Thomas E. Kelso, Managing Director & Principal

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Introduction
The pace of rapid consolidation within the industry continues to be robust although slowing somewhat from 2012 levels. In this issue we will focus on certain factors helping to drive this wave and look at the potential effects these factors may have on future consolidation activity.

Money is Available
Long gone are the days when a marketer borrowed almost exclusively from a local bank and likely sat on the bank’s Board. Two major factors have driven this change. The first is that consolidation within the banking industry has resulted in many local banking institutions being swallowed up by regional banks or banks with national aspirations. The result has been that relationships with lending officers change more frequently and loyalty is no longer the tie that it once was. Credit decisions are made remotely and many times by people with little or no industry expertise and almost no knowledge of your particular business.

The second factor is the combination of dramatic increases in the capital needs of marketer companies and the relatively low lending limits at community banks has made it necessary to have a lender or combination of lenders with greater loan capacity. The rising prices of raw land, the added costs required to get entitlements and significant increases in construction costs are certainly part of this increase. We also cannot overlook the substantial increase required in working capital as the price of motor fuels has increased and state taxing authorities have worked to reduce the float on motor fuels taxes. Finally, a competitive M&A market has driven up prices for acquisitions.

However, not all of the news is bad as nearly every regional bank in the country has had exposure to Convenience & Gas (“C&G”) loans in one form or another. This exposure typically comes in two forms; direct lending and loan syndications. Direct lending is defined as loans made directly to borrowers and these loans are typically originated by a bank’s lending relationship officers. Syndicated lending exists on a bank-to-bank basis as originating lenders seek to reduce risk by partnering a loan with another lender or, in most cases, multiple lenders. The originating bank typically serves as the syndicate manager and maintains the client relationship while also servicing the loan. Syndicated lending can present issues for borrowers, but we will cover that topic in a later issue.

As regional banks have gained exposure to the industry over the last few years, they have gotten more comfortable with what is best described as a capital intensive and low return industry. While many industries struggled through the last 4 – 5 years, the C&G industry has performed exceptionally well with a very low percentage of company failures and loan defaults. Another aspect of having so many knowledgeable industry lenders is that they have become less wary of environmental issues. They are more comfortable with advances in remediation technologies, state insurance trust funds and other forms of pollution legal liability insurance. Of course, having a number of regional and national banks more familiar with the industry is important, but it is just as important to locate that expertise within each bank.

Interest Rates are Low
It comes as no surprise that interest rates are at historic lows due to action by the Federal Reserve. At the time this publication was written 3-month LIBOR, the benchmark for almost all mid-market lending, was sitting at a fifty-two week low of .25%. The high over the last year has been .36%. The Prime Rate has remained steady for the entire year at 3.25%. Of course the base rate is not what a borrower pays as each loan rate is determined by the base rate plus a spread. The spread can range between 200 basis points for the best rated credits to as much as 550 basis points for weaker rated credits. While credit quality is a major determinant of the spread, competition among banks is also a factor and should not be overlooked.

While borrowing rates remain at historic lows, Ten Year U.S. Treasury Bond yields have risen significantly from a low of 1.58% in November, 2012 to about 2.75% at the time this paper was written. Interest rate fluctuations in the 10 Year Bond are thought to be reliable indicators of the direction of future interest rates as they change daily based on investor sentiment in anticipation of the Federal Reserve winding down or ending QE3. Rising interest rates will increase a borrower’s cost of capital and reduce valuations paid for acquisitions unless buyers are willing to accept lower returns in the future.

Our view is that even if the Federal Reserve winds down its quantitative easing program, borrowing rates will remain low. This is primarily due to the willingness of the Federal Reserve to keep the rate it charges banks at near zero in order to stimulate borrowing and, hopefully, economic activity.

Companies are Accessing the Capital Markets
Historically, marketers have accessed capital almost exclusively through bank or specialty lending in the form of senior term debt or working capital revolvers. Over the last fifteen years, or so, sale/leaseback financing has become a serious option as companies try to “borrow equity” as a way to further increase leverage and returns. Even more recently, marketers have begun to utilize various other forms of capital such as senior stretch facilities, mezzanine loans and private equity investments. All of these forms of capital remain outside the public markets.

Since the beginning of 2012, six companies have accessed the public markets through initial public offerings using a Master Limited Partnership (“MLP”) structure. A convergence of factors such as low interest rates and significant advantages from a tax perspective has created a demand on the part of public investors for these types of fixed income investments. These investments tend to have substantially higher after tax returns than traditional bonds and other forms of fixed income investment.

For the first time, relatively modest size companies have accessed the public markets for equity and, it is our belief that companies will be able to access the publicly traded debt markets in the near future.

