San Francisco-based Core-Mark International (ticker: CORE) distributes food, candy, beverages, cigarettes and other merchandise to convenience stores (“c-stores”) primarily in the western part of the U.S. and Canada. Generating over $5.5 billion in revenue and servicing over 21,000 customer locations across North America, CORE is the second largest such distributor measured on a national basis. The national market leader is McLane Company, which Berkshire Hathaway acquired in 2003 from Wal-Mart. Although this is a broad generalization, the c-store distribution industry is typically characterized by regional duopolies, with McLane usually holding the greatest share among chain accounts, and with large regional players usually holding the greatest share among mom and pops and smaller chains. In many regional markets the number three player is a fraction of the size of the first and second largest players.
As we discuss below, we believe players with local or regional scale can establish competitive advantages in the c-store distribution business, allowing them to generate attractive returns on invested capital. CORE is just such a player, with leading regional shares in many of its markets, and the company’s 20-25% pretax returns on net assets are indicative of this underlying competitive advantage. We believe it will be difficult for competitors or new entrants to overcome CORE’s regional scale advantage.
CORE is very capably managed by CEO Mike Walsh, who brings an uncommon level of passion to the business. We believe Mike is honest, hardworking and intelligent, with a good understanding of the role of a capital allocator. He has maintained a very strong financial position and is poised to take advantage of opportunities to use his balance sheet when they arise. For instance, last week the Company announced a $30 million buyback, which we think is a very attractive use of capital. Although Mike does not own a lot of the business in absolute terms, his nearly 2% stake is likely a meaningful if not majority portion of his net worth. We feel that our interests are aligned.
We believe CORE’s current earnings are relatively secure and that the company will benefit from the 4-8% medium-term organic growth inherent in the convenience store industry. This alone should allow the company to grow intrinsic value; however, CORE is also pursuing several other paths to value creation that could be transformative. We describe these other opportunities in detail below.
The valuation for CORE shares is very compelling. We believe we are paying less than 10x 2007 free cash flow (excluding holding profits) and about 1.1x tangible book value (supported by readily sale-able inventory and accounts receivable). While these multiples are very reasonable, we also think that we should benefit from the several mutually independent levers of value creation available to the company, including the flexibility that a strong balance sheet creates. Our calculations indicate fair value for the shares at around $40, which represents upside of 50% from today’s $26.50 stock price. While our models give some indication of value, we gain our real comfort in the quality of the business and the management team, and in the optionality inherent in the company’s current initiatives and strong balance sheet. We think there is limited downside and potentially significant upside to purchasing CORE shares at current market prices.
Core-Mark began operations in 1888 as Glaser Brothers and entered the modern era with the 1974 acquisition of the company by David Gillespie. In June 2002, Fleming Companies, a wholesale grocery supplier, purchased Core-Mark from private equity firm Jupiter Partners for what was believed to be about $400 million (compared to today’s enterprise value of $290 million). Less than a year later, Fleming filed for bankruptcy. Although the bankruptcy was not triggered by anything to do with the Core-Mark subsidiary, Core-Mark still suffered through the process as Fleming sucked all cash flow up to the parent, Core-Mark’s customers put the company on harsh payment terms, and some customers decided to take their business elsewhere. Through the restructuring, most of the other Fleming assets were liquidated and the interested parties determined Core-Mark was the only entity with true going concern value, along with a handful of Fleming distribution centers that were brought under the Core-Mark umbrella. The new Core-Mark emerged in late 2004 and began trading as a public company in April 2005. Some of Fleming’s former creditors received stock as part of the bankruptcy plan, which shares have all been distributed. The company retains no further liability associated with prior claims.
In June 2006, the company acquired Klein Candy, which was the #6 player in the c-store distribution industry, providing substantially the same services as CORE, but on the east coast out of its Pennsylvania distribution center. CORE paid $58 million for Klein, an amount that was partially financed by bringing Klein’s vendor payables into line with CORE’s. After adjusting for the vendor financing, we believe the Klein acquisition price approximated the liquidation value of Klein’s net working capital. The company funded the acquisition out of its credit facility. Management targets a 20-25% return on any capital projects, and now a year into the Klein purchase, we believe there is a high likelihood this acquisition will meet that goal.
The Convenience Store Industry
The in-store convenience store industry is a $150 billion market at retail ($110 billion at wholesale), with cigarettes making up around one-third of industry sales, followed by alcoholic and non-alcoholic beverages and foodservice. Convenience stores have become a fixture in the American landscape as a destination for consumers to refill their gas tanks, purchase soda, beer and other beverages, load up on cigarettes and buy basic food offerings like milk and eggs, and snacks like candy and potato chips. CORE management believes that beverages are the biggest driver of customer traffic, but clearly there are many reasons why customers frequent c-stores. Most c-stores are small format boxes (~2,500 square feet of selling space with 3,500 SKUs and 10 parking spots) and located conveniently for customers. According to NACS, the industry association, there are over 145,000 convenience stores nationwide, up from 120,000 in 2000.
