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Three auto-parts suppliers poised to turn the corner

These stocks were dragged down by the recent softening in the auto sector, creating sizeable discounts.

Vikram Barhat 20 June, 2018 | 5:00PM
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The automotive sector has been on a rollercoaster ride lately as it tries to navigate through an assortment of political issues and transformational forces. From the rapid advances in autonomous cars to the explosive growth in electric vehicles and U.S. President Donald Trump's highly controversial auto tariff proposal, a steady stream of disruptions and developments continue to change the automotive landscape and challenge industry participants.

There are signs, though, that the industry is emerging stronger from all this. Although auto sales are not at the record levels they achieved in 2015 and 2016, they are projected by the National Automobile Dealers Association (NADA) to remain strong, leading Moody's to upgrade its industry outlook for the year.

The auto parts manufacturing industry, whose fate is closely tied to the overall automotive sector, was also dragged down by the recent softening in the sector. The impact pushed the stocks of leading auto parts makers off their January peaks, creating sizeable discounts.

Last year, there were fears the automotive parts retail sector would be disrupted by  Amazon (AMZN). However, Morningstar equity analyst Zain Akbari asserted that "automotive parts pose unique challenges that will prove difficult" for Amazon to crack. The concerns over disruption "will create opportunities for investors to take a position in" the stocks of dominant industry players, he added.

The following auto parts companies are deeply entrenched in an oligopolistic industry. They're well positioned to maintain their hold on their market share through various economic cycles and grow faster than their smaller rivals. Trading at a reasonable discount to their fair value, they offer a margin of safety and have some upside potential, according to Morningstar equity research.

AutoZone Inc.
Ticker: AZO
Current yield: -
Forward P/E: 12.0
Price: US$685.75
Fair value: US$760
Value: 9.8% premium
Data as of June 18, 2018

A leading U.S. automotive retailer,  AutoZone (AZO) sells aftermarket automotive parts, tools and accessories to do-it-yourself consumers. The firm generates an increasing portion of its sales from domestic commercial customers (20% in 2017) and has a growing presence in Mexico and Brazil, while the bulk of its 6,029 stores are in the United States.

AutoZone is beefing up its commercial sales, leveraging its robust do-it-yourself aftermarket automotive parts franchise. "The company's endeavours come at a generally favourable time for the industry, despite recent cyclical softness, as increased miles driven and an aging vehicle fleet have bolstered sales growth," says a Morningstar equity report.

The auto parts retailer has a history of operational success and boasts industry-leading adjusted returns on invested capital (averaging 30% over the past five years) and strong operating margins, notes the report.

AutoZone benefits from a strong brand built by factors including a nationwide presence, effective customer engagement, a high standard of service and the success of its proprietary-label products.

Moreover, the company enjoys a cost advantage driven by the scope of distribution and leading DIY market share. "As vehicles become more complex and durable, AutoZone has an opportunity to deepen its engagement with DIY consumers seeking advice as they make repairs and with commercial clients as part failures drop in frequency but increase in cost," says Akbari, whose US$760 fair value estimate for the stock indicates about 10% upside potential.

AutoZone's customer base values service over price, which insulates the firm's returns and hedges against competition. Akbari forecasts the firm's profitability metrics to remain strong "as it scales and takes share from independent and regional competitors."

The company has been ramping up its presence in faster-growing markets in Mexico and Brazil. "Its measured approach to international expansion should poise the firm for continuing growth in the years ahead," says Akbari.

Advance Auto Parts Inc.
Ticker: AAP
Current yield: 0.17%
Forward P/E: 20.6
Price: US$136.82
Fair value: US$157
Value: 12.9% premium
Data as of June 18, 2018

 Advance Auto Parts (AAP) is one of the largest providers of aftermarket automotive replacement parts and accessories to DIY customers across North America. The company operates 5,183 stores and generates 58% of its sales from commercial clients, up from 30%-40% before completing its acquisition of General Parts at the end of 2013.

Although the company lagged its peers in profitability due to operations inefficiencies created by the acquisition, the company's ongoing turnaround effort can boost performance as it leverages its balanced professional-DIY segment exposure, Akbari says in a Morningstar report.

With increased focus on closing performance gaps with large-scale peers, the company is poised to gradually gain market share in an industry that should see consolidation, where large, national retailers will dominate by providing a higher standard of service. "While the industry has slowed recently because of transitory factors, fundamental indicators, including miles driven and average vehicle age, remain conducive to recovery," the report notes.

The company's returns on invested capital (6.1%) and operating margins (7.3%) in 2017 have trailed behind its peers. However, Akbari says: "it has ample runway for profitability growth over the years ahead."

Advance's extensive store and distribution network forms a robust cost advantage versus smaller peers. This cost advantage combines with the strength of its brand to provide "a durable competitive advantage that should shine through as the turnaround begins to deliver results and Advance's performance gradually moves toward that of its peers," asserts Akbari, who estimates the stock to be worth US$157.

The company has consistently generated returns on invested capital above the 9% average cost of capital until 2017, when turnaround-related investments held it back at 6%. Akbar projects the recovery in ROIC to begin in 2018, "building to a 12% mark by fiscal 2022."

Genuine Parts Co.
Ticker: GPC
Current yield: 2.93%
Forward P/E: 16.6
Price: US$94.30
Fair value: US$101
Value: 6.6% premium
Data as of June 18, 2018

 Genuine Parts (GPC) is a leading distributor of automotive parts (53% of 2017 net sales), industrial and electrical components (35%) and office products (12%). The company caters to commercial and retail customers through around 6,500 North American stores bearing the NAPA brand, of which about 5,300 are independently owned.

Nearly 70% of the auto-parts division's 2017 revenue came from the United States, with Canada, Australia, New Zealand and Mexico contributing the rest. "The company will achieve similar advantages as it scales globally, particularly in Canada, where NAPA already has a large presence, and Australia," says a Morningstar report.

The acquisition of Alliance Automotive should bolster its standing with global vendors and lead to "greater procurement leverage from global part manufacturers given its strong market share position," says the report. Alliance is top-ranked in France, second in the United Kingdom and third in Germany.

As a top distributor of automotive and industrial/electrical parts, Genuine Parts benefits from the scale of its service levels. "The firm will use its cost advantage to boost sales through its ability to offer a wide variety of parts on short order, building inventory and cost leverage as sales rise while fortifying brand value in a way subscale peers cannot economically replicate," says Akbari, who pegs the stock's worth at US$101.

Genuine Parts capitalizes on its brand strength to drive sales of its exclusive, own-label automotive products, which account for 90% of domestic sales. "Giving its own brands primacy offers a significant margin advantage," says Akbari, who projects 4% organic revenue growth and 8% operating margin over the next decade.

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About Author

Vikram Barhat

Vikram Barhat  Vikram Barhat is a Toronto-based financial writer specializing in investing, stock markets, personal finance and other areas of the financial services industry. He also writes for CNBC, BBC, The Globe and Mail, and Toronto Star.

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