Auto Parts In Gear

By Matt Cavallaro | January 11, 2012 AAA

There's strong evidence that the auto industry is being revitalized. Investors that want to go along for the ride, but are concerned about a possible head fake, should consider the red hot auto parts supply industry. (For related reading, see Analyzing Auto Stocks.)

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Auto Sales Accelerate
Just a few years ago, the auto industry crashed. Fueled in part by a government bailout, the industry returned to profitability in 2010. Then, last year, General Motors Company (NYSE:GM), Ford Motor Company (NYSE:F) and Chrysler all had strong sales growth, highlighted by a back end surge. The combination of pent up demand and low interest rates helped October, November and December become the strongest auto sales months of 2011. Now, automakers are ramping up production as 2012 is expected to start out strong as well.

There are several macro factors to support the apparent auto recovery. First, actual employment is improving. Friday's labor report revealed the real unemployment rate fell to 8.5%. Tangible jobless reductions are needed for any type of sustained momentum. Second, consumer sentiment is on the rise. The Conference Board's December consumer confidence index revealed an overwhelming rebound in sentiment. Buying a car is a big purchase, requiring some level of confidence about the future. Perhaps most importantly, interest rates continue to hover near historic lows, facilitating the purchase of new vehicles to those with access to credit. (For additional information, read Understanding The Consumer Confidence Index.)

Auto Parts Go Both Ways
It should be noted that, despite the improving landscape, the auto market isn't anywhere close to pre-recession levels. Still, the trajectory is clearly up. The parts supply industry is uniquely positioned to benefit from both a potential boon in vehicle sales, in addition to a continuation of consumers hoping to keep extending the lives of their old cars.

This reality has actually been playing out for quite a while. Over the past year, AutoZone, Inc. (NYSE:AZO), O'Reilly Automotive, Inc. (Nasdaq:ORLY) and Advance Auto Parts (NYSE:AAP) are up approximately 35, 41 and 15% over the past year. Automaker investors haven't seen anywhere near those types of returns. Looking further back, while General Motors was fighting to emerge from bankruptcy and shares of Ford hit their nadir in late 2008, auto supply companies saw relatively moderate losses. Consumers with budgets stretched thin by chronically high unemployment and flat wages sought to extend the life of their automobiles. For this reason, investors supported the auto parts supplier industry.

Auto parts suppliers are still cashing in though. AutoZone, for example, posted another great quarter to begin their fiscal 2012 year. Gross profits jumped around 8%, compared with the year-ago period. Results smashed expectations as net sales increased about 10% to around $1.92 billion. (For related reading, see A Look At Corporate Profit Margins.)

The Bottom Line
Results from the other auto parts suppliers have been mostly solid, too. However, there are a few reasons to be concerned, broadly speaking, about the group. Near-term, the current quarter is impacted by volatile seasonality. Looking further out, the dramatic slowdown in new vehicle sales that occurred over the past few years, in addition to the trend of fewer cars on the road and less miles being driven, could impact business in a few years. A decrease in driving translates to less wear and tear. That will reduce the number of failures and maintenance needed down the road. This could be troublesome, yet it is still a ways out.

There are also issues specific to each name. Sticking with AutoZone, the issue is a very heavy balance sheet, featuring a huge debt load and a fractional cash holding of just about $96.7 million. The company is issuing a lot of paper to fund expansion, along with a share repurchase plan that might be taking place at relatively high share prices. The counter is that AutoZone's strong operating cash flow and commitment to increasing an already enviable return on invested capital masks the leverage concern.

Auto parts companies are simply too well positioned for the momentum to slow. There's not much yield to be found here, but the fragmented environment provides plenty of room for capital appreciation potential. Look for auto part retailers to springboard off strong auto sales at the year's outset. (To learn more, read The Industry Handbook: Automobiles.)

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At the time of writing, Matt Cavallaro did not own shares in any of the companies mentioned in this article.

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