Advance Auto Parts (NYSE:AAP) runs as the second-largest aftermarket retailer of automotive accessories, parts, batteries, and maintenance items in the United States. It overhauled the marketing strategy of Auto Parts International after acquiring the latter's 202 stores to boost its growth in the industry during its preliminary years. Warren Trades blog alerts recommended to short AAP when it traded above $90.
As it seeks to increase its customer traffic and drive improvements in its sales in the next two quarters, AAP continues to open branches all over US for expansion. Currently operating over 3,800 stores in 40 different states, AAP also has eight distribution centers, 31 PDQs or Parts Delivered Quickly, warehouses, and 294 hubs. AAP is at a disadvantage in commercial as it lacks the daily replenishment distribution facilities that O'Reilly Automotive (NASDAQ:ORLY) offers but is close to opening its first facility. AAP management tried to solve this weakness by adding labor, trucks, hub stores and focusing on commercial customers. However, AAP is now losing share, specifically to Autozone (NYSE:AZO). While AAP is about to open its first daily delivery DC, I think it may be some time before the benefits are realized.
AAP preannounced in October 22 weak results for its third quarter and lowered full year guidance. I believe most of the weakness is AAP company-specific, but sales trends for all three players have not improved and likely won't until the spring.
It is essential to differentiate between the three auto parts players. Advance lacks the distribution capacity to be an effective competitor in both retail but especially in the commercial market. Their management team recognizes this and that is the reason behind creation of the Remington distribution center and future ones over the next few years. In a slower market, those infrastructure weaknesses tend to be more glaring and investors just want to avoid extra risks. It will take some time for AAP to close the competitive gap. I advice to stay away from Advance until this strategy starts materializing with improved results.
Most of the upside potential would come from greater share buybacks, of which several analysts have cut estimates in half for the balance of the year. I like to invest in companies that offer several drivers or catalysts for share outperformance. It is important to understand that AAP is delivering weak results in an overall low growth macro scenario. In the last Q2 report, EPS came in lower than expected at $1.34. The miss was almost entirely comp driven as comparables declined 2.7%. Negative 2.7% was below the low end of market expectations and implied an over 350 basis point deceleration in the two year trend. Gross margins were a bit better as comparisons were relatively easy and as lower shrink helped. SG&A was roughly in-line and was elevated for Q2 given the shifting of some expenses from Q1 into Q2.
Currently, shares of Advance Auto Parts are trading at 13.2x Zacks 2012 EPS estimate of $5.34. AAP current P/E multiple is 12.9x, compared with the 19.2x average for the peer group and 14.3x for the S&P 500. Over the last five years, shares of Advance Auto Parts have traded in a range of 11.7x to 17.5x trailing 12-month earnings. This clear undervaluation is evidence that the market is not expecting good things for this company.
I like to invest in high margin businesses. Advance Auto Parts has a 6.40% net profit margin, which is less than the 20% margins I look for in a company. It is also important to look for companies that generate above than average revenue and earnings growth. It is essential to see both top and bottom line growth because as Warren Buffett explains, EPS growth can be generated by using non-operating businesses activities, such as share buybacks or using retained earnings from past quarters. Advance shows top line growth of 4.14% year over year and EPS growth of 29.35% year over year. This shows a clear disparity between sales and earnings growth and is an indication that organic revenue is not the main driver of the growth in EPS.
In conclusion, while I think that the auto parts industry could be interesting, I like to invest in companies with proven growth that are leaders in its industry and are currently growing. While AAP is a fundamentally solid company and could look cheap with a P/E of just 13x, I would like to get a better clarity in its Remington strategy before investing.