Seeking Alpha

Alimentation Couche-Tard And Circle K - Invest In One Of The Best Retailers In The World

|
About: Alimentation Couche-Tard Inc. (ANCTF), ANCUF, Includes: CASY, CGC, CTXAY, FFLWF, MPC, MUSA, SVNDF, SVNDY
by: Brian Langis
Brian Langis
Value, contrarian, growth at reasonable price, special situations
Summary

ATD is an excellent retail operator. ATD has demonstrated a record of consistency and profitability few businesses can match.

M&A is the bread and butter of ATD. They are pros at buying, integrating, extracting synergies and operating.

ATD’s best opportunities have come after a difficult period.

Excellent balance sheet. Low leverage. Great cash flow.

ATD’s culture contributes to its success.

Note: Alimentation Couche-Tard use US$ as their reporting currency unless mentioned otherwise. USD-CAD 1.35, Price of 1 USD in CAD.

Alimentation Couche-Tard (TSX: ATD.A, ATD.B, OTCPK: ANCUF) is primarily traded on the Toronto Stock Exchange under the ticker ATD.B.

Alimentation Couche-Tard’s corporate logo and banner, an owl sleeping with one eye open.

Alimentation Couche-Tard (ATD) is a CAD$47 billion Canadian convenience store and gas operator juggernaut that’s flying under the radar. ATD is the second biggest convenience store and gas station operator in the world after 7-Eleven with 14,880 locations and 133,000 employees in 26 countries. For those readers that want to polish their French,‘Alimentation’ stands for food and a ‘couche-tard’ is a night owl, a person that stays up late. The night-owl also reflects the company’s personality: patient, quiet, keeping an eye on things, and when the right opportunity presents itself it is ready to strike like a predator.

Despite its global position, most people are vaguely familiar with the company. It keeps a low profile. The name Alimentation Couche-Tard, or Alain Bouchard, the co-founder and current chairman, might not ring a bell. But you probably bought something at a Circle-K, which is owned and operated by ATD across the world. Few would know that ATD is in the multi-bagger club, returning 875x since its IPO in 1984. Few Canadians would know the fact that outside financials ATD is the company with the most revenues in Canada with ~$58b in annual sales (pre-Covid). Most Canadians would be surprised to learn that Couche-Tard/Circle K is the second largest convenience store chain in the world. Only 7-Eleven Inc.(OTCPK:SVNDY)is bigger in terms of store count (~68,000, mostly franchised), but ATD has better financial performance.

ATD will release its 4 th quarter results on June 29, so we will have a better gauge on the effects of Covid in the last quarter. ATD’s fiscal year ends in April.

If you get a chance to read a really good business biography, that covers co-founder Alain Bouchard and the Couche-Tard/Circle-K story, I highly recommend Daring to Succeed: Couche-Tard & Circle K Convenience Store. Read it and pass it on. You will learn more in that book about business than what you find in a standard MBA textbook.

Thesis: By investing in Alimentation Couche-Tard, you are buying a piece of an excellent business that has a history of creating shareholder value. ATD is currently undervalued by at least 13% with potential upside of 23% to 39% in 3-4 years if they complete their growth targets. ATD is currently in a plan to double the business. ATD is a buy and hold.

Below I will go in details on the company.

Over time, ATD shareholders have been well rewarded. On August 22, 1986, with only 34 stores, ATD raised $2.5m by selling 1.1m shares at $2.25 (post split: $0.046), which represented 25% of ATD at the time. Here’s a chart of the returns for the past twenty years, the maximum I could get.

Here’s a chart of the last five years compared to two indexes, which is more reflective of the current times. You can see that ATD has outperformed both the S&P 500 and the TSX 60.

It’s established that ATD has performed very well in the past. But that’s yesterday returns. Now the main question is will ATD keep delivering in the future? I believe it will.

About Couche-Tard

Starting with just one store in Quebec in 1980, out of French speaking Quebec, Couche-Tard has grown into 14,880 locations worldwide, mostly under the Couche-Tard, Circle-K, and Ingo banners. ATD has 7,661 stores in US, 2,138 in Canada, and 2,697 in Europe (Norway, Sweden, Denmark, Estonia, Latvia, Lithuania, Poland, Russia, Ireland). There are also 2,384 Circle K stores under licence in 16 other countries and territories (Cambodia, China, Costa Rica, Egypt, Guam, Honduras, Hong Kong, Indonesia, Jamaica, Macau, Mexico, Mongolia, New Zealand, Saudi Arabia, the United Arab Emirates and Vietnam).

Couche-Tard operates under mostly under these three banners below: Couche-Tard in Quebec, Ingo in parts of Europe, and Circle in the US and everywhere else in the world. Other brands owned by ATD, such as Holiday, Kangaroo Express, Topaz, Corner Store, and Statoil among others should have been converted to Circle K if they haven’t done so already. Alimentation Couche-Tard is operating under three banners globally.

