Advance Auto Parts: Retailers Are Facing Headwinds (NYSE:AAP)

Investment thesis:

AAP was the largest automotive aftermarket parts retailer in the US at one point but has failed to capitalize on this and quickly lost market share. The company’s performance in recent years has been good, with the stock price seemingly ignoring this, with the business valued at its 2019/2020 level. Our objective is to assess if this poses an opportunity for investors to acquire the company below its fair value. We will consider the auto parts market as a whole, trends in the automotive industry, and the financial profile of AAP. This will assist with forming a long-term view of the business. We will conclude with an analysis of the company’s profile relative to its peers, to assess the company’s market share.

Company description:

Advance Auto Parts, Inc. (NYSE:AAP) sells automotive replacement parts, batteries, and maintenance items for a range of vehicles. Its products include brake pads, clutches, engines, as well as air filters, motor oils, and wiper blades. It serves professional installers and DIY customers through stores under the Advance Auto Parts, Autopart International, and Carquest brands, as well as branches under the Worldpac name.

Share price:

AAP’s share price has been incredibly volatile in the last decade, substantially gaining and losing value. This variability in performance was driven by transaction growth and subsequent poor performance. The company has managed to achieve some growth but the last decade can be best described as underwhelming.

Fuel prices:

One of the major factors impacting the automotive industry in the short term is fuel prices. This is because consumer driving habits are impacted by prices, with consumers generally driving less when prices are high. This is fairly logical as it encourages people to find substitutes/avoid travel where possible. For example, consumers may have their groceries delivered rather than making regular trips to the store. Fuel prices have sharply increased as a result of the Russian invasion of Ukraine, causing a material shock across the global energy market. As the following graph illustrates, gasoline prices in the US remain heightened compared to recent years.

This drives down the demand for maintenance as less mileage is driven, reducing the demand for AAP’s services. The below shows softening demand for motor gasoline across the last year.

Comparable store sales have declined to a soft 0.3% in FY22 (Source: FY22 Management presentation). It is difficult to assign a reason for this, as more headwinds will be explained below, but this has likely contributed to softening demand. With a lack of clear guidance on when we can expect prices to decline, this will likely continue to be an issue in the coming 12-24 months.

Electric vehicles:

A further headwind that has been developing in recent years and accelerated by the energy crisis, is the rising demand for electric vehicles. Increasing demand for EVs reduces the need for traditional auto parts and accessories. This is compounded by the fact that EVs are far more complicated technologically while having far fewer moving parts. This reduces the scope of services AAP can sell as a means of replacing ICE-power vehicle parts. For example, AAP currently provides the products necessary to repair an engine but the same is not the case for an EV battery. Therefore, there is a real risk that AAP becomes obsolete. This is likely decades away, however, as the US looks to be the slowest of all of the western nations to transition to EVs. EVs currently make up <10% of new car purchases in the US. Further, AAP could still secure partnerships with EV manufacturers, which we think would be a shrewd decision, as a means of securing OEM replacement parts.

Aging vehicles:

The opposing angle to the above is that with EVs becoming more and more popular and ICE-powered vehicles slowly being phased out, we are experiencing an increase in the age of the U.S. vehicle fleet. As these vehicles age further, the maintenance requirements will increase, thus contributing to higher demand for replacement parts and accessories. What the net effect will be is difficult to quantify by the company is unlikely to experience a pure decline but rather a soft decline once the tides turn toward EVs.

E-Commerce:

Like with many other industries, consumers have been shifting toward e-commerce for purchasing products due to selection and ease of delivery. This has encouraged the growth of the DIY segment, as consumers choose to save in areas that are fairly easy to do without expertise/tools. AAP has done well in both regards, with DIY making up 41% of total sales and the company boasting an impressive number of delivery outlets. The company has provided support to customers via their website, which has a handy tool that allows consumers to search for car-compliant parts only, thus reducing the risk of ordering incompatible parts.

Financials:

Presented above is AAP’s historical financial performance. The overarching assessment is stagnation, with the business seemingly unable to kick on from its early performance.

