I have been following
Dorman Products (
DORM) closely for 4 years, having previously
shared highly favorable views beginning in early 2009. The stock has been a great performer since the Great Recession, as it was very cheap four years ago and then benefited from the trends of used cars staying on the road longer and the shift from dealer-owned car repair shops to independents or do-it-yourself repair. I have been patiently awaiting the right time to formally recommend sale of the stock, and it now has likely priced in the continuation of very strong fundamentals that are likely to deteriorate. I recommend selling DORM, with an anticipated target of 28 in a year, based on 13 P/E on estimates that are below the current consensus (-17% projected return), with the potential of a 26% decline if its above-average margins revert.
What Does Dorman Do?
DORM, based near Philadelphia, was founded in 1978 and supplies replacement auto parts, which are significantly less expensive than those provided by automobile manufacturers.
According to the company, its parts can be broken down into the following categories:
- Powertrain - 33%
- Auto Body - 28%
- Chassis - 27%
- Hardware - 12%
79% of the products are sold under Dorman's various brands, while 21% are private-label, other brands or in bulk. 90% of sales are in North America. For years, the company has provided a breakdown of its sales into three different categories, though it has a single operating segment. The company's products (128K SKUs) are sold through traditional distribution (44%), which includes 10%+ customer
Genuine Products(
GPC) and also privately-held Carquest (among others) as well as through retail (46%), which includes directly to stores
Advance Auto Parts(
AAP),
AutoZone (
AZO),
O'Reilly Auto Parts (
ORLY) and
Pep Boys(
PBY). Another 10% is sold through other non-automotive retailers, which has declined from a few years ago from more than 20%, with the balance picked up evenly by the direct and indirect customers. The very high concentration of sales to named customers allows significant insight into business trends, which I address below.
CEO Steven Berman (53) has served in that role since his brother, Richard, passed away two years ago. Richard served as CEO from 1978, while Steven had served as COO since then. The company has a relatively new CFO, Matt Kohnke, who joined in 2002 as Controller and succeeded Matt Barton, who was promoted to Co-President in early 2011 along with Joseph Beretta, who had been SVP,Product since 2004. Insiders own 21% of the company roughly, with Berman owning about 19%. This excludes additional shares held by the Berman family.
Why Have They Done So Well?
DORM has had strong fundamental performance in the last few years, producing 5-year compound sales growth of 14% and EPS growth of 37%, driving the stock from a low near 4 in early 2009 to a recent all-time high of 35 (before a $1.50 special dividend):
(click to enlarge)
The company highlights some favorable trends that have served as tailwinds, including the lengthening of the average age of cars to 10.8 years due to tight credit and high unemployment. Additionally, there has been a decline in the auto manufacturers' share of aftermarket from 31% five years ago to 28%. Remember all those auto dealerships closing in 2009? This has resulted in customers seeking out more convenient repair shops, and this benefits DORM, as the independents are willing to substitute "generic" parts.
As I mentioned earlier, the big automotive repair retailers to whom DORM distributes directly make up a big part of DORM's business. AAP, AZO and ORLY are 10%+ customers (PBY is not). The company also defines GPC as a 10%+ customer. It and Carquest also have their own retail stores. Also, it's important to realize that the retail stores now act as just-in-time distributors for small auto repair shops. In aggregate, these four companies comprised 55% of sales in 2011 and 2010, remarkably high concentration. With PBY, the five publicly-traded companies likely represent 60% of overall sales.
In addition to the tailwinds that have helped drive their business, the company has also expanded into heavy duty trucks and has also introduced many new products in the past 3 years:
- 60 new categories
- 1058 new items
- >4200 line extensions
What's Going On With Their Customers?
Given the high customer concentration, investors can look for deeper insight into trends at DORM by examining the fundamentals at the customers. My analysis will focus on GPC, AAP, AZO and ORLY, which I estimate account for 55% of sales. I am disregarding PBY because of its smaller size, but I note that it has been struggling. 10% customer GPC is only partially exposed to the automotive replacement parts market. So far in 2012, auto represents 48% of sales for GPC, with the balance in industrial, office products, and electrical/electronic materials. On its last conference call, it described the market as "steady". Here is how they characterized the recent quarter:
Automotive is our company's largest business segment and we ended the third quarter with sales up 2.5%. For the 9 months ended September 30, our Automotive business is up 4% over the same period in 2011.
Our sales pattern in the third quarter was very similar to our second quarter results. In fact, when we account for the 1 less selling day in the third quarter this year versus 2011, total automotive sales were up 4%, in line with the 4% we delivered in the second quarter.
I will say our overall sales were softer than what we expected at the beginning of the quarter. We believe there are a number of factors impacting our industry, including the mild winter temperatures experienced in the northern half of the country, along with the ongoing uncertainty in the economy.
The quarter was boosted by an acquisition, as same-store-sales for automotive were just 1%. Further, in their company-owned stores, their retail business was down, while their commercial business grew. Finally, on the basis of internal growth initiatives, the acquisition and easier comps from weather, they forecast Q4 sales growth accelerating to 6-8%.
