Value Investing Congress Blog

A company I have followed on and off is O’Reilly Automotive ( ORLY )—the (previously) regional auto parts retailer.  Given the struggles retailers of all kinds are having, and expected to continue having in the short- to mid-term, Mr. Market has trimmed almost 25% off O’Reilly’s market price since the beginning of the year.
Why am I interested in O’Reilly now?  Well, the company is also undergoing fundamental change: it’s acquiring another regional player—CSK Auto—for approximately $1 B, including the assumption of debt.  The acquisition will give O’Reilly a little over 3,200 stores and puts that number within spittin’ range of Advance Auto Parts (approximately 3,300 stores) and AutoZone (approximately 4,200 stores).  O’Reilly has already arranged to refinance CSK’s debt at what-should-be a lower rate with corresponding interest expense savings.  O’Reilly also forecasts $100 MM in cost savings beginning in 2010 through increased buying power juicing gross margins and streamlining CSK’s SG&A to firm operating margins up to O’Reilly’s level.

The CSK acquisition is similar in relative-size as O’Reilly’s acquisition of Hi/Lo in 1998, so I’ve spent some time reviewing the Hi/Lo precedent.  Here are some of the more relevant data points:

• The CSK acquisition moves O’Reilly from a leading regional auto parts retailer into a larger national footprint with a big move into California . AutoZone has approximately 430 stores in California .  After the CSK acquisition, O’Reilly will have 500 stores in California .
• The Hi/Lo acquisition also gave O’Reilly 7 stores in California which O’Reilly chose to divest rather than hang onto as a toehold in a growth-at-any-cost effort.
• In 1997 AutoZone had 264 stores in Texas ; 382 after its 1998 acquisition of Chief Auto Parts.  O’Reilly’s  Hi/Lo acquisition moved the company into Texas —where 25% of all      O’Reilly stores were located at the end of 2007.
• O’Reilly has continued its Midwestern regional success even with the continuing outsized exposure to Texas .  I believe O’Reilly’s management will be similarly successful in the assimilation of Southwestern and California stores from the CSK  acquisition and prudent in its choice and timing of store branding  conversions.

Keep in mind that CSK’s total cash cost will ultimately end up being higher than the $1 B due to investments in CSK’s distribution centers and store conversions, but a quick back-of-the-envelope calculation puts the combined entity’s Total Enterprise Value (TEV) around $4.2 B with LTM EBITDA around $470 MM—before the $100 MM in cost savings and margin improvements.  Based on this simple estimate of $570 MM for 2010 EBITDA, O’Reilly is currently trading at less than 7.5x 2010e EBITDA.

There are a number of macro concerns (increasing gasoline costs, decreasing mileage driven, increasing manufacturer pricing power, etc.) when looking at O’Reilly, so additional research is crucial to any decision.

Photochannel Networks (PNWIF)

One of the interesting microcap ideas presented at the Value Investing Congress West in May was Canada-based Photochannel Networks, whose business is providing online digital photography solutions for retailers.  If you’ve ever electronically sent photos to a retail store for pick up, you may have used Photochannel technology.

Aaron Edelheit, of Sabre Value Management, presented the bull case for Photochannel , stating his belief that the company will continue to align with major retailers, and partners, pushing company growth.  The company recently announced deals with Kodak China, Kodak Australia, Sams Club USA. A previous agreement with Costco is expected to launch this month.

Earlier this month the company announced record revenues of $3.3 million, up 147% from the same period last year, and a loss $2.6 million (vs. $718K).  The loss was attributed to ramp-up costs, and the company believes it will be cash flow positive in the near future.  Perhaps the best news of the quarter was that transactional revenue-the catalyst for growth- nearly tripled to $1.9 million.

Shares of Photochannel currently trade for $3.67, up 22% in the past year.  Prospective investors need to keep in mind that Photochannel is an extremely tiny company, with a market cap of around $120 million, and light trading volume of less than 100,000 shares per day.

Jonathan M. Heller, CFA
No position in PNWIF

Last Month at the 3rd Annual Value Investing Congress West in Pasadena,  Atticus Lowe and Lance Helfert from West Coast Asset Management presented a compelling case for relatively underfollowed natural gas company Canadian Superior Energy.  They suggested that the company’s recent discovery of an offshore gas field near Trinidad was the potential catalyst to drive SNG shares much higher.

Since their presentation, Canadian Superior shares are up nearly 35% to $4.22 (June 6, 2008).  On May 20^th, the company announced a collaborative effort with Global LNG Inc on the Liberty Natural Gas Transmission Project, a $550 million effort to transport liquid natural gas from the Trinidad fields through a deepwater pipeline that will end 15 miles off the New Jersey coast. Canadian Superior expects this project to deliver up to 2.4 billion cubic feet of natural gas by 2011.

Canadian Superior Energy also recently reported first quarter earnings. Revenues from petroleum and natural gas sales were up 27% from the same quarter last year; earnings were ($.01) per share vs. breakeven last year.

With the price of natural gas up nearly 50% so far in 2008, to $12.47 per million BTU’s (July Futures price), and great prospects in Trinidad, this is a company to watch.  However, as Lowe and Helfert pointed out, SNG’s success is not dependent on soaring natural gas prices.  With a market cap just north of $625 million, the company is currently covered by just one analyst according to Bloomberg.  More positive news from the Trinidad fields will likely change that.

 Jonathan M. Heller, CFA

*The author has a position in Canadian Superior Energy