Petroleum Marketing in the Next Decade

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Petroleum Marketing in the Next Decade

• What does the future hold? Where does your firm
  fit in?

George A. Overstreet Associate Dean for
Research Walker Professor in Growth Enterprises
Director, Center for Growth Enterprises


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Objectives

• Analyze the American economy, assess its future
  patterns over the next decade for your industry
• Assess implications of structural change within
  the industry - Is the sky falling? Can things get
  worse?
• Reexamine the brutal facts of competing in highly
  competitive, fragmented markets - Are there
  better beds next door? How about the returns in
  other related industries?
• Which is the most viable business model relevant
  to current market conditions? Which model will
  win during the shake-out? - Broad, low cost
  strategic posture versus narrow differentiated
  strategic posture vs. stuck in the middle
  Question Can you have it both wayslow cost and
  differentiated? Are there examples in other
  related industries? Does history offer us any
  solace?

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The American Economy

• Its only when the tide goes out that you can
  see whos swimming naked
• Warren Buffett

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The American Economy

• Technology bubble of late 1990s masked excessive
  borrowing, widespread fraud, and
  managerial incompetence
• Effects of infectious greed irrational
  exuberance now lie exposed with the stock
  markets steepest slide since 1930s
• The positive side of the cycle has now turned
  vicious with the SP 500 index falling over 40
  since March 2000 and a loss of 7
  trillion in value (two thirds of
  annual GDP)

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The American Economy
Bubble Trouble U.S. Price-Earnings Ratio, SP 500
index divided by 10 year moving average of profits
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The American Economy
Although most economists are still predicting 3
to 3.5 growth over next 12 months, Americas
economic downturn is not yet over

• Protracted period of slow growth, even including
  a further slump, is highly likely
• This has not been a normal business cycle, but
  the biggest bubble in Americas history - never
  before have shares become so overvalued with such
  a zest for a new technology
• Until Americas excesses have been purged, robust
  growth is unlikely to resume

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Investment will not rebound until excess capacity
has been cleared and profits have improved. This
leaves us dependent on continued consumption plus
government and net exports
The American Economy

• Corporate Profitability Recessions
• Investment typically accounts for 1/6th U.S. GDP
• 1997 2000, investment equaled 1/3rd of its
  growth
• With corporate profits falling since 1998, as
  before every previous recession, we should have
  seen trouble coming

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The American Economy
We Should Have Seen It Coming U.S. Profits
As Of GDP
Start of Recession 1960 - 2002
9
The American Economy
Chicago Fed National Activity Index Best
Indicator Compilation of 85 Leading
Economic Indicators
-0.7
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The American Economy
Death of the business cycle? Not Dead But
Appears More Subdued
Americas Economic Heartbeat, 1870-2002 U.S. GDP,
Change Versus Prior Year
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Why Has The Business Cycle Become More Subdued?
The American Economy

• Services
• Better inventory control
• Globalization
• Automatic fiscal stabilizers
• Bigger government

Better monetary policy Bank reform Financial
deregulation Discretionary fiscal policy Luck
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Why Milder?
The American Economy
Why Less Volatile?

• Services
• Better inventory control
• Globalization
• Automatic fiscal stabilizers
• Bigger government

Better monetary policy Bank reform Financial
deregulation Discretionary fiscal policy Luck
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The American Economy
Other Factors Contributing To The Reluctant
Recession
Faster Productivity Growth Additional Tax Cuts In
Wake of 9/11 Resilient Financial
Markets Increased Business Flexibility Due To IT

• This Recession Occurring Without Traditional
  Oversupply of Housing Why?
• Depth of slump masked by credit driven
  consumption - Housing is another bubble likely to
  burst

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The American Economy
Savings on the Wane
U.S. Private Sector Net Savings,
of GDP
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The American Economy
Living In La-La Land
U.S. Private Sector Debt, as
of Disposable Income
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The American Economy
Corporations Have Pulled In Their Horns - Why Do
Consumers Continue to Borrow Spend As If Little
Has Changed? FED SLASHED INTEREST RATES OVER
500 BASIS POINTS SINCE
THE END OF 2000!
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The American Economy

