Valuing Synergies in M&A Transactions

April 13, 2017

Cedric C. Fortemps, CFA, Managing Director & Principal, Stephen C. Lynch, CFA, CPA, Vice President and Kyle A. Profilet, CPA, Analyst

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Introduction
In Volume 4; Issue 1 of the Capital Markets Perspective (CMP) series, Taking a Closer Look at Transaction Multiples, published in February 2015, we sought to explain the reporting of EBITDA multiples paid for petroleum marketing and convenience store companies and clarify how and why these transaction multiples can vary significantly when compared across different transactions. We discussed how these metrics, collected from publicly available merger and acquisition (“M&A”) disclosures and widely disseminated by financial news outlets, could be misleading when the EBITDA that is being used to calculate the multiple is not made obvious to the reader. Unlike some industries where transactions are analyzed primarily based on the seller’s corporate EBITDA, experienced industry participants and analysts in the C&G industry typically focus on the price paid for an acquisition as a multiple of the seller’s store level EBITDA or the buyer’s projected corporate EBITDA (also referred to as synergistic EBITDA). The fact that the EBITDA used to calculate a transaction’s EBITDA multiple is not always the same EBITDA measurement has historically resulted in multiple confusion, which was discussed in depth in the previous CMP article mentioned earlier. The primary reason that the seller’s store level EBITDA or the buyer’s synergistic corporate EBITDA are the most meaningful EBITDA figures to focus on in analyzing deals in the C&G industry is that a strategic buyer can realize a significant amount of synergies when acquiring another company in the industry, which leads to a much lower imputed EBITDA multiple for them than a multiple of the seller’s corporate EBITDA.

In this issue, we will analyze how significant these synergies can be and the impact they have on returns for a buyer. In addition, we will illustrate how, largely due to the enormous amount of synergies that strategic buyers can realize today, acquirers are able to generate significant returns for their shareholders even in cases when transactions are valued at EBITDA multiples that some observers may suggest to be extremely high or frothy.

Potential Synergies in the Fuels Distribution, Petroleum Marketing & Convenience Retailing Sector of the Downstream Energy Industry
One specific topic we highlighted in the previous issue was that in each transaction, a firm considering a potential acquisition will look closely at the existing operations of the company or assets for sale and begin to forecast the likely business improvements and cost efficiencies that the buyer could realize once the acquisition is complete. These synergies, which effectively increase the average per unit (or per store) EBITDA and can be achieved by increasing gross profits and/or by reducing expenses, are created primarily through the buyer’s ability to leverage economies of scale. Synergies can take many forms, but we will focus on the synergies that are most prevalent in M&A transactions taking place in the fuels distribution, petroleum marketing and convenience retailing sector of the downstream energy industry.

Synergies in M&A transactions typically fall into one of two broad categories – operating or financial. Operating synergies allow the buyer to increase the value of the combined entity by improving the profitability of its existing assets and/or the seller’s assets or by providing higher growth compared to what the two entities could achieve individually. Financial synergies are created by increasing shareholder value by doing things such as lowering an entity’s cost of capital, increasing its financial leverage or lowering its effective tax rate. While financial synergies can be significant in an acquisition, they typically are not discussed in detail in investor presentations or analyst calls when an M&A transaction is announced in the industry. Since publicly traded fuels distribution, petroleum marketing and convenience store companies often provide detailed data on the operating synergies that they expect to realize from significant acquisitions, we will primarily focus on analyzing the materiality of those operating synergies.

Some of the most typical – and significant – operating synergies that can result from an acquisition are the cost savings negotiated by a buyer that can improve fuel and merchandise procurement costs due to the increase in scale from combining the buyer’s and seller’s operations. In addition, the resulting combined entity may have stronger negotiating power with non-fuel and merchandise vendors that could allow them to reduce costs, such as credit card processing fees, utility costs, transportation costs and expenses associated with various service contracts. Economies of scale can also be experienced in the combined entity’s back-office and middle management levels as duplicate functions, departments and systems can be eliminated. This allows for a reduced level of overhead costs to be spread across a wider asset base, resulting in lower overhead costs per store.

