk is not being adequately discounted by the market.
Oxford’s 2014 Word of the Year was “Vape.” According to Altria, which owns 35% of the category leader JUUL, volume was relatively flat at 1.0-1.1 of EQ units from 2014-2017 but growth has recently escalated by a significant magnitude because of JUUL’s popularity. JUUL’s estimated market share reached 75% by November of last year, up from 56% during the summer of 2017.
The company JUUL Labs made deft use of social media (and many would say “deceptive advertising practices”) to popularize its device until pressure from the FDA led JUUL to shut down its Facebook and Instagram accounts last November. Most recently, on August 29th, we learned that the Federal Trade Commission is investigating JUUL Labs over its marketing practices. The investigation reportedly has been in the works since last year. The Food and Drug Administration along with several state attorney generals are also investing their marketing practices.
Youth vaping surged to “epidemic levels” last year as e-cigarette use among high school students rose 78% from 2017 to more than 3M students. The U.S. Surgeon General declared youth vaping as an epidemic in 2018 while specifically identifying JUUL in his advisory. While some health experts believe that e-cigarettes confer public health benefits as a smoking cessation aid, others express grave concerns that e-cigarettes—and especially JUUL—will increase nicotine addiction among young people. This is particularly disconcerting to the public health community since cigarette smoking rates among U.S. high school students have declined to the lowest level on record (7.6% in 2017) but vaping among high school students is almost triple that.
A range of policies has contributed to declining smoking rates among youth in the U.S. This includes laws restricting advertising and warning labels regarding nicotine that have raised visibility across younger people about the risks of smoking. The e-cigarette, which was first developed in China in 2003, arrived in the U.S. in 2006 and it is only very recently that the potential issues (which now includes seizures being investigated) associated with vaping are gaining increasing visibility. The CDC has recently reported over 150 cases of severe lung disease linked to vaping in sixteen states.
Although there is a predominance of youth awareness of the risks of nicotine and smoking cigarettes, according to a 2018 survey conducted by the Truth Initiative organization, 63% of 15-24 year olds were unaware that JUUL contained nicotine. Experts are concerned, based on numerous studies, that vaping might act as a “gateway” drug, leading teens to eventually begin smoking cigarettes and thereby reversing years of reduction in youth smoking. Per one study, adolescents who vaped were 3.5 times more likely to start smoking than never-vapers.
The e-cigarette category generated over $3.3B in retail sales across all channels during 2018 according to research by Wells Fargo based on Nielsen data. By 2018, nearly a third of e-cigarette products were sold by vape shops; another third was sold by convenience, food, and drug retail stores; and the remaining third were sold online. Approximately 12,000 convenience stores sold JUUL in 2018.
Since 2017, JUUL has driven nearly all of the electronic cigarette category volume growth. Altria estimates that the "e-vapor" category grew volume by over 35% in 2018 after 10% growth in 2017, and almost all such growth is ascribed to JUUL. In 2018, revenue at JUUL was $1B, up 5x from the $200M in 2017. As described in their most recent earnings presentation, Altria estimates ~40% category growth during the first half of 2019 with ~195% of JUUL growth. Before JUUL was introduced, 7-Eleven units averaged $20 per day from e-cigarettes but with the surge in JUUL’s popularity last year, some 7-Eleven units were generating $800 per day from the category. This is stellar growth but public sentiment for the category is increasingly gaining negative attention and particularly for the rise of vaping among young people in both middle school and high school. According to the FDA, the percentage of high school students using e-cigarettes nearly doubled between 2017 and 2018, jumping from 11.7% to 20.8%.
During March, the FDA named Walgreens, 7-Eleven, and Exxon, among more than a dozen named store brands, for repeatedly selling tobacco products to minors. Management at 7-Eleven recently implemented an age restriction of 21 for purchasing e-cigarettes. This age restriction is being debated at the federal government level but has been implemented across numerous states. According to CORE management, 38% of the e-cigarette volume is in states that already moved to age 21 restrictions.
