We plan to lift our $177 per share valuation for narrow moat Advance Auto Parts (AAP) by 5%-7% after it posted third-quarter results outpacing our full-year expectations, and released more information about efforts to reinvigorate sales and profitability growth. Advance saw a 2.0% revenue decline (driven by a 1% comparable store sales dip, an improvement on its 4% second-quarter shortfall) and a 9.7% adjusted operating margin on the quarter, which compares favorably to our negative 3.1% and 9.6% respective targets for 2016. The firm also forecast mid-single-digit sales growth and 500 basis points of adjusted operating margin expansion from 2017 to 2021, versus our 4.2% and 320 basis point expectations, respectively. While somewhat short on specifics, we were encouraged by the strategic vision outlined, including renewed focus on service as well as supply chain and inventory optimization. Initial signs of improved part availability and delivery time were welcome indications of progress on key metrics.
We still believe Advance offers investors the best opportunity to capitalize on attractive industry dynamics and suspect our valuation embeds a more optimistic take on the firm’s ability to close performance gaps relative to its peers than prevailing sentiment. Although we anticipate 2017 will be a transition year, with low-single-digit top line growth and only modest profitability gains, we see current trading prices as offering a sufficient margin of safety for patient investors.
That said, we anticipate remaining more reserved regarding Advance’s 2017-21 margin expansion prospects than management’s 500 basis point goal until the operational improvement plan starts to deliver more concrete results. While we expect vigilance on costs and leverage should boost profitability, we expect Advance will need to spend to optimize its supply chain, regain customers, and improve service. Consequently, we continue to anticipate around 300-350 basis points of pickup by 2021.
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Zain Akbari, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.