Core-Mark Holding Company, Inc.
Q3 2008 Earnings Call Transcript

Published: 11 Nov 2008

[Operator:]

Good morning. We would like to welcome you to Core-Mark Holding Company's third quarter earnings call. (Operator Instructions) At this time, I would like to turn the call over to Ms. Milton Gray Draper, Director of Investor Relations; please go ahead.

[Milton Gray Draper:]

Welcome, everyone. I would now like to now read a statement about the use of forward-looking statements and non-GAAP financial measures during this call. Statements made in the course of this call that state the company's or management's hopes, beliefs, expectations or predictions of the future are forward-looking statements. Actual results may differ materially from those projections. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements is contained in our SEC filings including our Form 10-K, our 10-Qs, and our press releases. We undertake no obligation to update these forward-looking statements. We are holding this call to review our third quarter results and to answer any questions you might have. If you have additional follow-up questions after the call, please call me at 650-589-9445. Joining me today is the Chief Executive Officer of Core-Mark, Michael Walsh; and the Chief Financial Officer, Stacy Loretz-Congdon. Also in the room is Chris Miller, our Chief Accounting Officer. Our line-up for the call today is as follows. Michael Walsh will discuss the state of our business and our strategy going forward, followed by Stacy Loretz-Congdon, who will review the financial results for the third quarter. We will then open up the call for your questions. Now, I would like to turn the call over to our CEO, Michael Walsh.

[Michael Walsh:]

