You Shouldn’t Discard This Auto-Parts Retailer Just Yet

The aftermarket retail industry has done very well this year as the average age of vehicles on U.S. roads has been increasing. According to Polk, the average age of light vehicles had hit an all-time high of 11.4 years earlier this year, with the number of vehicles older than 12 years increasing by more than 20%. As such, consumers have felt the need to keep their older vehicles in good shape, leading to good business for auto-parts retailers such as O'Reilly Automotive (NASDAQ: ORLY  ) , Advance Auto Parts (NYSE: AAP  ) , and AutoZone (NYSE: AZO  ) .

All three have outperformed the S&P 500 so far this year, but things haven't been looking up for O'Reilly of late. Ever since reporting its third-quarter results in late-October, O'Reilly has been in pullback mode. Despite posting better-than-expected results, O'Reilly's tepid outlook triggered a drop in the share price. But is the weakness temporary, or is there some greater danger lurking around for O'Reilly?

A short-term hiccup
O'Reilly blamed cautious consumer spending due to tough macroeconomic conditions as the reason behind its subdued outlook. Management said that total miles driven in the U.S. through August this year were relatively flat over last year, as unemployment levels are at more than 7%.

But the company is optimistic about the long-term fundamentals of the industry. O'Reilly sees a boost in new vehicle sales as a tailwind for its business since they would be requiring aftermarket treatment after a certain point of time. Also, the company sees flat vehicle scrapping rates, which means that customers are looking to keep their older vehicles running. In addition, superior engineering and manufacturing standards in today's vehicles means that owners are able to keep them for a longer time.

Notable moves
The above factors could help O'Reilly perform well in the future, and it has various strategies up its sleeve to make the most out of the opportunity ahead.

For example, in the second quarter the company initiated a loyalty program to attract do-it-yourself (DIY) customers through targeted promotions. This program has gotten off to a good start, and O'Reilly has already signed up 1 million members.  This initiative might help the company keep its DIY business in good health, which has been facing weakness due to the complex nature of today's vehicles.

In addition, O'Reilly is working on improving the availability of parts in its stores. It plans to relocate its distribution center in Lewiston, Maine, to Devens, Massachusetts. This distribution center is expected to serve 280 stores and strengthen O'Reilly's presence in the Northeast, apart from complementing the 56 stores of VIP Parts that O'Reilly had acquired earlier last year. Looking forward, O'Reilly has lined up more distribution centers, one in Lakeland, Florida, and another one in Naperville, Illinois. 

Also, O'Reilly is targeting 200 new store openings in 2014, almost double of its 109 net new stores target for this year. Considering the recent developments in the auto-parts industry, it is important for O'Reilly to expand aggressively.

Competition is getting tougher
O'Reilly can expect stiffer competition from Advance Auto Parts, which announced in October that it would be buying General Parts International. This acquisition would add 1,418 Carquest outlets to Advance Auto's stable, catapulting it way ahead of both AutoZone and O'Reilly in terms of store network. Advance Auto would have over 5,400 stores after the acquisition is complete, becoming the largest auto-parts retailer in North America. 

What's more important is that Advance Auto's position in the faster-growing do-it-for-me segment will get better after the General Parts acquisition. Advance Auto will get Worldpac, a supplier of replacement parts for imported vehicles, as a part of its network, and through this it will be able to tap the $40 billion commercial market better.

O'Reilly's commercial business could be pressured further as AutoZone is also aggressively moving into this market. AutoZone gets a majority of its business from DIY customers, but the company is now focusing on sales to commercial repair chains. AutoZone has made growth in the commercial business as one of its top priorities for 2014.  

AutoZone has already made some progress in this area as commercial sales were up 14% in the recently reported quarter and accounted for 16% of revenue. In fact, in the previous quarter, AutoZone introduced a commercial program in 125 stores, up from 37 in the prior-year period. Hence, it is quite evident that O'Reilly would have to contend with a lot of competition in the lucrative commercial market.

But O'Reilly's getting more traffic
Investors might consider booking their profits that they have enjoyed so far this year since O'Reilly has now become quite expensive. At 21.7 times trailing earnings, O'Reilly trades at a premium to both AutoZone (16 times earnings) and Advance Auto (19.5 times earnings).

However, considering the fact that O'Reilly has the best same-store sale performance among the three, a premium valuation looks justified. O'Reilly's same-store sales were up 4.6% in the previous quarter, while Advance Auto saw a 2% decline and AutoZone saw an improvement of just 0.90%. Moreover, O'Reilly has been making some good moves to grow its business further, and it could continue enjoying superior same-store sale growth as a result.

As such, it won't make sense to sell O'Reilly shares after just one bad outlook. Investors should refrain from selling the stock at present, since it is one of the best-performing aftermarket retailers out there.


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