Fear of Amazon's Auto-Parts Efforts Overblown

Although auto-parts retailers’ share prices dropped after January media reports that

While Amazon has been a category-changing competitor in many segments, customer demand for near-instantaneous availability and a high level of service is difficult for digital participants to meet, and we have long held that auto parts are more insulated from digital disruption than most of retail. Though do-it-yourself customers might be more easily enticed by Amazon’s price-based appeal, we believe DIY and professional clients require speed and services from their retailers, making an industrywide repricing based on digital-only sellers’ activities unlikely.

We believe the unfounded fears have created an opportunity for investors to build positions in

Availability and In-Store Services Are More Important Than Price The aftermarket auto-parts retail industry is characterized by relatively price-insensitive customers who require rapid access to a wide range of slow-turning components and high service levels; we believe this leaves scaled companies at a competitive advantage over smaller peers that cannot leverage distribution and inventory investments over a large sales base. Customers' prioritization of service over price has led to a relatively stable, rational pricing environment with attractive economics. Parts retailers obtain significantly different portions of their sales from the industry's two segments: DIY (motorists who repair their vehicles themselves) and professional/commercial (repair shops that order parts from retailers). We believe the two components of the industry have different exposures to the digital threat.

While DIY customers may be more receptive to digital retailers’ value proposition, we still think the barriers to meaningful price disruption are considerable. In particular, we believe customers’ need for convenient, quick access to components, along with diagnostic, part selection, and installation advice from in-store personnel, trumps price for most repairs.

Although large-scale retailers have some exposure to the enthusiast market, we do not believe these (generally performance-minded) people are a large part of the addressable DIY sector for the national parts sellers we cover. Rather, we think motorists generally choose to fix their cars or trucks themselves with parts purchased at national retailers (instead of going to a repair shop) out of economic necessity. While this might suggest price sensitivity at first glance, the cost of not having access to a vehicle is considerable, since motorists often depend on their cars and trucks for commuting, working, and other essential tasks. As a result, waiting until the next day for a part creates a meaningful cost in time, money (if alternative transportation must be arranged or work days skipped), and logistical heartburn, particularly if the motorist does not have access to another vehicle, making immediate access to parts and supplies critical.

To address this, national retailers operate extensive store networks, often numbering more than 6,000 stores. For example, 80% of Americans live within eight miles of an AutoZone store, the leader in DIY segment sales.

Because common maintenance and repairs are often unplanned, like windshield wipers in a rainstorm or replacing a dead battery, stores carry the most frequently purchased items, and customers depend on retailers to help them determine what they need to get back on the road quickly. Even for more complex repairs, stores have access to vast inventories at distribution centers, mitigating the benefit of next-day delivery from online parts retailers.

While convenience is essential, we believe in-store services are even more critical to national retailers’ ability to ward off the digital threat. Vehicle problems can be enigmatic, with knocks, ticks, and check-engine lights often not presenting obvious causes or solutions. All national retailers offer extensive diagnostic assistance delivered through a combination of tools (such as code readers and battery testers) and trained in-store sales professionals who can help customers troubleshoot and find the right part. Although online streaming video services have a wealth of tutorials, in-person access to a parts professional helps customers unfamiliar with vehicle repair not only determine the source of the problem, but also identify the needed component (a growing challenge due to ever-increasing vehicle complexity) and receive guidance on an unfamiliar installation. Tool loan programs are a further benefit, because the infrequency of vehicle repair often renders ordering a specialized tool specifically for the job uneconomical. We do not think online-only sellers can easily replicate the interactive service component of the brick-and-mortar retailers’ value proposition and suspect that this is a key reason incumbent online parts retailers such as RockAuto.com and eBay Motors have failed to significantly affect national retailers’ performance.

We anticipate that much of DIY digital sales growth will benefit incumbent national parts retailers as they increasingly use their online portals to drive click-and-collect sales. While absolute sales from this emerging channel are not yet significant, pickup in-store efforts have outgrown major retailers’ overall top-line expansion (albeit off a small base). We believe the option allows customers to combine the convenience of researching parts and determining whether components are in stock online and getting advice and diagnostic/installation support in the store. In our opinion, this should enhance brick-and-mortar retailers’ value proposition as they capitalize on their physical proximity to customers in an increasingly digital age.

Parts Retailers Are Critical Partners for Service Professionals While sales to commercial clients are lower-margin than to DIY customers (by about 300-500 basis points), professional clients' requirements especially favor scaled retail chains with dense distribution networks, particularly given the wide array of parts that sell infrequently but still must be available on short notice to service repair shops' needs. Owners rely on mechanics to diagnose their vehicles' problems, obtain and install parts, and dispose of failed items. Parts retailers are critical partners for service professionals at all phases, resulting in durable, trust-based selling relationships that we believe are difficult for entrants to crack.

