By: Thomas E. Kelso, Managing Director, Sean P. Dooley, Sr. Analyst, Stephen C. Lynch, CPA, Sr. Analyst

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A Mature Industry
It is never possible to exactly determine when an industry enters its mature phase, but it is our consensus that the downstream petroleum distribution industry is now mature. A “Mature Industry” is typically defined as an industry which has passed both the emerging and growth phases of industry development. Earnings and sales grow slower in mature industries. These industries have demand that is saturated and slow-growing, if not declining. There is often times an excess supply of competition too willing to discount, putting downward pressures on margins. All of this results in eroding margins, declining profits & returns on capital, added emphasis on cost-cutting to stay ahead of margin erosion and consolidation of competitors.

While reliable industry data is difficult to obtain, our anecdotal experience from reviewing the financial performance of dozens of companies each year is that motor fuels volume peaked in 2007/2008 in nearly all regions of the country. It has since declined each year thereafter with an average rate of decline somewhere between 1% and 2% compounded annually. Volume declines may be even greater in some regions of the country. This is mostly the result of higher CAFÉ standards, less miles driven on a per capita basis, and drivers switching to more fuel efficient and alternative fuels vehicles.

What Does This Mean to the Industry Overall?
In order to grow earnings in a mature industry, a company must acquire a larger share of the existing motor fuels market, improve motor fuels margins, increase in-store sales and/or margins, and/or reduce expenses. Companies typically start with operational improvements and try to squeeze more profitability out of existing assets as well as reduce corporate overhead. This includes trying to leverage better deals from suppliers as well as cutting costs as much as possible.

Companies that are committed to remaining in the industry long term also focus on growth; either organic or by acquisition, thereby spreading overhead costs over a wider asset and revenue base. Organic growth in our industry means new to industry store development and growth by acquisition is accomplished through a merger and acquisition transaction where the purchaser acquires the seller’s assets or equity. Acquisition growth is quicker than growth through new store development and, in many respects, less risky. Companies who are unable to grow typically begin to slide and become less competitive resulting in destruction of shareholder value as their assets become less productive and thereby less valuable. The pace of consolidation is much more rapid in a mature industry than it is in emerging or growth phase industries.

An Aging Shareholder Population
In a mature industry you will also see a large number of mature companies with shareholders approaching typical retirement age. Unless a company has a successor generation or management in place with an agreed transition plan, these companies are typically not focused on growth. In a number of cases, this risk actually diminishes the value of assets and thereby diminishes the value of shareholder equity as consolidators buy up competitors, reduce prices and begin to isolate companies within a market. While these shareholders may not want to exit today, they need to do a risk/reward evaluation before making a final decision.

Capital Availability
Any time there is access to inexpensive capital there is consolidation activity and the situation today is no different. While obtaining debt capital is more challenging now than it was a few years ago, it is readily available to good companies. Even though advance rates are lower, with debt/equity ratios near 65/35 +/- 5 percent, the lower cost of senior debt still means that weighted average cost of capital is low by historical standards. This allows buyers to actively pursue their growth strategies while, at the same time, improving valuations for potential sellers with good assets.

In mature industries, participants also begin to access capital from sources not typically tapped in the growth phase. In addition, Master Limited Partnerships have begun to appear in the downstream energy sector, such as when Global Partners LP purchased retail assets from Exxon in 2010 and when they purchased Alliance Energy LLC in 2012. As this is being written, Lehigh Gas Partners LP filed an S-1 with the Securities and Exchange Commission allowing them to potentially access the public equity markets. In the future, larger companies will be able to access the public debt markets as well.

Because there is a shortage of higher yielding fixed income alternatives to Treasury Securities and corporate bonds, the sale-leaseback market remains active with well funded public and private REIT’s looking for transactions. While many companies feel that a sale-leaseback transaction may not be right for them, fast growing companies looking for access to capital find this alternative attractive because they look at it as less expensive equity compared to other options.

Finally, mezzanine and private equity funds continue to look at the industry and to make select investments.

