Advance Auto Parts represents one of the most compelling deep-value stocks in the market. But a deep-value company is rarely one firing on all cylinders, and Advance Auto Parts has challenges ahead, as its management seeks to close the valuation gap with rivals AutoZone and O'Reilly Automotive . Let's take a closer look at the value proposition.
In a nutshell, the case for buying Advance Auto Parts rests on the idea that it can improve its operational metrics to the levels O'Reilly and AutoZone have achieved.
Sales in the auto-parts market are split into two areas: do-it-yourself (DIY), and do-it-for-me (DIFM). The latter represents the commercial market, which tends to be lower-margin but looks set for higher growth -- Advance Auto Parts' management has estimated DIFM growth at three times DIY.
Of course, it's not a pure comparison, because AutoZone has around 18% of its sales going to the DIFM market, while O'Reilly has around 42% and Advance has around 54%. Given that Advance has the highest percentage of DIFM, why is it trading at a discount to the other two stocks?
The answer is twofold. First, Advance's operational metrics are simply not up to AutoZone's or O'Reilly's. For example, here's the EBITDA margin:
And here is free cash flow-to-assets -- an indication of how well each company is generating cash out of its stores:
Second, Advance Auto Parts' integration of the 2014 acquisition of General Parts International -- owner of Carquest and Worldpac -- is not entirely going to plan. In fact, the integration demands caused comparable same-store-sales growth to slow to just 0.5% in the third quarter, and management was forced to reduce its full-year EPS guidance to a range of $7.75 to $7.90 from a previous range of $8.10 to $8.30. Indeed, this is the second time this year that guidance was cut because of the complexity of the integration. For reference, Advance started the year predicting EPS of $8.35 to $8.50.
The disappointing third-quarter results caused a mid-teens decline in the stock price and came accompanied by the news that eight-year CEO Darren Jackson will retire in January. Moreover, the company also announced that CEO Jeffrey Smith of Starboard -- a deep-value investment firm holding around 4% of Advance -- was appointed to the Advance board with immediate effect. In addition, Starboard is to designate two more independent directors.
Starboard has a plan to release value in the stock. Key highlights:
- Starboard believes Advance Auto Parts stock could be worth $350, compared with $164 as of this writing.
- The company is well positioned in a growth market with noncyclical properties and favorable industry dynamics.
- Advance's management is aiming for an EBIT margin by 2017 of 12% (equivalent to an EBITDA margin of around 15%), but Starboard believes an EBITDA margin of around 20% (see the first chart) is achievable.
Starboard's plan involves a combination of implementing a distribution model similar to O'Reilly's -- which requires distribution centers to supply stores with stock -- implementing working capital improvements, and unlocking value at Worldpac -- a distributor of parts for high-end import cars acquired as part of Carquest.
In short, Starboard's proposals, if successful, will release even more embedded value in the stock than Advance's management originally planned when it bought Carquest.
Is it a buy?
The long-term case here is compelling. O'Reilly's comparable-same-store sales rose 7.9% in its third quarter, while AutoZone's increased 4.5% -- there is nothing wrong with the auto parts market. It's also an indication that Advance's problems are largely limited to the integration. Meanwhile, the operational metrics at AutoZone and O'Reilly clearly set industry targets for Advance to aim for.
However, don't be surprised if there's more short-term weakness as management integrates Carquest. Moreover, the complexity of the integration suggests a risk that the initial targets may need to be realigned -- something the market would not like initially. On balance, Advance is an attractive stock for value investors, but be mindful of near-term risk.
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The article Is Advance Auto Parts the Value Pick in Its Sector? originally appeared on Fool.com.
Lee Samaha has no position in any stocks mentioned. The Motley Fool owns shares of O'Reilly Automotive. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .
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