Description

Business Description

Dorman Products (DORM) is a supplier of aftermarket auto replacement parts. It is the dominant supplier of “formerly dealer exclusive” parts. These are parts which were traditionally available to consumers only from original equipment manufacturers or salvage yards. These parts include, among other parts, intake manifolds, exhaust manifolds, oil cooler lines, window regulators, radiator fan assemblies, power steering pulleys, harmonic balancers, tire pressure monitor sensors, and keyless entry devices.

DORM caters primarily to the car and light truck aftermarket. In 2012, they forayed into the medium and heavy trucks aftermarket. In 2012 they also acquired Re-involt, a manufacturer of low cost batteries for hybrid cars. 85% of sales is under the Dorman brand and 15% is sold to white labels. Most of their revenues are from the North American markets.

The Aftermarket

Suppliers in the automotive aftermarket include OE parts suppliers and pure aftermarket players such as DORM. In the United States, the products are sold through automotive aftermarket retailers (such as AutoZone, Advance Auto Parts, and O’Reilly Auto Parts), national, regional and local warehouse distributors (such as Carquest and NAPA) and specialty markets and salvage yards.

The aftermarket is cyclical, similar to auto OEMs, but has much lower growth compared to the OE parts space which is highly coupled to the new vehicles market. Pure aftermarket suppliers such as DORM are more resilient to poor economic environments as against OE parts suppliers.

 Summary Investment Thesis: DORM is a short for the following reasons:

• Shrinking of the addressable aftermarket size to result in low revenue growth for DORM in the medium term

  • Economic recovery is accelerating new car sales and scrappage of old cars, shifting demand away from the aftermarket

  • There is severe pricing pressure in the aftermarket due to consolidation of the customer base

  • Market share gains are not sufficient to offset the decline in addressable market

• Margins and working capital efficiency are at all-time highs and are vulnerable to expected low revenue growth

• No structural growth avenues for DORM are obvious, nor has the management articulated any aggressive plans

• While DORM does have industry leading margins and return ratios, it has no competitive advantage that shields it from cycles

• No established dividend policy to support valuations

• DORM is a cyclical business with valuations at peak-cycle multiples, while a downturn in the aftermarket seems highly probable over the next 4-5 years

Fig. 1

Investment Considerations

Headwinds to the aftermarket

Average age of vehicles: Vehicles that are 6+ years old form the addressable market for aftermarket suppliers. The average age of light vehicles has risen from 9.5 in 2002 to 11.4 in 2012. This trend has been:

a) party structural- driven by better quality original equipment parts that lost longer

b) partly cyclical- driven by people holding on to vehicles longer, lower scrappage and weak new vehicle sales during the recession.

A more important reason for the rise in the number of 6+ year old vehicles since 2003 is that 15-18 million new vehicles were sold every year during 1994-2007. As these vehicles aged, 3-5 million vehicles per year were added to the aftermarket during 2003-2012. Suppliers such as DORM have greatly benefited from this expansion in their addressable market.

Fig. 2

The period 2008-2012 witnessed a severe slow down in new vehicle sales which began to affect the size of the aftermarket in 2013. With the economy turning around, scrappage is also on the rise since 2013, driven by cheap credit and pent up demand for new vehicles. Hence the aftermarket as seen in Fig. 2 is likely to decline/stagnate over 2014-2018. This is a major headwind for DORM. Fig. 2

Fuel cost: The recent rise in gas prices has adversely impacted total miles driven, which in turn reduces wear and tear of parts and hence lowers frequency of maintenance events.

End of demand shift from original equipment to aftermarket parts: The recession witnessed the closure of a large number of auto dealerships during 2009-2010. This resulted in a shift in market share from dealers to aftermarket players such as DORM, helping them stay resilient during the economic slowdown.

Fig. 3

With rise in new car sales driving profitability, new car dealerships have been on the rise. Logically, their services and parts department should erode some of the aftermarket demand.

Fig. 4

 Consolidation of customer base: The autoparts retailer segment (comprised of stores such as AutoZone, Advance Auto Parts, and O’Reilly Auto Parts) went through major consolidation during the recession, which is causing sustained pricing pressure on aftermarket suppliers. The trend in customer credits in Fig. 5 is evidence of pricing pressure rising.

 Fig. 5

Analysis of DORM's Business Model

Revenue Drivers

 Fig. 6

No. of 6+ year old vehicles: described in the previous section (Fig. 2)

Spend per vehicle: In absolute terms, the aftermarket spend per vehicle has declined from $1500+ to ~$1200. This is driven by a) pricing pressure from retailers b) shift in market share from original equipment to lower cost aftermarket parts. This is unlikely to go back to 2005-2007 levels.

Market share: The aftermarket is highly fragmented with 133 suppliers of OE+ aftermarket parts in the US. DORM has successfully increased market share from 0.39% to 0.8% of the light vehicle aftermarket over 2005-2013. I assume that DORM will continue to gain market share at the same pace in the medium term. I also expect them to increase their market share in the medium-heavy vehicle aftermarket, albeit gradually.

