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TravelCenters of America has provided outstanding operation leverage, possibly even greater than any company we have reviewed. This includes Adam’s Resources, whose equity has performed extremely well since it was included in our High Cash Stock Review portfolio. We have been following TravelCenters of America for awhile, knowing that the lease from its parent company seemed to be financially prohibitive and was penalizing its market valuation.

The company showed an extremely strong quarterly improvement and forecast a profitable net income for 2011. Despite broad industry weakness and weaker competitors, TravelCenters is poised for a potential multi-year improvement cycle while others are leaving the market. The company performed extraordinarily well last quarter with surprisingly strong execution, and the per share earnings exceeded expectations, especially considering the recent dilution.

Operations

Company operations, judged by profits per share, increased 14 times. Non-fuel sales saw a nice increase in sales and prices, with margins remaining about the same. Although fuel sales had a slight 4.3 % increase, the profit margin was reduced. Both the non-fuel increase and the fuel margin helped improve profits to 0.99 cents per share in the quarter, versus 0.07 cents for the same quarter the previous year.

In the new lease agreement, costs classified as rents decrease $10.7 million in this quarter. This newer agreement also changed interest rates to 0% from 1% a month, which reduced interest expenses by about $2.2M for the Q2 2011. With both improvements exceeding our rosiest forecast, we believe the execution and cost savings are sustainable. We also believe the cost savings of the most recent quarter have an extremely high probability of recurrence, and that we will continue to have quarterly improvements of similar magnitude impact the remainder of this calendar year. Together, these two factors should have about the same improvement year over year for each quarter of 2011.

Business Execution

The ability for TravelCenter of America to continue executing at this level is much more questionable, even though it had a 6 million dollar operating profit improvement year over year. To meet or exceed this level of improvement would be challenging given the slower economic growth and fast moving prices, but we believe that some improvement is possible. TravelCenter of America had an 11 million dollar improvement year over year, which the company achieved in the first quarter 2011.

The dilutive effect of the recent secondary offering hurt TravelCenter's stock performance dramatically. In hindsight, it was a very poor move for shareholders. To gain seven properties, the company spent over $31 million and committed to future improvements. And to obtain these additional company-owned stores, TravelCenter raised just over 50 million dollars in equity sales. By significantly diluting the ownership of existing shareholders, mathematically we see this seven store tradeoff as a significant dilution to the earnings per share for current and future quarters. This is, in our opinion, the reason for the recent severe drop in stock price. As shareholders, we contacted the company to protest these stock transactions, and asked to speak to upper management. However, they never returned our calls.

We seek that both TravelAmerica and its shareholders move to put true independents on their board, in order to insure that all board members understand their fiduciary duty to put the shareholder’s interest first. To read further about the major conflicts of interest this board has had in the past, click here.

At 2010 year-end, TravelCenter had about $105 million worth of unrestricted federal loss carryover. This could allow it to run a profitable operation without paying federal taxes for at least a couple of years. This should boost after tax earning per share going forward. Simply put, this quarter's tax drag was 1% and we can expect very little, if any, until this provision is depleted.

Summary

TravelCenters of America sits in the sweet spot of our greatly distressed value model, having the possibility for large profitability improvements. We enjoy owning highly distressed value companies that can potentially provide outstanding profit growth.

With the next two quarters, we expect close to 0.70 per share improvements each quarter just from the lease savings. The wild card is both the execution and costs, and whether they can repeat by adding another 0.22 per quarter going forward.

TravelCenters of America earned 0.26 cents in Q3 2010 and (- 1.71) in Q4 2010. Assuming only the baseline 0.70 cent improvement that was added to last year’s .26 cents (without any additional improved execution), we are looking at 0.97 cents. Adding the wildcard of execution and costs improvements could bring it as high as 1.23. Applying the same math for forecasting Q4 2011 brings the expected loss to around (-0.73). Operationally, if the company executes well, additional improvements could result in an earnings power in excess of 0.75 cents for the calendar 2011 year.

Conclusion

We believe that TravelCenter of America is trading at about a 6x’s P/E with outstanding improvements in bottom line profits, making the company quite discounted to many of its peers and well below most companies in the convenience store industry. We see TravelCenters of America reporting a greatly improved year, and due to its discounted value and huge leverage, we are currently keeping it in our High Cash Stock Review portfolio.

We hope that moving forward, management will not accept large dilutions to shareholder’s value for minor incremental improvements in sales and stores.

Additional charts, news, and updates for TravelCenters of America are located here.

Disclosure: I am long TA.

Source: TravelCenters of America: In the Sweet Spot for Distressed Value Investments