Advance Auto Parts Along For The Ride




Highlights

  • Successful BWP Acquisition: Advance Auto Parts acquired B.W.P Distributors, Inc at the end of 2012, and plan on completely integrating the 124 BWP stores into AAP stores by mid-2014.Sales and profitability of the BWP stores are currently exceeding AAP expectations.
  • General Parts Acquisition: Advance Auto Parts announced on October 15, 2013 that they are entering an agreement to acquire General Parts International Inc. which will position AAP as the largest automotive aftermarket provider of parts, accessories, batteries and maintenance items in North America. Acquisition is expected to close by late 2013 or early 2014.
  • Solid Q3 Results: Advance Auto Parts EPS for 2013 Q3 was at $1.42 which is up 17.3% compared to $1.21 for the comparable period of 2012. This is mostly due to an increase in operating income of 13% and a disciplined expense control despite 2.0% comparable store sales decline.


Business Description


Advance Auto Parts (AAP) is a leading specialty retailer of automotive aftermarket parts, accessories, batteries, and maintenance items primarily operating within the United States, as well as, in Puerto Rico and the Virgin Islands. Advance Auto Parts carries an extensive product line for cars, vans, sport utility vehicles, and light trucks. The company focuses on servicing “Do-It- Yourself” (DIY) and commercial customers. At the end of the third quarter 2013 there were approximately 4,018 total stores operated globally. Advance Auto Parts can be broken down into two segments Advance Auto Parts (AAP), and Autopart International Inc (AI); with AAP operating roughly 3,796 or 95% of the stores. Advance has two key business strategies: superior availability and service leadership. Superior availability is aimed at product availability and maximizing the speed reliability and efficiency of our supply chain. Service leadership leverages Advance’s product availability in addition to more consistent execution of customer facing initiatives to strengthen their approach to serving DIY and commercial customers.


Growth Strategies

Advance Auto Parts’ has taken on a new type of growth strategy. Recently, due to overall slowdown in market growth AAP has had to adjust to remain profitable. Organic growth has declined as can be seen by the 2% decline in comparable store sales in the third quarter. However, total sales increased 4.3% for quarter three and earnings per share increased 17.4% this is due to the amount of recent acquisitions, growth in commercial sales, and an effective job by management in cost cutting.

  • Acquisitions: At the end of 2012, Advance acquired B.W.P. Distributors Inc. (BWP), which is a privately held company that supplies, markets and distributes automotive aftermarket parts and products principally to commercial customers. Advance, as a result of the transaction, will operate 124 BWP company owned stores and two distribution centers. These stores are to be fully integrated into Advance stores by the beginning of 2014. Additionally, an acquisition for General Parts entered into an agreement earlier this month. With this transaction it will make Advance the largest automotive aftermarket provider of parts accessories batteries and maintenance items in
    North America. It also expands Advance’s presence geographically, specifically the West coast, which presents the company with a strong growth opportunity. Anticipated closing on this acquisition is planned for late 2013 or early 2014. These acquisitions as well as an accelerated pace of new store openings help create value. AAP has increased net store count by 291 over the last 12 months
  • DIFM Growth: There has been a decline in Do-It-Yourself (DIY) business recently which has historically been the major part of Advance’s business strategy. This is due to unfavorable macro factors resulting in consumers only performing repairs that are absolutely necessary to keep their vehicles on the road. However, Advance is taking strides to increase its commercial sales revenue as can be seen through the BWP acquisition since BWP dealt mostly with commercial customers. Commercial sales now make up 40% of Advance’s revenue and the company is going to keep trying to put a larger emphasis on the growth in commercial sales.
  • Effective Management: Margins for the firm are continuing to grow despite comparable store sales recent decline. This is partially due to acquisitions, but a large part is from the disciplined expense control managed by the business. SG&A expense for the most recent quarter was 39% which is an improvement from the same period last year by 49BPS. This was notably due to lower administrative and support costs, lower marketing expenses and improved labor productivity from a year ago. The management team has done a great job at being efficient and this continued efficiency will continue to grow profit margins.