No. of products: – DORM sold over 133,000 SKUs in 2012, up from 77,000 SKUs in 2006. DORM's main competitive niche is “formerly dealer only” products, which involves constantly identifying products which are available only in original equipment and introducing them to the aftermarket at a significant discount to original equipment prices. This strategy has been instrumental in gaining market share over the years. DORM is trying to implement the same strategy in the medium and heavy trucks market, which contributes <1% of revenue in 2013.

Cost levers

Asset light model: DORM's manufacturing is ~100% outsourced to a wide supplier base, which enables it to have industry leading gross margins. It has also been able to fund its investments and working capital needs without any debt.

Margins highly levered to growth: Studying the financials over the past 10 years, it appears that both SG&A as well as gross margins are vulnerable in poor growth scenarios, typical of cyclical industries. Evidence of operating leverage exists only in the 2009-2012 period when growth was very healthy. Gross margin and operating margin are at all time highs and are unsustainable in the short term, as the cycle turns.

Cash Flow Drivers

Working Capital management: Accounts Receivables is currently under stress, owing to constant pressure from customers for better credit terms. Autozone, Advance Auto Parts, O’Reilly, Auto Parts and Genuine Parts Co. account for 57% of revenues and ~85% of receivables. I expect receivables and inventory turns to deteriorate as the cycle turns.

Fig. 7

Accounts Receivables Sales: DORM relies on Accounts Receivable sales for liquidity. The table below shows the extent of the reliance on these programs. It's also evident that DORM needs to sell a much larger portion of its receivables during bad times because recovery rates are poorer.Any inability to sell receivables could impact free cash flow.

Fig. 8

Investments: DORM has grown almost entirely organically and does not have any major capital expenditure planned. The asset light model ensures that capital expenditure and depreciation are very low compared to industry standards. Investments are focused primarily on R&D for new product lines. They are currently in the midst of an $25M ERP implementation over 2010-2014. 

Management

The founding family still manages the company. The management, led by Steven Berman, has made commendable progress in increasing margins and scaling the company and has been quite disciplined with capital allocation. Management also had 29% ownership in November 2013.

Capital Allocation

Cash generation has been healthy but they require cash to fund their working capital (~40-45% of sales). The management states that it does not intend to pay any dividends in the near future, which offers no valuation support. This could change with build up of cash on the balance sheet. They buy back shares periodically, and announced a $10M buy-back program in December 2013.

Growth opportunities: Following are the growth arenas, although DORM is not aggressively investing in any of them and are hence immaterial to valuations:

• new geographic markets

• heavy vehicle market

• light duty diesel

• hybrid battery remanufacturing through the re-involt

• opportunistic acquisition for growth

 Ownership and Open market activity

Insiders owned 29% of the company as of Nov 2013 and have been steadily selling over the past year in the $30/share - $54/share range. Royce & Associates, which owned ~10% of the company in March 2013, has reduced its stake to ~1% as of January 2014.

Valuation

I use a 2 stage DCF model to value DORM. The key assumptions (shown in Fig. 6) for explicit cash flows for 2014-2018 are as follows:

• continued increase in market share in both light and heavy vehicle aftermarkets

• 1-2% increase in aftermarket spend per vehicle over 2014-2018

• 100bps deterioration in operating margins and 50bps increase in SG&A expenses as % of sales over 2014-2018

• marginal increase in working capital intensity as revenue growth slows

• reduction in capital spending by ~$4-5M/year after ERP roll-out ends in 2014, in line with historical levels

For stage 2, I assume 10% FCF CAGR during 2019-2023, to account for a potential cyclical recovery. Subsequently I apply terminal growth rate of 3% with 2023 as the terminal year.

As seen in Fig. 9 below, the intrinsic value of DORM works out to Enterprise Value of $1.2 Billion and Equity Value of $1.26 Billion. This is ~32% below the current market valuation.

Current Valuation implication: Performing a reverse DCF, the current valuation implies FCF CAGR of 36% over 2014-2018, and 10% over 2019-2023, and then 3% terminal growth thereafter.

Investment Conclusion

The market is factoring in excellent fundamentals for both the aftermarket as well as DORM. The auto aftermarket however looks very likely to deteriorate due to both structural as well as cyclical factors, posing a risk to DORM's growth and margins. Although DORM is a well run business with healthy free cash flow generation, the current valuation does not offer sufficient margin of safety to buy/own the stock. I recommend a short position with ~45+% upside potential and great margin of safety.

Risks to Short Thesis

• Weak/shaky economic recovery resulting in lower new car sales, lower scrappage and buoyant aftermarket demand

• With margins and working capital efficiency are at all time highs, DORM could be resilient to a downturn in the short term

• DORM could be acquired at a significant premium to intrinsic value

• Other unforeseeable corporate action

Fig. 9

Sensitivities

Fig. 10 

Comparables

Fig. 11

Catalyst