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As Its Automotive, Industrial Segments Recover, Genuine Parts’ Competitive Advantages Should Shine As Its Automotive, Industrial Segments Recover, Genuine Parts’ Competitive Advantages Should Shine Zain Akbari Equity Analyst Business Strategy and Outlook | by Zain Akbari Updated Apr 26, 2021 While the pandemic has posed challenges for Genuine Parts, the situation has not altered the firm’s long-term strength. As a top distributor of automotive and industrial parts (roughly two-thirds and one-third of net sales, respectively), Genuine Parts benefits from industry dynamics favoring its scale-enabled service levels. We believe it 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. Aftermarket auto-part retailers serve DIY and professional clients. The faster-growing latter category (more than 80% of segment sales) depends on high levels of part availability and rapid delivery to turn repair bays quickly. Both categories had benefited from rising miles driven and average vehicle age, along with low unemployment, but have shown resilience in past recessions. Genuine Parts (mostly via its NAPA brand) should benefit due to its infrastructure, which enables it to economically offer a vast catalog with quick delivery. We believe its Alliance Automotive acquisition elevated its standing with global vendors. Similar dynamics prevail in its industrial parts group (Motion Industries). Clients need to receive replacement parts quickly, particularly when failures result in costly downtime. Customers (facilities engineers) depend on the unit's part availability and its trained staff for assistance in locating the needed component, guidance on an oft-unfamiliar installation procedure, and rapid delivery. Spreading infrastructure and inventory investments over a large sales base leads to a cost advantage over small peers, while service levels reinforce the firm’s brand intangible asset in a way smaller rivals cannot duplicate. Genuine Parts maximizes automotive and industrial inventory turnover by centralizing slow-selling items, as many locations can call upon warehoused parts as demand warrants. We believe resulting virtually on-demand availability cannot be matched by subscale peers, enabling Genuine Parts to act as a consolidator. Economic Moat | by Zain Akbari Updated Apr 26, 2021 We assign Genuine Parts a narrow economic moat rating due to its brand intangible assets and cost advantages in its automotive parts and industrial parts groups (about two-thirds and one-third of net sales, respectively). The firm’s returns on invested capital support our contention, as it has consistently generated adjusted ROICs above our 9% weighted average cost of capital estimate. Over the next 10 years, we expect the company to perform near its 15% return in 2019 (before the pandemic) on average as it leverages its infrastructure, inventory, and part availability investments to benefit from favorable long-term industry dynamics in both key 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, scaled 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 more than 80% 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 (Genuine Parts’ primary auto retail brand) augments its relationships through its technician and shop owner training programs and technology solutions, which we believe deepen the firm’s engagement with professional clients and strengthen its brand equity. Genuine Parts uses digital ordering tools with professional clients, and we believe the company’s extensive inventory and rapid fulfillment makes disruption from digital retailers (such as Amazon) less of a concern in the commercial segment. As pure price-based competition is not overly 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 existing 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 less than 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 about 90% of domestic sales. Giving its own brands primacy offers a significant margin advantage, and although the company loses some sales to buyers seeking branded product, the offerings simultaneously boost its 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 long-standing 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, particularly considering an ongoing turnaround at Advance Auto Parts (which owns the Carquest network). Independent owners have generally remained solvent through the pandemic. 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 amounted to 118% of inventories in 2020, 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. Genuine Parts differs from competitors O’Reilly and AutoZone (and, to a lesser extent, Advance Auto Parts) due to its reliance on independently owned stores operated under the NAPA name; approximately 1,400 stores are company-owned and 5,200 are independent in North America. While this dynamic 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 long-term industrywide tailwinds that are benefiting the aftermarket auto-parts retail sector. Around 70% of the auto-parts unit’s revenue comes from North America, with Europe (most significantly the U.K., France, and Germany), Australia, and New Zealand contributing the bulk of the remainder. We expect the company will achieve similar advantages as it scales globally, particularly in Europe and Australia. Genuine Parts continues to leverage its global presence to improve its procurement opportunities and terms, a process we believe is still unfolding and should continue to be spurred by Alliance’s strong market share position (top-ranked in France, second in the U.K., and third in Germany). 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-turning parts for quick delivery (within 24 hours and often same day). 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 standing as a leading industrial maintenance, repair, and operations parts distributor in North America, the segment’s market share is only around 3%). Furthermore, leading distributors can use their reliable, on-demand component availability to secure service contracts that provide a recurring source of revenue (roughly half of Motion Industries' 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 further 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. Similarly, 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 (who are often facilities engineers) understand how to install a new component, which is important given the time-sensitive nature of repairs and their relative infrequency. These softer sales initiatives are costly to replicate and difficult to usurp, as they deepen Genuine Parts’ engagement with its customer base. Genuine Parts’ business model in the automotive and industrial parts groups depends on large distribution centers (including nearly 70 automotive locations in North America at the end of 2020) 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 (subject to the constraints of a low-turn industry) 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 firm’s cost profile improves in a way that is difficult for smaller competitors to duplicate. The sale of S.P. Richards in mid-2020 divested a unit which did not, in our opinion, benefit from sustainable competitive advantages. Fair Value and Profit Drivers | by Zain Akbari Updated Apr 26, 2021 With 2021 off