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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 31, 2005

 

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  x    No  ¨

 

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   21,773,880 SHARES
(Class)   (Outstanding at May 3, 2005)

 



Table of Contents

THE PANTRY, INC.

 

FORM 10-Q

 

MARCH 31, 2005

 

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

   21

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   30

Item 4. Controls and Procedures

   31

Part II—Other Information

    

Item 1. Legal Proceedings

   32

Item 4. Submission of Matters to a Vote of Security Holders

   32

Item 6. Exhibits

   33

 

2


Table of Contents

PART I-FINANCIAL INFORMATION.

 

Item 1. Financial Statements.

 

THE PANTRY, INC.

 

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

(Dollars in thousands)

 

     March 31,
2005


   September 30,
2004


ASSETS

             

Current assets:

             

Cash and cash equivalents

   $ 104,777    $ 108,048

Receivables, net

     41,723      43,664

Inventories

     96,852      95,228

Prepaid expenses

     16,354      13,446

Property held for sale

     6,672      5,939

Deferred income taxes

     10,818      7,507
    

  

Total current assets

     277,196      273,832
    

  

Property and equipment, net

     403,999      411,501
    

  

Other assets:

             

Goodwill (Note 2)

     341,898      341,652

Other (Notes 2, 3, 5, and 7)

     38,685      35,155
    

  

Total other assets

     380,583      376,807
    

  

Total assets

   $ 1,061,778    $ 1,062,140
    

  

LIABILITIES AND SHAREHOLDERS’ EQUITY

             

Current liabilities:

             

Current maturities of long-term debt (Note 4)

   $ 16,025    $ 16,029

Current maturities of capital lease obligations

     1,197      1,197

Accounts payable

     110,504      121,151

Accrued interest (Note 4)

     2,666      2,742

Accrued compensation and related taxes

     14,268      14,369

Income and other accrued taxes

     11,988      18,849

Accrued insurance

     19,856      17,228

Other accrued liabilities

     11,500      19,393
    

  

Total current liabilities

     188,004      210,958
    

  

Long-term debt (Note 4)

     543,000      551,010
    

  

Other liabilities:

             

Deferred income taxes

     68,651      63,257

Deferred revenue

     33,501      35,051

Capital lease obligations

     13,969      14,582

Other noncurrent liabilities (Note 3)

     38,154      35,096
    

  

Total other liabilities

     154,275      147,986
    

  

Commitments and contingencies (Notes 3 and 4)

             

Shareholders’ equity (Notes 5, 6 and 9):

             

Common stock, $.01 par value, 50,000,000 shares authorized; 20,695,183 and 20,271,757 issued and outstanding at March 31, 2005 and September 30, 2004, respectively

     207      204

Additional paid-in capital

     139,337      132,879

Accumulated other comprehensive income, net (Note 6)

     2,134      206

Retained earnings

     34,821      18,897
    

  

Total shareholders’ equity

     176,499      152,186
    

  

Total liabilities and shareholders’ equity

   $ 1,061,778    $ 1,062,140
    

  

 

See Notes to Consolidated Financial Statements

 

3


Table of Contents

THE PANTRY, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

(Dollars in thousands, except per share data)

 

     Three Months Ended

    Six Months Ended

 
     March 31,
2005


    March 25,
2004


    March 31,
2005


    March 25,
2004


 
     (13 weeks)     (13 weeks)     (26 weeks)     (26 weeks)  

Revenues:

                                

Merchandise

   $ 284,289     $ 270,073     $ 571,356     $ 540,222  

Gasoline

     661,471       516,280       1,315,947       990,572  
    


 


 


 


Total revenues

     945,760       786,353       1,887,303       1,530,794  
    


 


 


 


Cost of sales:

                                

Merchandise

     178,557       170,587       361,532       341,562  

Gasoline

     627,351       482,539       1,231,940       915,895  
    


 


 


 


Total cost of sales

     805,908       653,126       1,593,472       1,257,457  
    


 


 


 


Gross profit

     139,852       133,227       293,831       273,337  
    


 


 


 


Operating expenses:

                                

Operating, general and administrative expenses

     110,569       105,443       221,839       210,570  

Depreciation and amortization

     14,214       13,533       28,600       27,608  
    


 


 


 


Total operating expenses

     124,783       118,976       250,439       238,178  
    


 


 


 


Income from operations

     15,069       14,251       43,392       35,159  
    


 


 


 


Other income (expense):

                                

Loss on extinguishment of debt (Note 7)

     —         (23,087 )     —         (23,087 )

Interest expense (Note 7)

     (9,618 )     (14,166 )     (18,604 )     (27,307 )

Miscellaneous

     682       105       1,104       367  
    


 


 


 


Total other expense

     (8,936 )     (37,148 )     (17,500 )     (50,027 )
    


 


 


 


Income (loss) before income taxes

     6,133       (22,897 )     25,892       (14,868 )

Income tax benefit (expense)

     (2,361 )     8,815       (9,968 )     5,723  
    


 


 


 


Net income (loss)

   $ 3,772     $ (14,082 )   $ 15,924     $ (9,145 )
    


 


 


 


Earnings (loss) per share (Note 8):

                                

Basic

   $ 0.18     $ (0.71 )   $ 0.78     $ (0.48 )

Diluted

   $ 0.18     $ (0.71 )   $ 0.75     $ (0.48 )

 

See Notes to Consolidated Financial Statements

 

4


Table of Contents

THE PANTRY, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

(Dollars in thousands)

 

     Six Months Ended

 
     March 31,
2005


    March 25,
2004


 
     (26 weeks)     (26 weeks)  

CASH FLOWS FROM OPERATING ACTIVITIES

                

Net income (loss)

   $ 15,924     $ (9,145 )

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

                

Depreciation and amortization

     28,600       27,608  

Provision (benefit) for deferred income taxes

     4,187       (5,724 )

Loss on extinguishment of debt

     —         23,087  

Fair market value change in non-qualifying derivatives

     (423 )     (1,164 )

Amortization of deferred loan costs

     600       1,729  

Amortization of long-term debt discount

     —         534  

Other

     560       1,205  

Changes in operating assets and liabilities (net of effects of acquisitions):

                

Receivables

     (1,433 )     (3,644 )

Inventories

     (1,572 )     (147 )

Prepaid expenses

     (2,907 )     (1,573 )

Other noncurrent assets

     (531 )     (45 )

Accounts payable

     (10,647 )     873  

Other current liabilities and accrued expenses

     (6,257 )     (20,273 )

Reserves for environmental expenses

     1,047       (272 )

Other noncurrent liabilities

     (269 )     (5,637 )
    


 


Net cash provided by operating activities

     26,879       7,412  
    


 


CASH FLOWS FROM INVESTING ACTIVITIES

                

Additions to property held for sale

     (1,277 )     (1,376 )

Additions to property and equipment

     (26,622 )     (17,016 )

Proceeds from sale of land, buildings and equipment

     4,853       98,617  

Acquisitions of related businesses, net of cash acquired

     (1,627 )     (184,967 )
    


 


Net cash used in investing activities

     (24,673 )     (104,742 )
    


 


CASH FLOWS FROM FINANCING ACTIVITIES

                

Principal repayments under capital leases

     (613 )     (673 )

Principal repayments of long-term debt, including redemption premiums

     (8,014 )     (589,387 )

Proceeds from issuance of long-term borrowings

     —         675,000  

Proceeds from exercise of stock options

     3,150       756  

Repayments of shareholder loans

     —         109  

Other financing costs

     —         (10,385 )
    


 


Net cash provided by (used in) financing activities

     (5,477 )     75,420  
    


 


NET DECREASE IN CASH AND CASH EQUIVALENTS

     (3,271 )     (21,910 )

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

     108,048       72,901  
    


 


CASH AND CASH EQUIVALENTS AT END OF PERIOD

   $ 104,777     $ 50,991  
    


 


Cash paid during the period:

                

Interest

   $ 18,500     $ 35,207  
    


 


Income Taxes

   $ 6,806     $ 258  
    


 


 

See Notes to Consolidated Financial Statements

 

 

5


Table of Contents

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 (references to “the Company,” “Pantry,” “The Pantry,” “we,” “us,” and “our” mean The Pantry, Inc. and its subsidiaries). 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 31, 2005 and for the three and six months ended March 31, 2005 and March 25, 2004 are unaudited. 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.

 

The interim financial statements included herein should 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 30, 2004.

 

Our results of operations for the three and six months ended March 31, 2005 and March 25, 2004 are not necessarily indicative of results to be expected for the full fiscal year. 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 2005 fiscal year ends on September 29, 2005 and is a 52 week year. Fiscal 2004 was a 53 week year.

 

The Pantry

 

As of March 31, 2005, we operated 1,345 convenience stores located in Florida (453), North Carolina (319), South Carolina (235), Tennessee (103), Georgia (98), Mississippi (51), Kentucky (37), Virginia (30), Indiana (11), 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 1,319 locations, 869 of which sell gasoline under major oil company brand names including Amoco®, BP®, Chevron®, Citgo®, Mobil®, and Texaco®.

 

Recently Issued Accounting Standards

 

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 (“SFAS No. 151”). This statement clarifies that inventory costs that are “abnormal” are required to be charged to expense as incurred as opposed to being capitalized into inventory as a product cost. Examples of “abnormal” costs include costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage). SFAS No. 151 is effective for our 2006 fiscal year beginning September 30, 2005. Based on our initial evaluation, the adoption of SFAS No. 151 is not expected to have a significant impact on our financial position, results of operations or cash flows.

