PANTRY INC - 10-Q Quarterly Report

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 25, 2004

Commission File Number 33-72574

THE PANTRY, INC.

(Exact name of registrant as specified in its charter)

Delaware

56-1574463

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification Number)

1801 Douglas Drive

Sanford, North Carolina

27330-1410

(Address of principal executive offices)

Registrant’s telephone number, including area code: (919) 774-6700

N/A

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.


COMMON STOCK, $0.01 PAR VALUE		19,964,048 SHARES
(Class)		(Outstanding at May 3, 2004)

THE PANTRY, INC.

FORM 10-Q

MARCH 25, 2004

TABLE OF CONTENTS


		Page
Part I—Financial Information
Item 1. Financial Statements
Consolidated Balance Sheets		3
Consolidated Statements of Operations		4
Consolidated Statements of Cash Flows		5
Notes to Consolidated Financial Statements		6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		24
Item 3. Quantitative and Qualitative Disclosures About Market Risk		42
Item 4. Controls and Procedures		43

Part II—Other Information
Item 6. Exhibits and Reports on Form 8-K		44

PART I-FINANCIAL INFORMATION.

Item 1. Financial Statements.

THE PANTRY, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(Dollars in thousands)


	March 25, 2004			September 25, 2003
ASSETS
Current assets:
Cash and cash equivalents.	$	50,991		$	72,901
Receivables, net (Note 2).		35,828			30,423
Inventories (Note 2)		94,321			84,156
Prepaid expenses (Note 2)		8,015			6,326
Property held for sale (Note 2)		6,864			2,013
Deferred income taxes		4,334			4,334

Total current assets		200,353			200,153

Property and equipment, net (Note 2)		412,458			400,609

Other assets:
Goodwill (Note 2)		337,998			278,629
Deferred financing costs, net (Note 4)		7,736			10,757
Environmental receivables (Note 3)		15,784			15,109
Other (Note 2)		12,671			8,908

Total other assets		374,189			313,403

Total assets	$	987,000		$	914,165

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt (Note 4)	$	12,039		$	27,558
Current maturities of capital lease obligations		1,375			1,375
Accounts payable (Note 2)		91,194			78,885
Accrued interest (Note 4)		3,118			11,924
Accrued compensation and related taxes		12,520			12,840
Other accrued taxes		11,386			16,510
Accrued insurance		14,367			12,293
Other accrued liabilities (Note 2)		11,905			21,314

Total current liabilities		157,904			182,699

Long-term debt (Note 4)		583,025			470,011

Other liabilities:
Environmental reserves (Note 3)		14,226			13,823
Deferred income taxes		44,291			50,015
Deferred revenue		33,486			37,251
Capital lease obligations		15,106			15,779
Other noncurrent liabilities		19,820			15,922

Total other liabilities		126,929			132,790

Commitments and contingencies (Notes 3 and 4)
Shareholders’ equity (Notes 6 and 9):
Common stock, $.01 par value, 50,000,000 shares authorized; 19,824,215 and 18,107,597 issued and outstanding at March 25, 2004 and September 25, 2003, respectively		200			182
Additional paid-in capital		128,740			128,002
Shareholder loans		(64	)		(173	)
Accumulated other comprehensive deficit, net		(1,934	)		(690	)
Accumulated earnings (deficit)		(7,800	)		1,344

Total shareholders’ equity		119,142			128,665

Total liabilities and shareholders’ equity	$	987,000		$	914,165

See Notes to Consolidated Financial Statements

THE PANTRY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(Dollars in thousands, except per share data)


	Three Months Ended						Six Months Ended
	March 25, 2004			March 27, 2003			March 25, 2004			March 27, 2003
	(13 weeks)			(13 weeks)			(26 weeks)			(26 weeks)
Revenues:
Merchandise sales	$	269,795		$	234,900		$	539,820		$	477,240
Gasoline sales		516,280			431,719			990,571			833,652
Commissions		8,312			6,825			15,331			13,529

Total revenues		794,387			673,444			1,545,722			1,324,421

Cost of sales:
Merchandise		178,621			157,405			356,491			319,972
Gasoline		482,539			402,910			915,894			765,329

Total cost of sales		661,160			560,315			1,272,385			1,085,301

Gross profit		133,227			113,129			273,337			239,120

Operating expenses:
Operating, general and administrative expenses		105,443			92,323			210,570			185,464
Depreciation and amortization		13,533			13,098			27,608			25,605

Total operating expenses		118,976			105,421			238,178			211,069

Income from operations		14,251			7,708			35,159			28,051

Other income (expense):
Loss on extinguishment of debt (Notes 4 and 8)		(23,087	)		—			(23,087	)		—
Interest expense (Note 8)		(14,166	)		(12,042	)		(27,307	)		(24,815	)
Miscellaneous		105			507			367			941

Total other expense		(37,148	)		(11,535	)		(50,027	)		(23,874	)

Income (loss) before income taxes		(22,897	)		(3,827	)		(14,868	)		4,177
Income tax benefit (expense)		8,815			1,474			5,724			(1,610	)

Net income (loss) before cumulative effect adjustment		(14,082	)		(2,353	)		(9,144	)		2,567
Cumulative effect adjustment, net of tax (Note 7)		—			—			—			(3,482	)

Net loss	$	(14,082	)	$	(2,353	)	$	(9,144	)	$	(915	)

Net income (loss) per share (Note 10):
Basic and diluted:
Net income (loss) before cumulative effect adjustment	$	(0.71	)	$	(0.13	)	$	(0.48	)	$	0.14
Cumulative effect adjustment		—			—			—			(0.19	)

Net loss	$	(0.71	)	$	(0.13	)	$	(0.48	)	$	(0.05	)

See Notes to Consolidated Financial Statements

THE PANTRY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(Dollars in thousands)


	Six Months Ended
	March 25, 2004			March 27, 2003
	(26 weeks)			(26 weeks)
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss	$	(9,144	)	$	(915	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		27,608			25,605
Provision (benefit) for deferred income taxes		(5,724	)		1,610
Loss on extinguishment of debt		23,087			—
(Gain) loss on sale of property and equipment		(959	)		333
Impairment of long-lived assets		1,046			300
Fair market value change in non-qualifying derivatives		(1,164	)		(843	)
Provision for closed stores		1,117			1,135
Cumulative effect of change in accounting principle		—			3,482
Amortization of deferred loan costs		1,729			1,170
Amortization of long-term debt discount		534			—
Changes in operating assets and liabilities (net of effects of acquisitions):
Receivables		(3,644	)		55
Inventories		(147	)		4,930
Prepaid expenses		(1,573	)		(1,987	)
Other noncurrent assets		(45	)		(3,642	)
Accounts payable		873			(15,227	)
Other current liabilities and accrued expenses		(20,273	)		(12,672	)
Reserves for environmental expenses		(272	)		457
Other noncurrent liabilities		(5,637	)		(2,226	)

Net cash provided by operating activities		7,412			1,565

CASH FLOWS FROM INVESTING ACTIVITIES
Additions to property held for sale		(1,376	)		(1,074	)
Additions to property and equipment		(17,016	)		(6,810	)
Proceeds from sale of land, buildings and equipment		98,617			3,192
Acquisitions of related businesses, net of cash acquired		(184,967	)		(1,169	)

Net cash used in investing activities		(104,742	)		(5,861	)

CASH FLOWS FROM FINANCING ACTIVITIES
Principal repayments under capital leases		(673	)		(669	)
Principal repayments of long-term debt, including redemption premiums		(589,387	)		(20,650	)
Proceeds from short-term borrowings		—			10,000
Proceeds from issuance of long-term borrowings		675,000			—
Proceeds from exercise of stock options		756			—
Repayments of shareholder loans		109			256
Other financing costs		(10,385	)		(203	)

Net cash provided by (used in) financing activities		75,420			(11,266	)

NET DECREASE IN CASH AND CASH EQUIVALENTS		(21,910	)		(15,562	)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		72,901			42,236

CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	50,991		$	26,674

Cash paid (refunded) during the period:
Interest	$	35,207		$	26,200

Taxes	$	258		$	(59	)

See Notes to Consolidated Financial Statements

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—BASIS OF PRESENTATION

Unaudited Consolidated Financial Statements

The accompanying consolidated financial statements include the accounts of The Pantry, Inc. and its wholly owned subsidiaries (the “Company”). All inter-company transactions and balances have been eliminated in consolidation. Transactions and balances of each of these wholly owned subsidiaries are immaterial to the consolidated financial statements.

The consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. The interim consolidated financial statements have been prepared from the accounting records of The Pantry, Inc. and its subsidiaries and all amounts at March 25, 2004 and for the three and six months ended March 25, 2004 and March 27, 2003 are unaudited. References herein to “The Pantry” or “the Company” include all subsidiaries. Pursuant to Regulation S-X, certain information and note disclosures normally included in annual financial statements have been condensed or omitted. The information furnished reflects all adjustments which are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented, and which are of a normal, recurring nature.

We suggest that these interim financial statements be read in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended September 25, 2003, as amended.

Our results of operations for the three and six months ended March 25, 2004 and March 27, 2003 are not necessarily indicative of results to be expected for the full fiscal year. Additionally, on October 16, 2003 we acquired 138 convenience stores operating under the Golden Gallon^{^®} banner. See Note 2 for further discussion of this acquisition. The convenience store industry in our marketing areas generally experiences higher levels of revenues and profit margins during the summer months than during the winter months. As a result, we have historically achieved higher revenues and earnings in our third and fourth quarters.

Accounting Period

We operate on a 52-53 week fiscal year ending on the last Thursday in September. Our 2004 fiscal year ends on September 30, 2004 and is a 53 week year. Fiscal 2003 was a 52 week year.

The Pantry

As of March 25, 2004, we operated 1,374 convenience stores located in Florida (467), North Carolina (326), South Carolina (238), Tennessee (103), Georgia (99), Mississippi (52), Kentucky (38), Virginia (30), Indiana (13), and Louisiana (8). Our stores offer a broad selection of merchandise, gasoline and ancillary products and services designed to appeal to the convenience needs of our customers, including gasoline, car care products and services, tobacco products, beer, soft drinks, self-service fast food and beverages, publications, dairy products, groceries, health and beauty aids, money orders and other ancillary services. In all states, except North Carolina and Mississippi, we also sell lottery products. Self-service gasoline is sold at 1,348 locations, 939 of which sell gasoline under major oil company brand names including Amoco^®, BP^®, Chevron^®, Citgo^®, Mobil^®, Shell^®, Exxon^® and Texaco^®.

Recently Issued Accounting Standards

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

46R). This interpretation provides guidance related to identifying variable interest entities (previously known as special purpose entities or SPEs) and determining whether such entities should be consolidated. Certain disclosures are required if it is reasonably possible that a company will consolidate or disclose information about a variable interest entity when it initially applies FIN 46. This interpretation was effective for the Company’s second quarter ending March 25, 2004. The Company has no investment in or contractual relationship or other business relationship with a variable interest entity and therefore the adoption of FIN 46 did not have any impact on our results of operations and financial condition. However, if the Company enters into any such arrangement with a variable interest entity in the future (or an entity with which we currently have a relationship is reconsidered based on guidance in FIN 46 to be a variable interest entity), the Company’s results of operations and financial condition may be impacted.

Stock-Based Compensation

The Company accounts for stock options under the intrinsic value method recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Related Interpretations. No stock-based employee compensation cost is reflected in net loss, as all options granted under these plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation:


	Three Months Ended						Six Months Ended
	March 25, 2004			March 27, 2003			March 25, 2004			March 27, 2003
Net loss (in thousands):
As reported	$	(14,082	)	$	(2,353	)	$	(9,144	)	$	(915	)
Deduct—Total stock-based compensation expense determined under fair value method for all awards, net of tax		(39	)		(77	)		(165	)		(151	)

Pro forma		(14,121	)		(2,430	)		(9,309	)		(1,066	)

Basic and diluted earnings (loss) per share:
As reported	$	(0.71	)	$	(0.13	)	$	(0.48	)	$	(0.05	)
Pro forma	$	(0.71	)	$	(0.13	)	$	(0.49	)	$	(0.06	)

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:


	Three Months Ended
	March 25, 2004	March 27, 2003
Weighted-average grant date fair value	—	$	1.52
Weighted-average expected lives (years)	—		2
Weighted-average grant date fair value-exercise price equals market price	—	$	1.52
Weighted-average grant date fair value-exercise price greater than market price	—		—
Risk-free interest rate	—		1.8	%
Expected volatility	—		68	%
Dividend yield	—		0	%

Due to the factors (assumptions) described above, the above pro forma disclosures are not necessarily representative of pro forma effects on reported net income for future years.

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 2—ACQUISITION OF RELATED BUSINESS

On October 16, 2003, we completed the acquisition of 138 convenience stores operating under the Golden Gallon^® banner from Ahold USA, Inc. operating in Tennessee and Georgia. The acquired assets include 138 operating convenience stores, 131 of which are fee-owned stores, a dairy plant and related assets, a fuel hauling operation, corporate headquarters buildings and 25 undeveloped sites. Other than the dairy plant and related assets, the fuel hauling operation and the corporate headquarters buildings, the Company intends to use the acquired assets in the convenience store retail business. Simultaneous with the closing, the Company sold the dairy plant and related assets and the fuel hauling operation to existing suppliers of the Company.

The acquisition was structured as two simultaneous transactions, whereby 114 of the 131 fee-owned stores were purchased and financed through a $94.5 million sale/leaseback transaction, and the Golden Gallon^{^®} operations and the balance of the real estate assets were purchased with cash. The Company funded the second transaction with $80 million of debt through borrowings under an amendment to the Company’s existing senior secured credit facility, see Note 4, and available cash.

