A deeper dive into Advance Auto Parts

I've written three times recently about auto-parts retailer Advance Auto Parts (AAP), so let's cover the last part of the story today...

(In case you missed them, I discussed Advance in my September 6, September 11, and September 13 e-mails.)

In my previous e-emails, I highlighted the 84% crash in Advance's stock since it peaked at $241.65 per share on January 6, 2022... the company's weakening financial performance... and the degree to which Advance has underperformed its attractive sector, in which its peers – AutoZone (AZO) and O'Reilly Automotive (ORLY) – have been two of the greatest stocks of the past two decades.

So is there any hope for Advance to turn things around and see its stock take off? Let's take a deeper dive...

With a similar unit model, store locations, and end customers, there are no structural reasons why Advance should be so badly underperforming its peers, with an estimated 34% lower revenue per store and far lower earnings before interest, taxes, depreciation, and amortization ("EBITDA") margins – as this chart shows:

So what explains the underperformance?

In a word: management.

Much of Advance's current woes are self-inflicted, largely resulting from historical management teams with limited industry expertise and poor execution.

To address this, Advance brought in a new CEO a year ago, Shane O'Kelly, who has an impressive resume: West Point, seven years in the Army, Harvard Business School, McKinsey, and a number of leadership roles in the retail sector, most recently the CEO of Home Depot's (HD) HD Supply (you can see his LinkedIn page here).

While I don't think O'Kelly can be blamed for the company's poor performance, which began long ago, he hasn't even stabilized the situation, much less turned it around... which is reflected in the stock price: it's down 34% since he officially assumed the top job on September 11 last year.

The single biggest problem is that Advance is all too often out of the items customers need – and thus loses sales because 95% of aftermarket auto parts are purchased for repairs done the same day (this also explains why this sector has been largely insulated from online competition).

The main reason for Advance's chronic out-of-stock problem is that, despite having lower revenues, the company has 46 distribution centers while AutoZone and O'Reilly only have around 15.

This large network, which stems from the 2013 acquisition of Carquest (and which was never properly integrated) is inconvenient for vendors and creates enormous complexity.

O'Kelly and his team are working to rationalize this network, with the goal of reducing it to 14 distribution centers by closing underperforming ones and converting others into market "hubs" that have quicker, more efficient delivery to stores. Management is also converting several large stores into hubs that will service the store network. This is a huge, difficult undertaking that, even if done smoothly (a big "if"), will take time...

Also causing inventory (and other) issues is that fact that Advance is still in the process of moving to a single warehouse management system and still operates two point-of-sale systems that need to be merged into one.

But none of these issues are new... so why have Advance's margins plunged in the past two years?

The answer is that AutoZone started a price war, which O'Reilly quickly matched. But Advance was a laggard, first losing share and then bungling the price cuts. The only silver lining here is that my research indicates that the downward pricing trend is over.

Meanwhile, what about the rapid adoption of electric vehicles – which have fewer parts and require less maintenance?

To answer this, I turned to a friend and former student, Boris Senderzon of investment-management firm Hilbar Capital, who was kind enough to send me – and give me permission to share – his notes on Advance and the sector. Here's the excerpt on this matter:

The often mentioned competitive threat for the industry is the electrification of transportation. The [electric-vehicle ("EV")] thesis posits that since electric vehicles have fewer moving parts, there is less need for maintenance and thus, as electric vehicle adoption increases, the revenues for the industry will shrink. However, even under the most dire predictions, it will be decades before there is a detectable impact.

Here's his math:

In the US, consumers buy between 13.5 and 15 million new vehicles annually and there were almost 283 million cars and light trucks registered in 2022 according to the Federal Highway Administration.

Suppose that every one of the 15 million new cars sold today is electric (in 2023, only 1.4 million new cars sold were EVs). Assuming that the total number of cars will stay at 283 million (despite the upward trends), then it will take almost five years for electric vehicles to reach 25% of all registered cars and at least another seven years for them to become OKVs ["our kind of vehicles," a term AutoZone uses for cars that generally need lots of repairs]. I say "at least seven" because in all likelihood it will take longer since the most critical part of an EV, its battery, has a typical manufacturer's warranty of eight years or 100,000 miles.

Thus, it'll be a decade plus before there is a notable impact to revenues under the worst case scenario, giving the industry plenty of time to adjust and to pivot.

Considering all this, let's discuss the bull case for Advance's stock...

The single biggest pillar of the bull case is that since Advance's problems are well known and largely the result of bad management, then good management should be able to fix them... and there's a new CEO – and a new CFO from home-improvement retailer Lowe's (LOW) as of last November – in place to do so.

In addition, the Advance recently sold its WorldPac subsidiary for $1.2 billion of net proceeds in cash, which will allow it to pay down debt and invest in the turnaround.

Lastly, there are three credible activist shareholders involved – the largest of which is Third Point, run by the legendary Dan Loeb. He outlined his investment thesis in his April 30 investor letter, in which he praised O'Kelly as "a disciplined, motivated, and proven leader with experience in similar industries," and concluded:

Post the Worldpac sale, RemainCo's blended box model will look like O'Reilly and AutoZone, but at fraction of the valuation. At today's prices, RemainCo is valued well below $2 million per store vs. O'Reilly and AutoZone that are closer to $10 million per store. We believe even minor operational improvements at the core will drive considerable upside to shares and we are confident the company now has the right leadership in place to deliver.

Third Point formed an investment group with another hedge fund, Saddle Point Management, which is run by Roy Katzovicz – the former chief legal officer of Bill Ackman's Pershing Square Capital Management.

