Description

Investment Overview

O’Reilly Automotive (NASDAQ: ORLY) is the definition of a beautiful business that has the ability to continue to compound in value at an above average rate for many years to come. TallGuy wrote it up about six years ago. I highly recommend reading that very well-done, thorough report to better understand ORLY and the industry structure. Much of what was written back then still applies today. Since that write-up ORLY has grown revenue at a 9.9% CAGR, operating income at a 10.8% CAGR and EPS at a 20.2% CAGR (thanks in part to a 6.2% annualized reduction in shares outstanding) which has led to a shareholder return of 28.2% per annum—not too shabby!

Through its ~6k stores, ORLY operates as one of the largest retailers and suppliers of automotive aftermarket parts, tools, supplies, equipment, and accessories in the U.S. and Mexico. The company provides new and remanufactured automotive hard parts and maintenance items. It offers do-it-yourself (DIY) and professional (DIFM) service for domestic and imported automobiles, vans, and trucks. The company was founded in 1957 and is headquartered in Springfield, Missouri.

Currently, ORLY’s business mix is mid-high 50s in DIY while DIFM makes up low-mid 40s. DIFM is growing faster than DIY and is likely to continue to grow faster than DIY for the foreseeable future due to the growing complexity of fixing and maintaining today’s cars, especially as electric (EVs) and hybrid vehicles make up a greater mix of cars on the road over time.

ORLY’s financial metrics are fantastic. ORLY has 67.9% pre-tax return on capital employed. From 2019 to Q3’23, capital employed declined from ~$5.2B to ~$4.6B while operating income increased from ~$1.9B to ~$3.2B. Essentially, the growth in its negative working capital has more than offset the growth in its net PP&E to grow its store base, which makes this a beyond capital light growth business. Net income has converted to free cash flow (including subtracting minimal stock-based compensation) at 107.3% over the past nearly 14 years. Over that time, ORLY has taken Accounts Payable/Inventory from 44.3% to 133.9% in Q3’23. Inventory turns over that time have increased from 1.4x to 1.7x. Its proprietary brands penetration has steadily grown and now stands at 50% of its mix, which has helped increase its gross margin from 48.6% in 2010 to 51.1% in the LTM. Its sales/sq. ft. has increased from $216 in 2010 to $322 in 2022. This greater sales productivity has allowed it to leverage its SG&A nicely such that its operating margin has increased from 13.6% in 2010 to 20.2% in the LTM.

Industry Positives

·  The auto parts retail industry exhibits highly rational pricing behavior due to the failure-driven nature of the business.

·  In auto parts retail, the negotiating leverage skews toward the distributors. Vendors need the volume opportunities provided by major retailers/distributors, and retailers can often find replacement brands for vendors that try to negotiate.

·  E-commerce penetration rates for the auto parts industry is sub 10%. Within DIY immediate need/speed and customer service knowledge are key inhibitors to higher penetration rates.

·  Highly fragmented market (particularly within DIFM): the four public auto parts retailers (ORLY, AZO, AAP, GPC) have ~1/3 of the hard parts market. ORLY has ~11% of the ~$140B addressable market that should continue to grow over time.

o   AAP has been a steady share donor to ORLY and AZO

·  Industry growth drivers: rising average age of vehicles (~12 years old) in the U.S. with cars being made better, which allows them to stay on the road for longer and leads to a growing vehicle population (~1% CAGR) with the rate of new vehicles being sold into the market growing at a faster rate than what is being scrapped.

·  With interest rates at multi-year highs, the cost of money has risen to such a degree that it makes maintaining existing cars a much better value proposition than buying new.

o   These new UAW deals will likely translate into OEMs trying to pass at least part of these cost increases onto consumers in the form of higher prices on new cars.

ORLY’s Competitive Advantages

·  Culture Driven Leadership

o   Pride in its Culture and Team

• Many of its executives are “lifers” who grew up in the business, working their way to the top from beginning as an hourly worker in its stores

o   Ownership mindset by store managers

o   DIY Mantra: “Friendliest Parts Store in Town”, “Out Hustle & Out Service the Competition”, “Top Notch Customer Service”, “Never Say No Philosophy”

o   Best stores and sales team in the after-market with enhanced service levels and delivery times

o   Professional Pricing: best overall value (factoring in price, parts availability and speed of delivery) in order to increasingly be the pro’s first call

o   Distribution Network: 28 regional DCs and 375 Hub Stores (with 30k-90k SKUs) providing multiple deliveries per day to spoke stores

• 95% of its stores receive multiple same day deliveries and deliveries on weekends of hard to find parts from its DCs and Hub Stores

• Minimum five nights per week deliveries from its DCs to all of its continental U.S. stores

o   Omni-Channel Focus: improving search and content with better product images and “how-to-fix” videos; Improving Customer Support through voice and chat messaging.

