Advance Auto Parts Crushed On Outlook (NYSE:AAP)

We have traded Advance Auto Parts (NYSE:AAP) several times over the last few years. The company saw business pop during the COVID-19 pandemic and boom through 2021. Fast forward to November 2022 and we are seeing rampant inflation, a weakening consumer, questionable demand trends, supply chain issues, and stiff competition. Auto part suppliers should tend to do better in a tough economy as consumers fight to keep cars on the road longer. With higher interest rates, financing a new auto loan is expensive. The economy is still on relatively solid footing, but the price of fuel crushing the average family, not to mention the price of cars still being very elevated right now, people are still very likely to keep cars on the road longer, and that benefits Advance Auto Parts and its competitors.

This means consumers are likely to have high demand for parts and self-car care supplies in the coming quarters. However, the company’s results that it just reported were mixed and the outlook was poor. The stock is getting crushed here, to levels which are interesting in our opinion and we think this stock needs to be on your list for a possible trade. Let’s take a look at some of the key metrics of the company and where we see things going, as well as a trade.

A competitive sector

So there are still labor shortages, some supply chain issues, and painful inflation that is weighing on customers. But one of the largest issues is that there is severe competition with many choices for consumers’ auto parts needs out there. We have long held AutoZone (AZO) and also have a house position in O’Reilly Automotive (ORLY) following a very successful trade we made. We have traded AAP, along with a few others in the space, and think it should be on your list for reentry if the stock falls below the $140 level. Despite the large amount of competition, Advance has still grown successfully over the years and is a real competitor with the wide range of auto part suppliers in the country. Let us look into the trends here.

Advance Auto Parts’ Q3 Sales

The company just put out its Q3 report, and it was another quarter of gains and growth for the company, but far less than usual. Net sales in Q3 were $2.64 billion, a 0.77% increase from last year. However, one of the most critical indicators that we watch for retailers like this are comparable store sales. These had been rising nicely the last few years, but due to company branded items driving more sales volume but at lower price points, comparable sales were down 0.7%. We do not like seeing comp sales fall. The stock deserves to fall on that data point alone. These weak comps led to revenues coming in a touch below consensus expectations overall. Margins however remained strong and preserved Advance Auto Parts’ profit power.

Profit power of Advance Auto Parts’ in Q3

So we saw revenues increase marginally, but the margins on the revenues, which were always strong, saw continued strength from last year. Adjusted gross profit margin in Q3 was 47.2% of net sales, a 98 basis point improvement, which was driven by improvements in pricing actions overall and inventory advantages, as well as store branded sales volume. This expansion in profit margin was solid news. However, other expenses weighed and operating margin actually dipped, which was a negative. Adjusted SG&A was 37.5% of net sales, which was a 170 point increase from last year. There were once again much higher wages as well as higher delivery costs that weighed.

Taken together, we see that adjusted operating income was $258.0 million, a decrease of 5.8% vs. the prior year. Adjusted operating income margin as such fell to 9.8%, a decrease of 60 basis points compared to the prior year. Thus, there was mixed results on margins here, with gross margin expanding but operating margin falling. So overall profit power did fall due to the overall margin.

So operating income fell, but what about the actual final earnings? Often the two are so very linked as we know. But other items like currency issues and taxes weigh too. Earnings fell from last year. That is just painful. On a GAAP basis, EPS was $1.84, dropping a crazy 31.3% from $2.68 last year. Making customary adjustments, EPS was $2.84 which was still an 11.5% drop from $3.21 a year ago. EPS was negatively affected by approximately $0.20 as a result of foreign currency impact in the quarter due to the strong dollar.

Valuation

Shares are also expensive for, and considering the lackluster growth at $155 a share at the time of this writing, we think you need to let the stock fall even further. We suggest the $130s would be attractive enough to compensate for the stalled growth. The FWD P/E is still nearly 15X, but there is no growth. We like it lower however when we consider the shareholder-friendly nature of the company.

Forward look

Things are not looking great. We used to be very bullish because cash flow was always strong. Now it has been crushed. Free cash flow year-to-date is just $149.5 million, falling dramatically from $734.0 million last year. We see how the company is performing, sales are holding up a bit, but profit is falling. But what can we expect going forward? Well, the company did reiterate its prior guidance which was actually positive, but lowered its EPS guidance and that is why shares are getting crushed.

Management restated its revenue target of $11.0 billion to $11.2 billion on comps of -1.0% to flat. Not great. With operating margins of at most 10%, the company sees adjusted EPS of $12.6 to $12.80, a huge reduction in guidance from the $12.75 to $13.25 previously guided. The stock needs to come down.

Shareholder friendly

Despite the negativity that was this quarter and the poor EPS outlook, another 15-20% lower from here we would be bullish. A bad market week could easily take us there. We do like the dividend and the buybacks here. The company pays a $6.00 dividend annually. This brings the yield to about 3.9%. With a further pullback this will be an accidental high-yielder. We would like to see a 4.3% yield here as buyers. This would be coupled with management buying back shares to help the EPS power. During Q3, management repurchased 0.4 million shares of its common stock at an aggregate cost of $75 million, or an average price of $168.93 per share, in connection with its share repurchase program. The company still has about $1.0 billion remaining on the repurchase authorization.

Final thoughts

The quarter was mixed, no doubt. The stock is getting crushed on its EPS outlook. Let it come down 15 to 20 points then consider buying. We have some big share repurchases on tap and at our preferred entry there would be a 4.3% yield. We prefer competitors, but this is where we would be buyers.