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BIG DEALS, BIGGER WHEELS

Retail auto parts segment enters new phase as national chains expand

BY MYA FRAZIER

Whenever AutoZone or Advance Auto Parts opens a store, where does competitor O’Reilly Auto Parts want to be? Right next door.

“If they’ve done a nice job on a site, we want to be right there,” said Charlie Downs, vice president of real estate at Springfield, Mo.-based O’Reilly Auto Parts. “We don’t have any qualms in being close to the competition.”

Some analysts question the wisdom of such a corner-by-corner real estate approach, though. So far, the growth of the leading auto parts chains has come at the expense of the independents. But a new phase looms, these analysts say, one that will involve fierce market share battles among the top players.

This comes on top of another looming challenge facing the sector: a declining do-it-yourself market driven by demographic and technological changes. Things can only get even more interesting from here, observers say.

“You can never continue to have three competitors side by side by side, and we are seeing that in this space,” said Brian Postol, an A.G. Edwards & Sons analyst who covers these companies. “You have all three on the same street corner in some locations. You kind of scratch your head and wonder why the third thought they could make money too.”

Retail categories tend to shake out into duopolies, Postol says, citing as examples Wal-Mart and Target in mass merchandising and The Home Depot and Lowe’s in home improvement.

Over the past decade these chains have grabbed market share by buying up independent or regional players, trimming the total number of auto parts stores to 35,590 at the end of 2002 from 42,519 in 1997, according to the Automotive Aftermarket Industry Association.

In 1997 the top 10 auto parts retailers controlled 12 percent of total sales. By the end of last year, those retailers had consolidated down to five that controlled 25 percent, according to the AAIA. AutoZone is the leader, enjoying not just the broadest geographic reach (coverage of 48 states), but also the highest store count (3,448 in the U.S. plus an additional 64 in Mexico). Continued growth looks like a given, with AutoZone planning about 200 openings for the 2005 fiscal year that began in August.

The remaining four players cannot rival AutoZone’s national reach, but three remain bullish on new store openings.

Roanoke, Va.-based Advance Auto Parts is No. 2, with 2,612 stores in 39 states and another 33 in Puerto Rico.

CSK Auto Corp., based in Phoenix, dominates the Western U.S., operating a total of 1,129 corporate-owned stores under the Checker Auto Parts, Kragen Auto Parts and Schuck’s Auto Supply brands. Kragen alone has 469 stores in California. CSK plans to open about 50 units in fiscal 2005, which begins in February, mostly in outparcels at high-visibility open-air and power centers.

O’Reilly had just 165 stores 10 years ago, but today it operates 1,205 stores in 18 states, mainly in the Midwest and South. It plans to open 160 stores this year, up from 140 last year.

Over at Pep Boys, growth has stalled, though. At one time more than 700 stores strong, the now 595-unit chain has not opened a new unit in at least two years. The company launched a multi-million dollar remodeling program last year, but has no plans for new stores this year, according to Bill Furtkevic, Pep Boys’ director of marketing and advertising.

Uniquely among the top five, retail comprises only 45 percent of Pep Boys’ more than $2 billion in annual sales. Commercial sales to professional repair shops, on-site auto repair, tire installation and other services make up the rest.

Real estate ruction
This rapid expansion by four of the top five has led to skirmishing on the real estate front and hurt profits, according to Alex Vallecillo, senior portfolio manager at Cleveland-based Armada Funds, which sold its holdings in automotive retail stocks a year ago.

“The retailing capacity is pretty fully penetrated, so now the main competitors are fighting it out, and there’s some squeezing going on,” Vallecillo said. “That’s a clear sign of potential issues.”

CSK Treasurer Stephen Lewis confirms that real estate pressures do have a tendency to squeeze profits, but he insists the trouble is restricted to the smaller, rural markets.

“Whoever gets to the one-horse town first is going to own that market,” Lewis said. “The second person in is going to get about half the market, and then you are both just going to lose money.”

The larger metro markets, however, offer a larger pie, he says, and that means larger slices for everyone.

“Granted, when we are looking at site zones, we just assume the competitors are going to come,” he said. “But there’s a rational competitiveness and a lot of parity on pricing. The top five only dominate 25 percent of the entire pie. That’s not exactly saturation.”

