S&P revises The Pantry's outlook to stable from negative, saying company's debt reduction, stabilizing merchandise operations have improved its credit metrics

Cindy Allen

NEW YORK , March 20, 2012 (press release) –
Overview
-- Modest debt reduction and stabilizing merchandise operations have resulted in an increase in covenant cushion and improved credit metrics for U.S. convenience store operator, The Pantry Inc.
-- We are affirming our ratings on the company, including the 'B+' corporate credit rating, and revising the outlook to stable from negative. -- The stable outlook reflects our belief that additional debt reduction will keep credit metrics almost flat and the company will have adequate cushion under financial covenants going forward, despite our expectation for lower fuel margins.

Rating Action
On March 19, 2012, Standard & Poor's Ratings Services revised its outlook on Sanford, N.C.-based The Pantry Inc. to stable from negative. At the same time, we affirmed all ratings on the company, including the 'B+' corporate credit rating.

Rationale
The outlook revision reflects our view that the company should be able to maintain adequate cushion under its leverage covenant, of about 14% to 15%, due to modest debt reduction and somewhat stabilizing merchandising profits. Nevertheless, we see credit metrics remaining at levels consistent with a "highly leveraged" financial risk profile (based on our criteria).

The ratings reflect our view that credit metrics should remain consistent with what we consider to be a highly leveraged financial profile, and that its business profile will remain "weak". Credit ratios were improved for 2011, as earnings for convenience store operators, such as Pantry, benefited from retail prices lagging behind falling gasoline costs. Pantry generates about
30% of its gross profit from fuel sales, with the rest coming from merchandising operations. Its merchandise performance was favorable in the past year, and we predict some additional upside due to store initiatives such as labor cost management.

Our base-case assumptions for Pantry over the near term include the following:
-- We expect fuel margins to average about 12 cents per gallon, down from about 13.5 cents in 2011 due to the fuel price environment.
-- Merchandise same-store sales in the low-single-digit area and margins of about 34%, as the company benefits from profit improvement initiatives.
-- We forecast capital expenditures in the $90 million to $95 million range and we expect the company to generate close to $40 million to $50 million of free cash flow in 2012.
-- We think the company will use a substantial portion of cash flows for debt reduction.

Although our forecast shows further debt reduction in the next year, our earnings expectations for the fuel segment indicate that rising costs and the inability to raise retail gasoline prices to compensate will squeeze fuel margins. We expect leverage will be about 6x and funds from operations (FFO) to debt will be about 13%. In addition, we see interest coverage in the mid-2x area.

We assess Pantry's business risk profile as weak, based on its exposure to fuel price volatility and geographic concentration in the southeastern U.S. where unemployment remains high. The company's size partly mitigates these factors; it is the third-largest convenience store operator, with nearly 1,625 stores, which we think will continue to provide advantages of scale over other operators. Its store rebranding and renovation initiatives could lead to higher traffic, but we think economic conditions such as high unemployment will continue to pressure profit performance.

Liquidity
We view Pantry's liquidity as "adequate." Liquidity sources include $150 million of cash on hand on Dec. 29, 2011, and $124 million in borrowing availability under its $225 million secured revolving credit facility due 2013. Our liquidity assumptions include the following:
-- Sources will exceed uses by 1.2x or more over the next 12 months.
-- Sources will remain positive, even if EBITDA were to decline 15%.
-- Covenant cushion under the leverage covenant should be in the mid-teens area over the next few quarters.
-- We anticipate the company will refinance its revolving credit facility on a timely basis.

Pantry has some flexibility to lower capital spending if necessary, since a meaningful portion of the expenditures are for store upgrades that it could delay. Our forecasts incorporate the 50% mandatory cash flow sweep the bank credit agreement requires, resulting in debt reduction.

Recovery analysis
For the full recovery analysis, please see the recovery report on The Pantry Inc., to be published as soon as possible following this report on RatingsDirect.

Outlook
The stable outlook reflects our expectation of modest debt reduction and about 14% to 15% cushion under its financial covenants. We forecast somewhat stable performance in its merchandising segment and a modest contraction in fuel margins, to about 12.5 cents. These factors will result in debt leverage close to 6x, FFO to debt of about 13%, and interest coverage of slightly under 2.5x.

We could lower the ratings if weaker-than-anticipated market conditions lead to a decline in fuel margins to 10 cents per gallon and merchandise same-store sales decrease to negative levels. If these were to occur, we would expect the cushion under financial covenants to narrow to the mid-single-digit area and leverage to increase to over 6.5x. A lower rating could also occur if the company does not refinance its revolving credit facility on a timely basis, which would constrain liquidity.

Given the company's high debt levels, an upgrade is not a near-term consideration. However, if it reduces debt above our expectations and improves leverage to about 4x on a sustained basis, we could raise the ratings. Drivers of better credit metrics would include merchandise same-store sales of about 10%, gross margins improving by about 100 basis points, and fuel margins staying near 12 cents.

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