Good morning. A lot has happened since our last call. The investment world is to say the least, going through turmoil that is unparalleled in recent history. Like many companies, Core-Mark stock price has, as we all know, been pummeled to unreasonable levels. I do not view these levels as reflective of the value of our company, now or in the foreseeable future. It seems to be however a reflection of the need for investors in general, to accumulate cash. I do tend to believe the vision of the economy put forth by some, that we have begun a recession that will last through 2009. If so, what does this mean for Core-Mark? I will try to touch on a number of factors that provide the basis for assessing the company’s strength, in the context of the overall economic climate. First and foremost, our balance sheet is strong. Our credit line is solid and we have ample borrowing capacity. Our lead bank is JPMorgan with whom we maintain a solid relationship. Second, our business remains strong as the third quarter results would indicate. To be sure we are never satisfied with our performance. But the core trends are moving in the right direction and we believe we will see a good fourth quarter to end the year. Third, the convenience industry has not historically seen the volatility of other sectors during times of recession. There is no doubt that the full effect of the recession has yet to impact the economy and I am mindful about the risks that a deep recession could present. Nonetheless I am comforted by the fact that the industry while not recession proof, is to a significant degree recession resistant. One metric to follow is the price of gasoline at the pump. If the current trend continues and we can stabilize at current prices that are already significantly lower then those we experienced in the early summer, I believe this provides some basis for relative optimism at retail. I do understand that the recent world economic downturn has placed strains on many of our investors. Questions have arisen concerning our philosophy of capital allocation. As you know, the company announced a share buyback program last spring. Through the end of the third quarter we had purchased approximately $11 million in Core-Mark stock. The month of October witnessed a highly unusual credit crisis that prompted the US government to take unprecedented steps to bolster the strength of large financial institutions. There doesn’t seem to be a consensus as to what the solution is, or how far down the market will go, or how long the recovery might take. Management in consultation with our Board and our advisors, believe the best course of action is to be bias toward conservation of our cash, maintenance of our strong balance sheet, and keeping our powder dry during these periods of extreme uncertainty in the market. Of course, we are cognizant of the buying opportunity. We are also weighing the investment needs for capturing potential opportunities that we are pursuing. We are listening to our investors and we are sensitive to the needs of our owners. We’re working very hard at balancing current needs for liquidity against longer-term aspects of growth and stability. We will make course corrections as conditions change. In conclusion a fair representation of our philosophy is simply to protect the interest of all our investors, avoid hasty reactions during periods of extreme volatility, and pursue those options which present the best chance of increasing company value. Now I’d like to move onto a discussion on our third quarter results. As usual my comments are based on FIFO accounting. Also please take note that we had one extra sales day in this quarter versus the third quarter of 2007 which by itself, adds approximately 1.6% to dollar increases from sales to operating expenses. Our total sales in the third quarter were solid showing a 13% increase. A little more then half of that growth was generated by two new divisions. The remaining 6% growth can be segmented into two parts; same store sales growth and market share wins. For non-cigarettes sans the two new divisions and excise tax effects, a 9.35% increase was achieved comprised of a 4.1% same store rate plus a 5.3% growth in market share gains. The third quarter same store year-over-year performance for us was slightly higher then the increase we reported in the second quarter year-over-year increase. For cigarettes again omitting the two new divisions and excise tax effects, a 4.7% revenue dollar increase was achieved comprised of a 2.6% decline in same store cartons, offset by 2.6% gain in market share carton wins. In other words, cartons are basically flat but the dollars are up due to the manufacturers’ price and excise tax increases. In comparison to the second quarter the same store carton count dropped in the third quarter was somewhat less. Perhaps those customers who stopped smoking in the second quarter decided smoking was something they really missed and started buying again. Only detailed consumer market surveys could explain this pattern accurately. Now I would like to move on to a discussion about our gross profits which grew 11.1% but adjusting for inventory holding gain differences, the increase was actually 13.9%. Including the two new divisions, our non-cigarette gross profit grew 16.7% against the total non-cigarette revenue increase of 15.6% resulting in an 11 basis point improvement in the margins. Excluding the two new divisions, and taxes, our 9.4% non-cigarette revenue increase resulted in a 12% gross profit increase resulting in a 33 basis point improvement in our margins. This performance is slightly better then the gains we have reported in prior quarters. Including the two new divisions but excluding tax effects and holding gains our cigarette gross profit grew 7.6% against the total revenue increase of 10.8%. On the other hand, excluding the two new divisions, holding gains and taxes, our 4.7% cigarette revenue increase resulted in a 3.4% decline in gross profits. This decline is principally caused by three factors. One, we took on market share gains at lower cigarette margins in 2008. Two, we suffered carton consumption declines disproportionately in markets where we have historically commanded slightly higher margins. And three, the partial