J. Michael Jones
Shares of Advanced Auto Parts Company (New York Stock Exchange: August) has performed poorly over the past year, losing about 44% of its value. On Wednesday, the stock fell 11% in response to a disappointing quarter, and has now basically given it all back. of its annual profits. I last covered AAP September, and I rated the stock a “sell”, given cash flow concerns, saying the stock could find a floor at $50, which is the bottom. Since my recommendation, the AAP has significantly underperformed the market, rising 8% versus the S&P 500’s gain of 17%. With the new financials, now is a good time to see if the stock is still a sell-off or if there is a better opportunity. I remain careful.
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In the company’s first quarter, Advance Auto Parts earned $0.67, which beat the consensus by $0.06. Revenue fell 0.3% from a year ago to $3.41 billion. Regardless of the results, the start of the quarter was chaotic. On the first In releasing earnings, AAP is guided by revenue of between $11.3 and $11.5 billion this year compared to $11.3 and $11.4 billion previously. This increased high end of the range has given investors hope that sales will accelerate. However, this is wrong, and the guidance is still between $11.3 and $11.4 billion.
There is clearly some disappointment that guidance has not been put forward. Additionally, traders who bought the stock at the initial head of higher guidance may have immediately turned to selling, exacerbating the decline. Mistakes happen, and I don’t want to over-explain or over-punish, but this was a sloppy mistake. The earnings release is read by countless people across management, and it is very surprising that there is a misdirection. For a company working to rebuild investor confidence, this is a black eye. I don’t think a typo is a reason to buy or sell a stock, but to the extent that there is a “credibility” burden on the stock, that adds weight.
In fact, this confusion comes on the heels of the company having to reconfirm its 10K quarterly results due to poor internal controls. These changes added $0.09 to EPS for the first quarter of 2023 versus previously reported at $0.81 versus $0.72. In an effort to improve reporting, it has hired 30 accountants. Valuing companies can be difficult when the numbers are quite accurate; When published results are questioned, it becomes even more difficult. Most of these issues predate the CEO, who is trying to change operations, but I expect these issues to remain a continuing burden until we see many clean things up.
Looking at the actual business results, they are mixed, although I think AAP is making some progress. In my view, we are likely entering the “less bad” phase of the transition, but questions remain about when we will reach the “better” phase. Same-store sales fell 0.2% as the company sees weakness in the do-it-yourself category. In the face of tight budgets, consumer estimates were softer, and maintenance was deferred, affecting items such as brakes. On the bright side, her professional actions have had positive characteristics.
The company took action to improve the competitiveness of its professional offerings, including $40 million in price cuts across 8% of its items to align with other retailers’ prices. This seemed to boost professional traffic, but it affected margins. Gross profit fell 2.2% to $1.4 billion with margins compressed 82 basis points to 42%, as net sales fell $11 million while cost of sales increased $21 million.
While gross margins have come under pressure, the cost-cutting program is progressing well. SG&A expenses were $1.3 billion, down $20 million from last year. It fell to 39.4% of sales from 39.9% last year. It met its $150 million SG&A goal, and reinvesting that $50 million in pay savings cut district manager turnover in half. We hope that over time, lower turnover will lead to improved store experiences and selling performance.
However, due to weak gross margins, operating margins fell to 2.5% from 2.9%, and operating income fell 12% to $86 million.
Overall, sales activity has been weak, but cost control efforts are successful. We are also seeing an improvement in cash flow. It generated $2.7 million in operating cash flow, which represents a marked improvement from using $383 million last year. Last year accounts payable had a withdrawal of $424 million, and inventories were built up by $104 million. In comparison, this year inventories decreased by $20 million and amounts payable decreased by $147 million. Accounts payables were crushed last year before Standard & Poor’s credit rating downgrade, but most of that pressure now appears to be in the results. However, free cash flow in the first quarter was seasonally weak, and there was an outflow of $46 million.
Ignoring the typo in the earnings release, it continues to guide EPS of $3.75-$4.25 and same-store sales growth of 0-1%. This should result in at least $250 million of free cash flow, according to management. While full-year guidance was maintained, Q2 commentary was very weak. It expects companies to be similar to the first quarter as consumer spending faces continued pressure, describing consumers as “conservative” to spend. As a result, margins are expected to be weaker in the second quarter and then improve. Management also stressed that the transition “will take some time.” For the company to achieve its full-year results, there must be a tangible acceleration in the second half, which we have not yet seen. Given the magnitude of the errors, investors are reluctant to put their faith in these forecasts when actual revenue trends have not yet improved, leading to a negative stock reaction.
Beyond sales growth, there are many other aspects of this company’s transformation in progress. It is selling Worldpac, its wholesale distribution arm, and aims to make an announcement next quarter. There are 320 sites.
The first use of the sales proceeds will be to improve its strained balance sheet. The company currently has $1.8 billion in debt and $2.7 billion in operating leases versus $4.48 billion in adjusted debt. As a result, it has leverage of 3.9x debt/EBITDA, well above its target of 2.5x. At its current level of profits, it needs $1.6 billion in debt reduction. Even if it could increase its profits by 20%, it would need to reduce debt by more than $1 billion, and asset sales would also reduce profits. For this reason, after Worldpac sells, it may sell its operations in Canada. On the bright side, it has no maturities until 2026, which gives it time to repair its balance sheet. Even after selling these assets with only $170-190 million of post-dividend retained cash flow, it will likely take 2-3 years before you can achieve the leverage target. For this reason, the administration emphasized that the transformation will take some time.
Elsewhere, it is implementing a new inventory management system, and expects to complete that process next quarter. It also aims to reduce procurement costs by $50 million through supply chain optimization. In an effort to improve productivity, it closed 17 underperforming sites. Along with the earnings, AAP announced that its chief merchandiser will retire and be replaced by a Target (TGT) CEO. This is part of the organizational changes related to the transformation. Much of AAP’s problems began with its efforts to focus on its own brands, losing customers in the process. This shift to a new chief merchandiser is consistent with new management’s efforts to win back professional customers, but winning back customers and improving the product is not an overnight solution.
AAP is doing the right things. It is cutting costs, simplifying its operational footprint, looking to reduce debt, and taking action to win back customers. Unfortunately, the macro environment has weakened discretionary activity. This makes it difficult to know whether weak sales are a sign of lack of effort or due to macro headwinds. I have more confidence in its efforts to control costs and improve asset productivity than in its revenue growth efforts. Profit margins continue to face pressure, and sales growth is lacking with no evidence of acceleration. I see downside risk to guidance given what is likely to be a weak second quarter, as there is no reason yet to believe comp sales should rise meaningfully in the second half.
Furthermore, the balance sheet repair will likely take until 2027 to complete, even in an optimistic case where it can sell Worldpac and Canada at reasonable valuations. This means that investors will have to wait a long time for capital returns that exceed the company’s quarterly dividend of $0.25. Today the stock has a free cash flow yield of 6.5 to 7.2%, assuming free cash flow of $220 to $250 million, which I consider the central case, given the risk of sales remaining depressed for longer. For a company with a multi-year horizon before increasing shareholder returns and facing credibility issues, I see this as a complete valuation. I still see a free cash flow yield of ~8% as more appropriate for pricing the risk of no growth for longer, which is roughly $58 per share. This indicates a decline of approximately 8%. As such, even with Wednesday’s decline, I will remain a seller of AAP. Given its long turnaround and uncertainty, this stock will likely remain dead money, and investors should look elsewhere for capital appreciation opportunities.