 

In December 2004, the FASB issued SFAS No. 123 (revised 2005) (“SFAS No. 123R”), Share-Based Payment. This statement is a revision of SFAS No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements and establishes fair value as the measurement objective in accounting for share-based payment arrangements. This standard is effective for our 2006 fiscal year beginning September 30, 2005. We currently plan to adopt this standard using the modified version of prospective application and, beginning in the first fiscal quarter of 2006, will recognize compensation costs for the portion of outstanding awards for which the requisite service has not yet been rendered. While we cannot precisely determine the impact on net earnings as a result of the adoption of SFAS No. 123R, estimated compensation expense related to prior periods can be found below under “—Stock-Based Compensation”. The ultimate amount of increased compensation expense will be dependent on the number of option shares granted during the year, their timing and vesting period, and the method used to calculate the fair value of the awards, among other factors.

 

Other accounting standards that have been issued or proposed by the FASB or other standard-setting bodies that do not require adoption until a future date are not expected to have a material impact on our consolidated financial statements upon adoption.

 

Stock-Based Compensation

 

As permitted by SFAS No. 123R and SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, we continue to account for stock options under the intrinsic value method recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. No stock-based employee compensation cost is reflected in the consolidated statements of operations, 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 we had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation:

 

6


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

     Three Months Ended

    Six Months Ended

 
    

March 31,

2005


   

March 25,

2004


   

March 31,

2005


   

March 25,

2004


 

Net income (loss) (in thousands):

                                

As reported

   $ 3,772     $ (14,082 )   $ 15,924     $ (9,145 )

Deduct—Total stock-based compensation expense determined under fair value method for all awards, net of tax

     (280 )     (39 )     (460 )     (165 )
    


 


 


 


Pro forma

   $ 3,492     $ (14,121 )   $ 15,464       (9,310 )
    


 


 


 


Basic earnings (loss) per share:

                                

As reported

   $ 0.18     $ (0.71 )   $ 0.78     $ (0.48 )

Pro forma

   $ 0.17     $ (0.71 )   $ 0.76     $ (0.49 )

Diluted earnings (loss) per share:

                                

As reported

   $ 0.18     $ (0.71 )   $ 0.75     $ (0.48 )

Pro forma

   $ 0.16     $ (0.71 )   $ 0.73     $ (0.49 )

 

The above pro forma disclosures are not necessarily representative of pro forma effects on reported net income for the full year or future years.

 

NOTE 2—GOODWILL AND OTHER INTANGIBLES

 

We account for goodwill and other intangibles under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets, and as a result, our goodwill asset is reviewed at least annually for impairment. Other intangible assets which have finite useful lives will continue to be amortized over their useful lives. We determined that we operate in one reporting unit based on our current reporting structure and have thus assigned goodwill at the enterprise level.

 

The changes in the balance of goodwill for the six months ended March 31, 2005 consisted of the following (in thousands):

 

Beginning balance (September 30, 2004)

   $ 341,652

Goodwill acquired during the year

     246
    

Ending balance (March 31, 2005)

   $ 341,898
    

 

The goodwill acquired during the year relates primarily to a single store acquisition.

 

Other intangible assets consist of noncompete agreements and a trademark. For each of the dates presented, noncompete agreements consisted of the following (in thousands):

 

     March 31,
2005


    September 30,
2004


 

Gross carrying value

   $ 7,909     $ 7,959  

Less—accumulated amortization

     (1,898 )     (1,766 )
    


 


Noncompete agreements, net

   $ 6,011     $ 6,193  
    


 


 

Amortization expense related to noncompete agreements was $89 thousand and $97 thousand for the three months ended March 31, 2005 and March 25, 2004, respectively, and $182 thousand and $238 thousand for the six months ended March 31, 2005 and March 25, 2004, respectively. The weighted average amortization period of all noncompete agreements is 31.4 years. Estimated amortization expense for each of the five fiscal years following September 30, 2004 and thereafter is: $169 thousand for the remainder of fiscal 2005; $305 thousand in fiscal 2006; $206 thousand in fiscal 2007; $197 thousand in fiscal 2008; $197 thousand in fiscal 2009 and $4.9 million thereafter. Other intangible assets are classified in other noncurrent assets in the accompanying consolidated balance sheets.

 

7


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 3—ENVIRONMENTAL LIABILITIES AND OTHER CONTINGENCIES

 

As of March 31, 2005, we were contingently liable for outstanding letters of credit in the amount of approximately $29.7 million primarily related to several self-insurance 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 party to various legal actions arising in the ordinary course of our business. We believe these other actions are routine and incidental to the operation of our business. While the outcome of these actions cannot be predicted with certainty, we believe that the ultimate resolution of these matters will not have a material adverse impact on our business, financial condition or prospects.

 

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 United States Environmental Protection Agency, or 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 31, 2005, we maintain letters of credit in the aggregate amount of approximately $1.3 million in favor of state environmental agencies in North 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 for releases occurring through December 31, 1998 and meet such requirements for releases thereafter through private commercial liability insurance. In Georgia, we meet our financial responsibility requirements by state trust fund coverage for releases occurring through December 29, 1999 and meet such requirements for releases thereafter through private commercial liability insurance and a letter of credit. The trust funds generally require us to pay deductibles ranging from $10 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 $15.1 million and $14.1 million as of as of March 31, 2005 and September 30, 2004, respectively, represent our estimates for future expenditures for remediation, tank removal and litigation associated with 260 and 251 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 $14.0 million of our environmental obligation will be funded by state trust funds and third party insurance; as a result we may spend up to $1.1 million for remediation, tank removal and litigation. Also, as of March 31, 2005 and September 30, 2004 there were an additional 490 and 503 sites, respectively, 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 with remediation costs based on internal and external estimates for each site. Future remediation for which the timing of payments can be reasonably estimated are discounted using an appropriate rate to determine the reserve.

 

We anticipate that we will be reimbursed for expenditures from state trust funds and private insurance. As of March 31, 2005, anticipated reimbursements of $16.1 million are recorded as long-term environmental receivables and $1.3 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. We will perform remediation in other states through independent contractor firms engaged by us. 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 we are not aware of releases or contamination at other locations where we currently operate or have 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 us as to responsibility for clean up matters. Additionally, we are awaiting closure notices on several other locations which will release us 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.

 

NOTE 4—LONG-TERM DEBT

 

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

 

     March 31,
2005


    September 30,
2004


 

Senior subordinated notes payable; due February 19, 2014; interest payable semi-annually at 7.75%

   $ 250,000     $ 250,000  

Senior credit facility; interest payable monthly at LIBOR plus 2.25%; principal due in quarterly installments through March 12, 2011

     309,000       317,000  

Other notes payable; various interest rates and maturity dates

     25       39  
    


 


Total long-term debt

     559,025       567,039  

Less—current maturities

     (16,025 )     (16,029 )
    


 


Long-term debt, net of current maturities

   $ 543,000     $ 551,010  
    


 


 

8


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Our senior credit facility consists of a term loan with an outstanding balance of $309.0 million and a $70.0 million revolving credit facility, which bear interest at a rate of LIBOR plus 2.25%. 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 31, 2005, there were no outstanding borrowings under the revolving credit facility and we had approximately $29.7 million of standby letters of credit issued under the facility. As a result, we had approximately $40.3 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 31, 2005, the effective LIBOR rate was 2.85%.

 

The remaining annual maturities of our long-term debt as of March 31, 2005 are as follows (amounts in thousands):

 

Year Ended September:


    

2005

   $ 4,015

2006

     16,010

2007

     16,000

2008

     16,000

2009

     16,000

Thereafter

     491,000
    

Total long-term debt

   $ 559,025
    

 

As of March 31, 2005, 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, we assess 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 (expense) for the mark-to-market adjustment of those instruments that do not quality for hedge accounting was $(63) thousand and $409 thousand for the three months ended March 31, 2005 and March 25, 2004, respectively, and $423 thousand and $1.2 million for the six months ended March 31, 2005 and March 25, 2004, respectively.

 

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 31, 2005, other noncurrent assets include derivative assets of $3.5 million. At September 30, 2004 other noncurrent liabilities included derivative liabilities of approximately $700 thousand and other noncurrent assets included derivative assets of approximately $600 thousand. Cash flow hedges which were effective on March 31, 2005 represent interest rate swaps with a notional amount of $202.0 million, a weighted average pay rate of 2.72% and have various settlement dates, the latest of which is April 2006. Additionally, we are party to cash flow hedges which will become effective April 2006 with a notional amount of $130.0 million, a weighted average pay rate of 4.24%, and have various settlement dates, the latest of which is April 2009.

 

9


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 6—COMPREHENSIVE INCOME (LOSS)

 

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

 

     Three Months Ended

    Six Months Ended

 
     March 31,
2005


   March 25,
2004


    March 31,
2005


   March 25,
2004


 

Net income (loss)

   $ 3,772    $ (14,082 )   $ 15,924    $ (9,145 )
    

  


 

  


Other comprehensive income (loss):

                              

Net unrealized gains (losses) on qualifying cash flow hedges (net of deferred income taxes of $923, $(952), $1,207 and $(778), respectively)

     1,474      (1,521 )     1,928      (1,243 )
    

  


 

  


Comprehensive income (loss)

   $ 5,246    $ (15,603 )   $ 17,852    $ (10,388 )
    

  


 

  


 

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 31,
2005


    March 25,
2004


    March 31,
2005


    March 25,
2004


 

Unrealized gains (losses) on qualifying cash flow hedges

   $ 1,506     $ (1,748 )   $ 2,207     $ (1,648 )

Less: Reclassification adjustment for expenses included in net income (loss)

     (32 )     227       (279 )     405  
    


 


 


 


Net unrealized gains (losses) on qualifying cash flow hedges

   $ 1,474     $ (1,521 )   $ 1,928     $ (1,243 )
    


 


 


 


 

Accumulated other comprehensive income, net of related income taxes, is composed of unrealized gains on qualifying cash flow hedges of $2.1 million and $206 thousand as of March 31, 2005 and September 30, 2004, respectively.

