The Consolidation Curve in the Automotive Aftermarket in Paint, Parts, and Distribution Segments

The industry is consolidating. That statement probably comes as little surprise. The entire automotive aftermarket is consolidating. New car dealers, tire vendors, parts distributors, paint distributors, software providers, and collision repair shops are all consolidating. But were you aware that industries tend to follow a predictable path of consolidation, referred to as the consolidation curve?

Big companies are acquiring smaller companies using affordable capital to grow. This growth creates economies of scale. And economies of scale allow larger companies to provide goods and services relatively more efficiently and at a lower marginal cost than their smaller competitors.

Consolidation will continue because it is a virtuous cycle where success attracts additional investment that generates further business advantage. A growing consolidator will continue to acquire for two main reasons. First, each acquisition presents an opportunity to further build economies of scale to propel further competitive advantage. Second, disciplined acquisitions increase the value of a business in excess of the cost of the acquisition. This is generally referred to as an accretive acquisitions or multiple arbitrage in the financial world.

What are the Stages of Consolidation?

There are three stages of consolidation. Well actually four, but the last stage represents stability rather than consolidation. The stages are:

Stage 1: Fragmentation

Stage 2: Acquisitions

Stage 3: Expansion

Stage 4: Maturity

Stage 1: Fragmentation

Industries begin in a highly fragmented stage. Depending on industry dynamics some industries move very rapidly through this stage. In the collision industry, this stage has lasted for decades, but is rapidly changing due to internal and external forces that I discussed previously.

Leading companies in the initial stages of industry fragmentation focus on building a footprint. They are focused on establishing a “first mover advantage” in size and brand. These companies begin to develop an acquisition based growth strategy. They focus on building revenues over profit growth. Growth comes in fits and starts. Acquisitions are often “one off” in nature and tend to be opportunistic. Companies are still perfecting their acquisition and growth strategies. Sometimes there are spectacular failures. At this stage acquisitions are focused on enhancing revenues and expanding footprints.

Stage 2: Acquisitions

This stage is about rapidly building scale. Consolidation takes place rapidly in this stage. Major players begin to emerge from the chaos of a highly fragmented industry. Consolidated business models have been validated and leaders are able to attract capital. The major players begin to form empires, buying up competitors. The pace and frequency of acquisitions increase significantly. At this stage the leading companies develop a core competency in acquisitions based growth. The industry is still fragmented, but sizable players have emerged as clear leaders. The top three or four companies account for 30% to 45% of market share.

The type of company acquired also changes. One-off acquisitions that enhance revenue are still important, but maintaining the pace of growth and developing scale become the primary goals. For an acquiring company the focus shifts to larger targets that provide both revenue enhancement and cost reduction opportunities. In this environment platform acquisitions become more important. Platform deals tend to be much larger than the average one-off deal and often catapult a company into a new region. Platform acquisitions experience significant valuation inflation as they are important to active acquirers to maintain growth expectations.  Acquisition targets, while generally still smaller in size than the acquiring company, tend to increase in size to better leverage cost reduction opportunities.

Successful companies in Stage 2 are companies that are excellent in both acquisitions and integration. Retention of the best employees in these organizations becomes much more important. Building scalable platforms like sophisticated inventory management, operations management, integrated IT systems, and in-house employee training and development systems becomes important. Companies that survive to Stage 3 are those that acquire key competitors and build competitive advantage through successful integrations.

Stage 3: Expansion

After the rapid (and often rabid) consolidation in Stage 2, the leading companies in Stage 3 focus on expanding their business to aggressively outgrow their competitors. While consolidation continues, acquisitions tend to become less frequent but more focused. Acquisitions are often large scale megadeals between remaining companies. By the end of this stage top companies can control as much as 70% of the market.

Rather than buying one-off competitors, top companies shift their growth strategy to brownfield and greenfield development. One-off acquisitions become less frequent in nature because they do not provide sufficient revenue enhancements or cost reductions.  They also become less valuable because by this stage buyers usually have built enough brand recognition to justify paying a premium for a sellers’ existing customer base.

Both brownfield and greenfield developments have higher financial returns and lower risks than most acquisitions. They are more common at this stage as the leading companies use them to “fill in the dots” in areas where they have not been able to find a suitable or affordable acquisition. They also provide more predictable growth which is important to investors, especially in publicly traded companies.

At this stage companies begin to focus more on profitability and core competencies developed in prior stages. Leading companies have already developed economies of scale, a recognized brand and an experienced management team. There is no longer a pressing need to acquire talent and invest in projects to build scale as there was in Stage 2. The pace of acquisitions drops substantially, as do the premiums paid to target companies. The credible threat of building a greenfield rather than paying a high premium to a seller keeps prices in check and provides substantial negotiating power to buyers. Companies that survive to Stage 4 are ones that aggressively grow in a disciplined and cost effective manner.

Stage 4: Maturity

Every industry eventually reaches a maturity stage where the acquisitions trickle to a standstill, growth moderates to a few percentage points a year and the market becomes fully developed. In this stage a handful of dominate players will often control the industry. Examples of mature industries include pharmacies (domestically: CVS and Walgreens), aircraft manufacturing (Boeing and Airbus), automotive manufacturing (domestically: Ford, Chrysler-Fiat, Chevy), shipping (UPS and FedEx), and soft drinks (Coke and Pepsi).

Implications for the Future

The automotive parts manufacturing industry underwent significant consolidation from the late 1980s to present. In 1988 there were 30,000 independent parts suppliers. In 1999 there were 8,000. Presently there are approximately 1,300 businesses in the $65 billion dollar parts manufacturing industry in the U.S. according to IBISWorld.

Yet looking further afield to other segments in the parts business there are still substantial swaths that remain unconsolidated. The parts wholesaling segment is relatively unconsolidated, with about 13,000 individual businesses in the U.S according to IBISWorld.  Retail auto parts stores, while more consolidated now than in the past due to the shift away from a 3 step distribution model to a 2 step model, as well as the growth of large retail chains like O’Reilly, GPC, AutoZone, and Advance Auto parts, is an industry that remains relatively fragmented with about 17,000 independent businesses across the U.S., again according to IBISWorld. Collision repair, currently undergoing a multi-year round of rapid consolidation, still remains highly fragmented as an industry with 22,000 independent collision repair shops across a $32 billion industry. Collision repair used and aftermarket crash parts and paint distribution is similarly while already having gone through a round of consolidation is undergoing a secondary round of consolidation as LKQ continues to grow aggressively through acquisitions. New entrants such Fenix Auto Parts and Carl Icahn’s Auto Plus look for acquisitions in the fragmented parts industry.

So it begs the question, in what phase is the automotive parts retail and distribution segment? I would like to hear from you. Reach out to me through the contact page on my website at http://supp-co.com/contact. There you can also subscribe to my weekly automotive industry insights where I discuss consolidation and financial trends in the entire automotive industry. As a subscriber you get direct access to my inbox and join a group of professionals focused on increasing the value of their business. All information is kept confidential.