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.

Around the Roadrunner Portfolios

Taro Pharmaceuticals (Nasdaq: TARO)  reported quite impressive fourth-quarter results. The generic drug manufacturer generated a 30% jump in revenue and a rip-roaring 69% increase in earnings per share.  For the year ending March, growth was slightly less robust but remarkable none the less.  Revenue grew 14% and earnings per share increased 39%.  The stock, however, is down 4% year to date and up only 2.5% since our December 15, 2014 addition to the Roadrunner Momentum Portfolio.

Taro is valued with a PE of 11 times 2016 earnings, a conservative valuation for a company that has reported such powerful growth.  The reason for such a low valuation is the uncertainty attached to Taro’s product portfolio due to management’s conservatism. A shift in industry forces may also limit growth going forward.

Generic drug companies as a rule are quite secretive about their product portfolios.  The drugs for which they have submitted applications to the FDA for approval are by nature off patent.  As generic drug companies have little intellectual property to protect them against other competitors in the market, they like to remain quiet about which drugs will be hitting the market in the near future. In addition Taro has not been very investor friendly in the past.  The company hosted its first ever investor conference call back in November 2014 but has been hesitant to provide much detail on growth expectations.  As management slowly migrates to a more open dialogue with investors, the stock may get a lift.

In addition to not knowing the value of the products Taro has in its pipeline, investors are also worried about how sustainable Taro’s revenue growth is going forward.  All of Taro’s revenue growth has been generated by price increases on current drugs sold.  Volume of drug sold decreased slightly for the year ending March.  Management clearly notes this is a risk going forward.  In the fourth-quarter press release, Taro CEO Kal Sundaram calls out increased competition and price pressures from customer consolidations as issues that are already impacting earnings.

He is referring to the overwhelming trend of mergers in the prescription benefit manager (PBM) space.  United Health’s March 2015 purchase of Catamaran, a national PBM, was the latest in a wave of mergers that started in 2007 when CVS acquired Caremark.  In the face of escalating drug prices, insurers and PBMs have been banning together to gain pricing leverage over drug manufacturers. While most of this clout will be directed at controlling the skyrocketing prices of specialty drugs, there will certainly be some price pressure on generic drug manufacturers. It may take some time for Taro’s stock to reflect its growth potential, but its low valuation reduces the risk of holding it until the smoke clears.

Brocade Communications (Nasdaq: BRCD) continues to develop its portfolio of networking products to serve the needs of today’s data managers. Although total revenue for the company’s second quarter, reported on May 21st, was up only 2%, revenue from advanced IP networking products grew 19%. The overall revenue number was dragged down by a 2% decline in Storage Area Network (SAN) hardware which dropped 2%.

SAN products have been soft for some time now as this market matures. Management also noted a temporary issue with a distributor which weighed down SAN sales.  IP storage programs are currently a more attractive solution to network managers.  As enterprises are swamped with data, they are continually searching for the most effective ways to store, access, protect and manage critical data.  IP solutions are open standard and allow more flexibility when expanding storage and retrieval of data via wireless and mobile devices. Brocade’s recent purchases of SteelApp and Connectum will enhance its capabilities within IP storage products.

Brocade has been a huge winner for the Roadrunner Value portfolio, up 123% since its February 27, 2013 inclusion. Investors who can patiently wait for the company to work through the slowness in its SAN business should see continued gains.  Brocade generates significant free cash flow, the amount of cash left over after a company invests in the capital spending required to keep its business fresh.  Brocade used part of that cash in the most recent quarter to increase its dividend 29%. Although the SAN business will likely drag its feet for a few more quarters, this slowdown is included in estimates and should not surprise investors.  

Gentherm (Nasdaq: THRM) was your best friend last winter if you live in the Northeastern U.S. The manufacturer of heated steering wheels and seats has extended its reach into more and more car models over the years. Unfortunately for investors, their ride with the stock has not been as comfortable as for those in a cozy sedan.

The stock, which was added to the Roadrunner Momentum portfolio on September 10, 2014, dropped 40% to a low of $33 mid-winter.  The selloff was due to a significant deceleration in Gentherm’s revenue growth.  This was a result of a completed launch of several car models.  As Gentherm adds a new model for a particular customer, revenue charges higher as a whole fleet is outfitted with its thermal control devices.  However, once that rollout is complete, growth retreats to mimic new car sales for that particular line. Gentherm enjoyed revenue growth as high as 31% in early 2014 as it worked through launches for Jeep’s Grand Cherokee and GM’s full size truck, the K2XX.  As those launches completed, revenue growth stumbled to 13% in the final quarter of 2014 and 7% in the most-recent first-quarter results.  First-quarter earnings growth remained robust, however, at 20%.

Gentherm’s stock has rebounded nicely.  It is up 62% from the December low and is now up 3% from our recommendation. Estimates for 2015 and 2016 now reflect a lower growth rate, helping to insulate the stock against any earnings misses. Inclusion in the S&P600 on March 31st also helped to support the stock price.

Gentherm is currently priced at 19x 2016 estimates, exactly in line with its expected 19% growth rate.  A new program for Ford’s newly designed Mustang could lift growth above that level.  Improved action in the Euro could also bolster growth.  More than half of Gentherm’s revenue comes from outside of the U.S. with the weaker Euro (a temporary factor) dampening results.