The Pantry, Inc. F2Q09 (Qtr End 03/26/09) Earnings Call Transcript

The Pantry, Inc. (PTRY)

F2Q09 (Qtr End 03/26/09) Earnings Call

May 5, 2009 10:00 am ET

Executives

Berry Epley - VP and Corporate Controller

Pete Sodini - Chairman and CEO

Frank Paci - EVP of Business Operations, CFO and Secretary

Brad Williams - SVP of Field Operations

Analysts

John Heinbockel - Goldman Sachs

Simeon Gutman - Canaccord Adams

Mark Miller - William Blair

Karen Howland - Barclays Capital

Ben Brownlow - Morgan Keegan

Anthony Lebiedzinski - Sidoti & Company

Karen Short - FBR Capital Markets

Presentation

Operator

Welcome to The Pantry Incorporated Second Quarter 2009 Earnings Conference Call. (Operator Instructions).

Now, I would like to turn the presentation over to your host for today's call, Mr. Berry Epley, Vice President, Corporate Controller. Please proceed.

Berry Epley

As you know, earlier today we announced financial results for the second quarter of our 2009 fiscal year. If anyone does not have a copy of the release and would like one faxed or email to them, please contact Selby Kewin in our office at 919-774-6700, extension 7002 and she will see that you get what you need.

Before I begin today, I would like to point out that certain comments made during this call may be characterized as forward-looking statements under the Private Securities Litigation Reform Act of 1995. Generally speaking, comments regarding the company or management's beliefs, expectations, targets, goals, plans, outlook or predictions of the future are forward-looking statements. These statements involve a number of risks and uncertainties that could cause actual results to differ materially from the anticipated results implied by these forward-looking statements. These risks and uncertainties are detailed in The Pantry's filings with the SEC and in our earnings release issued this morning. We refer you to the SEC's website or our site, at thepantry.com, for these and other documents.

We also will discuss certain non-GAAP financial measures today that we believe are helpful to a full understanding of our financial condition. Certain of these non-GAAP financial measures were also included in the press release we issued this morning. We, therefore, refer you to our press release posted on our website, which includes a presentation and reconciliation of each non-GAAP financial measure to the most directly comparable financial measure included in the press release and an explanation of why we believe these measures provide useful information to our investors and how they are used by management.

With us today are The Pantry's Chairman and CEO, Pete Sodini; Tom Murnane, Lead Independent Director; and Frank Paci, our CFO.

I'll now turn the call over to Pete.

Pete Sodini

We're pleased to report second quarter EPS of $0.28 compared with a loss of $0.23 per share in last year's second quarter. As detailed in the press release, the results this year include $0.18 per share in gains from repurchase of outstanding debt at a discount, while the results a year ago included $0.23 per share in losses on gasoline hedging transactions.

Backing those items out, our earnings were $0.10 per share this year compared with essentially a breakeven a year ago. As many of you are aware, the second quarter is typically the seasonally low point of our fiscal year.

We were able to achieve these results despite a worsening economic environment. In our market, we saw our state weighted average unemployment rate increased to 9.6% during our second fiscal quarter, up from 7.3% in the first fiscal quarter, and 5.4% during the second fiscal quarter last year. While these factors have weighed on consumers, we started to see some improvement in our merchandise business this past quarter.

For the quarter, comparable store merchandise revenues were up 1.3% versus a 3% decline in the first quarter. Our merchandise gross margin was 37.2%, up 170 basis points from our first quarter margin of 35.5%, but down 30 basis points from a year ago. Both merchandise sales and margin results were positively impacted by cigarette cost increases and corresponding retail price increases taken in anticipation of the Federal Excise Tax to support the State Children's Health Insurance, commonly known as SCHIP. Frank will provide more detail later.

In the gasoline business, our volumes remain relatively soft with a 6.4% decline in comp for retail gas gallons. Again this quarter, a significant portion of the drop is attributable to diesel sales, which were down 22% in comparable store versus a year ago. Excluding diesel, our comp store gasoline gallons were down a more manageable 4.4%.

While miles driven in our markets in Jan and Feb improved to be down only 2.4% versus a Q4 decline of 6.3%, our region still trailed the national average, which showed miles driven down 1.9%. Our gasoline gross margin was relatively strong for the second quarter at $0.112 per gallon, which is up $0.022 from the $0.09 a year ago. Our gas margin last year, as I alluded to earlier, was reduced by $0.016 by losses on gasoline hedging transactions. Even excluding that, our gas margin was still up six-tenth of a cent.

During last quarter's conference call, we said we expect to see improved performance in gasoline comp sales as we move through the fiscal 2009. We've started to see signs of that this quarter.