Research data suggests that non-tobacco flavors were important to both younger and adult users. When the federal government outlawed flavored tobacco, a primary reason was to curtail the appeal to potential younger smokers. When JUUL removed most of its flavored pods from retail shelves, its market share declined by 200 basis points during the following month. The most recent data, released for the four-weeks ending August 10th, shows JUUL’s dollar share having slipped to 71.4% as vaping rivals like NJOY, Vuse, and Blu seek share through aggressive price promotions that appear to be working. The magnitude of business that CORE does with each supplier is not transparent but aggressive pricing actions by the manufacturers is not typically something a distributor will be immune towards unless it’s made up from a meaningful increase in overall volume.
Although the magnitude of these “alternative nicotine products” to CORE’s recent performance is not transparent, I highlight below some recent communication by CORE’s management for context.
· During the most recent earnings call, management noted that half of its 7.5% non-cigarette same-store sales growth was driven by alternative nicotine products. Its health, beauty and general category grew by $56.4M, or 35%. It’s interesting that other tobacco products grew by only 2% although some of that might pertain to a shortage of cigar supply.
· It is notable to highlight from the most recent 10Q the following: “Sales growth of alternative nicotine products, which has been strong for the past twelve months, may not continue at the same level going forward.” In the preceding 10Q, when describing the strong growth in alternative nicotine products, the language used was similar as noted, “…strong growth in alternative nicotine products which may not continue at this level for the duration of 2019.”
· The words “alternative nicotine” increased by 70% from ten in the first quarter 10Q to seventeen times in the second quarter 10Q. Alternative nicotine was described only seven times in the prior year’s second quarter 10Q. It’s undeniable that e-cigarettes have become an increasingly important component to CORE’s business.
· BMO Capital’s research analyst asked management during the first quarter earnings call, “And then just looking at the 1.4% growth in non-cigarette sales, could you quantify sort of how much of that came from the alternative nicotine products and how you sort of think about that going through the rest of the year as we start to lap some of that growth there?”
· CORE’s CEO responded that “quarter over quarter, we definitely had solid growth. About half of our same-store growth was from the general merchandise category. Now, that does have some regular general merchandise, some non-nicotine stuff in it as well…but it was about half of our same-store growth.” It is my hypothesis that CORE’s management has failed to respond with clarity to these type of questions because of the increasing importance of this controversial product category to its business.
· During the Q4’18 earnings call, the CFO said, “The increasing popularity in alternative nicotine products drove a 50% same-store sales increase in our health, beauty and general product category in Q4. Although this was higher than the year-over-year increase we saw in Q3, we expect increased regulation of alternative nicotine products and tough comps will impact year-over-year growth as we move through 2019.”
· During the Q4’18 earnings call, in March, the CEO said, “…I don’t anticipate a year like last year where JUUL went from being a $200M company to a $1B company in a year…I would anticipate that our revenues in that area [i.e., the alternative nicotine category] will be flat to up slightly compared to last year and that’s kind of how we’ve looked at it from a guidance standpoint.”
· During Q3’18, sales of alternative nicotine products increased by over 50%
· During Q2’18, the Company’s health, beauty and general product category generated the highest level of category growth, increasing 36%, driven by the growth in alternative nicotine products and the increase to gross margin was partially ascribed to the increased consumption of alternative nicotine products.
· During Q1’18, CORE’s CEO noted the “unforeseen benefit was kind of the alternative nicotine category”
I estimate the Company’s growth in e-cigarettes in 2018 was 4.6x the level of 2017. I estimate that e-cigarettes represented over 25% of CORE’s net sales growth in 2018 and almost half of CORE’s gross profit dollar growth. One cannot precisely know the magnitude of CORE’s e-cigarette sales that were ultimately consumed by youth but it is highly likely that CORE has generated some financial benefit from such sales. Given the movement to combat youth vaping coupled with the increased scrutiny regarding vaping in general, it is likely that e-cigarette consumption growth will moderate.