60% of these stores are one-store “mom & pops” (up from 50% in 2000) and only 18% are parts of chains of greater than 200 stores. Big oil companies were the historical owners of larger chains, but many have been exiting the business to focus on their core E&P operations.
There are several big picture trends affecting the convenience store industry today. The most important of these is a secular decline in tobacco consumption in the U.S. Since peaking in 1981, U.S. cigarette consumption has declined fairly consistently at a CAGR of about 2.15%, and now stands about 45% below its peak. It is worth pointing out that in 1998 cigarette manufacturers became bound by the Master Settlement Agreement (the “MSA”), which added about $5 to the cost of a premium carton. The MSA had a clear impact on cigarette volumes. The trend towards lower consumption has been driven by the compounding effect of higher state and federal excise taxes, as well as better education about the adverse health implications of tobacco use. We expect the trend will continue.
There have been several counter-trends that have served to mitigate the decline of tobacco consumption for vendors. For one, cigarette manufacturers have regularly raised prices to offset the impact of lower volumes on their own businesses. These price increases are typically passed on to the end customer, so while unit volume decreases, price and overall dollar volume tend to increase. The second offset to cigarette consumption is a shift in the channels where cigarettes are purchased. As cigarettes became more expensive, consumers began to purchase less frequently in bulk (cartons) and more frequently in single units (packs). Because the easiest way for consumers to buy a pack of cigarettes is through convenience stores (especially since vending machines disappeared), cigarette volume has moved out of the warehouse clubs and into the convenience channel. In 1999, for example, c-stores represented 54% of cigarette sales nationwide. This figure has climbed to 63% today. While we believe that c-stores will at least maintain their share of cigarette purchases at current levels, we are beginning to see evidence that the channel shift has played out and c-stores are not likely to continue to gain share. CORE’s results have also begun to show this impact, as in 2007 the company’s cigarette volumes decreased for the first time.
The second important trend in the industry is the impact of higher gas prices, and inflation more generally. To the extent that the need for gasoline is what drives consumers to convenience stores that have gas pumps, which make up about 80% of convenience stores (and 65% of CORE’s customer base), it is possible that recent high gas prices could cause a decline in in-store business. So far the effect of higher gas prices has been seen in somewhat lower demand for gasoline, but it has not translated to lower in-store sales.
Other than cigarette consumption and high gas prices, the other trends facing the convenience store industry tend to be positive. The channel has managed to grow in-store sales at a good clip (8% in-store CAGR from 2000-2005), with strong growth coming from fresher foods and in-store quick-service-restaurants. Merchandising and store design are also becoming increasingly important, particularly as the world moves towards higher quality fresh food offerings. On the whole we consider the convenience store channel to be a healthy and well-functioning industry with a GDP+ type of growth profile (CORE management believes there will be 4-5% annual organic growth and 2% store growth). Distributors like CORE should benefit from this general health and organic growth.
Core-Mark’s Basic Business
It is impractical for most manufacturers to distribute directly to c-stores because most products lack sufficiently high margins to absorb the costs of delivering small batches to so many stores scattered throughout the country. Only exceptionally well-branded high margin products like Coke, Budweiser and Frito-lay have the ability to sustain the high cost of distribution. This is why distributors like CORE have come to exist. With so many small stores, distributors have found that the most efficient means of distributing c-store goods is by using trucks to conduct regularly-scheduled milk runs out of a centrally located local or regional warehouse. CORE is the second largest player in this market for c-store distribution, behind McLane with about $10 billion in c-store sales. Eby-Brown ($4.4 billion), HT Hackney ($3.6 billion) and GSC ($1.2 billion) round out the top five. Many of these distributors, including CORE, service other channels in addition to c-stores (like liquor stores, mass merchant / drug stores, gift shops, etc.), but c-stores represent the vast majority of the business.
CORE maintains a mix of about 50% chains and 50% mom and pops, with a strategy to keep at least half of the business in mom and pops. CORE had been primarily a mom and pop provider, with McLane servicing the larger accounts, until 2001 when CORE locked in Circle K as its first large chain account (though the company had serviced smaller chains before then). Since then the company has expanded its business with Circle K in eastern Canada (April 2007) and has added other large accounts like Valero (2005) and Mapco (November 2007). National accounts tend to be lower margin, but they provide the necessary density for CORE to go after the more profitable mom and pop accounts. Mom and pops tend to be more profitable because those customers do not have as much leverage to negotiate with CORE on price, and they are more likely to make use of CORE’s other highly profitable value-added service offerings, like in-store plan-o-grams and merchandising.
The company reports its sales as either cigarette sales or food/non-food sales (which we also refer to as non-cigarette). Food/non-food sales include things like candy, beverages, prepared foods and miscellaneous merchandise. Although the company has historically generated a little over 70% of its sales from cigarettes, those sales only generate about 33% of total company gross profit, a proportion that has been declining for some time. So although cigarettes remain an important product for c-stores, CORE makes the substantial majority of its income from other items like food and beverages. As the shift continues away from cigarettes and towards other products, we should begin to see improvement in gross margins, though this will be somewhat offset by the higher handling and sales costs associated with non-cigarette products.