In the past five weeks of Q3, both gasoline gallons and merchandise comp sales have been positive. However, gas margins continuing to-date have been challenging due to the rising energy costs. In Q3 last year, we saw retail gas prices spike toward more than $4 per gallon and the gas price peaked last July, which clearly impacted both our merchandise and gasoline volumes a year ago.

We anticipate gas prices will remain much lower than last year in the coming months, but expect that challenging economic conditions might limit the benefits we could receive from having substantially lower gasoline prices.

We continue to work with our merchandise suppliers to ensure that over this summer we have competitively priced offerings that will allow us to maximize sales for the customers visiting our stores. Earlier this month, we announced the signing of a definitive agreement to acquire 40 convenient stores, primarily in the Mobile, Alabama market. This transaction fills in a gap in our existing store base, and was negotiated at relatively favorable returns for our shareholders.

While there will be some initial onetime remerchandising and other integration expenses in the short term, this deal should begin contributing to our bottom-line and we expect it to be accretive in its first full year after closing.

At the same time, we also announced that we repurchased $26 million in principal amount of outstanding bonds during the second quarter. We bought back $23 million of our convertible bonds and $3 million of our senior subordinated notes for an aggregate price of about $19 million, generating a pre-tax gain that is more than $7 million.

As we noted at that time, we consider both the pending acquisition and the bond buybacks to be great examples of our strategy, which balances growth with de-leveraging the business. We will continue to consider opportunistic acquisitions that are priced right and fit well within our existing store base. When it makes sense, we will continue to explore opportunities to reduce debt.

With that, I'll turn it over to Frank, who will review the numbers in greater detail. Frank?

Frank Paci

Total revenues for the quarter were $1.3 billion, down 35.5% from last year's second quarter, primarily due to a huge drop in gasoline prices. Our total gross profit was up 5.7% from a year ago to $200.3 million. Merchandise gross profit increased 1.6% and our gasoline gross profit rose 18.1%.

On the merchandise side, total revenues were up 2.4% and comparable merchandise sales increased 1.3%. Merchandise gross margin for the quarter was 37.2% compared with 37.5% in last year's second quarter, but up significantly from the 35.5% in the first quarter.

As Pete mentioned earlier, cigarettes had a positive impact on both merchandise sales and gross margin in the quarter. We saw manufacturers increase cigarette wholesale costs in early March in anticipation of the higher Federal Excise Tax related to the SCHIP program and passed along these cost increase to our customers.

As you might expect, we saw unit sales volumes decline, but still saw an increase in total sales. Margins increased as well as we sold some cigarettes at higher prices that were in inventory at lower historical costs.

As part of the SCHIP tax increase, we were required to pay $0.62 per pack floor tax on all cigarettes in inventory on April 1. We took aggressive action to reduce our inventory so as to minimize the impact of the floor tax, but still expect to see some adverse margin impact in Q3 as we sell some cigarettes that were acquired at the higher costs, but also incurred additional costs related to the floor tax.

We also anticipate slightly higher than normal LIFO charges as a result of higher cigarette inflation. We anticipate that cigarette margins will normalize at approximately 1.5% to 2% lower than last year and we believe the impact on our overall merchandise margin will be approximately 60 to 90 basis points.

In addition to the improvement in cigarette margin, we saw improved packaged beverage margins as a result of our 2009 reset. Finally, we were able to reduce merchandise shrink by approximately 50 basis points as a result of our increased focus in operating efficiency.

In the gasoline business, retail gallons sold for the quarter were down 4.9% overall and down 6.4% in comparable stores. Total gasoline revenues for the quarter declined 44.2%, primarily due to the 40.6% decrease in the average retail price per gallon from $3.10 a year ago to $1.84 in this year's second quarter. Our retail gross margin per gallon was $0.112 compared with $0.09 a year ago.

As most of you know, we report our gas margins net of credit card fees and equipment maintenance costs, which were $0.04 per gallon in this year's second quarter compared to $0.055 a year ago. We also saw credit card utilization decline further, from 60.3% to 57.4% sequentially and down from 60.7% a year go.

As I mentioned earlier, we've increased our focus on driving operating efficiency and this quarter delivered favorable results in store operating expenses, which came in at $126.7 million, slightly less than last year. These results were achieved despite higher utility and property tax expenses as well as additional expenses related to the ongoing rollout of our new POS system.

The most significant improvement in costs was in store labor expenses driven by the implementation of the first phase of our workforce management initiative. This program is targeted to improve the alignment of our labor staffing with sales volumes and to eliminate inefficient labor hours without impacting customer service.

With the help of this initiative, we were able to reduce labor costs on a per store basis by 4.6% this year in Q2, despite experiencing higher average hourly wage rates. We've also been able to reduce expenses in cash controls and general liability insurance.

Our general and administrative expenses for the quarter were $23.9 million, up $1.1 million, or 4.8%, from a year ago. This increase was due mainly to higher bonus accruals, as this year our performance is much better than last year's performance to-date.