The Effects of MLP’s
Before discussing the effects that MLP’s are having on the industry, we need to demystify the MLP itself. There has been a lot of confusion about whether an MLP is an exit strategy or a vehicle to access capital in the public markets. For petroleum marketers looking for capital to be used primarily for growth, an MLP is most certainly a means to access capital in the public markets. And while unit holders in MLP’s can exit, and do, the time it takes to exit major positions may take years as opposed to months.

Like all publicly traded companies, MLP’s come in all configurations and sizes. Of the recent MLP issues, only Susser Petroleum Partners LP (“Susser”) and Lehigh Gas Partners LP (“Lehigh”) contain only fuels distribution assets as opposed to refineries, terminals and pipelines that are significant parts of the other recent MLP’s. Susser’s pro-forma adjusted EBITDA for the year ended December 31, 2011 (the last full year before their IPO) was $39.1 million [i]. For the same period (the last full year of operation before their IPO), Lehigh had $31.232 million of adjusted EBITDA [ii]. It should be noted that pro-forma adjusted EBITDA is corporate level EBITDA after all selling, general and administrative expenses. While $30 million plus of EBITDA is certainly a very large privately held company, it remains an achievable goal through merger or large acquisition.

MLP’s are required to distribute a substantial portion of their cash flow to their unit holders through quarterly and annual cash distributions. Since investors have almost limitless investment options, the returns they receive on their investment in an MLP are compared to potential returns on other fixed income type investments and they can choose to exit an investment quickly. To continue to attract investors, MLP’s need to maintain or increase distributions. The most effective way to increase distributions for MLP’s is to make accretive acquisitions, which means MLP’s are active in the market and, even if they are not the successful buyer, they help drive values for sellers. While it may be unclear as to the number of new MLP’s coming up in the near future, any increase in the MLP population should continue to keep valuations strong. Higher interest rates could also have an adverse effect on MLP unit prices over time and need to be watched.

For an acquisition to be accretive for an MLP it must be at a purchase price below the multiple of EBITDA for which the MLP’s units trade. As an example, if an MLP trades at 10x corporate level EBITDA and the MLP has overheads at the corporate level of $20,000 per location, for an acquisition to be accretive it must be at a price lower than a target’s existing store level EBITDA less $20,000 per location times the MLP’s trading multiple. In summary, unless an MLP can improve store level EBITDA’s it cannot pay a seller the same multiple its LP units trade for in the public markets and provide any benefit for the unit holders. Of course, in valuing any acquisition there are many other factors an MLP, or any prospective purchaser, must consider including the need for future reinvestment in a location and the likelihood of sustaining store performance over time.

RFS and RINS
The Renewable Fuels Standards (RFS) and the Renewable Identification Number System (RINS) may also become a factor in driving consolidation. As an ever increasing EPA requirement for blending renewable fuels with gasoline and diesel collides with a reduction in motor fuels demand, one of the unintended consequences may be to increase the pace of consolidation and to bring a new class of buyers into the market.

Assuming the RFS requirements remain as passed in 2007 and motor fuels demand continues to decline, the only viable alternative is to offer higher renewable blends such as E-15, E-20 and E-85. These blends with higher ethanol components will require additional investment in retail facilities potentially driving weaker companies to sell and enticing growth companies to add more locations and volume to spread operating costs over a wider base. It may also drive some inefficient locations out of operation.

Maybe the most interesting aspect of the RFS situation is its effect on merchant refiners. A merchant refiner produces motor fuels and sells unblended motor fuels to multiple buyers at the refinery. Because all refiners have an RFS mandate to blend a specific amount of renewable fuels based on their refinery production and because ethanol cannot be blended at the refinery, the merchant refinery has almost no way to meet its RFS requirement without buying RINS. If RINS cost pennies a piece there is no economic issue, however, as RINS become more valuable as RFS mandates increase and motor fuels consumption shrinks, the price at which merchant refiners may need to market their refined products may become uneconomic. One solution for merchant refineries may be to acquire larger unbranded or private branded chains thereby assuring themselves of an outlet for their product blended with ethanol.

Summary
In this issue, we have identified factors which are influencing both the pace of consolidation and the valuations paid by acquirers. Consolidation activity remains robust with buyers having access to multiple forms of capital and costs of capital remaining at historic lows. There are factors which are favorable for continuing the current pace of consolidation such as the desire for MLP’s to continue to grow and the possibility of new MLP’s coming into the market place. There is, however, a warning sign on the horizon in the form of higher interest rates that we think will have more of an effect on valuation than the demand for consolidation. It will be interesting to see if the effects of the RFS on merchant refineries will affect consolidation.

[i] Susser Petroleum Partners LP prospectus page 2
[ii] Lehigh Petroleum Partners LP prospectus page 22

 

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.

 

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