How a Premier Quality Compounder Is Steering Growth in Automotive Maintenance
article 05-07-2024

How a Premier Quality Compounder Is Steering Growth in Automotive Maintenance

Senior Analyst Zachary Weiss offers the investment case for a holding in Royce Premier Fund that is growing market share in a traditionally recession-resistant industry.

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A holding in our Small-Cap Premier Quality Strategy, Valvoline (NYSE: VVV) is a leader in the large and fragmented automotive preventive maintenance services market. We believe Valvoline has a long runway for growth, with the potential to double its earnings over the next five years, since becoming a more focused operation following the divestiture of its Global Products business in March 2023.

Oil changes, tire rotations, battery replacements, and other preventive maintenance services are largely unaffected by economic cycles, having remained robust, for example, during the 2008-09 recession. Valvoline thus operates in a highly resilient industry, highlighted by the company’s consistent revenues, high customer retention, and more than 15 consecutive years of same-store sales growth.

“We see Valvoline as a high-quality, recession-resistant business with robust recurring revenue. We also like that its shares currently trade at an attractive cap rate of just above 5%—which bolsters our contention that the company enjoys a long runway for potential growth.”
—Zachary Weiss

Valvoline’s competitive edge is enhanced by its scale, company culture, and relationships with franchisees, which bolster its ability to consolidate a still fragmented industry. Annually, 450 million oil changes are performed in the U.S., where Valvoline has just a 5% market share. More than half of these oil changes are handled by quick lube locations (such as Valvoline) and car dealerships, with remainder serviced via do-it-yourselfers (“DIY”), tire stores, and other installers. Quick lubes are preferred for their cost-effectiveness and convenience. Valvoline can usually save customers up to 20-30% on these services compared to dealerships due to lower overhead costs and streamlined operations.

Additionally, Valvoline’s quick service model offers oil changes and other maintenance tasks in approximately 15-20 minutes, whereas dealerships may require appointments and longer service windows. This efficiency, along with the increasing complexity of modern vehicles and consumers’ preferences for convenience, is propelling the shift from DIY to professional services. Furthermore, a critical ‘rate of change’ moment in the industry—driven by a shortage of mechanics—has catalyzed quick lubes to capture additional market share from dealers as the latter perform often complicated repairs that require more highly skilled mechanics. Valvoline notes that 40% of its new customers come from dealerships.

Sixty percent of U.S. quick lube operators have one to five locations and often lack the operational capabilities, service breadth, and marketing prowess that Valvoline brings. Jiffy Lube, the number one player, is a small part of the Royal Dutch Shell portfolio and offers inferior service as customers must leave their cars and wait, which costs them time and, occasionally, trust compared to Valvoline’s drive-through operations. Take 5, another competitor, struggles with a debt-heavy balance sheet, which impacts its competitiveness.

We find the financial attributes of Valvoline’s business model highly attractive and like that management approaches growth opportunities in a data-driven, shareholder-oriented way. The company maintains robust gross margins of around 40%, indicative of its efficient operations and strong pricing power. Valvoline also operates a capital-light model, with new stores requiring less than 10% of Capex relative to sales, which underscores the efficiency of its expansion strategy. The company’s strategic plan includes doubling its store count through the 2020s as it leverages underpenetrated geographic markets. With only 15% of U.S. households within a five-mile radius of a Valvoline location, there is significant room for expansion.

Partnering with well-capitalized franchisees allows Valvoline to grow its footprint in a capital-efficient manner, minimizing direct investment risks while maximizing geographical coverage. New store development follows a repeatable real estate process, and returns on investment generally exceed twice the cost of capital. The company is also aiming to increase store efficiency, targeting service for 70 cars per day, up from 50 and reflecting operational improvements and capacity expansion. This strategic approach drives growth and does so with a great deal of capital efficiency, ensuring sustainable expansion and value creation.

While skeptics may point to the rise of electric vehicles (“EVs”) as a threat to Valvoline’s traditional oil change business, we think this evolving market landscape actually enhances the investment opportunity. Despite the growing presence of EVs, they currently constitute less than 2% of all vehicles in the U.S. Demand for oil changes is thus not expected to decrease significantly over the next 5 to 10 years. In addition, the average age of light vehicles in the U.S. is rising, which further drives the need for maintenance on internal combustion engines (“ICE”). Valvoline appears well-positioned to benefit from this transition by adapting its service offerings to cater to the unique needs of EVs, such as more frequent tire rotations due to the heavier weight of EVs, detailed battery health checks, and specialized thermal management fluids. These services, which extend beyond traditional ICE vehicle maintenance, will likely see increased demand as EV penetration, expected to reach 10% of new car sales by 2025, continues to rise.

We see Valvoline as a high-quality, recession-resistant business with robust recurring revenue. We also like that its shares currently trade at an attractive cap rate of just above 5%—which bolsters our contention that the company enjoys a long runway for potential growth.

Important Disclosure Information

Average Annual Total Returns as of 3/31/2024 (%)

  QTD1 1YR 3YR 5YR 10YR SINCE
INCEPT.
DATE ANNUAL
OPERATING EXPENSES
NET               GROSS
Premier 5.56 18.18 4.83 10.42 8.58 11.34 12/31/91  1.19  1.19
Russell 2000
5.18 19.71 -0.10 8.10 7.58 9.26 N/A  N/A  N/A
1 Not annualized.

All performance information reflects past performance, is presented on a total return basis, reflects the reinvestment of distributions, and does not reflect the deduction of taxes that a shareholder would pay on fund distributions or the redemption of fund shares. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, so that shares may be worth more or less than their original cost when redeemed. Shares redeemed within 30 days of purchase may be subject to a 1% redemption fee, payable to the Fund, which is not reflected in the performance shown above; if it were, performance would be lower. Current month-end performance may be higher or lower than performance quoted and may be obtained at www.royceinvest.com. Operating expenses reflect the Fund's total annual operating expenses for the Investment Class as of the Fund's most current prospectus and include management fees and other expenses.

Mr. Weiss’s thoughts and opinions concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future. The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

The performance data and trends outlined in this presentation are presented for illustrative purposes only. Past performance is no guarantee of future results. Historical market trends are not necessarily indicative of future market movements.

Percentage of Fund Holdings As of 3/31/24 (%)

  Small-Cap Premier Small-Cap Trust

Valvoline

0.5

1.7

0.6

Company examples are for illustrative purposes only. This does not constitute a recommendation to buy or sell any stock. There can be no assurance that the securities mentioned in this piece will be included in any Fund’s portfolio in the future.

Cap Rate is calculated by dividing a company’s past 12 months of operating income (earnings before interest and taxes) by its enterprise value (market capitalization, less cash and cash equivalents, plus total debt, minority interest, and preferred stock).

Sector weightings are determined using the Global Industry Classification Standard ("GICS"). GICS was developed by, and is the exclusive property of, Standard & Poor's Financial Services LLC ("S&P") and MSCI Inc. ("MSCI"). GICS is the trademark of S&P and MSCI. "Global Industry Classification Standard (GICS)" and "GICS Direct" are service marks of S&P and MSCI.

Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. The Fund also generally invests a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any one of these stocks would cause the Fund's overall value to decline to a greater degree. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund may invest up to 25% of its net assets (measured at the time of investment) in securities of companies headquartered in foreign countries, which may involve political, economic, currency, and other risks not encountered in U.S. investments. (Please see "Investing in Foreign Securities" in the prospectus.

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