Motoring Trends

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by: Douglas Adams

Summary

Retail auto parts stores ORLY, AZO and AAP have done well in the post-financial crisis era with returns that have consistently outpaced the S&P 500 benchmark.

Border adjustment taxes will hit imported auto parts hard which now constitutes about half of all parts sold in US markets, threatening the very viability of current business models.

Amazon recently announced its intention of entering the $50 billion do-it-yourself auto parts market, launching another challenge to bricks-and-mortar retailing.

ORLY, AAP and AZO shares are all down YTD in the face of a changed retail landscape.

The Auto Care Association estimates the secondary market for parts in the US at about $246 billion through the end of 2014. Of that total, $138 billion came into the US market via foreign manufacturers and/or distributors for the period. In 1990, only about $32 billion parts were sourced from abroad.

The retail market for auto parts is highly fragmented and quite mature with large chains carving up and dominating much of the market through highly visible bricks-and-mortar storefronts across the country. The retail market breaks down into two segments: to the do-it-yourself market, which has an estimated value of $50 billion and the commercial market that serves the public through state registered repair shops.

The sale of auto parts is driven by two primary forces:

  • The age of cars currently on the road. According to IHS/Market data, the average age of passenger cars and light trucks is 11.5 years through the end of 2015. For new cars, the average holding period is 77.8 months, or about 26 months more than in 2006. For used cars, the hold period is 63 months or about 25 months longer than in 2006. The older the car, the more likely repairs will be needed to keep the car operational. Pressures from slow economic and wage growth in the greater economy keep many cars on the road longer than in times past. Similarly, better car design and engineering continues to stretch the useful life of many vehicles. The useful life of cars will likely continue to increase as these two forces play out in the future.
  • The price of gasoline. The lower the price of gasoline directly correlates with the amount of driving that is actually done. In 2014, the average weekly retail price of regular gasoline was $3.58 a gallon, according to US Energy Information Agency data. That same national average retail price was $2.43 per gallon in 2015, falling yet again in 2016 to $2.14. The price at the pump correlates with the average national price of a barrel of crude on the New York Mercantile Exchange (NYME), which in 2014 was priced at $92.91. In 2015, that same barrel priced out at $49.47, close to half the price on a year-over-year basis. In 2016, the national average price of a barrel of crude on the NYME commanded a price of $43.50. The lower the pump price, the more miles that are likely to be driven in any particular year as more discretionary income is spread across the greater economy rather than being pumped into the gas tanks of US vehicles. Increased vehicular travel is just one of those discretionary income options.

O'Reilly Automotive (NASDAQ:ORLY), Advance Auto Parts (NYSE:AAP) and AutoZone (NYSE:AZO) are three major players in the retail automotive space in the US.

ORLY has 4,829 retail outlets in 44 states with an average store footprint of 7,273 feet. AZO has 5,835 retail stores in 50 states with an average store footprint of 6,587 feet; AAP has 5,171 stores in 44 states with an average store footprint of 7,600 square feet.

Figure 1: Selected Comparison Ratios

ORLY

AZO

AAP

S&P

Price/Earnings

25.02

26.29

17.17

22.60

Price/Sales

2.89

1.92

1.24

1.98

Price/Cash Flow

21.38

13.40

15.74

ROE

51.77

--

17.09

11.77

Price/Tangible Book

21.35

--

9.74

3.04

Market Cap (NYSE:B)

24.54

22.093

11.910

ORLY makes a pretty strong though somewhat pricey impression at first blush. While its price to tangible book tips the scales at seven times that of the S&P 500 benchmark, investors clearly are attracted to the stock in a big way. The company's return on equity and its strong cash flow are likely a big part of the attraction. ORLY is a momentum stock and aptly demonstrates its ability to maintain that momentum with average annual returns of more than 20% over the past ten years. The question is whether the company can maintain such a pace moving forward in an economic, political and market environment that remains highly uncertain - issues to which I would now like to turn.

The Economics

There is likely little doubt of the relationship between the rise in ORLY's market share and share price coincided closely with the slow and protracted recovery period of the greater economy after the Great Recession of 2007. The unprecedented loss of jobs in the 2008-09 period that saw 23 consecutive months of job losses with a monthly average for the two years of 297,000 and 422,000, respectively. New car sales plummeted during the period from an annual sales level of 16.5 million units in 2007 to 13.5 million units sold in 2008 to a trough of 10.6 million in 2009.

Annual sales didn't return to 2007 levels until 2014 when 16.9 million units were sold in the US. Maintaining one's own car kept many a car on the road during tough economic times for those so inclined as the do-it-yourself market grew into the $50 billion market of today. Each of our players are dependent on this market, ranging from a high of 75% to a low of 40% with ORLY coming in about 50% of its total revenue coming from the do-it-yourself market, according to Northcoast Research.