• CONCLUSIONS
• WE CANNOT ASSUME THAT THE U.S. ECONOMIC GROWTH
  ENGINE IS GOING TO BE YOUR INDUSTRYS SALVATION
• EXPECT SLOWER GROWTH GREATER VOLATILITY OR RISK
  COMPARED TO THE LAST DECADE
• DEFLATION HAS BECOME MUCH MORE LIKELY ALTHOUGH
  WE SHOULD NOT FALL INTO THE JAPANESE SYNDROME, WE
  ARE IN DANGEROUS TERRITORY

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The American Economy
Oh, What a Feeling!
Largest 7 World Economies
(G7) GDP, change vs. prior year
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The American Economy
Mirror Images? Profile of U.S. Japanese Share
Prices (indexed to 100)
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Implications of Structural Change Within
the Petroleum Marketing
Industry Is the sky falling? Can things get
worse?
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PORTERS FORCES GOVERNING COMPETITIVE POSITION
GOVERNMENT REGULATIONS
BARGAINING POWER OF SUPPLIERS
BARGAINING POWER OF BUYERS
MARKETS COMPETITIVE POSITION PROFITABLITY
CURRENT COMPETITORS
POTENTIAL COMPETITORS
INDUSTRIES WITH PRODUCT SUBSTITUTES
THREAT OF NEW ENTRANTS
Note Intensity of competition from existing
competitors will depend on several factors
number, relative size, similarity of products and
strategies, commitment and cost barriers.
Source Developed from Michael E. Porter
Competitive Advantage, p. 5.
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Implication of Structural Change Gasoline

• Trends
• Consolidation of Major Oils
• EPA balkanization of Fuel
• A zero sum game new pumps outpacing demand
• Hypermarkets entered gas business, better
  merchants with better technology often using gas
  as loss leader
• Majors abandoning superior fuel at higher price
  strategy

• Implications
• Tight Supply Chain Enhancing Supplier Power
• Volatile Swings in Retail Margin
• New Competitors Resistant to Margin Restoration
  Sufficient to Offset Higher Wholesale Costs
• Smaller Marketers Asking the Government to
  Intervene with Below Cost Selling or Minimum Mark
  Up Laws

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Implication of Structural Change C-Stores

• Trends
• 100 Cigarette Cost Increase in the last 5 years
• Overbuilding Tired Iron Continues to Operate
• Little Differentiation Between Competitors Other
  Than Location Price
• While food offers higher margins, industry is not
  very proficient at marketing operating food
  outlets
• Many operators levered up over the last several
  years while interest rates low

• Implications
• Like to like sales are either stagnant or eroding
  operators respond with price reductions
• Gross profit decreasing volume gains do not
  offset margin reduction
• Defaults on loans to marketers soar in 2001 and
  2002 growth portion of business for investment
  bankers is restructuring

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The Doom Loop
Competitors cut prices
You match
Margins fall
Earnings fall short
Roll in the consultants
Rationalize Improve
So Does Everyone
Here we go again
All Stakeholders Lose Value
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Convenience Store Industry Maturity Curve
Competitors converge on the same formula and
industry begins commoditization
Hypermarkets enter gasoline marketing
Zero Sum Game
Tightening of Petro Supply Chain
Drug stores update offering, build free-standing
units and become c-store for women
Torrent of new entrants including independents
and major oil companies
A Tired and Outdated Format In
Need of Reinvention
Chains like Starbucks, Panera Bread take
ownership of high margin convenience categories
Revolutionary Concept popularized by 7- 11
Lack of differentiation has forced C-stores to
compete based upon price, margins eroding and
profitability declining
1995
2000
1985
1975
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Industry Structural Change - Conclusions

• To develop a more profitable sales mix, a broader
  range of consumers, particularly women, teens
  and higher income earners, must view the
  convenience store as a credible
  destination with differentiated products
• The industry has not responded to the consumers
  new definition of convenience as the rate of
  change outside of the industry
  has far exceeded the rate of change within
• To be successful today requires understanding of
  the consumers ever-changing definition of
  convenience and a willingness to take
  the strategic leap to expand the convenience
  store beyond its traditional
  product offering and base of customers

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Industry Structural Change - Conclusions

• The industry is clearly now a zero sum game. We
  have moved rapidly through its adolescence with
  low cost, gasoline oriented real estate models to
  early maturity and early convenience store real
  estate models to late maturity and mature, almost
  truck stop models. In the process, industry
  players missed many opportunities that were
  captured by various niche players, now grown
  large and aggressive.
• Most firms are still real estate and operations
  oriented versus focusing on innovation and
  differentiation. Visionary firms adopted a dual
  model of excellence and achieved critical mass
  long ago. Many players stuck in the middle
  failed to exit during the up-draft portion of the
  recent cycle and must now exit with depressed
  asset values, risk operational failure during the
  down draft part of the cycle, or identify and
  exploit a niche in which it can excel. This will
  not prove easy during the next decade. Indeed,
  the future looks bleak for marginal players and
  tough for even great players during the coming
  decade.

