Morningstar Description: Advanced Auto Parts is one of the industry’s largest auto-parts retailers, operating more than 4,000 stores in the East and Midwest regions of the United States. The company generates a 40/60 do-it-for-me/do-it-yourself sales mix, but Advance’s proposed acquisition of the DIFM-focused General Parts will add another 1,246 Carquest company-operated stores, 1,418 independent Carquest locations, and 102 Worldpac branches to its store portfolio, shifting the mix to 55-45. The acquisition will also expand Advance’s geographic exposure to the West Coast.
Reuters Description: Advance Auto Parts, Inc. (Advance), incorporated on August 1, 2001, is a specialty retailer of automotive aftermarket parts, accessories, batteries and maintenance items primarily operating within the United States. The Company operates in two segments: Advance Auto Parts (NYSE:AAP), and Autopart International (AI). The AAP segment is comprised of its store operations, which operate under the trade names Advance Auto Parts and Advance Discount Auto Parts.The AI segment consists of the operations of Autopart International, Inc. which operates under the Autopart International trade name. The Company’s stores carry a product line for cars, vans, sport utility vehicles and light trucks.The Company serves both do-it-yourself (DIY), and do-it-for-me (Commercial), customers. Its Commercial customers consist primarily of delivery customers for whom the Company delivers product from its store locations to it Commercial customers’ places of business, including independent garages, service stations and auto dealers. On December 31, 2012, the Company acquired B.W.P. Distributors, Inc.
2.Detailed Segment Information from Reuters:
As of December 29, 2012, the Company operated 3,576 AAP stores throughout 39 states in the Northeastern, Mid-Atlantic, Southeastern and Midwestern (inclusive of South Central) regions of the United States, Puerto Rico and the Virgin Islands. These stores operated under the Advance Auto Parts trade name except for certain stores in the state of Florida, which operated under the Advance Discount Auto Parts trade name. These stores offer a selection of brand name and private label automotive replacement parts, accessories, batteries and maintenance items for domestic and imported cars and light trucks. Through its integrated operating approach, it serves its DIY and Commercial customers from its store locations and online at www.AdvanceAutoParts.com. Its online Website allows its DIY customers to pick up merchandise from a store or have their purchases shipped directly to their home or business. Its Commercial customers can conveniently place their orders online.
The average size of its stores is 7,300 square feet with the size of its stores ranging from approximately 6,000 to 8,000 square feet. Its stores carry a product offering of approximately 19,000 stock keeping units (SKUs), generally consisting of a custom mix of product based on the stores' respective market. Its stores also have access to an additional assortment of 115,000 SKUs for same-day or next-day delivery from one of its 339 HUB stores or its network of 22 Parts Delivered Quickly (PDQ), facilities. Additionally, its customers have access to over 483,000 SKUs by ordering directly from one of its vendors for delivery to a particular store or other destination as chosen by the customer.
The primary categories of product the Company offers in its stores include parts, accessories, chemicals, oil and other miscellaneous offerings. Parts include alternators, batteries, belts and hoses, chassis parts, clutches, engines and engine parts, ignition, lighting, radiators, starters, spark plugs and wires, transmissions and water pumps. Accessories include floor mats, mirrors, vent shades, MP3 and cell phone accessories, and seat and steering wheel covers. Chemicals include antifreeze, brake and power steering fluid, freon, fuel additives, windshield washer fluid and car washes and waxes. Oil includes transmission fluid and other automotive petroleum products. During the fiscal year ended December 29, 2012 (fiscal 2012), the Company’s Commercial sales consisted of sales to both its walk-in and delivery customers, which represented approximately 35% of its AAP sales.
AI's business serves the Commercial market, with an emphasis on parts for imported cars, from its store locations located primarily throughout the Northeastern and Mid-Atlantic regions of the United States and Florida. In addition, its North American Sales Division serves warehouse distributors and jobbers throughout North America. The AI stores offer approximately 30,000 SKUs through routine replenishment from its supply chain with access to an additional 100,000 to 120,000 SKUs through local sourcing networks. As of December 29, 2012, it operated 218 stores under the Autopart International trade name.
