Advance Auto Parts Stock: Can The New Management Deliver? (NYSE:AAP) (2024)

Summary

Advance Auto Parts (NYSE:AAP) is an aftermarket parts provider in the US and serves both the commercial and DIY markets. AAP stores offer a selection of brand-name, OEM, and private-label replacement parts, accessories, batteries, and maintenance items for light and heavy-duty vehicles.

I want to make it clear that this is a turnaround situation, and to all turnaround situations, it hinges on management's ability to execute the turnaround. For the benefit of readers that are not familiar with how to assess a turnaround situation, there are two key things to bear in mind: (1) is the potential upside worth the risk and (2) does management have the skill set to pull this through. In my valuation section, I talk about (1) and in my comments section, I talk about (2).

As per my assessment, I am initiating a neutral recommendation for AAP. The upside potential is attractive if the business is indeed turned around. However, I prefer to take a more safe approach by monitoring whether management is executing this turnaround situation as planned before I consider investing.

Financials / Valuation

AAP growth has been cyclical, as the business expands in good times due to more automobile sales and contracts in bad times when consumers cut back on discretionary spending. In FY20/21, growth was 4.1/8.8% but has fallen to 1.2% in FY23. A similar trend could be seen throughout history, for instance, between FY07-10, where growth saw 4.9/6.1/5.3/9.5% followed by a decline to 0.6% in FY12. The same goes for profit margins (using EBITDA in this case), where they generally follow the direction of revenue growth rates. In the recent 4Q23 quarter, net sales fell by 0.4% to $2.465 billion, relatively in line with the consensus estimate of $2.464 billion. Driven by the decline was a comparable store sales decline of 1.4% y/y. This was followed by gross margin compression of 504 bps to 38.6%, together driving down the EBITDA margin to 0.9%.

The reason for initiating coverage on AAP is because I think the upside potential is very attractive if the new management team can turnaround the business, and the market is not incorporating this into the valuation and estimates yet.

For clarity, let me make known that AAP ends their fiscal year on end December, and the latest fiscal year is FY23. My model above projects two-year forward (FY24 and FY25). The reason for forecasting only two years is because I believe it is not useful to conduct a 10-year DCF, considering this is a turnaround situation. In my opinion, the market is going to put a lot of focus on the near-term results (whether it can hit guidance / beat consensus estimates), as such, my model focuses on the next 2 years.

The question here is, what is the normalized (through-cycle) growth rate (remember this is a cyclical business), so looking at the industry historical performance (I used peers' performance as a reference). The average across the past 24 years is in the mid-single-digits (~5%).

As of today, consensus is expecting revenue of $11.5 billion and EBITDA of $752 million for FY25. However,

1. if management does turn the business around: AAP should see growth recover back to the mid-single-digit level (the historical through-cycle average is ~5% since FY10) and
2. If management succeeds in streamlining the business cost structure (from supply chain efficiencies and business unit optimization), margin could return to historical levels of low-teen percentage (AAP historical performance).

That said, for (2) this is a multi-year process, so AAP is unlikely to revert to 10+% EBITDA margin soon. I think a more plausible target is for margin to revert to FY22 levels at least. In this case, I don't think it's hard to believe that the market will value AAP at its historical average multiple (9x forward EBITDA), given that it is already trading at 8.3x today. For comparative sake, Genuine Parts trades at 10x forward EBITDA and is expected to grow at 4% with a 11% EBITDA margin, which is what I expect AAP to deliver if the turnaround is well executed.

Comments

In this section I lay out my view on whether the management has the execution capacity to succeed and how have they performed so for.

AAP is a turnaround story; as such, I would not pay too much attention to the recent financial performance. Rather, I think the focus should be on whether the new management term is delivering against its targets. For context, AAP announced executive leadership changes in September last year, which I was very supportive of given the lackluster performance in recent years. At a high level, the new management's direction is to streamline the business (in terms of organization structure, business units, and supply chain), reduce costs to stay competitive, and improve the productivity of assets. At a glance, my immediate takeaway is that this is going to take a much longer time than expected to execute, probably a multi-year one. As such, investors must have patience.

Encouragingly, management is working well towards streamlining the business. The proposed sale of AAP's Worldpac and Canadian businesses remains under way, with priority set for the sale of Worldpac (which is already actively engaging potential buyers and expects to finalize the process in 2Q24). While the unit economics post-deal is not revealed at the moment, my expectation is that it will enable it to better improve its supply chain as Worldpac does not align well (AAP now needs to specially carve out new inventory requirements for Worldpac) with the AAP strategy of servicing both Pro and DIY customers in the core stores. The timing for a potential sale of AAP's Canadian business remains unknown, but looking at how AAP has been on the ball on this sale, we should hear good news in FY24.

The major change (and bigger challenge) for AAP's turnaround story is whether management can successfully consolidate their supply chain network into a single, unified platform from the current bifurcated Advance Auto Parts and Carquest networks. The benefits are huge if management can deliver them because AAP has been operating an inefficient distribution network, because it will improve inventory availability throughout the entire network, which means less need to hold more inventory (working capital benefit) and also lower logistical costs (margin benefits). To a greater extent, this could improve growth as well because there will be a lower frequency of out-of-stock situations.

We know that our current network is inefficient and needs substantial work to improve our cost structure and inventory availability. Source: 4Q23 earnings

I am positive about management's plan to achieve this. The implementation of a new warehouse management system is scheduled to be finished by the end of the year. Additionally, smaller distribution centers (DCs) will be transformed into market hubs and linked to a larger DC network across the country. It is anticipated that this consolidation effort will continue throughout FY25 and possibly into FY26. In my view, I am pretty confident that management can deliver this because the new CEO is from Home Depot's HD Supply business unit, where the business had to handle more than 500,000 product assortments and be on point in terms of distribution (HD Supply is an industrial distributor in North America).

Risk

DIY consumer continues to be pressured with softness throughout the 4Q23 quarter, particularly in the last four weeks. I expect DIY to remain pressured throughout 2024 as macro continues to weigh on the lower-income consumer. Suppose the macro situation turns for the worse, this segment could drag down business by a lot more than expected, overshadowing the efforts that the new management team is implementing.

Conclusion

I am recommending a neutral recommendation. While I am attracted to the potential upside, I note this is a turnaround situation, and likely a multi-year one as the turnaround hinges on management successfully streamlining huge parts of the back end operations, which carries high execution risk. Hence, I like to see progress on key initiatives like supply chain consolidation before taking a more bullish view on the stock.

Normad Capital