Given the squeezing, the players are more aggressively pursuing locations with corner lots and high visibility and traffic. Of course, they are paying more for the real estate, says Jeffrey Howard, an assistant vice president and senior leasing representative at Inland Commercial Property Management Corp., a group of REITs that controls $15 billion in shopping center assets nationwide.

“It used to be three-dollar deals off the beaten path,” Howard said. “But in recent years they’ve recognized they can pay a few bucks more and get much better sites. Now they like to be up front with high exposure. The old stores were buried in the industrial parts of town a block off Main Street.”

Howard predicts a shakeout. “It’s like other retail businesses,” he said. “You can have two competitors in a market, and three come in, and no one makes any money.”

For their part, the auto goods chains show few signs of wanting to put the brakes on store growth.

Advance Auto Parts is sticking to its existing markets, but with close to $4 billion in sales last year, it plans to open 150 to 175 stores this year, up from 125 last year. Scott Miller, the chain’s senior vice president of real estate, defends the strategy.

Like O’Reilly Automotive’s Downs, Miller denies that the crowded real estate landscape poses a threat to growth. “Candidly, that’s not much different than having McDonald’s, Wendy’s and Burger King right next to each other,” Miller said. “There are differences among each of us that allow us to be successful together.”

Over the long term, Advance Auto Parts sees a market for 1,500 additional stores within the states in which it now operates. The chain has also embarked on a multimillion dollar chainwide remodeling program; it has already converted 1,022 stores from the existing format, which is dominated by a long parts counter that divides the selling floor from the merchandise shelves. The new format gives shoppers a series of workstations that open the parts area to the selling floor. The company plans to overhaul about 250 stores a year this way.

Some question the value of Advance’s investment, especially given that leader AutoZone isn’t following suit, though it says it has “refreshed” about 450 stores since the beginning of 2004. “The big question is, does the consumer care?” said Postol of A.G. Edwards. “AutoZone hasn’t updated stores, and their older stores don’t look as good.”

Brian Campbell, AutoZone’s director of investor relations, explains the strategy by pointing to the chain’s average sales per square foot figure of $260 and to its roughly $1.65 million in store sales last year as proof that function can very much trump form.

“You don’t want an auto store to be a Tiffany’s,” he said. “These stores are four walls, they are painted … There’s a tile floor with a parts counter, a manager’s desk and a bathroom in the back. That’s it.”

For these five, though, there’s more than just the retail-oriented competition to contend with.

As do-it-yourself sales continue to decline, the commercial side of the business has become more critical.

Other auto parts stores tackled the commercial market, focusing on sales to professional auto repair shops long ago. Among these is CarQuest, based in Raleigh, N.C., which has more than 1,300 stores nationwide and does 71 percent of its business on the commercial side.

Genuine Parts Co., based in Atlanta, has 900 corporate stores nationwide (an additional 4,900 stores operate under the NAPA [National Automotive Parts Association] banner as independents that pay no franchise fees but serve as distribution points for the company’s products) and does more than 60 percent of its business on the commercial side. Last year the company opened 50 new corporate stores and 50 independent units, a pace it plans to keep up over the next five years.

“We love the retail business because it’s easy business,” said Jerry Nix, executive vice president of finance and CFO of Genuine Parts. “It’s high-net. You don’t have any delivery expense, no sales expense. The customer walks in off the street and buys the product. But the growth side of the business is the commercial side. If you are going to get growth you are going to have to go after the commercial side.”

Advance Auto Parts and AutoZone are doing just that; they have launched ambitious commercial programs catering to mechanics, not just to the walk-in customer. By the end of last year, Advance Auto Parts had instituted commercial programs at nearly three-quarters of its stores, adding delivery trucks and outside sales staff. AutoZone has expanded its commercial business to account for 12 percent of its more than $5 billion in sales.

Postol says the top retail players must keep building a commercial business to insulate sales from future declines in the do-it-yourself market.

The commercial market demands a lot of investment, though, including trucks and a more extensive distribution network, to handle the greater volume of parts that professional repair shops require.

“You have to pay up,” Postol said. “You have to be in close proximate locations to the garages of the world. Most of the garages won’t go farther than five miles to a store.”