Thesis
O’Reilly Automotive (NASDAQ:ORLY) retails and supplies automotive aftermarket parts, and related tools to a range of customers from do-it-yourself [DIY] to professional mechanics and technicians. I have a positive view on the business as I see ORLY continue to enjoying the strong secular trend stemmed from increasing number of miles travel (recovery to pre-pandemic levels), inflation driven pricing increase and possible delay demand for new vehicles – leading to consumers extending used vehicles lifespan, which increase demand for parts. In particular, I anticipate share gains for ORLY within the DIFM segment as a result of the company’s ability to continue executing well and extend its lead in distribution capabilities against smaller peers. However, I believe ORLY stock has already priced in this positive momentum, especially after the 1Q results (which saw price surge further), at 24x forward earnings which is higher than its average P/E multiple. Hence, I recommend a hold rating until valuation gets cheaper.
1Q23 results
1Q23 saw a healthy increase of 12.5% in sales for ORLY, which brought in ~$3.71 billion. While the company’s operating margin decreased by 100bps to 19.3 percent, comparable store sales increased by 10.8%. As a percentage of sales, SG&A increased by 20bps, reaching 31.7%, while gross margin dropped 80bps, landing at 51%.
DIFM and DIY
The DIFM segment’s strong ticket count and higher comps sales as ORLY continues to gain market share were the highlights of the earnings report, in my opinion. I expect no less from the DIFM segment moving forward as I believe ORLY’s focus on execution, inventory optimization, and its supply chain advantage will continue enable it to gain market share. Aside DIFM, DIY markets are also experiencing a positive trend. DIY sales at ORLY were up every month of the quarter except March, when bad weather dampened demand – which was saved by the mid-single digits inflation that made up for the loss of business brought on by the decrease in ticket sales. For FY23, I hold a conservative view and expect growth to be somewhat flattish as the easy comp in 2Q22 will be balanced out by the tough comp in 4Q22 note. That said, we could see a surprise as management mentioned that they are not seeing any signs of trade down. Overall, my take on ORLY’s FY23 comp guidance of 4%-6% is that it might be too conservative. This is especially considering 1Q23’s stellar results and the positive momentum the company is experiencing right now. With the recovery in trend (and management comments being positive of no trade down), I also believe the company’s DIFM segment will continue to be strong and build on recent share gains. Given the intense competition in 2H22, however, I think it’s important to point out that ORLY’s growth may begin to sequentially slow in 1H23. It’s possible that this would have an effect on investor sentiment, leading to a downward re-rating of the stock.
Margin
At 51%, gross margin is down 80 basis points from a year ago. Given that management expected gross margin to fall in the first half of the year, the performance in the first quarter did not come as a shock. In particular, 1Q23 was expected to fall short of the annual guidance range of 50.8% to 51.3%. The implication is that the business is expected to see an improvement in 2H23 due to additional product cost clawbacks and capitalized freight recapture. We might see a surprise in gross margin performance as well since 1Q23’s performance in terms of freight acquisitions cost dynamics already surpassed the internal targets. However, variable opex, labour inflation, and investments in the store and delivery fleet all contributed to a 9.5% increase in operating expenses per store in Q1 2023. IAs inflation eases and investments to taper, I expect opex per store to start improving, thereby giving a boost to margins. The easing of headwind from last year peaked fuel prices would also be helpful.
Valuation
ORLY is currently trading at a premium to its historical average as well as peers such as AutoZone (AZO), Genuine Parts (GPC), and Advance Auto Parts (AAP). While I believe the premium over peers is justified given my belief that ORLY is a better executor, a larger player, and has a higher margin, I believe the massive premium over its historical average is difficult to justify. ORLY has historically traded in the 14x to 28x forward P/E range over the last ten years, with an average of 20.8x and a standard deviation of 2.5x. ORLY is currently trading above 1stdv away, and historical data shows that the valuation always reverts to mean within 1 to 4 quarters. As a result, I expect stock multiple re-rating headwinds to offset any earnings growth, muting shareholder returns to some extent.
Conclusion
ORLY’s recent 1Q23 results showed strong sales growth, particularly within the DIFM segment, and the company’s execution and distribution capabilities continue to position it well in the market. However, the stock’s current valuation at 24x forward earnings is difficult to justify, and I believe the headwinds of a potential stock multiple re-rating could offset any earnings growth in the near term. Therefore, my recommendation is to hold the stock until the valuation becomes more reasonable.
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