U.S. Auto Parts 4Q Results: Un Disastro

2. To take charge or care of

4. To handle, direct, govern or control in action or use

- Dictionary.com Definition of a Manager

US Auto Parts (PRTS), stock is down some 40%+ this week (and down a pretty similar amount from its initial public offering price of $10 completed in early February). "Un disastro" is an Italian word/expression a friend once taught me that needed no translation. And probably best sums up the conference call the company held Tuesday afternoon.

Management had to come on the call and explain to its new shareholders that after they got back from the road show and began to "close the books" they discovered a couple employees at their Parts Bin acquisition had mispriced (way below market price), the company's performance and accessories parts. The mispricing hurt profit margins and "fill rates." In some cases, the company had sold a part to a customer, but could not actually "fill the order" (with management indicating on the call that they experienced 10% lower fill rate at two of their vendors) and had to credit back the customer.

Don't these guys have controls in place to prevent something like this from happening? Essentially, can management, manage? This is why the stock dropped so much (I would suspect), not on any specific earnings numbers (although clearly there was an impact there as well). It called into question a very untested management team's (at least in the public eye) ability to lead the company.

To be honest, I think it happens a lot more than people think. Only with such a small company that is not used to dealing with the investment public, it can create said "disastro" I described above. Now people are weighing in already about whether this was just a "stumble" and creates a buying opportunity, or if it is a sign of things to come.

The real value proposition of sell side analysts
Thankfully, I do not have to weigh in on this debate (about whether or not US Auto Parts stumble creates an opportunity or not). They are not in the autoretailstocks index (although remain a prime candidate should one of the other companies be bought out or removed for some other unforeseen reason). And I have not met management.

Although as I have discussed before, I really dislike the idea of saying we (investors) have completed our due diligence because we met with management. Meeting with management is simply one part of the "due diligence" process, and to be honest, not the most important. If you really want to understand a company's prospects (going forward) and generate above market returns, I think you will be unsuccessful if you simply meet with management, take their financial goals and objectives (often referred to as "guidance,") plug it into your "valuation parameters" and then say "this is what the company should be worth."

Because everyone else is doing the same thing, and so future returns are already priced into the stock (or investment). As I have emphasized repeatedly in these email, generating above market returns comes from seeing something others do not. Now good portfolio managers will come back to me and say, you're right Jerry, this is exactly what we do. We go out and meet with vendors, customers, competitors and employees out in the field. Kudos to them. But for the average fund manager that has some 100 (to multiples of this figure) stocks in their portfolio, I don't see how they can do this (unless they have an "army" of employees to do it for them).

And this is where the real value proposition comes from the "sell side analysts" on Wall Street. You know the supposed "industry experts" that specialize in writing investment research on specific sectors like automotive, retail, or even crazy dudes out on the beach that write about auto retail. The analysts that never seem to be able to make the right "calls on the stocks" and more often than not underperform whatever benchmark you give them (myself included so far).

There are over 9,000 hedge funds, and over 8,000 mutual funds in the United States alone that all receive money from everyday (to really rich) investors (through things like 401k retirement plans, pensions, and even endowments and trust funds). They take your money, and invest it on your behalf. Each of these individual managers could hire an "army of industry experts" to focus on these specific sectors, but that seems like a tremendous inefficiency (and overly burdensome cost to the average investor).

Instead, the model that has evolved over the years is to have these "industry experts" all competing against one another (to prove they are the best at understanding the industry) and then weighing in on the stocks and companies. And this is why some of the "worst stock pickers" tend to get ranked at the top of Institutional Investors annual poll. I am not sure why the analysts that seem to understand their industry sectors best tend to be the worst stock pickers.

Maybe it is because these are the analysts that have paid "tuition in the University of Life" (meaning they have made so many mistakes that they can now tell investors what mistakes not to make going forward). Maybe it is because analysts become "too close" to the story as many fund managers often tell me (is the reason).

But I think if you understand the industry best, you should be one of the better stock pickers. And I don't mean over one year or the next (heck I even made the Wall Street Journal All Stars in 2004 for stock picking in specialty retail). I mean consistently year in and year out. Personally, it is something I have not succeeded in, but what I (and I think every analyst should) strive to achieve.

The internet and auto parts industry
So if you ask me why I am so interested in a company like US Auto Parts that seems to be floundering right out of the gate, it goes to that idea of understanding the industry.

