Americans’ gradual release from COVID-19-related immurement has led auto-part retailers’ sales to stem what had been double-digit comparable slides at the pandemic’s spring peak, allowing their long-term strengths to re-emerge. While plummeting miles driven has pressured sales, we do not expect the strain to last and think the industry is better positioned than most brick-and-mortar retail sectors for the long term. The current situation should favor sales to customers repairing their own vehicles (do it yourself) rather than the professional (do it for me) sector, as motorists rein in costs and garages grapple with social distancing and localized second-wave restrictions, but we expect the reverse will hold long term due to rising vehicle complexity and the time demands on consumers.
AutoZone (AZO), Genuine Parts (GPC), and O’Reilly Automotive (ORLY) all trade above our fair value estimates, while Advance Auto Parts (AAP) is a more attractive opportunity, trading at a discount. With a long turnaround paying off but injecting more volatility into the present unsettled environment, we see Advance Auto Parts increasing operating margins to the low double digits over the next five years (from 8% in 2019), with near- and long-term benefits from its DIY-related optimization efforts, including a partnership with Walmart, a revamped loyalty program, and its late-2019 purchase of DieHard.
Not Much Has Historically Upended Component Retailers’ Performance
With the COVID-19 pandemic triggering a sharp recession and shelter-in-place orders keeping cars and trucks off the road, auto-part retailers find themselves in a markedly different environment than the generally favorable conditions that existed before the outbreak. Although a mild winter depressed pre-pandemic sales in seasonally influenced categories (such as undercar components and batteries), domestic comparable sales were generally up by a low- to mid-single-digit percentage before March. The chains we cover generally did not shut down stores (though hours were reduced), but dramatic traffic declines in both the do-it-yourself and do-it-for-me segments led to comparable sales falling by a mid- to high-20s percentage during the worst week of the spring.
With the economy reopening, the part retailers face a recessionary environment that has not been particularly problematic for sellers in the past. With reticent consumers less likely to replace aging vehicles with new cars and trucks, the chains have a solid record of performance in challenged economies. As newer vehicles covered by manufacturer warranties are usually repaired by dealerships using OEM parts (and recently out-of-warranty cars and trucks are generally still fairly reliable and not in need of significant repairs), keeping older stock on the road is a benefit to the aftermarket component retailers. Vehicles’ average repair costs are highest in years 8-12 of their life. Furthermore, automotive market research firm IMR estimates that in 2019, more than 80% of DIFM repairs for this vehicle age cohort were completed in the aftermarket rather than at dealerships.
While O’Reilly and Advance have undergone significant merger and acquisition-driven expansion since the 2008-09 recession, more-stable AutoZone and Genuine Parts offer some indication of industry performance in poor economic conditions, with both chains posting strong sales relative to GDP in 2008 and 2009. With AutoZone’s sales skewed heavily toward the DIY sector (nearly 90% of its sales at the time) and Genuine Parts favoring DIFM (around 75%), the chains’ performance shows the broader industry’s strength.
The long-term drivers of industry performance remain miles driven growth and average vehicle age. The widespread reduction in vehicle use while shelter-in-place orders were effective is unprecedented and is a sales headwind. Still, pullbacks in years past can be instructive as traffic rebounds with an opening economy. As certain car parts (such as batteries) degrade as the vehicle is stored, even idle cars and trucks develop repair needs.
The total number of miles driven (on a trailing 12-month basis) in the United States has expanded over the last few decades, with prior pullbacks happening in 2008-10 and 2011-12. Despite the miles driven contractions, the retailers we cover generally posted solid results in the years of pullbacks and those that followed. While the magnitude of the pandemic-related slowdown is unprecedented, historical data suggests the industry has proved fairly robust, with sales merely delayed as repair needs are deferred. Additionally, although a mild winter is a 2020 headwind, the pandemic unfolded after the critical winter months and before the summer (extreme weather and precipitation elevate and accelerate repair needs), so the brunt of shelter-in-place orders fell in a season with more limited implications on subsequent quarters’ performance.