The following purchase price allocations for the Golden Gallon^{^®} acquisition are preliminary estimates, based on available information and certain assumptions management believes to be reasonable. Accordingly, such purchase price allocations are subject to finalization. The allocations are based on the fair values on the date of the acquisition (amounts in thousands):


Assets Acquired:
Receivables	$	1,263
Inventories		10,018
Prepaid expenses		116
Property held for sale		101,216
Property and equipment		31,942
Other noncurrent assets		432

Total assets		144,987

Liabilities Assumed:
Accounts payable		(11,436	)
Other accrued liabilities		(10,620	)

Total liabilities		(22,056	)

Net tangible assets acquired		123,931

Trademarks		2,800
Goodwill		59,719

Total consideration paid, including direct costs, net of cash acquired	$	185,450

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following unaudited pro forma information presents a summary of consolidated results of operations of the Company and the acquired assets as if the transaction occurred at the beginning of the fiscal year for each of the periods presented (amounts in thousands, except per share data):


	Three Months Ended					Six Months Ended
	March 25, 2004			March 27, 2003		March 25, 2004			March 27, 2003
Total revenues	$	794,387		$	779,688	$	1,557,570		$	1,520,516
Net income/(loss) before cumulative effect adjustment		(14,082	)		246		(9,271	)		7,426
Net income/(loss)		(14,082	)		246		(9,271	)		3,944
Earnings (loss) per share before cumulative effect adjustment:
Basic	$	(0.71	)	$	0.01	$	(0.49	)	$	0.41

Diluted	$	(0.71	)	$	0.01	$	(0.49	)	$	0.41

Earnings per share:
Basic	$	(0.71	)	$	0.01	$	(0.49	)	$	0.22

Diluted	$	(0.71	)	$	0.01	$	(0.49	)	$	0.22

The unaudited pro forma information set forth above is presented for informational purposes only. In management’s opinion, the unaudited pro forma information set forth above is not necessarily indicative of actual results that would have occurred had the acquisition been consummated at the beginning of fiscal 2003 or fiscal 2004, or of future operations of the Company.

NOTE 3—ENVIRONMENTAL LIABILITIES AND OTHER CONTINGENCIES

As of March 25, 2004, we were contingently liable for outstanding letters of credit in the amount of approximately $35.0 million primarily related to several self-insured programs, vendor contract terms and regulatory requirements. The letters of credit are not to be drawn against unless we default on the timely payment of related liabilities.

We are involved in certain legal actions arising in the normal course of business. In the opinion of management, based on a review of such legal proceedings and the facts as currently known, we believe the ultimate outcome of these actions will not have a material effect on the consolidated financial statements.

Environmental Liabilities and Contingencies

We are subject to various federal, state and local environmental laws. We make financial expenditures in order to comply with regulations governing underground storage tanks adopted by federal, state and local regulatory agencies. In particular, at the federal level, the Resource Conservation and Recovery Act of 1976, as amended, requires the EPA to establish a comprehensive regulatory program for the detection, prevention and cleanup of leaking underground storage tanks.

Federal and state regulations require us to provide and maintain evidence that we are taking financial responsibility for corrective action and compensating third parties in the event of a release from our underground storage tank systems. In order to comply with these requirements, as of March 25, 2004, we maintain letters of credit in the aggregate amount of approximately $1.4 million in favor of state environmental agencies in North

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Carolina, South Carolina, Virginia, Georgia, Indiana, Tennessee, Kentucky and Louisiana. We also rely upon the reimbursement provisions of applicable state trust funds. In Florida, we meet our financial responsibility requirements by state trust fund coverage through December 31, 1998 and meet such requirements thereafter through private commercial liability insurance. In Georgia, we meet our financial responsibility requirements by state trust fund coverage through December 29, 1999 and meet such requirements thereafter through private commercial liability insurance and a letter of credit. In Mississippi, we meet our financial responsibility requirements through coverage under the state trust fund. The trust funds generally require us to pay deductibles ranging from $5 thousand to $150 thousand per occurrence depending on the upgrade status of our underground storage tank system, the date the release is discovered and/or reported and the type of cost for which reimbursement is sought.

Environmental reserves of $14.2 million and $13.8 million as of as of March 25, 2004 and September 25, 2003, respectively, represent our estimates for future expenditures for remediation, tank removal and litigation associated with 243 and 236 known contaminated sites, respectively, as a result of releases (e.g., overfills, spills and underground storage tank releases) and are based on current regulations, historical results and certain other factors. We estimate that approximately $13.2 million of our environmental obligation will be funded by state trust funds and third party insurance, as a result we may spend up to $1.0 million for remediation, tank removal and litigation. Also, as of March 25, 2004 and September 25, 2003 there were an additional 511 and 487, respectively, sites that are known to be contaminated sites that are being remediated by third parties and therefore the costs to remediate such sites are not included in our environmental reserve. Remediation costs for known sites are expected to be incurred over the next one to ten years. Environmental reserves have been established on an undiscounted basis with remediation costs based on internal and external estimates for each site. Future remediation costs for amounts of deductibles under, or amounts not covered by, state trust fund programs and third party insurance arrangements and for which the timing of payments can be reasonably estimated are discounted using a ten-percent rate.

The Pantry anticipates that it will be reimbursed for expenditures from state trust funds and private insurance. As of March 25, 2004, anticipated reimbursements of $15.8 million are recorded as long-term environmental receivables and $2.6 million are recorded as current receivables related to all sites. In Florida, remediation of such contamination reported before January 1, 1999 will be performed by the state (or state-approved independent contractors) and substantially all of the remediation costs, less any applicable deductibles, will be paid by the state trust fund. The Pantry will perform remediation in other states through independent contractor firms engaged by The Pantry. For certain sites, the trust fund does not cover a deductible or has a co-pay which may be less than the cost of such remediation. Although The Pantry is not aware of releases or contamination at other locations where it currently operates or has operated stores, any such releases or contamination could require substantial remediation expenditures, some or all of which may not be eligible for reimbursement from state trust funds.

Several of the locations identified as contaminated are being remediated by third parties who have indemnified The Pantry as to responsibility for clean up matters. Additionally, The Pantry is awaiting closure notices on several other locations which will release The Pantry from responsibility related to known contamination at those sites. These sites continue to be included in our environmental reserve until a final closure notice is received.

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 4—LONG-TERM DEBT

Long-term debt consisted of the following (amounts in thousands):


	March 25, 2004			September 25, 2003
Senior subordinated notes payable; due February 19, 2014; interest payable semi-annually at 7.75%	$	250,000		$	—
Senior credit facility; interest payable monthly at LIBOR plus 2.75%; principal due in quarterly installments through March 31, 2011		345,000			—
Senior subordinated notes payable; due October 15, 2007; interest payable semi-annually at 10.25%		—			200,000
First lien term loan; interest payable monthly at LIBOR plus 4.25%; principal due in quarterly installments through March 31, 2007, net of unamortized original issue discount of $3,105		—			247,153
Second lien term loan; interest payable monthly at LIBOR plus 6.5%; principal due in full on March 31, 2007, net of unamortized original issue discount of $636		—			50,318
Other notes payable; various interest rates and maturity dates		64			98

Total long-term debt		595,064			497,569
Less—current maturities		(12,039	)		(27,558	)

Long-term debt, net of current maturities	$	583,025		$	470,011

On October 16, 2003, we entered into an amendment to our existing senior credit facility to increase the borrowing under the first lien term loan by $80.0 million. The proceeds from the amendment to the term loan were used to fund the Golden Gallon^® acquisition. We incurred approximately $2.6 million in costs associated with the amendment, which were deferred.

On February 19, 2004, we called for redemption all of our outstanding $200.0 million principal amount of 10¹/4% Senior Subordinated Notes due 2007 and completed the sale of $250.0 million of our 7.75% Senior Subordinated Notes due 2014. The redemption was completed on March 22, 2004. We incurred approximately $5.9 million in costs associated with the sale of the new notes, which were deferred and will be amortized over the term of the loan agreement.

On March 12, 2004, we entered into an Amended and Restated Credit Agreement to replace all amounts outstanding under our senior secured credit facility, which consisted of a $345.0 million term loan that matures in March, 2011 and a $70.0 million revolving credit facility which expires in March, 2010 to replace our previous first and second lien term loans. Each of the Revolving Credit Facility and the Term Loan Facility are available for refinancing certain existing indebtedness of the Company, working capital financing and general corporate purposes. In addition, the Revolving Credit Facility is available for issuing commercial and standby letters of credit. We incurred approximately $2.0 million in costs associated with the amendment, which were deferred and will be amortized over the term of the loan agreement.

We recorded a loss on the redemption of the 10¹/4% Senior Subordinated Notes and refinancing of the senior credit facility of approximately $23.1 million. See Note 8.

At March 25, 2004, our senior credit facility consists of a $345.0 million term loan and a $70.0 million revolving credit facility, which bear interest at a rate of LIBOR plus 2.75%. In the event our leverage ratio, as defined in the agreement, were to be below 3.5 to 1.0, the $345.0 million term loan would bear interest at LIBOR

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

plus 2.50%. Our senior credit facility is secured by substantially all of our assets, other than our leased real property and is guaranteed by our subsidiaries. As of March 25, 2004, there were no outstanding borrowings under the revolving credit facility and we had approximately $35.0 million of standby letters of credit issued under the facility. As a result, we had approximately $35.0 million in available borrowing capacity. Furthermore, the revolving credit facility limits our total outstanding letters of credit to $50.0 million. The LIBOR associated with our senior credit facility resets periodically, and as of March 25, 2004, the effective LIBOR rate was 1.09%.

The remaining annual maturities of our long-term debt are as follows (amounts in thousands):


Year Ended September:
2004	$	8,025
2005		12,029
2006		16,010
2007		16,000
2008		16,000
Thereafter		527,000

Total long-term debt	$	595,064

As of March 25, 2004, we were in compliance with all covenants and restrictions relating to all outstanding borrowings and substantially all of our net assets are restricted as to payment of dividends and other distributions.

NOTE 5—DERIVATIVE FINANCIAL INSTRUMENTS

We enter into interest rate swap agreements to modify the interest rate characteristics of our outstanding long-term debt and have designated each qualifying instrument as a cash flow hedge. We formally document our hedge relationships, including identifying the hedge instruments and hedged items, as well as our risk management objectives and strategies for entering into the hedge transaction. At hedge inception, and at least quarterly thereafter, the Company assesses whether derivatives used to hedge transactions are highly effective in offsetting changes in the cash flow of the hedged item. We measure effectiveness by the ability of the interest rate swaps to offset cash flows associated with changes in the variable LIBOR rate associated with our term loan facilities using the hypothetical derivative method. To the extent the instruments are considered to be effective, changes in fair value are recorded as a component of other comprehensive income (loss). To the extent there is any hedge ineffectiveness, changes in fair value relating to the ineffective portion are immediately recognized in earnings (interest expense). When it is determined that a derivative ceases to be a highly effective hedge, we discontinue hedge accounting, and subsequent changes in fair value of the hedge instrument are recognized in earnings. Interest income was $0.4 million and $0.6 million for the second quarter of fiscal 2004 and fiscal 2003, respectively, and $1.2 million and $0.8 million for the six months ended March 25, 2004 and March 27, 2003, respectively, for the mark-to-market adjustment of those instruments that do not qualify for hedge accounting.

The fair values of our interest rate swaps are obtained from dealer quotes. These values represent the estimated amount we would receive or pay to terminate the agreement taking into consideration the difference between the contract rate of interest and rates currently quoted for agreements of similar terms and maturities. At March 25, 2004, other noncurrent liabilities include derivative liabilities of $3.7 million. At September 25, 2003, other accrued liabilities and other noncurrent liabilities include derivative liabilities of $1.5 million and $1.4 million, respectively. Cash flow hedges at March 25, 2004 have various settlement dates, the latest of which are April 2006 interest rate swaps.

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 6—COMPREHENSIVE INCOME

The components of comprehensive income, net of related taxes, for the periods presented are as follows (amounts in thousands):


	Three Months Ended						Six Months Ended
	March 25, 2004			March 27, 2003			March 25, 2004			March 27, 2003
Net loss	$	(14,082	)	$	(2,353	)	$	(9,144	)	$	(915	)

Other comprehensive income:
Cumulative effect of adoption of SFAS No. 133 (net of deferred income taxes of $0, $34, $0 and $68, respectively)		—			56			—			107
Net unrealized gains (losses) on qualifying cash flow hedges (net of deferred income taxes of $(952), $535, $(778) and $1,053, respectively)		(1,521	)		855			(1,243	)		1,681

Other comprehensive income (loss)		(1,521	)		911			(1,243	)		1,788

Comprehensive income (loss)	$	(15,603	)	$	(1,442	)	$	(10,387	)	$	873

The components of unrealized gains (losses) on qualifying cash flow hedges, net of related income taxes, for the periods presented are as follows (amounts in thousands):


	Three Months Ended						Six Months Ended
	March 25, 2004			March 27, 2003			March 25, 2004			March 27, 2003
Unrealized gains (losses) on qualifying cash flow hedges	$	(1,748	)	$	1,767		$	(1,648	)	$	3,555
Less: Reclassification adjustment for expenses included in net loss		227			(912	)		405			(1,874	)

Net unrealized gains (losses) on qualifying cash flow hedges	$	(1,521	)	$	855		$	(1,243	)	$	1,681

Accumulated other comprehensive deficit, net of related income taxes, is composed of unrealized losses on qualifying cash flow hedges of $1.9 million and $0.7 million as of March 25, 2004 and September 25, 2003, respectively.

NOTE 7—ASSET RETIREMENT OBLIGATION

Effective September 27, 2002, we adopted the provisions of SFAS No. 143, Accounting for Asset Retirement Obligations, and, as a result, we recognize the future cost to remove an underground storage tank over the estimated useful life of the storage tank in accordance with SFAS No. 143. A liability for the fair value of an asset retirement obligation with a corresponding increase to the carrying value of the related long-lived asset is recorded at the time an underground storage tank is installed. We will amortize the amount added to property and equipment and recognize accretion expense in connection with the discounted liability over the remaining life of the respective underground storage tanks.

The estimated liability is based on historical experience in removing these tanks, estimated tank useful lives, external estimates as to the cost to remove the tanks in the future and federal and state regulatory requirements.

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The liability is a discounted liability using a credit-adjusted risk-free rate ranging from 8.35% to 9.3%. Revisions to the liability could occur due to changes in tank removal costs, tank useful lives or if federal and/or state regulators enact new guidance on the removal of such tanks.

Upon adoption, we recorded a discounted liability of $8.4 million, which is included in other noncurrent liabilities, increased net property and equipment by $2.7 million and recognized a one-time cumulative effect adjustment of $3.5 million (net of deferred income tax benefit of $2.2 million). We will amortize the amount added to property and equipment and recognize accretion expense in connection with the discounted liability over the remaining lives of the respective underground storage tanks.

