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Fool On The Hill

Tuesday, March 23, 1999

FOOL ON THE HILL
An Investment Opinion
by Warren Gump

Casey's General Story

The disfavor of small stocks is well known to most readers. Over the past three years, the Russell 2000 index, a measure of small capitalization stocks, has returned 7.8% annually compared to the whopping 28.8% return provided by the S&P 500 index of large cap stocks. Many people have hypothesized why these returns have been so divergent, such as the higher returns on capital and the dramatic earnings growth offered by some of the big technology companies in the S&P. While some of the reasoning offered is valid, I believe the primary reason for the significant outperformance of the S&P 500 is a shift in investor sentiment toward large cap issues.

Due to the tremendous recent returns of many large cap stocks and the lagging returns of many small cap non-technology companies, investors have been pouring money into the larger cap stocks at the expense of many smaller stocks. This increasing flow of funds into the better-performing stocks propels them even higher, continuing the cycle. At some point, investors are going to take a look at the price/growth prospects of their portfolios and reallocate some of their money to some of the faster growing small cap stocks that have missed out on the recent stock market rally.

I would prefer to be ahead, rather than behind, that shift in sentiment by digging through the rubble of small cap land to find the hidden gems. One company that falls into this category is Casey's General Stores (Nasdaq: CASY), a Midwestern operator of convenience stores. Not a terribly exciting business, mind you, but one that has posted significant annual earnings gains over the past eight years. The stock currently trades at around 20x earnings estimates for the fiscal year ending in April. Analysts polled by First Call project that the company will have a long-term earnings growth rate of 18%.

The primary advantage that Casey's has over its competitors is locating in small towns. According to the company's most recent 10-K filing, 71% of Casey's stores are located in towns with 5,000 or fewer people. Only 7% of the stores are in areas with populations over 20,000. This strategy reduces competition since many of the national competitors strive to locate in markets that are larger. In addition, since options for eating out are limited, Casey's has a better chance of selling a lot of high-margin prepared foods like pizza.

Most of the competition that Casey's encounters comes from local and regional competitors. Because of its size and deeper pockets, the company is better able than most competitors to provide customers with low gasoline prices, a clean store, and added services like extended hours.

As of last quarter, the company operated 1,176 stores (14% of which were franchised), up from 1,109 last April. The heaviest concentration of stores is in Iowa, Illinois, and Missouri, which each have more than 200 locations. No other state accounted for more than 100 stores. Management believes that Casey's has plenty of room to grow within its current nine state region. With a distribution facility large enough to support 1,500 stores, the company has the capacity to service growth over the next three years assuming its historical store growth rate of 6%-7%.

Sales and profitability of Casey's can occasionally be affected by fluctuating oil prices, which may be one reason investors have recently shied away from the stock. The only year in recent history when earnings increased at a less-than-double-digit rate was fiscal 1997, when oil prices hopped around frenetically. Once prices and margins stabilized, though, Casey's got back on its more typical 20% annual growth pace. If the recent low gas prices impact earnings, I would suspect that it would once again be a short-lived phenomena.

The reason fluctuating gas prices isn't that much of a long-term worry is that most of the company's profitability comes from non-gas sales. Although only 39% of retail sales over the past three years were not gasoline, these sales were responsible for 73% of gross profit. This is because gross margin on food (particularly prepared food) is much higher than the 10% or so the company gets on gas. Casey's strategy is to get people into the door with low gas prices, but to make most of its money from other purchases.

Other than a potential worry about the short-term impact of low gas prices, I can't find many negatives to Casey's story. The company has only modest leverage and cash flow covers most capital expenditures. Last year, return on invested capital was a satisfactory 11%. Growth plans continue to unfold as expected and the company is expected to continue improving earnings at a high-teens pace.

I can't tell you a specific catalyst that is going to lurch Casey's stock forward. The past year hasn't been great, with the stock still hovering around the $15 level at which it was selling at this time last year. Nonetheless, as an investor with a long-term focus, I try to look past stock price movements and look at the value of a company. I'm happy as long as a company continues to increase its earnings and cash flow generation capabilities. Other investors will likely recognize the value being created at some point. Casey's may not be a home run hitter, but it's done a heck of a job hitting singles and doubles.

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