Advance Auto Parts (AAP) surprised the market by reporting better than expected results. The earnings beat was driven by strong comparable sales growth of 7.6% while analysts were only expecting comparable sales growth of 2.6% for the quarter ended.
While shelter-in-place restrictions did affect AAP on the professional side of the business, the company saw its retail brick-and-mortar stores benefit from the pandemic. External factors that provided a tailwind to AAP’s second-quarter results can be pinpointed to stimulus checks, extended unemployment benefits, and to a lesser degree, time spent at home. We believe the combination of both three factors played an important role to spark discretionary spending. For example, a big category driver of sales growth was “maintenance and appearance”, which includes car waxes and wash products. Also, the fact that people had more time on their hands and fewer options to spend their money (restaurants, travel, and entertainment) fueled their interest to work on home projects. With stimulus checks expired, the good news is that management still sees strong momentum in the business, with the first 5 weeks of Q3 showing strong sales.
From a valuation point of view, analysts are currently expecting EPS of $8.99 and sales of $10B by 2021. At a recent price of $156, AAP is trading at a forward earnings multiple of 17x, which, compared to the 5-year average PE multiple of 23x, looks a bit pessimistic. If we apply the average earnings multiple to expected EPS of $8.99, we get a fair value estimate of $206 for AAP for a potential upside of 32%. Reasons for the market to re-rate AAP higher include implementing their Warehouse Management System, thus driving better efficiencies; brand expansion; a new pricing platform; and the restart of their buyback program. These initiatives (which would improve margins) and the use of their share repurchase program could accelerate EPS growth in the coming quarters.
Strong DIY results offset by a weak DIFM market, as professional service centers closed their doors
AAP reported second-quarter results a weak ago. Sales for the quarter came in at $2.5B, up 7.3% on a year-over-year basis, and beating the consensus estimate by $130M. The company also reported a non-GAAP EPS of $2.92, beating the analyst expectations by $0.95. Strong sales performance also resulted in gross margins of 43.9%, up 60 basis points from the prior-year period, and operating margins of 11.2%, compared to 8.4% a year ago.
The highlight of the quarter was the strong comparable sale growth of 7.5%, the highest quarterly growth rate in the last 10 years. As previously mentioned, the strong performance was related to external factors, such as stimulus payments and unemployment benefits. However, also contributing to the strong growth was the focus of large box retailers prioritizing the stock up of consumer staples like food and beverage while putting aside auto parts in their inventories, opening up a door to retailers like AAP. To take advantage of the strong demand, the company shifted its marketing strategy from “brand awareness” to the emphasis on “same-day delivery” and “same-day store pickup”. The company also started rolling out DieHard batteries nationwide in July, which are sold exclusively in AAP stores. AAP bought DieHard for $200M at the end of 2019. While results from DieHard batteries were meaningless for the quarter (as it recently launched), management feels it’s going to be a big differentiator moving forward:
“While it’s too early to quantify the impact of DieHard, we believe this iconic brand will be a long-term differentiator for us. We can see the share numbers. We like the share numbers a lot in batteries. And we’re optimistic that DieHard is going to sustain that momentum. We are very bullish on our ability to drive market share gains in batteries in the back half of the year.” – Q2 call
The company also saw strong performance in its online sales channel and the continued momentum in its SPEED Perks loyalty program. The number of active members grew to 13.5M, an increase of 30% year over year. Management also saw more members graduating to higher tiers within their program, increasing by 24% during the quarter. The benefits members get is as follows:
Increasing the number of loyalty members is an important strategy moving forward, as it shows management they are gaining wallet share:
“We indicated that the number of people year-on-year was up 30%. We also know that we’re graduating people that were in SPEED Perks to the higher tiers. We had a 24% increase in graduation rates in the quarter. So somebody who is a club member is now a VIP or an elite. So that tells us that, that person is increasing their wallet with Advance, which is very, very important in this time frame.” – Q2 call
Also, there are side benefits to running a loyalty program such as the ability to obtain first-party data and use that data to personalize product offerings. This is something we believe would put AAP in a level playing field with online auto part retailers while offering additional perks such as in-store pickup.
While AAP’s DIY sales channel benefitted from the pandemic, its Professional business (do-it-for-me or DIFM) didn’t enjoy the same benefits. COVID-19 negatively impacted this segment due to the temporary closure of service centers across the U.S. There was also a slight lag in growth sales as economies reopened in regions most impacted by COVID, such as in the Northeast, Mid-Atlantic, and the West Coast. These regions represent over 30% of sales in the Professional segment. However, in the final 4 weeks of Q2, Pro sales were up mid-single digits.
AAP moving forward
Besides the strong growth in comp sales, there were few highlights worth mentioning from their second-quarter conference call.
We believe one of the most important highlights was the increase in market share during the quarter. It is important to understand that the auto parts industry is very fragmented, with the big 4 players accounting for $40B in sales on a $150B market. So, AAP’s market expansion came from taking share away from smaller competitors:
“We absolutely gained share in the quarter. We can see from the syndicated data that inside of DIY, we gained share. We’ve got capabilities that smaller players just don’t have: A great online portal, omnichannel capability. We can turn on a dime and do curbside delivery or contact-free delivery. Our supply chains are robust. So we’re confident that we gained share in the quarter.” – Q2 call
Another highlight was restarting the implementation of their warehouse management system, which was put on hold due to COVID-19. The objective of such a program is to standardize their distribution centers, allowing for the cross-banner replenishment of inventory across AAP’s retail and professional segments which in turn should drive better efficiencies. The completion of the warehouse management system is scheduled for late 2021, with the vast majority of the planned savings for 2022. The company is also executing on their SG&A agenda by consolidating 4 ERPs into 1 platform.
Finally, while it is almost impossible to determine the long-term impacts of COVID on the economy and consumer behavior, a weak economic environment benefits companies like AAP, which we believe is a counter-cyclical business. A weak economy affects new car sales, increasing the number of old vehicles on the road and the probabilities of higher maintenance and the need for auto parts. While not 100% correlated, passenger car sales in the European Union are forecasted to drop by 25% according to the European Automobile Manufacturers’ Association. Regardless, the trend in new car sales doesn’t look bright at the moment.
The Bottom Line
The company ended its second quarter on a strong foot. Compared to its previous year, the company generated $380M in FCF, an increase of 60% compared to $237M in Q2 of 2019.
From a capital allocation perspective, AAP repaid the $500M previously borrowed under its revolving credit facility and is planning to redeem its 4.5% $300M notes due in 2022. The repayment of such debt would put them at a pre-pandemic leverage ratio.
Their strong liquidity has also allowed them to keep their dividend payments, which currently yields 0.64%. The company also lifted the suspension of its share buyback program, which we see as a sign of business stabilizing and confidence by management.
With analysts expecting EPS of $8.99 in 2021, AAP is trading at a forward earnings multiple of 17x based on a price per share of $156. Applying AAP’s five-year PE multiple of 23x, we get a fair value estimate of $206. We are bullish on AAP.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.