O'Reilly: Opportunity Ahead

Summary

• ORLY shares recently took a massive hit after comps growth disappointed and company warned of decreased profitability.
• The slowing growth likely has more to do with cyclical factors than it does with Amazon.
• Shares had likely been overpriced and are now returning to fair value.
• A further 10% drop would provide an excellent opportunity for long-term value and GARP investors.

In a previous article, I noted that O'Reilly (NASDAQ:ORLY) was a highly profitable company which

enjoys durable competitive advantages, is led by a management team with a strong record of wise capital allocation, and analysts project strong growth for its future. However, its share price reflects this optimistic outlook and its heavy debt burden must be addressed to shore up its long-term risk outlook. I recommend adding this company to your watchlist until management shows more of a commitment to paying down debt and either the share price dips or the company shows convincing signs of meeting analyst growth expectations.

So far the company has failed to convince of its ability to meet those optimistic analyst growth expectations, as its recent announcement of its disappointing same-store-sales growth (1.7% vs. 3%-5% expected) caused the share price to stumble to the low $170s from its ~$260 price at the time I wrote the article. Though this slowing growth will most definitely lead to a slower EPS growth rate, I believe this correction is overblown and could provide an opportunity for long-term value and growth-at-a-reasonable-price investors.

First of all, it is important to note that, although same-store growth has slowed significantly over the past two quarters, ORLY is still growing in same-store sales. In other words, its business model is not only maintaining its profitability, it is continuing to grow it in the face of increasing competition from Amazon (AMZN) and other internet parts suppliers. Given its pricing power, national network, and strong customer service, the company's business model should continue to prove resilient against the competition for years to come. During the 4th quarter conference call, CEO Greg Henslee echoed similar confidence in his business' ability to withstand the Amazon challenge:

[when it comes to] the transition to online [the company has] "not seen much in our business that's led us to be very concerned about it. I realize that Amazon is the strongest and the best run, and I obviously have a lot of respect for them and I am a customer for household items and other things, but ... some of the things that are a barrier to entry for these guys are that we're in a very technical business. We have highly experienced trained professionals in our stores, they help them solve these problems. Many times, customers, when they come in to buy a part, they don’t really know (what the part is) called, they think it's bad, it looks bad, we'll test it for them, we may lead him down another path. I mean it's just, it's a highly technical business.

The company's resilient growth is especially impressive considering that there are other factors likely more responsible for the slowing growth: "continued headwinds from a second consecutive mild winter" and "overall weak consumer demand" due to falling vehicle prices (increasing the likelihood that consumers will replace their cars rather than replace parts) and the fact that average vehicle age grew at an abnormally fast clip in the wake of the recession as new car purchases fell ~40% in 2008-2009. Though average vehicle crept higher to 11.6 years last year, "average age is returning to a more traditional rate of increase," according to Mark Seng, IHS Markit's director of global automotive aftermarket practice. Additionally, with advancing technology, vehicle quality continues to improve, thereby reducing the need for repairs. Given these headwinds for the industry, the slowing growth is completely understandable and does not indicate serious issues underlying ORLY's proven business model.

Given the ongoing buyback program (currently authorizing the repurchase of over 50% of the company's market cap), which will now increase its effectiveness due to the massive share price correction (~5% annually), organic growth (based on recent trends, ~1% EPS growth annually over the next 5 years seems reasonable), and inorganic growth (~5% EPS growth annually through new stores and acquisitions), the company seems primed to average 11% annual growth over the next 5 years (as opposed to 14% previously guided by analysts). Assuming a terminal EPS growth rate of 6% (supported primarily via share repurchases, though additional inorganic growth will likely be slowed due to the debt burden and organic growth will likely have approached zero), the company's current valuation is:

DCF Valuation	10% Discount	12.5% Discount	15% Discount
11%/6% Growth	$359.73	$226.5	$164.57

Click to enlarge

Simply Wall St. provides a similar assessment:

Given my assumption that ORLY's organic business is experiencing sustained slowed growth but will remain resilient in the face of mounting headwinds, the company appears significantly undervalued at present prices. However, given the company's considerable debt burden (and the constraints it could provide on continued inorganic expansion and share repurchases in the face of rising interest rates) and rapidly dropping share price, I believe it is prudent to wait until shares trade at a discount to the 15% discount rate valuation before initiating a position. ORLY remains on my watch list and I plan to initiate a position if the share price reaches ~$155.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in ORLY over 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.