Thursday, July 20, 2023
U.S. Economic Growth Remains Positive; Industry M&A Multiples Get Tested
Source: Observations from the Executive SuiteBy Jeff Kramer, Managing Director, NRC Realty & Capital Advisors
First, the good economic news is that the most advertised recession in history has again been avoided in 2Q of 2023, at least in the U.S. Heavy consumer spending for travel, plus a surprising uptick in both new housing starts and new car sales in spite of rising interest rates are all helping. A sizable unplanned financial release of almost $500 billion by our Federal Reserve right after the recent bank crisis in March also helped, although interest rates and the ongoing uncertainty from Federal Reserve Quantitative Tightening (QT) are keeping credit very tight. In fact, real interest rates, i.e., interest rates after inflation, are now positive in most countries, and hence even more restrictive. There is no question that some of this growth spurt may have been caused by a significant easing of supply shortages, so we'll see how these next several months develop and if new home sales and car sales continue their improvement. Also, it is important to remember that normally governments try to get recessions over with well before important elections, as should be the case for 2024 when both parties will have vivid memories of 2022 political surprises and the turmoil surrounding the 2020 presidential election. Regardless of reported economic strength, current and future earnings are more uncertain, mostly due to rising costs and the growing difficulty of passing them through to pinched consumers whose own savings net of debts are declining. There are more signs of stabilizing prices for existing and new homes in several markets, and sharply lower prices are showing up for used automobiles, which will eventually impact new car prices. Many important commodity prices, including farm products, have softened considerably, helping many companies. Unless there is an extremely hard landing, long-term and short-term interest rates remain historically on the low side, so we should not expect fast rate declines with our high level of debt if the economy maintains moderate growth. Some capital spending will also start showing up from ongoing spending spurred by Federal incentives promoting infrastructure, new energy, and EV-related programs. A still healthy economy makes the Fed's job more difficult, because it is unclear where will we get the skilled and unskilled labor with our demographic mix?
The other piece of good long-term economic news is that worldwide inflation is showing important signs of slowing for now, and perhaps much more so in the EU and China. Some countries are now even worried about deflation and more bad loan discoveries. It is perhaps most evident to our industry in the ‘soft' prices of oil helped by the ‘temporary' reduction of Strategic Oil Reserves to reduce reported inflation. Oil prices normally are good coincident indicators of economic strength or weakness. It is interesting that oil and natural gas production levels in the U.S. are holding steady at these so-called low prices even though drilling activity is on a decline. Is good old Yankee ingenuity and AI or real type technology helping sustain old oil basins?
Now let's catch up on our industry M&A activity. First, there is no question that bank and the now important non-bank credit markets remain very tight, raising interest costs for all businesses steadily over time as old loans expire. Basically, this tends to lower M&A bid multiples. Most recently, both Alimentation Couche-Tard (Circle K) and Casey's have mentioned a desire to pick up acquisition activity in anticipation of these lower multiples. I think this does represent confidence in the industry as synergies of scale in both buying power and cost savings make some acquisitions accretive to their earnings with their use of cash or often relatively lower cost funds. They are also focusing on foodservice for an important part of their growth plans, provided lot and building sizes are large enough for future needs. Is foodservice the key to the future in our industry? It seems to be increasingly so. Also, if total in-store sales are large enough and profitable enough, these operators are much less dependent on fuel profitability if E.V. new car sales start to accelerate at some point. I'm sure many M&A buyers would prefer to build their own designed NTIs, but they are expensive, very time consuming to zone and construct, and always have some uncertainties. Our industry offers owned or leased stores, plus a number of flexible modes of operation that can vary from time to time with regulations and changing economic conditions. So, my own conclusion is M&A should remain active even in a soft economy for the right stores and chains.
Overall, the range of multiples in our industry has likely slipped from 7-10X store EBITDA, defined as so called four wall cash flow before overhead, to 6.5-9.5X right now at this level of interest rates and economic situation. If that sounds like a wide range, it is because of the diversity of assets in our industry, uncertain growth, and the large differences in economic growth by state, which also impacts critical labor cost and quality. Buyers' synergies and individual corporate growth goals will always be very important, making it difficult to guess the range of buyers. Strong chains remain confident in skipping states for acquisitions if they have solid, low cost, back room support. But sellers may continue to remember earlier higher multiples.
In M&A, a company's final selling price is determined by store-level EBITDA times the associated multiple. The industry is coming off a period of record rising sales and profitability even though same store unit sales have often been declining. Certainly being deemed an ‘essential industry' during Covid helped gas and c-store sales and profits, and a subsequent strong enough economy retained most of those customers who continue to need convenience and will pay for it. A hot, sultry summer this year is helping to maintain that traffic pattern. Oil price stability at low levels helps save money for the consumer that often gets spent in the store. But, historically, oil price volatility as we have witnessed helped average retail margins, so economic conditions and more stability will normally soften profitability at the pump. Another important industry issue is that mass marketers like Costco, many supermarket chains, large travel center/truck stop operators, and strong NTIs continue to gain fuel market share. The net result is pricing power varies quite a bit by market, and larger companies can spread that risk.
Overall, in-store activity has been quite solid, albeit certainly helped by inflation and generally favorable weather conditions. Some new profit centers such as gaming, car washes, financial services, etc., are also helpful. But the big growth driver remains foodservice, as it drives so many store and fuel visits. The strong industry foodservice chains also keep gaining market share, including from other fast food chains and restaurants, as many are forced to close or reduce hours of operation due to labor shortages.
A large unknown going forward remains the growth of the E.V. industry. On the one hand, non union Tesla keeps growing sales and market share and even reduces prices, but the rest of unionized Detroit remains behind. It seems like Tesla is following the path of Henry Ford and John D. Rockefeller through scale and integration. It is also totally unclear how politics and the industry will deal with China and its growing quality, low cost E.V.'s. Extreme weather conditions keep the E.V. issue in the news. A little long-term good news for the E.V. industry and all of us breathing the air is that the U.S. Energy Information Administration expects solar electric energy production this summer to be 24% ahead of 2022's summer production. Higher use of relatively clean natural gas as well will actually lead to a decline in coal-fired electricity generation this year in the U.S.
In summary, the U.S. remains one of the world's strongest economies overall, led mostly by a strong consumer and a world leading tech industry. The future technical promise of AI, Chat GPT, and robotics gives hope for economic gains and hopefully sizable productivity gains at some point that will offset the need for our population to grow.
Furthermore, M&A interest in the fuel/c-store industry should stay robust, although at least temporarily there could be a sizable spread between buyers' bid prices versus sellers' expectations. Because of the overall resilience of the industry and many advantages over others, quality chains and locations will always remain in demand.