Now that the U.S. seems to be in a recession, we need to be thinking creatively about which industries will hold up the best, and which ones may continue growing earnings and profiting from new trends. (Speaking of recession, don't miss The Impact Of Recession On Businesses.)
When "recession investing" themes come to mind, budget-minded names like Wal-Mart (NYSE:WMT), Family Dollar Stores (NYSE:FDO) and Dollar Tree (Nasdaq:DLTR) are often tossed around as good beneficiaries of weak consumers. To be sure, all three of these stocks are positive for the year, quite the rarity as we know all too well.
Another industry with interesting prospects going forward is retail auto parts. We all know these places, even if most of us only visit sporadically, typically in a frenzy over a cracked headlight or dead car battery. When discretionary income is tight, many people forego big ticket items, and a new car is right at the top of that list. This recession is also marked by extremely inactive and weak credit markets. As a result, even people with stellar credit are finding it hard to get auto loans, and the availability for median-level credit scores is somewhere between low and zero. The auto industry is in a well-publicized and nasty downturn as evidenced by U.S. auto sales declining by a staggering 30% in recent months.
Auto Parts' "Big Three"
The competitive landscape in this industry is defined by three large players - AutoZone (NYSE:AZO), Advance Auto Parts (NYSE:AAP) and O'Reilly Automotive (Nasdaq:ORLY). All three have more than 3,000 locations nationwide, and together they control greater than 40% of the market.
In addition to low earnings multiples and a strong value proposition in a recessionary economy, the auto parts retailers should also benefit from falling gas prices. The fall in crude has so far outpaced the drop in retail gasoline, but the price of the latter is still down more than 50 cents per gallon at the pump. These retailers love to see more miles driven, as it leads to increased wear and tear on our vehicles.
O'Reilly A Standout
Of the three leading companies, I see O'Reilly as the standout operator. While AutoZone and Advance have higher gross margins, O'Reilly has the higher internal growth (19% annualized since 1995) and a much lower price-to-book ratio (1.44) and debt/equity ratio (.044) than the other two. In a market where balance sheet strength is paramount, metrics like these become more valuable than even earnings multiples. (Looking for a good read? See Digging Into Book Value.)
While the other two engaged in costly expansions and added to debt levels, O'Reilly went out and made a wonderfully strategic, all-cash buy of CSK Auto last spring. CSK's West Coast footprint is an ideal fit for previously Southeast- and Midwest-focused O'Reilly. The acquisition brings the potential for dramatic financial improvements to CSK, which generated a low 6% EBITDA margin in 2007.
By contrast, O'Reilly generated a much higher 16% EBITDA margin and stated in the most recent conference call that cost savings could be as high as $100 million starting in 2010.
Sales Growth Justifies Share Premium
Same-store sales are forecasted to be in the 2-4% range going forward, but results could be flat for the remainder of 2008 as comps at the CSK stores were running negative so far this year. Next year's earnings forecast calls for $2.03 per share, or a 15% increase over this year's EPS forecast. O'Reilly shares trade at a current P/E of 12 times, a bit of a premium to Advance and AutoZone's 10-times multiples.
The premium does seem justified given that AutoZone reported just 0.6% same-store sales last quarter, while Advance Auto has already warned on profits for the latest quarter and is forecasting flat to negative comps. O'Reilly generated 3.4% comps (excluding CSK stores) in Q2 and is set to report earnings October 29.
These are murky times, and finding clarity requires a little faith in fundamentals and some affection for staid businesses that we simply can't do without. These stocks don't pay dividends, and most investors should be overweighting toward companies that are returning cash to shareholders. But given the low earnings valuations and potential to benefit from purchase-deferring trends, I like the industry's prospects - and I can't say that for many.
As a final parting thought, this group of three companies outperformed the S&P 500 by greater than 50% during the last recession in 2001-02. In this case, history repeating itself could be a great thing for shareholders.
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