Evaluating Changing Market Conditions and Their Potential Impact on the Sale of a Company

September 5, 2019

Cedric C. Fortemps, CFA, Co-Head of Downstream Energy & Convenience Retail Group and John C. Duni, CFA, CPA, Senior Associate

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Introduction
So far this year we have attended a dozen national, regional or state industry association meetings and interacted with many business owners in the fuels distribution, petroleum marketing and convenience store industries. Each of their companies is unique and can vary greatly in size, geography, ownership structure, operating model, capital availability, volume and profitability trends. Out of the many discussions we have had with these owners, overall there have been two frequently recurring themes – and the theme all depends on the company’s plan for the future.

Business owners looking to grow and who are willing to do so through acquisitions as opposed to purely new development are dedicated to reinvesting in their company to try and stay ahead of the competition. They have a voracious appetite for strategic acquisitions and are eager to learn more about new opportunities potentially coming to market. They are hopeful that more opportunities are on the horizon and they want to be sure they are presented with the right type of opportunities. For many, their previous experiences from integrating acquisitions have shown that, despite being required to pay historically high multiples to acquire assets, in many cases the returns they have achieved have been well above expectations. These returns are also especially attractive given the real interest rate environment that U.S. investors have been in with real interest rates on 10-year treasury bonds in the U.S. being below 1.0% for the last nine years. A large component of what has driven their strong returns from acquisitions has been the synergies they have achieved from scale and implementing their brand and best practices into the target’s business. In addition, in some cases, they have also achieved reverse synergies and implemented the target’s superior practices, such as labor policies, food offerings, proprietary brands, rewards programs, or other industry leading practices into their existing operations.

On the flip side, conversations with business owners that are less confident about the future of fuels and less enthusiastic about the amount of capital required to reinvest and compete against well-capitalized convenience retailers and motor fuels distributors, are quite different. They are eager to learn more about why others are so bullish and are concerned about the channel blurring that is occurring with dollar stores and drug stores now competing with historically convenience retail dominated merchandise, the tight labor market, increasing costs to develop newer, competitive stores, etc. With these owners, the pressing question they most often ask is, “If I am contemplating a sale in the next few years, how long will this robust M&A market last?”

* The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate.

That is an excellent question, but as we all know, it is nearly impossible to predict and plan an investment exit at the top of the market. The bull market in C&G assets is being driven by a number of factors including low interest rates, a strong economy, access to capital, public stock valuations, industry maturity, high motor fuels margins and favorable tax policy for both acquirers and sellers. A change to any of these factors could result in an end to the bull market.

In this issue, we have not tried to predict that we have reached a peak in the M&A market for fuels distribution or convenience store companies. In fact, we continue to see a tremendous amount of competition from potential buyers on the sell-side engagements we advise on in the industry, which is a critical component of driving value. We have also not seen any decline in multiples being paid, despite some periods of economic uncertainty over the last year or so that caused the broader U.S. stock market to drop, at least temporarily. However, we do believe that for companies considering an exit in the next few years, the risks to the downside may be greater than the potential upside that can be achieved by holding on to the investment. Our goal in this issue is to provide an analytical view to help illustrate how certain occurrences, short of an end to the bull market, could have a significant effect on a seller’s after-tax proceeds.

Base Case Scenario
For our Base Case Scenario, we will use the sample hypothetical transaction that we used as the base case in the May 2018 Capital Markets Perspective, where we analyzed the potential impacts that the tax law changes, through the Tax Cuts & Job Act, could have on transactions. We will take a look at several scenarios where potential headwinds occur and impact transactions, as compared to the Base Case Scenario.

The target company in this hypothetical transaction is a convenience store chain that generates corporate EBITDA of $10 million. The company is an S-Corporation, and all of its convenience stores are owned with fee simple real estate interest. The buyer is a C-Corporation and acquires the assets for $120 million (12.0x corporate EBITDA), which based on the buyer’s base case projections for the target company’s assets, allows the buying entity to generate an after-tax IRR of 15.5% [2].

The seller’s after-tax net proceeds in this Base Case Scenario are $90,615,000.

[2] Projected after-tax compounded return on cash investment, assuming a sale at the end of year 10.

Scenario 1: Lower Fuel Volumes

The first potential headwind we modeled is a reduction in fuel gallons, with no impact to fuel gross margins to offset the lower volumes. Our Base Case Scenario model projected flat fuel volumes over a 10-year investment period, which resulted in the buyer’s after-tax IRR of 15.5%. In Scenario 1, we are adjusting projected fuel volume growth to an annual decrease of 1.0%. The key is focusing on how significant of an impact reducing annual fuel volumes by 1.0% from the base case has on a transaction. The projected long-term motor fuel volume growth for any given chain will vary by demographic changes in the specific market, hybrid and non-hybrid electric vehicle market share growth, the overall competitive landscape within that market, as well as national policies such as implementation of higher C.A.F.E. standards.