Depreciation and amortization expense was $26.3 million, down 1.9% from a year ago. Net interest expense for the quarter was $20.9 million, down almost $1 million or 4.5% versus last year. We also had a $6.7 million gain on the extinguishment of debt during the quarter related to the bond repurchase.

Pre-tax income for the quarter was $9.3 million compared with an $8.6 million pre-tax loss in last year's second quarter. The tax rate for the quarter was 31.8%, which reflects the recognition of various income tax credits.

Net income was $6.3 million or $0.28 per diluted share compared with a loss of $5.1 million or $0.23 per share last year.

EBITDA for the quarter was $49.8 million compared with $40.1 million a year ago. Net cash provided by operating activities was $18 million compared with $4.9 million in last year's second quarter.

For the first six months of fiscal 2009, our earnings per share were $2.06 compared with a loss of $0.08 per share in last year's first half. EBITDA for the six-month period was $161.6 million, an increase of more than 70% from $93.7 million a year ago.

Net cash provided by operating activities was $106.9 million compared with $31.2 million in the first half of fiscal 2008.

We finished the quarter with $242.8 million in cash and cash equivalents, down only about $12 million from the end of our first quarter despite the use of almost $20 million to buy back debt. So far this fiscal year, we have reduced our outstanding debt and lease finance obligations by $53 million while increasing our cash position by over $25 million.

In addition to the cash on the balance sheet, we also have approximately $145 million available under our revolving credit agreement after considering outstanding letters of credit. Capital expenditures for year to-date are $37.6 million and we now feel that capital spending for the year will be between $100 million and $105 million.

During the quarter, we acquired two stores, opened one new store and closed four stores. We still expect to open a total of four new stores in fiscal 2009.

In this morning's press release, we updated our guidance ranges for fiscal 2009. Our new ranges include the expected impact of the increase in cigarette taxes. We've increased our target range for merchandise sales to between $1.62 billion and $1.66 billion. We've reduced our expectation for merchandise gross margin to between 35.4% and 36%.

We now expect our range of retail gas gross margin to be $0.14 per gallon to $0.155 per gallon with retail gasoline sales between 2.02 billion and 2.05 billion gallons. Total store operating and general administrative expenses for fiscal 2009 are expected to be between $617 million and $623 million.

Depreciation and amortization expenses are expected to be between $105 million and $170 million with net interest projected at $83 million to $85 million. None of these estimates include our pending acquisition or any other potential acquisitions.

With that, I will turn it over to Pete for final comments.

Pete Sodini

I believe this concludes the formal portion of the presentation. Now, we'll turn it over to the operator for any questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of John Heinbockel with Goldman Sachs. Please proceed.

John Heinbockel - Goldman Sachs

Obviously, the merchandise comp is showing some life, gallons are not. As you see the consumer in your markets, is there any sign that we've bottomed and are seeing some better behavior out of your consumer? How low do you think gas prices have to go to see some improvement in comp growth gasoline?

Frank Paci

We've seen certainly seen an improvement so far in Q3. This quarter so far we're actually positive in gallon comps, including diesel, which has continued to be a drag. So, we've certainly seen that metric improve here within the last two months.

Again, this is what we said in our last call, is we expected as we move through the year and the comparisons got easier, we'd start to see that. Obviously, the difficult piece is where is the economy, in general, going? If you see the economy in general bottom as we've talked about as we start going against these really high gas prices last year, I think there is an opportunity there.

Pete Sodini

The one specific we look at closely is the Department of Transportation miles driven. That has continued to come down from last year. We're seeing some benefit off of that.

As Frank mentioned, our comps on gasoline this quarter are slightly positive. Diesel has been a laggard, but as you're well aware, diesel is the leading indicator when you are getting into a recession or whatever we're calling it. Conversely, we think it will be one of the positive ones whenever this thing bottoms out and you start to see some economic rebirth.

John Heinbockel - Goldman Sachs

Stripping out the excise tax impact, the merchandise comps improved also in the third quarter?

Frank Paci

Yes. They've improved versus what was in Q1 very similar to the trend that we've seen quarter to-date similar to what we've got in Q2.

John Heinbockel - Goldman Sachs

Secondly, what do you do with your cash forward? Probably difficult to buy back a lot of debt as much as you'd like. So when you look at acquisitions, what's the volume of interesting assets that are coming in front of you? Are a lot of those major integrated oil companies getting out of the retail business?

Pete Sodini

We continue to see an increase in the number of things coming before us. Some of them, like the Mobile acquisition, we think are being acquired at an attractive price and it fits geographically very nice into it. We see a lot of other stuff. One way that I can describe it is trashed or distressed, and we don't spend a lot of time on it.

