We See Rising Returns at Genuine Parts Despite Industry Weakness
We think the slump in auto-parts retail is cyclical in nature rather than structural.
As a top distributor of automotive and industrial parts, Genuine Parts (GPC) benefits from industry dynamics favoring its scale-enabled service levels. We believe the company 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 that subscale peers cannot economically replicate. We expect these advantages to outweigh industry-driven deterioration in the company’s office product unit.
Aftermarket auto-parts retailers serve do-it-yourself and professional clients. The faster-growing latter category depends on high levels of part availability and rapid delivery to turn repair bays and avoid costly service queue reshuffling.
Both categories have benefited from rising miles driven and average vehicle age, along with low unemployment. Genuine Parts--mostly via its NAPA brand--stands to benefit thanks to its infrastructure, enabling it to economically offer a vast catalog with quick delivery from a distribution center in case a part is not stocked in store.
Similar dynamics prevail in the company’s industrial parts group (Motion Industries) and, to a lesser extent, its electrical components unit (EIS). Clients need to receive replacement parts quickly, particularly when failures result in costly downtime. Facilities engineers depend on Motion Industries’ parts availability and trained staff to locate the needed component, receive guidance on an oft-unfamiliar installation procedure, and take rapid delivery to return to business. Spreading infrastructure and inventory over a large sales base leads to a cost advantage over small peers, while service levels reinforce the company’s brand intangible asset in a way that smaller competitors cannot duplicate.
NAPA and Motion Industries maximize inventory turnover by centralizing slow-selling items, as several locations can call upon warehoused parts as demand warrants. We believe the resulting virtually on-demand availability cannot be matched by subscale peers, enabling Genuine Parts to act as a consolidator.
Brand and Cost Advantages Dig a Narrow Moat
We assign Genuine Parts a narrow economic moat rating because of its brand intangible assets and cost advantages in its automotive parts and industrial parts groups. The company has consistently generated adjusted returns on invested capital above our 9% weighted average cost of capital estimate. We expect Genuine Parts to outpace its 16% three-year historical average return over the next five years (we forecast a 17% average) as it leverages its infrastructure, inventory, and part availability investments to benefit from favorable industry dynamics in both segments.
Consumer price inelasticity in the aftermarket auto-parts industry creates an opportunity for retailers to differentiate themselves based on service levels, leading to the formation of strong brands as customers navigate a fragmented industry in search of the retail partner that offers the most added value. Rapid part availability, location convenience, and in-store services (in the DIY segment) carry significant weight with purchasers, but as such benefits are costly to deliver, larger retailers are at an advantage as they can spread service costs (as well as inventory holding expenses) over a large sales base. Leveraging inventories held at distribution centers across a network of stores allows chains to provide a large catalog of readily available parts while maximizing the opportunities to sell infrequently purchased components.
The professional clients that provide approximately three fourths of the automotive parts group’s sales (with the remainder sold to DIY customers) value brands and tend to be retailer-loyal, preferring to stay with trusted partners as any cost differentials can largely be passed on through the repair bill to vehicle operators. Commercial customers depend on quickly sourcing necessary components in order to turn over service bays, making reliable part availability a key point of customer engagement and a way for retailers to build lasting client relationships in a way that is difficult for smaller chains to mimic. NAPA augments its relationships through its technician and shop owner training programs and technology solutions, which we believe deepen the company’s engagement with professional clients and strengthen its brand equity.
Genuine Parts uses digital ordering tools with professional clients, and we believe its extensive and fairly flexible inventory makes disruption from digital retailers like Amazon (AMZN) less of a concern in the commercial segment. As pure price-based competition is not beneficial in a fairly price-inelastic industry, a digital upstart would have to build the inventories and distribution infrastructure (including the ability to quickly collect returned parts and the serviceable cores of used components) needed to compete while also offering an added advantage to disrupt the exiting sales relationship. Similarly, we expect that a large-scale move by manufacturers in favor of direct shipping is unlikely, due to the infrastructure required, end customers’ price inelasticity, and the convenience associated with repair shops ordering parts made by multiple makers from one source. Repair shops often require delivery of purchased components within an hour of placing an order, creating a last-mile delivery expectation that is difficult to meet without an extensive store and warehouse network. From the DIY market’s standpoint, hard parts’ complexity and significant variance depending on the model year and selected option packages on a vehicle lead customers to value the advice provided by Genuine Parts’ trained in-store sales staff, putting digital-only competitors at a disadvantage. Furthermore, DIY users often need to obtain parts immediately in order to put their vehicle back into service, making a well-stocked store network (with quick access to components not commonly held at a particular location) a competitive advantage.
Genuine Parts has leveraged its brand strength to drive sales of its exclusive, own-label automotive products, which account for 90% of sales. Giving its own brands primacy offers a significant margin advantage, and although the company loses sales to customers seeking branded product, the offerings simultaneously boost the company’s brand strength as customers come to trust a NAPA-labeled item.
As Genuine Parts has the largest network of independent retailers under a major brand, it is best positioned to capture partnerships with individual store owners seeking the cachet and infrastructure of a large organization along with a large measure of independence. The company’s longstanding history with an independent-driven business model and its brand value boost Genuine Parts’ standing in the eyes of unaffiliated store owners considering a partnership and serve to keep existing affiliates in the fold.
Maximizing inventory turnover across a broad customer base also provides a balance sheet benefit, with large retailers able to secure attractive vendor financing to mitigate the impact of high inventory levels. Genuine Parts’ accounts payable were 96% of inventories in 2016, rising from 65% in 2012. Vendors have considerably more power in their relationships with smaller chains and independent stores, leaving such sellers at a marked working capital disadvantage that exacerbates the barriers to encroachment upon the national retailers’ availability advantage.
