2023-07-19 16:57:47 ET
Summary
- Sales are above pre-pandemic levels.
- The current contraction of profit margins has caused significant concerns among investors, and the management is raising the price of lower-end products.
- Debt has been significantly reduced in recent quarters, but this is not the case of interest expenses due to higher rates.
- The recent share price decline has caused an increase in the dividend yield on cost.
- This represents a good opportunity for long-term dividend growth investors.
Investment thesis
Monro ( MNRO ) is expected to report its Q1 2024 earnings results on July 26, 2023, and investors remain on the sidelines as the share price has declined by 56% from all-time highs of $89.62 reached on June 10, 2019. Although sales have exceeded pre-pandemic levels boosted by product price increases and strong demand, profit margins remain contracted due to wage inflation and customer's preference for the cheapest options from the company's catalog due to weakening purchasing power derived from inflationary pressures and more price-sensitive decisions caused by recessionary concerns. These recessionary concerns are also increasing the risk perceived by investors as recent interest rate hikes carried out by the central bank to combat high inflation rates could cause a recession in the United States.
But still, I think the company's prospects remain (relatively) intact as it remains profitable (in terms of cash from operations) and these headwinds are, in my opinion, of a temporary nature due to their direct link to the current macroeconomic landscape. This is why I believe that the recent share price decline represents a good opportunity for long-term dividend growth investors as the recent share price decline has left a dividend yield on cost of 2.82%, and the cash payout ratio remains at levels below 30%, which means the dividend is very sustainable despite current headwinds.
A brief overview of the company
Monro is a U.S. leading operator of tire and automotive repair stores. The company sells replacement tires and provides maintenance services for cars, light trucks, and vans. The company operates under a wide range of brands, including Monro Auto Service and Tire Centers, Tire Choice Auto Service Centers, Mr. Tire Auto Service Centers, Car-X Tire & Auto, Tire Warehouse Tires for Less, Ken Towery's Tire & Auto Care, Mountain View Tire & Auto Service, and Tire Barn Warehouse. Monro was founded in 1957 and its market cap currently stands at $1.29 billion as it operates 1,299 stores across the United States.
MONRO logo (Monro.com)
Despite operating in the automobile industry, Monro's cyclical nature is actually quite small as it operates in the automotive aftermarket services, so the company's operations are quite resilient year after year. The company's added value is its competitive pricing to consumers and their loyalty thanks to continuous efforts for long-term customer relationships. For shareholders, the most positive aspects of Monro are very sustainable growing dividends thanks to very stable profit margins and high cash from operations, as well as a very manageable debt load that produces very low interest expenses compared to cash from operations.
Currently, shares are trading at $39.66, which represents a 55.75% decline from all-time highs of $89.62 on June 10, 2019. Said drop in the share price appears to be directly related to the recent contraction in profit margins as wage inflation and an increase in sales from lower value-added products have had a negative impact on the company's ability to convert sales into cash in the past few quarters, a trend that has intensified in the fourth quarter of fiscal 2023. Despite this, sales have exceeded pre-pandemic levels as the company's acquisition program remains in full swing.
The number of operated locations keeps increasing as the company keeps acquiring new stores
Over the years, Monro has increased the number of store locations through acquisitions, which has allowed it to increase its market reach and revenues. This represents the long-term growth strategy of the company.
Monro's Company-operated stores (10-K filings)
Furthermore, the company acquired four stores in Iowa and another store in Illinois during the fourth quarter of fiscal 2023, which means the acquisition program remains in force. These newly acquired stores are expected to generate $6 million in revenues per year, and the management expects further acquisitions in the foreseeable future as the balance sheet remains strong. For this reason, I expect increasing revenues in the coming years despite the current complex macroeconomic landscape marked by recessionary risks.
In this sense, the company's strategy is quite simple since it is based on generating cash in existing locations in order to expand operations by acquiring other stores and using its brands in those acquired locations.
Revenues have already surpassed pre-pandemic levels
Thanks to the steady increase in the total number of locations operated by the company, sales have increased over the years. Despite a 10.41% decline in fiscal 2021 due to restrictions derived from the coronavirus pandemic, revenues increased by 20.75% in fiscal 2022 boosted by growing demand. Fiscal 2023 revenues slightly decreased by 2.50% as revenues declined by 5.24% year over year during the fourth quarter of fiscal 2023 as a consequence of the divestiture of wholesale tire and distribution assets.
