AGB 2021.18 - O'Reilly Automotive (ORLY)
Industry Tailwinds + Superior Execution
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O’Reilly is the second largest auto parts retailer by revenues and largest by market cap in North America. Products include hard parts, batteries, brakes, tools, supplies and accessories. The company sells to both professional or DIFM (Do it for Me) customers as well as retail or DIY (Do it Yourself) customers. The revenue breakdown from these groups in FY20 was 41%/59%.
O’Reilly’s core competency is its distribution network. Through its 29 distribution centers (DCs), >350 hub stores and 5,732 total stores (as of June 2021), the company can provide quick access to 22k SKUs in store and same day access to over 159k SKUs from the DC. O’Reilly’s tiered distribution network allows deliveries 5 days per week to the stores and 90% of the stores receive multiple deliveries per day. The quicker moving parts are available at the store while the slower moving parts (and usually larger in size and value) are stocked at a DC.
O’Reilly operates a dual market strategy of targeting both DIFM and DIY customers, but the company’s roots are in serving DIFM customers. A typical DIFM customer is a technician at an independent repair shop that is servicing a car that is usually 6-11 years old. These cars have just come off the manufacturers warranty. The repair technicians usually charge their customers based on predetermined hours of labor, even if they end up finishing the job in fewer hours. And because cars take up space in a shop, the quicker the technicians can finish a job, the quicker that space is freed up for the next job.
This is why parts availability (and reliability) is the most important thing that can be offered to DIFM customer as an auto parts retailer. Price is secondary because labor is a larger part of the end customer’s bill and the repair shop usually charges a mark-up on the price of the parts anyway. When the technician needs a part to complete a job, they start going down a call list of the different auto parts stores to find out product availability and pricing. O’Reilly aims to be at the top of each list but there is no way of knowing if that’s being achieved other than sales numbers relative to the peers in an area. The company has 765 full-time sales staff whose only job is to call on and service these DIFM customers.
DIY customers usually have older cars in the 12-15 years old range. These customers typically skew towards lower income, are willing to work on their own cars (to save on labor costs) and don’t have another car that they can drive. O’Reilly competes for these customers based on product availability and competitive pricing (as with most retail) but also on customer service and knowledge. These customers typically want help when buying more complex parts for their cars vs. something like supplies for an oil change.
O’Reilly competes with the other auto parts retailers in each region that the company has a store presence. Even as the largest auto parts chains have outgrown and consolidated the market, both the DIFM and the DIY markets are fragmented. Over 75% of the DIFM market and 65% of the DIY market are not commanded by the large public company players.
The large four public companies are AutoZone, Advanced Auto Parts, O’Reilly and Genuine Parts (Napa Auto). Each has a different approach to servicing the DIFM and DIY customer base but AutoZone and O’Reilly have been market share gainers over the past 10 years while Advanced Auto and Genuine have lost market share. AutoZone is more focused on DIY vs. DIFM, but the company has made strides to grow in DIFM recently. Advanced Auto and Genuine are more geared towards DIFM, but due to limited distribution capabilities (compared to O’Reilly) have not done as well.
O’Reilly has increased its store count by 170-210 annually over the eight prior years to 2020. The company methodically opens new stores in locations where O’Reilly can leverage its existing distribution capabilities. The top markets for the company are Texas and California, followed Georgia, Missouri, Florida, Illinois and Ohio. O’Reilly hasn’t made a large acquisition since the CSK acquisition in 2008 (1,342 stores). Instead the company has acquired regional players like VIP Auto in 2012 (56 stores), Bond in 2016 (48 stores) and Bennett in 2019 (33 stores).
And with the increase in store locations, efficiency gains were also achieved. O’Reilly’s sales/sq ft has increased by 28% over the past 10 years while store size has remained steady due to same store sales increases that averaged over 5% annually over that time period.
Why is it a good business?
Large auto parts retailers benefit from scale advantages and brand recognition. At the local level, increased store density means that product distribution can done at more cost advantaged ways. At the national level, scale results in better positioning when negotiating with suppliers. Furthermore, the company can market through national advertising, resulting in much better and lower customer acquisition costs (as we’ve seen with Five Below and Tractor Supply).
Specific to O’Reilly, the company has been able to negotiate better terms with suppliers as the company has gotten larger. The company has been able to receive price concessions, volume purchasing rebates and get help with co-advertising from its suppliers. O’Reilly also launched a vendor financing program in 2011, which has allowed the company to reduce supply chain costs and extend payment terms. This has resulted in O’Reilly reducing working capital required to run the business from 11.5% of sales in FY11 to -10.6% in FY20. O’Reilly likes to report the company’s accounts payables/inventory ratio which has followed a similar trend (inverse), increasing from 64.4% in FY11 to 114.5% in FY20.