Concerns about the Company’s growth confronted the wrath of the market twice within two months starting in the early part of November 2017 and then soon afterwards in the early part of January 2018. Pursuant to CORE’s release of its third quarter results in 2017 coupled with a reduction to its outlook, the stock declined by ~13.5% over three days and then on January 5thof 2018, the stock declined by 23% when management reduced its outlook again. It should be noted that management also revised its outlook lower when it released its results for the second quarter of 2017 and this reduction was in spite of the acquisition of Farner-Bocken for ~$190M. When its 2017 results were ultimately released, the Company’s $135M of EBITDA was over 20% lower than the original guidance at the mid-point and without the outlook having included Farner-Bocken which contributed to CORE from the closing of the acquisition in July of 2017. The Company’s EPS was over 31% below the original outlook. Management ascribed most of the challenges to lower-than-expected cigarette volumes coupled with execution challenges associated with on-boarding new business and off-boarding loss business.
The market did not overlook these missteps as CORE’s stock declined by almost 45% from the end of 2016 until January 5thin 2018 when management reset its outlook down for the third consecutive quarter. The stock continued to be challenged and hit its five-year low of $17.10 on May 9thof 2018 pursuant to the Company’s first quarter results which included management highlighting a steeper decline in cigarette carton sales coupled with a soft retail sales environment presenting challenges. However, the stock quickly rebounded from that five-year low to more than $38 at the end of October of 2018 and much of that 100% increase can be ascribed to the aforementioned growth that was driven from the e-cigarette product category. During Q2 of last year, CORE’s EPS exceeded consensus by 21% and that would be followed by another upside surprise of 37% in Q3. The Company nor the industry anticipated the success of e-cigarettes but industry participants have certainly derived many recent financial benefits. The looming issue is whether the critical growth engine can sustain a pace that is consistent with expectations in addition to the numerous structural and secular issues confronting CORE.
There are numerous issues that confront CORE which I believe are not being adequately discounted by the stock. This includes the following:
· Cigarette sales volume, which comprised ~67% of net sales and 26% of gross profit for Core-Mark in 2018, continues to slide and the cigarette industry has recently forecasted an acceleration of the decline
o Cigarette consumption in the U.S. and Canada has been declining gradually over the past several years and is expected to continue declining because of the increase in the price of cigarettes, restrictions on cigarette manufacturers’ marketing and promotions, increases in cigarette regulation and excise taxes, health concerns, increased pressure from anti-tobacco groups, and the rise in popularity of tobacco alternatives, including electronic cigarettes.
o As evidenced by Altria’s Q1 results, shipment volumes came under intense pressure and Wells Fargo Research noted that “shipment volumes declined sharply as we expected, but much worse than feared.”
o Altria then revised its estimate for total domestic cigarette industry volume decline rate to a range of 4-5% (from 3.5-5% a few months ago) and cited the revision was “primarily due to increased gas prices and other factors.”
o But Altria’s Q2 results worsened and Altria has since revised its 2019 estimate for total domestic cigarette industry volume decline rate down further to a range of 5-6%.
o For 2019-2023, Altria has expanded its estimated range for domestic industry volume decline rate to an annual range of 4-6%
· E-cigarette category growth has been strong but regulatory scrutiny coupled with escalating visibility regarding vaping risks is likely to slow e-cigarette momentum
o Federal regulators are trying to combat what some have called an “epidemic” of teen vaping while local governments pursue their own actions.
o The FDA remains focused on teen vaping. The FDA’s initiative on vaping is spurred by government data that showed e-cigarette use rose 78% among high schoolers and nearly 50% among middle schoolers in 2018. That means 3.5M children were vaping in early 2018, up from 1M from 2017.
o During January, then FDA Commissioner Scott Gottlieb suggested that the agency might pull the entire e-cigarette and vaping category from store shelves if youth smoking rates fail to drop over the next year. I am not anticipating this scenario but it would indeed be quite damaging to CORE as I estimate that a significant majority of the Company’s EBITDA growth in 2018 was ascribed to the growth of e-cigarettes.
