O’Reilly Automotive Should Take A Breather But Is An Exceptional Holding

About one and a half years ago, I analyzed why I invested 30% of my capital in O’Reilly Automotive, Inc. (NASDAQ:ORLY). Since my article, ORLY stock has outperformed the market by an impressive margin, as it has rallied 58% whereas the S&P 500 (SP500) has declined 9%. Since I first recommended buying O’Reilly, in late 2014, the stock has rallied 380% whereas the S&P 500 has rallied only 89%. Due to its steep rally in the last seven months and its resultant somewhat rich valuation, O’Reilly Automotive, Inc. stock will probably take a breather for a while. Nevertheless, O’Reilly Automotive, Inc. remains an exceptional holding from a long-term point of view.

Business overview

O’Reilly is a retailer of auto parts, tools, and equipment in the U.S. Due to its mundane business model, it passes under the radar of the vast majority of investors, but this is a shame. O’Reilly has offered outstanding returns to its long-term shareholders. Since its IPO in 1993, ORLY stock has rallied more than 300-fold (33,760%), from $2.50 to $844 now. It has thus outperformed the S&P 500 by an extremely wide margin, as the index has rallied 750% during this period.

The impressive outperformance of O’Reilly stock has resulted from its exceptional business performance record. Not only has the company grown its sales and its earnings at a fast pace, but it has also grown them with admirable consistency. The auto parts retailer has grown its revenue and its earnings per share every single year over the last decade, at average annual rates of 8.9% and 23.2%, respectively. As per Warren Buffett, a consistent growth record is one of the most important characteristics investors should look for. O’Reilly undoubtedly meets this criterion.

The high fragmentation of the automotive aftermarket has been a key growth driver for O’Reilly. Thanks to economies of scale, O’Reilly is much more efficient than its small competitors. Thus, it has been able to drive many smaller stores out of business. As a result, it has consistently grown its market share. As the top 10 auto parts retailers still have an aggregate market share of only 53%, there is still ample room for future growth for the top players in this business.

Despite the impressive growth of O’Reilly over the last decade, there is still ample room for future growth, with the company enjoying remarkably strong momentum right now. In the third quarter, O’Reilly grew its same-store sales by 7.6% and its earnings per share by 14%, from $8.07 to $9.17. This exceeded the analysts’ consensus by $0.68. O’Reilly has beaten the analysts’ estimates in 9 of the last 11 quarters.

Even better, the business momentum does not show any signs of fatigue. Sales volumes accelerated in the third quarter, with September finishing as the strongest month of the quarter. The business momentum is especially strong in the commercial division, which is more fragmented and thus has the highest growth potential. As O’Reilly exceeded its own expectations, it raised its guidance for its annual earnings per share from $31.25-$31.75 to $32.35-$32.85.

Investors should note that O’Reilly usually exceeds its own guidance due to its cautious management and the exclusion of future share repurchases from the guidance. Overall, O’Reilly is on track to nearly double its earnings per share in just three years, from $17.88 in 2019 to about $32.85 in 2022.

The performance of O’Reilly is impressive, especially given the headwind from the nearly 40-year high inflation, which has taken its toll on consumer spending. After the initial shock from sky-high inflation, it seems that consumers have decided to invest in their vehicles instead of purchasing new ones. This trend is in line with the experience of the management of O’Reilly from previous economic downturns.

Moreover, the company still has ample room for future growth. Analysts seem to agree on the promising growth prospects of the auto parts retailer, as they expect it to grow its earnings per share by 12% per year on average in 2023 and 2024. Given the reliable growth trajectory of O’Reilly, one can reasonably expect the company to meet or exceed the analysts’ estimates.

Valuation

O’Reilly is currently trading at 25.7 times its expected earnings in 2022 and 22.9 times its expected earnings in 2023. Under normal economic conditions, these valuation levels are reasonable for O’Reilly, given its admirable consistency and its exceptional growth record.

On the other hand, given the nearly 40-year high inflation prevailing right now, these valuation levels are somewhat rich. High inflation significantly reduces the present value of future cash flows, and thus, it tends to compress the price-to-earnings ratios of most stocks. This is the major reason behind the ongoing bear market of the S&P 500.

Nevertheless, the Fed has made it clear that it will exhaust its means in order to restore inflation to its long-term target of 2%. When inflation subsides, the current valuation level of O’Reilly will become much more attractive. It is also important to note that the fast growth of O’Reilly has always compensated investors for the premium usually required to buy this stock. To provide a perspective, the stock is currently trading at only 16.4 times its expected earnings in 2026. This means that the stock is likely to highly reward those who purchase it at a premium valuation level and wait long enough for the fast growth to offset the initial premium valuation.

Risk

The greatest risk factor for most stocks is the event of a potential recession, but this is not the case for O’Reilly. During recessions, many consumers postpone the purchase of a new vehicle, and thus, the average vehicle age tends to rise. As older vehicles require higher repair and maintenance expenses, O’Reilly usually thrives during recessions.

Even better, during recessions, the price-to-earnings ratio of most stocks, including O’Reilly, tends to shrink. O’Reilly has taken advantage of its cheap valuation during recessions and has greatly enhanced shareholder value via aggressive share repurchases. The company reduced its share count by 10% in 2020-2021.

The most prominent risk factor for O’Reilly is the high growth of the sales of electric vehicles. These vehicles require much lower repair and maintenance expenses, and hence, they negatively affect the business of O’Reilly. However, despite the fast-rising sales of electric cars, the vast majority of cars will remain conventional for more than a decade. Therefore, this is only a long-term risk factor.

Final thoughts

Due to its impressive outperformance and its resultant rich valuation, the stock of O’Reilly Automotive, Inc. is likely to take a breather sooner or later. ORLY stock has gone through extended periods of consolidation in the past but has invariably rewarded patient investors with steep rallies after such periods. As it is essentially impossible to time the market, investors should probably remain invested in O’Reilly and maintain a long-term investing horizon. O’Reilly Automotive, Inc. is an ideal example of a buy-and-hold stock thanks to its rock-solid business model and its exemplary management.