Perception matters a lot in investing. Is a poorly performing company simply a bad investment to be avoided at all costs? Or is it a potential value opportunity, particularly when it has peers with metrics that management can target? That's the dilemma facing potential investors in Advance Auto Parts (AAP 0.58%) now.
Let's look at the challenges its new CEO will face as he takes over in September and whether the stock is a value play.
Time for a change
Alongside its disappointing set of second-quarter earnings, Advance Auto Parts announced the appointment of a new CEO, Shane O'Kelly, who will start in mid-September.
The former HD Supply CEO has a tough job ahead because departing CEO Tom Greco (who will stay on as an advisor) has not left the company in good shape. The stock is down 62% since Greco took over as CEO in August 2016 while peers O'Reilly Automotive and AutoZone are up 222% and 202%, respectively, over the same time frame.
Recognizing the company's problems, management is launching a "comprehensive operational and strategic review." Moreover, Interim Executive Chair Gene Lee told investors on the earnings call that the board will "work with Shane and the management team to ensure Advance is taking the right steps to build a stronger, more resilient business."
Serial underperformance compared to peers
At this point, the appeal of Advance Auto Parts as a value play is easy to spot; after all, its valuation stands at a significant discount to its peers, O'Reilly Automotive and AutoZone. For example, here's a look at enterprise value (market cap plus net debt), or EV, to earnings before interest, taxation, depreciation, and amortization (EBITDA).
All the company has to do is improve the operational gap between it and its peers -- the strategic review will help -- and the stock should have a substantial upside. That's the value case for the stock.
AZO EV to EBITDA (Forward) data by YCharts
Better days ahead?
According to Greco and Lee, investors could see some improvement over the near term. For example, Citigroup analyst Steven Zaccone asked Lee on a recent earnings conference call whether the strategic review would be "a one-year invest-to-grow margin strategy, or is this something that's more multi-year in nature?"
Lee replied: "I think it's less than one year. I mean, I think that we should start seeing incremental improvement pretty quickly here." He continued to laud actions taken to improve operations, notably at the store level, the supply chain, and sales. These initiatives, he said, are coming through and "we're going to start seeing improvement pretty quickly."
As such, investors might conclude that improvement is on the way, and Advance Auto Parts is an excellent value proposition based on the classic value investing principle that it can aim toward improving performance in line with its peers. Hopefully, that improvement will be helped by a new CEO's fresh input. However, it's not quite that simple.
Image source: Getty Images.
Red flags for Advance Auto Parts
O'Kelly has a tough job ahead of him. As previously discussed, Greco took over in 2016 with many, including activist investor Starboard Value, believing in a similar value case.
Unfortunately, seven years on and with Starboard's involvement come and gone, Advance's management is still discussing the need to improve store inventory availability. It's still talking about investments to improve comparable same-store sales growth and the need to focus on its most important products.
Meanwhile, analysts are still asking questions about the company's supply chain and cash-flow management. The company takes far longer to clear its inventory than O'Reilly and AutoZone, and its cash management significantly trails its peers -- it pays suppliers relatively quickly for inventory, and is slow to collect receivables from customers.
As such, Advance does a poor job of generating free cash flow from its assets.
AZO FCF to Assets (TTM) data by YCharts
A stock to buy
All these metrics are not simply numbers; they reflect the company's operations and speak to fundamental issues that must be addressed. As such, it's hard to see how Advance's problems will be solved in the near term and certainly not in less than one year.
Hopefully, O'Kelly's tenure will lead to a substantive improvement. There's an obvious value case for the stock. Still, it makes sense to wait until the review is over and he outlines a fundamental restructuring of the company's operations before buying. Companies don't usually deal with multi-year underperformance in a quarter or two. There's plenty of time to monitor the company before buying in.
