Description

Recommendation:

I recommend shorting shares of Susser Holdings (SUSS).

Thesis:

Filing for an IPO of their MLP-able wholesale gas distribution business and the rapid decline in oil prices that benefitted second quarter earnings have created the opportunity to short a mediocre business trading at a peak multiple of peak earnings at a time when they are likely to fall short of forward earnings expectations.

Upon pre-announcement of better than expected 2Q earnings (and three weeks after announcing the IPO registration), SUSS's private equity sponsor Wellspring sold 87% of their remaining holdings (27% of FD shares) in a secondary that was priced at $36 -- eight months after having sold 3.8m shares at $21.75.

Background:

Susser Holdings is a convenience store chain with 541 locations in Texas, Oklahoma, and New Mexico. They also operate a wholesale gasoline distribution business that services their stores and third party retailers.  Both of these are decent, but highly competitive businesses with no real barrier to entry or competitive advantage. As such, returns on capital are historically decent but unimpressive until recently. Given the lack of barrier to entry, I don't expect these returns on capital to be sustained.

Susser has four gross profit drivers:

• Merchandise sales (including QSR): 
  • 55-65% of gross profit dollars
  • Stable gross margins of 32.5-34.5%.
• Retail Fuel:
  • 20-35% of gross profit dollars depending on margins
  • Highly volatile margins of 11.1-32.4c per gallon (quarterly)
  • This will become even more volatile if the wholesale business is separated and less volatile (with the volatility being absorbed by HoldCo SUSS).
• Wholesale Fuel
  • 4-6% of gross profit dollars (this will increase with the transfer pricing scheme used in the MLP prospectus to be 10-15% of total gross profits)
  • Fairly stable margin per gallon of 4-7c (will tighten and be less volatile with transfer pricing).
• Other
  • Environmental services business pertaining to gas stations
  • 10-15% of gross profit dollars
  • No COGS (costs in SG&A)

Beyond gross profits, SG&A is relatively fixed, so fuel margins drive the vast majority of the volatility in profits from period to period.

Retail fuel margins:

Below is a history of CPG since the beginning of 2004. Clearly there is some positive drift to fuel margins.

The main explanatory factor for this is the rising cost of credit card fees per gallon as a result of (1) higher gas prices and (2) a higher penetration of credit card usage. However, both of these factors have slowed since late 2007. Oil has risen and fallen, but been somewhat range bound (chart below) and credit card acceptance at c-stores has leveled out (CC cost as % of retail fuel price has been 1.6% the last three years).

The chart below shows retail fuel margins net of CC costs to the company -- what should be a better comparison year to year (shown with average margin for the quarter from 2007-2010). We observe some drift but less. We also see much higher volatility.

The two spikes in the chart correspond to the oil price declines in Q2/3 2011 (from ~$105 at 3/31/11 to ~$79 at 9/30/11) and the even more rapid decline in Q2 2012 (from ~$104 at 3/31/12 to $85 at 6/30/12). Clearly gas margins generally move inversely to oil prices. As oil rises, gas margins are compressed because retailers struggle to pass through all of the increase to customers (both because of the lag and customer actions like filling up less or shopping around more). As oil falls, retailers are slower to drop retail margins in order to recoup the lost margin from price increases. As such, when oil fell precipitously in 2Q12 (the most since fall 2008 when other factors were present), SUSS reported all time high gas margins.

MLP of wholesale segment

On June 22, 2012 Susser announced the filing of a registration statement for "Susser Petroleum Partners LP" to raise up to $200m.

http://sec.gov/Archives/edgar/data/1552275/000104746912006829/a2209959zs-1.htm#dq19901_selected_historical_financial_data

Below are the historical results. Note the historical transfer pricing assumed no margin on wholesale fuel distributed to the retail segment.

Pro forma results are below. The new MLP will charge the HoldCo 3c per gallon distributed at a fixed margin for gallons distributed to SUSS and consignment locations (leaving SUSS to bear the risk of better/worse margins).

Applying the same Opex would leave the MLP with approximately 25m in EBITDA for 2011 (out of $148m total). Assuming they are successful with an IPO, let's assume they get a 10x EBITDA multiple. That's about 3x higher than the rest of the consolidated entity (depending on EBITDA assumptions and without haircutting the remaining company for increased volatility). A $75m lift in valuation would be ~$3.75/share of increased value (for reference the stock rose ~$2.30 the day of the announcement). There would be further opportunity for value creation if they could consolidate wholesale fuel distributors, but that would likely take several years. As a result, I'm comfortable that the worst case (from a short perspective) outcome is about a 10% lift. Cancelling the IPO would likely cause a material stock decline, and I don't think success can be assured given the tough IPO environment and unconventional nature of this MLP.

Aggressive Sponsor Selling:

Wellspring has sold aggressively over the last nine months with a 3.8m share secondary (~19% of outstanding) in December 2011 at $21.75 followed by an upsized secondary of 5.75m shares (~28.7% of outstanding / 87% of remaining stake) in July 2012 after the MLP filing and positive 2Q pre-announcement. Everyone has their reasons for selling and they had been long time investors, but the significant sales relatively close together are a red flag, particularly because the well-informed seller was willing to accept $21.75 just nine months ago.

Valuation & Scenarios:

I use the 2007-2010 period to estimate normalized margins since the last two years have had anomalously high gas margins as a result of two precipitous declines (that were offset by slower increases and less "give back"). Applying the five year average EBITDA multiple of 5.88x (relatively in-line with peers CASY and PTRY -- CASY receives a premium for a higher % of owned stores and to my normalized EBITDA and subtracting the $322m net debt gives me an equity value of ~$418m, or $19.70/share (or $24 using the Co #/my forward estimate).

Risk / Reward:

I think the risk/reward is very favorable for a short position here. Margins are at all time highs and imply economics that are too good for such a competitive business (c-stores) with no barriers to entry. The signal value of the PE sponsor selling so aggressively gives me confidence, and the meaningful/sustained rally in oil in 3qtd should be a major headwind for gas margins.  As such, the base case ($20/sh) has a  reasonable likelihood of being realized or approached.

The near term risk scenario is harder to peg because it's trading near its peak multiple (6.9x consensus v 7.3x peak) on peak  earnings. Using 7.5x peak EBITDA, I get to $45. I'd be quite surprised if the market full capitalizes recent CPG margins, but I can't rule it out.

Finally, I think there is a hard catalyst -- if oil holds up and/or rises further and CPG doesn't fall, I will be proved wrong about CPG margins being inversely correlated with oil. It's a tougher call if oil falls back toward lows to benefit CPG margins, but I would still expect 3Q margins to be down sequentially and yoy (street is looking for 24c, historical avg 20c in 3q--only >24c in 3q11 with oil falling from 95-80 LY vs rising qtd this yr from 80-96).Additionally, we are over halfway through Q3, so the risk of oil falling and helping their margins gets smaller each day.

 Risks:

• Rapid decline in oil prices
• Current EBITDA valuation isn't unreasonable
• Successful IPO of the MLP and subsequent accretive acquisitions

Potential Catalysts:

• Cancelling MLP IPO
• Continued flat/rising oil prices hurting gas margins - Q3 earnings report in November, but typically provides an "Operating Update" 2-3 weeks after the quarter (~October 15-20).
• Re-rating based on normalized earnings

Catalyst