O'Reilly Automotive: Strong Margins Provide Resilience In Downturn
Summary
- O'Reilly has insulated itself from online disruption through strong customer service and investments in digital channels.
- The company's cost advantages should allow it to maintain its operating margins when worse companies are losing money.
- O'Reilly appears to be expensive, but the company has stronger forward estimates than peers.
O'Reilly Automotive Inc. (NASDAQ:ORLY) is a strong bet in an industry that is fairly resilient to online disruption. The company's service levels and omnichannel presence have insulated O'Reilly from falling sales growth experienced in the general retail industry. The company has also managed to maintain high operating margins by strengthening its relative scale against smaller peers. With these barriers of entry, O'Reilly should expect steady sales growth and operating margins going forward. At 16.5x forward EV/EBITDA, the company trades higher than peers but has better forward estimates due to robust advantages in place.
Service and availability have kept O'Reilly relevant
As more retail chains close down stores, one would expect that e-commerce will negatively impact the automotive aftermarket part industry. However, O'Reilly has opened 200 net, new domestic stores in 2019 and plans to open 180 net, new stores in 2020.
One key differentiator is the high customer service levels that O'Reilly provides. The company provides superior in-store service through highly-motivated personnel and enhanced service programs such as battery and electrical testing, wiper, and bulb replacement. These services are crucial to differentiate the company from online competition.
Furthermore, customers who find that their vehicles require servicing are sensitive to time. If their car or truck were defective, it is unlikely that they would wait for their online ordered parts even if there were one-day shipping. The likely customer behaviour would be to drive into a nearby auto part store and obtain their required item.
O'Reilly is also adopting an omnichannel approach
Customers are increasingly researching their purchases online before purchasing their products. Having a digital presence allows O'Reilly to offer their customers enhanced and seamless research and buying experience through any channel, be it in-store or online. It also provides a barrier of entry to O'Reilly's business as having both channels are very capital-intensive and O'Reilly is already serving customers effectively on the digital channel.
Having an online presence is also working out well for O'Reilly now as more customers restrict their visits to stores. Regular customers who already know what parts they require could easily obtain it through O'Reilly's digital channel. Customers with service requests could also contact a specialized auto parts company with deeper technical knowledge compared to online stores that sell general merchandise.
O'Reilly's relative size also keeps smaller competitors at bay
O'Reilly's scale also gives it larger bargaining power over suppliers compared to its smaller peers. The company has roughly 5,400 stores, 350 hub stores, and 28 domestic distribution centres at the end of 2019. This allows the company to move inventory around quickly to meet customer demand while keeping adequate reserves to be replenished in other stores if needed. With a denser network of stores than smaller peers, O'Reilly is able to turn its inventory faster and spread the investments in inventory-management technology over a larger customer base. This lowers the O'Reilly's cost structure, which allows the company to achieve better margins that it can choose to pass along to its customers or use it for investments.
The company's long-term prospects look promising
O'Reilly's revenue has grown from $5.3B in 2010 to $10B in 2019 at an annual rate of 6.5%. With its plans to open more stores and an omnichannel presence, we expect sales growth of roughly 5% going forward for the next 5 years. This factors in the likely downturn in 2020, which should cause some negative revenue impacts in the short term.
The company's operating margin has expanded from 13.6% in 2010 to 18.6% in 2019. With its cost advantages to smaller peers, O'Reilly is expected to at least maintain its high margins. Its strong customer service should reduce price elasticity which should keep gross margins steady going forward. As such, we expect operating margins to remain around 18-19% for the next 5 years.
Investment Risks
The trend towards electric vehicles could lead to fewer car parts sold overall due to the potentially more reliable configuration of these types of vehicles. O'Reilly's experienced management should be able to lead this shift in the long term. As electric vehicles age and require repairs, there would be a segment of customers who would prefer doing it themselves than opting for the more expensive dealer channel. O'Reilly's increasing presence in the commercial channel would also help it capture customers who prefer others to help repair their electric vehicles.
A shift towards autonomous and shared vehicles might also lead to reduced car parts sold overall. However, this impact should be relatively small as car ownership would likely remain high in the United States due to the lack of reliable interstate transportation. Nevertheless, this remains a threat in the longer term.
O'Reilly's debt is an issue if free cash flow dries up
Looking at its latest balance sheet, O'Reilly has $287M of cash with $4.4B of long-term debt. Since the debt is mostly long term and due in 2022, O'Reilly is likely not to face any cash crunch in the near term. Moreover, O'Reilly has about $840M of free cash flow in fiscal 2019. This provides a large cushion for O'Reilly to invest in growing the number of its new net stores. It also helps O'Reilly tide through any operational difficulties in volatile periods. If free cash flow slows down, there is a likelihood that O'Reilly might have to raise funds to pay down its debt.
(Source: 10-Q)
Valuation
Peer analysis shows that O'Reilly ranks more expensive than the median-peer group based on consensus EV/EBITDA and P/E. O'Reilly's forward EV/EBITDA is 16.5x, which is higher than the median 13.0x. The company's forward P/E of 24.9x is also higher than the median of 20.9x. However, O'Reilly has strong financial prospects than its peers. Its forward revenue growth is 0.6%, which is much higher than its peers of -7.6%. Its consensus EBITDA margin of 20.7% is also higher than the median of 9.9%. As such, potential investors will be paying a premium for higher expected financial results than the industry average.
(Source: Atom Finance)
Takeaways
O'Reilly has built a strong omnichannel brand with high service standards that have protected it against the threats from online channels. Its relative scale and cost leverage have contributed to its high operating margins in a competitive industry. Despite risks from electric and autonomous ride-sharing vehicles, the company's long history of success should allow it to continue generating strong returns in the future.
This article was written by
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.
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