Advance Auto Parts: Rock-Bottom Valuation With Massive Upcoming Catalyst, Strong Buy

RiverNorthPhotography Thesis In today’s top-heavy, tech-driven market, investors continue to chase the “shiny new object.” For long-term investors, this sentiment has created attractive opportunities beneath the surface, leading to many “boring” companies being overlooked. One of those “off the beaten path” companies is Advance Auto Parts (NYSE:AAP). Shares of AAP have fallen by over 70% since all-time highs in 2021, largely, in my opinion, due to years of mismanagement and a flawed strategy of increased promotional activity. In my view, prior management’s poor capital allocation decisions led to the “junk” debt rating where we stand today. However, I believe this is a turnaround situation in which pessimism has gotten overextended, and investors continue to underappreciate near-term catalysts. With an experienced leadership team now at the helm and a strategic plan to revamp core retail operations, AAP appears to be a bargain-priced opportunity for investors with a long-term time horizon. Management Overview A key factor in a turnaround is having the right leader in place, and newly appointed CEO Shane O’Kelly is a jockey that I would like to bet on. O’Kelly joins AAP with a proven track record as former CEO of HD Supply, one of the largest industrial distributors in North America. His military background and industry expertise make him the experienced, dedicated leader AAP desperately needs. With the help of activist involvement, AAP has also strengthened its board with three new directors, bringing invaluable experience that was previously lacking. Tom Seboldt joins the AAP board after spending over 30 years at O’Reilly Automotive. Renowned for his merchandising leadership, Seboldt will be key for advising inventory management and product placement strategies. Greg Smith is a seasoned supply chain expert with a reputation for large-scale overhauls. His extensive experience will play a crucial role as AAP works to unify supply chain operations. Brent Windom has spent his entire career in the auto aftermarket industry and was most recently CEO of Uni-Select, a leading parts distributor. In the weeks since joining the board, Windom added some skin to the game, purchasing $834,500 in AAP stock. This highly accomplished and experienced leadership team will be essential to the Advance Auto Parts turnaround story. Now, the focus shifts to execution. Nasdaq Worldpac Sale The near-term catalyst that I feel investors and the street continue to underappreciate is the sale of Worldpac. Worldpac is a wholesale distributor of original equipment and aftermarket parts, which AAP acquired during the 2014 General Parts International acquisition. Despite being a high-performing asset for AAP, Worldpac has always functioned independently from the core blended box model. Management has struggled for years to integrate the two business lines; unfortunately, potential synergies were unrealized. Shane O’Kelly is finally addressing the issue by deciding to divest Worldpac. This move aligns with the broader strategy of simplifying operations and focusing on selling auto parts out of the blended box model. Luckily, the sale of Worldpac comes from a position of strength and has attracted significant interest. According to activist investor Legion Partners, Worldpac is worth about $1.8 billion but could fetch between $2 billion and $3 billion on the open market. With current street assumptions of anywhere between $1.5 billion to $2 billion, this potential upside could be a massive catalyst. Shareholders won’t need to wait long, as management anticipates the sale to be completed before announcing Q2 earnings later in August. Management already outlined the three areas where the proceeds will be allocated during the Q1 earnings call: debt reduction, reinvestment in the core business, and returning capital to shareholders. We can expect management to pay off nearly all $1.36 billion outstanding net debt and, as a result, enhance its financial standing with credit agencies. The remaining proceeds will likely fund strategic initiatives such as supply chain unification, renovating retail stores, and salesforce investments. Depending on the share price at the time of the sale, I would like to see the remaining proceeds be allocated towards share buybacks rather than increasing dividend payments. “RemainCo,” AAP’s post-divestiture entity, will resemble the blended box model of peers like O’Reilly (ORLY) and AutoZone (AZO) at a significantly lower valuation. According to Dan Loeb and his team at Third Point, RemainCo is valued well below $2 million per store compared to O’Reilly and AutoZone, who are both valued north of $10 million per store. Looking ahead, management has also hinted at selling the Canadian portion of the Carquest business. However, management noted during the Q1 earnings call that this sale is intentionally sequenced behind the Worldpac sale and will be further evaluated post-Worldpac. In my view, these are the organizational changes that shareholders should embrace as management navigates the turnaround. Unified Supply Chain While the Worldpac divestiture offers tremendous financial gain, the true advantage lies in the ability to create a unified supply chain network now. Switching costs are minimal in the aftermarket auto parts industry, and availability is typically what dictates customer loyalty. Having the right parts at the right place at the right time is what drives business. Therefore, having efficient and timely supply chains is a crucial element and has been an area where AAP has historically struggled. Shane O’Kelly is no stranger to this priority, as this marks his third time implementing a unified supply chain across companies. The first step is completing a unified warehouse management system (WMS) across all distribution centers, scheduled for completion by the end of FY2024. Next, the focus shifts to creating an efficient distribution network. AAP currently operates more than 38 distribution centers across its Advance and Carquest network, which