AAP - Advance Auto Parts: Another Retailer Stuck Between 'A Rock And A Hard Place'

2023-10-17 16:35:12 ET

Summary

• The consumer retail sector is experiencing a trend towards bifurcation, benefiting chains with either exceptional customer experience or the lowest prices.
• Advance Auto Parts is losing ground to competitors like AutoZone and O'Reilly, which have aggressively focused on growth through capital investments in recent years.
• Advance Auto Parts is at greater risk from e-commerce because it is often viewed as having a poorer customer experience (than AutoZone), albeit at often lower prices (product-depending).
• One significant benefit of Advance Auto over its peers is its excellent liquidity position and lower CapEx overhead, avoiding AutoZone and O'Reilly's competitive race.
• I expect AAP to outperform its larger overvalued peers in a car part market slowdown, but the rise of Amazon car parts and electric vehicles limits its long-term potential.

The consumer retail sector is among the more interesting segments of the stock market this year. Generally, there is a solid long-term trend toward bifurcation (or trifurcation) amongst all retail companies, be they clothing, vehicle parts, or groceries. The same pattern is mirrored in most consumer-centric spheres, such as restaurants and retail-oriented REITs. Since 2020, although even before, people have seemingly exercised increased discretion regarding spending money. I would characterize this trend as benefiting consumer chains that offer an exceptional customer experience at a higher price, such as Lululemon ( LULU ), and those that offer the lowest prices at the cost of experience, such as Walmart ( WMT ) and Costco ( COST ). Those that fall somewhere in the middle, such as Target ( TGT ) and Best Buy ( BBY ), are slowly failing due to losing a firm niche in the market.

The vehicle parts retail industry is very similar, with high-flyers like AutoZone ( AZO ) performing exceptionally while its lower-tier competitor like Advance Auto Parts ( AAP ) loses out. While AutoZone has the best fundamental trends, I increasingly believe the stock is overvalued as it may not maintain the growth rate assumed by investors. Of course, that begs the question of whether Advance Auto Parts could be undervalued. The divergence between the two brands, as well as other competitors, is extreme:

The ratio chart shows how AAP held ground against AutoZone from 2020 to 2022 but has seen a consistent and accelerating relative downfall since 2022 began. Amongst other competitors, O'Reilly ( ORLY ) has performed nearly as well as AutoZone. At the same time, LKQ ( LKQ ) and Napa Auto's owner ( GPC ) have fallen in the middle, experiencing more significant relative decay in recent months. As such, investors must consider the possibility that, in the long run, AutoZone and O'Reilly are set to absorb their weaker competitors, with Advance likely being the first to fall. Of course, should that trend not continue, the vast valuation divide may benefit AAP, given its forward "P/E" is ~11X while AZO's is ~17X. Thus, while I do not believe AZO is particularly attractive today, further research may determine whether or not AAP is undervalued or a value trap.

Advance Auto's Fundamental Failure

There are many factors contributing to Advance Auto Parts' downfall. However, chief among them may be that its operating income has fallen during an otherwise intense period for the aftermarket auto parts retail industry. The past five years have been stellar for the industry, with all top companies gaining significant revenue with all but Advance earning operating income faster than inflation. See below:

This industry is far less exposed to the rise of e-commerce than most because most people prefer to see vehicle items in person and require more intelligent customer service (not found online). The market can be cyclical, but it is generally more durable across the economic cycle as demand for DIY repairs often rises as mechanics become less feasible, being increasingly expensive today due to labor shortages.

Advance Auto Parts consistently runs higher inventory than its two most direct competitors. As a result, its gross margins are always lower than its peers. Further, as the divide between its inventory level and that of its peers has increased since 2022, its gross margins have slipped faster while its competitors' margins have rebounded. See below:

High inventories usually lead to price reductions and lower gross margins for retail companies. Advance Auto's higher inventory position today than its peers may indicate lower gross margin levels going forward. That said, the company's gross margins remain generally within the 10-year range but are at the shallow end of that range.

Advance also has much higher operating expenses as a percentage of its revenue. Around 2018, both companies had similar OpEx-to-sales ratios, but since their size diverged around then, Advance has paid more in OpEx while AutoZone has paid less. See below:

Generally, companies with more significant market share will have lower operating expenses-to-sales. O'Reilly and Advance have similar OpEx-to-sales ratios, and sales bases are 50-70% larger than Advance. AutoZone and O'Reilly have more dominant marketing campaigns and benefit more from them because of their more extensive market share base. In my view, the well-known marketing campaigns of its larger peers are their most significant benefit, while Advance's poorer marketing campaign is its weakness.

Advance Auto's Growing Competitive Failure

Fundamentally, I believe Advance Auto is "caught in the middle" in the retail space. It is a comparatively cheaper chain than both AutoZone and O'Reilly, but the latter are believed to focus more on customer experience. Problematically, this means Advance is more closely competing with online automotive part sellers like Amazon, which will almost always have the lowest prices, albeit lack customer service. Thus, people who know what they're doing and want low prices can go to Amazon—those who need help and are willing to pay more go to AutoZone and O'Reilly. Thus, Advance Auto, being between the two, loses its niche.

