When assessing investment opportunities, it’s crucial to identify companies that appear to be undervalued for a reason. One such case worth exploring is Advance Auto Parts (AAP), a prominent player in the automotive retail industry. This week, the share price of AAP fell about 35%, AAP’s current valuation suggests a cheaper investment opportunity.
Q1 Financial Results
The recent financial results reflect the challenges faced by AAP, with lower-than-expected net and comparable store sales growth. In the first quarter, net sales increased by 1.3% to $3.4 billion, while comparable store sales decreased by 0.4%. These hurdles have raised concerns among investors, contributing to a lower valuation.
Earnings Missed Expectations Badly
One of the key issues impacting AAP’s performance was the lower-than-expected operating margin rate of 2.6%, primarily due to higher investments to narrow competitive price gaps in the professional sales channel and unfavorable product mix.
The company has been focusing on improving inventory availability while sustaining competitive pricing, but the competitive dynamics experienced in the first quarter are expected to continue, resulting in a shortfall to their 2023 expectations.
AAP’s gross profit margin has experienced a decline due to targeted price investments and unfavorable product mix. In the first quarter, the gross margin rate declined by 162 basis points to 43%, with the single biggest shortfall being less-than-planned price realization within the product margin.
This decline in gross margin, combined with increased supply chain costs, has affected investor sentiment and contributed to the perceived undervaluation.
Additionally, selling, general, and administrative (SG&A) expenses increased to $1.4 billion, representing 40.4% of net sales compared to 38.6% in the first quarter of 2022. This rise was driven by inflation in labor and benefit-related expenses, as well as costs associated with new store openings.
Overall, AAP’s operating income for the first quarter was $90.0 million or 2.6% of net sales, significantly lower than the 6.0% reported in the same period last year.
Dividend Cut
Worse of all, AAP also announced a reduction in its quarterly cash dividend to $0.25, a move aimed at enhancing financial flexibility. This is a huge cut, considering that it paid out $6 per share in dividends in 2022.
The decision to reduce the dividend may have been perceived negatively by income-seeking investors who prioritize consistent dividend payouts. It has contributed to a dip in investor confidence.
Operating Performance and Uncertain Outlook
AAP’s first-quarter financial results were below expectations, primarily driven by weaker performance in the professional business segment. The company acknowledged the challenging competitive environment in the Pro channel and reduced its annual guidance based on the shortfall experienced in the first quarter.
The company revised its full-year guidance, taking into account the current competitive landscape and softer top-line performance.
The updated guidance includes
- Net sales of $11.2 billion to $11.3 billion
- Comparable store sales of negative 1% to flat
- Operating income margin of 5% to 5.3%
- Diluted earnings per share of $6 to $6.50
- Capital expenditures of $250 million to $300 million.
- The company plans to open 40 to 60 new stores and branches
- $200 million to $300 million in free cash flow.
Most prominent of all was the reduction in Earnings Per Share (EPS) by about 40%.
The uncertain outlook, coupled with macroeconomic uncertainty and potential pressure on consumers, has further dampened investor sentiment and affected AAP’s valuation.
Potential Catalysts and Long-Term Growth
While AAP’s current valuation may be indicative of underlying challenges, several numbers suggest potential catalysts for future growth.
The company’s commitment to driving top-line growth through DIY omnichannel expansion, its successful loyalty platform, DieHard, and the continued growth of its e-commerce business are all positive signs. In the first quarter, DIY omnichannel slightly outperformed the DIFM segment, driven by a double-digit sales increase in the e-commerce business.
Moreover, the increasing car park and aging fleet, combined with modestly higher miles driven, present opportunities for AAP to tap into a growing market.
The outlook for the rest of 2023 is focused on improving operational execution, particularly in the professional sales channel. The company aims to regain top-line sales momentum by enhancing parts availability, sustaining competitive pricing, and improving field execution.
Is The Worse Over?
In Q422 earnings call, it was mentioned that they expect Q1 to be the worse quarter due to the three reasons.
- Shifting to GAAP accounting standards, where they expect higher product costs year-over-year in Q1 than in subsequent quarters.
- Expect to build sales momentum throughout the year as we improve availability.
- Higher transformation costs within SG&A in Q1.
Even so, let’s not forget that they missed and revised their own guidance after 4 months.
Conclusion
Advance Auto Parts’ undervaluation is not without reason, as it faces headwinds in a competitive market, margin pressure, and operational challenges in the professional segment. While Advance Auto Parts may appear cheap based on valuation metrics, it is important to consider the underlying reasons for its discounted valuation. Sluggish sales growth, margin pressure are significant challenges facing the company.
These factors have contributed to investor skepticism and a discounted valuation compared to its peers.
However, astute investors should also consider the potential catalysts for long-term growth, such as DIY omnichannel expansion, the loyalty platform, and favorable industry dynamics.