o The FDA recently banned gas stations and convenience stores from selling most flavored e-cigarettes under its new draft guidance.
o All e-cigarettes will eventually need to undergo FDA review. Representatives from the FDA have indicated that new restrictions on the sale of alternative nicotine products could be expected in the near future.
o On June 25th, San Francisco became the first city to ban e-cigarettes which is a harsh rebuke of the industry and especially with leader JUUL being based in San Francisco.
o San Francisco’s ordinance bans any e-cigarette that hasn’t received FDA clearance, effectively banning all e-cigarettes since none have been approved by the FDA.
o Rite Aid has communicated their intention to stop selling e-cigarettes, citing Federal data that showed a surge in high school students using the devices.
o CORE notes among its risk factors that actions such as legislation and related regulation is likely to continue adversely impacting the market for tobacco and alternative nicotine products.
· Bipartisan federal legislation being introduced to raise the minimum age to purchase tobacco products from 18 to 21
o According to the Centers for Disease Control and Prevention, ~34M American adults smoke cigarettes, and everyday there are 2,000 new smokers under the age of 18. The vast majority of smokers start before they turn 18.
o Approximately twenty states have passed laws raising the minimum age to 21 and other states are considering doing so as well. Furthermore, the Federal government has recently introduced a similar intent and there is likely bipartisan support for this potential legislation which is of course supported by public health advocates and also across selected tobacco companies seeking to reduce the use of e-cigarettes among youths.
o Senate Majority Leader Mitch McConnell cited his plan to introduce legislation to raise the minimum age (dubbed “T21”) to buy tobacco products, including vaping devices, as one of his top priorities. He considers teen vaping to be the “most serious threat” his new legislation will seek to combat.
o Antismoking group lobby spending is near a five-year high and bipartisanship exists for “T21” legislation
o During April, both Walgreens and Rite Aid announced their intention of raising the minimum age requirement to 21 to buy tobacco products (note: CVS stopped selling tobacco products in 2014 which incidentally was a favorable catalyst then for CORE and its customer base); Walgreens’ change starts September 1stand Rite Aid’s change was aimed to occur by the end of July.
o During May, Walmart in a letter to the FDA outlined its support of the agency’s efforts to keep tobacco products from minors and will raise the minimum age to purchase all tobacco products to 21 at all U.S. Walmart and Sam’s Club locations. In addition, Walmart discontinued the sale of fruit and desert-flavored electronic cigarettes and vapor products.
o Cigarette companies have also embraced “T21”. An Altria spokesman said, “Altria strongly supports raising the legal age of purchase for all tobacco products, including e-vapor, to 21. This is the most effective action to reverse rising underage e-vapor usage rates.” A spokesman for Reynolds said they support McConnell’s “efforts to raise the national minimum purchase age to 21 as an effective means of keeping tobacco products out of middle and high schools, where many youth obtain the products, especially vapor.” And the CEO of JUUL Labs issued a statement noting, “We commend these bipartisan lawmakers for introducing this Tobacco 21 legislation, as we strongly support raising the purchasing age for all tobacco products, including vapor products, to 21 and have been actively supporting legislation to do this at the federal level and in states across the country.”
o As evidence of a selected “cultural” movement towards reducing smoking consumption, it’s noteworthy that Netflix plans to add smoking warnings to its online rating system and omit smoking from all future films produced internally unless the director can prove it is essential to the creative vision of the story.
