O'REILLY: MASTERING THE INVENTORY MANAGEMENT
O'Reilly has turned inventory management into an unmatched competitive advantage. In an industry still highly fragmented, the company is well-positioned for continued growth.
Hi there, welcome back to AG Quality Capital! As always, we're diving into the world of long-term quality investing in the stock market.
This is the third deep dive for the blog, and it's about O'Reilly, a leading auto parts retailer in North America that consistently delivers outstanding results to its shareholders.
In this post, you'll find:
• The Business Model
• Industry Overview
• The Power of Its Distribution Network
• Competitive Advantages
• AutoZone: Its Main Competitor and Why I Prefer O'Reilly
• Growth drivers
• Financial aspects
• Risks
1. BUSINESS MODEL
1.1. What does the company do?
O’Reilly is one of the largest specialty retailers of automotive parts, tools, supplies, equipment and accessories in the aftermarket industry in the United States. It currently operates approximately 6,200 stores across 48 U.S. states, 78 stores in Mexico, and 26 in Canada.
The products include:
New and remanufactured automotive hard parts and maintenance items such as alternators, batteries, brake system components, belts, chassis parts, drivetrain parts, engine parts, fuel pumps, hoses, starters, temperature control components, water pumps, antifreeze, and more.
1.2. How does the company operate?
O’Reilly runs 32 distribution centers that stock approximately 175,000 SKUs, with most centers interconnected to provide access to the inventory of other regional centers. These distribution centers deliver five days a week, with 95% of stores receiving multiple deliveries per day.
Additionally, the company operates 375 strategically located hub stores that provide delivery services to nearby stores and offer same-day inventory access. This strength in distribution is a critical factor for O’Reilly’s business and forms the backbone of its competitive advantage, making it exceptionally difficult for competitors to replicate.
1.3. Business Segments:
O’Reilly operates a dual-market strategy catering to professional service customers (DIFM = Do It For Me) and DIY (Do It Yourself). Currently, 53% of the company’s total revenue comes from DIY, while the remaining 47% comes from DIFM.
The company's main strength lies in the DIFM segment. A typical customer in this segment is an independent repair technician working on vehicles between 6 and 11 years old, which are typically no longer under the manufacturer’s warranty. Since these technicians charge the final consumer based on predetermined labor hours, completing jobs faster is essential. Faster repairs mean freeing up space for the next vehicle, making quick distribution a key value proposition for DIFM customers. Moreover, these customers are less price-sensitive as labor costs are passed on to the final consumer.
On the other hand, DIY customers tend to own older cars (over 12 years old) and prefer working on their vehicles themselves. In this segment, availability is also critical, but price becomes a stronger factor. Companies in this space can differentiate themselves through superior customer service and product knowledge, as DIY customers often require additional guidance.
2. INDUSTRY OVERVIEW
The auto parts industry stands out for its resilience during economic crises, achieving comparable sales growth even in challenging years. With reduced disposable income among consumers, demand for new vehicles decreases, forcing people to continue using older cars. This dynamic benefits the industry, as older vehicles are more prone to repairs and require replacement parts to remain operational.
Additionally, auto parts are considered a non-discretionary necessity in the United States, given the poor performance of public transportation in many cities. According to data from its main competitor, AutoZone, 84% of the products it sells are critical or maintenance-related parts, emphasizing the urgency of having these items readily available.
The number of auto parts stores in the United States has remained relatively flat over the past decade, with the industry adding only 3,000 stores overall during this period. Within that timeframe, O'Reilly added 2,000 stores and AutoZone another 1,500. This means that the leading players in the industry are driving the growth in store count, while smaller competitors have been forced to close locations.
These figures are significant when considering further industry consolidation. It’s evident that the structural advantages held by both companies, which will be discussed later, place them in a strong competitive position to benefit from increased industry consolidation. The current trend suggests that while the total number of stores in the industry remains stable, O'Reilly’s market share should continue to grow as a percentage of the total (from 12% in 2014 to 15.8% in 2024).
2.1. Market Drivers
Miles Driven: The primary driver of demand in the auto parts industry is the total miles driven. In the United States, people typically rely on their own vehicles for transportation. Even with rising gas prices, private cars remain the most relevant and accessible means of transport.