CORE’s sales are booked at the wholesale price it charges to customers, inclusive of excise taxes, which are effectively collected by the company and passed through to the government. The cost of goods (including excise taxes) is deducted from this sales figure to arrive at gross profit. The company also includes cigarette holding profits in its gross profit. When a cigarette manufacturer announces a price increase, CORE’s inventory of that manufacturer’s products becomes more valuable. The gain that results from the higher value of the inventory following a manufacturer price increase is what the company calls a holding profit. For our purposes, we consider holding profits to be a recurring part of the business in the sense that manufacturers are likely to continue to raise prices and CORE is therefore likely to continue to realize holding profits. However, the realization of holding profits is unpredictable and lumpy. For this reason, we do not include holding profits in our calculation of underlying earnings. After the gross profit line, we see all the costs associated with providing the delivery service. As with many wholesale distribution businesses, CORE operates with a very low gross margin (5.6-5.9%) and a very lean cost structure, with EBITDA margins hovering around 1% of sales (we discuss the relevancy of these margins in more detail below). Since 2002, EBITDA margins have ranged between 0.9% and 1.3%, with a high degree of consistency around the 1.0% level (as it was in 2007). One thing to note is the performance of the business during 2003-2004, while the company was in bankruptcy. During this time, a number of distribution centers were closed down (all legacy Fleming centers) and the company lost some business to competitors. EBITDA margins bottomed in 2003 at 0.9%. In late 2006, the company also experienced a margin decline as a result of a large tobacco supplier in Canada deciding to distribute direct (this is discussed in detail later). Although CORE was able to largely offset the loss of this supplier, margins did not recover immediately.
We return now to discuss in more detail the apparently small EBITDA margins that CORE generates. If we are to be intellectually honest about the nature of the business, we realize that CORE bears very little true inventory risk. The company primarily takes large deliveries of shelf-stable consumable products and breaks them down into smaller packages for distribution. As such, inventory turns very rapidly (24x a year, or approximately every 15 days). The other major asset in this business is accounts receivable. When CORE sells products to a c-store, it in essence finances the c-store’s inventory for a period of days. On average, these receivables turn over 32x a year, or approximately every 12 days. As we can see, CORE does not provide long terms to the customer. If the customer does not pay, the customer will go out of business as its product is also turning rapidly. One could make the argument that CORE has exposure to its inventory for only 27 days (equal to the average time inventory sits on the books plus the average time the company finances it on its customers’ shelves). This figure drops to 18 days if we net off accounts payable. Cash, inventory and accounts receivable account for 75% of the company’s total assets.
Given these dynamics with regard to the limited inventory risk, we believe that measuring profitability by looking at the company’s operating profit as a percentage of gross profit is a better representation of the actual health of the business than the traditional operating margin on sales. A hypothetical case illustrates this point. If we assumed CORE’s inventory was supplied entirely on a consignment basis, then the company’s GAAP sales would be the same as their current “real world” reported gross profit as CORE would never take legal title to the goods. Given there is on average only 27 days of exposure (18 days if we net off accounts payable) and this exposure is primarily to low risk products like Snickers bars and Evian water, we do not believe there is a great deal of risk in viewing the business this way. On this basis EBITDA margins are significantly higher at around 17%, and more representative of the competitively advantaged company that we know CORE to be.
Importantly, this quick turning inventory provides very good protection against inflation in what is proving to be a more and more inflationary macroeconomic environment. The greatest risk for a business in an inflationary world is the inability to pass through cost increases in the form of higher sales prices. We believe CORE has pricing power in the sense that any increases in cost of goods can be more or less immediately passed through, as 70% of CORE’s balance sheet turns over every 27 days. Compare this to a manufacturer of auto parts, for example, that has to purchase higher cost commodities as an input to its finished product and then fight to the teeth to pass even some of the cost through to its customers. For CORE this is a relative non-issue. Furthermore, many of the company’s longer-term contracts with larger suppliers are on a cost-plus basis, ensuring the immediate pass-through of higher costs. As the cost of product increase, CORE should be able to increase absolute dollar profits and maintain at least a constant nominal return on invested capital. In the current environment of rising commodity prices and a declining dollar, we view this characteristic of the business as attractive.
Since CORE emerged from bankruptcy, management has done a very nice job restoring the business to health. Customers that had been lost through the bankruptcy process have returned and new customers have signed on. Management claims they have won $1.3 billion of revenue from McLane over the last five years without having to offer a lower price. Margins are improving and working capital has been brought back into line after several years of poor credit terms following the bankruptcy (most recently with regard to state governments’ terms for cigarette excise taxes). There is a real opportunity for the company to continue to add larger customers to its base of business. New customer wins and organic growth should lead to reasonably strong revenue growth in the coming years. Management believes the company can grow revenues by 10% per year in general, and expects 8% top-line growth in 2008.