I think it’s important to read/listen to their Analyst/Investor Day presentations and quarterly conference calls to get a better sense of the company culture. This is from COO Brad Beckham at their most recent Analyst/Investor Day on 8/23/22:

“I started with O'Reilly in the summer in 1996 as a 17-year-old kid. And it's the only job I've ever had is here at O'Reilly. So 26 years this year. Started out sweeping floors and just had the opportunity growing up in Oklahoma after we bought Hi/LO to move down to the Texas market and run on store and be a district manager and all these things that I had the great fortune of, with our with our massive growth over the last couple of decades. But everything at O'Reilly, to Mark's point this morning, starts with our culture.

And I know in a lot of companies, I'm sure there's some type culture that's documented, a banner hanging on the wall. But I can tell you, over the last 25, 26 years, the week that I went to work for O'Reilly back in the summer in 1996, our culture wasn't even really defined. It wasn't on a piece of paper. It wasn't on a culture card. It wasn't on the wall. It was all these things behind me here that I felt as a new team member, that we have for every one of our customers and our team.

When I think about pride, not in a selfish way, but pride in our team, pride in our teamwork, when I think about ownership, passion and intense focus on our fundamentals, Greg and Mark already talked about it a little bit, our business, even though it's not easy, it's really a simple business. It's about giving great customer service, having professional parts people and all these things that so many of you have heard us talk about.

But really, our culture hasn't changed a lot in the last 26 years. A lot's changed, but that hasn't. And I just want to make sure that everybody remembers that when you look through the numbers and you look past even like our industry-leading supply chain and the way we run stores, we absolutely work in a people business that the O'Reilly family really founded those foundational things that we ended up documenting is our culture that, again, to Mark's point, we live each and every day.

At the heart of our culture is promote from within. Somebody like me that didn't even go to college has been very fortunate to grow up with a company that promoted virtually 100% from within, especially in store operations. I had the fortune to grow up in our stores and run districts and regions. And we're extremely proud that really, over the last several decades, we've never had to hire outside the company for our field leadership. Our EVP of stores and professional sales that's in the back room, Doug Bragg. He's on his 31st year at O'Reilly. Started out in the distribution center loading trucks, and then working in stores and selling parts and managing stores and similar story to mine, even before me.”

ORLY’s Long-term Growth Algorithm

Industry Growth (1% unit volume + 2% inflation) = 3% CAGR

ORLY Share Gains: 1% - 2% contribution to annual revenue growth

ORLY Revenue: 4% - 5% CAGR

ORLY Operating Income: 5% - 6% CAGR (operating leverage + increase in higher margin proprietary brands mix)

Share Repurchases: ~5% annual share shrink

EPS Growth: ~10-11% CAGR

Shareholder Return: ~10% CAGR

·  Currently, ORLY’s forward P/E multiple is slightly elevated at ~21.8x vs. ~20.6x (2010-2023 average) so I assume some multiple contraction over time. Since 2010 the forward P/E multiple has ranged from 14x-28x.

Risks: In my opinion, the greatest ones to an investment in ORLY are industry risks—namely, greater adoption of EVs, less miles driven due to more people working from home at least part of the week and possibly over time, mass adoption of full self-driving (FSD) vehicles/robo-taxis.

·  EVs have fewer moving parts than ICE cars. Fewer moving parts means less wear and tear on vehicles and results in less demand for replacement parts. Even parts that are the same on all cars such as brake-pads are not used as frequently in EVs and obviously EVs do not require things like oil changes.

·  Mass adoption of FSD/robo-taxis and/or more work-from-home could lead to fewer accidents and thus less maintenance/replacement of parts.

Important Disclaimers

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT. YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

The provision of this report does not constitute (and should not be construed as) a recommendation, financial promotion, investment advice, encouragement or solicitation to buy, sell, or hold the security of the subject issuer (the “Security”), or any other securities, discussed herein. This report is for informational purposes only. All of the information contained herein is based on publicly available information with respect to the security and the author’s analysis of such information. Past performance is no guarantee, nor is it indicative, of future results.

Certain statements reflect the opinions of the author as of the date written, may be forward-looking and/or based on current expectations, projections, and/or information currently available. The author cannot assure future results and disclaims any obligation to update or alter any statistical data and/or references thereto, as well as any forward-looking statements, whether as a result of new information, future events, or otherwise. Such statements/information may not be accurate over the long-term. The views are those of the author acting in his individual capacity and not as a representative of the firm.  The author’s opinions on this Security may change at any time in the future and the author will not, and disclaims any obligation to, update this report to reflect any change in opinion. The author further disclaims any obligation to respond to any comments or questions posted regarding the Security discussed herin.

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Catalyst

A restructuring from AAP could speed up share gains by ORLY.