Pencils Purchase: Dorman Products
There are value investments available in any market, but the value opportunities are not always glaringly obvious. The stock market has had a heck of a year, pushing many stocks to all-time highs. Recently I stumbled upon a business that I find very intriguing, despite the fact that the stock has had a substantial run-up over the past few years like many other stocks. I take notice any time I find a business with a quality and innovative product, a record of consistent earnings growth and cash flow production, along with an experienced management team. I think I have found that with Dorman Products.
The Business: Dorman Products (DORM)
Dorman Products supplies automotive replacement parts, fasteners, and service line products primarily for the "automotive aftermarket" and mass merchandise markets. To give you a better idea of what this entails, Dorman's four largest customers are AutoZone, Advance Auto Parts, O’Reilly Auto Parts, and Genuine Parts Co. In other words, Dorman is exactly the sort of un-flashy business that will manage to fly under the market's radar. Dorman supplies approximately 133,000 automotive replacement parts to these four and numerous other automotive aftermarket retailers. The business was founded in 1978 and operates around the world, focused primarily in the United States, Canada, Europe, Mexico, Middle East, and Asia.
As of 2012, Dorman generates revenue from three customer groups:
- Automotive aftermarket retailers make up 49% of Dorman's revenue (generated from sales to AutoZone, Advance Auto Parts, O’Reilly Auto Parts, etc.).
- Automotive parts distributors make up 43% of Dorman's revenue (generated from sales to retail venues such as Carquest and NAPA)
- International sales and special markets contribute approximately 8% of Dorman's revenue. This comes from venues such as Walmart, other mass merchants, and special markets including salvage yards.
Dorman is in excellent financial condition. The company carries $48.34 million of cash with no long-term debt. Between 2009 and 2012, Dorman's operating cash flow production nearly doubled from $27.58 million to $48.91 million. Dorman's profit margin has been under pressure this year, with today's third quarter results placing the profit margin at 12.86% (down slightly from 13%). However, year-over-year Dorman's gross margin increased to 39.2% from 38.2%. Increased investment in research and development contributed to Dorman's lower profit margin year-over-year.
Earnings and revenue continue to grow at a respectable rate; over the past five years the EPS has grown at an annual rate of 34.23% while sales have grown at an annual rate of 12.51%. In the most recent quarter, sales increased 16% and net income increased by roughly 12.5%. Year-to-date, however, EPS increased 19% compared to 2012.
Here are some brief key statistics for Dorman (keep in mind that not all of these numbers reflect the results of the 2013 third quarter):
Market Cap: 1.78B
Qtrly Rev Growth (yoy): 13%
Revenue (ttm): 608.13M
Gross Margin (ttm): 39%
EBITDA (ttm): 123.76M
Operating Margin (ttm): 19%
Net Income (ttm): 73.42M
EPS (ttm): 2.03
P/E (ttm): 23.45
PEG (5 yr expected): 1.10
P/S (ttm): 2.93
Steven Berman, Chariman and CEO of Dorman, has been with the company as a director since 1978. Mathias Barton, who serves as President of the company, has been with Dorman since 1999. Matthew Kohnke, Dorman's CFO, joined the business in 2002. Having an experienced management team (all of whom are under the age of 53 years old), which has managed to successfully expand the company and consistently increase earnings and cash flow production, tremendously boosts my confidence in Dorman's continued growth and future success. 19% of Dorman's stock is owned by insider owners, with CEO Steven Berman owning nearly 3% of the company.
Dorman's management focuses on three foundational principles: profitable growth, risk mitigation, and a culture of contribution.
Competition and Risks
The automotive aftermarket turns out to be a very competitive industry. Dorman, while being one of the smaller competitors in the field, is in a much better financial situation than its larger counterparts. Federal-Mogul Corporation operates at a loss and a fraction of the margins that Dorman manages to consistently hold. Genuine Parts Company manages to turn a profit, but holds similarly low margins (less than half) compared to Dorman.
The industry itself is not exceptionally risky. Automotive parts and various automobile components will always be needed so long as automobiles are on the road, and I don't see automobiles losing traction anytime soon. The risk comes in based on how the products are delivered. I see Dorman's primary long-term risk surrounding the fact the company's four largest customers (AutoZone, Advance Auto Parts, O’Reilly Auto Parts, and Genuine Parts Co.) accounted for 57% of Dorman's revenue in 2012. This unquestionably puts Dorman in a vulnerable position should any of these four customers reduce or eliminate Dorman as a supplier.
Future Value Evaluation
I expect Dorman to continue growing earnings at an average rate of at least 17% per year for the foreseeable future. Dorman has an extensive portfolio of products which continues to expand with new additions, such as hybrid vehicle components. In addition, Dorman has increased research and development by 22% this year (compared to 2012) to $9.5 million. 20% of Dorman's 2012 revenue was generated by new products developed between 2010-12. 2700 new products were introduced in 2012 alone. This commitment to innovation, carried out by an experienced management team, is why I see 17% annual earnings growth as a reasonable expectation for at least the next five years. This might be considered a modest expectation given the fact that Darmon's earnings have grown to the tune of 30%+ annually for the past five years.
Given these assumptions, I believe we can expect Darmon to trade at a P/E of 20 in five years, given its superior margins and growth compared to its larger competitors. (The industry average P/E ratio hovers around 17.) With these numbers in mind, let's run a Future Value analysis (which is, I remind you, Current EPS*(Expected Growth Rate^# of years)*Expected Future P/E):
2.09 * (1.17^5)*20 = $91.64
This would result in a near double in value from Dorman over the next five years. If we boost that number to 20% earnings growth and a P/E of 25, the stock would more than double:
2.09*(1.20^5)*25 = $130.01
Today Darmon is trading at a P/E of approximately 23.5. Considering Darmon's impressive track record of regular increases in earnings, margins, and cash flow production, coupled with an experienced management team, I am comfortable opening a position at these levels. Of course, I intend to be a long-term shareholder in Darmon, and will perhaps add to my position if Mr. Market chooses to offer a discount price for this quality business. I look forward to following Darmon going forward, and will do my best to share an updated analysis of the business as time allows.
For those interested in learning more about the business, I encourage you to start by looking over Dorman's 2012 annual report: http://www.dormanproducts.com/documents4rb/ar/ar2012/2012AnnualReport.pdf