Description

Summary
We believe Core-Mark (CMRK) offers +25% upside in the near-term and 65%+ upside in the event the company can list as an income trust.

Core-Mark (CMRK) is a classic case of a misunderstood post-reorg equity. Core-Mark, one of the largest wholesale distributors to the convenience retail industry, emerged from bankruptcy one year ago and is quickly recovering to pre-bankruptcy levels of business. The company is presently net debt free (pro forma warrant exercise) and has fully diluted shares outstanding (pro forma) of 12.3 mm trading at $32 per share, equating to an EV of $394.0 mm. We estimate that CMRK will generate $70mm in 2006 EBITDA (LTM is $55mm, up from $41mm in 2004, note that the company did $75mm in EBITDA in 2002 before the Fleming bankruptcy.) At these levels, CMRK is trading at 5.6x 2006 EBITDA and less than 6.5x EBITDA – maintenance CAPEX. We estimate that CMRK could easily pay a $20 per share dividend (leaving leverage at a manageable 3.5x EBITDA) and still generate free cash per share of $2.00, creating the stub @ $12.0 per share, or 6.0 x free cash flow. Alternatively, the company could convert to the income trust structure, which has favorable tax characteristics, and generally trade at premium valuations. The BMO Nesbitt Burns Royalty & Income Trust Weekly dated 9/02/05 shows the average Trust is presently valued at a 9.0% yield and 9.5x 2006 EBITDA. At a 9.0 % free cash flow yield ($70.0 mm EBITDA – $10.0 mm CAPEX ), the stock would equate to $54 per share.

In the research that has been published on the company, CMRK has generally been compared to supermarket wholesale distributors, Nash Finch and Supervalu, which is misleading for several reasons:

First, both Nash Finch and Supervalu have substantial supermarket/grocery retail operations which are generally second or third tier operations and should trade at very low multiples.

Second, supermarkets/grocery stores are a declining channel in general as they continue to lose share to Wal-Mart and other discounters. Valuations across the industry have compressed dramatically over the last few years reflecting this diminished outlook. By contrast, the C-store channel is growing and C-Store valuations with it.

Third, there is much less upselling potential in the supermarket wholesale distribution business. A supermarket wholesaler will typically provide over 85% of customers’ total needs day one, so there is little incremental revenue to be gained with existing customers. By contrast, C-Stores presently only get 45-55% of their products supplied by wholesalers like CMRK, leaving meaningful up-selling potential. While some areas of distribution are tightly controlled (CMRK unsuccessfully tried to break into the beer market) others offer the potential for very high margin incremental sales (milk, bread, coffee bar service). Recently, CMRK management stated that they have had success selling branded coffee stations into roughly 1,000 stores, with the potential to penetrate up to 6,000 of its 18,000 C-store customers. These incremental sales have the potential to be extremely high margin since “the truck is already in the parking lot”.



While overall revenue gains may be modest due to the company’s sales mix (70% cigarettes) CMRK has a major opportunity to meaningfully grow EBITDA through incremental high margin sales. This stands in sharp contrast to the limited growth potential of the supermarket wholesaler business.

CMRK is a company with state-of-the-art logistic capabilities serving a growing market, yet trading at a deep value price.


Background
Coremark’s origin dates back to 1888, when Glaser Bros., a family owned-and-operated candy and tobacco distribution was founded in San Francisco. In August 1996, the company completed a recapitalization resulting in Jupiter Partners, LP and senior management owning 75% and 25% of the company’s equity, respectively. In June 2002, Fleming acquired Core-Mark and on April 1, 2003 Fleming filed for bankruptcy. Fleming’s problems were well-known – the company serviced a declining customer base (smaller independent supermarkets) and had major exposure to K-Mart prior to its own bankruptcy. CMRK emerged as the surviving entity August 23 of 2004 and recently issued its audited financials and Form 10 after a lengthy delay due to issues with “fresh-start” accounting.

