Advance Auto Parts (AAP): A Good Turnaround Story

October 31, 2017

We all love a good turnaround story, whether it’s the New England Patriots coming back from a 25-point deficit in last year’s Super Bowl, Detroit rising from the ashes after the pummeling of the U.S. auto industry, high crime and a decimated housing market, or Steve Jobs triumphantly returning to Apple (AAPL) (and bringing it back from near-death) after being publicly ousted. The same can be said about a turnaround stock on Wall Street.

Throughout my career, I have often bet on—and profited from—the underdogs of the stock market, and continue to look for such opportunities in the 200+ publications I review each month for my Wall Street’s Best Investments and Wall Street’s Best Dividend Stocks newsletters.

George Putnam III, editor of The Turnaround Letterand one of my contributors, has this to say about turnaround stocks: “Lucrative stock profit potential can be found among temporarily out-of-favor companies. The strategy with turnaround investing is relatively simple: Beaten down stockswith real value will prevail regardless of the overall market and/or short-term setbacks. Of course, not all distressed companies meet our selective criteria for a potential turnaround opportunity. For a down-and-out stock to offer true contrarian potential, the company must be poised for a rebound.”

George knows what he’s talking about. His turnaround stock selections for the past 15-years have returned 13.4% annually—more than 40% higher than the S&P 500’s 9.4% gains.

Not all out-of-favor stocks are good turnaround stock candidates. Sometimes, a dog is just a dog. But there are certain criteria that—if met—can turn a down-and-out stock into a winner. In an April report, Cabot’s president, Tim Lutts, wrote this about turnaround stocks: “A good turnaround stock needs capable management in place with a good plan for reversing a decline in business. The turnaround needs to rekindle confidence among both customers and investors. It needs to revive revenue growth. And above all, it needs to spark real earnings growth.”

And those are the key elements to a turnaround. In a recent issue of Wall Street’s Best Investments, I featured a turnaround stock selected by George Putnam—a company that was founded in 1932, survived many business cycles, but ran into challenges with overexpansion and acquisitions.

The company is Advance Auto Parts (AAP).

Here is an excerpt from George’s article: “AAP is one of the nation’s largest aftermarket auto and truck parts suppliers. The company’s history of growth by acquisition has produced a disorganized and overly complex operation. Its internal distribution network appears to be a jumble, leading to bloated inventories and excessive costs as well as reduced availability of parts in its stores. These problems, as well as Advance Auto’s inefficient storefront and office operations, have driven its EBITDA margins down to less than half the average of its peers.

“These factors, combined with tepid industry growth over the past year and fears of competition from potential new entrants like Amazon, have caused many investors to be skeptical about Advance Auto’s future. Even a complete changeover in leadership—including the addition of respected activist Jeff Smith of Starboard Value as chairman, a new CEO, a new CFO, and a new head of supply chain, has done little to stoke investor interest. Advance Auto’s shares are down more than 40% so far, this year.

“Advance Auto’s problems are deep, and so fixing them will take some time. We look at investors’ impatience as providing an opportunity to buy into the turnaround at an even better price.

“The new leadership is highly capable and has a clear mandate for change and despite the market’s pessimistic view, the new management is making progress already. Inventories in 2Q17 fell 2.9% from a year ago, despite higher revenues. A better organizational structure is in place. Zero-based budgeting is being implemented, and many other changes are underway.

“Management has outlined plans for a 5-percentage point margin improvement in five years. Better inventory management should improve cash flow, improve customer satisfaction and help ward off competition from Amazon. Meanwhile, the balance sheet is solid with modest debt along with $257 million in cash. Broad industry conditions look favorable, as people are increasingly keeping their cars longer. Moreover, auto parts retailers can be a counter-cyclical investment, because if economic weakness depresses new car sales, there will be more older cars remaining on the road.

“The turnaround’s complexity means that it won’t be linear, and investors should expect it to take a few years. But with the strong new management, supportive industry conditions, and an attractive valuation at 7.7x next year’s EBITDA, Advance Auto should eventually have an open road ahead. We recommend the PURCHASE of shares of Advance Auto Parts (AAP) up to 140.”

I, too, see AAP as an opportunity to buy a discounted stock at a pre-turnaround price. As George noted, several internal catalysts are in place to turn the company’s fortunes around. But the most important boost to the company’s fortunes may lie in the optimistic outlook for the global automotive aftermarket industry. By 2020, experts forecast that the industry will expand to $722.8 billion, due to several factors:

•Consumers are keeping their vehicles longer—an average of 11.5 years (a record high), according to an HIS Automotive survey, which means a greater demand for parts. There are over 14 million autos that are more than 25 years old on our roads—almost double the 8 million of 15 years ago. And Americans are also driving 44 million vehicles 16 to 24 years old. Cars are just being made better so we can keep them longer, leading to a 17% rise in U.S. vehicle fleet age over the past decade.

•There’s a revolution afoot in the online aftermarket business. According to Hedges & Company, e-commerce car parts sales are estimated to grow to $8.9 billion this year, with $4 billion of that from mobile devices. This sector of the industry is forecast to expand by 15% both this year and next.

•The Asia Pacific region, especially China, India and Thailand, are looking at annual growth of more than 6% in the aftermarket parts business through 2024 because of higher spending on automobiles, rising population and a return to swift urbanization as their economies continue to rebound.

•Increasing maintenance requirements due to more stringent emission regulations and safety require more frequent repairs.

•Vehicle complexity and a rising demand for customization require additional and more complicated parts.

•The do-it-yourself automotive aftermarket industry has risen from $41.7 million to $56.9 million in sales since 2008.

Independent auto repair shops perform three-quarters of auto repairs, leaving just 25% for dealerships—a great opportunity for continued consolidation of the industry Consequently, it seems that the turnaround for AAP couldn’t come at a better time.

Wall Street thinks so, too. Two analysts have recently raised their earnings forecasts for the company, projecting 18.4% growth over the next year, with nine analysts currently rating the stock ‘strong buy’ or ‘buy.’ AAP is the only 5-star-rated auto parts stock by Morningstar; even new competitor Amazon (AMZN), and stalwarts O’Reilly Automotive and Autozone, rate just 4 stars. And insiders are piling into the stock, with 57 insiders buying 476,317 shares in the past 12 months.

AAP seems to have all the right stuff in place for a turnaround. But turnaround stocks can be speculative, so be judicious when buying, and keep a tight stop on the shares, just in case.

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