The company has also been able to increase its private label brand penetration as the company has grown in scale. It’s estimated that in 2007 private label accounted for 25% of revenues and now accounts for almost 50%. Recently, the company’s private label brands have moved up the value chain. Initially, the private label brands were a value-based offering, appealing to DIY customers that wanted to save money. But the company now also offers may brands that DIFM customers buy in the mid to premium tier.
Auto parts retailers are benefiting from industry tailwinds. Cars now have longer lifespans due to better engineered and manufactured vehicles, which results an increase in the average age of the vehicle population. A higher average age means a larger percentage of miles driven is by a car that is out of a manufacturer’s warranty period, when customers turn to repair shops or elect to do a fix themselves.
Another tailwind for auto parts retailers is that Seasonally Adjusted Annual Rate (SAAR) for new car sales in the U.S. have remained above 16M since 2014. The positive impact from this is usually a 6-9 year lag for the DIFM segment and a 9-12 year lag for DIY. RBC analyzed the vehicle count for 6-9 year old cars in the U.S. by year and 2017 was the trough (due to the low SAAR from 2008-2011). The DIFM segment should benefit from more 6-9 year old cars being on the road for a the next few years.
Auto parts retail also has limited threats from eCommerce, which skews towards accessories and supplies like motor oil. This is due to the immediate need for most car parts. We’ve already discussed how product availability benefits DIFM customers. Parts are the smaller cost component of a job and faster project completions lead to more revenues and profitability for the repair shop. DIY customers are more price sensitive and would be willing to wait for a better price. But we have to remember that DIY customers usually don’t have another car to use at home.
Amazon launched its auto parts store in 2006 and has been improving its offering by partnering with retailers. Most of the items purchased through Amazon are not hard parts but are more like tires, batteries and accessories. Amazon partnered with Sears to allow tire installations for customers who purchase tires through Amazon and later partnered with Pep Boys under a similar offering.
Returns on incremental capital?
Over the past 10 years, O’Reilly has spent 95% of its capital on capex related to new store openings, store renovations and relocations, technology investments and distribution center builds and improvements. The company has spent the remainder of its capital on acquisitions, which has been light compared to the company’s previous decade.
New store builds are typically done in clusters around geographies that leverage the existing distribution network. By opening many stores at same time, the company can leverage initial marketing and advertising costs across more stores and can keep preopening/distribution costs lower than opening just one store at a time. Five Below, another retailer that has rapid store expansion strategy, has a similar opening strategy when entering new markets. After the initial cluster has been formed, the company can then easily fill out the remainder of the region depending on the needs and opportunities available in that market.
Because O’Reilly’s strategy caters to both DIFM and DIY customers, the company can still meet its return hurdle in less densely populated markets. The company can also change the inventory at each store depending on the needs of the market. O’Reilly has mentioned that some markets are mostly DIFM, so those stores are stocked 90%/10% catering to DIFM. Others have 20%/80% in heavy DIY markets. This comes in handy during economic downturns as many consumers who would have bought a new car elect to purchase a used car, which requires repairs and maintenance. And customers of DIFM customers trade down to DIY as well.
In terms of unit economics, it costs $1.5M-$1.8M to build a new store and this number is lower if the store is leased vs. bought. We know that the average store does $2.05M in revenues and the firm wide EBITDA margin is 23.6%. If we assume that the 1 year productivity rate for a new store is roughly 65%, we get to revenues of $1.33M. If we apply at EBITDA margin of 20% for the 1st year and then ramp up over time to above the corporate average of 23.6% (remember that this is store level EBITDA), we get to ~$290k store level contribution in the 1st year and then up to ~$500k at maturity. This puts the return on investment between 16%-31% returns for a new store as it reaches maturity.
On the acquisition front, the company hasn’t made any meaningful deals in the past decade. The last transformational acquisition was of CSK Auto in 2008. At the time of acquisition, CSK was almost 3/4 the size of O’Reilly by store count. The company paid $1B for the equity of CSK, $11 in O’Reilly stock and $1 in cash per CSK share. CSK expanded O’Reilly’s footprint into the western and mountain states in the U.S. The combined company was able to achieve significant cost synergies related to purchasing power, leverage SG&A costs, and allowed the company to take advantage of national advertising opportunities. Furthermore, O’Reilly was able to implement its superior distribution and sales processes to the CSK assets.
We estimate that O’Reilly has generated returns on incremental capital between 20%-30% over the past 5 years prior to FY20. Remember that while the company did experience a slowdown in FY20Q2 due to Covid related lockdown measures, the DIY segment really flourished after the fiscal stimulus checks. Returns in FY20 was much higher than a normal year would be for O’Reilly.