The outlook isn't nearly as good for the pure-play retailers, which represent 46% of DORM sales. Let's look first at AAP. Here is what CEO Darren Jackson had to say on November 8th, when the company reported Q3 earnings:
As you've seen in our earnings release and as we indicated in our pre-release last month, our business and industry continues to face weak consumer demand in both DIY and Commercial.
CFO Mike Norona detailed a 0.5% decline in sales, with same-store-sales off by 1.8%.
AZO was more upbeat when they reported December 8th. Same-store-sales were up 0.2% for its Q1. CEO Bill Rhodes shared significant insight, pointing out that part of the weakness for the sector is skipped maintenance. He also suggested that the resurgence in new car sales isn't necessarily bad, as used car registration is flat. Despite flattish sales, which were up overall by 3.5%, inventory jumped. Here is what CFO Bill Giles said:
We reported an inventory balance of $2.7 billion, up 6.8% versus the Q1 ending balance last year. Increased inventory reflects new store growth along with additional investments and coverage for select categories. Inventory per store was up 2.6%, reflecting our continued investments in hard parts coverage.
To be clear, inventory is growing above sales trends, which benefits DORM. ORLY laid it out even more explicitly: Here is what ORLY CEO Greg Henslee said on 10/25 when the company reported Q3 earnings:
Now I would like to take a few minutes to update everyone on some of our key initiatives. First, I would like to update everyone on our initiative to improve customer service levels by increasing our store level inventories. As I mentioned on previous calls, we have evaluated our store and hub stocking levels and based on multiple data points, and made the decision to invest an additional $100 million in store level inventories. We have done an extensive review using a variety of very sophisticated proprietary systems and have worked with over 250 vendors to determine the most appropriate inventory to add to each store. Through the end of the third quarter, we have approximately 80% of the inventory rolled out to the stores and would anticipate rolling out the remaining 20% during the fourth quarter of this year.
I share this backdrop of weak fundamentals for the customer near-term but strong inventory growth because I think that it illustrates how DORM (and its stock) have outperformed its customers fundamentally recently. In the recent 10-Q, they stated it explicitly:
In addition, sales during the third fiscal quarter of 2012 benefited from the shipment of several large line updates to a few large customers.
Here is some data (from Baseline) that I would like to share to further illustrate the point:
(click to enlarge)
DORM has rallied 82% in 2012, far better than its customers, and it is clearly the best performer over the past five years. Looking at the sales, it grew 17% over the past year in Q3, while none of its customers grew more than 4%. Longer-term, its growth has been somewhat similar. The middle panel highlights strong earnings growth relative to the customers over the last year.
Let's now compare DORM's stock price to that of the customers, looking first at the past five years and then 2012:
(click to enlarge)
DORM historically had traded in line with its customers, but it separated from them mid-year. It is more clear in the YTD chart:
(click to enlarge)
Bottom-line: DORM is doing better than its peers fundamentally, benefiting from its own efforts to some degree but, more cautiously, from purposeful inventory builds which are likely ending. The separation from the pack with respect to the stock price is a yellow flag.
How Expensive Is DORM?
We have already discussed how favorable many trends have been, which has led to solid fundamentals. First, I want to focus on profit margin, which was detailed above. The customers are all enjoying average to above average margins relative to their history, but DORM has seen its margins expand dramatically. In fact, it now has the highest net income margin among the group. The current 11.5% NIM is 1.5X the average of the past five years.
How have those margins expanded? The table below shows the evolution of the income statement since 2007. Note that 2012 is YTD through three quarters:
(click to enlarge)
In 2007, sales were $328mm, while 2012 sales are expected to be about $589mm, an increase in total of 80%. The company has been able to enjoy both rising gross margins (about as high as they have been) and sharply lower SG&A relative to sales (it has increased 50% over five years).
Now, let's discuss valuation. Investors are paying high valuations on these stoked-up margins. On a trailing basis, 18.5X is a record PE (see below), 1.5X its historical average (looking back 5 or 10 years). Giving them credit for their strong balance sheet (though this calculation is too generous because it doesn't incorporate the $1.50 per share special dividend), DORM now trades at >10X EV/EBITDA (bottom panel), nearly the highest valuation in the group. Boy, it's come a far way:
(click to enlarge)
One of the most dangerous practices when it comes to investing, one which gets the momentum guys into trouble, is to pay peak price for peak margin. DORM has benefited from many favorable trends, and the margins seem to reflect favorable trends. If they don't persist, then 10X EV/EBITDA is expensive not only to its history but to manufacturers in general. To pay this type of valuation assumes these tailwinds keep blowing. If not, valuation should regress to a more typical 8X. Most stocks are trading BELOW their 5-year average valuations these days!
What Is Expected Fundamentally?
On the way up, it was always surprising to me how conservative the analysts were, which led to positive surprises quarter after quarter. The company doesn't guide (or even hold conference calls), and it's not widely followed, so perhaps it's not too surprising that the estimates haven't been such good forecasters of results.
The two analysts (BB&T and BWS Financial) have an expected 2012 EPS of 1.91 for 2012, with a quarter to go, with both within .01 of that estimate. This implies Q4 EPS of .52, up 20% from a year ago on sales of about $156mm (up 12%).
