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Favorable cycle to continue in 2011

Wednesday, January 26, 2011 - 01:00

Entering 2010, there was a healthy degree of skepticism within the broader investment community as to whether the auto part retailers would experience another solid year of sales trends given challenging 2009 comparisons. But results in 2010 ultimately surprised well to the upside driven by an accelerating pace of revenue growth, in turn driving substantial outperformance for Advance Auto Parts, AutoZone, and O’Reilly (composite +54 percent) relative to the S&P 500 (+13 percent).

Heading into 2011, we continue to believe that the secular tailwinds provided by further aging of the vehicle fleet — as a result of still depressed new vehicle sales — will remain supportive of aftermarket demand. Many of the parts’ manufacturers have demonstrated that end users are requiring a broader SKU assortment now more than ever before. In our opinion, parts proliferation, an aging fleet and increasing rates of critical parts failures and the simple propensity to repair rather than replace have all attributed to the strength we have seen for the aftermarket over the past two years. Interestingly, the number of 5-year-old or newer cars on the road is expected to continue to decline at least until late 2012 or early 2013. In turn, the aging of the parc should continue and the need for aftermarket parts and services should remain robust. What we don’t know is exactly how long this favorable cycle will last, but we don’t think it ends in 2011.

Let’s also take a minute to differentiate between a company and a stock. In our view, company fundamentals remain strong. However, in light of this group’s sizable outperformance in 2010, rising gasoline prices, expectations of further, albeit gradual, seasonally adjusted annual rate improvement, and our belief that 2011 guidance could fall shy of current estimates, sentiment for stocks may be somewhat negative in the near term. In fact, we have already begun to see a rotation away from the group in January. With our view of limited positive near-term catalysts, investors could be presented with more advantageous entry points to these names. To be clear, we do not expect to see a significant sell-off as secular fundamentals remain favorable and valuations look reasonable in light of long-term averages, but we are concerned that further sentiment deterioration could send the stocks lower in the short term.

Overall, we expect Q4’10 results to come inline with or modestly ahead of current street expectations. However, stacked same store sales comparisons become far more challenging this year, and if management teams approach 2011 guidance with a similar level of conservatism used in the provision of initial 2010 guidance, we believe that 2011 earnings per share guidance could fall shy of current consensus forecasts. Ultimately, we think that current estimates are attainable, but investors should be cognizant of the potential for downward pressure on the shares in the near term until the overhang of disappointing guidance is removed.

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