When the financial media starts using words like “carnage” to describe an industry or sector of the economy, I love it. The auto industry has been a favorite punching bag over the past year or so – and despite the press’ consistent swings and misses, they continue at it. The industry and all connected to it have been attacked on peak sales, subprime buyer saturation, Amazon’s inevitable market share grab (parts), peak profits, residual values falling fast, self-driving cars taking over the world – soon, electric cars taking over combustion – soon, and an inevitable (and immediate) cyclical downturn of both auto sales and the economy.
Like Moody’s, the mass media is always late. By the time their chorus is singing coordinated woes, prices have already fallen and if there was a train coming, it already ran you over. Nevertheless, they (the media) probably help to further negativity and drive optimism out of prices – which is a good thing (as long as I don’t already own too much of the asset in the electric chair).
Optimism is probably the most fascinating aspect related to asset prices, and its absence can be a strong protection. For example, If a high performing business has consistently pleased “the market” by beating estimates, raising guidance, attracting sell-side analysts, and winning customers and fans alike, the market comes to expect and then demand such actions in the future (we as pattern-seeking humans have (strong) a tendency to extrapolate current trends. Not much in business life is linear, but for some reason, we insist on viewing most things that way – to the contrary, business is prone to cycles). If those baked-in high expectations come to fruition, the upside keeps plucking along and doesn’t surprise anyone, it reinforces perceptions and expectations and therefore doesn’t usually cause large upside movements in market value. When everyone believes a business is great and will do great and therefore is almost a sure thing, they usually bid it up to the point where it’s enormously risky. No risk is feared, and therefore no risk premium is demanded. The businesses that are the most esteemed can become the most risky. To a business in this seemingly great situation, a small disappointment can cause dramatic falls in market value at a very rapid pace. The air out of a balloon almost always leaves faster than it went in.
On the contrary, when a business that is in an industry under attack, at a cyclical low, or has stumbled upon hard times (which all businesses inevitably do), it is barraged by negativity. One additional piece of negative news doesn’t often produce large downsides as there are not many sellers left. When everyone believes something is risky, their unwillingness to buy, and eagerness to sell, usually reduces the price to the point where it’s not risky at all. Broadly negative opinion can make it the least risky thing since all optimism has been driven out of its price. If optimism starts to shine through, upside surprises can be large and often develop quickly.
So, the first question one might ask themselves when buying an asset is “How much optimism is embodied in the price?”. If there is a lot, go in with your eyes wide open – because your wallet is too.
Recent Examples in Auto Land
Various automotive businesses have lost a lot of the optimism that once was common in their prices. To name a few of the big ones: AutoNation, O’Reilly, Autozone, Advanced Auto Parts, Ashbury Automotive, and Monro have all had the wind come out of their sails over the past year or two.
These companies have seen their market values fall anywhere from -34% to -50% as compared to their recent highs. The five-year price charts for each are shown below.
Think about that price movement for a minute – intrinsically, have all of these businesses become 1/3rd to 1/2 less valuable over this time period? I doubt it. Some were likely priced too high at their peaks, some have fallen too far, and perhaps some need to fall further. I don’t know each of their stories in depth, though I do know a few of these businesses decently well. For a quick filter, some decent starting questions when sifting through fallen angels might look like this:
- Is this a business that’s difficult to kill? (are its wounds potentially fatal)
- Is this a business that will create more value than it’s currently creating five years from now? And does it have the balance sheet to do it?
- Is the management composed of competent, honest, efficient, and rational people?
- Does this business have a proven track record?
- How much optimism is in the price?
