Advanced Auto Parts (AAP) is one of the largest auto repair parts supplier in the US serving primarily commercial customers (repair shopes) and DIY (Do-It-Yourself) market. On the back of Q2’17 disappointing guidance and 200 basis points cut to project margins, the stock has taken a nosedive and is cumulatively down 50% from 2015 levels. We examine attractiveness of investment case for AAP.
AAP is perennial underperformer with margin levels of 3-5% which are half of industry peers (O’Reilly Auto Parts, AutoZone, Genuine Parts Company). New management has inherited a tough hand and a clear ambition to close the margin gap with the competition.
Management strategy rests on improvement in levels of service, structural supply chain actions (stock availability, delivery, inventory mgt) and productivity drive ($500mln cost out target over 5 years). We don’t’ object to the strategy proposal and await execution results.
Sources of Margin CompressionAs indicated on Q2 call, margins are anticipated to actually fall on the back of high-cost inventory draw-down (positive), fixed cost operating deleverage (negative) and muted sales outlook (negative). By our calculations, AAP’s operating leverage is 5.4 %, that means that for every 1% increase in sales, operating profit
As indicated on Q2 call, margins are anticipated to actually fall on the back of high-cost inventory draw-down (positive), fixed cost operating deleverage (negative) and muted sales outlook (negative). By our calculations, AAP’s operating leverage is 5.4 %, meaning that for every 1% increase in sales, operating profit increases by 5.4%. This is extraordinary high leverage driven by healthy gross profit $4.2bln (44% gross margin) and high fixed cost base of $3.5bln. Given current muted sales outlook, margins will remain depressed until sales get back to $9.8 to $10.0bln range.
AAP operates in a relatively attractive industry of selling service parts to professional and DIY customers. This segment of hardline retailing has fared well and is less susceptible to online competition from the likes of Amazon.
US vehicle fleet remains large with 250mln vehicles on the road and aging average life of some 10 years. AAP and other national chains have the advantage of the broad distribution network to drive efficiency, improve parts availability and offer better levels of customer service and thus capturing larger market share from smaller players. Rising miles driven coupled with aging vehicle fleet and robust employment bode well for the industry.
AAP business model possesses very high operating leverage with high gross margin (44%) and an ability to spread the distribution cost over large sales. The customer is less price sensitive and focused instead on parts availability and high touch levels of services. AAP has been successful in increasing private-label mix to present 40% levels.
AAP continues to advance multi channel offering, favorably competing on availability, service levels and price with the likes of Amazon. Availability of parts remains the most important source of value for both professional and private DIY customers as they aim to increase service bay turnovers and minimize time spent on repairs respectively. DIY customers particularly appreciate AAP’s knowledgeable in-store sales staff and support services (basic diagnostic, tool loans, DIY videos).
Underlying business drivers
Miles driven continue to growth at a healthy pace of 1-2% annually, gasoline prices remain low albeit up 15% through June, fleet size continues to grow with 250mln vehicles on the road, fleet age increases with 10 years average vehicle age. Headwinds are primarily in the mild weather pattern (extreme weather leads to more breakage and repair), lower spending by Hispanics, increase dealer share of after market services, fewer cars in 6-12 year cohort (following great recession), used car prices moderating, and internet competition (Amazon).
Share BuybackWe see some upside should management resume share buyback at $400mln a year as contributing both to cash returns to shareholders but also attractive value accretion at the present depressed share price levels.
We see some upside should management resume share buyback at $400mln a year as contributing both to cash returns to shareholders but also attractive value accretion at the present depressed share price levels.
|Fair Value Estimate||$43.00 - $54.00|
|Consider Buying Below||$34.40 - $43.20|
|52 Wk range||59.99- 43.55|
|Dividend Yield (%)||2.82%|
The market remains skeptical of AAP’s ability to deliver and focuses more on the short-term margin and sales trajectory. Share price went from just shy of $200 per share in Nov’15 to current $93. As the industry is generally slow growing, the single biggest opportunity and driver of value going forward will be net margin and cash generation. We believe that with current depressed expectations, management has a fair shot at increasing enterprise value from current levels.
Low barriers to entry – competitive pressures are intense, market place is fragmented with large number of smaller regional competitors and characterized by low barriers to entry
Little differentiation – customers face little cost to change suppliers of spare parts and with the advent of online competition there’s limited differentiation between different suppliers
The online competition – increasingly online channel is taking market share from traditional brick and mortar retailers. AAP is benefiting from multi-channel offering
Margin pressures – AAP business model is very sensitive sales level due to high fixed costs and high gross margin on each sale. With 5% net margin, +/- variation in margins of 2%-3% results in profits swinging by 50%.
Long-term structural challenges – modern casts require less maintenance, branded service garages are taking market share as complexity and diagnostics requirements increase, electric/self-driving cars have fewer moving parts and will likely follow different maintenance model
Due to the significant operating leverage, the valuations of AAP vary significantly as with net margin and long-term growth assumptions. The market is presently pricing AAP for 3% growth and 5.5% net growth margin, both in line with historical trends. Should AAP succeed in raising net margins to 6-7% and maintain historical net margins, the stock offers 20-30% upside, prior to targeted $500mln supply chain efficiencies.
On the flip side, the risks of lower margins and lower growth levels (chiefly due to online competition, increased reliability of cars, branded service station competition, and penetration of electric/self-driving cars) pose significant downside. The balance of upside and downside risks appears to be relatively equal. The balance of upside and downside risks appears to be relatively equal.
On that basis, we cannot conclude that AAP is trading in the fat-pitch territory at present levels.
- Industry consolidation enables national chains such as AAP to capture higher market share and drive operating leverage to improve margins and profitability
- Fleet size, age, and miles driven are all supporting the long-term demand for spare parts.
- Newly appointed management is pursuing productivity cost savings, improved service levels, and supply chain efficiencies to close the margin gap the with competition.
- Competitive pressures remain high with online players such as Amazon targeting parts market place, increased vehicle complexity driving more business towards branded service providers who can invest in better diagnostics equipment and staff training, as well as traditional competitors (national chains) fighting for market share
- Newer vehicles are more reliable leading to less maintenance.
- Over the long-term, increased penetration of electric vehicles with fewer moving parts and autonomous vehicles allowing sharing instead of car ownership will depress demand for parts