to a faster-than-expected start in Genuine Parts’ automotive and industrial segments as domestic vaccination progress leads economic conditions to improve, we are lifting our valuation of Genuine Parts to $109 per share from $104. Our valuation implies forward fiscal 2021 enterprise value/adjusted EBITDA of 11 times and adjusted forward P/E of 18, incorporating 4.5% organic revenue growth and a nearly 8% adjusted operating margin, on average, over the next decade. As the pandemic eases (by mid-2021, according to our estimates), both segments should normalize after a volatile 2020, when the pandemic’s dramatic reduction in economic activity hit both units. With the domestic professional segment returning to growth in the first quarter, we expect mid-single-digit percentage revenue growth for the automotive unit in 2021. Longer-term conditions are sound, with rising vehicle age and benefits to come from larger, post-financial-crisis sales cohorts aging into retailers' sweet spot. We still expect 4% average organic segment sales growth long term, outpacing low-single-digit industry expansion as scaled sellers assert their advantages. Focus on more profitable DIY customers as well as rising infrastructure and inventory leverage should lead segment margins to approach 10% long term from 8.0% in 2020. The industrial parts group should also benefit from consolidation, enabling margin improvements from turning inventory more quickly and escalating operating leverage. We expect the segment to see mid-single-digit growth long term, recovering after a low-double-digit dip in 2020 as the industrial economy normalizes. Our marks suggest Genuine Parts outpaces an industry average far closer to long-run U.S. GDP growth. Margins should expand as cost leverage boosts profitability, clearing 9% by the end of our 10-year explicit forecast. The sale of the business products unit in June 2020 does not materially alter Genuine Parts’ prospects, in our view, and we are encouraged that Genuine Parts is focusing its attention on its core automotive and industrial operations. While we expect Genuine Parts to make acquisitions, due to the uncertain timing and nature of purchases, our model assumes excess cash is used to buy shares (around 30% of yearly cash flow from operations by the end of our 10-year explicit forecast). Risk and Uncertainty | by Zain Akbari Updated Apr 26, 2021 The pandemic injects near-term uncertainty. While the automotive part sector has performed relatively well thus far, unemployment and global lockdowns have slashed miles driven and slowed vehicle wear and tear. Genuine Parts’ industrial unit benefits from a skew toward critical components, but shelter-in-place orders effectively paused the repair stream for many clients. Fleet and government exposures add risk in both segments. Volatile oil prices intensify the challenges facing the firm’s energy sector clients, but cheap gas prices are a benefit in automotive. We expect the automotive segment carries less risk, as hard-pressed motorists delay new vehicle purchases and instead look to keep their current cars and trucks running. The key longer-term risks facing Genuine Parts consist of industry-level trends in each of its operating segments. Long-term automotive segment dynamics are attractive, with average U.S. vehicle age rising to 11.9 years in 2020 versus 10.6 years in 2010. However, the sector is sensitive to weather and fuel prices (in addition to unemployment). In a stronger economy, increased sales of new (under-warranty) cars and trucks could lead scrappage rates higher, reducing demand as older vehicles are replaced with more reliable alternatives that will not need significant aftermarket components for years. The industrial segment is exposed to the state of the U.S. industrial economy. Segment results depend on driving sales through an expansive (and expensive) infrastructure, with mix shifts dictated by the relative health of the firm’s clients across sectors as diverse as energy, food and beverage, pulp and paper, mining, and pharmaceuticals. Both segments are exposed to the automotive and energy sectors, which pose some indirect ESG-related risks as the vehicle fleet electrifies. We do not believe the threat is material, as the firm has managed fleet changes in the past and has a well-diversified, agile industrial unit. Capital Allocation | by Zain Akbari Updated Mar 24, 2021 We assign management’s capital allocation practices a Standard rating. The company’s sound balance sheet has enabled considerable acquisition-driven expansion and, more recently, allowed it to withstand the pandemic’s challenges. Leverage was modest prior to the crisis and management prudently reduced indebtedness in 2020, ending the year with net debt at 1.2 times adjusted EBITDA. Debt maturities are well-managed (less than $150 million due annually over the next three years, on average), and we believe the firm has sufficient financial flexibility to withstand the remainder of the pandemic and volatility associated with normalization. The firm’s investment history has been fair, in our view, with a long record of smaller bolt-on acquisitions and occasional larger deals (such as the 2017 acquisition of Alliance). Under CEO Paul Donahue (who took office in 2016), we believe the company has been sufficiently disciplined, ensuring that purchases made are value-enhancing. The firm has executed integrations well, capitalizing on acquired firms’ inherent strengths while quickly bringing the new acquisitions onto Genuine Parts’ platform and achieving efficiencies. We have a favorable view of the Alliance acquisition and believe the price paid ($2 billion, or 10 times synergy-adjusted EBITDA) was reasonable for an asset that can boost Genuine Parts’ global procurement leverage and is scalable, as seen by the purchase of Hennig Fahrzeugteile (a German light and commercial vehicle parts supplier), Todd Group (a French distributor of heavy-duty truck components), and PartsPoint (a Dutch distributor). We also have a favorable view of the firm's acquisition of the rest of Inenco, boosting its industrial unit in Australia and New Zealand. We are encouraged that management did not enter into a protracted bidding war over its unsuccessful plan to combine its S.P. Richards office product unit with Essendant; the segment was ultimately sold in mid-2020 for around $375 million. We are encouraged that the deal (along with the divestiture of EIS in 2019) focused Genuine Parts’ operations on its core automotive and industrial businesses. The acquisition and divestiture history has not detracted from organic investment; the firm has deployed roughly 1%-2% of revenue toward capital expenditures over the last three years (around $220 million, on average), which we see as prudent for a firm with a fully-formed and largely independent national store network. Shareholder distributions have largely been appropriate, in our view. The firm targets a dividend payout ratio between 50% and 55% of prior-year earnings (though it exceeded the upper threshold for 2017-19, before the pandemic). We are not enamored with some of management’s recent stock-buyback efforts as we believe they were executed above the fair value of Genuine Parts’ shares. |
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