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Thursday, January 7, 2021

Still Good, But Perhaps "As Good As It Gets"?

Source: Observations from the Executive Suite
By Jeff Kramer, Managing Director, NRC Realty & Capital Advisors

The fuel/convenience store industry is pulling off yet another great profit year in 2020, as record fuel margins and strong inside store sales offset lower fuel volumes, less store traffic, and declines in foodservice sales. Deemed an "essential industry" during Covid-19 created many problems, especially labor-related, but in the end, generally great profits. Competition was less important than convenience, market offerings and cleanliness. Remember the movie "As Good As It Gets"? Perhaps this year's sequel will be titled "Getting Back To a 'New' Normal".

Looking past Covid is tricky, since it is unlikely to end in an instant. I will try to focus on the long term impact of the key factors affecting store and company valuations, which ultimately are determined by profits, selling multiples and interest rates.

Regardless of the ultimate severity of Covid-19, many developing trends that might have taken six years to develop, have compressed to six months out of necessity. A key one affecting our industry is "work from home". A recent survey showed 42% of the workforce working from home compared to 3.5% pre-Covid. Another accelerated trend is the remarkable growth of internet sales and the subsequent distribution networks led by Amazon, and now WalMart and others. The health of the planet and its people is bringing a serious resurgence of fuel systems designed to replace carbon fuels. The growth of Tesla and electric vehicles is bringing scale to an industry that has the potential to grow more quickly than ever anticipated, except perhaps by Elon Musk. And then there is also hydrogen based fuel cell technology at some point.

Recent OPIS data shows 2020 gasoline demand on a same store basis will likely be 18% lower than 2019. The volume declines varied a great deal by location and type of facility. Industry professionals have estimated that work from home and fuel efficiencies have likely created a 10% permanent decline in gasoline volume. Any subsequent liquid fuel losses from New Age vehicles can be partially made up, but not without sizable capital investment for facilities and parking. And there remains a yet unknown impact on c-store sales.

OPIS currently estimates that U.S. rack to retail margins averaged 35c/gallon in 2020, compared to 25c in 2019. The virus lockdowns created a huge worldwide decline in the demand for petroleum. Crude oil prices crashed and refiners could not cut back production quickly enough, resulting in a windfall for retailers that is unlikely to be repeated in subsequent years. In addition, strong c-store marketers who typically achieve over 70% of their total gross margins from inside store and foodservice sales may use fuel prices to drive traffic to the site.

Covid certainly increased the need for quick in and out convenience near home. Store traffic continued its general decline, but average ticket size increased, sharply helping store profits, despite very soft foodservice sales. "Feel good" product sales like snacks, sweets, beer and other alcohol led the category increases--ironically often unhealthy items that may not be as popular post-Covid as people get out more. Convenience will remain important, and drive-thru windows will bring much more traffic than in the past. Delivery systems are effective, but very expensive without scale.

Labor will continue to be difficult, from both a cost and quality standpoint. Covid has taught us to make labor work with fewer people at the same time the public has been forced to be more patient, for now. Automation will create labor savings over time, but it is sometimes capital intensive, adding to already high construction costs. Fortunately, interest rates are very low, although difficult to predict in the future depending on the strength of the economy and even overall U.S. government debt and confidence in the U.S. Dollar.

On balance, industry profitability and return on investment should remain quite good, favoring companies with scale to compete with good locations, clean well merchandised stores, and strong sales and support personnel. Company consolidation will continue due to overhead savings, likely increasing regulation and buying power. Weaker stores will be closed or sold to lower cost operators with a different model, such as dealers or possibly franchisees.

Recent record selling multiples are perhaps the most problematic question in our industry, as interest rates and money availability often drive valuations, as in the housing market. A return to normal economic growth is important if inflation stays tame and interest rates low. High rates of unemployment are likely to persist, so consumer spending could be quite variable in the future depending on consumer optimism. The future impact from New Age vehicles and potential returns to healthier diets post-Covid remain to be seen. Fortunately, these trends take time to impact in a large way.

Future income tax rates are critical in this industry for rapid depreciation and ultimate retention of pre- tax profits. Industry participants have estimated that the Tax Cuts and Jobs Act of 2017 added about 2X to market multiples. Tax rates may stay where they are until the economic recovery takes hold, but they are almost certain not to decline for successful businesses, and could get much higher.

As always, it is important to have a growth plan and vision of the future for any company. Growth has typically come from "Build or Buy" decision making, which is much more "gray" than before. Convenience will always be demanded by the public, but we are clearly facing a very different environment.

Selling prices are determined by "Normalized Profits" times "Market Multiples", with money availability and interest rates factored in the equation. With record profits and very high selling multiples, it may well be a "Good As It Gets" environment for those companies considering a sale. As a minimum, expect more individual units to be sold off that may have difficulty competing in the new environment, especially compared to potential new build sites.

To see a list of convenience stores and gas stations for sale, click here.