The graph shows a significant decline in miles driven during the 2008 financial crisis, which persisted for a few years before recovering. This drop was due to reduced new vehicle purchases and rising fuel prices, both influenced by lower consumer income resulting in fewer miles driven during that period.
As of the latest measurement, total miles driven have returned to pre-pandemic levels and are expected to continue growing in the coming years. This projection considers additional factors like the number of vehicles in operation and population growth, both of which are also expected to trend upward.
Average Age of Vehicles:
The average vehicle age also shows a positive trend, driven by improvements in vehicle quality. Advances in automotive engineering have resulted in more durable and reliable vehicles, leading to longer lifespans before replacement is necessary. With higher-quality cars, the need for maintenance and repairs throughout a vehicle’s lifespan becomes a consistent source of demand for the auto parts industry. Vehicle owners are more likely to invest in preventative maintenance and repairs to extend the life of their cars.
Currently, the average fleet age is 12.5 years, compared to 11.4 years a decade ago. With cars becoming more durable and reliable, consumers are likely to continue spending on maintenance for vehicles that are beyond their warranty period (typically more than five years).
Number of Vehicles in Operation:
The number of vehicles in operation also presents a favorable trend for the industry. According to the latest data, there are approximately 280 million vehicles in the current fleet. This indicator has grown by around 1% annually over the past 30 years. The growth rate may be even higher in Mexico, where O’Reilly continues to invest in its international expansion.
3. THE POWER OF ITS DISTRIBUTION NETWORK
O'Reilly makes its distribution the key differentiating factor in the industry. Typically, I tend to stay away from companies that rely on managing their inventories for success; it becomes a complex logistical task where there must be a perfect balance between supply and demand to achieve the highest levels of efficiency. However, O'Reilly has proven over the years to be a master of its distribution chain.
As mentioned earlier, this is an industry where competition primarily revolves around availability, especially in the DIFM segment, where service professionals pass on any price increases to the end customer. Under these circumstances, the company that can have the right parts at the right time gains the largest market share.
To begin with, none of the more than 6,000 stores carry exactly the same SKUs. All central stores and distribution centers operate based on vehicle data in operation and demand signals for a given region of the country.
The average number of SKUs in a regional distribution center is around 175.000, representing a large volume of inventory available to supply stores. Each distribution center, on average, serves around 250 stores and makes deliveries five nights a week. It is the only company in the sector that consistently operates with this level of service at all its locations.
Additionally, 95% of stores have same-day service provided by a central service store or the urban counter at the distribution center. This enables multiple shipments per day, offering customers a precise delivery commitment for the parts they need, ensuring their vehicles are back on the road quickly.
Finally, 100% of the distribution nodes include reverse logistics capability, which enables efficient management of the product lifecycle, adjusting inventory levels based on market demand.
4. COMPETITIVE ADVANTAGES:
Scale: O'Reilly greatly benefits from the advantages offered by its scale. Locally, having a higher density of stores allows for more efficient and cost-effective distribution in those areas, while also speeding up delivery times. On a national level, the larger volume of purchases enables better negotiations with suppliers, generating economies of scale that positively impact the company’s margins.
The growth in scale that O'Reilly has achieved has also given it strong negotiating power with its suppliers. In 2011, the company introduced a supplier financing program, which has allowed it to reduce supply chain costs and extend payment terms. This has resulted in a reduced need for working capital to operate the business efficiently.
This strategy with its suppliers has allowed it to increase its Accounts Payable / Inventory ratio from 86% in 2013 to 130% in 2023.
With these levels of efficiency with its suppliers, O'Reilly has been able to: 1) Increase return on capital employed and 2) Boost cash flow from operating activities.
Delivery times: As previously mentioned, delivery times are crucial in the industry, and O'Reilly has managed to stand out in this aspect. O'Reilly holds the largest market share in the DIFM segment and can continue to increase it due to the existing fragmentation. On the other hand, DIY customers are more price-sensitive and may be willing to wait a little longer, which makes companies like Autozone suffer more from the cyclical nature of the economy, as they have a larger proportion of revenue from this part of the business (more on this later).
