The O'Reilly Automotive Case

Assume that you work for a major bank as a lending officer.

O'Reilly is one of the largest specialty retailers of automotive aftermarket parts, tools, supplies, equipment and accessories, selling its products to both do-it-yourself customers and professional installers. It is listed on ASX and its credit rating evaluated by Moody's is A. On December 31, 2019, the company operated 3,421 stores. The stores carry an extensive product line, including, but not limited to, the following products:

New and remanufactured automotive hard parts, such as alternators, starters, fuel pumps, water pumps, brake system components, batteries, belts, hoses, chassis parts and engine parts

Maintenance items, such as oil, antifreeze, fluids, filters, wiper blades, lighting, engine additives and appearance products

Accessories, such as floor mats, seat covers and truck accessories

A complete line of auto body paint and related materials, automotive tools

The stores average approximately 7,000 total square feet in size. They are served primarily by the nearest distribution centre, but they also have access to the broader selection of inventory available at one of O'Reilly's nearly 200 master inventory stores. In addition to serving do-it-yourself and professional installer customers in their markets, master inventory stores also supply other stores within the contiguous area, providing access to a large selection of inventory on a same-day basis.

O'Reilly leases certain office space, retail stores, property and equipment under long-term, non-cancellable operating leases. Most of these leases include renewal options. On December 31, 2019, future minimum rental payments under all of the operating leases for the next five years average about $175.000 million, declining to $126.223 million by 2024. Rental expense amounted to $226.049 million, $142.363 million and $55.358 million for the years ended December 31, 2019, 2018, and 2017, respectively.

O'Reilly's Credit Requirements and Business

On July 11, 2018, in connection with the acquisition of a complementary company, O'Reilly entered into a credit agreement for a five-year $1.2 billion asset-based revolving credit facility arranged by your bank. This credit is comprised of a five-year $1.2 billion revolving credit facility, which matures on July 10, 2023. As of March 31, 2020, O'Reilly had outstanding borrowings of $593.2 million. As part of the credit facility, O'Reilly has pledged substantially all of its assets as collateral and is subject to an ongoing consolidated leverage ratio covenant, with which O'Reilly has complied. For balance sheet data, see the Exhibit below.

O'Reilly Automotive Inc.

Consolidated Balance Sheet (in million $)

As at 31 December 2019

Assets

Current Assets

Cash and cash equivalent $30

Account receivables (net) 124

Other receivables 64

Inventory 1903

Deferred Income Tax 74

Other current assets 37

Total current Assets 2232

Property and Equipment 2448

Less accumulated depreciation (664)

Net property and equipment 1784

Notes receivable 11

Goodwill 744

Other assets 67

Total assets 4838

Liabilities and Shareholder's Equity

Current Liabilities

Accounts payable 795

Accrued Expenses 171

Income tax payable 35

Other current liabilities 149

Current portion of long term debt 105

Total current liabilities 1255

Long term debt less current portion 597

Deferred Income Tax 24

Other liabilities 162

Total liabilities 2038

Owner's Equity

Paid In capital 1060

Retained Earnings 1740

Total Shareholder's Equity 2800

Total of liabilities and Shareholder's equity 4838

Number of shares on issue 138 million

Market value of shares: $25 per share.

O'Reilly Automotive Inc.

Consolidated Statement of Income ( in million $)

As at 31 December 2019

Sales $1280

Less: Cost of Goods sold 662

Gross Profit 618

Selling, general and administrative expenses (450)

Operating Income (EBIT) 168

Other income (expense)

Interest expenses (11)

Interest income 0.4

Other income 0.6

Total other expenses (10)

Income before tax 158

Provision for income tax (61)

Net Income 97

Additional Information about O'Reilly

1. For O'Reilly, there is a low capital requirement, as it is a retailer whose largest costs are leases of stores, and warehouses and inventory. A low capital commitment is desirable for lenders, because a future default will not require the forced sale of significant amounts of fixed assets at a fraction of their book value.

2. Aging of vehicles on the road. As the average age of a vehicle increases, the vehicle goes through more routine maintenance cycles requiring replacement parts such as brakes, belts, hoses, batteries and filters. As reported by the Automotive Industry Association ("AIA"), the average age of the vehicle population has increased about one year over the past decade due to difficult economic conditions and better-engineered vehicles. It is expected that this trend will continue.

