The auto part retailers have long been the darlings of the retail industry with consistent earnings growth, the highest margins in the sector, and protection from online players. And as a result, the stocks have been rewarded with a high valuation and market outperformance. However, there's a looming technology that could disrupt the industry that I don't think is being accounted for by investors.
Before I get into what people aren't talking about, we need to first establish what people are talking about. For those who aren't familiar with my writing, my Word on Wall Street posts talk about the bull and bear theses among the largest buy-side investors. The intent is to establish what the consensus arguments are (which most retail investors are not familiar with) so that we understand what will move the stock and what is baked into the stock price. So let's kick off this discussion with a look at what those arguments are for the auto part retailers.
The Current Discussion Focuses on Secular Tailwinds and Defensiveness
Auto part retailers have been on a tear since the recession with a trajectory that has been just about straight up. The group has increased 493% over the last 10 years compared to the 72% gain for the S&P 500.
The tailwinds are well understood in the industry. Auto parts are one of the few areas in retail where investor sentiment (both sell side and buy side) have been uniformly bullish since the recession. Currently, 67% of ratings on auto part retailers are Buys (mostly for O'Reilly and AutoZone), 30% are holds, and just 1% are sells.
To recap, the bull thesis is that the industry faces a number of favorable secular tailwinds that should drive continued longer-term growth. Additionally, the company offers several defensive features that allow investors to sleep at night.
Tailwind 1: Increasing average age of vehicles. As cars get older, they require more repairs. This in turn drives business at the auto part retailers, which sell to both consumers and local mechanics (the pro customer). The average age has increased every year since the data was available (from the Bureau of Transportation Statistics) and now sits at 11.4 years.
Tailwind 2: Increasing number of vehicles on the road. Vehicle sales have been surging. Auto sales recently hit the 18M SAAR mark in December, and have returned to levels not seen since before the recession. Auto registrations have increased as well, increasing 1.7% to 260 million in 2014. As more vehicles get on the road, more auto maintenance and repair will be needed.
Tailwind 3: Increased driving. Miles driven, a metric from the government, shows that people are driving more than ever. After taking a brief pause between 2009-2014, miles have begun to increase again. Low oil prices have likely helped this metric as well. As the cars are driven more and more, repairs will be increasingly necessary.
Tailwind 4: Increasing complexity of cars. This will make repairs more complicated, which will likely drive higher spend as consumers require more services to help fix things.
Eating the local retailers
Outside of the factors that are benefiting the industry as a whole, the public auto part retailers also offer a compelling share gain story. The industry, sized at roughly $100B, remains extremely fragmented. The top 5 retailers hold just 20% of the DIFM side and 36% of the DIY side (if you are unfamiliar with these terms, see the bottom of the article for explanations). Who holds the rest of the industry's sales? It's mostly local, smaller shops. And as the big 3 (ORLY, AAP, and AZO) grow, the benefits of scale will continue to grow over these smaller players. We have already seen this happen over the last two decades, as census bureau data suggests that roughly a fourth of the industry's store base (outside of the big 3) has disappeared. The auto part retailers' small market share suggests that a significant amount of upside remains as they continue to take share from the smaller, less competitive retailers.
Defensive characteristics protect the industry from Amazon and recessions
The group also offers several attractive defensive characteristics that most of retail does not offer. Perhaps the biggest defensive characteristic is its insulation from the online threat. The nature of auto parts is favorable to the auto part retailers and unfavorable to online players. Purchases are often out of necessity and are time sensitive. Local mechanics or your average consumer may need a spare part or a tool within the next hour. And online retailers are currently unequipped to get parts to the customer that quickly. Meanwhile, the auto part retailers have an entire infrastructure of regional hubs set up to deliver necessary parts to its customers quickly.
Additionally, the DIFM side is heavily relationship-based. Mechanics will often call "the guy they know" that has been delivering hard-to-find parts quickly and consistently over time. They're much less likely to go online and order something. Furthermore, many customers, even the local mechanic, might go to an auto part store looking for advice. Online retailers would not be able to offer customer support to the degree that the auto part stores are able to.
The other defensive characteristic is that the auto part retailers have historically outperformed in recessionary environments. This occurred during the last recession in 2007-2009. Auto part purchases are largely not discretionary; when someone's car breaks down, they have to get it fixed. In fact, one could even argue that consumers are more likely to fix their cars and try to extend the life of their existing car in a recession as opposed to buying a new car.
With such strong tailwinds behind it, the auto part retailers have consistently posted strong same store sales trends over the last several years. Several of the retailers have company-specific initiatives as well. For example, O'Reilly continues to benefit from growing DIFM sales at its stores (a separate story for another time). Meanwhile, Advance Auto Parts has lagged the rest of the sector, but also has the most upside of the three as it seeks to improve on its operations.
