AZO - Advance Auto Parts: Better Safe Than Sorry

2023-07-05 05:53:41 ET

Summary

• Advance Auto Parts' share price is at its lowest in five years, with the company's fundamentals appearing weaker than before, leading to a justified fall in share price.
• AAP has cut its dividend by 83% and its buybacks have not been efficiently allocated due to the high prices at which they have been repurchased in 21/22.
• Despite short-term and long-term incentives for management, the company's ROIC-WACC spread is the lowest in its peer group, indicating AutoZone and O'Reilly have better long-term prospects due.

Thesis

In difficult times, it is always important to focus on the essentials. And shareholders of Advance Auto Parts ( AAP ) are in one of those situations, with the share price at its lowest level in the last five years.

The big question now is whether this is a temporary phase or whether the company's fundamentals are broken. I think the company is in a worse position today than it was five years ago, and therefore the fall in the share price is justified, and I would rate two competitors as higher quality. Therefore, I am not interested in owning shares in this company at the moment, as it is a turnaround play that is likely to be painful for shareholders.

Analysis Of Advance Auto Parts

AAP is a supplier of automotive parts to professional and DIY customers, with professional customers accounting for 59% of sales. Typically, their sales are somewhat dependent on the weather, as extremely hot or cold weather usually boosts sales.

In recent years, AAP has developed a reputation as a shareholder-friendly company, aggressively buying back its own shares and paying a growing dividend. However, this came to an end when they announced that they were cutting the dividend from $1.50 to $0.25, a drop of 83%.

As a result, the dividend will return to its level in 2020 and 2021. AAP also repurchased 3 million shares in 2022 at an average price of $201 and 4.6 million shares in 2021 at an average price of $192. With the share price now down to $70, this does not look like an efficient allocation of capital.

In total, they returned $934 million to shareholders through buybacks and dividends in 2022, and said in the 2022 annual report that the actions in 2022 will contribute to growth in 2023. In my opinion, this is not yet apparent in 2023.

Q1 EPS missed by $1.99 and revenue missed by $8.28m . Furthermore, they have indicated that there is likely to be a shortage in 2023 compared to their original targets. Margins and FCF were also worse than expected.

Proxy Statement

Since a bad quarter should not normally unsettle a long-term investor, I like to take a look at the proxy statement to see what short-term and long-term incentives management has.

Short-term incentives are dependent on the company's adjusted operating income, comp store sales and FCF. And I think these are good short-term metrics because they should lead to a good foundation for long-term success. But it should be noted that accounting techniques can always influence adjusted figures and FCF to some extent, which is why I prefer unadjusted figures.

Over the long term, incentives are linked to ROIC, which I think is one of the most important metrics, as well as total shareholder return and average annual comp store sales growth. I think these metrics also align the interests of shareholders with those of management. One criticism could be that the focus on TSR could lead to buybacks in times of high prices, as we have seen in 2021 and 2022, in order to boost this metric to meet targets.

All in all, I'm pretty comfortable with these metrics, but it will be interesting to see if and how the targets change after 2023.

In the last 10-K, management also stated that the goals are to grow faster than the industry, expand margins and return cash to shareholders. All good goals for shareholders, but achieving them will be key.

Margins

To find out whether a company has a competitive advantage, I like to look at margins and the ROIC-WACC spread. And for this comparison I have chosen AutoZone ( AZO ) and O'Reilly ( ORLY ). While AutoZone and O'Reilly are in a close race, AAP is relatively far behind. In particular, the EBIT margin is ~15% lower, while the gross margin is only ~8% lower. The conclusion is that both competitors are more efficient and are likely to have economies of scale leading to lower costs.

ROIC WACC Spread

The 5Y median ROIC paints the same picture as AutoZone and O'Reilly have almost 4x and 3x the ROIC of AAP respectively, which is very impressive. And the cost of capital is as follows: AZO 5.88% , O'Reilly 7.3% and AAP 5.3% which also shows that AAP has the worst ROIC-WACC spread in the peer group. Since the ROIC-WACC spread is the best indicator of competitive advantage, I think it is safe to say that AutoZone and O'Reilly are playing in a different league and therefore have much better long-term prospects because they can allocate capital more efficiently and are therefore likely to grow faster.

Reverse DCF

The reverse DCF model is based on a 2023 diluted EPS guidance of $6 to $6.50. And to justify the current share price, EPS must grow by 7% per year over the next 10 years. Unfortunately, the 10-year CAGR for diluted EPS is only 2.87% . So it will be interesting to see if the next 10 years are better or the same.

Conclusion

Finally, it should be noted that AAP filed its last 10-Q a few days later and that its last 10-K had a critical audit matter related to vendor incentives. These two things may not mean anything, but it is better to keep them in mind and see if more of these things happen. Better to be safe than sorry.

In general, I prefer to invest in companies with a high ROIC-WACC spread and a market-leading position, which rules out AAP for me. However, AAP has the opportunity to exceed the expectations built into the share price, which would most likely lead to market-beating results, but I am also not a big fan of turnarounds and would therefore favor O'Reilly or AutoZone in this industry.

Gross profit and profit margins have also been on a downward trend in recent years and are likely to fall further in 2023, showing us that the company was in a better position in the past than it is today.

In particular, the development of the FCF is something that could cause problems, depending on how it develops in the coming quarters. In addition, there is a possibility that net income will also fall back to the level of 2019.

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