A Boring Company for an Uncertain Economy

Earlier this year, we introduced Morningstar Opportunistic Investor readers to  Core-Mark , a boring, simple company with favorable tailwinds trading for a very compelling valuation. We doubt many of you have heard of Core-Mark, but it's very likely that you've bought something that's been through a Core-Mark warehouse, driven on a Core-Mark truck, or handled by a Core-Mark employee. In short, Core-Mark is one of the thousands of sleepy and largely invisible companies that shape the American landscape every day.

Core-Mark's business is simple: It's one of the largest distributors of goods to convenience stores, especially on the West Coast.

With the stock under $30, Core-Mark is trading for about 10 times adjusted 2009 earnings of $2.73. This looks pretty decent by itself, but we think the company is well positioned to take advantage of several secular trends within the convenience store distribution industry. If we are right, the company can grow earnings at a mid-teens pace for several years, and deserves to trade for a much higher valuation.

The Street's lack of interest in the industry (only a few analysts cover Core-Mark) and the awful margins of the distribution business discourage further investor interest. In addition, the industry's largest player, McLane, is owned by  Berkshire Hathaway (BRK.B), and its results are not publicly available. We think this helps hide any positive trends for the industry, and this lack of investor awareness creates an investment opportunity for us.

Company Background
It's really as easy as it sounds. Core-Mark buys stuff on one hand, consolidates it in a distribution center, and dispatches it at a small markup to convenience stores. Thanks to Core-Mark, small convenience stores can carry a compelling assortment of goods without dealing with hundreds of different suppliers. In addition, Core-Mark allows convenience stores to adjust their inventory quickly in response to market conditions, provides some vendor financing, and offers marketing programs and sometimes information technology support.

Although margins are very low, distribution is not a bad business. The profitability of a distributor is heavily influenced by the density of its route network. Imagine if you had to deliver 100 packages to 100 houses in Chicago. If these houses are randomly scattered all over the city, you'd be stuck in traffic for a week. However, if the houses are all lined up along a few blocks, you might be done in a few hours.

To translate that analogy to Core-Mark: the company has a distribution network of 24,000 stores. This dense and large customer base allows Core-Mark to make more deliveries per truck route and to operate with fuller trucks than smaller competitors. This makes per-unit delivery costs low, which creates a decent barrier to entry, as a competitor needs a near-equivalent regional presence to match Core-Mark's costs and prices.

We are not saying that there is no competition, but rather that each region is dominated by two or three large and efficient distributors. Though these distributors compete on price, especially for large accounts, network effects allow return on capital from a well-established regional distribution center to be quite attractive. Depending on the circumstances, distributors can exert a surprising amount of pricing power as well. For example, in 2006, when Imperial Tobacco decided to distribute its cigarettes directly to stores rather than use Core-Mark, the company was able to increase prices to the rest of its Canadian customers to compensate for the lost revenue, which was over $200 million.

That brings us to our next topic. Currently, two thirds of Core-Mark's revenues (though a much smaller percentage of profits) come from cigarette sales. Although cigarette volumes have been declining for years, the trend has been mitigated for Core-Mark because consumers have been buying more cigarettes from convenience stores instead of warehouse clubs. Convenience retailers accounted for 69% of cigarette sales in 2007, up from 54% in 1999. However, this shift in purchasing behavior has generally halted. It's likely that the prospect of continual cigarette sales erosion is an overhang on the stock.

We don't have a particularly favorable view of cigarette sales either. Industry volumes will continue to decline, but Core-Mark will fare better thanks to manufacturer price increases and some distribution gains. Overall, we think cigarette gross profits will fall from 2009 highs and stay flat for the next several years. If we are right about the Core-Mark's long-term prospects, cigarettes will become a progressively smaller piece of company profits and will eventually cease to matter.

The Growth Opportunity
You wouldn't know it just by looking at the company, but we think Core-Mark has an interesting set of growth opportunities that should allow EPS to expand at a mid-teens pace for years if all goes well.

These initiatives target three areas: vendor consolidation, a national expansion effort, and the delivery of fresh food and dairy products.

Vendor consolidation offers convenience stores the ability to receive one delivery for the bulk of their supplies, versus numerous inefficient deliveries throughout the day from different distributors.

The national expansion effort would see Core-Mark entering new territories (probably through acquisitions), especially in East Coast states, which have a greater density of convenience stores. Core-Mark has already made some progress here with new distribution centers in New England and Toronto. We think there are further growth opportunities in Florida, North Carolina, and Texas, which have considerable convenience store populations. Of course, as with any acquisition-focused strategy, success here greatly depends on the caliber and prudence of the management team.

