Advance Auto Down, But Not Out (AAP)

Includes: AAP, AZO
by: Daniel Andres Jacome

We stepped on a landmine Thursday after shares of auto parts purveyor Advance Auto Parts (NYSE:AAP) -- the second-largest auto parts retailer in the US operating approximately 3,000 stores in 40 states -- tumbled 17% on lower 2Q guidance and same store sales growth.

The company said it now expects EPS to fall in the 57-59 cent range, down from prior guidance in the 65-68 cent range. Additionally, Advance now expects same-store sales to increase 1% to 2%, versus prior guidance of 3%-5% increase. Management remains confident that the top line will gain traction after Labor Day.

Based on yesterday's sell off, it's clear that the market disagreed with the bullish report we published on May 24th. In addition to what's already been stated there, we urge readers to mull over the following considerations and risks:

1) One reason our thesis got murdered is because the low-income consumer is getting squeezed by higher prices at the pump. With gas prices so lofty, AAP's target market (both do-it-yourselfers and professional installers) is rapidly changing its driving [consumption] habits. Because Advance Auto is a stock that depends on heavy driving patterns, we admit that we should have been more concerned with pump prices. We have revised our price target to accommodate a more sober view on the macro picture.

2) One interesting piece of information the market has not priced in: summer weather. Advance Auto is a not-so-obvious play on unbearable, Dante-esque heat. Piper Jaffray has conducted a rigorous weather analysis spanning across 10 markets, concluding that an early onset of extreme heat summer would spur above-normal demand for auto repair and maintenance: "Extreme heat causes car parts to break down, while dry conditions are conducive for do-it-yourselfers to complete auto repair and maintenance." In other words, if this summer turns out to be a real steamer, shares of AAP could fathomably climb back to a less irrational valuation.

3) With 15% EPS growth projected for 2007 (our estimates), and the stock currently trading at 10.5 X forward earnings and less than 10 x cash flow, we conclude that Advance Auto's worst days are probably over. The market may also be overlooking the fact that Advance Auto has boosted its ROE more than 200% in the last 5 years and axed debt by 50% to $477 million. Given robust store expansion plans and upcoming summer season, we see sizable upside but still lower our price target from $48 to $40, representing a 33% premium to Thursday's closing price of $30. If Advance Auto can narrow the margin gap between itself and rival Autozone (NYSE:AZO) -- whose pre-tax and net margins surpass Advance Auto's by 600 basis points and 400 basis points, respectively -- patient investors in the underdog should be duly rewarded.

AAP 1-yr chart:

AAP 1-yr

Related article: Auto Industry Points to Mixed Signals for U.S. Consumers.