O'Reilly Automotive, Inc. (ORLY) Earnings Call Transcript & Summary

Good afternoon, everyone. Thank you for joining us for our fireside chat with O'Reilly. This is Kate McShane again, the retail, hardlines and broadlines analyst here at Goldman Sachs. And it's my pleasure today to introduce Tom McFall, Executive Vice President, Chief Financial Officer of O'Reilly Automotive. For those that don't know, O'Reilly is one of the largest specialty retailers of automotive aftermarket parts, tool supplies, equipment and accessories in the United States, serving both professional service providers and do-it-yourself customers. The company operates over 5,500 stores in the U.S. and 20 stores in Mexico. The company also just reported a very strong second quarter comp, and we'll be going through some of that today. So Tom, thanks so much for joining us.

My pleasure to be here.

So I wondered if we could just start out with walking through what your business has looked like from January up until this point in time. If you could maybe walk us through what happened during the height of the pandemic and then walk us through the very remarkable swing in growth -- comp growth that you saw from Q1 and Q2 despite miles driven still being down.

Sure. So January and February were softer months than we expected as winter was pretty mild across the U.S. When we look at January and February, they're not ideal times to fix your vehicle. So it's really a need-based. Cold weather is a big driver in our business, and cars will fail in cold weather. We had a relatively mild winter, so January and February were below expectations. As spring started to hit across our markets in March, we saw sales tick up above our expectations for the first 2 weeks. Then we started to have -- excuse me. We began to see stay-at-home orders across really the West Coast and then the East Coast and then across the country pretty rapidly, both orders and organizations keeping their people at home in the middle of March. So from the middle of March through the first couple of weeks of April, we saw sales down low double digits, which we talked about on our first quarter conference call. On our first quarter conference call, we also alluded to the fact that in the third week of April, we started to see stimulus payments go out and the additional unemployment, and that had helped our business, but we were uncertain how long that would be a positive tailwind for our business. So that was through the first quarter call. On the second quarter call, we obviously put up extremely strong comps, and we gave some more details. At third week, we started to see the DIY business pick up as those payments went out and people had time to do repairs. And we also, within our industry, see a pickup in business as people begin to be concerned about their economic outlook. They will work harder at repairing their vehicles. In addition to miles driven, which is over the long period of time, the driver of our business is people drive their cars, especially cars outside of warranty. That's the driver of our business, but we have ebbs and flows in what we call unperformed or underperformed maintenance, which our industry estimates at $50 billion at any time. And to the extent that people start looking at their vehicle and worry about their economic situation on a go-forward basis, they start thinking, well, I'm not going to get a new car or I'm not going to trade-in and get a newer used car anytime soon, so I better maintain the vehicle I have now. And in the past, when we've gone into potential -- into recessionary periods or down economic turns, we've seen that underperformed or unperformed maintenance go down, and that's a boost to our business. So we started to see that in April. As we talked about, it was much more of an immediate impact on our do-it-yourself business for, what we believe, a couple of reasons. First is the demographics of our professional customers tend to be a higher demographic. They have the ability to go pay someone to do the work, and those tend to be more -- line up better with stay-at-home jobs. Your do-it-yourself customer tends to be a more hands-on job, so a lot of those are necessary businesses, and they were still commuting. The other thing that happens when economic times look difficult. There is a certain segment of our customer base that when they feel good about their economic situation, they'll pay somebody to do their automotive repairs. When they're a little more concerned, they'll do it themselves. So we see some shift. But we saw an immediate and strong positive reaction starting in the third week of April, which continued throughout the second quarter on the do-it-yourself side of the business. As stay-at-home orders started to lift in May and June and miles driven returned, we saw the professional side of the business pick up, finished stronger -- much stronger than it started. And for the second quarter, we commented that our professional business was above our beginning of the year expectations. So it was a driver to our strong comp growth, but it was really led by the DIY side of the business. And on our second quarter call, we commented that, that strong business had continued through the call.

Okay. Thank you for that recap. That's very helpful. I want...

And then -- sorry, I wanted to...

Oh, sorry, Tom. Yes, go ahead.

