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Stock Analysis & Ideas

O’Reilly Automotive: Competitive Advantage Supports Profitability

O’Reilly Automotive (ORLY) is a retailer of aftermarket auto parts, tools, and equipment. We are neutral on the stock.

Competitive Advantage

There are a couple of ways to quantify a company’s competitive advantage using only its income statement. The first method involves calculating the earnings power value (EPV).

Earnings power value is measured as adjusted EBIT after tax, divided by the weighted average cost of capital, and reproduction value can be measured using total asset value. If earnings power value is higher than reproduction value, then a company is considered to have a competitive advantage.

The calculation is as follows:

EPV = EPV adjusted earnings / WACC
$36.8 billion = $2.5 billion / 0.068

Since O’Reilly Auto has a total asset value of $11.7 billion, we can say that it does have a competitive advantage. In other words, assuming no growth for O’Reilly Auto, it would require $11.7 billion of assets to generate $36.8 billion in value over time.

The second method is by looking at a company’s gross margins because it represents the premium that consumers are willing to pay over the cost of a product or service.

An expanding gross margin indicates that a sustainable competitive advantage is present. If an existing company has no edge, then new entrants would gradually take away market share, leading to decreasing gross margins as pricing wars ensue to remain competitive.

With O’Reilly Auto, gross margins have remained steady in the past several years. As a result, its gross margins indicate that a competitive advantage is present in this regard as well.

Profitability

Most investors look at earnings when analyzing a company. This is especially true for institutional investors who tend to overreact to the slightest earnings miss. However, these paper profits have the potential to be very misleading, which is why we prefer to look at free cash flow.

In the last 12 months, O’Reilly Auto has recorded $2.8 billion in free cash flow, making it profitable by our definition. This indicates that the company doesn’t have to rely on equity raises to continue funding its growth.

However, it’s important to note that free cash flow has been fairly volatile in recent years. To us, this means that the company’s free cash flows are not very predictable. Nonetheless, the overall trend has been upwards.

Risks

To measure O’Reilly Auto’s risk, we will first check to see if financial leverage is an issue. We do this by comparing its debt-to-free cash flow. Currently, this number stands at 2.12. Historically, this metric has been volatile as well with no clear pattern.

Overall, we don’t believe that debt is currently a material risk for the company because its interest coverage ratio is 20.2 (calculated as EBIT divided by interest expense).

However, there are other risks associated with the firm. According to Tipranks’ Risk Analysis, O’Reilly Auto disclosed 16 risks in its most recent earnings report. The highest amount of risk came from the Finance & Corporate category.

The total number of risks disclosed by ORLY is lower than the sector average, suggesting that it is relatively safer than most of its peers.

Wall Street’s Take

Turning to Wall Street, O’Reilly Auto has a Moderate Buy consensus rating, based on eight Buys, six Holds, and zero Sells assigned in the past three months. The average O’Reilly Auto price target of $752.08 implies 13.8% upside potential.

Final Thoughts

ORLY is a fundamentally strong company with a measurable competitive advantage. We remain neutral at the moment as the company is currently on a year-to-date downtrend. However, we’ll be keeping an eye on the stock for when the trend reverses.

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