Similar to other aftermarket auto parts retailers, Advanced Auto Parts’ business model is characterized by high profit margin (~50%), high SG&A cost (~40%) most of which are arguably fixed in nature such as salaries and expenses, low single digit net margin and low inventory turnovers (~1.5 times). Also noteworthy is that as depreciation expense, a large non-cash expense, is added back to operating cash flows whereas capital expenditures are included in investing cash flows, Advanced Auto Part’s operating cash flow has historically been higher than operating income.
4.History of Business
In 1932 Arthur Taubman, the son of Austro-Hungarian immigrants, purchased from Pep Boys, the Advance Stores, with two stores in Roanoke, Virginia and one in Lynchburg, Virginia. The Advance Stores followed a four-point philosophy in the early years: provide value to customers; earn a reputation for honesty and integrity; ensure repeat business by providing quality merchandise and good customer service; and treat employees like family.
Advance Store grew during the 1930s due to a variety of social-economic factors. Advance Stores Company expands into Winston-Salem, North Carolina, signaling the beginning of the company's multi-state growth and it began carrying toys for the holiday season, often offering a town's largest selection.
As a result of World War II, Advance Store was forced to begin to stock a wide variety of housewares and appliances. Advanced stores continued to add to its mix of products in the following decades of the World War II until Arthur Taubman’s son, Nicholas Taubman took the reign. Nicholas Taubman was determined to transform the business because he couldn’t see the businesses’ niche. He eliminated items that did not sell well and tried to find the niche. In 1978, Advance Store changed its name to Advanced Auto and started to focus on aftermarket auto parts. To better service the customers, Advanced Auto introduced the Parts Delivered Quickly system. In 1985, Advanced Auto changed its name again to Advanced Auto Parts and in the same year, Advanced Auto Parts reached 100 stores. . Nick Taubman steps into the role of Chairman of the Board and CEO of Advance. Garnett Smith is named President and COO. Arthur Taubman becomes Vice Chairman of the Board.
AAP then entered into a rapid growth period. By the end of 1996, the chain has owned almost 700 stores with revenue close to $1 billion. In April of 1998, the Taubman family sells a majority interest in the company to the investment firm, Freeman Spogli & Co. In August of 1998, Advance Auto Parts buys Western Auto Supply Company/Parts America, which doubles the company's size almost overnight.
In 2001, Advance Auto Parts acquires Carport Auto Parts, a regional retail chain with 29 stores in Alabama and Mississippi. The combination of Advance and Carport locations establishes Advance Auto Parts as the market leader in Alabama and Mississippi. In November of 2011, Advance acquires 671 Discount Auto Parts, Inc., a regional auto parts chain in Florida, Alabama, Georgia, South Carolina, and Louisiana. The acquisition strengthens the company's position as the market leader in Florida. Upon completion of this merger, Advance Auto Parts becomes a publicly traded company, listed as a common stock on the New York Stock Exchange under the symbol AAP. After the Company went public in 2001, AAP continued to expand both organically and through acquisition. On October 16th 2013, Advance Auto Parts entered into a definitive agreement to acquire General Parts International, Inc. (GPI), a leading privately held distributor and supplier of original equipment and aftermarket replacement products for commercial markets operating under the CARQUEST and WORLDPAC brands, in an all-cash transaction with an enterprise value of $2.04 billion. The transaction has been approved by the boards of directors for both companies. The deal creates the largest automotive aftermarket parts provider in North America, with annual sales of more than $9.2 billion and more than 70,000 employees.
5. Competitive Advantages:
Advanced Auto Parts is one of the largest players in the aftermarket auto parts retail industry. AAP has competitive advantages in customer service, marketing, inventory selection, purchasing and distribution as compared to independent retailers and jobbers that are not part of a chain or associated with other retailers or jobbers. It offers one of the largest selections of brand name and proprietary automotive parts, accessories and maintenance items in the automotive aftermarket industry.