 

NOTE 7—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 31,
2005


   March 25,
2004


    March 31,
2005


    March 25,
2004


 

Interest on long-term debt

   $ 8,644    $ 12,453     $ 16,900     $ 23,595  

Interest rate swap settlements

     51      690       453       2,041  

Interest on capital lease obligations

     516      553       1,033       1,106  

Fair market value change in non-qualifying derivatives

     63      (409 )     (423 )     (1,164 )

Amortization of deferred financing costs

     342      876       600       1,729  

Miscellaneous

     2      3       41       —    
    

  


 


 


Subtotal: Interest expense

   $ 9,618    $ 14,166     $ 18,604     $ 27,307  

Loss on debt extinguishment

     —        23,087       —         23,087  
    

  


 


 


Total interest expense and loss on extinguishment of debt

   $ 9,618    $ 37,253     $ 18,604     $ 50,394  
    

  


 


 


 

The loss on debt extinguishment relates to the redemption of our $200 million 10.25% 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.

 

10


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

NOTE 8—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 31,
2005


   March 25,
2004


    March 31,
2005


   March 25,
2004


 

Net income (loss)

   $ 3,772    $ (14,082 )   $ 15,924    $ (9,145 )
    

  


 

  


Earnings (loss) per share – basic:

                              

Weighted average shares outstanding

     20,418      19,799       20,354      19,103  
    

  


 

  


Earnings (loss) per share – basic

   $ 0.18    $ (0.71 )   $ 0.78    $ (0.48 )
    

  


 

  


Earnings (loss) per share – diluted:

                              

Weighed average shares outstanding

     20,418      19,799       20,354      19,103  

Dilutive impact of options outstanding

     1,102      —         948      —    
    

  


 

  


Weighted average shares and potential dilutive shares outstanding

     21,520      19,799       21,302      19,103  
    

  


 

  


Earnings (loss) per share – diluted

   $ 0.18    $ (0.71 )   $ 0.75    $ (0.48 )
    

  


 

  


 

There were no options or warrants to purchase shares of common stock that were not included in the computation of diluted earnings per share for the three months ended March 31, 2005. Options 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 30 thousand for the six months ended March 31, 2005 and 1.4 million for the three months and six months ended March 25, 2004, respectively.

 

NOTE 9 – FORWARD SALE OF EQUITY

 

During October 2004, we completed a secondary stock offering in which Freeman Spogli & Co., or Freeman Spogli, sold 3,850,000 shares of our stock at a public offering price of $22.96 per share. In connection with this secondary stock offering, we sold 1,500,000 shares of our common stock under a forward sale agreement with Merrill Lynch International, an affiliate of Merrill Lynch & Co., as forward purchaser, under which, at our request, Merrill Lynch International borrowed 1,500,000 shares of our common stock from stock lenders and sold such borrowed shares at a net price of $21.8694 per share to certain underwriters pursuant to a purchase agreement.

 

We may elect to settle the forward sale by means of a physical stock, cash or net stock settlement. The forward sale will settle in twelve months, or earlier at our option. At any time during that period (up to a maximum of four settlement dates in total), we have the option to settle the forward sale in whole or in part. We may physically settle the forward sale by delivering all or a portion of the shares to Merrill Lynch International for cash proceeds approximately equal to the product of the applicable number of shares and our share price as of the date of the forward sale, plus an imputed interest rate of the Federal Funds Rate minus 1.0%. The actual proceeds to be received by us will vary depending upon the settlement date, the portion of the shares designated by us for settlement on that settlement date and the method of settlement.

 

If we elect to physically settle all of the 1,500,000 shares subject to the forward sale with stock, based on an initial forward price of $21.8694, which is the public offering price less the underwriting discount, we will receive aggregate proceeds of approximately $32.8 million. The forward sale agreement provides that the initial forward sale price will be subject to increase based on a floating interest factor equal to the Federal Funds Rate, less a spread of 1.0%. However, because the spread may be greater than the Federal Funds Rate for at least part of the term of the forward sale agreement, the actual forward sale price received at settlement may be less than the initial forward sale price. In no event are we required to deliver more than 1,500,000 shares under the forward sale agreement.

 

If we elect cash or net stock settlement, Merrill Lynch International or one of its affiliates will purchase shares of our common

stock in secondary market transactions over a period of time for delivery to Merrill Lynch International’s stock lenders in order to unwind its hedge. In connection with a cash or net stock settlement election by us, if the price paid by Merrill Lynch International or its affiliates in secondary market transactions to unwind its hedge exceeds the price that Merrill Lynch International would have been obligated to pay us had we instead elected a physical stock settlement under the forward sale agreement with respect to such shares, then we would pay Merrill Lynch International an amount in cash equal to such difference in the case of a cash settlement or would deliver a number of shares of our common stock having a market value equal to such difference in the case of a net stock settlement. On the other hand, if Merrill Lynch International or one of its affiliates is able to unwind its hedge by purchasing shares in secondary market transactions for an amount less than the price that Merrill Lynch International would have been obligated to pay us in connection with a physical stock settlement, Merrill Lynch International would pay us such difference in cash in the case of a cash settlement or in shares of our common stock having a market value equal to such difference in the case of a net stock settlement.

 

11


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

Prior to settlement, Merrill Lynch International will utilize the aggregate net proceeds from the sale of the borrowed shares as cash collateral for the borrowing of shares described above. We have not received any proceeds from the sale of the borrowed shares and will not do so until settlement of all or a portion of the forward sale.

 

Under limited circumstances related to our default or certain other extraordinary or otherwise unanticipated events, Merrill Lynch International also will have the ability to require us to settle the forward sale prior to the maturity date.

 

On April 20, 2005, we partially settled the forward sale agreement by issuing and delivering 1,078,697 shares of our common stock, par value $.01 per share. In connection with the partial settlement, we received $23.8 million in proceeds. The remaining 421,303 shares subject to the forward sale agreement may be issued and delivered by us in settlement of the forward sale agreement by means of physical stock, cash, or net settlement and must be settled no later than twelve months following the effective date of the forward sale agreement. If we elect to physically settle the remaining shares we expect to receive aggregate proceeds of approximately $9.2 million.

 

NOTE 10—SUBSEQUENT EVENTS

 

On April 22, 2005, we completed the acquisition of 53 convenience stores operating under the Cowboys® banner in Alabama (23), Georgia (29) and Mississippi (1) from D&D Oil Company, Inc., or D&D Oil. The purchase price was funded from available cash and approximately $23.8 million in proceeds from the partial settlement of a forward equity sale agreement we executed in October 2004, as described above. We will be leasing all of the stores under operating leases primarily from the seller. In connection with the acquisition, we entered into an amendment to the Distribution Services Agreement dated October 10, 1999 by and between The Pantry, Inc., Lil’ Champ Food Stores, Inc. and McLane Company, Inc. (the “Agreement”). The amendment extends the term of the Agreement until April 21, 2010. In addition, the amendment requires McLane to pay us certain additional fees relating to the stores currently covered by the Agreement, as well as additional fees relating to the stores acquired by us in connection with the acquisition of D&D Oil, and modifies certain provisions of the Agreement relating to service charges and rebate amounts.

 

12


Table of Contents

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., collectively referred to as the Guarantor Subsidiaries, which 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 of our direct and indirect subsidiaries. Combined financial information for the Guarantor Subsidiaries is as follows:

 

THE PANTRY, INC. AND SUBSIDIARIES

Supplemental Combining Balance Sheets

March 31, 2005

(Dollars in thousands)

 

    

The

Pantry
(Issuer)


    Guarantor
Subsidiaries


    Eliminations

    Total

ASSETS

                              

Current assets:

                              

Cash and cash equivalents

   $ 104,777     $ —       $ —       $ 104,777

Receivables, net

     41,723       —         —         41,723

Inventories

     96,852       —         —         96,852

Prepaid expenses

     16,352       2       —         16,354

Property held for sale

     6,672       —         —         6,672

Deferred income taxes

     10,818       —         —         10,818
    


 


 


 

Total current assets

     277,194       2       —         277,196
    


 


 


 

Investment in subsidiaries

     40,723       —         (40,723 )     —  
    


 


 


 

Property and equipment, net

     403,999       —         —         403,999
    


 


 


 

Other assets:

                              

Goodwill

     341,898       —         —         341,898

Intercompany notes receivable

     (23,477 )     43,872       (20,395 )     —  

Other

     38,628       57             38,685
    


 


 


 

Total other assets

     357,049       43,929       (20,395 )     380,583
    


 


 


 

Total assets

   $ 1,078,965     $ 43,931     $ (61,118 )   $ 1,061,778
    


 


 


 

LIABILITIES AND SHAREHOLDERS’ EQUITY

                              

Current liabilities:

                              

Current maturities of long-term debt

   $ 16,025     $ —       $ —       $ 16,025

Current maturities of capital lease obligations

     1,197       —         —         1,197

Accounts payable

     110,504       —         —         110,504

Accrued interest

     2,666       —         —         2,666

Accrued compensation and related taxes

     14,268       —         —         14,268

Income and other accrued taxes

     11,988       —         —         11,988

Accrued insurance

     19,856       —         —         19,856

Other accrued liabilities

     11,565       —         (65 )     11,500
    


 


 


 

Total current liabilities

     188,069       —         (65 )     188,004
    


 


 


 

Long-term debt

     543,000       —         —         543,000
    


 


 


 

Other liabilities:

                              

