Description

Advance Auto Parts

After a painful multiyear integration process, Advance Auto Parts is finally expanding margins while growing its store base.  The resulting combination of margin expansion, a defensive category and capital allocation allows us to buy a LDD EPS growth profile at just under 10x 2025 EPS.  Given the recession resistant attributes of this industry and a large valuation discount to peers we see this as an excellent risk reward with a base case target of $300/shr (+65%) by year end 2023.  

Business Overview

Advance Auto Parts (AAP) is a leading automotive parts provider in North America, serving both professional installers (DIFM) and “do-it-yourself” (DIY) customers, as well as independently owned operators. Through its integrated operating approach, AAP serves its customers through various channels such as traditional brick and mortar locations and self-service e-commerce sites. AAP’s supply chain consists of a network of distribution centers, HUBs, stores, and branches that enable it to provide same day or next-day availability to customers. No single merchandising vendor accounts for more than 10% of AAP’s purchases. 

The business is understandably seasonal in nature, with the highest sales usually occurring in the spring and summer. Weather conditions also impact the business. While unusually heavy precipitation tends to soften sales as elective maintenance is deferred, extremely hot or cold weather tends to enhance sales by causing automotive parts to fail at a faster rate. The fourth quarter is generally the most volatile, as weather and spending tradeoffs typically influence professional and DIY sales.

AZO has the highest DIY exposure at 77% and 23% DIFM, while ORLY has 59% DIY and 41% DIFM, and AAP has 43% DIY and 57% DIFM. 

The Turnaround Story

AAP’s turnaround efforts began in 2016 with the arrival of CEO Tom Greco. The 5-yr plan called for EBIT improvement of 500bps from 9.4% in 2016, along with comp sales accelerating to MSD by 2021. AAP highlighted long-term initiatives to improve its supply chain by creating a uniformed parts catalog to support its multiple brands (Advance, Carquest, etc.), stronger parts availability, and new sales training compensation plans. Essentially, AAP’s goal was to make use of its existing Advance and Carquest supply chain instead of investing in new facilities, by creating common IT infrastructure, optimizing inventory replenishment, and reducing miles for delivery trucks. AAP also put out a plan to take $1B (or ~20%) out of gross inventory levels to improve cash flow and margins. A large part of the operational issues AAP was its highly fragmented supply chain network, comprised of 10 distribution centers opened by Advance and 40 distribution centers from the Carquest/Worldpac acquisition. A notable example of this was in 2016 when Greco joined the company – there was incompatible software that inhibited Carquest stores from communicating with Advance DCs and other warehouse management systems throughout the company. 

To highlight AAP’s operational issues hindering margin growth, take ’16-’21 abs. op margin bps change – AAP only saw +14bps, while AZO saw +67bps and ORLY saw +211bps. However, half of the ~1000bps margin gap between AAP and AZO/ORLY can be viewed as from rent (ORLY owns ~40% of stores, AZO ~50%, and AAP just ~15%) and lower margin mix (which growth in private label will improve), while the other half can be closed on through AAP’s idiosyncratic initiatives, as further detailed below. 

We understand that many of these goals have not yet been fully completed, but we believe AAP is in the best position it has ever been in achieving this successful turnaround that will unlock its margin potential (cross-banner replenishment, integrated WMS, strategic pricing, and private label), which we have evidence of from the latest quarter(s). Put simply, we think the market is ignoring the current/forward state of AAP’s middle-innings turnaround and when coupling this with the stock’s recent de-rating, we see a unique entry point in a unique story. 

Financial Targets

At the 2021 Investor Day, AAP outlined a 3-yr plan, consisting of 2-4% comps and 10.5-12.5% op margins in 2023, resulting in $13.90-16.60 in EPS. 