As far as oil company divestitures, the only one announced that's going to impact our region would be the Exxon proposed divestiture in the South, and we assume the South probably means Memphis, Nashville and Charlotte. That originally was going to be up in the first quarter this year. It's been delayed.

I think we anticipate now seeing it sometime late May, June, but, obviously, they control the schedule. We'll just have to wait and see when that comes out. We compete in or near a number of those assets and those would be considered substantially better assets than we are likely to see in terms of typical physical plant location, et cetera.

John Heinbockel - Goldman Sachs

Will the price be right?

Pete Sodini

They don't comment on price expectations but I think that will be determined by the marketplace.

John Heinbockel - Goldman Sachs

If you don't do any deals for sometime here, is it going to be more because the quality is not there or the price is too high?

Pete Sodini

No, it is going to be the former, because the quality is not there. There are not a lot of buyers in this market, quite frankly, because of the same reason everybody else sees, and that is the general condition of the banks putting money into this channel or a lot of other channels. That probably gets better somewhat as you move towards the end of the calendar year.

Right now, the only ones that have been active recently in our market are we and Couche-Tard. You saw their release last week, I guess, on some of the Exxon dealer assets. So, not a lot of competition there for assets. At least, that's been our experience thus far.

John Heinbockel - Goldman Sachs

So it sounds like the cash balance is going to be large for a while. It's going to sit there and it will earn a little bit of a return, but this is really not a good outlet short term for a lot of that money.

Pete Sodini

As we sit here today, we don't see anything compelling that's on the market that we would say is large character.

Frank Paci

There is smaller stuff out there, John. Yes, nothing that would suck up all of the cash that's out there.

Operator

Your next question comes from the line of Simeon Gutman with Canaccord Adams. Please proceed.

Simeon Gutman - Canaccord Adams

The question related to the previous one to some degree. You nudged up the merchandise revenue guidance a bit, even a little bit more so than the gallon guidance. What are you seeing, and what are going in the assumptions there? Is the same number of velocity coming to the store, just feeling a little bit better about buying a couple of more items? Are there any particular merchandising strategies that are built into the merchandise revenue forecast?

Frank Paci

I think a combination of a couple things. One, obviously, we've talked a little bit about the improved trend in gas gallons. Obviously, that means you're getting some better improvement in terms of people coming to the store. Some of that is our experience was better than we had forecast previously. So we factored in both those effects.

There are things that we're improving. One of the areas we have our offerings improved is in our take home, noncarbonated beverages where we've got a better offering in waters and a better offering in ready to drink teas lined up for this year. So we've improved some of our offerings as well. So, a combination of all of those things factor into that.

Simeon Gutman - Canaccord Adams

The increase is more or less based on what you're seeing today as opposed to a little bit of optimism that some of these strategies will play out successfully over the next several months?

Frank Paci

I would say it's a combination of our experience today as well as obviously there is an impact from cigarette pricing.

Simeon Gutman - Canaccord Adams

On the gasoline business, especially if you take gallons modestly up so far for this quarter, even if they are flat again in the fourth quarter, you should be probably north of your guidance on the gallon basis. Is there conservatism in there or is there something maybe about the summer driving season that is working for you to stay conservative?

Pete Sodini

I think two things. One, when we come into the fourth quarter we always tend to be cautious on our guidance. You're getting into hurricane season. No one, including the federal government, has been very successful in forecasting either the number or the impact of those.

We think that we have seen some firming up of gasoline. The interesting question for us is last year was an abysmal year on the coastal resort venues that we dominate going down the coast, starting with Wilmington, Myrtle Beach and down through Hilton Head and the Northern Coast of Florida.

So the comparative with last year is not too strong we think, because clearly people stayed away or greatly reduced their vacation expectations a year ago. This year, based on some early holiday visitations in places like Myrtle Beach and Charleston, one could be inclined to be a little more optimistic because the numbers last year were so weak.

So, I think we're reasonably optimistic going into the summer session. We are not looking for a boomer though in terms of resort business. Last year was so weak that the comparative should be better.

Operator

Your next question comes from the line of Mark Miller with William Blair. Please proceed.

Mark Miller - William Blair

I was wondering if you thought you might have gone too far towards having a stronger gas margin and perhaps giving up some volume in the quarter with trail length of miles driven, or just you're probably talking about how you are balancing that tradeoff. I know there is improvement in the gallons this quarter, but do you think you will be up as much as the miles driven?

Pete Sodini

If you take one component that we mentioned, the diesel component, which in prior years it was so consistent in our business that we didn't give it much discussion. If you look at the amount that we talk about diesel gallons being down, primarily coming out of the truck stops, primarily because of slowed economic activity, that's a huge item to us and it is a leading indicator. We would think that would be one of the first things that would reflect a stronger economy if and when that happens.