In today’s recessionary environment, it is reasonable to be somewhat skeptical of this projection. We would argue, however, that CORE is a relatively recession-resistant business. The c-store industry in general has shown that it can grow through most any economic environment as consumers still purchase the types of goods sold at convenience stores more or less regardless of the economic backdrop. Some commentary from industry insiders (including CORE’s own Mike Walsh) as quoted in the January 2008 NACS Magazine would seem to substantiate this claim:
“I think we’re relatively [recession] resistant, but not recession proof. And we certainly have some other factors, such as the cost of crude oil, that affect our industry more radically. The cost of credit cards and various other things like that can have across-the-board effects on us more than just the general state of the economy because most of the items we sell are consumed every day and almost immediately by the consumer.”
- Carl Bolch, CEO of c-store operator RaceTrack Petroleum
“For the [c-store] consumer, if they are losing a paycheck they would spend less money more often. So then convenience becomes something very attractive instead of going to a large format and buying large quantities.”
- Mario Guevara, CEO of consumer goods company BIC Group
“Thinking about the industry as well as the brands and the categories that are sold in convenience stores, I would agree that it’s broadly recession resistant but not recession proof.”
- John Brock, CEO of Coca-Cola Enterprises
“You have to ask yourself the question, if a recession hits do I want to be in the automobile manufacturing business or would I rather be in the packaged consumable goods business? I’d rather be in the latter. People are going to give up buying cars and refrigerators more readily than they’re going to give up buying sandwiches and beer. That’s not to say it won’t be felt even in a national recession. Typically you’ll have pockets of real depression that can create real havoc on certain segments of the industry. But I think overall one has to say that we’ve weathered recessions pretty well in the past, and I think the industry is strong enough to weather it.”
- Mike Walsh, CEO of Core-Mark
The question of the impact of a recession notwithstanding, CORE’s recent business wins with Couche-Tard in eastern Canada and Mapco in the U.S. should provide a significant underpinning of support to sales in 2008. Management maintains that in past recessions CORE has used the downturn to take meaningful share from weaker competitors and expects to do the same this time around.
Competitive Advantages in C-Store Distribution
We believe that CORE plays a valued role in the convenience store supply chain and deserves to earn at least a competitive return on its capital, which is to say that we have a high conviction in its business model. There is some tangible proof of this notion – in September 2006, Imperial Tobacco, the largest Canadian cigarette manufacturer, decided to distribute directly to customers and therefore no longer supplied CORE with product to distribute to c-stores in Canada. CORE in turn went to its customers and explained that it needed to earn an adequate return and it would therefore be forced to raise prices to compensate for the lost volume from Imperial (~$380 million, or 40% of Canadian sales). The price increase was accepted and the company makes the same profit in Canada now as it did prior to losing the Imperial Tobacco revenue. Although this is just one example, it speaks to distributors’ competitive position in the supply chain.
So what underlies a competitive advantage in this industry? The economic dynamics of the industry are not complicated. Cost of goods is the same for everyone (there is no bulk discount as long as the company can purchase by the truckload, which most everyone can). Sales, marketing and corporate overhead are generally not materially different across organizations. Capex for warehouses and trucks are the same for everyone. So fundamentally, to be the low cost provider a company must have efficiencies in one or more of the following categories: truck driver wages, truck fuel and warehouse labor. All three of these can benefit from local economies of scale.
The best way to leverage truck driver wages and truck fuel expense is to optimize routes and maintain maximum route density. The name of the game is to have shorter truck runs, fewer stops per truck, and fuller trucks than competitors. The ability to optimize these three elements is clearly an advantage that accrues to the largest player in the region. Truck route optimization software and an ability to monitor unit-level profitability also helps – and this advantage goes to the firm most able to afford such luxuries, which is typically the largest and most profitable one. Warehouse labor is optimized through volume (high utilization) and better technology – things like pick-to-light systems that automate some of the process of fulfilling orders and minimize human errors. Like truck route optimization software, the luxury of pick-to-light and other high-tech systems goes to those who can most afford them, which again tends to be the larger and more profitable players.
Because the economics are fundamentally determined at the local warehouse level, it makes sense for larger players with multiple warehouses to operate on a decentralized basis and keep corporate overheads low. CORE operates its distribution centers as if they were autonomous businesses, giving the local manager a great deal of flexibility in managing his or her unit. As a result, it is also easier to align incentives as managers and staff can be paid based on their own unit’s contribution. Also, locally generated ideas for improvement are easily implemented, and frequently shared across divisions. Management has recognized that the distribution centers generate the profit, not corporate HQ, and they have set up the business with this truth in mind. We believe this structure makes a lot of sense.
