Minor Improvements Will Send This Stock Soaring

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Demand for aftermarket auto parts has soared in recent years as deleveraging consumers put off buying new cars in favor of repairing old ones. This has been a tremendous boon to auto parts suppliers like AutoZone (NYSE: AZO) and O'Reilly Automotive (NASDAQ: ORLY), which have profited tremendously from the increase in demand.

However, Advance Auto Parts (NYSE: AAP) has not done quite as well as its peers. Although it has participated in the industry's upswing, it has always lagged its competitors in terms of profitability. However, that may soon change as the company makes important changes to its cost structure that will enable it to earn a higher profit per dollar of sales.

Catching up in an industry with no competitive advantages

The only competitive advantages in the auto parts industry come in the form of barriers to entry. Over the years, consolidation has enabled the largest players to add even more scale, which makes it likely that the industry will soon be dominated by only a few major players.

Although scale provides protection from new entrants, it does not afford any protection against competition between existing firms. As a result, the biggest firms should be roughly equal in terms of profitability over the long run.

Therefore, it is unreasonable for investors to be overly concerned with Advance Auto Parts' lagging operating margin. Although it currently trails its peers, it is likely to catch up over the long run.

The current difference in profitability between the firms is party explained by differing business lines. O'Reilly is heavily concentrated in the commercial market, but is quickly expanding in the do-it-yourself (DIY) market. Meanwhile, AutoZone has a stronghold in the DIY market, and has only recently begun making serious investments in the commercial market.

Advance Auto Parts is more evenly balanced between both the DIY market and the commercial market. Eventually, AutoZone and O'Reilly will have an even mix as well.

However, Advance's lower profitability is not fully explained away by its target markets; its gross margin is similar to that of AutoZone and O'Reilly, but its operating margin is much lower due to excesses in SG&A.

Management has declared it can reach a 12% operating margin over the next year due to a combination of operating leverage and trimming fat from SG&A. Over the long run, I believe its operating margin will be similar to that of O'Reilly. However, AutoZone's superior working capital management and shrewd capital allocation should allow it to continue earning slightly higher returns than its competitors.

Valuation

Advance and AutoZone trade at about 15x earnings, while O'Reilly trades at a higher 21x earnings. However, Advance trades at a meaningful discount to both AutoZone and O'Reilly on an EV/EBITDA basis.

The market is awarding AutoZone and O'Reilly for being more profitable than Advance. However, if you have the choice between a stock selling for 15x earnings with little room to improve and a stock selling for 15x earnings with substantial opportunity for margin improvement, you should take the latter. The choice is even more obvious on an EV/EBITDA basis.

Bottom line

The laws of economics dictate that a group of companies whose businesses afford them no durable competitive advantage will earn similar profits over time. Advance Auto Parts is making the changes necessary to catch up with its peers' profitability, and even a small improvement should send its stock soaring.


Ted Cooper has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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