ADVANCE AUTO PARTS INC AAP S
June 30, 2018 - 6:48pm EST by
baileyb906
2018 2019
Price: 135.70 EPS 6.70 7.20
Shares Out. (in M): 74 P/E 20 19
Market Cap (in $M): 10,069 P/FCF 18.3 17.5
Net Debt (in $M): 973 EBIT 697 745
TEV ($): 11,042 TEV/EBIT 15.8 14.8
Borrow Cost: Available 0-15% cost

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Description

Advance Auto Parts (AAP)

 

Summary:

 

Advance Auto Parts is a perennial turnaround story that has run through several management teams over more than four years and has structural, company-specific challenges to the turnaround that are underappreciated. At the same time, the long-term, secular challenges to the aftermarket auto part retail industry that it participates in have been written off as overblown, but may not be. AAP’s stock is up almost 70% from its October lows, despite the many false starts in its turnaround, the jury still being out on its latest CEO, and it continuing to lag its peers in sales and margin metrics. Why has it performed so strongly? It’s partially driven by optimism over the anticipated cyclical recovery in the sector, and also driven by the strong move YTD in retail generally and investor optimism over stocks leveraged to consumer spending. Turnarounds are in favor, and stocks further down the quality curve have outperformed their better managed peers in retail for the most part YTD. AAP’s move has largely been on the back of huge multiple expansion, as earnings beats have been relatively modest, and paired with topline misses.

 

Bulls are attracted to the stock because its operating margin severely lags that of its industry competitors, and are currently depressed and below average and peak historical levels for the company. While this presents an opportunity, the degree of difficulty in closing the gap to the company’s own historical margins increases the longer they go without doing so because of:

 

1.     Corporate turnover and other self-inflicted damage,

2.     Competitive actions by traditional competitors (other after-market auto part specialists) and Wal-Mart,

3.     Increasing competitive threat over time from new online entrants and auto dealers (non-traditional competitors).

 

The stock is by no means cheap at 20 P/E on 2018, but is trading on the hope that future earnings will expand greatly with a return to historical margins AND a return to growth on the topline (revenues were down in 2016, 2017, and 1Q2018). Even if they manage a return to low single digit growth (2%) and can get to historical average margins of 9% in 2019 (as the street is looking for), the stock would be around 16x at the current quote, which isn’t screamingly cheap, given the secular threats from heightened competition and the degree of difficulty to achieve such results. Bulls also hope for a takeout, but there is no natural acquirer for the company, and if there were to be one, time is on the buyer’s side.

 

Structural challenges to the turnaround, full valuation, and secular overhangs on the industry make AAP a short, especially after a sharp, steep run.

 

In the short-term to intermediate-term (next 1-3 years), I expect the earnings recovery from sub $7 to $9+ to fail to materialize primarily because I think margin expansion will disappoint. On the company-specific side, years of failure to integrate mergers has made the very act of integrating them harder, as false starts has led to employee turnover, negative customer experiences, and years of standing still when competitors continue to innovate and expand. Secondarily, I think revenue growth will disappoint for more industry-wide reasons: rising competition from incumbents and rising competition from new entrants or redoubled efforts by formerly peripheral players. Periods of rising competition rarely favor the weak zebra that has been the market share donator in the recent cycle. Finally, in the longer-term, I think aftermarket auto part industry volumes will continue to come under pressure secularly from a number of long-term trends – everything from the rising share of electronic cars (which have fewer parts and are more likely to be serviced at the dealer) to the movement towards more digitally enhanced and dependent cars with traditional motors (the digital components make them harder to fix, making a lot of their components not addressable by DIY enthusiasts, and also favor share shift from the independent shops that AAP services towards dealers service operations, who favor OEM parts). Retail is always a high fixed cost business with the lease commitments (in this case 5000+ stores), as well as the distribution center infrastructure. Here that fixed cost is compounded by the need to carry high amounts of pricey, and often slow-moving inventory. If the overall addressable market starts shrinking by even 1-2%/year eventually because of these secular factors, and this secular pressure is compounded by even small but persistent incremental annual share losses to online players, dealer service operations, and big box general retailers selling high volume items, then it is not inconceivable the public pure play participants like AAP could see their comps go into low single digit decline over an extended period (regardless of economy/SAAR cycle or weather), which would lead to operating deleverage in a flat pricing environment. More likely in this scenario, discounting would pick up, exacerbating the operating margin deleverage, in what has historically been an unusually orderly retail sector in terms of pricing discipline.

 

To be clear, I am articulating a short here at $135-136 primarily because I think it is rather unlikely AAP makes $7.68 next year and extremely unlikely it makes $9.25 in 2020. Given the leverage, the checkered operating history, the strong absolute performance over the last 6-8 months, and its huge outperformance relative to indices and its peers in the YTD, it’s trading very rich here given the operational risks. I think if the earnings recovery fails to materialize and earnings stay stuck around $7, the stock could go back to the low $90s (blend of 8x EBITDA which gets to high $80s and 14x EPS which gets you to high $90s). Note that I don’t see it retesting the lows of $78-9 from last fall without earnings going south from the present level, because that $79 was prior to tax reform, which was a huge windfall for them as a domestic company and full tax payer. So my base case of failed turnaround and stagnant topline as the industry loser and underperformer has about 30% downside. If the entire industry comes under pressure in the longer term (2+ year time frame), I could see this stock having 50% or more downside, as the 6x EBITDA multiple often afforded to secularly challenged retail segments with no growth would imply low $60s at the current earnings level, before the impact of any price wars or further deleveraging, or the psychological impact of any more management turnover, which would be likely if the current management team doesn’t pull off this margin recovery in the next year or  two.

 

 

Company and Industry Background:

 

Aftermarket auto parts retail is a large ($148 bn) and growing (approx. 2.5% per year) market that is still relatively fragmented. AAP participates in both large sectors of the market: professional or do-it-for-me (DIFM), which is 2/3 of the market, and lower margin, and do-it-yourself (DIY), which is 1/3 of the market, and higher margin. Given its large size, consistent growth, and fragmentation, the aftermarket auto parts sector was historically an above average, and relatively predictable performer within retail for some time, with volatility introduced by factors such as the weather, macroeconomic conditions, and vehicle fleet age dynamics.

 

Unlike many retail industries, price is not the most important factor to the customer when buying auto parts, whether DIFM or DIY. The #1 factor for customer satisfaction is part availability, the #2 is service, and #3 is finally price.

 

Within the aftermarket auto parts sector, there are 4 remaining major public players. AutoZone (AZO) has long been the leader in DIY and historically had the highest margins as a result (although ORLY has recently caught up) at around 19%. AZO has been pushing to build its DIFM business in recent years, but remains about 82% DIY. The predominantly DIFM (80%) public player is NAPA, a division of Genuine Parts (GPC), which has margins just under 10%, driven by the lower gross margins of the DIFM business. ORLY has been the leader in margins among the two players pursuing a balanced DIY/DIFM model. Those two players are ORLY and AAP. ORLY’s mix is approximately 55% DIY/45% DIFM, while AAP is 60% DIY/40% DIFM. While on the surface their businesses look rather similar, ORLY has consistently enjoyed much higher operating margins than AAP. Over the last 10 years, ORLY has outpaced AAP by 800-1000 bp and the differential currently stands at around 1200 bp. While the argument, “if only AAP could close even some of the gap to ORLY” seems obvious and compelling, it is important to note that this gap has persisted for a long time, across several business and economic cycles, across several different management teams, and before and after different mergers, for both companies. Some of this margin gap is clearly structural, and some of it is likely self-induced (discussed below).  

