Will we buckle in the coming years?

Projecting forward three to five years, industry analysts and experts share how new challenges will impact our landscape. Though some may have different viewpoints on how certain obstacles or opportunities will impact our marketplace, they all agree that the aftermarket’s players, from top to bottom, will have to become extremely sophisticated and savvy if they want to ensure they’ll still be in business when the clock strikes midnight on Dec. 31, 2009. Those with the “business as usual” mentality may very well find themselves with little reason to celebrate when the ball drops.

Merging until we can’t?

Almost every week, we hear about a new partnership, merger or acquisition in the aftermarket.

According to Capstone Financial Group, there were more than 29 mergers and acquisitions between retailers and distributors in 2005. There were 57 among suppliers. This movement will continue “unabashed for the next several years,” says Dan Smith, president of the firm. “It’s impacting (the industry) violently now so it will only get more pronounced in the next three to five years.” In 1980, there were 600 WDs, according to Motor & Equipment Manufacturers Association (MEMA) statistics. That number made its way down to 450 by 2000 — and keeps dwindling.

Smith explains that the nature of consolidation tends to feed itself. When retailers and distributors began consolidating several years ago, it forced manufacturers to consolidate. “It’s much like a snowball effect,” he says, one perhaps so big that Aftermarket Business may have to provide readers with the top 25 auto chains report in future years instead of the top 50. Smith agrees with this notion, as he thinks the list will shrink by two or three a year.

This continuing trend of consolidation is partially due to the new flow of capital into the aftermarket from private equity firms. These new investments are creating a river of opportunity for companies that require more financial backing while at the same time making the market more complex to swim around in.

According to an article in Modern Distribution Management, financial players participated in at least 35 distribution transactions in 2005 and reported more total revenues in one year than in the previous four combined. It is said that one reason they have their eyes on distribution industries is because of the high rate of return (the stock of these companies is rising).

Smith suggests that in a market where many owners are unaware of their gross margins, a private equity firm can step in, make simple operational improvements and significantly increase the company’s profitability. He suggests that many of the companies that have received private equity capital have been able to grow both organically and through acquisitions.

In the aftermarket, the participation of private equity firms will accelerate growth, says Smith. The trend will drive up purchase price multiples, but that doesn’t mean we won’t continue to struggle with margin erosion due to raw material price increases, Asian imports and other factors all too familiar to our marketplace.

But if this type of aggressive consolidation continues in the coming years, only time will tell what the benefits will be. Steve Handschuh, the new executive director of the Automotive Aftermarket Suppliers Association (AASA) and the VP of MEMA, says that in the last eight or nine years, merger and acquisition activity was supposed to produce significant synergies, but unfortunately not much has materialized.

Bill Wade of Wade & Partners, an aftermarket-consulting firm, supposes the aftermarket could look very much like the hardware business in a few years. “It’s made up of four big groups and very few independents…I wouldn’t be at all surprised to see the automotive aftermarket well on its way to that level of consolidation.” And just weeks before Home Depot announced their entrance into the auto parts market with a pilot program, he told us it was highly likely a national home care store would soon invest in the aftermarket since it would allow them to leverage their existing distribution technology. Depending on how involved Home Depot (and possibly other home retailers) gets will impact how the traditional aftermarket keeps hold of its market share.

Entering a no-man’s land

This trend of consolidation will certainly lead to new strategies at each level. Frost & Sullivan’s Mary-Beth Kellenberger, consulting analyst, foresees WDs going deeper into the delivery systems, even moving into markets that jobbers previously occupied. “The whole system is becoming much more two-step,” she says, adding that the jobber is really coming under attack.

“The jobber area is becoming a bit of a no-man’s land unless you are in a specific geographic area or product category.”

Kathleen Schmatz, president of the Automotive Aftermarket Industry Association (AAIA), certainly thinks “the decline of jobber outlets will continue modestly. The strongest ones will have the closest relationships with their suppliers. The ones that aren’t connected to strong program groups are going to be challenged to compete in a highly competitive market.”

Further squeezing the jobbers, adds Kellenberger, will be the retailers’ continued investment in their commercial divisions. “Retailers are investing in the knowledge and the inventory (to serve the commercial customers). Installers used to be reluctant to use them because they weren’t knowledgeable enough.” But that’s not the case now, especially considering the fact that about three-quarters of the aftermarket is now do-it-for-me — it’s the key growth opportunity and everybody wants a piece.

Tony Cristello, senior VP of equity research for BB&T Capital Markets, agrees that if they haven’t already, retailers will be making serious investments in their commercial businesses to compete with wholesalers. For instance, he says Advance is now 25 percent wholesale as a result of the purchase of Autopart International. “They bought expertise in the business where you need to know the nuances, you need to have a high level of service, good relationships with the installer base,” says Cristello.

Some retailers are also trying to source directly as a way to cut costs, says Smith, though he doesn’t see this taking hold.

