Friday, April 14, 2023
Convenience Store Industry M & A in the Most Telegraphed Recession in History
Source: Observations from the Executive SuiteBy Jeff Kramer, Managing Director, (303) 619-0611
Will the much discussed recession start to show up more in the statistics? Sticky consumer spending and very low unemployment have continued to delay the forever anticipated recession. At least many businesses have had time to prepare, which normally reduces the recession pain for business regardless.
The dust is settling from two significant U.S. bank failures and a very important Swiss international bank failure of formerly safe and reliable Credit Suisse, the first significant bank failures in almost 15 years. The rescues have eaten up about $500 billion of U.S. rescue funds so far, offsetting almost half of the official Federal Reserve Quantitative Tightening started mid-2022, and have stabilized markets for now. No one ever said getting off "free money" interest rates would be easy, especially as debt continues to increase. We won’t know if markets will settle down for some time yet as the ongoing Fed tightening takes time to be felt in the economy, other than temporary emergency funds. Complicating matters further is the combined U.S. Federal Budget and critical debt ceiling impasse, the Ukraine War, and other World geopolitical and financial risks in countries that may be in far worse financial shape than the U.S. This includes normally fast acting "Communist" China which made plenty of serious mistakes as well, but is for now in the middle of their own post-Covid economic recovery.
The U.S. economy and even inflation are finally starting to show many more signs of slowing, as short and long-term interest rates have receded more than a full percentage point from recent highs, normally reflecting economic slowing and less demand for credit. Besides our Fed being late acting on inflation, we don’t know as yet the full impact, especially since many "zombie" companies such as Carvana and Bed Bath and Beyond continue to somehow come up with more expensive money to survive another few months. The recent failure of SVB was the result of management’s overinvesting in unhedged long term bonds, but where was the Fed or FDIC as a watchdog agency? Now, where will the uninsured cash which was moved out of smaller U.S. banks into money market funds wind up? Money market mutual fund cash more than doubled over the last several months to $5 trillion, and Barclays Bank has forecast another $1.5 trillion is in the works. If history is a guide, there will probably be more financial issues evolving from the ongoing tightening of credit overall. Wall Street seems to be anticipating lower profitability in general as a result, but perhaps companies have already reacted accordingly?
A very real problem for our still strong convenience store industry is this huge money shift plus tighter loan portfolio scrutiny by the Federal and State agencies for small and medium size banks resulting in less funds for small business through loans. The smaller banks that are seeing their deposits depart have been the heartbeat of lending to small business, commercial buildings, and retailers in general. These banks can borrow from the Fed or issue new certificates of deposit, but now at much higher rates. So, interest rates may not drop for many companies even in a recession because of the greater risk of loan repayment. Manufacturing industry data show manufacturing is already receding, and retail sales gains are slowing while unit sales continue their decline. Consumer credit debt continues to increase. Hopefully, the economy will not turn to the dreaded Stagflation, which combines slow growth with too high inflation rates, often for longer periods of time.
So, where does this leave our industry, perhaps one of the strongest industries of the Covid outbreak, having been deemed an "essential industry"? First, profits in our industry could get pinched in a recession. Immigration is in flux, and the U.S. simply does not seem to have the labor force with the needed skills to grow, plus productivity is not improving as yet either. That is why the Fed is looking for unemployment to increase to give a cushion for more growth and not just go to increasing inflation. As the economy continues to slow, the first impact could be loss of sales and profits as the lower end consumer feels their own budget limits and starts to buy less and are more cost conscious. Expiring Covid-related SNAP rules are no help. Foodservice can be a sizable plus but can be difficult to manage and execute profitably. Gaming can be a terrific positive, if available, as it brings other store business with it. Like it or not, marijuana may be a new source in the future as Federal and State agencies need more revenues.
Fuel margins are hard to predict, as World geopolitics are having more of an impact on prices than normal, leaving open the possibility of retail consumer price shocks, which usually impact store sales. Our industry has cured any volume decreases in the last few years with price increases which more than offset volume losses and expense increases, but this is not guaranteed to be sustainable. Our M&A observations so far this year are that buyers are looking more critically at most recent record 2022 retail fuel margins. Government intervention in the free market adds more confusion and uncertainty to sales and capital investment, ultimately impacting M&A and multiples as well.
U.S. electric vehicle sales are growing at a slow pace, as car companies struggle with new untested models, typical for any new industry, but even including far more established Tesla. At the same time, internal combustion engine car prices remain high for both new and used vehicles, and it certainly appears to me that Tesla’s strategy is to increase production to scale by lowering prices, quickly. Tesla has seen the impact of lower prices and improving car quality in China, while regulatory restrictions and costs are much more difficult in the U.S. As E.V. costs and technology take time to improve, fortunately the American consumer also has fuel efficient hybrid electric vehicles to choose from, but they don’t help fuel sales as much in what otherwise remains a very stable fuel demand environment as gas is an economic bargain right now.
The other big industry M&A question is what happens to multiples, which, as this is written, remain in the 7-10x range of store cash flow for decent chains of company operated and owned stores. The upper end of that range is clearly getting more scrutiny. Money continues to be reasonably available for our industry, and transactions with good synergies or hidden value for growth will clearly continue to be completed. Capital gains tax rates remain reasonable, and sellers now can obtain 4.5% on short term U.S. Government paper and, surprisingly, 4% on a number of short and long term State or Local municipal tax free instruments. A very different post-Covid world.
I do not ever remember a period of so many moving parts. The huge fluctuations in the normally stable U.S. Treasury markets are unprecedented, perhaps reflecting these uncertainties. Government rescue plans for the past 25 years or more have changed business and consumer thinking dramatically, yet our Government clearly remains the leader of the World, at times a scary role. Convenience has survived many speed bumps and always recovered by keeping expenses under control, keeping up with new sales products and services, managing debt, and being certain to maintain high standards of top quality management to keep up with the fast changing regulations and market trends.
The economics of consolidation will remain strong as scale for most companies will be more critical than ever to compete effectively, which is even more important in the age of Artificial Intelligence and all it brings with it, such as robotics. Exciting and yet challenging at the same time.