Is "The Pantry" Bare?-Piotroski Says No

"You can't buy what is popular and do well" is one of the great Warren Buffett quotes. Though over time, I have learned to be far more comfortable investing in quality businesses that throw off lots of free cash flow and earn superior returns on invested capital, many value investors start their search for cheap stocks with the new low list and those that are making news headlines that portray disappointment. Contrarianism does work, as Buffett says, there are many ways to get to "financial" heaven. As is obvious, the real challenge for us as investors is separating those businesses that have been unfairly beaten down because of Street overreaction from those that truly deserve to be disregarded and ignored. "Moribund and poorly run businesses deserve to languish" as the great mutual fund investor, John Neff once described.

So how do you separate these businesses? For many years, academics focused on low price to book value companies (or put another way, high book to market companies) as a place to seek superior returns. As it turns out, these companies demonstrated an anomaly to the prevailing capital assets pricing theory. Subsequent analysis showed that a low price to book value ratio implies that prices contain expectations of low ROE expectations. Such companies, at current prices are generally expected by the consensus to be poor performers and therefore considered risky.

In a Seeking Alpha article earlier this year, John Reese of Validea highlighted an enhancement of this value investing screening technique developed by Joseph Piotroski of the University of Chicago. These refinements focused on generation of operating cash flow (as opposed to earnings), improvements in liquidity or leverage, as well as some signs of improving profitability and turnover. As John described it earlier:

Piotroski thus applied a series of additional tests of financial strength to identify a set of criteria that did lead to market outperformance. I've listed the 10 criteria below.

• Book/market ratio
  
• Return on assets
  
• Change in return on assets
  
• Cash flow from operations
  
• Cash compared to net income
  
• Change in long-term debt/assets
  
• Change in current ratio
  
• Change in shares outstanding
  
• Change in gross margin
  
• Change in asset turnover
  

In essence, this is contrarian investing with a wrinkle, some sign of internal improvement, cheap but with some light at the end of the tunnel. Rather than seeking excellence, Piotroski looks for encouragement. Most investors tend to "over-extrapolate" past performance trends, as I like to say, extrapolate short term trends into the hereafter. Overly pessimistic extrapolations do tend to reverse as the reality of changing actual earnings hit the tape. Ditto for those companies with a positive bandwagon…overly optimistic extrapolations reverse as well.

Having done some recent work on retailing (Tiffany's Valuation Looks Too Rich), I thought it may be of interest to look at a retailer at the other end of the spectrum, one that was bumping its bottom in the new low list, and with apparently few friends, The Pantry Inc (PTRY) .

The Pantry operates a convenience store chain in the southeastern United States. Its merchandise products include tobacco products, packaged beverages, beer and wine, general merchandise, health and beauty care products, self-service fast foods and the usual snack and grocery items. As of December 2009, it operated 1,668 convenience stores in 11 states primarily under the banner, "Kangaroo Express."

Like most convenience chains, gasoline and fuel sales drive overall sales but contribute significantly less to gross profits (data per Gridstone Research)

Pantry Inc
	2005	2006	2007	2008	2009	CAGR
Gasoline Sales	3200.3	4576	5335.2	7358.9	4731.2	10.27%
COGS Gasoline	2986.5	4294.8	5110.5	7096	4417.5
Gross Profit -Gasoline	213.8	281.2	224.7	262.9	313.7	10.06%
GPMargin	6.68%	6.15%	4.21%	3.57%	6.63%
Merch Sales	1228.9	1385.7	1575.9	1636.7	1658.9	7.79%
COGS-Merch	779.6	867.7	989.9	1041.6	1071.8
Gross Profit-Merch	449.3	518	586	595.1	587.1	6.92%
GPMargin	36.56%	37.38%	37.19%	36.36%	35.39%
Gasoline as % of Total Sales	72.25%	76.76%	77.20%	81.81%	74.04%
Gasoline as % of Total Gross Profits	32.24%	35.19%	27.72%	30.64%	34.82%