More on margin expansion, guidance over the next three years implies incremental margins of 35% at the midpoint, which is well above ORLY at 24% and AZO at 21% over the past five years. This should allow AAP to close the op margin gap between its peers over time. There are three main initiatives that will drive op margins:

1. (+) 180-200bps from category management (pricing, own brand expansion, input cost reduction)

2. (+) 130-180bps from supply chain (cross banner replenishment, warehouse management system)

3. (+) 210-350bps from SG&A and store productivity (ERP and integrated merchandising platform represents the majority of cost savings and consolidating back-office operations is expected to see $30M in annual corporate cost-out)

4. (-) An offset of 280-290bps inflation headwind (note, AAP has recently said the drag has been greater than expected, but believes it can be offset by pricing, which it expects to do in the coming quarters)

Beyond 2023, AAP believes it can drive further margin expansion through its new tiered supply chain and optimized fulfillment, such as using its new WMS and CBR initiatives to find more efficiencies within its supply chain by separating high and low velocity SKUs, leading to a tiered distribution structure in which higher volume SKUs are available at primary DCs. Cross banner fulfillment should result in 14% annual reduction in miles driven from DCs to stores.

The total shareholder return of 20-22% is driven by 4-5% rev growth, 12-13% margin contribution, and 4% share repurchase and dividends. 

The Debate / Our View

The stock is pricing in a lot of pessimism that we do not fully agree with. At this valuation, we see the near-term debate boiling down to whether or not AAP will meet its 2022 guide. We acknowledge that an in-line/mixed 1Q print does slightly increase the risk that AAP may fall short of this, but we see a line of sight to meeting 2022 guidance. Longer-term, there are continued margin drivers such as a tiered supply chain, optimized fulfillment, and private label expansion that mgt has noted will be a multiyear effort to close the 10-15 pt gap vs. peers. Again, we think there is exaggerated pessimism on the longer-term profile. 

The implied avg 2Q-4Q22 numbers AAP must deliver to reach FY guidance are 2.6% comps (1-3% FY guide), 13.2% EBIT growth (implied 9.5% FY guide), and 10.6% margins (10.1% FY guide). We believe this is achievable, which our model below implies, especially with AAP noting 2Q QTD trends as performing in-line with its 2022 outlook. We see pricing and an increased mix of owned brands (which are higher margin) benefitting GMs, such as pricing on a daily basis vs. prior only 1x a week and continued cross banner replenishment that is currently in about 45% of stores. We see more SG&A leverage in the back half of the year as AAP laps large increases in wages and incentives. This near-term margin story contrasts with AZO, whose GM/EBIT margins may be pressured as it focuses on growing out its DIFM business. For example, in 1Q, AAP saw +231bps of GM expansion y/y, while AZO saw -54bps and ORLY -126bps, as well as AAP seeing the largest gross profit $ percentage increase. 

Why are we confident that these initiatives can work in the NT/LT? In 1Q, on adj. basis, GMs expanded +231bps, in which most of it was due to the adjustment from LIFO (GAAP) to FIFO (this benefits GMs in inflationary times). On a GAAP basis since GMs were flat, the ~240bps negative impact from LIFO was offset by something a bit substantial – we attribute this to the self-help initiatives (owned brand and pricing, for example) that are simply working as intended, if not better. 

AAP’s pricing has gone from uniform prices across the country to market level pricing with variances across DIY/DIFM segments. Prior, AAP could only make a limited number of price changes each Sunday night. Now, it can make changes on a daily basis and has the analytics capabilities to measure elasticities and optimize profitability.

AAP has increased its private label penetration to the high-40% (up from high-30% and vs. peers in the mid-50% range), which is margin accretive, and has expanded its selection of undercar and engine management parts through its Carquest brand. This is a multi-year effort. 

Plus, while inflation remains a concern, but AAP is not seeing consumers trading down. Currently, AAP is seeing MSD inflation, which should continue in 2Q and moderate a bit in 2H. Historically, high gas prices have put pressure on vehicle miles driven, but mgt has not seen an impact from this yet, nor (more importantly) seen evidence of consumers trading down due to inflation. On store growth, AAP expects to open 125-150 stores this year and expects to continue at this run rate moving forward (1-2%). Note, it takes about 4-5 years for a new AAP store to reach maturity. 