Deferred income taxes

     68,651       —         —         68,651

Deferred revenue

     33,501       —         —         33,501

Capital lease obligations

     13,969       —         —         13,969

Intercompany notes payable

     17,124       3,208       (20,332 )     —  

Other noncurrent liabilities

     38,152       2       —         38,154
    


 


 


 

Total other liabilities

     171,397       3,210       (20,332 )     154,275
    


 


 


 

Shareholders’ equity:

                              

Common stock

     207       523       (523 )     207

Additional paid-in capital

     139,337       40,551       (40,551 )     139,337

Accumulated other comprehensive income, net

     2,134       —         —         2,134

Retained earnings (deficit)

     34,821       (353 )     353       34,821
    


 


 


 

Total shareholders’ equity

     176,499       40,721       (40,721 )     176,499
    


 


 


 

Total liabilities and shareholders’ equity

   $ 1,078,965     $ 43,931     $ (61,118 )   $ 1,061,778
    


 


 


 

 

13


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

THE PANTRY, INC. AND SUBSIDIARIES

Supplemental Combining Balance Sheets

September 30, 2004

(Dollars in thousands)

 

    

The

Pantry
(Issuer)


    Guarantor
Subsidiaries


    Eliminations

    Total

ASSETS

                              

Current assets:

                              

Cash and cash equivalents

   $ 108,048     $ —       $ —       $ 108,048

Receivables, net

     43,664       —         —         43,664

Inventories

     95,228       —         —         95,228

Prepaid expenses

     13,444       2       —         13,446

Property held for sale

     5,939       —         —         5,939

Deferred income taxes

     7,507       —         —         7,507
    


 


 


 

Total current assets

     273,830       2       —         273,832
    


 


 


 

Investment in subsidiaries

     40,723       —         (40,723 )     —  
    


 


 


 

Property and equipment, net

     411,501       —         —         411,501
    


 


 


 

Other assets:

                              

Goodwill

     341,652       —         —         341,652

Intercompany notes receivable

     (23,477 )     43,872       (20,395 )     —  

Other

     35,098       57       —         35,155
    


 


 


 

Total other assets

     353,273       43,929       (20,395 )     376,807
    


 


 


 

Total assets

   $ 1,079,327     $ 43,931     $ (61,118 )   $ 1,062,140
    


 


 


 

LIABILITIES AND SHAREHOLDERS’ EQUITY

                              

Current liabilities:

                              

Current maturities of long-term debt

   $ 16,029     $ —       $ —       $ 16,029

Current maturities of capital lease obligations

     1,197       —         —         1,197

Accounts payable

     121,151       —         —         121,151

Accrued interest

     2,742       —         —         2,742

Accrued compensation and related taxes

     14,369       —         —         14,369

Income and other accrued taxes

     18,849       —         —         18,849

Accrued insurance

     17,228       —         —         17,228

Other accrued liabilities

     19,458       —         (65 )     19,393
    


 


 


 

Total current liabilities

     211,023       —         (65 )     210,958
    


 


 


 

Long-term debt

     551,010       —         —         551,010
    


 


 


 

Other liabilities:

                              

Deferred income taxes

     63,257       —         —         63,257

Deferred revenue

     35,051       —         —         35,051

Capital lease obligations

     14,582       —         —         14,582

Intercompany notes payable

     17,124       3,208       (20,332 )     —  

Other noncurrent liabilities

     35,094       2             35,096
    


 


 


 

Total other liabilities

     165,108       3,210       (20,332 )     147,986
    


 


 


 

Shareholders’ equity:

                              

Common stock

     204       523       (523 )     204

Additional paid-in capital

     132,879       40,551       (40,551 )     132,879

Accumulated other comprehensive income, net

     206       —         —         206

Retained earnings (deficit)

     18,897       (353 )     353       18,897
    


 


 


 

Total shareholders’ equity

     152,186       40,721       (40,721 )     152,186
    


 


 


 

Total liabilities and shareholders’ equity

   $ 1,079,327     $ 43,931     $ (61,118 )   $ 1,062,140
    


 


 


 

 

 

14


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Three Months Ended March 31, 2005

(Dollars in thousands)

 

     The
Pantry
(Issuer)


    Guarantor
Subsidiaries


   Eliminations

   Total

 

Revenues:

                              

Merchandise

   $ 284,289     $ —      $ —      $ 284,289  

Gasoline

     661,471       —        —        661,471  
    


 

  

  


Total revenues

     945,760       —        —        945,760  
    


 

  

  


Cost of sales:

                              

Merchandise

     178,557       —        —        178,557  

Gasoline

     627,351       —        —        627,351  
    


 

  

  


Total cost of sales

     805,908       —        —        805,908  
    


 

  

  


Gross profit.

     139,852       —        —        139,852  
    


 

  

  


Operating expenses:

                              

Operating, general and administrative expenses

     110,569       —        —        110,569  

Depreciation and amortization

     14,214       —        —        14,214  
    


 

  

  


Total operating expenses

     124,783       —        —        124,783  
    


 

  

  


Income from operations

     15,069       —        —        15,069  
    


 

  

  


Other income (expense):

                              

Interest expense

     (9,618 )     —        —        (9,618 )

Miscellaneous

     682       —        —        682  
    


 

  

  


Total other expense

     (8,936 )     —        —        (8,936 )
    


 

  

  


Income before income taxes

     6,133       —        —        6,133  

Income tax expense

     (2,361 )     —        —        (2,361 )
    


 

  

  


Net income

   $ 3,772     $  —      $ —      $ 3,772  
    


 

  

  


 

15


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Three Months Ended March 25, 2004

(Dollars in thousands)

 

     The
Pantry
(Issuer)


    Guarantor
Subsidiaries


   Eliminations

   Total

 

Revenues:

                              

Merchandise

   $ 270,073     $ —      $ —      $ 270,073  

Gasoline

     516,280       —        —        516,280  
    


 

  

  


Total revenues

     786,353       —        —        786,353  
    


 

  

  


Cost of sales:

                              

Merchandise

     170,587       —        —        170,587  

Gasoline

     482,539       —        —        482,539  
    


 

  

  


Total cost of sales

     653,186       —        —        653,186  
    


 

  

  


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  
    


 

  

  


Other income (expense):

                              

Loss of 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 )
    


 

  

  


 

16


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Six Months Ended March 31, 2005

(Dollars in thousands)

 

    

The

Pantry
(Issuer)


    Guarantor
Subsidiaries


   Eliminations

   Total

 

Revenues:

                              

Merchandise

   $ 571,356     $ —      $  —      $ 571,356  

Gasoline

     1,315,947       —        —        1,315,947  
    


 

  

  


Total revenues

     1,887,303       —        —        1,887,303  
    


 

  

  


Cost of sales:

                              

Merchandise

     361,532       —        —        361,532  

Gasoline

     1,231,940       —        —        1,231,940  
    


 

  

  


Total cost of sales

     1,593,472       —        —        1,593,472  
    


 

  

  


Gross profit

     293,831       —        —        293,831  
    


 

  

  


Operating expenses:

                              

Operating, general and administrative expenses

     221,839       —        —        221,839  

Depreciation and amortization

     28,600       —        —        28,600  
    


 

  

  


Total operating expenses

     250,439       —        —        250,439  
    


 

  

  


Income from operations

     43,392       —        —        43,392  
    


 

  

  


Other income (expense):

                              

Interest expense

     (18,604 )     —        —        (18,604 )

Miscellaneous

     1,104       —        —        1,104  
    


 

  

  


Total other expense

     (17,500 )     —        —        (17,500 )
    


 

  

  


Income before income taxes

     25,892       —        —        25,892  

Income tax expense

     (9,968 )     —        —        (9,968 )
    


 

  

  


Net income

   $ 15,924     $  —      $ —      $ 15,924  
    


 

  

  


 

17


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

THE PANTRY, INC.

Supplemental Combining Statement of Operations

Six Months Ended March 25, 2004

(Dollars in thousands)

 

    

The

Pantry
(Issuer)


    Guarantor
Subsidiaries


   Eliminations

   Total

 

Revenues:

                              

Merchandise

   $ 540,222     $ —      $ —      $ 540,222  

Gasoline

     990,572       —        —        990,572  
    


 

  

  


Total revenues

     1,530,794       —        —        1,530,794  
    


 

  

  


Cost of sales:

                              

Merchandise

     341,562       —        —        341,562  

Gasoline

     915,895       —        —        915,895  
    


 

  

  


Total cost of sales

     1,257,457       —        —        1,257,457  
    


 

  

  


Gross profit

     237,337       —        —        237,337  
    


 

  

  


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  
    


 

  

  


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

     5,723       —        —        5,723  
    


 

  

  


Net loss

   $ (9,145 )   $ —      $ —      $ (9,145 )
    


 

  

  


 

18


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

THE PANTRY, INC. AND SUBSIDIARIES

Supplemental Combining Statements of Cash Flows

Six Months Ended March 31, 2005

(Dollars in thousands)

 

     The
Pantry
(Issuer)


    Guarantor
Subsidiaries


   Eliminations

   Total

 

CASH FLOWS FROM OPERATING ACTIVITIES

                              

Net income

   $ 15,924     $   —    $ —      $ 15,924  

Adjustments to reconcile net income to net cash provided by operating activities:

                              

Depreciation and amortization

     28,600       —        —        28,600  

Provision for deferred income taxes

     4,187       —        —        4,187  

Fair market value change in non-qualifying derivatives

     (423 )     —        —        (423 )

Amortization of deferred loan costs

     600       —        —        600  

Other

     560       —        —        560  

Changes in operating assets and liabilities (net of effects of acquisitions):

                              

