When you think of convenience stores, what memories come to mind? I think of my teenage years and an insatiable, guilt-free appetite for anything fried, crispy, heavy in fat, and light on the wallet. C-stores also appeal to my professional sense as an investor. A confluence of factors involving cigarettes, wages, and falling fuel demand has become a point of debate for c-store investors.
Gross profits per unit of fuel sold in the US have accelerated rapidly since 2018. Debate in the financial community about the potential for this trend to continue has influenced the share price of one of our Canadian large cap strategy’s largest investments, Alimentation Couche-Tard (ATD), the owner of Circle K convenience stores. Circle K is a global brand, though approximately 2/3rds of the company’s total sales are made in the US.
U.S. Industry Gross Fuel Margin
Source: NACS/Nielsen, Convenience Store News
MOM-AND-POP’S AUTHORITY ON MARKET STRUCTURE
To set some necessary context into the US fuel and c-store industry, approximately 80% of all gasoline sold is at c-stores. Secondly, of all the c-stores in the US, about 60% of them are single-store operators (a.k.a. “mom-and-pop” shops). Everyone might recognize the logos of Circle K or 7-Eleven, but the small players that need more sales to break even have a considerable collective influence on the direction of fuel profits for the entire industry.
FALLING FOOT TRAFFIC
Small chains and single shops have had a rough time keeping the lights on in the last few years because of cost inflation and fewer customers coming through the doors. Finding good employees to tend the shop costs a lot and keeping them around is getting costlier. Customer traffic is being impacted by a few factors, but arguably none more than the continuation of decades of falling demand for both gasoline and cigarettes. The indirect cost of less in-store traffic is fewer opportunities to sell them something else with a far higher profit margin every time they come through the doors.
Source: U.S. Energy Information Administration
SEARCHING FOR RELIEF
To offset these pressures, if only temporarily, mom-and-pop shops have few alternatives except to capture more margin from the fuel pumps.
Source: Murphy USA Investor Materials
One may intuitively conclude that higher gasoline profits alongside shrinking in-store profit opportunities should result in fuel growing as a proportion of the total typical c-store profit mix. This is happening, though the pace of that change is surprising. Industry data shows that fuel gross profits have remained around 40% of the total for several years, implying that the industry is fighting hard to keep this balance intact. The read-through could be that the industry is tacitly cooperating to keep a floor under fuel profitability.
Source: Convenience Store News Industry Reports
The positive effect of such a floor under fuel margins is magnified for large retailers of gasoline, including Circle K. The company is able to flex its fuel buying power through a marketing partnership which makes it one of the largest fuel retailers in the country. In other words, it can buy fuel for resale at a lower cost than the vast majority of c-stores with which it competes. This is part of the reason ATD earns among the most on a per-gallon basis in the US market.
AN EVOLUTION IN-STORE
Beyond fuel profits, keeping customers interested in buying things inside the shop remains a challenge. The most impactful means to achieve this is to invest in becoming a destination for breakfast, lunch, or dinner.
Food at convenience stores in North America is evolving from taquitos and hot dogs made on a roller grill into a far more diverse offering of hot breakfast sandwiches, pizza, burgers, salads, deli sandwiches, and freshly-ground coffee. Prepared foods from convenience stores offer better value and save customers precious time compared to quick service restaurants. Contrasting with cigarettes, prepared food is a growing business, earns approximately three times more in profit, and has far fewer restrictions imposed by governments. So far, data suggests that consumers may be getting as enthusiastic about c-store food as I am. Total sales of prepared foods from c-stores is up approximately 50% relative to 2018 and more than three quarters of the American population have tried a ready-made meal from one of them.
Source: Convenience Store News
CIRCLE K’S ADVANTAGES
Foodservice appears to be an essential solution to the trends of shrinking gasoline consumption and the declining habit of smoking. Not only are its prepared foods attracting foot traffic, Circle K is also finding tremendous success in building customer loyalty through other means including remodeling premises, introducing self-checkouts, selling its own brand of snacks and drinks, striking exclusive product deals with suppliers, opening carwashes, and sending customers special offers through its app. Most smaller c-store chains do not have the scale or the financial resources to invest in these opportunities, in turn making competition easier for Circle K.
QV has been a shareholder of ATD for many years, in part because the c-store business model is simple to understand, its profits are typically more recession resilient than other industries, stores usually cater to immediate and recurring needs, they are among the few businesses which are not being displaced by online marketplaces, and they produce meaningful free cash flow for reinvestment or distribution to owners. Though the industry is evolving, we perceive ATD’s competitive edge is getting sharper. We see Circle K being less afflicted by trends that are pressuring its competition, leading to our conviction that in five years the company may be able to almost double its profits.