Monro revenues (Seeking Alpha)
To alleviate the negative impact of the increase in demand for cheaper products, the company has decided to increase the prices of lower-end products, so sales are expected to remain strong in the coming quarters. In addition, the current balance sheet allows the company to continue with the acquisition of new stores. In this regard, revenues are expected to increase by 2.26% in fiscal 2024 and by a further 3.68% in fiscal 2025, a growth that despite being modest, would be very positive if we take into account that the macroeconomic context is currently in a delicate situation and that sales are already 5.5% above those of fiscal 2020.
But the recent share price decline despite recent revenue growth has caused a sharp decline in the P/S ratio to 0.977, which means the company currently generates annual revenues of $1.02 for each dollar held in shares by investors.
This ratio is 46.61% lower than the average of the past 10 years and represents a 63.81% decline from decade-highs of 2.700 reached in 2015, reflecting the growing pessimism among investors as they are placing far less value on the company's sales due to its weakened ability to convert these sales into actual cash.
Profit margins are (temporarily) depressed
Overall, I think the company has maintained very healthy profit margins over the years, with gross profit margins of over 35% and EBITDA margins well above 10%. Despite this, increased labor costs due to inflationary pressures and labor shortages, as well as customers opting for lower-priced tires as a consequence of weakening purchasing power derived from these inflationary pressures, have caused a recent decline in profit margins. In this regard, the trailing twelve months' gross profit margin currently stands at 34.42%, and the EBITDA margin at 11.83%.
But the worrying thing is that profit margins have continued to fall in recent months and, during the fourth quarter of fiscal 2023, the company reported a gross profit margin of 33.93% and an EBITDA margin of 8.05%, well below the current trailing twelve months' margins, and the management is currently focused on recovering pre-COVID profit margins. The company currently owns 300 small or underperforming stores, and the management's focus has turned toward them. Ongoing profitability initiatives in these locations include improvements in technician staffing levels and staff training programs, and comparable store sales grew by 7% in these stores during the fourth quarter of fiscal 2023 compared to the same quarter of 2022 (and 11% in full fiscal 2023). But despite that remarkable progress, profitability remains lower than the company's average at these locations.
Still, the management stated, during the Q4 2023 earnings call conference, that March 2023 was the strongest month of the quarter in terms of profit margins as it decided to raise the price of the cheapest tires in the catalog, so a slight profitability improvement is expected in the first quarter of fiscal 2024. Also, a recent reduction in overtime hours in the company's stores is expected to deliver labor cost savings during fiscal 2024. In this regard, the management expects to achieve gross profit margins of 35.8% to 36.2% during the first quarter of fiscal 2024, which is a significant improvement from the 33.93% reported in the fourth quarter of fiscal 2023.
Debt is very manageable and the balance sheet is very strong
Monro has some debt exposure due to acquisitions carried out over the years, but store location growth was very modest in fiscal 2021, 2022, and 2023 as the management is currently deleveraging the balance sheet in order to position the company advantageously in the face of increased interest rates and a potential recession. In this regard, long-term debt currently stands at $105 million.
Monro's long-term debt (Seeking Alpha)
Net interest expense increased to $5.9 million during the fourth quarter of fiscal 2023 (from $5.7 million during the same quarter of fiscal 2022) due to higher interest rates despite a reduction of long-term debt to $105 million (from $176 million during the same quarter of fiscal 2022) as the company has recently emptied part of its inventories in order to convert them into cash and use it for debt reduction. This should help keep interest expenses as low as possible in order to face the current complex macroeconomic panorama.
But despite emptying efforts, inventories have increased by $18.7 million in the past three quarters to $147.40 million, so the company does not have a significant need to replenish inventories. In this regard, I think the company's balance sheet is very strong as annual interest expenses of ~$24 million represent a very low percentage of cash from operations while inventories are at healthy levels.
The dividend is safe
The company has paid dividends since 2006 and has progressively raised them over the years. The latest raise was announced in May 2022 when the company increased the quarterly dividend by 7.7% to $0.28 per share.
This makes Monro a shareholder-friendly company in my eyes as long-term dividend investors could enjoy growing dividends year after year. In addition, the recent share price decline has caused an increase in the dividend yield on cost to 2.82% (based on a $39.66 share price), which is very generous if we take into account that the cash payout ratio usually dances around 30%. In the following table, I have calculated the percentage of cash from operations allocated to dividends paid and interest expenses over the years, since in this way the sustainability of the dividend through actual operations can be ascertained.