At ~13x/12x/10x our ‘22/’23/’25 EPS ests, we view AAP’s risk/reward as compelling, especially as we enter a slowing macro backdrop, in which defensive companies like AAP will shine brightest. It is one of the few retailers (and sub-sectors) that we are confident can manage the current landscape and various external factors. We model a 12% EPS CAGR (’21-’25) along with 150bps of EBIT margin expansion, but we believe this may prove conservative simply given the strength of AAP’s idiosyncratic initiatives such as private label, strategic pricing, and supply chain improvement, coupled with industry demand tailwinds that should yield further upside.  We believe the company’s execution combined with the defensiveness of the category (2008/09 outperformance highlighted below) will allow this to rerate back to a high teens multiple, which is where it has historically traded on a forward basis.  

Historic Multiple & Valuation

Aside from the Covid crash, AAP has had a pretty consistent EPS multiple in the 16-18x range since 2015 (see chart below).  Peers ORLY and AZO currently trade 17-18x forward EPS.  We believe AAP is a better business than it was several years ago due to the operational improvements, though to be conservative our $300 target (~17x 2024 EPS of $17.27) only assumes it gets back to 17x by the end of 2023.  

Where We Could Be Wrong

The main risk is that auto parts retail is a highly competitive business and earnings are sensitive to SSS. There may be unexpected shifts in competitive dynamics amongst the big three players that could impact pricing. However, if investors embed GDP-like LT SSS growth and reasonable margin assumptions, the end result is a very high-quality retailer with a multitude of self-help margin initiatives in a defensive sector – not to mention a cheap turnaround story. 

We do not expect EVs to pose a meaningful risk over the next decade and even though EV sales are set to accelerate over the coming years, it will take time for it to filter through to the aftermarket sweet spot (7-12 years old). This timeline may even be elongated given current recession probabilities and EV cars being more expensive than ICE cars. In 10 years, there will be 6.6M EVs between 7-12 years old, which is an estimated ~7% of the overall sweet spot for the aftermarket, suggesting a rather large runway before the impact of EVs on the auto aftermarket becomes significant. The question is what happens 11-15 years from now with an estimated 30% of the sweet spot being electric. Notably, California accounts for a disproportionate number of EV registrations and electric charging stations in the US – ORLY and AZO are most exposed on this front with both >10% store footprint exposure, while AAP is LSD. 

When comparing an EV to an ICE car, the former (say a Chevy Bolt) contains 35 total moving and wearing parts vs. 167 in the ICE car (say a VW Golf). The total annual maintenance for an EV of $255 comes in well below the $610 for the ICE car. Overall, the cost to repair an EV is about 70% the cost to repair an ICE car. Importantly, AAP has launched the first and only EV 12-volt battery, which has 30% more efficacy than the current battery available for EVs. 

Defensive Category

Auto aftermarket is historically one of the more defensive hardline categories.  In tough times consumers keep their cars longer and are more likely to try a DIY fix when possible.  For example, during the financial crisis (AAP posted +5% comps in 2009; +7% 2-yr stack), a combination of deferred maintenance spending, gas prices -35% at trough, new vehicle sales declining to 10M from 17M, and general uncertainty led to a counter-cyclical boost to auto parts comps. The 2001 recession shows a similar outperformance.  

Auto Parts Comps – 9/11, SARS, Iraq Invasion

Auto Parts Comps – Financial Crisis

• "We believe our industry as a whole has continued to realize better DIY results from increased traffic as consumers are saving money by maintaining their existing vehicles rather than replacing them." – 2Q09

Auto Parts PCE Declined Less and Recovered Faster than Durable Goods PCE During the Financial Crisis

Catalyst

Q2 Earnings & continued margin expansion.