Advance Auto Parts, Inc.

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

Advance Auto Parts is a leading automotive aftermarket parts provider in North America, serving both professional installers and do-it-yourself customers.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Advance Auto Parts (AAP) operates in a mature and competitive industry characterized by both professional and DIY customers.

Business Overview

Advance Auto Parts (AAP) is a leading automotive aftermarket parts provider in North America. It operates through two main segments:

Professional: This segment caters to commercial customers such as service garages, national and regional chains, and fleet operators. This is a higher margin business due to the higher value provided by the services.
Do-It-Yourself (DIY): This segment primarily serves individual customers who buy parts for personal vehicle maintenance and repair.

AAP’s primary sales channels are its stores and online platforms. These channels are used to provide automotive parts, accessories, batteries, and maintenance items to a wide range of customers.

Industry Trends and Competitive Landscape:

The automotive aftermarket industry is influenced by several macroeconomic factors:

Inflation, including logistics and labor expenses
The cost of fuel
Interest rates
Unemployment rates
Consumer confidence and purchasing power
Changes in new car sales
Economic and political uncertainty
Increased foreign currency exchange variability

The industry is characterized by:

High competition due to numerous players including Autozone, O’Reilly and other online retailers
Increasing consolidation of distribution channels, and
A focus on e-commerce, both B2B and B2C.

AAP’s financial performance is also influenced by weather conditions, which affects demand for certain seasonal items. The company is focused on improving the customer experience, expanding its store network, enhancing its e-commerce presence and also on improving the supply chain. It’s a highly competitive industry with little brand differentiation as the same parts from different vendors are available at all major suppliers. There is no direct interaction between suppliers and buyers for do-it-yourselfers and even with the Professional side the buyers mainly look at the inventory and delivery efficiency, not the supplier.

Financial Performance and Discussion

Here is a detailed breakdown of AAP’s financials:

Revenue: For the year ended December 31, 2022, Net sales totaled $11.2Billion which was a 1.2% decline compared to 2021. For the 40 weeks ended October 7, 2023, net sales totaled $7.6 billion, compared to $6.9 billion in 2022. Comparable store sales decreased 0.2% for the first quarter of 2024 and increased by 1.6% in the second quarter of 2024. Third quarter 2024 revenue decreased 3.1% compared to 2023’s third quarter, indicating a decline and possible loss of market share.
Gross Profit: Gross profit margin for 2022 was 44.5%, whereas it was 42.8% for the forty weeks ended October 7, 2023 which signifies reduced profitability. Inflationary pressures and higher product costs impacted the gross margin in the most recent periods. While gross profit increased in absolute dollar amounts, they were not increasing by much as the cost of sales increased at a faster pace, leading to the decline in margins.
Selling, General and Administrative Expenses: In the forty weeks ended in October 2023, SG&A expenses as a percentage of sales were 38.6%, which was higher than the prior year.
Operating Income: Operating income for the year 2022 was $1.1Billion whereas for the forty weeks ended October 7 2023, it was $158 million compared to $545 million from 2022, which illustrates how the profitability is severely declining. The decline was primarily due to higher expenses. Operating income was $43M in the first 16 weeks of 2024 and is still extremely low, compared to historic values.
Net Income: Net income was -$55 million for the year 2022, while net income for the forty weeks ended October 7, 2023 is at -$114 million. This indicates a concerning trend in declining performance for AAP. Net income is also not consistent across reporting periods, showing an unstable trend. Net income for the 16 weeks ended April 20 2024, was $45.3 million.

The results for 2023 (including Q3) are worrying given the company is posting a loss in a high-inflation market with robust sales, indicating that there is either a major problem with the business model or the company’s operational efficiency.

Margins:

As noted previously, margins are generally declining for AAP.
This is particularly worrying given that AAP also enjoys some pricing power due to the high switching costs from the professional side.
The management seems to blame supply chain issues, but also mentions that there is increasing competition and their ability to maintain pricing is being affected by it.

