Making an Investment Recommendation Meredith Adler Managing Director Lehman Brothers Equity Research (617) 526-7146 [email protected]smartwomansecuritie s 2006 Smart Woman Securities. All materials are for SWS members’ use only November 29, 2006 Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this email communication. Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800- 2LEHMAN to request a copy of this research. Investors should consider this communication as
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2006 Smart Woman Securities. All materials are for SWS
members’ use only
November 29, 2006
Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this email communication. Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research. Investors should consider this communication as only a single factor in making their investment decision. Please see Analyst Certification and Important Disclosures beginning on page 30.
Getting a Recommendation
The process is methodical but not straightforward
• Research the industry dynamics: what are drivers, who competes, what is necessary for success?
• Learn the company: is it well-positioned, does its strategy make sense, can it control its future?
• Meet with management: can they be trusted, can they execute the strategy?
• Develop a financial outlook: most important for us are P&L, cashflow, DCF. If company is leveraged, understand sources of liquidity.
• Look at valuation: compare it to peers, historical ranges, M&A multiples, underlying asset values, DCF
• What is the market’s view: earnings potential, strategy, management, risks, external drivers, potential for a buyout
• Make a recommendation: be able to articulate the view concisely and clearly.
Review of the Process – it is iterative
• Read 10K• Find trade publications• Contact industry experts (vendors, consultants)• Speak with colleagues
Research the Industry
Learn the company
• Read financial statements and annual reports
• Listen to conference calls
• Talk to vendors, customers, consultantsMeet with management• Goal is to judge integrity
• Ask about strategy
• Goal is to judge ability to execute
Review of the Process – it is iterative
• Based on historical relationships• Use external data points when appropriate (e.g. oil prices)• Make assumptions – should match your point of view• Look at street estimates
Build a model
Look at valuation• Appropriate metric will vary
• Sometimes you use more than one methodology
• History does not always repeat itself, though its amazing how often the market’s view is fixedFigure out the market’s view• Very challenging to accomplish, especially with a new stock
• Views can be contradictory
• Views can be just plain wrong, but important to know that anyone
Case Study: The Pantry Inc (PTRY)
Historical Stock Price and Key Dates
KEY DATES:
Jun 1999: IPO
2001-2002: Downturn in the economy; gas margin falls to 10¢ vs past 5 year average of 13¢
Oct 2002: JPMorgan Chase sells off 12% stake into the market place
Sep 2003: Announced Golden Gallons acquisition and reported a 900% increase in annual earnings
Oct 2004: Hurricane’s in FL drive gas margin to 14.6¢
•Leading c-store in the fast growing Southeast. Majority of the 1600 stores are in FL, GA, SC and NC
•Store growth is focused on interstate & coastal locations
•Growth historically through acquisitions; beginning to develop new stores as well
•77% of sales from gas, 23% from merchandise. 35% of gross profit from gas, 65% from merchandise
PTRY Valuation
•Gas margin volatility creates large swings in stock price
•Using long-term avg gas margin of 13¢ our 10-year DCF gives a value of $58; price at close 11/27 -- $47
•PTRY’s 1-year forward P/E has ranged from 11.8x-23.4x over the last three years. The stock is currently trading at 14.0x our CY07 EPS (14.6x consensus).
•Last 3-yr avg. forward P/E multiple is 17.2x but below the LTM multiple of 18.4x.
Pantry Inc (PTRY); 3 buy ratings, 4 neutral ratings, 0 sell ratings LEH EPS estimates are 8% higher than consensus in FY07 and 14% higher in FY08, driven by our optimistic view of the benefits of acquisitions
C-Store is Highly Fragmented and Now Consolidating
C-store industry is highly fragmented & now consolidating1 store
•Almost 60% of the c-stores are one-store operations.
•Big oil companies have been selling off their operations to both independents and chains.
•Total store growth is expected to be stagnant over the next several years, as consolidation increases.
Source: NACS: State of the Industry; Retail Forward
C-stores are Highly Dependent on Gasoline
Retail price of gasoline
$-
$0.80
$1.60
$2.40
$3.20
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06
Fuel sales as a percentage of total sales
60.4%
62.4%
65.5%66.5%
69.5%
52%
56%
60%
64%
68%
72%
2001 2002 2003 2004 2005
•Gas continues to be the main driver to the stores and accounts for over 70% of the industry sales, but just 35% of the industry gross profit.
•75% of all gasoline is bought at convenience stores
•Retail gas margins depend on both the wholesale price and the local competitive environment
•C-stores have traditionally had difficulty dealing with the rising cost of inventory, as customers will shift to a lower price store.
Source: NACS: State of the Industry; EIA
General Merchandise and Prepared Food Sales are Growing
Total In-Store sales ($m)
$-
$20,000
$40,000
$60,000
$80,000
$100,000
$120,000
$140,000
$160,000
1998 1999 2000 2001 2002 2003 2004 2005
8% CAGR
•Industry in-store sales have grown at an 8% CAGR over the past seven years, with only 3.0% increase in unit growth
•In 2005, in-store sales grew 14.4%, faster than most other retail channels
•In-store sales continue to be dominated by traditional c-store products, like cigarettes, packaged beverages and beer, which combined made up almost 60% of in-store sales in 2005
•Food prepared on site has seen strong growth, 11% CAGR over the past seven years; this business has almost a 50% margin -- almost double the rest of the in-store margin.
Source: NACS: State of the Industry
39% 36% 34% 35% 34%
12% 12% 13% 12% 13%
10% 11% 11% 12% 12%
11% 12% 13% 12% 12%
28% 29% 29% 29% 29%
0%
20%
40%
60%
80%
100%
2001 2002 2003 2004 2005
Cigarettes Packaged Beverages Beer Foodservice Other instore
Alternative Channels for Gasoline Continue to Expand
•Mass merchants and supermarkets have been adding gasoline islands to their parking lots to get the additional traffic and drive customers to the inside of the store.
•Alternative channels can offer incentives to buy their gas and have developed some exciting cross-marketing programs.