On March 11, the two activists agreed to stand down until the end of the year in exchange for three board seats for Thomas Seboldt, Brent Windom, and Gregory Smith, who bring extensive automotive industry and supply chain experience.

Seboldt spent 31 years at O'Reilly (you can see his LinkedIn here)... Windom most recently served as president and CEO of Uni-Select (see his LinkedIn here)... and Smith is a proven supply chain expert with experience at Medtronic (MDT), Walmart (WMT), and Goodyear Tire & Rubber (GT) (see his LinkedIn here).

A third activist, hedge fund Legion Partners Asset Management, also recently got involved. You can see its bull case in this presentation at the VALUEx Vail investing conference in June, which I shared slides from and discussed in my September 13 e-mail.

(For more on the bull case for Advance, I also recommend checking out this ValueInvestorsClub write-up from last November.)

To summarize the bull case, Advance has:

• A No. 3 position in a great industry
• Stable revenues
• A decent balance sheet and positive free cash flow
• Clearly identifiable, self-inflicted problems
• Promising new management
• A stock down 84% to levels first seen nearly two decades ago

So what's not to like?

Well, I'd be remiss not to cover the bear case...

This can be summarized in one sentence by Warren Buffett, who famously warned of the perils of investing in turnarounds led by dynamic new CEOs:

When a manager with a reputation for brilliance tackles a business with a reputation for bad economics, the reputation of the business remains intact.

For a more detailed bear case, check out this ValueInvestorsClub post (which is also from this past November). The anonymous author, natey1015, argued that Advance was a "quintessential value trap" and points to how many similarly positioned retailers collapsed, sucking in value investors betting on a turnaround all the way down:

Retail in general is a tough business. The fixed cost operating leverage of stores is a beautiful thing when the business model is working and there are consistent positive same store sales above inflation. But the operating leverage cuts both ways. And once it begins to go in the opposite direction, it is very tough to reverse.

If you're a student of retailers, history is littered with the failure of many tier 2 and tier 3 players. Just to cite some examples over the past two decades: Rite Aid, Circuit City, J.C. Penny, Sears/K Mart, Toys R Us, Bed Bath & Beyond, Linens & Things, Radio Shack, Borders, Sports Authority, and the list goes on.

The author also thinks O'Kelly won't be able to undo the damage that prior management did to the business over the past decade:

At the end of the day, parts availability and speed of delivery is what this business lives and dies by. On the commercial side, if you stop being the "first call" for that professional due to inconsistent service, it is very difficult to win that relationship back over time. And the same goes for the DIY side of the business. When that customer comes in due to a part failure that part needs to be in stock and it needs to be accompanied by great, knowledgeable customer service.

One of my readers, Doug R., is a good example. As he said in a feedback e-mail last week about Advance's customer service:

Advance Auto's store service sucks. Their web site is horrible to use. And their rewards program went downhill but is slowly coming back. I switched to AutoZone around five years ago – the customer service is way better and the website is a lot easier to use. Their rewards program is easy and automatic.

Finally, natey1015 concludes by showing how the business could spiral into bankruptcy:

So here's the simple math/path to a zero in the stock over the next few years. In the LTM, AAP had ~7% market share and $262 sales/sq. ft. with a 5.1% operating margin. Every incremental dollar of sales it loses carries a ~40% incremental margin with it. Assuming some inflation in the coming years, all it would take is AAP to lose ~10% of its revenue or less than 1% of a share shift away from AAP mainly to ORLY/AZO for the stock to be a zero. ORLY and AZO know AAP is on the ropes and is continuing to go after its business.

I'll note that since natey1015's post on November 1, AAP shares rose as much as 68% through mid-March 1 before collapsing again. Through Friday's close, Advance's stock is down 20% since the post.

So, to conclude...

Natey1015 doesn't even come close to convincing me that Advance is a good short. Unlike most of the other examples he cites of retailers that went under, Advance isn't being battered by online competition... and its revenues are stable, its cash flows are positive, and its balance sheet is decent.

In light of how much the stock has fallen and the overwhelming negative sentiment toward it, if the company reports even a mediocre (rather than catastrophic) quarter, the stock could quickly pop 50%.

But there's a big difference between believing something is a bad short and concluding that it's a good long...

I wouldn't be willing to call Advance a "buy" right now because there's too great a chance that it's a value trap. O'Kelly has been in charge for a year and things are getting worse, not better. And natey1015 is right that, in retail, things can go south in a hurry.

One of my friends, a long-time professional investor who wishes to remain anonymous, summarizes it nicely:

We have owned AutoZone for many years. I've always been skeptical of AAP – even when it optically looked attractive.

AZO and ORLY have consistently had good management teams – people count in every business, but especially this one. AAP has struggled and the team always seems to be the problem.

It's kind of like baseball. The Yankees, Dodgers, and White Sox all play in the major leagues – but the Sox suck.

So I'd stay away from AAP. As Warren Buffett has said, turnarounds seldom turn.

To be clear, I'm not ruling out recommending Advance's stock at some point. But at these levels, I wouldn't try to be a hero by attempting to precisely time the bottom.

If O'Kelly can turn Advance around, even to a modest degree, the stock looks like an easy double. And if the company really turns around, the stock could be a 10-bagger, just as Best Buy (BBY) was from 2013 through 2021.

Personally, I would be OK waiting and watching for concrete signs of a turnaround... even though that likely means I would miss the first 50% rebound in the stock.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.