The strength in industry fundamentals and end-user demand over the past 24 months — as we have previously written — has led to substantial outperformance, relative to market benchmarks, for publicly traded aftermarket equities, in turn drawing interest from hedge funds and traditional long-only shops alike. What is also interesting, however, has been the increased interest of private equity funds in potentially putting money to work within the automotive aftermarket.
In our opinion, the aftermarket offers investors a number of desirable characteristics including continued industry fragmentation, and thus opportunity for consolidation, as well as a long-term track record of consistent and steady growth. For private equity funds, we believe that the resiliency of aftermarket demand and relative predictability of cash flows make this segment particularly appealing. While no two deals are exactly the same, generally speaking, the typical private equity transaction involves the use of financial leverage to amplify returns. This typically entails raising somewhere in the range of 20 percent to 30 percent in equity capital, supplemented by a combination of high-yield bond issuance and reliance on bank debt.
Over time, the sponsor will look to drive operational improvements throughout the business and gradually utilize free cash flow generation to reduce the amount of transaction debt outstanding, eventually culminating in a sale of the company to another strategic/financial buyer, or perhaps in a stock offering. Critical to this model is the consistent generation of cash flow such that the private equity sponsor can be confident in its ability to effectively service its debt.
With steady long-term growth in the number of vehicles on the road and miles driven, aftermarket fundamentals are generally accommodative, in our opinion, to private equity investment. And with buyout fundraising exceeding equity deployments every year since 2004, according to Thomson Reuters Buyouts, there is currently more than $400 billion in outstanding equity capital that has been raised with sponsors looking for suitable opportunities in which to commit these funds. In addition, high-yield paper, as measured by the Credit Suisse Bond Fund High Yield Index, Yield to Worst, is now trading at yields below levels seen in 2006 and 2007, effectively lowering the hurdle for successful portfolio company acquisitions. While the majority of this article focuses on the potential for heightened merger and acquisition activity by financial buyers, we would also point out our expectation for continued transaction activity by strategic players as industry participants look to solidify and expand their businesses.
So, where do we see the most opportunity for industry consolidation? Over the past 10-15 years, we would characterize the majority of aftermarket consolidation as having occurred within the retail and distribution channel. Recall AutoZone’s 1998 acquisition of approximately 560 Chief Auto Parts stores; Advance’s 1998 purchase of Western Auto and the 2001 acquisition of Discount Auto Parts; and O’Reilly’s 1998 purchase of Hi/Lo, 2001 acquisition of Mid-State, Midwest Auto in 2005, and of course, most recently, its 2008 acquisition of CSK Auto.
Moving forward, we expect to see continued consolidation within the retailer and distributor base, although at a slower pace as that seen in recent years. In our opinion, over the coming years it should be the aftermarket supplier base and service shops that see the greatest amount of activity.
As an example, just recently the Rank Group, a New Zealand-based private company, acquired well-known aftermarket supplier UCI International in November for $375 million and the assumption of roughly $600 million in debt, valuing the company at nearly $1 billion in total consideration. Then, just a few weeks ago, Honeywell announced that the Rank Group would acquire its automotive Consumer Products Group (CPG) business in a cash transaction valued at approximately $950 million. Based in Danbury, Conn., the CPG generates annual revenue of approximately $1 billion with its product portfolio including a number of very well known automotive brands such as FRAM® filters, Prestone® antifreeze, Autolite® spark plugs and Holts® car care products. So within a matter of months, Rank Group now has established itself as a large aftermarket supplier with great brand recognition and a solid product portfolio.
As previously indicated, we also believe that the professional service segment is ripe for consolidation with independent service shops still representing 60 percent to 65 percent of the $145 billion light-vehicle service market. Monro Muffler has been aggressively seeking — and we believe will continue to seek — value-priced acquisitions of service and tire stores in order to build further market density and leverage its buying power and marketing expenditures. Pep Boys too has been vocal in laying out its plans to consolidate the market, looking to add “spoke”-type service locations to build market density and leverage its existing Supercenter locations.
And just several weeks ago, Pep Boys shares spiked on speculation that Manny, Moe, & Jack were in fact themselves potentially in play for a takeout. While the business model still has its inefficiencies, we believe the strategy to build a “hub and spoke” service model is the right one, albeit one that will take time. Mike O’Dell and team have done a solid job at attacking costs and returning the company to profitability. So, in our minds the “low-hanging fruit” that typically makes an acquisition target compelling is absent. Instead, we believe the buyer will likely need to invest heavily in the core business and accelerate the pace of service store purchases.
In 2011, we expect aftermarket fundamentals to remain strong, and believe that industry consolidation is likely to further accelerate as private equity sponsors, flush with committed capital and strategic buyers with ample balance sheet flexibility, look to capitalize on the growth opportunities provided by what we view as still a relatively fragmented marketplace.
About BB&T Capital Markets:
BB&T Capital Markets is a full-service investment banking firm that focuses on specific industries, including the Automotive Aftermarket. BB&T Capital Markets is a division of Scott & Stringfellow, LLC, member NYSE/FINRA/SIPC. Scott & Stringfellow is a wholly-owned nonbank subsidiary of BB&T Corporation, one of the nation’s largest financial holding companies with $155 billion in assets. Securities and insurance products or annuities sold, offered or recommended by Scott & Stringfellow are not a deposit, not FDIC insured, not guaranteed by a bank, not insured by any federal agency and may lose value.
Disclosures:
BB&T Capital Markets makes a market in the securities of Advance Auto Parts, Inc.; AutoZone, Inc.; Monro Muffler Brake, Inc.; O’Reilly Automotive Inc; and The Pep Boys—Manny, Moe & Jack.
BB&T Capital Markets has managed or co-managed a public offering of securities for Advance Auto Parts, Inc. and O’Reilly Automotive Inc. in the last 12 months.
BB&T Capital Markets has received compensation for investment banking services from Advance Auto Parts, Inc. and O’Reilly Automotive Inc. in the last 12 months.
BB&T Capital Markets expects to receive or intends to seek compensation for investment banking services from Advance Auto Parts, Inc.; AutoZone, Inc.; Monro Muffler Brake, Inc.; O’Reilly Automotive Inc.; and The Pep Boys—Manny, Moe & Jack in the next three months.
Advance Auto Parts, Inc.; and AutoZone, Inc. is or during the past 12 months was a client of BB&T Capital Markets, which provided non investment banking, securities-related services to, and received compensation from, the aforementioned company for such services. The analyst or employees of BB&T Capital Markets with the ability to influence the substance of this report know the foregoing facts.
An affiliate of BB&T Capital Markets received compensation from Advance Auto Parts, Inc.; AutoZone, Inc.; Monro Muffler Brake, Inc.; and O’Reilly Automotive Inc. for products or services other than investment banking services during the past 12 months. The analyst or employees of BB&T Capital Markets with the ability to influence the substance of this report know or have reason to know the foregoing facts.