Operating synergies can also come from top-line growth. Acquirers will often leverage their brand-name recognition, proprietary offerings, merchandising strategy, loyalty programs and larger networks to increase merchandise sales, fuel volumes, overall margins or all of the above. Other operating synergies can exist that are harder to quantify. For example, an acquirer may pursue an M&A opportunity in order to acquire a different set of functional strengths, organizational abilities or concepts. For example, in August 2014, Energy Transfer Partners, L.P. (NYSE: ETP) acquired Susser Holdings Corporation (NYSE: SUSS) partially in order to roll out Susser’s coveted, well-developed and highly successful food service concept, Laredo Taco Company, to ETP’s existing stores. Within this difficult-to-quantify set of operating synergies, are those synergies that result from being able to access certain resources that are really only available in a larger organization. Examples include being able to leverage dedicated, specialized resources, such as merchandising, construction or procurement departments or working with ‘big data’ in order to find and exploit patterns, trends and associations that smaller organizations simply do not have the luxury of focusing on.

Impact of Expected Operational Synergies on Recent Notable M&A Transactions
Thanks to the amount of information that has been publicly disclosed by the public company acquirers listed below, we can analyze the materiality and impact of the expected operating synergies on the three most notable M&A transactions that have closed in the last few years in the fuels distribution, petroleum marketing & convenience retailing sector. These transactions are:

1. Energy Transfer Partners, L.P.’s (NYSE: ETP) (“ETP”) acquisition of Susser Holdings Corporation (formerly NASDAQ: SUSS) (“Susser”)
2. Marathon Petroleum Corporation’s (NYSE: MPC) (“Marathon”) acquisition of Hess Retail Holdings, LLC (“Hess Retail”), a wholly-owned subsidiary of Hess Corporation (NYSE: HES)
3. Alimentation Couche-Tard Inc.’s (TSX: ATD.A & ATD.B) (“Couche-Tard”) acquisition of The Pantry, Inc. (formerly NASDAQ: PTRY)

Before we delve into the details of each transaction, Exhibit 1 provides a summary of each transaction and illustrates how significant of a factor expected operating synergies were on the acquirer’s projected corporate EBITDA within 12 – 36 months of closing on the acquisition. On average, these three acquirers expected to be able to increase the seller’s corporate EBITDA by 68.9% through various operating synergies. Based on these acquirers’ EBITDA projections, the average synergistic corporate EBITDA multiple for the three transactions was 7.25x, which is 41.7% less than the 12.4x average corporate EBITDA multiple calculated when using the seller’s reported corporate EBITDA as the measurement for EBITDA. We believe the remarks about acquirers overpaying for acquisitions in the industry over the last few years would not be as prevalent if the focus wasn’t on the headline multiple that is based on the seller’s historical corporate level performance, but rather on the implied multiple after considering the operating synergies that the buyer expects to be able to achieve. If buyers are not focused on analyzing acquisitions with potential operating synergies when they are evaluating a possible acquisition, they could miss out on a unique opportunity to transform their business.

Energy Transfer Partners, L.P.’s Acquisition of Susser Holdings Corporation
In a transaction that is further summarized in Exhibit 1, ETP announced on April 28, 2014 that it was acquiring 100% of the outstanding common stock of Susser for approximately $1.8 billion. Based on Susser’s trailing twelve month (“TTM”) adjusted corporate EBITDA of $148 million as of the announcement date, ETP paid a 12.08x multiple of Susser’s corporate EBITDA . However, in the investor presentation used to discuss the acquisition, ETP disclosed that they were projecting operating synergies of $70 million annually across three broad categories that are detailed in Exhibit 2.

After taking the projected operating synergies of $70 million into consideration, ETP’s synergistic corporate EBITDA on this transaction was projected to be $218 million. Using this synergistic corporate EBITDA lowers ETP’s implied corporate EBITDA multiple on the acquisition down to 8.20x, which is 32% lower than the 12.08x multiple paid when these operating synergies are not considered. Although these synergies were not anticipated to be fully realized immediately after the closing of this transaction, ETP management was very explicit that an aggressive approach would be taken to ensure full operating synergy realization, particularly with Robert Owens, CEO and President of Sunoco, Inc. Mr. Owens made the following comment during the deal announcement conference call, “I will tell you, I will be extremely disappointed if we don’t significantly exceed the numbers you see here on Page 11 [referring to the $70 million in operating synergies].” Based on more recent disclosures, it appears that ETP not only met their original goals, but actually exceeded the initial operating synergies projected by approximately 35%.

