Feeling Bullish On Monro Muffler, Though Questions Remain

| About: Monro Muffler (MNRO)
As I indicated Tuesday, Monro reported pretty solid (record) 3Q results, with earnings per share (eps) up 19%. I’ve raised my fiscal 2007 fourth quarter (so for the time period December 24, 2006 to March 25, 2007) eps estimate to $0.38 (from $0.37). “The trend is your friend” (a method I often point out analysts use), and given the operating improvement trends (and prospects for improved sales in fiscal 2008) I’ve also raised my fiscal 2008 (March 2007 until March 2008) eps estimate to $1.92 from $1.81. My 2012 eps estimate remains unchanged at $2.83.

I’ll update the snapshot section on the current website, and when the new website is launched (hopefully this week, we’re just working through a few last kinks), you should also be able to pull up an excel model.

Why did I raise my fiscal 2008 estimates? Basically because management said so, but also because I think the trends (as mentioned above) are pretty favorable. Remember how I talked about the real way analysts (actually more likely their juniors) come up with the figures? I said we basically input the historical figures and then trend out the earnings growth and profitability metrics over the next year or two (or in my case all the way to 2012). But management likely has a better handle on what their budget is going to look like in the coming year (new project investments, staff hirings, etc.), so we tend to default to their “guidance.”

Every once in a while if management guidance is based on something that we thoroughly disagree with, we deviate (i.e. management says they are expecting 10%+ same-store sales growth in the coming year and the analyst is expecting an industry- wide downturn). But for the most part management guidance plus or minus a penny or two is really how analysts determine their estimates.

So in the case of Monro, while management does not plan to provide formal fiscal 2008 guidance until sometime prior to reporting their 4Q results in May, they sure hinted (on the conference call) at where the guidance was likely headed. Monro’s CEO Rob Gross brought up on the conference call that the company was likely to benefit from $0.10+ accretion from the Pro Care acquisition in fiscal 2008, they would not have an $0.11 charge (like they did in fiscal 2007) with the Strauss write off, and that they think same-store sales (adjusted for equivalent days) will likely be up 3% to 5%.

Mr. Gross, also pointed out that while they were encouraged with the performance in December and January (where same-store sales had moved up to the “high single digit range” by the first three weeks of January), certain headwinds remained. Specifically, Mr. Gross pointed out raw material costs continued to rise (which I find interesting and indicative of the “stickiness” of manufacturer and jobber pricing as crude oil prices have moved down), and that the company will not benefit from the extra selling week in fiscal 2008 (like they will benefit in the quarter they are currently in.) But (and here’s the kicker), Mr. Gross stated:

We see nothing at this time both with the acquisition pipeline and our business model that would preclude us from achieving our previously stated goals of 15% top line and 15% bottom line growth.

Ding! Ding! Ding! We have a winner. The second an analyst has a growth or trend target (like 15%), now all of a sudden we have a general direction of where our bottom line eps numbers should head. And so if you look at my $1.92 eps estimate, it is conveniently ~15% higher than what I forecast the company will earn in fiscal 2007.

I suspect most figures as they are published in the analyst community will move in the $1.90 to $1.95 range. Although I should point out that since Mr. Gross mentioned not having the Strauss charge, does the 15% start from fiscal 2007 earnings before or after the Strauss charge? Remember most analyst estimates (for fiscal 2007) of ~$1.67 (at least that is what I am forecasting), excludes the $1.7 million after tax charge the company incurred in the second quarter as they walked from acquiring bankrupt Strauss.

I left a message with the company’s CFO, Cathy D’Amico about the store count, and if I hear back from her I will raise this question as well and get back to you. But from my vantage point, I think easy same-store sales comparisons as well as a potential acquisition makes the prospects of 15% earnings growth (even excluding the Strauss charge) possible. Between now and May (or possibly earlier depending on when management decides to give formal fiscal 2008 guidance) I suspect the eps guidance figure will depend on two critical factors: 1) same-store sales trends (which I think should bode well as the industry environment stabilizes), and 2) acquisition announcements (which I think will prove the wildcard).