return of Imperial Tobacco in Canada, came at lower then average cents per carton. I would now like to address the operating expenses we incurred in the third quarter in some detail. Now after normalizing for last year’s $5.2 million bad debt reserve, our expenses for the quarter increased by $9.9 million. Here’s the breakdown of the causal factors. Operating expenses for the new Toronto and New England distribution centers contribute 58% of the increase. Variable operating expense on new growth excluding the two new divisions, accounts for 27% of that growth. Unusual increases in health and welfare rates contributed 19% and finally, uncovered fuel expenses caused 9% of the increase. If you’re keeping track, this list covers more then 100% of the expense growth. In a nutshell excluding the two new divisions, we experienced a 6% sales growth with a 5.5% expense increase. This is an indication we are leveraging our fixed costs with sales growth. For example, we gave merit increases of approximately 3% to our employees in 2008. The numbers show we covered this increase with improvements in productivity, a situation we would normally expect. One last point that I would like to make regarding expenses, there is little doubt that our third quarter would have been significantly better if we hadn’t experienced the operating difficulties in a couple of our divisions which began to occur late in the second quarter and which I alluded to in our last call. While we did not return those divisions to Core-Mark standards in the third quarter we did however make improvements in both customer service levels and expense control. Comparing June, our worst period for these divisions, with October, the most recent period, our operating expenses, and shrink declined two full percentage points as a percent of sales. The bottom line, our normalized EBITDA after adjusting for last year’s $5.2 million bad debt was up 14%. The company is fundamentally strong and we have tangible opportunities ahead to continue growing revenues and leveraging our operating expenses. Looking to the future, the fourth quarter absent any surprises should also be solid. I can reaffirm our revenue guidance of $6 billion as well as our CapEx projections of $20 million. We are currently in the seventh inning of our annual business planning process focusing on 2009. In fact, I spent last week visiting several divisions across North America to review their plans and get a better sense of what is happening in their respective local markets. I learned that our folks are looking to 2009 with commitment and optimism. Summarizing a few key observations, fuel prices look like they will be better next year, same store sales growth may be somewhat below historical levels, but we believe they will nonetheless be up over 2008 and everyone believes we will continue to grow market share. While we do recognize the reality of declining carton sales, we do not view this circumstance as a major impediment to our overall profitability. We are certainly planning on avoiding the traditional hiccups we experienced in a couple of locations this year. We anticipate some reductions in insurance and audit fees next year due to the cooperation and support of our outside professionals. From a strategic perspective we have been working very hard throughout the course of the year in cultivating meaningful prospects that could lead to a strong growth in future years. I make no promises, but these are exciting times for us. On the speculation front, it would not surprise me if Imperial Tobacco doesn’t return to traditional distribution in Canada, thus abandoning their foray into the [DSD]. What that would mean for Core-Mark is unclear but it is interesting. A key strategy for our 2009 year will be the continued focus on what we believe are the two major trends in the convenience industry; vendor consolidation and fresh foods. I am more committed, more confident, and more focused then ever that positioning Core-Mark to fulfill these retail demands will pay good dividends over the long-term. I know you are always looking for statistics and here are a few I can share with you. So far this year we have increased by over 1,100 the number of retail locations where we are delivering milk. We targeted more then that but I am nonetheless encouraged by recent developments. In addition we have already exceeded by 50% the number of planned locations in which we deliver fresh totaling 750 year-to-date. So I’m quite pleased with this performance. We are currently on a run rate of $200 million in VCI revenues with an incremental growth rate of about 36% year-to-date from last year. I attribute in large measure the sustained success we are having in growing our non-cigarette margins to our migration towards VCI and fresh. I started my comments this morning in recognition of the economic upheaval and uncertainty in the financial markets and acknowledge that conventional wisdom suggests we are headed for a recession on Main Street. While I have painted a relatively rosy picture for our foreseeable future, we do have issues that we have to manage. We know we have to be diligent in monitoring accounts receivable. Fuel prices are volatile and could have a dampening effect on in-store retail sales not to mention our operating expenses if they spike again next year. We experienced a health benefit spike in the third quarter and we are currently digging into the statistics to find out why and what we can do and should do about it if it persists. As the dollar strengthens against the Canadian currency we have experienced year-to-date $3.5 million swing in our pre-tax net year-over-year. This is not a cash item but it does effect our earnings per share. Finally we are still experiencing the labor shortage woes in Alberta. At some point supply and demand has to take effect. In the meantime we are backfilling with people from other divisions as necessary to ensure good customer service. On balance our business is sound. Our future looks reasonably good and we look forward to a more accurate reflection of these basic fundamentals in our stock price. As always thanks for your interest in Core-Mark. Now I will turn it over to Stacy Loretz-Congdon to discuss in greater detail the financial results.