Core-Mark is one of the largest wholesale distributors to the convenience retail industry (“C-Stores”) in North America. CMRK operates a network of 24 distribution centers, generally serving the western and southeastern US, and western Canada. Approximately 45-55% of the items sold in convenience stores are supplied by wholesale distributors like CMRK. Some items, like milk, bread, and coffee service represent excellent high margin incremental revenue opportunities for CMRK. Other areas (beer, for example) may be too fiercely protected to be penetrated in the near term.

CMRK serves a growing market. Over the ten years from 1994 to 2004, convenience store sales increased by a compound annual growth rate of 6.9%, with a 3.5% compounded annual growth rate in the number of C-Stores.

While there has been some consolidation, CMRK serves a diverse customer base. The traditional C-Store sector is divided into two principal categories: (1) corporates, defined as corporate-owned and operated chains with a national or multi-regional footprint, such as Circle K, Petro-Canada and Valero; and (2) independents and smaller chains, including franchisees, dealers and individually operated locations. CMRK estimates that independents and smaller chains with less than 50 stores account for 76% of the C-stores in the United States.


Sales Mix
Approximately 72% of CMRK’s revenues comes from the distribution of cigarettes. The cigarette component of CMRK’s business has not been generally well understood, however, the following are important points:

Cigarette distribution has some barriers to entry due to the cost and complexity of the tax stamping machines.

It is important to note that the C-Store channel is gaining cigarette volumes from other channels, mainly grocery stores and supermarkets. While overall cigarette consumption is declining, unit volumes have been, and are expected to continue to, increase through the C-store channel.

While cigarette percentage margins have declined over time, gross profit dollars have not. Core-Mark makes a fixed dollar amount per cigarette carton. Given the strong secular trend in the convenience store channel, CMRK should continue to grow cigarette carton volumes, and gross profit dollars.

CMRK can sometimes (depending on the state and the way manufacturers increase prices) realize “one time” gains on inventory due to excise tax or manufacturer price increases. Core-Mark is able to immediately pass on price increases, while turning through the current inventory at prior cost, producing a temporary higher profit margin. While “one time” in nature during the course of the year, excise tax and product price increases tend to be more or less annual events, providing a nice source of additional cash flow.

Cigarette excise taxes understate operating margins, as they are a 100% pass-thru cost. Excise taxes represent more than 1.0 bn dollars in sales and cost of good sold.

Finally, cigarettes only account for 36% of the company gross profit, it is the distribution of food and general merchandise, which generates 64% of gross profit dollars, that will drive the company’s growth going forward.


Competitors
CMRK estimates that there are over 400 wholesale distributors to C-Stores in the United Sates, approximately 30 of which are broadline distributors similar to CMRK. CMRK and McLane Company, Inc, (a subsidiary of Berkshire Hathaway, Inc.) are the two largest. It is worth noting that the vast majority of McLanes business consists of distributing to Wal-Mart and Target, and as a result, McLane’s systems and truck fleet are better suited for larger retail customers. McLane’s trucks are 50+ feet in length (vs. CMRK trucks of 27ft) and are not as conducive to serving convenience stores, as deliveries can be disruptive to customer traffic in the parking lot. Other regional players include The H.T. Hackney Company in the Southeast, Eby-Brown Company in the Midwest, Mid-Atlantic and Southeast and GSC Enterprises in Texas and surrounding states.
While price competition in the industry is fierce and CMRK recently lost two contracts, CMRK has been and should continue to be a net winner of market share. CMRK information systems and logistics capabilities are state of the art (think UPS) and the company offers a superior value proposition. CMRK is capable of scheduling deliveries for a particular hour, as opposed to scheduling a delivery for a particular day, which is what is offered by McLane and others.



