What’s Driving Growth in Retail?
When analyzing companies, we often look for signs of sustainable competitive advantages, ranging from persistent high returns on capital to long-term market leadership. However, doing so in the retail space can be difficult because of the proliferation of retail concepts and changing consumer tastes. Today’s popular retailers could become tomorrow’s bankrupt concepts. Despite these challenges, we’ve uncovered one bright spot in the retail landscape: auto aftermarket retailers.
Auto aftermarket retailers, such as Genuine Parts Company (NAPA), Advance Auto Parts, AutoZone and O’Reilly Automotive, distribute and sell parts for automotive repair and maintenance to both do-it-yourself (DIY) customers and professional do-it-for-me (DIFM) installers. Traditional car dealers own roughly one-third of the $280 billion auto aftermarket, with independent shops, wholesalers, distributors and retailers owning the majority. The parts channel is roughly a $100 billion retail market selling to DIY customers and professional installers. Today, the DIFM parts market is roughly twice the size of the DIY retail market and has grown more rapidly in recent years as customers are more frequently choosing to have professional mechanics tackle repairs as vehicles have become more complex.
What Drives Industry Demand?
Demand for auto parts is generally steady, but tends to increase during periods of economic uncertainty because car owners repair and maintain their vehicles rather than purchase new ones. This trend has played out in 2020, as auto aftermarket retailers saw record sales and financial performance in 2Q20 amid the pandemic. Routine car maintenance and some costly repairs can be deferred, so the overall health of the economy does matter for sales in the short term. The good news for the industry is that maintenance and repairs cannot be delayed forever. Other factors that impact demand are the age of cars on the road, miles driven, vehicle population growth, gas prices and weather. In short, the industry performs particularly well when gas prices are low and older cars are being driven a lot.
Parts availability is the key to success for aftermarket retailers, and a strong distribution system is an important competitive advantage. This has been especially true in recent years as the DIFM market has grown faster than the DIY market. Professional installers demand availability and speed when choosing a parts distributor, so a strong distribution system wins and keeps business. The four publicly traded retailers distribute parts to professional installers out of their retail store locations, and these stores rely on large distribution centers and hub stores to efficiently stock and move inventory to ensure the right part is in the right place at the right time.
Today, DIY customers often start their vehicle repair research online. How-to videos aid in diagnosis, and parts can be found online for purchase or price discovery. Because vehicles need to be repaired quickly and cost effectively, DIY customers often find internet purchase delivery options unacceptable. This problem is made worse if a parts mistake is made during diagnosis or ordering, so the convenient buy-online-and-pickup-in-store option provided by major auto parts retailers is becoming increasingly popular. Despite having a lot of parts and repair information available online, customers value the physical retail store and knowledgeable parts associates. Conversations with parts associates can identify needed parts or tools that were overlooked in online diagnosis, and retailers often have convenient loaner tools that save customers both time and money. While overall retail sales are migrating to the internet, auto parts retailers continue to show there is value in their retail store model.
Today, we own two auto aftermarket retailers: O’Reilly Automotive and Advance Auto Parts. O’Reilly has built a best-in-class distribution system and cultivated a customer-centric culture that has led to superior sales and market share growth. Over the last few years, the company has improved its website and recently added a curbside pickup option for online orders.
Our favorable industry outlook has given us the confidence to also invest in Advance Auto Parts, which is several years into a turnaround. The company has made investments that we believe will lead to better sales growth and margin improvement over the long term, including a same-day delivery service they introduced in select markets early in the pandemic. We expect this program to expand over time and believe this service will appeal to DIY customers with simple repair or maintenance jobs, such as battery replacements or oil changes.
Over the last few years, the market has provided opportunities to buy and add to our positions at attractive discounts to our estimates of intrinsic value. Market concerns have ranged from unfavorable weather to COVID-19, and in every situation we maintained our long-term belief that demand would normalize and sales would improve. We are aware that future challenges are likely to arise from the adoption of electric vehicles and autonomous public transportation, and we monitor those developments closely. Fully electric vehicles will likely have fewer, but potentially more expensive, parts to repair than internal combustion engine vehicles, and autonomous public transportation could be damaging as the auto parts aftermarket depends on individual car ownership. We believe that the impact from new technology will be slow to materialize and that looming threats could provide our holdings opportunities to further consolidate the industry to enhance shareholder value.
As of 8/31/20, Diamond Hill owned Advance Auto Parts, Inc. (equity) and O’Reilly Automotive, Inc (equity).
The views expressed are those of the research analyst as of September 2020, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.