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Auto Parts Business Springs a Leak

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

The retail auto parts business has enjoyed success over the past few years, as the financial crisis led people to hold on to their cars longer and purchase more maintenance services to increase their vehicle's performance.  The business also consolidated significantly with the advent of national chains, including the big four of AutoZone (NYSE: AZO), Advance Auto Parts (NYSE: AAP), O’Reilly Automotive (NASDAQ: ORLY), and Pep Boys (NYSE: PBY).  These four giants reported $22.6 billion in combined revenues in their latest fiscal years and represented over half of the industry’s total sales.  The net result of the consolidation activity has been a general increase in operating margins, as the chains are able to use their national distribution networks to efficiently supply customers with thousands of products at cheaper prices than their local competitors.

In 2012, the federal government’s continued support of new vehicle production through ultra-low interest rates has crimped the industry’s growth.  According to the NADA, annualized U.S. sales of new vehicles have rebounded to approximately 14.8 million this year from 12.8 million in 2011, an increase of 15%.  The fairly consistent cash flow characteristics of the business, though, have led private equity firms to engage in discussions for potential leveraged buyouts.  Two potential deals, for Advance Auto Parts and Pep Boys, were promising, but failed to be completed due to changing expectations about future growth.

How are Manny, Moe, and Jack?

Founded in 1921 by four buddies, Pep Boys offers parts, accessories, and service through a national chain of 738 stores.  Despite growing its store count by 31% over the last four fiscal years, revenues fell by 3.4% during the period.  Lately, the company has tried to differentiate itself by focusing on the service business, roughly 20% of annual revenues, and by opening smaller stores.  In its latest fiscal year, Pep Boys reported sales growth of 3.8%, but operating income fell 20.6% versus the prior year.  While merchandise profit margins were stable, service profit margins fell sharply due to a higher percentage of low margin business, like oil changes and tire purchases.

In 2012, Pep Boys’ profit margin compression has continued, leading it to scale back its pace of store openings.  For the first nine months of FY2012, revenues were flat, but adjusted operating income declined 43.8% compared to the prior year period.  The company suffered from less efficient stores, as same stores sales dropped 1.8% and customers continued to opt for basic, low-cost maintenance services.  Private equity was wise to let this deal go.

What About Advance Auto?

This auto parts retailer posted solid growth over the past four fiscal years, with increases in revenues and operating income of 26.3% and 59.6%, respectively.  Advance Auto has increasingly focused on the commercial supply business, through a network of over 200 Autopart International stores in the Northeast and Mid-Atlantic regions.  In its latest fiscal year, the company reported revenues and operating income of $6.1 billion and $664.6 million, increases of 10.3% and 13.6%, respectively, versus the prior year period.  Both gross and operating margins reached their highest levels of the past five years, as Advance Auto increased their store base and gained efficiencies in their distribution system.  The company used its strong cash flow to build more stores and buy back shares, with average outstanding shares declining 12% during the period.

In 2012, Advance Auto’s revenue growth has been flat, which is below its historical growth but in line with overall industry trends.  For the first nine months of FY2012, it reported revenue growth of 0.7%, while operating income fell 1.6% versus the prior year period.  Despite higher overall revenues from an additional 82 stores, same store sales fell 0.5% due to declining customer volumes and lower transaction prices.  While cash flow generation remains strong at the company, private equity couldn’t make this deal work at the premium price that management wanted.

Don’t Fight Uncle Sam

Where should investors look to find opportunities in the auto business?  Given the continued rebound in new vehicle sales, investors should be focused on diversified, growing dealer franchises.  One of the best positioned companies is Group 1 Automotive (NYSE: GPI).  After dipping into red ink during the financial crisis in 2008, the company has bounced back nicely alongside the domestic auto manufacturers.  In its latest fiscal year, Group 1 reported revenues and operating income of $6.1 billion and $193.5 million, increases of 10.4% and 32.4%, respectively, compared to the prior year.  Despite supply problems in Japan due to natural disasters, the company benefited from higher volumes and a 5.4% increase in average sales prices.

In the first nine of months of FY2012, Group 1 has continued to generate solid results, with increases in revenues and operating income of 24.3% and 28.1%, respectively, versus the prior year period.  The company sold roughly 26% more vehicles than in the prior year, and it also generated sales increases in its finance and parts businesses.  With its stock at a 14 P/E multiple at recent prices, Group 1 deserves a seat in investors’ portfolio.

rghanley owns shares of Advance Auto Parts. The Motley Fool has no positions in the stocks mentioned above. 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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