A reconciliation of the Company’s liability is as follows (in thousands):


	Six Months Ended
	March 25, 2004			March 27, 2003
Beginning balance	$	9,240		$	8,443
Liabilities incurred		6			149
Liabilities assumed—acquisitions		1,236			—
Liabilities settled		(239	)		(38	)
Accretion expense		410			418

Ending balance	$	10,653		$	8,972

NOTE 8—INTEREST EXPENSE AND LOSS ON EXTINGUISHMENT OF DEBT

The components of interest expense are as follows (amounts in thousands):


	Three Months Ended						Six Months Ended
	March 25, 2004			March 27, 2003			March 25, 2004			March 27, 2003
Interest on long-term debt	$	12,453		$	9,097		$	23,595		$	18,476
Interest rate swap settlements.		690			2,425			2,041			4,900
Interest on capital lease obligations		553			547			1,106			1,095
Fair market value change in non-qualifying derivatives		(409	)		(624	)		(1,164	)		(843	)
Amortization of deferred financing costs		876			585			1,729			1,170
Miscellaneous		3			12			—			17

Subtotal: Interest expense	$	14,166		$	12,042		$	27,307		$	24,815
Loss on debt extinguishment		23,087			—			23,087			—

Total interest expense and loss on extinguishment of debt	$	37,253		$	12,042		$	50,394		$	24,815

The loss on debt extinguishment relates to the redemption of our $200 million 10¹/4% senior subordinated notes and the refinancing of the senior credit facility. The loss includes the write-off of deferred financing costs of $11.8 million, the call premium on the senior subordinated notes of $6.8 million, the call premium on the second lien term loan of $1.0 million, and the write-off of the unamortized original issue discount on the senior credit facility of $3.5 million.

NOTE 9—OTHER EQUITY INSTRUMENTS

In December 1996, in connection with its purchase of 17,500 shares of Series B preferred stock, Freeman Spogli acquired warrants to purchase 2,346,000 shares of common stock. The fair value of the warrants at date of

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

issuance approximated $600 thousand and is included in additional paid-in capital. On December 9, 2003, Freeman Spogli exercised the warrants to purchase 2,346,000 shares of common stock at an exercise price of $7.45 per share. The exercise was cashless whereby shares of common stock received were reduced by the number of shares having an aggregate fair market value equal to the exercise price, or approximately $17.5 million. The aggregate fair market value was based on the average closing price on each of the ten days prior to December 9, 2003, or $23.68 per share. Consequently, upon exercise Freeman Spogli received 1,607,855 shares of common stock.

NOTE 10—EARNINGS PER SHARE

We compute earnings per share data in accordance with the requirements of SFAS No. 128, Earnings Per Share. Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding plus the effect of outstanding warrants and stock options using the “treasury stock” method.

The following table reflects the calculation of basic and diluted earnings per share (dollars in thousands, except per share data):


	Three Months Ended						Six Months Ended
	March 25, 2004			March 27, 2003			March 25, 2004			March 27, 2003
Net income (loss) before cumulative effect adjustment	$	(14,082	)	$	(2,353	)	$	(9,144	)	$	2,567
Cumulative effect adjustment		—			—			—			(3,482	)

Net loss		(14,082	)	$	(2,353	)	$	(9,144	)	$	(915	)

Loss per share—basic and diluted:
Weighted average shares outstanding		19,799			18,108			19,103			18,108

Net income (loss) per share before cumulative effect adjustment	$	(0.71	)	$	(0.13	)	$	(0.48	)	$	0.14
Loss per share on cumulative effect adjustment		—			—			—			(0.19	)

Net loss per share	$	(0.71	)	$	(0.13	)	$	(0.48	)	$	(0.05	)

Options and warrants to purchase shares of common stock that were not included in the computation of diluted earnings per share, because their inclusion would have been antidilutive, were 1.4 million and 3.6 million for the three months and six months ended March 25, 2004 and March 27, 2003, respectively.

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

NOTE 11—GUARANTOR SUBSIDIARIES

We have two wholly owned subsidiaries, R. & H. Maxxon, Inc. and Kangaroo, Inc. (the “Guarantor Subsidiaries”) that are guarantors of our senior credit facility and our subordinated notes. The guarantees are joint and several in addition to full and unconditional. The Guarantor Subsidiaries do not conduct any operations and do not have significant assets. The Guarantor Subsidiaries comprise all direct and indirect subsidiaries of the Company. Combined financial information for the Guarantor Subsidiaries is as follows:

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Three Months Ended March 25, 2004


	The Pantry (Issuer)			Total Guarantor Subsidiaries		Eliminations		Total
Revenues:
Merchandise sales	$	269,795		$	—	$	—	$	269,795
Gasoline sales		516,280			—		—		516,280
Commissions		8,312			—		—		8,312

Total revenues		794,387			—		—		794,387

Cost of sales:
Merchandise		178,621			—		—		178,621
Gasoline.		482,539			—		—		482,539

Total cost of sales		661,160			—		—		661,160

Gross profit.		133,227			—		—		133,227

Operating expenses:
Operating, general and administrative expenses		105,443			—		—		105,443
Depreciation and amortization		13,533			—		—		13,533

Total operating expenses		118,976			—		—		118,976

Income from operations		14,251			—		—		14,251

Equity in earnings of subsidiaries		—			—		—		—

Other income (expense):
Loss on extinguishment of debt		(23,087	)		—		—		(23,087	)
Interest expense		(14,166	)		—		—		(14,166	)
Miscellaneous		105			—		—		105

Total other expense		(37,148	)		—		—		(37,148	)

Loss before income taxes		(22,897	)		—		—		(22,897	)
Income tax benefit		8,815			—		—		8,815

Net loss	$	(14,082	)	$	—	$	—	$	(14,082	)

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Three Months Ended March 27, 2003


	The Pantry (Issuer)			Total Guarantor Subsidiaries		Eliminations		Total
Revenues:
Merchandise sales	$	234,900		$	—	$	—	$	234,900
Gasoline sales		431,719			—		—		431,719
Commissions		6,825			—		—		6,825

Total revenues		673,444			—		—		673,444

Cost of sales:
Merchandise		157,405			—		—		157,405
Gasoline		402,910			—		—		402,910

Total cost of sales		560,315			—		—		560,315

Gross profit		113,129			—		—		113,129

Operating expenses:
Operating, general and administrative expenses		92,323			—		—		92,323
Depreciation and amortization		13,098			—		—		13,098

Total operating expenses		105,421			—		—		105,421

Income from operations		7,708			—		—		7,708

Equity in earnings of subsidiaries		—			—		—		—

Other income (expense):
Interest expense		(12,042	)		—		—		(12,042	)
Miscellaneous		507			—		—		507

Total other expense		(11,535	)		—		—		(11,535	)

Loss before income taxes		(3,827	)		—		—		(3,827	)
Income tax benefit		1,474			—		—		1,474

Net loss	$	(2,353	)	$	—	$	—	$	(2,353	)

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Six Months Ended March 25, 2004


	The Pantry (Issuer)			Total Guarantor Subsidiaries		Eliminations		Total
Revenues:
Merchandise sales	$	539,820		$	—	$	—	$	539,820
Gasoline sales		990,571			—		—		990,571
Commissions		15,331			—		—		15,331

Total revenues		1,545,722			—		—		1,545,722

Cost of sales:
Merchandise		356,491			—		—		356,491
Gasoline		915,894			—		—		915,894

Total cost of sales		1,272,385			—		—		1,272,385

Gross profit		273,337			—		—		273,337

Operating expenses:
Operating, general and administrative expenses		210,570			—		—		210,570
Depreciation and amortization		27,608			—		—		27,608

Total operating expenses		238,178			—		—		238,178

Income from operations		35,159			—		—		35,159

Equity in earnings of subsidiaries		—			—		—		—

Other income (expense):
Loss on extinguishment of debt		(23,087	)						(23,087	)
Interest expense		(27,307	)		—		—		(27,307	)
Miscellaneous		367			—		—		367

Total other expense		(50,027	)		—		—		(50,027	)

Loss before income taxes		(14,868	)		—		—		(14,868	)
Income tax benefit		5,724			—		—		5,724

Net loss	$	(9,144	)	$	—	$	—	$	(9,144	)

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Six Months Ended March 27, 2003


	The Pantry (Issuer)			Total Guarantor Subsidiaries		Eliminations		Total
Revenues:
Merchandise sales	$	477,240		$	—	$	—	$	477,240
Gasoline sales		833,652			—		—		833,652
Commissions		13,529			—		—		13,529

Total revenues		1,324,421			—		—		1,324,421

Cost of sales:
Merchandise		319,972			—		—		319,972
Gasoline		765,329			—		—		765,329

Total cost of sales		1,085,301			—		—		1,085,301

Gross profit		239,120			—		—		239,120

Operating expenses:
Operating, general and administrative expenses		185,464			—		—		185,464
Depreciation and amortization		25,605			—		—		25,605

Total operating expenses		211,069			—		—		211,069

Income from operations		28,051			—		—		28,051

Equity in earnings of subsidiaries		—			—		—		—

Other income (expense):
Interest expense		(24,815	)		—		—		(24,815	)
Miscellaneous		941			—		—		941

Total other expense		(23,874	)		—		—		(23,874	)

Income before income taxes		4,177			—		—		4,177
Income tax expense		(1,610	)		—		—		(1,610	)

Net income before cumulative effect adjustment		2,567							2,567
Cumulative effect adjustment		(3,482	)						(3,482	)

Net loss	$	(915	)	$	—	$	—	$	(915	)

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

THE PANTRY, INC. AND SUBSIDIARIES

Supplemental Combining Balance Sheets

March 25, 2004

(Dollars in thousands)


	The Pantry (Issuer)			Total Guarantor Subsidiaries			Eliminations			Total
ASSETS
Current assets:
Cash and cash equivalents	$	50,991		$	—		$	—		$	50,991
Receivables, net		35,828			—			—			35,828
Inventories		94,321			—			—			94,321
Prepaid expenses		8,013			2			—			8,015
Property held for sale		6,864			—			—			6,864
Deferred income taxes		4,334			—			—			4,334

Total current assets		200,351			2			—			200,353

Investment in subsidiaries		40,722			—			(40,722	)		—

Property and equipment, net		412,458			—			—			412,458

Other assets:
Goodwill		337,998			—			—			337,998
Deferred financing costs, net		7,736			—			—			7,736
Environmental receivables		15,784			—			—			15,784
Intercompany notes receivable		(23,477	)		43,872			(20,395	)		—
Other noncurrent assets		12,614			57			—			12,671

Total other assets		350,655			43,929			(20,395	)		374,189

Total assets	$	1,004,186		$	43,931		$	(61,117	)	$	987,000

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt	$	12,039		$	—		$	—		$	12,039
Current maturities of capital lease obligations		1,375			—			—			1,375
Accounts payable		91,194			—			—			91,194
Accrued interest		3,118			—			—			3,118
Accrued compensation and related taxes		12,520			—			—			12,520
Other accrued taxes		11,386			—			—			11,386
Accrued insurance		14,367			—			—			14,367
Other accrued liabilities		11,968			—			(63	)		11,905

Total current liabilities		157,967			—			(63	)		157,904

Long-term debt		583,025			—			—			583,025

Other liabilities:
Environmental reserves		14,226			—			—			14,226
Deferred income taxes		44,291			—			—			44,291
Deferred revenue		33,486			—			—			33,486
Capital lease obligations		15,106			—			—			15,106
Intercompany notes payable		17,124			3,207			(20,331	)		—
Other noncurrent liabilities		19,819			1			—			19,820

Total other liabilities		144,052			3,208			(20,331	)		126,929

Shareholders’ equity:
Common stock		200			523			(523	)		200
Additional paid-in capital		128,740			40,552			(40,552	)		128,740
Shareholder loans		(64	)		—			—			(64	)
Accumulated other comprehensive deficit, net		(1,934	)		—			—			(1,934	)
Accumulated deficit		(7,800	)		(352	)		(352	)		(7,800	)

Total shareholders’ equity		119,142			40,723			(40,723	)		119,142

Total liabilities and shareholders’ equity	$	1,004,186		$	43,931		$	(61,117	)	$	987,000

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

THE PANTRY, INC. AND SUBSIDIARIES

Supplemental Combining Balance Sheets

September 25, 2003

(Dollars in thousands)


	The Pantry (Issuer)			Total Guarantor Subsidiaries			Eliminations			Total
ASSETS
Current assets:
Cash and cash equivalents	$	72,901		$	—		$	—		$	72,901
Receivables, net		30,423			—			—			30,423
Inventories		84,156			—			—			84,156
Prepaid expenses		6,324			2			—			6,326
Property held for sale		2,013			—			—			2,013
Deferred income taxes		4,334			—			—			4,334

Total current assets		200,151			2			—			200,153

Investment in subsidiaries		40,723			—			(40,723	)		—

Property and equipment, net		400,609			—			—			400,609

Other assets:
Goodwill		278,629			—			—			278,629
Deferred financing costs, net		10,757			—			—			10,757
Environmental receivables		15,109			—			—			15,109
Intercompany notes receivable		(23,477	)		43,872			(20,395	)		—
Other noncurrent assets		8,851			57			—			8,908

Total other assets		289,869			43,929			(20,395	)		313,403

Total assets	$	931,352		$	43,931		$	(61,118	)	$	914,165

LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Current maturities of long-term debt	$	27,558		$	—		$	—		$	27,558
Current maturities of capital lease obligations		1,375			—			—			1,375
Accounts payable		78,885			—			—			78,885
Accrued interest		11,924			—			—			11,924
Accrued compensation and related taxes		12,840			—			—			12,840
Other accrued taxes		16,510			—			—			16,510
Accrued insurance		12,293			—			—			12,293
Other accrued liabilities		21,379			—			(65	)		21,314

Total current liabilities		182,764			—			(65	)		182,699

Long-term debt		470,011			—			—			470,011

Other liabilities:
Environmental reserves		13,823			—			—			13,823
Deferred income taxes		50,015			—			—			50,015
Deferred revenue		37,251			—			—			37,251
Capital lease obligations		15,779			—			—			15,779
Intercompany notes payable		17,124			3,208			(20,332	)		—
Other noncurrent liabilities		15,920			2			—			15,922

Total other liabilities		149,912			3,210			(20,332	)		132,790

Shareholders’ equity:
Common stock		182			523			(523	)		182
Additional paid-in capital		128,002			40,551			(40,551	)		128,002
Shareholder loans		(173	)		—			—			(173	)
Accumulated other comprehensive deficit, net		(690	)		—			—			(690	)
Accumulated earnings (deficit)		1,344			(353	)		(353	)		1,344

Total shareholders’ equity		128,665			40,721			(40,721	)		128,665

Total liabilities and shareholders’ equity	$	931,352		$	43,931		$	(61,118	)	$	914,165

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

THE PANTRY, INC. AND SUBSIDIARIES

Supplemental Combining Statements of Cash Flows

Six Months Ended March 25, 2004

(Dollars in thousands)


