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O'Reilly's in the Pole Position

We think its distribution network sets it up for success in the race for professional and DIY sales.

We believe the market underappreciates the distribution advantage that the auto-parts retailers we cover-- Advance Auto Parts (AAP),  AutoZone (AZO),  Genuine Parts (GPC), and  O'Reilly Automotive (ORLY)--have over their smaller rivals. This strength is a key contributor to our narrow economic moat rating for these companies.

Sentiment remains fixated on the threat of disruption from Amazon (AMZN), which we believe is overstated, and we think a cyclical industry slump has made the buying opportunity more attractive.

We believe large retailers can use size to cost-effectively deliver superior service relative to small rivals, but their distribution models are not homogenous. Comparing O’Reilly and AutoZone reveals the differences in their approach to economically delivering strong part availability.

O’Reilly’s approach is capital-intensive, but we contend it enjoys a persistent advantage over AutoZone in the faster-growing professional segment, with accelerating returns as cost leverage builds. Prevailing valuations put Advance (whose ongoing turnaround casts some uncertainty on its ultimate distribution footprint) atop our recommendations in a target-rich sector, but more risk-averse investors would do better to look to O’Reilly.

Shifting From DIY to DIFM
Increasing vehicle complexity has driven motorists away from attempting to repair their vehicles themselves and to third-party and dealer repair facilities. Complex electronics have made repairs more daunting, and as newer vehicles age and take the place of their less complicated forebears, we anticipate the shift toward the professional, or do-it-for-me, segment will persist over the long term. Our industry forecast is based on 2% average annual long-term new-vehicle sales growth, continued flat scrappage rates, and an average vehicle age that should show modest growth from its current 11.6-year mark (compared with 10.0 years in 2007; the metric has not declined in over 10 years) as consumers retain their increasingly reliable cars and trucks.

While the do-it-for-me segment’s margins are about 300-500 basis points lower, in our estimation, relative to do-it-yourself sales as a result of greater per-client volume, mechanics’ sophistication, repair shops’ reticence to use private-label parts, and required delivery speed, we believe the DIFM segment still carries strong returns and, together with a robust DIY offering, allows retailers to maximize their opportunities to sell slow-turning parts. The sheer breadth of components that constitute a modern vehicle, along with the differences among makes and models (and options even within a single model), result in retailers’ need to stock several slow-turning items if they wish to provide a high level of part availability. By virtue of their dense store networks, large-scale retailers have more chances to sell slow-turning stock-keeping units by placing less frequently ordered components in centralized locations with rapid delivery to the store as the parts are needed. As rarer components can take more than a year to sell and are often stocked in very limited numbers, regional scale is critical to large-scale retailers as it enables a level of part availability and delivery speed that small-scale retailers cannot match economically. While all of the auto-parts retailers we cover operate in both the DIY and DIFM markets, the sales mix varies, from AutoZone’s roughly 80/20 split in favor of DIY to Genuine Parts’ approximately 75/25 DIFM skew.

Part availability is important to DIY motorists whose need for their car or truck to get back on the road trumps price considerations, particularly as most such customers of the large-scale retailers tend to service their vehicles themselves for economic reasons and the opportunity cost of not having a vehicle at their disposal demands urgency.

However, availability is even more critical to professional repair shops. Repair facilities earn a markup for parts used, passing component costs on to a fairly price-insensitive motorist. This leaves repair shops far more concerned about turning over service bays, necessitating rapid access to components. As labor is charged at an hourly rate, mechanics maximize earnings if required components are delivered quickly. Furthermore, the repair shop incurs opportunity costs from the moment a car or truck enters a service bay for diagnosis, creating a powerful incentive for facilities to demand rapid access to parts in order to minimize bay idle time and keep repair flow high. This dynamic leads to demands for rapid part delivery, with facilities expecting components in as little as 15-20 minutes for common items like brake pads and rotors; 30-minute windows are typical for many failure-related categories. As part catalogs can exceed 150,000 SKUs, retailers need to be able to maintain broad inventories that are accessible virtually on demand.

Labor market dynamics have added to repair facilities’ need for rapid part delivery. Trained automotive mechanics are in short supply, as computerization of modern vehicles has required an influx of personnel who are both mechanically and digitally competent. Industry turnover is high, and as a result, a 2014 U.S. Bureau of Labor Statistics study indicated 237,000 automotive repair jobs could open through 2024, against a total mechanic population of about 740,000. Rapid part delivery from a retailer maximizes mechanics’ potential billing hours in a day (and therefore their commission) by keeping service bays turning, aiding retention. With repair shop labor rates often exceeding $125 per hour, idle time costs both repair shops and mechanics dearly; an extra hour per day of idle time can reduce shop revenue for the bay by well over 10%.