Circle K is ATD’s global banner. In 2016, ATD decided to retire most of their banners and adopt Circle K as their global identity, except in Quebec where the Couche-Tard brand is strong, and the Ingo automated stations (fuel only) in Sweden and Denmark.

ATD is also a wholesaler of transportation fuel and runs a large commercial fuels operation, including terminals and depots.

Before the shutdown due to the pandemic, ATD’s Q3 results cover a 40-week period that ended on February 2, 2020. Q4-2020, which will be released on June 29, will include a full quarter of Covid impacted results. For the nine months, business was good. Revenues came in at $40b, EBITDA at $3.3b, operating income at $2.1b, and net earnings at $1.5b.

Revenues are composed of mostly Merchandise and Services, and Fuel sales. Fuel is 73% of sales and Merchandise and Services is 25%. The other 2% of sales composed of everything else like car washes, ATM fees, aviation fuel, rent income and other things. Merchandise and Services contributes to 54% of gross profit vs 43% for fuel. The main take away is that fuel brings in revenues and the profit is in the store. It makes sense that ATD is focused on getting people into the store to buy high margins. The table below illustrates that: Source: ATD March 2020 Presentation. Figures based on fiscal year 2019.

The table also illustrates that the US is responsible for 69% of sales and gross profit with Europe in 2 nd and Canada 3 rd. Despite being a global company, the US still mostly drives the results for Couche-Tard and probably will for the foreseeable future. There’s still a lot of room for growth in the US.

The following slide does a good job catching the key business metrics:

Source: Alimentation Couche-Tard March 2020 Presentation Slide 8

The slide is self-explanatory. The numbers that stick out are Return on Equity (ROE) of 22% and Adjusted Return on Capital Employed (ROCE) of 13.7%. As a principle, ATD aim for a ROCE of 15% and average 15.4% per year since 2011. ROE 5-year average is at 23.5%. What do these numbers mean?

Ratios like ROE and ROCE have to be analyzed to get to know the real picture. Simply put, ROE considers profits generated on shareholders' equity. It simply means that the company increases shareholder value by reinvesting its earnings in order to make more profits. The higher the number, the more efficient management is. ROCE measure of how efficiently a company utilizes all available capital to generate additional profits. In other words, how well ATD is generating profits from its capital.

An interesting number is EBITDA, despite its flaws and critics, gives you a picture of the operations. EBITDA for fiscal 2020 is expected to be around $4-$4.2 billion. It will probably dip for FY2021 once Covid is taken into account. ATD redeploys 35%-40% of EBITDA towards CAPEX. On average just over one third of EBITDA is converted to FCF. I estimate that ATD will generate close to $1.6b in FCF for FY2020, or $1.4b after dividends. Buybacks, at $236m for the first three months, have been suspended due to Covid. The FCF is available to pay down debt or for acquisitions. If ATD continue to operate the same way they have done in the past, EBITDA and FCF should continue to grow.

The Economics of a Convenience Store

ATD is an excellent retailer. One of the all-time great if you look at what they have accomplished. They are not an Amazon where you wait for your items. Plus you can’t fill your car on Amazon. They are not a Costco where you need to plan your trip. Couche-Tard is different. Couche-Tard is in the business of selling time. ATD’s mission is “making our customers’ lives a little easier every day.” They offer convenience. They respond to impulse. When you are on the road three things come to mind: gas, washroom, food. This is where Couche-Tard comes in. Key factors are price, cleanliness, safety and, most important, location. The right store at the right location is a gauge of success. A good store in the wrong location won’t be as profitable. Just think about your behavior when you get off the highway to get gas and food, if the store is at the wrong exit or corner, it will get less volume. Hence, picking the right site is paramount.

The basic principles of convenience store retailing, as a biography of Bouchard explains, are "a clear, well-laid-out interior, proper lighting, nice colour and general cleanliness, no lineups, well-trained and welcoming employees, and the elimination of useless jobs in the administrative offices," since all the money was made in-store. The focus has always been to convert fuel dollars and foot traffic into food sales.

A convenience store is a cash flow business. Once the store is established, it generates a certain level of cash flow. How do you grow? You buy or build a new store, apply the blueprint, and repeat.

There’s a monopoly feel to a good convenience store. It’s normally located at the right location, and you can’t really have more than one or two in the same area. Once the territory is established, the convenience store is there to serve our addictions. We might not realize it, or we might not see it that way, but most customers in a convenience store are there to fill the impulsive “I need something right now” need. We are addicted to fuel, nicotine, alcohol, gambling, sugar, caffeine, junk food, and *cannabis (ATD has a cannabis retail venture, more on that below). Couche-Tard is there for addicts to get their legal fix. It’s all about quick sale, at a premium. Whatever you need, ATD can adapt to customer behavior.