Also recognize that with the problems that Flying J has had with their Chapter 11 filing, they were traditionally a very aggressive pricer on diesel. Customarily, we would look at maybe $0.07 to $0.08 margin at our truck stops, but composite for the second quarter on diesel for us and we would maintain we were very competitive at our truck stops. It was about $0.232.

So, some of the inflation you see in the CPG is coming from diesel. We don't think we have to do anything more to maintain our competition there. You've got the unusual world where those margins are very high at truck stops, and thus, give us some upward bias.

So, our competitive posture in terms of gasoline is about where it's always been if you look at that compared to what we call our comp ones. That's not likely to change as we go forward. It's always worked for us. The way we look at the gasoline business is there is some balancing out between margin and gallons because we have such a large presence in some of these markets.

We think we're, we have been and will continue to be priced right on gasoline, and we will let the economic activity take care of our biggest problem right now, which has been diesel, although it is a very profitable item at the moment.

Mark Miller - William Blair

You partly answered my next question, which was then on the upside at least versus our expectations on the CPG. I was wondering about ethanol blending. I know you don't want to give a lot of detail there, but could you qualitatively comment on that lift? Are we near the peak of the year-to-year benefit from that or do you have further to go there?

Pete Sodini

No. There is very little to be said about ethanol. It's absolutely the horrid margins. We aren't doing any blending on our own right now because the economics aren't there. The economics have not been there for the last six, seven months. All you've got to do is look at the ethanol industry as a separate and look at the number of bankruptcy filings.

VeraSun, which is the third largest, bellied up in the fall. That's a very unhealthy industry even with all the government subsidies and tax benefits. So we don't know right now where ethanol is going. We follow the market regularly. It is traded, so we can keep a pulse. We haven't seen any upward emphasis in terms of margins nor do we forecast any coming from the ethanol here.

Mark Miller - William Blair

On the workforce management initiative, your element for operating expenses is basically the same at the midpoint even as the merchandise revenues and gallons are going higher. Can you talk about where you're seeing better gains from those initiatives? When you make acquisitions, can you talk a little bit about the ability to implement those systems into the acquisitions, and does that give you potentially higher levels of accretion than you had before? Is it meaningful?

Pete Sodini

Our ability to integrate these stores quickly, we talk about 30 days, and we deliver those time frames. It has a material impact. Our model that we use assumes that and it's invariably realized. This one we're talking about now certainly is no different. We think there are significant synergies based on us looking at his operation in great detail, how he buys product, where he gets it from, et cetera, as compared to what we do. We also have an infusion of private label. He, like most small operators, has virtually none. Those synergies are no different now in terms of our anticipation than they were last year or the year before.

Brad, can touch on the labor system that we've employed and continue to ratchet up into our operation.

Brad Williams

We were very optimistic with the labor workforce management work that we've done thus far. We're really excited about the preliminary results. We expect in the following quarters to continue to realize benefits from that new labor model as well as the new labor scheduling tool that we put into place throughout the company, in both the C-store division, truck stop division as well as our food service operations. So that's phase one. We plan to get into phase two in our third quarter and have that launched in the fourth quarter of our fiscal year.

Pete Sodini

The other thing that's helpful, I think we may have mentioned it last quarter, Brad has taken his field operations. We have, for the first time, broken out truck stops other than conventional operations and it has its own district and hierarchy now. The focus of those people is strictly on truck stops, the merchandising and operation.

Whereas in the past, we've used whatever district it fell into, the DM would pick that store up. I think doing that, we recognized the fact that truck stops are an entirely different animal, and if you want to run them properly and get the maximum profit and cash flow out of them, they have to be run as a specialized function. We've done that last quarter.

Brad Williams

I think part of this is part of a continuous improvement process that we've had, which started in the fall of 2007. We reorganized the field management. Last August, we eliminated some of the administrative tasks that the field was performing, which actually released some additional hours for field management.

We've invested in the workforce management initiative. We've also seen improvement in cash controls and other areas of our operation. So I think it has actually been a coordinated effort to really kind of attack our expense lines, knowing that the economic environment was going to be challenging. We continue to see benefits from that.

Operator

Your next question comes from the line of Karen Howland with Barclays Capital. Please proceed.

Karen Howland - Barclays Capital

I was wondering if you had actually given the impact in this quarter in your guidance for the rest of the year of what the cigarette tax contributed to the 1.3% comp.

Frank Paci

It's difficult because there has been multiple price increases in the past year. If you look at the summers, there was a price increase in early March. Obviously, it did not have a huge impact because our fiscal quarter ended March 26. So there is some impact, but it's not as big as on the ongoing forecast because it was really only two weeks.

One of the other things we did as well during the quarter is as part of managing the inventory, we actually eliminated some SKUs of cigarettes that we carried and we discounted those cigarettes to help them move out. So there is a whole lot of moving pieces in there.