For 2013, the sales growth is expected to be 13%, with EPS projected to be $2.27 (2.23 and 2.30 are the two estimates). This would be growth of 19%, suggesting further margin expansion. By the way, you can see this information for yourself
here.
One fundamental point I would like to introduce is that there are some warning signs in the balance sheet and in operating cash flow. On the balance sheet, we see Receivables have increased dramatically over the past year. Remember, sales in the last quarter were up 17% from a year ago. Receivables? 39%! To be fair, they were perhaps a bit low a year ago. More alarming is that what we see isn't what is really going on, as the company sells off its Receivables:
Over the past several years we extended payment terms to certain customers as a result of customer requests and market demands. We participate in accounts receivable sales programs with several customers which allow us to sell our accounts receivable to financial institutions to offset the negative cash flow impact of these payment terms extensions. Without these programs, these extended terms would have resulted in increased accounts receivable and significant uses of cash flow. Pursuant to these agreements, we sold accounts receivable in the aggregate amount of $235.2 million and $149.7 million during the thirty-nine weeks ended September 29, 2012 and September 24, 2011, respectively. If receivables had not been sold, $165.8 million and $137.0 million of additional receivables would have been outstanding at September 29, 2012 and December 31, 2011, respectively, based on standard payment terms.
Source: 10-Q, page 14
CFO through the first 3 quarters is just $28.6mm, down from $30.6mm a year ago. The company has generated Free Cash Flow of $14mm YTD and will likely just match last year's $20mm. I would be more encouraged by the strong sales and earnings trends if cash flow were also growing.
Conclusion
DORM has enjoyed years of strong growth. While the company has done a great job of introducing new products, the real driver, in my view, has been exactly what I suggested years ago: Older cars and fewer dealer-owned repair shops. The trend towards keeping cars on the road longer has been a great boon for DORM and its value-priced products, but it's one that is likely abating.
More recently, clouds have formed, with customers representing over half of DORM's sales reporting lackluster growth, including both its retail customers (AAP, AZO, ORLY and PBY) as well as its largest distributor, GPC. DORM has been spared near-term slowing due to inventory programs, especially at ORLY, that have boosted near-term demand. New car sales have been soaring, but no one seems to yet think that's the issue (new cars don't need replacement parts early in their life).
I think that the company isn't likely to grow as expected, and my forecast is that earnings for 2013 and 2014 will trail the consensus estimates as sales growth slows. The diminishing of near-term fundamentals will likely result in a more normal valuation. While I am not sure if Q4 will miss or not and will just go with the analyst forecast for 2012, I do think that sales will likely grow 8% or so for the next two years, leading to 2014 sales of $687mm. It's worth noting that sales trends in the past few years have been 21% in 2010, 16% in 2011 and 15% YTD after a strong Q3 (when ORLY apparently bought aggressively). In the prior five years (2004-2009), sales grew an average of 8.7% per year. I suspect that DORM's near-term growth will more closely align with sales growth of its key customers.
An 11.5% NIM on sales of $687mm would suggest EPS $2.15, which I view as conservative for the purposes of my analysis, as a more reasonable assumption would be for some margin contraction. One of the two analysts is forecasting $2.57 for 2014, which I think is unrealistic. In the table above, we see that GM is near the highest it has been in years. I think that this could change, resulting in a lower margin, as the company could face some pressure. While it may be boiler-plate language, the company's recent 10-Q spells it out very clearly (page 13):
While the overall automotive aftermarket in which we compete has benefited from the conditions mentioned above, our customer base has been consolidating over the past several years. As a result, our customers regularly seek more favorable pricing, product returns and extended payment terms when negotiating with us. While we attempt to avoid or minimize such concessions, in some cases pricing concessions have been made, customer payment terms have been extended and product returns have exceeded historical levels. The product returns and more favorable pricing primarily affect our profit levels while payment term extensions generally reduce operating cash flow and require additional capital to finance the business. We expect our customers to continue to exert pressure on these and other factors for the foreseeable future. We also expect our customers to continue to exert pressure on our margins.
When a company doesn't guide, doesn't hold conference calls and isn't widely followed, it pays to study the details. The inventory accumulation by its customers helped DORM, but this was likely a short-term event. More than half the sales are represented by 5 companies, all of which point to surprisingly challenging conditions for the industry. When I first discovered DORM years ago, it was emerging from a period of weak margins and weak cash flow generation due to pressure from its customers. Pay attention!
My year-end 2013 forecast is for DORM to trade at 13 P/E on a forward basis (2014 EPS of 2.15), resulting in a target of $28 compared to the current price of $33.63. If I have been too conservative on margins and they normalize to let's say 10%, EPS would be closer to $1.88, leading to flat earnings for two years and a stock price likely closer to $25 (26% decline).
Of course, it may not take a year to play out. In my most pessimistic scenario, the company struggles to meet the consensus this quarter of 12% sales growth, as the weak trends reported by customers just months ago lead to cautious purchasing. An immediate shortfall would lead to reduced estimates for 2013 and a likely reduction in P/E, allowing the stock to more quickly realize my one-year target.
