Why the auto-parts industry is attractive

When I have my eye on a hated, battered stock, a good industry or sector is one of the conditions I like to see...

In last Friday's e-mail – in the context of an initial look at chip giant Intel (INTC), drugstore chain Walgreens Boots Alliance (WBA), and automotive-parts retailer Advance Auto Parts (AAP) – I wrote:

I've sometimes found incredible opportunities among the most hated, beaten-down stocks... but generally only when many (ideally all) of the following conditions are true:

• Modest (rather than catastrophic) declines in revenue and net income...
• Even if it's declining, positive (or at least not too negative) free cash flow (operating cash flow minus capital expenditures, or "capex")...
• A decent balance sheet, which gives a company time to right itself...
• A good sector (a reasonably competitive environment in which other companies are doing well)...
• And new management.

Then on Wednesday, I took a closer look at the financial statements of Walgreens and Advance. I concluded that Walgreens' financials were so ugly as to be disqualifying, but that "Advance is interesting for a number of reasons."

One of those reasons is that Advance isn't just in a good sector... but a great one.

In fact, its two direct competitors, AutoZone (AZO) and O'Reilly Automotive (ORLY), have been two of the best stocks of the past two decades – vastly outperforming Advance since it went public in November 2001, as you can see in this chart:

 I'll note that Advance significantly outperformed the S&P 500 Index in the first roughly 20 years after it went public... but it now trails badly due to the 84% collapse in the stock since it peaked at $241.65 per share on January 6, 2022. Take a look:

Looking at the broader auto-parts industry with the retailers, there are a number of reasons why it's attractive...

First, it's a very large market with $160 billion in annual revenues, roughly evenly split between do-it-yourself ("DIY") customers ($75 billion) who fix their own cars and do-it-for-me ("DIFM," or "professional") customers ($85 billion) who are mechanics with their own garages.

This slide from a June presentation at the VALUEx Vail investing conference by hedge fund Legion Partners Asset Management gives a nice overview:

The industry structure is also highly favorable, as there are only four large players: Advance, AutoZone, O'Reilly, and a less-direct competitor, NAPA Auto Parts – owned by Genuine Parts Company (GPC) – which focuses on the professional market.

The remaining 69% of the market is mostly small mom-and-pop operators that are competitively disadvantaged, so the big guys take a little bit more share year after year, a trend that is likely to continue for a long time...

And the overall market has solid growth dynamics. As this next slide from the Legion presentation shows, industry revenue should continue to grow 2% to 3% annually thanks to more people driving more miles in more, older cars:

And when their cars break down, drivers have no choice but to repair them, as transportation is not a luxury but a necessity... so the industry is recession resistant.

And online competition isn't much of a threat, for two primary reasons.

First, if something in a car breaks, owners usually need to fix it immediately – they can't wait two days or more for a part to arrive.

And with the increasing complexity of modern cars, most owners need some sort of help to fix their car – either from a sales associate at an auto-parts store or at a garage.

This is a business driven mainly by speed, service, and inventory availability... not price.

Despite these many favorable industry characteristics, Advance has badly underperformed its peers in terms of same-store sales – as this next slide from the Legion presentation shows:

And Advance's earnings before interest, taxes, depreciation, and amortization ("EBITDA") margins have consistently trailed its peers – with a huge widening of the gap in the past year and a half. Take a look:

So why has this happened... and can Advance close the gap with its competitors? I'll address these questions next week when I continue my analysis, so stay tuned!

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.