On April 1, O'Reilly announced that it had entered into a definitive agreement to acquire CSK Auto for $12 per share, which represents a 50 percent premium to O'Reilly's previously announced $8 tender offer. But it is arguably a fair price given the potential opportunity the combination provides for the long term. The deal is subject to customary closing conditions and antitrust approval, but should close at the end of the second quarter.
While the $12 offer was slightly higher than our expectations, we think it was a fair deal. Would shareholders of CSK have liked to receive more per share? Yes. Although there was some speculation as to whether its peers (Advance Auto Parts and AutoZone) would make a "serious" offer and perhaps drive up the bidding, timing kept the other parties at bay.
From the Advance viewpoint, CSK would have made a terrific fit geographically, but with a new management team and the myriad of initiatives under way at the company, taking on such a sizable transaction could have been disruptive.With AutoZone, acquiring CSK probably was not its best use of capital. In fact, we think AutoZone is likely to be more aggressive with respect to its debt pay-down in the coming quarters. And with committing more inventory to drive better parts coverage in its commercial segment, it was another instance where we don't think management wanted to take on the amount of work required to turn CSK around.
As evident in Figure 1, strategically, CSK's 1,349 stores concentrated in the western half of the country make an excellent complement to O'Reilly's base of 1,830 stores. It gives O'Reilly immediate market density on the West Coast and significantly narrows the store count gap relative to the two largest auto parts retailers — AutoZone with 4,128 stores and Advance with 3,261 stores. After the deal closes, O'Reilly will operate 847 stores in California, Arizona, Nevada, Oregon and Washington, as compared to 649 stores operated by AutoZone.
Although much of the discussion regarding the strategic benefits of the transaction have revolved around expanding O'Reilly's West Coast presence, the acquisition of CSK would also reinforce some of O'Reilly's existing Midwest markets as well as stake a claim in the Mountain time zone. Additionally, when O'Reilly opens its 15th distribution center in Lubbock, Texas, in early 2008, the new DC should not only free up additional capacity at the Houston and Dallas DCs, but also quickly provide infrastructure to better support the acquired CSK stores in the Southwest.
Given the sheer size of the acquisition, O'Reilly already has indicated that it will be slowing its 2008 core store growth to a range of 140 to 150 stores (down from previous guidance of 205). In recent years, a large portion of its store expansion has focused on moving into more East Coast markets. At the end of fiscal 2000, O'Reilly's store base of 672 locations stretched across nine states (from Iowa and Nebraska straight down through Texas and Arkansas), with three states (Texas, Missouri and Oklahoma) representing 72 percent of total O'Reilly stores.
The acquisition of Mid-State in October 2001 brought O'Reilly 85 more stores in seven new states and marked the company's initial entrance into the East Coast and east central regions. Since 2001, store growth in non-core East Coast and east central states has represented 48 percent of O'Reilly's total annual store growth. Locations in these 10 traditionally non-core states went from 9 percent of O'Reilly's total store base at the end of 2001 to 30.2 percent at the end of 2007.So, what does this mean for other retailers and independent jobbers? For those with a large East Coast presence, the acquisition of CSK is likely a modest positive to business as O'Reilly slows its expansion eastward in order to concentrate on integrating the CSK base. For those companies with a large West Coast presence, the transaction is likely to create a stronger competitor, so share gains might be a bit more difficult to come by.
As CSK is integrated, we believe there is an opportunity to leverage buying power with vendors, expand gross margins and reduce operating expenses. Over time, we expect a sizable amount of capital spending for distribution centers, IT and systems infrastructure and store remodeling, but we expect the incremental integration capex to be deployed gradually as opposed to front-end loaded.
We don't think an additional three to four DCs are needed immediately to extract value from the combination of the two companies, but rather preferred over time to differentiate its business model from other competitors in the space and enhance CSK's existing commercial sales program.
Over the long term, as O'Reilly implements its business model and operations practices throughout CSK stores, we think there is opportunity to bring companywide operating margins closer to 12 percent, implying combined earnings power in excess of $3.50 per share. The transaction is expected to be modestly accretive to fiscal year 2009 results, with the full benefit of the $100 million in anticipated annual cost savings starting in 2010.
BB&T Capital Markets is a full-service investment banking firm that focuses on specific industries, including the Automotive Aftermarket industry. BB&T Capital Markets is a division of Scott & Stringfellow, Inc., NYSE/SIPC. Scott & Stringfellow is a registered broker/dealer subsidiary of BB&T Corporation, one of the nation's largest financial holding companies with $132.6 billion in assets.
Disclosures: BB&T Capital Markets makes a market in the securities of Monro Muffler Brake, Inc. and O'Reilly Automotive Inc.
BB&T Capital Markets expects to receive or intends to seek compensation for investment banking services from Advance Auto Parts, Inc.; AutoZone Inc.; Genuine Parts Company; Midas, Inc.; Monro Muffler Brake, Inc.; O'Reilly Automotive Inc.; Standard Motor Products, Inc.; and The Pep Boys — Manny, Moe & Jack in the next three months.
Advance Auto Parts, Inc.; Midas, Inc.; and Monroe Muffler Brake, Inc. are, or during the past 12 months were, clients of BB&T Capital Markets, which provided non investment banking, securities-related services to, and received compensation from, the aforementioned companies for such services. The analyst or employees of BB&T Capital Markets with the ability to influence the substance of this report knows the foregoing facts.
An affiliate of BB&T Capital Markets received compensation from Advance Auto Parts, Inc.; AutoZone, Inc.; Genuine Parts Company Monro Muffler Brake, Inc.; and O'Reilly Automotive Inc. for products or services other than investment banking services during the past 12 months. The analyst or employees of BB&T Capital Markets with the ability to influence the substance of this report know or have reason to know the foregoing facts.