After a tough 2008, the aftermarket parts industry has delivered record growth over the past few quarters, thanks to pent-up demand and declines in new car sales. Since demand for replacement parts and maintenance tools stems primarily from necessity, rather than discretionary purchases, we think the industry's long-term growth prospects are bright. Additionally, the industry remains highly fragmented, with national retailers representing less than 20% of the entire market. We believe this leaves national players plenty of opportunities to capture market share from independent retailers. In our view, AutoZone (NYSE:AZO - News), Advance Auto Parts (NYSE:AAP - News), and O'Reilly Automotive (NasdaqGS:ORLY - News) are in the best position to benefit from these favorable industry dynamics, thanks to scale advantages and superior distribution capabilities.

Although these companies generate the majority of their sales from the automotive parts retail business, they have been expanding aggressively into the faster-growing commercial market, which sells automotive parts to professional installers and repair garages. We believe these national retailers could leverage their expansive store network by adding the commercial program to existing stores, which should help boost returns on invested capital. Demand in the professional segment tends to be more resilient to economic swings, as the rise in the average age of vehicles often results in more vehicle maintenance, offsetting the negative impact of fewer miles driven. Furthermore, the commercial business stands to gain from favorable tailwinds as independent garages may benefit from incremental business due to the closures of automotive dealerships.

The Aftermarket Parts Industry Switched Gears in Late 2008
As gasoline prices soared to more than $4 per gallon in July 2008, from $3 in the year-ago period, the aftermarket parts industry faced significant headwinds as miles driven--a key metric in gauging demand for parts--declined. According to the United States Department of Transportation, annual miles driven decreased by 3.7% in 2008, compared with a 1.4% compound annual growth rate over the past decade. Additionally, demand for automotive parts took a hit as tight-budgeted consumers chose to defer maintenance on their vehicles to conserve cash. As a result, automotive parts retailers reported weaker results during the period, posting slightly negative or relatively flat same-store sales growth.

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Over the next three quarters, however, this trend reversed and AutoZone, O'Reilly, and Advance Auto delivered same-store sales growth averaging in the mid-single digits. We believe part of this growth stemmed from pent-up demand in the industry as consumers could no longer defer vehicle repairs. And as gas prices have eased from historical highs to less than $3 per gallon, vehicle miles driven has improved over the past few months, following 16 months of consecutive declines (as shown in graph). Furthermore, given the weak economic environment, consumers have been seeking ways to extend the lives of their vehicles instead of buying new ones. With new car sales down 18% in 2008 and down another 25% year-to-date, the average age of vehicles will continue to rise in the near term, boosting demand for automotive parts. Additionally, with more automotive dealerships closing, the commercial segment could benefit from greater demand as independent garages gain new customers.

Although we expect demand for automotive parts to moderate as new car sales improve from record lows in the earlier part of 2009, we remain optimistic about these retailers' long-term outlook. Despite cyclical swings in the industry, the aftermarket parts industry has proven to be relatively stable over the long haul. Prior to 2008, both the automotive retail and commercial segment grew at a compounded rate of more than 4% annually. We believe this is mostly attributable to the fact that demand for auto parts and accessories is driven primarily by necessary maintenance rather than optional upgrades.

Size Matters
In our view, large national retailers are in the best position to benefit from favorable industry trends. Given the lack of customer switching costs, low barriers to entry, and intense rivalry in this industry, we think economies of scale are the primary driver of excess returns as bigger players gain cost advantages from greater purchasing volumes and by leveraging operating expenses over a larger sales base. Additionally, large retailers have the ability to stock a wide range of products and have shorter delivery lead times, which ensures better parts availability in their stores. In fiscal 2008, AutoZone's stores produced $239 in average sales per square foot, compared with $211 for Advance Auto and $201 for O'Reilly. Therefore, we believe scale advantages and unparalleled productivity have allowed AutoZone, the nation's largest automotive parts retailer (more than 4,000 stores), to consistently generate returns on invested capital in excess of our estimate of its cost of capital.

In contrast, smaller players, such as Pep Boys (NYSE:PBY - News), which has about 550 stores spread across 35 states, have struggled to compete with these larger competitors. The company receives less-favorable pricing from suppliers and is not able to leverage its advertising and distribution costs like the larger players.

Advance Auto and O'Reilly Are Revving Up
We think national retailers such as Advance Auto and O'Reilly (about 3,400 stores each) have gained a significant foothold in the industry. Over the past decade, Advance Auto has more than doubled its store base through aggressive new store openings. Furthermore, Advance Auto has seen early success in the commercial market, posting double-digit same-store sales growth over the past years. Through the acquisition of 62 Autopart International professional stores, the company has a head start and has further penetrated this market by introducing commercial delivery programs in its existing store base. As a result, Advance Auto generated almost $1.4 billion in commercial sales in the most recent fiscal year, which is almost twice as much as the $770 million delivered by industry leader AutoZone.

In April 2008, O'Reilly transformed itself from a strong regional player to an industry leader with a nationwide footprint through the acquisition of CSK Auto. In addition to cost savings from shared advertising and the consolidation of duplicate corporate functions, we believe O'Reilly stands to benefit from lower merchandise costs, thanks to greater purchasing volume. As evidence, gross margins have expanded about 260 basis points for the first nine months of 2009. Furthermore, we think O'Reilly could gain significant market share in the commercial segment by overlaying the firm's dual-market strategy, which serves both the retail and commercial market, on CSK's store base. In fiscal 2008, commercial sales represented only 10% of CSK's overall sales, versus approximately 48% at the core O'Reilly stores. In our view, scale advantages from incremental sales volume, as well as its strength in the commercial market, have placed O'Reilly in a better competitive position.

In conclusion, we believe AutoZone, Advance Auto, and O'Reilly are set to benefit from favorable industry dynamics, while smaller players like Pep Boys will continue to struggle. Given that the aftermarket parts market is highly fragmented, the national retailers have more room for growth and will continue to gain market share at the expense of small independent retailers. In our opinion, industry stalwart AutoZone will be the biggest winner, while O'Reilly and Advance Auto are better-positioned to capitalize on favorable tailwinds in the commercial market. Despite these positive industry trends, we think these stocks are fairly valued in the market as much of these benefits are already priced in.