Perhaps Core-Mark's most important initiative is its early leadership in providing fresh food in convenience stores. This business generates gross margins of 15% to 25%, versus the typical 3% gross margin on cigarette sales. It's really a win-win situation for Core-Mark. The company can leverage its existing relationships and route density to deliver much higher margin goods to its customers. And its customers love the service because fresh foods carry higher margins and help to drive traffic into their stores.

That said, why doesn't everyone jump on this bandwagon? In fact, industry leader McLane's fresh food initiative, Fresh-On-The-Go, was launched in 2009. However, prior to that, McLane was already delivering various fresh food items to specific customers. The firm distributes the fresh food to its customers from 20 distribution centers, which reach every zip code in the United States. In order to distribute the fresh food, McLane uses 2,000 tri-temperature trailers (which have three separate sections with different temperatures for frozen, refrigerated, and fresh goods) while Core-Mark has a little more than 360 tri-temperature trailers out of its 660 trailer fleet.

The fresh food business also requires some route management, as food deliveries are about two to three times a week, versus the industry standard of once a week. This gives an even larger advantage to Core-Mark, as smaller players making ad hoc deliveries may find themselves dispatching half empty trucks to just a few customers multiple times a week. Furthermore, deliveries take a little longer, as the driver usually has to wheel the food into the store by hand, versus offloading it at a warehouse distribution center. Core-Mark has an advantage over McLane here, as McLane's much larger trucks are generally built towards serving  Wal-Mart's (WMT) distribution centers, which represent a significant portion of its revenue. Core-Mark's smaller trucks are better able to fit into the smaller parking lots of its mom-and-pop customers. Core-Mark believes that fresh food distribution and vendor consolidation could be a $1 billion revenue opportunity for the company, which would add $150 million to $250 million in incremental gross profits.

Risks
With that in mind, the low operating margin does present some challenges for Core-Mark. It's possible that the company will overpay for an acquisition, or be mired in restructuring or integration efforts after making a bad deal. Furthermore, larger suppliers, such as  Philip Morris  and R.J. Reynolds, may choose to directly distribute their products, which would eliminate a significant amount of scale efficiencies from Core-Mark's business. However, this shift would force the companies to invest heavily in building large distribution networks and extending credit to customers, making such change unlikely. In addition, cigarette carton sales could decline faster than Core-Mark's ability to gain new market share to offset the volume losses, which may lead to substantially lower gross profits from its cigarette segment. Finally, high oil prices could weaken convenience store traffic over time, and therefore demand for Core-Mark's services.

Valuation
We think Core-Mark could be worth as much as $50 per share without making aggressive assumptions. That's about 100% upside, considering that the stock is under $30 today.

If we are right about the potential in food sales, which should drive gradual margin expansion in the non-cigarette segments, we think earnings can expand to $5 per share just a few years out. In a razor thin margin business, even a few basis points per year of margin expansion from good execution and a smart business plan can pay huge dividends.

We can also look at valuation as a function of free cash flows or EBITDA. The capital spending needs of the distribution business are quite low at around $20 million annually as Core-Mark typically only has to purchase warehouse and truck equipment each year. Thus, as the business grows, the incremental income generated could fall right into shareholders' hands. We estimate free cash flow could average around $30 million annually, providing plenty of cash for share buybacks or dividends. If we assign a 15 free cash flow multiple, we think Core-Mark could be worth around $42 per share. On an EBITDA basis, we estimate Core-Mark's EBITDA could top $100 million in 2012 from about $83 million today. We think applying a reasonable 6.5 multiple leads to Core-Mark being worth about $60 per share, which is more than 100% upside. In short, valuing Core-Mark using a number of different ratios leads to the same conclusion: the stock is cheap.

On the other hand, downside is fairly limited. Convenience stores will need distributors, and Core-Mark is an entrenched incumbent in most of its territory. Barring a vicious price war or some other massive disruption (like a huge and stupid acquisition), it's hard to imagine the earnings power being too much lower than where it is today.

Editor's Note: Information in this article was amended on September 10, 2010. Click here to learn more.

This article was originally published in April 2010 for theOpportunistic Investornewsletter.

Disclosure: Co-editors Stephen Ellis and Michael Tian are long Core-Mark stock. The Opportunistic Investor is long shares of Core-Mark.

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