Monro does what its logo says. The business owns about 1100 auto service stores and franchises about 115 more that focus on scheduled car and truck maintenance, under-car repairs, and tire sales. They are the largest chain of undercar auto service facilities in the USA. They own the CarX, Monro Muffler/Brake, Tire Barn, Tires Now, Tread Quarters, Towery’s, Tire Warehouse, and Mr. Tire brands – among others. Their sales mix looks like this:
Brakes – 13%
Exhaust – 2%
Steering – 9%
Maintenance – 27%
Tires – 49%
They’re essentially an automotive service location just like the hundreds you come across on any American highway. Perhaps Monro has an undifferentiated commodity business that’s easy to compete with by anyone who can qualify for an SBA loan. Or perhaps they are a low-cost provider with better service and a scaled supply chain looking and able to further consolidate a fragmented industry that happens to be led by a management team who has done this before. I’m leaning toward the latter explanation.
Monro is headquartered in Rochester, New York. They’re primarily an east-coast shop with a particularly heavy presence in New York, Ohio, and Pennsylvania. More recent expansions have been into the Southeast and Midwest. Further expansion plans are currently focused on the South. The business was started about 50 years ago and by its tenth anniversary had 20 stores. The company went public in 1991 and accelerated expansion – primarily through acquisitions. The business has been a serial acquirer and has established a solid acquirers’ track record. For a lot of investors, serial acquirers ring alarm bells, but continuous bolt-ons done over decades with successful integration and without balance sheet expansion are much different than borrowing to grow an empire or buying because as a manager you get paid on something like adjusted EBITDA or revenue growth. Monro’s strategy and the success it has bred speaks for itself. Over the past 20 and 10 years, the company has delivered about 13% annualized to its shareholders. Over those same time-periods, earnings per share have grown at about 9% and 11% annualized respectively. There’s been some PE expansion (the market has gradually been willing to pay more for each dollar that Monro makes) and a small dividend to boot which takes returns to that 13% mark.
The automotive service industry has been a private equity favorite since about 2010. Money has been flowing into the industry almost continuously – with acquisition multiples getting very steep as of late. Blackstone, Apollo, Transom, Sun Capital, American Capital, and more recently Carl Icahn have all participated in large (and so far successful) buyouts and eventual sales of automotive service businesses. Through the private equity owned competition, Monro has held its own (and the PE activity might end up becoming a positive for Monro). Since inception, high-interest rates, high unemployment, gas shortages, and Ralph Nader have threatened Monro’s business, yet it’s been able to thrive and has proven difficult to kill. The track record has been a steady and non-dramatic one.
Driving the stock performance over the past two decades is the business performance. Over the past decade, revenue has grown about 240% from $440 million to just over $1 billion. Net income has roughly tripled from $22 to $62 million, cash flow has quadrupled to $150 million. Book value per share has also grown by about 290% during that time period. Financial leverage (total assets/total shareholder equity) has stayed roughly flat during the period.
Debt is manageable, nonthreatening, and in line with historical ratios at about $180 million today vs. about $120 million in trailing twelve months earnings before tax. Interest expense on the debt is about 1.9% of sales or ~$19 million.
Maturities don’t look particularly daunting:
The company has a $600 million revolver and has drawn $180 million. Capital leases are about $235m. Between the cash flow of over $130 million annually and the revolver capacity, the balance sheet looks fine with plenty of capacity to go after an attractive acquisition.
Where Do Returns Come From?
Let’s get a little more clear about where those historical 13% annualized returns came from and what drives them. This is what really matters and it’s what will help us gather ideas about what returns might be reasonable to expect moving forward. With any successful business, earnings (free cash flow) are produced and a business has only four choices of what to do with that cash. This capital allocation between four choices is one of, if not THE main task of a CEO. With the cash produced, the business can:
- Hoard it
- Pay it out as dividends
- Buy back stock
Monro has completely avoided hoarding and mainly avoided buybacks. They do pay out dividends (which I don’t particularly agree with – I’ll get there later), though the largest portion of their earnings are reinvested into the business. Moving further, what matters for long-term business performance is:
- What rate of return the business achieves on their invested capital
- How much of their future profits can and will be reinvested
There is actually a pretty simple way to quickly figure out the returns a business has been able to achieve on its invested capital. Return on invested capital (ROIC) is found by taking the after-tax profit divided by debt + equity. In other words, profit/total capital invested.