Karen Howland - Barclays Capital

Maybe I should phrase it another way. Of the 1.3% comp, how much of that was cigarette overall compared to the rest of the in-store?

Frank Paci

If you look at in-store excluding cigarettes, it was negative 0.8% versus in Q1 it was a negative 3.9%. So you actually saw a 3.1% improvement in non-cigarettes.

Karen Howland - Barclays Capital

The increase in the merchandise sales for the year, the majority of that is coming from cigarette price increases.

Frank Paci

I'd say that certainly the majority of that's coming from cigarette price increases, but there is certainly some contribution from the non-cigarette area as well.

Karen Howland - Barclays Capital

What other categories are you seeing improved outside of that cigarette increase?

Frank Paci

We've seen some improvement in the food service area certainly as we've rolled out additional hotdog grills. We've also seen improvement in our other tobacco products and some of that may be people trading down from cigarettes into other tobacco products.

Karen Howland - Barclays Capital

Grocery and categories like that still remained under pressure?

Frank Paci

Other tobacco products are in our grocery category. We're changing some suppliers in the grocery category, especially in our packaged sandwich area. So we've actually had some areas that have declined, which we think will come back. We've actually seen an increase in some non-carbonated areas and in some fountain, as well.

Karen Howland - Barclays Capital

The acquisition is not at all included in your guidance, right, the acquisition that you guys have announced but haven't closed yet?

Frank Paci

That's correct.

Karen Howland - Barclays Capital

Is it reasonable to assume that those stores have similar metrics on a top-line basis to your existing stores, so $1 million to $1.2 million on gas gallons and about $1 million in dollars of in-store sales?

Frank Paci

They are actually very similar to our average store base in terms of merchandise sales per store, gas gallons per store, square footage per store. There are six Subways that are in that portfolio as well. So it's actually very similar to kind of what our average portfolio looks like.

Pete Sodini

It's almost a mirror image from a competitive standpoint to what we experience in Birmingham, Tuscaloosa, Montgomery markets, a fragmented market, predominance of branded competitors, a lot of dealer business in the market. We looked at this thing obviously very closely, particularly from a competitive standpoint.

The good experience we've had in Birmingham, Montgomery and Tuscaloosa Circle will be a mirror image of what we get in predominately Mobile, Alabama, good healthy economy, new business coming in, large manufacturing coming in, huge steel plant just 20 miles north of the city. The Deep South continues to track some very solid, large businesses because of labor conditions and government assistance.

Karen Howland - Barclays Capital

What sort of investment is going to have to go into these 40 stores? Are they going to be converted to Kangaroos to get them up to your standards?

Pete Sodini

I'll take it in two parts. One, gasoline, their current brand is Shell. We are working with Shell now. We have a little bit of a relationship with them in Northern Mississippi. We have none anywhere else. Good brand in that market, good supply profile. So we would be hopeful we would work something out with them.

On the boxes, the merchandise component, they will be called Kangaroo Express. As we've done with all other acquisitions, we model to spend a little bit of capital in these stores in terms of freshening up, bringing in some equipment that they may not have because they don't sell that type of merchandise.

To get them up to a good spec, it is not an inordinate amount of money because these stores are not in terrible shape. We, at a minimum, spruce up these stores and put the requisite equipment in that we need to run our programs.

Karen Howland - Barclays Capital

Is it safe to say that the investment in the stores would be $100,000 per store?

Frank Paci

I think we've estimated it at about $3 million in total.

Karen Howland - Barclays Capital

$3 million total?

Pete Sodini

Round numbers, yes.

Karen Howland - Barclays Capital

You said that it's going to be accretive in the first 12 months from when you close or after the first 12 months?

Pete Sodini

No. I thought we made it clear, in the first 12 months, total. We always have some initial expenses while you're transitioning the merchandising program.

Frank Paci

Doing training and things like that.

Pete Sodini

Those are not horrific. We expense them as we incur. We're very confident that 12 months post our takeover that these stores will be accretive. That's the way we've modeled them.

Operator

Your next question comes from the line of Ben Brownlow with Morgan Keegan. Please proceed.

Ben Brownlow - Morgan Keegan

Can you give me a little bit more color? You've touched on it a little bit, but a little bit more color on which markets are starting to pick up and which ones are still weaker than the company average?

Frank Paci

If you look at it, one of our best performing markets has been the Alabama market. We've had big merchandise comps in that market. Georgia has actually been favorable. From a gas standpoint, Florida has actually been our best performing market, although its struggled a little bit on the merchandise side and primarily because cigarettes haven't performed as well in Florida as some of the other markets.

