The Auto Parts Wars

Insight. Brilliance. Determination. Resolve. All traits of America's top business leaders. Notice that "grammatical ability" is nowhere on that list.

Enter Advance Auto Parts.

Advance Auto Parts? "Advance" is a verb, akin to terms such as "touch," "assuage," or "engorge." Verbs cannot serve as adjectives. At least they're not supposed to.

Maybe they just forgot the "d." This, though, raises the question: "If management forgot the 'd,' what else did management forget?"

I'm no fan of textual molestation, so I must get to the bottom of this. I will call the company, demanding answers.

But for now, I'll settle for cheap oil. Actually, I want expensive oil -- ExxonMobil's (NYSE:XOM) Mobil 1 Synthetic -- but I want it cheaply. And I'm at an Advance Auto Parts (NYSE:AAP) store scoping out prices to compare with rival AutoZone (NYSE:AZO). I want to see for myself whether there will be an oil price difference between the stores. Actually, since they seem to carry the same products in similar layouts, I want to see whether there's any difference between the clones -- I mean, stores.

I do know that AutoZone does about $5.6 billion in yearly revenue, compared with $3.6 billion for Advance, and that, combined, these top two players constitute 25% of the mom-and-pop-dominated do-it-yourself auto parts business.

A quart of my synthetic ooze runs $4.79 at AutoZone versus $4.78 at Advance. A penny doesn't count. No difference so far.

But just because these companies are selling for the same price doesn't mean they're buying for the same price. I find that AutoZone pays $50.40 for what it can sell at $100 retail, while Advance pays... $50.90. That's about as close as you can get in business.

Well, at least they look different, right? Color scheme for Advance Auto Parts: red and yellow. Color scheme for AutoZone: red and yellow.

Zone no clone
While I'm mulling over who copied whom on the paint, I finally stumble upon a difference. AutoZone turns $100 in retail sales into almost $10 profit, while Advance barely musters half that. I've caught scent of something.

I delve deeper into their operations and discover that about 30 days elapse between AutoZone's paying suppliers for goods and collecting the money from subsequent retail sales. But if AutoZone is FedEx (NYSE:FDX), Advance is sea mail, taking 115 days to do the same. What's more, like a pretty lady who never buys her own movie ticket, AutoZone has gradually removed the need for working capital -- akin to a company's cash in the wallet for day-to-day operations -- from its business. Its was a negative $9 million most recently. In comparison, Advance's $383 million looks, well, engorged.

The Zone is powerful. Even in my delving I feel its pull, and I realize why it is the eighth-most shareholder-friendly company out of the 5,000 on Institutional Shareholder Services' ranking list. What normally takes hours is reduced to minutes -- AutoZone has paved my way by kindly supplying all sorts of labor-intensive metrics. I am in love. Save for those metrics incorporating share price, they've got all the data I'd want.

Based on their recent analyst conference, Advance's people seem long on the nuts and bolts of the business. While I really admire this, I must acknowledge that, ironically, AutoZone is clobbering Advance when it comes to those very nuts and bolts.

Now back to the "missing 'd'" imbroglio. I've been searching for answers, but can't find anything. Nobody seems to know how "Advance" came about, which would ordinarily be of grave concern were the prefix not from the 1920s which, in Advance's case, it is.

Delving still deeper, I see that an average AutoZone store sells $1.7 million per year, whereas an Advance outfit sells only $1.4 million. Things aren't looking good for Advance as I prepare to look at the ultimate operating metric.

Spread 'em, partner... and wider is better
Pretend you are in the business of borrowing from the bank at 7% and investing in Hidden Gems, earning 30% (in this hypothetical example, mind you). Your return on invested capital (ROIC) is 30%, and your cost of capital is 7%. The spread is the value added to your business and is arguably the most important metric of operating health. Companies do the same thing, taking money from both debt and equity markets and investing it in the best projects available to them. But a company's debt and equity investors have different return expectations. To produce a cost of capital, we first estimate these expectations and then subsequently weight them proportionate to the debt/equity breakdown of the company's total market value. The end result of this elaborate process is termed "WACC," for weighted average cost of capital.

I plod through the WACC computations, hoping to score something exciting, but I end up with disappointingly similar 7.5-ish% WACC estimates for both companies for each of the past three years.

Remember, to add value, these companies' ROICs must exceed their 7.5% WACCs. Both ROIC and WACC are ballpark estimates calculated many ways by many different experts, so let's just look at the big picture here and not try to be too exact.

Ouch! AutoZone has enough percentage points of spread that it could support Advance as a charity case.

To be fair, Advance is going through more growing pains, and its 2001 numbers especially aren't good for comparison. And, truth be told, Advance has momentum in some key things I've noticed along the way but disregarded while under AutoZone's spell. The Zone's numbers, mind you, look so good it almost feels like an honor to be reading them.

Advance fights back
ROIC minus WACC might be the most important operational thing to look at, but a quick peek at some valuation info can't hurt. Though the market has relatively little say in the quality of a company's operations, the market has quite a bit of say in the price at which that quality is sold to the investor. With money no object, picking a DaimlerChrysler (NYSE:DCX) Mercedes over a run-of-the-mill Ford (NYSE:F) or General Motors (NYSE:GM) Chevy is a no-brainer. But money is always an object.

I decide to see how much free cash flow to equity (FCFE) a $100 investment in either company's stock buys me. FCFE is akin to a cash net income and is generally accepted by society as the cash "owned" in abstraction via share ownership. In other words, FCFE determines equity value, at least for many investors. Although future FCFE is particularly important, being unknown it takes a back seat in this particular analysis to historical FCFE, which I compute per $100 equity investment at each year's average stock price.

Not only is Advance the better value, according to this metric, it has the trend on its side. Wall Street analysts, admittedly not bastions of long-term accuracy, predict Advance will outgrow The Zone, a company past its heyday of revenue growth and cost-cutting ability. AutoZone is better at doing its job, but Advance is on the upswing and seems to be surpassing AutoZone in the valuation department, or is at least on par with it if we consider the additional risk accompanying Advance's less-stabilized operations.

Somehow a forgotten figure returns to my brain: AutoZone's quarterly comparable-store sales were down 1%, while Advance's were up 6.9%. That's a big score in Advance's favor.

In the end, though, we have no clear winner. "Buy companies, not stocks" extremists would prefer AutoZone for its business superiority, especially ROIC to WACC spread, and attest to still-ample expansion opportunity in this unconsolidated industry, not to mention EPS-enriching buybacks. Other knowledgeable investors would favor Advance's FCFE, trends, and additional growing room.

But I don't have to worry about deciding between the two, at least with oil. I've learned I can get a quart at Wal-Mart (NYSE:WMT) for $4.54.

Recent Fool Articles:

• Getting Into AutoZone
• AutoZone Keeps Revving

Fool contributor James Early doesn't admit to owning any of the companies mentioned but does admit to normalizing and adjusting (for more accurate comparison of ROIC-WACC and FCFE ) some of the numbers used in this article. He accepts offers for movie tickets via email .