The Working Capital Squeeze
The amount of capital necessary to fund working capital needs has put pressure on even the strongest of companies. Weaker companies have little or no access to lines of credit beyond what is typically provided by their suppliers and the suppliers are reluctant to raise credit limits even as the carrying cost of motor fuels inventories at times increases by 50% or more. Smaller and less well capitalized companies face significant risk of business failure due to this issue. Our view is that anything above the $4.00 per gallon wholesale cost of motor fuel will create disruptions. Larger companies with access to bank working capital facilities are certainly at a competitive advantage, which provides them leverage in dealing with their suppliers and competing in the market.

Technology
Technology available to management today has advanced substantially and companies looking to improve earnings are aggressively using technology to shed costs and track performance. Investing in technology is expensive, but companies committed to growth are making the investment. Employment of technology permits companies to spread their business operations over wider geographies which allow growth companies to look at acquisition possibilities in regions well beyond their existing base of operations. Technology also permits acquisitive companies to more quickly integrate acquisitions, allowing these companies to reduce the risk in acquisitions and grow more quickly.

The Effects of Regulation
It seems as if every week new regulations are being proposed that affect petroleum and convenience store marketers. Many participants today are studying how to implement ADA requirements and trying to measure the cost of doing so while other, more aggressive companies are making the investments. Our view is that regulation will increase over time.

Conclusion
A mature industry with well funded, growing companies means a more competitive market place in which to operate. Consolidators will focus on cost cutting, spreading overhead over a wider base and employing new technology. Consolidation typical in a mature industry is being accelerated, fueled by lower cost capital and access to new aspects of the capital markets. Working capital demands will add significant additional risks for companies without properly aligned balance sheets and access to bank lines of credit. A graying shareholder population will provide acquirers with a large base of targets and will be a significant factor in the pace of consolidation. Companies that employ technology will gain competitive advantages and the demands of new regulation will continue to increase. While year-over-year transaction value may fluctuate, the trend over the next five years will be for significantly more consolidation.

 

This report reflects the consensus opinion of the investment bankers in our Energy & Multi-Site Retail Group.

Matrix’s Energy and Multi-Site Retail Group is recognized as the national leader in providing transactional advisory services to companies in the downstream energy and multi-site retail sectors including convenience store chains and petroleum marketers.

CASE STUDY: High’s of Baltimore, Inc.

SITUATION

• The shareholders of High’s of Baltimore, Inc. decided it was time to sell the Company, comprised of 46 company operated retail units trading as High’s Dairy Stores. The Company had been in business for over 60 years.
• Matrix had previously executed a rationalization sale of approximately 20 units, in order to prepare the Company for a portfolio sale to a single strategic buyer.

OBJECTIVE

• To customize, execute, and complete a confidential sale process that would allow High’s to realize maximum value for their assets.

SOLUTION

• Matrix provided valuation guidance to High’s shareholders and then structured and executed a highly confidential sale process by contacting select national convenience store chains and regional jobbers who had the financial capacity to complete the transaction.
• Several competing offers were received, and Carroll Independent Fuel Co. was selected as the purchaser.
• Matrix assisted in the negotiation of the purchase agreement and coordinated due diligence.
• Several members of the High’s management team, including one of the existing shareholders, were retained by Carroll to oversee the newly formed retail division.

CASE STUDY: Pester Marketing Company

SITUATION

• Pester Marketing Company’s debt amortization periods were maturing and Pester sought the advice of Matrix; given that Matrix had previously been engaged to value the Company and its wholly-owned subsidiaries.

OBJECTIVE

• To lower financing costs and to consolidate, expand and reconfigure Pester’s debt capital structure and treasury management services to better suit the more sophisticated financial needs of the growing company.

SOLUTION

• Having previously valued Pester, Matrix was in an ideal position to move quickly and solicit competing refinancing packages from various senior lenders.
• Matrix built a comprehensive, corporate financial projection model to test future balance sheet capacity, income and cash flow generation, and capital structures under various scenarios.
• Several competing refinancing packages were received, and Pester chose to pursue the RBS Citizens option.
• Matrix assisted in the negotiation of the credit terms and agreements.
• Today, Pester’s senior credit facilities are more appropriate for the Company and provide for much greater flexibility going forward. The balance sheet is more liquid to withstand margin volatility and allows for future investment to facilitate growth.