Description

Thesis Summary: PTRY is a structurally challenged levered play on high gasoline prices and weak consumer environment in the US which I believe will persist throughout 2011-2012. As a rollup, PTRY is highly indebted (5x EBITDA excluding off-balance sheet leases), has stranded FCF and 22% of its assets is goodwill. PTRY is a low-margin, low ROIC low-growth business which trades at 14x forward (normalized) earnings, a valuation not supported by the company's long-term growth and return opportunities. Given multiple future risks to earnings, the multiple should contract to 10x-8x of 2012 (normalized) earnings, offering 27%-42% return on short.

Short Merits:

• Competitive low returns business: PTRY operates in a highly competitive environment and competes with other gas stations chains. Since the business model requires (low margin) gasoline traffic to drive (high margins) convenience store sales, the competition for market share is fierce and PTRY has been steadily losing it since approximately 4 years ago as same store gasoline sales grew by 1%, (4.4%), (3.3%) and (4.9%) in 2007-2010, and most recently by (6.9%) in Q2 of 2011. As a result, PRTY earned only 5% ROIC on average over these years
• Pricing pressures pose risk to earnings:

1. o On the gasoline side (75% of sales, 35% of gross profit) PRTY is currently forced to absorb price increases to maintain its market share. As a result, its fuel gross margins declined from 5.1% to 4.2% in Q2 (y-o-y) and persisting high fuel prices will continue pressuring the margins
2. o On the merchandise side (25% of sales, 65% of gross profit) PRTY is at risk of being squeezed by higher food prices and experience pricing pressures from its powerful supplier (McLane - 60% of general merchandise)
3. o Heavy reliance on tobacco is a negative: roughly 40% of general merchandize sales is tobacco products, which are facing a shrinking pool of customers in the US. This category has been steadily cannibalizing others (such as food and beverages), growing from 31% of merchandise in 2006 to 39% in 2010

• Valuation: PTRY trades at 14.2x 2011 and 11x 2012 consensus earnings. While 2011 consensus appears fair, 2012 numbers I believe are overly optimistic and are at risk of downgrades, making it a demanding valuation for a 5% ROIC no-growth business in a competitive market. On 8x-10x more realistic 2012 estimates the stock is worth $13.7-$11, or 27-42% downside from the current level
• No intrinsic value: Applying long-term fuel margin ($0.1275/g) and log-term gross convenience margin to 2012 sales, it appears that the company has no intrinsic equity value at its fair NOPAT multiple of 10x. The current valuation implies 16.8x EV/NOPAT multiple, an unrealistic figure for a 5% ROIC cyclical company in a low-growth market
• Poor balance sheet: PRTY was bought out of bankruptcy in 1996 and used as a rollup to consolidate competing convenience stores. PTRY reinvests substantially all of its FCF in the rollup strategy and increased its debt level in the process. As a result, it now has 5x of debt over EBITDA (or 80% of cap structure) and 22% of its assets is goodwill.
• Asset Light: PTRY owns only 24% of its stores and the rest is leased

Short Risks:

• Crashing gasoline prices could have temporary positive effect on margins, however it would be substantially mitigated (if not offset altogether) by the fact that such a crash is likely to be a result of demand destruction and the margin benefit would be mitigated by lower volumes
• o The upcoming Q3 results pose near-term risks as retail gasoline prices have declined by ~3% during this quarter (while still being at 2008 level). Such intra-quarter dynamic is conducive to fuel margins expansion (see analysis below). However, the front-end of the WTI curve remains in steep contango and I expect gasoline prices to recover towards the end of the year and the margins to revert towards their long-term average ($0.1275/g)

Catalyst