As I have discussed in the past, smarter people than I have conducted forums (like the Aspen institute) and studies about "economic revolutions." And invariably these "revolutions" (as I have quoted from a paper out of the Aspen Institute) tend to follow three similar patterns: 1) invention (which often has an initial boom then bust), 2) diffusion of the innovation (which is propelled by specializations), and 3) displacement (in which the new economic order transforms the employment base from the preceding order).

AutoRetailStocks and the Auto Retail Informer are merely the natural outgrowth of this "diffusion" and specialization process occurring on Wall Street. Just as the internet becoming an increasingly important part of retailer's lives is a natural outgrowth from people being able to quickly and easily access information via google or any other search engine out there. When Guttenberg invented the printing press, I don't think people hardly expected that a simple enhancement in communication would allow scientists to easily communicate amongst one another and within a matter of 50 years or so, view the world in a completely different light (literally as it became widely accepted that the earth revolved around the sun versus the sun and planets revolving around the earth).

I understand the internet is only about 3% of retail sales today, but I have given you the example before about how the cell phone industry (a little less than 10 years after being rolled out in the market place) only accounted for about 1% of the U.S. population with no one making a profit (in the early 1990s). And yet by 2001 cell phones were owned by more than one out of every person in America. It just needed to pass the "tipping point."

So I would be very careful about saying the way American's consume products (yes even Auto Parts) could not be fundamentally different 10 - 20 years from now. Let me give you a real life example. . .

I try to be a great student of auto retail industry trends. But if you were to open the hood of a vehicle, I have to admit, I could probably not tell you what most of the components and parts were. Sadly, despite popular myth, I am a research analyst, not "a car guy" (someone who loves to work on the vehicle). So within a couple weeks of taking my car into the dealership for its usual service appointment, the "coolant error" began flashing. Now here is the shift. I "googled" Audi A4 coolant, where I easily found an article at consumerguideauto that said "The oil cooler is prone to turning during oil filter removal, which causes damage to the coolant lines resulting in a coolant leak."

Now I didn't do this until after I had gotten it fixed (at the dealership). But imagine if I "googled" the problem right when it occurred (before taking it into the shop?) Someone like myself would be able to readily surmise that the reason why the cooler is leaking, is because a mistake was probably made when they did the last oil change (called "service appointments nowadays at luxury dealerships). It was covered under warranty, so I did not need to make a big deal about it and go back to the dealership. But have you noticed the changed reality repair shops now face?

People that were previously left to the "mercy of the repair shop" (because they didn't have a clue what was wrong with their vehicle) now all of a sudden are becoming much smarter, more educated about what really needs to be done (and sometimes even what really caused some of the problems) with their vehicle.

Another example; as I flew to Chicago Thursday, I ended up being on the same flight with a friend. This friend pointed to an advertisement in the flight magazine that showed a computer diagnostic device that could be bought for $150. He said: "boy this pays for itself with just a few visits to the repair shop." I said, "or you could go to Auto Zone or any of the other auto parts stores and they'll usually do it for free." "Really?" he said.

This is why I continue to emphasize that the organizations that are likely to dominate the parts distribution world going forward are those that become the best "resource" center for the consumer. The companies that empower the consumer so they no longer feel like they are left to the "mercy" of the repair shop. If you control where consumers look first (to figure out what is wrong with their vehicle) you are likely to be able to "steer" the customers to where they should get their vehicle fixed (emerging as the voice of the customer to the repair shop).

I know, the doubters say that the majority of their customers don't have access to the internet. Well, first of all maybe they need to expand the definition of their customer. But the folks at Nielson say that something like 7 out of 10 American's today have access to the internet, and as a younger (more net savy) customer continues to become a greater proportion of the buying public, I can only suspect that the internet (and other "networked information sources" like Onstar) are going to play a MORE not less important role in consumers decision vehicle maintenance and repair decision making process.

Whether new entrants like Amazon.com or US Auto Parts that are unhindered by the existing cultures of traditional players emerge as the winners remains up for debate. Because while they benefit from being encumbered with the culture of the traditional "jobber" (folks that run the parts over to the repair shops almost like a "Domino's pizza,") they also lack the skill set of matching up hundreds of thousands of different types of vehicle parts (known as stock keeping units) when and where they are needed. Concepts like "drop shipments" (going directly from manufacturer to the customer/repair shop) that have been a growing piece of NAPA's business for years sounded like "the new frontier" on US Auto Parts call.