Receivables

     (1,433 )     —        —        (1,433 )

Inventories

     (1,572 )     —        —        (1,572 )

Prepaid expenses

     (2,907 )     —        —        (2,907 )

Other noncurrent assets

     (531 )     —        —        (531 )

Accounts payable

     (10,647 )     —        —        (10,647 )

Other current liabilities and accrued expenses

     (6,257 )     —        —        (6,257 )

Reserves for environmental expenses

     1,047       —        —        1,047  

Other noncurrent liabilities

     (269 )     —        —        (269 )
    


 

  

  


Net cash provided by operating activities

     26,879       —        —        26,879  
    


 

  

  


CASH FLOWS FROM INVESTING ACTIVITIES

                              

Additions to property held for sale

     (1,277 )     —        —        (1,277 )

Additions to property and equipment

     (26,622 )     —        —        (26,622 )

Proceeds from sale of land, buildings and equipment

     4,853       —        —        4,853  

Acquisitions of related businesses, net of cash acquired

     (1,627 )     —        —        (1,627 )
    


 

  

  


Net cash used in investing activities

     (24,673 )     —        —        (24,673 )
    


 

  

  


CASH FLOWS FROM FINANCING ACTIVITIES

                              

Principal repayments under capital leases

     (613 )     —        —        (613 )

Principal repayments of long-term debt

     (8,014 )     —        —        (8,014 )

Proceeds from exercise of stock options

     3,150       —        —        3,150  
    


 

  

  


Net cash used in financing activities

     (5,477 )     —        —        (5,477 )
    


 

  

  


NET DECREASE IN CASH AND CASH EQUIVALENTS

     (3,271 )     —        —        (3,271 )

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

     108,048       —        —        108,048  
    


 

  

  


CASH AND CASH EQUIVALENTS, END OF PERIOD

   $ 104,777     $  —      $  —      $ 104,777  
    


 

  

  


 

19


Table of Contents

THE PANTRY, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

 

THE PANTRY, INC.

Supplemental Combining Statements of Cash Flows

Six Months Ended March 25, 2004

(Dollars in thousands)

 

    

The

Pantry
(Issuer)


    Guarantor
Subsidiaries


   Eliminations

   Total

 

CASH FLOWS FROM OPERATING ACTIVITIES

                              

Net loss

   $ (9,145 )   $ —      $ —      $ (9,145 )

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  

Fair market value change in non-qualifying derivatives

     (1,164 )     —        —        (1,164 )

Amortization of deferred loan costs

     1,729       —        —        1,729  

Amortization of long-term debt discount

     534       —        —        534  

Other

     1,205       —        —        1,205  

Changes in operating assets and liabilities (net of effects of acquisitions):

                              

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  
    


 

  

  


 

 

20


Table of Contents

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 30, 2004, our Quarterly Report on From 10-Q for the quarter ended December 30, 2004 and our other filings with the Securities and Exchange Commission.

 

This report, including without limitation, statements under our discussion and analysis of 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 acquisitions, 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;

 

    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, 2005. 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.

 

Executive Overview

 

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 1,345 stores in ten states as of March 31, 2005. 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.

 

We had favorable results for our second quarter of fiscal 2005 with net income of $3.8 million compared to a net loss of $14.1 million in the second quarter of fiscal 2004. During the quarter, our comparable store merchandise revenue increased 6.6%, our

largest gain since the second quarter of fiscal 2000 or 20 quarters, while comparable store gasoline gallons increased 7.7%, our largest comparable store volume gain since third quarter of fiscal 1999 or 22 quarters. We achieved these results despite an unfavorable wholesale gasoline environment in which wholesale crude costs peaked at $55 per barrel in March 2005 from a low of $42 per barrel in January 2005. We continue to remain focused on several key initiatives, including the following:

 

Re-imaging and re-branding initiative – During the second quarter of fiscal 2005, we completed the brand conversion or image upgrades at an additional 132 stores, bringing the total as of March 31, 2005 to 866 locations. Almost all of these stores have also been converted to Kangaroo ExpressSM branding for their merchandise operations. 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.

 

21


Table of Contents

Merchandise programs – During the second quarter of fiscal 2005, we continued to upgrade and fine tune our merchandise mix to maximize sales and profitability and upgraded our food service offerings across our store base. Our merchandise enhancements are ongoing as we introduced additional private label products in the second quarter of fiscal 2005 with the introduction of Celeste® sports drink. Our quick service restaurant revenue increased 15.3% in the second quarter of fiscal 2005 compared to the second quarter of fiscal 2004 and we opened our first Quizno’s Sub® location in March 2005 with additional openings planned over the remainder of fiscal 2005. Historically, quick service restaurant revenues have averaged approximately 4% of merchandise revenue. In addition, we completed the rollout of our scanning and polling systems during the second quarter of fiscal 2005.

 

Acquisition strategy – We believe there are significant acquisition opportunities to strengthen our position in existing markets and expand into other markets. We believe our advantageous supply agreements and operating expertise make acquisitions an attractive way to grow our business. On April 21, 2005, we completed the acquisition of D&D Oil which operated 53 convenience stores under the Cowboys® banner in Alabama (23), Georgia (29) and Mississippi (1). We believe that the Cowboys® locations complement our existing store base and provide an entrance into the state of Alabama. We plan to 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 approximately 1,400 stores.

 

Market and Industry Trends

 

During the second quarter of fiscal 2005, we experienced a volatile wholesale gasoline cost environment as domestic crude oil prices peaked at a high of approximately $55 per barrel in March 2005 from a low of approximately $42 per barrel in January 2005. 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 any related increase or decrease in retail prices is affected by competitive conditions. As a result, we tend to experience tighter gasoline margins in periods of rising wholesale 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 on an annual basis.

 

Increases in wholesale cigarette costs during 2005, 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 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 operations as a percentage of our total revenue:

 

     Three Months Ended

    Six Months Ended

 
     March 31,
2005


    March 25,
2004


    March 31,
2005


    March 25,
2004


 

Total revenue

   100.0 %   100.0 %   100.0 %   100.0 %

Gasoline revenue

   69.9 %   65.7 %   69.7 %   64.7 %

Merchandise revenue

   30.1 %   34.3 %   30.3 %   35.3 %

Cost of sales

   85.2 %   83.1 %   84.4 %   82.1 %
    

 

 

 

Gross profit

   14.8 %   16.9 %   15.6 %   17.9 %

Gasoline gross profit

   3.6 %   4.3 %   4.5 %   4.9 %

Merchandise gross profit

   11.2 %   12.6 %   11.1 %   13.0 %

Operating, general and administrative expenses

   11.7 %   13.4 %   11.8 %   13.8 %

Depreciation and amortization

   1.5 %   1.7 %   1.5 %   1.8 %
    

 

 

 

Income from operations

   1.6 %   1.8 %   2.3 %   2.3 %

Loss on extinguishment of debt

   —       (2.9 )%   —       (1.5 )%

Interest and miscellaneous expense

   (0.9 )%   (1.8 )%   (0.9 )%   (1.8 )%
    

 

 

 

Income/(loss) before income taxes

   0.7 %   (2.9 )%   1.4 %   (1.0 )%

Income tax benefit (expense)

   (0.3 )%   1.1 %   (0.6 )%   0.4 %
    

 

 

 

Net income (loss)

   0.4 %   (1.8 )%   0.8 %   (0.6 )%
    

 

 

 

 

The table below provides a summary of our selected financial data for our three and six months ended March 31, 2005 and March 25, 2004.

 

     Three Months Ended

    Six Months Ended

 
     March 31,
2005


    March 25,
2004


    March 31,
2005


    March 25,
2004


 

Merchandise margin

     37.2 %     36.8 %     36.7 %     36.8 %

Gasoline gallons (millions)

     346.2       321.8       686.8       647.4  

Gasoline margin per gallon

   $ 0.0986     $ 0.1048     $ 0.1223     $ 0.1154  

Gasoline retail per gallon

   $ 1.91     $ 1.60     $ 1.92     $ 1.53  

Comparable store data:

                                

Merchandise sales%

     6.6 %     3.4 %     6.2 %     2.9 %

Gasoline gallons%

     7.7 %     1.2 %     5.9 %     2.3 %

Number of stores:

                                

End of period

     1,345       1,374       1,345       1,374  

Weighted-average store count

     1,348       1,380       1,351       1,370  

 

22


Table of Contents

Three Months Ended March 31, 2005 Compared to the Three Months Ended March 25, 2004

 

Merchandise Revenue. Merchandise revenue for the second quarter of fiscal 2005 was $284.3 million compared to $270.1 million during the second quarter of fiscal 2004, an increase of $14.2 million or 5.3%. The increase is primarily attributable to a 6.6%, or $17.5 million, increase in comparable store merchandise revenue compared to the second quarter of fiscal 2004. These increases were partially offset by lost revenue from closed stores of approximately $3.7 million.

 

Gasoline Revenue and Gallons. Gasoline revenue for the second quarter of fiscal 2005 was $661.5 million compared to $516.3 million during the second quarter of fiscal 2004, an increase of $145.2 million or 28.1%. The increase in gasoline revenue is primarily attributable to an increase in comparable store gallons of 24.6 million, or 7.7%, and the 31 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 2005. These increases were partially offset by lost revenue from closed stores of approximately $5.7 million.

 

In the second quarter of fiscal 2005, gasoline gallons sold were 346.2 million compared to 321.8 million during the second quarter of fiscal 2004, an increase of 24.3 million gallons or 7.6%. The increase is primarily attributable to the 7.7% comparable store gasoline gallon increase discussed above, partially offset by lost gallon volume from closed stores of approximately 3.6 million gallons. We believe that the comparable store volume increases were driven by our re-branding and re-imaging initiatives as well as general economic strength in Florida and throughout the Southeast.