In terms of some ratio analysis (again, per Gridstone), here is how the business has developed:

	FYE Sep-05	FYE Sep-06	FYE Sep-07	FYE Sep-08	FYE Sep-09
[ST] Gross margin	15.0%	13.4%	11.7%	9.5%	14.1%
[ST] Operating margin	3.4%	3.4%	1.7%	1.5%	2.7%
[ST] EBIT	148.5	204.9	121.2	141.1	176.6
[ST] EBIT margin	3.4%	3.4%	1.8%	1.6%	2.8%
[ST] EBITDA	212.9	280.9	217.1	249.4	286.2
[ST] EBITDA margin	4.8%	4.7%	3.1%	2.8%	4.5%
[ST] EBITDA (TTM)	212.9	280.9	217.1	249.4	286.2
[ST] EBITDA margin (TTM)	4.8%	4.7%	3.1%	2.8%	4.5%
[ST] Pretax margin	2.1%	2.5%	0.6%	0.6%	1.5%
[ST] Net margin	1.3%	1.5%	0.4%	0.4%	0.9%
[ST] Effective tax rate	39.3%	39.1%	38.8%	38.1%	36.8%
[ST] Return on equity	28.8%	30.3%	7.7%	8.5%	13.8%
[ST] Return on assets	4.4%	6.0%	1.5%	1.5%	2.7%
[ST] Return on invested capital	9.4%	11.2%	5.2%	5.2%	6.3%
[ST] Net operating profit after tax	90.2	123.1	71.9	85.3	107.7
[ST] Cash flow from operations to Sales	3.0%	2.6%	2.0%	1.8%	2.7%

Obviously, this is a business whose metrics are far less appealing at first brush to most investors having just salivated at the metrics of high end retailing.

Yet, there is some evidence of improvement in operating margins, in returns on assets and equity, and invested capital.

There are certainly some issues here that are disturbing, a lot of debt, for example, with $1.67 billion in total liabilities versus $440 million in equity. Interest coverage is about 2.7 times. Leverage has often been high in this consolidating industry, and in particular at PTRY where some heavy acquisition years of 2006-2007 impacted the balance sheet. Given the significant assets here and the relatively low equity base, the hunter may well turn into the "hunted."

Standard and Poors recently affirmed its corporate credit rating announcement of The Pantry as a "B+" and noted:

"Credit measures deteriorated, with total debt to EBITDA at 6.6x compared with 4.9x one year ago. Although we expect some improvement in fuel and merchandise margin through 2010, credit measures are not likely to improve to levels needed to support a higher rating. We revised our rating outlook to stable from positive, and affirmed our 'B+' corporate credit rating on Pantry Inc."

Of note, there is $180 million in cash on hand as compared to a market cap of only $278 million as well as availability of an additional $142 million through its revolver. The next tranche of debt that comes due is convertible debt due in November of 2012.

Book value is about $19.50, most of which consists of goodwill, hence, at current market prices, PTRY trades at about 60% of book, certainly "qualifying" it for Piotroski's scrutiny. Five years ago, this stock sold at almost four times book value at a time when ROE was near 30% and ROA was about 6%. These metrics seem impossible now.

Taking a somewhat more recent perspective, consensus earnings are now around the $1.27 area having dropped down from $1.66 some nine months ago. Certainly this represents a different trajectory for expectations than most retailers have had in the same period. Sales per share is enormous at over $300 per share…there is tremendous operating leverage…both ways primarily because of gasoline sales. Even looking at just the non-gasoline sales, these represent over $80 per share in sales.

Though not a perfect demonstration of Piotroski's criteria, (shares outstanding have increased YOY and asset turnover has yet to show improvement) most of the other parameters have been met.

Though not a name I would want to stake my retirement assets in, I think The Pantry is a worthwhile speculation at current levels. High risk but potentially high reward.

Please find an investor presentation by The Pantry management at the Bank of America Merril Lynch Consumer Conference of March 10th, 2010.

Disclaimer: I, my family and clients do not currently own a position in PTRY.