O'Reilly and Advance have expanded their store bases through acquisitions and organic growth, enhancing their cost advantages.
O'Reilly Automotive (NASDAQ:ORLY) and Advance Auto Parts (NYSE:AAP) have both rapidly and profitably expanded their store bases through a mix of acquisitions and organic growth, enhancing their cost advantages in the process. These developments have led us to upgrade the economic moat ratings of O’Reilly and Advance to narrow from none. From our view, industry dynamics have become increasingly favorable for the largest auto-parts retailers; including AutoZone (NYSE:AZO) and NAPA [operated by Genuine Parts (NYSE:GPC)], we now think there are four auto-parts retail businesses that have achieved the scale to obtain narrow moats.
Macro conditions have become more favorable for the auto-parts retail market in recent years, but the industry's gains have been highly concentrated on just a few companies. In fact, while each of the narrow-moat retailers has expanded rapidly, the total number of auto-parts retail outlets has remained static over the past decade. Moreover, public disclosures of (formerly) private competitors (General Parts, for example) and other smaller publicly traded companies suggest that competitors are generating much lower profitability levels.
We believe the narrow-moat retailers' gains are structural and reflect the increasing costs to manage the auto-parts category's complexity. Because of increased SKU proliferation and the rising average age of vehicles (to a record high of 11.4 years at the end of 2013), auto-parts retailers must carry an ever-growing breadth of parts. From our perspective, these trends have elevated the importance of the cost advantage moat source, since narrow-moat retailers can leverage their increased purchasing power and superior distribution network to offer much greater availability levels at a lower internal expense, and this divide will only widen over time, in our view. In the long run, we expect that the domestic auto-parts retail market will continue to evolve into an oligopoly, which should result in highly attractive economics for the leading retailers.
O'Reilly and Advance Both Champion the Dual-Market Approach
O'Reilly was an early adopter of the dual-market approach, historically generating a 50/50 mix of sales in the do-it-yourself and commercial/do-it-for-me markets. We believe this strategy presents unique challenges and is generally more capital-intensive than either of the single-market approaches. However, the payoff can be quite high since a successful implementation can strengthen scale by expanding the market opportunity and increase asset productivity by leveraging existing infrastructure.
These advantages became apparent after O'Reilly acquired CSK Auto in 2008, which added more than 1,300 Western stores to its portfolio, catapulted the company's scale, and transformed O'Reilly from an efficient regional retailer to a formidable national one. O'Reilly quickly sought to increase commercial sales at CSK, which represented only 10% of sales at the time of acquisition, by implementing best practices and investing substantial resources in CSK's distribution infrastructure and commercial sales force. The subsequent boom in DIFM sales continues to improve productivity at Western stores and has contributed to more than 500 basis points of margin expansion since 2008.
Advance began as a retailer focused on the "do it yourself" market but transitioned to a dual-market approach to capitalize on the consolidation potential in the fragmented "do it for me" market. This approach has generated strong results, as Advance has annualized 17% DIFM sales growth over the past decade, raising its DIFM sales mix from 15% to over 40% (55% including the General Parts merger). Advance achieved productivity gains since it could build on top of its retail infrastructure and has accelerated the rollout of its new DIFM-centric concept store, which targets a 70/30 DIFM-DIY sales mix.
Advance's comparable sales have stumbled in recent quarters, though, as it struggled with its transition from a DIY to a dual-market retailer as DIY sales productivity has faltered, while rolling out DIFM concept stores in its core markets. Advance has also built up its commercial inventory inefficiently in its haste, in our view, and is testing the limits of its hub-centric distribution strategy. However, we continue to think that Advance can remedy these issues as it gains experience and optimizes its infrastructure for the dual market. In the long run, we expect Advance can reaccelerate its growth in the DIFM market, due to its robust cost advantages over smaller competitors. However, we believe O'Reilly holds a considerable lead over Advance thanks to its expertise, customer relationships, and extensive infrastructure lead. Competitors are still figuring out the workings of the business and are experimenting with less capital-intensive strategies (such as eschewing distribution centers for hubs) to circumvent the significant capital expenditures O'Reilly has already made.
O'Reilly's Fair Value Estimate Is $140 per Share
After increasing our moat rating to narrow, we raised our fair value estimate for O'Reilly to $140 from $125, as we have adopted more favorable long-term return on incremental capital assumptions. We are maintaining our long-term debt/capital target at 20%, reflecting our view that O'Reilly can take on more leverage in the future (beyond what it has added over the past year) and are keeping O'Reilly's weighted average cost of capital at 8.6%. Our fair value estimate implies calendar 2014 price/earnings of 20 times, enterprise value/EBITDA of 10 times, and a free cash flow yield of approximately 5%.
