CASY - Casey's General Stores: Fuel Margin Is The Key Issue Of Concern

2023-03-18 05:35:42 ET

Summary

• 3Q23 results were better than expected, driven by lower opex and stronger-than-anticipated grocery and merchandise performance.
• While recent months have shown strong fuel margins and solid EBITDA growth in FY23, there is uncertainty around the future impact of cost pressures and inflation on the industry.
• I believe valuation needs to go cheaper for better margin of safety.

Thesis

In my opinion, Casey's General Stores (CASY) is one of the best convenience store chain in the country because of its strong, unrivaled prepared foods business, its vertically integrated model (CASY operates its own distribution), and its distinctive geographical profile in mostly rural regions of the Midwest. Given fuel's importance to CASY's P&L, I believe the sustainability of fuel margins is the primary issue that bulls and bears are debating. For reference, fuel is 60+% of revenue and close to 1/3 of gross profit, as such it is a very important stream of profits. On this point, as I mentioned below regarding quarter-to-date trends, I would say that the recent months of strong fuel margins suggest CASY will post solid EBITDA growth in FY23. In the future, once inflation reaches its highest point and cost pressures in the industry begin to ease, fuel margins needed for smaller operators to break even may decrease, leading to lower retail fuel margins for larger operators. As a result, I'm still worried about how this domino effect might affect CASY and other regional players in the future. Especially against the backdrop of the uncertainty of consumer spending in an inflationary economy and the volatility of the fuel operating environment. Also, I think the stock's valuation (CASY is 1.3x S&P on a forward PE basis) needs to go lower for better margin of safety, so I'm recommending a hold rating.

3Q23 overview

CASY's 3Q23 results was much better than what I and consensus expect thanks to lower opex and stronger-than-anticipated grocery and merchandise performance. On the flipside, gallon growth and grocery store margins were weaker than expected. Regarding the trends in recent month (February), management stated that the inside sales and same-store fuel gallons were at levels that would meet annual expectations, and the fuel margins were around 35 CPG. As was previously mentioned, this is where the debate settles, with no clear indication of where fuel margins will go from here on out (2CH23 or 1CH24). One perspective I hold is that the industry's structural shift will likely uphold profitable fuel margins in the future since smaller, less durable operators will still experience comparatively higher cost pressures, resulting in sustained breakeven margins. On the other hand, once inflation has peaked and cost pressures have eased, particularly for the marginal player, I anticipate fuel margins to normalize and rebase lower, perhaps stabilizing their break-even margins. Consequently, this could lead to lower fuel margins across the industry, which would have a sizable adverse effect on EBITDA. Although I anticipate continued strength, I do see a slight downward trend in fuel margins in the near future, so I am remaining cautious.

Other updates

Inside SSS grew by 5.6%, with grocery and other merchandise SSS growing by 5.8%, which is much stronger than I had anticipated, but the prepared food SSS grew by only 5.0%, which is a little lower than I had expected. Strong inside margins of 40.6%, up 120bps y/y, were driven by increased demand for NAB, snacks/candy, donuts/pizza slices, energy drinks, and private label in CASY. The 0.5% drop in fuel sales based on same-store gallon volume was a minor letdown. With 20 net new stores, CASY is on track to add 47 net new units in Q4 and reach its reaffirmed 80-store total.

The 8.0% increase in operating expenditures was in line with management's most recent guide that it would be at the lower end of the 9-10% range. The higher 3Q23 Opex was caused by more stores being open, higher same-store employee expenses, and shorter store hours. In general, the grocery and merchandise sales exceeded expectations and the operational expenses were lower than anticipated. As a result, the adjusted EBITDA grew by 19.3%, which is noteworthy because the management had set a mid-term growth target of 8% per year for FY23.

Conclusion

In conclusion, while I believe that CASY is the best convenience store chain in the country due to its unique strengths, including its strong prepared foods business, vertically integrated model, and rural Midwest presence, the sustainability of fuel margins is a key issue of concern. While recent months have shown strong fuel margins and solid EBITDA growth in FY23, I am cautious about the potential impact of cost pressures and inflation on the industry in the future. Net-net, I recommend a hold rating, but I do believe that CASY's unique strengths make it a strong player in the convenience store space.

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