	The Pantry (Issuer)			Total Guarantor Subsidiaries		Eliminations		Total
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss	$	(9,144	)	$	—	$	—	$	(9,144	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		27,608			—		—		27,608
Benefit for deferred income taxes		(5,724	)		—		—		(5,724	)
Loss on extinguishment of debt		23.087			—		—		23.087
Gain on sale of property and equipment		(959	)		—		—		(959	)
Fair market value change in non-qualifying derivatives		(1,164	)		—		—		(1,164	)
Provision for closed stores		1,117			—		—		1,117
Impairment of long-lived assets		1,046			—		—		1,046
Cumulative effect of change in accounting principle		—			—		—		—
Amortization of deferred loan costs		1,729			—		—		1,729
Amortization of long-term debt discount		534			—		—		534
Changes in operating assets and liabilities, net:
Receivables		(3,644	)		—		—		(3,644	)
Inventories		(147	)		—		—		(147	)
Prepaid expenses		(1,573	)		—		—		(1,573	)
Other noncurrent assets		(45	)		—		—		(45	)
Accounts payable		873			—		—		873
Other current liabilities and accrued expenses		(20,273	)		—		—		(20,273	)
Reserves for environmental expenses		(272	)		—		—		(272	)
Other noncurrent liabilities		(5,637	)		—		—		(5,637	)

Net cash provided by operating activities		7,412			—		—		7,412

CASH FLOWS FROM INVESTING ACTIVITIES
Additions to property held for sale		(1,376	)		—		—		(1,376	)
Additions to property and equipment		(17,016	)		—		—		(17,016	)
Proceeds from sale of land, buildings and equipment		98,617			—		—		98,617
Acquisitions of related businesses, net of cash acquired		(184,967	)		—		—		(184,967	)

Net cash used in investing activities		(104,742	)		—		—		(104,742	)

CASH FLOWS FROM FINANCING ACTIVITIES
Principal repayments under capital leases		(673	)		—		—		(673	)
Principal repayments of long-term debt, including redemption premiums		(589,387	)		—		—		(589,387	)
Proceeds from issuance of long-term borrowings		675,000			—		—		675,000
Proceeds from exercise of stock options		756			—		—		756
Repayments of shareholder loans		109			—		—		109
Other financing costs		(10,385	)		—		—		(10,385	)

Net cash provided by financing activities		75,420			—		—		75,420

NET DECREASE IN CASH AND CASH EQUIVALENTS		(21,910	)		—		—		(21,910	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		72,901			—		—		72,901

CASH AND CASH EQUIVALENTS, END OF PERIOD.	$	50,991		$	—	$	—	$	50,991

THE PANTRY, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

THE PANTRY, INC.

Supplemental Combining Statements of Cash Flows

Six Months Ended March 27, 2003

(Dollars in thousands)


	The Pantry (Issuer)			Total Guarantor Subsidiaries		Eliminations		Total
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss	$	(915	)	$	—	$	—	$	(915	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Depreciation and amortization		25,605			—		—		25,605
Provision for deferred income taxes		1,610			—		—		1,610
Loss on sale of property and equipment		333			—		—		333
Fair market value change in non-qualifying derivatives		(843	)		—		—		(843	)
Provision for closed stores		1,135			—		—		1,135
Impairment of long-lived assets		300			—		—		300
Cumulative effect of change in accounting principle		3,482			—		—		3,482
Amortization of deferred loan costs		1,170			—		—		1,170
Changes in operating assets and liabilities, net:					—		—
Receivables		55			—		—		55
Inventories		4,930			—		—		4,930
Prepaid expenses		(1,987	)		—		—		(1,987	)
Other noncurrent assets		(3,642	)		—		—		(3,642	)
Accounts payable		(15,227	)		—		—		(15,227	)
Other current liabilities and accrued expenses		(12,672	)		—		—		(12,672	)
Reserves for environmental expenses		457			—		—		457
Other noncurrent liabilities		(2,226	)		—		—		(2,226	)

Net cash provided by operating activities		1,565			—		—		1,565

CASH FLOWS FROM INVESTING ACTIVITIES
Additions to property held for sale		(1,074	)		—		—		(1,074	)
Additions to property and equipment		(6,810	)		—		—		(6,810	)
Proceeds from sale of land, buildings and equipment		3,192			—		—		3,192
Acquisitions of related businesses, net of cash acquired		(1,169	)		—		—		(1,169	)

Net cash used in investing activities		(5,861	)		—		—		(5,861	)

CASH FLOWS FROM FINANCING ACTIVITIES
Principal repayments under capital leases		(669	)		—		—		(669	)
Principal repayments of long-term debt		(20,650	)		—		—		(20,650	)
Proceeds from issuance of short-term borrowings		10,000			—		—		10,000
Repayments of shareholder loans		256			—		—		256
Other financing costs		(203	)		—		—		(203	)

Net cash used in financing activities		(11,266	)		—		—		(11,266	)

NET DECREASE IN CASH AND CASH EQUIVALENTS		(15,562	)		—		—		(15,562	)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		42,236			—		—		42,236

CASH AND CASH EQUIVALENTS, END OF PERIOD.	$	26,674		$	—	$	—	$	26,674

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of our financial condition and results of operations is provided to increase the understanding of, and should be read in conjunction with, our Consolidated Financial Statements and the accompanying notes appearing elsewhere in this report. Additional discussion and analysis related to our Company is contained in our Annual Report on Form 10-K for the fiscal year ended September 25, 2003, as amended.

This report, including without limitation, statements under our discussion and analysis of our financial condition and results of operations, contains statements that we believe are “forward-looking statements” under the meaning of the Private Securities Litigation Reform Act of 1995 and are intended to enjoy protection of the safe harbor for forward-looking statements provided by that Act. These forward-looking statements generally can be identified by use of phrases such as “believe,” “plan,” “expect,” “anticipate,” “intend,” “forecast” or other similar words or phrases. Descriptions of our objectives, goals, targets, plans, strategies, anticipated capital expenditures, costs and burdens of environmental remediation, anticipated gasoline suppliers and percentages of our requirements to be supplied by particular companies, anticipated store banners and percentages of our stores that we believe will operate under particular banners, expected cost savings and benefits and anticipated synergies from the Golden Gallon^{^®} acquisition, anticipated costs of re-branding our stores, anticipated sharing of costs of conversion with our gasoline suppliers, and expectations regarding re-modeling, re-branding, re-imaging or otherwise converting our stores are also forward-looking statements. These forward-looking statements are based on our current plans and expectations and involve a number of risks and uncertainties that could cause actual results and events to vary materially from the results and events anticipated or implied by such forward-looking statements, including:

•

Competitive pressures from convenience stores, gasoline stations and other non-traditional retailers located in our markets;

•

Changes in economic conditions generally and in the markets we serve;

•

Unfavorable weather conditions;

•

Political conditions in crude oil producing regions, including South America and the Middle East;

•

Volatility in crude oil and wholesale petroleum costs;

•

Wholesale cost increases of tobacco products;

•

Consumer behavior, travel and tourism trends;

•

Changes in state and federal environmental and other regulations;

•

Dependence on one principal supplier for merchandise and two principal suppliers for gasoline;

•

Financial leverage and debt covenants;

•

Changes in the credit ratings assigned to our debt securities, credit facilities and trade credit;

•

Inability to identify, acquire and integrate new stores;

•

The interests of our largest stockholder;

•

Dependence on senior management;

•

Acts of war and terrorism; and

•

Other unforeseen factors.

For a discussion of these and other risks and uncertainties, please refer to “Risk Factors” below. The list of factors that could affect future performance and the accuracy of forward-looking statements is illustrative but by no means exhaustive. Accordingly, all forward-looking statements should be evaluated with the understanding of their inherent uncertainty. The forward-looking statements included in this report are based on, and include, our estimates as of May 10, 2004. We anticipate that subsequent events and market developments will cause our

estimates to change. However, while we may elect to update these forward-looking statements at some point in the future, we specifically disclaim any obligation to do so, even if new information becomes available in the future.

Introduction

We are the leading independently operated convenience store chain in the southeastern United States and the third largest independently operated convenience store chain in the country based on store count with 1,374 stores in ten states as of March 25, 2004. Our stores offer a broad selection of merchandise, gasoline and ancillary products and services designed to appeal to the convenience needs of our customers. Our strategy is to continue to improve upon our position as the leading independently operated convenience store chain in the southeastern United States by generating profitable growth through merchandising initiatives, sophisticated management of our gasoline business, upgrading our stores, leveraging our geographic economies of scale, benefiting from the favorable demographics of our markets and continuing to selectively pursue opportunistic acquisitions.

During the second quarter of fiscal 2004, we continued to focus on our re-branding and re-imaging initiative, which began in the second half of fiscal 2003. As part of this initiative, we began to re-brand approximately 1,000 of our stores’ gasoline operations to the BP^®/Amoco ^®, Citgo ^® or Kangaroo^® brands while simultaneously re-imaging the merchandise logo at these locations to our Kangaroo Express^SM banner. We expect that approximately 35% of the total cost of this initiative will be funded by our gasoline partners. We believe this combined initiative allows us to leverage the cost of a complete facelift to most of our facilities, provides us with increased brand identity, and helps us in our efforts to optimize our gasoline gallon growth and gross profit dollars.

As of March 25, 2004, we have re-branded and re-imaged 366 locations, including 126 stores that have been converted or re-imaged to BP^®/Amoco^®, 131 stores that have received Citgo^® image upgrades and 109 stores that have been converted to our Kangaroo^® private brand format. Almost all of these stores have also been converted to Kangaroo Express^SM branding for their merchandise operations.

During the second quarter of fiscal 2004, we continued implementing our merchandising initiatives which are focused on driving sales and profitability with recognizable value on high-traffic items. We plan to further improve our merchandise offerings and related results through selective expansion of quick service restaurant and proprietary food service offerings, increased private label penetration, including our proprietary Celeste^® beverage line and continued merchandise vendor consolidation and contract negotiation.

On October 16, 2003, we completed the acquisition of 138 convenience stores operating under the Golden Gallon^{^®} banner from Ahold, USA, Inc. This acquisition included 90 stores in Tennessee and 48 stores in northwest Georgia and enhances our strong regional presence, increasing our store count to 1,374 stores as of March 25, 2004. The aggregate purchase price was $187.0 million. The acquisition included (1) the purchase of certain real estate assets (114 fee-owned stores), financed through a $94.5 million sale-leaseback transaction and (2) the purchase of the Golden Gallon^{^®} operations and the balance of the real estate assets (17 fee-owned stores, corporate headquarters building and certain undeveloped properties) for approximately $92.5 million in cash, financed with $12.5 million of existing cash and $80.0 million of debt through borrowings under our amended senior secured credit facility. The acquired assets also included a dairy plant and related assets and a fuel hauling operation, which we subsequently sold to two of our existing suppliers.

Throughout the remainder of fiscal 2004, we plan to remain focused on maximizing the benefits of our merchandise and gasoline initiatives as well as upgrading our network of stores. We will continue to selectively review acquisition opportunities to reinforce our market position. Since 1996, we have successfully completed more than 40 acquisitions, growing our store base from 379 to 1,374 stores. With over 42,000 convenience stores currently operating in the southeastern United States, we believe there are significant acquisition opportunities to strengthen our position in existing markets and expand into contiguous markets.

Market and Industry Trends

During fiscal 2004 we have experienced rising wholesale gasoline costs as domestic crude oil prices have risen from $28 per barrel in October 2003 to $38 per barrel as of March 25, 2004. We attempt to pass along wholesale gasoline cost changes to our customers through retail price changes. However, we are not always able to do so, and the timing of the related increase in retail prices is affected by competitive conditions. As a result, we tend to experience tighter gasoline margins in periods of rising costs and higher margins in periods of decreasing wholesale costs. Since 1995, our gasoline margin per gallon has remained relatively stable and averaged more than 12 cents per gallon.

Increases in wholesale cigarette costs during 2004, as well as national and local campaigns to discourage smoking in the United States, have had an adverse effect on unit demand for cigarettes domestically. We have attempted to pass along cost increases to our customers and have not generally experienced a deterioration in cigarette gross margin or in average cartons sold per store week.

Results of Operations

The following table presents for the periods indicated selected items in the consolidated statements of income as a percentage of our total revenue:


	Three Months Ended				Six Months Ended
	March 25, 2004		March 27, 2003		March 25, 2004		March 27, 2003
Total revenue	100.0	%	100.0	%	100.0	%	100.0	%
Gasoline revenue	65.0	%	65.0	%	64.1	%	63.0	%
Merchandise revenue	34.0	%	34.0	%	34.9	%	36.0	%
Commission income	1.0	%	1.0	%	1.0	%	1.0	%
Cost of sales	83.2	%	83.2	%	82.3	%	81.9	%

Gross profit
Gasoline gross profit	4.3	%	4.3	%	4.8	%	5.2	%
Merchandise gross profit	11.5	%	11.5	%	11.9	%	11.9	%
Commission gross profit	1.0	%	1.0	%	1.0	%	1.0	%
Operating, general and administrative expenses	13.3	%	13.7	%	13.6	%	14.0	%
Depreciation and amortization	1.7	%	1.9	%	1.8	%	1.9	%

Income from operations	1.8	%	1.1	%	2.3	%	2.1	%
Loss on extinguishment of debt	(2.9	)%	—		(1.5	)%	—
Interest and miscellaneous expense	(1.8	)%	(1.7	)%	(1.7	)%	(1.8	)%

Income/(loss) before income taxes	(2.9	)%	(0.6	)%	(1.0	)%	0.3	%
Income tax benefit (expense)	1.1	%	0.2	%	0.4	%	(0.1	)%

Net income/(loss) before cumulative effect adjustment	(1.8	)%	(0.3	)%	(0.6	)%	0.2	%
Cumulative effect adjustment, net of income tax	0.0	%	0.0	%	0.0	%	(0.3	)%

Net loss	(1.8	)%	(0.3	)%	(0.6	)%	(0.1	)%

The table below provides a summary of our selected financial data for our three and six months ended March 25, 2004 and March 27, 2003.