It is not surprising that the c-store distribution industry has evolved into one where regional or local density and scale drive the economics of the business. There are several reasons for this: (1) the high cost of fuel and truck driver time dictates that distribution centers must be physically located near customers, (2) there are large numbers of small customers within a region, and (3) there are constraints placed on the quantity of goods that can be delivered by one truck. The distributor with the greatest customer density will be the most efficient service provider in any given region, and as such will be able to offer the most attractive prices. Said differently, the marginal cost of an additional delivery is lowest for the competitor with the greatest existing regional scale. In order for a competitor to be more efficient and therefore be able to offer a more competitive price, that competitor would need even greater density. But because that competitor doesn’t have the density in the first place, it can’t offer the competitive price needed to win the business that is required to have the density needed to support its competitive price. It is a therefore a chicken and egg problem for a new entrant – it is good to be the chicken.
In most western regions of the U.S. and Canada, CORE is the chicken. Its customer density allows it to offer the best prices and maintain high market shares in and around most of its 25 distribution centers. This strength is evident in CORE’s return on net assets (or “RONA,” which is equivalent to adjusted operating income divided by adjusted average net assets), a figure which the company uses as one of its key financial metrics. CORE has earned a 20-25% RONA over the past few years since emerging from the Fleming bankruptcy process, and had earned in the 27-30% range prior to its acquisition by Fleming. The bulk of CORE’s capital is invested in inventory, receivables and other working capital items. Although both turn very rapidly, the sheer dollar volume of the goods CORE distributes makes for a large investment in working capital. There is very little investment required in fixed assets, which are primarily trucks (cabs are owned and boxes are leased), and distribution center PP&E.
At this moment, CORE distributes items like Snickers bars, sunglasses and seltzer. Until very recently, it did not carry items like milk, eggs or bread. Management estimates that CORE handles about 60% of the store’s in-store products. Of the remaining 40%, about 75% (or 30% of the total) is off-limits to CORE as it is distributed directly by large manufacturer-controlled direct-store-delivery networks like Coke, Budweiser and Frito-lay. The remaining 25% (or 10% of the total) are things like dairy, bread, eggs and flowers. These “fresh” categories require constant refrigeration throughout the supply chain and have short shelf-lives, so inventory turns very quickly. As a result, these categories have historically been distributed by the local dairy or bakery. This means that convenience stores take delivery many times a day from many different vendors, which presents a distraction and a cost for store managers and employees, as well as an inefficient means of distribution. For example, management told us that Circle K takes delivery from over 400 separate vendors in one region alone.
What CORE realized is that by leveraging its relationship with its larger chain anchor tenants, it could have the local dairy or bakery deliver to the CORE distribution center instead of to the end customer, and CORE could load its own trucks with these fresh goods on delivery runs that it is already making for the non-fresh items. By doing so, convenience store chains could limit the number the deliveries they would need to accept, and would realize significant cost savings from the more efficient supply chain. These savings would fall out of the operating leverage CORE would realize by adding volume to trucks already making deliveries to these customers, as the marginal cost of this additional volume would be quite low. In many cases, the local dairy or bakery or other supplier is actually quite happy to distribute to CORE’s warehouse as it can eliminate a non-core and costly part of its business (c-store delivery) and realize potentially larger volumes as it gains access to all of CORE’s c-store customers in that region.
The ten categories identified by the company as the “low hanging fruit” with respect to this initiative - what management calls the vendor consolidation initiative (“VCI”) – represent approximately $1 billion in potential sales to CORE, assuming the company maintains its existing share among its customers. The margins on these sales are considerably higher than CORE’s base business, given the need for more frequent deliveries and higher touch (think eggs, for instance) and more complicated service (refrigeration). Management believes that the company will earn a 15-25% gross margin on VCI related products, with a 3-4% EBIT contribution margin. As important, as long as CORE remains the only distributor with capability to deliver fresh products, VCI should introduce a significant switching cost for customers. Moving from CORE to another competitor would require the c-store to un-bundle the VCI products from the traditional products. If CORE gets a large head start in VCI, it will become that much more difficult for a competitor to replicate because that competitor would lack the scale necessary to effectively compete – it is essentially the same chicken-and-egg competitive advantage we discussed for CORE’s base business. If CORE remains unchallenged in VCI, management may even be able to raise prices down the road and garner a larger share of the VCI savings. A successful VCI could be a game-changer.
CORE has been investing in the assets required to pull off VCI over the last year or so, and is about 80% done with the installation of chill docks in its distribution centers, at a cost of about $1 million per chill dock (they will need 20 or so in total, as three or four locations will cross-dock). The company has been replacing its single-temp truck boxes with tri-temp boxes as leases roll off. The total capex for VCI will come out to be about $22 million initially, including chill docks and working capital investment (which will grow as sales grow). Working capital for VCI is actually more favorable than the company’s base business, and possibly will be zero or even negative. For instance, terms with local dairies to buy milk are around 14 days, while receivables are collected in 10 days and inventories should turn every day due to the short shelf life. Realizing just $500 million in VCI sales could lead to a 50% improvement in EBIT versus where the company stands today ($20 million of incremental EBIT in year five as compared to $40 million in 2007 EBIT – again excluding holding profits). We think it will take the Company about five years to realize the full potential of VCI.
