Morningstar Magazine - October/November 2017 - 70

Strategies

Driving Forward
Advance Auto Parts is positioned
to improve after an acquisition.

BEST IDEAS: EQUITY

Zain Akbari

This article is adapted from a Morningstar equity
research report dated Aug. 23, 2017.
Advance Auto Parts AAP is one of the largest
retailers of aftermarket automotive parts,
tools, and accessories to do-it-yourself, or DIY,
customers in North America. Advance operated
5,189 stores as of the end of 2016, in addition to
servicing 1,250 independently owned Carquest
stores. The company's Worldpac unit is a premier
distributor of imported original-equipment
parts. Advance derived 58% of its 2016 sales from
commercial clients, up from 30% to 40% before
its 2014 purchase of General Parts.
While we believe the General Parts deal was wise
given the attractiveness of the dual-market
model, the integration was difficult, compounding
already-present inefficiencies in its supply
and distribution efforts. The firm stands to benefit
as the purchase is digested and it refocuses
on closing performance gaps with large-scale
peers. The combined company is poised to capture
share in a market that should see consolidation
behind national retailers that can leverage
a broad distribution network to efficiently provide
a high standard of service. The industry
has slowed recently because of transitory factors,
but fundamental indicators, including miles
driven and average vehicle age, remain conducive
to recovery.
While Advance's adjusted returns on invested
capital and operating margins have lagged peers,
the company has ample runway for profitability
growth ahead. An expanded store network should

70

Morningstar October/November 2017

help Advance lift private-label penetration
(currently about 40%) while spreading distribution
costs over a larger base. Increased reliance on
commercial sales requires expensive investments
in inventory management to provide services
like rapid store inventory replenishment. However,
such moves offer national players like Advance
an opportunity to differentiate themselves
from local and regional competition in a relatively
price-inelastic industry. Advance's size should
also help its acquisition costs and improve its
accounts-payable-to-inventory ratio.
Economic Moat

The cost advantages associated with Advance's
national presence, together with the
strength of Advance's brand intangible assets,
provide a durable competitive advantage
and we have assigned Advance a narrow
economic moat rating. Advance has consistently
generated returns on invested capital
above our 9% weighted average cost of capital
estimate. While its turnaround should
pressure short-term returns as Advance reinvests
in efficiency and parts availability, we expect
Advance to post an 11% mark by fiscal 2021.
Advance is in an industry where differentiated
service levels can lead to strong brands.
Consumers are price-inelastic, with part availability,
convenience, and in-store services (in the DIY
segment) carrying significant weight. Larger
retailers are at an advantage as they can spread
costly service costs (as well as inventory holding
expenses) over a large sales base. On the
commercial side, clients prefer to stay with trusted
partners as any cost differentials can be passed
on to vehicle operators. Advance strengthens its
brand equity through its technician and shopowner training programs and technology solutions.

DIY consumers depend on the expertise of in-store
sales staff. The company also offers tool loans,
oil and battery recycling, how-to videos, and
simple diagnostics at its stores, gratis. Advance's
high level of part availability and consumer
loyalty program (Speed Perks) help keep
consumers in the fold. Its strong DIY brand and
trusted salesforce also drive significant traction
for its proprietary brands (approximately 40%
of sales). The retail customer's need for assistance
should forestall significant entry by nontraditional,
digital retailers for the foreseeable future-
despite recent efforts by Amazon.com AMZN
to sign distribution agreements with manufacturers. In addition to personalized service,
customers often need a part immediately to regain
reliable use of a car or truck in commuting or
business. Few digital retailers are able to combine
depth of inventory with speed of delivery.
Advance already uses online tools with its
professional clients, and the company's extensive
and fairly flexible inventory makes disruption less
of a concern in the commercial segment.

While the firm lags O'Reilly Automotive ORLY
and AutoZone AZO, Advance's scope has allowed
it to mitigate its working capital burden through
its 0.7 accounts payable to inventory ratio
(as of 2016), as vendors agree to generous payment
terms. This offsets the balance sheet cost
of providing high availability levels for slowmoving SKUs.
Valuation

Disappointing second-quarter profitability amid
an industry slowdown leads us to cut our
valuation for Advance to $154 per share from $169.
However, we attribute the industry dip to transitory
factors (including mild weather) and expect
Advance to strengthen as it improves efficiency
and invests in its standard of service. Our
revised valuation implies 2018 enterprise value
to adjusted EBITDA of 11 and adjusted P/E
of 22, incorporating 10-year average sales growth
and operating margins of 3% and 10%,
respectively. We see 2017 as a transition year,
with a 2% sales dip due to the industry slump.
As Advance improves availability, we anticipate
yearly sales growth will rebound to 4% by
2020, with the professional unit building faster
than DIY (4% and 3.6% average annual


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