We think that only retailers with dense store networks can achieve the proximity to repair shops needed to support rapid delivery, and that only scaled sellers with multiple potential points of sale (through individual stores that cater to DIFM and DIY clients) can economically hold the slow-turning inventory needed to underpin a broad catalog of SKUs available on demand. As the relationship between retailer and repair shop is based on the client’s faith in the seller to have fast access to a wide array of parts, we argue that availability investments boost companies’ brand intangible assets, while increased scale generates a cost advantage by leveraging distribution and inventory investments. The ensuing economic moat protects incumbent retailers from subscale rivals as well as digital retailers such as Amazon.

Differences Abound in Distribution Capabilities
We believe the current industry slowdown is attributable to cyclical factors, particularly mild weather and slower growth in miles driven, rather than shifts in long-term industry dynamics. We also believe the market underestimates the degree to which the companies we cover enjoy a distribution advantage over subscale rivals and upstarts, including digital competitors.

These companies’ distribution capabilities vary despite high-level structural similarities. Overall, each of the companies we cover relies on a tiered distribution model, with individual stores calling on hub stores with larger- and broader-than-normal part inventories and distribution centers for inventory replenishment and access to infrequently ordered components. In the professional segment, parts needed to fulfill customer orders are sent to the store first and then delivered onward to the client for last-mile fulfillment.

Distribution centers can carry 140,000 or more SKUs and cost $40 million-$60 million to build, while hub stores generally offer 35,000-50,000 SKUs and standard stores, which stock the fastest-turning items, about 20,000-25,000. AutoZone, which has long sought a less capital-intensive means of servicing its customers, is also adding mega hub stores, stocking 80,000-100,000 SKUs, in an attempt to bridge the gap between its considerably lower distribution center capacity than its peers. While the ongoing integration of General Parts, its turnaround, and limited disclosure reduce visibility into Advance’s efforts, we expect a combination of large-format distribution centers and smaller facilities colocated with a Carquest store (effectively akin to a mega hub) will prevail, as the company cites a wide distribution center square footage range of 55,000-665,000. Hub stores can act as a precursor to market expansion; for example, O’Reilly originally supported its locations in the San Antonio and Austin areas through hub stores before building a distribution center in 2016. By contrast, Genuine Parts’ heavy tilt to professional clients (around 75% of automotive segment sales) and majority-independent store base lead to a skew toward additional distribution centers.

Distribution centers receive a constant stream of parts from suppliers to replenish sold inventory and maintain modest safety stocks. Retailers’ nascent online direct-to-customer efforts are also serviced out of select distribution centers. Even within a single company, distribution centers vary considerably in estimated square footage based on local market demand, real estate availability, and historical market conditions. All companies blend long-term leased and company-owned locations.

We think each of the companies’ distribution footprints is essential to its sustainable competitive advantage and cannot easily be replicated. Local parts retailers have historically achieved attractive economics by favoring one segment or the other, with stores targeting the professional segment buying directly from manufacturers and selling directly to nearby clients through a warehouse operation (without the additional salesforce that scaled retailers employ). However, we believe large retailers’ growth and ability to call upon slow-turning parts through several potential points of sale challenge independent and regional sellers that cannot economically hold the same breadth of inventory. As the scaled retailers grow, we expect their advantages to build alongside cost leverage. We think prevailing sentiment underappreciates the degree to which this infrastructural investment protects scaled retailers from digital disruption, providing the physical proximity to customers needed to meet rapid commercial order delivery requirements.

O’Reilly’s Approach Optimized for DIFM Success
With Advance in the midst of a turnaround that leaves its ultimate distribution footprint somewhat uncertain and Genuine Parts having a majority independently owned store network, O’Reilly and AutoZone provide the cleanest opportunity to contrast distribution strategies, particularly as they have taken very different approaches.

AutoZone’s historical DIY orientation and O’Reilly’s long-standing goal to serve both markets have resulted in significantly different footprints; we believe O’Reilly’s approach is more conducive to dual-market success and carries lower risk of disruption in the event that digital sales have more impact than we expect.

O’Reilly has around twice as much distribution center space as AutoZone, despite AutoZone’s 10% larger store count. While AutoZone’s distribution centers are on average larger, O’Reilly has about 2,200 square feet of distribution center space per store, versus roughly 1,000 for AutoZone domestically.

Hub and mega hub store data is less granular, but even after AutoZone finishes constructing its planned network of 25-40 mega hub locations, we think the difference in SKU count between such venues and distribution centers (about 50,000-70,000) will serve as a drag on availability.

