Just when we thought the world was stabilizing following two years of a global pandemic, a new war arises and reminds us that the road to full recovery, if there is such a thing, is a long and winding rocky road. While we have been a beneficiary of a very strong and robust economic recovery following the COVID-19 crisis, we have seen some pretty big macro headwinds in the form of rising inflation, led mostly by skyrocketing oil prices, which have recently accelerated as a byproduct from the war in Ukraine. As a result of this, most major economists are revising their forecast for future economic growth downward.

Globally, we are experiencing widespread rising costs, and while higher energy prices are a big driver of this, fuel and oil are certainly not the lone culprit. Everywhere we turn, even beyond the gas pump, things are getting increasingly more expensive — clothing, food, housing, cars, you name it. The effects of inflation are being felt everywhere we turn (chart 1). In the United States, the Consumer Price Index (CPI) rose 7.9 percent for the year ending February 2022, and unfortunately it is only going to get worse, not better, from here.

US CPI: February 2022 Breakdown

As the United States and NATO allies move away from Russian oil over the war in Ukraine, the consequential squeeze in supply will continue to put pressure on oil prices. Russia is a major global supplier of oil, accounting for roughly 10 percent of global production, and while the United States only receives about 3 percent of oil from Russia, Russian-supplied oil accounts for nearly 60 percent of oil consumed by our European counterparts. For this reason, WTI (West Texas Intermediate) crude oil prices have increased by more than 20 percent since the start of the invasion, which is not accounted for in the 26 percent year-over-year increase in energy prices captured in February’s CPI reading (see chart 1).

What can be done to fight inflation on a macro level? First, we need to remind ourselves of what causes inflation. In the current state, it is a mosaic of factors including a surge in global demand following the COVID-19 recovery, issues in the global supply chain, and $1.9 trillion dollars of stimulus taking full effect. In general, the most effective tool to battle inflation is through contractionary monetary policy, which is influenced by the U.S. Federal Reserve. The U.S. Federal Reserve can tighten monetary supply which essentially cools down the economy so that inflation comes down. This is achieved by raising short-term interest rates, thus increasing the cost of borrowing and limiting the supply of money in the system, which is something we saw as recent as the March meeting of the Federal Reserve when the Fed increased their target rate by 0.25 percent, marking the first rate hike since 2018. The path to normalcy will not stop here. The CME Group (Chicago Mercantile Exchange) provides a probability calculator which assesses the likelihood of future rate increase by looking to the derivatives market. Based on what the market’s pricing-in is today, there is a 100 percent implied probability of a rate hike at every Fed meeting from now all the way through next summer. In an uncertain world, there is near certainty that recent increases in interest rates are just the beginning as the Federal Reserve attempts to control inflation while battling the potential negative effects on the economy.

WTI Crude Oil Prices: Year-to-Date

What Does Inflation Mean for Car Wash Operators?

The most direct impact to the car wash industry is by way of weakening consumer demand and rising input costs. The University of Michigan conducts a consumer sentiment survey, which asks more than 500 geographically diverse participants about their expectations for their personal finances as well at their personal outlook for the economy over the short and intermediate time horizons. What the most recent survey has found is that consumer sentiment is at its lowest level in more than a decade. The biggest question car wash owners face today is, how discretionary is car washing?

As consumers continue to embrace the ease and convenience of the express car wash model, car washing has become engrained in the daily life of the consumer. We saw this during the early stages of COVID-19, in which the car wash industry displayed amazing resiliency to the negative economic effects of the pandemic. So far, we haven’t seen a significant impact on the car wash industry in the current inflationary environment. We suspect this is partially due to wage inflation, especially for the lower rung of income earners who typically spend more on gas. To help quantify this, lower income households spend around 14 percent of their income on gas.

However, this same group also benefited from a 16 percent increase in wages over the last year, so in effect, lower income households have been able to completely offset the negative effects of inflation, and then some. While we haven’t experienced a slowdown in the growth trajectory of the car wash industry, continued inflationary pressures could certainly start to weigh on consumers and have a negative effect on spending habits. This will be a good test to see where car washing falls in the pecking order of discretionary goods and services.

To no surprise, cost structures are changing due to rising input costs like chemistry, utilities, wage labor, et cetera. For example, silicone, a key ingredient in many tire dressing compositions, surged more than 300 percent in October of 2021. As a result, many car wash chemical vendors were forced to pass back these increases to car wash operators. With rising costs, the knee-jerk reaction for some car wash operators may be to raise prices in an effort to preserve margins. However, with low consumer confidence you need to evaluate how accepting consumers will be to a price change. Operators considering price changes must think strategically. For starters, know your local market. If you operate in a highly competitive area with alternative options for car wash tunnels, you may find yourself in a game of chicken with your peers. Whoever flinches first can send consumers to the car wash down the street. Also, understand your local demographics. What are the income levels of my market? How much disposable income does my average customer have? How much do my customers spend on automotive services? All of this data is available, and we encourage any operator to answer these questions when evaluating price increases.

