O’Reilly Automotive’s Q2: Gaining Market Share In A Tough Environment (NASDAQ:ORLY)

Introduction

O’Reilly Automotive, Inc. (NASDAQ:ORLY) has recently reported its Q2 results, and while the company is starting to feel the tough comparables from previous quarters, combined with softer consumer demand, especially in non-discretionary items, and some headwinds from cool wet weather, there are also many positives developments.

In this article, I will focus on the development of the first full quarter under the leadership of new O’Reilly’s CEO Brad Beckam, and why I believe despite being short on consensus expectations for top and bottom lines and lowering the guidance for 2024, the stock price went up the day after the release (25th of July 2024).

Company Overview

O’Reilly Automotive is the largest specialty retailer of automotive aftermarket parts, tools, supplies, equipment, and accessories in the United States, generating half of its revenue through sales to professional service providers and the other half to do-it-yourself (DIY) customers.

Founded 67 years ago, the company is currently operating over 6,000 stores in the U.S., 69 stores in Mexico, and has recently entered the Canadian market through the acquisition of Groupe Del Vasto in January 2024.

For those readers who are not familiar with the company, I would encourage reviewing my previous article where I covered its business model, growth strategy, management, main risks, and the overall auto parts market.

Financials

Although it is never good news when a company misses expectations and decreases its guidance, as we will show in the following sections, I consider that O’Reilly’s financial performance has been good when compared to its competitors and taking into account that customers are behaving more conservative due to the cumulative impact of inflation and the uncertainty about the broader macroeconomic environment.

Revenues: Outperforming The Industry

During Q2, revenues increased by 5% (2.3% increase in comparable store sales), which is a significant decrease when compared to last year’s Q2 when revenues increased by 10.8% (9% increase in comparable store sales).

From the DIY and professional category’s perspective, most of the growth has been driven by the professional segment, which increased by 7.8% compared to a modest growth of 1% in DIY.

Higher growth rates in professional services have been the trend over the last years, and after a spike in DIY revenues during the first quarters of the pandemic, when they reached 61% of O’Reilly’s revenues, professional services have been growing at faster rates, and currently represent close to 50% of revenues.

Market Share Gains

While one could focus on the lowering growth rates in revenues, if we compare the performance with its main competitor AutoZone, Inc. (AZO), O’Reilly performed significantly better than the 3.5% sales increase delivered by the former in its latest earnings release, and I see this market share gains as one of the main positive aspects during Q2.

This market share gain and the increase in revenues have been mainly fuelled by an increase in ticket counts rather than the average ticket value. Given the lowering inflation, the company is no longer benefiting from higher revenues through price increases as much as in previous quarters.

Margin Decrease

When looking at gross margins at first sight one could get worried about the 53 basis point decrease (from 51.3% a year ago to the current 50.7%), but when looking deeper, there are no reasons to be concerned as long as you are a long term shareholder as I am.

The main driver of the gross margin decrease (by 35 b.p.) has been the acquisition a few months ago of the Canadian business Groupe Del Vasto which operates a higher mix of distribution sales to independent parts stores at substantially lower gross margins.

Despite the short-term effects on gross margins, I believe the acquisition opens a great opportunity to expand into a new market over the following years, and the overall benefits significantly exceed the short-term decrease in margins.

The other factors that caused lower gross margins have been the composition of revenues, with higher growth in maintenance revenues that carry lower margins and headwinds in the higher-margin DIY business.

Going down to bottom line figures, the 6% increase in selling, general and administrative expenses (SG&A), slightly higher than revenue growth, has also caused a decrease in operating margins (20.2% compared to 21% a year ago).

In the SG&A area of the business, the management is not willing to cut costs significantly due to its commitment to deliver superior customer service:

When we talk about softness in our industry from a sales perspective, these are not huge movements in candidly, they don’t matter to our customers.

If sales are a little bit soft, they still need a high level of service, and we won’t sacrifice that. So there are limits to how you manage that broader cost structure.

(Jeremy Fletcher, Executive Vice President and CFO. Q2 Earnings Call)

The decrease in margins has reduced net income by 1% YoY, which has been compensated with a reduction in share count, and earnings per share have modestly increased by 3% YoY.

Good Inventory Turnover

One of the figures I tend to take a close look at when assessing O’Reilly’s results is the inventory turnover, since inventory it is one of the main components of its balance sheet and will determine the long-term returns on capital of the company.

During the last quarter, the inventory turnover increased compared to last year, from 1.73x to 1.75x.

The main contributors to higher inventory turnover have been the strong performance of hot weather categories such as batteries and HVAC as well as maintenance categories like brakes, oil changes, and spark plugs. On the other side, the main detractors have been non-discretionary items such as appearance and accessory categories.

Store Growth

For the full year, the management is expecting to open between 190 and 200 new stores, and despite during the first half of the year O’Reilly has only opened 64 new stores (27 in Q2 and 37 in Q1), the first half of the year has been historically slower at new store openings.

If we take into account the 23 stores acquired in Canada, the company is on a good track to achieve its 2024 goals regarding store growth and the management hasn’t decreased its guidance on that front.

Compared to last year’s results, the company has accelerated its store openings in Mexico to 6 new stores in Q2 compared to only 1 in Q2 2023 but has reduced its growth rate in the U.S. For the back half of the year, the company is expecting to open between 15 and 20 new stores in Mexico, which would represent a significant increase from the current 69 stores.

