Spencer P. Cavalier, CFA, ASA, Director

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Business owners, CFOs and other senior executives in the downstream energy industry are increasingly focused on finding tools to measure financial performance, with the ultimate objective of improving the aggregate Return on Invested Capital (ROIC).  While somewhat ironic in an era of interest rates hovering at historic lows, this elevated focus on capital efficiency underscores how important capital allocation is today, especially in a consolidating, maturing industry.

Measuring the historical financial results or the potential returns of new investments is certainly the primary focus of these tools.  However, it is also important to consider the transformative nature these tools can have on your organization.  As consolidation of the downstream energy industry continues and consolidators grow into larger, more complex multi-market companies, it will be imperative that employees are empowered to think like business owners, especially when it comes to capital.  It has been our observation that the failure of companies to establish incentives and constraints that promote capital efficiency is a primary limitation in their ability to grow successfully.

There is no perfect set of performance measurement tools and none should be viewed in isolation as all have certain limitations.  Some traditional ratios, such as volume growth and profit margins, are misleading because they only consider one performance dimension.  Further, some financial ratios are scaled by the denominator, such as ROIC.  For example, if a company is operating in a high return business today, management may reject fundamentally attractive, long-term growth projects because applying that capital to those projects today would lower current ROIC.  Or, it may forgo a large project in which returns exceed the required cost of capital in favor of a smaller project with a higher return.  Meaning, ROIC can become a static measurement of performance in a constantly changing environment that requires a “long-term” view of investing for future performance.  Sometimes you have to shrink ROIC in order to grow aggregate shareholder value.

While not a new concept, one financial measurement tool that is getting more attention today, especially in consolidating and maturing industries, is Economic Value Added (EVA™).  EVA™ is an estimate of a company’s economic profit or the value created in excess of the required return on the company’s invested capital.  Simply, EVA™ is the economic profit earned by a company less the cost of financing its capital.  Many leading companies in the downstream energy industry have adopted it as a method to aid in making capital decisions and to establish a corporate culture of capital efficiency among its employee base.

EVA™ focuses on economic earnings, or Net Operating Profit After Taxes (NOPAT). NOPAT can be calculated by different formulas, but one of the most common is: NOPAT = Operating Income (or Adjusted EBIT) x (1 – Tax Rate). Since EVA™ is simply a measure of the operating profit less a charge for the use of capital, it is calculated as: EVA™ = NOPAT – (Average Amount of Invested Capital x Cost of Capital). The following tables provide two different examples of calculating EVA™:

The primary challenges in determining EVA™ are estimating your company’s cost of capital, which is essentially a Weighted Average Cost of Capital (WACC) calculation, and calculating your company’s ROIC. Exploring the different and proper ways to calculate a WACC is beyond the scope of this article, but suffice it to say major drivers of the WACC is the weight given to equity and its cost. For example, many private companies debate whether to use a book value of equity or an estimated market value of equity, as well as debate what their true return on equity (ROE) requirement should be. At Matrix, we favor using the market value of the equity and a build-up of the required ROE based on an Adjusted Capital Asset Pricing Model (ACAPM) anchored by return data from Ibbotson Associates, a leading authority on asset allocation with expertise in capital market expectations and portfolio implementation.

Disciples of EVA™ are usually very loyal to its performance measurement because of its objectiveness in evaluating new capital investments and the performance of existing investments. EVA™ corrects for the accounting distortions of certain financial ratios that rely on generally accepted accounting principles, and more importantly doesn’t begin to count profit until shareholders earn at least the ROE they could expect to earn elsewhere at the same risk. It also seems to better promote the decentralization of management decisions for growing companies due to the ability to “spin-off” divisions internally to focus on the capital tied-up in those divisions. It helps to mitigate the tension between a business unit’s superior knowledge of its business prospects and the executive office’s control over the allocation of capital. Basically, the employees begin to think like owners: (1) to achieve greater operating efficiency by generating the most revenues for the least operating cost; and (2) to achieve greater capital efficiency by realizing the most profit for the least investment. As management teams learn to employ and customize EVA™ properly for their company, it begins to serve as one of the determining parameters in setting compensation.