· If taxes on other tobacco products were to increase substantially, sales of e-cigarettes could decline or experience a moderation of growth relative to high expectations
o Cigarette products are subject to substantial excise taxes in the U.S. and Canada and it is likely that increases in such taxes will continue.
o These tax increases have negatively impacted aggregate consumption. A study by the National Bureau of Economic Research estimated that a $1 tax increase on cigarettes reduces use by ~2%. Despite the higher cigarette tax rate, some states are exploring taxes on e-cigarettes as either a source of additional revenue to offset the decline in cigarette tax revenue (i.e., the higher cigarette tax rate has not offset the decline in consumption) and/or an approach to combat the “vaping epidemic.”
o For example, Wisconsin ranked fourth in share of general revenue collected from tobacco taxes, with 2.6% of the state’s revenue coming from them in 2016, but this is down from ~3.5% in 2011. Wisconsin collected ~$105M less from cigarette taxes in 2018 than it had in 2010. “The state’s reliance on tobacco tax revenue increasingly is undermined by declining use of traditional cigarettes.” This is a similar issue in many states and prompted Wisconsin lawmakers to capitalize on the growing electronic cigarette industry by imposing a recently-passed five cent per milliliter excise tax on e-cigarette fluid. This new tax, effective October 1st, is projected to collect only ~$5.5M over the next two years. Since research in Wisconsin indicates that e-cigarette use among state high schoolers has increased tenfold in the past six years, there are many state lawmakers who sought a higher tax with the objective of combating the “vaping epidemic.” The $5.5M is far less than the Democratic Governor’s plan would have generated, at almost $35M, based on taxing both the devices and fluids 71% of the manufacturer list price. At least twenty states have passed an e-cigarette tax statewide or in select jurisdictions.
o In Vermont, as of July 1st, a 92% e-cigarette tax went into effect. At the end of June, only nine states were pursuing e-cigarette taxes but there is a high likelihood that many other states will embrace such taxation in the near term and this could cause a reduction in consumption.
o For some context on the potential impact from taxes, the Campaign for Tobacco-Free Kids reported that every 10% increase in prices reduces consumption by 3-5%. Furthermore, although somewhat dated in 2014 from one of the first studies to explore the effects of prices on e-cigarette sales, a 10% increase in price was said to impact volume by 12%. I doubt the impact would be nearly as severe but the evidence of some recent market share degradation at JUUL against competitors focus on winning share with a lower price is demonstrative of some elasticity to demand.
· Cross-channel competitors are putting the heat on convenience stores
o As described during the NACS State of the Industry Summit, c-stores are in the crosshairs of channel blurring, with an array of retailers both invading and reinventing the convenience model.
o Dollar stores, restaurants, mass merchants, drugstores and online retailers are all making a grab for the convenience space.
o The CEO of the largest C-store operator 7-Eleven said, “The consumer is changing as fast as I’ve ever seen. Product life cycles are a lot shorter. Consumers are much more demanding and discerning…encroachment of dollar stores and aggressive QSRs, and the growth of e-commerce. There has been a buzz about retail channels blurring…there are no more channels…we need to recognize that, and certainly our supplier partners need to recognize that…”
o Dollar stores are expanding into key c-store categories such as beer, snacks, and tobacco. The COO of RaceTrac said, “We’re right in the bull’s eye of dollar stores.”
o And Amazon Go stores, which is Amazon’s chain of convenience stores, is another potential risk to Core-Mark but this is not a likely significant threat in the near-term given few Amazon Go stores currently, at less than twenty. However, during September 2018, Bloomberg News reported that Amazon was considering plans to open as many as 3,000 Amazon Go locations by 2021 although Amazon has refuted this news report.
o Wal-Mart has also been testing a C-store strategy.
o And in regards to the critical e-cigarette category (i.e., CORE’s health, beauty & general category), I should note that during May, it was reported that JUUL has considered opening its own retail shops that would only admit adults.