Miles driven should remain depressed against prior-year totals until the worst of the spring’s marks are lapped in 2021 (though with overall numbers still below trend), with shelter-in-place orders giving way to continued voluntary and involuntary social distancing practices that should leave many Americans working or learning from home. As of June 2020, cumulative travel (in vehicle miles) was down 17% for the year. The slide has moderated as the economy reopens, a trend that we expect to continue through the rest of the year, with complete recovery likely coming after a vaccine emerges.
The current situation is unprecedented for the part retailers, and the pullback in miles driven should push some sales outward. However, Advance, AutoZone, Genuine Parts, and O’Reilly cater to generally lower-income customers who have far fewer telework options, limiting the impact. The typical DIY shopper who frequents the chains is not an enthusiast or hobbyist but is instead merely looking to save on labor costs for an older, generally widely available vehicle. Similarly, the chains’ core mechanic clients cater to somewhat better-off motorists that nonetheless have out-of-warranty cars and trucks (again generally from among widely available, accessible makes and models). Recent polling data suggests significant differences between work-from-home rates during the pandemic depending on education level, which we believe can be used as a rough proxy for income. This should insulate part retailers somewhat from nationwide declines in miles driven, as vehicles outside of their core market are more likely to be idled.
Other long-term industry fundamentals remain strong. The average age of vehicles in the U.S. has risen consistently over the last several years, in conditions as varied as a strong pre-pandemic economy and a recession-induced cash-for-clunkers scheme in 2009 that encouraged Americans to trade in their old cars and trucks. We do not expect the dynamic, which we believe is fueled by increasing vehicle reliability (and also extending the window in which it makes financial sense for a motorist to repair rather than replace a vehicle, also boosting part retailers), to change materially. Additionally, low fuel prices should serve to bolster motoring while easing some of the pandemic’s discretionary income burden (though with reduced impact, as pre-pandemic fuel prices were not onerous).
Also, the parts retailers’ core vehicle age cohort corresponds to increasingly strong years for new vehicle sales, with larger model years aging into the sellers’ wheelhouse. We believe this suggests the flow of cars and trucks entering the part retailers’ crosshairs is strong and will remain a tailwind for roughly another six years.
DIY Should Continue to Lead the Way
After the pandemic took hold, the sector saw stronger sales in the DIY channel than in the professional segment, a trend we expect to continue. For example, O’Reilly’s comparable sales grew 16%, while Genuine Parts’ U.S. automotive unit saw a 14% decline; around 60% of the former’s sales come from DIY, versus only around 20% for the latter. We were not surprised by the relative performance, with customers looking to save on labor costs, several repair shops closed on account of the pandemic, and many motorists left with an unexpected surplus of idle time that could be used to complete a repair.
The dynamic is not new. In the recession of 2008-09, the DIY sector generally led the professional segment. And we expect the past dynamic to hold, with DIY continuing to outperform DIFM for the rest of the year. With the pandemic significantly increasing unemployment and depleting savings for motorists who experienced furloughs or layoffs, we expect meaningful continued pressure on customer pocketbooks. While this should postpone some DIY sales in more discretionary categories like car care and mobile accessories, the pressure on DIFM transactions should be more significant. For a sense of scale, only around 15% of AutoZone’s auto-part sales come from discretionary categories. Although the commercial segment’s limited need for such items and AutoZone’s relatively modest share of professional sales mean the DIY sector’s discretionary exposure is likely closer to 20%, products in such categories are also fairly widely available at general merchandise stores and online, and so we suspect they are less lucrative than failure-related parts and most maintenance items as a result.
We are not perturbed by the prospect of rising digital DIY sales amid the pandemic. We have long argued that the sector is well protected from the digitization of retail. With customers dependent on trained in-store personnel for advice, including diagnostic support, part identification, and basic installation assistance, we are not surprised that digital orders only accounted for a low- to mid-single-digit share of sector DIY sales in the most recently completed quarter. Furthermore, the stronger relative popularity of buy online/pick up in store options relative to delivery is consistent with our thesis, as a purchase completed at a physical location gives customers access to the advice and services offered.