5. AUTOZONE: ITS MAIN COMPETITOR AND WHY I PREFER O'REILLY.
There is no doubt that Autozone has also managed to stand out in the industry, resulting in excellent stock market performance over the past decade, with its shares multiplying around six times. However, I believe O'Reilly has a superior and more predictable business model, which makes it the best option in the industry.
The main difference between the two companies lies in their focus and target customers: While O'Reilly is more focused on increasing its share in the professional side of the business (DIFM), Autozone targets the DIY segment. For the most recent fiscal year, 47% of O'Reilly's sales were from DIFM. Although Autozone does not break down sales by segment, it is estimated that around 75% of its sales come from DIY, with only 25% from DIFM. This is despite the recent initiatives Autozone has undertaken to increase its share of the professional side.
Now, why is this important? Having a greater capacity in the DIFM market gives O'Reilly structural advantages that it can continue to leverage in the future:
• Aging Population: The aging population influences the growth of the DIFM segment because older people tend to prefer paying for repairs at mechanic shops rather than doing the repairs themselves. DIY automotive repairs are often physically demanding, involving lifting parts of the vehicle, working in uncomfortable spaces, or handling heavy tools.
Additionally, older individuals are more likely to keep their vehicles longer rather than purchasing new ones. These vehicles usually require more maintenance and repairs, which drives demand at mechanic shops.
• Complexity of Vehicles: Advanced technology and more sophisticated systems make repairs more difficult for average vehicle owners. Modern vehicles have advanced electronic systems, more efficient engines, and technologies like sensors, cameras, and integrated software. Repairing or diagnosing problems in these vehicles requires specialized tools, which only professional shops typically have.
Furthermore, many modern car manufacturers recommend or even require that certain repairs be carried out by certified professionals to maintain the vehicle's warranty, leading owners to choose DIFM.
• Higher Barriers to Entry: DIFM requires quick and consistent deliveries to maintain workshop operations, and O'Reilly has already mastered this process. This is difficult to replicate for new competitors, who would need to heavily invest in logistics infrastructure. Additionally, O'Reilly already operates with economies of scale that allow it to offer competitive prices to mechanic shops while maintaining healthy margins. A new competitor would need to make massive investments to reach this level of efficiency.
• Greater Resilience: DIFM shops focus on more complex and critical repairs (engine, brakes, electrical systems) rather than smaller jobs that are easier to postpone. These repairs are essential for vehicle safety and operation, ensuring a constant demand.
Similarly, in the DIFM segment, repair costs are often passed on to the end customer with less resistance, as consumers are less likely to compare prices piece by piece. This allows companies like O'Reilly to maintain their margins, even if part prices fluctuate.
For these reasons, I consider that investing in O'Reilly is much more predictable than investing in Autozone. DIY lacks these structural advantages and is, in my view, a slightly riskier investment. It is important to note that DIFM is still a very fragmented market. While O'Reilly is the main player, its market share does not exceed 7% of the total, so there is still much room for greater consolidation.
6. GROWTH DRIVERS
The main growth opportunity for O'Reilly comes from the international market. Recently, efforts have been ramped up to increase its market share in Mexico.
O'Reilly's efforts in the Mexican market are still in their early stages. The average age of its stores in this market is only 2 years, so the growth opportunity is still substantial, especially considering how Autozone has successfully competed in this market.
The industry in Mexico also has characteristics that make it attractive from an investor's perspective. The average age of vehicles in Mexico is 16.5 years (compared to 12.5 years in the U.S.), the roads are in worse condition than in its main market, and the industry is notably more fragmented than in the U.S., making the opportunity for consolidation very appealing in the coming years.
Similarly, the growth opportunity in the local market remains attractive. As I mentioned earlier, the top 10 companies in the sector control about 53% of the market, so there is greater potential for consolidation. As this is achieved, growth in comparable stores should naturally increase, as they could more effectively leverage pricing power to drive growth.
7. FINANCIAL ASPECTS
RETURN OF CAPITAL EMPLOYED:
The graphic showing the return on capital employed speaks for itself. O'Reilly is a company with enviable returns, even if halved, they would still be better than the average company in the S&P 500. It continues to surprise me to find a company in the retail world with these returns; it seems like a completely opposite model to the typical retailer who sells cheaply and frequently. In O'Reilly's case, they sell parts with low turnover and a significant profit margin.
