On solid footing

The recessionary environment has actually helped retailers in the short-term, believes Jon Vander Ark, a consultant with McKinsey & Co.’s Automotive and Assembly Sector.

“In quarter over quarter reports of retailers, they’ve actually been up. As people stop buying cars and are driving their cars longer, they end up being in the sweet spot for automotive repair,” he says.

The stability and performance of the manufacturing sector depends heavily on the kind of product lines they offer, believes Smith.

However, “We’ve seen some that are off by 50 percent. It seems that a lot of the higher-priced point items have been suffering. Truck accessories have fared the worst, generally speaking, over the last year and a half. Manufacturers are really kind of a hodgepodge, but most of them are not down as much as others.”

“You look at a quarterly statement, something from O’Reilly, Advance, etc., where same store sales are up double digits, while a manufacturer is not making that much money on the product,” says Spivey. “They are up 10 to 20 percent, but not up nearly as much as the companies selling their products.”

Spivey adds: “A lot of the manufacturers have sort of become distributors. It used to be that products were made in U.S. factories and now the products are made in China. What used to be a manufacturing company is now a marketing company that takes advantage of lower costs overseas.”
Distributors haven’t fared as well as the retailers and some of the manufacturers, according to industry insiders.

But some distribution leaders such as NAPA and CARQUEST “have capitalized on the weakness of their competitors’ balance sheets and inefficient distribution channels,” says Angelo Onello II, principal for Onello Associates.

Each channel has its own value and opportunities, says Jonathan Carey, vice president of BB&T Capital Markets.

“Each individual company will have its own unique characteristics that will dictate value, and we see opportunities in most of the aftermarket segments,” he says.

“For example, we really like the service sector. It is a $170 billion market (including parts and labor) and is still extremely fragmented. Companies like Monro, Firestone, Meineke and Midas are some of the largest players in undercar service and maintenance, but combined their market share is still not commanding, meaning they and other strong service chains have an opportunity to continue to take share organically and through acquisition.”

Carey adds, “Moving downstream from the professional installers, the distributors that service this market will benefit from a rising tide. However, those distributors with appropriate overhead structures to serve the professional installer may benefit most, as will certain specialty distributors that can offer superior service and pricing for niche markets.”

Spivey notes some of the nuances one would encounter when moving to different parts of the distribution channel.

“It seems that the farther you move down the channel the more power that you have,” he says. “The manufacturer makes very little, he sells it to a program distributor, and so on. The margins get bigger and bigger as you go down.”

Some investors are reaping clear benefits from the service channel.

Jeremy Thompson, managing director for ONCAP, is an investment banker who has stakes in the Mister Car Wash and Caliber Collision Centers chains.

“Getting to know the space and the people, the automotive aftermarket is a sector we have spent some time on,” he says. The Mister Car Wash chain had 39 car washes and about 15 lube stops when Thompson got involved.

“It’s since grown to about 66 car washes and a few more lubes,” he says. “And that’s sort of the type of model that we’d like to follow, where we find a management team we really like, we think who knows how to run a business very well, and then we provide them the capital backing so they can grow their business.”

Upsides, downsides
For those looking to spend money on aftermarket ventures, they should consider all potential pluses and minuses, say those we spoke with.

For example, even though the country is suffering financially and unemployment is up, these same people still need cars and trucks, points out Smith. “Granted, they are not getting them fixed quite as much, but the kinds of non-discretionary items still have to be used.”

The advantages of aftermarket investments depend on whether you are an “active or passive investor,” says Vander Ark. If you’re passive, he adds, “you’re taking equity position in the space but not trying to influence the performance of the company. You’re just betting on the return of the company.”

Active investors have a large equity position or buy the company entirely and try to manage its performance, he says.

“But in either of those respects, the stable cash flows are a very real benefit. And then especially for an active investor, there is an opportunity to buy in at multiple different investment sizes. This is such a large market, so fragmented with so many different players that you have the opportunity to buy small companies or buy large companies. Many industrial investments have more consolidated industries where you’d be forced to make quite a big bet in the space to take on a company, where that is not the case here.”

Pricing can bring on an added edge, Vander Ark adds, and margin expansion opportunities are present in the market. “Historically, a lot of players have done across-the-board pricing action at an annual three percent, four percent” increase, he says.

“Now, people are taking a more tailored view to pricing. In some places, in highly competitive markets, that is too much. In other areas where you have an advantage and you are providing unique values to customers, the prices could be higher. There are pricing opportunities,” Vander Ark says.

And there can be opportunities in global sourcing. “Many aftermarket parts lend themselves to global sourcing, but in large number these parts are still taken from domestic supply.”