ATD is using fuel stations to boost convenience store sales. Like I mentioned above, it’s all about getting the customer in the store. There’s a reason why pump stations are facing the stores now versus the old days when the pump stations were parallel to store so vehicles could leave faster. ATD is retail first, fuel second. Now when you pump gas, you are starring at that nice shiny store that’s tickling a bunch of impulses in your body; beer, sugar, nicotine, coffee, lottery ticket, washroom, sugar…anything to respond to your nervous system. The store offers the types of high margins that pumping gas doesn’t. ATD’s merchandise and service gross margin are 33% in North America and 41% in Europe. Combine that with an increase in same- store merchandise sales and you have a nice cash flow machine. If I can borrow a phrase from the software industry, if done properly, a convenience store can have recurrent revenue feel to it.

Technology plays a massive role. Couche-Tard is more of a data company disguised as a convenience store. Data mining, AI, and technology drive same-store sales. With the data they build reliable customer profile. Their system knows instantly what is selling where. Shelf space is allocated at each store accordingly. For example, they learned that they sell more flowers if you place them in the dairy section instead of the beer section. It turns out customers create a stronger association. You know these high margin items in front of you at the cash registers? They have put a lot of thoughts into that.

What is ATD focusing on now? At the core they want to drive organic growth. ATD wants a more balanced growth going forward between acquisitions and organic. At the moment organic growth is at 30% and they want that number at 50%. You achieve that with greater focus on the offering.

They are pushing their private-label items like Polar Pop fountain programs and the Simply Great coffee, which offers high margins. The private-label also provides more clout with suppliers like Coca-Cola and Nestlé.

On the coffee side, ATD is rolling out $15,000 coffee machines in their stores. Now you can have a glamour coffee for a fraction of the cost at Starbucks. I know I’ve tried their expresso and it’s good. It just doesn’t have the Starbucks “status symbol” if that means anything.

ATD is also currently testing Holiday’s, one of their acquiree, unique store layout. Holiday has a unique store layout where customers are routed thoughtfully through the food section back to the coolers and into the impulse area where they wait to pay.

ATD is also focusing on their food offering. Improving Couche-Tard's food products, especially in North America, is a pivotal part of the plan. While fresh food is its number 1 profit category in Europe, that's not the case here. In Europe, stores are viewed as more of a foodservice destination than in North America. In Europe, stores have about 35% ready-to-eat, house-made sandwiches, coffee and other baked goods, but no perishables. In North America, it’s 20%. ATD wants to change that. ATD has embarked on a major growth initiative dubbed "Food at Scale", another idea borrowed from Holiday. The company has been building out and installing the necessary structures and equipment inside stores for its Food at Scale program, which is focused on strengthening foodservice offerings. Couche-Tard targets 1,500 locations for its Food at Scale program. The stores that have not kept up with the modern evolution on foodservice are going to be left in the dust.

Brian Hannasch, CEO

Brian Hannasch is Couche-Tard’s CEO since 2014, when he took over co-founder Alain Bouchard, and he hasn’t disappointed.

Brian was the VP of Operations with Bigfoot Food Stores LLC, a 225-unit convenience store chain in the US Midwest when it was acquired by Couche-Tard in 2001. When Bigfoot was acquired, he figured he would stick around for the transition, and then find something else. It’s usually how these things go. Not only had he never heard of Alimentation Couche-Tard, but he couldn't even pronounce the company's name or understand a word of what the French-Canadians (the four co-founders) were saying. But after getting to know the co-founders and the company culture, he stayed and has remained with the company ever since. Brian has proven himself many times over the years, mostly focusing on the operations.

Under his leadership, ATD has grown to be the largest company in Canada in terms of revenue (outside financials) and the 2nd largest convenience store groups in the world. He has piloted the acquisitions of The Pantry, Statoil, CST Brands and Holiday Station stores. EBITDA as grown an average of 17% per year during his tenure. If he can maintain that growth, and it won’t be easy, you can expect ATD’s stock to perform well. He also led the global rebranding campaign to bring the company’s diverse brands together under the Circle K banner.

Where in the past Alain and the co-founders shun the press, Brian is better at communicating with the press and financial community. He does interviews and conference calls.

The appointment of an American at a Quebec based company has ruffle feathers, enough for shareholders to bring it up on at past AGMs. But Alain Bouchard dismisses the criticism, saying the CEO's role is to deliver returns for investors, not to learn languages. The reasons the founders picked Hannasch as Bouchard's successor are tough to debate. Brian is currently in his mid-fifties and should be around for a while.

Culture

Culture is what makes a business unique. It’s really their identity. It is like a finger print, it may be similar to others, but is uniquely distinct to your business. There’s nothing glamour about a convenience store chain. What has made ATD a success for forty years is its culture. It’s also what will carry the company forward.

