Is The Rally Of Advance Auto Parts Overdone?

| About: Advance Auto (AAP)

Summary

AAP has rallied 20% since it released its Q3 results, two weeks ago.

The stock rallied, not because the results were great, but because they exceeded the analysts’ expectations.

The market has already priced a successful turnaround into the stock price.

Advance Auto Parts (NYSE:AAP) jumped 15% when it released its Q3 results, two weeks ago. The stock has enjoyed an overall rally of 20% since that day and currently stands near its 52-week high. After this great run and given the volatility of the stock, it is only natural to wonder whether the recent rally is overdone or there is more upside ahead.

First of all, the stock rallied, not because the results were great, but because they exceeded the analysts' expectations. To be sure, the comparable sales decreased 1% while the earnings per share [EPS] decreased from $1.63 to $1.53. However, the comparable sales had decreased 4.1% in Q2 and hence the market was expecting a figure around -3.5% for Q3. Therefore, the actual result of just -1% greatly surprised the market, which thus generously rewarded the stock. In addition, the significant improvement from Q2 may indicate that the company is in the right direction in correcting its inefficiencies.

This is actually what the management emphasized in the conference call, as it pledged that it would remain relentless in pursuing positive same-store sales. The most prominent weakness of Advance Auto Parts is that its operating margin (8.2%) is less than half of its two major competitors, AutoZone (NYSE:AZO) and O'Reilly Automotive (NASDAQ:ORLY), which have an operating margin of 19.4% and 19.6%, respectively. This dramatic underperformance is mainly the result of inefficiencies in the supply chain. That's why the management stated that it is trying to reduce the inventory levels without affecting the availability of items to consumers.

Judging from the rally of the stock, one can safely conclude that the market is enthusiastic over the ongoing turnaround initiatives of the management. However, it is critical to note that the management did not reveal any details regarding this turnaround plan. It justified its stance by saying that it was better to avoid mentioning any details in order to keep its competitors in the dark. While this seems reasonable, investors should keep in mind that the turnaround plan has not bear any fruit yet, as the sales and the earnings are still lower than they were last year. Moreover, it has been more than a year since the activist group Starboard Value acquired a large stake in the company but there has been no improvement in the business performance yet. Therefore, the success of the turnaround initiative should not be taken for granted.

Nevertheless, the market is pricing the stock as if a successful turnaround is a given. More specifically, the analysts are currently expecting 8% EPS growth for next year. Moreover, the stock is now trading at 21.7 times those optimistic EPS. This forward P/E is certainly high for a stock that is going through a transformation plan and is currently experiencing declining same-store sales.

Investors who want to get exposure to the automotive aftermarket can find better deals in other places. For instance, AutoZone has grown its EPS at a double-digit pace for 40 consecutive quarters and is currently trading at a forward P/E=17.2 while O'Reilly has grown its EPS by more than 15% for 31 consecutive quarters and is currently trading at a forward P/E=22.4. These two companies have exceptional performance records and hence they clearly deserve a premium valuation compared to Advance Auto Parts. By this, I do not mean that the ongoing turnaround of Advance Auto Parts will not succeed. Instead it has good chances of succeeding. However, if some investors want to get exposure to the sector, I advise them to purchase shares of one of the other two companies, which have an unparalleled record and are trading at similar or better valuation levels.

Investors should not underestimate the importance of highly consistent and predictable performance over volatile results and a resultant volatile stock. Advance Auto Parts plunged 30% about a year ago and dived 20% twice during the last 12 months due to its volatile results and outlook. While most investors may claim that they can easily tolerate price moves of this magnitude, this is actually much easier said than done. Therefore, I strongly advise investors to purchase stocks with great consistency so that they do not have to put their stomach under test on a regular basis.

To sum up, Advance Auto Parts is going through a turnaround plan, which has good chances of succeeding. However, the market has already priced a successful turnaround into the stock price. Therefore, after the recent rally, the valuation of the stock does not represent a bargain, particularly given the volatile business performance of the company. Consequently, I advise the investors who want to gain exposure to the sector to take a look at the two main competitors of Advance Auto Parts, which have exhibited remarkably consistent and predictable business performance for many years and thus deserve a premium valuation.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.