Alabama has also outperformed on the gas side if you exclude diesel. Part of the challenge in this, when you look at our truck stop locations aren't necessarily proportionally around by the different states. So there is a higher preponderance of truck stops in Alabama than there is in some of our other states. As a result, that has a negative effect. If you look at gas excluding diesel, the top performers would be Florida, which is down 1% in the past quarter, and Alabama, which was down 2.3% last quarter.

Ben Brownlow - Morgan Keegan

I think I missed something, the credit card fees per gallon?

Frank Paci

Credit card fees were $0.04 including the maintenance.

Ben Brownlow - Morgan Keegan

Then just cigarette volumes, where are you seeing those trend?

Frank Paci

I think we're still in the settling out process. There has been a lot of price movement around and we've actually just completed the competitive surveys, looking at how we're priced competitively. In some places, we're kind of adjusting our prices in both directions. So I think it's a little bit early to tell.

As we anticipated early, the declines would be a little bit steep. There was a little bit of pantry loading in advance of the taxes. So we're seeing volumes down a little bit more than double-digit. We expect longer term that will bounce back. The price increases right now are in the mid 20s in terms of how much the prices are up.

Pete Sodini

We were told by the major tobacco companies that using the Texas market three years ago as a surrogate, where they put through a $1 tax increase on cigarettes that we would see initially first eight weeks double-digit negative comps. As it follows the profile of their experience in Texas and we think it probably will, then those mitigate and there is some ensuing movement back towards the branded cigarettes, top brands and away from what you might generally call the generics.

Clearly, an increase of this kind is going to have some impact. It also has an impact on some of our competitors outside of our channel. That's always been the case.

So we would expect that more people will now buy packs versus cartons. Once they make that decision, the pack customer is largely in our domain, ours being the channel, because we are a hell of a lot more convenient and competitively priced. If you're going to go to one pack, you are not likely to go to a supermarket or a Wal-Mart or a Costco or anybody else. You're going to migrate to the C-store channel. If you look at trend lines for the last 20 years, we've been a net beneficiary of higher prices and more regulation as people reduce to a pack purchaser versus a carton.

Ben Brownlow - Morgan Keegan

Along those lines, given the trade down from the carton to the pack, can you just go back and kind of recap why you're giving the merchandise margin guidance that you're giving? It just seems a little conservative. I know there are some LIFO charges, et cetera, but can you just recap that?

Pete Sodini

As Frank alluded to, there is a lot of noise in the numbers none of which we control in the Feb, March timeframe. So if you view what we said as being guarded or somewhat conservative, we are in unknown territory here with the magnitude of the lower tax that went in at the end of March coupled with the Fed tax April 1, which followed an increase by Phillip Morris late February, March.

Frank Paci

Right. On April 1, which occurred during this quarter, we had some inventory which had price increases that also got hit with a $0.62 tax increase. So you do have a little bit of extra expense while you burn through that inventory this quarter. The other part of that is we are forecasting a little bit of additional LIFO expenses because of the magnitude of the price increase.

Part of what we're trying to do to minimize that is manage our inventory, but that could be in the neighborhood of $2 million to $3 million in costs, which is a non-cash charge but will run through our margin line. So that may be why you think those numbers look a little bit conservative, but there are some things in there that do have a little bit of a bounce back in Q3.

Pete Sodini

I also think if we allow May and June to pass-through, by July we would think the category has settled out and we can give much better perspective on where we think its going.

Operator

Your next question comes from the line of Anthony Lebiedzinski with Sidoti & Company. Please proceed.

Anthony Lebiedzinski - Sidoti & Company

Just to touch base on the cigarette issue again, did you guys see any surge in people buying cigarettes towards the end of the quarter ahead of the Federal Excise Tax, if you could maybe quantify the impact of that?

Pete Sodini

We can't quantify it, but there were some people who were loading up. Some of those people on interstate locations could have been people from our sister state, New York or Jersey, all who have high taxes. That's why we would prefer not to try to make too many forecasts off what's been going on because we've had a period of very atypical activity and we got to give the consumer a point to rest and reassess.

Those who still have the addiction reassess how they want to govern the rest of their life and what brands they want to buy and what quantities they want to buy in. All we can go on is history. The history suggests that when you raise the category to the extent that it has been raised, that generally it's going to impact consumption.

Frank Paci

My guess is it was more limited than it would have been because of the early adoption of cost increases by the cigarette manufacturers in anticipation of that. So if you were waiting till the last minute, you already saw higher prices out there in the marketplace.

Anthony Lebiedzinski - Sidoti & Company

I was wondering if you guys intend to purchase back any more debt. Is that factored into your guidance for interest expenses?

Frank Paci

There is no anticipation. We are treating the debt like we are our acquisitions. Obviously, once we do it we will factor it in. A lot of that will depend on the market conditions. The debt markets have strengthened recently which makes it less attractive to do that, but we'll continue to explore options in that area.