The company has grown revenue at a CAGR of only 2%, suggesting the company has been unable to materially outperform inflation during the said period. This is due to an inability to directly compete with its peers, namely O’Reilly Automotive (ORLY) and AutoZone (AZO), who have both taken substantial market share from the business. They have been able to do this by better catering to consumer needs, increasing the chances of repeat customers. This comes primarily with customer service, product choice, and competitive pricing. These are seemingly simple factors but a decade has gone by and the company has massively fallen behind. As the below graph illustrates, AAP is the personification of stagnation.

AAP has focused on improving its supply chain and distribution capabilities in order to improve its competitive positioning. The company has invested in new technologies to streamline its operations in order to ensure a better inventory delivery process for customers while contributing to greater efficiency. AAP’s supply chain initiatives have helped to reduce costs somewhat but the company’s topline figures do not reflect this, with the EBITDA margin trending down. This has been driven partially by recent cost pressures as a result of current economic conditions. Despite this, Management was unable to show improvements before FY19.

Although the performance has been poor, the financials are quite attractive. Investors can earn a consistent EBITDA multiple, with this translating into what looks to be a 3-5% FCF margin. This will allow for consistent dividends and buybacks.

Moving onto the balance sheet, the company has experienced a decline in inventory turnover and an increase in CCC. This suggests inventory is becoming slower to move as demand begins to soften, indicating the company could have a tough time in 2023. This is only a marginal change and should not be read into too deeply.

AAP has been aggressive with its capital allocation in recent years, significantly buying back shares and paying dividends, more than cash generated. This has left their cash balance at a 5-year low. Although liquidity is not a concern, these levels will certainly need to substantially decrease. The company is forecasting $400M in FCF for FY23, which means we are either looking at a debt increase or a c.50% haircut on distributions.

Looking at debt, the company’s current ND/EBITDA ratio is 2.33x, which is fairly good and has some room to increase in our view, with anything over 3x beginning to look unsettling.

AAP’s financials do show a lot of potentials but the real concern is growth. With AZO and ORLY boasting an impressive decade, AAP has no excuse as to why growth cannot increase sustainably. Management is forecasting 2.2% growth for 2023 on the low end, which seems to suggest we are returning to AAP’s “normal” growth again.

Outlook:

Presented above is a breakdown of analysts’ consensus forecasts for the business.

Analysts seem to believe the company will return to more of the same, only forecasting 2% growth in the coming 5 years. Further, they believe margins will remain relatively sticky, with only FCF margins improving. We concur with the overarching view (Not the FCF estimates), as the business has not shown us enough to suggest it will turn around its performance. With long and short-term headwinds ahead, AZO and ORLY seem far better placed to weather what is to come.

Comparison to the leaders:

Presented above is a comparison of AAP to the 2 largest players in the market.

As is evident, AAP underperforms across every metric. This is the issue the company now faces, it faces the impossible task of taking back market share. The company cannot compete on price without destroying its marginal FCF and equally cannot invest as much money as the others in its services. This leaves the company in no man’s land, seemingly unable to develop beyond its current position.

Valuation:

With this significant underperformance in mind, we must value the business from the perspective of being a weaker member of its industry. Further, there is a material gap between 13% FCF and 3%, which must be captured, as this will generate the majority of the delta between investment returns.

To value AAP, we have considered its relative performance to its peer group. We have taken the average EBITDA multiple for ORLY, AZO, and AAP from 2014 to date, the period in which AAP has underperformed these companies. Comparing the ORLY/AZO average to AAP has allowed us to quantify the implied discount markets are applying, which comes out at 23%. Based on this, AAP has an upside of 13%.

We consider this to be the best way to value the business as it accurately reflects how the markets see the company’s underperformance, which we believe will continue. All headwinds facing the business will impact its peers too, so we see no reason to attribute or deduct additional value.

Final thoughts:

As one of our graphs above illustrates, at one point AAP was the leader by revenue in the market. Since then the company has achieved very little, seemingly unable to deliver its potential. Our view is that things will only continue in the same vein, with no indications of improvement. The company is facing some headwinds but these are shared by the industry are contribute to both short and long-term headwinds. With these in mind, it is unwise to consider the company a buy on such a small upside, therefore suggesting a hold.