Auto Parts Retailers might Be Running Out of Gas Shortly
By Zoe TanOver the last two years, the country's three largest auto parts retailers, advance auto coupon (take a look at the site here
) Auto NYSE:AAP, AutoZone NYSE:AZO, amd O'Reilly Automotive NASDAQ:ORLY delivered record same-store sales increase in the mid- to high-single-digit range find Exhibit 1, thanks to favorable industry tailwinds. New vehicle sales plummeted in late 2008 and stayed well below historical averages in 2009 and 2010, as consumers made a decision to prolong the lives of these vehicles rather than buying new ones. This occurrence pushed the average age of vehicles on the way to 10.3 years in 2010, up from just 9.5 years in 2005, which boosted demand for auto replacement parts in the last few years.
In our view, a rebound in light vehicle sales will weigh on interest in aftermarket components during the following couple of years. As shown in the chart above, auto parts retailers' comparable-store sales have historically decelerated when new vehicle sales improved.
Actually, December United States automobile sales came in ahead of expectations, having an annualized sales rate of 12.6 million vehicles, the greatest rate in 16 months. Major automakers including Ford NYSE:F and General Motors NYSE:GM expect favorable trends to carry on into 2011, and each predictions that sales will top the 13 million vehicle mark from the conclusion of this year. Yet, based on Advance Auto's management team, the tipping point to get a slowing and ultimate reversal in replacement parts demand will come as new auto sales exceed 14 million units annually the number of vehicles scrapped every year.
In our view, while the market hasn't reached the inflection point yet, the tendency toward slowing auto parts demand will continue to play out as the year progresses, financing support to our view that Advance Auto, AutoZone, and O'Reilly are modestly overvalued, with price/rational values of 1.05, 1.20, and 1.21, respectively.
We Anticipate Secure Demand Over the Long HaulAlthough we expect demand for automotive components to moderate as new auto sales improve from record lows over the the next couple of years, we remain optimistic about the long term outlook for these three chains. Despite cyclical swings in the industry, the aftermarket parts industry has proven to be comparatively steady on the long haul. For the 10-year period before the 2008 economical downturn, the automotive retail and commercial segment sales rose at over a 4% compound annual rate. We believe that, as well as having more vehicles on the road today, the secular increase is attributable primarily to the fact that need for replacement parts as well as care tools stems primarily from requirement, rather than discretionary purchases.
Today, the industry remains highly fragmented, with national retailers representing less than 20% of the total market. We believe this leaves national players plenty of opportunity to get market share from independent retailers. In our view, AutoZone, Advance Auto Parts, and O'Reilly Automotive have been in the best position to profit from these favorable industry dynamics, thanks to scale edges and exceptional distribution capacities.
Although these businesses generate a lot of their sales in the automotive components retail business, each continues to be expanding aggressively into the faster-growing commercial market, which sells automotive components to professional installers and repair garages. We believe these national retailers should have the ability to leverage their expansive shop network by adding the commercial application to existing shops, which should help boost returns on invested capital. Demand in the professional segment is often more resistant to economic swings, as it's less reliant on spending patterns.
Advance Auto and O'Reilly are Fueling UpWe believe national retailers such as Advance Auto and O'Reilly about 3,600 shops each have attained a major foothold in the industry. Additionally, Advance Auto has seen early success in the commercial market, posting double digit same-store sales increase over the past five years. Through the acquisition of 62 Autopart International professional shops, the firm had a head start and has further penetrated this market by introducing commercial delivery programs in its existing store base. Because of this, Advance Auto generated almost $2 billion in commercial sales in the most recent fiscal year, which is more than double the $900 million delivered by industry leader AutoZone.
In April 2008, O'Reilly transformed itself from a strong regional player to an industry leader having a nationwide footprint through the acquisition of CSK Auto. Along with cost savings from shared advertising and the consolidation of duplicate corporate functions, O'Reilly has benefited from lower merchandise prices, thanks to greater purchasing volume. As evidence, operating margins expanded by 340 basis points in fiscal 2009 and by another 220 basis points a year ago. We believe O'Reilly will continue to gain share in the commercial segment by overlaying the company's dual-market strategy, which serves both the retail and commercial market, on CSK's shop foundation. Prior to the acquisition, commercial sales represented only 10% of CSK's complete sales, versus around 48% in the core O'Reilly shops. In our view, scale edges from incremental sales volume, along with its strength in the commercial market, have placed O'Reilly in a much better competitive standing.
Despite close-term headwinds, we believe AutoZone, Advance Auto, and O'Reilly's long term prospects appear bright. Given that the aftermarket components market is highly fragmented, the national retailers have significantly more room for increase and certainly will continue to gain market share in the expense of small independent retailers. In our view, industry stalwart AutoZone will likely function as the biggest winner, while O'Reilly and Advance Auto are better-placed to capitalize on favorable industry trends in the commercial market.
Advance Auto: A potential Takeover Target?As corporate deal action picks up in 2011 and with Pep Boys placing itself up for sale earlier this year, we took a deeper dip into the auto parts retail sector for feasible takeover candidates. Following a wave of strategic acquisitions and consolidation of regional chains by CSK Auto, now possessed by O'Reilly, in the earlier part of this decade, we believe a private equity acquisition in the auto parts retail industry is a more likely scenario today.
In addition, a private equity trade makes sense, as the prospective buyer could reap the benefits of developments in Progress's operations. While shop productivity appears similar across all three chains, Advance continues to lag its peers regarding profitability; the company's financial 2010 operating margin was 10.1%, versus 17.9% at AutoZone and 13.6% at O'Reilly, excluding costs.
Based on a preliminary evaluation, we believe a $67-$78 takeout range would be realistic, based on several assumptions: $3.6 billion in additional debt, somewhat more aggressive revenue growth and operating margin assumptions over the forecast period, and an internal rate of return demand of 15%-20%.
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