Anthony Lebiedzinski - Sidoti & Company

You mentioned that your tax rate was a little bit lower because of some tax credits. What's your anticipation for the rest of the year for your tax rate?

Frank Paci

There is an ongoing small tax credit. Part of the magnitude this quarter was because the income number was not that high. On an ongoing basis, we expect our tax rate will be in the 38% range on a net basis.

Operator

Your next question comes from the line of Karen Short with FBR Capital Markets. Please proceed.

Karen Short - FBR Capital Markets

Sorry to belabor this whole tobacco thing, the LIFO that you just called out, LIFO expense $2 million to $3 million, that's just in the third quarter or split between the third and the fourth?

Frank Paci

It will be split between third and fourth.

Karen Short - FBR Capital Markets

So then you would also expect that in the first and second next year?

Frank Paci

No. The way we treat LIFO in the business, and we've always had LIFO in there, it is phased in through the fiscal year. And we true it up at the end of the fiscal year. If you remember last fiscal year, we took a larger than expected charge at the end of the year to true it up at the end of that year. Once you close that year off, you create a new layer on a go-forward basis.

So, no, that will only be for the balance of this year.

Karen Short - FBR Capital Markets

So what's the total LIFO charge expected in dollars for the full year?

Frank Paci

It would be $3 million for this. Typically, LIFO runs about 40 basis points as a drag on our margin each and every year, but that's always in there. This is on top of those 40 basis points.

Karen Short - FBR Capital Markets

What are you seeing in terms of inflation in the rest of the categories? I would have expected there to be more deflation than anything.

Frank Paci

Not yet. You haven't seen it yet. This gets into one of these challenges. We talk with our suppliers. Last year, a lot of the candy manufacturers, the packaged beverage manufacturers, carbonated soft drinks, beer, have all passed through price increases based on higher commodity costs last year. We haven't really seen a rollback on any of those. I think some of the issue is that people got concerned about these prices, and so they went out and hedged forward some of these costs.

So, even though commodities have come down from their peaks last year, I think in some instances they are still higher than they were at this time last year. I would expect that you won't see major price rollbacks on that, but what you would see is if commodity costs stay lower you will see some additional discounting to drive volumes.

Pete Sodini

The question is do we see deflation and the answer is no. Do we see the potential for increased promotional activity on the part of vendors, the answer is yes.

Karen Short - FBR Capital Markets

Just to clarify on your comps this quarter, your gallon comps are positive, including the negative impact of diesel and your merchandise comps are also positive. Would they be positive excluding tobacco?

Frank Paci

Again, part of that is difficult to tell. It would probably be closer to where they were last quarter without tobacco. Excluding tobacco, they are just slightly negative.

Karen Short - FBR Capital Markets

On tobacco again, can you just remind me what the difference is in the margin between a carton and a pack? Also, can you maybe talk a little bit, what's your price differential on a carton with, like, say a Costco?

Frank Paci

Again, on the carton prices, I'm not sure that I know that one off the top of my head in terms of our prices versus a Costco where our carton price would be. They are going to be higher because part of our strategy is based on convenience. In terms of carton margins versus individual pack margins, carton margins will be five to six points lower than what your pack prices would be.

Karen Short - FBR Capital Markets

I was just wondering could you give us an update on where you stand with the QSR opportunities in terms of rolling out additional Subways. I know you talked about that in the past a little bit.

Frank Paci

I think one of the things that's happened this past year, as you know, last year we pulled back on capital. As a result of that, we deferred some projects last year. We've now kind of started ramping those back up again this year. We've already purchased additional Subways and we anticipate opening in the neighborhood of around 18 this year.

We have upped our targets as we look at fiscal 2010 to see if we can do more of those. We've certainly got a favorable response from Subway. I think part of this is that because of the economic conditions, they are looking at us because of our cash and our ability to open stores versus individual franchisees, who may have difficulty accessing funds.

Pete Sodini

We pick up how many in Flamingo?

Frank Paci

We'll pick up six in Flamingo.

Karen Short - FBR Capital Markets

How many Subways do you have now then?

Pete Sodini

We've got 108 now.

Frank Paci

Right. We've got another two that are scheduled to open this coming week.

Karen Short - FBR Capital Markets

Does your CapEx include the acquisition or is that excluding?

Frank Paci

The CapEx does not include the acquisition because we don't know exactly when it's going to close.

Karen Short - FBR Capital Markets

Could you give us some comments on succession thinking? Pete, sorry, you're leaving.

Pete Sodini

No. I think we've included and explained it in the release. We've got a search committee of the Board. We expect the process to be wide ranging and fully anticipate having somebody in here prior to my departure on September 30.

Operator

That concludes the presentation for today. Thank you for joining and have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you!