Core-Mark-Too Early for Prime-Time?

SEC filings can be absolutely fascinating. You don’t see filings like the one I am about to describe very often….and that’s a good thing.

Core-Mark (CORE) is one of the largest wholesale distributors to the convenience retail industry in North America, operating 24 distribution centers and distributing some 38,000 SKU of packaged consumer goods to about 20,000 store locations in the US and Canada.
This is a distribution business with some $4 billion in sales through 2004, and about $3.7 billion in sales for nine months of 2005. But margins are extremely narrow. Sales of cigarettes constitute some 72% of sales and excise taxes are a significant part of cigarette sales. Gross profits for the first nine months of the year were only about $207 million or only 5.6%. Net income for the nine months was $6.7 million. This represents a net profit margin of merely a sliver, 0.18%. All this on a share base of only 10.5 million shares outstanding, so there is plenty of sales leverage.

Distribution companies provide valuable service to their customers in terms of planning and inventory control. The cigarette business represents a much lower gross profit margin than non-cigarette businesses which have only 28% of the revenue mix but 64% of the gross profits (2004 figures.)

Core-Mark has emerged from the bankruptcy of Fleming Companies which filed Chapter 11 in April of 2003. The re-org plan of Fleming became effective in August of 2004, and Core-Mark emerged as a separate entity.

This ought to be a fairly interesting, steady-eddy cash flow generating business. It is second only (in cigarette volumes) to McLane Company, Inc, formerly a WalMart subsidiary and now part of Berkshire Hathaway. Capital expenditure needs are de minimus. Cash flow from operations significantly exceeds net income. This really should be an interesting business. Cash flows should be fairly reliable…but the financial statements need to be reliable.

But somehow, Core-Mark may have emerged before it was ready for primetime. The company has just announced that is unable to file its 10-K on time:
“Core-Mark Holding Company, Inc. (the “Company”) is unable to file its 2005 Annual Report on Form 10−K by March 31, 2006, as a result of the need to restate the Company’s audited consolidated financial statements as of December 31, 2004 and for the period from August 23, 2004 to December 31, 2004 and the Company’s unaudited condensed consolidated financial statements as of and for the six months ended June 30, 2005, each included in the Company’s registration statement on Form 10, and the Company’s unaudited condensed consolidated financial statements as of and for the three and nine months ended September 30, 2005 included in the Company’s Form 10−Q for the third quarter of 2005, because of errors in those financial statements relating to the accounting of foreign currency translation adjustments related to intercompany balances.”

These foreign currency translation adjustments seem to be relatively small and somewhat insignificant in the grand scheme. But far more disturbing was the announcement that its auditor, PWC would no longer stand for re-election as auditor.

Though there were no material disagreements apparently, PWC did cite a large number of deficiencies in internal controls, such as:
1) …Insufficient complement of personnel with an appropriate level of accounting knowledge, experience and training in the application of generally accepted accounting principles (“GAAP”) commensurate with its financial reporting requirements and the complexity of the Company’s operations and transactions.
2) The Company did not maintain effective controls to ensure the accuracy of debt discount and debt issuance costs.
3) The Company did not maintain effective controls to ensure the appropriate classification and presentation of accounts and disclosures in the consolidated financial statements. Specifically, the Company did not maintain effective controls to ensure the appropriate balance sheet classification and presentation based upon the nature of the account or balance. This control deficiency resulted in audit adjustments to cash, accounts receivable, other receivables, deposits and prepayments, other non−current assets, accounts payable, book overdrafts, cigarette and tobacco taxes payable, and operating expenses in the Company’s 2005 annual consolidated financial statements.
4) The Company did not maintain effective controls to ensure there is adequate analysis, documentation, reconciliation, and review of accounting records and supporting data. Specifically, the Company did not maintain effective controls over the completeness and accuracy of the payroll expense and payroll accrual, and did not maintain effective controls to ensure the timely reconciliation of the payroll registers to the general ledger.
It is very disturbing to think that a company which is so highly linked to cigarette distribution has failed to properly account for cigarette and tobacco taxes payable. Even accounting for “cash” about as basic as you can get, managed to get fouled up. You name it, accounts receivable, accounts payable, operating expenses, payroll…everything needed to be corrected and adjusted.

This has the makings of being an interesting business, but until I see reliable financials, it can’t be considered as an investment possibility. The valuation (based on what could well be mistaken numbers) looks very reasonable at only 4.9 times EBIT on an EV/EBIT basis. Return on Invested Capital in the last twelve months (again subject to restatement) is also quite attractive at 15.95%.

The company has received a confirmatory waiver on potential defaults regarding its bank borrowings. The company has indicated that it should have its 10-K filed by April 17th. CORE estimates that net income for 2005 was $14.5 million and operating income was $44.3 million. One should also be aware that a potential overhang of 4.4 million shares held by Fleming are subject to distribution by the bankruptcy court and the Post Confirmation Trust which could be distributed to Fleming creditors.

Disclosure: Neither I, my family, or clients have a position in CORE, however, all do have a position in WalMart (WMT.)