Shares of Advance Auto Parts, Inc. (NYSE:AAP) have been decimated in recent trading action, warranting a long-overdue update on AAP shares after I concluded in 2017 that shares were falling apart, down 50% at the time. Right now, we find ourselves in a similar situation, perhaps worse, as I fail to become attracted to AAP shares despite the pullback.
A Recap
While it is six years ago, I find it very useful to see how a thesis, company and industry performance has evolved over time. The company operates in a competitive but large auto parts business, back in 2016 measuring more than $130 billion. Operating in a fragmented but steadily growing industry, the opportunity looked interesting, also given the industry fragmentation.
That said, continued focus on e-commerce, more technological advanced cars and electrification, means that companies like Advance Auto Parts had to adjust their business models as well, as the company looked slow in doing so. In fact, many of its peers have seen better operational performance.
Back in 2017, Advance Auto Parts posted sales of $9.6 billion based on the 2016 numbers, actually down slightly from 2015. The company posted operating margins of 9.4%, coming down from low double-digit margin percentages, with earnings seen close to $6 per share for 2017. Adjusted EBITDAR came in at $1.5 billion, for a near 3 times leverage ratio, although that straight line net debt was just about a billion, with much of the leverage ratio being due to rental commitments being added to adjusted debt.
Fearing that the business was slow to adjust, and competitive pressures would remain, I failed to see great appeal at $85, even as shares were down 55% from a high around $200 per share in 2015 already.
That cautious strategy has not paid off as the cautious stance made that I missed out on a huge rally with shares doubling to $170 in 2018, and with exception to a brief move to double-digit territory amidst the Covid-19 outbreak. Ever since, shares have seen a huge rally to $240 in 2021, but now trade at a mere $69, the lowest levels in about a decade.
What Happened?
Forwarding from 2017 to today, we have seen a struggling business. The company has posted sales close to the $10 billion mark for years, reported at $11.2 billion in 2022 with growth aided by inflationary trends of course. High single-digit operating margins have come down a bit, coming in at around 7% last year. To deliver on some earnings growth amidst rather flattish operating earnings, the company has bought back about a fifth of shares since 2017.
Zooming into the numbers reported in February, we see that Advanced Auto Parts has grown sales by just over a percent in 2022 to $11.2 billion. That was really all about the good news with full year operating earnings down from $839 million to $714 million, with net earnings down to $502 million, hurt a bit more due to higher interest expenses.
Amidst continued buybacks, the decline in earnings per share was a bit limited, with earnings down from $9.55 per share to $8.27 per share, both on a diluted basis. Net financial debt of $1.1 billion was pretty stable, as adjusted debt of $4.0 billion (including lease liabilities) resulted in reasonable leverage ratios with EBITDA reported at $1.7 billion (although it was down about a hundred million as well last year).
After a tougher year, the company guided for 2023 sales at a midpoint of $11.5 billion, operating margins around 8% and GAAP earnings between $10.20 and $11.20 per share.
With earnings power near $10 per share, valuations ran away in 2021 as a valuation at $150 at the start of 2023 looked more than fair already. By May, shares had fallen to $120 as concerns on the state of the auto market continued to increase, pressuring shares in the meantime, but the bombshell news was the release of the first quarter earnings report.
A Bombshell Report
On the final day of May, Advance Auto Parts reported a more than 1% increase in sales to $3.4 billion, in what typically is a seasonally stronger quarter. GAAP operating profits fell from $203 million to $90 million, a dismal result. Moreover, interest expenses more than doubled to $29 million, making that GAAP earnings fell from $140 million to just $42 million and change.
This is bad enough as it is, yet a reduction in the accounts payable meant that straight line net debt shot up to $1.9 billion, with adjusted net debt up to $4.6 billion (that is including lease liabilities). With EBITDAR down to $1.5 billion, leverage jumped to 3 times overnight, but EBITDAR clearly comes under pressure, likely pushing up leverage a bit more in the coming quarters.
On the back of the poor results, the company cut the full year sales guidance by a quarter of a billion to a midpoint of $11.25 billion, with the midpoint of the earnings guidance cut from $10.70 per share to $6.25 per share, indicating that pressure is set to last for the coming quarter.
Many of the issues appear self-inflicted, with the company talking about inventory availability, and at the same time the need to be competitive with prices as well, as the company cited an unfavorable product mix and some supply chains issues as reasons for the margin shortfall as well.
With the leverage ratio creeping up rapidly, the company announced a rather aggressive move, cutting the dividend from $1.50 per share to $0.25 per share. This cut is very aggressive after the company only started paying out such significant dividends from 2021 onwards.
The move is significant, as the $6 per share annual dividend sets the company back about $360 million based on the current share count, indicating that the company will preserve $300 million a year following the dividend cut.
And Now?
The reality is that Advance Auto Parts, Inc. has been posting soft operating performance for years, with sales really being down if we adjust for inflation, indicating that the company is losing market share to apparently better-run peers like AutoZone, Inc. (AZO) and O’Reilly Automotive, Inc. (ORLY), among others.
Besides the softer operational issues, there are real management and capital allocation questions to be asked. With that comment, I point towards an excessively hiked dividend in recent years, as well as share repurchases at higher levels which hurt the business here amidst the first signs of headwinds.
Amidst leverage and poor operational performance, I am extremely cautious here, although given that the valuation reset has been huge, with shares now trading in the high-sixties, down nearly three quarters from the 2021 highs.
While I am normally inclined to discount setbacks, I must say that the degree of the shortfall and real questions on both the operational performance of the Advance Auto Parts, Inc. business and the capital allocation moves is shocking, meaning that I am not willing to commit to AAP shares here.
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