This article appeared earlier in our February 2012 client newsletter. To receive these articles earlier you can sign up for our newsletter here.
Selling replacement auto parts is a fairly simple (don’t say that to the employees in charge of the inventory and distribution systems) and boring business. You build a bunch of outlet stores and fill them with high turnover inventory items and knowledgeable staff. You also build a bunch of larger distribution centers to serve groups of outlet stores and fill them with slower selling, lower turnover inventory items. You also use this distribution system to sell parts to commercial customers like dealers and independent shops.
For the most part, the parts you are selling are manufactured by independent third parties and are the same at each competitor. Competing on price is a nonstarter as your competitors can easily match what you do. Competitive advantage comes down to having the right staff and a well-oiled distribution system–something all competitors have (otherwise they would quickly be out of business) or can easily put in place
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Management tries various strategies with varying success to differentiate themselves to Wall St. Strategies can include focusing on certain segments (commercial versus consumer) and focusing on cost cutting initiatives (buy our stock, we are “right sizing our staff”). Or management trips over themselves to install the latest and greatest in inventory management and distribution systems. Based on the success of these programs, different auto parts supplier stocks fall in and out of favor at various times.
Some auto parts chains don’t cover the entire nation yet and thus are busy opening new stores, giving Wall St. some of the illustrious growth they covet in every stock. (I guess the analysts never stop to think what would happen once the entire country is plastered in that brand’s stores; growth has to return to the level of the industry at some point.)
Over the long run, though, there are two things that determine the industry’s growth trajectory. First, and most important, is the number and age of automobiles in the country. The more cars and the older those cars are means the greater the demand for replacement parts. Second, is the breakdown of consumers’ transportation budgets. Lower fuel prices means more driving and more of the transportation budget gets spent on parts. Higher gas prices mean less driving and less money in the budget for replacement parts.
If we are interested in investing in a replacement auto part retailer, then it would be best to look at those two issues. You can read our thesis on why we think high commodity prices, and oil prices especially, are unsustainable that was published in a past newsletter here.
Replacement auto parts retailers have enjoyed record sales the past few years as new car sales plummeted and the average age of vehicles on the road rose. Many analysts think a robust economic recovery is just around the corner judging by the number of references to a “normalized environment”. (Maybe it’s still hiding in the closet? Maybe under the bed? I’m not sure where they see it.) When recovery happens and new car sales return to their old levels, then replacement auto parts companies will see their profitability drop. For example, Morningstar says this
We think a reversal of industry tailwinds (brought on by higher new car sales, for example) would reduce the record-high levels of profitability that auto part retailers have achieved in recent years…
The consensus is that the gravy days are over. (In all fairness some analysts still like the auto parts stocks.) Well, we think the gravy days still have a ways to go for the foreseeable future.
Let’s look at the first issue, the one of new cars sales (I’m going to refer to both passenger cars and light duty trucks as “cars” throughout the article. “Cars” is a lot easier to type than “light duty passenger vehicles” or some such phrase.)
New car sales have been skyrocketing the past few years. But that is because basically no one bought a car in 2009.
The big percentage increases in car sales are coming off the extremely small base of sales in 2009. We think new car sales will continue to increase as the economy slowly improves. (If it doesn’t improve, then we just get more used auto part sales. I’m fine with that.)
The real question is at what level will new car sales settle? What everyone ignores is that new car sales have been steadily falling in relation to the number of licensed drivers for decades. This isn’t just a new paradigm brought on by the great recession and car manufacturer massacre of 2009. It’s been happening for awhile.
We can see even before the recession that new vehicle sales were not keeping up with population (and licensed driver) growth. In 1999, one new vehicle was sold for every 11.8 licensed drivers. In 2009, one new vehicle was sold for 23 licensed drivers. The median and mean age of all cars has been steadily increasing since 1969 (NADA) and is now approaching 11 years.
So, the logical next step would be to ask why this is happening. One reason is that new cars are built better and last longer. That’s a fine explanation. Even though cars last longer, that doesn’t fully explain why people choose to keep them longer.
Who buys new cars? The answer is people with money who have saved up the entire purchase price of a new vehicle or people with incomes high enough to make the monthly payments on a new car or people with low incomes who are able to find financial institutions dumb enough to extend them credit.
Despite the talk of an improving economy, we haven’t seen any substantial improvement in the jobs market. The following chart shows one of the better ways to measure the health of the labor market: the civilian employment to population ratio.
Prior to the 2008-2009 recession, a little more than 63% of the population was working. Since then, we bottomed out at about 58.5% of the population working and have stayed there ever since. The headline unemployment numbers have come down because people continue to drop out of the labor force. (They give up looking for work, go back to school, retire, etc.) People without jobs generally don’t buy new cars.
The next problem is that a majority of the people who do have jobs are seeing their real wages decline. The chart below shows the latest estimates from the BLS for the changes in real hourly earnings for production and nonsupervisory employees over the past year.
We are looking at real wages as opposed to other measures of compensation that include benefits, since you can’t spend benefits to buy a car. We are also looking at production and nonsupervisory employees, since they make up the bulk of the labor force and thus potential car buyers.
In fact the trend in stagnating or falling real wages has been happening since the 1970s.
If you can’t buy a new car with the money you make, your only option is to borrow it. And, boy, did consumers ever borrow. The chart below shows household debt as a percentage of GDP.
Once wages began to stagnate, households turned to borrowing to make up the difference. You can also clearly see that the debt-fueled housing boom begin around 2001. Households are now beginning the painful process of deleveraging by cutting back on spending and paying down their debt.
With consumers and banks having recently been burned by respectively taking on too much debt and making too many dodgy loans, we highly doubt a new credit-fueled boom will materialize in the near future. Even then, the past credit-fueled boom was only enough to keep new car purchases level. Despite an absolutely massive amount of credit extended to households, not enough new cars were sold to keep the average age of vehicles from rising.
Despite increasingly positive headline economic data coming out we are not seeing anything that would lead to a large scale underlying improvement in the household income and debt picture.
Disclosure: Long AAP, GPC