With Quiver Quantitative's recent institutional holdings data, we can see that hedge funds and asset managers have been increasing their holdings in O’Reilly Automotive Inc. (NASDAQ: ORLY). Firms such as Point72 Asset Management, Two Sigma, and Putnam Investments have all recently added to their ORLY positions. Most notably, Point72 Asset Management increased shares held by 89.26% (as filed on 9/30), bringing their total ORLY holdings to 203,574 shares worth around $209.7 million dollars at current market prices. With this in mind, we took a closer look at some of the reasons why many investors may be bullish on O’Reilly Automotive.
In October, O’Reilly Automotive released earnings results for the third quarter of FY23. Highlights of the quarter included third quarter sales (revenue) of $4.2 billion dollars (11% YoY increase), gross profit of $2.16 billion dollars (12% YoY increase), EBIT of $897 million dollars (12% YoY increase), and net income of $650 million dollars (11% YoY increase). O’Reilly Automotive CEO Greg Johnson had this to say about the quarter, “We are pleased to once again report another quarter of strong performance and profitable growth, highlighted by an 8.7% increase in comparable store sales and a 17% increase in diluted earnings per share to $10.72/share. Team O’Reilly’s consistent execution of our proven dual market strategy and dedication to our culture of excellent customer service resulted in another quarter of mid-teen professional and solid DIY comparable store sales growth. Our profitable growth is the direct result of our Team Members’ hard work and unwavering commitment to providing the highest level of service in our industry, and I would like to thank each of them for their ongoing contributions to our long-term success.” With this strong earnings result in mind, we believe that O’Reilly Automotive is a compelling investment opportunity trading at a cheap valuation.
O'Reilly Automotive, a major player in the U.S. automotive aftermarket parts sector, operates primarily by selling automotive parts, tools, supplies, equipment, and accessories. Founded in 1957, the company has expanded significantly, operating 5,929 stores across 47 U.S. states and 42 stores in Mexico as of December 31, 2022. O'Reilly caters to both do-it-yourself customers and professional service providers, employing a dual market strategy. Their revenue is generated from a diverse product line that includes new and remanufactured automotive hard parts, maintenance items, and accessories. Additionally, the company enhances its income stream by offering various services such as battery diagnostic testing, parts replacement, and recycling programs.
The automotive aftermarket industry, valued at approximately $357 billion, is highly competitive, with O'Reilly Automotive operating in a segment estimated to represent $130-$140 billion of the automotive aftermarket industry’s value. Key competitive factors include customer service, product availability, brand recognition, and pricing. O'Reilly faces stiff competition from national and regional retail chains, wholesalers, automobile dealers, and online retailers, including major players like AutoZone, Advance Auto Parts, and Amazon. The industry is also influenced by external factors such as inflation and seasonality, with O'Reilly effectively managing cost increases through strategies like supplier incentives and forward buying.
O'Reilly Automotive's strong position in the automotive aftermarket industry is underpinned by a unique blend of competitive advantages. Their effective dual market strategy has been pivotal in simultaneously catering to DIY and professional service provider customers, enhancing their market reach and utilization of their expansive store and distribution network. The company's commitment to superior customer service, highlighted by a technically proficient workforce and an efficient regional tiered distribution network, ensures high product availability and customer satisfaction. Furthermore, the depth of experience within their management team, cultivated largely through internal promotions, has consistently driven the company's growth and profitability. These factors collectively not only set O'Reilly apart in the competitive landscape but also bolster its ongoing success and market leadership.
Management is solid, and their capital allocation priorities do a great job of creating long-term shareholder value. Management likes to return excess cash to shareholders via share repurchases. Management’s history of share repurchases started in 2011, when the business’ Board of Directors authorized a share repurchase program. Under this long-standing authorization, management is authorized to repurchases shares from time to time based on factors like price and overall market conditions. While most management teams have caps on repurchases, it seems like this authorization is open-ended, with management repurchasing shares when it makes sense (i.e. valuations are low / below the business’ intrinsic value). All repurchased shares are retired indefinitely, and O’Reilly has plenty of runway for future share repurchases (as the business continues to compound earnings and cash flows over time, management can tap into a larger cash reserve to repurchase additional shares). While management likes to return value to shareholders via share repurchases, they have never offered cash dividends on the business’ common stock, with no intentions to do so in the future. We are a big fan of this capital allocation decision, as we believe that reinvestments back into the business at high rates of return and share repurchases at cheap valuations drive stronger value creation for shareholders compared to cash dividends.
Looking at management incentives, we can see that management is incentivized well, with a compensation structure that does a great job of aligning shareholder and management interests, while also doing a great job of retaining executive talent over the long-term. The executive compensation structure includes a base salary, an incentive compensation plan, and long-term stock-based incentives. The incentive compensation plan provides annual incentive compensation for NEOs that achieve predetermined financial metric performance goals. In FY22, these predetermined financial metric thresholds included comparable store sales (30% weight), operating income (30% weight), ROIC (20% weight), and FCF (20% weight). We believe the financial metric thresholds selected are stellar performance indicators of the business, and we further believe that this compensation structure incentivizes management to meet important financial metric thresholds that tie in nicely to the business’ growth strategy. In addition to this annual incentive compensation plan, the long-term stock-based incentives allow management to build equity in the business over the long-term, with rewarded stock options being vested over multi-year periods. This further incentives management to meet financial metric thresholds and sustainably grow the business (since a large part of their pay is coming from stock price appreciation). Additionally, with stock options and equity rewards being vested over multi-year periods, management is further incentivized to stay with the business over the long-term. While this may seem obvious, it is very hard to run and sustainably grow a business where management is a revolving door, so it’s great to see a management team incentivized to stay at the business over the long-term.