First, regarding the same-store sales trends. As I have stated, I continue to believe the demand for hard parts remains in decline. But things are likely stabilizing, and this is causing serious benefits for Monro (that has been gaining share). Even listening to CEO Rob Gross talk about the results, one thing you should have noticed was that he mentioned (as he does almost every call) that they raise prices by about 3% (to help offset rising raw material costs) every 6 months. Since the price increases are to offset higher raw material costs it doesn’t do much for the gross profit margin (although I think vendor rebates from growth in the company’s store count does afford margin expansion), what do you think this suggests about unit demand?

Think about it. . . Monro’s same-store sales were up only 1.1% in the fiscal second quarter, and down 2.9% in the first quarter (and these are based on selling prices). If prices are being raised by ~3%, it suggests underlying unit demand is in decline. Now I think most people share the same opinion as myself that through this most recent downturn Monro has likely been gaining market share from smaller “mom and pop” repair shops, many of whom are exiting the market. And on top of that, even the published Automotive Aftermarket Industry Association [AAIA] data book (that shows reported growth in the industry that I have been suspect of) shows the “do- it-for-me” (the repair shop you take your vehicle into) growing at a faster pace than the do-it- yourself store (DIY stores where people go in and buy a part and then do the repair themselves). In other words, repair shops are gaining share from the DIY market, and Monro is likely gaining share from the “mom and pop” repair shops.

I think we all need to accept vehicle parts are lasting longer and that the automotive aftermarket (at least measured in units) is not growing this “steady” 4%/5% like investors seem to believe. When I was growing up we had to get a new muffler every couple years. I don’t think I have replaced the muffler in either of the two new cars I have owned over the past eight years. I used to get my oil changed every 3,000 miles. Granted, I drive a luxury vehicle and so I use synthetic oil, but I now get the oil changed every 10,000 miles, and it is done (for “free”) as part of the service contract I got with the manufacturers’ warranty when I purchased the vehicle (so even though I don’t know it, it really was baked into the purchase price of the car).

I know, you’re going to say using anecdotal evidence like oil changes and mufflers can in no way prove the demand for “hard parts” in the automotive aftermarket (which likely has some 300,000+ total different types of parts) is in decline. Well try this. John McElroy (host of Autoline Detroit) in a piece titled “parts and service a key to customer loyalty) in September 2003 (available here) indicated domestic automaker warranty costs have dropped from ~$1,000 per vehicle to $600 per vehicle over the last decade.

And any of you that listen to the public dealer conference calls hear (like I do) that the warranty business at the franchised auto retailers has been in decline, but they continue to try to offset this with increased “customer pay” business. And judging by the publicly traded franchised dealer same-store sales comps they look to be doing a pretty good job of gaining said customer pay business (the peer group of public dealers had service and parts comps of 3.4% and 5.2%, in their most recent two quarters).

This is the conundrum (problem) I have wrestled with. How are automakers extending (and often times enhancing) their warranties, and yet the warranty costs per vehicle for manufacturers continues to go down, dealer groups are losing warranty business, while the published industry data claims that the automotive aftermarket is growing at a “steady” 4%/5%? It just has not added up. What I think is helping to offset declining automotive aftermarket unit demand (per vehicle) has been a growing U.S. light vehicle population and these price increases. But let’s not kid ourselves, automotive parts are lasting longer.

Yet when did a growing market (underlying demand for your products) become the requirement for a good investment? Certainly it makes for a nice comforting slide for all of the automotive aftermarket participants to show investors. But these are not tech stocks, and just because the demand for a product is in decline, it does not mean the business is going away. Sure, the parts are lasting longer. Does this mean vehicles are going to never break down? Of course not. As far as I can tell, until we learn how to start teleporting people places, there is always going to be a need for personal transportation units (we call them vehicles), and as a result, at least for the foreseeable future, there is going to be demand for replacement parts.

And if the market is not going away, the game becomes market share. It’s actually highly fragmented markets experiencing structural shifts (downward) that I think afford some of the greatest investment opportunities. Think about my top three picks in the auto retail stocks index rankings: Lithia Motors (NYSE:LAD), Sonic Automotive (NYSE:SAH), and United Auto Group (NYSEARCA:UAG). If you think it is based on robust demand for new vehicles in the coming years, you are sadly mistaken.