We think O’Reilly’s advantage is essential to its ability to effectively achieve a balanced sales mix between the faster-growing DIFM segment and the more profitable DIY sector. Inventory’s proximity to stores and customers dictates the speed with which the company can replenish store stocks and deliver slower-turning components to customers. O’Reilly’s busiest stores have long received multiple deliveries per day from hub stores and distribution centers, with daily store-level inventory replenishment common. By contrast, AutoZone took steps to increase its replenishment frequency from once a week to three times a week at about 2,300 stores but pulled back on the initiative in mid-2017 as economics were not compelling and its distribution infrastructure was strained.

Despite the implications for availability, we think AutoZone’s pullback is prudent, as the accelerated cadence strained a distribution infrastructure that was built to suit the DIY segment’s more languid pace, and we think many of AutoZone’s stores were constructed to capitalize on the company’s DIY dominance rather than to capitalize on proximity to independent repair shops. While we believe new commercial programs at many of its stores will help build DIFM sales, we anticipate the company’s newfound attention to the professional segment is limited by its existing stores’ locations.

Still, efforts to target the commercial segment should necessitate some closing of the distribution gap, particularly as AutoZone’s network offers far less flexibility to build part availability, in our estimation. O’Reilly indicates it is able to offer five deliveries per day to about 95 stores around its Selma, Texas, distribution center and that even twice daily is superior to most local competition. We anticipate it will be difficult for AutoZone to meet such a cadence for a broad range of parts across its store network without significant incremental distribution center expansion.

As a proxy for retailers’ ability to offer fast access to needed parts across the widest range of SKUs, we analyzed the number of people who live within a given radius of AutoZone’s and O’Reilly’s distribution centers. We used a 40-mile and a 100-mile radius to capture distances over which we believe regular rapid deliveries are especially economical.

Using population rather than stores within the radius captures potential future expansion opportunities, as we do not believe any of the major retailers have reached store saturation in the United States. Management teams have indicated the country can support around 6,500 locations for each of the major retailers, a figure we do not dispute as we anticipate their increasing dominance will lead to attrition of subscale players. The largest of the pure-play retailers, AutoZone, had just under 5,500 stores at the end of fiscal 2017.

The results of our density analysis indicate a striking difference between AutoZone’s and O’Reilly’s footprints: O’Reilly has distribution centers within a 40-mile radius of about 3.5 times as many people as AutoZone; at a 100-mile radius, the factor drops to a still impressive 2 times. The difference is intentional; O’Reilly has stated a willingness to pay for more expensive real estate nearer major population centers, though land costs and economic incentives can make rural centers attractive. We believe this supports our contention that O’Reilly should maintain a part availability lead over AutoZone along with a slight inventory turnover benefit, though both companies should benefit at subscale retailers’ expense.

Apart from providing the best infrastructure for part availability, we think that O’Reilly’s architecture gives it additional flexibility in case the industry is more susceptible to digital disruption than we expect. We believe even relatively sophisticated e-commerce customers are likely to demand an omnichannel experience that allows them to research needed components and stock levels online before obtaining in-store advice and services (such as diagnostics, confirmation that they have identified the right part, and basic installation guidance for what is often an unfamiliar task). Although we think click-and-collect will lead the sector’s digitization, we believe O’Reilly’s distribution center footprint will allow it greater flexibility to handle an unexpectedly large surge in direct-to-customer orders. Management indicates digital orders are currently fulfilled through about half of the company’s distribution centers, a number we believe could grow if sales required such an expansion. Centralizing ship-to-customer fulfillment (with its attendant consolidation, packaging, and shipping needs) minimizes costs and avoids disruption of in-store operations, in our opinion, and we hold that proximity to customers would be needed for retailers to offer acceptable fulfillment time.

Despite O’Reilly’s advantages, however, we continue to see AutoZone as well protected in competition against smaller retailers as even its more languid store-replenishment efforts relative to O’Reilly are far more than subscale peers can economically match across a broad catalog. While we do not believe AutoZone’s mega hub strategy will fully close the gap with O’Reilly, our favorable view of the company’s prospects does not assume it will. Although the DIY segment should lag DIFM growth, we do not foresee a long-term contraction in the foreseeable future, allowing AutoZone to capitalize on its core strength and capture professional sector market share from subscale rivals. The moat that AutoZone’s distribution capabilities provide is strengthening with its growth as inventory and infrastructure leverage build, in our view. As such, we expect the company’s returns on invested capital to remain in the mid- to high 20s over the course of our explicit forecast, with escalation after industrywide cyclical challenges ebb.

