Buffett-Munger Highlight Weekly Report – O’Reilly Automotive

O’Reilly Automotive Inc. (NASDAQ:ORLY) and its subsidiaries (collectively O’Reilly) are specialty retailers of automotive aftermarket parts, tools, supplies, equipment and accessories in the United States, selling its products to both do-it-yourself (DIY) customers and professional service providers. At December 31, 2010, it operated 3,570 stores in 38 states. Its stores offer products, including new and remanufactured automotive hard parts, such as alternators, starters, fuel pumps, water pumps, brake system components, batteries, belts, hoses, chassis parts and engine parts; maintenance items, such as oil, antifreeze, fluids, filters, wiper blades, lighting, engine additives and appearance products, and accessories, such as floor mats, seat covers and truck accessories. Its stores offer services, including used oil and battery recycling, battery diagnostic testing, electrical and module testing, loaner tool program, drum and rotor resurfacing, custom hydraulic hoses, and machine shops.

Market Cap: $8.3 billion

Business Predictability: 5 stars

Industry: Auto Parts Stores

Analysis:

Over the past decade of economic uncertainty, do-it-yourself (DIY) fever has taken hold of consumers who appreciate the value of saving money. The aftermarket auto parts industry has played directly into this theme with great success. The industry has experienced the emergence of dominant national players at the expense of the mom and pop stores – very similar to other retail outlets (i.e. drugstores). O’Reilly has grown to one of the larger operators with great success. The company has begun to embark on a more ambitious acquisition strategy with the latest buy of CSK Auto. The newly combined entity has created the country’s third largest auto parts chain.

O'Reilly should benefit from its nationwide presence, greater purchasing power, and better productivity as the new acquisition is integrated. The buyout also helps with entry into the commercial space which may lead to market share gains. The company now has the capability of serving professional installers at converted stores and a more extensive distribution center build-out (23 sites compared to just eight sites at AutoZone and Advance Auto). There has been public acknowledgement by competitors that the newly combined companies pose a serious threat. It is on the commercial side that O’Reilly looks for future growth. There is an approximately 350 new commercial programs in the works which could accelerate growth. Furthermore, the deal was an attractive opportunity for the firm because O'Reilly and CSK stores operated in distinct regions, with minimal geographic overlap. CSK Auto holds attractive real estate on the West Coast, particularly California - a notoriously difficult market for retailers to expand into internally. Given the magnitude of the CSK acquisition, which represented a 70% increase to O'Reilly's store base, the integration process has been time consuming, but the end is in sight.

O'Reilly has done a tremendous job in transforming itself from a strong regional player into an industry leader with a nationwide footprint. O'Reilly now has 3,560 stores, putting it head-to-head with the number-two player, Advance Auto (3,563 stores). Over the past two years, the firm has improved the productivity of CSK's struggling store base and has successfully integrated all the CSK stores into the O'Reilly distribution systems. Converted stores have the added capability to serve professional installers in the commercial business as well. Before the acquisition, commercial sales represented only 10% of CSK's overall sales, versus about 50% at the core O'Reilly stores. The commercial division is expected to add stability to financial results which have been cyclical. O'Reilly has made significant investments to enhance the distribution infrastructure surrounding CSK's store base. Prior to the acquisition, CSK operated one distribution center for every 335 stores, compared with 125 at O'Reilly. The investment includes adding distribution centers and upgrading CSK's inventory-replenishment system. This is expected to improve parts availability and ensure timely deliveries.

As is the case with the retail industry, maintaining a market lead will depend and outstanding execution and service. Consumer appetites can be very fickle when it’s a highly competitive industry based predominantly on price and convenience. Because this group has relatively low barriers, management’s focus must be on efficient allocation of capital, maintaining the brand, and protecting consumer loyalty. Additionally, the commodity nature of auto replacement parts makes it difficult for the auto parts retailer to charge a premium on its merchandise. Therefore, sustaining robust sales volume is critical to maintaining margins. Although, the company does have some power over its suppliers due to large purchasing volumes, it competes head-to-head with industry stalwart AutoZone AZO, which has greater purchasing power due to its market-leading position. While the company doesn’t have any structural advantage, they have been able to generate above returns on capital – which implies the ability to protect their competitive position. The company produces industry-leading productivity and operating margins and is growing its store base aggressively. In fiscal 2010, O'Reilly generated about $2 billion in commercial sales. As the industry continues to consolidate, it is very likely that they will continue to gain share in the space.

As for the industry, long-term demand for auto parts is relatively stable, especially in the commercial segment. The bulk of sales are driven by necessary maintenance, rather than optional upgrades. With the average age of cars on the road at over ten years and rising, the $200 billion automotive aftermarket should benefit from increased demand. Slow new-car sales amid the uncertain economic climate also bode well for this trend. O'Reilly boasts a seasoned management team with extensive industry expertise and relationships. The firm will also benefit from a surge in demand for automotive replacement parts as consumers defer new vehicle purchases amid the weak economic environment. However, technological improvements have extended the quality and useful life of automotive parts, which may result in less frequent replacement and maintenance.

Even with the skittish retail environment, the company is expected to generate approximately $350 million in annual average free cash flow over the next several years. This level of consistent cash flow lends itself to DCF valuation.

Valuation:

Ratios – P/E (ttm) 19.8X

P/S 1.51X

P/B 2.6X

EV/EBIT 12.5X

Discounted Cash Flow Analysis –

Financials:



Risk:

- Macroeconomic pressures could result in maintenance deferrals.

- Highly competitive industry and pricing.

- Significant rebound in new vehicle sales could have a negative impact.

- Legal challenge to the CSK acquisition.

- Threat of higher input costs and inability to pass through to customer.

Conclusion:

O’Reilly has proven to be an industry-leading operator in the competitive world of retail auto parts. This model has produced very consistent earnings and cash flow. Their strategic initiative in penetrating the commercial side should provide a new catalyst for growth. The growth and margins will need to be maintained in order to overcome the premium valuation.

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