[Stacy Loretz-Congdon:]

Thanks Michael and good morning to everyone. As Michael mentioned there’s been a significant amount of uncertainty in the credit markets in recent weeks and we have received a number of inquiries about several specific issues including capital allocation, inquiries about the credit worthiness of our AR portfolio, and the funded status of our pension liabilities. Since Michael has already commented on our capital allocation philosophy, I’m going to focus on the last two issues. Given the impact of the current economic conditions on consumer confidence and spending levels and the large bad debt charge we took last year, there have been questions regarding the health of our accounts receivable portfolio. Keep in mind that last year’s bad debt charge related to two customers that filed for protection under Chapter 11. To be clear the circumstances surrounding these two customers were unrelated to anything happening on a macroeconomic level today. That being said, the current environment had heightened our awareness and our attention to our credit portfolio and we continue to monitor risks with rigor. To reiterate our infrastructure includes a robust credit policy, a skilled credit professional at each division, corporate oversight, legal resources when appropriate, and a very thorough ongoing credit risk assessment process. We believe our credit risk is minimized by the large number of customers that make up our AR portfolio with approximately 50% of our customer base representing large national chains, many of these backed by oil companies, and the other 50% representing smaller independents. Further it is important to note that we have a very short cash cycle with DSOs averaging approximately 9.3 days through September. This gives us an opportunity to react immediately to payment delays and minimizes the credit risk to the value of one or two deliveries at best before we switch the customers to COD credit terms for nonpayment. Further our past due accounts in excess of 30 days trended in the 2% to 3% range this year excluding the two accounts which were substantially reserved for last year and continued to age. I will say that during the third quarter we took a very conservative view of our higher risk accounts. We believe our current reserves are adequate based on what we know today. While I can’t guarantee that we won’t see any increased credit exposure in the future, I do believe that we are doing all the right things to monitor and minimize those risks. Regarding the funding status of our frozen pension plan, we will be revaluing our portfolio during Q4 consistent with past practice. Given what has happened in the credit markets we conducted a preliminary analysis in October to determine what the potential unfunded pension liability could be using current investment and discount rates. Based on that analysis our pension could be approximately 75% to 80% funded at the end of 2008 on our current obligations compared with 89% funded at the end of 2007. Investment and discount rates have improved somewhat since we completed our analysis, so we could end up at a higher funding level assuming rates improve. An increase in our unfunded pension liability at the end of the year will not impact the P&L for 2008, instead it will be a charge to other comprehensive income, a component of stockholders equity. What this means to our cash flow assuming no market recovery or changes in rates, is that our funding contributions may increase beginning in 2010. We also anticipate that some of you would like to be assured about our availability and access to our credit facility. I will cover this topic towards the end of my comments. I would now like to recap briefly certain financial results for the third quarter. Sales were $1.67 billion, an increase of 13.2% or $195.1 million compared to the prior year’s third quarter. Our cigarette sales grew by approximately 12% with cartons increasing 5.7%. Excluding Toronto and New England, cigarette sales dollars including excise taxes, increased 4.6% while cartons were essentially flat. Carton declines in the US were offset by carton increases in Canada. Non-cigarette categories for the third quarter increased from $456 million last year to $528 million this year or 15.6% improvement. The three fastest growing categories were fast food, other tobacco products, and candy. Price inflation influenced candy and our VCI and fresh initiatives benefited some of the other non-cigarette categories. Excise taxes which are imbedded in our revenues increased by approximately $53 million or 15%. Both cigarette and non-cigarette sales were significantly improved by the addition of two new divisions and these same divisions contributed 68% of the growth in excise taxes. For Q3 2008 foreign currency translations did not have a meaningful impact on sales growth over prior year. I hope that all of you saw the new chart we added to our 10-Q. It drills down into the categories that make up our food and non-food sales. We hope this will provide a better benchmark to track the progress we are making in the sales of these important higher margin products. Michael has already discussed at length our gross profits for both of our major categories, so I will just add a few comments. First, our remaining gross profit dollars for cigarettes on a cents per carton basis improved 1.8% largely due to the higher cigarette profits earned by our New England division. As to our non-cigarette gross profit I would like to clarify one point. You will notice that the remaining gross profits which reflect FIFO results for this category grew 16.7% compared to the base of our financials which showed a non-cigarette GP on a LIFO basis, increasing only 11%. This is because LIFO expense was heavily weighted towards the non-cigarette categories this quarter compared to last year primarily due to candy inflation this year taking the lead whereas cigarette inflation was the story last year. Non-cigarette LIFO expense represented 86% of total LIFO expense this year compared to only 34% in the third quarter last year. Moving to operating expenses, they decreased 36 basis points as a percent of sales compared to last year. However if you remove last year’s bad debt, operating expenses as a percent of sales were flat at 5.1%. Michael has provided commentary on the causal factors that contributed to the total dollar increase so I will provide a little more color on the detailed line items. Warehouse and delivery costs increased 16 basis points as a percentage of sales. While still under-levered this basis point increase is only half of the increase we reported for the second quarter. Approximately 10 basis points of this increase represented costs associated with the two new divisions, health and welfare costs, as well as fuel costs. We will continue to lever the new divisions and with fuel prices headed in the right direction coupled with our higher surcharge, we should see this line item improve along with overall profitability. SG&A expenses improved over 50 basis points, however last year included the $5.2 million bad debt charge. Excluding this, SG&A expenses improved 17 basis points as a percent of sales. We achieved this despite a significant increase in health and welfare costs, through reductions in insurance premiums, audit fees, and several other line items. Foreign currency losses continue to dilute EPS with a $1.5 million charge recorded in Q3 this year compared to $300,000 gain in the third quarter of 2007. This reflects the revaluation of our investment in Canada and is a non-cash item. If the Canadian dollar continues to weaken we will see additional losses in future quarters. Our effective tax rate for the quarter was 19.7% compared to 28.3% for the same quarter last year before adjusting for interest and other items. Our tax rate this quarter as in prior quarters benefitted from the expiration of the Statute of Limitations on uncertain tax positions which we had reserved for totaling $1.3 million. Without this benefit our effective tax rate would have been approximately 41% for both quarters. Diluted EPS was $0.49 per share for the third quarter of this year versus $0.30 per share for the third quarter last year, a $0.19 improvement. This increase is essentially the same even after you remove the bad debt, holding gains, foreign exchange loss, and LIFO expense using our statutory tax rate. The impact of these line items on our year-to-date diluted earnings per share is more pronounced as well as being impacted by two larger non-recurring items last year. As such, we hope you saw the reconciliation table included in our press release. Additional non-cash items effecting our quarter results include depreciation and amortization which amounted to $4.5 million for Q3 2008 compared to $3.6 million in Q3 2007, stock-based comp was approximately half of our prior year’s expense due to the 2005 incentive plan becoming fully vested in the first part of the year, and as I mentioned previously, foreign exchange generated a loss of $1.5 million this quarter versus a gain of $0.3 million last year. Year-to-date cash flow generated from operations was $23.2 million compared to $28.8 million last year. Working capital uses of cash were $17.9 million year-to-date compared to $20.2 million used during the first nine months last year, including our investments in Toronto and post-close investments in and AP balances generated for our New England divisions. We have spent approximately $14 million for fixed assets during the first nine months of the year which is about 70% of our projected spending for the year. In addition we spent $26 million net of cash acquired for the purchase of A and B assets and $11 million for our share repurchase program. Moving to our balance sheet our key statistics remain stable. Our year-to-date monthly average DSO is running approximately 9.3 days, down from 9.8 days last year. Inventory on hand is running 15 days versus 14.6 days last year. Our average AP days including taxes payable improved to 11.9 days compared to 11.2 days last year. Our borrowings under our credit facility at the end of the quarter were $57.5 million compared to $29.7 million at 12/31/07, and $53.7 million as of September 30 last year. Total third quarter balances were higher then typical due to heavier cigarette inventories. In addition our debt balance in 2008 was impacted by working capital requirements for Toronto and the purchase of Auburn Merchandise at the end of Q2 this year. Our initiative investment for AMD has been reduced by approximately $9.4 million in payables generated after the purchase. We are aware that some companies have experienced difficulties drawing on their credit lines, issuing debt and raising capital generally. However based on our anticipated cash needs our availability under our revolver which was approximately $160 million at the end of the quarter, we believe we have sufficient capacity to meet our anticipated needs during the next 12 months. We have two years left on our facility and we are in close contact with our syndicate members who have shown a genuine interest in continuing and supporting our relationship. In closing we want investors to understand that we are aware of the weakness in the retail universe. While same store sales are softer then we would like them to see, we are still showing growth. Our history shows that we have survived recessionary periods in the past and we believe we are very well positioned in terms of our available credit, and our under leveraged balance sheet to see us through this economic downturn. With our steady-Eddy conservative approach we are superbly positioned to take advantage of strategic and competitive opportunities as they present themselves. That being said, there may be bumps along the way but we have a long history of riding through these storms successfully. As always I would like to thank our employees, our vendors, our customers, and you our shareholders for your continued support. We are now ready for questions.

