Dorman Products (DORM) has tremendously benefited from the average age of cars in the U.S. increasing to an all-time high of 11 years post-recession, well above the historical average of around 8 years. However, this extension is likely to reverse over the coming quarters as more consumers replace old cars. Edmunds.com predicts new car sales will increase 4% in 2013 and used car sales will soften during the period, even with lower used car prices from waning demand. Also of note, scrappage of used cars has increased by 20% between 2010 and 2011, further showing that the replacement of used cars is picking up in the U.S.. DORM's stock price was trading below $5 during 2008 and has seen a phenomenal rise to its 52 week high above $38, but the reality is that the good times for the used car parts market are behind us and DORM's stock price will soon be returning back to earth. I have a $25-$26 price target on the stock over the next year.
Recent Industry Trends:
DORM just reported Q4 earnings of $135 million, down 3% from 2011 and EPS was $.42, down 5% from 2011. This missed The Street's expectations of $158 million in revenue and EPS of $.52. DORM still had double digit growth for the year, but its flat Q4 earnings are in line with what the rest of the used auto parts industry is seeing. Since DORM's stock has been far outpacing the rest of the industry, I think it is time for it to give back some of those excess gains.
(click to enlarge)
DORM's largest customers have seen flat to negative sales growth over recent quarters and their stock prices already reflect the industry slow down. Same store retail sales at Pep Boys Manny, Moe & Jack (PBY) declined 5.6% year-over-year in Q3 2012 and the company held back 8% of planned capital expenditures due to softening auto part sales. PBY's payables to inventory increased 11% due to looser credit terms with its suppliers and a buildup of inventory. AutoZone's (AZO) same store sales were up .2% year-over-year in Q3 2012 versus the prior year increase of 4.6%. AZO began to shift its focus to international expansion in Latin America and Europe in 2012 due in part to the weakening of the U.S. market. AZO also built up inventory levels, but indicated that slower sales will warrant a pull back to historical inventory levels. Same store sale at Advance Auto Parts (AAP) declined 1.9% year-over-year in Q4 2012 versus the prior year increase of 2.9%. AAP announced in November 2012 that it is seeking a buyer to help the company weather operational issues and the slowing auto parts market.
Of additional note, approximately 80% of DORM's accounts receivable are concentrated with 5 customers, including PBY, AZO, and AAP. Since 2009, DORM's accounts receivable have been rising dramatically due to loosened credit terms with certain customers, coming at the customer's request. Accounts receivable sales, which DORM periodically does to generate cash flows, have grown from $55M in 2009 to $235M in just the first 9 months of 2012. This represents an increase of 321% over the period while sales were only up 55%. Receivables, adjusted to account for accounts receivable sold, have increased to 64% of sales from a historical average of 37% of sales (this is a rough estimate as it is difficult to project the timing for receivables sold). If its customers continue to have growth issues, receivable sales could be more expensive for DORM and could eat away at its margins going forward. This is not necessarily an imminent threat for DORM, but it is a trend to keep in mind as the used car part industry peaks in the U.S.
Correlation Between New Car Sales and Stock price:
An interesting metric to look at for DORM is the correlation between DORM's stock price and the average TTM new car sales in the U.S. This correlation has historically been negative when looking at pre-2008 periods. Increasing new car sales mean fewer used cars on the road as well as a lower average age of all cars on the road. Between January 2004 and December 2007, the correlation between DORM's stock's price and average TTM new car sales was -.41. The average TTM new car sales ranged between 1.325 million and 1.450 million per month during the period of January 2004 and December 2007 with a low of 1.060 million and a peak of 1.802 million sales on any single month.
Recently, the correlation between DORM's stock price and the average TTM new car sales in the U.S. post-recession have been highly positively correlated. This is not unexpected because new car sales plummeted starting in 2008 and have had a long road to recovery. Between January 2009 and December 2012, the correlation between DORM's stock price and average TTM new car sales was .86. The average TTM new car sales ranged between .850M and 1.200M per month during the period of January 2009 and December 2012 with a low of .654M and a peak of 1.400M sales on any single month. During 2012, the average monthly new car sales totaled 1.203M.
The current highly positive correlation is significant as new car sales approach historical levels. The 2012 average sales of 1.2 million new cars are only slightly below the 1.33-1.45 million historical ranges. Further, the peak of 1.4 million is squarely in the middle of the historical highs for any given month. I believe that when average TTM sales in the U.S. meet and exceed the historical range pre-2008, then the correlation between DORM's stock price and new car sales should again become negative. Continued economic recovery in the U.S. is crucial to see the 4% or better new car sales growth projected by Edmunds.com, but expect a reversal in the correlation between DORM's stock price and new car sales if new car sales growth remains strong.
Other Items of Note:
It is also interesting to look at the insider stock sales of the past twelve months. Over the past 12 months, a total of 687k shares have been sold by insiders. There were 95 sale transactions and only 1 buy transaction over the period. With the stock price well above the historical range of $2-$7 pre-recession, management has taken the opportunity to lock in gains at all time high stock valuations. Some 33% of the company is owned by the founding family and its affiliates and they have sold approximately 2% of their holdings over the past 12 months. Additionally, DORM paid a special dividend of $1.50 in late 2012, although it does not regularly pay dividend, as a way for its insiders to extract more cash from the company. The significant amount of selling versus buying does not look good for the stock price and could be a further indication that a greater pull back is warranted.
DORM's sales growth has had double digit expansion post recession, which is well above historical growth in the low single digits. The trends in new car purchases and the softening sales of used cars indicate that sales growth should trail off in the coming years. When creating a DCF model for the company, I assumed sales growth would decline from around 10% in 2013 to 4% by 2017. DORM also has had significant operating margin expansion from a historical average of 8% to a high of 17% in 2012. Margin expansion has recently tracked sales growth; however, DORM has been adding a ton of new products and increasing expense as well, such that as revenue growth slows, margins should compress toward historical averages. I assumed margins would decline to 11% over the next 5 years and remain at that level going forward. Based on those two main assumptions in my DCF, I calculated a value of $25.50 for DORM.
Additionally, DORM currently has some of the highest multiples in the auto parts industry. DORM multiples are at all time highs due to its above industry revenue growth. DORM had double digit revenue growth in 2012 versus less than 8% for the industry. Based on similar assumptions to those used in the DCF, revenue growth and margins should compress in the coming quarters and should bring DORM's multiples more in line with the industry. Assuming DORM's EV/Revenue multiple falls to within 1 standard deviation of industry averages, then this implies a valuation for DORM of $24.75. Assuming the same for EV/EBITDA multiple, then this implies a value of $29.00.
Under the above valuation metrics, DORM is well overvalued at its current price and this is way I have a $25-$26 price target on the stock over the next year.
I cannot predict exactly when the average age of cars in the U.S. will peak, but all signs are pointing to the peak being near (if not already here). When this does occur, I expect DORM and many others in the used car part industry to see significant weakness. These stocks have had a great run post-recession, but it is time for the new car industry to have its run and stocks like DORM should be sold (or shorted) to the scrap yard.