Monro’s ROIC has come down over the past five years from the mid and high teens to the very low double digits/high single digits. This probably has some relationship to why the stock has fallen to under $45 from its recent high of $75. Same store sales growth is one of the culprits behind this and has been slipping continuously over the past five years; returns on invested capital have fallen in lockstep.
When I think about the profit a company makes, I try to think in terms of actual earnings to a sole outright owner of the business – not necessarily taxed GAAP earnings or per share figures. If this was my family business, I want to know what the free cash flow to my family will be. This means that there are often estimations and adjustments to be done to sort out what that number would actually be. For example, if operating cash flows came in at around $125 million and maintenance capital expenditures came in at around $30 million, one might say that free cash flow to an owner is $95 million. But there’s also stock-based compensation that’s a non-cash expense, but a real expense. That would need to be subtracted from that $95 million. Or I might care about the steady-state free cash flow of the business. Meaning, If I wanted to support this business as is and not worry about growing it, how much cash could this throw off? Another way to look true earnings or earning power might be after-tax earnings plus depreciation, less capital expenditures (as capital expenditures are a direct offset to depreciation allowance; the former is as certain a use of cash as the latter is a source).
Monro produced about $125 million of cash last fiscal year (operating cash flow or funds from operations). Out of that, about $35 million goes to capital expenditures (about $30 to maintenance) and $25 million towards dividends. That leaves $60 million left to reinvest. To that $60 million left for reinvestment, the company could and likely will use an additional $20+ million per year in long term debt – which is very reasonable considering the balance sheet. I’m estimating the fiscal year 2018 owners earnings coming in at about $90 million. With that, we can calculate ROIC’s. Ending 2017, Debt and capital leases totaled ~$400 million and equity totaled $581 million. With owners earnings at about $90 million, we’re at a ROIC of 9.2%. Because MNRO chooses not to reinvest all of its earnings back into the business and it instead pays a dividend we might assume that the reinvestment rate is around 67% ($60 million available for reinvestment/owners earnings of $90 million).
Meaning, if Monro gets ROIC’s of 9.2% and reinvests 67% of its profit back into the business, the returns on any incremental invested capital of the company might compound at a paltry 6.2% (67% * 9.2%). This is just to give us an idea of a range that the company might be able to compound at. 6.2% is nothing to get excited about, so there needs to be something else going on here – and as of today, I believe there is. I think the market might be focusing too much on the recent margin compression and same store sales growth slide while the industry, as shown by the charts above, has seen large outflows of investment. I don’t think either of those trends should be extrapolated, and I think they market is extrapolating. This has released some optimism and given way to a little pessimism.
A New Jockey
I’ve long admired Heartland Jiffy Lube, the largest operator of Jiffy Lube stores in North America. For a decade I have taken my cars there to get an oil change for the same price that I can do it myself. Along the way, I have admired the business model and thought of ways to replicate it in other industries. Sure, for purists it may not be the optimal way to service your 1969 Chevelle SS, but Jiffy Lube knows that. They know and understand that their market is the average American car owner who has little interest or desire in automotive intricacies. “Just do it for me”. Jiffy Lube’s model is to provide a service (or services) that most people don’t know how, or don’t want to do, themselves. They hope to make the service quick, keep the location convenient, treat the customer with respect, and make a large part of their money with high margin add-on services and parts like transmission fluids, lights, wiper-blades, filters, etc. Beyond that, the business continually doles out coupon books to drive repeat customers and employs a non-professional work force that doesn’t have salary level expectations and shops that mainly avoid expensive build-outs (no hydraulic lifts, cranes, machining, etc.). The business has clearly been a success. I’ve long wished I was the founder of Heartland Jiffy Lube.