[Operator:]

(Operator Instructions) Your first question comes from the line of Jonathan Lichter - Sidoti & Company

[Jonathan Lichter:]

What are you seeing in terms of same store sales weakness or strength, by geographic region?

[Michael Walsh:]

It varies, for example Las Vegas where we have a presence the economy of Vegas probably has taken a bigger hit then other markets that we serve so that is, we’re certainly seeing an effect there. Canada, we’re struggling with Alberta but the sales there are very robust. It’s a matter of keeping up with them. But generally overall I’d say on the average, and I reported our same store non-cigarette sales were up about 4.1% which is pretty consistent with historical numbers over the years. So I don’t think you could say that we have seen the effect of the recession. Its been kind of lumpy due to local market factors, some ups, some down but on the average its about normal. And as I said the same store sales in the, if you look year-over-year was up in the third quarter relative to the second quarter which indicates some strengthening. I do think this lower gasoline price, going from less then $60 down from $147 in early July, I think that has as much to do with our consumers as anything else.

[Jonathan Lichter:]

How much availability do you have for acquisitions and are you seeing more companies approaching you that are interested in selling?

[Michael Walsh:]

I wouldn’t say there’s been a rash of companies calling us to sell, but there are a couple that maintain some interest and we’re looking at them.

[Operator:]

Your next question comes from the line of James Lee – Unidentified Company

[James Lee:]

Given the performance this quarter over 6% organic growth and your guidance was $6 billion, it seems like you’re implying a 5.4% growth for Q4, are you being overly conservative, or are you seeing anything unusual in Q4.

[Michael Walsh:]

We’re not seeing anything unusual and maybe we’re being a tad conservative. It wasn’t enough to change the guidance but we feel very good about the fourth quarter. We don’t see any signs through October that there’s been any change in our glide path.

[James Lee:]

Is next year, if the economy is in a worst case, how likely is that you can still say profitable, or cash flow positive?