In response to these pressures, Advance is making some changes to improve its lost market share. Based on its last management discussion , its primary focus appears to be on supply-chain management, focusing on expanding faster-moving products and expanding its distribution network. While its larger peers are aggressively expanding through high CapEx and store count growth, it is slowing store opening expansion (although it is still elevated). Advance focuses on improving its profit margins by lowering COGS, but not necessarily enhancing its market share. In the long run, I do not believe the company can be sustained if it continues to lose customers to its larger peers.

To me, we can see that Advance is trying to build a niche in the market by focusing on becoming cheaper among its peers through its supply chain investments. At this point, it may be too difficult for Advance Auto to try to compete directly with AutoZone and O'Reilly (focusing on quality over price competition) because they've achieved market share dominance over it. However, further entrenching itself in price competition may be unwise because Amazon will almost always have a price advantage (given its lack of physical overhead). Thus, it seems likely to continue on the path of mediocrity, which often leads to further competitive weakness. To complicate matters, the company is getting a new CEO at year-end , which may be poor timing given its need for immediate improvement.

What is Advance Auto Parts Worth Today?

Financially, Advance is not in a terrible position, but its balance sheet is trending in an adverse health direction. The company's debt-to-EBITDA ratio has climbed quickly since 2022, going from below that of competitors to well above them. Its competitors have seen their times-interest-earned ratio decline due to higher interest rates; however, Advance has seen the most significant total decline due to its higher leverage and credit risks. See below:

To make this issue worse, Advance was downgraded to "junk" credit status last month as S&P detailed issues regarding its market share trend and strategy. That said, Advance Auto has a superior liquidity position to its peers, with a 21.3% quick ratio compared to 3.3% and 7.4% for AutoZone and O'Reilly, respectively. Its working capital position has deteriorated, but it remains positive at +~$1.3B compared to AutoZone at -$1.7B and O'Reilly at -$2.4B. Fundamentally, I believe this difference stems from Advance's lack of focus on competitive growth and its trend toward entrenchment.

AutoZone and O'Reilly have focused and invested tremendously in growth, investing vast amounts into store expansion and marketing instead of supply chain management (as has Advance). That has left Advance in a better liquidity position, with AutoZone and O'Reilly appearing to be too stretched. Eventually, I expect both firms to face issues as their market share expansion will inevitably lead to more direct price competition between the two, potentially unwinding much of their recent benefits. Comparatively, Advance may have more significant defensive potential because it focuses more on supply than demand, giving it less direct competition and potential benefits in a recession. However, that does not limit its competitive pressure with Amazon, which almost always wins the supply-side game.

The Bottom Line

Advance Auto Parts is among the more notable stocks today because its situation resembles many retailers. Fundamentally, its customer experience is not sufficient for enough customers to prefer it dramatically over e-commerce and not cheap enough for customers to choose it over e-commerce. Thus, not unlike Target, it is losing significant market share as customers bifurcate to either extreme.

While Advance has undoubtedly lost ground against its competitors, I would not yet say that its failure is inevitable. Its operating income, though almost 50% lower than its peak, is still around $500M annually, giving it ample cash flows to reinvest in improvements. Although its debt-to-income measures are worse than its larger peers, that is primarily because of its relative decline in income. Fundamentally, Advance has a much better liquidity position than its peers because it is not focusing on aggressive growth. Indeed, although this approach is causing it to lose market share, it may shield it against pitfalls that could occur as AutoZone and O'Reilly become neck-and-neck competitors (both not having enough cash to maintain losses).

For me, the primary issue with Advance is that it is at greater competitive risk to e-commerce than its peers. Although Amazon has struggled to move into the car part space, it has improved by lowering delivery times and improving its "Garage" feature. As people become more comfortable with online car part shopping (particularly younger generations), I expect that Advance is at greater risk than its larger peers. However, should the auto parts market slow, Advance may outperform its peers because it is more defensively positioned than them.

Of course, the entire industry is at risk from the rise of electric vehicles. Indeed, if EVs are the future, these companies will still have products to sell, although likely far less (not needing oil, transmissions, etc). Companies like Tesla ( TSLA ) are also notorious for blocking "right-to-repair" on its products. EV sales have skyrocketed this year as Model 3 Teslas became cheaper than average new cars. A more significant factor is the declining price of lithium and lithium batteries due to increased lithium production, allowing for much more affordable EVs. I expect lower lithium prices and increased factory development to benefit the EV market over conventional vehicles, eventually leading to issues for all aftermarket car part sellers.

Given this and Advance Auto's numerous issues, I am not particularly bullish on the stock and do not believe it is a rebound value opportunity. However, I am also not bearish on AAP because it is trading at a significant valuation discount to its larger peers and has a superior liquidity profile than it, not being so caught up in its aggressive growth strategies. In fact, for that reason, I believe AAP will likely outperform AZO and ORLY over the next year. Still, based on this analysis, I feel that despite AZO and ORLY's overvaluation, AAP is not necessarily undervalued. Instead, I believe AAP is trading at a very reasonable price, given its issues. Additionally, I do not expect AAP to fail anytime soon (in the next three years) due to its decent income and strong liquidity. It could rise in value as short-sellers (10% of its market share) eventually close positions.

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