Advance Auto Parts: Slightly More Encouraged By Its Long-Term Prospects

Today Advance Auto Parts (AAP) reported 3Q06 earnings per share of $0.56 versus $0.55 in the prior year period (including $0.03 of stock option expense whereas last year’s quarter did not include pro forma stock option expense of $0.02). The company's gross margins were up 100 basis points as the company benefited from things like improved material costs and a favorable mix. Advance is beginning to see more opportunity to direct import parts (I think mostly from places like China). This is an area I have truly underestimated with respect to the DIY and just automotive aftermarket players in general. While underlying demand may prove sluggish (because I think the market is saturated), the companies (like Advance) are likely to continue to benefit on the gross margin front as they source lower cost product from abroad while at the same time potentially benefiting a bit from higher ticket prices.

During the conference call, Advance’s CEO Mike Copolla said the average transaction size remains strong, while the customer count remains a challenge. As I listen to the public dealer conference calls, and hear them continue to discuss how warranty business is in decline, but customer pay business continues to grow, it continues to lead me to the belief that dealers are gaining share, but parts are simply lasting longer. Having said that, Advance (and the other large and sophisticated players) competitive advantage (versus the independent jobber not affiliated with a NAPA or CarQuest) will likely come under more pressure than ever as the ability to source products from abroad becomes an emerging trend.

Another area where I have to give Advance a lot of credit with has been their acquisition of Automotive International [AI]. I have discussed this acquisition in the past, but it deserves reiterating. Management noticed that their store base did not have the capabilities (beyond a certain level) to penetrate the commercial (repair) market. The commercial and retail businesses are just incredibly different. I have said the DIY retailers will need to either reconfigure their store model to become 1) more of a company owned jobber model like O’Reilly with variable compensation plans, or 2) target the “real end” DIFM (do-it-for-me) customer, but initially alienating your existing commercial base. But Advance seems to have found a third option. Take the solid cash flows from a more mature business, and deploy those into a faster growing (company owned jobber) business model like AI, where you get considerable benefits from purchasing leverage, even some local inventory sharing capabilities (with Advance stores), and enable the expansion of AI (as AI did not have the capital to expand like what Advance can provide).

Having said that, selling, general and administrative (SG&A) expenses as a percent of sales were up 200 basis points (year over year). Comps of 1.4% (negative 0.6% retail and up 8% in commercial) for the most part resulted in de-leverage from things like higher property insurance, workers compensation, medical, etc. And management also said the stock option expense items accounted for about 42 basis points of the increase. And the ramp up of AI impacted SG&A by about 20 basis points.

Next year management has re-tooled their expense structure (making them a leaner and more efficient company), and so they look to get SG&A leverage on only 3-4% comp growth. I remain worried about the competitive landscape and underlying demand trends, but investors seem encouraged with today’s rather sluggish results, pushing the stock up 5.34% today. And so while I am leery about the company’s 2007 outlook, I have to admit, I am becoming a little more encouraged with the prospects for the company longer term (specifically due to AI). I only wish they would stop building so many DIY stores.

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