The average age of cars on the road today is more than 11 years according to research firm R.L. Polk. This is an all-time high and industry expectations are that the average age will continue to creep up to 15 years before the trend ends. Certainly the impact of the recession and a very slow recovery has contributed to this situation, which seems unlikely to change much in the near term. In a market environment like this, there are auto stocks that will profit from the trend towards older cars in need of more maintenance and parts.
We have been watching Monro Muffler Brake (MNRO) for a few days now since it triggered an entry signal on Dec. 6. However, we wanted to wait to see how the auto parts store announcements would look before making a recommendation. Those are out this week with unsurprisingly disappointing data from The Pep Boys-Manny, Moe & Jack (PBY) and a positive release from AutoZone (AZO). However, even the bad data from PBY wasn’t all that bad as consumers with aging vehicles shop for parts and service.
PBY is a bit of both DIFM and DYI (do-it-yourself) and the service side of the business was the bright spot for growth, which is good for our trade recommendation. MNRO is in a particularly sweet spot in the industry because the DIFM market is highly fragmented. This means that the company has significant pricing power due to lower than average costs, and acquisitions will likely be accretive.
MNRO took a hit to earning per share earlier this year that led to a drop in earnings for their year-end (April 2012) and the first quarter (June 2012). The issues were a combination of overstocked inventory, higher than expected gas prices, slow economic growth, and acquisition costs. Ultimately the stock dropped from a high near $50 to a low around $42. Market and fundamental conditions have improved significantly since then.
The relationship between MNRO and gasoline prices isn’t perfect but it is reasonable to assume that lower gas prices will lead to more driving, which increases demand for MNRO’s services. The last two big declines in the stock’s price followed a spike in gas prices and the last few rallies came following a decline in gas prices. With the average age of cars on the road expected to hit 15 years and fuel prices in decline we think the fundamentals point towards future growth.
From a technical perspective, the stock looks ready to slingshot beyond July’s highs. On Dec. 4 and 5, the stock formed a bullish engulfing pattern as the stock shook out weak hands just under short-term support. That pattern was confirmed on the Dec. 6, but we held off on our recommendation until the auto-part retailers were out with earnings this week. MNRO stock eased off a little Tuesday as the PBY announcement put a little pressure on the stock but it is still within an attractive buying range.
Source: Monro Muffler Brake (MNRO): Chart Courtesy of MetaStock Professional
The current setup is very similar to the move in 2011 when the stock rallied off lows near $27 to $40 per share. Based on the depth of the drawdown this year, we estimate potential upside near $60 per share as a minimum target following a break above November’s highs.
There are some special risks that traders should also watch out for in the short term. MNRO is carrying an excessive amount of debt. The company has plans to de-leverage but capital is also needed for acquisition opportunities and a growing dividend payment. This exposure helped to create problems for the company earlier this year and could become an issue again if rates spike.
Traders worried about the risk in MNRO may consider a pairs trade that combines a long position on MNRO with a short one on PBY. Based on the fundamentals, the relative performance between the two should help neutralize some of the market risk and allow traders to profit from faster growth from MNRO in a bullish market and excessive losses in PBY in a bearish environment.
We recommend new entries on MNRO between $49.50 and $53. Our short-term target is $60 but momentum could easily take the stock higher in 2014. We recommend stop losses be placed under the lows from the bullish engulfing pattern in December. The stock is also likely to get more volatile as it approaches earnings in January, which is when it probably makes sense to raise your stop loss to break-even or higher. Options traders may look to buy longer-term at the money calls with a conditional stop placed at the same price on the stock.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.