 

Merchandise Gross Profit and Margin. Merchandise gross profit was $105.7 million for the second quarter of fiscal 2005 compared to $99.5 million for the second quarter of fiscal 2004, an increase of $6.2 million or 6.3%. This increase is primarily attributable to the increased merchandise revenue discussed above as well as a 40 basis point increase in our merchandise margin. We believe that the increase in merchandise margin is primarily attributable to our improvements in merchandise mix as a result of increased private label and food service offerings as well as continued leveraging of our purchasing volumes.

 

Gasoline Gross Profit and Per Gallon Margin. Gasoline gross profit was $34.1 million for the second quarter of fiscal 2005 compared to $33.7 million for the second quarter of fiscal 2004, an increase of $379 thousand or 1.1%. The increase is primarily attributable to the 7.7% increase in comparable store gallons, partially offset by a decrease in our gross profit per gallon to 9.9 cents for the second quarter of fiscal 2005 from 10.5 cents in the second quarter of fiscal 2004. During the second quarter of fiscal 2005, our gasoline gross profit per gallon was impacted by steadily increasing wholesale gasoline costs and the timing of related gasoline retail price increases. We present gasoline gross profit per gallon inclusive of credit card processing fees and cost of repairs and maintenance on gasoline equipment. These fees and costs totaled 3.3 cents per gallon and 2.7 cents per gallon for the three months ended March 31, 2005 and March 25, 2004, respectively. The increase in these fees and costs was primarily due to higher credit card fees as a result of a 19.4% increase in retail gasoline prices.

 

Operating, General and Administrative Expenses. Operating, general and administrative expenses for the second quarter of fiscal 2005 totaled $110.6 million compared to $105.4 million for the second quarter of fiscal 2004, an increase of $5.1 million or 4.9%. This increase is primarily due to comparable store increases in labor and other variable expenses. As a percentage of total revenue, operating, general and administrative expenses were 11.7% in the second quarter of fiscal 2005 and adjusted for the impact of gasoline inflation were 11.9% in the second quarter of fiscal 2004.

 

Income from Operations. Income from operations totaled $15.1 million for the second quarter of fiscal 2005 compared to $14.3 million for the second quarter of fiscal 2004, an increase of $818 thousand or 5.7%. 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. EBITDA for the second quarter of fiscal 2005 totaled $30.0 million compared to EBITDA of $27.9 million during the second quarter of fiscal 2004, an increase of $2.1 million or 7.4%. 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 31,

2005


   

March 25,

2004


 

EBITDA

   $ 29,965     $ 27,889  

Interest expense and loss on extinguishment of debt

     (9,618 )     (37,253 )

Adjustments to reconcile net income (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)

     1,040       24,499  

Changes in operating assets and liabilities, net:

                

Assets

     (9,284 )     (4,756 )

Liabilities

     (1,365 )     (4,169 )
    


 


Net cash provided by operating activities

   $ 10,738     $ 6,210  

Net cash provided by (used in) investing activities

   $ (12,597 )   $ 7,765  

Net cash provided by (used in) financing activities

   $ (5,473 )   $ 546  

 

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. Interest expense for the second quarter of fiscal 2005 was $9.6 million compared to $14.2 million for the second quarter of fiscal 2004. The decrease of $4.6 million is primarily the result of the benefits of our refinancing which was completed in March 2004, which reduced our effective borrowing rate by approximately 250 basis points.

 

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Additionally, on September 30, 2004, we reduced the effective LIBOR spread on our senior credit facility by an additional 50 basis points. Included in interest expense in the second quarter of fiscal 2004 was approximately $1.7 million in duplicative interest on our senior subordinated notes during the 30-day call period.

 

Net income (loss). Net income for the second quarter of fiscal 2005 was $3.8 million compared to a net loss of $14.1 million for the second quarter of fiscal 2004. The increase is primarily attributable to the charges associated with the debt extinguishment and additional interest expense, and the increased income from operations discussed above.

 

Six Months Ended March 31, 2005 Compared to the Six Months Ended March 25, 2004

 

Merchandise Revenue. Merchandise revenue for the first six months of fiscal 2005 was $571.4 million compared to $540.2 million for the first six months of fiscal 2004, an increase of $31.1 million, or 5.8%. The increase is primarily attributable to a 6.2%, or $29.3 million, increase in comparable store merchandise revenue compared to the first six months of fiscal 2004 and an $8.0 million increase in revenues from the stores acquired in the Golden Gallon® acquisition. These increases were partially offset by lost revenue from closed stores of approximately $7.6 million.

 

Gasoline Revenue and Gallons. Gasoline revenue for the first six months of fiscal 2005 was $1.3 billion compared to $990.6 million during the first six months of fiscal 2004, an increase of $325.4 million or 32.8%. The increase in gasoline revenue is primarily attributable to an increase in comparable store gallons of 32.8 million, or 5.9%, an increase in gallons sold by stores acquired in the Golden Gallon® acquisition of 12.2 million, and the 39 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 2005. These increases were partially offset by lost revenue from closed stores of approximately $10.6 million.

 

For the first six months of fiscal 2005, gasoline gallons sold were 686.8 million compared to 647.4 million during the first six months of fiscal 2004, an increase of 39.4 million gallons or 6.1%. The increase is primarily attributable to the 5.9% comparable store gasoline gallon increase, partially offset by lost gallon volume from closed stores of approximately 7.2 million gallons.

 

Merchandise Gross Profit and Margin. Merchandise gross profit was $209.8 million for the first six months of fiscal 2005 compared to $198.7 million for the first six months of fiscal 2004, an increase of $11.2 million or 5.6%. This increase is primarily attributable to the increased merchandise revenue discussed above. Merchandise margin decreased to 36.7% for the first six months of fiscal 2005 from the 36.8% reported for the first six months of fiscal 2004.

 

Gasoline Gross Profit and Per Gallon Margin. Gasoline gross profit was $84.0 million for the first six months of fiscal 2005 compared to $74.7 million for the first six months of fiscal 2004, an increase of $9.3 million or 12.5%. The increase is primarily attributable to the comparable store gallon increase discussed above as well as an increase in our gasoline gross profit per gallon to 12.2 cents for the first six months of fiscal 2005 compared to 11.5 cents for the first six months of fiscal 2004.

 

Operating, General and Administrative Expenses. Operating, general and administrative expenses for the first six months of fiscal 2005 totaled $221.8 million compared to $210.6 million for the second quarter of fiscal 2004, an increase of $11.3 million or 5.4%. This increase is primarily due to comparable stores increases in labor and other variable expenses. As a percentage of total revenue, operating, general and administrative expenses were 11.8% in the first six months of fiscal 2005, and adjusted for the impact of gasoline inflation were the same in the comparable period in fiscal 2004.

 

Income from Operations. Income from operations totaled $43.4 million for the first six months of fiscal 2005 compared to $35.2 million for the first six months of fiscal 2004, an increase of $8.2 million or 23.4%. 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 for the first six months of fiscal 2005 totaled $73.1 million compared to EBITDA of $63.1 million for the first six months of fiscal 2004, an increase of $10.0 million or 15.8%. The increase is attributable to the increase in income from operations discussed above.

 

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 31,
2005


    March 25,
2004


 

EBITDA

   $ 73,096     $ 63,134  

Interest expense and loss on extinguishment of debt

     (18,604 )     (50,394 )

Adjustments to reconcile net income (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)

     739       25,390  

Changes in operating assets and liabilities, net:

                

Assets

     (6,443 )     (5,409 )

Liabilities

     (21,909 )     (25,309 )
    


 


Net cash provided by operating activities

   $ 26,879     $ 7,412  

Net cash used in investing activities

   $ (24,673 )   $ (104,742 )

Net cash provided by (used in) financing activities

   $ (5,477 )   $ 75,420  

 

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 for the six months ending March 25, 2004, 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 2005 was $18.6 million compared to $27.3 million for the first six months of fiscal 2004. The decrease of $8.7 million is primarily the result of the benefits of our refinancing which was completed in March 2004, which reduced our effective borrowing rate by approximately 250 basis points. Additionally, on September 30, 2004, we reduced the effective LIBOR spread on our senior credit facility by an additional 50 basis points. Included in interest expense in the first six months of fiscal 2004 was approximately $1.7 million in duplicative interest on our senior subordinated notes during the 30-day call period.

 

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Net Income (loss). Net income for the first six months of fiscal 2005 was $15.9 million compared to a net loss of $9.1 million for the first six months of fiscal 2004. The increase is attributable to the items discussed above.

 

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 $26.9 million for the first six months of fiscal 2005 compared to $7.4 million for the first six months of fiscal 2004. The increase in cash flow from operations is primarily attributable to the $8.2 million increase in income from operations and a $16.7 million decline in cash paid for interest as a result of the reduction of our effective borrowing rate subsequent to our debt refinancings in February and March 2004. These increases were offset by a $6.5 million increase in cash paid for income taxes and other changes in working capital. We had $104.8 million of cash and cash equivalents on hand at March 31, 2005.

 

Capital Expenditures. Gross capital expenditures (excluding all acquisitions) for the first six months of fiscal 2005 were $27.9 million. Our capital expenditures are primarily expenditures for store re-imaging and 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.

 

In the first six months of fiscal 2005, we received approximately $8.2 million in proceeds, including asset dispositions ($4.0 million), vendor reimbursements ($2.2 million), and sale-lease back transactions ($0.9 million). As a result, our net capital expenditures, excluding all acquisitions, for the first six months of fiscal 2005 were $20.8 million. We anticipate that net capital expenditures for fiscal 2005 will be approximately $55.0 million.