For example, Couche-Tard has no ‘headquarters’ in the traditional sense. The word ‘headquarter’ is banned because it releases hierarchical superiority, a form of centralized decision making that gets shoved down the line. They are trying to remove ego in the decision process. Administrative offices are service centers. It’s more than just a PR move to make people feel better. The wording reflects the organizational philosophy of the company. The employees at the service centers are there to serve the stores, and not the inverse. Alain Bouchard’s office is on the ground floor, not corner office in a glass tower. You will find dry wall and wall dividers, not mahogany wood. They do have a Bang & Olufsen sound system, but it’s from the last century. Bouchard often says that the money is made in stores, not offices. The customers are in the stores, not in the office.

Here’s what Alain Bouchard had to say about the service center in Laval: Source: Financial Post. Highlights mine.

Source: ATD, highlights mine.

ATD has a decentralized business model and it’s more than just a buzz word. It’s actually how the company is run and sets them apart from the competition. ATD manage most of their operations and workforce in a decentralized way to speed up decision-making and address local demand for specific product and services. If Circle-K customers in Laredo Texas want tacos, then tacos it is. This process eliminates overhead costs. Each store operates as a distinct business unit and store managers are responsible for meeting their financial and operation targets. They are empowered where the workers have a lot to say and take a lot of decisions. ATD wants their manager to act and feel like he owns the store. How? It goes back to the empowerment principle by giving managers a lot of power. Rigorous performance measurement and benchmarking process ensures that best practices are used across the network.

Why care about a company culture? From an investor point of view, it’s not just“nice-to-have.” Companies with strong cultures tend to be higher performers. When a culture is strong, it leads to motivated employees and high performing managers. Also it helps with the process of integrating an acquisition. At first an acquiree is suspicious. But from what I’ve read during my research, there’s a pattern that repeats itself. After getting to know the Couche-Tard team and culture, the acquiree has nice things to say about Couche-Tard. They actually like being part of something bigger and successful. We have seen this with Circle K and Statoil in Norway. One of the best things you can do is help others succeed.

What’s Next?

In fiscal 2019, ATD adopted a 5-year plan. The plan’s objective is straightforward: To double again by 2023. To double revenues and profits through both organic growth and network expansion. ATD has doubled numerous times in the past. However ATD is putting more emphasis on organic growth this time, more than 50%.

ATD has the financial muscle to grow. As at February 2, 2020, it had US$4.3b of liquidity comprised of US$1.8b in cash and US$2.5b in credit facility (maturing in December 2024). Its cash balance has improved since then. ATD aim to keep adjusted net debt to EBITDAR below 2.25x. The current leverage ratio is below the 2.25x target.

ATD has two covenants in their credit facility:

Leverage ratio: A Leverage Ratio not greater than 4.00:1.00, provided that following a Permitted Acquisition in respect of which the purchase price exceeds US$200,000,000, the maximum Leverage Ratio of 4.00:1.00 shall be adjusted to a maximum Leverage Ratio of 4.50:1.00 for a period of twelve (12) months following such Permitted Acquisition. Interest Coverage: An Interest Coverage Ratio of not less than 3.00 to 1.00

ATD had over $7b of balance sheet capacity for growth.

M&A

Merger & acquisitions is Couche-Tard’s bread and butter. M&A is not easy and most of the time they are value destructive. A lot can go wrong. Companies have a mandate to grow. So they look outside and buy their competitors, often at inflated price. Acquiring is the easy step. Integrating, operating, and extracting synergies are the hard part. To create value, acquisitions have to be completed at the right price with the right conditions. ATD doesn’t favor store count growth to the detriment of profitability. ATD has a long track record of successful integration and synergy capture. ATD has the right playbook. How does ATD succeed at it?

The link here provides a timeline of the most important deals ATD made. Below is a slide with some of the deals since 2003 Circle K acquisition. It’s definitely not their first rodeo.

Source: Alimentation Couche-Tard March 2020 Presentation. Slide 23.

ATD has a disciplined operating track record and has demonstrated the ability to integrate and generate positive free cash flow with which to de-lever after closing large debt-funded acquisitions. Couche-Tard achieves synergies by eliminating of lot of their corporate overhead because as they grow, their overhead per store keeps going down. But it doesn’t stop with just cutting cost. Because ATD is an excellent operator, they increase revenues and margins. If you increase revenues, margins, and reduce overhead, you increase EBITDA. The ability to save more gives ATD the ability to pay more. For example ATD has boosted The Pantry's EBITDA by more than 30% versus pre-acquisition levels.

The convenience store sector is highly fragmented and in a consolidating phase. ATD gains market share when they acquire, when competitors close sites, and by improving their offering. ATD currently has 5% of the market share in the U.S. There are plenty of targets. There are 152,720 corner stores in the U.S., most are single unit (62%). You also have regional chains, like Casey's General Stores (CASY) and Murphy’s USA (MUSA). Privately owned operators like Pilot, QuikTrip, Sheetz or Wawa could be potential targets. Integrated oil companies are in the process of selling, or are expected to sell, their retail assets. It represents quick money for them, money they desperately need in current times. Expect ATD to be part of the process.