Since just under 60% of all auto parts sold in the US are foreign sourced, global macroeconomics come into play. In a weak dollar environment, it likely makes more economic sense to source the manufacture of parts in the US as foreign components are both expensive in relative dollar terms and transportation costs only add to the unfavorable cost differential. In the months following the fall of Lehman Brothers in September 2008 through December of 2014, the Federal Reserve pumped an estimated $3.20 trillion in liquidity through three separate asset purchase programs after cutting the effective federal funds rate to essentially zero.

The Dollar Index (DXY) hit a trough measure of 74.52 midway through the period in April of 2011 - its lowest post since October 1995. Earnings per share for ORLY went from $0.72 in 2011 to $1.61 through the end of 2014, up just under 124% for the period. AZO's increase over the period was in excess of 34% while AAP increased almost 49% according to company filings.

In a strong dollar environment, US retailers and distributors reap a comparative advantage in both foreign exchange as well as domestic markets. While the US trade deficit suffers as exports are more expensive in world markets, a US retailer buying goods for US markets is able to arbitrage the relative strength of the dollar to buy comparatively more foreign goods. The extra bonus comes from the differential in labor cost input between foreign and domestic producers.

Transportation costs become negligible in comparison. On the 1st of April, the Dollar Index posted a reading of 79.78, a rise of just over 7% from its April 2011 low of 74.52. By the turn of the New Year 2015, the Dollar Index had soared to a reading of 98.38 for its highest read since October of 2004. The Federal Reserve has just ended its asset purchase program in December and the dollar appeared to be on a tear.

Trading in a range on the high end at 98.69 to a low of 94.63, the dollar hit a 21-year high of 102.21 on the 1st of October less than a month before the US presidential election. ORLY earnings per share went from $1.61 through the end of 2014 to $2.59 through the end of 2016, a gain of almost 61%. The earnings per share of AAP rose 6.47% while AZO rose almost 49% for the period.

The Politics

The new administration has, early in its tenure, been unusually vocal in its stand on the US trade deficit, which stands at $502 billion through the end of 2016 - a curiously small component of a $17 trillion economy. China, by far, holds the largest trade surplus with the US at a whopping $347 billion, down measurably from years past. China's January trade data reported a 7.9% YOY increase in exports and a 16.7% jump in imports, according to government statistics.

The robust pace of imports reflects steady progress on the crucial front of reorienting the economy toward domestic consumption and away from exports. Japan is a distant second with a surplus of $69 billion where monetary policy offers up strong incentives for Japanese multinational companies to invest abroad.

Germany turned in a close third at $65 billion. Again, low interest rates provide strong incentives for corporate decision makers to invest abroad. Germany's current account surplus hit Eur266 billion or 8.5% of GDP through the end of 2016 - its highest post since records began in 1991. Meanwhile, Mexico's trade surplus weighed in at $63 billion for the period.

Most Americans now know about Section 338 of the Trade Act of 1930, otherwise known in history as the Smoot-Hawley Trade Act (1930), that allows presidents to impose tariffs of up to 50% on imports from countries found to have unfairly disadvantaged the US in world markets. This is the same trade act that didn't cause the Great Depression in the aftermath of its enactment, but was certainly a contributing factor in the sixteen consecutive quarterly contractions in overall US economic output that has tarred the Hoover administration in the annals of history ever since.

We all know that the administration's trade representative and director of the National Trade Council are outspoken trade hawks while a third cabinet position holder at Commerce form the troika that has been charged to put an American First trade policy with the greater world in place.

What we don't know, at least at this stage, is just how the administration's endgame will turn. Uncertainty in world capitals and global markets abound and theories, in the absence of clear policy statements, are rife. The administration continues to shoot from the hip on the subject of trade with almost daily fuselages that oscillate wildly from slapping border tariffs on imported goods to building walls and deportations to accusations of currency manipulation.

None of these approaches contribute to high levels of market confidence - especially when about 50%+ of annual revenues of S&P 500 companies derive from foreign sales. Each of these countries have been threatened with 35% tariffs in a tireless, full-throated assault on rules-based trading regimes. In the case of Germany, trade and current account surpluses have been a red button item for most of the past decade - the subject of a long series of accusatory reports from the IMF, the OECD and the US Treasury.

The current twist allows Germany to hold up the red herring of monetary policy to shield its own failings in causing gaping imbalances in both the European and global economies. Then again, maybe Americans should make better cars. The streets of Tokyo and Berlin still beckon.