 

Cash Flows from Financing Activities. For the first six months of fiscal 2005, net cash used in financing activities was $5.5 million and related primarily to scheduled principal payments on our senior credit facility, partially offset by proceeds from the exercise of employee stock options. At March 31, 2005, our long-term debt consisted primarily of $309.0 million in loans under our senior credit facility and $250.0 million of our 7.75% senior subordinated notes.

 

Senior Credit Facility. On March 12, 2004, we entered into an Amended and Restated Credit Agreement, which consists 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. As of March 31, 2005, our outstanding term loan balance was $309.0 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 $29.7 million. Furthermore, the revolving credit facility limits our total outstanding letters of credit to $50.0 million. As of March 31, 2005, we had no borrowings outstanding under the revolving credit facility, we had approximately $40.3 million in available borrowing capacity and $29.7 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.

 

Shareholders’ Equity. As of March 31, 2005, our shareholders’ equity totaled $176.5 million. The $24.3 million increase from September 30, 2004 is primarily attributable to the net income for the period of $15.9 million and an increase in additional paid in capital as a result of option exercises, including income tax benefits, of $6.5 million.

 

Long Term Liquidity. We believe that anticipated cash flows from operations, funds available from our existing revolving credit facility, and funds available under the forward sale agreement (see Item 1. Financial Statements—Notes to Consolidated Financial Statements—Note 9—Forward Sale of Equity), 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 of March 31, 2005, we had $40.3 million available under our revolving credit facility. Additionally, if we elect to physically settle the remaining shares under the forward sale agreement, we expect to receive aggregate proceeds of approximately $9.2 million. 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.

 

Recently Issued Accounting Standards

 

In November 2004, FASB issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 (“SFAS No. 151”). This statement clarifies that inventory costs that are “abnormal” are required to be charged to expense as incurred as opposed to being

capitalized into inventory as a product cost. Examples of “abnormal” costs include costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage). SFAS No. 151 is effective for our 2006 fiscal year beginning September 30, 2005. Based on our initial evaluation, the adoption of SFAS No. 151 is not expected to have a significant impact on our financial position, results of operations or cash flows.

 

In December 2004, the FASB issued SFAS No. 123 (revised 2005) (“SFAS No. 123R”), Share-Based Payment. This statement is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS No. 123R requires that the cost resulting from all share-based payment transactions be recognized in the financial statements and establishes fair value as the measurement objective in accounting for share-based payment arrangements. This standard is effective for our 2006 fiscal year beginning September 30, 2005. We currently plan to adopt this standard using the modified version of prospective application and, beginning in the first fiscal quarter of 2006, will recognize compensation costs for the portion of outstanding awards for which the requisite service has not yet been rendered. While we cannot precisely determine the impact on net earnings as a result of the adoption of SFAS No. 123R, estimated compensation expense related to prior periods can be found in Item 1.- Financial Statements – Notes to Consolidated Financial Statements - Note 1 – Basis of Presentation – Stock Based Compensation. The ultimate amount of increased compensation expense will be dependent on the number of option shares granted during the year, their timing and vesting period, and the method used to calculate the fair value of the awards, among other factors.

 

Other accounting standards that have been issued or proposed by the FASB or other standard-setting bodies that do not require adoption until a future date are not expected to have a material impact on our consolidated financial statements upon adoption.

 

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Risk Factors

 

You should carefully consider the risks described below and described elsewhere in this report before making a decision to invest in our securities. The risks and uncertainties described below and elsewhere in this report 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 63.4% of total revenues and our gasoline gross profit accounted for approximately 27.4% 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 operating results.

 

Sales of tobacco products have averaged approximately 10.7% of our total revenue over the past three fiscal years and our tobacco gross profit accounted for approximately 16.3% of total gross profit for the same period. 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 2004. 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 fiscal 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 March 2005, we acquired 1,305 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.

 

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    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 substantial indebtedness and capital lease obligations could adversely affect our financial health.

 

We have a significant amount of indebtedness. As of March 31, 2005, we had consolidated debt, including capital lease obligations, of approximately $574.2 million. As of March 31, 2005 our availability under our senior credit facility for borrowing or issuing additional letters of credit was approximately $40.3 million, with availability to issue letters of credit up to $50.0 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 substantial indebtedness could have important consequences to you. For example, it could:

 

    make it more difficult for us to satisfy our obligations with respect to our debt and our leases;

 

    increase our vulnerability to general adverse economic and industry conditions;

 

    require us to dedicate a substantial portion of our cash flow from operations to payments on our debt and lease obligations, thereby reducing the availability of our cash flow to fund working capital, capital expenditures and other general corporate purposes;

 

    limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

 

    place us at a competitive disadvantage compared to our competitors that have less indebtedness or better access to capital by, for example, limiting our ability to enter into new markets or renovate our stores; and

 

    limit our ability to borrow additional funds in the future.

 

If we are unable to meet our debt and lease obligations, we could be forced to restructure or refinance our obligations, seek additional equity financing or sell assets, which we may not be able to do on satisfactory terms or at all. As a result, we could default on those obligations.

 

In addition, the indenture governing our senior subordinated notes and our senior credit facility, which includes a term loan and a revolving credit facility, contain financial and other restrictive covenants that will limit our ability to engage in activities that may be in our long-term best interests. Our failure to comply with those covenants could result in an event of default which, if not cured or waived, could result in the acceleration of all of our indebtedness, which would adversely affect our financial health and could prevent us from fulfilling our obligations.

 

Despite current indebtedness levels, we and our subsidiaries may still be able to incur additional debt. This could further increase the risks associated with our substantial leverage.

 

We and our subsidiaries are still able to incur additional indebtedness. The terms of the indenture that governs our senior subordinated notes permit us to incur additional indebtedness under certain circumstances. In addition, our senior credit facility, as amended, permits us to potentially borrow up to an additional $75.0 million for permitted acquisitions (assuming certain financial conditions are met at the time) beyond the $70.0 million we can borrow under our revolving credit facility. If we and our subsidiaries incur additional indebtedness, the related risks that we and they now face could intensify.

 

To service our indebtedness, we will require a significant amount of cash. Our ability to generate cash depends on many factors beyond our control.

 

Our ability to make payments on our indebtedness and to refinance our indebtedness and fund planned capital expenditures will depend on our ability to generate cash in the future. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control.

 

Based on our current level of operations, we believe our cash flow from operations, funds available from our revolving credit facility, and funds available under the forward sale agreement (see Item 1. – Financial Statements – Notes to Consolidated Financial Statements – Note 9 – Forward Sale of Equity), will be adequate to meet our future liquidity needs for at least the next 12 months. We cannot assure you, however, that our business will generate sufficient cash flow from operations or that future borrowings will be available to us under our revolving credit facility in an amount sufficient to enable us to pay our indebtedness or to fund our other liquidity needs. We may need to refinance all or a portion of our indebtedness on or before maturity. We cannot assure you that we will be able to refinance any of our indebtedness on commercially reasonable terms or at all.

 

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If we do not comply with the covenants in our senior credit facility and the indenture governing our senior subordinated notes or otherwise default under them, we may not have the funds necessary to pay all of our indebtedness that could become due.

 

Our senior credit facility and our indenture governing our senior subordinated notes require us to comply with certain covenants. In particular, our senior credit facility prohibits us from incurring any additional indebtedness except in specified circumstances or materially amending the terms of any agreement relating to existing indebtedness without lender approval. In addition, our senior credit facility limits our ability to make capital expenditures. Further, our senior credit facility restricts our ability to acquire and dispose of assets, engage in mergers or reorganizations, pay dividends, or make investments. Other restrictive covenants require that we meet fixed charge coverage and leverage tests, and also maximum capital expenditure limits as defined in the senior credit facility agreement. A violation of any of these covenants could cause an event of default under the senior credit facility. If we default under that facility because of a covenant breach or otherwise, all outstanding amounts could become immediately due and payable. We cannot assure you that we would have sufficient funds to repay all the outstanding amounts, and any acceleration of amounts due under our senior credit facility or our indenture governing our senior subordinated notes likely would have a material adverse effect on us.

 

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, public accessibility 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 increased operating and maintenance costs. The remediation costs and other costs required to clean up or treat contaminated sites could be substantial. We pay tank registration fees and other taxes to state trust funds established in our operating areas and maintain private insurance coverage in Florida and Georgia 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 maintenance and continued solvency of the various 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 laws, ordinances or 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. In addition, certain states regulate relationships, including overlapping ownership, among alcohol manufacturers, wholesalers and retailers and may deny or revoke licensure if relationships in violation of the state laws exist. While we are not aware of any alcoholic beverage manufacturers or wholesalers having a prohibited relationship with our company, an investment fund related to our largest stockholder recently acquired an interest in a wine wholesaler. Although we do not believe this relationship is prohibited by the laws of any state in which we operate, if a regulatory authority were to take a contrary view and revoke our retail alcohol license, it could have a material adverse effect on our business and results of operations. In addition, our ability to expand into certain states, should we desire to do so, may be adversely affected if the laws of any such state prohibit the type of relationship which exists among our largest stockholder, the investment fund affiliated with it, the wine wholesaler in which the fund invested, and us.

 

Any appreciable increase in the statutory minimum wage rate or income or overtime pay or adoption of mandated healthcare 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 April 2010, 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 2003, we signed new gasoline supply agreements with BP® and Citgo®. We expect that BP® and Citgo® will supply approximately 90% of our future gasoline purchases, after an approximately 27 to 33 month conversion process that began in March 2003. We have contracts with Citgo® until 2008 and BP® until 2009, 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 expect to generate approximately $10 to $12 million of annualized cost savings and other benefits from our gasoline supplier and brand consolidation initiatives. 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. In addition, we cannot assure you that unforeseen factors will not offset the estimated cost savings and other benefits from these initiatives. As a result, our actual cost savings and other anticipated benefits could differ or be delayed, compared to our estimates and to the other information contained or incorporated by reference in this report.