In order for the buyer to achieve an after-tax IRR of 15.5% (to match the Base Case Scenario returns) with fuel volumes declining 1.0% annually from the base case, the buyer’s purchase price would need to decrease to $103,575,366, which results in lower after-tax net proceeds to the seller of $79,606,389, or 12.1% less than in the Base Case Scenario of $90,615,000.

Scenario 2: Lower Fuel Margins

According to the NACS 2019 State of the Industry report, national retail fuel margins during the five-year period from 2014-2018 averaged 22.05 cents per gallon, which is 29.0%, or 4.96 cents per gallon, higher than the average from 2009-2013, which was 17.09 cents per gallon. It is unknown whether this increase is secular due to major oil companies no longer flooding the market with gallons at cheap prices at their retail stores or due to retailers’ increased costs of doing business (e.g. labor, credit card fees, insurance, site construction costs, debt service, etc.) and requiring a return on their capital; or if this change is temporary and driven by the overall decrease in oil prices over the last five years or other factors. We can only speculate on these points, as well as where margins will be in the future.

Regardless of what the answer may be as to the future of retail motor fuel margins, for a buyer to generate the same 15.5% after-tax IRR as it did in the Base Case Scenario, while projecting motor fuel margins that are 1.0 CPG lower, the buyer’s purchase price would need to decrease to $111,293,950, which results in after-tax net proceeds to the seller of $84,779,770, which is 6.4% lower than the Base Case Scenario of $90,615,000.

Scenario 3: Higher Income Tax Rates

Although some industry participants and analysts are somewhat comfortable trying to predict future changes to motor fuel volumes, motor fuel margins, and M&A multiples, one very important variable to future exit outcomes is exactly what the tax laws and tax rates on ordinary income and capital gains will be in 2-3 years. It’s very likely that the outcome of the 2020 presidential election will impact the number and severity of changes to the tax laws and rates, as well as their impact to businesses and wealthy individuals. We believe one opinion that has almost unanimous consensus, however, is that today’s tax laws and tax rates are as beneficial now to wealthy individuals and companies as they are likely to be in the foreseeable future. However, the timing and impact of potential tax law changes is definitely unknown. Since we could spend months running various analyses on the myriad of ways the tax laws and tax rates could change in the future and sensitivity-test the impact on after-tax proceeds to sellers from those changes, we instead decided to focus on one potential change based on current feedback.

In this scenario, our higher income tax rates case assumes that capital gains at the federal level are taxed at the same rate as ordinary income. The most concerning aspect of changes in the tax laws and tax rates that are detrimental to individuals and businesses, is that in some cases, they can have a dual or compounding impact on sale proceeds to the seller. These changes can negatively impact the price that buyers are willing to pay, and in turn, negatively impact the percentage of the gross purchase price that the seller nets after taxes. However, in this scenario it does not negatively impact the buyer’s returns, so their purchase price does not change.

If federal capital gains rates were to be increased to today’s ordinary income tax rates, the seller’s after-tax net proceeds would decrease to $79,905,000, which is 11.8% lower than the Base Case Scenario of $90,615,000.

Scenario 4: Lower Purchase Price Multiples

As stated earlier, another potential headwind for sellers of fuels distribution, petroleum marketing and convenience store businesses is the high multiples being paid in today’s market and how much longer they are likely to last, all other factors aside.

The good news is that in addition to most buyers in the industry successfully growing the earnings of companies they have acquired, the market value of the acquired earning streams (i.e. EBITDA) has also grown significantly, as valuations in the industry are at historic highs. Record valuations in the industry are partly evidenced by the fact that all three of the North American-based publicly traded companies that focus on convenience store operations [i.e. Alimentation Couche-Tard, Inc. (TSX:ATD.B.TO), Casey’s General Stores, Inc. (NASD:CASY), and Murphy USA Inc. (NYSE:MUSA)], are all trading at or near all-time highs in terms of the multiples (i.e. Enterprise Value as a multiple of Corporate EBITDA) under which they trade, as well as their total market capitalizations.