You probably read in the news that Marathon Petroleum (MPC) is exploring their options regarding their Speedway gas station unit. According to the WSJ, MPC is in talk with potential buyers. ATD is rumored to be one of those potential buyers. This is not breaking news. MPC has been talking of spinning off Speedway since October 2019. Seven & I Holdings (OTCPK:SVNDY), 7-Eleven’s corporate parent, dropped their $22 billion bid for Speedway, after balking at the price according to the Nikkei newspaper and Bloomberg News.

It’s worth noting that activist investor Elliot Management is on MPC’s case to “unlock” value. I actually invite you to check out their extensive presentation on MPC, it mentions ATD quite a few times with key data point, and the case for selling/spinning Speedway.

ATD will not overbid for Speedway. Normally, if the business deserves it ATD pays 10x EBITDA pre-synergies, which come down to 7-8x EBITDA post synergies. ATD has walked away in the past, like they did with Casey's General Stores (CASY) back in 2010.

On the menu is also Caltex Australia (OTCPK:OTCPK:CTXAY). The acquisition would have helped contribute to their “Double Again” plan. Caltex has about 2,000 stores in its network across Australia, $5.6b in sales and $600m in EBITDA. Couche-Tard’s bid is worth almost $8 billion, its largest ever. The acquisition was suspended due to the pandemic. However, ATD has not dropped the idea completely and it’s possible that renegotiation restarts once the picture is clearer. The acquisition of Caltex was supposed to be the springboard for ATD’s Asia-Pacific expansion. If the talk even resumes, it shouldn’t take long since financing was secured and due diligence completed.

3 Main Concerns

Couche-Tard faces two long-term challenges, the decline of tobacco sales and oil, and a short term one, Covid-19. Let’s start with the current one.

Covid-19

ATD was deemed an essential business. Despite the status, the pandemic has hit convenience stores—especially their fuel business—hard. Fuel sales have dropped, stabilized, and are now improving. In a sense, hurricanes and floods have prepared Couche-Tard for the challenges of Covid. The convenience store industry plays a key role on providing fuel, emergency items and staples.

The China Circle K stores, while I would take the insights lightly, observed that the shopping experience there “has started to feel more normal” of late and some consumer behaviors have gone back to what they were. Their words, not mine.

The pandemic was not all negatives. Of course the business suffered from lower sales and higher operating cost. Some good came out of it.

For example, the company said it has been able to expand many delivery platforms and pull forward enabling technologies that could become key to serving customers beyond the current pandemic. These initiatives include:

The expansion of home delivery capabilities in North America to more than 620 stores. In partnership with Favor, a Texas-based on-demand delivery company. The delivery can be done in under an hour (US$3 delivery fee with no minimum order). Click and collect and curbside delivery in both Europe and North America, with pre-ordering and payment through the Circle K app Frictionless payment technology in Norway to accept fuel payments using license plate recognition

Also the current crisis can offer opportunities for ATD to take advantage of. Brian Hannasch told analysts that the retailer also has the financial flexibility to withstand any pressures and also take advantage of acquisition opportunities that may arise from struggling competitors. Brian said "If I look back over the years, I would say some of our best opportunities have come after a difficult period". Companies that are under financial distress are often forced to sell valuable assets. Mom and pop convenience store faces higher cost and issues related to the pandemic. I’m sure many of them want to stay in business. The main question is how many of them want too?

Tobacco

Tobacco products represents 41% of merchandise sales. That’s significant percentage is considering the war on nicotine by health authorities around the world. While tobacco sales are a good thing for Couche-Tard at the moment, how will it be impacted in the long run considering that tobacco consumption is expected to decline over time? There’s also the health issues associated with the use of e-cigarette or vaping products.

Source: ATD 2018 Annual Information Form

Last year Tobacco performed extremely well in FY2019 with SSSG of 7% across ATD’s global network. These good numbers were supported by extremely strong growth from e-cigarettes and tobacco was a key driver behind ATD’s strong consolidated merchandise SSSG of 4.3% in FY19. The Trump administration has introduced a limited flavor ban applied only to vaping cartridges – not to tanks, disposables, and other means of flavoring the content of vapes. I find it hard to find accurate data on what’s going on in the field. It seems that each state is going about this their own way. New-York announced they are banning flavors, making it the 4 th state to introduce such measures. What’s the impact? We don’t have FY2020’s numbers since their fiscal year ended in April. We will get more accurate numbers on June 29, 2020 when they release they annual numbers. We can assume that a good chunk of e-cigarettes users will switch to other tobacco products to feed their addiction.

