Engine Capital LP (together with its affiliates, “Engine”), a shareholder of CST Brands Inc., with ownership of approximately 1% of the outstanding shares of the Company, has delivered a letter to CST’s Board of Directors. The letter implores CST to alter its business strategies to increase profitability or to explore a sale.
Wells Fargo Securities’ Senior Analyst Bonnie Herzog weighed in on the letter. “After reviewing Engine Capital’s letter, we broadly believe their thesis is sound, and their arguments should be seriously considered. We share Engine Capital’s bullish outlook for CST, but equally share investors’ frustrations at the lack of performance. Key points that we agree with include: (1) CST is significantly undervalued given its ‘collection of valuable assets’ including real estate, retail stores and its MLP Partnership; (2) CST has a significant opportunity to improve its in-store performance; and (3) Management could do a better job communicating its strategy and the ways in which it can enhance value. Bottom Line – We continue to see substantial upside potential for CST, and believe that with an activist shareholder outlining what we have long believed to be true, this might be the catalyst needed to get the stock to finally reflect more of CST’s inherent value. We therefore reiterate our Outperform rating and our $47 – $49 valuation range.”
The letter from Engine to CST Brands begins: “ Engine Capital LP, together with its affiliates, owns approximately 1% of the outstanding shares of CST Brands Inc. CST represents a significant investment for Engine. We invested in CST because we believe the Company is deeply undervalued and that there exist opportunities readily within the control of the Board of Directors to substantially increase shareholder value.
“Over the last few months, we have shared with you a number of concerns and suggestions around the poor stock performance of CST since its spinoff from Valero Energy Corp., the significant operational underperformance of the Company, executive compensation, capital allocation, real estate monetization, corporate governance matters, investor communication and board composition. We had hoped, following our discussions, to work cooperatively to increase value for all shareholders. Unfortunately, given the lack of progress to date together with the importance to act with urgency, as described in more detail below, we have little choice but to share our thoughts publicly at this time.
“CST has a collection of valuable assets, including (i) a large portfolio of retail stores in the U.S. in populous, growing areas such as Texas, Colorado and California, (ii) a large retail presence in Ontario and Quebec, (iii) a very significant portfolio of real estate holdings, and (iv) an attractive legal and capital structure with a “sponsored MLP” relationship. The public market is not currently ascribing appropriate value for these substantial assets. CST trades at a significant discount to its public peers with Alimentation Couche-Tard and Casey’s General Stores, Inc., trading at approximately 13x and 10x EBITDA, respectively versus approximately 8x for CST. CST also trades at a significant discount to what it would fetch in a sale given the scarcity value of this at-scale asset, the consolidating nature of the industry and the recent transaction multiples. Based on recent M&A transactions, we estimate that CST would sell for between $50 and $55 per share, implying a premium of around 43% to the current stock price (assuming the midpoint of our valuation range).
“Fundamentally, CST is in a strategic quandary. The Board and senior management view the Company as one of the industry consolidators, yet is unable to articulate how it improves operations at its target companies. A consolidation strategy works when the consolidators are the best operators and bring the most value to their targets. As we describe below, CST has consistently lagged the better operators on the key relevant metrics. In CST’s case, it is the targets that tend to have the best-of-breed merchandising practices that CST is trying to acquire. In this consolidation phase, CST competes with entities such as Speedway (a division of Marathon Petroleum Corporation), Sunoco LP and Couche-Tard. These three companies are top-tier operators that significantly improve the operations of their targets and that can therefore afford to pay more than CST for their acquisitions. As an example, Speedway monitors and manages its business using a statistic called Light Product Breakeven, which incorporates merchandising productivity and fuel volumes to determine the fuel breakeven pricing. Speedway’s breakeven cents per gallon is below 3 cents compared to approximately 7 cents for CST, indicating much better merchandising and operating productivity at Speedway. Additionally, the recent and dramatic decline in value of CAPL is further exacerbating this strategic issue. Without the CAPL currency, it has become even harder for CST to compete for assets against larger players with lower cost of equity. In other words, CST has a higher cost of capital than the three natural consolidators and is not as productive on the merchandising side. CST must quickly demonstrate it can increase its merchandising and operating productivity if it is to be one of the enduring consolidators in the industry.
“The recent Flash Foods deal is a case in point. As part of the deal synergies, CST has communicated that it expects a $4 million improvement in gross profit by year three, which equates to an approximately $24 thousand benefit per acquired store. By comparison, in the recent purchases of Hess Retail (by Marathon Petroleum Corporation) and The Pantry (by Couche-Tard), the increase in anticipated gross profit dollars per store was approximately $56 thousand and approximately $39 thousand, respectively. These better operators can squeeze more profits from their targets and can therefore afford to pay more, which make them the natural consolidators in this space. While it is difficult to evaluate the financial attractiveness of the Flash Foods acquisition because management has not shared any financial metrics of the target, our point is that CST must become a best-in-class operator if it wants to pursue a successful consolidation strategy given the competitiveness of the M&A market.
“With this as relevant industry background, we believe that two avenues exist for senior management and the Board to significantly increase shareholder value. One option is for CST to remain a standalone public company, but make the necessary changes to aggressively improve the numerous aspects of its business operations that we highlight below. If management is able to execute on this, we believe CST can compound earnings attractively over the medium to long term given the industry tailwinds, which include an expanding convenience store market and competitive advantages over smaller gasoline retail players. The other option is to promptly initiate a review of the Company’s strategic alternatives and explore what buyers may be willing to pay for CST in the current robust M&A market. Engine would be supportive of the option that creates the most risk-adjusted value for CST shareholders.
“It is imperative that the Board act with a sense of urgency given the stock performance of CST versus its peers and the S&P 500 since the Company was spun off from Valero more than two years ago.
The letter further outlines ways for CST to become a “top tier operator,” including improving merchandising sales in a number of ways, such as “more foodservice penetration (CST has one of the lowest foodservice penetration among its peers), better private label offerings, loyalty card offerings, and better merchandising and operations in general. This is about blocking and tackling every day. Speedway, for example, expects to significantly increase the merchandise sales at its recently purchased Hess locations by introducing its leading loyalty program which will drive in-store traffic and provide merchandising opportunities. On Marathon’s latest earnings call, the company stated it has realized more than two times as many synergies as anticipated in the first year of the acquisition. Sunoco has also been aggressive with its foodservice offering with the rollout of the Laredo Taco foodservice brand.”
The letter expressed concern over CST’s real estate portfolio: “We hope that the Board is getting advice from a nationally-recognized top-tier investment bank as it considers this real estate review.”
And compensation structure: “We are concerned that the current compensation structure fails to align executive compensation with the most relevant metrics for shareholder performance.”
As well as concern regarding the corporate governance and board composition.
“In particular, we note that the Company maintains a classified Board and a combined position of Chairman and CEO. In light of this governance structure, we question whether there is proper accountability and oversight at the board level.”
It also highlighted concerns about the way the CST communicates with its stakeholders, as well as suggested a review of “strategic alternatives” for the company.
“In conclusion, we think CST is significantly undervalued. There are many levers for management and the Board to significantly enhance shareholder value. In order to justify remaining a standalone public company and not taking advantage of this unprecedented period of M&A, CST must act quickly and make the necessary changes to improve its operations along the lines we highlight above. Alternatively, CST could evaluate all strategic alternatives to maximize shareholder value and explore what one of the large consolidators would pay for the Company’s valuable assets. The one thing that is certain is that the status quo is unworkable and the Board needs to act with a sense of urgency.”
To read the letter in its entirety click here.