To the contrary, I think the (new vehicle) industry is biding time before a MASSIVE downturn in demand as right now supply is creating demand. But sometime over the next few years excess capacity will either be eased through successful union negotiations or bankruptcy protections laws. And when this happens, similar to when block exemptions caused a massive separation between the “haves” (those auto retail with superior systems and processes) and the “have nots” (those retailer without said processes) in the United Kingdom (and likely throughout Europe) causing an initial blip (downward) in earnings and stock price performance and then a massive consolidation wave (and stock price appreciation in industry leaders like Pendragon), I think the U.S. franchised auto retail industry is poised for a similar rationalization.

It even applies to my business. Many of you often ask me when I am going to start charging for this newsletter. Let me ask you this. When do you think is the best time to change consumer purchasing habits? When there is ample supply of a product, or when there is a dearth (shortage) in the supply of the product? So right now the stock market (like Dow Jones Industrial Average) keeps hitting new highs, brokerage firms are reporting record profits, and the big debate on CNBC are the bonuses at places like Goldman Sachs too big? These brokerage firms are hiring more analysts, and you see more brokerage firms “picking up coverage” of these smaller cap auto retail stocks.

I’ve lived through a peak and downturn (late 1990s/early 2000s) to know that this is when the amount of investment research is ample (not at a dearth) and to know this is not the time to strike. It doesn’t mean I won’t pursue other revenue producing opportunities, and you’ll learn more about this in a few months. But, like all market booms, it will at some point be followed by a downturn. Is that this year, next year, I don’t know? However, when it happens, trading volumes dry up and brokerage firms lay off analysts. It is the small cap companies (that naturally have less trading volumes) where you most often see coverage being dropped (either because the analyst was laid off, or his or her attention was diverted by their Director of Research to focus on larger cap names where there is higher trading volume).

On top of that, I suspect investment research will be going through another structural shift (like it did in the last downturn). In the last downturn, investors seemed appalled as they learned the investment research reports (almost all “buys”) they were getting were not much more than investment banking propaganda. This became especially problematic when corporate scandals like Enron and Worldcom emerged. So (mostly as a byproduct of the corporate scandals) regulators had to step in and tell brokerage firms to separate their investment banking departments from their investment research. And without the banking profits, many research budgets were slashed.

Now corporate scandals and accounting problems existed before the early 2000s. But it tends to take a downturn for people to really take notice. In the same manner, people seem to be overlooking “hedge fund” blow ups like Amaranth and Bayou funds. I am not saying hedge funds are evil. They are not. In fact, I continue to argue their rise has led to greater shareholder activism, which for the most parts has been a favorable dynamic as it has required greater stewardship (out of management) of shareholder resources.

Only when a sector (like hedge funds) of the investment community grows so fast (now 9,000+) in a rather unregulated environment, it invites problems. And just like Amaranth turned out to be taking more risk than investors realized, and the Bayou fund was flat out fraud, you have to figure another Amaranth or Bayou fund is lurking. And particularly if it turns out to manage serious money for a large state or corporate pension fund, it is likely to bring the issue of greater regulation in the industry to the front and center. So the regulators will be forced to step in and look at how hedge funds operate.

And one of the byproducts of regulators scrutinizing how hedge funds (and asset management in general) work (just like a byproduct of the corporate scandals was separating investment banking departments from research), investors will be appalled to learn that the “real” investment research was occurring verbally to mutual fund and hedge fund managers and all they were receiving (in the written reports) was regurgitated press releases and company filings.

This will likely prompt a call for regulators to put an end to the unethical practice of “soft dollar” research where mutual and hedge fund investors were completely unaware (and undisclosed) they were paying $0.03 - $0.05 a share to buy the stocks (because the investment research was supposedly included in the trade commission) when the asset management group could have really been paying less than a penny a share. For most money managers, it shouldn’t be a problem, and I don’t think they will mind the shift at all.

Even though reported management fees (for mutual funds and hedge funds) will go up, it will go up for everyone in the industry (and remember this is just reported expenses, the money is actually already being spent via trading commissions). As a result, the consumer will end up the winner by seeing the real cost of investment research, while the brokerage firms end up the losers as these excessive fees are no longer paid in trading commissions. If a fund manager (mutual or hedge) wants investment research a dollar should equal a dollar. There should be no “soft dollars” (investment research paid for included in the trade commission) and “hard dollars” (actual cash paid for investment research). The sooner we put an end to this madness the better.