Financial Analysis
Revenues


Total sales for Advance continued to increase and rose 4.3% for Q3 despite the 2% comparable store sales decline. The soft performance in comparable store sales was driven by the decrease in DIY business and partially offset by a modest increase in Advance’s commercial sales. This increase in commercial sales was mostly due to the early success BWP acquisition. The sequential decline in our business from Q2 results was consistent with the slowdown in the overall market growth. As the overall market continued to face headwinds from limited consumer sentiment the market softness witnessed in July and early August continued through Q3.Sales are expected to continue to grow despite slow overall market growth through the General Parts acquisition which will expand geographical presence, channels of distribution and a stronger focus on commercial sales. As can be seen in Exhibit 7, Advance with the acquisitions has more potential growth as can be seen in the revenue growth comparison with O’Reilly’s. Even though Advance has underperformed O’Reilly’s the last few years in revenue growth, 2014 should turn things around with the acquisition of General Parts . The General Parts acquisition which should close in early 2014 and the full integration of BWP are the specific acquisitions that will drive growth in revenue.

Earnings

Earnings per share increased 17.4% for the third quarter vs third quarter last year which includes a
$0.02 transition cost per share with the integration of BWP and $0.04 related to the pending acquisition of General Parts. This profitable outcome was not only driven by increase in sales, but the management team demonstrated strong execution to our gross profit rate improvements in addition to effectively managing costs which resulted in a 91 basis point improvement in our operating income this quarter. Although bottom line results were strong, Advance needs to continue profit expansion through improve sales performance while continuing the disciplined spending they have exhibited thus far in 2013. As can be seen by Exhibit 8 on the left, in the recent years O’Reilly’s Auto Parts has outperformed Advance in earnings growth.
However, 2014 estimates show Advance having around 27% earnings growth mostly due to acquisitions on the horizon and the growth of market share.



Growth Analysis
Sustainable Growth Rate

The sustainable growth rate is a measure of how much a company can grow without borrowing money. In order for growth to exceed this rate, the Company will require external financing to facilitate growth. Advance currently offers a dividend of $0.24, or a 0.2% dividend yield, which makes sustainable growth rate equal to 29.79%

Historical Growth Rate


The historical growth rate was found by analyzing the basic adjusted EPS for the past five years which excludes abnormal items. This analysis produced a historical growth rate of 15.03%

Acquisition vs. Organic Growth Rates


Advance has made some big acquisitions recently with BWP. The last three quarters have really seen the success of this acquisition with acquisition revenue growth YTD at 6.29% compared to the same period last year. This strong acquisition growth has made up for the soft sales growth from Advances’ comparable stores which YTD have returned a disappointing -1.83% from the comparable period last year. This may be due to the focus of Advance’s time and finances on the acquisition being successful rather than focus on already existing stores. However, more historically the average comparable stores revenue growth was 3.3% and acquisition revenue growth was 1.13%. Hopefully, Advance will see similar revenue growth from the acquisition of General Parts that was recently proposed as it did from the BWP acquisition.

Top Line Growth Rate
The top line growth rate analyzed the growth of Advance’s revenue. This growth rate is most useful during poor economic conditions. To find a more appropriate growth rate in revenue, historical annual revenue since 2005 and expected revenues for the 2013 year and 2014 were analyzed. After calculating this average a top line growth rate of 8.06% was found.

Bottom Line Growth Rate
The bottom line growth rate the growth of Advance’s EPS. This growth rate is most commonly used during periods of positive economic conditions. The growth rate was found by analyzing EPS growth since 2005 and the estimated EPS growth of 2013 and 2014. After running the regression a bottom line growth rate of 14.4% was found.

Imputed Growth Rate
The imputed growth rate is important because it is the growth rate that investors are currently paying for. To do this, I chose to use the residual Income Model. Residual income is the extra return a company generates above the required rate of return. The residual income model measures the value added in excess of opportunity costs. In my calculation I used a current book value per
share of 20.18, a required rate of 16.176%, a ROE of 30.17%, and the current price. With this data I was able to solve for growth or g of 12.2%.


Pro-forma Analysis


Pro-forma analysis was used to estimate future EPS. To find out the expected quarterly revenues I ran an analysis on quarterly revenues going back to 2005. Through this analysis, it was determined that the growth rate used to expand quarterly year of year revenue was 6.49%. Using a common sized statement, I used average historical percentages of revenue to determine expense items for the pro forma. As a result, for fourth quarter 2013 had revenues of $1,386 M which is seasonally correct as fourth quarter is normally a down period for Advance. Quarter one 2014 revenue was
$2,455 M which corresponds to the high seasonality of the industry. The remaining quarters of 2014 had revenues of $1,649M; $1,618M; and $1,475M. This translated into 2014 annual earnings per share of $6.61. Advance’s bottom line growth determined from the pro forma is 18.84% which is mostly due to growth in revenues and improvement in margins.


