The World's Unsexiest Business
adding a little sizzle to the convenience store industry
Disclosure: I do not currently hold a position in Costco (COST) but have one in Core-Mark (CORE)
In response to a highly founded and ever increasing growing threat from and declining market share to Amazon, Costco should consider repositioning itself with an integration one strategic competitor or supply chain acquisition at a time to take advantage of opportunities in areas where competition from the internet retailing giant may not be directly present.
Therefore, I see one avenue for strong exploration for Costco being the convenience retailing distribution / wholesale space not only on a product direct sales basis but also by leveraging its price leverage, supply chain, logistics, transportation, and technology strengths.
Complementing Costco’s existing B2C focus with a fast growing and mildly leveraged B2B player will help it jump start its foray into the latter circumventing the need to invest heavily in structural reform.
After all, if you don’t consider these two companies to be essentially in the same business, then Amazon is strictly to be viewed as solely a technology company.
In light of no recent publicly announced acquisitions or significant growth considerations, Costco has nearly reached a maturity point in its business model lifecycle where its arsenal of shareholder enhancing tools is limited to the following:
Primary motivations for Core-Mark to consider acquisition:
Source: Core-Mark Q3 Earnings and 2016 Annual Report
Both companies carry an equal long term debt duration profile with the highest interest rate of such debt sub 3%—that being towards the lower end of investment grade corporate.
Note: McLane’s Berkshire Hathaway ownership and substantially higher enterprise valuation suggests it may be out of the running in consideration for merger or outright acquisition.
While Core-Mark currently trades at what appears to be a lofty 31.98 P/E, with Costco’s purchasing leverage enabling it to achieve the upper end of its gross margin range (85% of 13% = 9.75%) that would enable it to free more than $94.5MM in EBITDA (assuming most if not all trickles down to cash) on an annual basis given the prevailing SG&A cost structure. The synergies associated with reducing distribution centers and perhaps circuitous transportation logistics would then initially free another $105MM in cash (50% of the $211.6MM PP&E value).
A key assumption here is that the 50% liquidation value of PP&E implies that asset sales do not take on distressed levels.
Then there's the issue of a high receivable line item on the balance sheet to the tune of $413.2MM (10.9% of revenue). Reducing that to the midpoint of an acceptable range (5 - 10%), 7.5%, would mean that even at a 1% annual investment rate, another $2.7M could be freed up in earnings which would flow to cash. Additionally, Core-Mark’s $15.5MM distribution of dividends (2016 payout) can be eliminated as shareholders will be distributed Costco’s existing dividend payments under its current structure. Therefore those savings would be earmarked for retained earnings. Using this sum of parts methodology: $94.5MM EBITDA via gross margin improvement + $105MM / 10 year conservative cash liquidation value + $15MM cash dividend + $2.7M better float management = $122.7MM annual cash improvement.
The single greatest incentive for Costco is an integration of a low cost growth player which can potentially add nearly $4B of revenue carrying an acquisition cost of $1.5B ($32.54) or a 13.6% premium to Core-Mark’s current share price.
An unknown number of convenience store operators still rely on Costco for a significant attribution of store merchandise. While delivery can be arranged, many of these convenience retailers still choose to load their own vehicles with purchases. With such a ‘brute force’ practice, returns, exchanges, invoice data entry, and inventory management become a series of heavy handed poorly integrated ‘one-off’ tasks which can easily force the retailer to spend more time managing product procurement than actually merchandising or selling them. For those operators currently partnering with Core-Mark, supply outages can be frequent for top selling and/or recent top trending items. Such products may then become susceptible to a resupply of first preference by the supplier. Specifically, whether or not the practice exists, what may be founded speculation is that larger (higher revenue generating accounts) get first ‘dibs’ leaving single site operators out of stock for a more significant period of time.
Additionally, when accounts are located in major metro markets, existing hub and spoke model distribution can be done away with as delivery distances are drastically reduced with an even more local warehouse store becoming the effective distribution center (DC) starting point. Such a decentralized model cuts the time to resupply convenience retailers who may already be operating on a 3 - 5 day ordering cycle instead of a 7 - 9 day one.
Though formerly a source of strength, current it seems as though an inordinate amount of time, energy, and resources seem to be spent on acquiring and managing accounts which could be better spent on ensuring execution and supply chain logistics rival that of Amazon.
One fewer large player (disintermediator) means gross margins might see the establishment hard floor of profitability instead of merely running the risk of persistently hovering above break even.