So just like the last downturn (but likely even more pronounced) you’ll see investment research budgets slashed, and small cap companies that spent years trying to educate investment analysts about the investment merits of their companies with very little investment research coverage. In all likelihood, about that time, the stock market will probably have started turning back up, and a lot of times small cap (quasi cyclical) stocks lead these recoveries (as “early recovery” plays). So demand for investment research in these stocks will be on the rise at the very time when the supply (of investment research in these names) is on the decline. That’s when I strike.

You may see websites spring up all over the place to capitalize on said dearth (shortage). But most investors won’t know who to turn to aside from some management teams pointing out to investors what website are now being “blogged” by analysts that have followed their company for years. Established sites (as autoretailstocks.com fully intends to be) should therefore possess an immense competitive advantage, and the ability to transition consumers (investors and industry participants) from this notion of “free content” to a subscription model should begin to take hold.

Will it work? Honestly, who knows. It has something to do with high risk/high reward, and pioneers (and some ending up with “arrows in their heads” as an industry participant told me once). But I can tell you my operating overhead is SIGNIFICANTLY lower than that of a brokerage firm. And so if the industry does shift, and the model transitions to a subscription model, most of my revenues will almost immediately be invested into new personnel to replicate the model. This is how I begin to move the industry toward my vision of a business model that requires 25% of the revenues and 33% of the people versus the traditional brokerage industry (with the 75% net savings getting passed onto the consumer).

This is the important “take away” (and why I took you on the detour). What I have learned from almost every successful business (and investment) observed over the years is that they run lean during the good years, and then when a downturn hits, they buy like crazy. Assets, personnel, whatever drives your business (or capital if you are an investor). Jim Awad (Awad Asset Management) articulated this best last year in a radio interview when he said: “buy into fear, sell into greed.”

And this is why I like Monro’s prospects so much. It is not because I agree with management and see this great underlying industry trend. I see a lousy industry (underlying demand) trend. But I also see 164,000+ (as of the last U.S. government census) automotive repair and maintenance facilities, and hardly any of them part of a national chain (and even then, most of the chains are franchises).

Incidentally, this is why I like O’Reilly (NASDAQ:ORLY) and Genuine Part’s (NYSE:GPC) emphasis on their Auto Care Centers, as they provide systems and processes (basic support) in return for these struggling repair garages buying more parts from these “jobbers.” And this is why I like the idea of “information” centered DIY and more importantly DIFM websites (Amazon, and what I keep pushing for AutoZone and Advance to move toward). If you control where people turn for advice when a vehicle breaks down, you can control where they go for the repair and hence where those repair shops should be getting their parts from (because that’s where they are getting their customers from).

So if Monro has the ability to acquire shops like ProCare, and experience 30% same-store sales declines, but put in their systems and processes and move it from losses to profits (just because of the systems and processes they have put in), imagine how powerful the model can be when industry demand just stabilizes a bit? And just like how I plan to acquire people in the next stock market downturn, you see Monro’s acquisition pipeline filling up. During the conference call, Mr. Gross said they are “actively evaluating various options.” If you look at the company’s recent quarterly store count (699) it is actually down from the first two fiscal quarters of this year (702). In other words, they are no longer building new stores. This is what I called and left the message about. Why aren’t they building new stores?

When you add into the equation the company’s share buyback announcement, it suggests to me the company is on the verge of a big (or a couple semi big) acquisition(s). They have simply determined that deploying their capital is better in buying versus building right now, and the share buyback simply gives them leverage to quickly deploy the capital into buying their own stores (via the stock) if the prices (of stores they want to acquire) aren’t reasonable in the open market. But like I said, management’s comments on the conference call and lack of new store growth all suggests they are getting close to an acquisition or two.

This is also why I emphasized (above) the wildcard to the fiscal 2008 guidance is acquisitions. I just don’t know if the company (like initially with the ProCare acquisition) they potentially acquire is dilutive to earnings or accretive. So from my standpoint, “core” fiscal 2008 earnings prospects look pretty bullish, but what the actual guidance turns out to be remains somewhat questionable. It just depends on who/what they may acquire. It does, however, leave me a little more bullish when I think about my 2012 estimates as I forecast very little new store growth into my estimates. But at this point I think it is appropriate to leave my estimates unchanged and continue to evaluate in the coming months as we learn more about the company’s acquisition prospects.

MNRO 5-yr chart:

MNRO 1-yr chart