Balance Sheet Health

Assets: As of October 5, 2024, total assets for AAP stand at $12.5 Billion compared to $12.7 Billion as of December 30, 2023. There is a small decline in assets.
Liabilities: Total liabilities were $9.7 Billion in October 2024 compared to 9.7 Billion as of December 30, 2023. Overall liability levels seem very high.
Equity: Shareholder’s equity is at $2.7 Billion which is down from 3.0 billion as of December 30 2023, a sign of declining financial strength.

AAP has a large amount of debt ($1.8 Billion) compared to its equity ($2.7 billion), which does present a fair amount of risk and its balance sheet is somewhat unhealthy.

Moat Assessment

AAP possesses a limited moat mainly because of:

Switching Costs: Professional customers have fairly high switching costs as a lot of integration with their system and supply chains is involved, as well as the difficulty and time it takes to switch suppliers. However, since customers primarily care about price, this isn’t a strong moat and can be out-competed by offering the same parts at cheaper prices.

Switching costs for DIY customers is virtually nonexistent due to no switching costs and no brand loyalty in an environment where the quality of parts is essentially a commodity.

Economies of Scale: AAP’s large scale enables the company to spread fixed costs over a larger sales base, potentially leading to some cost advantages. However these benefits are likely small and competitors have similar scale and can easily match the pricing. The scale is somewhat limited because logistics become costly with more stores and supply lines so that the advantages quickly disappear as the company gets bigger and bigger.

It is important to note that AAP is not the industry leader and therefore doesn’t have the ability to be the lowest cost producer. It has also not vertically integrated into supply chains, reducing any further cost advantage.

Given that the company has limited intangible assets, and competition is strong, AAP only has a weak moat, therefore the moat rating is at a 2/5.

Risks to the Moat and Business Resilience

Several risks could potentially harm AAP’s moat and business:

Intense Competition: The highly competitive automotive aftermarket industry could erode profit margins and market share.
Economic Downturn: Lower economic activity and high unemployment can decrease discretionary spending of consumers and limit business.
Supply Chain Issues: AAP’s reliance on a complex supply chain with a global vendor base and high reliance on Chinese suppliers can make it vulnerable to unexpected shocks in the supply chain and increase its operating costs.
Technological Changes: Shift towards Electric Vehicles or new technology within ICE vehicles can disrupt the nature of parts and maintenance needs, potentially lowering AAP’s competitive advantage.
E-commerce Competition: Aggressive e-commerce players might erode AAP’s retail sales and market share.
Changing Customer Preferences: Shifts in consumer behavior and preferences can also lead to lower spending or change the way they consume their services and goods.

AAP seems to possess limited resiliency. Based on the financial performance, it looks like the company has low resiliency and cannot quickly turn around, making the business vulnerable to outside influences.

The current leadership is also unproven given the new CEO has been very recently installed.

Understandability Rating:

2/5: Understanding the basic business of AAP is simple, but the full picture of the complex business and the supply chain relationships, different competitors, their margins and financial details makes it hard to understand the business fully and properly assess it.

Balance Sheet Health:

3/5 While the balance sheet is not disastrous, AAP carries a high amount of debt. Cash reserves have been declining, making it slightly unhealthy. It still has good assets though.

Recent Concerns and Management Outlook:

There have been significant concerns raised in the recent earnings calls. Notably, the decline in profitability, shrinking margins and negative net income are worrying. Management has expressed confidence in its turnaround strategy which includes cost-cutting, reducing inventory, and also better marketing. Furthermore, a new CEO was hired in late 2023. But results from recent quarters show little improvement. There is also an expectation that there will be a slight slowdown in the car market and the general economy in the near future.

A lot of management’s plan has a strong reliance on the success of their new initiatives, without any indication if they would improve the company’s financial position. Management has continued to focus on creating a strategic direction for the business but a lack of results might make it more difficult to justify their strategy. A positive is that supply chain issues have improved since 2022 and inventory costs are being monitored actively. Management has decided to divest its Canadian arm, and seems intent on reducing operations in other parts of the business too.