Should You Get in the Zone (the Auto One)?

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

America has a long-running love affair with the automobile. Contrary to popular belief, Henry Ford was not the inventor of the automobile. French inventor, Nicolas-Joseph Cugnot, is credited with that honor. In 1769, his bulky steam-powered contraption toured the streets of Paris at a maximum speed of 2.5 miles per hour.

The first automobile powered by an internal combustion engine was patented in Germany in 1885 by Karl Benz, the eponymous founder of Mercedes-Benz (now a division of  Daimler AG).  

Petty details aside, there aren't many countries on Earth that exhibit such a passionate fondness for cars as the U.S.A. When thinking about investing in the automotive industry, major car makers like Ford, General Motors, or Toyota probably pop into the minds of most people.

But, I want to shed some light on another group of companies, the ones that provide products and services to keep your automobile in tip-top shape after you've driven it off the lot.

In case you didn't know

The title of this article was a reference to the motto of AutoZone (NYSE: AZO). The zone I'm referring to encompasses retailers of aftermarket automotive parts. AutoZone is the largest company in that line of business. Aftermarket automotive parts include nearly everything you need to maintain your vehicle, from engine parts to antifreeze.

The second largest company in the field is O'Reilly Automotive (NASDAQ: ORLY). Two other companies also worth comparing to AutoZone are Advance Auto Parts (NYSE: AAP) and Pep Boys (NYSE: PBY).

Now that we have an idea of who the major players are, let's take a look at some data to see if this zone is a worthy place to park our capital.

How strong are the balance sheets?

One of the first places I go when examining any company is the balance sheet. That snapshot of a company's financial situation can sometimes tell me immediately if the company will make a good investment. For example, if current assets exceed total liabilities by an amount substantially above the company's market cap, investments like that are usually good ones, provided no malfeasance is present. 

On the other hand, the balance sheet can also provide warning signs that maybe this isn't a company you should be considering. Serious dilution of shareholder value, excessive debt load, or negative shareholder's equity are examples of potential red flags.

<table> <tbody> <tr> <td> </td> <td>AutoZone</td> <td>O'Reilly</td> <td>Advance Auto Parts</td> <td>Pep Boys</td> </tr> <tr> <td>Shareholder's Equity</td> <td>$-1.53 billion</td> <td>$2.07 billion</td> <td>    $1.27 billion</td> <td>$542.4 million</td> </tr> <tr> <td>Equity 5-year CAGR:</td> <td>     N/A</td> <td>  4.65%</td> <td>       5.6%</td> <td>    2.75%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Working Capital:</td> <td>$-657.73 million</td> <td>$392.17 million</td> <td>   $538.73 million</td> <td>$138.15 million</td> </tr> <tr> <td>As a % of Market Cap:</td> <td>     N/A</td> <td>     3%</td> <td>         9%</td> <td>    20.9%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Price/Tangible Book Ratio:</td> <td>    -8.03</td> <td>    9.96</td> <td>         5.97</td> <td>     1.32</td> </tr> </tbody> </table>

Taking a look at this data leads me to conclude that AutoZone is not worth investing in because the company has a weak balance sheet. Dang, I really did like the company's motto, though.

It looks like there aren't any working capital bargains to be found here either. Pep Boys comes closest, with working capital equal to approximately one-fifth of its market cap. But, that's far from bargain territory.

Examining income statements

The only thing I found out from looking at the balance sheets of these companies is that AutoZone is not right for me. But, do any of the remaining companies make for a good investment? Taking a look at information contained on, and derived from, the income statements will put me in a better position to answer that question.

<table> <tbody> <tr> <td> </td> <td>  O'Reilly</td> <td> <p>Advance Auto Parts</p> </td> <td>Pep Boys*</td> </tr> <tr> <td>Net Income 2012:</td> <td>$585.75 million</td> <td>       $387.67 million</td> <td> $12.81 million</td> </tr> <tr> <td>Net Income (avg 2009-2011):</td> <td> $411.5 million</td> <td>       $337 million</td> <td> $29.52 million</td> </tr> <tr> <td>Net Income (avg 2006-2008)</td> <td> $186.1 million</td> <td>       $234.7 million</td> <td> $-24.7 million</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Net Profit Margin (TTM):</td> <td>     9.5%</td> <td>           6%</td> <td>     0.7%</td> </tr> <tr> <td>Net Profit Margin (5-year avg):</td> <td>     7.8%</td> <td>           5.7%</td> <td>     0.7%</td> </tr> <tr> <td> </td> <td> </td> <td> </td> <td> </td> </tr> <tr> <td>Return on Equity (TTM):</td> <td>    23.97</td> <td>          33.36</td> <td>     3.04</td> </tr> <tr> <td>Return on Equity (5-year avg):</td> <td>    15.97</td> <td>          30.42</td> <td>     3.18</td> </tr> </tbody> </table>

*The fiscal year for Pep Boys ends at the end of January. The company has already reported 2013 results. Therefore the years in the leftmost column are off by one (2012 results are actually 2013, 2009-2011 ratio is actually 2010-2012, etc.)

Pep Boys has not reported an earnings deficit in any of the past four years. But, if you examine data that stretches back a decade, you will notice that net income was negative for Pep Boys 50% of the time. Margins and ROE look weak too, so I would avoid investing in Pep Boys.

Final foolish thoughts

Investors with a love for all things automotive will, no doubt, want to own stocks that have to do with cars. Major automobile manufacturers are the obvious choices, but there are also several companies to consider in the field of aftermarket auto parts.

Some companies in the space seem better than others. I dismissed AutoZone because of its weak balance sheet, and Pep Boys had margins and earnings that simply weren't up to snuff. That leaves O'Reilly and Advance Auto Parts. In terms of balance sheet strength, I give the edge to Advance Auto Parts. However, O'Reilly has been growing net income at a faster rate. 

Both of these companies seem solid, but I like Advance Auto Parts more. It's market cap is less than half of O'Reilly's giving it more room to grow. Additionally it's cheaper on a tangible book value basis, and the company has an impressive five-year average return on equity of over 30%.

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Fool blogger Ryan Palmer has no position in any of the stocks mentioned. The Motley Fool owns shares of O'Reilly automotive. 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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