	Three Months Ended						Six Months Ended
	March 25, 2004			March 27, 2003			March 25, 2004			March 27, 2003
Merchandise margin		33.8	%		33.0	%		34.0	%		33.0	%
Gasoline gallons (millions)		321.8			277.1			647.4			561.0
Gasoline margin per gallon	$	0.1048		$	0.1040		$	0.1154		$	0.1218
Gasoline retail per gallon	$	1.60		$	1.56		$	1.53		$	1.49

Comparable store data:
Merchandise sales %		3.3	%		2.5	%		3.0	%		2.9	%
Gasoline gallons %		1.2	%		(0.2	)%		2.3	%		(0.5	)%

Number of stores:
End of period		1,374			1,274			1,374			1,274
Weighted-average store count		1,380			1,278			1,370			1,281

Three Months Ended March 25, 2004 Compared to the Three Months Ended March 27, 2003

Merchandise Revenue. Merchandise revenue for the second quarter of fiscal 2004 was $269.8 million compared to $234.9 million during the second quarter of fiscal 2003, an increase of $34.9 million or 14.9%. The increase is primarily attributable to merchandise revenue from the Golden Gallon^{^®} acquisition of $30.6 million and a 3.3%, or $7.6 million, increase in comparable store merchandise revenue compared to the second quarter of fiscal 2003. These increases were partially offset by lost revenue from closed stores of approximately $3.8 million.

Gasoline Revenue and Gallons. Gasoline revenue for the second quarter of fiscal 2004 was $516.3 million compared to $431.7 million during the second quarter of fiscal 2003, an increase of $84.6 million or 19.6%. The increase in gasoline revenue is primarily attributable to gasoline revenue from the Golden Gallon^{^®} acquisition of $68.7 million, an increase in comparable store gallons of 3.2 million, or 1.2%, and the 4 cent per gallon increase in the average gasoline retail price per gallon. The increase in the average gasoline retail price per gallon is a result of our passing along to customers the increases in wholesale fuel costs experienced in the second quarter of fiscal 2004. These increases were partially offset by lost revenue from closed stores of approximately $3.3 million.

In the second quarter of fiscal 2004, gasoline gallons sold were 321.8 million compared to 277.1 million during the second quarter of fiscal 2003, an increase of 44.7 million gallons or 16.1%. The increase is primarily attributable to an increase in gallon volume of 43.9 million from the Golden Gallon^{^®} acquisition and the comparable store gasoline gallon increase, partially offset by lost gallon volume from closed stores of approximately 2.2 million gallons.

Commission Income. Commission income for the second quarter of fiscal 2004 was $8.3 million compared to $6.8 million during the second quarter of fiscal 2003, an increase of $1.5 million or 21.8%. The increase is primarily due to an increase in commission income of $1.0 million from the Golden Gallon^{^®} acquisition and comparable store increases in lottery income. During the second quarter of fiscal 2004, the State of Tennessee introduced its lottery, and sales of Tennessee lottery tickets contributed approximately $0.3 million to commission income in the second quarter.

Merchandise Gross Profit and Margin. Merchandise gross profit was $91.2 million for the second quarter of fiscal 2004 compared to $77.5 million for the second quarter of fiscal 2003, an increase of $13.7 million or 17.7%. This increase is primarily attributable to the merchandise gross profit contribution of $9.9 million from

stores acquired in the Golden Gallon^{^®} acquisition, increased merchandise revenue discussed above and a 80 basis points increase in our merchandise margin. Merchandise margin increased to 33.8% for the second quarter of fiscal 2004 from the 33.0% reported for the second quarter of fiscal 2003. Our merchandise gross margin has been positively impacted by the introduction of private label products and increased quick service restaurant volume.

Gasoline Gross Profit and Per Gallon Margin. Gasoline gross profit was $33.7 million for the second quarter of fiscal 2004 compared to $28.8 million for the second quarter of fiscal 2003, an increase of $4.9 million or 17.1%. The increase is primarily attributable to the gasoline gross profit contribution of $3.9 million from stores acquired in the Golden Gallon^{^®} acquisition and the comparable store gallon increase discussed above. Gasoline gross profit per gallon of 10.5 cents was consistent with the comparable prior year period.

Operating, General and Administrative Expenses. Operating, general and administrative expenses for the second quarter of fiscal 2004 totaled $105.4 million compared to $92.3 million for the second quarter of fiscal 2003, an increase of $13.1 million or 14.2%. This increase is primarily due to operating, general and administrative expenses of approximately $10.8 million associated with stores acquired in the Golden Gallon^{^®} acquisition and comparable store increases in labor and other variable expenses. As a percentage of total revenue, operating, general and administrative expenses were 13.3% in the second quarter of fiscal 2004 and adjusted for the impact of gasoline inflation were 13.5% in the second quarter of fiscal 2003. Administrative expenses also include approximately $0.7 million associated with the Company’s secondary offering of common stock, which closed in January 2004.

Income from Operations. Income from operations totaled $14.3 million for the second quarter of fiscal 2004 compared to $7.7 million for the second quarter of fiscal 2003, an increase of $6.5 million or 84.9%. The increase is primarily attributable to the increases in gasoline and merchandise gross profit discussed above, partially offset by the increase in operating, general and administrative expenses.

EBITDA. EBITDA is defined by us as net income before interest expense, income taxes, depreciation and amortization and cumulative effect of change in accounting principle. EBITDA for the second quarter of fiscal 2004 totaled $27.9 million compared to EBITDA of $21.3 million during the second quarter of fiscal 2003, an increase of $6.6 million or 30.9%. The increase is attributable to the increase in income from operations discussed above.

EBITDA is not a measure of performance under accounting principles generally accepted in the United States of America, and should not be considered as a substitute for net income, cash flows from operating activities and other income or cash flow statement data. We have included information concerning EBITDA as one measure of our cash flow and historical ability to service debt and because we believe investors find this information useful because it reflects the resources available for strategic opportunities including, among others, to invest in the business, make strategic acquisitions and to service debt. EBITDA as defined by us may not be comparable to similarly titled measures reported by other companies.

The following table contains a reconciliation of EBITDA to net cash provided by operating activities and cash flows from investing and financing activities (amounts in thousands):


	Three Months Ended
	March 25, 2004			March 27, 2003
EBITDA	$	27,889		$	21,313
Interest expense and loss on extinguishment of debt		(37,253	)		(12,042	)
Adjustments to reconcile net loss to net cash provided by operating activities (other than depreciation and amortization, provision for deferred income taxes and cumulative effect of change in accounting principle)		24,499			810
Changes in operating assets and liabilities, net:
Assets		(4,756	)		(4,766	)
Liabilities		(4,169	)		6,307

Net cash provided by operating activities	$	6,210		$	11,622
Net cash provided by (used in) investing activities	$	7,765		$	(5,602	)
Net cash provided by (used in) financing activities	$	546		$	(942	)

Loss on Extinguishment of Debt. As a result of the retirement of our 10.25% subordinated notes and the refinancing of our senior credit facility during the second quarter of fiscal 2004 we incurred $23.1 million in debt extinguishment costs that have been included as a component of interest expense. These charges include the write-off of approximately $11.8 million in unamortized deferred financing costs, the write-off of approximately $3.5 million of unamortized original issue discount and call premiums of approximately $7.8 million.

Interest Expense. Interest expense is primarily comprised of interest on borrowings under our senior credit facility and senior subordinated notes and the 23.1 million loss on extinguishment of debt referred to above. Interest expense, excluding the loss on extinguishment of debt, for the second quarter of fiscal 2004 was $14.2 million compared to $12.0 million for the second quarter of fiscal 2003. The increase of $2.2 million is primarily the result of $1.7 million in duplicative interest on our subordinated notes, during the 30-day call period, in addition to the increase in our weighted average outstanding borrowings as a result of the Golden Gallon^® acquisition. During the second quarter of fiscal 2004, we called $200.0 million of our outstanding 10.25% subordinated notes and replaced them with $250.0 million in 7.75% subordinated notes. The 10.25% notes included a 30-day non-cancelable call notice. During this 30-day call period, both the 10.25% and 7.75% notes were outstanding, which resulted in duplicative interest expense of $1.7 million. Interest expense associated with the $80.0 million increase in our outstanding borrowings as a result of the Golden Gallon^® acquisition was approximately $0.9 million for the second quarter of fiscal 2004.

Net loss. Net loss for the second quarter of fiscal 2004 was $14.1 million compared to a net loss of $2.4 million for the second quarter of fiscal 2003. The increase is primarily attributable to the charges associated with the debt extinguishment and additional interest expense partially offset by the increased income from operations discussed above.

Six Months Ended March 25, 2004 Compared to the Six Months Ended March 27, 2003

Merchandise Revenue. Merchandise revenue for the first six months of fiscal 2004 was $539.8 million compared to $477.2 million for the first six months of fiscal 2003, an increase of $62.6 million or 13.1%. The increase is primarily attributable to merchandise revenue from the Golden Gallon^{^®} acquisition of $55.1 million and a 3.0%, or $14.1 million, increase in comparable store merchandise revenue compared to the first six months of fiscal 2003. These increases were partially offset by lost revenue from closed stores of approximately $7.4 million.

Gasoline Revenue and Gallons. Gasoline revenue for the first six months of fiscal 2004 was $990.6 million compared to $833.7 million during the first six months of fiscal 2003, an increase of $156.9 million or 18.8%. The increase in gasoline revenue is primarily attributable to gasoline revenue of $117.9 million from the

Golden Gallon^{^®} acquisition, an increase in comparable store gallons of 12.7 million, or 2.3%, and the 4 cent per gallon increase in the average gasoline retail price per gallon. The increase in the average gasoline retail price per gallon is a result of our passing along to customers the increases in wholesale fuel costs experienced in fiscal 2004. These increases were partially offset by lost revenue from closed stores of approximately $6.3 million.

For the first six months of fiscal 2004, gasoline gallons sold were 647.4 million compared to 561.0 million during the first six months of fiscal 2003, an increase of 86.4 million gallons or 15.4%. The increase is primarily attributable to an increase in gallon volume of 78.7 million from the Golden Gallon^{^®} acquisition and the comparable store gasoline gallon increase, partially offset by lost gallon volume from closed stores of approximately 4.5 million gallons.

Commission Income. Commission income for the first six months of fiscal 2004 was $15.3 million compared to $13.5 million during the first six months of fiscal 2003, an increase of $1.8 million or 13.3%. The increase is primarily due to an increase in commission income of $1.6 million from the Golden Gallon^{^®} acquisition. During the second quarter of fiscal 2004, the Sate of Tennessee introduced its lottery, and sales of Tennessee lottery tickets contributed approximately $0.3 million to commission income in the first six months of fiscal 2004.

Merchandise Gross Profit and Margin. Merchandise gross profit was $183.3 million for the first six months of fiscal 2004 compared to $157.3 million for the first six months of fiscal 2003, an increase of $26.1 million or 16.6%. This increase is primarily attributable to the merchandise gross profit contribution of $18.1 million from stores acquired in the Golden Gallon^{^®} acquisition, increased merchandise revenue discussed above and a 100 basis points increase in our merchandise margin. Merchandise margin increased to 34.0% for the first six months of fiscal 2004 from the 33.0% reported for the first six months of fiscal 2003.

Gasoline Gross Profit and Per Gallon Margin. Gasoline gross profit was $74.7 million for the first six months of fiscal 2004 compared to $68.3 million for the first six months of fiscal 2003, an increase of $6.4 million or 9.3%. The increase is primarily attributable to the gasoline gross profit contribution of $7.8 million from stores acquired in the Golden Gallon^{^®} acquisition and the comparable store gallon increase discussed above. These increases were partially offset by a 0.6 cent per gallon decline in gasoline gross profit per gallon to 11.5 cents for the first six months of fiscal 2004 compared to 12.2 cents for the first six months of of fiscal 2003. During the first six months of fiscal 2004, we have experienced increasing wholesale fuel costs. As a result of retail price increases reacting more slowly to the increased wholesale costs we have experienced tighter margins in the first six months of fiscal 2004 when compared to the first six months of fiscal 2003. Historically, our gasoline margin per gallon on an annual basis has remained relatively stable, averaging above 12 cents per gallon.

Operating, General and Administrative Expenses. Operating, general and administrative expenses for the first six months of fiscal 2004 totaled $210.6 million compared to $185.5 million for the second quarter of fiscal 2003, an increase of $25.1 million or 13.5%. This increase is primarily due to operating, general and administrative expenses of approximately $19.1 million associated with stores acquired in the Golden Gallon^{^®} acquisition and comparable stores increases in labor and other variable expenses. As a percentage of total revenue, operating, general and administrative expenses were 13.6% in the first six months of fiscal 2004, and adjusted for the impact of gasoline inflation were 13.7% in the comparable period in fiscal 2003. Administrative expenses also include approximately $1.3 million associated with the Company’s secondary offering of common stock which closed in January 2004.

Income from Operations. Income from operations totaled $35.2 million for the first six months of fiscal 2004 compared to $28.1 million for the first six months of fiscal 2003, an increase of $7.1 million or 25.3%. The increase is primarily attributable to the increases in gasoline and merchandise gross profit discussed above, partially offset by the increase in operating, general and administrative expenses.

EBITDA. EBITDA is defined by us as net income (loss) before interest expense, income taxes, depreciation and amortization and cumulative effect of change in accounting principle. EBITDA for the first six

months of fiscal 2004 totaled $63.1 million compared to EBITDA of $54.6 million for the first six months of fiscal 2003, an increase of $8.5 million or 15.6%. The increase is attributable to the increase in income from operations discussed above.

EBITDA is not a measure of performance under accounting principles generally accepted in the United States of America, and should not be considered as a substitute for net income, cash flows from operating activities and other income or cash flow statement data. We have included information concerning EBITDA as one measure of our cash flow and historical ability to service debt and because we believe investors find this information useful because it reflects the resources available for strategic opportunities including, among others, to invest in the business, to make strategic acquisitions and to service debt. EBITDA as defined by us may not be comparable to similarly titled measures reported by other companies.

The following table contains a reconciliation of EBITDA to net cash provided by operating activities and cash flows from investing and financing activities (amounts in thousands):


	Six Months Ended
	March 25, 2004			March 27, 2003
EBITDA	$	63,134		$	54,597
Interest expense and loss on extinguishment of debt		(50,394	)		(24,815	)
Adjustments to reconcile net loss to net cash provided by operating activities (other than depreciation and amortization, provision for deferred income taxes and cumulative effect of change in accounting principle)		25,390			2,095
Changes in operating assets and liabilities, net:
Assets		(5,409	)		(644	)
Liabilities		(25,309	)		(29,668	)

Net cash provided by operating activities	$	7,412		$	1,565
Net cash used in investing activities	$	(104,742	)	$	(5,861	)
Net cash provided by (used in) financing activities	$	75,420		$	(11,266	)

Loss on Extinguishment of Debt. As a result of the retirement of our 10.25% subordinated notes and the refinancing of our senior credit facility during the second quarter of fiscal 2004, we incurred $23.1 million in debt extinguishment costs that have been included as a component of interest expense. These charges include the write-off of approximately $11.8 million in unamortized deferred financing costs, the write-off of approximately $3.5 million of unamortized original issue discount and call premiums of approximately $7.8 million.