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Industry Structural Change - Conclusions

• Increased levels of competition from new formula
  entrants such as hyper markets pose a ever more
  serious threat to the continued profitability and
  asset values of traditional petroleum marketing
  firms. This is juxtaposed against a slow growth
  trajectory for the economy with an increased risk
  potential over the next five to ten years. It is
  clearly time for wise diversification and asset
  selection given the risk of deflation during the
  next business cycle.
• Structural obsolescence of a large part of the
  industrys real estate infrastructure is upon us.
  Tired iron does not play. Successful new
  formula players are already preparing for the
  obsolescence of the current c-store model. Yet,
  the vast majority are still moving to the new and
  more capital intensive models? Are bigger units
  with the same marketing models the path to
  success? I think not. The industry must
  transition from a petroleum distribution model to
  a retail merchant model recognizing
  socio-demographic, competitive opportunities.

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Industry Structural Change - Conclusions

• We have the same problem as the wine industry?
  Retarded demand growth in an oversupplied,
  cyclical, capital intensive industry. We too
  have to expand our customer base.
• Sheetz has more than proven the validity of its
  current model for the existing c-store customer
  base. They are the benchmark for that segment,
  however, Wawa appears closer to expanding the
  customer base beyond our traditional niche. In
  my own local market, Liberty has demonstrated the
  viability of a regional brand cooperatively
  delivered, at least as it relates to the
  marketing of gasoline. Tiger Fuel has reached
  out successfully to a more up-scale market
  segment. Their return on capital may be slow
  coming with their newer unit investments but
  proved quite successful initially. Such
  innovations have proven that one does not require
  200 plus units to be successful marketwise and
  financially.

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Industry Structural Change - Conclusions

• Excellence and passion--nothing less is what is
  required in the hyper-competitive marketplace of
  the next decade. The innovators dilemma is not to
  get so committed to high cost models that newer,
  more efficient models slip under the radar
  screen.
• My previous comment that hyper markets were not
  the greatest threat to oil distributor value
  enhancement has proven ill advised (if not
  stupid)
• Non-differentiated, weakened players will not
  survive the consolidation period unless they are
  extremely cost effective players in obscure
  markets. Awkward sized and strategically
  unfocused players of any size are also at
  significant risk. Exit strategies for such firms
  need to be strategic priorities. Granted, in the
  current marketplace, these are limited
• ESOPs and aggressive seller financing
• Debt restructurings, including, bankruptcy, will
  be the order of the day for many players over
  the next three to five years

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Industry Structural Change - Conclusions

• Increasing loyalty and customer switching costs
  requires more than mere hype it ultimately must
  be built on true differentiation around key
  customer value attributes
• Position your firm to have as many options as
  possible realizing that these represent valuable
  opportunities. Strategic alliances with the
  right structure offers possibilities to create
  sustainable, competitive advantages
• Concentrate not on survival but offensive moves
  that build a sustainable competitive advantage.
  Rethink your business model from the ground up
• The nature of the structural changes underway are
  so significant that all houses must be put in
  order. Our industry can no longer afford poor
  financial management, lack of creative planning,
  and undisciplined operational control mechanisms.
  Those that continue with business as usual do
  so at their significant risk

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Industry Structural Change - Conclusions

• The convenience store industry is at an
  inflection point. Those industry players who
  choose to compete by the conventional rules will
  continue to fight, and ultimately lose, the
  global commodity battle. For those players who
  choose not to compete by the conventional rules,
  there are only two alternatives, either exit, or
  innovatively reinvent the convenience retail
  format for your markets.
• Todays industry focus is on scale and supply
  chain management, both portents of future
  competition based upon operational efficiencies
  not innovation and growth. For smaller firms
  that need to adopt a focused differential generic
  strategy, food appears to be the most logical
  choice. Upscale niches represent the most
  hospitable alternatives for small players.
  Despite increased interest in this category, high
  margin foodservice still represents only 14 of
  sales industry wide.

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