Well, Monro has a similar model. And it so happens that they just hired the manager who ran Heartland Jiffy Lube for its parent private equity group, Blackstone. Mr. Brett Ponton came into Heartland as a fixer/improver and sold the business to Sun Capital in 2012. After Heartland, Mr. Ponton went to American Driveline Systems (the parent of AAMCO Transmissions, Cottman Transmission Systems, and Global Powertrain Systems) to orchestrate a turnaround of the business for its private equity parent, American Capital Group. He succeeded with the turnaround then sold the business to Transom Capital Group in January of this year. He has successfully turned around and/or improved then sold two very large automotive service businesses in the past five years. He has obvious relationships with some of the largest private equity firms in the country and his presence hints that Monro could be on the auction block sometime in the next few years.
Monro is a good business, not a great business. ROIC’s and same store sales growth have been sliding for five years straight although overall profitability has continued to increase – thanks to acquisitions and successful integrations. The business has recently begun to see this same store sales shrinkage reverse course and the long slide in same-store sales growth (SSSG) might be puttering out. We’ve seen a couple quarters of positive consecutive SSSG and the company is guiding to an increase in SSSG for the fiscal year 2018. On the most recent investor call, Mr. Ponton communicated that acquisitions and consolidation of this incredibly fragmented industry are still very much the playbook – probably even more so now that he is in charge. The company continues to expect about 20 – 40 store openings per year with acquisitions often dwarfing that number, depending (importantly!) on price.
Turnarounds and margin improvement stories are hard to pull off, and Mr. Ponton has successfully and recently pulled off two. Monro isn’t in need of a turnaround per se, just an operational and margin improvement. It’s a business that is still growing quickly, but not the growth, margin, and consistency darling it once was. This has allowed some (not most) of the optimism out of the price. I don’t think this business has seen its long-term prospects dim, just slow down temporarily. Actually, if it was a business in need of a turnaround, I would likely not be interested.
The business is trying to make itself a bit more sticky considering it’s scale. Repeat customers are much higher margin and cheaper to retain. Along these lines, Monro recently introduced a credit card to drive loyalty. The card gives customers discounts on routine service – like an oil change for $15, free tire rotations, $20 off any service over $50, etc. The card also gives customers zero interest for six months when used at Monro locations. 10% of the company’s retail sales are processed on their credit card. The business has the goal of driving this to 20%.
In the USA, the average age of vehicles on the road continues to climb. Currently, the average age is 12 years. There are 260 million vehicles on the road and that number is also climbing. Monro’s sweet spot is vehicles 6 years old and older – the fastest growing segment of vehicles on the road. Vehicles 13 years and older was about 30% of 2017 traffic – a record for Monro. The more aged cars on the road – out of dealer service and warranties – mean a larger customer base for Monro.
I see the runway as very long. The Do-it-for-me segment of automotive aftermarket is $197 billion. The Do-it-for-me segment is at about 80% of the aftermarket industry. Monro could easily 10x in size and still have just a fraction of the market. The larger they get, the more efficient their purchasing and supply chain becomes which further drives their ability to be the low-cost provider. The business has customer satisfaction scores among the highest of any large automotive service organization and just completed a review survey among 100,000 of their customers refreshing this data.
The story and thesis with Monro is one of improving margins and increasing same store sales growth while continuing to consolidate the very fragmented industry at attractive prices. They have a jockey that’s done this before and I expect him to use a very similar playbook at Monro. The company is far from broken; it’s currently growing earnings per share in mid-teens % growth, the top-line at a healthy rate, and has a healthy balance sheet. If they can keep the growth in the double digits and if margins, ROICs, and SSSG improve just a bit, I believe optimism will again be reflected in the price. As an example, if we see ROICs move up about one percentage point per year for the next five years to settle at 13.2% – conservatively in-line with historic norms, we’d probably see the underlying business value compound at about 11%. If in addition, if we were to get a higher reinvestment rate, operational and margin improvements, smart acquisitions, or a sale of the business, we should expect more than 11%. The business believes it has plenty of acquisition opportunities for the foreseeable future and I tend to agree. If returns on invested capital can return to the teens, I see the dividend is a silly use of capital – although the company is unlikely to change that. It doesn’t make sense to return the capital to me, allow it to get taxed again as it becomes my income, then expect me to find opportunities to match or exceed your returns on invested capital when you have ample opportunities to deploy it in the teens to start with.
