Achieve Double Digit Gains From Aging Cars

Ken is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

No matter what the current economic conditions are, there is virtually always some segment of the business community that will be able to benefit from it. When the economy is bad and consumers are fearful, they will take actions to defer major expenses into the future and save their money to pay existing bills.

The decision to purchase a new car is an easy one to postpone, as it is almost always less expensive to fix up an existing car than to make the down payment on a new one, and add a higher monthly payment to the existing bills.

How to find profits from older cars

When consumers postpone the purchase of a new vehicle, there tends to be an increase in the basic maintenance cost of the existing vehicle. While most of us can’t perform any significant work on our vehicles anymore, there are a lot of tasks that we can perform and some that the employees at the local auto parts store will perform for us. If people are going to be spending more money maintaining their vehicles, then they will have to purchase the supplies required to do so.

Buying shares of retail auto parts businesses is the automotive equivalent of buying shares of Home Depot because you believe people will take care of their homes. Automobiles are the second largest capital investment made by most people, and they will take care of it accordingly. AutoZone (NYSE: AZO), O’Reilly Automotive (NASDAQ: ORLY), Advance Auto Parts (NYSE: AAP) and The Pep Boys - Manny, Moe & Jack (NYSE: PBY) are four of the publicly traded companies that sell auto parts directly to consumers in the secondary retail market.

As consumers hold their cars for longer periods of time, the sales and profits recognized by these businesses will inevitably rise. However, as always, it is imperative for investors to analyze the businesses that participate within this sector, and invest only in those that present the best combination of fair current value and future growth prospects.

Is there opportunity in the sector?

Pep Boys is a widely recognized brand and advertises quite heavily. Unfortunately, over the last five years, all of those advertising dollars have resulted in a dismal 0.45% annual decrease in sales volume. To compound the poor sales growth numbers, the five year returns on assets and capital have been a meager 1% and 1.5%, respectively.

When these numbers are coupled with a razor thin average net margin of 0.7% for the last five years, until such time as there is solid evidence of improvement, it will be very difficult to justify allocating capital here.

Advance Auto Parts is where I do most of the shopping for my own automotive needs as there is a location that is very convenient for me. However, shopping there and buying the stock are two very different things.

Overall, Advance represents a much better value than Pep Boys. It is trading at a multiple of 13.25 times its projected 2014 earnings, has a 5-year average projected earnings growth rate of 11.1%, and a very reasonable price to cash flow multiple of 10.3. With net margins averaging 5.7% for the last five years, and 5-year average returns on assets and capital of 9.8% and 20.5%, respectively, management seems to be doing a good job of managing the business and allocating investors’ capital. However, investing is about isolating the best opportunity in a market segment, not just a good one.

A step above the reasonable value to be found in Advance is O’Reilly Automotive. Its average net margins over the past five years are 7.8%, 2.1% better than those achieved by Advance, and its projected five-year earnings growth rate is 16.7% against a current price multiple of 15.38 times 2014 earnings.

So, it is growing faster than Advance and carries a lower PEG ratio as well. The five-year ROA and ROC at 8.5% and 11.8% are not as strong as Advance, and these are important numbers in retail as they reflect how effectively management is reinvesting shareholders’ money in the business. O’Reilly is a better value than Advance; but we need to isolate the best investment opportunity in the sector.

Saving the best for last

AutoZone is the final subject of this evaluation of auto parts stores, and I really did save the best for last. Currently, AutoZone trades at a 12.42 multiple of its 2014 projected earnings and carries a 5-year projected earnings growth rate of 15.8% per year; the lowest PEG of the group.

Over the last five years, AutoZone has also provided the highest annualized return on assets and capital at 13.9% and 29.7%, respectively. As if to add some extra icing to the cake, the 5-year average net margins for AutoZone have also been the highest of the four at 10.2%.

Sporting a very reasonable price to cash flow multiple of 10.2 is just one more bit of evidence as to the superior value of this business within this sector. This is a business that is well run and represents exceptional value, not only within its own industry segment but within the overall market as well.

A Foolish conclusion 

It is always important to remember that opportunities are finite but the capital of individual investors is not. Therefore, it is incumbent upon us to allocate that capital with the greatest of care to the top opportunities in a sector. Through this practice, we can build a diverse portfolio spread across a selection of the best businesses in each market sector. AutoZone presents a very strong case, as it meets that criteria in the retail segment of the automotive parts business.

Ken McGaha has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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