Over the next five years, we project that revenue will grow more than 7% annually, driven by same-store sales growth over 4% and the net addition of approximately 200 new stores per year. During this time, we believe O'Reilly's primary growth drivers will be improved productivity at CSK stores and accelerated store expansion in the Western and Northeastern U.S. Over the next decade, we project O'Reilly will average 7% annual revenue growth as it adds almost 1,900 stores to its domestic store base (to more than 6,000 total stores).
O'Reilly's operating margins have increased about 550 basis points to 16.6% over the past five years, thanks to nearly 500 basis points of gross margin expansion (to 50.7%). Some of the lowest-hanging fruit (for example, lower procurement costs from increased scale) has already been leveraged, but we expect operating margins will continue to rise as a result of increased scale efficiencies and improved commercial productivity at CSK outlets.
Advance's Fair Value Estimate Is $130 per Share
After raising our moat rating to narrow, we increased Advance Auto Parts' fair value estimate to $130 per share from $115, as we have adopted more favorable long-term return on incremental capital assumptions. Our updated valuation represents a forward fiscal 2014 price/earnings ratio of 18 times, an enterprise value/EBITDA of 9 times, and a free cash flow yield of 4%.
Advance remains vulnerable to numerous integration risks, since General Parts' Carquest and Worldpac businesses do not overlap as directly with Advance’s core business as previous mergers in the sector. However, we remain optimistic that Advance can drive significant cost and productivity synergies from the integration. The acquisition will help Advance saturate some of its existing markets, but should also accelerate its expansion into untapped markets, such as the West Coast. We project store expansion will temporarily slow as Advance digests the General Parts acquisition, but still expect the firm will average 150 net new store openings annually over the next decade.
Cost Advantages and Intangible Assets Point to Narrow Moats
We have raised O'Reilly's economic moat rating to narrow from none because of improved cost advantages and the strength of the firm’s intangible assets. The company was one of the primary innovators of the dual-market approach and has leveraged this strategy to gain significant share in the auto-parts retail sector.
We have also raised Advance Auto Parts' moat rating to narrow from none, since we expect the acquisition of General Parts to further solidify the company’s scale-endowed cost advantages and intangible assets. Pro-forma for the GPI acquisition, Advance generated the highest sales and operated the largest store footprint, among any of its domestic peers in 2013.
Pricing is relatively stable in the auto-parts aftermarket, since most consumers are relatively price inelastic regarding their auto-parts purchases and care more about the retailer’s parts availability, convenience, and service offerings. These dynamics limit the efficacy of price competition, so mass merchants and e-commerce retailers have struggled to capture share beyond the industry’s most price-sensitive consumers.
Inventory availability drives productivity in the auto-parts retail sector, so specialty retailers locally stock tens of thousands of slow-moving SKUs, contributing to some of the retail industry’s lowest inventory turns. However, large industry players can offset much of this cost by negotiating significantly lower product acquisition expenses and more favorable payment terms from vendors. For instance, though O’Reilly’s inventory only turned 1.4 times in 2013, the company mitigated the working capital burden by achieving an 87% accounts payable/inventory ratio and earned gross margins exceeding 50%. By reducing these costs, O’Reilly can economically invest in more inventory than smaller peers and drive increased traffic through greater availability.
Likewise, though Advance’s inventory only turned 1.3 times in 2013, the company offset the working capital burden by achieving an 85% accounts payable to inventory ratio and earned gross margins approaching 50%. The acquisition of General Parts should further augment Advance’s purchasing power and enable it to negotiate even more favorable terms from vendors. These factors should help Advance provide greater availability at a lower cost and should drive continued share gains.
Both firms' distribution capabilities have also reduced the cost of providing greater availability, as they are able to shift inventory more efficiently to their most productive locations. Auto-parts retailers carry few duplicate SKUs to maximize overall breadth, so each distribution point must interact with each other frequently to minimize SKU count depletion.
By the end of 2014, we expect that O'Reilly will operate 26 distribution centers, 240 hub stores, and over 4,000 retail locations. These investments enable O’Reilly to deliver industry-leading availability to its customers, as the firm’s distribution centers and hubs are able to deliver SKUs and replenish local inventory every day (multiple times per day in some urban locations). Auto-parts retailers carry few duplicate parts to maximize overall availability, and the increased rate of replenishment enables O’Reilly to carry even greater inventory breadth.
Advance’s distribution build-out includes 10 distribution centers, 19 Parts Delivered Quickly warehouses (nine of which are located in the distribution centers), 363 hubs, and over 4,000 stores; the acquisition of General Parts will add 2,600 stores (including 1,400 franchisees), over 100 Worldpac warehouses, and 38 smaller, more manual distribution centers.
