It's important for long-term investors to develop a guide for doing their investment research. Over the years I have developed questions to guide me in my thinking when researching the publicly traded universe. Today let's talk about Advance Auto Parts (NYSE: NYSE:AAP).
1.) What does the company do?
When you buy shares in a company you effectively become part owner of that company. Therefore, it's important for an investor to understand what a company sells. Advance Auto Parts sells car parts and accessories. It also caters to the commercial customer under the Carquest, Worldpac, and Autopart International names.
2.) What do the fundamentals look like?
Investors should also look for companies that grow revenue and free cash flow over the long-term, retaining some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains. Advance Auto Parts saw decent expansion in revenue and net income, but not so much in free cash flow. Over the past five years its revenue, net income and free cash flow expanded 71%, 49% and 10%, respectively (see chart below).
Advance Auto Parts pulled multiple levers to grow its revenue over the past five years. It opened and acquired new stores and expanded sales at existing stores with the exception of 2012 and 2013. However, capital expenditures and inventory pertaining to some of those acquisitions hindered free cash flow during that time.
Advance Auto Parts is doing ok so far in FY 2015. Its revenue, net income and free cash flow expanded 2%, 0.3% and 120%, respectively, year-over-year in the most recent quarter. The expansion in revenue came from existing stores. Advance Auto Parts kept its costs in check contributing to the slight increase in net income. Favorable accruals and lower capital expenditures contributed to the expansion in free cash flow.
However, Advance Auto Parts' balance sheet leaves much to be desired. This mostly stems from Advance Auto Parts' huge acquisition of General Parts International in the early part of 2014. In the most recent quarter, its cash came in at $124 million, which represents a mere 6% of stockholder's equity. I always like to see companies with cash to stockholder's equity amounting to 20% or more to get them through tough times, self-finance acquisitions and cover new product development.
I don't like long-term debt. It creates profit choking interest cost. I prefer companies with long-term debt to equity amounting to 50% or less of stockholder's equity. In the most recent quarter, Advance Auto Parts' long-term debt amounted to 75% of stockholder's equity. However, operating income exceeded interest expense by 12 times in FY 2014. The rule of thumb for safety lies at five times or more.
Advance Auto Parts does pay a dividend. I like to see companies pay out less than 50% of their free cash flow in dividends for a full year retaining the rest for other purposes. In FY 2014, the company paid out a miniscule 4% of its free cash flow in dividends. Currently, Advance Auto Parts pays its shareholders $0.24 per share per year and yields 0.1% annually.
3.) How much management-employee ownership is there?
Investors should always look for businesses where the managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits, which will enhance share price and their personal wealth along with the wealth of shareholders. According to Advance Auto Parts' latest proxy, no executive or employee owns more than 1% of the company. This means that they lack the extra incentive provided by a huge ownership stake in the company.
4.) How does its "Report of Independent Registered Public Accounting Firm" stack up?
Every year a company employs external auditors to audit financial statements and evaluate whether it maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language "unqualified" or "fairly presents", which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see "qualified" or "adverse" in the auditing letter's language then deeper issues in a company's financial statements may exist. Last year, Advance Auto Parts' auditors said the company maintained adequate internal controls and rendered an "unqualified" opinion on its financial statements.
5.) What types of risk does it have?
It's always important for investors to weigh the various risks such as exposure to political risk in parts of the world where war is the norm, competitive positioning, and market price risk. Advance Auto Parts operates mostly in the United States and Canada, which means its political risk resides in the low to moderate range.
Advance Auto Parts competes with companies like AutoZone (NYSE: AZO), Genuine Parts Company (NYSE: GPC), O'Reilly Automotive (NASDAQ: ORLY) and Pep Boys Manny Moe and Jack (NYSE: PBY). Advance Auto Parts resides at the bottom of the pack in terms of positive free cash flow generation (see chart below).
Advance Auto Parts trades at a P/E ratio of 26 vs. 19 for the S&P 500 as a whole, according to Morningstar, which resides a little in the high range for an average company like Advance Auto Parts.
6.) What does its forward analysis look like?
Overall, Advance Auto Parts does ok. It manages to grow same store sales, expand its locations and acquire companies that share its core competency. Moreover, some positive macroeconomic catalysts, including Americans holding onto their cars longer, should bode well for parts retailers. However, I would like to see Advance Auto Parts pay down some of its debt and for the valuation to shrink before I consider investing in the company.