Shares of Advance Auto Parts (NYSE:AAP) have been a poor performer over the past year, losing about 44% of their value. On Wednesday, the stock plunged 11% in response to an underwhelming quarter, and it has now given back essentially all of its year-to-date gains. I last covered AAP in September, and I rated shares a “sell,” given cash flow concerns, saying shares could find a floor around $50, which has been the bottom. Since my recommendation, AAP has meaningfully underperformed the market, rising 8% vs the 17% S&P 500 gain. With new financials though, now is a good time to see if the stock is still a sell or if there is a better opportunity. I remain cautious.
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In the company’s first quarter, Advance Auto Parts earned $0.67, which beat consensus by $0.06, as revenue fell by 0.3% from last year to $3.41 billion. Aside from results, the rollout of the quarter was a mess. On the initial earnings release, AAP guided to $11.3-$11.5 billion in revenue this year from $11.3-$11.4 billion previously. This increased top-end of the range gave investors hope sales are accelerating. However, this is an error, and guidance is still $11.3-$11.4 billion.
Obviously, there is some disappointment in guidance not being raised. Additionally, traders who bought the stock on the initial headline of raised guidance may have immediately turned around to sell, exacerbating the decline. Mistakes happen, and I do not wish to over-interpret or be overly punitive, but this was a sloppy error. An earnings release is read by countless people across management and to misstate guidance is very surprising. For a company working to rebuild investor trust, this is a black-eye. I do not think a typo is a reason to buy or sell a stock, but insofar as there is a “credibility” overhang on shares, this just adds to it.
Indeed, this sloppiness comes in the wake of the company having to restate last year’s quarterly results in its 10-K due to weak internal controls. These changes added $0.09 to Q1 2023 EPS vs prior reporting at $0.81 v $0.72. In an effort to improve reporting, it has made 30 accounting hires. Evaluating businesses can be difficult when the numbers are entirely accurate; when published results come into question, it is even harder. Most of these problems predate the CEO, who is trying to turn around operations, but I expect these problems to be a persistent overhang until we see several clean quarters.
Looking at the actual business results, it is mixed, though I believe AAP is making some progress. In my view, we are likely entering the “less bad” stage of the turnaround, but questions remain as to when we get to the “better” stage. Same-store sales fell by 0.2% as the company sees weakness in the do-it-yourself category. Facing tight budgets, consumer discretionary was softer, and maintenance is being deferred, impacting items like brakes. On the bright side, its pro business had positive comps.
The company has taken action to improve the competitiveness of its pro offering, including $40 million of pricing cuts, across 8% of its items to align with other retailers’ pricing. This is seeming to boost pro traffic, but it has weighed on margins. Gross profits fell by 2.2% to $1.4 billion as margins compressed 82bps to 42% as net sales fell by $11 million while cost of sales rose by $21 million.
While gross margins have come under pressure, its cost reduction program has gone well. SG&A expenses were $1.3 billion, down $20 million from last year. They declined to 39.4% of sales from 39.9% last year. It has achieved its $150 million SG&A target, and its $50 million reinvestment of those savings into wages has reduced district manager turnover in half. Hopefully over time, lower turnover should improve store experiences and sale performance.
Still given weaker gross margins, operating margins declined to 2.5% from 2.9%, and operating income fell by 12% to $86 million.
Overall, sales activity is subdued, but cost control efforts are working. We also are seeing improved cash flow. It generated $2.7 million of operating cash flow, which was a marked improvement from a $383 million usage last year. Last year accounts payable were a $424 million drag and inventories built by $104 million. By comparison, this year inventories fell by $20 million and payable fell by $147 million. Payables were being crunched last year ahead of an S&P credit ratings downgrade, but it appears most of this pressure is now in results. Still, Q1 free cash flow is seasonally weak, and there was a $46 million outflow.
Ignoring its earnings release typo, it continues to guide to $3.75-$4.25 in EPS and same-store sales growth of 0-1%. This should result in at least $250 million of free cash flow, according to management. While full year guidance was held, its Q2 commentary was quite weak. It expects comps to be similar to Q1 as consumer spending faces continued pressure, and it described consumers as “reticent” to spend. As a consequence, margins are expected to be weaker in Q2 and then improve. Management also emphasized its turnaround “will take time.” For the company to achieve its full-year results, there will need to be a material second-half acceleration, which we are not yet seeing. Given the magnitude of missteps, investors are reluctant to put faith into this forecast when actual revenue trends are not yet improving, driving the stock’s negative reaction.
Beyond sales growth, there are many other facets of its turnaround that are in progress. Namely, it selling Worldpac, its wholesale distribution arm, and it aims to have an announcement next quarter. There are 320 locations.
The first use of any sales proceeds will be to improve its strained balance sheet. The company currently has 1.8 billion of debt and $2.7 billion of operating leases for $4.48 billion of adjusted debt. As a consequence, it has 3.9x debt/EBITDAR leverage, well above its 2.5x target. At its current level of earnings, it needs $1.6 billion of debt reduction. Even if it can grow earnings by 20%, it needs to reduce debt by over $1 billion, and asset sales will also reduce earnings. That is why after it sells Worldpac, it may sell its Canadian operations. On the bright side, it has no maturities until 2026, giving it time to repair its balance sheet. Even after these asset sales with just ~$170-190 million of retained cash flow after its dividend, it will likely be ~2-3 years before it can bring leverage to target. This is why management emphasized its turnaround will take time.
Elsewhere, it is implementing a new inventory management system, and it expects this process to be complete next quarter. It also aims to cut purchasing costs by $50 million via supply chain optimization. In an effort to improve productivity, it closed 17 underperforming locations. Alongside earnings, AAP announced its Chief Merchant would be retiring and be replaced by a Target (TGT) executive. This is part of turnaround-related organizational changes. Much of AAP’s troubles began with its effort to pivot towards its own brands, losing customers in the process. This pivot to a new Chief Merchant is in keeping with the new management’s effort to win back pro customers, but winning back customers and improving product is not an overnight fix.
AAP is doing the right things. It is cutting costs, simplifying its operating footprint, looking to reduce debt, and take actions to win back customers. Unfortunately, the macro environment has caused discretionary activity to weaken. This makes it harder to tell if weak sales are a sign its efforts are lacking or due to macro headwinds. I have greater confidence in its effort to control costs and improve asset productivity than in revenue growth efforts. Margins are still facing pressure, and sales growth is nonexistent with no evidence of acceleration. I see downside risk to guidance given what is likely to be a soft Q2, as there is not yet reason to believe comp sales should tick up materially in H2.
On top of this, its balance sheet repair is likely to take until 2027 to be complete, even in an optimistic case where it can sell Worldpac and Canada at reasonable valuations. This means investors will wait a long-time for capital returns beyond the company’s $0.25 quarterly dividend. Shares today have a 6.5-7.2% free cash flow yield, assuming $220-250 million in free cash flow, which I view as the central case, given the risk of sales staying lower for longer. For a company with a multiple year horizon before boosting shareholder returns and facing credibility problems, I see this as a full valuation. I still view an ~8% free cash flow yield as more appropriate to price in the risk of no growth for longer, which is ~$58/share. That points to about 8% downside. As such, even with the Wednesday drop, I remain a seller of AAP. Given the length and uncertainty of its turnaround, this stock is likely to remain dead money, and investors should look elsewhere for capital appreciation opportunities.
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