AAP - Advanced Auto Parts: Broken Down But Repairs Being Made

2023-12-17 07:40:20 ET

Summary

• Advance Auto Parts has experienced a decline in market share; and was downgraded to junk status by S&P Global in September.
• The company has struggled with subpar gross margins, high SG&A expenses, and increased net interest expenses.
• Advance Auto Parts has hired new management, which is now implementing strategies to drive profitable growth.

Advance Auto Parts, Inc. ( AAP ) has fallen on hard times after ceding market share to AutoZone, Inc. ( AZO ) and O'Reilly Automotive ( ORLY ) as evidenced by their net sales growth over the last 2 years. Costs have also spun out of control. In September 2023 , S&P Global even downgraded the auto retailer from investment grade (BBB-) to junk (BB+), primarily based on its assessment of the company's negative operating performance.

Going down the P&L, Advanced Auto Parts has produced subpar gross margins relative to its peers due to combination of inadequate pricing power, less operating scale, inventory issues, and supply chain inefficiencies. Its Q3 2023 earnings report further detailed that gross profitability declined based on the following: "During the twelve and forty weeks ended October 7, 2023, Gross profit margin was negatively impacted by a change in estimate associated with inventory reserves of $119 million. Higher product costs were not fully covered by pricing actions and elevated supply chain costs contributed to gross profit margin decline. This was partially offset by a reduction in LIFO-related expenses."

An inventory reserve of $119 million is significant and indicates that inventory will likely be written off. Management needs to avoid having these mistakes repeated to sustainably normalize its gross margins.

For operating expenses, Advance Auto Parts' SG&A expenses to revenue has crept up from ~37% over the last decade to nearly ~39% in 2023. Comparatively, AutoZone and O'Reilly Automotive have SG&A-to-revenue in the range of ~30%-32%, which indicates AAP has a bloated cost structure.

Lastly, the company's net interest expenses have increased somewhat due to incrementally borrowings and the higher rate environment. All in, these factors have absolutely destroyed its bottom line and free cash flow in 2023.

If that's enough to scare you away as an investor, then you can stop reading here, but for those with a risk appetite, let's see how the company can potentially turn the business.

Staging The Turnaround

There's a lot to unpack here, and it will be an evolving story as time progresses, but it all starts with management. Advance Auto Parts hired a new CEO, Shane O’Kelly, and a new CFO, Ryan Grimsland, in September and November 2023, respectively. The vast majority of Shane's previous experience was with Home Depot, moving through different positions in strategic business development and other senior roles, as well as executive positions at other companies. Ryan's experience included 18 years at Lowe's, where he gradually moved up through various finance department positions, i.e. FP&A, finance, treasury, etc. Together, these two are excellent individuals to position Advance Auto Parts for a turnaround since both worked for large, highly successful retailers. Not only do both companies have tens of thousands of SKUs to manage in terms of inventory efficiency and profitability, but they also each have their own automotive categories. So they certainly have skills and knowledge bases that are transferrable to AAP.

Looking at the top line, based on AAP's Q3 2023 Form 10-Q, the company opened 19 new stores through the first 42 weeks of 2023, which is largely immaterial relative to its 4,785 store locations today. Comparatively, AutoZone opened 197 for the full year in 2023 and O'Reilly Automotive opened 140 for the first 9 months in 2023, or 187 at run rate. Part of AAP's lost market share can likely be attributed to this trend, aside its negative same store sales in prior periods. Effectively, the broader industry is growing, albeit slowly, this is an important area for AAP management to identify opportunities to recapture market share. They simply need to open more stores in good locations. For 2024, it has guided to open between 55 and 65 new stores and branches, so that's also a good sign.

In terms of pricing, management discussed that their average ticket price was "down slightly" in an effort to maintain competitive pricing, and that price increases only covered a portion of their costs. Notably, unit volumes were up, so that's a good sign. I think if AAP can rationalize its inventory, it will be able to deliver much needed price increases that AutoZone and O'Reilly Automotive routinely enjoy. Also note that it doesn't take long for consumers in aggregate to discover product pricing discrepancies, and so I think AAP's string of negative same-store sales are behind it. In AAP's Q3 2023 report , management disclosed same store sales increased 1.2%.

For other strategic decisions, management stated that they are looking to sell their Worldpac trade name as part of an effort to rationalize its assets, i.e., target more profitable growth. Without disclosing the actual financial figures behind this anticipated sale, the intended goal is to divest this lower margin business and use the proceeds for higher growth/margin investments.

Turning to operating costs, management emphasized that they are seeking to curtail spending, specifically low productivity spending, i.e. sustain or even increase the greatest IRR spend in terms of human capital, physical assets, internal systems, etc. Circling back to the SG&A-to-revenue metric, an approximate 7% improvement (AAP's 39% to comparable peers at 32%) would translate to nearly $800 million in operating profit. Management outlined in their Q3 conference call that they are targeting about $150 million in annualized savings in 2024, while $50 million of that savings would be reinvested to increase salaries and wages. This is a sound strategy. Remember, a company is only as good as its people, so I'll applaud management on this initiative. Destroyed employee morale will destroy any business. Furthermore, the delta of $150 million and $800 million, or $650 million, may give management the ability to identify incremental improvements beyond 2024.

Overall, I believe there is a ton of opportunity for management to drive topline growth, control costs, and ultimately deliver the operating leverage that shareholders are looking for.

Looking to valuation, AAP deserves to sell at a discount to AutoZone and O'Reilly Automotive simply given its relatively sluggish topline performance and lower profit margins. However, for investors who believe this new management team will drive profitable growth and increase returns on capital, then there's a clear opportunity here. The most simplistic and generous approach would be to analyze it from an enterprise value to sales perspective. Presently the company trades for 0.46x sales, and I think it's reasonable to say that it could revert back to 1x.

Alternatively, from an actual profitability standpoint, the company generates about $11.3 billion in TTM net sales and historically generates after-tax profit margins of 4.5%. That's about $500 million in annualized profit compared to its $5.2 billion enterprise value, which is about 10.4x. If management can accelerate sales growth from its current low-single-digit rate closer to peers that are in the low-teens, then the multiple would likely expand to mid-teens and translates to ~50% upside. That's a more conservative approach and offers $95 price target. That will take some time, but I think it's attainable.

Bottom Line

Advance Auto Parts has had a very challenging 2022 and 2023, and turning the business will be difficult. AutoZone and O'Reilly Automotive are not standing still and there's certainly the possibility that they continue taking market share from AAP. All of the aforementioned issues regarding sales and costs are precisely why this immense valuation discount exists. However, I think there's some margin of safety baked in here and if management can delivery on this tall order, then the return potential for shareholders is significant. Thanks for reading and please comment below.

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