[Michael Walsh:]

I’d say its extremely likely. I don’t, California could fall off with an earthquake, but absent something very dramatic, some kind of world event, or something, I’m fairly optimistic about next year. We are certainly going to plan a year of growth in profit as well as revenues.

[James Lee:]

In this environment given the economy and the credit, I imagine a lot of players in this industry are having some tougher times, are you seeing someone like a [McLean] getting more aggressive and trying to get more market share in terms of going out and trying to outbid on contracts? Are you seeing that happening and given the backing from Brookshire?

[Michael Walsh:]

No I haven’t and I would say [McLean] has been a very intelligent competitor as far as I’m concerned. They do not have a history of dragging down the market and I have certainly seen no change in the behavior of that. It is as we all know this industry is, its predicated on very, very thin margins and they have their business model which incorporates the needs of Wal-Mart and their food service and so I’m sure they have a number of interests and they seem to be doing well. We don’t see much in the way of abnormal behavior. I think there’s a question about the overall declining carton trends. Core-Mark plans to be a market leader in that. We think that ultimately the profitability of the declining cartons has to be shifted in a logical fashion to traditional non-cigarette categories. I think that is ultimately, has to be the solution but that’s not to say that in any one given market one competitor may decide to, if they perceive they’re stronger then another competitor won’t take that as an opportunity to try to make it tough in that marketplace. But so far I have not seen evidence of that.

[James Lee:]

So do plan to be like that given that you are pretty well capitalized, would you take that opportunity to go take out some of the weaker competitors?

[Michael Walsh:]

That is not my strategy. I do not think as one of the market leaders, I do not think that that is a beneficial strategy for our investors or in the long-term health of Core-Mark. I can’t take off for two years and say I’m going to go grind weaker competition. That’s just not a good strategy and we want to be a market leader and set the tone and try to help the industry get through this transitioning from a cigarette-based market to a fresh and other products as the industry migrates through that transition. We want to help that, facilitate it and be the market leader in establishing an orderly transition.

[James Lee:]

On CapEx it looks like you’re looking at $20 million this year, what does it look like next year, is it going to be less next year? I think you had a building out the Toronto division this year, I imagine next year it should be less right?

[Stacy Loretz-Congdon:]

We haven’t disclosed that yet. Stay tuned.

[James Lee:]

But do you foresee building out new distribution centers next year?

[Stacy Loretz-Congdon:]

We’re in the process of reviewing our plans as Michael alluded to. He has just come back from a week and we have the other senior VPs out there reviewing the rest of the divisions. Once they get back we’ll be rolling up their needs requirement and then we’ll be issuing guidance in January, February timeframe.

[Operator:]

Your next question comes from the line of Analyst – Winfield Capital Corporation

[Analyst:]

I was just curious how you go about taking the data from the PPI and is on a lag basis and how you use that data to determine your FIFO.

[Stacy Loretz-Congdon:]

Basically there’s just a published PPI indexes and our VP of Tax identifies it. It may be one month off. I’d have to check with him and get back to you on that issue.

[Analyst:]

But its not a big lag then right?

[Stacy Loretz-Congdon:]

Not that I’m aware of, no.

[Analyst:]

How should we think about FIFO charges in an environment characterized by a lot of volatility in the PPI?

[Stacy Loretz-Congdon:]

We really look at it more as a tax strategy in order to minimize our taxes through a higher cost of sales on a tax basis. But we don’t manage and we’ve said this in the past, we don’t manage our business on a LIFO basis. We manage our business on a FIFO basis. Because cash flow as you know is generated real time and the LIFO is a basically a paper entry based on an PPI estimate.

[Analyst:]

Right so that’s why you’re always focusing on cash flow from operations which I think is the right thing.

[Operator:]

Your next question comes from the line of Kian Ghazi - Hawkshaw

[Kian Ghazi:]

Could you talk a bit about what you’re seeing as far as rebates from your CPG vendors? Is that turning up, down, flat from prior periods?

[Michael Walsh:]

Its, I would say strong, good, consistent with our growth. We look forward to a pretty good year with various discounts, rebates, allowances, incentive payments and that sort of thing that we earn and so far throughout the year its been very good and we expect it to end the year on a good note.

[Kian Ghazi:]

On the cigarette side, are you seeing any changes from the cigarette manufacturers?

