Advance Auto Parts: defensive stock; meaningful upside (NYSE:AAP)

Stocks of Advance Auto Parts (New York Stock Exchange: AAP) fell by about 20% as the business proved not entirely recession-proof.strong With its balance sheet, solid free cash flow generation, and long-term tailwinds, AAP has a fundamentally positive dynamic. At just 13x earnings at a 3.5% yield, this is an attractive, relatively defensive stock with meaningful upside.

The company’s adjusted EPS for the second quarter was $3.74, up 10% from last year. Despite strong revenue growth, net sales increased only 0.6% to $2.7 billion, with same-store sales growth of -0.6%. Part of this was due to a strategic shift to sell more of their own brands, which have lower prices but customers continue to come to Advance Auto Parts over other auto parts retailers. Despite this, the company’s profit margins were excellent. Adjusted gross profit increased 4.2% to $1.3 billion, and margin increased his 166bp to 48%. Adjusted operating margin was 11.7%, the highest in seven years. During the quarter, AAP returned his $291 million to shareholders, repurchased $200 million, and authorized his remaining $1.1 billion.

That said, the company is under pressure from a softening economy. On the professional side of the business, AAP continues to record growth and as a result holds its price and is willing to sacrifice some volume to preserve margins. The DIY (do-it-yourself) side of the business had some weaknesses as real incomes declined amid high inflation, causing consumers to put off arbitrary projects. There are some automotive projects (battery replacement, etc.) for AAP, but AAP has not made an impact in this regard. However, there are some ‘fun’ projects such as repainting the car and adding accessories, and sales here are declining.

As a result, management withdrew its guidance and is expected to cut midpoint sales by approximately $250 million, or 2%, with slightly negative same-store sales. Adjusted EPS is currently expected to be around $13, and the company expects him to generate more than $700 million in free cash flow from a previous $775. Given the conservative balance sheet policy, the buyback will be slightly less, at about $550 million.

Compared to other retailers such as Target (TGT) and Nordstrom (JWN), the AAP’s guidance cut is relatively small, and this is due to the fact that cars sometimes break down and need to be repaired. reflects the fact that it has considerable non-discretionary aspects. In fact, there can be a counter-cyclical aspect to this business. Older cars are generally more likely to have problems than newer ones. With new car prices rising and semiconductor issues limiting production, the age of the car on the road continues to grow and is now at his 12.2 years, a record high. Older fleets may support demand for parts.

At some point, you may have to decide whether to continue fixing the car you own or buy a new one. According to the University of Michigan Consumer Sentiment Survey, consumers have never felt that now is a bad time to buy a car. Persistent supply chain issues are driving up new car prices and limiting options. Combine that with the uncertainty of the future, and many consumers would rather spend their $30,000 on their own car than spend his $30,000 on a new car repaired. .

This theoretical argument for why the auto parts business has weathered a recession so well may sound compelling, but more importantly, it worked. During the 2008 recession, retail sales fell more than 8% from his January 2007 level, while auto parts sales stayed within 1% of that level.

Auto parts sales have continued to rise since the start of COVID and have not shown the same headwinds as retail’s more discretionary parts. The outlook is pretty bright in my view as consumers are in no rush to buy new cars and own more old cars than ever before.

Many of these DIY projects are deferrable rather than purely discretionary and will happen at some point. Management expects DIY transaction growth in 2023 after the current soft patch, and I agree. The company also maintained its margins, as evidenced in the quarter. The company is introducing new tools and is already seeing progress in matching work hours and transaction volumes to improve productivity. Unlike other retailers who overordered, the company’s inventory has increased by just 4% year-to-date. We do not need to push out products and are positioned to maintain our prices.

So far this year, the company has generated $97 million in free cash flow, but faces $175 million in working capital headwinds, with most of its capital expenditures spent in the first half. As these normalize in the second half, we believe his FCF target of $700 million is achievable this year.

AAP has just $1.3 billion in debt, free cash flow has less than doubled, and a cash flow-funded share buyback program has reduced its share count from 6.8% to 60.8 million. Advance Auto Parts is well positioned to pursue a modest share buyback, along with an aggressively growing 3.5% dividend from 2020.

Even with the reduced guidance, the AAP is only trading 13x profit. Given the nature of the business, we do not expect AAP to make a series of downward revisions. Vehicle aging should provide long-term support for the auto parts business, and auto parts sales tend to hold up during recessions. He expects sales to grow in the low single digits as deferred DIY projects materialize next year, and his EPS in 2023 should support him between $13.25 and $13.75. As investors get used to his AAP’s limited cyclical exposure and lucrative long-term environment, I believe the stock could at least rebound by a factor of 15. For investors concerned about the economy, AAPs are excellent investments that provide upside while minimizing macroeconomic impact.