Analyst Forecasts


Analysts forecast that Advance will have earnings of $5.43 for full year 2013, with projected growth looking into 2014 at 27%, or earnings of $6.90 for the year. More conservative analysts forecast only 19.78% boost in earnings from $5.51 to $6.6 full year 2013 to 2014. Optimistic revenue forecasts suggest revenues will increase from $6.47B to $9.68B or 49.6% growth from 2013 to 2014. More conservative estimates still show exceptional growth with revenue growth of 29.52% or an increase from $6.47B to $8.38B. Recently, analysts have moved Advance from a neutral to overweight and have set a price target of $130.
Pessimistic Growth Rate: 15.03%
The pessimistic growth rate is from the historical growth rate of the company. This was chosen because it does not take into consideration the General Parts acquisition which is underway, and unless the acquisition turns sour, Advance will most likely see a pretty large return on the deal. 15.03% pessimistic growth rate represents the acquisition of General Parts failing.
Expected Growth Rate: 18.84%
The expected growth rate is determined from the pro forma. This 18.84% takes into consideration a moderate return from Advance’s acquisition of General Parts, and all around improvement of margins.
Optimistic Growth Rate: 27%
The optimistic growth rate was determined based off of Yahoo! and Basline analysts. This is counting on the acquisition of General Parts to be a huge success, and a turnaround in comparable store sales



Valuation
Growth Duration Model


The Growth Duration Model is based on the price to earnings ratio of two companies or industries. This model solves for the market implied growth period, given the growth rates and dividend yields of both companies and industries. In this model, Advance is compared to Automotive Retail Industry and O’Reilly’s Auto Parts under three different stress tests of pessimistic growth,
expected growth, and optimistic growth. When compared to the automotive retail industry using pessimistic growth rates the fair value of the Advance is $102.19, expected growth rates is
$105.57, and optimistic is $112.81. When compared to O’Reilly’s which has a slower growth rate than Advance the fair values for Advance are $121.79, $125.8, and $134.44 respectively for the pessimistic, expected, and optimistic scenarios. Taking the averages of the valuations derived from comparisons to the industry and O’Reilly’s Auto Parts leads to an overall fair value of
$117.10. This means that Advance’s current value of $100.04 is 14.57% undervalued. In Exhibit 10 on the left the P/E ratio comparison between Advance and O’Reilly’s is given. P/E growth for AAP is outperforming O’Reilly’s this is due to the expected growth of the company through acquisitions of General Parts.


Sales Franchise Value Model


The Sales Franchise Model was also used to calculate the fair value of Advance Auto Parts. The key component of this model is the profit margins. The model breaks down current operations in comparison to future operations through distinguishing Advance’s current profit margin and the profit margin from future operations. This model was appropriate because it incorporated the growth of Advance’s new acquisition expansion of General Parts Inc. The profit margins were calculated through the pro-forma analysis; current profit margins were calculated at 6.37% and the future profit margin was calculated at 6.62%. A required rate of return of 9.5% was used through the expected increase through acquisitions and the historical top line growth rate of 8.06%. The model produced a fair value of $125.91, currently undervalued by 20.54%


Residual Income Model


Using the residual income model, it was determined the fair stock value of $115.19 using a required rate of return from CAPM plus additional return increase due to liabilities increasing due to upcoming acquisitions. In addition, a growth rate of 18.84% was used as this is the expected return from the company. Using these inputs it was determined that the stock was undervalued by 13.15%.


Average Fair Value


The average fair value for Advance Auto Parts when considering the following three models: Growth Duration Model, Sales Franchise Value Model, and the residual income model is calculated at $119.4, which means the current stock price of $100.10 is 16.16 % undervalued.


Recommendation

Advance’s is currently implementing an aggressive acquisition strategy to continue growth of sales and earnings through the relatively soft macroeconomic environment. Advance is also restructuring to focus more on commercial sales which have shown stronger growth than DIY business, and management is continuing to cut costs and improve margins. As a result I find that the fair price of Advance Auto Parts to be $119.4, and the current price of $100.10 is 16.16% undervalued.
Therefore, I recommend that the Roland George Investments Program purchase 600 shares or a
$60,000 position of Advance Auto Parts.

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