|Shares Out. (in M):||73||P/E||13.6x||12.2x|
|Market Cap (in $M):||4,990||P/FCF||13x||11.5x|
|Net Debt (in $M):||550||EBIT||670||710|
Advance Auto Parts (AAP) is an undervalued retail business positioned in an industry with terrific dynamics, and managed by a well-regarded CEO that should enable the company to earn upwards of $7.00 by 2014. Assuming a return to normalized multiples (from both a historical and relative perspective), the stock should garner a 20%+ IRR. Though hardly a “homerun” by most investors’ standards, the downside protection as more fully explained below makes this a unique, low-risk investment with enough upside to justify the attractiveness at current levels.
By way of background, AAP is the third largest automotive aftermarket retailer of parts, accessories, batteries and maintenance items with 3,627 stores in 39 states, Puerto Rico and the Virgin Islands. The company generates approximately $6bn of annual revenues with an approximate 9% market share of the $43 billion retail, or “Do it Yourself”(DIY) market and 4% share of the $54 billion commercial, or “Do It For Me” (DIFM) market. DIFM sales grew at a 19% CAGR from 2000 to 2010, and DIY sales grew 8% during that time period.
The competitive positioning and market opportunities are very favorable for AAP, as the underlying end market is stable, acyclical and benefits the large players (AAP is the third largest retailer behind Autozone (AZO) and O’Reilly(ORLY)). Primarily, long-term industry trends should continue to provide support for low to mid-single digit same store sales growth in the retail/DIY segment and high-single to low double-digit growth in the commercial/DIFM segment – a segment which AAP is vigorously attacking (35% of sales currently; should eventually reach 50%) and gaining market share in. Not only has the average vehicle age continue to increase (to approximately 10 ½ years in 2011), but vehicles themselves are getting more complicated, and manufacturers continue to produce more models – hence, the greater need for parts.
Moreover, the auto parts retail industry differs from the vast majority of retail industry due to the nondiscretionary nature of the products it sells. This has been manifested in that fact that AAP, AZO and ORLY have generated positive same store sales growth since 2000, with the exception of 2005 when AZO had negative same store sales largely due to company-specific issues. The same store sales growth has also been supported by the fact that unlike other retailers, the auto parts retailers are not over-stored, as the number of outlets has remained relatively constant over the last decade (approximately 35-36k in the coutnry)
As a result of these dynamics, in conjunction with the critical importance of inventory and SKU availability (the average AAP store has 17,500 SKUs), AAP, ORLY and AZO have grown their combined market share from approximately 13% to 20% over the last 10 years. The remaining 80% are largely mom-and-pops, which they should continue to gain share from.
AAP’s management team, commercial focus, and capital allocations should continue to benefit shareholders. Darren Jackson, a board member who took over as CEO in 2008 after spending the previous eight years in various senior management positions at Best Buy, including CFO and EVP of Customer Operating Groups. Jackson has brought on other members of the team from Best Buy, and together, the team has achieved record operating results with sales per store increasing 11.5%, EPS nearly doubling to an expected $4.60 this year and returns on invested capital approaching 30%. The company has repurchased over $600m of its shares this year, and has done an outstanding job leveraging its working capital to free up cash for share repurchases.
Growth opportunities include a potential expansion out west, where AAP currently does not have a presence, leveraging their online efforts, and a continued focus on the commercial market, which grows at a much faster clip than retail. Indeed, AAP's commercial focus has also been one of the main pillars of the bear case, given its lower gross margin profile. Nonetheless, AAP has undertaken several initiatives (e.g., global sourcing, better inventory management, etc) that have enable them to sustain relatively high gross margins in their commercial business, and given the tremendous growth opportunities, is willing to trade off some margin % for the large absolute dollars opportunity.
AAP should also continue to expand its operating margin, reaching its stated target of 12% in the next two to three years. Notably, AAP lags AZO and ORLY by 400-500 bps in SG&A, and hence there should be low-hanging fruit. AAP has met/exceeded their OM targest the last two quarters, and are clearly on track to achieve their goals.
When the foregoing factors are taken together, the company has ample room to grow EPS to $7.00+ over the next three to four years (without using heroic assumptions: a 3% SSS growth combined with the achievement of a 12% OM and continued buybacks), with limited downside given the industry characteristics, quality of the business and prolific free cash flow generation. Multiple expansion should follow the consistent EPS growth, and while AAP may never garner the multiple of AZO, a narrowing of the gap shd accrete value as well.