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Has Greece contagion spread to the aftermarket?

Monday, May 24, 2010 - 00:00

For a while, the market surge in 2010 seemed too good to be true. But now fears of contagion from the issues plaguing Greece spreading throughout Europe have developed into a general uneasiness for most investors, resulting in meaningful market corrections and increased volatility.

While the dollar has strengthened throughout 2010, the pace of appreciation has accelerated substantially since April. European currencies have been particularly weak of late (as we write this piece in mid-May), with the Euro trading at roughly $1.23 (down from $1.50 in early December) and the British Pound trading at $1.45 (down from $1.64 in mid-January).

But concerns over the viability of the European Union and substantial currency shocks are not the only issue. Unemployment remains stubbornly high (9.9 percent in April) even as the economy exhibits some signs that recovery is underway. Today, the percentage of the labor force unemployed for six months or longer is 4.3 percent, which is the highest proportion ever seen (by a considerable margin) since records were first kept in 1948. What will be interesting is the time period it takes to actually recover the more than 8 million jobs that were lost during this recession.

Critical to improving labor market conditions and job growth are increases in aggregate economic output, to which consumer sentiment, consumer spending, and access to credit are key. In recent months, consumer spending (and sentiment) and access to credit appear to be thawing from their recessionary freeze. That said, initiatives launched during the downturn to bolster output per employee (or productivity, broadly speaking) could act as somewhat of a governor to limit declines in the unemployment rate in the near term. Another thing to consider is that it may be that some of these 8 million jobs are simply lost for good. Some economists have opined that it may take as many as 5 years to recover, with as many as 20 percent of the jobs lost being permanent.

While market and economic conditions remain challenging, it is important to note that trends for the automotive aftermarket have actually been quite strong. Investors that had once rotated out of the group in an effort to seek “beta,” appear to be returning once more for the same reason they owned them during the worst of the recession: the aftermarket provides solid defensive characteristics.

Consider the latest earnings results from public companies across the supply chain. Suppliers Federal-Mogul (FDML), Standard Motor Products (SMP), and Dorman Products (DORM) all noted that sales trends accelerated in March and into April. With underlying end-user demand still strong (evident in the results of the distributors and installers), sales out the door should translate into stronger replacement orders for the manufacturers. After several quarters of destocking, we believe that inventories have now been reset and think that sales results for the major suppliers should now more closely mimic the results of their customers.

The group that led the charge, with respect to fundamentals, for the Aftermarket throughout 2009 was the parts retailers. Consumers’ lack of new vehicle purchases and constrained budgets elevated DIY work, and trade-down from the dealerships in efforts to save every penny helped boost do-it-for-me sales at independent garages. Most investors believed the trade in this group would be over this year as tough comparisons made same store sales (SSS) growth a challenge. However, to date, it looks like fundamentals are holding up better than expected. O’Reilly recently reported SSS growth of 6.9 percent on top of a +5.8 percent last year in Q1.

Our sense is that 2010 will be another good year, and we believe that investors are likely to return to the group. Even if Greece contagion did spread to the share prices of Aftermarket stocks, we think the fundamentals remain unscathed.

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