O’Reilly Automotive: Initiate Hold As Valuation Is Not Cheap (NASDAQ:ORLY)

Investment summary

My recommendation for O’Reilly Automotive (NASDAQ:ORLY) is a hold rating. While I like the competitive advantages and how the business is well positioned to benefit from the current rate environment, my model suggests a limited upside to the ORLY share price. As such, I am initiating a hold rating until the valuation gets more attractive.

Business Overview

ORLY sells automotive aftermarket parts, including tools, supplies, equipment, etc., primarily in the United States. As of 1Q24, ORLY has 6,131 operating stores in the US, 63 in Mexico, and 23 in Canada. Segment-wise, ORLY reports DIY (do-it-yourself) and DIFM (do-it-for-me), representing 52% and 48% of total revenue, respectively.

Competitive advantage snowballs as ORLY scales

ORLY’s competitive moat is its massive scale, making it one of the largest players in the industry. There are a few aspects to this scale advantage. The beauty is that all of these advantages will continue to snowball as ORLY scales up, further solidifying its competitive position.

Firstly, ORLY is able to stock up more SKUs (note that there are thousands of SKUs in the industry) as it has visibility to demand, and hence, this attracts car owners to look for ORLY because they know ORLY has what they need. A smaller player cannot do this because they risk not clearing the inventory. Secondly, scale gives ORLY very strong purchaser’s buying power in that it is able to negotiate heavily against suppliers for lower costs as it procures inventories in bulk. Some of this lower cost could be passed on to consumers, making ORLY competitive in price. For reference, ORLY gross margin has expanded from the low-40% to the current low-50% over the past two decades. Thirdly, scale provides ORLY with a lot of financial resources and capacity to conduct M&As (part of ORLY’s growth strategy) to roll up this fragmented industry (as per IBISworld, there are more than 44 thousand auto parts store businesses in the US), providing it with more scale. This ability to consistently roll up the industry not only provides ORLY with more scale, it also extends the distribution capabilities of ORLY (increased number of stores), giving it more brick-and-mortar presences, thereby further anchoring its mind share amongst consumers.

Benefit from current high rates environment

I believe ORLY is an indirect beneficiary of the current high interest rate environment on a few fronts. Firstly, it pushes up the cost of car loans, which caused the demand for cars to go down, and we can see this from the price of cars (both used and new) coming down (demand<supply). Lesser car purchases also mean existing cars are running on the road longer, and it is only natural that older vehicles require more repairs, which is an opportunity for ORLY. Secondly, the inflationary environment pushed up the cost of car repairs, forcing more car owners to repair their vehicles themselves, which benefits the ORLY DIY segment. Thirdly, because ORLY is under-indexed to national accounts in the DIFM segment, it is able to win relative share against peers (AutoZone (AZO), Advance Auto Parts (AAP), and Genuine Parts Co. (GPC). For numerical reference, ORLY’s comparable growth over the past few quarters (since 3Q22) has consistently outpaced peers’ averages by a mid-to-high single-digit percentage. The reason for this is that only higher exposure to independent accounts allows it to better pass through inflationary pressures (supporting comp sales and gross margins). Whereas for peers that are dealing with more national accounts, they are generally at a disadvantage due to the scale of their national account customers.

When we look at kind of our book of business and you look at the general independent garage versus strategic accounts, whether it be a regional account or whether it be a national account, you know — as you know, we have a smaller portion of our business that is the national account business than some of our competitors. 1Q24 earnings

1Q24 comps sales could have been better

Released on April 24, 2024, ORLY reported sales growth of 7.2% to $3.976 billion and comp sales growth of 3.4%. Split by segment, DIFM comp sales grew by a mid-single-digit percentage, while DIY segment sales grew by a low single-digit percentage. EBIT margin compressed by 40 bps to 18.9%, below consensus of 19.2%, as the 18 bps increase in gross margin was offset by an increase in SG&A. This led to ORLY reporting EPS of $9.20, below consensus expectations of $9.28. ORLY 1Q24 comp sales would’ve been better if not for the delayed tax refunds in February and the unseasonably wet weather in March. I would expect the impact of unfavorable weather to moderate throughout the coming months, and 2H24 to see cleaner like-for-like growth vs. last year.

Capital return policy still intact

Compared to the average of $687 million over the previous few quarters, ORLY’s share repurchases in 1Q24 were relatively low at $270 million. Additionally, this was the lowest quarterly repurchase amount since 2Q20. However, I wouldn’t be too concerned about this, as ORLY did pay down debt ($310 million for their commercial paper) and did use cash for the Groupe Del Vasto acquisition. While it is unlikely that ORLY can continue buying back the same level of shares because of the debt level, I don’t think there is a change in direction for capital returns. ORLY is still expected to generate ~$2 billion of FCF in the coming years, and I expect EBITDA to continue steadily growing with the top line. Both of these will push down the leverage ratio (currently near 2x), making it easier for ORLY to step up on share buybacks again.

Valuation

I model ORLY using a forward PE approach, and using my assumptions, I believe ORLY is worth ~$1070, with a total return of 1%. ORLY should have no issues and continue to grow at high single-digits (the midpoint of the FY24 revenue guide calls for 7%) as it continues to benefit from the current inflationary environment tailwinds. Historically, ORLY has been growing at this rate, and I note that my model does not assume any inorganic growth (from M&A) that could support higher growth (the industry is still fragmented, so ORLY can still continue its M&A strategy). Margins are likely to see some form of pressure in FY24 from the continuous inflationary environment (while ORLY can easily pass through the cost, I think it is safe to assume they will need to bear some of the pain) before recovering to a pre-inflationary environment of <15% net margins. As relative performance against peers is much better (from a comp sales perspective: ORLY is still growing near 4% while peers average comp sales are near low single-digit percentages), ORLY should continue to trade at a premium. Historically, ORLY has traded at a premium of 1.25x and is currently trading at a 1.33x premium (24x vs. peers’ average of 18x). I assume this premium will revert back to historical levels as we move into FY25 (a better macro environment, in my opinion). As ORLY has higher debt, I assumed it would buy back shares at half the rate of what it did in recent years (FY24 to buy back 3% of shares outstanding).

Risk

If the cost of living is to go higher, it might cause consumers to abandon their cars altogether, and with fewer cars on the road, it has a direct impact on ORLY as there would be fewer repair occasions. In addition, if the bad weather continues to persist for longer than expected, ORLY could see a really bad 1H24 performance that makes hitting FY24 targets a lot harder (more pressure on 2H24 performance), risking a potential miss.

Conclusion

My view for ORLY is a hold rating, as the valuation is not cheap at this level, based on my model. However, I do like ORLY scale advantages, which enables it to negotiate for better pricing from suppliers, stock up a wider assortment of SKUs, and have more financial capacity to conduct M&A. I also like that ORLY benefits from the high-rate environment. However, I believe its current valuation reflects most of the upside potential.