Advanced Auto Parts has also built up a solid brand name since it was founded by Arthur Taubman in 1932. The brand name is especially strong in Southern states such as Florida, Georgia, North Carolina and Alabama.
Furthermore, AAP’s business model has also enabled it to generate decent free cash flows every year. Since AAP became a public company in 2011, the Company has generated roughly $3.5 billion free cash flows on aggregate as of 09/30/2013. Of this $3.5 billion, about $165 million was paid out as dividends and more than $2 billion was used for share repurchases. Diluted shares outstanding decreased from $109 million to $73.1 million from 2012 to the latest quarter.
According to the Company’s most recent 10K, Advanced Auto Part’s competitors include national and regional retail chains of automotive parts stores, such as AutoZone, Inc., O’Reilly Automotive, Inc. and The Pep Boys–Manny, Moe & Jack, wholesalers or jobber stores, including those associated with national parts distributors or associations, such as NAPA, independent operators, automobile dealers that supply parts, discount stores and mass merchandisers that carry automotive products, including Wal-Mart, Target and K-Mart.
7. Important Operating Metrics
· Number of Stores
· Sales Per Store
· Operating Income Per Store
· Return on Invested Capital (defined as net operating profit after taxes divided by average invested capital. Invested capital consists of total assets and liabilities, excluding cash and debt, and estimated capital lease obligation calculated as annualized rent expense for the applicable year times 6 years.)
· Earnings per Diluted Share
· Same Store Sales
Below are charts from AAP’s 2012 10K for the 5 year history of the above Operating Metrics excluding Same Store Sales
Below is the quarterly same store sales chart from Baird Research, the full research report can be found at http://www.rwbaird.com/bolimages/Media/PDF/Research/AAP-model.pdf.
8.Profitability and Financial Strength (data from S&P Capital IQ):
Advanced Auto Parts has a high gross margin, generates high return on assets and return on equity. The net income margin is low as the business requires a substantial SG&A expenses such as rent, salary, shipping. The liquidity and solvency ratios show good financial health with total debt only 29% of total capital and current ratio over 1. In order to gain a better understanding of the financial numbers, I conducted a DuPont analysis for Advanced Auto Stores. For those who are not familiar with the DuPont Analysis, essentially the DuPont analysis dissects the ROE into 3 parts:
Operating efficiency measured by profit margin
Asset use efficiency measured by total asset turnover
Financial leverage measured by the equity multiplier
ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)
The following table represents AAP’s historical ROE and the components:
From the above table, we can tell that AAP’s ROE has been rising mainly due to an increase in the net profit margin. This is a positive sign for the company. However, leverage ratio has been rising in the past 10 years as well, which means the Company has been taking on more debts and leverage. The Asset Turnover has been consistent around 1.7 times prior to 2012 and decreased to 1.3 times in 2012. The combination of higher leverage and lower asset turnover can be worrisome. Ideally, we would like to see Advanced Auto Store to maintain a high ROE ratio by improving margins and asset turnover.
9. Management and Board:
Darren Jackson took over as CEO of Advanced Auto Parts in 2009. He had previously served as the company's president (since 2008) and director (since 2004). Before he joined Advanced Auto Parts, he held positions as CFO and Executive Vice President of Customer Operating Groups at Best Buy. Prior to joining Best Buy, he served as VP and CFO for Nordstrom. Jackson started his career at KPMG.
In my opinion, Mr. Jackson’s background as financial professionals and financial executives prior to taking the CEO reign at Advanced Auto Parts is less than ideal. Although he has extensive experiences in retail, he was not in the specialty auto parts industry prior to Advanced Auto Parts. This is very different from previous leaders such as Arthur and Nick Taubman, Garnett Smith, who devoted their entire careers to Advanced Auto Parts.
