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On May 1st, Valero (NYSE:VLO) shareholders will receive one share of CST Brands (NYSE:CST) for every nine shares of VLO they own. CST presents Valero shareholders a unique special situation investment, and it might also present investors with a unique entrance point for the company.

Business Background:

CST operates 1,900 independent motor fuels and convenience stores in United States and Canada.

As of December 31st, 2012, CST had 1,032 convenience stores in nine states located predominantly in the southwestern U.S.

As of December 31st, 2012, CST had 848 retail sites in six eastern Canada provinces including 261 convenience stores, 507 filling stations and 80 cardlocks.

I will not go too much into detail the economics of a gas station/convenience store. The business model is quite simple, and the competition is pretty intense. The margin on the gasoline is bare to none, and it's a heated price war. No one with their right mind would want to be in a business like this one, and that is one particular reason why this is a special situation.

Special Situation Catalysts:

As I explained earlier, the economics of a gas station/convenience store is horrid. Profit margin is so slim, and the buildup cost for a gas station/convenience store could range from $1 million to $1.75 million depending on the structure. There are a lot of environmental regulations that are involved with operating a gas station/convenience store, so the yearly maintenance cost could be hefty.

But here's the catch:

Catalyst number 1: (Long-Term Motor Fuel Agreement with Valero)

Just like any other gas station/convenience store, the primary money maker is gasoline. It's simple and it's easy to understand. The convenience store buys the fuel from a supplier, and marks up the price, then sell it off to consumers. However, in CST's case, they have a long-term motor fuel agreement with Valero. While the details of this agreement weren't disclosed in the Form 10, I am going to speculate that the terms won't damage CST's profit margin in anyway.

If we think about this through the executives' minds, what and how would they have arranged this agreement? If Valero was already supplying fuel to CST prior to the spinoff, then the profit margin on the fuel must have been adequate enough for CST to remain profitable. So why was it that they needed to spinoff CST? Simple, they wanted the two capital intense businesses to be separated so that they can pursue their own growth plans. Now with that being deciphered (or told because they said that in the form 10…), let's continue to speculate on what the terms could be.

If Valero maintains a stake of 20% in CST until a later date (disclosed in Form 10), then we can reasonably assume that Valero wants the market to fully assess what CST is worth, and in no way do I see the Valero team present CST with disadvantageous fuel terms. So putting that speculation on the side, I am going to reasonably assume that this long-term motor fuel contract will be advantageous for CST, and it will give it a competitive advantage over the other convenience stores.

Catalyst Number 2: (Institutional Investors will sell like Hot Cakes)

You would think that institutions conduct a lot of due diligence before buying and selling a security, but not in the case of a spinoff. To bring up an idea from my favorite book, "You can be a stock market genius," by Joel Greenblatt. He said that institutions most of the time will sell regardless of the investment merits. Let's take a look.

  1. The new spinoff company could be operating in a different industry. CST operates in the retail industry, while Valero is a refiner company. The two are in completely different industries despite having gasoline as their common profit maker.
  2. The company could be considerably smaller. CST will have a market value of roughly 2.41 billion. This is derived from the calculation that for every 9 shares, investors will receive 1, which equates to roughly 11.11% of the parent company's market value, 21.7 billion. This could prompt a lot of institutions to sell.
  3. Lastly, CST isn't in the S&P 500 index fund. The parent company, Valero, is included, but because CST will be given to investors in Valero, many institutions following the S&P 500 will dump the stock right away.

The three reasons I presented could cause negative selling pressure on the newly issued CST common stock, but just like any assumptions, these could prove brutally false.

Catalyst Number 3: (Valuation)

CST is currently trading on a "when issued" basis, and as of 4/19/2013, the stock was trading at 29 per share. That gives it a market cap of 2.204 billion with 76 million shares outstanding. Let's take a look at the financials now.

This here is the company's pro forma income statement for CST.

(click to enlarge)

The pro forma EPS number would be 2.12 with an EBITDA of 344 million. If we look at a very close comp, Casey's General Stores, Inc (NASDAQ:CASY), we can clearly see that based off of CASY's valuations, CST will be undervalued.

(click to enlarge)

If we average the four prices, we arrive at a price target of 35.26. This implies a 21.58% return on investment if an investor were to buy the "when issued" shares. However, like I stated earlier, if institution investors were to sell off, then the entry price could be much more rewarding.

Risks:

Just like any investments, there will always be risks associated with it.

After the spinoff, CST will carry a new debt load of 1.04 billion payable to the parent company. The annual interest expense is calculated to be 43 million, and the interest coverage ratio is at a healthy 6.58.

So what does the downside look like? If we think about it from an asset view point, the company has 1,900 convenience stores, and they own roughly 81% of them (includes land and building/infrastructure), which equates to roughly 1,539 stores. If the average cost of building one is $1 million to $1.75 million, the underlying assets could be worth between 1.539 billion to 2.693 billion. These land assets will give the investors that margin of safety in case of economic turmoil, while also generating a steady stream of cash flow.

Conclusion:

An investment thesis shouldn't be too complicated to explain. I believe that the three scenarios I laid out in this article should present an investment opportunity for investors. The investment return, however, is completely dependent upon if institutional investors will sell off their shares and create that selling pressure Joel described in his book. If the scenario plays out and the share price goes down to the 25 range, investors will be more than compensated to take the risk.

Source: Special Situation: CST Brands