But Cristello, who points out that AutoZone and Advance are direct sourcing already, says this is clearly a trend that could intensify in the coming years.

Most executives we spoke to believe the top retailers will remain strong, although there is some speculation as to what will happen with Pep Boys in terms of its future growth. The top five retailer has been under analyst and investor scrutiny for several months due to several changes in strategy.

Schmatz is confident that the top 10 retailers have tremendous staying power. “They continue to apply solid marketing plans with conservative financial outlooks.”

Wade, on the other hand, thinks that in five years there will only be three retail heavy hitters — Advance, AutoZone and O’Reilly. He anticipates a retailer stepping up with a new format altogether, “as in how they sell, what lines they carry and maybe how they connect with end users.”

As for WDs, Cristello is confident that they will be able to handle the retail competition due to their established alliances with manufacturers and suppliers and history in the marketplace. He ascertains that when retailers drove wholesalers out of the retail business, it forced WDs to “build better systems, better networks, better relationships with suppliers. They are much more defensible now with their model” on the commercial side, says Cristello.

That doesn’t mean WDs will be resistant to change. In fact, those who embrace it will likely get bigger and stronger as they take on more responsibility. “The manufacturer is taking a smaller margin on the sale in exchange for WDs being responsible for advertising, stock buy-backs and other things like warranties. It helps manufacturers be more competitive on price and gives customers a little more flexibility of pricing on their end,” suggests Stephen Spivey, research analyst with Frost & Sullivan.

But the jobber’s fate paints a different picture altogether. Wade sees the independents branching out into niche groups as a means to survive. You have the “dealer, the retail channel and the traditional channel all contending for the same dollars,” he says, purporting that something will have to give.

Kellenberger believes that some jobbers will get much bigger in order to compete within this new landscape — maybe taking on a similar appearance to that of a WD. Or, she suggests they will focus on their unique selling points, being much more of a niche market participant. Regardless, it sounds as if jobbers have their work cut out for them.

Role of program groups to intensify

There’s no question jobbers will have to rely on the buying power and marketing finesse of their program groups as one means for survival. Those choosing to go it alone will most certainly be challenged by the new dynamics, says Cristello.

Kellenberger explains that originally, most jobbers wanted to join a group so they could compete with two-steppers, bigger jobbers or retailers. There really wasn’t a strategy in choosing which group to join, and most program groups had an open-door policy. But due to changes in recent years, Kellenberger tells us some program groups are even pushing away less valuable members and encouraging them to go elsewhere, especially if they don’t drive enough revenue or purchases.

Smith says many of the companies that are members of the program group are “more important than the program groups themselves.”

Though program groups have already experienced a bit of consolidation, Schmatz thinks the future will bring even more. “Some of the bigger program groups are doing so well, making it harder for some of the smaller ones to compete.”

Wade predicts that in five years, there will be five program groups, not including NAPA and CARQUEST. “I think it’s just a question of footprint overlaps,” where the groups have to figure out how much saturation they have in certain markets.

Supplier woes trickle their way down

Any shortcomings at the OE and Tier 1 level will eventually slither down to the aftermarket. “If the OEs don’t get their legacy costs and healthcare costs under control, you will see severe trickle-down effects. It’s already gone through Tier 1 and into Tier 2, and you’ll see a lot of it in the aftermarket since many have OE-supplied contracts,” says Capstone’s Smith. Add in the pressure that the WDs and program groups are putting on these suppliers, and they are being all but forced to go to China, get out of the business or merge with another company that already has a strong global front.

“I think we’ve got to learn a lesson from Detroit. We cannot have our suppliers fail at the hands of other folks in the distribution chain. We can’t let it happen. We can’t squeeze those folks until there is nothing left. The future will be dependent on healthy suppliers...they must have the resources to do research, add technology and improve products. I’m not a fan of the low-cost supplier point of view and I think the aftermarket has made mistakes seeking that as a new platform. We aren’t keeping up with consumer price indexes. We all need to get a fair price for our products, service and expertise. That includes the manufacturers,” states Schmatz rather emphatically.

Regardless, price seems to be winning the war as China’s hand in the aftermarket continues to grow larger, adding to a very significant trade imbalance and even more possible repercussions for the economy. “Offshore manufacturers have the market cornered,” says Spivey. “In order to become competitive at that price level, you’ll see ongoing consolidation” and more jobs going overseas.

This trend will continue to affect profit erosion and price margins, and many we spoke with don’t see this fixing itself anytime soon. Handschuh says the average price of the aftermarket part hasn’t changed much in the last 12 years, a true detriment to our industry. “If anything, there has been depreciation.”

Could that be why many companies will spend their next several years fighting bankruptcy, almost futilely? A recent report from Bloomberg suggests that a dozen auto parts suppliers may file for bankruptcy over the next two years. At least seven have sought court protection in the last 24 months. The article says that higher raw material costs and the inability to raise prices may be impossible to overcome.