· Increases to federal or state minimum wages coupled with the ongoing improvement to wages by numerous companies for lower-skilled labor could create pressure on CORE to raise its wages, thereby creating a headwind to the Company’s profitability
o Given the highly competitive end markets of its customers, it’s unlikely that CORE would have much latitude to raise its prices to offset all of its inflationary cost pressures
o CEO noted that driver wage pressure is likely to be prevalent for the next 12-18 months
· Longer-term there are potential structural issues if the magnitude and frequency of consumers seeking to fuel their vehicle declines
o The magnitude of consumers visiting a convenience store to fuel their vehicle could decline in the longer-term for two primary reasons: the growth of the electric vehicle (“EV”) and ride-sharing.
o C-store executives are well-aware of the EV-charging substitution issues and there has been some experimentation with the installation of chargers to attract EV owners to the convenience store but the vast majority of C-stores are waiting for an acceleration of EV adoption before making any changes.
o For context, Morgan Stanley Research described a scenario during 2018 in their bull case for electrical vehicles which could impact convenience store sales by 25%.
In regards to how I am thinking about the potential downside, I have reduced some of my short exposure from a cost basis above $39 but am hoping to short more on potential strength. Based on my research and impression of the variability of growth prospects, I am currently valuing CORE at a ~10% discount to its peer group. I think this multiple, at 15x 2020E EPS (almost 9x management’s 2019 EBITDA outlook) is generous based on the historical pattern of financial results, a low ROIC, and earnings variability compounded by the aforementioned issues in tobacco and the recent reliance on e-cigarettes for a majority of its growth which is not likely to prove sustainable. This gets me to a target of ~$27.15 (~15% downside to Friday’s close). I also think that consensus EPS growth of 12% for next year could prove to be too high and a reduction is likely to further compress the earnings multiple but since I think expectations have already been somewhat reduced by management in the near-term as described below, I am not yet prepared to ascribe a much lower target absent increasing clarity of the degradation of performance that I deem possible. In fact, I think management was likely being prudent in managing expectations downward and among the reasons I have reduced exposure accordingly with price action.
The Company recently reported its Q2 results, on August 7th, and EPS exceeded consensus by over 15%. Management did not, however, increase its outlook and the stock is down ~8% versus the S&P up ~2% and Russell 2000 virtually flat since the earnings conference call.
The fact that management did not increase its outlook might be ascribed to their internal concern regarding the tough e-cigarette comp during Q3 and Q4 but they explained it being based upon their outlook for having incorporated a $19M cigarette price increase to their outlook that has yet to fully materialize relative to their expectation and is subject to whether, when and to what magnitude the cigarette manufacturers raise pricing again. This specific component of Company guidance is related to management’s expectation that cigarette manufacturers will continue to raise prices as carton sales decline in order to maintain or enhance their overall profitability. During 2018, CORE generated a benefit on its cigarette inventory of $1.90 per carton and much of that benefit accrued late September with a second cigarette price increase of $1 per carton from most major brands. Through Q2 of 2019, CORE’s cigarette inventory holding gains were $12.6M based on a total increase of $1.70 per carton. This year the second price increase of $0.60 per carton was announced in mid-June and such resulted in an inventory holding gain of $3.8M that has been recognized in full during Q2. The issue is that the YTD price increase per carton is below the prior year level but the timing of price increases has accelerated and so management is assuming (and hoping) that the cigarette manufacturers will announce another price increase on major brands before the end of this year to achieve their $19M expectation versus $12.6M YTD. During 2018, the cigarette inventory gain benefit totaled $19.6M, up from $16.1M in 2017. I have no well-informed perspective on the cigarette manufacturers’ intent to raise pricing again this year. There’s clearly a lot going on at Altria with their reported discussion to combine back with Phillip Morris International.
The fact that the Company will garner an unforeseen benefit of $5M from candy inventory holding gains (based on price increases from Mars, Wrigley and Hershey in July) coupled with the fact that e-cigarette contribution this year has been greater than management was communicating in their expectations for 2019 (perhaps to manage expectations down accordingly when the CEO said “flat to up slightly” during their Q4’18 earnings call) makes me think that management should have raised their outlook pursuant to the strong Q2 unless they are indeed uncomfortable with other parts of the business, beyond what they called out regarding the cigarette inventory gains. I think it’s probable that the e-cigarette business is indeed moderating and this will be magnified against the tough comps in both Q3 and Q4. That said, since management did not raise its outlook, thereby effectively managing expectations down, I chose not to press this short and instead book some profits on the absolute and relative price decline as I monitor the developments, including the possibility of management’s hope for a cigarette price increase, during the seasonally strong Q3 (which is benefitting from lower fuel prices).