Optimism is not absent from the price, only lessened. I like lessened optimism, but I love pessimism. More optimism could come out of the price if SSSG again turns negative. That being said, I believe that mid-cycle ROIC’s are higher than today, the company is taking market share within its industry, incremental ROICs could be markedly higher than current levels, the Do-it-for-me sector is growing as a proportion of the overall industry’s profit pool, and the business is not a very economically sensitive one – especially compared to selling actual cars and trucks or discretionary items (Monro is selling to household maintenance operating expenditures, not to household capital expenditures).
It’s worth noting the Mr. Ponton agreed to stock option strike price of about $65/share. We’re purchasing at $45. Obviously, he thinks the business is undervalued…but then again, what manager doesn’t think their business is undervalued. He did put a large chunk of his compensation on the line.
Finally, we might just see Monro go into the hands of a private equity buyer. Mr. Ponton seems awfully comfortable with that route.
10-year DCF Valuation – Always precisely wrong, but often directionally correct:
Starting with $90 million in owners earnings. Growing that by 9.2% (current ROIC, though far below current EPS growth rate guidance of 15%) for 5 years. Slowing the growth to 6% for the next five years then selling at 11x cash flow discounted back at a 10% discount rate gives us $1.55 billion in value. With 33.29 million shares outstanding, we get a value of $47 today. Less debt per share of $5.25.
|Initial Cash Flow:||$90,000,000|
|Terminal Growth Rate:||0%||Discount Rate:||10%|
|11 (Sale @ 11x Cash Flow)||2,057,205,670.60||$721,082,400|
|Shares Outstanding in 11 years||33,292,000|
|Cash Flows Value per share:||$47|
There are a number of ways the company could blow it. They could begin paying up for acquisitions and search to grow for growth’s sake. Per the 2017 Q3 call, they’re paying about 7X EBITDA for recent acquisitions. If they move that multiple up or get impatient/greedy, the subsequent accretion to earnings may not look so nice. I see that as risk numero uno.
ROIC’s may not recover and SSSG growth may become less likely due to better, smarter and more competition, global warming and less demand for winter tires, or bad execution (among other things). This could be a problem and is another important risk to watch closely.
Amazon and the like will continue to grow in tire sales. Monro will lose some tire sales to Amazon and tires are a large part of Monro’s business. If they lose some sales, it’s unlikely that they lose the service – the high margin part of tire sales is in the install. Amazon won’t install your tires.
The new CEO could taint the culture of long-time Monro insiders that have previously been running the show. His management style could be a culture shock or demoralize key employees.
The company could start making larger acquisitions or rely more on “synergies” than it has in the past in an effort to grow more quickly or please the street. This could destroy the balance sheet or make integrations more difficult and time-consuming.
There’s always the threat of new entrants or of substitute products, although I see the near-term likeliness of these quite low. Self-driving cars could take over the world in the next few years and most Americans could decide they no longer need to own a vehicle because of it.
A new manufacturer or government program could make the purchase of a new car extremely attractive or cheap thus quickly retiring a large number of aged-cars or Monro loyalists on the road.
The company is a good business, not a great business. It doesn’t benefit from obvious network effects and doesn’t have powerful intangibles like patents. It has very minor pricing power, minor customer captivity (stickiness), but does have benefits of scale and cost. Because of this, management matters considerably more than in a business like Visa or Google.
I’m long MNRO.
*I started this note at the beginning of August, and here we are on September 8th. Some of the numbers are off just slightly as Monro’s price has moved up about 10%. All else holds true.
****As is forever and always the disclaimer, this is not investment advice. Do your own work and verify your own numbers. I might buy, sell, or ignore anything at any time and have no obligation to update anything on this site. I won’t be held hostage by commitment and consistency bias.****