So far management has had excellent traction with its customer base in pushing through VCI, and the financial results are just beginning to show up in higher margins and higher non-cigarette sales. For instance, of the four divisions that had VCI for more than a year as of Q2, their non-cigarette sales were up over 35% and margins improved by over 40bps. We believe run-rate VCI revenues are around $100 million, and the company has locked in anchor tenants for about half of its locations. If CORE manages to lock up even just a portion of the $1 billion opportunity identified by management, the impact of VCI on the company’s profits could be substantial.
Although the VCI opportunity for existing c-store products that CORE is not currently distributing, like milk and eggs, is large, there is more. If the industry continues to follow the fresh food trend and CORE is able to introduce new fresh products like prepared salads and fruit into the convenience store channel, as management currently plans to do, this upside could be considerably greater. Convenience store customers are pushing for this type of fresh offering. For instance, 7-Eleven said that 40% of its in-store product should be fresh food. 7-Eleven is currently distributing fresh food for itself as there is no distributor capable of handling it at the moment (a telling sign). WaWa, another fresh food leader, also self-distributes. We believe CORE is a pioneer in this sense and is well ahead of the curve as the industry moves from tobacco dependency to a focus on fresh foods.
The other main strategic lever to create value in CORE, aside from VCI, is geographic expansion. Right now there is only one industry participant with national scale – McLane. With its 48’-53’ single-temp trucks, McLane is not set up to service mom and pops well, and has therefore focused on servicing larger chain accounts. To date there has not been anyone to compete with McLane on a national scale, providing McLane with a strong franchise among national chains. Anecdotally, we have heard that McLane is not well-liked by its customers, and many chains begrudgingly use McLane, while mom and pops are serviced by regional players like HT Hackney in the southeast and Eby-Brown in the Midwest. Hackney and Eby represent the next two largest players in the industry after McLane and CORE.
If CORE were able to expand across the country, either through green field efforts or through acquisition, CORE could (1) service national chains, giving them an alternative to McLane, (2) introduce VCI to many more customers, (3) charge a lower price given its ability to service both chains and mom and pops, and (4) weaken the industry’s biggest player. We think green fielding is a very low likelihood for exactly the same reasons why it is difficult for a new entrant to compete against CORE in CORE’s existing markets – the lack of scale and route density. The only way a green field can make sense is if CORE can lock in an anchor tenant before building out the distribution infrastructure. Just such a case actually occurred recently with regards to the Couche-Tard business that CORE won in eastern Canada. With Couche-Tard as an anchor tenant, CORE can much more effectively compete for other local business and build out its route density. Management has expressed these basic points to us in the past – they do not believe they can enter the southeast, for example, without buying a competitor because they wouldn’t have the necessary scale. In our minds, this is a pretty compelling endorsement of CORE’s existing competitive advantage in its own regions.
We believe many of the competitors, particularly the smaller ones, are relatively unsophisticated from a financial perspective. The majority of the larger players are family-run businesses that are now onto their second or third generation. As such, many of these operators lack the fiscal discipline to grow their businesses. In fact, we have been led to believe many of the owners are simply living off the proverbial “fat of the land.” As such, many lack strong balance sheets and have limited earnings as the owners take most excess cash flow out as salaries. HT Hackney is a notable exception to the above comments. It is probably the most treasured target as 50% of all c-stores are in the southeast part of the country. Bill Sampson runs the company and is very well connected (for instance, he is Chairman of the Tennessee Valley Authority). We believe Hackney is profitable and has a good balance sheet, so like anything treasured, the company is unlikely to be for sale at an attractive price. Hackney has 28 distribution centers, though they are much smaller than CORE’s, and has annual revenue of $3.5 billion.
Eby-Brown is the largest competitor in the Midwest. The company has been led by members of the Wake family for nearly 50 years. Bill Sayles Wake began his Eby-Brown career in the late 1940s as a salesperson, and bought Aurora Eby-Brown in 1957 with a partner. He sold the company to two of his sons (Thomas and Richard) in 1983, but he remained chairman until his death in 2004. Thomas and Richard are co-presidents of the company. Our market intelligence has led us to believe that the two brothers do not get along. We have been further led to believe that the company does not have the strongest profitability or balance sheet. If available at the right price, this company would be a very attractive investment opportunity for CORE. Eby-Brown has annual revenue of about $4.4 billion.