How is ATD addressing tobacco’s long-term decline? ATD offset tobacco yearly usage declines of about 3%-4% a year (long-term average) with a 5% price increase. Tobacco use has been declining for decades. Despite being a significant portion of sales, it’s not the cash cow it used to be.

ATD is evolving from a just a basic essential need store. They are testing new ideas to attract new customers. They are focusing on to-go meals and fresh food. They have sleek coffee programs. They are putting a lot of emphasis on beverage, a high growth category. I don’t know if you have been in a new convenience store lately, but the beverage category is massive. Every wall is a fridge.

Basically anything is possible. ATD collects enough data to figure out what customers want. It’s all about enhancing the shopper’s experience.

I expect tobacco, although in decline, to remain around for a long time. The numbers of smokers might be smaller over time and will remain an important part of Couche-Tard’s sale. Addicts are reliable customers. Drug dealers know that.

The Norway Lab

Fuel demand will decline over time as fuel efficiency improves and electric vehicle penetration increases.

Couche-Tard has a front row seat in Norway on the convenience store/gas station of tomorrow with its EV laboratory. With 43% of new car sales in Norway being EVs, Norway provides a good testing ground on the change to come. Norway has an ambitious target of having all new vehicles be zero emissions by 2025. ATD understands this trend is not reversing. ATD is now testing different approaches to the changing fuels market, namely EV.

Source: Alimentation Couche-Tard 2020 Presentation, slide 24.

ATD is also in the unique position of being the fuel leader in Norway. Most countries have pretty aggressive targets on achieving zero carbon emission. Achieving that goal means leaning off oil and having more EVs on the road. I don’t think we can dispute the decline of oil over the long-run. I think the main question is how fast we adopt “alternative” technologies. Although early in the experiment, there are some insights to share.

Source: electrek.com - Fuel-retail chains are visiting Norway to ponder a future when gas stations don’t exist.

  • It took EV penetration reaching ~10% before there was a notable decline in fuel consumption. The decline appears to be accelerating, from 1–2% in 2017–18 to 4% in the year to date in 2019. Has fossil fuel consumption reached an inflection point in Norway? I believe it’s important to monitor this trend closely and see what impact it could have on ATD’s financials as well as sentiment on the stock over time.
  • It will take time in North America for EVs to reach a 10% market penetration. Given the immense size of North America, as well as for political reasons, generous financial incentives are costly and might not be fiscally sustainable.
  • In addition, according to the Norwegian Electric Vehicle Association, 70% of its members also own a fossil fuel car. One reason could be ‘range anxiety’, with the ICE vehicles able to go longer distances.
  • A lot of ATD’s fuel volume is sold in the B2B market (e.g. trucks), which is less affected by the EV shift. Also, EVs tend to have a bigger impact on fuel sites in the cities; a relatively small percentage of ATD’s sites are in the cities (low-single-digit), with the majority being in rural and suburban markets.
  • While EV charging is a logical extension for ATD and fuel retailers, return on investments is going to be impacted by numerous factors. Utilization rate must be relatively high for EV charging to be profitable. Some locations might have constrained electric grids that cannot provide the required high voltage. The charging stations are not that profitable at the moment. The fuel retailers will need to set a charging fee that is reasonable to users and earn an acceptable return. Currently, most fee arrangements are focused on acquiring users, rather than on earning a sustainable return.
  • Despite the gradual pressure on fuel demand, fuel margin dollars will have a more important impact on ATD’s earnings in the next few years.
  • ATD has invested in the largest network of EV charging stations. They are a partner in IONITY a JV with the BMW Group, Daimler AG, Ford Motor Company and Volkswagen Group with Porsche and Audi. The JV was founded in 2017 with the goal of building an extensive 350kW high-power charging network or EVs along major highways in Europe.
  • Despite the slowdown in fuel volume, ATD has so far managed to produce solid results in terms of merchandise SSSG and margin, and fuel margin. This is largely due to the company’s successful execution of merchandising and marketing initiatives.
  • Silver lining: Smaller less profitable fuel stations will close first which will led to consumers migrating to the better more efficient operators like ATD.
  • Silver lining: Car manufacturers are making engines more fuel efficient (often with a turbo). But turbo engine require higher quality fuel, like supreme, that come with better margins.

For further readings, a 2019 Boston Consulting Group report titled “ Is There a Future for Service Stations?” provides interesting food for thought on what the future of gas stations might look like. According to the report, amid the rise of EVs, car sharing and autonomous vehicles likely to be refueled in special parking areas, as many as four out of five gas stations may be unprofitable within 15 years.

