O'Reilly Automotive: Buy On The Drop?

Summary

• O'Reilly is down close to 20% after a sales for Q2 warning.
• Comparable store sales missed expectations badly, sparking growth concerns.
• The comps miss is very discouraging and could signal deeper issues with the industry.
• I rate O'Reilly Automotive a Sell on the drop.

This article is the 65th installment in a segment called "Buy on the Drop?" in which I choose a stock that recently experienced a large decrease in price and give a recommendation on whether investors should "buy on the drop" or not. The recommendations are Sell, Hold, Speculative Buy, Buy, and Strong Buy.

O'Reilly Automotive (NASDAQ:ORLY) reported Wednesday that it missed comparable store sales guidance by a wide margin, sparking a 20% sell-off in shares of the auto parts retailer. The miss is substantial and I think it may be a harbinger for developments to come, which leads me to rate O'Reilly a Sell on the drop.

ORLY data by YCharts

ORLY is usually billed as a growth stock as it has reported year-over-year ("YoY") revenue growth for every quarter stretching back years. Similarly, Q1 2017 was the first time in years O'Reilly reported less than high single-digit growth (>5%) due to weak consumer demand:

ORLY Revenue (Quarterly YoY Growth) data by YCharts

The guidance originally issued during Q1 was solid with comps growth expected to be between 3% and 5% in Q2. However, on Wednesday, O'Reilly warned it saw weaker than expected consumer demand and pegged comps growth at just 1.7% for the quarter.

This is a big disappointment for investors after it appeared, from original guidance, that Q2 would perhaps be a first step in a recovery to revenue growth comparable to that of past years. But instead, the sales miss, which will undoubtedly trickle down into profits and margins, affirmed the concerns that have dogged ORLY and other stocks in the sector over the past 12 months.

For its part, O'Reilly's management claims the comps is due to "continued headwinds from a second consecutive mild winter and overall weak consumer demand". While the first reason could be seen as a temporary situation that might resolve itself next winter, the second reason seems broader and more worrisome. Management of course says it is confident in the long-term health of its business, but what's with this "overall weak consumer demand"?

Part of it could be the plunging prices of used cars, which are at monthly prices not seen since December 2010 and are expected to fall 6% in 2017 and between 3% and 5% in 2018. And it's not just used cars -- new-vehicle prices are falling as well after the boom in sales during the recovery following the Great Recession. Incentives on new vehicles are to $3,500 in Q1 2017, about $371 higher than Q1 2016.

As the prices of used cars and new cars decline, consumers have less incentive to buy parts to repair vehicles that can be otherwise replaced relatively cheaply. O'Reilly is bound to be hurt by these trends, and if the comps miss is any indication, the company's already feeling these effects. Beyond the short-term outlook, it seems likely that O'Reilly's problems will only worsen.

Electric vehicles are becoming more popular and are the ultimate future of the auto industry, but more importantly are semi-autonomous and autonomous vehicles and how they will re-shape the market landscape. The key points are that autonomous vehicles will result in fewer accidents, will reduce wear-and-tear, and will allow the creation of ride-sharing networks which require many fewer cars than are currently on the road today. This is admittedly more of a long-term negative catalyst and might not affect ORLY anytime soon, but it is certainly a development to keep an eye on if you're an investor in the stock.

But in the short-term, the effects of lower used and new car prices are having an impact on operating results, specifically and vitally, free cash flow. The chart clearly shows a recent decline in FCF, which is likely to be exacerbated by whatever performance the company turns is for Q2:

ORLY Free Cash Flow (TTM) data by YCharts

The entire sector as a whole appears poised for some rough waters, and O'Reilly is no exception as the poor comps and lower FCF demonstrate. Auto parts are becoming commoditized with less and less to distinguish between the various parts companies in the market. I don't expect prospects in this industry to improve much over the next few quarters due to this issue and the related problems it is causing in regards to growth and profits.

Due to the significant miss in comps growth, the recent decline in free cash flow, and the weak market environment for O'Reilly short-term and long-term due to low prices of car sales and the implementation of up-and-coming car technologies respectively, I don't see much value in owning ORLY at this time. There is downside risk from here as the impact of the comps miss on earnings and margins is fully realized and digested by the market, and whatever upside there might be is capped by the current low-priced state of the auto industry. Therefore I rate O'Reilly Automotive a Sell on the drop.

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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.