Advance Auto Parts (NYSE:AAP)

Disclaimer - I do own shares and am short puts.

The Context

I am a regular reader and appreciator of Eagle Point Capital’s post. Their recent excellent post on AAP 0.00%↑ is what led me to dig further into the company.

In complete serendipidity, Value Degen has also written about it and I figured its about time I get off my ass and just pen my thoughts.

I highly recommend you read both articles over (both are free) as I won’t be discussing too much about the business’s key drivers in detail.

I wrote before in 2021 about why I bought Autozone.

Advance Auto Parts, Inc. is an American automotive aftermarket parts provider. Unlike its peers, Autozone and ORLY, who both have compounded share prices at roughly 15-20% average over the past decades, AAP is down -66% since 2015, one year post its supposedly accretive Worldpac acquisition.

Within the aftermarket car parts business, item availability + customer service dictrates trust, traffic, and even sales.

AZO and ORLY enable customers to get needed or defective parts replaced almost immediately if not on the same day - critical to preventing car downtime for anxious car owners who depend on their vehicle for daily commute and for whom a disabled car represents a signifant financial and emotional pain.

Unlike AZO or ORLY, AAP’s Worldpac and Carquest brands seems to have only made it harder for consumers to buy from them.

1. Exhibit A

2. Exhibit B

Keen readers and thinkers can extrapolate a multitude of problems from the 2 simple reddit posts.

1. A poorly integrated digital and physical supply chain

2. Poor customer service

3. Disintegrated customer trust in parts availability leading to declining sales and profitability

In combination, it’s not hard to see why AAP is down -66%. Price does drive narrative, but AAP’s shit show could have been seen decades ago for anyone who trawls reddit.

For clarification - it’s not as if the post was “hey, AAP is shit yet I’m still buying from them.” The overriding sentiment is “AAP is shit and I’m going elsewhere with my money”.

I continue to believe that for any customer facing businesses, trawling reddit threads from users remain a viable way of discerning whether the business is going to enter the shitters or not over time.

The Turnaround Potential

Now that we know the problem, gauging the probability of a turnaround is the key question.

The primary troubling question posted by Dan from Eagle Point is if matters are simple to turnaround, why haven’t they?

My counterpoint is that the previous CEO Thomas Greco was never keen on selling.

He was asked point blank about it on an earnings call and this was his response.

Advance Auto Parts' (AAP) CEO Tom Greco on Q1 2016 Results

New CEO (Q4, 23) Shane O'Kelly seems to have no qualms about excising parts of the business that are contributory to a shitty business performance. His plan remains simplistic in its Munger-inspired business transformation.

1. Sell off Worldpac.

2. Sell off Canadian business.

3. Shutter underperforming Carquest banners.

4. Re-invest in distribution and frontline.

Worldpac was acquired for $2bn back in 2014 and I can’t imagine the combination of Worldpac + Canadian businesses to be worth less than. Assuming even a $1.5bn price tage would mean a substantial boost to $AAP’s $3.5billion market cap and $7billion enterprise value.

The streamlining of the business operations will take 3-4 years to shake out and it remains to be seen if the supply chain integrations will take place as smoothly as it needs to be done, but if AAP can even sell off Worldpac, it should unlock significant value for shareholders and enable a massive share buyback or massive deleveraging, each of which is good.

AAP 0.00%↑ has enterprise value of $7.6bn and $470 million of free cash flow, about a 16x EV/fcf multiple and a price to free cash flow multiple around 7.5x. If we expect worldpac and canadian businesses to close at $2bn for a sale, that’s a 11.9x ev/fcf. 11.9x is not a high hurdle for good returns. Both AZO and ORLY trade at 35x ev/free cash flow valuations so that’s about a triple if we assume AAP can get to equilibrium over the next 5-6 years with the more immediate catalyst being the sale of worldpac and associated canadian businesses.

Hierarchy wise, return on incremental capital invested will be greatly aided by negative cash conversion cycles (as at AZO 0.00%↑ and ORLY 0.00%↑) and inventory turnovers will be a leading indicator of that. I would assume if AAP is slowly but surely turning it around that eventually, CCC will turn negative, per store returns will go up, stepwise investments in spoke and hub models for AAP will increase and we will see the flowthrough in greater free cash flow and greater returns on capital over time.

• Holding period: 5-10 years.

• Indicators to watch: CCC, inventory turn over rates, new investments in hub and spoke model, sale of worldpac and Canadian businesses

• Potential return: 1.5x - 3x or more.

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