 

Given that the mostly DIY AZO has steadily put up margins around 19%, and the mostly DIFM NAPA has steadily put up margins around 9%, you would have expected the half and half AAP and ORLY to be both have operating margins of around 14%, with some volatility around that for cycles, regional exposure, and execution. ORLY has however marched steadily towards closing the gap with AZO, while AAP has been stuck at 9%, and recently stumbled towards 7%.

 

Looking back several years ago, there were more players – both public and private – and the remaining public players via tuck-in acquisitions have increasingly consolidated the industry over time, especially in DIY.

 

The high free cash flow generation of AZO and its commitment to stock buybacks made it a favorite of

value investors (it has been written up on VIC 5 times, but only once recently). ORLY was the subject of a well-timed long write-up on the site last fall, and I would refer you to that write-up by TallGuy for its rich data on market share and store count by location for each industry player.

 

Other major industry players include Walmart for DIY soft parts (such as motor oil), and the relatively recent arrival of internet-only players such as Amazon, RockAuto (which runs a 3P business), and eBay. The threat of the internet is clearly a large overhang on the industry, although many people assume the threat will be isolated to the DIY segment, since DIFM customers often demand parts within 2 hours (or less), or if not that, same day. That said, there is concern the internet will lead prices lower and erode industry margins all around.

 

The other competitive force in the industry are the auto dealers, who have been aggressively promoting and investing in their parts and service operations, which are more profitable for them than the new car sales business, and less economically cyclical. As more consumers move to leasing new cars or leasing certified pre-owned late model cars, which usually require all servicing be done at the dealer, share is taken from the traditional aftermarket auto part players. Dealer parts and service operations can be customers of AAP, ORLY, NAPA, and (possibly) AZO, but they tend to favor OEM parts when they can.

 

Risk Factor to AAP #1: High Degree of Difficulty in the Turnaround only Made Worse by How Long it Has Been in Process

 

AAP completed its acquisition of Carquest in January 2014, substantially diversifying its exposure from DIY to a more balanced DIFM/DIY mix in the process. It’s 4.5 years later, and they are still struggling to integrate this acquisition. The aftermarket auto part business is challenging in that it is extremely SKU-intense. There are literally thousands of SKUs, some of which move very slowly, and there are also over 5000 stores to manage demand across. At the same time, as mentioned above, part availability and speed of order fulfillment is the #1 factor in customer satisfaction. These are extremely complex businesses operationally in terms of logistics and systems, particularly on the DIFM side. An initial failure to quickly integrate the Carquest acquisition led to the departure of a long-time CEO at AAP in early 2016, who was replaced by an interim CEO, who was replaced in April 2016, by the current CEO, Tom Greco, who came over with a strong reputation as a Divisional Vice President for Frito-Lay at Pepsi. While he came in with great hope and fanfare, things were initially rocky as margins contracted, sales fell, and the stock tumbled in his first two years.

 

Based on field research and conversations, there are indications that errors were made operationally in hopes of cost cutting that led to AAP underperforming its peers. One example involved the rebranding initiative of Carquest properties to Advance, which led less sophisticated DIY customers to come into formerly DIFM locations. AAP rebranded without first bringing in new DIY-oriented staff, so the newly acquired DIY customers were not serviced well, and in some locations, they couldn’t be serviced at all, because they required Spanish-speaking personnel, who were not hired. Other complaints on the DIY side included reports of understaffing at stores which led to share losses, underinvesting in advertising, and lack of price integrity across channels (i.e., the AAP website was underpricing the AAP physical stores – something that neither AZO or ORLY reportedly do). In competitive markets, which most AAP stores are, these self-inflicted mistakes were leading to declines in the customer experience and in share losses.

 

On the DIFM side, the dilemma is always weighing inventory availability versus the cost of carrying inventory. The best way to optimize this is IT around predictive inventory analysis and having great logistics. The well-broadcast problem at AAP is the systems at legacy Advance (DIY), Carquest (DIFM), and Worldpac (foreign car part DIFM) don’t talk to each other well. AAP 3+ years post-merger still lacked the IT that would enable inventory visibility across the entire organization. While management talked constantly about supply chain, there is no way to improve supply chain without every end distribution point having that inventory visibility. Until Carquest, Worldpac, and Advance can share supply chains and product inventory, it will be hard to meaningfully move margins. Also a thorn in the side to DIFM employees were cuts to the district manager ranks that had managers overseeing 17 stores on average, versus 10-12 prior, and often having to travel as far as 400 miles from one end to the other in their region. Another point of contention were reductions to compensation in many regional management roles. These changes have reportedly led to heightened turnover in these field management roles, especially as AZO looks to enter AAP markets with their recent focus on growing their DIFM business.

 

Turnover was also increased in key corporate departments such as IT (critical to the merger integration and inventory optimization efforts) and vendor management/sourcing, exacerbated by the relocation of entire departments from Roanoke to Raleigh, or vice versa.

 

These actions to transfer people’s jobs and reduce compensation, combined with the addition of several senior level corporate leaders with no industry experience has created at least some wariness of Tom Greco among current and former employees, who see him as an industry outsider heavy on sales and marketing and general leadership experience, but light on operations and merger integration experience.

 

These are all the mistakes of the past, but what does this mean for going forward? They have already had some talent attrition, and the longer they underperform their peers, the more vulnerable they are to further attrition, especially as AZO looks to beef up its DIFM presence, and will be looking for salespeople and vendor management people with real relationships. And while the Amazon threat in DIFM may be far off, the longer they take to get their act together, the more likely Amazon emerges as a competitor.

 

Risk Factor to AAP #2:Competitor Actions (traditional)

 

The industry has been thought to be a great secular grower, but the leading players have been doing acquisitions of independents for years. This stream of steady deals seems to be slowing down, and they seem to be more dependent on green field openings. While each of the major players traditionally had their geographic stronghold, they have been and are continuing to move into each other’s territories as a potential source of green field growth.

 

While fighting for market share with the traditional incumbent brick and mortar retailers, it is worth noting that the Big 3 in DIY are also seeing increased pressure from Wal-Mart in stores primarily and to a lesser extent online. While Wal-Mart doesn’t go wide in its DIY inventory, it goes deep and cheap as a traffic driver…and we saw how damaging it can be when they siphon off volume in the “greatest hits” (think of toys).

 

Risk Factor 3 to AAP #3: Increasing Competition – Competition from New Entrants Online (Amazon and others) and Redoubled Focus from Peripheral Players (Auto Dealers)

 

The threat of the web to aftermarket auto part incumbents has been much hyped and discussed, but also mostly dismissed by investors as “too far out to care.” While it is something people talk about a lot, worry about a lot, monitor actively – especially in terms of pricing, consensus is that industry weakness is due to macro factors such as the weather and where we are in the cycle of cars on the road aging, what is happening with miles driven, etc. It is assumed that Amazon will be a player in DIY only, and they are mostly dismissed in DIFM.

