Alimentation Couche-Tard: 100 Bagger at a 40% Discount

Alimentation Couche-Tard listed on the Toronto stock exchange in late 1999. A dollar invested in the company in January of 2000 is worth more than $100 today. Shareholders have enjoyed a total return of more than 10,000% or nearly 25% annually for 20 years. The S&P 500 has returned 7% annually over the same time period.

Despite these exceptional long-term returns, today the stock trades at more than a 40% discount to the S&P 500. Here I’ll take a look at the business, and why such a valuation gap exists.

Overview

Alimentation-Couche Tard, French for “food for those who go to bed late”, is a leader in the convenience store industry.

Couche-Tard was founded in Quebec in 1980 by Alain Bouchard, who still serves as the company’s Chairman. Back then, laws in Quebec prevented major grocery chains from operating during the evenings or on Sundays. Convenience stores used this legislation to serve the market when grocery stores were closed. These laws were repealed in the early ‘90s leading many to pronounce the death of the convenience store. As big chains left the country, Bouchard doubled-down and consolidated the Canadian market.

In 2003 the company broke into the U.S. by acquiring Circle K. In the years since, the business has grown organically and inorganically across North America and Europe.

Acquisitions since 2004. Source: March 2021 Investor Presentation

Today, with over 14,000 locations globally Couche-Tard is one of the largest owner-operators of convenience stores in Canada, the U.S. and Europe. The company’s brands include Circle K, Couche-Tard, and Mac’s.

Industry

The convenience store industry is highly fragmented in both North America and Europe. Single-store locations represent over 60% of the market, with large chains comprising less than 20% of stores. Despite being one of the largest players, Couche-Tard owns just 5% of the U.S. market.

Source: March 2021 Investor Presentation

Industry sales are remarkably steady. Through 2019 sales grew for 17 consecutive years at a 4.4% annual compound rate. Recessions and stock market corrections have little impact on the convenience store industry, with sales growing solidly during the dot-com crash and Great Financial Crisis.

Financial results are mainly a function of merchandise and fuel sales.

Most stores (80%) offer both fuel and merchandise. Within merchandise, convenience stores specialize in age-restricted products, specifically tobacco and alcohol. According to Nielson, 90% of cigarette sales, 97% of other tobacco sales, and 60% of beer sales come from the convenience channel. Food and other beverages make up the rest of merchandise sales.

Fuel results depend on the volume of gasoline pumped and the profit per gallon earned by stores. Profit per gallon is correlated to the price of oil, but has marched steadily higher (2.4% annually) over the past decade through multiple oil cycles. Since 2014 U.S. convenience stores have averaged around 22 cents of profit for each gallon of gasoline pumped. Electric vehicles and concerns over future gas consumption have recently depressed Couche-Tard’s valuation, which I’ll look at in detail later.

Couche-Tard’s geographic, revenue, and gross profit mix looks like this:

Convenience stores grow organically by growing same-store sales or adding new locations, and inorganically by acquiring stores from competitors. Inorganic growth is especially important given the fragmented nature of the convenience store industry. Cost control is also critical in any form of retailing, especially when dealing with low-margin products like fuel and food. In each of these areas Couche-Tard enjoys compelling competitive advantages.

Competitive Position

The convenience store industry faces several cost headwinds making scale crucial. Over the past 15 years industry-wide credit card fees have increased from less than $4B to almost $12B. Further, wages for store associates are increasing rapidly. In 2008, the average store associates wage was $8.37 per hour. In 2019 the average hourly associate wage was up to $11.30.

Scale

For the 70%+ of convenience stores operating at a small scale, these costs are increasingly difficult to contest. Couche-Tard has a lean corporate structure, the capacity to invest in high-ROI efficiency initiatives, a long-standing cost discipline embedded in its DNA, and immense buying power. All are necessary to fight these industry headwinds.

For example, Couche-Tard has a dedicated continuous improvement team solely focused on optimizing store operations to improve the working conditions for store employees and make the company more efficient. The company recently rolled out a best-in-class labor model that adapts to store needs to allocate labor based on individual store metrics. Labor scheduling tools automate shift schedules and allow for easy shift-swapping. In Europe, over the last five years, administrative-oriented hours in stores have declined 15% thanks to these efforts. Small competitors don’t have the resources to invest in this technology.

Buying power is also incredibly important in this industry. Decentralizing store-level activities while centralizing procurement allows Couche-Tard to enjoy the benefits of scale without bloating its cost structure. This allows the company to serve as a low-cost producer.

Relentless focus on cost and efficiency combined with scale have allowed the business to offset most of the headwinds mentioned above. Since 2011, adjusted SG&A costs in the business have grown just 1.6% on average.

While cost discipline, scale, and an emphasis on efficiency have delivered exceptional results, they are not in and of themselves an irreplicable moat. The real secret to Couche-Tard’s sustained success is its management team, structure and culture.