And that's a lot more detail on a shorter period of time than historically we've given, but because of the dramatic shifts in business, we felt it was important to let everyone know what's going on in our business. We have never seen that dramatic of a shift in our business. Sometimes during the winter, if it gets super cold, you'll see business pick up quite a bit, but in the springtime, our business is relatively consistent. So we provided that color, as did our major competitors, just because of the dramatic changes in the environment.

Thank you. And yes, they certainly are dramatic changes. One thing that we did notice during the height of the pandemic is there were quite a few garages that were closed or just the business was low because people weren't leaving their homes, as you indicated in your comments. I wondered if you could comment at all about the health of the garages, the more do-it-for-me customer. Are you hearing or seeing any kind of disruption there at all because of the disruption that happened during March and April and into May?

We feel good about our professional customers. The shock and the real dramatic drown -- downturn wasn't long enough that most of our shops couldn't sustain it. Obviously, if you look at the restaurant business, much bigger impact, much longer impact. So we have not seen a significant population of our shops not turnaround and do well as the business picked back up.

Okay. Thank you. One question that we're getting a lot, and it's kind of in the same vein of how do we lap some of the strength that we've seen for categories like food, for instance. In auto part retail, the question we get a lot is how do you view headwinds from more what seems to be maybe permanent work-from-home arrangements versus tailwinds from lesser reliance on mass transit. And then for travel, more perhaps car travel versus plane travel. Does that all add up to an inflection in miles driven anytime soon?

Well, when you look at the trend of miles driven that have come back, it's coming back relatively strong despite the issues that still remain out there. And I think you've hit on great points. More people, at the end of this, will work from home. How many more people will move out of the cities and be in the suburbs as businesses work to mitigate the risk of having concentration of employees is yet to be determined. How many people decide that they're going to want to be in control of their own [ travel leisure ] is another great point. And I think the leading indicator for us is always what happens with the new car sales. Now when we look at miles driven, it's a great statistic for our industry, but really, the ideal statistic would be miles driven on cars outside of warranty. So with new car sales being down, you know that more of the miles are being driven on cars outside of warranty. But ideally, what we'd like to see is continued increase in the number of vehicles that are out there. Just from an industry perspective, we continue to see vehicles age and the population age as vehicles are engineered and manufactured to stay on the road longer. I think what our hope is, is that people will want to control their own transportation more and we'll see a solid SAAR, and we'll have a growing vehicle population as people drive more, but that's yet to be determined.

Okay. Thank you. I wondered if we could switch gears and talk about the competitive landscape a little bit. It's still a very highly fragmented industry. And -- but it does seem like your -- the comps that you reported in the second quarter outpaced some of your main competitors. So how much of your second quarter strength would you attribute to market share gains? And why do you think perhaps you're maybe gaining more share now than you did in the past?

That's a great question that we'll determine over time. But to discuss some of the details on that, when business is good, market shift -- market share doesn't tend to shift around a lot. When business is difficult is an opportunity to acquire new customers and keep those customers. So within our industry, the #1 determinant of your ability to make the customer happy is to have the part that they want and have the people in the store that can provide the service that keeps that customer coming back. So hard to determine how much market shift has occurred right now because there's geographic differences, there's mix of sales differences. Obviously, NAPA does a lot more government and fleet than anyone else. But our focus has always been on taking care of customers. And in this environment, we've worked extremely hard to make sure that we are -- have the product. We have the product at the stores, which has been a challenge as we've had suppliers that have had challenges. We've had a dramatic increase in how many parts we need to distribute with sales and demand going up and making sure our DCs are staffed. And at the same time, making sure that our stores are appropriately staffed, which we've gone from a situation where it looked like the business was going to be down low double digits and making staffing adjustments to see the business boomerang back and be up double digits. So making sure that our DC -- we have the inventory. Our DCs are staffed. Our stores are there to take care of customers. That's our opportunity to permanently grow market share by having customers come in that might have been a competitor's customer, competitor didn't have the product or didn't have the store open or didn't have the staffing to take care of that customer and they come into our store, and to win that customer for life. So what the permanent market share changes are will take some time to sort out. Our average DIY customer shops 3 to 4 times a year, so determining if you've won a lot of those customers or if you've just been fortunate from a geographic standpoint takes some time to determine. But we feel like we've worked extremely hard to make sure that we're there to support people's automotive needs, have had very limited store closures, have maintained very good in-stock rates and have taken care of a lot of customers.

