J. Michael Jones
Advance Auto Parts stock (New York Stock Exchange:Australian Airlines) has had a poor financial performance over the past year, losing about 44% of its value. On Wednesday, its shares plunged 11% after disappointing quarterly results, and have now regained virtually all of that value. It accounts for half of the profits so far this year. Septemberand I rated the stock a Sell due to cash flow concerns that could see the stock bottom near its low of $50. Since my recommendation, AAP has significantly underperformed the market, gaining 8% versus the S&P 500’s 17% gain. However, with the new financial picture, now is a good time to determine whether the stock is still a sell or if a better opportunity exists. I remain cautious.
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The company First quarter, Advance Auto Parts earned $0.67; consensus $0.06, Revenues fell 0.3% year over year to $3.41 billion. Financial results aside, the quarter was a mixed bag. initial In its earnings release, AAP forecast revenue for this year to be $11.3 billion to $11.5 billion, up from $11.3 billion to $11.4 billion previously. This increase at the top end of the range gave investors hope that sales were accelerating. But this proved to be a mistake, and guidance remains at $11.3 billion to $11.4 billion.
Obviously, there is disappointment that the guidance was not raised. Additionally, traders who bought the stock on the initial headline of the guidance increase quickly turned to sell, likely exacerbating the decline. Mistakes happen, and I don’t mean to overinterpret or overly punish, but this was a sloppy mistake. Earnings calls are read by countless people across management, and misstating guidance is very surprising. For a company trying to restore investor confidence, this is a blemish. I don’t think a typo is a reason to buy or sell a stock, but to the extent the stock has a “credibility” baggage, this only adds to it.
In fact, this sloppiness comes after the company had to restate last year’s quarterly financial results in its 10-K due to weak internal controls. These changes increased Q1 2023 EPS by $0.09 to $0.81 versus the previously reported $0.72. In an effort to improve reporting, the company hired 30 accounting personnel. Valuing a business is difficult when the numbers are perfectly accurate, but it becomes even more difficult when published results are called into question. Most of these issues predate the CEO’s time trying to turn the business around, but I expect these issues to be persistent issues until a series of clean quarters follows.
Looking at actual performance, I think AAP is making some progress but it’s mixed. In my view, we are likely entering the “not bad” phase of recovery but the question remains as to when we will enter the “good” phase. Same-store sales declined 0.2% as the DIY division weakened. Facing tough budgets, the consumer discretionary sector was weak and deferred maintenance impacted products such as brakes. On the bright side, the Professional business posted positive same-store sales.
The company has taken steps to make its pro products more competitive, including marking down 8% of its products by $40 million to match the pricing of other retailers. This appears to have increased pro foot traffic, but has negatively impacted margins. Gross profit decreased 2.2% to $1.4 billion, and margins fell 82 basis points to 42%, while net sales decreased $11 million and cost of goods sold increased $21 million.
Despite gross margin pressure, our cost reduction program remains on track. SG&A expenses were $1.3 billion, $20 million lower than last year. SG&A expenses decreased to 39.4% from 39.9% last year. We achieved our SG&A expense target of $150 million and reinvested $50 million of the savings into salaries, which reduced district manager turnover in half. We expect reduced turnover to lead to improved store experience and sales performance over time.
Still, lower gross margins caused operating margins to fall to 2.5% from 2.9%, and operating profit fell 12% to $86 million.
Overall, sales activity has been slow, but cost management efforts are paying off. Cash flow has also improved. Operating cash flow was $2.7 million, a significant improvement from last year’s $383 million outflow. Last year, accounts payable dragged down $424 million and inventory increased $104 million. This compares to a $20 million decrease in inventory and a $147 million decrease in accounts payable this year. Accounts payable were reduced last year ahead of the S&P credit rating downgrade, but most of this pressure now appears to be showing up in the results. Nevertheless, first quarter free cash flow was seasonally weak, with a $46 million outflow.
Ignoring a typo on its earnings call, the company continues to expect EPS of $3.75 to $4.25 and same-store sales growth of 0 to 1 percent, which management said should generate at least $250 million in free cash flow. While full-year guidance remained unchanged, its second-quarter commentary was very weak. The company expects same-store sales to be in line with the first quarter as consumer spending remains under pressure, blaming consumers for “increasing demand for its products and services.”Silence” As a result, profit margins are expected to decline in the second quarter and improve thereafter. Management also stressed that a recovery in performance will “take time.” A significant acceleration in the second half of the year is needed for the company to achieve full-year results, which remains to be seen. Given the scale of the failure, investors are reluctant to trust the forecast when actual earnings trends have yet to improve, leading to a negative reaction from the stock price.
Beyond sales growth, there are many other aspects of the company’s turnaround that are underway, including the sale of its wholesale division, Worldpac, and the purpose We’ll be announcing that in the next quarter. We have 320 locations.
The proceeds from the sale will first be used to improve the company’s strained balance sheet. The company currently has $1.8 billion in debt and $2.7 billion in operating leases, totaling $4.48 billion in adjusted debt. As a result, debt/EBITDAR leverage is 3.9x, well above the target of 2.5x. At current profit levels, $1.6 billion in debt reduction is needed. Even if it can grow profits by 20%, it will need more than $1 billion in debt reduction, and asset sales will also reduce profits. Therefore, after the sale of Worldpac, it may sell its Canadian business. On the bright side, it has time to repair its balance sheet, as it has no maturities until 2026. Even after these asset sales, it will only have about $170-190 million in retained cash flow after dividends, and it will likely take about two to three years to raise leverage to its target. This is why management emphasized that a turnaround will take time.
The company is also implementing a new inventory management system, a process that is expected to be completed next quarter. It also aims to reduce purchasing costs by $50 million through supply chain optimization. It has closed 17 underperforming locations to improve productivity. Along with the earnings, AAP also announced Announced The chief merchant retires and TargettargetThe move is part of a restructuring linked to the company’s turnaround. Many of AAP’s troubles began with its attempt to pivot to its own brands and lose customers in the process. The shift to a new chief merchant is in line with the new management’s efforts to win back professional customers, but winning back customers and improving products is not an overnight fix.
AAP is doing the right thing. It is taking steps to cut costs, simplify its scope, seek to reduce debt, and win back customers. Unfortunately, the macro environment has weakened discretionary activity. This makes it difficult to gauge whether the sales weakness is a sign of lack of effort or due to macro headwinds. I have more faith in the efforts to control costs and improve asset productivity than in revenue growth efforts. Margins remain under pressure, with zero sales growth and no signs of acceleration. We see downside risk to guidance as the second quarter is likely to be soft. There is no reason yet to believe that same-store sales will grow significantly in the second half of the year.
Add to this that even in an optimistic case where Worldpac and Canada can be sold at a reasonable valuation, it will likely take until 2027 for the balance sheet repair to be completed. This means that investors will be waiting a long time for capital returns beyond the company’s $0.25 quarterly dividend. The current stock price represents a 6.5-7.2% free cash flow yield assuming $220-250 million of free cash flow, given the risk that sales will remain low for a long period of time. This is what I see as the core case. For a company that is several years away from increasing shareholder returns and facing credibility issues, I see this as a perfect valuation. I still think a free cash flow yield of about 8% is more appropriate to factor in the risk of no growth for a long period of time. This is about $58 per share. This represents a decline of about 8%. So even with Wednesday’s decline, I remain a seller of AAP. Given the duration and uncertainty of the recovery, the stock is likely to remain dead money and investors should look elsewhere for capital appreciation opportunities.
