A Few Reasons Why This Stock’s Premium Valuation Is Justified

Harsh is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Auto parts retailers have had a solid run this year with all the major players recording solid gains. However, O’Reilly Automotive (NASDAQ: ORLY) is the one which takes the cake when it comes to share price appreciation and growth trajectory. The stock is up almost 27% so far this year, easily outperforming its peers and considering the moves it is making, I doubt that there will be any let up in its momentum.

The stock’s rise this year has been helped by a couple of stellar earnings reports while its initiative to return cash to shareholders through buybacks is another positive. More importantly, what really adds to the allure of owning O’Reilly is its positive same-store sales growth, while peers such as Advance Auto Parts (NYSE: AAP) and AutoZone (NYSE: AZO) have been struggling with negative same-store sales.

Reading the trends

O’Reilly has positioned itself well to benefit from the high average age of vehicles on the U.S. roads, which is at 10.8 years. While sales of new vehicles might be picking up due to the housing rebound and consumers finally deciding to upgrade, it is unmistakable that vehicles require maintenance and routine maintenance of vehicles will lead to better revenue for the company going forward.

Moreover, management believes that the new vehicles being manufactured are superior in terms of engineering and manufacturing, and this should contribute to the long-term success of the aftermarket retailers. Also, the complexity in the engineering of the new vehicles means costlier parts that result in higher sales, and this was one of the reasons behind O’Reilly’s solid performance in the previous quarter.

Thus, a combination of older vehicles on the road and an increasing number of new, state-of-the-art vehicles indicates that aftermarket retailers aren’t going out of business and the positive outlook for new vehicle sales this year isn’t exactly a disadvantage for the likes of O’Reilly. This makes companies in this sector a solid pick irrespective of the state of the economy as the older vehicles will ultimately require maintenance.

Delivering growth and value

To benefit from the rising number of vehicles on the road, O’Reilly has been aggressively opening stores and distribution centers. O’Reilly intends to open around 190 stores this year as it looks to expand its network and compete with the others. The company’s distribution centers have been contributing to its efficiency and leading to gross margin growth, leading it to bump up its gross margin guidance in its last quarterly report.

O’Reilly is also looking to bolster its presence in the higher margin do-it-yourself market further through initiatives such as a new loyalty card program. Also, the company has been rolling out its B2B platform so as to satisfy customers’ requirement in a more efficient manner. All these initiatives should lead to both top line and bottom line growth going forward, while an impressive share repurchase program should aid earnings growth further.

O’Reilly recently increased its share repurchase authorization by $500 million, taking the total authorization to $3.5 billion. The company believes in returning cash to shareholders through repurchases and uses excess cash for the purpose, and I think that this is the right way to go.

A premium stock

However, one point of contention which might stick out is that O’Reilly is expensively valued as compared to peers and also the fact that it’s trading near its 52-week high. A trailing earnings multiple of 22.5 times looks expensive when stacked against Advance Auto’s and AutoZone’s 16 times. But then, none of the other two have been in green territory as far as same-store sales are concerned and as such, O’Reilly deserves the premium valuation.

AutoZone’s same-store sales had dropped 0.1% in the previous quarter but revenue and earnings were up 4.5% and 7%, respectively. In comparison, O’Reilly delivered 1.9% same-store sales growth (adjusted for Leap Day last year), revenue growth of 4% and earnings growth of 19%. Moreover, AutoZone’s huge debt load of $4 billion is something which investors should worry about, and this further makes O’Reilly more attractive since its debt is just $1.1 billion and it has ample cash flow to deal with it.

However, Advance Auto might prove to be a good choice as well, and could provide some tough competition to O’Reilly as it’s been rapidly growing its business by aggressively building stores and making acquisitions.

However, the company had witnessed a 9% decline in profit and 3.2% decline in same-store sales in its previous quarter due to various factors. Thus, when you’re getting a company which is delivering growth and value to shareholders in the form of O’Reilly, I think it would be more prudent to go with it rather than considering the others.

The bottom line

Considering all these factors, O’Reilly’s premium valuation is justified and I believe that it is the stock to pick in this industry right now. Going forward, analysts expect the company to grow its earnings at 16% for the next five years, at par with the industry average, but I won’t be surprised if O’Reilly keeps outperforming the industry like it has done so far.

Harsh Chauhan has no position in any stocks mentioned. The Motley Fool owns shares of O'Reilly Automotive. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

blog comments powered by Disqus