O'Reilly 2Q07 Follow Up Thoughts: Long-Term Sustainable Returns

While we wished our comp sale result of 2% better reflected the outstanding effort made by our team during the quarter than it did, I want to assure you that our culture is not to be content with slow business periods due to weather, high fuel prices, or the economy. And we feel there is significant opportunity to increase our market share in both the DIY and professional installer area. O'Reilly (ORLY) team members know and have what it takes to grow business, which is the best availability of quality parts at competitive prices. And most important, OReilly team members giving outstanding customer service. That being said, we are also hoping for the rest of the summer to be dry and hot.

Source: Ted Wise, COO, O'Reilly Auto Parts

I am not a big fan of the gas and weather comments. But I will concede that things were pretty slow in the second quarter for the automotive aftermarket (if we did not know that already from Genuine Parts Automotive segments sluggish 2% sales growth as well).

Actually, April in general seemed slow for auto retail.

Management said if they excluded out their Texas and Oklahoma stores, the company experienced same-store sales growth of 4%.

But even Greg Henslee (O'Reilly's CEO) said "the weather will be the weather." So let's not fret about this stuff.

Instead, we need to focus on what generates long-term sustainable returns.

So I just wanted to follow up on four critical topics with you this morning about O'Reilly's results: A) what is the underlying demand for hard parts? B) What was management's responses to my questions? C) Earnings guidance. And D) Why retailers like O'Reilly should not ignore the internet.

A) What is the underlying demand for hard parts?

I think the guy from Virginia went to the heart of the issue:

Greg, you look over the last 12- 15 months and business has clearly been difficult. And you think about the mindset of the consumer as one of deferral. As vehicles age, and the replacement of critical parts increases. And basically fewer dollars then are spent on more normalized maintenance. If that deferral approach is more permanent on the part of the consumer. How do you drive average ticket up? And how do you up sell when all the consumer's thinking about is saving money with respect to automotive repair?

Source: Tony Cristello, BB&T

Well, first it depends on the kind of items that we're talking about if it's air conditioning for instance. . . At the point they decide to trade cars they really almost have to have the air conditioner fixed or take one huge hit on the trade in value. . . You know over time cars have to be maintained correctly. If a car isn't maintained correctly then it becomes unsafe, for example brake pads. . . At some point the consumer is going to decide listen it is ridiculous for me not to replace the rotors and fix this thing right. But I'll do it in better economic times when I have more cash in my pocket. So that's basically my feeling on that.

Source: Greg Henslee, CEO

And I guess a follow up. Are you seeing on the part of your professional installer base, are they commenting on the life cycle of parts? Are they lasting a little longer and is that enabling the customer to push out repairs as well?

Source: Tony Cristello, BB&T

Well, some parts are. If you look at say starters and alternators. . . But at the same time. . . the cars did not have all these sensors. . . So there are a lot of offsets to the various components that now last longer than what they did at one point. Because the individual components are better. And that offset is that the cars have much more technology on them today. . . And all of us that are in this business, us and all of our competitors, are very much in the sensor and computer system business because they are primary parts of the car today. And so to me there is at least a full offset if not a positive offset to some of the components that are lasting longer.

Source: Greg Henslee

I think Greg Henslee's argument about new (more expensive) componentry in the vehicle offsetting longer lasting parts is the best refutation I have heard yet about my concerns over the demand for hard parts being in decline. Although I think the complexity of vehicles is also why you see franchised dealers regaining market share.

But it still really does not address the issue of how bad weather and high gas prices can cause people to defer maintenance items for over a year?

I don't think anyone will deny the second quarter was a tough environment for the automotive aftermarket. But I just cannot make heads or tails out of these gas price/weather issues.

What I do know is what should be the most boring sector in the world (automotive replacement parts) has been anything but boring over the last few years. When you're battery dies, how do you defer a purchase? (I know I am using one product category to kind of over emphasize my point).

My point is that the volatility in sales (in what should be a very consistent replacement market) leaves me worried that there is more supply (stores trying to sell auto parts) than demand (people who need to buy auto parts).

