Genuine Parts (GPC) reported Q1 results on Friday that generally exceeded Wall Street expectations, but still fell short in some areas that raise some concerns (see conference call transcript here). However, overall, I think there are reasons to be optimistic and I will continue to hold my shares, earn a 3.4% dividend yield and look for opportunistic times to accumulate more shares as I think earnings will continue to exceed expectations, especially in the second half of the year. Further, I expect hefty dividend increase next year.
The Financial Results
1Q results looked great on the surface. Revenues were up 14%, which was well above guidance ("8% or a little higher") and my forecast (+10%). EPS of $0.80 was also above the consensus forecast of $0.75 and about what I was looking for. EPS annual guidance was raised $0.10 to $3.32-$3.42, which places it above the consensus at $3.35. Sales are now expected to grow 9%-11%, up from prior guidance of 6%-8%.
However, the 1Q EPS got a boost from a lower than expected tax rate that added about $0.04. So, despite the strong revenue, operating income barely beat Street expectations.
The big issues that restrained income growth were lower gross margins driven by competition, inflation and customer mix and higher SG&A expense. Additionally, the company did not buy back very much stock in 1Q ($9 million) despite having $465 million on its balance sheet at the end of the quarter.
On the gross margins, it appears that the company is being squeezed through a combination of factors. Despite efforts to push back on its supplies, the company is receiving price increases including year-to-date (YTD) increases of 0.5% in automotive, 0.6% in Industrial, 0.9% in Office Supplies and 1.6% in Electrical. These are the biggest 1Q price increases the company has seen since 2008, another year that started off with inflationary pressures bubbling over.
Near term, GPC is having trouble passing on these price increases as the competition is extremely aggressive in some sectors and many customers are simply not taking any price increases. Additionally, the company is seeing its strongest growth with its largest customers, which weighs on margins given these customers are get better pricing. Finally, the company is not seeing large increases in volume rebates commensurate with its sales increases as GPC is growing its inventory at a much slower pace.
On the SG&A front, expenses (ex-equity compensation and interest) were up 10.4%, which was a much larger increase than last quarter (up 4.6%) or last year (up 5.7%). The company pointed to higher incentive compensation as well as fuel costs, with the latter adding several million to this year's expenses.
Putting It in Perspective
Gross Margins: Focusing solely on the gross margin decline ignores the strong revenue growth. Revenues and gross margins are often opposite sides of the same coin, as companies can give up some margin for higher revenue or vice-versa. Its a balancing act where management is focused on maximizing gross dollars. In this case, gross dollars were up a strong 11.6%, the largest gain the company has had since the third quarter of 2005!
Additionally, it is not uncommon for a distributor like GPC to see gross margins compress at the early stages of inflation acceleration. Often, its bigger customers want to hold off the increases as long as they can, taking advantage of their size to gain an advantage over smaller competitors. History has shown that the margins eventually re-inflate, but it takes a few quarters to pass on the increases and/or offset inflation with cost reductions. This is exactly what Genuine Parts seemed to be implying as it talked about stabilizing gross margins shortly.
Finally, CFO Jerry Nix gave some interesting details on its conference call regarding vendor rebates:
...we were basically flat in what we accrued for in the first quarter. We expect for the year to be up less than 10% in rebates for the whole company, and we accrued that and we were right at 25% in the first quarter based on the best estimates we can make for the full year.
If you work through the logic in this statement, it implies that GPC should see a bigger benefit from vendor rebates the rest of the year than it did in 1Q for a few reasons. First, rebates were flat with last year despite a 14% increase in sales, which means vendor rebates were a relative drag on gross margins in 1Q. However, the company is accruing the rebates it expects evenly throughout the year.
As sales growth is expected to slow the rest of the year from the blistering pace set in 1Q, this implies that the vendor rebate benefit will inherently grow. Additionally, the company said it expects rebates to be up "less than 10%" this year, which is the rate it is accruing at. However, it also said that the company's accrual was flat with last year in 1Q. This means that rebate accruals will have to be up overall for the remaining three quarters.