has proven to be highly inefficient and has introduced years of inventory availability and cost structure headwinds. As noted in the Q1 FY2024 earnings call, this number is beyond excessive, and management aims to consolidate into 14 larger nationwide distribution centers. This transformation is a multi-year process and will require significant investment, with management projecting capital expenditures of $200 to $250 million in FY2024 alone. However, these are the efficiency improvements that not only drive massive cost savings but contribute to the longer-term goal of winning back market share. Margin Restoration The key to the Advance Auto Parts turnaround story is restoring the margin structure, specifically operating margins. Prior to the Worldpac acquisition, AAP consistently maintained operating margins ranging from 9% to 11%. Data by YCharts As a result of supply chain inefficiencies, profitability gradually deteriorated since the 2014 acquisition, reaching a low of (3.27%) during Q4 2023. Luckily, this is an inflection point, as operating margins have since rebounded to 2.5%. This downturn is a stark contrast to industry peers like AutoZone and O’Reilly, who typically command operating margins north of 20%. The divergence becomes overwhelmingly apparent when looking at the operating margins of the three companies over the past fifteen years in the chart below. Data by YCharts Management has guided for significant progress in FY2024, forecasting a range of 3.2% to 3.5%. These improvements are primarily attributed to the $150 million of SG&A savings expected to be realized in FY2024. In the long term, margin expansion will be driven by the Worldpac sale and unification of supply chains. To add some color to the potential impact of returning to double-digit margins, we can turn to Legion Partners analysis. During the Bloomberg Activism Forum, Legion pitched that regaining 12% EBITDA margins could potentially lead to shares tripling. Analyst Chris Kiper believes this is “really doable” as these double-digit margins still sit 50% below industry peers. While this margin restoration will require a longer-term time horizon and concerted effort, I find this target to be highly feasible. If assumptions of suppressed margins from supply chain inefficiencies hold true, the turnaround looks highly promising post-Worldpac sale. With the groundwork laid out and a seasoned leadership team in place, I see a return to double-digit operating margins as a matter of “When,” not “If.” Cyclical Tailwinds Advance Auto Parts operates within the aftermarket auto parts industry, a sector renowned for resilience during economic downturns. Investors worried about consumer health and discretionary spending can take comfort in this stability. This resilience largely stems from the business’s essential nature; if a car battery dies, replacement is a necessity. These stable fundamentals were evident during the 2007-2009 recession, when AAP delivered top-and-bottom-line growth alongside expansion in store numbers. AAP also benefits from a key competitive advantage: a strategic customer mix skewed towards professional repair shops rather than DIY customers. For example, AutoZone’s customer base leans much more towards the DIY side, leaving it vulnerable to trends of EV and hybrid vehicles that require fewer moving parts. AAP’s diverse customer mix continues to shield them from these challenges and smooth out choppiness across different market environments. Advance Auto Parts also benefits from several cyclical tailwinds, one of which is the rapidly aging vehicle fleet. According to S&P Global Mobility, the average age of cars and light trucks in the U.S. is a record high of 12.6 years. S&P Global Mobility Not only do these aging vehicle demographics provide robust aftermarket auto part demand, but they also ensure frequent trips to the mechanic. As the bulk of vehicles on the road hit the 6 to 11-year age range, where repairs are most common, Advance Auto Parts Pro division continues to benefit from rising demand. Miles-driven trends are also projected to experience a sharp uptick, largely thanks to stabilizing gasoline prices. Together, these cyclical tailwinds continue to strengthen AAP’s attractive business model. Valuation AAP Public Filings, Author’s Calculations Starting with FY2024 top-line sales, I elected to use the midpoint of management’s guidance of $11.3 to $11.4 billion. I then opted for a conservative forecast of 1.5% revenue growth through FY2027, well below AAP’s 5-year average growth of 3.43%. Next and arguably the most important, I forecasted 3.35% operating margins, the midpoint of management’s guidance range. This was followed by an additional expansion of roughly 150 basis points through FY2027, reaching 8% margins. This expansion is predicated on successfully implementing a unified supply chain network and realizing guided cost savings. While these margins are still well below the pre-Worldpac double-digit margins, I elected a more conservative approach. Next, I forecasted roughly 2% net income margins for FY2024, with sequential expansion to 3.5% by FY2027. This compares to AAP’s 5-year average net income margins of 4.3% and, once again, is still well below pre-Worldpac levels. I forecasted no reduction in shares outstanding through FY2027, despite proceeds of the Worldpac sale likely to be allocated to modest share buybacks. That leaves us with an FY2027 EPS of $7.04. By assigning a 17x P/E multiple to these earnings, in line with AAP’s five-year average of 17.86 x P/E, we land at a share price of $119. This price target implies 81% upside potential from today’s current share price. Over three years, this boils down to a 22% compounded annual growth rate (CAGR) before considering any quarterly dividend payments. Bottom line The turnaround story at Advance Auto Parts is just getting started. With a seasoned leadership team, significant upcoming catalysts, and favorable cyclical tailwinds, AAP is poised for a rebound. I recommend AAP as a strong buy with a target price of $119.

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