We expect all the auto-part retailers we cover to outperform the industry, part of a longstanding but gradual consolidation that is independent of the pandemic. As the industry has considerable fixed costs associated with operating distribution networks that can meet DIFM clients’ onerous speed of delivery demands (with order-to-delivery windows of as little as 15-20 minutes for many categories), maintaining broad inventories of slow-turning parts, and offering a strong DIY service proposition alongside a range of branded and unbranded components, we see significant opportunities for the scaled, national chains to gain share at the expense of the independent and regional sellers that we suspect compose 65%-75% of the market.
We assume a low- to mid-single-digit percentage uptick for the DIY segment at large and a mid- to high-single-digit swoon for DIFM in 2020. Our expectations stand in contrast to fairly flat sales in 2019 and mid-single-digit annual percentage growth for both sectors over the last five years. Our forecast assumes that miles driven recovers in the second half as motorists return to work and school, but subsequent waves of infection could spur a reversal. Our marks consider the scaled retailers’ performance in their most recently concluded quarter, including 16% comparable sales growth for O’Reilly, 8% expansion for Advance (which garners about 40% of its sales from the DIY segment), and considerably more challenged results for commercial-heavy Genuine Parts’ U.S. unit (AutoZone has yet to report results for a comparable period). We expect improving results for the industry (relative to the spring) through the middle of the year, though increasing case counts combined with the fall flu season could result in new restrictions in certain parts of the country.
Our expectations for the industry at large assume that U.S. GDP declines by 5% in 2020, with the differential between the two segments reflecting the mix shift we expect between DIY and DIFM. We anticipate that the mix shift (which we estimate to be approximately 10 points) will be somewhat larger than the roughly 3.5-point change seen in the 2008-09 recession, spurred by unprecedented shelter-in-place orders and social distancing mandates during the spring as well as sharply higher unemployment, but offset to some extent by increased vehicle complexity since the prior downturn.
Unfavorable backdrop aside, we expect the chains to gain market share as they pick up sales from smaller competitors that are either forced to close entirely or lack the sourcing strength needed to navigate challenging supply conditions during the pandemic. The share gains continue a long-standing consolidation trend that we expect to persist post-pandemic, with retailers that can leverage distribution and inventory investments better suited to address the short order-to-delivery windows needed in the professional segment and with scaled sellers better able to economically provide value-added services for DIY customers (including advice from trained sales professionals, basic diagnostic and installation services, and a wide range of parts available on demand across a spectrum of branded and private-label components). For each of the firms, we expect a 2021 recovery as a vaccine and improved treatment options return American life to something near the prior normal, with greater long-term remote work affecting higher-income demographics more than the chains’ core customers. We believe the pandemic gives advantage to scaled retailers’ supply chain flexibility, distribution breadth, and resources, which can cover costs imposed by heightened store sanitation requirements as well as temporary lockdown-related sales declines in various markets.
Our longer-term assessment of the industry’s growth prospects is unchanged from before the pandemic. With rising vehicle complexity making it more difficult for the average motorist to perform even basic repair and maintenance tasks, we suspect the DIFM segment will grow faster than DIY over the decade ahead, with the overall industry expanding at a similar low-single-digit rate as U.S. GDP.
The growth differential carries margin implications. While the DIFM segment is faster growing, DIY sales are more lucrative (to the tune of 300-500 basis points in gross margin on average, by our estimate). Consequently, despite the slower DIY growth, we believe a balance between the two segments is critical to retail success, maximizing leverage over distribution costs and increasing the opportunities to sell inventories of slow-turning parts that must nonetheless be available virtually on-demand (prospects further improved by centralizing less commonly sold items in distribution centers and hub stores called upon by several smaller locations, an advantage for scaled national sellers). Our expectations for the industry are somewhat lower than our top-line growth targets for the scaled retailers. However, with DIY revenue related in large part to location (as customers favor proximity when a problem occurs for diagnostic and repair support) and DIFM sales dependent on trust-based, long-standing client relationships, we expect the national retailers’ distinct economic and service advantages over smaller regional and independent sellers to manifest themselves in only gradual long-term market share gains.