AAP - Behind Advance Auto Parts' Dividend Cut: What It Means For Investors

2023-07-14 05:54:39 ET

Summary

• Advance Auto Parts' share price has hit a five-year low, with a recent 83% dividend cut and supply shortage issues adding to investor concerns.
• The company is facing significant inflation related challenges on the cost side and is having limited success passing that cost on to consumers.
• The leadership expects these inflation pressures to persist for some time.

When the tide of the stock market ebbs, it exposes those who have been swimming without adequate protective gear. And for Advance Auto Parts ( AAP ), this is one of those moments. With the company's share price touching its lowest level in five years, investors are inevitably asking whether this slump is just a temporary blip or indicative of a more systemic issue.

Looking Under the Hood

As a leading supplier of automotive parts to both professional and DIY customers, AAP's financial health is often very resilient. When you think about it, as people hold onto cars longer due to rising financing costs as well as the overall purchase costs, Advance Auto Parts should benefit. If we look at what happened in the 2008 recession, the underlying business actually did a fairly good job at resisting the downturn due to this dynamic. So what changed this time? The company has been hit pretty hard with inflation on the supply and wage front. The result was a pretty significant EPS miss in the last quarter.

Due to its product mix, the firm was unable to pass on costs to the customer effectively in some segments, like batteries, than in other segments. This caused the stock to capitulate.

Apart from the dividend cut, big scare from investors had to do with the risk of auto vehicle manufacturers' attempts to reduce the part count per vehicle to create a more efficient manufacturing and maintenance process. This concern is likely overblown as we haven't seen similar struggles in Advance Auto Parts' competitors.

Historically, AAP has been lauded for its shareholder-friendly approach, making aggressive share buybacks and paying steadily growing dividends. However, recent developments suggest that this golden era might be coming to an end.

The dividend, which once stood at $1.50, was recently slashed to a meager $0.25 - a whopping 83% drop. A look backward reveals that the company 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. Fast forward to the present day, with the share price hovering around $70, these decisions may not be viewed as the most efficient capital allocation by shareholders, and management has been heavily criticized for the whole debacle. I believe this is actually quite harsh. The problem is not Advance Auto Parts' business model so much as a rapid shift to inflation that was not checked by the Federal Reserve. One could argue that the leadership team should have been more agile, but one can often benefit from a steady hand in business. Unfortunately, this time, the leadership team was burnt by it. Nobody could have reasonably suggested that a high-flying auto parts supplier coming out of a very difficult market to purchase cars in the US would be treating that 1/3 of its highs over the past two years. I believe management should be given some grace here to turn things around though the likeliness of that transpiring is another story.

Despite returning $934 million to shareholders via buybacks and dividends in 2022, and suggesting these actions would contribute to growth in 2023, the reality seems far from this assertion. The company missed its Q1 EPS by $1.99, and revenue fell short by $8.28 million. Adding to the gloom, AAP has signaled that supply shortage issues are likely to persist, threatening their original targets for 2023.

So Has the Company Broken Down?

In short, no. The company's facing a business agility problem. I have seen my fair share of broken companies over the years, and Advance Auto Parts is simply not one of them. We would like to see some pain over the next few quarters as the leadership team figures out that corporate product mix and offloads slow inventory, but the company will likely be back soon. At these depressed levels, I would argue that it's a value play if you believe that it will return to normal earnings.

The stock is trading at a P/E ratio of just 10.5, but investors should expect earnings to cool over the coming quarters as management works to resolve the inventory issues.

The current cash balance is relatively low for the firm, so the company can't just authorize a large buyback program to make the problem disappear. We need to see solid business changes from the leadership team, and this can take some time.

The solutions to component and wage inflation are well documented, but investors should look out for a concrete plan by leadership to address this issue. It certainly cannot be a case of doing nothing and hoping for the best. Component inflation in and of itself is not usually a problem as long as the distributor has the pricing power to pass those costs on to consumers effectively. Typically cash cow businesses like AAP tend to focus on battling for market share and simply ensuring that they have the inventory to much consumer demand. This normally provides stable cash flow which allows the companies that fit this criteria to aggressively return cash to shareholders.