From the moment a vehicle enters a service bay for diagnosis, the repair shop incurs labor expenses and the opportunity cost of a bay that’s unavailable for another job. This necessitates rapidity, as costs mount by the minute, resulting in behavior that we think favors national retailers’ speed and agility. To save time and because they know they can return unneeded items later, mechanics will often order a number of parts that they think might remedy the problem to minimize each vehicle’s time in the garage. This is especially important because an immobilized vehicle may have to be taken apart significantly for diagnosis and cannot be moved out of a bay once work has begun. As parts needs are unpredictable and in-shop storage space is limited, mechanics depend on retailers to have items in stock and provide rapid delivery. The need to turn over service bays as quickly as possible requires a retailer that can deliver components quickly and reliably, so mechanics will prioritize retailers based on relationship strength and reputation. Parts orders are generally placed over the phone, though a meaningful portion of sales are executed online. For example, Advance says that 25% of its professional sales are placed through its business-to-business portal, Genuine Parts sees 40%, and we estimate O’Reilly is at 15%-25%. Because facilities price repairs on a markup basis for parts, and because taking extra time to price-shop before placing an order carries a significant opportunity cost (idle service bay and the service professional’s time), we believe the commercial segment is unlikely to be swayed by digital-only retailers’ core, price-based value proposition.

We believe incumbent retailers’ last-mile two-way delivery infrastructure will be especially difficult for online-only rivals to replicate, notwithstanding Amazon’s demonstrated efficiency with same-day delivery for items that turn much faster than many auto-parts categories. While the rarest components are delivered next day, repair facilities often demand parts within minutes (including as little as 15-20 minutes for common items like brake pads and rotors), with 30- to 60-minute delivery windows typical across catalogs that can exceed 150,000 stock-keeping units. Having the right part in stock is critical--any delay in availability forces a repair shop to move down its call list to find another retailer that can provide better service, lest the job’s economics deteriorate as more time is spent on the vehicle. We believe retailers’ method of addressing the challenge is optimal--sellers operate vast, tiered distribution networks, fulfilling orders through a combination of store inventory for the fastest-turning items (about 20,000-25,000 SKUs), hub stores (35,000-50,000 SKUs), megahub stores (80,000-100,000 SKUs), and distribution centers (150,000 or more SKUs). Stores can receive multiple deliveries per day for professional client orders of components not carried at the location, with larger repair shops receiving seven to eight deliveries per day from their local store (the retailer is responsible for last-mile delivery).

The retailer’s role does not end at delivery. Service departments require quick removal of surplus parts that were ordered before a diagnosis, along with components that failed during a warranty. Also, many worn parts contain a serviceable core that is remanufactured into a refurbished replacement part for later sale. Because space in a garage is limited, mechanics demand quick removal of these items as a portion of the value proposition from retailers, creating a need for a deep reverse logistics infrastructure that complicates retailers’ already-formidable distribution challenges. While digital-only retailers can replicate this network, we believe the time and investment required greatly favor existing national retail chains that already have tiered distribution networks and highly frequent deliveries and returns in place, capabilities that we expect would take years and significant capital to duplicate.

The trust-based relationships that dictate the repair shop’s first call when a part is needed create opportunities for retailers to reinforce their competitive advantages. For example, the national retail chains offer enhanced versions of their online catalogs that are a part of digital shop-management tools ranging from simple part procurement to comprehensive software solutions that address virtually all of a shop’s business operation needs. This, along with garage owners’ hesitance to retrain employees on new software, can create a significant competitive edge by embedding retailers’ ordering tools into all of the client’s day-to-day practices. Separately, strong relationships can boost retailers’ private-label offerings, particularly where retailers invest to build the strength of their proprietary brands’ marquees. Professional clients demand high-quality components because the repair shop suffers reputational damage and incurs costs when a failed component leads to a recall for further repair. While this generally leads commercial clients to branded components, the strength of a shop/retailer relationship can eventually encourage mechanics to consider higher-quality proprietary-branded products that carry a higher margin for the retailer and the repair facility alike, particularly when those brands are tenured and nationally known.

Because of the professional segment’s difficult-to-meet needs and relative price insensitivity, we do not expect digital-only retailers to meaningfully disrupt incumbent retailers’ sales or profitability prospects among commercial clients, nor do we anticipate such online purveyors to challenge the narrow economic moats of the four aftermarket retailers we cover.