A positive aspect is that there has been no store closings during the last quarters, and if the company achieves its goal for the full year, the store count will increase by 3.16% over 2024, which would be the highest store growth since 2019.

Share Buybacks

One of the most positive aspects of O’Reilly’s capital allocation is the great execution of its share buybacks.

In Q2 2024, the company accelerated its share buybacks compared to last quarter due to a decrease in valuation.

While during Q1 the average EV/EBIT was around 22x and reached as much as 24x, the company only repurchased 0.2 MM shares for a total consideration of $270 MM.

On the other hand, as the valuation came down during Q2 between 20x and 21x EV/EBIT, the company accelerated its share buybacks, reducing the share count by 0.8 MM shares, spending $793 MM.

When reviewing the relation between valuation and share buybacks as a percentage of cash from operations (excluding change in net working capital), we find a value of -0.66, indicating higher buybacks during periods of lower valuation multiples.

Expected Growth

As stated before, one of the negatives of the earnings release has been the decrease in the full-year guidance, as can be seen in the image below.

Even though the company kept intact its expectations in new store openings, gross margins, and free cash flow, there has been a 1% adjustment in comparable store sales, which reduces total revenue expectations, a 0.1% decrease in operating margins, and a 1.45% decrease in expected earnings per share.

Taking into account the released guidance, management expects higher margins in the second half of the year compared to Q2, due to a normalization in the revenue mix and some purchase power at the supply side of the business.

Despite the short-term headwinds and the slight decrease in guidance, management remains confident about the long-term value proposition of the company:

The size and growth of the car park in North America coupled with the quality of vehicles and a continually rising average vehicle age drive resilient demand in our industry.

We expect to see continued steady growth in total miles driven, underpinned by population growth and the critical nature of the daily transportation needs of vehicle owners.

We also believe that the value proposition for continued investment in an existing vehicle has never been higher and that consumers will continue to prioritize funding the cost of repair and maintenance of older, higher mileage vehicles.

Ultimately, the macroeconomic conditions we face do not affect our company’s philosophy for how we execute our business model. We have instilled an ownership mentality throughout our organization.

(Brad Beckham, CEO. Q2 Earnings Call)

When reviewing management’s comments with independent reports, such as the latest S&P Global Mobility report, we can clearly corroborate that indeed the average age of the U.S. vehicles is hitting new highs, which will support demand for aftermarket parts.

Given the short-term headwinds and the decrease in guidance, I am adjusting my valuation on O’Reilly compared to the one presented 9 months ago, when the company was trading at $880 and presented a significant undervaluation compared to my previous fair price of $1,130 per share.

Despite my confidence in the company’s long-term performance (I haven’t sold any shares since then and will add up if the valuation comes down), I am adjusting my fair price based on the recently released information.

Assuming a 5% yearly decrease in share count (the average yearly decrease since 2014 has been 5.8%), and an 8% discount rate (based on a 0.83 beta, a 4.8% cost of debt, and a 4.6% equity risk premium), with a 3.5% long term growth rate, slightly above inflation, and a 23x FCF multiple, my current fair price stands at $1,072 per share.

In my base case scenario, I am not assuming a significant expansion over the following years in the Canadian market. Otherwise, if store count growth rates accelerate, the revenue growth should be increased.

Valuation

Given the decrease in fair price from both growth in perpetuity and FCF multiple approaches, I believe O’Reilly is currently trading close to its fair price or with a small premium, and therefore I am downgrading its rating from strong buy to buy.

However, I consider O’Reilly a high-quality company and will increase the position if the valuation decreases to between 20x-22x its next twelve months’ EPS from the current 25.4x, which would be around $960 to $1000 per share.

Conclusions

At first sight, O’Reilly’s Q2 results could be interpreted as somewhat negative given the miss on expectations, lower margins, and the reduction in growth rates. However, when looking under the hood, there are many positive developments that reinforce my conviction as a shareholder of the company.

The market share gains prove its strength when compared to its closest competitors, delivering superior growth rates in a tough environment. Store count growth continues as expected, and the acquisition in Canada could provide room for a significant expansion over the next decades.

The share buyback strategy has been outstanding and the management has proven its ability to successfully deploy its cash from operations into organic growth, acquisitions, and share count reduction.

The core fundamentals that drive O’Reilly’s business haven’t changed, and the average age of U.S. vehicles continues to increase.

While O’Reilly could lower its growth rates over the next quarters with weaker consumer spending and lower inflation, and my fair price has slightly decreased, I consider its business model as highly defensive. Consumers can delay some non-discretionary car accessories spending, but the maintenance of their cars needs to be done. Also, an uncertain economic environment will result in fewer new cars sold and higher maintenance costs for older vehicles.

Finally, I’d like to finish this quarterly review with a couple of phrases pronounced by the company CEO during the earnings call, since I believe they faithfully summarize the company’s philosophy:

Our run it like you own it philosophy does not accept external pressures as an excuse when there is still market share to gain in every local market, simply by outhustling and outservicing our competition. Even though we believe we gained market share in the first half of 2024 in a tough environment, I can guarantee that none of our teams in our stores, distribution centers and offices are satisfied with a 2.8% year-to-date comparable store sales increase.

Our teams are committed to putting in the work, it takes to win every day in every one of our markets and remain hungry to achieve performance that matches the high bar we have set as a company.

(Brad Beckham, CEO. Q2 Earnings Call)