O’Reilly still has ample opportunity to expand its footprint and grow into its TAM. The company estimates that of the $290B+ automotive aftermarket market, O’Reilly addresses $90B-$100B of that opportunity. This is because the company doesn’t do any service work or sells/installs tires. The company addresses just the auto parts and DIY sales portion of the market. The company generated $11.6B in revenues in FY20, implying a 12% penetration rate.
In terms of stores, there are 37k+ auto parts stores in the U.S. with the top 10 retailers commanding more than 50% market share, most of which are the top 4 public companies that have a combined 18k locations. The company estimates that the DIFM segment is more fragmented than the DIY (AutoZone leads in this area, O’Reilly is 2nd). O’Reilly’s 5.7k locations are just behind AutoZone’s 6.7k.
O’Reilly has stated that the company has identified 6.5k total potential locations (up from 6k a few years back) given its current distribution network. Geographic regions in the U.S. where O’Reilly has more room to grow are in the Northeast and the Atlantic coast. Since the company opens between 170-210 stores per year (167-175 slated for FY21), this would imply that the company would reach that ceiling in 4 years. It’s anticipated that the company will look to expand more internationally, with North America being a priority, to continue to keep its reinvestment rate high.
With a reinvestment rate between 30%-35% and a return on incremental capital between 20%-30%, we estimate that O’Reilly has increased its intrinsic value between 7%-9% over the past 5 years. That may be on the low-end of the companies that we’ve analyzed in AGB, but the consistency of the returns and intrinsic value growth are impressive. We’d also like the point out the returns look better in recent years (not just FY20) as the company continues to implement operational improvements at the store level by leveraging its scale.
If O’Reilly were able to reinvest more of its capital through meaningful M&A (like it did in the past with CSK or with many smaller acquisitions in a short time period), the growth in value would look even better. The company instead has elected to spend most of its FCF on share repurchases, resulting in share count reductions between 5%-11% of the company annually over the past 10 years. Cumulatively this has resulted in share count reduction of 48% during that time period, which is one of the reasons that the stock price performance has been much greater than the intrinsic value growth of the company.
What else is important?
What happened in 2016/2017?
FY16 and FY17 were tough years for O’Reilly and the industry as many of the top companies experienced same store sales growth deceleration from the high levels of 2015. There are many explanations for this: (1) Two consecutive mild winters in 2015 and 2016. Cold weather leads to more breakage in key auto parts. (2) Slowdown in markets with larger Hispanic populations. These regions skew towards DIY. (3) Fallout from the energy market crash and economies around those regions with heavy exposure. (4) A dip in the number of vehicles coming off of warranty from the drop in new car sales in 2008-2011.
For O’Reilly specifically, the last two reasons are likely the biggest drivers of what happened in FY16 and FY17. The DIFM business was impacted more due to the lower number of 6-9 year old cars on the road. AutoZone also felt similar trends, even though they have a much lower exposure to DIFM. That company’s same store sales growth went from 3.8% in FY15 to 0.5% in FY17 while O’Reilly’s went from 7.5% to 1.4%.
O’Reilly also has larger exposure to stores in oil producing states (19% as of 2018) with its high concentration in Texas. AutoZone was at 14% and Advanced Auto was only at 9%.
Shift to EV
The move from ICE to EV cars is something to be mindful of when investing in auto supply chain companies. However, as mentioned in our write-up for Alimentation Couche-Tard, the move from ICE to EV is still in the early innings. The number of EV vehicles in the 6-9 year old age range is still minuscule and won’t likely reach meaningful penetration well into the 2040s.
Furthermore, the jury is still out on whether EV cars will require fewer dollars for repairs over the total lifespan of the vehicle compared to ICE cars. The trend towards longer lasting cars is already underway and what the company has experienced is that the parts may last longer, but they are more expensive to repair. Similarly for EVs, there are fewer moving parts and may fail less (this is to be determined) but the high cost and complexity of these cars could lead to similar economics for professional repair shops, or DIFM customers.
The largest upside option is meaningful M&A. This would boost the reinvestment rate and allow O’Reilly to apply its superior operating process to a lower performing asset (presumably since O’Reilly is considered to be best in the industry).
Outside of M&A is geographical expansion. The company has stated that it would like to expand in North America in a meaningful way in the future. Mexico and Canada have similar car populations and there is an opportunity for O’Reilly to implement its business model in both countries. The company has even talked about expanding to other countries within North America like the Caribbean Islands.
O’Reilly has already made its acquisition to enter the Mexican market in 2019. Mayasa was acquired for almost ~$140M. The company had 6 DCs and 21 stores, which served over 2k DIFM customers in 28 Mexican States. The acquired business had lower gross margins, due to its heavy exposure to DIFM (usually lower margins than DIY due to negotiating power).
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Great write up my friend!
On Bonhoffer last letter there is an interesting study on Ausbury, it looks like it is a very good option and probably a target.