ATD is aware and understands this long-term declining trend. Instead of fighting the wave, the solution is to go with it. ATD understands that you need to adapt to stay in the game. Retail is critical to their long-term success. Convenience store revenues will be essential to offset declining sales at the pumps. Whether its tobacco, sugar, coffee, or fuel, the idea is always to get customers in the store. While it is still very early days, examples include the installation of Amazon lockers for pickup, which could potentially increase foot traffic. As reported by CSP, Amazon has expanded Counter, “a network of staffed pickup points that gives customers the option to pick up their Amazon packages in-store at a partner location”.

If Couche-Tard didn’t adapt to change, they would look like this:

Source ATD. A Couche-Tard store in the mid-1980s and today.

Cannabis/CBC Opportunity

Couche-Tard is laying the foundation to participate in the marijuana space. At the moment the results are immaterial. It’s hard to quantify the opportunity. Is there a future there? Probably if you play your cards right but it’s too early to tell. There are many challenges. There’s still a lot of regulatory work to get through, so much unknown, especially in the U.S., and the competition will be ferocious (already is) if and when the light turns green. It seems that everybody, from grocery stores to pharmacies, wants a piece of the pie. Legalized since fall 2018, Canada can provide some insights. Although, not related to ATD, feel free to read my article on marijuana to learn more. Retail distribution is mostly restricted to licensed dispensaries (government-run or private).

The way ATD plays the cannabis space is through the retail side. ATD announced a strategic investment in Fire & Flower (TSX: FAF, FFLWF), a cannabis retailer in parts of Canada (Alberta, Saskatchewan, and Ontario). Eventually, once all the warrants are exercised, it would increase Couche-Tard’s ownership interest to 50.1%. If fully exercised, the warrants would provide between $380-$830 million of growth capital. FAF currently operates 45 stores and is expanding. Feel free to check FAF’s shareholder presentation here. The idea here is to bring retail best practice and know-how to the marijuana space. This is very early stage and the question of “will it work” remains uncertain.

Couche-Tard also announced a multi-year agreement with Canopy Growth (TSX: WEED, CGC). ATD is currently operating a “Tweed” branded store in London, Ontario. On the face of it, the agreement to open a single store doesn’t exactly scream “big deal.” But the tie-up could prove to be the most significant deal for Canopy if it can leverage Couche-Tard’s massive global footprint. Former CEO was tight-lipped about the tie-up, declining to comment on whether the London store will be a launchpad for a bigger partnership.

While these partnerships are small financially, it positions ATD to participate in the cannabis space. More importantly, ATD will be able to leverage its experience in Canada and participate in the much bigger recreational cannabis market in the US once cannabis is legalized at the federal level. Well that’s the idea. At the moment I can’t quantify the impact of ATD stepping into the cannabis space. It’s a long-term initiative. It will need to be reviewed in the future.

Dual Share Class Collapse

Couche-Tard has a dual share class structure that carries a sunset clause set to expire in December 2021. Hatched in 1995 when Mr. Bouchard and the other founders were in their 30s and 40s, it stipulates that their voting rights – by which they control the company through a Class A shares with 10 votes each despite collectively owning just 22.7% of the equity – would end when the youngest of them turns 65 – and that occurs in December 2021 when Jacques D’Amours turns 65. Class B shares have one vote per share. Together the four co-founders have 66% of the voting rights. It’s worth noting that the co-founders were denied extending their control of the chain in the past. ATD needs to have the two-thirds support necessary from Class B shareholders to pass an amendments to the article of association to nix the automatic termination of the company's dual-class share structure so the founders could continue to exert voting control with their Class A shares.

The basis for the dual share class was to provide takeover bid protection. In the early-mid 90s, when ATD’s stock would have been more ripe for the picking, it could have easily been swallowed by a competitor, or some type of speculative investing fund. Without the protection, who knows if ATD would have become the success it is today.

Now I’m not endorsing dual share structure. But I’m also not totally against them. I see the purpose of having them. Multiple voting shares gives you power. It comes down to how you use that power. In this case, the co-founders have not abused their power. They actually used it for the benefits of all the shareholders. If they had acted against the interest of the shareholders, the market wouldn’t have rewarded ATD the way it did. ATD is one good example. But more often than not, not everybody acts like Couche-Tard and dual share classes have been associated with governance issues.

Now what does this mean?

Once ATD has one share class and the founders’ power is curbed, there would be fewer obstacles in the scenario if somebody tries to take over it. However, Couche-Tard’s $47b market cap would make it a pretty big fish to swallow. ATD is more likely to acquire than be acquired. Also the province of Quebec is highly sensitive about takeovers of its homegrown companies.

Not being able to extend founders’ control beyond 2021 has been a source of frustration for the founders. Alain Bouchard expressed shock that investors rejected the idea given the stellar returns on investment generated and talked of selling the company if it gets to it.

Valuation

Let’s work with the idea that ATD’s earnings normalized for FY2022 (we are in FY2021) and no acquisition is completed. We can expect ATD to earn $1.91 per share in FY2022.