 

This could turn out to be backwards looking. This is first and foremost a logistics business. It is secondarily a big data business, in terms of the fact that predictive software that accurately forecasts buyer behavior by location will drastically decrease the logistics burden, and with it the inventory financing cost. The challenge is getting the right part to the customer fast, i.e., logistics (inventory management across many points of distribution). But a big part of that of that is planning and predictive inventory analysis – using big data to guess who is going to order what, where, and when – so you can have the inventory in position, without holding all inventory everywhere at all times. This second piece is giant core competency of Amazon’s in its 1P business and in its fulfillment business for 3P. And in terms of logistics, Amazon is rapidly expanding the number same day delivery and 2-hour delivery PrimeNow markets. The volume behind both their 1P and 3P/Fulfillment by Amazon businesses allows them to keep rolling out more and more shorter delivery window trading areas. And while they may not have the scale in auto parts alone to roll out 2- or 4-hour delivery across the entire country today, they have the opportunity going forward to bundle the auto parts business with other local businesses they are building that demand immediacy, such as grocery or office products, and gain economies of scale through bundling of routes/sharing of DCs across business lines. Amazon therefore may not be a threat in DIFM right now, but I believe they will be in the future, and this is very much an out of consensus opinion. In trying to quantify it, it’s true that you need 5000-6000 locations to deliver in 30 minutes, but I have also been told you only need 100 to deliver in 2 hours. AMZN in the US had 116 fulfillment centers and 53 PrimeNow hubs in 4Q2017. Some portion of DIFM will demand 30 minutes, but some other portion is probably OK with 2 hours. They are closing in on being able to do this. They also have over 1000 auto parts vendors selling directly to them now.

 

It's worth noting that it’s not just Amazon. Rock Auto is a big player online. They don’t carry inventory – it’s a 3P type business. They are the most disruptive force in the market right now from a pricing perspective. It’s not Amazon leading pricing down (which is consistent with what Amazon would say is the case). It is really Rock causing the price deflation. They are also big enough that they are running ads on basic cable. eBay is also significant in terms of size.

 

The Bull Case – Part 1: Macro Factors Due to Improve

 

Bulls will attribute the slowdown in comps in 2017 as the perfect storm of macro factors. Weather was unfavorable – the weather was not particularly harsh (too little snow), then the summer was rather mild (reducing need for AC servicing, among other things). On top of the unfavorable weather, the “sweet spot for vehicle age” in terms of needing auto parts is 7-10 years, and we were comping the low SAAR years of the global financial crisis. The y argue weather should be non-recurring (Q1 was a fluke again), and we know SAAR bounced back in 2011 and 2012 and that the addressable cohort will continue to substantially improve as we go through 2018 and 2019. Against this back drop of improving macro, you layer on the opportunity to continue to secularly take share from (or roll up) independents, who still control about 80% of DIFM and 35% of DIY, and one could make an argument for overall industry comp acceleration into the mid-single digits or better, which would certainly be very attractive, especially within the context of the broader retail opportunity set.

 

When comps failed to materialize as expected in 1Q18, the goal post for the quarter was simply moved from sales turnaround to margin improvement for AAP.

 

The Bull Case – Part 2: The Margin Opportunity Quantified

 

AAP reported a 7.3% margin in 2017 versus its 10.8% 10-year peak and 10-year average of 9.5%. ORLY reported a 19.2% 2017 margin versus its 19.8% 10-year peak and 10-year average of 15.7%. It’s not a big leap to assume that years of management turnover, at both the senior and intermediate levels, combined with a botched merger integration, have led to a 200-300 bp compression in margins at AAP versus historical levels.

 

But how about the larger opportunity, of the approximately 1200 basis points that separate the current margins at AAP from those at ORLY, how much of it is structural and how much is execution? The structural sources of margin differential include:

1.     100 bp from lower mark ups on inventory to Carquest independents versus what you make when selling product in owned stores (it’s higher ROI but lower operating margin business)

2.     200-300 bp of structural real estate disadvantage because Advance stores are 1000 SQF larger thus needed an extra $300K per store to get to the same occupancy cost ratio, plus ORLY owns 40% of stores whereas AAP only owned 20% of stores pre-Carquest

 

You add this up, and it’s about 400 bp of structural disadvantage. That leaves about 800 bp of differential attributable to execution. AAP has said that they see opportunities for $750 mm in cost savings. They have approximately $9.4 billion in sales. 8% of $9.4 billion is $752 million. It all ties out. And it is all completely theoretical if they have the wrong CEO and people at every level of the company are running for the exit doors. I think it is ridiculous to apply ORLY’s margin to AAP, as they have never come to close to it, even when they had a CEO in place for 8 straight years and fewer issues with attrition, AZO completely disinterested in the DIFM business, ORLY completely out of many of their markets (such as the NE), and Amazon, Rock Auto, and eBay as non-players in the market. If you want to play the “dream earnings” scenario, I would use their own peak margin of 10.9%, which on current sales gets you to more like $10.20 in earnings, and maybe $163 eventually (16 P/E) or $153 (using 10x EV/EBITDA at recovery). So 10-20% upside in the perfect scenario, on a stock that just ran 70% in the last 8 months...it seems less than compelling unless they can get past prior peak margins…which just seems like a dream.

 

 

The Bull Case – Part 3: Takeout

 

This was probably s more relevant question at $80, when it wasn't trading at 20x. I don’t think it happens because:

·       Concerns about anti-trust from a merger with ORLY or AZO. Market is big enough that share wouldn’t seem to be a problem if the market was defined broadly, but could have a lot of in-market problems with DIY where they could control 80%, 90% or more of a trading area. The DIY market overall is 65% controlled by the Big 3. With the amount of store dispositions necessary, would it make sense? Also, for ORLY or AZO, why would they want to dilute their own margins so much? They seem to be doing just fine picking off AAP’s disgruntled employees and expanding green field. And a merger with NAPA seems out of the question given they haven’t integrated Carquest yet.

·       PE can’t LBO this because an investment grade rating is essential to this business to factor the inventory. It can’t take any more debt

·       Any buyer would have to be a left field one – like Icahn or Amazon.

 

The Bull Case – Part 4: Starboard Will Save Them

Starboard established their position in 2015 at $171. Their premise was: it’s a good, relatively stable and cyclically resilient industry because of the tailwinds of aging cars (statistics still hold) and increasing miles driven (data has disappointed somewhat here since). Within this context, they offered that AAP had been an underperformer price-wise versus ORLY and AZO because its margins had lagged so much, and there was a substantial opportunity to narrow the margin gap. They mentioned opportunities to improve working capital, that Worldpac is a gem and could be sold, that the industry is still fragmented, etc. That presentation can be found here:

 

https://www.10xebitda.com/wp-content/uploads/2016/11/Starboard-Advanced-Auto-Parts-Presentation-Sep-2015.pdf

 

Starboard bought more stock last year at approximately $138 (before the stock went pretty much in a straight line to $79). They are basically even on that second tranche now. They own around $325 mm worth of shares and it’s 7-8% of their portfolio I believe, they represent over 4% (but less than 5%) of the shares and are the 6th largest shareholder. I have no insight into their intentions, and would only caution that the best investors in the world make high profile mistakes, and you can be a wild stock market success being right 2/3 of the time, so that means even billionaires are wrong 1 out of 3 times, so I personally try not to let the presence of any single investor sway me too much one way or another. That said, it should be noted there is an activist here.