Okay. Thank you. Stepping back a little bit when it comes to price, before the pandemic, it did seem like because of the tariff situation that the industry was benefiting a little bit from inflation, somewhere in the 2% to 3% range. And as we looked out to 2020, that was something that, on the comp side, you are going to lap. Can you talk at all about what pricing action has looked like since the beginning of the year and then during the pandemic, and what you might expect for the second half of 2020?

Pricing has been very consistent throughout the year as we talked about on our fourth quarter call when we provided guidance. Because the tariffs were staggered on different lines, we expected to continue to see positive tailwinds primarily in the first half of the year as we fully anniversaried all the tariff increases that drove sale prices going up and less in the back half of the year. Saying that prices have been consistent through the beginning of the year, it's just a comparative issue. And we haven't seen dramatic changes in pricing or tariffs during the year, which is consistent with our expectation.

Okay. Thank you. Your gross margin has expanded pretty consistently over the last several years. I do think part of that has been as a result of vendor negotiations. Can you talk a little bit about that? And how much more room is there to go with this particular driver of gross margins?

So really over the last 12 years, our gross margins have expanded significantly since we bought CSK Auto in 2008, and a lot of that had to do with just volume. When we bought CSK, we are substantially below AutoZone from a purchase volume standpoint. We were quite a bit smaller than they were. And a lot of that volume -- it's good when you're chasing #1 because you know there's room to catch up, and there was quite a bit of room if we go back to 2008. So that's been a big driver for us. The other part has been sourcing and finding the appropriate cost structure with our suppliers to produce parts in the right areas of the world to be the most economical. And the third piece has been use of private label. And for us, it's really more house brands and brands that we've acquired that already have a cache in the market and using that as a way to improve our gross margin. When we -- so that's ramped us up to be pretty consistent with other players in the market, given differences in business mix. We are continually looking for opportunities to improve our gross margin percentage. But ultimately, as a retailer, what we would tell you is the important thing for us is to be able to increase our comp gross margin dollars. And typically, in retail environment, you see that through same SKU inflation. But for the past decade plus, as our industry has worked to reduce acquisition costs, no one was jumping up and down to raise prices and -- on the same SKUs. We are all driving comp gross margin dollars by reducing acquisition cost per unit. We've gotten quite a ways down that road. And if we look over the next -- the past 1.5 years, we've driven more comp gross margin dollar growth by raising prices. The impetus for that was the tariffs and other inflationary costs and also that's typically what happens in a retail environment where acquisition costs are going up. And when we look forward, those are both levers for us is the opportunity to have some inflation in our selling price and continuing to marginally increase and optimize our acquisition costs. Obviously, we are not going to see the same level of percentage growth that we've seen over the last 12 years during the next 12 years, but the focus for us is how do we continue to increase comp gross margin dollars to support our SG&A and maintain or grow our operating profit percentage.

Thank you. I wanted to move on to talk about your supply chain network. You've had a big project underway that entails opening new distribution centers and modernizing the fleet. Wondered if you could talk about what is the optimal number of DCs for you? And where do you stand with using your stores as distribution?

So what our optimal distribution number is, is a moving target. And it really depends on the volume of stores and the number of stores that we have. 15 years ago, we thought, gosh, there's not a lot more room to grow in Texas. We've got a DC in Houston and a DC in Dallas. We're set. And now we've got one in San Antonio and one in Lubbock also because the market continued to grow. We continued to further penetrate the market. So that's a difficult question to answer. It's more than we have now. And part of it has to do with some of the modernization we've done where we have DCs that we acquired through acquisition. As an example, in Tennessee, we have 2 that we're consolidating to 1 now. And that's really from the Mid-State acquisition, which happened quite a bit of time ago, but it takes a while to reposition distribution centers. I'm uncertain exactly on your question of using stores as distribution centers.

Just with regards to super hubs and hubs, is that fully built out? Or is it kind of the same answer when it comes to the hubs as the DC?