“Publicly traded auto aftermarket companies tend to have stable, recurring revenue streams that enable the companies to be an attractive defensive investment in periods,” says Sponheimer. “At Gabelli & Company, Inc., we’re drawn to companies that are able to generate significant recurring cash flow with potential catalysts that help unlock shareholder value for investors. For the automotive aftermarket, that catalyst has manifested itself in the form of weak new auto sales pushing consumers toward maintenance of vehicles they currently own.”

On the flip side of the positives, the industry is operating under a “last man standing” approach. “From the manufacturer and distribution perspective, the money coming in has to be a lot more careful, because you have to pick the last man standing,” continues Smith. “So there is a lot more due diligence, a lot more statistics, a lot more analysis (involved). But if you pick the right (company), you do have a much better chance at making much better returns than you did a few years ago. Everybody is not going to be there when the smoke clears. But generally one, two or three will be there.”

Another disadvantage, says Vander Ark, is “there are spots in the market that are more subject to global competition and commoditization, and consumers are less interested in the brand.”

The competition is heated in an industry like the automotive aftermarket, cautions Frost & Sullivan’s Spivey.

“There is not a lot of room,” he says. “There is some room to digress to be creative and come up with an innovative product, but you need OEM form, fit and function. That is the most important thing that the installer is looking for, that is what the distributor is looking to buy, that is what the manufacturer is looking to put out there.”

Spivey agrees that the commoditization of products has become an issue. “Brakes is one category where you actually see some sort of differentiation. There is room to do that, but it is getting harder and harder because of the cost associated with it. You are not making very much money on the sale. You are getting squeezed by distributors, your clients. They are going to squeeze you on the price. As the manufacturer, you have to compromise to get the account. And since they are taking a very small margin, it is hard to invest in research and development for new products.”

Regardless of where investors decide to put their money, the overall credit markets have a direct influence. As in other industries like the housing market, good credit may not even be enough to get loans at present.

“The state of the financing market affects the ability of buyers to borrow money, and hence affects the purchase price, which is much like the residential housing market,” says Thompson.

“People’s ability to buy that house depends a lot on how much they can borrow,” he adds. “When banks aren’t lending, you have to put all equity dollars in to buy that house, and that’s a very challenging thing for people, it means they can’t pay as much. So certainly the same thing happens when you’re buying businesses, be they in the automotive aftermarket or not, where that overall financing environment affects it.”

“Credit markets are tight and tough, but if a buyer or investor is willing to sufficiently equitize the investment, they certainly can still get commercial loans,” says Smith. “That is the major external factor, and it is all related to the housing crisis and every other crisis. But when it comes down to it, it is just your availability of credit.”

“Just generally looking at investors, it is only getting more difficult to borrow money in this economy,” Spivey agrees. “It is causing aftermarket investors to turn to capital markets.”

Public vs. private
When asked to evaluate the performance of publicly traded versus privately owned companies, Capstone’s Smith offers this perspective: “Just by happenstance, most of the retailers are public, so they are performing well, but it really doesn’t have anything to do with the fact that they are public so much as their size and what their ownership is,” he admits.

“In terms of manufacturers, so few are public that you can’t really get a good feeling for that.”

As for what the retailers sell, privacy rules the day. Graham Payne, also from Capstone, says if you walk through a retail store, the majority of the items you see on the shelves are produced by privately held companies.

“We track private equity ownership in all segments of the automotive aftermarket and currently follow 96 private equity owned aftermarket companies,” says Carey, from BB&T Capital Markets.

“This number has grown steadily over the past several years, but today we see heightened private equity interest in the space and for good reason.”
Amid the backdrop of the current state of the financing markets, many don’t foresee private companies making the jump into public offerings.

“With the uncertainty of the economy and the fragile state of the automotive industry, 2009 and 2010 would not be a good time for initial public offerings (IPOs),” says Onello. “However, on the other side of things, it may be a great opportunity for a public to go private to cultivate a get lean and mean culture mentality and capitalize on the blotted competition.”

“I wouldn’t be surprised to see more private investors come into this market since you can’t borrow money because of the interest rates and the credit market,” says Spivey.” It makes sense to turn to someone who can stabilize your business and help you get through the current rough spot.

“The general problem with the aftermarket is in some ways it is a race to the bottom,” he says. “Everything is becoming commoditized. A lot of creativity and innovation is being removed from the process. Products are designed here, sent overseas for production, and sent back.

“When you compare products, the level of differentiation is not there. When you are selling a commodity, there is not a lot of room there for profits. If you are an investor, that is what you are seeking. There are not a lot of profits unless you move down the channel to the distributors,” Spivey says.
Looking ahead
As the economy starts to show signs of recovery, the term “cautiously optimistic” surfaces frequently.

Smith says as drivers begin to pay for deferred maintenance and engage in more discretionary spending, “pent-up demand will be evident.

“Anybody looking to invest is going to know that,” he adds. “The industry is down, but it is not out. As the economy comes back, it will get back to its old levels.”