Description

I am recommending a short position in Susser Holdings (SUSS).  Sadly the stock is down 10% or so from when this was submitted as my application a few days ago, but it still represents a good trade at these levels.  The stock closed at $22.78 and has 34% downside to fair value of $15.00.  Nothing has fundamentally changed from my prior write up, but they have brought a 3.5M primary share secondary offering to the market so all estimates are now pro forma for the deal.  For what its worth, the group lunch was relatively hostile as management admitted that fuel margins (and implicitly earnings) will most likely be down next year, this is tough to swallow with the stock close to an all time high.

Brief Business Description

Susser’s main business is the operation of 535 convenience stores, predominately (90%) in Texas.   It also runs a wholesale fuel business which distributes gasoline from refiners to smaller independent operators.  A more detailed description of each business will follow below.

Investment Thesis

• The core script revolves around the company’s highly volatile retail fuel margins seeing reversion to the mean after a record year in 2011
  • SUSS will make roughly $2.50 in 2011 up from $1.11 in 2010, a full $1.20 of this earnings jump is due to record fuel margins which are dependent on movements in Brent Crude and should be considered unsustainable
  • The fuel margin per gallon will equate to roughly $0.227 vs a 5 year average of $0.159, each incremental $0.01 in margin adds/subtracts $0.29 to EPS
  • Sharp moves downward in oil are ideal for margins as pricing is stickier than COGS, due to the macro disruptions of the past 6 months there have been three large moves down to help boost profitability
• Other areas of concern include:
  • Vehicles are getting more efficient.  According to the EPA the average MPG of a light vehicle has gone from 38.6 in 2000 to 46.1 in 2010, a 19.5% increase.  This will directly impact the volumes pumped as new vehicles enter the fleet
  • Private equity (Wellspring Capital) still owns 39% of the company and has not sold a share since they invested pre-IPO in 2005.  Sam Susser owns 20% of the company and has vocalized his refusal to sell.  Because the stock is close to an all time high they represent a large overhang
  • It’s a capital intensive business.  SUSS has a net debt to cap of 80% and 2010 was the first year since 2005 they generated any FCF (a measly $10m).  Indeed, they had to tap the public markets for roughly $80m to grow units at just 5%
  • It is also a mature and competitive industry.  Traditional convenience stores like SUSS have been share donors to grocers and discounters as they try to drive traffic with cheap gas

A Quick Note on the Secondary Offering

• They are bringing 3.5M shares, total s/o will now be around 20.9M, its a dilutive offering
• Prices Thursday night
• Use of proceeds is growth capital, ie—take unit growth from 2-3% to around 5%
• Private Equity didn’t sell anything, still an overhang

Business Segment Description

Motor Fuel Sales (81% of sales, 31% of gross profit)

• Retail fuel sales
  • Each of SUSS’s 535 convenience stores pump approximately 1.45M gallons of fuel each year
  • The mix is 80% regular fuel/20% diesel, diesel has been the driver of same store gallon growth in the past twelve months (regular gallons are already comping negatively) as new stations are fitted with higher diesel capacity, due to pump constraints management has indicated that diesel could reach the “high 20%” range of the mix
  • Going forward this segment’s growth will be limited to new units, roughly 4-5% per year, as mentioned above higher fuel efficiency will be a headwind to same store sales in the future
  • Below are the quarterly margins for the past five years, I believe they will revert to $0.165-$0.17, closer to their long term average, all that needs to happen for this to play out is oil trading sideways (as it is Q4 to date), sharply down is positive, sharply up is negative

Q1                           Q2                           Q3                           Q4                           Average

2006                       $0.092                   $0.154                   $0.21                      $0.092                   $0.137

2007                       $0.12                      $0.173                   $0.159                   $0.141                   $0.148

2008                       $0.12                      $0.195                   $0.223                   $0.177                   $0.179

2009                       $0.118                   $0.152                   $0.197                   $0.119                   $0.146

2010                       $0.111                   $0.248                   $0.228                   $0.15                      $0.184

2011                       $0.153                   $0.312                   $0.277                                                   $0.227

5 year avg up to 2011 of $0.159

• Wholesale fuel sales
  • Purchases gasoline from refiners such as Valero/Chevron and distributes to 440 smaller independent gas stations as well as 560 branded operators
  • Margins are much more stable than the retail segment and typically average between $0.053-$0.056
  • Approximately 50% of the volume is zero price risk cost plus based contracts, the other 50% is done on consignment
  • Organic growth is limited, it has been 1-2%

Merchandise Sales (18% of sales, 60% of gross profit)

• High quality retail operation, has comped positively for 22 straight years and grown gross profit every year since going public
• Steady 33-34% gross margin
• Own 45% of the properties, use net leases for the remainder
• Company now aims to grow units at 4-5% (although it should be mentioned that this guidance was raised with the fresh capital infusion and unit growth was stagnant from 2008-2010 as it could not be funded), and comps typically run +3-5%
• New units are close to 5000 square feet, cost $2.5-$3.5M, and have an unlevered ROI >20%
• Despite the attractiveness of the retail operation it gets drowned out by fuel margins, for example, in 2009 this business comped +4% and grew gross profit by 4% (not bad during those days!), however, because the fuel spread dropped 3 cents EPS was down 87% y/y and stock returned -41% vs the S&P +21.3%
• It should also be noted that cigarettes are 20% of sales and in secular decline

Other (1% of sales, 9% of gross profit)

• A collection of essentially pure margin operations inside the stores (ATMs, DVD kiosks, check cashing counters)

Capital Structure and Cash Flow (pro forma)

                Cash                       $155m                                  

                Debt                       $450m                                  

                Market Cap          $473m

                EV                          $768m

                D&A                       $45m

                Capex                    $90m  (mgmt claims maintenance is $20-25m, but since 2006 it hasn’t been lower than $50m so I find that to be a stretch)

Model

Valuation

• SUSS should trade at 12.5x its normalized out year earnings power of $1.20 or a fair value of $15.00
• CASY owns 100% of their store base (vs 45% at SUSS)and has a larger mix of high margin merchandise sales, at the very least SUSS should be trading at a discount to their equity
• PTRY is in the exact same business and is a good template for what valuation can look like after a few missteps

Conclusion

I believe SUSS is a very attractive short at these levels.  The thesis has proven to be valid in the past (2009) and management/analysts have convinced investors that this time might be different.  The bull case revolves around the strength of their retail business and the long term tailwinds of the Texas economy, as mentioned above, this is all true, but the true driver of incremental profitability in the business are the gas margins.  The business should be valued based on a normalized level of profitability and right now it seems the market believes 2012 will be another $2.00+ year at SUSS.  I do not claim to know where oil will trade from here, but to get paid on the short it just needs to either grind sideways or work higher.

What would cause me to cover?  Another sharp gap down in Brent Crude.

Catalyst