Advance Auto Parts: Strong presence of DIFM (NYSE: AAP)


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Investment Summary

With the Covid pandemic receding, people are more and more comfortable going out in their vehicles. Thus, the miles traveled are recovering in most parts of the United States. This will help the demand for auto parts in the near future. Moreover, used car sales have increased significantly after the pandemic and aging cars on the roads will also be a positive factor for the demand for advanced auto parts (AAP). Additionally, the company’s above-average exposure to the Do-It-For-Me (DIFM) end-market and multiple margin improvement initiatives also bode well for its fundamentals. The stock appears to be trading well at a discount to its historical valuation.

Fourth Quarter Revenue Analysis

Advance Auto Parts recently released its fourth quarter results and the company posted better than expected results. The company’s revenue increased approximately 1.3% year-over-year to approximately $2.4 billion from the consensus estimate of approximately $2.37 billion. The fourth quarter adjusted operating margin was approximately 7.4%, almost flat compared to the fourth quarter 2020 adjusted operating margin of 7.3%, as the impact of inflationary headwinds (particularly within the workforce) and increased incentive compensation have offset some of the margin improvement initiatives the company is implementing. We believe this is only a temporary setback and the long-term margin outlook looks good as the company continues to work on cost reduction initiatives. Despite shrinking margins, Adjusted EPS rose to $2.07 (vs. consensus $1.96) from $1.53 in Q4 a year earlier.

I believe there are many macroeconomic and company-specific factors that make AAP an attractive investment for both short-term and long-term investors.

Aging vehicles and recovery in kilometers traveled

During the Covid pandemic, there was a significant increase in demand for cars, but production of new cars was affected due to supply chain issues and other lockdown-related production disruptions. This led to a surge in used car sales. New car production still faces disruption due to the impact of chip shortages. This bodes well for auto parts retailers, as older vehicles require more maintenance and the chances of them needing a replacement for an auto part are much higher. The more these cars circulate in cities, the better it is for the company.

In addition, auto parts retailers are also benefiting from the increase in kilometers driven. During the pandemic, people traveled less and nested at home most of the time. But as Covid cases dwindle and restrictions are lifted, they venture out in their vehicles. This has led to a recovery in the number of kilometers traveled and the AAP should benefit from this. According to management, miles driven in the Northeast market, where the company has a significant presence, are still below 2019 levels. This indicates that the company will continue to benefit from a recovery in miles driven in a near future.

The Northeast is still nearly 10% below what it was two years ago if you look through the end of last year on miles driven. Now it’s going up, but it’s still below. So I think you will continue to see the miles driven improve. The information we have indicates that it is still down from ’19. We expect that to continue to improve.”

— Tom Greco, CEO of Advance Auto Parts, Q4 2021 Earnings Call

Strong position in the DIFM market

Of the three major auto parts retailers – Advance Auto Parts, O’Reilly (ORLY) and AutoZone (AZO) – Advance Auto Parts has the most exposure to the DIFM market.

DIFM vs DIY sales of Advance Auto Parts, O

DIFM vs. Advance Auto Parts, O’Reilly and AutoZone DIY Sales (Company Data, GS Analytics Research)

During the pandemic, people were spending more time at home and there was an increase in DIY activities. However, with the opening of the economy and the lifting of restrictions, it is expected that DIFM activities will see an increase and some of the pent-up demand will be released. With approximately 60% of sales coming from this end market, Advance Auto Parts is well positioned to benefit from this increase.

Margin improvement potential

One setting that Advance Auto Parts lags its O’Reilly and Auto Zone peers on is margins.

Margin Comparison for Advance Auto Parts, O

Margin Comparison (GAAP) for Advance Auto Parts, O’Reilly and AutoZone (Company Data, GS Analytics Research)

Management is aware of this and is undertaking various initiatives to improve the company’s margins. Here are some of the initiatives taken by management to reduce costs:

  • Integration of the Advance brand and the Carquest brand into a single supply chain

  • Deployed cross-banner replenishment that steers a store towards more logical freight distribution to reduce miles traveled in its fulfillment centers and stores

  • Launch own brands to drive gross margin expansion. The company launched Diehard power tools in the fourth quarter of 2021 and plans to launch Diehard hand tools in the first half of 2022.

  • Transitioning the entire distribution center under one warehouse management system to efficiently manage all major and minor warehouse tasks to reduce costs. The company has transitioned approximately 44% of its distribution centers to the new warehouse management system and is already realizing savings, but the warehouse management system will only fully benefit by the end of 2023. The company also integrates the labor management system. increase productivity and save part of labor expenses.

  • Enhance strategic pricing capabilities to eliminate unproductive discounts and respond quickly to inflation-related cost increases using a new technology platform the company rolled out in 2020.

  • Integrate assortments, supply chain, technology platforms within Worldpac and Autopart International to accommodate professional business under one roof to further improve gross margin and achieve incremental sales.

The Company’s adjusted operating margins increased to 9.6% in fiscal 2021 from 8.3% in fiscal 2020. For fiscal 2022, management has forecast operating margins of operations adjusted between 10.1% and 10.2%. I believe this improvement will continue over the next few years as the company implements its margin improvement initiatives and attempts to close the gap with its peers.

Evaluation

AAP is trading at ~15.33x FY2022 EPS estimates, which is a significant discount to its 5-year average P/E of ~19.14x. According to consensus expectations, the company’s EPS is expected to grow about 12.21% this year and about 15.15% next year. I believe the business will continue to see good EPS growth going forward, helped by both macro (mileage recovery, aging vehicles) and business-specific factors (high proportion of DIFM’s sales versus its peers, potential for margin expansion). Therefore, I think the stock is a good buy at current levels.

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