Although either Hackney or Eby-Brown would make an excellent strategic fit, the reality is that it will be much easier for CORE to invest in some of the smaller competitors in specific regions and build up scale via these purchases, a la its Klein acquisition. It would appear based on recent structural moves that Mike has realigned his management team to accomplish this goal. There are smaller companies with regional concentration that, in conjunction with CORE’s distribution centers, would provide very attractive regional density. For example, S. Abraham & Sons (SAS) has been a family run business for nearly 80 years. SAS services retailers in the states of Illinois, Indiana, Kentucky, Michigan, Minnesota, Ohio and Wisconsin, and has annual revenue of around $900 million. Harold Levinson (HLA) is another example of a smaller competitor with significant regional scale. With distribution facilities located in Farmingdale, NY, Albany, NY and Naugatuck, CT, HLA is able to service the entire northeast market. HLA has annual revenue of over $800 million.
It is our belief that an acquisition of either of these entities, or a few like it, at reasonable prices would create significant earnings power for CORE as management leverages the increased regional scale and introduces CORE’s more sophisticated systems and management practices. Furthermore, we believe encroachment into either Eby-Brown’s or Hackney’s markets would make them more likely sellers at reasonable prices. Again, the company must be able to have the requisite scale to compete effectively. Assuming CORE could operate either of these assets (SAS or HLA) at the 1% EBITDA margin the company generates from its existing operations (this implies no incremental G&A leverage), then an acquisition of either of these entities could provide incremental EBITDA of $10 million (assuming $1 billion in sales). This represents a nearly 20% increase from 2007 EBITDA. Historically, management has targeted a 20%–25% return on invested capital. If we assume they get to the low end of this range, it would imply a capital investment of about $40 million (assuming $8 million of EBITDA less capex). Given the capacity and cost of the existing revolver, these types of acquisition become very attractive. If CORE were able to purchase one of the larger competitors (Hackney or Eby), assuming a 1% EBITDA margin on $4 billion of sales would imply $40 million of incremental EBITDA, or 75% growth from 2007 EBITDA,. An acquisition like this at a 20% return would require $165 million of capital (assuming $33 million of EBITDA less capex). The company could (in theory) nearly fund this out of their existing revolver, which has $160 million of current capacity. However, it would likely need additional capacity given seasonal working capital funding requirements. With the hard asset nature of these businesses, additional capacity should be available in rational lending markets. The above returns give no credit to the VCI opportunity within the geographic region of the acquisition, or the ability for CORE to take additional chain business with its larger national footprint.
Mike Walsh has been CORE’s CEO since 2003 and with the company for over 16 years, during which time he headed the operations, sales and logistics functions. He took over as CEO when the Board was looking for someone to lead the company through bankruptcy. Mike’s background was as an engineer and he also worked for his family’s foodservice distribution business that was acquired by Sysco. We have met with Mike a handful of times at the company’s offices in San Francisco and believe he is an honest, hardworking and intelligent manager who has a real passion for his business. Mike’s engineering background and operations focus make him very process-oriented, which we believe is a valuable trait in a business that depends on maintaining a low cost position based on operating efficiency. A visit to one of the CA distribution centers confirmed Mike’s heavy involvement with day-to-day operations and his knowledge of the details underpinning his organization (the manager there told us that Mike new how many broomsticks were in his location’s operating budget). He understands the concept of capital allocation and we believe will show good judgment in directing shareholder resources towards acquisitions, as he has with the Klein acquisition, share repurchases and initiatives like VCI. He is devoted to the business – he (along with other employees) purportedly helped fund it with his personal credit card during the bankruptcy days – and he has a meaningful nearly 2% stake in the business.
In addition to Mike’s nearly 2% ownership stake, other senior managers and employees own over 8% of the company through stock and options. We believe that the combined 10% management ownership goes a long way towards aligning management with shareholders. Most of the 10% stake was granted during the company’s emergence from bankruptcy. CORE’s compensation policies further serve to align interests. Bonus incentives are typically tied to company- or region-level sales and FIFO pre-tax profit (as defined in the proxy), as well as individual goals. Stock-based incentives are also granted to tie management’s incentives to the stock price. Salaries are very reasonable, with Mike making a $450k salary and other senior managers in the $200-$325k range.
CORE’s Board is comprised to a large extent by individuals placed there to oversee the bankruptcy process, so many of the Board members have financial, legal and distressed / turnaround-related backgrounds. Mike has told us that his Board is very supportive of him and his team, and the VCI initiative in particular. The company has received a lot of flak from shareholders that are becoming impatient with the stalled share price (the stock has been essentially flat since the company came public in 2005, and is currently near its all-time low). Some of these shareholders are known activists, such as Third Point (10.2% position), Loeb Arbitrage (7.5%) and Wynnefield (6.3%). Many shareholders feel that the company should be taken private (CORE incurs $7-$8 million of annual public company costs), and others feel that the company should slowly take itself private through share buybacks. To date, management has been careful to keep its powder dry in the hopes that it can acquire one of its larger competitors; however, the recent buyback announcement should partially address shareholder concerns. We believe an acquisition could be highly accretive to shareholder value and support management in this stance, as does the Board. We also believe a share buyback is an excellent use of shareholder capital and were encouraged to see the Board endorse a buyback at these share price levels.
