Turnaround Progressing at Advance Auto Parts

We plan a low- to mid-single-digit percentage uptick for our $157 per share valuation for narrow-moat  Advance (AAP), as its second-quarter earnings suggest its turnaround is progressing. Our reaction to the news is more muted than trading; we have long believed Advance's work to boost availability, improve efficiency, and optimize its supply chain and distribution network would boost performance. While the results indicate the turnaround may be ahead of schedule, our long-term forecast (mid-single-digit average top-line growth, adjusted operating margins rising into the low double digits from 7% in 2017 over the next decade) endures.

First-half sales rose 1%, with 49 basis points of adjusted operating margin expansion (to 8.3%). Management lifted 2018 guidance, calling for $9.3 billion-$9.5 billion in sales and a 7.5%-7.8% adjusted operating margin (versus earlier $9.1 billion-$9.4 billion and 7.3%-7.8% marks), with our pre-earnings estimates within the new ranges ($9.3 billion, 7.5%). Leadership indicated it plans to repurchase up to $200 million of shares in 2018; we are skeptical of such a use of capital as the stock trades near its fair value estimate.

Management cited its cross-banner availability and digital efforts as performance drivers, along with favorable weather. We see the availability work as the first step to distribution efficiency improvement, enabling footprint rationalization as Advance finally streamlines operations after its 2014 General Parts purchase (a view bolstered by its plans to close two distribution centers). We are also encouraged by early results for Advance Pro, a new online portal for professional clients (higher conversion rate, dollars per transaction), and Advance's new DIY website (visits up 90% in June with flat conversion rates). We argue that Advance and its peers will withstand pressure from online-only retailers but expect omnichannel offerings to generate sales, leveraging distribution networks and trained store personnel.