In addition to delivering hard parts, O'Reilly and Advance also provide ancillary services to independent repair shops to increase customer loyalty, including free electronic parts and repair catalogs (which doubles as an online ordering platform), knowledgeable sales associates, and quick delivery of maintenance and service tools. Both firms can leverage their connections with customers to push their own in-house brands (representing 30% of sales for each firm).
Both O'Reilly and Advance have been assigned a positive mat trend, since they both should continue to benefit from the commercial auto-parts retail market's consolidation. O’Reilly was one of the early innovators of the balanced dual-market approach and still benefits from an infrastructure and commercial expertise lead over many of its peers, assisting its rapid share gains. Large competitors, including Advance, are beginning to adopt many elements of O'Reilly's approach, so we think the relative advantage over large peers will narrow over time. However, O'Reilly has accumulated significant scale-endowed cost advantages in the process and should continue to enhance its competitive advantages by capturing share from subscale competitors. And though Advance has experienced numerous growing pains as it has rapidly increased commercial sales and transitioned toward the dual-market approach, we believe the firm is well-equipped to iron out these inefficiencies over time, as management leverages General Parts' reputation and expertise in the commercial market. More importantly, Advance's scale-endowed cost advantages should continue to drive organic consolidation gains.
O'Reilly's Management Sets the Example
We assign O'Reilly an Exemplary stewardship rating. Through a series of well-executed acquisitions, management has transformed the company from a regional entity into a top-three national player. We believe management has proved itself to be highly adept, as it has been very successful at extracting synergies and increasing the productivity of its acquisition targets. As a result, we think O'Reilly has established itself as one of the most efficient commercial auto-parts retailers and is poised to be one of the main beneficiaries of industry consolidation trends. The majority of the executive staff has decades of experience working at O'Reilly, which gives us greater confidence that management will execute on its strategic initiatives.
Gregory L. Henslee became CEO and co-president in 2005 and is the first non-O'Reilly family member to hold the CEO position. Henslee started as a parts specialist at O'Reilly 25 years ago and had a variety of internal leadership roles before adopting his current position. We like that the CEO and chairman roles are split. Since the O'Reilly family continues to hold more than $100 million in O'Reilly equity, we think this third-party oversight will prevent egregious abuses by management. However, we are concerned about the family's extensive influence. The board consists of four O'Reilly family members, and the firm leases a few stores from the family. In addition, the company's bylaws employ a staggered board and poison pills, limiting minority shareholders' voice. As a result, the O'Reilly family's incentives may not entirely be aligned with shareholders', although we have not seen any significant abuses.
Advance's Management Shows Promise as It Tries to Close the Gap
We have assigned Advance Auto Parts' management team a Standard stewardship rating. Darren Jackson took over as CEO of the firm in 2009 and had previously served as the company's president (since 2008) and director (since 2004). Before he joined Advance, Jackson was the executive vice president of Customer Operating Groups at Best Buy, and he recruited several executives from his old firm to join him at Advance, including, but not limited to, Michael Norona, the current CFO and executive vice president, and George Sherman, the president. In fact, the current executive team is largely composed of members who joined after 2008 and were recruited by Jackson; while the majority of these executives have retail experience, few members had directly worked in the auto-parts retail industry. In contrast, the majority of AutoZone and O'Reilly's executive teams have served at their respective companies for over a decade. Consequently, we think Advance's management team, while sharp, is still ramping up the learning curve, a factor that may have contributed to some of the firm's recent operational missteps.
In our view, outperformance in the auto-parts retail industry depends largely on the company's efficient scale and management's ability to consistently execute and improve distribution efficiency. Since there is no need to reinvent the wheel, we think Advance can reduce the profitability gap between the firm and its larger peers by observing and adopting its rivals' best practices. Several of the recent initiatives, including, but not limited to, the insourcing of the commercial credit program, smaller commercial-oriented stores, and the adoption of a traditional hub and distribution center model (and the concurrent move away from PDQ warehouses) seem to take a page directly from O'Reilly's playbook. We remain optimistic that should Advance remain a stand-alone entity, management will continue to narrow the gap between itself and the other large industry participants.
Executive compensation is slightly higher than the peer average, but compensation practices seem reasonable, in our view. We are pleased that management's performance is measured using economic profit-added metrics, and roughly two thirds of compensation is tied to long-term incentive compensation. We like that the chairman and CEO positions are split, as we think it should help prevent potential conflicts of interest. Advance has a good track record of curbing repurchases when shares are pricey, and aggressively increasing repurchases when shares are weak. Although we typically avoid reading too much into any company's share repurchase activity, we would follow Advance's share repurchase initiatives, since we think it provides a greater signal into management's confidence on the company's operating performance.