Market Measures

The recent cold snap and several early winter storms appear to have been a positive catalyst to calendar fourth quarter sales, as many respondents noted extremely strong sales of batteries and other winter-weatherization products. We believe that the deferral of automotive maintenance has been the consumer mindset since early 2006, spurring significant reductions in discretionary automotive parts purchases. That said, the auto parts industry once again will face easy year-over-year comps in fourth quarter 2007 and throughout 2008, and at some point the significant amount of maintenance deferrals should translate into sales improvement. We expect positive sales comps from all auto aftermarket participants when companies next report earnings, with those more heavily exposed to the do-it-for-me (DIFM) segment posting better results than the do-it-yourself (DIY) segment.

With regard to December trends, the deceleration from November was most pronounced in the South and Midwest, while the Northeast and West witnessed sequential trend improvement. Overall, weather appears to have had a positive impact on aftermarket part sales across the nation. Survey respondents in the Northeast and West noted benefits, followed by the Midwest and South.

Survey respondents across the nation indicated that maintenance items were selling at a stronger-than-average pace over the past two months, led by the western and northeastern regions. Additionally, sales of hard parts appear to be trending stronger than average, with consumer demand for hard parts falling just shy of that for general maintenance items. Sales of hard parts appear strongest in the Northeast and West, followed by the South and Midwest.

So what do we expect heading into 2008? While we don't anticipate significant acceleration in top-line trends for aftermarket participants, recent channel checks (including our survey) and third quarter earnings results indicate that same store sales (SSS) trends have stabilized and that the operating environment is not deteriorating further. Although we think the "shock factor" of $3 per gallon gasoline experienced in 2006 was somewhat diminished in 2007, with oil still north of $90 per barrel, it appears that we might have to wait a while longer for the robust acceleration in aftermarket trends so eagerly awaited by auto parts retailers and investors alike. Perhaps part of the reason behind the softer trends (aside from the financially strapped consumer) is related to the miles driven data, as it appears vehicle owners are driving a bit less at the same time that vehicle registrations continue to climb. The net effect is that consumers are able to spread drivable miles over multiple vehicles, allowing for service deferrals.

We don't believe the automotive aftermarket is in a worse situation this year than last, but we think the mindset of the consumer has been conditioned to one of deferral, and that might continue to plague the industry for some time. While we think deferrals have played a role in softer-than-expected demand, we also think that parts longevity is extending the useful cycle, essentially allowing the consumer a larger window in which to defer automotive services.

The automotive aftermarket always has been somewhat insulated from big macro swings as demand for automotive repair is contingent upon parts failure rather than consumer disposable income, but it appears somewhat different this time. Continued elevation in gas prices along with deferrals of higher-end ticket items such as brakes and tires have resulted in a challenging operating environment. Sales trends for auto parts retailers and distributors began to decelerate in the second quarter of 2006, and despite the easy year-over-year comparisons, SSS comps remained under pressure for 2007.

We would point out that during the difficult operating environment of the past 18 months, companies with greater exposure to the commercial or DIFM segment outperformed their DIY peers in SSS comps by a noticeable margin. If gas prices remain elevated for an even longer period of time, we could see a bit of a reversion to the DIY side as some on the fence (DIY vs. DIFM) customers decide to work on their own vehicles for economic reasons.

While we don't expect a surge in demand during any one quarter, we think sales momentum should gradually build as we enter the spring and early summer of 2008, with a modest elevation in sales trends as we progress through the year. Stability in gas prices will remain a key factor, providing consumers with more flexibility to allocate dollars toward automotive needs, as well as boost miles driven, which is the key determinant of component parts failure.

BB&T Capital Markets is a full-service investment banking firm that focuses on specific industries, including the Automotive Aftermarket industry. BB&T Capital Markets is a division of Scott & Stringfellow, Inc., NYSE/SIPC.

Disclosures: BB&T Capital Markets expects to receive or intends to seek compensation for investment banking services from The Pep Boys — Manny, Moe & Jack in the next three months.