New metrics from an online parts perspective
But the emergence of online players also begins to give us new metrics and approaches to think about and focus on when trying to understand the competitiveness of an AutoZone, Advance Auto Parts, CSK, NAPA, O'Reilly, or Pep Boys. I doubt we will start seeing all of the same metrics disclosed by the large public "brick and mortar" players (and at some point I have to admit it just becomes "info overload.")

But here are some of the figures that US Auto Parts focused on (which is important to online retailers) that will be important for investors and industry observers to get a better handle on at the previously mentioned brick and mortar parts providers . . .

1) Unique visitors/conversion rate. How many "unique" (and I understand that term can be debated) visited these companies web sites? At US Auto Parts, it was 20.4 million in the fourth quarter. And out of those 20.4 million "unique visitors," 1.2% (245,000 visitors if I understand the definition correctly) were "converted" from a visitor to someone who actually bought something (although I admit this is probably off slightly because I am applying the annual conversion figure to a quarterly unique visitor figure).

2) Orders/order value. In 2006, I guess US Auto Parts placed 748,000 orders through their e-commerce websites with an average order value of $120 per order. This is very similar to "brick and mortar" retailers that often times directionally discuss something called "traffic and ticket values" on their conference calls (how much traffic or people come into the store and how much the ticket or average purchase value of their visit is). For US Auto Parts the ticket, or order value has remained pretty stable (year over year), while most of the brick and mortar auto parts retailers generally suggest they saw rising ticket values in 2006 and somewhat sluggish "traffic."

3) Customer acquisition cost. For US Auto Parts this figure was $10 in 2006, up from $8 in 2005. I suspect the brick and mortar parts retailers can gain significant leverage/benefit in this area, because the same online "acquisition" marketing expense could have a dual effect of increasing online purchases as well as people (traffic) just going to the auto parts store.

Evaluating Managerial Controls: 9 areas/questions for new and used auto retailers
To be honest, the US Auto Parts "implosion" is a good illustration of how we in the investment community do a really poor job of assessing managerial controls. I (like so many of my sell side peers) have found myself going back to management (after the fact) and saying things like: you mean you didn't have this electronic menu in place right off the bat to prevent the department of motor vehicles coming in and shutting down the dealership because a rogue "finance and insurance" manager was over charging customers on the rate?

And while all of the due diligence (and sometimes even the best management teams in the world) can not completely prevent these things from happening, we should at least try to understand where the risks lie. Going forward, I think this is an issue I am going to raise at all sorts of auto retailers (and more importantly vendors) about where the potential for abuses reside. So to start, I turned to my friend Jim Lawrence at Compli. Compli, from what I understand (everyone calls themselves "the leader") is one of the larger vendors of compliance systems for franchised auto retailers.

Right off the bat, while I have a high regard for Mr. Lawrence, I in no way can attest to whether they (versus any competitors or even internal departments) are the best at providing systems to help ensure managerial controls. They tell me they have never lost a customer, although even here I think we need to be a little careful because they just haven't been around that long and these tend to be long term contracts.

But I think a place like Compli (where they are putting in managerial control/compliance systems at dealerships) are as good a place to start as any to help us (investors and industry observers) understand where the risks reside.

In response to this question, Mr. Lawrence said UUG/Zurich (insurance company) has identified 9 top causes of loss at a dealership. Those include:

1) Auto Liability/Collision - Mr. Lawrence added: "hence the problem with demo vehicles to employees to get them insurance."

2) Worker's compensation.

3) Theft (fraud) - Inventory and employee related. He said: "I have seen estimates that dealerships lose as much as 6% of their gross" (CroweChizek llc)

4) Employment practices - "refers to harassment, discrimination, wrongful terminations, turnover issues"

5) Fire.

6) Products and Completed Operations - "service issues generally."

7) Statute and Title Errors and Omissions - "DMV, sales and F&I, consumer information, all areas associated with the core sales process at a dealership"

8) Premises Liability - "protecting customer vehicles with the proper security, protecting people with the proper security protocols, e.g. locking up procedures for service, the lot, etc."

9) General Business Protection - "misc weird stuff - flood, hurricanes, hail, acts of God, etc."

So if you are an investor trying to do "due diligence" on a franchised (probably any new or used) auto retailer (at least), this seems like as good a start as any to begin asking the management teams what systems and controls they have in place to protect from these risks. I would like to thank the folks at Compli for helping construct this list.

Going forward hopefully I will be able to develop a similar list of questions for some of the other sectors of auto retail.