O’Reilly Automotive is a very efficient business. The business currently operates at a LTM ROIC of 53.5% and a WACC of 7.9%, meaning that the business operates at a ROIC to WACC ratio of 6.77x. This high ROIC to WACC ratio showcases the business’ ability to generate excess returns on capital relative to the business’ weighted average cost of capital. Businesses that operate with strong returns on capital are compounders, businesses that are able to rapidly compound earnings and intrinsic value over the long-term, much to the delight of long-term passive shareholders. Looking further, we can see that O’Reilly Automotive has had stellar sustained growth in operating income (EBIT), with flat EBIT margins (EBIT margins have hovered around 19-22% over the last decade), over the last ten years. Looking at operating income is important, as it shows the profitability of a business’ core operations. Since 2013, O’Reilly Automotive has grown EBIT at a CAGR of 10.4%, showcasing the business’ operational efficiency improvements over that time frame.
Analyzing O’Reilly Automotive’s income statement, we can see some stellar sustained growth in revenue, gross profit, and earnings within the last decade. Since 2013, O’Reilly Automotive has grown revenue at a CAGR of 8%, with gross profit growing at a CAGR of 8.2% in that same time frame. As we can see, growth in gross profit and revenue was largely even over the last ten years, signifying that margins stayed flat during that time period. O’Reilly Automotive is an efficient business, with gross margins hovering around 50-52% over the last ten years. In terms of earnings, O’Reilly Automotive has grown EBITDA at a CAGR of 9.9% since 2013, with EPS growing at a CAGR of 18.6% during that same time period. This growth in EPS can largely be attributed to share repurchases. O’Reilly Automotive is a cannibal, decreasing shares outstanding by 44.4% since 2013 through share repurchases.
Looking at O’Reilly Automotive’s balance sheet, we can see that the business operates in solid financial health. O’Reilly Automotive currently holds around $82.66 million dollars worth of cash and equivalents on the balance sheet, with no short-term borrowings and long-term debt of $5.1 billion dollars. While this low cash to long-term debt ratio may be a red flag for some investors, we don’t think that it should be a cause for concern. The business currently operates at a Net Debt / EBITDA of 1.79x (meaning that net debt is 1.79x annual EBITDA, representing moderate leverage) and an interest coverage ratio of 16.81x (meaning that the business generates $16.81 of EBIT for every dollar of interest expense that the business incurs). Note that these figures represent moderate leverage in the business, and that these ratios are better than O’Reilly’s closest competitors (AutoZone and Advance Auto Parts). Additionally, we believe this low cash pile and moderate leverage through debt shows that the business has plenty of room for continued growth, with management continuing to plow earnings and capital back into the business at high rates of return. As mentioned above, O’Reilly Automotive operates with very efficient return on capital metrics (LTM ROIC of 53.5% and a ROIC to WACC ratio of 6.77x), meaning that these capital reinvestments into the business will allow for strong compounding growth going forward, leading to large increases in the business’ intrinsic business value and stock price over the long-term.
Analyzing O’Reilly Automotive’s cash flow statement, we can see some stellar sustained growth in net income and free cash flow over the last ten years, showing the business’ increased operational efficiency during that time period. Since 2013, O’Reilly has grown net income at a CAGR of 12.5%, with free cash flow growing at a CAGR of 17.6% in that same time frame. This growth in free cash flow can largely be attributed to expanding free cash flow margins. In 2013, the business operated at a FCF margin of 7.7% of revenue, compared to today where the business operates at a FCF margin of 15.3% of revenue (LTM FCF margin). Expanding FCF margins act as a catalyst for future free cash flow generation. Strong top-line revenue growth (10-yr CAGR of 8%) and expanding FCF margins act as a “twin-engine” for free cash flow growth, allowing the business to rapidly compound free cash flow over the long-term. This increasing pile of cash can be used for further share repurchases, reinvestments back into the business at high rates of return, and dividend increases, all of which create value for shareholders over the long-term.
After conducting a reverse discounted cash flow analysis on O’Reilly Automotive, we can see that the business is trading at share prices that imply a 5.8% growth rate (CAGR) in free cash flow over the next ten years, using a perpetuity growth rate of 3% (largely in line with US GDP growth) and a discount rate of 7.9% (O’Reilly Automotive’s WACC). As highlighted above, we believe that O’Reilly Automotive is a very high quality business, and we further believe that the market is underestimating O’Reilly’s FCF growth potential over the next ten years. While past performance is not indicative of future results, O’Reilly has grown FCF at a growth rate of 17.6% over the last ten years, which is significantly above what the market is projecting for O’Reilly over the next ten years (5.8% CAGR). This implied FCF growth rate of 5.8% is even below O’Reilly’s 10-year top-line revenue growth rate of 8%, which doesn’t even begin to factor in things like FCF margin expansion, which can really drive FCF growth over time. We believe a fairer implied FCF growth rate is 10%, which implies a share price of $1,342/share (implying a 34.2% upside from current share prices).
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