 

What could make this stock really go up and make this short a loser?

·       AAP could sell Worldpac  - Starboard is right. This acquired division, which distributes parts for foreign cars to DIFM shops, is a great boutique asset, and they could probably sell it for a nice valuation. It’s accretion value was probably higher when AAP was trading at 10x and not 12x EBITDA, but it is still safe to assume they could sell this asset at a premium to what the whole company trades for. They could use that cash to buy back shares (which I obviously think would be a bad investment here), but that would likely give the stock a short-term boost, as their capacity for buybacks is currently constrained.

·       Icahn could buy whole thing – he has been buying things in the space and could theoretically bolt this onto his Pep Boys position, but seems rather low probability. It would be one more integration to throw on the pile of half-completed merger integrations.

·       Amazon could buy their way into the space with AAP the same way they bought into grocery with Whole Foods. But it seems out of character for them to go for the industry laggard and not a leader like ORLY.

·       The long awaited industry recovery could finally come. Normal weather and the anniversary-ing of the low SAAR years and moving into the “sweet spot” of 7-year-old cars when the stronger SAARs occurred could finally propel industry volumes upward. If you believe this is coming though, and you believe the threats from Dealers/Amazon/Other Online are overblown, then why not buy ORLY instead, which is only trading a multiple point or two higher, is only up half as much in percentage terms since the October lows, and is a far superior company with far less executional risk over the next 12 months?

 

Valuation and Summary:

AAP is currently trading 19.8x 2018e earnings and 11.9x estimated EBITDA. This is a substantial expansion from 4Q2017 when it traded 15-16 P/E and 9.5-10x EBITDA. Since that time, the price has risen, EBITDA estimates have come down in the mid single digits, and EPS estimates are up 32% but down about 5% adjusting for the tax rate change.

 

After its near 70% run, AAP is vulnerable should sales growth and/or operating margin expansion disappoint in the remainder of 2018 or in 2019/2020. While margins have admittedly improved and were up 70 bp in the first quarter, adjustments and charges abound in the fourth year of the integration, and they are still operating at a very low level on an absolute basis. Additionally, sales growth and comps remain negative and industry lagging.  Expectations are for operating margins to expand in a stair step function 70-100bp/year smoothly until they reach historical levels, accompanied by low single digit topline growth. One quarter does not a trend make (especially with improvements supported by excluded charges), and they had basically promised sales growth this quarter, and then moved the goal post again. If this promised scenario of margin expansion and modest topline growth actually materialized, AAP could conceivably make $10 in 2021 (2.5% topline CAGR, 10% op margin in 2021). But what do you pay for that? Do you pay 20x for a 2% topline company that still has leverage, is fully built out with limited organic growth prospects, and secular threats on the horizon (I didn’t even get into electronic cars here). Even if you assume the 20x multiple holds, that’s a $200 price target in 3.5 years. If you discount that $200 back 3 years at 10%, you get $150, versus a $136 stock. So 10% upside on a discounted basis assuming a hefty multiple holds and a troubled turnaround is finally executed properly.

 

On the flip side, if you believe the company has dug itself a bit of a hole that is hard to fix by losing long-tenured salespeople on the DIFM side, and regional management on the DIY side, and have concerns about a corporate organization dominated by non-industry veterans in such an operationally intense and specific industry, and also worry that secular challenges from dealers and the web may increase price competition, reduce demand in a high fixed cost business, or otherwise limit topline growth and/or margin expansion, the case for margin expansion and return to sales growth may just go away. It might be helpful to look at this on an EV/EBITDA basis and think about how retailers in secularly challenged segments trade. The department stores, WSM, and BBBY trade at 6-6.5x, 6x, 3x, respectively. At 6x,  EV/EBITDA, AAP would be $62. This represents 55% downside. I believe with time, the secular challenges to the industry will become more apparent and the steady rise in earnings predicted for the next several years will fail to materialize, and the stock will be re-rated as a result. You could make similar secular arguments against AZO (definitely most vulnerable to AMZN and Rock Auto) and ORLY (highest margins and highest multiple – so farthest to fall – and at risk to all the same things that AAP is). But ORLY has been an outstanding performer operationally and has great management, AZO has been well managed too and has been a great shepherd of capital. AAP has been a horror show operationally for 4 years now, an industry laggard, and has a management team that came from other industries…and recently at least, its stock has significantly outperformed its peers. Thus I would rather shoot at what I perceive to be the weak zebra in the space, versus shoot at the best player even if it is a bit more expensive (ORLY). Also, I believe there is a scenario where the much anticipated industry recovery finally materializes, and AAP fails to fully benefit because it vastly underperforms its peers (as it did in the first quarter and for several prior quarters in terms of sales performance and market share). If I am wrong and the industry turns out to be OK, I still think this is a decent short on earnings missed and a failed turnaround with 30% downside. If the industry turns out to be not as good as people think, there could be a lot more downside over the longer term.

 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

  1. 2H2018/2019 earnings miss when operating margin recovery and sales recovery fail to materialize
  2. Share loss as ORLY and AZO continue to open in AAP's markets
  3. Industry competition continues to increase from online and dealer parts and service operations, pressuring overall sales growth for traditional players (Big 4)
  4. Longer-term, increasing competition (from all players) reduces the historical price stability in the industry, which pressures margins given the high fixed costs
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    Description

    Advance Auto Parts (AAP)

     

    Summary:

     

    Advance Auto Parts is a perennial turnaround story that has run through several management teams over more than four years and has structural, company-specific challenges to the turnaround that are underappreciated. At the same time, the long-term, secular challenges to the aftermarket auto part retail industry that it participates in have been written off as overblown, but may not be. AAP’s stock is up almost 70% from its October lows, despite the many false starts in its turnaround, the jury still being out on its latest CEO, and it continuing to lag its peers in sales and margin metrics. Why has it performed so strongly? It’s partially driven by optimism over the anticipated cyclical recovery in the sector, and also driven by the strong move YTD in retail generally and investor optimism over stocks leveraged to consumer spending. Turnarounds are in favor, and stocks further down the quality curve have outperformed their better managed peers in retail for the most part YTD. AAP’s move has largely been on the back of huge multiple expansion, as earnings beats have been relatively modest, and paired with topline misses.

     

    Bulls are attracted to the stock because its operating margin severely lags that of its industry competitors, and are currently depressed and below average and peak historical levels for the company. While this presents an opportunity, the degree of difficulty in closing the gap to the company’s own historical margins increases the longer they go without doing so because of:

     

    1.     Corporate turnover and other self-inflicted damage,

    2.     Competitive actions by traditional competitors (other after-market auto part specialists) and Wal-Mart,

    3.     Increasing competitive threat over time from new online entrants and auto dealers (non-traditional competitors).

     

    The stock is by no means cheap at 20 P/E on 2018, but is trading on the hope that future earnings will expand greatly with a return to historical margins AND a return to growth on the topline (revenues were down in 2016, 2017, and 1Q2018). Even if they manage a return to low single digit growth (2%) and can get to historical average margins of 9% in 2019 (as the street is looking for), the stock would be around 16x at the current quote, which isn’t screamingly cheap, given the secular threats from heightened competition and the degree of difficulty to achieve such results. Bulls also hope for a takeout, but there is no natural acquirer for the company, and if there were to be one, time is on the buyer’s side.