Amazon Targets Failure-Related Hard Parts The threat from digital retailers, including Amazon, is not new to parts retailers. AutoZone broadly divides sales into three categories that we believe are a useful proxy for the industry: failure (a component is no longer working), maintenance (normal wear and tear), and discretionary items. Digital retailers, along with nonautomotive channels such as grocers and mass merchandisers, have long competed in discretionary and several maintenance categories, with basic items widely available. We do not believe the major auto-parts retailers have a significant advantage over peers in discretionary categories (which are largely not time-sensitive purchases) or in many maintenance items that are widely available.

However, the bulk of brick-and-mortar parts retailers’ sales come from the more lucrative and less widely available failure category, as well as more specialized maintenance items. AutoZone reports that about half of its sales come from replacements of failed parts; while competitors’ disclosures are limited, we believe the split is unlikely to be significantly different among the major retailers. While we believe the failure category is at the heart of the new competitive battlefield--Amazon’s recent contracts with manufacturers appear focused on this area--parts retailers have long had experience in dealing with digital-only competition. Hedges & Co., a research and marketing firm focused on the automotive aftermarket and powersports industries, estimates that online parts sales (including those from brick-and-mortar sellers’ online portals) should hit $8.9 billion in 2017, up 16% from 2016, even before Amazon’s latest moves.

Given the factors that we believe will keep professional sales fairly insulated from online disruption, we estimate that the universe of large retailers’ sales potentially affected by Amazon’s incremental encroachment--consisting of failure and select maintenance categories in the DIY segment--is relatively modest, ranging from slightly more than half for AutoZone to less than 20% for Genuine Parts’ automotive unit.

All told, we see Amazon and other digital retailers primarily competing among themselves for sales to expert DIY customers who can wait to receive parts, a segment that has seen competition from online sellers for years. While conventional retailers have some exposure, we anticipate their differentiated offering will forestall significant disruption.

Industry Conditions Are Favorable, and Complexity Trends Should Drive Growth Digital fears come at an otherwise attractive time for the industry, bolstering our view that the misguided agita presents a buying opportunity. Low gas prices and an improving employment picture (an indicator of commuter miles driven) have increased overall vehicle miles driven in recent years, with growth in that metric recovering after declines during the 2008-09 recession. The trend bodes well for aftermarket parts retailers in the near term because maintenance needs are correlated with vehicle use.

Factors promoting long-term industry health are similarly strong. Improving vehicle quality has helped push the average age of the fleet to new highs, with relatively stable scrappage rates despite record-high light-vehicle sales (18.3 million in 2016). The industry garners most of its sales from cars older than six years, because such vehicles are well out of warranty and parts fail more frequently because of use. According to IHS Markit, the number of vehicles 6-11 years old will increase 5% and vehicles 12 or more years old will grow 10% over the next five years, with vehicles 16 years and older forecast to grow 30% over the same period. Genuine Parts estimates that the average repair cost per year for a vehicle that is six or more years old is over $800 versus a little more than $500 for a newer model.

As vehicle manufacturers’ warranties leave new cars and trucks largely outside large aftermarket parts retailers’ domain for three to five years (with powertrain coverage extending as long as a decade), the recently strong sales cycle should keep sector growth strong for years to come and underpins our forecast for 3% average industry growth through 2021 (DIY and professional combined). However, newer vehicles are more complex and more reliable than their forebears, which we believe should push the professional segment’s growth rate about 100 basis points higher than DIY over the next five years and continue the aftermarket industry’s shift toward less-frequent replacements of generally more expensive components.

We believe this favors leading retailers with a large presence in both segments. National retailers that have established relationships with professional repair shops and the wherewithal to purchase regional and independent competitors that have strong reputations with local clients, but cannot compete with national chains’ inventory and distribution investments, should stand to gain share in the commercial segment. However, despite its slower growth, we believe a strong presence in the DIY segment is vital for retailers to maximize inventory turnover by increasing the number of opportunities to sell specialized components. By leveraging inventory over a large sales base and using stores to service commercial and DIY clients in the same location, we expect a dual-model approach to prevail in the long term. Retailers are already moving in this direction, with Advance acquiring General Parts to diversify its DIY-heavy mix, AutoZone expanding its percentage of stores with commercial programs from 55% in fiscal 2010 to 83% in fiscal 2016, and Genuine Parts attempting to make certain storefronts more attractive to DIY customers by refreshing layouts and extending store hours. As such, we anticipate national chains to slowly gain share at the expense of smaller peers over the next decade. We foresee outsize growth for scaled retailers in both segments, though professional gains should come more slowly as incumbent shop-retailer relationships are hard to disrupt. Furthermore, as cost and inventory leverage is a critical driver of returns, we expect consolidation-driven growth to add to large retailers’ competitive advantages over time, resulting in our positive moat trend ratings for each of the four covered firms.