Consistent Investment Required to Maintain Distribution Advantage
Of the companies we cover, O’Reilly has the most significant opportunity to expand its U.S. footprint and add store density, as reflected by its smaller store count versus rivals (just under 5,000 versus almost 5,500 for AutoZone and about 5,200 for Advance). The 2016 acquisition of Bond Auto Parts accelerated O’Reilly’s efforts to build its presence in the Northeastern United States, adding 48 stores and repair shop relationships built over the target’s 60-year history. Still, the company is underpenetrated in the region; for example, it has 32 stores in Massachusetts, corresponding to around 215,000 people per location, given the state’s population of about 6.8 million, considerably less than the slightly more than 65,000 people per location that O’Reilly’s store count represents nationally. While the company has distribution assets near its larger expansion markets, we believe it will need to add resources to support store growth that should exceed that of its pure-play peers.

We assume O’Reilly opens six new distribution centers each servicing 250 stores over the course of our explicit forecast, consistent with Advance, as it consolidates, streamlines, and modernizes its delivery infrastructure. We anticipate mega hub stores will enable AutoZone to continue to lag its peers in distribution center square footage, particularly given a DIY-oriented bent we think will persist even as the share of sales it derives from commercial clients rises (we anticipate Advance will garner about 40% of its sales from the DIY segment and O’Reilly roughly 55% by fiscal 2026). However, we expect AutoZone will also add eight large-format domestic distribution centers over the course of our explicit forecast to support its commercial capabilities.

Our long-term capital expenditure forecasts incorporate these expected openings, along with the costs of opening additional stores and maintenance needs for existing assets. While we have assumed that capacity and store count is built organically, small-scale purchases akin to the Bond deal could accelerate companies’ efforts to grow in strategic markets. Although disclosure about purchase prices and the economic terms of acquisitions can be limited, we have a generally favorable view of retailer efforts to buy small stores, as well-run subscale operations can have valuable, long-term relationships with key commercial accounts. As it can take five or more years for a commercial sales effort at a new store to mature as relationships build, acquisitions can be a valuable tool to quickly gain scale while benefiting from smaller shops’ competitive challenges against their larger brethren. However, recent acquisition activity (capped by the 2014 General Parts purchase) has limited the number of large-scale assets available, and we think the likelihood of consolidation among the four largest retailers is low, given store footprint overlap concerns. Therefore, new acquisitions are unlikely to come with significant infrastructure, necessitating continued investment in distribution centers and hub stores.

We anticipate AutoZone’s need to build mega hub stores and incremental distribution center capacity and O’Reilly’s geographic expansion and store count growth will lead both companies to dedicate about 5% of annual sales to capital expenditures, with Advance lagging at around 4% as its store count is relatively large, contains more leased and independent stores than peers, and is supported by a widespread, if far less homogenous, distribution center network (10.8 million square feet of distribution center space, comparable to O’Reilly, in units varying from 55,000 to 665,000 square feet). Universally, we anticipate organic cash flow will be sufficient to fund the required investments, with companies maintaining current adjusted debt/EBITDAR levels of around 2.0-2.5 times long term.

O’Reilly Attractive, but Advance More Compelling
O’Reilly’s distribution advantage leaves the company poised to generate industry-leading top-line growth and approach AutoZone’s returns, and current trading levels offer an opportunity for investors to capitalize on what we see as a cyclical industry slowdown along with unfounded fears of digital disruption. Still, Advance and AutoZone provide even more compelling opportunities for patient investors at current valuations. In a sector rife with attractive opportunities, Advance offers the greatest differential against fair value, although there is risk associated with its ongoing five-year turnaround plan.

O’Reilly’s distribution strength, balanced sales mix, and strong management team make it our top pick in the sector independent of valuation. We anticipate the company will continue to post outsized top-line growth as it rounds out its U.S. geographic presence and leverages part availability that we believe leads the industry. The sales growth should contribute to continued margin and return improvement as the company leverages fixed costs, particularly as industry conditions normalize. We think the company’s distribution strength makes it best suited to a faster-than-expected digitization of sales in the sector, combining with its strong presence in both the DIY and professional segments to offer the most attractive risk profile of the pure-play companies in our coverage universe. However, O’Reilly’s strengths are reflected in its share price to a greater extent than those of its peers.

From a valuation standpoint, we believe Advance offers patient investors significant upside opportunity, though it will take time for its turnaround efforts to bear fruit. Investors unwilling to take on the turnaround risk associated with Advance could look to AutoZone for a well-managed company that has been unduly punished for its DIY exposure as a result of the Amazon threat, though incremental investment will be needed as its commercial sales efforts grow. While O’Reilly trades at less of a discount than its pure-play peers, we see its shares as carrying the least risk as the company blends a balanced sales mix with strong operational performance under the guidance of an exceptional management team. While we believe Advance carries the greatest risk among the three pure-play companies in our coverage universe and O’Reilly the least, we give all of them a medium fair value uncertainty rating.

Zain Akbari does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.