Management and Culture

A 40 year track record doesn’t happen by accident. While owning convenience stores can be a good business, the company does not enjoy irreplaceable network effects like Facebook or the high customer switching costs of Black Knight. Instead - much like NVR has done in the home building industry - the management team, incentive systems, and owner-minded culture that permeates Couche-Tard have taken a good business and delivered outstanding results over long periods of time.

One of the common threads of “Outsider” CEO-run organizations is decentralization. Management harps on the company’s decentralized operating structure, allowing the thousands of stores to operate according to local needs and trends to best serve their geographies. Decentralization allows the company to agilely adjust to local and macro trends. COVID-19 was a perfect example as regions quickly adapted to varying government mandates and implemented delivery and pick-up at their stores. There’s no single initiative that has allowed Couche-Tard to consistently grow same-store sales. Rather, it’s the product of the company’s entrepreneurial culture fostered from headquarters.

Next, the business employs a highly rational incentive system. Executive’s stock awards are tied to five areas critical to creating shareholder value:

- Return on capital employed (which has historically exceeded 15%);

- Same-store convenience sales;

- Merchandise margin;

- Store fuel volume compared to industry demand, and;

- Employee engagement.

Return on capital is probably my single favorite measure of performance, yet it is astonishingly rare in corporate compensation plans. Couche-Tard has no revenue or adjusted earnings targets, more signs that they are focused on real drivers of value and not just growth for growth’s sake.

All of the variables above are both critical to the business and, equally important, directly controllable by employees. It makes no sense to reward or penalize management for factors beyond their control, and shareholder-friendly compensation systems must be tied both to performance drivers and factors under the influence of executives.

It makes sense that Couche-Tard emphasizes variables that drive shareholder value, as the Chairman of the board (founder Alain Bouchard) owns more than $5.5B worth of stock in the business. Talk about skin in the game.

Finally, Couche-Tard has a long history of successfully identifying, acquiring, and integrating acquisition targets without overpaying. This is very rare. Much research has been published over the years that large corporate M&A has destroyed hundreds of billions of dollars of value for shareholders in the last few decades. When making large acquisitions, executives usually tout that 2+2 will equal 5 when it usually equals 3. Fortunately, things are different at Couche-Tard.

When executives are focused on return on capital and profit measures, they’re hesitant to undertake acquisitions that don't make financial sense. Hitting return on capital measures requires valuation discipline and ensuring that acquisitions are effectively integrated. There are a few companies – Berkshire, HEICO, Transdigm, Constellation Software, and Danahar, to name a few – that have persistently acquired businesses while creating tremendous value for shareholders. Alimentation Couche-Tard belongs in this group thanks to its management team and incentive structure.

Management is poised to continue opportunistically acquiring locations. In Europe, integrated oil companies own a large share of the convenience stores and have indicated an interest in divesting that part of the business to free up capital to focus on clean energy initiatives. Couche-Tard is likely to be a willing buyer from these willing sellers – a good combination for Couche-Tard shareholders. The U.S. market also remains extremely fragmented and ripe for continued consolidation.

Despite all of these competitive advantages and exceptional track record, Alimentation Couche-Tard currently trades for 13x earnings, over 40% lower than the S&P at 22x. Why is a business with a multi-decade track record of execution selling for such a discount?

Threats

Electric vehicles seem inevitable. Many countries have carbon-neutral targets and planned limits on gasoline powered consumer vehicle sales starting in the mid-2030’s. Initiatives like these call into question future demand for fuel. Of course, with fuel representing 45% of gross profit, this has important implications for Couche-Tard over the long term, and it appears to be the main driver depressing the stock’s valuation.

Management has addressed this issue directly, as you might expect. CEO Brian Hannasch said on the March earnings call:

“electrification is the reality. I'm not sure everybody in the industry, our industry, generally believes that yet. But we do. And we're preparing to face it head on.”

By luck or skillful foresight, Couche-Tard has a heavy presence in the world’s most advanced EV market – Norway. Their foothold in Norway is allowing the company to experiment with ways to evolve and thrive when electrification comprises a meaningful part of the market. Hannasch explained:

“Norway shows us that convenience and fuel sites have a role to play in the build-out of the infrastructure and that there is a business model...But it does change the model. So we've got many successful ingredients in place in Norway, but also recognize Norway and the pace at which it developed, like some other countries in Europe, it had cheap renewable hydropower. And the government is fairly wealthy and have the ability to aggressively subsidize the purchase of vehicles and build out of the infrastructure. Not every market is the same, and we're learning about the U.S. and seeing how we apply our experience in Norway to make sure we participate at the right level in North America. We'll also begin to do work to strengthen our B2B position in the U.S. as we see in Europe that has just been very, very resilient in the face of EV. And finally, and I think most important, we're building out capabilities that will give us the ability to consolidate what's just tremendous demand in a very fragmented industry for years to come.”

Charging infrastructure needs to be built out in the U.S. and other markets before we can expect mass adoption of EVs. Couche-Tard should have first crack at providing charging stations if they choose to do so. In 2020 Couche-Tard converted some gas stations to charging stations in Scandinavia and now operates over 500 fast chargers. The company is using Norway as an EV “laboratory” to ensure they can capture the future EV customer.