     

    Structural challenges to the turnaround, full valuation, and secular overhangs on the industry make AAP a short, especially after a sharp, steep run.

     

    In the short-term to intermediate-term (next 1-3 years), I expect the earnings recovery from sub $7 to $9+ to fail to materialize primarily because I think margin expansion will disappoint. On the company-specific side, years of failure to integrate mergers has made the very act of integrating them harder, as false starts has led to employee turnover, negative customer experiences, and years of standing still when competitors continue to innovate and expand. Secondarily, I think revenue growth will disappoint for more industry-wide reasons: rising competition from incumbents and rising competition from new entrants or redoubled efforts by formerly peripheral players. Periods of rising competition rarely favor the weak zebra that has been the market share donator in the recent cycle. Finally, in the longer-term, I think aftermarket auto part industry volumes will continue to come under pressure secularly from a number of long-term trends – everything from the rising share of electronic cars (which have fewer parts and are more likely to be serviced at the dealer) to the movement towards more digitally enhanced and dependent cars with traditional motors (the digital components make them harder to fix, making a lot of their components not addressable by DIY enthusiasts, and also favor share shift from the independent shops that AAP services towards dealers service operations, who favor OEM parts). Retail is always a high fixed cost business with the lease commitments (in this case 5000+ stores), as well as the distribution center infrastructure. Here that fixed cost is compounded by the need to carry high amounts of pricey, and often slow-moving inventory. If the overall addressable market starts shrinking by even 1-2%/year eventually because of these secular factors, and this secular pressure is compounded by even small but persistent incremental annual share losses to online players, dealer service operations, and big box general retailers selling high volume items, then it is not inconceivable the public pure play participants like AAP could see their comps go into low single digit decline over an extended period (regardless of economy/SAAR cycle or weather), which would lead to operating deleverage in a flat pricing environment. More likely in this scenario, discounting would pick up, exacerbating the operating margin deleverage, in what has historically been an unusually orderly retail sector in terms of pricing discipline.

     

    To be clear, I am articulating a short here at $135-136 primarily because I think it is rather unlikely AAP makes $7.68 next year and extremely unlikely it makes $9.25 in 2020. Given the leverage, the checkered operating history, the strong absolute performance over the last 6-8 months, and its huge outperformance relative to indices and its peers in the YTD, it’s trading very rich here given the operational risks. I think if the earnings recovery fails to materialize and earnings stay stuck around $7, the stock could go back to the low $90s (blend of 8x EBITDA which gets to high $80s and 14x EPS which gets you to high $90s). Note that I don’t see it retesting the lows of $78-9 from last fall without earnings going south from the present level, because that $79 was prior to tax reform, which was a huge windfall for them as a domestic company and full tax payer. So my base case of failed turnaround and stagnant topline as the industry loser and underperformer has about 30% downside. If the entire industry comes under pressure in the longer term (2+ year time frame), I could see this stock having 50% or more downside, as the 6x EBITDA multiple often afforded to secularly challenged retail segments with no growth would imply low $60s at the current earnings level, before the impact of any price wars or further deleveraging, or the psychological impact of any more management turnover, which would be likely if the current management team doesn’t pull off this margin recovery in the next year or  two.

     

     

    Company and Industry Background:

     

    Aftermarket auto parts retail is a large ($148 bn) and growing (approx. 2.5% per year) market that is still relatively fragmented. AAP participates in both large sectors of the market: professional or do-it-for-me (DIFM), which is 2/3 of the market, and lower margin, and do-it-yourself (DIY), which is 1/3 of the market, and higher margin. Given its large size, consistent growth, and fragmentation, the aftermarket auto parts sector was historically an above average, and relatively predictable performer within retail for some time, with volatility introduced by factors such as the weather, macroeconomic conditions, and vehicle fleet age dynamics.

     

    Unlike many retail industries, price is not the most important factor to the customer when buying auto parts, whether DIFM or DIY. The #1 factor for customer satisfaction is part availability, the #2 is service, and #3 is finally price.

     

    Within the aftermarket auto parts sector, there are 4 remaining major public players. AutoZone (AZO) has long been the leader in DIY and historically had the highest margins as a result (although ORLY has recently caught up) at around 19%. AZO has been pushing to build its DIFM business in recent years, but remains about 82% DIY. The predominantly DIFM (80%) public player is NAPA, a division of Genuine Parts (GPC), which has margins just under 10%, driven by the lower gross margins of the DIFM business. ORLY has been the leader in margins among the two players pursuing a balanced DIY/DIFM model. Those two players are ORLY and AAP. ORLY’s mix is approximately 55% DIY/45% DIFM, while AAP is 60% DIY/40% DIFM. While on the surface their businesses look rather similar, ORLY has consistently enjoyed much higher operating margins than AAP. Over the last 10 years, ORLY has outpaced AAP by 800-1000 bp and the differential currently stands at around 1200 bp. While the argument, “if only AAP could close even some of the gap to ORLY” seems obvious and compelling, it is important to note that this gap has persisted for a long time, across several business and economic cycles, across several different management teams, and before and after different mergers, for both companies. Some of this margin gap is clearly structural, and some of it is likely self-induced (discussed below).  

     

    Given that the mostly DIY AZO has steadily put up margins around 19%, and the mostly DIFM NAPA has steadily put up margins around 9%, you would have expected the half and half AAP and ORLY to be both have operating margins of around 14%, with some volatility around that for cycles, regional exposure, and execution. ORLY has however marched steadily towards closing the gap with AZO, while AAP has been stuck at 9%, and recently stumbled towards 7%.

     

    Looking back several years ago, there were more players – both public and private – and the remaining public players via tuck-in acquisitions have increasingly consolidated the industry over time, especially in DIY.

     

    The high free cash flow generation of AZO and its commitment to stock buybacks made it a favorite of

    value investors (it has been written up on VIC 5 times, but only once recently). ORLY was the subject of a well-timed long write-up on the site last fall, and I would refer you to that write-up by TallGuy for its rich data on market share and store count by location for each industry player.

     

    Other major industry players include Walmart for DIY soft parts (such as motor oil), and the relatively recent arrival of internet-only players such as Amazon, RockAuto (which runs a 3P business), and eBay. The threat of the internet is clearly a large overhang on the industry, although many people assume the threat will be isolated to the DIY segment, since DIFM customers often demand parts within 2 hours (or less), or if not that, same day. That said, there is concern the internet will lead prices lower and erode industry margins all around.

     

    The other competitive force in the industry are the auto dealers, who have been aggressively promoting and investing in their parts and service operations, which are more profitable for them than the new car sales business, and less economically cyclical. As more consumers move to leasing new cars or leasing certified pre-owned late model cars, which usually require all servicing be done at the dealer, share is taken from the traditional aftermarket auto part players. Dealer parts and service operations can be customers of AAP, ORLY, NAPA, and (possibly) AZO, but they tend to favor OEM parts when they can.

