This is a tough market to find stocks that are working, but one group that has performed well of late is the retail auto parts stores. Last week, O'Reilley (ORLY) and Advanced Auto Parts (AAP) spiked after delivering strong earnings report and guidance. This group is one of several that I profiled in October that I thought might benefit from the recent auto industry turmoil. While many of the stocks that I thought might benefit from the abrupt and steep decline in the credit available to and the sales generated by the automobile dealers haven't fared very well in this tough market (yet), the parts dealers have been strong over the past 4 months. While tiny Pep Boys (PBY) has been weak, the three larger chains have performed quite well:
- Advance Auto Parts (AAP): +34%
- Autozone (AZO): +37%
- O'Reilly (ORLY): +46%
As I mentioned in that article, "As people keep their cars longer, they will need to maintain them. While these stores cater to the do-it-yourself repair person (not me!), they also act as just-in-time inventory hubs for repair shops. An aging fleet of vehicles implies more repairs." I don't believe that much has actually yet happened on that front, but I do think that investors are beginning to better appreciate this dynamic.
In January, I came across a company that is a supplier to the industry, Dorman Products (DORM) (8.67, $153mm market cap). In contrast to the sharp rise of the industry to which it supplies, its stock has dropped slightly over the same time-frame. 38% of its sales are into the three companies I mentioned above, so it would seemingly be better correlated, but it is a microcap at $150mm. I have reviewed their SEC filings and had a discussion with the CFO to answer a few questions that I had.
While DORM isn't what I would describe as a highly unique company with any sort of moat around its business (10% EBITDA margin, 9% Return on Capital), it is a well-positioned company with great relative prospects in a lousy economy with a strong balance sheet, a fantastically cheap valuation and high insider ownership and institutional sponsorship. The company makes over 92k parts in 50 broad product lines, most of which are original equipment manufacturer replacement parts. It competes with divisions of larger companies for the most part. For those not familiar with this niche, the value proposition is significant cost savings to the consumer relative to buying a part from the car manufacturer.
From what I can gather, DORM works very well with its customers, using their feedback to design new products. According to the CFO, while the market is highly competitive, DORM is able to use innovation to get a 2 year window of no competition on its new parts. Many of the parts are engineered to work across various manufacturers, which is a real advantage to the chain stores. I also learned that no company competes with DORM across more than 5 of its 50 product lines. Perhaps the strongest reason the auto parts dealers value DORM is their tremendous breadth in product offerings.
The past few years have been tough on DORM, with their customers pushing back on pricing to them while they have endured pressures. Hopefully this is now changing. When gas prices were high, consumers deferred spending on auto repairs, and I believe we are now seeing signs of a resumption of growth. As you can see, earnings have been rather flat the past four years or so (second panel) despite continued primarily organic sales growth. Besides the pressure from customers, the company absorbed higher input costs last year as well:
I want to address the balance sheet first, as it is generally very strong with the caveat that there is too much inventory. The company has acknowledged this point, which is a good first step, but there will be a continued drag on GM until this overhang is lifted. With that said, the company has a book value of $185mm and $159mm net of intangibles and goodwill and $21mm in long-term debt ($14mm net). The company is asset-light due to its outsourced manufacturing business model, so most of the equity is tied up in working capital. While I noted the high level of inventories, AR has been very well controlled. Historically, the company has been a high generator of free cash flow.
Valuation is quite low by several measures. In addition to a low PE, a low EV/Sales ratio and a low EV/EBITDA ratio, the stock trades below book value and slightly below tangible book value:
Here are the metrics and some operating metrics in comparison to its 3 largest customers:
You will have to click on the chart to see it more clearly, but there are some stark contrasts:
- The comps have soared, while DORM has performed poorly
- DORM trades at substantial discounts in terms of PE, EV/EBITDA and EV/Sales
- DORM trades at discount to Book Value and at Tangible Book Value, while peers are at a big premium
- DORM lags on growth over the past 5 years
- DORM margins are lower, but slightly more impacted compared to past 5 years
- DORM balance sheet is significantly stronger
It looks to me like we have a situation where the little guy has been somewhat squeezed by his larger customers. Hopefully, as the environment seems to be improving for them, the pressure lets up a little on DORM. Higher sales and falling input costs do bode well.
DORM insiders own a slug of the company (33%), and the Bermans don't seem to sell. Very interesting to me is the extremely strong base of institutional holders, including
- Royce (10.9%)
- DFA (7.6%)
- TROW (6.8%)
- Columbia (B of A) (5.9%)
None of these holders sold shares in Q4 and in fact all added slightly. With a combined 31% owned by these managers and 64% including the insiders, it is no wonder that the stock trades by appointment only: just 15k shares per day. It is for this reason that I hold it solely where I can invest and can't recommend it to my clients or include it in my model portfolio despite my own convictions regarding its relative outlook. It is covered by a single analyst as well. In other words, this one is quite under the radar!
As you can see in the chart below, the stock hasn't done poorly relative to the market (the black line in the top panel). It appears to have buyers below 9 and sellers at 14:
My own expectation is that the stock may trade as high as 16 later this year, though it will require a couple of things to happen. First, the margin erosion must stop by mid-year. Despite the higher inventory than the company should be holding, I am optimistic that the improved sell-through should help clear that overhang. The company reports on 2/27, so we may learn more about the outlook for margins then and perhaps see signs of inventory improvement. Second, someone will have to notice! I think that the fact that the stock trades at tangible book value but should continue to offer a decent free cash flow yield (once it works through the inventory), that it has little debt, that its growth outlook isn't nearly as bad as for companies in general due to the secular theme of cars being on the road longer, and that its margins have plenty of room to expand as input prices have now corrected and the pressure is lifting off of its customer base could be the catalysts. I base my 16 target on a couple of different assumptions:
- 1.5X projected 2009 ending book value
- 13.3X my projected 2010 EPS of 1.20 (sales growth, margin improvement)
While M&A isn't too prevalent these days, there is always that possibility, as many larger companies already compete in the space to a limited degree. I don't ever invest with that goal, but I do consider the potential for acquisition. In any event, that potential should at least provide some downside protection given that the company has the resources to weather whatever the economic decline brings.
Undiscovered gems these days tend to be cubic zirconia at best rather than truly diamonds, so I don't want to suggest that DORM is the 10-bagger one has to grab now, because it isn't. I do view it, though, as a good way to climb aboard a nice secular story and coinvest with some very smart long-term investors who have all stuck with this company. I believe that the downside is very limited due to the strong balance sheet of the company and its very low present valuation. I don't expect that the stock will remain as inexpensive to its customers as it is now, but one never knows how that plays out (the stores could just come crashing back down). Finally, I caution that the stock is the most illiquid one in which I have ever invested. I tend to use this to my advantage, trading more frequently than I would typically do for an "investment", but one must be cognizant that it trades on an extremely wide bid-offer spread.
Disclosure: Long DORM