Gross margins consistently above 50% are not very common for a retail business. This compares, for example, to the gross margins of Costco (a company of enormous quality), which are around 15%.
CASH CONVERSION
Its cash conversion has also remained at very healthy levels. The ability to negotiate powerfully with its suppliers has allowed the company to increase its accounts payable levels at much higher rates than its inventories. Therefore, as the company grows, it does not need to fund new stores with cash, as it is generated by its suppliers.
This aspect is tremendously important in O'Reilly's financial model. Financing the business with supplier capital instead of resorting to third-party debt reduces its cost of capital and increases value creation for shareholders. This, in turn, boosts cash generation and returns on capital employed.
DEBT.
O'Reilly is a company that is prudently financed. A Net Debt/EBITDA ratio of around 2.0-3.0 is reasonable for companies in the automotive retail sector, which typically have solid and predictable cash flows.
8. RISKS
ARE ELECTRIC VEHICLES A THREAT?
One of the main concerns in the market regarding the industry is the rise of electric vehicles (EVs) and how it might affect the operations of companies like O'Reilly. EVs have simpler designs compared to internal combustion engine vehicles. They do not require oil changes, belts, spark plugs, or other components associated with traditional engines. In response, management has expressed that, rather than being a threat, EVs present an opportunity.
Recently, management highlighted the following:
"More than 50% of the vehicles sold new in 2023 had start-stop technology. What happens with start-stop technology is that these are additive parts. They are added sensors, reinforced alternators, and electrical components that can measure the battery load and turn the car off and on.
Think of a hybrid vehicle; again, it's additive. You have all the components of the operating system you had, and then you also have a battery-powered hybrid system. So, it’s additive. There’s more expense there, more points of failure. We see this as an opportunity for our industry in the long term. Electric vehicles, yes, the powertrain is battery-powered. But when you think of all the other components in the car, nothing is removed."
On the other hand, it is important to consider the adoption timeline for electric vehicles. Currently, EVs make up between 5% and 10% of annual new car sales, and this number is growing rapidly. However, it is important to note that the average age of vehicles in circulation in the United States is 12.6 years, meaning the traditional vehicle fleet will still have a dominant presence over the next decade.
Additionally, O'Reilly primarily serves vehicles that are more than seven years old. Since EVs still represent a small fraction of the overall vehicle fleet and their mass adoption will take time to be reflected in this older segment, the impact on O'Reilly’s core business is likely to be limited in the short and medium term.
THE RISE OF ECOMMERCE: HOW PROTECTED IS THE INDUSTRY?
The entry of giants like Amazon has always posed a potential threat to major players in the industry. In 2018, Amazon attempted to enter the auto parts market, but it was unsuccessful. It is likely to try again in the future, but the industry has inherent advantages that make it very difficult for non-specialized e-commerce to succeed:
• Service: Specialized retailers don’t just sell a part; they include the service in their value proposition. Customers value the knowledge and expertise of staff at specialty stores, which is difficult to replicate on an online platform.
• Low turnover inventory: Many auto parts have low turnover and require a wide variety of SKUs to meet demand. This increases storage costs and makes it difficult to maintain a profitable inventory for less common models.
• Logistical challenges for some products: Liquids (oil, windshield washer, brake fluid) and batteries pose significant logistical challenges due to their weight, size and the regulations associated with transporting hazardous materials. These factors significantly increase shipping costs. It's important to note that batteries are one of the highest-selling and most important categories in auto parts stores. Running a business where selling the most popular products is a challenge becomes complex.
This situation gives an advantage to physical stores, where consumers can purchase these products without shipping costs and with technical advice, making it difficult for e-commerce to compete in this sector.
FINAL THOUGHTS
O'Reilly is yet another example that the best investments can be found in the least expected places. The auto parts industry has characteristics that may seem boring to many, but if there's one thing I've learned when it comes to investing, it's that the boring stuff usually turns out to be quite good, while industries that attract the most attention often end up being unpredictable and unattractive for investors.
O'Reilly is in a dominant position that will allow it to continue consolidating the industry. The levels of efficiency and logistics it has achieved with its distribution network are very difficult to match, even for well-established competitors like AutoZone. Given these circumstances, it would be logical for this company to continue delivering good returns for its shareholders.