By Linda McDonough

With auto sales booming, investors may be tempted to buy the auto supplier stocks.  Buying names like Dorman Products (Nasdaq: DORM), Remy International (Nasdaq: REMY) and Motorcar Parts of America (Nasdaq: MPAA) can diversify an investor’s risk across many auto brands.  But based on the trends seen in the customers of all of these companies, it would be better to pass on this ride.

Sometimes the easiest way to predict a company’s future is to “go vertical.” This means going “up the chain” to see how a company’s customers are faring or “down the chain” to study its suppliers. If those companies up and down the chain are public, investors can then decide whether it makes sense that one company’s good fortune will extend to another in the chain.  Assessing the health of a company’s counterparts, including both customers and suppliers, is often a clue the stock market overlooks.

This is a well-honed game of Apple investors. Sophisticated analysts often hire experts to dismantle the newest iPhone to confirm whose parts Apple is using. One of those suppliers, Cirrus Logic, gets 72% of its revenue from Apple and lives or dies on the success of Apple products.  

The reverse is true if a company’s sales are slowing. Wouldn’t it make sense that orders to its suppliers would moderate soon? This is the situation aftermarket auto suppliers face now. The market for automotive parts is split into two parts. Original equipment manufacturers (OEMs) supply engines, wheel hubs and gears to companies like General Motors, Ford and Volkswagen for new cars. The aftermarket auto industry, on the other hand, makes replacement parts, distributing them to retail stores like AutoZone (NYSE: AZO) or to commercial garages that repair cars.

Retailers Shift Gears

Although the retail channel for aftermarket auto parts has been fairly weak, the commercial market rode the wave of two positive trends. The first is pretty straightforward; a weak economy left many consumers holding on to their cars longer, and older cars require more maintenance, ergo, more replacement parts.

The second trend is less intuitive. Almost every function in new cars, from tuning the radio to reading the gas gauge, is electronic. The days of running into the nearest AutoZone for a new headlight and screwing it in are long gone. The beeping, flashing gadgetry that operates our cars befuddles many owners so that even the most mechanically minded visit the corner garage to get a muffler fixed. Retailers like AutoZone and Advance Auto Parts (NYSE: AAP) felt the effects head on as slowing do-it-yourself sales forced them to shift over to the commercial do-it-for-me market.

To address this market, in January 2014 Advance Auto Parts bought General Parts International, which supplies and distributes OEM and commercial aftermarket auto parts. Buying this supplier helped Advance Auto increase its commercial business from 35% to 60% of total sales. Competitors AutoZone and O’Reilly Automotive (Nasdaq: ORLY) were also eager to grab more of that business. To better serve commercial garages all three retailers added delivery services and expanded their inventory. This makes sense. While the common retail customer is looking for new wiper blades and a bottle of Castrol motor oil, a mechanic needs a specific make and model carburetor barrel or a screw and bracket for a steering shaft.

Suppliers Get Squeezed

With so many customers bulking up on inventory, parts suppliers like Dorman Products, Motorcar Parts of America and Remy International cleaned up. Dorman Products, which specializes in hard-to-make parts, derives 94% of its sales from AutoZone, Advance Auto Parts, Genuine Parts (NYSE: GPC) and O’Reilly Automotive. Motorcar Parts of America obtains 87% of its sales from these four retailers. Remy International sells mostly to the original equipment manufacturers and is less exposed to the retailers, which generate only 20% of company revenue.

But when Advance Auto Parts bought General Parts International, the industry’s landscape changed. The acquisition consolidated the buying power for aftermarket parts to three major players. Advance Auto Parts increased its sales 40% by acquiring General Parts International and is now the largest buyer of aftermarket auto parts, edging out AutoZone for first place. In the 18 months since the deal closed, management centralized back-office functions and aligned its sales force. Next on the agenda are product changeovers and pricing. The company wants to leverage its purchase by getting better pricing from suppliers. Having fewer customers with more clout is not a good sign for aftermarket suppliers, nor is recent data showing that sales at retailers are slowing.

After enjoying same-store sales, or comps, as high as 2.6% last year, Advance Auto Parts reported results for the most recent quarter that even its own management found disappointing—a comp of less than 1%. At AutoZone, comps slowed from 4.5% a few quarters ago to 2.3% in March. Only O’Reilly Automotive, the smallest of the three retailers, kept its comps steady.

This slowdown is probably because new car sales surged. According to industry group Auto Alliance, 16.4 million new cars were sold in 2014, a 6% increase over the prior year and the highest count since 2006. Unfortunately for the replacement part market, the pool of aging cars from the recession is shrinking. None of this would matter if investors were braced for the slowdown. But rosy estimates call for revenue growth in the high teens for these suppliers despite all three reporting declining revenue in the most recent quarter. It’s time investors step on the brakes for these stocks.