[Michael Walsh:]

No, well I would say traditionally in years past, you’d get typically an annual price increase and it would be across all brands. The trend now seems to be very lumpy and they apparently are looking at product rationalization. They seem to be raising prices on some of the slower moving items which probably makes sense. So we’re seeing, this year we saw a few lumpy, odd brands where they would raise prices, $0.50 a carton or something like that, I’d say that’s unusual and different from trends in the past 18 years I’ve been with Core-Mark.

[Kian Ghazi:]

To understand the scenario where the cigarette manufacturers might reduce the rebates or incentives they’re providing to you, if they actually cut back which is in essence a price increase that they would benefit from, do you have mechanisms in your contracts with your customers to pass that along?

[Michael Walsh:]

Yes. Learning from the school of hard knocks over the years, we put clauses in our contracts that say material changes in our manufacturers’ programs, they have to be reflected in our pricing and in the past where we’ve had decreases in those manufacturers’ programs, that has resulted in a generally industry wide price increase.

[Kian Ghazi:]

Do you already have built in mechanisms into your contracts with your customers for the anticipated declines in cigarette cartons that has been the trend over the period and we’re no longer getting the channel shift into see stores offsetting that, so do you have that built into historical contracts and are you building that into new contracts such that it anticipates the declines and matures at your whole, during the course of let’s call it a three year contract?

[Michael Walsh:]

Yes, to the latter, probably no to the former. Remember the cigarette, this notion of declining cigarette cartons really became manifest to Core-Mark in the fourth quarter of last year because historically we had been the beneficiary of a channel shift in volume from grocery stores and drug stores and other venues to the convenience industry. Fifteen years ago the convenience industry sold 30% of all cartons, today its roughly 65% of all cartons. So we [inaudible] up until about the fourth quarter of last year, when it became apparent that channel shift wasn’t going to make up for the declining fall, so from about that point forward we became very attentive to inserting clauses in our contracts that say if for declining cartons we’ve got to be able to make that up by some mutually agreeable mechanism. And they are in all of the contracts that we’ve done since the fourth quarter.

[Kian Ghazi:]

Contracts would be for larger customers, your street business which is approximately 50% of the business, I imagine that’s re-pricing on a regular basis and those would already factor in both of those contract structures that we talked about, both anticipating declines in cigarettes as well as if there was a change in cigarette manufacture rebates, that would be immediately reflected in your street business?

[Michael Walsh:]

Well certainly the latter would be immediately reflected, the former is a little more, that’s a process not a project. That’s a process that will be, I believe that that process with independents in making up for the decline in the carton volume over time, will be through diligence on our part and communication with the retailers. We as an organization, we have projected what the carton would mean at the division level over the next 10 years. And we have focused all of our division people to say look this is the issue, and here are the mechanisms that we’d like to use in negotiations with your retailers. We provide them with excellent movement information by store and it gives them the basis to go out and adjust the prices as we need to and we have had some pretty good success this year in doing that. That hasn’t been 100% but there is no doubt that we are making adjustments as we go along. It will not be a perfect linear process but it is a process that we have made progress this year and its just part of the, managing our place in the market and I do think that we’re focused and that the cigarette carton decline will not be one of the top three, four or five items that we are concerned with at any one point in time. Its just something that we have to be mindful of.

[Kian Ghazi:]

So when you go to that customer in trying to negotiate a portfolio of options of things they could do to offset the decline in cigarette sales, is VCI one of those options to offset the cigarette declines?

[Michael Walsh:]

No.

[Kian Ghazi:]

So that’s something that’s standalone and you’re not cannibalizing essentially cigarette declines with VCI sales.

[Michael Walsh:]

Correct and that is a tenant in the creed of VCI and fresh. It’s a very important concept that we do not use VCI and fresh to fill in for the declining cigarette cartons. It is through traditional non-cigarette margins and/or higher margins on remaining cigarette cartons sold, that’s the mechanism. Everybody understands that. I’m hoarse from talking about that to all the divisions. I think everybody knows that very, very clear that that’s just not a strategy that we have.

[Kian Ghazi:]

On your warehouse and distribution costs, through the prepared comments it sounds like there may have been an ounce of satisfaction that the basis point increase as a percent of revenues was lower this quarter then last quarter, and I just want to remind, or point out that the increases in the first half of this year were unacceptable and a smaller increase as a percent of sales is still unacceptable and we need to be making absolute dollar reductions in warehouse and distribution. Would you agree?