Today’s thriving M&A market is supported by plenty of access to inexpensive capital driven by low interest rates, record industry profitability over the last few years, and significant competition for assets from well capitalized regional companies, national consolidators, international companies and private equity funds. Purchase price multiples for companies in an industry can change for a myriad of reasons, including:

Higher perceived risk, whether due to macro-economic, industry-specific or company-specific factors;
Less competition for assets in the industry;
Higher interest rates;
Less access to capital and/or debt capital providers lowering allowable leverage ratios;
Higher inflation, resulting in investors demanding higher nominal returns to maintain the same level of real returns;
Changes to tax policies and/or rates that are less favorable for buyers, sellers or both; and
State or federal regulatory changes to fuel efficiency requirements, carbon emission caps, electric vehicle penetration, etc.

Based on conversations we have had with strategic acquirers in the industry, we don’t anticipate multiples decreasing in the immediate future. However, this is certainly a variable that potential sellers should understand and be sensitive to because multiples are not constant over time, especially when economic factors can change unexpectedly.

The chart below tracks the median Enterprise Value to Corporate EBITDA multiple for publicly traded fuels distribution and convenience store companies from 1995-2019. As you can see, valuations decreased significantly during the periods from 1999-2003 and 2008-2010, and there was a tremendous amount of pain felt by investors, through loss of market value, as multiples dropped dramatically and quickly. In times such as those, market forces typically slam windows of opportunities shut. Multiples on transactions were impacted similarly, but in many cases, transactions did not close, and sellers either accepted much less for their business than they had expected, or sellers were forced to wait for a recovery before trying to exit.

If purchase price multiples were to decrease by a very modest 1.0x, resulting in a purchase price of 11.0x corporate EBITDA in our hypothetical transaction (Base Case Scenario multiple was 12.0x), and with all other factors remaining the same, the purchase price would decrease to $110,000,000 and the buyer would generate an after-tax IRR of 18.5%. In this scenario, the seller’s after-tax net proceeds would decrease to $83,912,500, which is 7.4% lower than the Base Case Scenario of $90,615,000.

Scenario 5: Cumulative Effect from Scenarios 1-4

Scenarios 1-4 analyzed potential isolated factors that could negatively impact sellers of fuels distribution petroleum marketing, and convenience store businesses. We have chosen these specific scenarios to analyze primarily because they are foremost on the minds of business owners. You have probably noticed that the sensitivity cases were based on somewhat subtle changes to market conditions (i.e. 1.0 CPG, 1.0% volume change, 1.0x turn reduction in purchase multiples and changes to capital gains rates only). When market conditions deteriorate, it often impacts several assumptions and elevates overall risk, so we also included a scenario that analyzes the compounding effect of multiple potential market headwinds. Scenario 5 includes each headwind from Scenarios 1-4.

In combining all of the factors from Scenarios 1-4 (i.e. Lower Fuel Volumes, Lower Fuel Margins, Higher Income Tax Rates, Lower Purchase Price Multiples), the buyer’s purchase price would decrease to $83,984,126 and the seller’s after-tax net proceeds would decrease to $59,898,182, which is 33.9% lower than the Base Case Scenario of $90,615,000.

Conclusion
Our goal with Capital Markets Perspective has always been to inform through analysis and research so readers can be better informed and make better decisions. In this issue, we have not attempted to answer the question of how long the current robust M&A market will last – that is unknown and a change to any or many of the factors contributing to this market could trigger a slight softening or an abrupt end. We have, however, tried to quantify the impact on after-tax proceeds to the seller from some of the potential headwinds that could be experienced even as overall market conditions remain favorable. As illustrated by each scenario, a relatively minor change in underlying assumptions can have a significant impact on a seller’s after-tax proceeds. More significantly, after assuming only relatively minor impacts from each individual headwind, when they are combined as depicted in Scenario 5, the cumulative effect can be quite drastic on after-tax proceeds. In reality, the overall impact could be much more dramatic if the bull market were to end as abruptly as it has in the past.

We look forward to your feedback and questions.

Disclaimer
The contents of this publication are presented for informational purposes only by Matrix Capital Markets Group, Inc. and MCMG Capital Advisors, Inc. (“Matrix”), and nothing contained herein is an offer to sell or a solicitation to purchase any of the securities discussed. The contents of this publication are presented for informational purposes only. While Matrix believes the information presented in this publication is accurate, this publication is provided “AS IS” and without warranty of any kind, either expressed or implied, including, but not limited to, the implied warranty of merchantability, fitness for a particular purpose, or non‐infringement. Matrix assumes no responsibility for errors or omissions in this Presentation or other documents which may be contained in, referenced, or linked to this publication. Any recipient of this publication is expressly responsible to seek out its own professional advice with respect to the information contained herein.

Matrix’s Downstream Energy & Convenience Retail Group is recognized as the national leader in providing transactional advisory services to companies in the downstream energy and multi‐site retail sectors.