Revving up for Advance Auto Parts

AAP has massively underperformed, but is it time to catch the falling knife?

As a deep value investor, a shared badge of honor is catching falling knives, aka “cheap” stocks that continue to get cheaper.

Advance Auto Parts (AAP) is one such falling knife that has nicked many value investors during the past decade. Adding insult to injury is how well its peers Autozone (AZO) and O’Reilly’s (ORLY) have performed, with AZO up almost 5x and ORLY up more than 6x in the past 10 years!

Source: Seeking Alpha

With AAP stock taking yet another dump after a bad Q2 earnings release and guidance for rest of 2024, I have decided to take a nibble on AAP stock for the Hidden Rock Capital Model Portfolio. Given that AAP has been covered by several other value investors, I have decided to open this one for all subscribers.

So why does AAP stock look interesting at these levels? To answer this question we need to understand why AAP stock has massively underperformed. There are several factors, which I list below:

1. Lower profit margins vs. peers due to poor operational execution

2. Poor management of working capital, leading to lower free cash flow

3. Misguided acquisition of Worldpac business which never performed up to expectations and tied up working capital

4. Lower margins & cash flow from above factors leading to lower shareholder return programs (dividends, buybacks) vs. peers

The good news is that the company is positioned to reverse all of these bearish factors provided it can execute successfully.

It starts at the top, with AAP bringing in a new outsider CEO, Shane O’Kelly in August of 2023. Given the firm’s issues with operations, it is notable that O’Kelly has deep expertise in operations, distributions, and supply chain with stints as CEO for Home Depot Supply, PetroChoice, and AH Harris.

The company also recently announced the sale of its non-core Worldpac business for $1.5B from private equity firm ($1.2B after tax & fees) which should go a long way towards deleveraging the firm’s balance sheet as well as freeing up working capital.

Management is next targeting a sale of its Canadian Carquest division, and this potential future sale combined with the recent Worldpac divestiture will help management’s plans to improve operations and cut costs. Why is this the case?

Inexplicably, the main AAP retail business, Carquest, and Worldpac were running on 3 different inventory systems, which sounds like a logistical nightmare and surely contributed to the firm’s operational challenges. Certainly, focusing on just optimizing the core AAP retail business is certainly a lot easier than trying to juggle 3 different inventory SKU systems.

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Valuation Thoughts

Currently AAP is guiding for at least $100M in free cash flow for 2024, which are I believe trough levels for the company given the turnaround efforts discussed. This free cash flow guidance also implies just a 1% free cash flow margin (relative to sales).

By contrast, competitors AutoZone and O’Reilly sport free cash flow margins in the 10-15% range. Granted, these two competitors are much better operators than AAP but AAP was generating mid single digit free cash flow margins as recently as 2021. If AAP can return to generating 5-6% free cash flow margins, which is still a long ways off from its competitors, then we could be looking at a $500-$600M annual free cash flow run rate for the company.

Apply a very conservative 10x free cash flow to this normalized forecast, and we have a stock that should be trading at $80 to $100 per share. That is mor than a double from current share prices near $40! Also keep in context that O’Reilly and AutoZone are trading for 25-30x free cash flow, so a 10x free cash flow multiple would be very conservative for AAP (and honestly may be a fair multiple given that AAP is a show me story).

Add in a dose of activist investors like Third Point and Saddle Point recently getting involved to pressure management, and we have a stock that may finally be bottoming after a brutal down cycle for investors. It is in fact a situation reminiscent of another Hidden Rock Capital pick Paypal, which suffered a 80% peak-to-trough drawdown from 2021 to 2023 before rebounding by more than 20% this past month as the company’s turnaround is starting to gather steam.

As falling knife catchers, we may be a bit earlier to the party for AAP. But once the turnaround starts gaining traction in perhaps the next 12-18 months, I expect the stock price to quickly follow, and it may be better to be slightly early than too late.