Tuesday, December 27, 2022
Recession Or Not? Some Buyer Caution On Gasoline/C-Store M&A
Source: Observations from the Executive SuiteBy Jeff Kramer, Managing Director, NRC Realty & Capital Advisors
The U.S. is currently facing stubborn inflation of approximately 6%, presently largely blamed on low unemployment and wage pressures of about 5% in a mature service-oriented economy. Post-Covid consumers are spending fairly freely on service-related businesses and restaurants, and home repairs and upgrades, especially as they are being priced out of the market on new housing and new car purchases due to the fast rise in interest rates. Lower- and middle-income wage earners are especially impacted as their built up savings during Covid are being depleted and their debts, often through credit cards, are increasing rapidly. Unfortunately, most of our gas and c-store customers, as well as our in-store employees, are in these groups.
The U.S. Government response has been to keep raising interest rates to market levels reflecting the latest thoughts on how to slow inflation. The Federal Reserve has been largely financing the government deficits by almost $5 trillion over the last five years, and now the Fed recently began to try withdrawing those funds from the banking system through Quantitative Tightening (QT), which has never been tried to the extent being used right now. Unfortunately, our government continues to spend with new legislation that continues to add to the deficit and keep the economy going, which could add to less credit available for business and consumers. Some spending programs have been termed “inflation reducing”, but I believe that is only true over time, such as those relating to deglobalization and climate control - however badly needed. So, monetary policy is pushing in one direction at the same time that fiscal policy is pushing in the opposite direction. And the same is true in many other countries. These policies get even more complicated when unexpected events, such as war, cryptocurrency collapses, bankruptcies, pension funding problems and Covid recurrences in China, bring unexpected liquidity problems. Think of the world economy as turning around a big battleship, which takes time, and ours is the biggest battleship of all.
I will let the reader speculate how you think it will end. I do believe inflation is already decreasing, ironically perhaps with oil as one of many important leading indicators. Granted, some of the price decreases in oil and at the pump have been helped by sales of Strategic Oil Reserves, but the demand decreases for gasoline and now even diesel fuel are stunning, at least for now. But have you noticed that other commodities like lumber prices have declined 75% from their 2020 peaks, although obviously not reflected at retail or in home prices? While good news on lower commodity prices continues, service workers and other employee wages are still increasing. Considering our country’s overall debt position, we may not see an end to rising interest rates for some time. Is that part of the Fed’s warning signals? I’m sure policy makers are thinking of yet another important election coming up in 2024 and knowing the long time lags between monetary and fiscal policy effects on the economy, they are concerned about repeated bumps in inflation rates.
In the meantime, the U.S. gasoline convenience store industry is perhaps the strongest it has ever been, if profitability and asset appreciation are the benchmarks. The large volatility in crude oil prices and recent important oil refining capacity tightness have generally helped retailers for now, who have also benefited from industry consolidation in the recent low interest rate environment, giving pricing power even with lower demand. C-store and foodservice demand also remain strong as convenience and full employment allow the consumer to pay a premium.
M&A activity may continue to be slowed by antitrust pressures going forward. But M&A interest should remain robust, as synergies in purchasing power, overhead savings, and the difficulties of keeping up with automation will keep M&A incentives in play. And the aging demographics of our population affecting our economy are certainly evident in our industry ownership and management of a not so easy business.
In recent NRC offerings, second and third tier buyers took center stage, having been effectively shut out of the market by the largest operators over the past several years, and they have been able to take advantage of still low interest rates historically.
Also, fortunately, our industry remains considered unique by banks and Wall Street, I feel, largely by its historical flexibility from good retail traffic placements. Over time, because of rising demand and convenience, the industry has changed from 15c/gallon retail gas stations to full convenience stores, to now in many cases quick serve fast food restaurants with more complementary items than all pure fast food operators will ever have. More recently, some c-stores have added gaming machines, CBD dispensaries, Interstate Highway rest and shopping sites, and who knows what is next? How many retail industries can offer that much potential growth if you can be an innovator?
So, regarding future industry M&A, the first question is how much do you feel profitability will be affected by economic conditions over the next two years? Regarding the overall economy, most economists expect profitability decreases can be as much as 25-50%, the key being the depth and length of the decline in the economy and the industry position. Fed Chairman Powell may believe he needs that result in order to stabilize inflation at lower long-term levels.
The 2009-2010 recession brought oil price reductions that helped buffer our industry’s profit declines. Regardless, the real and psychological changes of tight credit from the banking industry, and uncertain demand and profitability decreased store cash flow selling multiples (i.e., before non-store overhead, interest and depreciation) from about an 8x level to 5x for owned and operated properties and chains. The 5x level lasted for about four years until the rise in the economy and industry improved confidence, while interest rates continued their decade long decline.
Our industry selling multiple levels climbed as high as 12x-14x during the height of the recent so-called “free money” era for larger chains, and before allowing for synergies even including refining and distribution savings. Publicly traded companies frequently stated that these synergies were expected to bring their effective purchase multiples to nearer an 8x. Current selling multiples are more in the 7x-10x range and before some non-overhead synergies. The other good news is that buying activity remains robust, perhaps because of some of the previously mentioned reasons and we are apparently not in a recession currently. In addition to the usual industry buyers and consolidators, we still see activity from private equity buyers, and even several oil refining companies who seem to prefer to diversify their cash flow sources plus benefit from having secure volumes for their refinery output. Some may be thinking about outlets for electric vehicle charging. An interesting approach for large refiners seems to be joint venture operations, rather than operate directly for many reasons. Many operators can form their own joint ventures without oil company participation, something NRC has seen and can help with in the future.
It has been an incredible period for our industry with record profits and valuations. Normally that money will be spent on acquisitions and/or New To Industry (NTI) site construction. Despite excellent tax incentives to continue in those directions, buyers realize that with multiples high and new construction costs remaining expensive, the interest rate and economic outlook may continue the trend towards more buyer caution.