The solution: prudent capital allocation (AutoZone is actually really good in this area besides their store expansions).

And you need to have a really good strategy to fill a real need in the commercial market.

Because frankly I think the do-it-yourself game is played out.

Fortunately, I think O'Reilly is filling a need in the commercial market.

They have created a variable compensation structure with their store managers and employees so that it can function (as close as possible) to an entrepreneurial environment (a model that works well in dealing with other entrepreneurs that run the repair shops).

And if you haven't checked out www.certifiedautorepaircenters.com you should see how O'Reilly is just starting to add even more value to independent repair shops through this quasi franchise agreement with them (no formal franchise, they just agree to buy more parts).

So this is why I continue to think the company should be acquiring more stores versus building them.

B) Answers to my questions from yesterday

As you may recall, yesterday I posed 5 questions that I felt investors should have answered by the end of the call. To a certain extent, the questions were answered on the call. But I also followed up with Tom McFall [CFO] for a little clarity.

#1) How much of the net store growth is acquisition versus new "Greenfield" stores?

Answer: 10% - 15% of the stores this year will likely be acquired.

#2) Why are they doing any Greenfield stores when the productivity metrics are in decline?

Answer: valuation. "If you can find a nice chain for us, we're happy to entertain it."

I said I thought CSK should sell Murray's to them. I think the new management at CSK is going to have its hands full trying to leverage the existing assets it has on the west coast. I don't think a 90% do-it-yourself [DIY] auto parts chain in the Midwest fits well with CSK.

Whereas O'Reilly's roots stem from the Midwest. They have a great model they can put in place (shifting it to 50% commercial). I think they have better distribution center efficiencies in the Midwest than CSK/Murray's. And who would better understand how to integrate Murray's into O'Reilly than Tom McFall, who was the CFO of Murray's and is now the CFO of O'Reilly.

#3) Why did the other income line item spike up?

Answer: higher cash balance (interest income).

#4) Why did net cap-x per store go up in the quarter so much?

Higher costs associated with investments into information technology system.

#5) Why did "other liabilities" go up so much?

New accounting rule (Fin 48), shifted from deferred tax to other liabilities.

C) Earnings Guidance

Below is the guidance management provided on the conference call:

click to enlarge

D) Why retailer's like O'Reilly should not ignore the internet

Most of you should remember my discussions about the internet. I know it is easy to say business isn't changing because of the internet. That people were proven wrong in the bubble and brick and mortar is here to stay.

I often discuss the Aspen Institute's summary of economic revolutions where they tend to go through three general phases: 1) innovation (boom/bust), 2) diffusion/specialization, and 3) Replacement of the old employment base with the new model.

And I have talked in the past about Amazon's entry into the automotive aftermarket. About how I told them not to get into it (several years ago) because it is a bunch of slow turning parts that need to be delivered yesterday (not really the Amazon business model).

But after I talked with the folks from Amazon, I said that I think they have chance. Especially if the DIY chains do not focus on becoming a resource center to the consumer.

Usually the more efficient model thrives. So while I don't know what Amazon's (AMZN) revenues and profits are per person in the automotive segment, below is Amazon's second quarter (company-wide) profitability metrics per employee:

Now I think O'Reilly is one of the best run companies in the space, with a great business model and some of the highest returns on invested capital and profitability metrics.

But as you probably recall from my piece yesterday, O'Reilly only generated $2,171 in net income per employee in the second quarter. And that was down 6.3%.

The point I am making is that while it may be tough for etailers to make inroads, you are starting to see success from some of the early "e-tailers" as they gain leverage. And while these are slow turning parts that need to be delivered "yesterday," over time I think vehicle technology will allow for more reactive parts distribution (pull versus push). So I just don't think people should ignore the potential the internet and etailers can have on the space.

If the auto parts retailers are not leading the change, they are likely to find themselves following it (or losing to it).

- O'Reilly Automotive Q2 2007 Earnings Call Transcript

ORLY 1-yr chart: