Havana Syndrome and Advance Auto Parts: $AAP

Muddling Midcaps

One of the major developments taking place in the world over this last decade is the advancement of Asian auto manufacturing to create incredibly efficient and inexpensive vehicles.  It would be easy to miss this trend in the US, as those vehicles are prohibited here under the guise of consumer safety, but in reality as a protection for the heavily unionized auto workers.  Would you pay $9,700 for a new BYD Seagull?

When a legacy brand is confronted with a new, lower cost, competitor, one strategy is to retreat into quality.  This is what the Swiss watchmakers did when confronted with cheap Japanese digital watches.  Every year the luxury manufacturer goes deeper and deeper into luxury, for a smaller and smaller market share.  The US auto manufacturers might be stuck in this trap, with their high costs of production, the only escape is to go further down the luxury path, supported by regulators who will do almost anything to protect the union. 

Even though the cheap Asian cars are not allowed in the US, they are being purchased in South Asia, South America, and Africa, which were once robust markets for used American cars.  The decline in demand for used American cars overseas, as well as the constant march up the luxury spectrum, has contributed to a rapidly aging US car fleet, with the average passenger car now at 14 years old.  

The US has 288.5 million cars that in 2023 drove 3.19 trillion miles, still below the pre-covid peak, but rising again.  The result of cheap Asian vehicles and expensive American vehicles is likely to be a US auto fleet that is reminiscent of Cuba under trade embargoes.  With consumers repairing cars for longer and longer, there should be an incredible tailwind for auto parts.

There are three major auto parts stores in the US, all publicly traded, O’Reilly (ORLY), AutoZone (AZO), and Advance Auto Parts (AAP).  For my international readers, those three stores are almost always located near each other, economics nerds call this a Marshallian industrial district after Alfred Marshall or an agglomeration economy, and for the most part, consumers find the three chains interchangeable, and will shop around if one doesn’t have the part they need.

ORLY has a market capitalization of $63.4 billion on $16 billion of trailing 12 month revenue from 6,000 stores.

AZO has a market capitalization of $51.7 billion on $17.95 billion of trailing 12 month revenue from 6,500 stores.

AAP has a market capitalization of $3.5 billion on $11.2 billion of trailing 12 month revenue from 4,700 stores.

In the immortal words of Sesame Street, one of these things is not like the others. 

Advance Auto Parts has been riding the struggle bus, and has hired a new CEO, Shane O’Kelly to manage the turnaround.  My best understanding of the reason why AAP is struggling so badly was purely a logistics and inventory management problem.  The new CEO is the former head of Home Depot Logistics, so if my understanding of AAP’s problems is correct, it is very likely that Shane O’Kelly is the right man for the job. 

AAP is currently executing a five point strategy for their turnaround.  The first step is to execute a sale of two business divisions, Worldpac, a wholesale distributor, and potentially the Canadian subsidiary Carquest.  Since we don’t have segmented accounting, I don’t know what portion of AAP’s revenues these subsidiaries are.  Also, AAP is in no liquidity or solvency crunch, they have over $6.3 billion in current assets to match against $5.3 billion in current liabilities.  AAP has $2.5 billion in shareholder equity, compared to ORLY with negative -$1.7 billion and AZO with negative -$4.3 billion in shareholder equity.  The new CEO wants to streamline operations, and as I am a strong believer in diseconomies of scope, I wholeheartedly approve of the asset sales.  The sale of Worldpac is predicted to close and be announced on the upcoming Q2 earnings call.

The second step is reducing costs, with most savings expected to come for full year 2025, but already Q1 2024 has $21 million less in SG&A than Q1 2023, and that is with inflationary pressures.  The goal is to lower costs by $150 million annually, but then to spend $50 million on employee retention efforts.

The third step is organizational changes, AAP just hired a new chief merchant to help with merchandizing, Bruce Starnes, formerly of Target.

The fourth step is improving productivity, AAP closed their worst performing 17 stores out of 4,700 last quarter, but they did open 7 new stores as well.  AAP also implemented a new inventory management system, and is currently loading their 130,000 SKUs on it.  The full rollout of this new system should be finished by this upcoming earnings call.

The fifth step and the largest of the five is a total supply chain restructuring.  AAP is planning on having four layers of distribution network where they used to have only three.  There will be 14 major distribution centers, there are currently 13 and the 14th will be a greenfield build.  The average size is about 550,000 sqft.  The second layer of the distribution system is the new layer, and that is the market hub node, with about 80,000 SKUs, and AAP expects to have 20 finished by the end of 2024 and 60 by the end of 2026 mostly from conversion and not from greenfield construction.  The third layer is the 300 existing transfer centers which have about 35,000 SKUs.  And the fourth layer is the traditional store with about 23,000 SKUs.  

As a generalist, I am not a supply chain management expert.  What I know is that the consensus is that AAP’s only problem is logistics, and they hired the head of Home Depot Logistics to solve their problem.  The solution he is providing sounds plausible, but it will likely take a couple of years to have full effect.  Management is guiding toward Q2 having difficult comps for next quarter, but there should be improvements after that.

Given the massive difference in valuations between the three auto parts chains, I was expecting AAP to be in a much worse situation, perhaps I have been sifting through the dregs of small caps for too long, but for a company to have maintained profitability even during the covid period, the selloff seems overdone. I believe the culture of the market has changed since the strategy of Tiger Global has proliferated. Under Tiger Global’s strategy, upon any negative surprise, the entire position is liquidated and the investment is reanalyzed from first principles to see if it should be reentered. This creates a game theory outcome where all portfolio managers have to follow suit, or their quarterly results will be trashed. Upon any negative news or uncertainty, everyone smashes the sell button as fast as they can to not be last one holding the bag.  This creates enormous opportunities for value investors, but we should know that at any time, our positions can get cut by 80% without much warning, and when the uncertainty is removed, they bounce back almost as quickly. So as Frank Knight claimed in “Risk, Uncertainty, and Profit,” the ultimate source of profits to the businessman are due to the uncertainties in the market, not the calculable risks.

ORLY has a $61 billion market cap with a little under $2 billion of free cash flow in the last 12 months, about a 30x free cash flow multiple.  AZO has a $51 billion market cap and still a little under $2 billion of free cash flow, about a 25x free cash flow multiple.  AAP has a market cap of $3.5 billion and $470 million of free cash flow, about a 7.5x free cash flow multiple.  Efficiency gains could bring AAP’s free cash flow in line with peers at between $1 billion to $1.4 billion annually.

If I were a quality investor, I would go for ORLY, they have compounded at 20.9% since 1993.  They put their free cash flow entirely into share buybacks.  Similarly AZO has compounded at 19.5% since 1991, and for the same reasons.  A value investor buying AAP is relying on the execution of the new CEO’s turnaround strategy and a reversion to the mean. If successful, and if AAP achieves half of ORLY’s multiple, the stock price would have to go from $60 to $360, or a 6x.  If that process takes three years, the rate of return would be an annualized 81%, not including any return of capital to shareholders during those years.