Many EVA™ loyalists argue ROIC ignores the definite requirement that the rate of return should be at least as high as the cost of capital and that ROIC does not recognize that shareholders’ wealth is not maximized when the rate of return is maximized. Shareholders should want a company’s management to maximize the absolute return above the cost of capital and not to maximize percentages. Thus, management should not reject projects yielding more than the cost of capital just because the return is lower than the current return being achieved.

To summarize, EVA™ is a different method of performance measurement and not as popular as other forms, such as ROIC or the Internal Rate of Return approach (IRR). It takes much more work and discipline to employ EVA™ as the primary performance measurement tool of an organization because capital has to be broken down into divisions and also viewed as a whole. It also has limitations. As stated before, EVA™ results are heavily dependent on the cost of capital hurdle established by management, and calculating that can be challenging. Management teams sometimes make decisions on acquisitions and capital investments that could ultimately lower their cost of capital in the future because they are trapped by today’s rules governing their EVA™ parameters. While EVA™ takes a commitment to make it work well, it certainly piques the interest of many business owners of growing companies hungry for employees to think like owners.

References:

• Stewart, B. (2009). EVA Momentum: The One Ratio That Tells the Whole Story. Journal of Applied Corporate Finance, 21, pp. 74 – 86.
• Hodak, M. (1994). How EVA™ Can Help Turn Mid-Sized Firms Into Large Companies. Journal of Applied Corporate Finance, 7, pp. 98 – 102.
• Jensen, M., Murphy, K. (1990). CEO Incentives – It’s Not How Much You Pay, But How. Harvard Business Review, 3, pp. 138 – 153.

 

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: Florida Oil Holdings, LLC – Exclusive Sale

SITUATIONThe managing members of Florida Oil Holdings, LLC had decided to sell the company’s 29 company-operated stores in the Orlando metro market so that they could concentrate their efforts and capital on their assets in the Atlanta area. The assets had been acquired from BP Products North America Inc. in March 2010.

OBJECTIVE

• To customize, execute, and complete a confidential sale process that would allow Florida Oil to realize maximum value for their assets in a sales process that would require no more than six months.

SOLUTION

• Matrix provided valuation guidance to Florida Oil’s managing members and 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.
• Multiple competing offers were received, and Circle K Stores, Inc. was selected as the purchaser.
• Matrix assisted in the negotiation of the purchase agreement and coordinated due diligence.
• Matrix worked with the managing member to coordinate issues with BP concerning the branded fuel contract and existing store branding.
• The transaction was successfully completed in less than six months with all of Florida Oil’s objectives achieved.

CASE STUDY: Strasburger Enterprises, Inc. – Exclusive Sale

SITUATION

• Strasburger Enterprises, Inc.’s shareholders contacted Matrix regarding their desire to sell the Company’s company operated and dealer operated convenience stores and dealer supply contracts in order to focus on their other lines of business.
• The portfolio consisted of 21 company operated stores, 9 commissioned agent stores, 2 dealer operated stores, 2 closed sites, and 3 wholesale supply agreements.

OBJECTIVE

• To customize, execute, and complete a confidential sale process that would maximize value for Strasburger’s assets.

SOLUTION

• Matrix provided valuation guidance to Strasburger 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 a transaction of this size.
• Several competing offers were received for all of the assets as well as subgroups of the assets.
• 7-Eleven, Inc. was selected as the purchaser for nearly all of the company operated stores and several dealer stores.
• Empire Petroleum acquired the fuel supply agreements and it was decided to negotiate with the existing dealers for the few remaining sites.
• Matrix negotiated the offers and the purchase agreement and coordinated the due diligence and closing processes.
• This transaction successfully closed in June 2012.