AutoZone and Advance Auto Parts Are Attractive Of the four auto-parts retailers we cover, we believe AutoZone and Advance Auto Parts provide investors with the best opportunity to capitalize on unfounded fears and long-term industry growth.

AutoZone combines a leading DIY franchise with a growing professional presence under an excellent management team that has delivered consistent returns on invested capital exceeding those of industry peers, as reflected in our Exemplary stewardship rating. With 80% of sales coming from the DIY segment, AutoZone is more vulnerable to the digital threat than more-balanced peers, but we believe its strength is formidable and the firm should gain currency with professional clients as its efforts to target that segment bear fruit. By adding megahub stores and investing in diagnostic and repair software platforms, AutoZone should be able to deepen its engagement with commercial clients, embedding itself through mechanic training and shop-management efforts. Although growth could be slow to build and create a profitability headwind as DIY sales feature higher margins, we expect cost and inventory leverage to more than offset the pressure. We expect AutoZone to defend its midteens DIY share and expand its commercial share from the current low single digits to the midsingle digits over the next 10 years and believe the shares’ 15% discount to our valuation provides a sufficient margin of safety.

While Advance Auto Parts has been dogged by a tougher-than-expected turnaround and its troubled 2014 acquisition of General Parts, we believe it has turned a corner and should benefit from industry tailwinds. With a skew toward the faster-growing commercial segment but a reasonably balanced sales mix (58% of 2016 sales came from professional clients versus DIY’s 42%), we believe the company is well-positioned to benefit from a dual-market strategy that should increase its working capital efficiency even as parts availability improves. While structural factors should keep operating margins well below the high-teens marks shown by pure-play rivals AutoZone and O’Reilly (in part a result of Advance’s increased use of rented locations, higher commercial mix, and the presence of independently owned stores), we still see substantial room for improvement and expect 310 basis points of operating margin expansion by the end of 2021. We view the company’s resurgent top-line growth in the fourth quarter of 2016 (a 2.4% uptick versus a 1.7% full-year decline) as the first signs of a revival on the way to 4% long-term average annual expansion and expect margin expansion to follow as cost leverage builds. Our valuation is attractive versus prevailing trading levels despite a more conservative take on operating margin growth than management’s targets, which call for 500 basis points of expansion over the same period; furthermore, we believe activist investor Starboard’s position on the board should help provide accountability, potentially offering upside. Despite the risk associated with the ongoing turnaround, we view the shares’ 23% discount to our valuation as a sufficient margin of safety.

We see O’Reilly as the prototypical aftermarket parts retailer, with a stellar management team (reflected in our Exemplary stewardship rating) leading a balanced firm (58%/42% DIY/professional mix) that should see outsize top-line growth as it capitalizes on geographic expansion opportunities that its already-scaled peers lack. As the firm builds its presence in the Northeast, in part through acquisitions, we anticipate it will boost returns on invested capital at a higher rate than its large-scale peers (we forecast nearly 380 basis points of expansion, to about 24%, over the next five years), in part due to average annual sales growth that should outpace Advance and AutoZone by about 190 basis points and 110 basis points, respectively, through fiscal 2021. However, we believe the tailwinds working in O’Reilly’s favor are reflected in the current share price.

Genuine Parts only garners about half of its revenue from the auto-parts segment, alongside significant industrial/electrical component and office product distribution efforts. While we believe the industrial and electrical units should benefit from many of the same tailwinds as the automotive unit, the office products group should continue to weigh on profitability. Although we see the office products unit’s benefits in securing attractive freight rates for the rest of the firm’s offerings by increasing volume, we anticipate that the segment will be significantly margin-dilutive over the next 10 years (6.4% average operating margin versus 8.2% overall and 10% for the automotive segment, which is lower than peers because of Genuine Parts’ majority-franchised store network). We do expect returns and margins to build at Genuine Parts, albeit at lower levels than AutoZone and O’Reilly. Genuine Parts offers investors exposure to a basket of factors apart from those driving the U.S. auto-parts retail industry, such as the health of the industrial economy and local market conditions in Australia, Canada, and Mexico, where Genuine Parts has a substantial auto-parts presence. This, combined with a market valuation above our fair value estimate, leads us to counsel investors to look elsewhere to capitalize on attractive aftermarket automotive parts retail trends.