3. According to estimates compiled by the AIA, the annual amount of unperformed or underperformed maintenance affects about 20% of vehicles. This metric represents the degree to which routine vehicle maintenance recommended by the manufacturer, is not being performed.

4. Competitors include auto parts chains, repair shops, and auto dealers, in addition to discount stores, hardware stores, supermarkets, drugstores, and convenience stores. Two prominent competitors are Autopro and Car Boys.

Autopro believes that expansion opportunities exist in underserved markets. The company attempts to obtain high visibility sites in high traffic locations and to this end, undertakes substantial research prior to entering new markets. The most important criteria for opening a new store are its projected future profitability and its ability to achieve their required investment hurdle rate.

Car Boys is more concerned with vendor relationships than is Autopro due to its smaller size and lesser capital position. A disruption of vendor relationships could have a material adverse effect on its business results. Disruptions could occur due to financial difficulties that vendors may face, increasing the cost of the products purchased from them.

5. Approximately 30% of O'Reilly's stores are located in two states. The business is sensitive to the economic and weather conditions of those regions. Unusually inclement weather has historically discouraged customers from visiting the stores during the affected period causing reduced sales. A number of competitors have more financial resources, are more geographically diverse or have better name recognition, which might place O'Reilly at a competitive disadvantage.

6. This industry historically has been able to return excess items to vendors for credit. Future changes in vendors, in their policies or in their willingness to accept returns of excess inventory, could affect profitability. O'Reilly believes that the extended nature of the life cycle of its products is such that the risk of obsolescence is minimal. The industry has developed sophisticated systems for monitoring the life cycle of products and has historically been very successful in adjusting the volume of inventory in conjunction with a decrease in demand.

Given the above scenario for O'Reilly, you as lending officer are required to analyse the lending proposal of O'Reilly and make a recommendation on a $100 million unsecured loan application. You should:

(a) Calculate ratios and analyse the ratios calculated. Complete the table given below. (15 marks)

Ratios O'Reilly 2019 Autopro Industry

Liquidity

Current Ratio 1.5 1.6

Quick Ratio 0.7 0.6

Activity Utilization

Inventory Turnover Ratio 0.5 0.5

Average Collection Period 37 days 40 days

Sales to Total assets 0.25 0.26

Profitability

Gross Profit/Sales 45% 40%

Net Profit/Sales 10% 5%

Net Profit/Equity 3.5% 3.5%

Net Profit/Assets 2.3% 2.5%

Leverage

Long term debt/Equity 50% 30%

Interest Coverage 10 12

(b). Carryout a credit analysis using expert basis (5C approach). (15 marks)

(c) Carryout a credit analysis using market-premium basis given that the company's bonds are selling at the rate of 5% and risk free rate is 3% (5 marks)

(d). It is expected that the bank could realise 90% of the loan amount by selling the collateral it has. Calculate the risk premium with this situation (5 marks)

(e). Using Altman z-score evaluate the credit risk of the proposal. (5 marks)

(f). Evaluate each of these conclusions critically and make a recommendation on the loan giving reason. (5 marks)

Given Altman Z-score model

The cutoff levels are Z < 1.81 Firm likely to default

1.81< Z < 2.675 May or may not default

Z > 2.675 Firm unlikely to default

Formula Used:

Current Ratio = Current Assets/Current Liabilities

Quick Ratio = (Current Assets- Inventory)/Current Liabilities

Inventory Turnover Ratio = Cost of Goods Sold/Inventory

Average Collection Period = Receivables/Average sales per day

Sales to Assets Ratio = Net Sales/ Total Assets

Gross Profit-Sales ratio = Gross Profit/ Net Sales

Net Profit-Sales ratio = Net Profit/Net Sales

Net Profit-Equity ratio = Net Profit/Total Equity

Net Profit- Total Assets ratio = Net Profit/Total Assets

Long term debt-Equity ratio = Long term liabilities/Total Equity

Interest Coverage ratio= Earnings before Interest and Tax/Interest payables on loans