Also interesting is that both President George Sherman and CFO Michael Norona also held senior positions at Best Buy prior to joining Advanced Auto Parts and also had limited experiences in specialty auto parts industry before they came on board with AAP. In comparison, most senior executives from AutoZone and O'Reilly's have served at their respective companies for over a decade.
The Board of Directors has 10 members and 8 of them are independent. Chairman of the Board, John Brouillard has been a member of the Board since 2004 and served as Interim President and CEO of the Company from May 2007 to January 2008. He also had a background as accounting and finance executives before joining Advanced Auto Parts.
10. Employee Satisfaction:
Employees are not very satisfied with CEO Jackson as indicated by a 47% CEO approval rate on glassdoor.com, compared to 72% for O’Reilly’s CEO and 51% for AutoZone’s CEO. Below are review highlights from glassdoor.
The above reviews indicate that one of the founding philosophies established by Arthur Taubman may have been violated by the current management – treating employees like family. However, it looks like employee reviews for Advanced Auto Parts’ competitors such as AutoZone and O’Reilly’s Auto Parts are not that great either. It may be the nature of the work that makes employees dissatisfied. Although customers are more likely to base their auto parts purchase decisions on price, location and convenience, eventually unhappy employees are unlikely to provide high quality customer services, which will ultimately reflect in business performance.
11. Bull Arguments:
· Average age of passenger cars and light trucks has been rising. This rise means more maintenance needs in the upcoming years. However, as newer models are to be more durable than the older ones, the average light vehicles age has a upward bias naturally. Below is a table that shows the average age of light vehicles according to Polk, a global auto intelligence firm.
· Store Growth Momentum: The Company is planning to keep the growth momentum through a combination of new store opens and acquisition.
· Management states that the GPI acquisition should result in significant synergies, estimated around $160 million per year within three years after closing and earning per share should see accretion of more than 20% not including amortization and one-off costs.
12. Bear Arguments:
· Integration and execution risk of the GPI acquisition is high given the differences in the two businesses, particularly in mix and operating structure. – Morgan Stanley Research Report.
· Within 5 miles, CarQuest (part of GPI) has a 44% overlap with AAP. The vast majority of the overlap is in the Eastern portion of the US, where AAP has most of its business. – Morgan Stanley Research Report
· Competitors are opening many of their new stores (80%, by management's estimates) in Advance's territory. O'Reilly, for instance, will accelerate its expansion in Florida, currently one of Advance's strongholds, and has reported solid comps during this process. – Morningstar Research Report
· Heightened competition from AutoZone, O’Reilly, especially in markets where Advanced is dominating such as the Southeast.
· As noted in the bear case, Integration and execution risk of the GPI acquisition is high given the differences in the two businesses, particularly in mix and operating structure.
· Rising oil prices could decrease total vehicle miles driven, which will decrease the demand for aftermarket auto parts.
· As new auto models become more and more sophisticated and durable, demand for auto parts related to the newer models and future models is likely to be in a secular decline.
· Management team includes executives holding senior financial positions before joining Advanced Auto Parts. The relative lack of operation experiences, compared to executives at competitors, poses a decent threat to business execution.
1. Using gurufocus’s 10 year financial data, I pulled the information I needed in order to perform the valuation analysis. Of all the valuation metrics, I found AAP’s price is mostly correlated with EPS, Sales Per Share and Free Cash Flow Per Share. FCF in 2004, 2005 and 2006 was distorted due to disproportionate capex relative to operating income.
2. Establishing the worst case multiples using historical low, the base case multiple using historical average excluding abnormal years, the best case multiple using historical high applying a 20% peak discount.
3. Applying the multiples to estimated forward EPS, Sales Per Share and Free Cash Flow Per Share.
4. Calculate the percentage difference from current price.
A snapshot of the worksheet is below:
At the current price, AAP does not offer sufficient margin of safety.
Disclosure : No position in AAP.