Description

O’reilly Automotive is a beloved member of the DIY/DIFM autoparts retailers.  Trading at 18x 2012 earnings, and 9x EBITDA, it is priced for growth, and in a backwards looking world, that would be appropriate.  Since the acquisition of CSK Auto in 2008, the company has grown bottom line at 15-20% and shown comps steadily in the high single digits ~ impressive for a 50 year old retailer.  Fortunately for those in the need of shorts, the tailwinds which generated these excellent results are fading, and what is left is an overvalued company with increasing competitive forces in an industry that at best should grow in line with GDP.   

The story

O’Reilly has been a beloved retailer since it went public in the early nineties.  The company benefitted from superior comp growth to its peers (AZO, AAP, CSK, PBY) largely due to a much younger store base.  Unlike many retailers, new store productivity in this sector is only about 50%, and store maturity isn’t reached for 5-7 years.  As a result, those with a young store base should show better results than their peers with older store bases, regardless of the quality of the operation.  In addition, ORLY always had a different business model ~ catering to the DIFM customer by providing parts to mechanics and dealers.  While this is a lower gross margin business, by levering their store infrastructure, they were able to justify locations in smaller MSA’s with less competition from the other national chains. 

Around 2008, the average age of their store base was about 6 years, and growing.  At this point, in theory, their comps would have slowed, and the multiple would have contracted to be more in line with their peers.  Surprisingly, at this point, they decided to do the acquisition of CSK Auto, a company whose financials were so firm that their CFO ended up in jail shortly after the acquisition’s close.  While the financials might have been questionable, CSK Auto did increase ORLY’s store base by about 1/3 and provided them with new geographies.  In addition, it was poorly run, and had no business with DIFM customers ~ which allowed ORLY to enter into a new business line levering the existing store infrastructure.  While initially the acquisition hit some road blocks, the launch of DIFM (aka commercial business) in the CSK Auto stores throughout 2009/2010 significantly accelerated sales growth.  Post transition, CSK stores were comping 20-30%, driving ORLY comps to the high single digits. 

While their comp story has continued to be strong, ORLY has also worked with their vendors to extend their payable days significantly ~ adopting AZO’s approach to working capital.  Their DPO has expanded about 100 days over the past 2 years, benefitting cash flow by close to a billion dollars.  They have returned this cash to shareholders through significant share buybacks at the current valuation, which has provided support for the stock’s value despite slowing growth relative to their peers. 

Recently the company has stumbled, showing comps of a mere 1% in Q2 and missing their guidance by a couple hundred basis points.  Despite this miss, there is still significant valuation premium in the stock as the street believes that core industry growth is about 4-5% top line.  However, good luck getting an analyst to provide data showing long term industry growth at this level.  In fact, there were many years of data where the industry has growth at less than GDP, when miles driven or average vehicle age decline.  There has been a benefit in the last few years given lower car scrapping an increasing vehicle age.  However, given there will be less cars entering into the sweetspot of “7-9 years”, overall healthier cars, lower raw materials inflation leading to lower price points, and increased direct competition with peers, strikes me as you could have a couple years of -1% to 1% core comp growth industry wide.

ORLY in particular is starting to show some weakness in it’s older stores.  If you exclude out the benefit from CSK auto, it seems like the legacy ORLY stores have been comping in low single digits for a while, and turned negative in the most recent quarter.  This slowdown also, ironically, coincides with AZO becoming more aggressive with a DIFM rollout in all of its store base.  With the last refurbish of the CSK stores being completed in early 2010 (and given 3-4 years to maturity in DIFM segment), that means they should start comping in line with my expected industry growth of -1 to +1%.  In that event, earnings growth estimates of 15% long term are far too high.  On top of this, the excess cash from working capital will fall of dramatically by the end of the year, ending their ability to execute large share repurchases going forwards. 

The numbers: current valuation

Historical financials

Risks

1)      Q3 numbers are pretty conservative given the company likes to beat numbers (and missed the last quarter), so I’d expect them to beat.

2)      Share repurchase plan still provides stock support in the near term

Catalyst

1)      2013 guidance lower than estimates

2)      End of share repurchase