     

    Risk Factor to AAP #1: High Degree of Difficulty in the Turnaround only Made Worse by How Long it Has Been in Process

     

    AAP completed its acquisition of Carquest in January 2014, substantially diversifying its exposure from DIY to a more balanced DIFM/DIY mix in the process. It’s 4.5 years later, and they are still struggling to integrate this acquisition. The aftermarket auto part business is challenging in that it is extremely SKU-intense. There are literally thousands of SKUs, some of which move very slowly, and there are also over 5000 stores to manage demand across. At the same time, as mentioned above, part availability and speed of order fulfillment is the #1 factor in customer satisfaction. These are extremely complex businesses operationally in terms of logistics and systems, particularly on the DIFM side. An initial failure to quickly integrate the Carquest acquisition led to the departure of a long-time CEO at AAP in early 2016, who was replaced by an interim CEO, who was replaced in April 2016, by the current CEO, Tom Greco, who came over with a strong reputation as a Divisional Vice President for Frito-Lay at Pepsi. While he came in with great hope and fanfare, things were initially rocky as margins contracted, sales fell, and the stock tumbled in his first two years.

     

    Based on field research and conversations, there are indications that errors were made operationally in hopes of cost cutting that led to AAP underperforming its peers. One example involved the rebranding initiative of Carquest properties to Advance, which led less sophisticated DIY customers to come into formerly DIFM locations. AAP rebranded without first bringing in new DIY-oriented staff, so the newly acquired DIY customers were not serviced well, and in some locations, they couldn’t be serviced at all, because they required Spanish-speaking personnel, who were not hired. Other complaints on the DIY side included reports of understaffing at stores which led to share losses, underinvesting in advertising, and lack of price integrity across channels (i.e., the AAP website was underpricing the AAP physical stores – something that neither AZO or ORLY reportedly do). In competitive markets, which most AAP stores are, these self-inflicted mistakes were leading to declines in the customer experience and in share losses.

     

    On the DIFM side, the dilemma is always weighing inventory availability versus the cost of carrying inventory. The best way to optimize this is IT around predictive inventory analysis and having great logistics. The well-broadcast problem at AAP is the systems at legacy Advance (DIY), Carquest (DIFM), and Worldpac (foreign car part DIFM) don’t talk to each other well. AAP 3+ years post-merger still lacked the IT that would enable inventory visibility across the entire organization. While management talked constantly about supply chain, there is no way to improve supply chain without every end distribution point having that inventory visibility. Until Carquest, Worldpac, and Advance can share supply chains and product inventory, it will be hard to meaningfully move margins. Also a thorn in the side to DIFM employees were cuts to the district manager ranks that had managers overseeing 17 stores on average, versus 10-12 prior, and often having to travel as far as 400 miles from one end to the other in their region. Another point of contention were reductions to compensation in many regional management roles. These changes have reportedly led to heightened turnover in these field management roles, especially as AZO looks to enter AAP markets with their recent focus on growing their DIFM business.

     

    Turnover was also increased in key corporate departments such as IT (critical to the merger integration and inventory optimization efforts) and vendor management/sourcing, exacerbated by the relocation of entire departments from Roanoke to Raleigh, or vice versa.

     

    These actions to transfer people’s jobs and reduce compensation, combined with the addition of several senior level corporate leaders with no industry experience has created at least some wariness of Tom Greco among current and former employees, who see him as an industry outsider heavy on sales and marketing and general leadership experience, but light on operations and merger integration experience.

     

    These are all the mistakes of the past, but what does this mean for going forward? They have already had some talent attrition, and the longer they underperform their peers, the more vulnerable they are to further attrition, especially as AZO looks to beef up its DIFM presence, and will be looking for salespeople and vendor management people with real relationships. And while the Amazon threat in DIFM may be far off, the longer they take to get their act together, the more likely Amazon emerges as a competitor.

     

    Risk Factor to AAP #2:Competitor Actions (traditional)

     

    The industry has been thought to be a great secular grower, but the leading players have been doing acquisitions of independents for years. This stream of steady deals seems to be slowing down, and they seem to be more dependent on green field openings. While each of the major players traditionally had their geographic stronghold, they have been and are continuing to move into each other’s territories as a potential source of green field growth.

     

    While fighting for market share with the traditional incumbent brick and mortar retailers, it is worth noting that the Big 3 in DIY are also seeing increased pressure from Wal-Mart in stores primarily and to a lesser extent online. While Wal-Mart doesn’t go wide in its DIY inventory, it goes deep and cheap as a traffic driver…and we saw how damaging it can be when they siphon off volume in the “greatest hits” (think of toys).

     

    Risk Factor 3 to AAP #3: Increasing Competition – Competition from New Entrants Online (Amazon and others) and Redoubled Focus from Peripheral Players (Auto Dealers)

     

    The threat of the web to aftermarket auto part incumbents has been much hyped and discussed, but also mostly dismissed by investors as “too far out to care.” While it is something people talk about a lot, worry about a lot, monitor actively – especially in terms of pricing, consensus is that industry weakness is due to macro factors such as the weather and where we are in the cycle of cars on the road aging, what is happening with miles driven, etc. It is assumed that Amazon will be a player in DIY only, and they are mostly dismissed in DIFM.

     

    This could turn out to be backwards looking. This is first and foremost a logistics business. It is secondarily a big data business, in terms of the fact that predictive software that accurately forecasts buyer behavior by location will drastically decrease the logistics burden, and with it the inventory financing cost. The challenge is getting the right part to the customer fast, i.e., logistics (inventory management across many points of distribution). But a big part of that of that is planning and predictive inventory analysis – using big data to guess who is going to order what, where, and when – so you can have the inventory in position, without holding all inventory everywhere at all times. This second piece is giant core competency of Amazon’s in its 1P business and in its fulfillment business for 3P. And in terms of logistics, Amazon is rapidly expanding the number same day delivery and 2-hour delivery PrimeNow markets. The volume behind both their 1P and 3P/Fulfillment by Amazon businesses allows them to keep rolling out more and more shorter delivery window trading areas. And while they may not have the scale in auto parts alone to roll out 2- or 4-hour delivery across the entire country today, they have the opportunity going forward to bundle the auto parts business with other local businesses they are building that demand immediacy, such as grocery or office products, and gain economies of scale through bundling of routes/sharing of DCs across business lines. Amazon therefore may not be a threat in DIFM right now, but I believe they will be in the future, and this is very much an out of consensus opinion. In trying to quantify it, it’s true that you need 5000-6000 locations to deliver in 30 minutes, but I have also been told you only need 100 to deliver in 2 hours. AMZN in the US had 116 fulfillment centers and 53 PrimeNow hubs in 4Q2017. Some portion of DIFM will demand 30 minutes, but some other portion is probably OK with 2 hours. They are closing in on being able to do this. They also have over 1000 auto parts vendors selling directly to them now.

     

    It's worth noting that it’s not just Amazon. Rock Auto is a big player online. They don’t carry inventory – it’s a 3P type business. They are the most disruptive force in the market right now from a pricing perspective. It’s not Amazon leading pricing down (which is consistent with what Amazon would say is the case). It is really Rock causing the price deflation. They are also big enough that they are running ads on basic cable. eBay is also significant in terms of size.

     

    The Bull Case – Part 1: Macro Factors Due to Improve

     

    Bulls will attribute the slowdown in comps in 2017 as the perfect storm of macro factors. Weather was unfavorable – the weather was not particularly harsh (too little snow), then the summer was rather mild (reducing need for AC servicing, among other things). On top of the unfavorable weather, the “sweet spot for vehicle age” in terms of needing auto parts is 7-10 years, and we were comping the low SAAR years of the global financial crisis. The y argue weather should be non-recurring (Q1 was a fluke again), and we know SAAR bounced back in 2011 and 2012 and that the addressable cohort will continue to substantially improve as we go through 2018 and 2019. Against this back drop of improving macro, you layer on the opportunity to continue to secularly take share from (or roll up) independents, who still control about 80% of DIFM and 35% of DIY, and one could make an argument for overall industry comp acceleration into the mid-single digits or better, which would certainly be very attractive, especially within the context of the broader retail opportunity set.

