Should You Bet on the Action at The Pantry?

Source: The Pantry.

Shareholders in convenience-store operator The Pantry (NASDAQ: PTRY  ) haven't been the happiest lot over the past five years, due to a very marginal gain for the company's stock price over that time period. The company has anecdotally been hurt by a difficult competitive environment, especially from deep-discount operators like Dollar General (NYSE: DG  ) and Dollar Tree Stores (NASDAQ: DLTR  ) that share a similar merchandise focus.

However, The Pantry's share price has received a lift lately, thanks to a proxy battle for control of the boardroom, which ended with activist investors taking three seats on the board of directors. So, with a few fresh eyes at the top, is the company a good bet?

What's the value?
The Pantry is a major operator of convenience stores under the Kangaroo Express brand name, with a network of more than 1,500 locations around the country, mostly in popular tourist areas, like Orlando and Biloxi, Mississippi. The company uses fuel sales to generate high customer volumes, despite the notoriously low margins, hoping it will bring people into the stores for higher-margin purchases of prepared foods and an assortment of impulse merchandise, including tobacco and packaged grocery items. 

While The Pantry's strategy has worked to some extent, as evidenced by higher comparable-store merchandise sales over the past few years, lower per-store sales of fuel have led to reductions in overall profit and cash flow.

In its latest fiscal year, it was a continuation of the negative trend for The Pantry, highlighted by declines in revenue and adjusted operating income. Despite a slight improvement in the profitability of its merchandise segment, the company was negatively affected by a 5.7% decline in fuel volumes sold as well as marginally lower average prices. The net result for The Pantry was a drop in operating cash flow, hurting its ability to fund its capital expenditures and pay down its relatively sizable debt load.

Looking into the crystal ball
Of course, the question for investors is whether the changes in The Pantry's boardroom will lead to an upward trajectory for its future profit growth.  Unfortunately, that seems unlikely given the unrelenting competition from the deep-discount retailers, like Dollar General.

One of the nation's largest discount retailers with roughly 11,000 locations in 40 states, Dollar General has outgrown its dollar-store roots and now offers a broad assortment of merchandise, including packaged food, personal care, and houseware items. More disconcerting for The Pantry and its convenience-store competitors, though, is Dollar General's major inventory investments in the food consumables area, which accounts for a large part of The Pantry's sales mix. 

While the move has led to a slightly lower gross margin for Dollar General, it has allowed the company to continue generating increases in customer traffic volumes, providing opportunities for sales of higher-margin products.

Likewise, Dollar Tree seems to be operating from the same playbook as Dollar General, aggressively investing in freezers, which covered a majority of its overall store base at the end of its latest fiscal year. The strategy was undoubtedly partly responsible for an increase in the company's customer volumes in fiscal year 2013, culminating in its best sales-per-square-foot performance since 2001. 

More important, the greater store productivity led to a continuation of strong operating profitability for Dollar Tree, despite some gross margin erosion. Consequently, Dollar Tree continued to enjoy solid operating cash flow, allowing it to further invest in a greater inventory assortment and likely put further pressure on lower-margin competitors, like The Pantry.

The bottom line
The Pantry is an interesting bet, as the presence of activist investors in the boardroom should theoretically provide greater oversight of management's decisions and has the potential to improve the company's financial results. That said, it appears that The Pantry has an uphill battle to realize a higher profit trajectory, given the better cash-flow profiles of its deep-discount competitors.  While the company is an intriguing story to watch, investors should probably leave it on the shelf.

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