VALUE CREATION IN DOWNSTREAM US-Conclusion: Retail model must fit local market needs

Market attractiveness and competitive position determine the success of a downstream company in the retail segment.

Companies who wisely consider these factors before entering a market are able to deliver decent shareholder returns despite the competitive retail industry.

PricewaterhouseCoopers LLP, global energy and mining, examined the range of retail models today in eight US markets to determine profit opportunities and investments required for success. Markets varied from being highly profitable to dismal and from being predisposed to convenience stores (c-stores) to lacking a culture for c-stores.

This article, an analysis of the retail segment of the oil industry, concludes a two-part series on creating value in the US downstream industry. The first part was published on Dec. 4, 2000.

This article also includes recommendations for the entire downstream industry: refining, wholesale, and retail. While the specifics vary by market, general themes emerged from the entire Pricewaterhouse Coopers' study regarding these three segments:

First, understanding the value proposition that a segment brings to the market is crucial. For example, a major should evaluate how it is positioned relative to an independent, and vice-versa. Among a set of competitors, such as among majors, companies should make sure they are playing their strengths as well or better than their competitors.

Second, regional positioning is important. Has the company been located in losing markets for years? Where are the most profitable areas, that is, those most exposed to niche competition?

Finally, within a given region, companies should consider how they are positioned relative to their competitors. Are their assets playing to the natural preferences of the region more so than the assets of their competitors?

A strong competitive position in the right regional markets is essential for downstream profitability. By diligently working through these issues, obtaining a clear picture of the current results and future potential in each business unit, and aggressively taking action and managing performance, companies can create value in the mature downstream market.

Retail models

Retail abounds with more business models than any other area of the downstream-value chain.

The low barriers to entry encourage competitors to experiment with different models. These low barriers have naturally fostered an intensely competitive landscape. Each business model contends for an advantaged position, but no company owns more than a fraction of the overall share.

Attempts to increase regional share beyond a tolerable threshold through mergers invite intense regulatory scrutiny. Exxon and Mobil learned this with the divestiture of their fee and leased northeastern and mid-Atlantic US service stations at the end of 1999.

Retail can be a double-edged sword. While retail can provide a comfortable upgrade for wholesale barrels, this upgrade often comes at the price of significant investment.

The average retail pretax profit is less than $40,000/year, and the average investment for a new store is greater than $1 million.¹ The other common option, dealer-owned and operated stations, can come at a great loss of brand control for downstream companies.

Despite the competitive environment and the unique challenges with retail, there are companies that deliver significant returns to shareholders. To understand the source of their success, it is important to examine the range of retail models today:

• The full-service, independent convenience store (c-store) and gasoline outlet, such as QuikTrip Corp.
• The downstream, independent refiner with a c-store and mid-price gasoline, such as Ultramar Diamond Shamrock Corp. (UDS) and Tosco Corp.
• The major integrated full-service retail outlet, such as Shell Oil Co., ExxonMobil Corp., and Chevron Corp.
• The discount super-pumper, such as Racetrac Petroleum Inc.
• The service chain providing gasoline, such as Bridgestone-Firestone, Jiffy Lube International, and Pep Boys.
• The major store chain providing additional services, such as Wal-Mart Stores Inc. and Albertson's Inc.
• The c-store with a few gasoline pumps, such as Southland's 7-Eleven Inc. and UDS' Stop N Go.

Eight US markets

PricewaterhouseCoopers examined both the retail models and the markets representative of the major metropolitan and high-growth areas of the US.

While a downstream company often will use a similar retail strategy for each of its US markets, each retail model plays differently in each market. Some markets are highly profitable; others are dismal. Some markets are predisposed to large c-stores. In other regions, c-stores are not part of the culture, making a focus on gasoline essential.

Oil companies should not enter markets purely on the basis of geography or volume. A downstream company must consider which new markets to enter and whether to remain in existing markets based on relative attractiveness and competitive position.

The study examined eight representative metropolitan, high-growth markets in the US:

• Chicago. The Chicago market, the most profitable market studied, is attractive for both gasoline and c-store sales, although the greater emphasis is on gasoline.

Chicago's ability to support high prices, volumes, and c-store sales makes a variety of retail models successful in this area.

• New York. New York is a relatively small market. Gasoline sales make up almost all of its gross margins. Even though sales are relatively low, it is a profitable market. C-store sales, the lowest of all markets studied, are relatively inconsequential. New York has the highest value proposition for the majors.
• Washington DC. Although it has the highest wholesale gasoline prices in the US, the Washington DC retail market has low margins. In addition, low c-store sales make it unattractive, with no strong performers. The emphasis in Washington DC should be on gasoline, not on c-stores.

Although margins on gasoline can be thin, the market has the capacity to support fairly high gasoline prices. Gasoline-oriented models, particularly the majors, have an advantage in this market.

• Atlanta. The Atlanta market is well saturated. Successful players in this market have focused on increasing c-store sales because gasoline margins are historically low in this area. Atlanta has the highest c-store sales of the markets studied.

Two business models are most successful in Atlanta: the full-service c-store and the discount super-pumper.

• Dallas-Fort Worth. Dallas-Fort Worth is a heavily saturated and generally unattractive market. A difficult market for margins, it has few successful retail models. The emphasis in Dallas-Fort Worth must be in the c-store area. The market has the highest c-store sales and lowest gasoline sales of those studied.

The market is extremely price-sensitive as well. The discounter model works best in this market, followed by mid-priced independents. The majors are the least likely to be successful in Dallas-Fort Worth.

• Los Angeles. Los Angeles is the largest market in sales and number of outlets. It is highly profitable, and players have benefited from focusing, on gasoline sales and pumpers. The emphasis in Los Angeles is clearly on gasoline sales. It has the highest sales per store of the markets studied. C-store sales tend to be low.