Overlaying this uncertainty on trade is the House Republican plan on tax overhaul. Destination-based cash flow tax (DBCFT) is expected to generate about a $1 trillion over the next decade that in theory at least offsets the tax revenue lost to the US Treasury from cutting the statutory corporate tax rate from its current 35% to 20% upon full enactment. DBCFT starts with the notion that companies are taxed on income generated in the US.

DBCFT targets domestic cash flows - import income - that flows from the sales of goods and services within the US less the direct cost of employees and the purchase of supplies. Exports escape taxation entirely. The plan drops the tax advantage of debt over equity and allows companies to book tax savings on capital investment immediately and in full, rendering the concept of amortization to the dustbins of history.

Forgetting for a short moment that targeting imports is patently illegal under World Trade Organization (WTO), a cash flow-based tax with a border adjustment would cause the dollar to strengthen dramatically in world currency markets, roughly offsetting the level of tax on imports over the course of time. During this implementation period, market distortions will be at their highest - not only in the US but worldwide as US trading partners adjust quickly to patch together a response to the new US tax regime.

While a phase-in of the tax regime could lessen the impact of a strengthening dollar in world currency markets, the impact on banks and corporations with high debt balances will be immediate as debt service becomes all the more burdensome. Americans holding foreign assets or investments as well as foreign holders of US assets will experience one of the biggest shifts of wealth from the former to the latter in recent history.

Interest rates in the emerging market space will soar as capital flows head singularly to safe harbor vehicles - particularly dollar-based assets. Local currencies will plunge as will purchasing power, grinding much of economic growth to a standstill. Meanwhile, the poor here in the US are forced to pay proportionately more for such basic items like imported food, clothes and energy as income disparity ratchets higher.

In essence, DBCFT is a cross-the-board tariff on foreign goods that supersedes the rule making bodies of international trade organizations and free-trade pacts like WTO, NAFTA or any other free-trade agreement inked by the US in the post-WWII period. The impact on retailers that import their goods will be singular. For many, the estimated 20% border adjustment and the inability to deduct import or interest costs will push business models beyond the pale of viability as currently construed.

The impact over time would necessitate the resourcing of goods manufacturing to US shores, which is likely the long-term goal of the legislation. Yet such investment decisions will take time - years to decades before full implementation. In the short and medium term, retail business models dependent on foreign sourcing for the goods they sell will likely not survive the transitionary period.

The Market

Some of the biggest names in US retail including Sears (NASDAQ:SHLD), Macy's (NYSE:M), Kohl's (NYSE:KSS) and Barnes & Noble (NYSE:BKS) reported weak sales during the important holiday shopping period, dealing a blow to the nascent recovery in investor sentiment towards the sector. Shares of Macy's fell 14.3% and Kohl's were knocked back 18% in the first week of January after the companies' sales dropped more than expected in November and December.

Both stores cut earnings forecasts. Macy's announced the layoff of as many as 10,000 workers. The disappointing performance at Macy's and Kohl's came despite the easiest compares since the recession: lean inventory, favorable weather and two extra shopping days.

The malaise was further underscored by Sears, which announced plans to shut another 150 stores or 10% of its total same store sales at Sears, and Kmart fell 12-13% during December. Sears is selling its Craftsman line to Stanley Black & Decker for about $900 million. The bad news spread to Barnes & Noble as same store sales fell 9.1% during the holiday season, prompting its shares to drop 6.8%.

In the meantime, on-line sales rose 11% in 2016, led in large part by Amazon (NASDAQ:AMZN), which is projected to surpass the sales volume of Macy's as the number one retailer of apparel by the end of the year. Macy's, a bricks-and-mortar department store that has been selling apparel for the past 158 years is about to be upstaged by a company whose humble beginnings trace back to an on-line Seattle-based book purveyor founded in 1994.

Amazon was also largely responsible for the demise of Borders Bookstores and a host of other smaller bookstore chains whose bricks-and-mortar business model simply could not keep pace with the efficiencies of on-line shopping and delivery model perfected by Amazon, now the western world's largest on-line retailer. Barnes & Noble still stands but continues to bleed as its most recent holiday tally amply demonstrates.

Amazon has now turned its sights on the $50 billion do-it-yourself auto parts market, The company has signed contracts with a host of major auto parts distributors and currently lists auto parts on its website, complementing its Amazon Vehicles section of its website launched last year that delivers research to consumers on buying new and used cars. As in its past retail forays, Amazon appears willing to play the long-game by following its highly successful market penetrating strategy of old complete with heavily discounted parts, prompt delivery and patiently but relentlessly gathering market share.

Profits, as always, are low on its list of priorities over the short and medium term. The company expects a 5% market share in the do-it-yourself market by year's end. There is little in Amazon's history to doubt such an eventuality.

ORLY has fallen 6.6% since the beginning of the year while AZO and AAP have fallen 6.42% and 3.84%, respectively.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.