Description

Investment Thesis

In my view, Advance Auto Parts (NYSE: AAP) is the quintessential value trap. The stock is at the same price as it was in July 2010! Why? Because AAP’s operating income has actually declined over the past 14 years. To get a sense of the bull case, please reference gary9’s write-up from 7/11/22. The stock is down 71.4% since then.

I think AAP is good standalone short, but also serves as a nice hedge/paired trade against industry/macro risks for a long position in ORLY given the similar business mix. Only 10.9% of the float is short as of 10/13/23. AAP has low-mid 40s in DIY compared to mid-high 50s in DIFM. ORLY is mid-high 50s DIY and low-mid 40s in DIFM.

Retail in general is a tough business. The fixed cost operating leverage of stores is a beautiful thing when the business model is working and there are consistent positive same store sales above inflation. But the operating leverage cuts both ways. And once it begins to go in the opposite direction, it is very tough to reverse.

If you’re a student of retailers, history is littered with the failure of many tier 2 and tier 3 players. Just to cite some examples over the past two decades: Rite Aid, Circuit City, J.C. Penny, Sears/K Mart, Toys R Us, Bed Bath & Beyond, Linens & Things, Radio Shack, Borders, Sports Authority, and the list goes on.

When an industry is growing at a high rate, it can mask a lot of underlying issues, but once the growth slows down to more mature levels, the problems are really exposed—especially if one is competing against much better managed players. And that is exactly what AAP faces—competition against ORLY, AZO and GPC that are continually taking market share.

In 2010, AAP had revenue of $5.9B and operating income of $585M. In the LTM it had revenue of $11.2B and operating income of $573M. Over that time, its gross margin declined from 50.0% to 43.6%. Its operating margin declined from 9.9% to 5.1%. Inventory turns declined from 1.7x to 1.3x.

So now that I’ve explained the symptoms, what is the disease? Unlike ORLY and AZO, which mainly grew organically and has had consistently good corporate culture bred by good, steady management that grew up through the ranks, AAP is essentially the opposite. In 2014, AAP acquired Carquest/Worldpac and since then it has been downhill for the company. There has been one operational issue after another due to a highly fragmented supply chain network with disparate systems that made it challenging for Carquest stores to communicate with AAP’s existing distribution centers for inventory re-stocking in a timely manner. At the end of the day, parts availability and speed of delivery is what this business lives and dies by. On the commercial side, if you stop being the “first call” for that professional due to inconsistent service, it is very difficult to win that relationship back over time. And the same goes for the DIY side of the business. When that customer comes in due to a part failure that part needs to be in stock and it needs to be accompanied by great, knowledgeable customer service.

AAP has $1.9B of debt and $2.7B of capital lease obligations. As you can imagine, AAP is paying a much lower interest rate on its debt than what it would pay if it had to refinance that debt at current rates. It has some big chunks of debt maturing over the next four years. Meanwhile AAP’s debt rating was recently cut to “junk” status by S&P Global on 9/12/23. 

So here’s the simple math/path to a zero in the stock over the next few years. In the LTM, AAP had ~7% market share and $262 sales/sq. ft. with a 5.1% operating margin. Every incremental dollar of sales it loses carries a ~40% incremental margin with it. Assuming some inflation in the coming years, all it would take is AAP to lose ~10% of its revenue or less than 1% of a share shift away from AAP mainly to ORLY/AZO for the stock to be a zero. ORLY and AZO know AAP is on the ropes and is continuing to go after its business.

Risks: The company somehow turns itself around or is bought out by private equity and/or a strategic acquirer.

Important Disclaimers

CERTAIN STATEMENTS CONTAINED HEREIN REFLECT THE OPINION OF THE AUTHOR AS OF THE DATE WRITTEN. NO INVESTMENT DECISIONS SHOULD BE BASED IN ANY MANNER ON THE INFORMATION AND OPINIONS SET FORTH IN THIS REPORT. YOU SHOULD VERIFY ALL CLAIMS, DO YOUR OWN DUE DILIGENCE AND/OR SEEK ADVICE FROM YOUR OWN PROFESSIONAL ADVISOR(S) AND CONSIDER THE INVESTMENT OBJECTIVES AND RISKS AND YOUR OWN NEEDS AND GOALS BEFORE INVESTING IN ANY SECURITIES MENTIONED. AN INVESTMENT IN THE SECURITY DOES NOT GUARANTEE A POSITIVE RETURN AS STOCKS ARE SUBJECT TO MARKET RISKS, INCLUDING THE POTENTIAL LOSS OF PRINCIPAL.

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Catalyst

Continual shares losses mainly to ORLY/AZO that lead to a restructuring.