O'Reilly Automotive: Business Continues To Outperform, But Valuation Is High

Overview

ORLY stands as a prominent player in the automotive aftermarket industry in the United States. Renowned for its wide range of automotive parts, tools, supplies, equipment, and accessories, the company caters to two distinct customer segments: do-it-yourself [DIY] and Do-It-For-Myself [DIFM]. My recommendation for O'Reilly Automotive (NASDAQ:ORLY) is a hold rating as I believe the market has high expectation for the stock (ORLY is trading at 23x forward PE, the high end of its trading range, and also much higher than peers). Even though ORLY continues to outperform peers, I don’t see enough margin of safety for me to invest at this valuation.

Strong Q223 comparable store sales but moderation for 2H23

In the second quarter, ORLY once again exceeded expectations with a remarkable 9% increase in comparable store sales. This impressive performance was driven by a year-to-year acceleration in commercial sales, while the DIY segment remained steady, even in the face of a broader industry trend of a slower June. Additionally, retail trends surpassed internal forecasts, with ticket counts staying relatively unchanged and mid-single-digit growth in ticket sales, leading to consistent positive monthly comparable sales.

Looking ahead, I expect comparable store sales will moderate in the second half of 2023, following the strong 9.8% growth seen in the first half. This moderation is expected as the company faces comparisons with pricing increases implemented in the previous year and stronger ticket counts. It's worth noting that during the second quarter, there was a mid-single-digit increase in same-SKU inflation, but management anticipates this measure will return to a more typical low single-digit rate as the year progresses. That said, despite a softer June due to customers trading down or deferring services, management observed some instances of customers choosing to "trade up." They also pointed out that extremely hot summer weather has led to preliminary results that are in line with the second quarter's performance. So there is certainly room for ORLY to perform than I expect.

Share gains in DIFM market

ORLY's success in the DIFM market continues to be evident as the company consistently gains market share. Their impressive DIFM sales growth relative to peers like AutoZone (AZO) supports the idea that ORLY is gaining share. This is especially impressive when we consider the strong growth in the prior year, and ORLY is growing on top of that. However, I think it is unlikely that ORLY is gaining share from the big players like AZO as AZO is growing as well. I believe it is likely that these gains primarily come at the expense of subscale players that typically do not have the necessary scale to compete (lack of inventory SKU, lack of geographical coverage, etc.). With ORLY market position and its strong supply chain, combined with the successful implementation of their professional pricing initiative, I think it will enable them to continue capturing market share in the highly fragmented DIFM sector in the long term. Management comment during the call is especially encouraging with regards to ORLY market position and share gains potential:

“I would say is that, especially from operations and sales, the first thing they point to when we talked to them about what we're seeing in the market, Simeon, is the position we're in from a supply chain standpoint. As you know, as good as anybody, our immediacy of need and non-discretionary business, it's all about on both sides of the business, it's all about who has the right part at the right place at the right time. And I just couldn't be more pleased with the job that Brent, and the merchant team, the inventory management purchasing team, and our distribution teams are doing for our store operators, that they have just got us in a better position than we've been in a long time. And we feel like, we're playing from a position of strength from the team side, from the supply chain side, and all the work we're doing with our professional customers out in the field every day making sales calls. And then, obviously, we still feel good about everything we did with PPI.” from: 2Q2023 earnings call

SG&A investments are necessary

SG&A expenses per store saw a significant increase of around 10% compared to the previous year. While this increase is quite huge, I see it as management’s commitment to enhancing service quality and positioning itself for long-term sales growth and market share expansion. One of the primary contributors to this increase was spending on store imaging and refreshing, which I see as essential in order to continuously attract customers.

Valuation and risk

According to my model, ORLY is valued $939.70 in FY24, representing a 6% increase, or in other words – fairly valued. This target price is based on my growth expectation that growth will gradually revert back to normalized level of mid-single digits as per historical.

ORLY is now trading at 23x forward PE. Looking at history, this is at the high end of the training range which has typically reverted downwards when it touches this level. However, given the strong comparative growth vs peers, I think this multiple could sustain for the near-term. However, even at this level, ORLY is only fair valued. This is indicative (in my opinion) that the market has high expectation for the stock, which is something that I tend to avoid as missing expectation would be bad for the stock price in the near-term (consensus revised estimates + multiples revising downwards). When comp against peers, ORLY is also trading at a much higher multiple, which means there is quite a room for ORLY multiples to revert downwards (the low end of ORLY trading range historically was 18x, for what it's worth).

I would also note that while ORLY's supply chain is described as best-in-class, any disruptions in the supply chain, such as those caused by external factors like global supply chain challenges or logistics issues, could affect the company's ability to meet customer demand and impact its financial results. Although the input cost environment has returned to a more normalized pattern, any unexpected spikes in input costs could squeeze ORLY's profit margins if the company is unable to pass on these cost increases to customers.

Summary

My recommendation for ORLY is a hold rating. ORLY's strong performance in comparable store sales and DIFM market share gains are commendable, driven by its supply chain strength and professional pricing initiatives. However, the substantial increase in SG&A expenses, particularly for store improvements, indicates a long-term commitment to enhancing customer service and growth. That said, my valuation model suggests a target price of $939.70 for FY24, indicating that ORLY is currently fairly valued. While its premium multiple could be sustained due to strong growth relative to peers, the stock's high expectations pose a short-term risk, especially if consensus estimates and multiples revise downward.