     

    When comps failed to materialize as expected in 1Q18, the goal post for the quarter was simply moved from sales turnaround to margin improvement for AAP.

     

    The Bull Case – Part 2: The Margin Opportunity Quantified

     

    AAP reported a 7.3% margin in 2017 versus its 10.8% 10-year peak and 10-year average of 9.5%. ORLY reported a 19.2% 2017 margin versus its 19.8% 10-year peak and 10-year average of 15.7%. It’s not a big leap to assume that years of management turnover, at both the senior and intermediate levels, combined with a botched merger integration, have led to a 200-300 bp compression in margins at AAP versus historical levels.

     

    But how about the larger opportunity, of the approximately 1200 basis points that separate the current margins at AAP from those at ORLY, how much of it is structural and how much is execution? The structural sources of margin differential include:

    1.     100 bp from lower mark ups on inventory to Carquest independents versus what you make when selling product in owned stores (it’s higher ROI but lower operating margin business)

    2.     200-300 bp of structural real estate disadvantage because Advance stores are 1000 SQF larger thus needed an extra $300K per store to get to the same occupancy cost ratio, plus ORLY owns 40% of stores whereas AAP only owned 20% of stores pre-Carquest

     

    You add this up, and it’s about 400 bp of structural disadvantage. That leaves about 800 bp of differential attributable to execution. AAP has said that they see opportunities for $750 mm in cost savings. They have approximately $9.4 billion in sales. 8% of $9.4 billion is $752 million. It all ties out. And it is all completely theoretical if they have the wrong CEO and people at every level of the company are running for the exit doors. I think it is ridiculous to apply ORLY’s margin to AAP, as they have never come to close to it, even when they had a CEO in place for 8 straight years and fewer issues with attrition, AZO completely disinterested in the DIFM business, ORLY completely out of many of their markets (such as the NE), and Amazon, Rock Auto, and eBay as non-players in the market. If you want to play the “dream earnings” scenario, I would use their own peak margin of 10.9%, which on current sales gets you to more like $10.20 in earnings, and maybe $163 eventually (16 P/E) or $153 (using 10x EV/EBITDA at recovery). So 10-20% upside in the perfect scenario, on a stock that just ran 70% in the last 8 months...it seems less than compelling unless they can get past prior peak margins…which just seems like a dream.

     

     

    The Bull Case – Part 3: Takeout

     

    This was probably s more relevant question at $80, when it wasn't trading at 20x. I don’t think it happens because:

    ·       Concerns about anti-trust from a merger with ORLY or AZO. Market is big enough that share wouldn’t seem to be a problem if the market was defined broadly, but could have a lot of in-market problems with DIY where they could control 80%, 90% or more of a trading area. The DIY market overall is 65% controlled by the Big 3. With the amount of store dispositions necessary, would it make sense? Also, for ORLY or AZO, why would they want to dilute their own margins so much? They seem to be doing just fine picking off AAP’s disgruntled employees and expanding green field. And a merger with NAPA seems out of the question given they haven’t integrated Carquest yet.

    ·       PE can’t LBO this because an investment grade rating is essential to this business to factor the inventory. It can’t take any more debt

    ·       Any buyer would have to be a left field one – like Icahn or Amazon.

     

    The Bull Case – Part 4: Starboard Will Save Them

    Starboard established their position in 2015 at $171. Their premise was: it’s a good, relatively stable and cyclically resilient industry because of the tailwinds of aging cars (statistics still hold) and increasing miles driven (data has disappointed somewhat here since). Within this context, they offered that AAP had been an underperformer price-wise versus ORLY and AZO because its margins had lagged so much, and there was a substantial opportunity to narrow the margin gap. They mentioned opportunities to improve working capital, that Worldpac is a gem and could be sold, that the industry is still fragmented, etc. That presentation can be found here:

     

    https://www.10xebitda.com/wp-content/uploads/2016/11/Starboard-Advanced-Auto-Parts-Presentation-Sep-2015.pdf

     

    Starboard bought more stock last year at approximately $138 (before the stock went pretty much in a straight line to $79). They are basically even on that second tranche now. They own around $325 mm worth of shares and it’s 7-8% of their portfolio I believe, they represent over 4% (but less than 5%) of the shares and are the 6th largest shareholder. I have no insight into their intentions, and would only caution that the best investors in the world make high profile mistakes, and you can be a wild stock market success being right 2/3 of the time, so that means even billionaires are wrong 1 out of 3 times, so I personally try not to let the presence of any single investor sway me too much one way or another. That said, it should be noted there is an activist here.

     

    What could make this stock really go up and make this short a loser?

    ·       AAP could sell Worldpac  - Starboard is right. This acquired division, which distributes parts for foreign cars to DIFM shops, is a great boutique asset, and they could probably sell it for a nice valuation. It’s accretion value was probably higher when AAP was trading at 10x and not 12x EBITDA, but it is still safe to assume they could sell this asset at a premium to what the whole company trades for. They could use that cash to buy back shares (which I obviously think would be a bad investment here), but that would likely give the stock a short-term boost, as their capacity for buybacks is currently constrained.

    ·       Icahn could buy whole thing – he has been buying things in the space and could theoretically bolt this onto his Pep Boys position, but seems rather low probability. It would be one more integration to throw on the pile of half-completed merger integrations.

    ·       Amazon could buy their way into the space with AAP the same way they bought into grocery with Whole Foods. But it seems out of character for them to go for the industry laggard and not a leader like ORLY.

    ·       The long awaited industry recovery could finally come. Normal weather and the anniversary-ing of the low SAAR years and moving into the “sweet spot” of 7-year-old cars when the stronger SAARs occurred could finally propel industry volumes upward. If you believe this is coming though, and you believe the threats from Dealers/Amazon/Other Online are overblown, then why not buy ORLY instead, which is only trading a multiple point or two higher, is only up half as much in percentage terms since the October lows, and is a far superior company with far less executional risk over the next 12 months?

     

    Valuation and Summary:

    AAP is currently trading 19.8x 2018e earnings and 11.9x estimated EBITDA. This is a substantial expansion from 4Q2017 when it traded 15-16 P/E and 9.5-10x EBITDA. Since that time, the price has risen, EBITDA estimates have come down in the mid single digits, and EPS estimates are up 32% but down about 5% adjusting for the tax rate change.