Operating Results/Projections
CMRK dramatic improvement in operating results for the first half of 2005 is attributable to recent new customer wins as the company recovers market share post-chapter 11. The results were also boosted by $5mm of excise tax increases which lead to inventory profits. Off setting those excise tax increases, the company estimates that it incurred $2-3mm of non-recurring audit and legal costs associated with filing the Form 10. Revenues are projected to be flat in the second half, reflecting the roll off of some recent customer defections. On balance, however, we expect CMRK to continue to gain market share.

Historical Operating Results:
6 mos ended, 6/30
2002 2003 2004 LTM 2004 2005
Revenue $4,662.1 $4,324.3 $4,222.4 $4,534.0 $2,036.3 $2,347.9

EBITDA 75.3 47.0 41.2 56.7 15.4 30.9

CAPEX 5.5 8.4 12.1 10.8 4.7 3.4

Note that excise taxes are a pass-through (run through both sales and
cost of goods sold), and will equate to roughly $1.1 bn for 2005.


Currently, Core-mark is 1 year ahead of its plan projections. Management gave guidance of $4.6 bn in revenues for 2005 which is slightly ahead of the 2006 revenue projection, and LTM EBITDA is roughly tracking to 2006 plan projection.

Core Mark Newco Projections: Disclosure Statement
8/1/2004E
Through
Operating Data: 12/31/2004E 2005E 2006E 2007E 2008E
Revenue $1,667.3 $4,247.3 $4,575.1 $4,935.5 $5,312.9
% Growth 7.7% 7.9% 7.6%

Gross Profit 100.6 251.8 273.6 294.9 317.6
% Margin 6.0% 5.9% 6.0% 6.0% 6.0%

EBITDA 15.9 44.3 56.8 70.7 81.3
% Margin 1.0% 1.0% 1.2% 1.4% 1.5%

CAPEX 2.8 9.7 9.9 10.1 10.4

EBITDA - CAPEX 13.1 34.7 46.9 60.6 71.0









Capitalization
At June 30, 2005, CMRK had total debt of $77.1 mm, however, net of balance sheet unrestricted cash of $35.5 mm and assuming the warrants/options are exercised, net debt would be roughly zero. Total shares outstanding pro forma for this exercise would be 12.3 mm.

Capitalization Summary
6/30/2005 Pro-Forma
Cash:
Unrestricted Cash 35.5 35.5
Restricted Cash 13.2 13.2
Total Cash 48.7 48.7
Cash From Option/Warrant Exercise 41.4
Pro Forma Cash 90.1

Debt Outstanding:
Revolving Credit Facility 59.2 59.2
Tranche B Notes Payable 17.9 17.9
Total Debt Outstanding 77.1 77.1

Net Debt (excludes restricted cash) 41.6 0.2

Shares Outstanding (mm)
Primary Shares 9.8 9.8
Restricted Shares Ex Price 0.2 0.2
Options Issued to Tranche B Lenders $15.50 0.2
Option Pool for Mgmt $15.50 1.1
Warrants to Junior Creditors $20.93 1.0
Shares Outstanding 10.0 12.3


An initial distribution of CMRK shares was made to bondholders and claim holders whose claims were accepted by the estate. Additional shares will be issued to these creditors as the size of the claim pool is refined; however, the total number of shares, 9.8 mm, is set and final. 45% of the presently outstanding shares are still in the Fleming estate, awaiting distribution to former creditors as their claims are accepted by the estate.

The structure of the Fleming bankruptcy left two post- confirmation trusts to sort out the remaining unresolved Fleming claims – both claims against the estate and claims of the estate. These trusts were capitalized by cash contributions from the Fleming estate. While CMRK is contingently liable in the event that these contributions prove inadequate, progress to date suggests that the probability of any liability is remote.


Risks
Rising gasoline prices may negatively affect customer purchasing of in-store food and general merchandise.

CMRK is presently thinly traded and may be volatile. It is worth noting that a significant proportion of the stock remains to be distributed to former creditors who may not be longer term holders of the stock.

