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Robert Abbott
Robert Abbott
Articles (320)  | Author's Website |

O’Reilly Automotive: An Assessment for Value Investors

Will it be able to address internal problems as well as soothe investors’ concerns about Amazon.com?

March 09, 2018 | About:

O’Reilly Automotive Inc. (NASDAQ:ORLY) is a relative star at GuruFocus, boasting inclusion on the Undervalued Predictable Screener and enjoying a five-star (top) ranking for predictable earnings.

Obviously, it is also undervalued. When that word pops up, investors want to know why it became undervalued and if the problem that caused the share price decline has been resolved.

A quick look at this 10-year chart confirms there was a serious pullback, one which continued throughout the first half of 2017:

1597417908.png

With the recovery that began in July 2017, investors probably breathed a sigh of relief. But it was a brief respite. Since the beginning of 2018, O’Reilly’s price chart has been looking like a luge run once again.

In October 2017, Chuck Akre (TradesPortfolio) said of O’Reilly, there is “pervasive investor concern about Amazon (NASDAQ:AMZN) and online competitive incursion into auto parts. This Amazon narrative has weighed heavily and broadly on retail shares in 2017.” That concern was not for O’Reilly alone; Serge Berger at InvestorPlace said investor attitude afflicted all auto parts companies.

As for the 2018 price slump, the Benzinga website summed up Credit Suisse Group AG analyst Seth Sigman’s thinking this way: “It is clear the market is worried about several factors in O’Reilly’s industry. Specifically, he noted deceleration in O'Reilly's business after April, uncertainty from key drivers and vulnerable margins.”

Management at O’Reilly’s appears confident the company will make progress. Last September, its board of directors upped its share buyback program by $1 billion, taking the total authorization to $9.75 billion.

With all these positives and negatives, let’s turn to an actionable assessment of the company, one that will allow us to decide, reasonably quickly, whether O’Reilly’s deserves more due diligence.

To do that, we will use the Macpherson model to ask if O’Reilly is a great company and if it is available at a great price.

Great company?

The model is designed to find great companies at great prices.

To identify great companies, Thomas Macpherson uses three criteria:

  • A competitive moat.
  • Financial strength.
  • Profitability.

A competitive moat is considered to exist if a company has at least a 15% median return on capital over the previous 10 years, and a minimum 15 median return on tangible equity across the preceding 10 years.

  • Return on capital: The median over the past 10 years is 19.5%. Note the company has steadily increased this ratio from 8.93% to 34.36% since 2008.
  • Return on tangible equity: GuruFocus reports O’Reilly has negative tangible equity, so it will not be included.

For financial strength, Macpherson uses cash-to-debt and sets the minimum at 100; he also wants a GuruFocus financial strength rating of at least 9. Both criteria are available on the dashboard. O'Reilly has cash-to-debt of 0.2 and a financial strength score of 5 out of 10.

O'Reilly Automotive financial strength

Clearly, O’Reilly meets neither of these criteria; in particular, its debt load is a problem (although it has reasonable interest coverage).

Profitability is the third element in assessing whether a company is a great company, from a value investor’s perspective, at least. This excerpt from the dashboard shows O’Reilly meets this standard:

O'Reilly Automotive profitability

Note all the green in areas that show profitability and growth.

Summing up the great companies through the Macpherson model produces a pass on a competitive moat and profitability, but a fail on financial strength. Given the failure involves debt load, most value investors would likely skip O’Reilly for now, but maintain a watch.

Great price?

To test the valuation of a stock, Macpherson looks at three types of discounted cash flow:

  • DCF-free cash flow.
  • DCF-earnings.
  • Projected free cash flow (for companies with inconsistent flows).

Information for all three at once comes from the All-in-One screener (to find these figures, enter the stock name or symbol, press "Go," scroll to near the bottom of the page and click on "Valuation"):

  • The stock closed at $242.67 on March 8. That is more than double the DCF-free cash flow estimate of $112.00 and suggests serious overvaluation.
  • DCF-earnings goes in the opposite direction: it puts the intrinsic value at $361, which would make the price 33% below the intrinsic value.
  • Projected free cash flow comes in a $155, which also suggests the stock is overvalued. This measure is included because a 10-year chart of free cash flow shows inconsistencies over medium term.

O'Reilly Automotive free cash flow

Two of the three metrics for a great company show an overvalued stock, while one puts it in the undervalued category. Serious value investors would likely be skeptical and give it a fail on great price.

Other thoughts

Among the gurus, 13 have stakes in O'Reilly; Akre has the biggest holding at almost 1.9 million shares, while Pioneer Investments (Trades, Portfolio) (1.3 million shares) and Ruane Cunniff (Trades, Portfolio) (1.2 million shares) are second and third largest.

Among the 13 holders, only one, Ray Dalio (Trades, Portfolio), reduced his holding in the last quarter of calendar 2017. He cut his holdings by a bit more than a third. On the other hand, four increased their stake and one made a new buy.

Among the analysts followed by NASDAQ.com, the mood is definitely bullish:

O'Reilly Automotive analysts

Conclusion

O’Reilly Automotive has the distinction of being a five-star, undervalued predictable company. That’s a small universe and reflects very positively on the company.

On closer scrutiny, however, and that is what the Macpherson model prompts us to do, there are several indicators that should give pause to value investors:

The first criterion for great company status was a competitive moat, an advantage that would allow it to maintain its pricing power. O’Reilly has that, with a nearly 20% return on capital.

The second requirement was financial strength, as shown by its cash-to-debt standing and its GuruFocus rating. It failed on both of those counts.

The third and final element of reaching great company status is profitability, for which O’Reilly received a passing score.

Overall, two passes and one fail in the quest for a great company. For strict value investors, one fail is one too many; they will continue looking for a company that has passes for all three criteria.

Whether the company is available at a great price involves two relevant criteria, one pointing to overvaluation and one pointing to undervaluation. Again, no clear-cut result.

What’s one to do in the case of split decisions like these? Probably best to keep looking; as many investing legends have pointed out, patience is a very big virtue among value investors. Indeed, it is better to wait than to jump into a mediocre stock, not that O’Reilly is one. It is a very good company available at a very good price, but not currently a great company at a great price.

Disclosure: I do not own shares in any company listed, and I do not expect to buy any in the next 72 hours.

About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995, and in 2010 added options, mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the Unseen Revolution. In Big Macs & Our Pensions: Who Gets McDonald's Profits?, he looks at the ownership of McDonald’s and what that means for middle class retirement income.

In an eclectic career, Robert Abbott was a radio news writer and announcer, a newsletter writer and publisher, a farmer, a telephone operator, and a construction worker. When not working, he has been a busy volunteer, which includes more than a decade of leadership roles at the Airdrie Festival of Lights, one of North America’s leading holiday light displays. He lives in Airdrie, Alberta, Canada.

Visit Robert Abbott's Website


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