There are a few more important questions to consider before writing Couche-Tard’s obituary in a fully electrified world.

How long will it take for gas stations to become obsolete? I have no idea what the answer is, but I’d venture to guess it will be many decades. Fuel consumption is continuing to rise in most markets, COVID demand declines notwithstanding. S&P Global predicts that U.S. gasoline consumption might peak by 2023, but will remain the primary transportation fuel until 2050.

The average vehicle is staying on the road longer as vehicle prices rise, meaning even if and when new sales of combustion engine vehicles are banned, there will still be loads of gas-burning vehicles on the road for more than a decade. Further, electric vehicles are still far too expensive for the average consumer and prices must come down for mass adoption.

Most nations charging infrastructure, especially in large cities, is not close to being able to handle a huge increase in demand. If every American purchased an electric car today the United States would end up using roughly 25 percent more electricity than today. Our grid cannot handle that kind of increase in its current state. Utility companies will need to build many new power plants and upgrade their transmission networks to handle this increase. Finally, trucks and buses are quite a bit behind passenger vehicles in terms of electrification. It’s likely large vehicles will consume gas long beyond the average sedan or SUV.

To be clear, all of the above problems can and probably will be addressed, but it’s going to take time and resources. In the meantime, Couche-Tard’s fuel business will generate cash, and lots of it.

Even if the company completely fails to benefit from EV charging stations (which I find unlikely), 65% of transactions are merchandise-only and another 10% are a mix of fuel and merchandise. Couche-Tard’s merchandise business has grown 10%+ annually for the past decade and they own a powerful niche in age-restricted products. To me, the most important question when addressing this looming problem is – will there be a place for convenience stores in a fully electrified world? I think the answer is an emphatic yes. When people are driving to work, going on road trips, or just in need of a snack or six pack, convenience stores will be there no matter what kind of cars people are driving.

Let’s see what all of this means for the current valuation and potential returns.

Valuation and Returns

Alimentation Couche-Tard currently trades for under 13x last years’ earnings compared to the S&P at more than 22x. Let’s assume the valuation discount is due to concerns over the company’s future fuel earnings. Is the current price justifiable?

Last year Couche-Tard earned about $4.5B in gross profit from fuel sales. To compensate for the unknown trajectory, let’s assume that for the next 10 years the company averages $4B in fuel gross profit (90% of last years’ figure) and after 10 years that profit suddenly drops to zero. Merchandise sales were about $15.4B over the last 12 months, and have grown more than 10% annually for the last decade. If merchandise sales over the next decade grow only 7% annually the company will generate more than $30B in merchandise revenue 10 years from now. The company does not break out SG&A costs associated with fuel operations compared to merchandise, so I’ll assume they would generate around a 4.5% operating margin on merchandise if the fuel operation goes away. This would put margins in line with grocers like Kroger.

Applying a long-term market-average multiple of 15x (implying just 3% long-term growth) on pre-tax earnings and the merchandise business alone would be worth ~$21B in 10 years. Over that span the company would have collectively earned $45B after taxes from fuel and merchandise operations. When adding up the out-year value of merchandise operations, cumulative earnings, and expected dividends, the collective value for shareholders would be close to $70B over 10 years. This compares to a $36B market cap today. This scenario equates to roughly a 7% annual return – hardly a disaster. Remember, this is if profit from fuel evaporates overnight in 2030, something that seems implausible to put it mildly.

It’s more likely that the next decade looks similar to the past decade. If that’s the case, Couche-Tard will retain more than 100% of net income reinvested at mid-teens incremental returns, for a high-teens compounding rate. Management plans to double earnings in five years, and I don’t have any reason to doubt that they will. Further, if the stock revalues to a more fair and historical valuation (around 16x earnings), stock returns would exceed business returns.

Most business face a day of reckoning. The average lifespan of an S&P 500 company is just 18 years. In 2016 McKinsey estimated that by 2027, 75% of the companies in the S&P 500 at that time will have disappeared; they’ll either be bought-out, merge, or go bankrupt. Tech companies specifically face major risks of obsolescence in the decades ahead, but the risks are nebulous and therefore often not reflected in valuations. Couche-Tard has recently been penalized with a low valuation simply because of the known, albeit distant, threat to a portion of its business brought on by the mania in EV players. However, when judgement day arrives for gasoline, people will still consume salty snacks and beer, and Couche-Tard will be there to sell them. From now until then, investors will enjoy a growing cash stream generated from both the gas and merchandise segments.

You don’t need a scale to know that a 350 lb. man is fat. Similarly, I don’t need to forecast precisely what fuel and merch sales will do over the next 10 years to know Alimentation Couche-Tard looks cheap. The current price appears more than justifiable from the merchandise segment alone. In a scenario where the company earns nothing from fuel after 10 years, fails to capture any benefit from converting gas stations to charging stations, and grows merchandise revenue 30% slower than in the last decade, I can still see reasonable annual returns. If the company, run by a stellar management team squarely aligned with shareholders, can step over this low bar, the stock could do far better.

Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.

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