[Michael Walsh:]

Absolutely and if there was any tone of satisfaction in our operating expenses, I mis-communicated and apologize for that. I think I merely tried to comment on the two divisions that while are not where we want them to be I am not satisfied, I am not happy about this year, they did make progress through that. And part of what’s going on, this health and welfare thing, its not just productivity in the warehouse or efficiency of our routes, it’s the fuel which I think is coming down and will help us. Its this health and welfare benefit thing that we had a spike in that and we’re trying to pour through that, we have to manage our health and welfare benefits just like we manage anything else but I think some of these external things are masking some modest, not let’s beat our chest and let’s go to Phoenix and have a nice posh three day celebration, not that at all. You’re exactly right and if my tone portrayed anything different I mis-communicated. We are not happy with that but I think we are beginning to see some improvement and we’re going to keep pushing very hard on that.

[Kian Ghazi:]

So to be clear, absent an acquisition or the opening of another DC, or anything unusual like that, we should be seeing at some point if you are successful absolute dollar declines in warehouse and distribution because we’re running the 24 or whatever number of DCs we have today, at excessive expense levels.

[Michael Walsh:]

I would say this, I’m not sure about the absolute dollar decline because we still intend to have organic growth which cost vary with volume on a net variable basis, but I do expect holding external factors constant and no acquisitions and so forth, that our operating expense as a percent to sales will come down. That’s just the way distribution works or should work.

[Operator:]

Your final question is a follow-up from the line of Jonathan Lichter - Sidoti & Company

[Jonathan Lichter:]

On fuel surcharges, were they a positive or negative in the quarter based on the surcharges that you would have set at the end of June?

[Michael Walsh:]

Our surcharges went up, there is a quarterly program and at the beginning of the third quarter our surcharges went up and of course fuel began to come down although there seems to be a lag factor, there’s always a lag factor in the billing but there’s also a lag factor as a consumer of fuel, what happens in the industry its both good and bad. Wholesale prices go down faster then retail prices. That’s how the retailer makes money because they’re certainly losing it when prices are going up so because of that, you say, well gee how come my fuel price isn’t falling with the price of crude. Its because the retailer is lower prices at a slower rate then wholesale and frankly that spread in our uncovered fuel price didn’t go down as much as I think we all were hoping that it would every day as we’d seen the price of crude, but going into the fourth quarter I think we’re back to a normal spread and I’m knocking on wood, but I don’t think we’ll be talking about fuel in the fourth quarter as a factor in our financials.

[Jonathan Lichter:]

So how much was the uncovered fuel costs in Q3?

[Michael Walsh:]

It was $800,000.

[Jonathan Lichter:]

And non-alcoholic beverages, what’s included in that category?

[Michael Walsh:]

Our retail beverages has everything, its water, all different kinds of water, juices, Gatorade, isotonics—

[Jonathan Lichter:]

Is there any reason that sales were down, is it just a cooler summer or something along those lines.

[Michael Walsh:]

No, there are reasons that our sales are down. Gatorade for example came out with a new line that in effect they are delivering on their DSD trucks and it cannibalized the Gatorade products that we deliver on our trucks and its had a major impact on our volume. Campbell took V8 and moved to having Coke distribute V8. That was an issue with us. So there’s been, those sales declines were 100% attributable to structural changes in manufacturers method of delivering liquids to our retailers. Now we, you might have heard a couple of years ago, one of the major distributors sort of declared, drew a line in the sand and said we’re not making enough on this stuff and we’re going to start back-charging you the manufacturers or come and get your stuff and pull it out of our warehouse. We, in the situation we are today, I’m not sure that was the best course of action because we made a 33 basis point improvement in our non-cigarette margins in the third quarter, it would have been better because the margins on that stuff that we lost with the dollar sales, that had a counter growth effect on our margins and so I wish we hadn’t lost those sales, but those were structural changes made at Coke corporate and Campbell corporate and all that stuff and so be it. That did happen, but its not that those products or that line in general is losing favor, its still very much in demand at a convenience retail store.

[Jonathan Lichter:]

Is there any indication that there will be more of these switches?

[Michael Walsh:]

Well you’d have to say that long-term Pepsi who bought Quaker may over, there was a contract that when they bought them over a number of years, I don’t know if it was 10 years or so, that it could be that Pepsi is going to absorb Gatorade into their distribution system. I don’t know that, but that’s the biggest issue that I think we have going forward that we may in fact, the industry may lose Gatorade.

[Operator:]

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

[Milton Gray Draper:]

Thank you for your participation in our conference call and for your interest in Core-Mark. If you have any question, give me a call at 650-589-9445.