Many of our aftermarket manufacturers may be forced to sell directly to consumers, according to Smith, and will master online selling to do so. He believes they were hesitant in the past due to their relationships with distributors, but it’ll be one of the only ways for them to sustain growth.

Those who keep their loyalties to the traditional channel will become importers and distributors, not principal manufacturers, concurs both Wade and Spivey.

Therefore, finding parts may become more difficult. Without principal manufacturers creating full lines, a distributor may have to purchase the same type of product from three to five different sources. “When it gets to the retail level, (no one) will know what percentage of their line is Chinese vs. N.A. manufactured,” says Kellenberger. No one will have a clue what’s in the box.

What the industry does know is that the white box seems to be winning the game: Our distribution channel eats up and spits out product without much regard to name brand. Some suggest that as WDs and program groups grow, the brand names they create and sell will continue to gain ground.

“Not sure what cache some consumer brands will continue to hold,” says Smith, adding that there are so many parts that people already know are made in China, though where a product is made seems to have little to do with the actual brand name.

“I hope that brand equity gets back to what it used to be,” imparts Schmatz, who adds that we’ve spent years building consumer confidence in our brands. “We have to be able to tell the quality story, without regard to where something has been produced.”

Wade argues that parts are only worth something in application. “We may not have a heck of a lot of foundries left in the U.S., but if I handed you the finest casting you’ve ever seen, and you don’t know how to put it on the car, all the Chinese or brand name parts in the world aren’t going to help that sale.

“It’s the catalog, clinics, diagnostics that are going to have to define the supplier.” He cites Moog as an example. “Unless they screw it up, that box will continue to stand for a part of acceptable quality that fits, that has installation instructions that are readable, an 800 hotline, and OE to Moog interchange, 24-hour customer service lines. That’s what they will be all about. They will not be about a ball joint.”

He thinks many brand names will hold strong, considering it just doesn’t make sense to buy certain items offshore.

Prepared to repair?

With consolidation and its possible repercussions raining down on the entire chain, it’s only natural to wonder what it means for our independent shops.

Schmatz is certain attrition will occur among the independents in a big way in the next three to five years. She thinks there will be more mergers among professional, well-run repair shops, while others that don’t invest in technology and training will fall by the wayside. “We have to do a better job at the firing line. All of us in the aftermarket must be invested in the success of professional repair shops so they can sell with confidence and don’t come across as rip-off artists.”

Cristello says bigger operators stand to benefit from macro trends that are driving service levels. “The larger ones with access to capital, scale and buying power are going to be able to consolidate this industry. The local garages without succession plans may not want to invest in new tools, and the diagnostics needed to compete…so they will either sell out or bring their operation under a franchise blanket.”

Despite the extent of consolidation, many wonder how the remaining shops will be successful without a solution to Right to Repair. The debate on whether it’ll be successful carries on.

“We are going to win the guarantee for the aftermarket’s access to information,” says Schmatz, though she is not sure if it’ll be via a legislative or non-legislative solution. “We’ve come a long way, made strides, but we have to get this because there are other issues that we will have no chance of winning if we don’t get this right.”

Cristello is worried that we are too fragmented to tackle the issue. “A more consolidated, united approach to attacking this problem could go a long way.”

Spivey points out, however, another challenge we face: A lot of cars don’t even enter the aftermarket anymore. Everyone is well aware of the fact that replacement intervals for many parts have been on the decline. “You used to replace starters and alternators at 40,000 miles; now you are going to get it at 150,000 miles.” Brake pads get changed after four and a half years, instead of after three. Gaskets don’t need replacing for 10 years in some instances.

But Schmatz is confident we’ll keep our share of business as we begin to see a much greater shift from repair work to maintenance work.

Not the end of the world
Regardless of consolidation, squeezing margins and fierce competition, this industry is still making strides. Schmatz says we’ve successfully reached consumers with the Be Car Care Aware campaign and will continue to do so. Plus, “We are doing a better job not fighting with each other,” she says, reminding the industry that the enemy is not ourselves. “The enemy is a lack of education among consumers or the threat of OEs wanting cradle to the grave ownership.”

There have also been greater steps toward collaboration. We’ve added profitability and productivity in the form of enhanced data standards. We have more vehicles on the road than ever before. At the end of 2006, MEMA predicts the motor vehicle parts market will be a $391 billion market. It has gotten bigger every year for the past five fiscal years, and the aftermarket has managed to keep its share. Spivey points out, too, that the aftermarket is still the preferred sales channel because of its inventory selection, product expertise and post-sales support.

“I get discouraged when I hear people talk about the end of the world as we know it,” says aftermarket consultant Wade, who adds that our industry has changed so many times since 1910.

“We are coming up on the 100th anniversary of the aftermarket. What a surprise things are changing. We have more smart people than ever before, we have different problems but not any bigger than others we’ve faced, like after World War II or after the recession.”