CORE sports a market cap of about $290 million with basically no net debt, tangible book value of $263 million and 2007 EBITDA and free cash flow (assuming $10 million of maintenance capex for the latter) of $55 million and $28 million. These implied multiples are attractive, we believe, but what really gives us comfort in underpinning value is the fundamental nature of the business itself. There is a true margin of safety in the stability of the business model and in the competitive advantage that CORE maintains through regional scale and route density. On a simple level, we can think of it this way – we are paying a very reasonable price (10x free cash flow) for a well-managed, well-positioned, un-leveraged, high-return business as it exists today, and are receiving free options on a successful acquisition strategy, a successful VCI initiative or a takeover of the company at a private market multiple. We believe this is a bargain price as these options are quite valuable.
We believe that CORE shares represent a compelling investment opportunity for the following main reasons:
1. Bullet-proof balance sheet
2. Honest, hardworking, intelligent, passionate management
3. Very good and easy to understand business with competitive advantages created through regional economies of scale
4. Industry-wide medium-term organic growth opportunities based on same-store convenience store growth and growth in the number of convenience stores
5. Attractive price at 10x trailing free cash flow and 1.1x tangible book value, with strong skewness from organic growth and “free” options on VCI and geographic expansion opportunities
6. Very little identifiable downside risk given quality of business and management, and strength of balance sheet
- Share buybacks; acquisition(s) announced; shareholder activism; VCI starts to show up in financials
|Entry||03/18/2008 11:34 PM|
Nice write-up. Have some questions:
1. What do you make of the recent 13D filings from Loeb Partners and Wynnefield Capital? I also see that Third Point owns over 10%.
2. On much dilution is there from warrants and stock options/awards?
3. What have net margins been historically?
|Entry||03/19/2008 12:03 AM|
1. We don't have any specific insight, though clearly any of the three you mentioned is a likely closed-door activist at the moment, and a possible out-loud activist at some point. Some of these holders have been in the stock for a while (some from the bankruptcy emergence). We would guess that the major issue with the company has been slowness to put a meaningful buyback in place (as we heard on the call today from Loeb). There has also likely been some agitation to sell the company. There does not seem to be any real problem with management's oversight of operations.
2. There are 10.5 million common shares out + 0.9 million options (struck around $17 for the most part) + 1.1 million warrants (struck around $20 on average)+ a small amount of unvested RSUs. A lot of the grants came from the time of the bankruptcy.
3. There are a lot of adjustments so I would encourage you not to take my word as gospel, but if you normalize to a 39% tax rate, net income margins have ranged from 0.3% - 0.5% for the most part. They were 0.43% in 2007.
|Entry||03/19/2008 01:05 AM|
|Thanks for the detailed write up. I admit to being a little confused. I have never heard the term "net assets." By the way I measure pre tax roa (operating income divided by total assets) the return is underwhelming at around 7% (rounding up from the mid 6s). In my opinion, it doesnt matter how fast your accounts receivable and inventories turn over - it still counts as working capital that costs real money to fund and consequently lowers any form of roa either pretax or aftertax. Are you suggesting ignoring inventory and accounts receivables, "netting them" or what? I dont mean to sound arguementative, in fact I am hoping to learn a little. I only looked at 2007, maybe that was an unusual year.|
|Subject||RE: High ROA?|
|Entry||03/19/2008 07:31 AM|
|We frequently try to look at companies using the same metrics that management uses internally, and "RONA" is one of their terms. However, it is virtually equivalent to the concept of return on capital. By "netting," we are simply netting the non-interest bearing liabilities (accounts payables, accrued expenses, etc) against assets. This is a very standard procedure in calculating working capital. It by no means ignores inventory and accounts receivable - these are two of the THE critical balance sheet items and components of return. Effectively, in short-hand, "net assets" is the net working capital plus fixed PP&E. |
I think it is not particularly meaningful to look at ROA for this business (as well as many others). Managing working capital is a key component and by looking at ROA, you are ignoring the "free" financing the company receives from accounts payable and other accruals.
I think if you reread my write-up this will all be internally consistent.
|Entry||03/19/2008 11:09 AM|
|Very interesting idea.. I think DIT, an earlier post of mine in the same industry, may be amenable to a sale in the next few years, and the footprint overlaps would seem to be ideal. From your research do you have any thoughts on valuations/metrics typically used in a sale in this business? It is still very cheap based on forward earnings but I've struggled to get a firm idea of likely value in a sale. Thanks.|
|Subject||RE: acquisitions, DIT|
|Entry||03/19/2008 11:20 AM|
|Many competitors in this industry are not profitable or are barely profitable, so they may trade for net asset value or something around there (see CORE's acquisition of Klein). DIT clearly is quite profitable, so I don't have a good answer on that one. Buffett stole McLane from WalMart (I don't remember the multiple but it was low), but there were other issues attached to that acquisition and there were no legitimate strategic buyers. A private equity firm could clearly lever up and buy CORE at attractive returns to equity even at much higher prices than the current quote.|