Picking Off Corner Stores

Merrill Lynch says large chains eyeing mom & pops

NEW YORK -- The North American convenience store industry, dominated by mom-and-pop operators, is ripe for consolidation, a trend that would favor the large, publicly traded store operators, according to a report in The Globe & Mail, citing analysts at Merrill Lynch.

With significant scale advantages, economics favor large chain operators in the c-store industry, the analysts said in a report released Tuesday. With a still high degree of fragmentation, the publicly traded c-stores stand to be beneficiaries of the inevitable consolidation we foresee.[image-nocss]

The Merrill team reinstated coverage of industry leader 7-Eleven Inc., Dallas, with a neutral rating. It said the neutral rating was based solely on valuation, given that 7-Eleven is already trading at near-peak multiples of its earnings.

Merrill also reinstated coverage of Sanford, N.C.-based The Pantry Inc., with a buy rating. Although the company faces higher risks because of its higher exposure to gasoline sales, it has ample acquisition opportunities in its main Southeastern U.S. market, where there are over 40,000 stores that it could potentially buy, according to Merrill Lynch.

The brokerage also raised its target on Alimentation Couche-Tard Inc. and reinstated its buy rating, noting that the Laval, Quebec-based company has proven it can acquire assets and successfully integrated them. Couche-Tard currently trades at a significant discount to U.S. industry leader 7-Eleven, but at a premium to Southeast regional operator The Pantry. We anticipate a narrowing of the gap between 7-Eleven and the other two players over the coming 12 months, the report said.

Merrill Lynch noted that the publicly traded c-stores have outperformed the S&P 500 composite index and the S&P 500 retail index for the past four years. Also, growth in the c-store industry surpassed that of any other retail segment in 2003 and 2004, it said. The acquisition and improvement of operations of the smaller operators will be a significant growth driver for established operators such as Couche-Tard and 7-Eleven, it added.

According to the National Association of Convenience Stores (NACS), most U.S. c-store operators are composed of chains of 10 or fewer outlets. The proportion of outlets controlled by the top four well known non-oil-company chain players7-Eleven, Couche-Tard, Ankeny, Iowa-based Casey's General Stores Inc., and The Pantryaccount for only 8% of the total. Single-store operators still account for the majority of outlets, 61% in 2004, while chains make up 39% of the outlets, said Merrill Lynch.

One of the primary reasons for our sanguine outlook for the publicly traded convenience store operators is the consolidation opportunity, the report said. As established, well capitalized c-store operators continue to redefine their in-store offering, the introduction of additional products and services should serve to improve profitability and further establish the c-store as a destination for consumers.

Risks to Merrill Lynch's targets include volatility linked to selling gasoline and the fact that cigarette consumptiona main driver of sales for convenience storesis in a state of long-term decline, the paper said.