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Today I wanted to discuss a company that I think has a clear differentiating factor versus the rest of its peers: O’Reilly Auto Parts (ORLY). And I think it stems from one simple ingredient: a variable compensation system. This one little difference I think changes the competitive dynamics of O’Reilly versus anyone else in the industry. And while it sounds simple, it was hardly an easy task to accomplish.

You have to understand that in the auto parts distribution business you have two distinct models: 1) the retail, or “do-it-yourself” [DIY] business, and 2) the commercial (professional repair shop) business. These customers are very different, and have in the past required two distinct business models. On the retail end, people like you and I walk off the street (maybe a few times a year) and are looking for a part. We hardly remember the person we dealt with, and chances are (unless he/she was really cute) are unlikely to remember the person we dealt with. Instead, our decision on where we go first, usually depends on the “relationship” or perception we have of the store, not the people within the store.

Companies like Advance (AAP) and AutoZone (AZO) have done a really good job catering to the retail/DIY crowd. Offering things like convenient location, a good price, an aesthetically pleasing store format, and other attributes typical of successful retail establishments, where the relationship primarily rests between the store and the customer, not the employee and the customer.

In the commercial (professional repair shop) business, on the other hand, the repair shop really could care less about the previously mentioned issues. Instead of a retail customer that may come in 3x–4x a year, the commercial customer is dealing with a parts distributor on a weekly if not daily basis. They don’t care about what store brand they deal with, they care about the actual person on the other end of that phone line. A person that hopefully they have come to trust over the last several years to get them the right part, when they need it. Oh, and if it is at an affordable price, that is nice too, but for the most part the repair shop is pricing from cost (usually marking it up 2x). So what really matters to the owner of the repair shop is that the part is of high quality, it is the part the shop needs (to do the repair) and the distributor (we call these folks “jobbers”) can get it to the shop in a reasonable time frame.

The dynamics of the commercial market being so relationship-oriented has lent itself incredibly to “independent” jobbers. Entrepreneurs and individual owners that really care about the relationships they develop with these repair shops. As an aside, this is why I am always so perplexed that car dealers seem so focused on developing “repeat and referral” business and relationships on the “front end.” A customer buys a car once every few years. So it seems to me the relationship at the dealership is really built at the service side of the equation. This is why I continue to think dealers should experiment a little with using service repair writers to sell new vehicles.

In any case, if repair shops only care about the relationship with the owner of the “jobber” store, it becomes pretty difficult to scale. This is why companies like Genuine Parts (GPC) have built such a great business distributing to these independently owned jobber stores, like their ~5,000 National Auto Parts Association [NAPA] stores. And so the NAPA stores for the most part have 60% to 70% of their business going to the repair shop (commercial) market. Because their entrepreneurs know how to service the repair shop owner by developing longstanding relationships. And the DIY retailers focus on the “off the street” customer.

O’Reilly, on the other hand, has done something rather different. And this is why you see them with a 50%/50% split between commercial and retail customers. They have designed their store like a retail shop, owning (or leasing) the facility and putting its systems and processes (like being in charge of merchandising) in place. All very similar to Advance and AutoZone. BUT, they pay their store managers on something called “internal controllable profit” [ICP] metrics, and even their store employees are basically paid minimum wage plus commission. In effect, what this does is it allows the store manager to control his/her own destiny with something like nearly half of their compensation determined by the profitability of the store (the parts they can control so things like rent are excluded). Which is another issue I continue to encourage large dealer groups to focus on. Compensation plans should be focused on things the managers can control, not “corporate” issues.

As I have said in the past, this is exactly where I think the large public dealers are headed, taking a relationship driven model (just like O’Reilly) and maintaining the entrepreneurial spirit (allowing the manager to control their own destiny), while at the same time allowing the store manager and personnel to benefit from the economies of scale of things like merchandising, human resource management, accounting, etc. O’Reilly is a living testament that it can be done! And what it has allowed them to do, is in my opinion, nothing short of amazing.

The company has been able to demonstrate consistent double digit square footage growth over the years and mid-single digit comp growth, while at the same time continuing to expand their operating margin. And internal cash flows more than fund this growth (always a good sign of a real ROI). With most retailers it is usually an either/or issue - either growth or better operating margins. But I think the biggest competitive advantage that a variable compensation plan has created for O’Reilly is the ability to move into markets where others can not. And you have to remember that O’Reilly remains about a third the size of AutoZone. Given O’Reilly’s “dual market” strategy of being able to compete in both the commercial and retail side of the market, they are able to go into more rural areas, that maybe would not support a store (jobber) that catered to just one end of the market. Actually chances are, there was an existing jobber in the market that they can buy out (often times even keep the management) and get significant profit leverage due to their superior systems, processes, purchasing power, and ability to also now cater to the DIY market better.

And this makes a world of difference.

ORLY 1-yr chart:

ORLY 1-yr chart

Source: O’Reilly Auto Parts' Dual 'Retail-Commercial' Approach Has Led To Continued Success