Selected Risks to Short Thesis
· The convenience store channel is generally effective managing age-restricted product sales and therefore is perceived to benefit as a go-to channel when it comes to the sale of products like e-cigarettes.
· Tobacco smoking has been going down and vaping is going up and how much of the diminishment in tobacco smoking is attributed to vaping is difficult to discern. Given the perceived benefits to further reduce smoking relative to the detrimental issues associated with vaping, it is not a likely scenario that the “alternative nicotine product” category will be eliminated. There is much controversy regarding JUUL but the company just closed on an additional ~$800M although largely to fund their international expansion. The short thesis is not predicated on the elimination of this high growth/high margin category but instead whether the growth that is anticipated is likely to endure relative to expectations.
· CORE’s most important quarter is Q3 because it captures the critical summer driving season and fuel costs have proven to be an influence to in-store retail sales. As we head into Labor Day weekend, GasBuddy is predicting that the national average price per gallon will be ~10% less than last year and the lowest-priced Labor Day weekend fuel since 2016. During Q3 2019, the average gas price has trended below Q3 2018 and this should be a positive contributing factor to the C-store industry and CORE this quarter.
· The opportunity to pursue tuck-ins remains attractive based on the valuation arbitrage for how CORE is currently valued by the public market versus the multiples that historically have been paid in the private market.
· CORE’s management recognizes the challenges within its industry and has sought to adapt through numerous initiatives which are having a positive impact
o The Company’s Vendor Consolidation Initiative is a program targeting inefficiencies in the supply chain by offering the retailer the ability to receive multiple weekly deliveries for the bulk of their products, including dairy, the cornerstone of this strategy, and other merchandise that CORE’s convenience store customers previously purchased from multiple direct-store delivery companies and small “wagon jobbers.” According to management, only 46% of a typical store’s products are delivered by a broad-line distributor like Core-Mark. The Company’s Vendor Consolidation Initiative targets increasing CORE’s share of wallet with other product categories which management estimates comprise 24% to exclude their estimated 30% mix which is represented by Coca-Cola, Pepsi/Frito-Lay, and the beer distributors.
o Working towards increasing its mix of independents with its Focused Marketing Initiative which is a more consultative-driven approach applying category management with smaller chains. Management estimates that customers working with CORE’s Focused Marketing Initiative experience 7.8% growth compared to 4.5% growth in non-FMI stores.
o An increased emphasis on fresh and prepared foods which delivered 9% growth last year, but this category has witnessed moderating growth each year since 2014.
· Performance Food’s acquisition of Eby-Brown could prompt PFGC peers US Foods and/or Sysco to consider an acquisition of CORE to gain a meaningful presence in the C-store distribution segment. There’s also the possibility of McLane’s consideration but I very much doubt that Berkshire would think of such near CORE’s current valuation.
· There is always some potential that some new product category comes along (ala e-cigarettes) that generates unforeseen growth that CORE and its customer base capitalize upon until that category moderates or fades. One potential category that gets called out where the C-store channel and therefore CORE could benefit is CBD. Management noted on their recent earnings call that they are selling “very select few manufacturers and a very select product mix today in a select number of states” and industry research suggests it could be a multi-billion-dollar category during the next five years.
· Balance sheet is least levered across publicly-traded peer group and is not a current concern
· Regulation of e-cigarettes/vaping by the FDA that restricts sales
· Heightened visibility and scrutiny regarding dangers of vaping that reduces pace of growth relative to expectations
· Larger than expected decline in cigarette volumes
· Absence of another price increase by cigarette manufacturers in 2019
· Ongoing consolidation across C-store industry, thereby increasing customer balance of power
· Slowing same-store sales across customer footprint
· Loss of significant customer and/or margin degradation during contract renewal bid process
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