Morningstar Magazine - October/November 2017 - 71

Advance Auto Parts AAP
Fair Value Estimate Per Share
Month-End Closing Price
200
$
154.00 150

97.90 100
50
09/2014

09/2015

09/2016

Sector

Consumer Cyclical

Market Cap ($ Bil)

7.1

Price ($)

97.90

Fair Value Estimate ($)

154

Morningstar Rating

QQQQQ

Uncertainty

Medium

Economic Moat

Narrow

Stewardship Rating

Standard

Morningstar Credit Rating

BBB

Data as of 08/31/2017.

2018-26 sales growth, respectively), echoing
industry trends.

We anticipate a return to store growth in
2017 after closures in 2016. Openings and the need
to maintain a rapid delivery cadence should
require investment, with forecast capital spending
averaging 4% of sales through 2026. Shortterm troubles should cost market share in 2017
(with estimated DIY and commercial share
expected to dip to 7.2% and 8% from 2016's 7.4%
and 8.3%, respectively), but the firm should
benefit from industry consolidation thereafter. By
2026, we anticipate Advance will achieve 8.2%
share in DIY and 8.4% in commercial, recovering
lost ground with more profitable results.

2021 (down from our earlier 12% forecast as
a result of greater-than-expected short-term cost
deleverage). Our forecast trails management's
targeted 500 basis points of expansion from
2017 to 2021; we need to see more plan details and
signs of progress before revisiting our assessment.
We also suspect much of management's $750
million five-year gross productivity target will need
to be reinvested.

O'Reilly and AutoZone post operating margins
near 20%, but those businesses benefit from
a company-controlled store network. (About 20%
of Advance's store network is independent,
with estimated gross margins about half that of
company-owned counterparts.) Improved inventory
management and scale should lift Advance's
payables to inventory ratio, to near 100% by 2026,
from 71% in 2016.

formerly head of the North American Frito-Lay
division of PepsiCo PEP, as its CEO in April 2016.
The hire came in the wake of activist investor
Starboard Value's acquisition of a 4% stake in the
company, which led to the hedge fund gaining
control of three board seats and, subsequently, the
chairmanship. The investment firm is urging
Advance to improve margins through operational
efficiencies, capitalize on Worldpac's advantages, implement a more robust dividend or share
buyback program, and push further industry
consolidation. We expect the road ahead to
be a long one, given the needed efficiency
improvements and the dearth of large potential
acquisition targets. A sizable portion of Advance's
performance gap with O'Reilly and AutoZone
is due to its reliance on independent stores,
greater mix of commercial sales, and lower level of
owned locations versus rented properties, all
structural dynamics that are difficult to change.

Risk

While management is acting prudently to improve
efficiency, the risks are double-edged: The 500
basis points in operating margin expansion that
the company targets by 2021 may not materialize if
Advance is insufficiently aggressive in reducing
outlays. A move too far may alienate customers
and independent owners if service levels drop.
Industry dynamics have provided some support.
Miles driven (up 3% in 2016) and vehicle age
(11.6 years in 2016 versus 10.6 years in 2010) have
risen, increasing the need for repairs. Meanwhile,
unemployment fell, increasing customers'
ability to pay for repairs. Demand could drop if
higher fuel prices or unemployment reduces miles
driven, while higher scrappage rates could
depress parts demand as more reliable products
under warranty replace older vehicles.
We assume U.S. tax reform will lead to a
high-single-digit point reduction in the firm's
effective tax rate starting in 2018; deviation
from that could affect performance. CEO Thomas
Greco is new to the firm and the industry. His
ability to manage the turnaround will have a big
impact on Advance's prospects.

Greco lacks retail experience, but the firm's hiring
of Tom Okray as CFO helped allay our concerns.
His decades in supply-chain optimization (including
a long stint at General Motors GM) brings
a needed influx of sector-related experience.
Okray's skillset should complement Greco's
admirable record at PepsiCo, where he successfully led a turnaround of Frito-Lay.
As the firm improves its inventory management
and copies best practices from industry leaders,
we expect Advance will grow revenue and
margins, capitalizing on its scale to boost returns.
We are encouraged by Greco's prioritization
of part availability, delivery times, and inventory
efficiency, as these areas offer the most
opportunity to resuscitate sales and improve
working capital deployment.
Advance's diverse, largely independent board
of directors includes significant automotive
and retail experience. Starboard's presence should
lead to a renewed focus on value creation.
That said, activist funds like Starboard can
overemphasize short-term gains, so we hope that
the firm's new leadership keeps its sights on
dependable long-term returns. K

Management

Operating margins should expand as Advance cuts
costs, rebounding from 9% in 2016 to 11% by fiscal

We rate management's stewardship of shareholder
capital as Standard. The company hired Greco,

Zain Akbari, CFA, is an equity analyst with Morningstar
Research Services.

global.morningstar.com/Morningstarmagazine

71


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