The leadership may have been guilty of taking the stability for granted, but selfishly, as a shareholder, I find it hard to aggressively judge the leadership team that was trying to reward shareholders for their faith. I think step one was acknowledging that the dividend payout needed to be aggressively cut.

With respect to step 2, I would expect the new leadership team to provide guidance about their plan to refine the product mix and eliminate low-value inventory from their catalog. High-value items like batteries and other items that generate walk-through traffic will likely be the focus in the coming quarters. I believe a part of the problem for shareholders is that things have become a bit quiet on the company's side, with CEO Tom Greco leaving at the end of 2023. While the board searches for a replacement, it is understandable that no clear strategy has been put forward for the turnaround apart from the dividend cuts. Cutting the dividend will help with building up the balance sheet to support a new strategy or aggressive inventory rebalancing. In uncertain times like this, it is important to remember that the leadership team isn't just the CEO, and the company has been in tough places like this before.

Let's take a trip back to 2016 and find ourselves knee-deep in the same type of mucky waters Advance Auto Parts is wading through today. Then, the company was wrestling with the hefty challenge of integrating General Parts International, a move that led its financial metrics to perform an unwelcome nosedive. Between December 2016 and October 2017, the shares were basically cut in half - falling from $178 to $81.

We also saw a similar selloff during the Covid-19 pandemic. Where remote work and shelter-in-place guidelines greatly reduced people's reliance on motor vehicles which was definitely a negative for an auto parts provider. In fact, one would argue that the challenges faced just two years ago are perhaps more complex than the challenges the company faces today.

In the rearview mirror, AAP's shares were changing hands at a relative bargain compared to its counterparts in the sector, painting a familiar picture to the one we're seeing today. Besides, the company had a tough nut to crack: improving its free cash flow and operating margin that had been bruised and battered post-acquisition. Today's scenario seems to be a déjà vu of 2016, adding a layer of tested resilience to AAP's narrative.

Barring an acquisition, I would expect this time to be no different. The leadership team has already said that they expect the inflation challenges to persist for some time, and this is something investors should key into any thesis here. The turnaround could be long, particularly if a recession takes root and the consumer taps out on discretionary purchases to conserve cash. For the moment, unemployment rates remain low.

It is important to note that interest rate hikes by the Federal Reserve have not yet bitten the economy. We will likely have a clear picture of what damage has been done to the economy by the aggressive rate hikes throughout the second half of the calendar year 2023.

The Takeaway

So here we are, parked at the crossroads, eying Advance Auto Parts sputter and smoke. The question is, is this just a hiccup, or has the engine truly conked out?

AAP has always been a sturdy beast, weathering market storms like a pro. But the current slump paints a grim picture, with its share price tanking to a five-year low. A lethal cocktail of inflation, cost mismanagement, and a serious EPS miss in the previous quarter has caused a fair degree of panic. But remember, this isn't their first rodeo.

Sure, their once-celebrated shareholder-friendly approach, marked by aggressive buybacks and escalating dividends, now seems to be running out of steam. That fat dividend has been reduced to crumbs - a staggering 83% drop. Hindsight makes their past repurchases seem wasteful, even reckless, with shareholders pointing fingers at the management. But before we brandish the pitchforks, let's remember the giant elephant in the room - inflation. Could the management have been nimbler? Maybe. But sometimes, even a steady hand can get scalded.

So, is the party over for AAP? Far from it. AAP might be down, but it's definitely not out. This isn't a broken company, just one that's taken a hard blow and is in need of some fine-tuning. At the currently depressed levels, AAP could be a value play for those willing to ride out the storm. I will likely initiate a position on the stock this week. I expect cloudy days ahead, but there's a fair enough degree of value for me to begin a position. I think the best way of approaching the stock is to wait for a concrete plan from leadership before getting aggressive. I rate the stock a buy.

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