A diamond in the rough

Jan. 1, 2020
The investment brilliance of many industries has faded as the economy has faced turmoil and instability; yet investors continue to see the aftermarket as a precious gem ? an attractive, long-term and valuable undertaking.

The investment brilliance of many industries has faded as the economy has faced turmoil and instability; yet investors continue to see the aftermarket as a precious gem — an attractive, long-term and valuable undertaking.
 
>img src="diamond.gif" align="left">“Like all businesses, aftermarket companies are valued on future earnings. The industry is set to ride some very attractive tailwinds, including what many expect to be an increase in miles traveled, an aging vehicle fleet and new car dealership closings which will create a $6 billion jump ball for aftermarket businesses,” says Jonathan Carey, vice president of investment firm BB&T Capital Markets.
 
“Couple this with expected growth and relatively low beta or risk as demonstrated by the industry’s relative stability over the past two years as compared to other consumer businesses and one can understand the increased interest in the aftermarket.”
 
Granted, the opportunities may have changed shape — those who once looked for steady and historically strong companies to back may now seek out distress deals or merger and acquisition (M&A) activities. But the money is still coming in.
 
“We certainly don’t see any slowdown in the investment capital coming into the industry. We get pretty much as many queries as we ever have,” says Dan Smith, president of Capstone Financial Group, an investment firm that handles interests in the aftermarket.
 
“Granted, it’s different. With so many aftermarket companies suffering these days, or having diminished sales and diminished profitability, it is a different kind of money, meaning a lot these days may be looking for distress deals,” Smith adds.

An M&A about-face
Current and potential investors are looking for the opportunities available, and those most common throughout this economic environment tend to fall around merger and acquisition activity.
 
“The term M&A has been around forever, but the “M” was not so prominent until a couple years ago,” says Smith. “We are seeing a lot of mergers, just outright mergers from institutional money that owns a company merging with other companies. The influx of capital and the importance of capital will not diminish, it is just different kinds of deals.”
 
The presence of what Capstone’s Managing Director Graham Payne deems “healthy” M&A activity — or typical succession planning — has taken a backseat in the past 12 months to more unhealthy distress M&A deals, mainly because of the economic state of the industry.
 
“But now we’re starting to come out of that and we’re seeing more healthy M&A deals getting done,” he says.
 
Not much merger and acquisition activity is anticipated from the manufacturers and retailers, but big distributors are expected to continue picking off profitable or salvageable competitors to expand customer reach, says Angelo Onello II, principal of Onello Associates, a consulting firm specializing in the automotive aftermarket.

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Opportunity growth
Despite the changing investment landscape within the industry, last year’s recession left not nearly as big of an impact on the aftermarket as it did on other industries. But still, what little recovery was needed for the aftermarket to regain stable footing is already in motion.
 
“As a caveat that we can’t tell the future, certainly if the economy, if the industry continues to grow as we’ve seen it grow very recently, as we talk to a lot of folks out there, we seem to, in the last two to three months, have begun to see signs of recovery. Some call it green shoots — the first signs of coming back to a thriving environment. We are cautiously optimistic about the future,” Payne says.
 
Faltering new automotive sales have driven the aftermarket through dollars spent on repair and maintenance — services that will always be in demand, says Kristin Newhall, partner with the Riverside Company, a global private equity firm.
 
“From my experience there’s been a shift from accessorizing your vehicle, back to just keeping it on the road. The age of the vehicle fleet is getting older. People prepare their 86 Taurus because that’s what will get them to work every day. There will always be a demand, it just will swing from one end to another depending on what’s happening with the broader economy."

The increases presence of the Internet in the supply chain and its impact on efficiency throughout the distribution and procurement area will also prove to be a dramatic factor in improving the aftermarket, she says.

The continued enhancement of vehicle technology sophistication, globalization and new and growing segments in the aftermarket have all allowed new opportunities to come to the surface, Carey says.
 
“There are also several great brands in the aftermarket that have an opportunity to expand into new product offerings or a new channel such as the DIFM market.  Technology is also playing an increasingly important role in the aftermarket as software providers are finding ways to make the industry more efficient. Also, as many realize there is also an enormous opportunity outside of North America and not just in low cost manufacturing,” he says.  
 
“For example, we are currently working with a full-service aftermarket service chain that is bringing western style retail to the automotive aftermarket in China. This company has a handful of stores on the ground now in China but the runway for growth is enormous.”

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Proceeding with caution
But not everyone is so optimistic on the stability and future of the aftermarket. While the recession has boosted the aftermarket in the short-term, not all long-term effects are promising, says Jon Vander Ark, a consultant with the automotive and assembly sector at consulting firm McKinsey & Co.  
 
“As people have stopped buying cars and are driving their cars longer, they end up in the sweet spot for automotive repair. So it helps in the short term,” he says. “Conversely, it hurts over a 5-7 year period. The number of cars sold was 17 million a few years ago, and this year it will be probably 10 million. There are fewer vehicles that will be moving through the funnel 5-7 years from now into their prime service years.”
 
Vander Ark also predicts a reduction in market demand and increased competition.
 
“People are looking to the aftermarket as a source of profitable growth, so you are getting increased competition,” he says. “There is a real consumer trend for store brands in the market, and I think there is a real shift toward the independent market away from dealers as a broad class, so lots of dynamics are changing in the market.”
 
But how these changes will play out and the impact they will have on the industry will be different in each segment.
 
“What does this mean in terms of investment? It depends because you are talking about a $200 billion-plus industry, so I think some areas will be challenged and some areas will be attractive,” Vander Ark says.
 
“For the core activist investors, this is a fairly interesting time to think about investing in the aftermarket,” he says.
 
Whether the optimists or pessimist predictions prove true in the end will remain to be seen, but one thing is certain — industry change and evolution remains a certainty for the future.