SG&A: Higher gasoline prices should continue to weigh on expenses at least into 3Q, although the impact should gradually lessen if gasoline prices stabilize. Executive compensation, however, should face easier comparisons after 1Q. The company does not break out this expense, but keep in mind that last year started out slow in 1Q, with revenues up 6.4% and operating earnings up 11.3%. It wasn't until 2Q that business picked up more sharply, with revenues up 12.3%-13.6% during the next three quarters and operating profits up 14%-23.5%. It seems likely that the company ended up accruing at a larger incentive compensation rate some time after 1Q last year, suggesting the comparisons will become easier as 2011 progresses. In total, SG&A was only up 2.3% in 1Q last year but ended up accelerating to 4.6%-8.3% growth the rest of the year for a total SG&A increase of 5.7%.
Another way to look at this is to compare SG&A this year to the prior five-year average. In 1Q, SG&A was up 10.7% versus its prior year average. If we assume a similar increase (+11%) over each quarter's five year average, GPC should see less SG&A expense growth the rest of the year. Specifically, 11% SG&A growth over its five year average would result in SG&A growth slowing in 2Q, 3Q and 4Q to 8.5%, 6.5% and 5% respectively, down from 1Q's 10.4% rate. While using an average such is this is not precise, it does support my argument that expense comparisons will ease as the year progresses.
Reasons for Optimism in 2011
The previous section highlighted reasons to think gross margin erosion could lessen the rest of the year while SG&A growth rates should moderate. There are other reasons to be optimistic about the momentum in each of GPC's divisions as well as the overall financial outlook for the company
Automotive: GPC's NAPA division had a 9% increase in sales, which was the same as 4Q despite poor weather in January and early February. The strength came in the commercial business, which is about 75% of the company's automotive business. The retail business (DIY) was a bit weaker than 4Q, especially in March. An important trend could be developing. During the recession, retail/DIY flourished as many consumers held on to their cars longer and opted to do their own repair or maintenance. With the economy starting to show signs of recovering, it could be we are seeing early signs of a shift back to more professional installers from DIY. Given GPC's focus on commercial over DIY, this should put them in a strong position than competitors with a much larger percentage of DIY in its mix (i.e., AZO, AAP)
Industrial: This division was up 24.5% and the company raised its guidance to 15%-17% from 8%-10% for the year. Industrial tends to track the industrial production and capacity utilization figures issued by the Federal Reserve each month. The two year trend in this data and GPC's sales suggest significant gains still ahead in 2011.
Office Products: This was the biggest surprise for me in 1Q. Office products were up a strong 5.4%, an acceleration from 4Q's 2.9% despite a more difficult comparison. GPC now expects this division to grow 4%-6%, up from its previous guidance of 2%-4%. Office products demand is driven by white collar employment growth, which tends to lag in an economic recovery. That certainly has been the case in this recovery, but there are signs that job growth is finally starting to show some signs of life. Office Supplies could be in the early stages of a multi-year recovery.
Electrical: This division was up a strong 35% in 1Q, or about in line with 4Q's 36%. While about 15% of this is from acquisitions and inflation/price increases were about another 4%, the core business is still growing robustly. Similar to the industrial business, the strong momentum in the economy should keep growth chugging along here for the near term at least.
Strong Cash Flow Supports Buybacks and Dividend: Genuine Parts is forecasting $700 million ($4.45/share) in cash flow from operations this year and $600 million ($3.80/share) in free cash flow (FCF) that I define as cash flow from operations less all capital expenditures. This is an extremely impressive amount of FCF, 13% higher than the company's forecasted net income for the year. It appears this is being driven by tight inventory management, better payable terms, and other working capital initiatives.
Even after paying out its dividend, this leaves the company with $325 million to spend on stock buybacks or acquisitions. The company seems committed to doing more smallish acquisitions, but that should still leave more cash for a stronger buyback than the $36 million annual pace it is on after 1Q.
Earnings and Dividend Forecast
Assuming the company accelerates its stock buyback to $125 million in total this year, I believe the company can earn $1.55-$1.60. This is well above guidance and consensus. Most of the upside will likely come in the back half of the year, but the stock could benefit as this becomes more obvious in the coming months.
While the annual dividend increase is almost a year away, I think its important to consider now as it is a big attraction for long-term investors. GPC increased the dividend 10% in 2011, the biggest increase in at least 15 years (my model only goes back to 1996). Given the strong momentum the company has this year, its large cash balance and the prospect for higher margins down the road, I believe GPC will increase the dividend at least another 10% next year (probably 11%, as that would take it to $2.00).
In conclusion, while I was a bit disappointed earnings didn't beat the consensus forecast by a wider margin in 1Q, the potential for stronger margins and earnings in the coming quarters has me looking to add to positions opportunistically.