     

    After its near 70% run, AAP is vulnerable should sales growth and/or operating margin expansion disappoint in the remainder of 2018 or in 2019/2020. While margins have admittedly improved and were up 70 bp in the first quarter, adjustments and charges abound in the fourth year of the integration, and they are still operating at a very low level on an absolute basis. Additionally, sales growth and comps remain negative and industry lagging.  Expectations are for operating margins to expand in a stair step function 70-100bp/year smoothly until they reach historical levels, accompanied by low single digit topline growth. One quarter does not a trend make (especially with improvements supported by excluded charges), and they had basically promised sales growth this quarter, and then moved the goal post again. If this promised scenario of margin expansion and modest topline growth actually materialized, AAP could conceivably make $10 in 2021 (2.5% topline CAGR, 10% op margin in 2021). But what do you pay for that? Do you pay 20x for a 2% topline company that still has leverage, is fully built out with limited organic growth prospects, and secular threats on the horizon (I didn’t even get into electronic cars here). Even if you assume the 20x multiple holds, that’s a $200 price target in 3.5 years. If you discount that $200 back 3 years at 10%, you get $150, versus a $136 stock. So 10% upside on a discounted basis assuming a hefty multiple holds and a troubled turnaround is finally executed properly.

     

    On the flip side, if you believe the company has dug itself a bit of a hole that is hard to fix by losing long-tenured salespeople on the DIFM side, and regional management on the DIY side, and have concerns about a corporate organization dominated by non-industry veterans in such an operationally intense and specific industry, and also worry that secular challenges from dealers and the web may increase price competition, reduce demand in a high fixed cost business, or otherwise limit topline growth and/or margin expansion, the case for margin expansion and return to sales growth may just go away. It might be helpful to look at this on an EV/EBITDA basis and think about how retailers in secularly challenged segments trade. The department stores, WSM, and BBBY trade at 6-6.5x, 6x, 3x, respectively. At 6x,  EV/EBITDA, AAP would be $62. This represents 55% downside. I believe with time, the secular challenges to the industry will become more apparent and the steady rise in earnings predicted for the next several years will fail to materialize, and the stock will be re-rated as a result. You could make similar secular arguments against AZO (definitely most vulnerable to AMZN and Rock Auto) and ORLY (highest margins and highest multiple – so farthest to fall – and at risk to all the same things that AAP is). But ORLY has been an outstanding performer operationally and has great management, AZO has been well managed too and has been a great shepherd of capital. AAP has been a horror show operationally for 4 years now, an industry laggard, and has a management team that came from other industries…and recently at least, its stock has significantly outperformed its peers. Thus I would rather shoot at what I perceive to be the weak zebra in the space, versus shoot at the best player even if it is a bit more expensive (ORLY). Also, I believe there is a scenario where the much anticipated industry recovery finally materializes, and AAP fails to fully benefit because it vastly underperforms its peers (as it did in the first quarter and for several prior quarters in terms of sales performance and market share). If I am wrong and the industry turns out to be OK, I still think this is a decent short on earnings missed and a failed turnaround with 30% downside. If the industry turns out to be not as good as people think, there could be a lot more downside over the longer term.

     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise do not hold a material investment in the issuer's securities.

    Catalyst

    1. 2H2018/2019 earnings miss when operating margin recovery and sales recovery fail to materialize
    2. Share loss as ORLY and AZO continue to open in AAP's markets
    3. Industry competition continues to increase from online and dealer parts and service operations, pressuring overall sales growth for traditional players (Big 4)
    4. Longer-term, increasing competition (from all players) reduces the historical price stability in the industry, which pressures margins given the high fixed costs

    Messages


    SubjectVery well done
    Entry07/02/2018 02:17 PM
    MemberTallGuy

    I was considering this same write-up. I haven’t pulled the trigger as I see as a stronger macro tailwind that outweighs the idiocy of AAP operations (for now)

    I do believe the market is writing off/failing to understand how poorly AAP handled the interstate batteries deal. Its an indication of management’s lack of knowledge of key vendor relationships within the industry. I think the early announcement of the deal with interstate was a carryover from Frito-Lay’s culture were posturing and politics were valued over substance. This is a glaring negative for me on AAP’s management.

    Regarding a transaction – I would be quick to do a massive pair trade with ORLY or AZO if either of them bought AAP. (short the acquiror long the other). I do not see how a buyout of AAP works for anyone.

     


    SubjectRe: Very well done
    Entry07/05/2018 07:35 PM
    Memberbaileyb906

    Thanks for the kind words. 

    Agree the Interstate Batteries deal (or non-deal...it reminds me of a 1999 dot com JV press release with no follow up) is very indicative of how current management gives "good presentation" but really doesn't have the domain expertise to follow up on their promises, and this is one of those industries where domain expertise may in fact be super relevant. Even if you can get comfortable with domain expertise not being a prerequisite (not only for the CEO, but for a number of the SVP positions he has filled beneath him), it just seems on the CEO-level at least, the skill set is mismatch. There are the cultural issues that you mention, which are very much real. But also, when you think about the Frito-Lay business: they are a vertically integrated marketing company that also manufactures. They have maybe 50-100 SKUs that matter if you consider all the flavors and the different size packaging, and domestically at least, probably 50% of their business is consolidated into a handful of accounts (WMT, TGT, KR, COST, Safeway/Albertsons, Publix, etc.) and then 80% is probably in the top 25 or 50 accounts (all the big boxes and grocers plus the largest convenience chains: Seven 11, Casey, Murphy, Wawa, etc.). Selling a limited SKU array of stuff you make mostly into a finite customer list on a B2B level is the exact opposite of a supply chain that is externally sourced consisting of thousands of SKUs, self-distributed to 5000 owned locations, servicing hundreds of thousands of end customers. There is a consumer marketing element to both, but beyond that, the skill sets are really different. One emphasizes internal suppply chain and B2B large customer/contract management and the other is external supply chain with tons of suppliers and tons of end customers plus retail operations management. The latter is much more operationally intensive, so it doesn't surprise me they would promise something to interstate batteries (be good at negotiating a high level B2B deal - that's the Frito-Lay skill set) and then realize later the operational complexity of what they promised is too hard (because executing on something like this is new terrain to this management team).

    I agree entirely with a pair trade. I would actually be inclined to go long ORLY/short AAP, even without a deal, given the near-term outperformance of AAP versus ORLY. The VIC format doesn't really allow for recommending that. It would remove the question of near-term macro strength, which I am on the margin dubious of, but am more agnostic about than any of my other bear points (i.e., I am a little skeptical of the industry bouncing back because it has been one excuse after another, but it is also possible it does eventually given the underlying data). At this point, the valuation of AAP is almost equivalent ORLY's, just a point or two discount, which is as narrow as it gets, so if the industry does rebound as you expect, I am sure ORLY will do very well. I am pretty sure AAP will lag in terms of pick up in that scenario, because I think they are losing share for structural issues and the operations remain challenged, and this period of outperformance has thus been unwarranted - so in a period of industry strength, ORLY will outpace operating performance wise and then catch up and then some stock performane wise. If the industry disappoints, AAP will surely underperform operationally, and also has farther to fall as a stock. Of course if either player actually bought AAP, I would be inclined put on the pair trade you mentioned...but I really don't see that acquisition happening. I don't know why ORLY would want to mess up its well-functioning B2B side with that mess. If AZO was desperate to catapult into higher B2B share, I guess it is possible, but as I think I mentioned in the write up, anecdotally, I hear they are doing OK picking off salespeople and location managers from former Carquest branches when they open new markets, so it seems like that may be the cheaper and less risky way for them to proceed, unless online cannibalization of B2C picks up so much that they end up in a bigger rush to grow B2B (although in that situation, they would be half buying more B2C exposure as well...so still a deal seems like a stretch...especially up here...maybe well below $100 gets more interesting). So yeah, I just don't see how a deal is logical, especially at these levels, for anyone.

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