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The investor gamble

Friday, March 5, 2010 - 01:00

Investor sentiment toward O'Reilly Auto Parts, as well as many other parts retailers, has grown negative over recent months, in our opinion. From July 30, 2009 (when shares of O'Reilly hit a high of $42.29) until Feb. 9, 2010, the Standard & Poor's 500 (S&P) appreciated 8 percent, and the consumer discretionary segment of the S&P is up 15 percent. In contrast, shares of O'Reilly have declined 8 percent, Advance Auto Parts is off by 12 percent and only AutoZone managed to post a modest gain (2 percent).

We believe this relative underperformance for aftermarket stocks is a function first of investors searching for higher beta names (those whos fortunes are more closely tied to potential economic recovery) ; second, concerns that same-store sales (SSS) growth will falter in 2010 against challenging comparisons from 2009; and thirdly, for O'Reilly in particular, that an integration misstep is imminent.

Our though is that sector rotation back into the more "defensive" names, including the aftermarket parts distributors, is likely as uncertainty regarding the pace of economic recovery continues to mount. No doubt 2009 was a year of strength for the aftermarket as consumers devoted a larger share of their wallets to the maintenance and repair of existing vehicles, given the assumption that it would be some time before they purchased a new vehicle. This is evident in the depressed 10.4 million new light vehicles sold in 2009.

While we believe that 2010 could prove to be an even better year for the aftermarket, particularly in the wholesale distribution segment given the fallout of dealership closings, we think that a number of investors have become concerned that SSS in the core O'Reilly stores will not fare well against a challenging 6.7 percent SSS comparison from 2009. Though we agree that the comparison from 2009 is somewhat challenging, we believe it is important to look back to the company's excellent record of growing its comparable store revenue that proves otherwise. With an aging fleet, still-depressed new vehicle sales levels and opportunity for parts distribution wins through dealership fallout, we see no reason why O'Reilly shouldn't be able to post solid SSS in the 3 to 5 percent range.

As far as the CSK conversion, we think everything is on track or even ahead of plan. At the end of the fourth quarter 2009, 405 CSK stores had been converted, or approximately 30 percent of the CSK store base. The period of greatest "risk" as it pertains to the conversion process, in our opinion, will be the first half of 2010, as an estimated 460 additional CSK stores will undergo conversion. However, we think the West Coast conversions will be different that those in the Midwest. For example, the Midwest converted stores were closed for roughly one week because of the sheer amount of heavy lifting required to completely reset the stores, and this lost week of sales created a material approximate 8 percent headwind to SSS. The Midwest stores (123 Checker and 141 Murray's) headed iinto the process completely CSK merchandised, and within one week had their entire inventory swapped out, on top of numerous operational changes.

While we believe near-term volatility in the shares is certainly possible (particularly given broader equity market moves), if no material integration disruption arises by the end of Q2 (when we expect roughly 67 percent of all O'Reilly conversions to be complete), we suspect many investors are likely to begin shifting focus to the significant growth potential that exists in 2011 and beyond.

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