While the pumpers are the most favored in this market, the majors and independents are likely to be successful in Los Angeles as well.

• Denver. Denver's tight gasoline margins make it a difficult market. It has no specific successful retail model. C-store sales tend to be high in Denver and gasoline prices exceptionally low. Companies with a low to mid-priced gasoline price point and a focus on c-store sales should be successful in this market.

Denver is not attractive for the majors.

• San Jose. San Jose is a highly profitable market with several successful players. It is gasoline-focused and has a tolerance for higher gasoline prices. The San Jose market has characteristics similar to those of Los Angeles. Majors and mid-priced independents are likely to be successful in San Jose.

In analyzing relative profit opportunities and investments required in the eight markets, PricewaterhouseCoopers constructed three tiers of profitability. Fig. 1 shows cities in the descending tiers of profitability and the profitability position of each relative to the average.

Models' longevity

As seen from the above rationale, several business models have the potential for success if they are employed in the right market. Although companies should understand their markets before deciding which model to use, the current strategy of many oil companies is to make their brand offering consistent for all their outlets regardless of the market.

In the future, some business models will be more sustainable than others. The following list provides a brief glimpse at the relative longevity of the seven business models mentioned:

• Discount super pumper with c-stores may have a difficult time as new competition, such as grocery stores, enters the market. The subsidence of the gasoline supply glut reduces opportunities for distressed gasoline.

The model will continue to function well, however, as a result of strong consumer value proposition.

• Full-service c-stores with gasoline will continue to survive. Continuous innovation and technology will benefit this model more than other business models.
• The major integrated models will continue to exist. Retail-oriented models (vs. gasoline-focused models) will require a cobranding with c-stores to achieve further profitability. Cobranding with c-store companies will become more prevalent, although results have been mixed to date. The strong brand will continue to drive sales.
• Service station chains that sell gasoline are not sustainable in the long run.
• The integrated, independent with a c-store and mid-priced gasoline will be a model difficult to sustain. Limited capital, old store locations, and an unclear value proposition will make survival difficult for some companies.
• A c-store with only a few pumps does not appear sustainable in the long run. The reasons are similar to those given for the independents and for its nonpremium locations. This model may be the most vulnerable to the emergence of the fuel-selling grocery chains.
• Major store chains that provide additional services will continue to thrive in specific markets. They will capture a niche, particularly in small towns, and will enhance wholesale margins for majors and independents by competing with the discounters.

Recommendations for downstream

By agreeing on the appropriate strategic approach and focus for the US downstream market, by configuring the appropriate business models to meet that approach, and by pursuing the goals set forth, companies can achieve success in this mature market.

PricewaterhouseCoopers' made recommendations for the industry in three areas: asset management and capital allocation, optimization across all assets, and performance management.

Effective companies will develop strategic relationships to provide asset value without significant asset investment.

In refining, companies should carefully consider on which regions to focus, based on the regional economics and competitive position in the area. They should divest noncore assets, strengthen focus areas, and investigate new areas for growth on a region-by-region basis. Management should closely examine each area to see where capacity expansion would be optimal, given the macroeconomics of the region.

Companies should also continually examine their wholesale assets to assess whether they contribute to value or detract from it. Integrated companies must shed wholesale assets that do not contribute to shareholder value.

Koch, for example, left the northeast market when it found that the wholesale price it could achieve for many of its products was less than its supply cost.

In retail, it is critical to tailor business models to the market characteristics of the region.

Majors and independents should follow an adaptive business model to reflect market characteristics.

Value-adding retailers should enter only those markets that suit their operating style. For example, QuikTrip entered markets such as Atlanta, which has relatively high c-store sales.

Companies should exit those markets when their assets are not configured to the market, that is, when their business models do not match the markets.

Optimization of chain

Optimization should consider across all stages of the value chain: supply, refining, wholesale marketing, and retail. Oil companies do not always optimize their decisions (planning, capital investment, or working capital) across these businesses. Thus, what is best for the refining group is not always best for retail or the company as a whole.

In refining, companies should raise the level at which potential crude sources and demands are analyzed. By raising the level of decision-making and coordination and working more closely with traders and schedulers, companies can better optimize their assets, resulting in higher profitability.

Hess' St. Croix joint venture is an example of success in this area. Hess reconfigured its sweet-crude refinery in St. Croix to process heavy Venezuelan crude, allowing it to effectively toll-process the crude into refined products to meet Venezuelan demand.

A wholesale company would focus on managing its position and understanding its components (inventory, obligations, assets, market place), then make decisions using a trading mentality measured by economic return.

Refiners should view refining as only a source of refined product, valued against all other sources, and implement a trading mentality tempered by long-term planning.

Majors should revise their mindset that retail is principally an outlet for gasoline sales. Clearly, there is a need for retail to be run more on an overall business level. Majors should focus more on their c-store sales and in upgrading c-store facilities.

Performance management

Critical to achieving performance improvement is an intimate understanding of the sources of value in the company and of how each business unit delivers value potential.

This understanding of value-creation potential leads to the setting of long-term goals and the establishment of strategies.

Next, the planning process should include setting ambitious, specific targets, with which all managers agree, and establishing accountability for achieving results.

While managing according to the plan, managers should be able to quickly see the current strategic position of each management unit, in a consistent and reliable way, across divisions.

Plans and results should integrate seamlessly, so that deviations are immediately identified and corrected at the lowest levels in the organization.

These actions imply the need for robust decision-support tools. Implementing the right tools frees planners to focus their attention on business advising and partnering rather than performing solely in an information-gathering role.

Putting the proper infrastructure, information, and tools into place should go hand-in-hand with an increase in ownership and accountability.

Reference

1. 1998 NACS-CS News Industry Databank.