Pantry, Boxing Kangaroos in Q3

The Pantry grew revenues, but margin contraction hit EPS this quarter.

(Companies in article: PTRY, CASY, WMK)

The Pantry (NASDAQ: PTRY), a company quickly making a name for itself in America’s Southeast, reported earnings a couple weeks ago. The convenience store chain indicated that continued store expansion drove revenue growth, while costs related to that growth and to rising gasoline prices, impacted EPS.

The Pantry’s 1,642 stores, located in eleven states, offer gasoline and convenience products like cigarettes, beverages, fast-food and snacks. You know Pantry by its Kangaroo Express branded stores located near highways, coastal resorts and in America’s suburbs. The company is in the process of converting its entire store base to the Kangaroo Express brand, with about 80% of its stores converted to date.

Pantry’s third fiscal quarter, ended June 28, was highlighted by 24.8% revenue growth. The company breaks up its revenue into two segments, merchandise sales and gasoline sales. This allows Pantry to better isolate fluctuations in volatile gasoline prices. Gas prices were 4% higher during this year’s quarter, and with a 19.9% increase in gallons sold, retail gasoline revenues climbed 24.5%.

“Inside the house,” so to speak, the company sells stuff, like tobacco and snacks. Merchandise revenues increased 15.8% in Q3, driven by store count growth and 1.9% comparable store growth.

While revenues leapt at the Kangaroo retailer, margins did not fare so well. PTRY’s slim operating margin narrowed 80 basis points, to 2.1%. You see, the company is still in its high growth stage, and bears the cost of that effort. Merchandise margins narrowed 80 basis points, as newly acquired stores typically hurt PTRY’s profit comparisons until they are converted into the company’s richer format. During the quarter, Pantry bought eleven “Fast Phil’s” stores from the Willard Oil Company, Inc., 66 Petro Express stores and a couple others here and there. Acquisitions totaled 152 stores, three-quarters of the way through fiscal 2007.

Retail gasoline margins did not hold up much better than merchandise, as it’s not easy for the company to shift rising gas prices to consumers. Retail gross margin per gallon at Pantry’s pit stops was 12.8 cents, compared to 14.1 cents a gallon in the prior year period.

After it was all said and done, Pantry reported EPS of $0.55, beating the analysts’ consensus expectation, even after a charge of $0.06 on debt refinancing costs. Still, the result was well short of last year’s Q3 EPS of $0.86.

The Greek expects the store conversion process and brand building effort PTRY is undertaking to add value, as consumers often take to a store they recognize, especially when traveling. There was even some evidence of brand value-add in PTRY’s third quarter results. Gasoline sales volume rose 1.0% on a same-store basis in the quarter, and we think brand and operational improvement probably drove that.

The company carries a hefty debt load, at some 59% of capital, and its interest coverage ratio (EBITDA/ Interest Expense) was just 3.3X. However, this is not overly concerning to us, since the company sells a somewhat none discretionary offering in gasoline. I have to admit though, that I’m not sure how high gasoline has to get before people seriously shift to carpooling and mass transit to save gas.

In terms of valuation, PTRY, trading at roughly 16 times trailing twelve month EPS, compares well to peers Casey General Stores (NASDAQ: CASY) at 23X and Weis Markets (NYSE: WMK) at 22X. The problem is, PTRY’s earnings estimate momentum of late has been negative. According to Thomson Financial, the consensus figure for fiscal ’07 (Sep.) has decreased 27% in the last 90 days, to a current $1.68 a share. That kind of momentum has a way of impacting valuation.

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