Bear Arguments are Harder to Find, but Revolve Around Online Threat, Valuation
What are the bear arguments? Recent stock price performance has driven valuation significantly higher for all the auto part retailers. Currently, the group trades at a 19x PE multiple (NTM) despite consensus estimates of 11% growth in 2017. Admittedly, this is likely due to the great degree of confidence that investors have that the auto part retailers will hit their estimates. The group has been remarkably consistent over the years and has a strong bull case going for it. As a result, you'll need to pay up for each point of growth that they're expected to generate.
Additionally, while many investors are aware of the defensiveness to the online threat, investors are still wary of the impact of Amazon's entry into the industry. And for good reason. Amazon has a long history of getting into industries that were once thought to be insulated from the online threat, and quickly disrupting it. And Amazon appears to be getting more serious about the auto part industry. The company recently struck deals with auto part suppliers to sell their parts directly on the Amazon platform. While the sector's supposed insulation from the online threat is well known, many investors are hesitant to conclusively say that it will not be impacted. Arguably, at a minimum, Amazon's entry into the space is worthy of a 1-2 point discount on the multiple given the increased risk.
The other bear argument that has lingered for several years is the declining amount of cars in the 6-11 age bracket. The entire existing fleet of cars has a certain number of cars in the 0-5 year bracket, a certain number of cars in the 6-11 year bracket, and a certain number of cars in the 12+ year bracket. The 6-11 bracket is considered the sweet spot because cars are old enough to start breaking down, are potentially out of warranty, and are valuable enough for consumers to want to make them last longer. Unfortunately, 6-11 years ago was the time that we were going through one of the most severe recessions in the history of the country. Car purchases dropped off a cliff as consumers tightened their budgets. As a result, there will be a smaller number of cars in the sweet spot in the coming years. Bears believe this could potentially hurt auto part purchases over the next year. However, this thesis has been around since 2014, and auto part retailers have continued to post fairly strong results despite the sweet spot decline. As a result, this argument has lost supporters in recent years.
Self-Driving Cars Could Leave Auto Part Retailers Out of the Equation
There's another longer-term bear thesis that's not talked about - the impact of self driving cars. I get the sense that investors often think of self-driving cars as one of those long-term technologies that will get pushed back further and further as it hits technological and regulatory issues. And as I have discussed before, public equity investors are mostly near-term focused, especially institutional investors. As a result, it's a topic that I think most investors mentally think they can revisit and think a bit harder about in 5-7 years.
However, as I'll discuss soon, self-driving cars could come sooner than expected. And stocks could react even sooner than that. Venture capital investors, which have longer-term horizons and are arguably the closest to the technology, are paying a significant amount of attention to it now. In fact, many of the arguments I'll put forward actually come from the VC world, but just have yet to bleed into public equity conversations.
Self-driving fleet operators would not need auto part retailers
Self driving cars have the potential to leave auto part retailers out of the car-repairing equation. And while this scenario involves multiple assumptions to play out, the sheer magnitude of the impact is enough to warrant investors' attention. Let's walk through the exact way that this thesis could play out.
The benefits of self-driving cars are well established. Without a required driver behind the wheel, cars can now be used more frequently for the benefit of others. Cars are currently used <5% of the time during their lifetime. Additionally, even when they are used, they are underutilized and often have only one driver in them. With the advent of self-driving cars, we will have fewer cars on the road, fewer accidents, and higher usage per vehicle.
Some of you may be anticipating how this will impact auto part retailers already. Big deal, you might think. There might be less cars on the road, but they will be driven much more and will need repairs more frequently. Auto part retailers should continue to benefit from this.
However, many VC investors believe that the characteristics of self-driving cars lend itself well to an oligopolistic industry with only a handful of major players offering self-driving cars as a service. In a world where all cars on the road are self-driving, we'll have 1) a small fraction of the total number of cars on the road, and 2) fairly expensive cars with lots of sensitive gear. Additionally, if there are ever any technical issues (i.e. fog preventing the cameras from operating fully, network hacks, significant construction in certain areas, etc.), transportation service providers could quickly fix the issue by temporarily rolling out their fleet with human drivers. It makes a lot of sense to have the cars owned and maintained by a few other companies rather than the consumer. This obviously positions Uber or Lyft well as they already offer transportation services on demand, but it could possibly also include Tesla, the car manufacturers, or another tech company as being major players as well. Ultimately, many VC investors believe that in a self-driving car world, there will only be a handful of major players in the industry operating and owning all of the cars on the road.