Interest Expense. Interest expense is primarily comprised of interest on borrowings under our senior credit facility and senior subordinated notes and the 23.1 million loss on extinguishment of debt referred to above. Interest expense, excluding the loss on extinguishment of debt, for the first six months of fiscal 2004 was $27.3 million compared to $24.8 million for the first six months of fiscal 2003. The increase of $2.5 million is primarily the result of $1.7 million in duplicative interest on our subordinated notes, during the 30-day call period, in addition to the increase in our weighted average outstanding borrowings as a result of the Golden Gallon^® acquisition. During the second quarter of fiscal 2004, we called $200.0 million of our outstanding 10.25% subordinated notes and replaced them with $250.0 million in 7.75% subordinated notes. The 10.25% notes included a 30-day non-cancelable call notice. During this 30-day period, both the 10.25% and 7.75% notes were outstanding, which resulted in duplicative interest expense of $1.7 million. Interest expense associated with the $80.0 million increase in our outstanding borrowings as a result of the Golden Gallon^® acquisition was approximately $1.9 million for the first six months of fiscal 2004. These increases were offset by a $2.9 million decline in our interest rate swap settlements.

Cumulative Effect Adjustment. During the first six months of fiscal 2003, we recorded a one-time cumulative effect charge of $3.5 million (net of taxes of $2.2 million) relating to the disposal of our underground storage tanks in accordance with the adoption of SFAS No. 143.

Net Loss. Net loss for the first six months of fiscal 2004 was $9.1 million compared to a net loss of $0.9 million for the first six months of fiscal 2003. The increase is attributable to the items discussed above. For the first six months of fiscal 2003, net income before cumulative effect of change in accounting principle was $2.6 million.

Liquidity and Capital Resources

Cash Flows from Operations. Due to the nature of our business, substantially all sales are for cash, and cash provided by operations is our primary source of liquidity. We rely primarily upon cash provided by operating activities, supplemented as necessary from time to time by borrowings under our revolving credit facility, sale-leaseback transactions, and asset dispositions to finance our operations, pay interest and principal payments and fund capital expenditures. Cash provided by operating activities increased to $7.4 million for the first six months of fiscal 2004 compared to $1.6 million for the first six months of fiscal 2003. The increase in cash flow from operations is primarily attributable to the $7.1 million increase in income from operations. We had $51.0 million of cash and cash equivalents on hand at March 25, 2004.

Capital Expenditures. Gross capital expenditures (excluding all acquisitions) for the first six months of fiscal 2004 were $18.4 million. Our capital expenditures are primarily expenditures for store improvements, store equipment, new store development, information systems and expenditures to comply with regulatory statutes, including those related to environmental matters. We finance substantially all capital expenditures and new store development through cash flow from operations, proceeds from sale-leaseback transactions and asset dispositions and vendor reimbursements.

Our sale-leaseback program includes the packaging of our owned convenience store real estate, both land and buildings, for sale to investors in return for their agreement to lease the property back to us under long-term leases. We retain ownership of all personal property and gasoline marketing equipment. Our leases are generally operating leases at market rates with lease terms between fifteen and twenty years plus several renewal option periods. The lease payment is based on market rates applied to the cost of each respective property. Our senior credit facility limits or caps the proceeds of sale-leasebacks that we can use to fund our operations or capital expenditures. We received $1.2 million in proceeds from sale-leaseback transactions in the first six months of fiscal 2004, excluding the Golden Gallon^{^®} transaction.

In the first six months of fiscal 2004, we received approximately $5.5 million in proceeds, including asset dispositions ($2.9 million), vendor reimbursements ($1.3 million) and sale-leaseback transactions ($1.2 million), excluding the $94.5 million received in the Golden Gallon^{^®} transaction. As a result, our net capital expenditures, excluding all acquisitions, for the first six months of fiscal 2004 were $12.9 million. We anticipate that net capital expenditures for fiscal 2004 will be approximately $40.0 million.

Cash Flows from Financing Activities. For the first six months of fiscal 2004, net cash provided by financing activities was $75.4 million. The net cash provided was primarily the result of additional net borrowings of $86.0 million offset by additional financing costs of approximately $10.4 million. At March 25, 2004, our long-term debt consisted primarily of $345.0 million in loans under our senior credit facility and $250.0 million of our 7.75% senior subordinated notes. See “—Contractual Obligations and Commitments” for a summary of our long-term debt principal amortization commitments.

Senior Credit Facility. On March 12, 2004, we entered into an Amended and Restated Credit Agreement to replace all amounts outstanding under our senior secured credit facility, which consisted of a $345.0 million term loan that matures in March, 2011 and a $70.0 million revolving credit facility, which expires in March, 2010. Proceeds from the new senior secured credit facility were used to repay all amounts outstanding under our previous credit facility and loan origination costs. In connection with the amendment, we incurred debt extinguishment charges of $12.4 million, which consisted of the $3.5 million write-off of unamortized original issue discount, $7.9 million in unamortized deferred financing costs and $1.0 million in call premium. We

incurred approximately $2.0 million in costs associated with the amendment, which were deferred and will be amortized over the term of the loan agreement. As of March 25, 2004, our outstanding term loan balance was $345.0 million.

Our $70.0 million revolving credit facility is available to fund working capital, finance general corporate purposes and support the issuance of standby letters of credit. Borrowings under the revolving credit facility are limited by our outstanding letters of credit of approximately $35.0 million. Furthermore, the revolving credit facility limits our total outstanding letters of credit to $50.0 million. As of March 25, 2004, we had no borrowings outstanding under the revolving credit facility, we had approximately $35.0 million in available borrowing capacity and $35.0 million of standby letters of credit were issued under the facility.

Senior Subordinated Notes. On February 19, 2004, we completed the sale of $250.0 million of 7.75% senior subordinated notes due February 19, 2014. Interest on the senior subordinated notes is due on February 19 and August 19 of each year. Proceeds from the sale of the senior subordinated notes were used to redeem $200.0 million in outstanding 10¹/4% senior subordinated notes, including a $6.8 million call premium, pay principal of approximately $28.0 million on our senior credit facility and pay related financing costs. We incurred debt extinguishment charges of $10.7 million which consisted of the $6.8 million call premium and $3.9 million of unamortized deferred financing costs. We incurred approximately $5.9 million in costs associated with the new notes, which were deferred and will be amortized over the term of the loan agreement.

Shareholders’ Equity. As of March 25, 2004, our shareholders’ equity totaled $119.1 million. The $9.5 million decrease from September 25, 2003 is attributable to the net loss for the period of $9.1 million, an increase in our accumulated other comprehensive deficit related to our derivative instruments of $1.2 million, a decrease in our shareholder loans outstanding of $0.1 million and an increase in additional paid in capital as a result of warrant and option exercises of $0.7 million. On December 9, 2003, Freeman Spogli exercised its warrants to purchase 2,346,000 shares of our common stock at an exercise price of $7.45 per share. The exercise was cashless whereby shares of common stock received were reduced by the number of shares having an aggregate fair market value equal to the exercise price or approximately $17.5 million. The aggregate fair value was based on the average closing price on each of the ten days prior to December 9, 2003, or $23.68 per share. Consequently, upon exercise of its warrants, Freeman Spogli received 1,607,855 shares of our common stock.

Long Term Liquidity. We believe that anticipated cash flows from operations and funds available from our existing revolving credit facility, together with cash on hand and vendor reimbursements, will provide sufficient funds to finance our operations and fund our contractual commitments at least for the next 12 months. As a normal part of our business, depending on market conditions, we from time to time consider opportunities to refinance our existing indebtedness, and although we may refinance all or part of our existing indebtedness in the future, there can be no assurances that we will do so. Changes in our operating plans, lower than anticipated sales, increased expenses, additional acquisitions or other events may cause us to need to seek additional debt or equity financing in future periods. There can be no guarantee that financing will be available on acceptable terms or at all. Additional equity financing could be dilutive to the holders of our common stock; and additional debt financing, if available, could impose greater cash payment obligations and more covenants and operating restrictions.

Contractual Obligations and Commitments

Contractual Obligations. The following table summarizes by fiscal year our expected long-term debt amortization schedule, future capital lease commitments (including principal and interest) and future operating lease commitments as of March 25, 2004:

Contractural Obligations

(Dollars in thousands)


	Fiscal 2004(1)		Fiscal 2005		Fiscal 2006		Fiscal 2007		Fiscal 2008		Thereafter		Total
Long-term debt	$	8,025	$	12,029	$	16,010	$	16,000	$	16,000	$	527,000	$	595,064
Capital leases		1,799		3,286		3,065		2,994		2,740		22,658		36,542
Operating leases		32,101		62,033		58,903		56,916		54,959		460,159		725,071

Total contractual obligations	$	41,925	$	77,348	$	77,978	$	75,910	$	73,699	$	1,009,817	$	1,356,677

(1)

Includes only payments to be made for the remaining 27weeks of fiscal 2004.

Letter of Credit Commitments. The following table summarizes by fiscal year the expiration dates of our standby letters of credit issued under our senior credit facility as of March 25, 2004:

Other Commitments

(Dollars in thousands)


	Fiscal 2004(1)		Fiscal 2005		Fiscal 2006		Fiscal 2007		Fiscal 2008		Thereafter		Total
Standby letters of credit	$	3,170	$	31,811	$	—	$	—	$	—	$	—	$	34,981

(1)

Includes only standby letters of credit that expire during the remaining 27 weeks of fiscal 2004.

At maturity, we expect to renew a significant number of our standby letters of credit.

Environmental Considerations. Environmental reserves of $14.2 million as of March 25, 2004 represent our estimates for future expenditures for remediation, tank removal and litigation associated with 243 known contaminated sites, respectively, as a result of releases (e.g., overfills, spills and underground storage tank releases) and are based on current regulations, historical results and certain other factors. We estimate that approximately $13.2 million of our environmental obligation will be funded by state trust funds and third party insurance. Also, as of March 25, 2004 there were an additional 511 sites that are known to be contaminated sites that are being remediated by third parties and therefore the costs to remediate such sites are not included in our environmental reserve. Remediation costs for known sites are expected to be incurred over the next one to ten years. Environmental reserves have been established on an undiscounted basis with remediation costs based on internal and external estimates for each site. Future remediation costs for amounts of deductibles under, or amounts not covered by, state trust fund programs and third party insurance arrangements and for which the timing of payments can be reasonably estimated are discounted using a ten-percent rate.

Florida environmental regulations require all single-walled underground storage tanks to be upgraded/replaced with secondary containment by December 31, 2009. In order to comply with these Florida regulations, we will be required to upgrade or replace underground storage tanks at approximately 185 locations. We anticipate that these capital expenditures will be approximately $16.5 million and will begin during fiscal 2004. The ultimate costs incurred will depend on several factors including future store closures, changes in the number of locations upgraded or replaced and changes in the costs to upgrade or replace the underground storage tanks.

Merchandise Supply Agreement. We have a distribution service agreement with McLane Company, Inc., pursuant to which McLane is the primary distributor of traditional grocery products to our stores. We also purchase all of the cigarettes we sell from McLane. The agreement with McLane continues through October 10, 2008 and contains no minimum purchase requirements. We purchase products at McLane’s cost plus an agreed upon percentage, reduced by any promotional allowances and volume rebates offered by manufacturers and McLane. In addition, we received an initial service allowance, which is being amortized over the term of the agreement, and also receive additional per store service allowances, both of which are subject to adjustment based on the number of stores in operation. Total purchases from McLane exceeded 50% of total merchandise purchases in the first six months of fiscal 2004.

Gasoline Supply Agreements. We have historically purchased our branded gasoline and diesel fuel under supply agreements with major oil companies, including BP^{^®}, Chevron^{^®}, Citgo^{^®}, Shell^{^®}, Mobil^{^®}, Texaco^{^®}, and Exxon^{^®}. The fuel purchased has generally been based on the stated rack price, or market price, quoted at each terminal. The initial terms of these supply agreements range from three to ten years and generally contain minimum annual purchase requirements as well as provisions for various payments to us based on volume of purchases and vendor allowances. These agreements also, in certain instances, give the supplier a right of first refusal to purchase certain assets that we may want to sell. We have met our purchase commitments under these contracts and expect to continue to do so. We purchase the majority of our private branded gallons from Citgo^{^®}.

During February 2003, we signed new gasoline supply agreements with both BP^{^®} and Citgo^{^®} to brand and supply most of our gasoline products for the next five years. After a conversion of approximately 718 locations over the 18 months following the signing of the new supply agreements, we expect that BP^{^®} will supply approximately 25% of our total gasoline volume, which will be sold under the BP^{^®}/Amoco^{^®} brand. Citgo^{^®} will supply both our private brand gasoline, which will be sold under our own Kangaroo^{^®} and other brands, and Citgo^{^®} branded gasoline. Including our private brand gasoline, we expect that after the 18-month conversion period, Citgo^{^®} will supply approximately 60% of our total gasoline volume. The remaining locations, primarily in Florida and Tennessee, will remain branded and supplied by Chevron^{^®} or Exxon^{^®}. We entered into these branding and supply agreements to provide a more consistent operating identity while helping us in our efforts to maximize our gasoline gallon growth and gasoline gross profit dollars.

Other Commitments. We make various other commitments and become subject to various other contractual obligations, which we believe to be routine in nature and incidental to the operation of the business. Management believes that such routine commitments and contractual obligations do not have a material impact on our business, financial condition or results of operations. In addition, like all public companies, we expect that we may face slightly increased costs in order to comply with new rules and standards relating to corporate governance and corporate disclosure, including the Sarbanes-Oxley Act of 2002, new Securities and Exchange Commission regulations and Nasdaq Stock Market rules. We intend to devote all reasonably necessary resources to comply with evolving standards.

Recently Issued Accounting Standards

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) 46, Consolidation of Variable Interest Entities—an Interpretation of ARB No. 51 (revised December 2003, FIN 46R). This interpretation provides guidance related to identifying variable interest entities (previously known as special purpose entities or SPEs) and determining whether such entities should be consolidated. Certain disclosures are required if it is reasonably possible that a company will consolidate or disclose information about a variable interest entity when it initially applies FIN 46. This interpretation was effective for our second quarter ending March 25, 2004. We have no investment in or contractual relationship or other business relationship with a variable interest entity and therefore the adoption of FIN 46 did not have any impact on our results of operations and financial condition. However, if we enter into any such arrangement with a variable interest entity in the future (or an entity with which we currently have a relationship is reconsidered based on guidance in FIN 46 to be a variable interest entity), our results of operations and financial condition may be impacted.

