John wrote about O’Reilly (ORLY) a few months back and I just wanted to write down my thoughts from a more general and less financial perspective. Primarily, I would like to use my thoughts on ORLY to highlight a key skill all investors should keep in mind.
“If past history was all there was to [investing], the richest people would be librarians.” Warren Buffett
ORLY is a good Rorschach test for value investors. ORLY looks quite remarkable from a historical perspective if you open up any of its past financial statements. Revenue growth, margin expansion, declining share count, increasing free cash flow conversion, the list goes on. From a stock performance perspective, ORLY, and its main competitor Autozone (AZO), have outperformed Buffett’s Berkshire Hathaway over any given time period as far as my sophisticated software allowed me to check (google finance, if you are looking to upgrade your own investing software). Clearly, ORLY and AZO have been great businesses. The question for today and one that sometimes trips up investors is whether ORLY and AZO are great or even good businesses going forward. As the famous Danish investor, Kierkegaard, once said, “Great companies can only be understood backwards, but you have to investing going forward.”
Most investors don’t like to boil investing decisions down to simple questions. It makes for bad marketing pitches and probably hits a little below the belt from an ego perspective. However, I have found my best investments have relied on being able to articulate and answer a very simple question about the business. Often, I can boil the investment decision down to a simple question. Sometimes, I have a harder time answering the question, which is usually when I do nothing.
Let’s try to do that with ORLY. (I am using ORLY in this post, but I don’t think there is a big difference between ORLY and AZO. If you think they are “buggy whip makers,” the marginal difference won’t really matter in the long run).
My simple question is this: Who will be repairing cars in 5-10 years? There are a few different possibilities. I break the possibilities into three options.
DIY Market (Do It Yourself)
DIFM Market Mom and Pop (Do It For Me)
Let’s say you have a 12-year old Honda Civic, which breaks down. You basically have three options. As a car owner, you can fix the car yourself, you can take it to Joe’s Mechanic Shop (DIFM Mom and Pop) or take it to your local Honda Dealer (DIFM Corporate). ORLY has the highest margin when you work on the car yourself. You have no buying power, very little negotiating leverage (other than your ability to walk next door to AZO) and probably need some assistance. This provides ORLY with a high gross margin sale.
Your second option is taking it to Joe’s Mechanic Shop. Joe looks at your Civic and orders the part from ORLY and they deliver it to him within a few hours. This sale is slightly less profitable since Joe is a frequent buyer, is more sophisticated about what a part should cost and needs no assistance.
Finally, taking the car to a corporate store is your third option. This might be a Honda Dealer, Meineke, Pep Boys or other chain store.
ORLY will encounter two large headwinds in the future. So far, ORLY has focused investors on tax refunds, winter weather and investors themselves have focused on the Amazon threat. Personally, I am not sure if any of those are as big as the incompetence and complete lack of interest in car repairs from my generation and younger. My wife’s battery died the other day and it took my at least 10 minutes to figure out how to open the hood of the car (and it’s a 6-year old car).
Often, I am guarded when extrapolating my own experiences. However, I think this trend is fairly common and one that is not going to reverse itself. I can call my father for advice on cars, but when my children call me in 10 years, the line will be silent…
The second trend is a little more under the radar but equally worrisome for ORLY. Joe’s Mechanic used to be the place where you could take your car to get fixed. However, one of the reasons individuals aren’t fixing their cars as much these days in how complicated and integrated with computers cars have become. Car repairs require a sophisticated computer diagnostic tool to figure out what is wrong with the car. This diagnostic and general complication problem is making it harder to smaller auto repairs shops to fix a wide variety of cars, leading to either scale (corporate chains) or specialization (dealerships).
Basically the trends, however slow or fast I don’t know, are moving people from the most profitable channels to the least profitable channels (with dealerships most likely eliminating some or even all of the revenues for ORLY).
None of these insights are particularly groundbreaking. However, the question is clear, who is going to be fixing the cars in the future. My hunch is that the DIY is going to decline dramatically over the years and the DIFM is going to shift more to corporate or dealerships. Both of these trends are bad for ORLY. This doesn’t make ORLY a bad business, but it does impact how you should look at their past financials. In other words, I think their past financials are going to look different in 5 years than they currently look.
I could be wrong on my answer here. I am not sure. However, being able to answer that question dramatically in the favor of ORLY would require me to assume that DIY and DIFM Mom and Pop segments are going to continue to maintain share or even grow. I don’t think that is the case. Your alternative is that ORLY will be forced to continue to take share from a shrinking market share pie. This is never a good proposition.
Some of the best investments Buffett has made over the years involve situations where a temporary “issue” creates a dramatic decline in the valuation of a good business. Once the temporary issue is resolved, maybe within 1-3 years, the valuation gap closes and the company is once again valued as a good business. This could be the case with ORLY and AZO, however, I am not sure this issue is temporary. It could be a permanent shift away from DIY and DIFM Mom and Pop markets. I just can’t answer that question yet. Interestingly, I don’t know if management can answer that question yet or if they are just not willing to fess up to the answer.
“On our last conference call, we discussed the impact on the second quarter of the delay in income tax refunds, and that headwind continued for the first five weeks of our third quarter. Our expectations have been that much of those delayed refunds would lead to incremental store sales in Q3 but that never materialized. We don’t have any empirical evidence of where those funds went but they seem to go to some other part of the economy this year. While our March sales did improve, we saw inconsistent week to week performance. It wasn’t until April that we began to see stronger sales results. We can speak at length about delayed income tax refunds and the second consecutive mild winter but the more overarching thing for us was sluggish customer demand across virtually every category, resulting in disappointing sales performance during a specific eight-week period.”
I like to follow a few sports here and there. My father followed the Boston Celtics, Washington Redskins and BYU football. Since these teams were always far away from where we lived, I often noticed biases people have to their local teams. My favorite team is the Boston Celtics, but I currently live in Utah. This past week, Utah’s best player, Gordon Hayward, left Utah to play for the Celtics next year. What’s interesting is how biased fans can remain when it comes to Utah’s prospects for next year. Immediately after Hayward left, there were articles and conversations about the up and coming players in the development league, the recent draft picks, etc. Absent the mafia breaking the legs of the entire starting line-up for the Jazz, I am not sure what would cause Utah fans to resign themselves to the prospect of a poor upcoming season.
In some ways, ORLY and AZO mimic the Utah Jazz. Some companies have had great runs, but you should recognize when the environment around you is changing (your best player leaves). It is much easier to see this in sports when your star player leaves, but harder in the case of ORLY and AZO because the shift may be a slow trend.
Circling back to the Buffett quote from the beginning: the best investors incorporate the past financials into an understanding of the prospects of the future business. However, these great investors understand the librarians aren’t the best investors and you need to be able to see why the past may not be like the future. Merely extrapolating the past success of AZO or ORLY fails to incorporate any changes that could impact the future earnings power of the company. If someone wants to make a case for AZO or ORLY, they should be able to precisely identify why sales growth has declined dramatically over the past year, and even gone negative at AZO. Management hasn’t done a great job of this and I can’t seem to figure out a good temporary reason, so I am standing on the sidelines for this one.
I do want to be clear that I could be wrong and missing the reason for the temporary slowdown (my best guess here would be the average age of the cars on the road) and if there is a good reason, for the temporary slowdown, I think both will probably be good investments from today’s prices with a slight preference for AZO.
Matt Brice is the portfolio manager of The Sova Group, LLC. Matt can be reached at firstname.lastname@example.org.