Where Will Auto Parts Retailers Find Growth?

One of the hottest sectors in the stock market over the past few years has cooled off significantly at the start of 2011. With the exception of Pep Boys (NYSE: PBY  ) , which appears to be on the selling block, the aftermarket parts retailers have mostly traded down in January even as the broader market has continued its grind upward. I don't believe investors should take this as a reflection of a changing trend in the industry, as the fundamentals are still quite strong. However, as I said at year's end, many of these stocks had simply moved too far, too fast and 2011 will prove to be a more challenging year.

The likely catalyst for the recent sell-off is the overall improvement in new car sales, and January was another strong month comparatively. Numbers released Tuesday showed that combined January U.S. sales of the top seven automakers improved 17.7% over the prior year, and Ford (NYSE: F  ) , General Motors (NYSE: GM  ) , and Toyota (NYSE: TM  ) still control more than 60% of the market combined.

While improving car sales might have a very marginal effect on these parts retailers, I don't believe the pace at which the industry is growing is enough to impact earnings. New car sales still remain well below historical levels, and the all important "SAAR" -- seasonally adjusted annualized rate of vehicle sales – actually decreased in January. Additionally, Ford's earnings report shows a full recovery is not quite on the horizon.  While I believe industry trends are still favorable for the auto parts retailers, there are a few important factors that investors should look for when the group begins reporting this week.

The right conditions
A rudderless economy benefitted parts retailers as new car buying came to a screeching halt during the recession. Consumers were taking their vehicles to repair shops or even fixing them the old-fashioned way, with their own tools. Perhaps the biggest beneficiaries were AutoZone (NYSE: AZO  ) , O'Reilly Auto Parts (Nasdaq: ORLY  ) , and Advance Auto Parts (NYSE: AAP  ) . The average age of vehicles on the road has continued its steady increase from 8.4 years in 1995 to 10.6 years today. In addition, thousands of dealerships have closed, sending this repair work to independent repair shops that are serviced by aftermarket parts from these retailers.

While a weak economy certainly helped boost the average car's age, cars are made better today, and as a result can be kept much longer. These older cars are mostly free of dealer warranties, and repairs go to independent shops serviced by the aftermarket.

Push for commercial sales
As more and more auto repair work goes to independent shops, the retailers have been looking to boost commercial service to gain a larger share of this highly fragmented $40 billion market. O'Reilly is the leader in this space, generating 50% of its revenue from commercial sales, which is still only about 6.6% of the commercial market.  Advance's commercial sales represent 34% of its revenue or 4.9% of the market, and AutoZone is the leader in the retail space, but generates only about 11% of its revenue from commercial sales, or about 2% of the commercial market.

As these retailers attempt to add more commercial sales to the revenue mix, investors need to keep a particularly close eye on margins as well as accounts receivable. Commercial sales generate a smaller margin, as prices are significantly lower for more knowledgeable mechanics and independent garages than for retail customers. In addition, these parts are often delivered to the mechanics by the stores free of charge. With gas prices on the rise, obviously so are costs for these retailers.

Commercial customers are also typically given credit with the option to pay monthly. As the retailers open up more and more lines of credit to customers, investors must watch to make sure the receivables ledger is not expanding too fast.

Less-than-ideal weather
Throughout the past year, the parts retailers have seen a significant lift from weather conditions. The industry thrives on extremes. The summer was extremely hot; the winter has been just the opposite. AutoZone CEO Bill Rhodes attributed 20% of the company's same-store sales increase during its last quarter to the weather conditions.

Time to wait
The slowly recovering economy is still a positive for the aftermarket, and the trends that have buoyed the industry remain intact. However, those looking for a reason to sell these stocks after a great run have been given a good excuse as a result of the comparatively stronger U.S. new car sales data over the past few months. While not insignificant, I believe investors should keep a closer eye on the trends I discussed and how these retailers are progressing with commercial initiatives, and the higher costs of growing this business.

Andrew Bond owns no shares in the companies listed. Ford Motor is a Motley Fool Stock Advisor choice. General Motors is a Motley Fool Inside Value pick. You can follow Andrew on Twitter @Bond0 or on his RSS feed. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (5)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On February 10, 2011, at 3:33 PM, united9198 wrote:

    This article started out well, but he commercial sales numbers being quoted for the big three retailers look like something right out of a sales pitch. I have heard about O'Reilly's "dual-market" strategy of 50-50, but have seen no evidence to suggest that is anything more than a goal. The same applies to Advance. Show me even one Advance store in the country that is doing 34% of their business in commercial sales and I will eat a rusty soup can. I wish the press would dig into these numbers before repeating them like an urban legend.

  • Report this Comment On February 10, 2011, at 3:55 PM, backstreets wrote:

    start eating your rusty soup can.

    all you need to do is listen to their conference calls and those are the numbers they are stating.

    hard to believe they would be stating false sales numbers on a quarterly conference call.

  • Report this Comment On February 10, 2011, at 7:34 PM, TMFBond007 wrote:

    united9198,

    I'm going to have to agree with Backstreets here.

    Do you think the executives of these companies are lying to its investors? I sure don't

  • Report this Comment On February 15, 2011, at 4:38 PM, PeterCAnthony wrote:

    Andrew,

    Your points are all valid. Improvements in new car sales may have caused some investors to steer clear of aftermarket companies, but the aftermarket industry knows conditions are favorable for continued growth. Cars are remaining on the road longer and longer. Additionally, many new car buyers shop for aftermarket parts to personalize their vehicles.

    The paragraph about weather was particularly striking. 20% is nothing to sneeze at! Your post inspired me to write about aftermarket sales and winter weather on my own blog.

    Peter Anthony, CEO, UGN, Inc.

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