Risk Factors

You should carefully consider the risks described below before making a decision to invest in our securities. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us, or that we currently deem immaterial, could negatively impact our results of operations or financial condition in the future. If any of such risks actually occur, our business, financial condition or results of operations could be materially adversely affected. In that case, the trading price of our securities could decline, and you may lose all or part of your investment.

Risks Related to Our Industry

The Convenience Store Industry Is Highly Competitive and Impacted by New Entrants.

The industry and geographic areas in which we operate are highly competitive and marked by ease of entry and constant change in the number and type of retailers offering the products and services found in our stores. We compete with other convenience store chains, gasoline stations, supermarkets, drugstores, discount stores, club stores and mass merchants. In recent years, several non-traditional retailers, such as supermarkets, club stores and mass merchants, have impacted the convenience store industry by entering the gasoline retail business. These non-traditional gasoline retailers have obtained a significant share of the motor fuels market and their market share is expected to grow. In some of our markets, our competitors have been in existence longer and have greater financial, marketing and other resources than we do. As a result, our competitors may be able to respond better to changes in the economy and new opportunities within the industry. To remain competitive, we must constantly analyze consumer preferences and competitor’s offerings and prices to ensure we offer a selection of convenience products and services consumers demand at competitive prices. We must also maintain and upgrade our customer service levels, facilities and locations to remain competitive and drive customer traffic to our stores. Major competitive factors include, among others, location, ease of access, gasoline brands, pricing, product and service selections, customer service, store appearance, cleanliness and safety.

Volatility of Wholesale Petroleum Costs Could Impact Our Operating Results.

Over the past three fiscal years, our gasoline revenue accounted for approximately 61.5% of total revenues and our gasoline gross profit accounted for approximately 27.8% of total gross profit. Crude oil and domestic wholesale petroleum markets are marked by significant volatility. General political conditions, acts of war or terrorism, and instability in oil producing regions, particularly in the Middle East and South America, could significantly impact crude oil supplies and wholesale petroleum costs. In addition, the supply of gasoline and our wholesale purchase costs could be adversely impacted in the event of shortage, which could result from, among other things, lack of capacity at United States oil refineries or the fact that our gasoline contracts do not guarantee an uninterrupted, unlimited supply of gasoline. Significant increases and volatility in wholesale petroleum costs could result in significant increases in the retail price of petroleum products and in lower gasoline gross margin per gallon. Increases in the retail price of petroleum products could impact consumer demand for gasoline. This volatility makes it extremely difficult to predict the impact future wholesale cost fluctuations will have on our operating results and financial condition. These factors could materially impact our gasoline gallon volume, gasoline gross profit and overall customer traffic, which in turn would impact our merchandise sales.

Wholesale Cost Increases of Tobacco Products Could Impact Our Merchandise Gross Profit.

Sales of tobacco products have averaged approximately 12.8% of our total revenue over the past three fiscal years. Significant increases in wholesale cigarette costs and tax increases on tobacco products, as well as national and local campaigns to discourage smoking in the United States, may have an adverse effect on unit demand for cigarettes domestically. In general, we attempt to pass price increases on to our customers. However, due to competitive pressures in our markets, we may not be able to do so. These factors could materially impact our retail price of cigarettes, cigarette unit volume and revenues, merchandise gross profit and overall customer traffic.

Changes in Consumer Behavior, Travel and Tourism Could Impact Our Business.

In the convenience store industry, customer traffic is generally driven by consumer preferences and spending trends, growth rates for automobile and truck traffic and trends in travel, tourism and weather. Changes in economic conditions generally or in the Southeast specifically could adversely impact consumer spending patterns and travel and tourism in our markets. Approximately 40% of our stores are located in coastal, resort or tourist destinations. Historically, travel and consumer behavior in such markets is more severely impacted by weak economic conditions. If visitors to resort or tourist locations decline due to economic conditions, changes in consumer preferences, changes in discretionary consumer spending or otherwise, our sales could decline.

Risks Related to Our Business

Unfavorable Weather Conditions or Other Trends or Developments in the Southeast Could Adversely Affect Our Business.

Substantially all of our stores are located in the southeast region of the United States. Although the Southeast is generally known for its mild weather, the region is susceptible to severe storms including hurricanes, thunderstorms, extended periods of rain, ice storms and heavy snow, all of which we experienced in fiscal 2003.

Inclement weather conditions as well as severe storms in the Southeast could damage our facilities or could have a significant impact on consumer behavior, travel and convenience store traffic patterns as well as our ability to operate our locations. In addition, we typically generate higher revenues and gross margins during warmer weather months in the Southeast, which fall within our third and fourth quarters. If weather conditions are not favorable during these periods, our operating results and cash flow from operations could be adversely affected. We would also be impacted by regional occurrences in the Southeast such as energy shortages or increases in energy prices, fires or other natural disasters.

Inability to Identify, Acquire and Integrate New Stores Could Adversely Affect Our Ability to Grow Our Business.

An important part of our historical growth strategy has been to acquire other convenience stores that complement our existing stores or broaden our geographic presence, such as our acquisition of 138 convenience stores operating under the Golden Gallon^{^®} banner on October 16, 2003. From April 1997 through October 2003, we acquired 1,303 convenience stores in 21 major and numerous smaller transactions. We expect to continue to selectively review acquisition opportunities as an element of our growth strategy.

Acquisitions involve risks that could cause our actual growth or operating results to differ adversely compared to our expectations or the expectations of securities analysts. For example:

•

We may not be able to identify suitable acquisition candidates or acquire additional convenience stores on favorable terms. We compete with others to acquire convenience stores. We believe that this competition may increase and could result in decreased availability or increased prices for suitable acquisition candidates. It may be difficult to anticipate the timing and availability of acquisition candidates.

•

During the acquisition process we may fail or be unable to discover some of the liabilities of companies or businesses which we acquire. These liabilities may result from a prior owner’s noncompliance with applicable federal, state or local laws.

•

We may not be able to obtain the necessary financing, on favorable terms or at all, to finance any of our potential acquisitions.

•

We may fail to successfully integrate or manage acquired convenience stores.

•

Acquired convenience stores may not perform as we expect or we may not be able to obtain the cost savings and financial improvements we anticipate.

•

We face the risk that our existing systems, financial controls, information systems, management resources and human resources will need to grow to support significant growth.

Our Financial Leverage and Debt Covenants Impact Our Fiscal and Financial Flexibility.

We are highly leveraged, which means that the amount of our outstanding debt is large compared to the net book value of our assets, and we have substantial repayment obligations under our outstanding debt. We have to use a portion of our cash flow from operations for debt service, rather than for investing in our operations or to implement our growth strategy. As of March 25, 2004, we had consolidated debt including capital lease obligations of approximately $611.5 million and shareholders’ equity of approximately $119.1 million. As of March 25, 2004 our availability under our senior credit facility for borrowing was approximately $35.0 million.

We are vulnerable to increases in interest rates because the debt under our senior credit facility is at a variable interest rate. Although in the past we have on occasion entered into certain hedging instruments in an effort to manage our interest rate risk, we cannot assure you that we will continue to do so, on favorable terms or at all, in the future.

Our senior credit facility and the indenture governing our senior subordinated notes contain numerous financial and operating covenants that limit our ability to engage in activities such as acquiring or disposing of assets, engaging in mergers or reorganizations, making investments or capital expenditures and paying dividends. These covenants require that we meet interest coverage, minimum EBITDA and leverage tests. Our senior credit facility and indenture permit us and our subsidiaries to incur or guarantee additional debt, subject to various limitations.

Any breach of these covenants could cause a default under our debt obligations and result in our debt becoming immediately due and payable, which would adversely affect our business, financial condition and results of operations. For the twelve-month period ending September 27, 2001, we failed to satisfy two financial covenants required by our senior credit facility. During the first quarter of fiscal 2002, we received a waiver from our senior credit group and executed an amendment to the senior credit facility that included, among other things, a modification to the financial covenants and certain increases in the floating interest rate. In March 2004, we refinanced our senior credit facility. Our ability to respond to changing business conditions and to secure additional financing may be restricted by the covenants in our senior credit facility, which may become more restrictive in the future. We also may be prevented from engaging in transactions, including acquisitions that may be important to our long-term growth strategy, as a result of covenant restrictions or borrowing capabilities under our credit facilities.

We Are Subject to State and Federal Environmental and Other Regulations.

Our business is subject to extensive governmental laws and regulations including, but not limited to, environmental regulations, employment laws and regulations, regulations governing the sale of alcohol and tobacco, minimum wage requirements, working condition requirements, citizenship requirements and other laws and regulations. A violation or change of these laws could have a material adverse effect on our business, financial condition and results of operations.

Under various federal, state and local laws, ordinances and regulations, we may, as the owner or operator of our locations, be liable for the costs of removal or remediation of contamination at these or our former locations, whether or not we knew of, or were responsible for, the presence of such contamination. The failure to properly remediate such contamination may subject us to liability to third parties and may adversely affect our ability to sell or rent such property or to borrow money using such property as collateral. Additionally, persons who arrange for the disposal or treatment of hazardous or toxic substances may also be liable for the costs of removal or remediation of such substances at sites where they are located, whether or not such site is owned or operated by such person. Although we do not typically arrange for the treatment or disposal of hazardous substances, we

may be deemed to have arranged for the disposal or treatment of hazardous or toxic substances and, therefore, may be liable for removal or remediation costs, as well as other related costs, including governmental fines, and injuries to persons, property and natural resources.

Compliance with existing and future environmental laws regulating underground storage tanks may require significant capital expenditures and the remediation costs and other costs required to clean up or treat contaminated sites could be substantial. We pay tank fees and other taxes to state trust funds in support of future remediation obligations.

These state trust funds or other responsible third parties including insurers are expected to pay or reimburse us for remediation expenses less a deductible. To the extent third parties do not pay for remediation as we anticipate, we will be obligated to make these payments, which could materially adversely affect our financial condition and results of operations. Reimbursements from state trust funds will be dependent on the continued viability of these funds.

In the future, we may incur substantial expenditures for remediation of contamination that has not been discovered at existing locations or locations that we may acquire. We cannot assure you that we have identified all environmental liabilities at all of our current and former locations; that material environmental conditions not known to us do not exist; that future laws, ordinances or regulations will not impose material environmental liability on us; or that a material environmental condition does not otherwise exist as to any one or more of our locations. In addition, failure to comply with any environmental regulations or an increase in regulations could adversely affect our operating results and financial condition.

State laws regulate the sale of alcohol and tobacco products. A violation or change of these laws could adversely affect our business, financial condition and results of operations because state and local regulatory agencies have the power to approve, revoke, suspend or deny applications for, and renewals of, permits and licenses relating to the sale of these products or to seek other remedies.

Any appreciable increase in the statutory minimum wage rate or income or overtime pay or adoption of mandated health benefits would result in an increase in our labor costs and such cost increase, or the penalties for failing to comply with such statutory minimums, could adversely affect our business, financial condition and results of operations.

From time to time, regulations are proposed which, if adopted, could also have an adverse effect on our business, financial condition or results of operations.

We Depend on One Principal Supplier for the Majority of Our Merchandise.

We purchase over 50% of our general merchandise, including most tobacco products and grocery items, from a single wholesale grocer, McLane Company, Inc., or McLane. We have a contract with McLane until October 2008, but we may not be able to renew the contract upon expiration. A change of suppliers, a disruption in supply or a significant change in our relationship with our principal suppliers could have a material adverse effect on our business, cost of goods, financial condition and results of operations.

We Depend on Two Principal Suppliers for the Majority of Our Gasoline.

During February of 2003, we signed new gasoline supply agreements with BP Products, NA, or BP^{^®}, and Citgo Petroleum Corporation, or Citgo^{^®}. We expect that BP^{^®} and Citgo^{^®} will supply approximately 85% of our projected gasoline purchases after an approximately 18-month conversion process. We have contracts with each of BP^{^®} and Citgo^{^®} until 2008, but we may not be able to renew either contract upon expiration. A change of suppliers, a disruption in supply or a significant change in our relationship with our principal suppliers could have a material adverse effect on our business, cost of goods, financial condition and results of operations.

We May Not Achieve the Full Expected Cost Savings and Other Benefits of Our Acquisition of Golden Gallon^®

We expect to achieve $8-$10 million of cost savings and benefits within the 12 to 24 months following the acquisition of Golden Gallon^{^®}. These cost savings and benefits include, among others, savings associated with the elimination of duplicate overhead and infrastructure, benefits received by Golden Gallon^{^®} under our merchandise and gas supply agreements and the expansion of quick service restaurants in selected stores. While we believe our estimates of these cost savings and benefits to be reasonable, they are estimates which are difficult to predict and are necessarily speculative in nature. There can be no assurance that we will be able to replicate the results that we achieved at our stores at the Golden Gallon^{^®} stores. In addition, we cannot assure you that unforeseen factors will not offset the estimated cost savings and other benefits from the acquisition. As a result, our actual cost savings and other anticipated benefits could differ or be delayed, compared to our estimates and from the other information contained in this report.

Because We Depend on Our Senior Management’s Experience and Knowledge of Our Industry, We Would Be Adversely Affected if Senior Management Left The Pantry.

We are dependent on the continued efforts of our senior management team, including our President and Chief Executive Officer, Peter J. Sodini. Mr. Sodini’s employment contract terminates in September 2006. If, for any reason, our senior executives do not continue to be active in management, our business, financial condition or results of operations could be adversely affected. We cannot assure you that we will be able to attract and retain additional qualified senior personnel as needed in the future. In addition, we do not maintain key personnel life insurance on our senior executives and other key employees. We also rely on our ability to recruit store managers, regional managers and other store personnel. If we fail to continue to attract these individuals, our operating results may be adversely affected.

Other Risks

Future Sales of Additional Shares into the Market May Depress the Market Price of Our Common Stock.