At a current share price of $42, ATD is undervalued. We can expect ATD to trade between $47.7 and $49 per share, for a return between 13.6% and 16.6%. The multiple of 18.5x PE is based on its historical 5-year average.

However you are not investing in ATD for the status quo. ATD has a plan to grow and to double again over the next 3-4 years supported by M&A and organic growth. They have the financial and plan in place to achieve that. So what would it look like if they actually achieve what they said?

I added a 20% margin of safety to the target valuation. This provides a buffer for judgement error. Under the double again model, ATD could trade at $51.95, an upside of 23.7% including the margin of safety. Without the margin of safety, you get a return of 54.6%. However it’s better to be conservative. Some argue that my 20% margin might be too much when you take into consideration such a high quality company.

What if ATD achieves their doubling their EBITDA target from $3b to $6b? ATD currently generates $4b of EBITDA and should be expected to dip for FY2021 due to the pandemic. But let’s play with numbers. Let’s work with the idea that ATD acquires Speedway, which generates $1.5b in EBITDA. That would get them closer to their goal of $6b. $4b in normalized EBITDA + $1.5b gets you to $5.5b. Add Caltex Australia generates about $600m and you got all the pieces. You have a leading market share in the US and a platform to grow in Asia-Pacific. In that scenario I didn’t take any organic growth into account.

Of course acquiring both businesses anytime soon stretch reality. Life is not that easy. Not only do you need to pay the right price, these targets will probably have competing offers. Will 7-Eleven let ATD get Couche-Tard? Will EG Group let ATD get Caltex? You also need to secure the financing, integrate the businesses, find synergies to be realized over a few years, and operate them. These are two massive bites to swallow. The M&A community believe that a traditional spin-off of Speedway could yield between $15-billion and $17-billion in value for Marathon Petroleum shareholders. The Caltex bid was around $8 billion. So $25 billion for ~$2-2.2b in EBITDA, slightly over 10x. We know that ATD had the financing secured for the Caltex bid before suspending the process. Going after Speedway will require more financing, likely a combination of debt and equity. Respecting the covenants, ATD could get ~$13b (3.5x pro forma net Debt/EBITDA), and another $3b-$4b in new shares. Maybe a stretch, but they could pull it off.

Below I’ve derived the EBITDA multiple from previous take overs. You can see that ATD pays around 10x EBITDA. Energy Transfer paid top dollar for Susser Holdings (Stripes convenience stores), which inflates the average take out multiple. Speedway was looking for 15x EBITDA before 7-Eleven backed out.

The numbers above are not far stretched when you look at comparable. Casey’s trades at 11x EV/EBITDA. Murphy’s is at 10x EV/EBITDA. ATD is a superior retailer than both of them. Couche-Tard currently trades at 10x EBITDA (EV C$57b/C$5.67 EBITDA). If you apply past transactions take out multiple or comparable, you get some upside.

In my analysis I used FY2022 because FY2021 is depressed by Covid-19. The downside is an extra year or two to achieve their goals and a slower than expected recovery. Valuations are going to be interesting as they’re driven by cash flow. Markets are forward looking machines. In general the market kind of skips over 2020 like nothing happened (except for travel related companies and others). Current valuations tells us that the market believes that everything is going to be fine in twelve months. I’m not sure if I share that point of view. Things might be better but volatility is on the menu. The first quarter of 2020 was strong for most convenience stores but the second quarter will take a big hit. Those financial results are an important part of the valuation process. It drives multiples and flow of capital. The bigger question is: How long will the downward trend in numbers continue?

Summary

One might argue that ATD is not cheap by looking at its current P/E multiple. Simply looking at P/E multiples to determine if a stock is cheap or not is very narrow. It’s less about a high or low multiple, but more about what are you paying for? ATD currently trades below its 18.5x 5-year average. But with a ROE consistently above 20% and average ROCE at 15.4% since 2011, these are excellent indicators that you are buying a high quality company. ATD deserves a high P/E multiple. If we have learned anything during the pandemic, it’s that paying more for quality is worth it. The companies that took a beating during the pandemic are lower quality ones. The high quality companies are barely dented. Plus, high quality companies can take advantage of opportunities provided by the current crisis. In fact, Couche-Tard has managed to keep growing through the past three recessions.

Convenience stores are not glamorous investments. Alimentation Couche-Tard is not a sexy company. But they make money and it’s one of the great retail success story of the last forty years. Why? Convenience stores are a simple business. They are predictable. ATD generates tons of FCF and has consistently earned high return on capital. They have excellent management and culture. Couche-Tard's executives do what they say. Go back to any time, even 80s and 90s, they told you what they were going to do and they did it. They said that they were going to buy this chain and that competitor. They got it done. They said that they were going to America. They got that done. Then they said they were going to double the business over and over again. They got that done too. ATD is in the business of selling time and they are the best at it.

Disclosure: I am/we are long ATD.B. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long ATD.B

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.