NAPA Sets Genuine Parts Apart
Genuine Parts differs from competitors O’Reilly (ORLY) and AutoZone (AZO) (and, to a lesser extent, Advance Auto Parts (AAP)) due to its reliance on independently owned stores operated under the NAPA name; about 1,300 stores are company-owned and 5,400 independent in North America. While this reduces the company’s control over store-level decisions and reduces earnings (albeit with a corresponding benefit to invested capital through less owned or leased property and in-store inventories limited to company-owned locations), we believe the ownership structure does not preclude Genuine Parts from enjoying the benefits of the competitive advantages inherent in the company or the favorable industrywide tailwinds that are benefiting the aftermarket auto-parts retail sector.
Approximately 70% of the auto-parts unit’s revenue comes from the United States, with Canada, Australia, and New Zealand contributing the remainder (in addition to a small Mexican presence). We expect the company will achieve similar advantages as it scales, particularly in Canada, where NAPA already has a large presence, and Australia.
The dynamics at Motion Industries are similar. Components such as Motion Industries’ pump, power transmission, and motion offerings are often critical to clients’ ability to quickly resume operations active after a part failure. Consequently, the industrial unit’s clients require leading players to carry a large supply of slow-turn parts for quick delivery. This favors large, well-funded players like Genuine Parts that are able to leverage inventory and infrastructure over a large sales base to maximize the opportunities to sell slow-to-move components. Consequently, the unit also has a cost advantage relative to smaller, regional participants, important in an industry that is highly fragmented (despite its top-two standing in the markets in which it competes, Genuine Parts’ share is only about 7%).
Leading distributors are able to use their reliable, on-demand component availability to secure service contracts that provide a recurring source of revenue (about half of the industrial parts group’s sales volume). There is little incentive for clients who prioritize getting equipment back up and running as quickly as possible to switch to an unproven supplier, as down time from a delay translates to cost without revenue. The resultant sales relationships and company reputation for quick component availability across a wide range of inventory lead to a brand intangible asset that is difficult for small, regional competitors to replicate. Genuine Parts develops these relationships by offering additional value-added services, such as inventory management and point of sale technology designed to help clients plan future component needs, while also interfacing with Motion Industries’ own digital ordering platform. Services meant to help customers identify opportunities for energy and efficiency improvements often lead to sales as clients implement solutions. Perhaps most important, the company’s trained sales staff helps clients understand how to install a new component, important given the time-sensitive nature of repairs and the relative infrequency of repairs. These softer sales initiatives are costly to replicate and difficult to usurp, as they deepen Genuine Parts’ engagement with its customer base.
Genuine Parts’ distribution model in the automotive and industrial parts groups depends on large distribution centers that serve individual stores, acting to replenish inventories while also holding slow-moving stock-keeping units that can rapidly be delivered to stores if needed. This maximizes inventory turnover while minimizing the need to hold units of slow-moving SKUs at individual stores, reducing capital costs. As its investments in inventory management technology and supply chain automation are invested across a broader pool of sales and stores, the company’s cost profile improves in a way that is difficult for smaller competitors to duplicate.
Genuine Parts’ office products group faces significant competitive exposure from traditional and nontraditional distributors. While the company is developing stronger relationships with the largest office supply retailers, we expect this sector will remain exposed to disruption by less established digital purveyors, threatening incumbent distributors and the retailers that purchase from Genuine Parts. As large retailers continue to look for ways to reduce costs and smaller independent retailers find it harder to survive against larger and digital participants, we expect distributor margins will come under increasing competitive pressure. That said, we believe the segment contributes marginally to Genuine Parts’ aggregate cost advantage by improving per unit shipping and freight costs through added volume.
The electrical/electronic materials group is exposed to many of the same dynamics as the industrial parts unit, though it is somewhat less well positioned to take advantage because of its relatively small size. Still, its relationships with clients are valuable, and the unit benefits from a distribution network that can provide mission-critical electrical components to customers reliably and efficiently.
Industry Dynamics Can Help or Hurt
The key risks to Genuine Parts’ ability to deliver returns consistent with our forecasts consist of industry-level trends in each of its operating segments.
Industry dynamics have been a boon to parts retailers, with upward trends in miles driven and vehicle age and falling unemployment supporting the need for vehicle repairs and maintenance as well as customers’ ability to pay. Higher fuel prices or unemployment could reverse the positive trend. Similarly, increased sales of new (under-warranty) cars and trucks could lead scrappage rates higher, reducing demand as motorists replace older vehicles with more reliable alternatives that will not need significant aftermarket components for at least three years. Conversely, persistent positive trends could propel demand.
The industrial and electrical segments see less attractive dynamics. Recent commodity price declines hit Genuine Parts’ energy sector clients hard and led to capital investment cuts. The iron and steel and machinery categories have also seen softness. Segment results depend on driving sales through an expansive (and expensive) infrastructure, and the 2.6% 2015 industrial parts revenue dip led to a nearly 50-basis-point operating margin contraction. While we expect recovering growth in 2017, a sharper or more prolonged pullback could cause the segments to underperform (with outperformance possible if conditions improve).
Office products distribution has seen an onslaught of competition from several traditional and nontraditional market participants. If this continuing dynamic leads to faster-than-expected revenue and margin deterioration, Genuine Parts’ segment performance could suffer.
Our forecasts assume U.S. corporate tax reform will benefit Genuine Parts starting in 2018; deviation from our expectation of a mid-single-digit point reduction in the effective tax rate could lead performance to stray from our valuation.
We believe Genuine Parts’ conservative balance sheet approach, strong cash flow generation, and significant undrawn revolving credit facility capacity should keep liquidity and operational flexibility intact even in times of strain.
Zain Akbari does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.