How Car Wash Operators Can Combat Inflation

So, beyond raising prices on wash packages, what can operators do to combat inflation? Evaluating and adjusting your business strategy can help prepare you today for rising costs and continue to serve you in the long run. As interest rates go up with inflation, now is a good opportunity to understand how your debt is structured. If you have short-term variable rate debt, now may be a great time to refinance into longer-term fixed rates. Or, if you own your real estate, you may want to consider engaging in a sale leaseback to take chips off the table and recapitalize your organization. We are certainly seeing an increased demand for capital advisory services by car wash owners looking ahead and wanting to protect themselves in an inflationary environment. To further mitigate expense volatility, connect with your vendors to lock in long-term contracts at a fixed price. This can be a win/win demonstrating you value the long-term relationship with your vendors by committing to continued future business.

Also, study your internal workflows to identify where your organization can become more efficient and productive. Over the last several years, we’ve benefited from a major boom in technology. Increased computing power coupled with expanded data storage by way of cloud solutions and emerging data sets have presented new and innovative solutions across many industries, car washing included. Advanced forms of automation and data analytics provide ample opportunities to systematize workflow and increase efficiencies, which can help protect your business during such a volatile period. Now is also the time to ramp up training on customer retention tactics. Focus on the value and importance of monthly plan sales and retention to add stability to your cash flow. Create solid responses and approaches for staff to deploy when customers request to cancel their memberships by incorporating down selling strategies. Do not be complacent! Operators must be proactive in taking steps to help successfully navigate these challenging times.

What Does Inflation Mean to the M&A Market?

A big driver of mergers and acquisitions activity in this car wash industry has been through financial buyers such as private equity and global family offices. To no surprise, elevated geopolitical and macroeconomic uncertainty means there is more risk for big institutional buyers who may be less willing to enter the space or less active than they have been historically. Though these buyers may be more risk aware, they are still sitting on an abundance of dry powder that they need to put to work somewhere. And the good news for the car wash industry is it has proven over the last two years to be more stable and resilient as compared to other industries. So, while there may be a greater emphasis on risk management by financial buyers, we have not seen a meaningful impact on the amount of interest in this industry from the likes of private equity and family office investors.

Year-over-year Changes in Rates by Duration

At the end of the day, the car wash industry is still ripe for growth. With market fragmentation and continued consumer acceptance of the express car wash model, there is still a massive void in supply to meet consumer demand. What is changing, however, is the economics and incentives behind the build versus buy debate. Due to rising costs, whether it be labor, materials, or equipment, new builds have become increasingly expensive. Depending on the local market, greenfield builds are about 10 percent to 20 percent more expensive than they were just a year and half ago. In addition, disruptions in the global supply chain have introduced significant delays in completion. Putting this all together, the path to growth via acquisition of existing sites may be more attractive now than ever.

Now, the Million-Dollar Question: What Does Inflation Mean for Valuations?

One of the most widely accepted valuation models is the Discounted Cash Flow (DCF) model. A DCF model assigns a present value on an investment based on projected future cash flows. One of the most important inputs in a DCF model is the discount rate which is tied to the level of interest rates. This rate is used to discount future cash flows back to a present value.

Generally speaking, there is an inverse relationship between interest rates and present values. As you discount future cash flows at a higher rate, the present value on that stream of cash flows is lower. Conversely, as rates are lower, the present value of future cash flows is higher. Why does this matter?

As stated earlier, rising rates are frequently associated with higher inflation. Based on the theoretical framework of a DCF model, this should result in lower valuations. However, not all rates are the same. As we examine the yield curve, which measures the level of rates across different durations (i.e., two-year versus 10-year rates), we’ve seen shorter duration interest rates, particularly two- to three-year durations, increase at a much greater pace than longer duration rates.

For example, three-year rates have increased by nearly 2.4 percent over the last year, while 10-year rates have increased by a more modest 0.6 percent (chart 3). This is known as a flattening of the yield curve. Shorter-term interest rates are influenced more by Federal Reserve policy, whereas longer-term rates are a reflection of future economic growth.

Tying this back to the current environment, we have a Federal Reserve raising short-term rates to cool inflation, which is in turn weakening expectations for future economic growth, hence the flattening of the yield curve.

Why does this matter? Longer duration interest rates are more relevant in determining valuations as investors are holding investments for longer periods of time. Since longer-term rates haven’t increased as much as short-term rates, we haven’t seen much of a compression in valuations as would have otherwise been expected.

Final Thoughts

While the car wash industry has proven its resiliency following the COVID-19 crisis, we acknowledge the potential for headwinds in the near-term horizon. Macroeconomic uncertainty resulting from rising inflation and geopolitical risks could pose a threat to the short-term health of the economy, and ultimately the car wash industry. That said, consumers have demonstrated that their appetite for car wash consumption is still growing, and the market is still far from saturation, which is precisely what has caught the attention of institutional investors contributing to a major boom in the industry. While there are short-term risks, our long-term position remains that the car wash industry is an attractive place to be, and we still see the future growth trajectory fully intact. But for now, as we explored above, there are tools and strategies you can deploy to help protect your business during a period of uncertainty.

Chris Jenks, CFA, is the chief operating officer of Amplify Car Wash Advisors, a leading advisor of multi-site car wash operators nationwide on mergers and acquisitions and capital advisory services. For information about debt restructuring and sale-leasebacks, options for decreasing risk by selling a majority or minority equity stake in your business, or how to make a full exit with maximum value, please reach out at (480) 581-1000. To hear more from Chris about the potential impacts of inflation on the car wash industry listen to Episode 2 of Car Wash M&A, The Podcast at Amplifywash.com/podcast. You can reach Chris at CJenks@AmplifyWash.com.