 

 

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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 we or our existing stockholders sell shares of our common stock in the public market, including shares issued upon the exercise of outstanding options or upon settlement of the forward sale agreement recently entered into by us, or if the market perceives such sales or issuances could occur, the market price of our common stock could decline. As of May 3, 2005, there are 21,773,880 shares of our common stock outstanding, of these shares, 21,503,256 shares are freely tradable (unless held by one of our affiliates). Pursuant to Rule 144 under the Securities Act of 1933, as amended, or the Securities Act, 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. 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 after issuance.

 

Any issuance of shares of our common stock in the future could have a dilutive effect on your investment.

 

We may sell securities in the public or private equity markets if and when conditions are favorable, even if we do not have an immediate need for capital at that time. We may also, either mandatorily or at our option, issue shares upon settlement of the forward sale agreement recently entered into by us. We may elect to settle the forward sale by means of a physical stock, cash or net stock settlement. If we elect to physically settle the forward sale agreement in total, we would be required to issue 1,500,000 shares of our common stock. In no event are we required to deliver more than 1,500,000 shares under the forward sale agreement. On April 20, 2005, we partially settled the forward sale agreement by issuing and delivering 1,078,697 shares of our common stock.

 

Raising funds by issuing securities dilutes the ownership of our existing stockholders. 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” beginning on page 26 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

 

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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. For example, our certificate of incorporation makes us subject to the anti-takeover provisions of Section 203 of the General Corporation Law of the State of Delaware. In general, Section 203 prohibits publicly-held Delaware corporations to which it applies from engaging in a “business combination” with an “interested stockholder” for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. This provision could discourage others from bidding for our shares and could, as a result, reduce the likelihood of an increase in our stock price that would otherwise occur if a bidder sought to buy our stock.

 

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.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

 

Quantitative Disclosures. 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. 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 hold derivative instruments primarily to manage our exposure to these risks and all derivative instruments are matched against specific debt obligations. There have been no material changes in the primary risk exposures or management of the risks since the prior year. Our debt and interest rate swap instruments outstanding at March 31, 2005, including applicable interest rates, are discussed above, in “Item 1. Financial Statements - Notes to Consolidated Financial Statements—Note 5—Derivative Financial Instruments.”

 

The following table presents the future principal cash flows and weighted average interest rates based on rates in effect at March 31, 2005, on our existing long-term debt instruments. Fair values have been determined based on quoted market prices as of May 5, 2005.

 

Expected Maturity Date

as of March 31, 2005

(Dollars in thousands)

 

     Fiscal
2005


    Fiscal
2006


    Fiscal
2007


    Fiscal
2008


    Fiscal
2009


    Thereafter

    Total

    Fair Value

Long-term debt

   $ 4,015     $ 16,010     $ 16,000     $ 16,000     $ 16,000     $ 491,000     $ 559,025     $ 564,910

Weighted average interest rate

     6.24 %     6.44 %     6.68 %     6.69 %     6.59 %     7.13 %     6.77 %      

 

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 31, 2005, the interest rate on 80.9% of our debt was fixed by either the nature of the obligation or through the interest rate swap arrangements compared to 79.7% at September 30, 2004. The annualized effect of a one percentage point change in floating interest rates on our interest rate swap agreements and other floating rate debt obligations at March 31, 2005, would be to change interest expense by approximately $1 million.

 

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 31,
2005


    September 30,
2004


 

Notional principal amount

   $ 202,000     $ 202,000  

Weighted average pay rate

     2.72 %     2.72 %

Weighted average receive rate

     2.97 %     1.84 %

Weighted average years to maturity

     1.05       1.55  

 

We have also entered into swap agreements having a notional amount of $130.0 million which will become effective April 2006. These swap agreements have a weighted average pay rate of 4.24% with various settlement dates, the latest of which is April 2009.

 

As of March 31, 2005, the fair value of our swap agreements represented a net benefit of $3.5 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.

 

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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.

 

As required by paragraph (b) of Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), our Chief Executive Officer and our Chief Financial Officer have evaluated the effectiveness of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and our Chief Financial Officer conclude that, as of the end of the period covered by this report, our disclosure controls and procedures are effective, in that they provide reasonable assurance that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods required by the United States Securities and Exchange Commission’s rules and forms. From time to time, we make changes to our internal controls over financial reporting that are intended to enhance their effectiveness and which do not have a material effect on our overall internal control over financial reporting. We will continue to evaluate the effectiveness of our disclosure controls and procedures and internal control over financial reporting on an ongoing basis and will take action as appropriate. There have been no changes in our internal control 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 report that we believe have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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THE PANTRY, INC.

 

PART II-OTHER INFORMATION

 

Item 1. Legal Proceedings.

 

As reported in our Annual Report on Form 10-K for the fiscal year ended September 30, 2004, there is pending (instituted on July 17, 2004) a suit (Constance Barton, Kimberly Clark, Wesley Clark, Tracie Hunt, Eleanor Walters, Karen Meredith, Gilbert Breeden, LaCentia Thompson, and Mathesia Peterson, on behalf of themselves and on behalf of classes of those similarly situated vs. The Pantry, Inc.) seeking class action status and asserting claims on behalf of our North Carolina present and former employees for unpaid wages under North Carolina Wage and Hour laws. The suit also seeks an injunction against any unlawful practices, damages, liquidated damages, costs and attorneys’ fees. We have filed an Answer denying any wrongdoing or liability to plaintiffs in any regard. The suit originally was filed in the Superior Court for Forsyth County, State of North Carolina. On August 17, 2004, we filed a Notice of Removal, removing the case to the United States District Court for the Middle District of North Carolina. The Plaintiffs have filed a motion to remand the case to the Superior Court for Forsyth County, which is presently pending before the federal district court, and on May 4, 2005, filed a motion to amend their Complaint to assert certain additional claims under the federal Fair Labor Standards Act on behalf of present and former store employees in the southeastern United States and adding one additional named plaintiff, Chester Charneski. If the motion is allowed, it would moot plaintiffs’ pending motion to remand, with the result that the case would remain in the federal district court. We believe our employment policies and procedures comply with applicable law and intend to vigorously defend this litigation. We are presently in the preliminary stages of this matter and cannot at this time predict the outcome or provide a reasonable estimate of the potential liability, if any, that might arise.

 

We are party to various other legal actions in the ordinary course of our business. We believe these other actions are routine in nature and incidental to the operation of our business. While the outcome of these actions cannot be predicted with certainty, we believe that the ultimate resolution of these matters will not have a material adverse impact on our business, financial condition or prospects.

 

Item 4. Submission of Matters to a Vote of Security Holders .

 

On March 29, 2005, we held our Annual Meeting of Stockholders, during which our stockholders:

 

(1) Elected nine nominees to serve as directors each for a term of one year or until his successor is duly elected and qualified. The votes were cast as follows:

 

Name


   Votes For

  

Votes

Withheld


Byron E. Allumbaugh

   18,783,342    341,711

Paul M. Brunswick

   18,779,142    345,911

Todd W. Halloran

   18,783,442    341,611

Bryan E. Monkhouse

   18,821,667    303,386

Thomas M. Murnane

   18,643,972    481,081

Charles P. Rullman

   18,787,642    337,411

Peter J. Sodini

   18,821,498    303,555

Peter M. Starrett

   18,722,802    352,251

Hubert E. Yarborough, III

   18,783,142    341,911

 

(2) Ratified the appointment of Deloitte & Touche LLP as independent public accountants for the Company and its subsidiaries for the fiscal year ending September 29, 2005. The votes were cast as follows:

 

     Votes For

   Votes
Against


  

Votes

Withheld


Ratification of Deloitte & Touche LLP

   19,055,723    65,407    3,923

 

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THE PANTRY, INC.

 

PART II-OTHER INFORMATION (CONT.)

 

Item 6. Exhibits.

 

Exhibit
Number


 

Description of Document


10.1   Fifth Amendment to Distribution Service Agreement dated April 1, 2004, by and between The Pantry and McLane Company, Inc. (asterisks located within the exhibit denote information which has been deleted pursuant to a confidential treatment filing with the Securities and Exchange Commission).
10.2   Summary of Material Terms of The Pantry, Inc. Annual Incentive Plan.
10.3   First Amendment to Amended and Restated Addendum to Distributor Franchise Agreement by and between CITGO Petroleum Corporation and The Pantry, Inc. dated March 31, 2005 (asterisks located within the exhibit denote information which has been deleted pursuant to a confidential treatment filing with the Securities and Exchange Commission).
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.]

 

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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, Chief Financial Officer and Assistant Secretary

(Authorized Officer and Principal Financial Officer)

Date: May 10, 2005

 

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EXHIBIT INDEX

 

Exhibit
Number


 

Description of Document


10.1   Fifth Amendment to Distribution Service Agreement dated April 1, 2004, by and between The Pantry and McLane Company, Inc. (asterisks located within the exhibit denote information which has been deleted pursuant to a confidential treatment filing with the Securities and Exchange Commission).
10.2   Summary of Material Terms of The Pantry, Inc. Annual Incentive Plan.
10.3   First Amendment to Amended and Restated Addendum to Distributor Franchise Agreement by and between CITGO Petroleum Corporation and The Pantry, Inc. dated March 31, 2005 (asterisks located within the exhibit denote information which has been deleted pursuant to a confidential treatment filing with the Securities and Exchange Commission).
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.]

 

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