Year | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | 2022 | 2023 |
Cash from operations (in millions) | $126.3 | $126.5 | $129.9 | $121.2 | $152.9 | $121.3 | $184.9 | $173.8 | $215.0 |
Dividends paid (in millions) | $16.8 | $19.7 | $22.5 | $24.0 | $26.8 | $29.7 | $29.8 | $34.7 | $36.4 |
Interest expenses (in millions) | $11.3 | $15.5 | $19.8 | $24.3 | $27.0 | $28.2 | $28.2 | $24.6 | $23.2 |
Cash payout ratio | 22.25% | 27.83% | 32.56% | 39.85% | 35.19% | 47.73% | 31.37% | 34.12% | 27.72% |
As one can see, the cash payout ratio rarely exceeded 40%, which means that the dividend has historically been very sustainable. Also, the cash payout ratio (including interest expenses) was 27.72% in fiscal 2023, so the dividend remains safe as cash from operations was $215 million in fiscal 2023 (including capital reductions of $95 million), which was more than enough to cover dividends of $36.4 million and interest expenses of $23.2 million. As for the past quarter, cash from operations was $43.8 million, inventories increased by $6.1 million, and accounts receivable increased by $0.1 million, but accounts payable also increased by $33.3 million. This weakening cash generation capacity reflects the current contraction in profit margins, so dividend investors should keep an eye on profit margins in the coming quarters as the company also needs to cover almost $40 million in annual capital expenditures. In this regard, cash from operations is expected to improve in the coming quarters as pricing efforts materialize.
Undoing share dilution as a way to reward shareholders
The company announced a share repurchase program of up to $150 million in May 2022, and it already repurchased 2.2 million shares for $97 million. Thanks to these buybacks, the management has undone the share dilution that has taken place in the last 10 years.
Once the macroeconomic outlook (and with it consumer purchasing power and/or confidence) improves, the company should be able to continue generating similar amounts of cash from operations as in recent years, and the fact that the company has already grown to a significant size through the expansion of store locations in recent years puts it in a position that should allow to continue performing share buybacks in the long term, although this is only a possibility.
Risks worth mentioning
Overall, I consider that Monro's risk profile is very low in the long term thanks to the fact that the company operates in the aftermarket industry, which is very resilient over time, in addition to ever-growing revenues, a low debt balance, and very stable profit margins and high cash from operations. But even so, there are certain risks that I would like to highlight below, especially regarding the short and medium term.
- Investors expect a significant improvement in profit margins in the immediate future as pricing initiatives are still very recent (and the management already stated that profit margins should improve significantly during the first quarter of fiscal 2024). Therefore, if these pricing measures fail to absorb the increase in labor costs, and/or if volumes decline as consumers stop perceiving the company's stores as price-competitive, investors could be disappointed, which could cause a further share price decline.
- If inflationary pressures continue to be part of the current macroeconomic landscape, profit margins could remain depressed for longer than expected, leaving a higher-than-usual cash payout ratio.
- If a recession finally materializes as a result of recent interest rate hikes to alleviate high inflation rates, the company's sales could be negatively affected. As Monro operates in the aftermarket services industry, this impact could be more related to an increase in demand for products with lower profit margins, and not so much a reduction in volumes per se.
Conclusion
The recent contraction in profit margins, and therefore weakening cash from operations, has caused concerns among investors as recent interest rate hikes could push the US economy into a recession, which could cause further disruptions to the company's operations. These growing concerns have caused a share price decline of 55.75% from all-time highs. But despite this, I think it is important to keep the perspective of the company's general situation as things are not as ugly as they seem.
First, long-term debt has been reduced by more than 50% in the past few quarters, and revenues have already surpassed pre-pandemic levels. Also, the company has historically enjoyed very stable profit margins and has operated for many decades, so it has demonstrated its viability year after year. Furthermore (and this is very important), the management has identified the root of the problems related to profitability, which is that customers are choosing products with a lower profit margin as a consequence of the current macroeconomic landscape. This has, in my opinion, two main meanings. The first, and most important, is that the headwinds appear to be temporary as they are directly linked to the macroeconomic context. And secondly, that the management has a roadmap to offset these contracted margins, in this case by raising the price of lower-end tires.
For these reasons, I believe that the recent share price decline represents a good opportunity for long-term dividend growth investors since we must not forget that the company has historically been shareholder-friendly thanks to continuous dividend increases and a sufficiently low cash payout ratio to allow it to keep expanding through acquisitions.
For further details see:
Monro: Long-Term Prospects Remain Intact