And in a world where only a handful of companies own all the cars on the road, they will likely not go to a local mechanic to maintain and repair their fleet. They also won't go directly into an auto part store. These two channels comprise all of an auto part retailer's revenue (DIFM in the former situation and DIY in the latter). Instead, the manufacturers are much more likely have their own in-house operation. In that scenario, the auto part stores will be cut out of the equation.
Counterarguments Exist, but Do Not Fully Allay Concerns
Current earnings expectations and multiple demonstrate how far the stock could fall
You might think that they won't lose all of their revenue. After all, there will still be people driving cars out there. But stocks are highly sensitive to changes in growth rates, and slight changes vs. investor expectations could lead to a big impact on the stock price.
The current expectations for the auto part retailers is for sales growth of 2-7%, margin expansion of 20-50 bps, and earnings growth of 6-16% (with AZO and ORLY at the high end of these ranges).
Should they miss these expectations, consensus estimates would lower significantly as analysts change their growth estimates for the business going forward. And over time, a change in a couple percentage points can make significant differences in earnings projections when compounded over time. This is likely further hurt by the auto part retailers' elevated margins, which are the highest in all of retail. While the auto part retailers' extremely high margins are a testament to the auto part industry and to the efficiency of the operators, it is also a risk given how far they can fall. We saw something similar happen to Bed Bath and Beyond several years ago once their sales started to slow and the company was forced to reinvest in the business to drive further growth.
Furthermore, the biggest impact would be a decline in the multiple. If the auto part retailers miss earnings expectations, investors would lower the multiple for the business due to 1) its lower growth trajectory, and 2) increased risks and uncertainty on its future.
After all, if someone told you that there is a potential scenario out there where the auto part retailers could lose half of their sales (or more) in 5 years, and that that scenario had a 10% chance of occurring, how would you react? The multiples would have to take a hit. It might be akin to something like GameStop's situation, a retailer in which its business model could eventually go away with video game distribution over the internet. While the company has enjoyed moments of outperformance, the multiple has remained below 15x post-recession and below 10x for most of that time period.
Timeline of events could be shorter than you might think
You might think, "OK fine, but it will take a long time for the impact of self-driving cars to roll out and move the needle. Ten years maybe."
But, the impact to stocks could happen sooner than you might think for several reasons.
First of all, many manufacturers expect self-driving cars to begin entering the market by 2019-2020. That's in just 2-3 years - well within the 3-5 year framework that many investors use to value stocks.
Second, once self-driving cars are rolled out, they could easily replace existing cars on the roads much more quickly than is currently believed. The average car age is 11.5 years, and many models assume that for our entire fleet of cars to turn into self-driving cars, it would take ~13 years. However, technology has sped up the rate of adoption for more recent innovations. And if we assume that people will begin to use shared vehicle services more frequently (whether through Uber, Lyft, or another car manufacturer), then the cars will be used much more heavily, which will age them more quickly, and cause the entire fleet of cars to turn over in a shorter period of time. In that scenario, the entire existing car fleet could turn over in a fraction of that time - as little as 3 years by some estimates.
Third, the stocks could potentially move before the impact is seen in the fundamentals. Already you can see this from Amazon's impact on the auto part retailers (see the chart in the Bear section). While Amazon has yet to actually impact their results, just the announcement that they would enter the space has increased selling and contracted the multiple slightly.
So when could the stocks actually move? It really depends on how quickly investors grasp how this might impact auto part retailers. Let's take the extreme cases. At the latest, investors might begin to take notice once it actually hits financial results. In that case, it could occur once self-driving cars become more mainstream, which could be 5+ years from now at the later range of estimates. At the earliest, investors could begin to take notice as self driving cars begin to launch some time in 2019, or even before that (potentially even now, although this seems aggressive and unlikely to me). So we have a time span of 2-5 years potentially of when the stock could begin to feel pressure from this threat.
Increased Caution for the Auto Part Retailers As Self-Driving Technology Arrives
Now obviously, this is a huge range and leaves investors with little to actually act upon in the near-term. And admittedly, it is much more likely that the auto part retailers continue to outperform during that time frame given the bevy of positive secular tailwinds that the companies are enjoying. However, for those investors who currently own auto part shares, or are looking at the sector, I would be increasingly cautious of these companies as the launch of self-driving cars approaches. At some point in the near-term, it could become a talking point that depresses the multiple. And longer-term, it could significantly disrupt the operations of the businesses and hurt the stocks even further.
DIY - Do It Yourself. This represents sales from the auto part retailers to consumers who are trying to fix their car themselves. Think of things like oil changes or fixing a flat tire.
DIFM - Do It For Me. This represents sales from the auto part retailers to local mechanics who are fixing someone's car. They generally will need more specific car parts and tools.