Marathon Petroleum Corporation’s Acquisition of Hess Retail Holdings, LLC
In September 2014, Marathon, via its wholly-owned subsidiary, Speedway, LLC, closed on the acquisition of Hess Retail, a wholly-owned subsidiary of Hess Corporation, which was valued at approximately $3 billion after factoring in Marathon’s required conversion cost capital expenditures. Based on Hess Retail’s TTM corporate EBITDA of $175 million prior to the deal’s announcement, Marathon paid a 17.21x multiple of Hess Retail’s corporate EBITDA, which turned the heads of some industry observers. However, after a more thorough review of this acquisition and Marathon’s associated disclosures, the implied synergistic corporate EBITDA transaction multiple was substantially lower than 17.21x due to the $190 million of operating synergies that Marathon was projecting related to the transaction.

After adjusting for these expected operating synergies, Marathon’s synergistic corporate EBITDA transaction multiple was approximately 8.25x as it anticipated being able to more than double EBITDA from $175 million to $365 million. The $190 million in projected annual operating synergies were expected to be fully realized by the end of the third year following the acquisition. Marathon’s management team was optimistic that they could exceed their estimates, especially through additional merchandise marketing enhancements.

Alimentation Couche-Tard Inc.’s Acquisition of The Pantry, Inc.
Couche-Tard acquired 100% of the equity of The Pantry on March 16, 2015 at a total valuation of approximately $1.76 billion, which was 7.97x The Pantry’s TTM corporate EBITDA of $221 million. In its presentations to investors and analysts, Couche-Tard identified $112 million in annual operating synergies (see Exhibit 4 for details) that it expected to be able to realize within 24 months of closing on the acquisition. Achieving these synergies would result in corporate EBITDA of $333 million, a 50% increase over The Pantry’s historical corporate EBITDA. Factoring in these expected operating synergies, the synergistic corporate EBITDA multiple that Couche-Tard paid for The Pantry was 5.29x.

In addition, although Couche-Tard management stated that potential top-line growth in merchandise sales and fuel volumes was present and that enhancements in fuel supply economics may also exist, Couche-Tard never provided specific guidance in regard to these areas, so those potential synergies were not included in the operating synergies’ estimates provided. In March 2017, as part of Couche-Tard’s discussion of its 4Q 2016 earnings, management commented on the operating synergies already realized from the acquisition of The Pantry, stating that it had reached its 24-month cost reduction annual run-rate objective of $85 million and quickly exceeded its merchandise and services supply cost reduction objective of $27 million.

The Effects of Synergies on M&A Transactions
In order to show the significance that operating synergies can have on a buyer’s internal rate of return on an acquisition, we’ve provided two illustrative examples of a hypothetical M&A transaction – one without synergies (“Scenario 1”) and one with synergies (“Scenario 2”). The scenarios isolate the impact of synergies on returns as both scenarios include the exact same assumptions: other than the specific impact that operating synergies have on future performance, neither scenario projects any inflation, growth or capital expenditures; no leverage is used as the purchase price is funded 100% with equity; and state and federal income taxes are not considered, so cash flows and returns are on a pre-tax basis. Both scenarios are based on a 50 store company operated chain and are roughly based on benchmark profit and loss data produced by the National Association of Convenience Stores (NACS) as part of its 2015 State of the Industry (SOI) report.

In both scenarios, the buyer acquires the assets for 12.42x corporate EBITDA, which is the average TTM corporate EBITDA transaction multiple in the three transactions we summarized in the preceding section.

Scenario 1: No Synergies
In this scenario, the assumption is that the buyer is not able to generate any operating synergies, which results in a very marginal unlevered, pre-tax equity return of 8.05% due to the buyer acquiring the assets at a 12.42x corporate EBITDA multiple (see Exhibit 5 for details). Due to the simplified assumptions used in this scenario, with the projected corporate EBITDA being identical to historical corporate EBITDA, the same exit multiple assumption after a 5 year holding period as the 12.42x corporate EBITDA multiple used as the entry (acquisition) price and the fact that no leverage is employed as part of the transaction, the buyer’s internal rate of return using these assumptions will be the inverse of the EBITDA transaction multiple [1/12.42x = 8.05%]. It is very unlikely that a buyer that expected to realize no operating synergies and obtain no leverage would be willing to pay 12.42x corporate EBITDA for these assets due to the low returns that such an acquisition would generate.