While the case for CMRK is not predicated on conversion to an income trust structure (we still think the stock is worth + $37) we do not know definitively whether such a structure is feasible.

We believe that management may be considering acquisitions. Our sense, however, is that such acquisitions would likely be “fill-in” in nature, to complete the company’s national footprint, and would not be dilutive.

Conclusion
In summary, CMRK presents a classic post- reorg equity situation – misunderstood and deeply undervalued. Management’s interest is well-aligned with shareholders in the form of more than 1.0 mm options, and 190,000 restricted shares, given them ownership of nearly 10.0%. Catalysts/upcoming events include investor meetings to present a possible new bank financing to take-out high interest debt, management’s planned equity investor roadshow and the listing of the stock (Form 10 recently filed). Even as a U.S. listed C-Corp we believe the stock is worth $40 (7.0x 2006 EBITDA), up 25% from the current price, and the potential conversion to an Income Trust structure (which is still being explored for feasibility) could generate a value north of $50. Lastly, CMRK’s recent Valero contract win is an interesting template for the future. The Valero contract is a logistics management contract, which provides for a management fee for CMRK and involves low capital investment, as CMRK does not take title to the inventory. This contract suggests a possible move in the future of the business towards simply being a logistics manager, businesses which are awarded high multiples by the market.


Comps

Market Enterprise EV/ EBITDA
Cap Value 2005E 2006E
Sysco Corp $20,949.6 $22,221.7 11.56 x 10.71 x
- Distributor of food and related products to foodservice sector.
- Provides its products and services to approximately 400,000
customers, including restaurants, healthcare and educational
facilities, lodging establishments and other foodservice customers.
- Restaurants represent 64% of sales.
- SYSCO's operating companies distribute both nationally-branded
merchandise and products packaged under SYSCO's private brands
Market Enterprise EV/ EBITDA
Cap Value 2005E 2006E
Performance Food Group Co. $1,137.3 $1,082.8 11.05 x 10.31 x
- Markets and distributes a total of more than 61,000 national and proprietary
brand food and non-food products to more than 43,000 customers, including
street customers and certain corporate-owned and franchisee locations
of chains such as Burger King, Church’s, Compass, Popeye’s and Subway
- also serve casual and family dining chain restaurants such as Cracker Barrel
Old Country Store, Inc., Outback Steakhouse, Inc., Ruby Tuesday, Inc. and
T.G.I. Friday’s.
Market Enterprise EV/ EBITDA
Cap Value 2005E 2006E
Reddy Ice $292.2 $739.5 9.89 x *
* Represents EV/LTM EBITDA.
- largest manufacturer and distributor of packaged ice. Customers include
supermarkets, mass merchants, and convenience stores.
Market Enterprise EV/ EBITDA
Cap Value 2005E 2006E
Nash Finch $531.6 $947.3 6.26 x 5.48 x
- distribute nationall branded, and private label grocery products from 15
distribution centers to more than 1,500 grocery stores.
- largest distributor by revenue of grocery products to U.S. military bases.
- 85 company-owned stores in upper midwest. 78 conventional supermarkets,
3 AVANZA grocery stores, and 3 Wholesale Food Outlets
- retail represents roughly 20% of sales and 25% of segment ebitda (pre-corp)
Market Enterprise EV/ EBITDA
Cap Value 2005E 2006E
Supervalu $4,315.3 $5,436.0 5.55 x 5.27 x
- Wholesale distribution customers include single and multiple grocery store
independent operators, regional and national chains, mass merchants and
the military.
- 1483 retail stores, including 821 extreme value stores.
- retail represents roughly 50% of sales, 65% of segment ebitda (pre-corp)


DISCLAIMER: This does not constitute a recommendation to buy or sell this stock. We own shares of the company, and we may buy shares or sell shares at any time.

Catalyst

Catalysts/upcoming events include investor meetings to present a possible new bank financing to take-out high interest debt, management’s planned equity investor roadshow and the listing of the stock (Form 10 recently filed).