In the last 52 weeks, shares of Advance Auto Parts (AAP, Financial) are down 42%. Is this fair, or is it completely out of touch with the real value of the business?
Advance Auto Parts is a leading retailer of automotive aftermarket parts and accessories in the United States. The company offers a wide range of products, including engine parts, batteries, brakes and belts, among others, for both professional installers and do-it-yourself customers. The company was founded in 1932 and is headquartered in Raleigh, North Carolina. Over the years, it has expanded its operations through strategic acquisitions, such as its purchase of Carquest in 2013, which now serves roughly 1,250 independent locations.
In my view, even if the company is in the same position in 2028 as it is today, the stock is still undervalued. The company is priced at a price-book ratio of just 2.65 while its larger competitors AutoZone (AZO, Financial) and O’Reilly (ORLY, Financial) operate with negative book values. Advance Auto Parts also has the cheapest forward price-earnings ratio of the three at 11.18.
What's the difference between the competitors? Advance Auto Parts has grown much slower than its peers, as it made the decision to pay out dividends and retain earnings while the other two did not. However, with the retirement of the President and CEO, Tom Greco, the company has an opportunity to start turning around its strategy with an eye toward further growth.
A look through the financials
In February, Advance Auto Parts reported fourth-quarter and full year numbers. Fourth-quarter revenue displayed resilience, with quarterly revenue increasing 3.2% to $2.5 billion on the back of a 2.1% rise in same-store sales. Revenue for the year increased 1.4% to $11.2 billion with comps up a tiny 0.3%.
Over the last decade, revenue has risen from $6.5 billion to over $11.5 billion; gross profit from $3.2 billion to north of $5 billion; and net earnings from $391 million to over $501 million. Advance Auto Parts has kept long-term debt at around $1 billion while building retained earnings from $1 billion to nearly $4.8 billion, more than doubling its book value. Until the decline in price from 2022 to present, the company had produced nearly $2 for every $1 retained.
Comparisons with competitors
When compared to AutoZone and O’Reilly, the long-term negative difference seem to have been driven in part by margins: it underperforms on both its gross margins and operating margins. While Advance Auto Parts' gross margin sits at a very respectable 44%, gross margins at both AutoZone and O’Reilly are over 50%. This also helps boost net profit margins and drive bottom line earnings growth at a greater level, which really compounds over the years. So, while top line growth across the three companies is very close, the bottom line is a different story. AutoZone has grown net income by nearly 140% while O’Reilly is up 224% over the last decade. As for Advance Auto Parts, its bottom line is only up 29%, a key indication of why it has struggled against these two.
The company has let operating expenses get a little out of control. 10 years ago, it was spending 78% of gross profit on operations. Today, the company is spending nearly 85% on operating expenses. That has basically kept profit flat, confidence shaky and the stock price fluctuating. By comparison, AutoZone and O’Reilly spend 63% and 66% on operating expenses, respectively. If, and this may be a big if, Advance Auto Parts could get its costs down to that level, profits could increase substantially. However, the company is also spending a lot on its dividend still, which is a drawback on growth investments.
Future prospects and valuation
The time for change has finally come as the Advance Auto Parts CEO is retiring, and the problems of operational integration due to its 2014 purchase of General Parts is mostly behind the company now. Advance Auto Parts has a market cap of more than $7 billion, and under the right CEO, I believe it could start extracting more earnings.
Despite the move towards electric vehicles, combustion engines still dominate the roads and should do so for decades. Auto part stores will eventually be able to adjust with the evolution of the market, but for now, the industry can rely on automobiles breaking down and a base of do-it-yourself customers.
That said, as long as Advance Auto Parts can continue to grow revenue, earnings and book value at a similar pace while buying back stock and supplying investors with a dividend yield of nearly 5%, I believe it would be shocking if the market value didn’t rise even if growth continues to lag compatitors. If Advance Auto Parts was priced at where AutoZone and O’Reilly are currently valued, its stock would trade between $188 and $230.
Only time will tell if Advance Auto Parts will be able to tighten operating expenses to drive profitability higher. It's on the hunt for a new CEO and that will also impact the stock in the short term and the long term. Even if new management turns out to be insufficient, the company could be a a great acquisition target for a private equity firm or activist investor. With a market capitalization of just $7 billion, it's easily affordable for many buyers. I think it's only a matter of time before investors recoup the loss in market value from highs of 2022.