Scenario 2: With Synergies
Using the same underlying assumptions as Scenario 1 above, but now assuming that the acquirer can generate the average amount of operating synergies as the buyers in the three transactions summarized in Exhibit 1 did, resulting in an increase in the acquired assets’ corporate EBITDA of 68.9% by Year 3, the buyer’s unlevered, pre-tax equity return increases to 21.14% (see Exhibit 6 for details). The 21.14% average annual return on equity in this scenario (Scenario 2), which factors in operating synergies, is more than double the 8.05% return in the base scenario above (Scenario 1) that does not include any synergies. Furthermore, the projected rate of return of Scenario 2 is even more impressive when you consider that no leverage was used as part of the acquisition; including leverage would only enhance returns if it were to be employed in this example. The substantial increase in profitability from operating synergies by the end of Year 3 results in an implied corporate EBITDA multiple of 7.35x as opposed to the 12.42x EBITDA multiple that is based on the seller’s corporate EBITDA. Comparing the two scenarios, it is clear that, due to the significant amount of potential operating synergies that are available to a strategic buyer of fuels distribution, petroleum marketing and convenience store assets, companies that can identify and execute on achieving those synergies can pay a premium for assets – or in other words, pay a higher multiple of EBITDA for acquisitions – and still generate strong returns for their shareholders.

Based on the two scenarios we have presented, a buyer able to generate and willing to incorporate all of the benefits from the projected operating synergies we have discussed in

to their potential returns, could pay almost 53% more than a buyer that projected no synergies, assuming the two buyers sought to achieve the same IRR. As we all know, a buyer is unlikely to want to pay the seller for value that will be created from synergies that it can generate, but all things being equal, the more competitive a sale process is, and the more transformative an acquisition is for a buyer, the more likely the buyer will be to increase their offer based on the synergies that will be created.

Summary
In this issue, we have described various synergies that buyers may be able to generate in M&A transactions within the fuels distribution, petroleum marketing and convenience retailing sector of the downstream energy industry. We have reviewed three marquee transactions that included sufficient disclosures to enable us to gain insight into each buyer’s estimated operating synergies. We then applied the synergies observed in these three transactions to illustrative examples that showed the impact synergies can have on M&A transactions. The material operating synergies that are available to acquirers of assets in the industry today allow a buyer to increase EBITDA significantly compared to the seller’s EBITDA, which can, and has, resulted in higher valuations to the benefit of sellers. The ability of a seller to receive benefit for the value of those synergies can be heavily influenced by the competitiveness of the sale process, which often times is the result of the quality of the assets for sale.

References:

Energy Transfer Partners’ Acquisition of Susser Holdings Corporation
1. Energy Transfer Partners’ Form 8-K, filed on April 28, 2014.
2. Energy Transfer Partners’ Form 10-Q, filed on November 6, 2014.
3. Energy Transfer Partners’ “Acquisition of Susser Holdings Corp” presentation, given on April 28, 2014.
4. Energy Transfer Partners; “Wells Fargo Meeting” presentation, given on December 7-8th, 2015.
5. Susser Holdings Corp’s Form 10-Q, filed on May 9, 2014.
6. Susser Holdings Corp’s Form 10-K, filed on February 27, 2014.
7. Susser Petroleum Partners’ Form 10-Q, filed on May 9, 2014.
8. Susser Petroleum Partners’ Form 10-K, filed on March 14, 2014.

Marathon Petroleum Corporation’s Acquisition of Hess Retail Holdings, LLC
1. Marathon Petroleum Corp’s Form 8-K, filed on May 21, 2014.
2. Marathon Petroleum Corp’s “Speedway Acquisition of Hess Retail” presentation, given on May 22, 2014.
3. Hess Retail Corp’s Form 10, filed on January 8, 2014.

Alimentation Couch-Tard Inc.’s Acquisition of The Pantry, Inc.
1. The “Agreement and Plan of Merger among Couche-Tard U.S. Inc., CT-US Acquisition Corp. and The Pantry, Inc., filed on December 18, 2014.
2. The Pantry, Inc.’s Press Release, filed on December 18, 2014.
3. The Pantry, Inc.’s Form 10-K, filed on December 9, 2014.
4. The Pantry, Inc.’s “FY 2014 Fourth Quarter Earnings Call” presentation, given on December 9, 2014.
5. Alimentation Couche-Tard’s “Q3 2015 Earnings Call” presentation, given on March 17, 2015.
6. Alimentation Couche-Tard’s “Inventors Presentation November 2015” corporate presentation.
7. Alimentation Couche-Tard’s “Annual Report 2015” corporate presentation.
8. Alimentation Couche-Tard’s “Q2 2017 Earnings Call” presentation, given on November 22, 2016.

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.