If our existing stockholders sell shares of our common stock in the public market, including shares issued upon the exercise of outstanding options, or if the market perceives such sales could occur, the market price of our common stock could decline. As of May 3, 2004, there were 19,964,048 shares of our common stock outstanding. Of these shares, 12,229,679 shares are freely tradable (unless held by one of our affiliates) and 7,734,369 shares are held by affiliate investment funds of Freeman Spogli & Co. Pursuant to Rule 144 under the Securities Act of 1933, as amended, during any three-month period our affiliates can resell up to the greater of (a) 1% of our aggregate outstanding common stock or (b) the average weekly trading volume for the four weeks prior to the sale. In addition, the Freeman Spogli & Co. investment funds, or Freeman Spogli, have registration rights allowing them to require us to register the resale of their shares. Sales by our existing stockholders also might make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate or to use equity as consideration for future acquisitions.

In addition, we have filed registration statements with the Securities and Exchange Commission that cover up to 5,100,000 shares issuable pursuant to the exercise of stock options granted and to be granted under our stock option plans. Shares registered on a registration statement may be sold freely at any time.

The Interests of Our Largest Stockholder May Conflict with Our Interests and the Interests of Our Other Stockholders.

As of May 3, 2004, Freeman Spogli owned 7,734,369 shares of our common stock. Freeman Spogli’s beneficial ownership of our common stock is approximately 38.7%. In addition, four of the nine members of our board of directors are representatives of, or have consulting arrangements with, Freeman Spogli. As a result of its stock ownership and board representation, Freeman Spogli is in a position to affect our corporate actions such as

mergers or takeover attempts of us or may take action on its own in a manner that could conflict with the interests of our other stockholders. In the past from time to time we have considered strategic alternatives, including a sale of The Pantry, at the request of Freeman Spogli and with the consent of our board of directors. Although we are not currently considering any strategic alternatives, we may do so in the future.

Any Issuance of Shares of Our Common Stock in the Future Could Have a Dilutive Effect on Your Investment.

If we raise funds in the future by issuing additional shares of common stock, you may experience dilution in the value of your shares. Additionally, certain types of equity securities that we may issue in the future could have rights, preferences or privileges senior to your rights as a holder of our common stock. We could choose to issue additional shares for a variety of reasons including for investment or acquisitive purposes. Such issuances may have a dilutive impact on your investment.

The Market Price for Our Common Stock Has Been and May in the Future Be Volatile, Which Could Cause the Value of Your Investment to Decline.

There currently is a public market for our common stock, but there is no assurance that there will always be such a market. Securities markets worldwide experience significant price and volume fluctuations. This market volatility could significantly affect the market price of our common stock without regard to our operating performance. In addition, the price of our common stock could be subject to wide fluctuations in response to the following factors among others:

•

A deviation in our results from the expectations of public market analysts and investors;

•

Statements by research analysts about our common stock, our company or our industry;

•

Changes in market valuations of companies in our industry and market evaluations of our industry generally;

•

Additions or departures of key personnel;

•

Actions taken by our competitors;

•

Sales of common stock by the company, senior officers or other affiliates; or

•

Other general economic, political or market conditions, many of which are beyond our control.

The market price of our common stock will also be impacted by our quarterly operating results and quarterly comparable store sales growth, which may be expected to fluctuate from quarter to quarter. Factors that may impact our quarterly results and comparable store sales include, among others, general regional and national economic conditions, competition, unexpected costs and changes in pricing, consumer trends, the number of stores we open and/or close during any given period, costs of compliance with corporate governance and Sarbanes-Oxley requirements, and other factors discussed in “Risk Factors” and throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

You may not be able to resell your shares of our common stock at or above the price you pay.

Our Charter Includes Provisions that May Have the Effect of Preventing or Hindering a Change in Control and Adversely Affecting the Market Price of Our Common Stock.

Our certificate of incorporation gives our board of directors the authority to issue up to five million shares of preferred stock and to determine the rights and preferences of the preferred stock, without obtaining stockholder approval. The existence of this preferred stock could make it more difficult or discourage an attempt to obtain control of The Pantry by means of a tender offer, merger, proxy contest or otherwise. Furthermore, this preferred stock could be issued with other rights, including economic rights, senior to our common stock, and, therefore, issuance of the preferred stock could have an adverse effect on the market price of our common stock. We have no present plans to issue any shares of our preferred stock.

Other provisions of our certificate of incorporation and bylaws and of Delaware law could make it more difficult for a third party to acquire us or hinder a change in management even if doing so would be beneficial to our stockholders. These governance provisions could affect the market price of our common stock. We may, in the future, adopt other measures that may have the effect of delaying, deferring or preventing an unsolicited takeover, even if such a change in control were at a premium price or favored by a majority of unaffiliated stockholders. These measures may be adopted without any further vote or action by our stockholders.

Any of the above factors may cause actual results to vary materially from anticipated results, historical results or recent trends in operating results and financial condition.

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Quantitative Disclosures. We are exposed to market risks inherent in our financial instruments. These instruments arise from transactions entered into in the normal course of business and, in some cases, relate to our acquisitions of related businesses. We are subject to interest rate risk on our existing long-term debt and any future financing requirements. Our fixed rate debt consists primarily of outstanding balances on our senior subordinated notes and our variable rate debt relates to borrowings under our senior credit facility.

The following table presents the future principal cash flows and weighted average interest rates based on rates in effect at March 25, 2004, on our existing long-term debt instruments. Fair values have been determined based on quoted market prices as of May 3, 2004.

Expected Maturity Date

as of March 25, 2004

(Dollars in thousands)


	Fiscal 2004			Fiscal 2005			Fiscal 2006			Fiscal 2007			Fiscal 2008			Thereafter			Total			Fair Value
Long-term debt	$	8,025		$	12,029		$	16,010		$	16,000		$	16,000		$	527,000		$	595,064		$	598,514
Weighted average interest rate		6.04	%		6.09	%		5.88	%		5.62	%		5.67	%		6.59	%		6.17	%

In order to reduce our exposure to interest rate fluctuations, we have entered into interest rate swap arrangements in which we agree to exchange, at specified intervals, the difference between fixed and variable interest amounts calculated by reference to an agreed upon notional amount. The interest rate differential is reflected as an adjustment to interest expense over the life of the swaps. Fixed rate swaps are used to reduce our risk of increased interest costs during periods of rising interest rates. At March 25, 2004, the interest rate on 76.0% of our debt was fixed by either the nature of the obligation or through the interest rate swap arrangements compared to 78.0% at March 27, 2003.

The following table presents the notional principal amount, weighted average pay rate, weighted average receive rate and weighted average years to maturity on our interest rate swap contracts:

Interest Rate Swap Contracts

(Dollars in thousands)


	March 25, 2004			March 27, 2003
Notional principal amount	$	202,000		$	185,000
Weighted average pay rate		2.72	%		5.75	%
Weighted average receive rate		1.09	%		1.39	%
Weighted average years to maturity		2.06			0.60

As of March 25, 2004, the fair value of our swap and collar agreements represented a liability of $3.7 million.

Qualitative Disclosures. Our primary exposure relates to:

•

interest rate risk on long-term and short-term borrowings;

•

our ability to pay or refinance long-term borrowings at maturity at market rates;

•

the impact of interest rate movements on our ability to meet interest expense requirements and exceed financial covenants; and

•

the impact of interest rate movements on our ability to obtain adequate financing to fund future acquisitions.

We manage interest rate risk on our outstanding long-term and short-term debt through our use of fixed and variable rate debt. We expect the interest rate swaps mentioned above will reduce our exposure to short-term interest rate fluctuations. While we cannot predict or manage our ability to refinance existing debt or the impact interest rate movements will have on our existing debt, management evaluates our financial position on an ongoing basis.

Item 4. Controls and Procedures

The Company’s management, with the participation of the Company’s Chief Executive Officer (principal executive officer) and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this Form 10-Q. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by Form 10-Q, the Company’s disclosure controls and procedures provide reasonable assurances that the information required to be disclosed by the Company in the reports it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time period required by the United States Securities and Exchange Commission’s rules and forms. There have been no changes in the Company’s internal controls over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the period covered by this Form 10-Q that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

THE PANTRY, INC.

PART II-OTHER INFORMATION.

Item 6. Exhibits and Reports on Form 8-K.

(a)

Exhibits


Exhibit Number		Description of Document

4.1	(1)	Indenture, dated as of February 19, 2004, among The Pantry, subsidiaries of The Pantry and Wachovia Bank, National Association, as Trustee.

4.2	(1)	Form of 7.75% Senior Subordinated Note due 2014 under Rule 144A of the Securities Act (included in Exhibit 4.1).

4.3	(1)	Form of 7.75% Senior Subordinated Note due 2014 under Regulation S of the Securities Act (included in Exhibit 4.1).

4.4	(1)	Registration Rights Agreement, dated as of February 13, 2004, between The Pantry and the Initial Purchasers.

10.1	(2)	Amended and Restated Credit Agreement dated March 12, 2004 among The Pantry, as borrower, R&H Maxxon, Inc. and Kangaroo, Inc., subsidiaries of The Pantry, as guarantors, Wachovia, as administrative agent and lender, Credit Suisse, as syndication agent and lender, Wells Fargo, as documentation agent and lender, and Credit Industriel Et Commercial, Guaranty Bank, IKB Capital Corporation, and Raymond James Bank, FSB as lenders.

10.2	(2)	Amended and Restated Pledge Agreement dated as of March 12, 2004 between The Pantry and R&X Maxxon, Inc. and Kangaroo, Inc., subsidiaries of The Pantry, all as pledgors and Wachovia, as administrative agent.

10.3	(2)	Amended and Restated Security Agreement dated as of March 12, 2004 between The Pantry and R&H Maxxon, Inc. and Kangaroo, Inc., subsidiaries of The Pantry, all as obligors and Wachovia, as administrative agent.

31.1		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) or Rule 15d-14(a), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) or Rule 15d-14(a), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

32.2		Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

(1)

Incorporated by reference from The Pantry’s Registration Statement on Form S-4 (Registration No. 333-115060).

(2)

Incorporated by reference from The Pantry’s Current Report on Form 8-K dated March 17, 2004.

(b) Reports on Form 8-K

On January 15, 2004, the Company filed a Current Report on Form 8-K disclosing selected results of operations for its first quarter of fiscal 2004 ended December 25, 2003 and also furnished a copy of the press release issued January 15, 2004 announcing results for its first quarter of fiscal 2004. Information furnished under Item 7 and Item 12 of the Form 8-K referenced in the prior sentence is not deemed to be incorporated by reference into this Form 10-Q or filed with the SEC for purposes of liability under the Exchange Act.

On February 9, 2004, the Company filed a Current Report on Form 8-K attaching press releases issued February 9, 2004 announcing its intent to issue approximately $225.0 million principal amount of senior subordinated notes and also its plan to refinance existing senior credit facilities.

On February 17, 2004, the Company filed a Current Report on Form 8-K attaching a press release issued February 13, 2004 announcing that it priced an offer to issue $250.0 million principal amount of 7.75% Senior Subordinated Notes due 2014.

On February 17, 2004, the Company filed a Current Report on Form 8-K disclosing the unaudited pro forma statement of operations for the three-month period ended December 25, 2003 providing the effect to our October 16, 2003 acquisition of Golden Gallon^{^®}and related financing transactions as if such events occurred at the beginning of such three-month period.

On February 19, 2004, the Company filed a Current Report on Form 8-K attaching a press release issued February 19, 2004 announcing that it was calling for redemption all of its outstanding $200 million principal amount of 10¹/4% Senior Subordinated Notes due 2007 and that it had completed the sale of $250 million of its 7.75% Senior Subordinated Notes due 2014.

On March 17, 2004, the Company filed a Current Report on Form 8-K reporting the completion of its refinancing of its existing senior credit facilities with the issuance of a $345 million term loan and $70 million revolving credit facility. In connection with the refinancing, the Company entered into an Amended and Restated Credit Agreement dated March 12, 2004, an Amended and Restated Pledge Agreement dated as of March 12, 2004, and an Amended and Restated Security Agreement dated as of March 12, 2004. Copies of each such agreement were attached to the Form 8-K.

On March 22, 2004, the Company filed a Current Report on Form 8-K attaching a press release issued March 22, 2004 announcing the completion of the redemption of all of its outstanding $200 million principal amount of 10¹/4% Senior Subordinated Notes due 2007.

SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


THE PANTRY, INC.

By:		/s/ Daniel J. Kelly
		Daniel J. Kelly Vice President, Finance, Chief Financial Officer and Assistant Secretary (Authorized Officer and Principal Financial Officer)

Date: May 10, 2004

EXHIBIT INDEX


Exhibit Number		Description of Document

4.1	(1)	Indenture, dated as of February 19, 2004, among The Pantry, subsidiaries of The Pantry and Wachovia Bank, National Association, as Trustee.

4.2	(1)	Form of 7.75% Senior Subordinated Note due 2014 under Rule 144A of the Securities Act (included in Exhibit 4.1).

4.3	(1)	Form of 7.75% Senior Subordinated Note due 2014 under Regulation S of the Securities Act (included in Exhibit 4.1).

4.4	(1)	Registration Rights Agreement, dated as of February 13, 2004, between The Pantry and the Initial Purchasers.

10.1	(2)	Amended and Restated Credit Agreement dated March 12, 2004 among The Pantry, as borrower, R&H Maxxon, Inc. and Kangaroo, Inc., subsidiaries of The Pantry, as guarantors, Wachovia, as administrative agent and lender, Credit Suisse, as syndication agent and lender, Wells Fargo, as documentation agent and lender, and Credit Industriel Et Commercial, Guaranty Bank, IKB Capital Corporation, and Raymond James Bank, FSB as lenders.

10.2	(2)	Amended and Restated Pledge Agreement dated as of March 12, 2004 between The Pantry and R&X Maxxon, Inc. and Kangaroo, Inc., subsidiaries of The Pantry, all as pledgors and Wachovia, as administrative agent.

10.3	(2)	Amended and Restated Security Agreement dated as of March 12, 2004 between The Pantry and R&H Maxxon, Inc. and Kangaroo, Inc., subsidiaries of The Pantry, all as obligors and Wachovia, as administrative agent.

31.1		Certification of Chief Executive Officer Pursuant to Rule 13a-14(a) or Rule 15d-14(a), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer Pursuant to Rule 13a-14(a) or Rule 15d-14(a), As Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

32.2		Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of The Sarbanes-Oxley Act of 2002. [This exhibit is being furnished pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by that act, be deemed to be incorporated by reference into any document or filed herewith for purposes of liability under the Securities Exchange Act of 1934, as amended, or the Securities Act of 1933, as amended, as the case may be.]

(1)

Incorporated by reference from The Pantry’s Registration Statement on Form S-4 (Registration No. 333-115060).

(2)

Incorporated by reference from The Pantry’s Current Report on Form 8-K dated March 17, 2004.