Advance Auto Parts' Potential Overshadowed by Difficult Integration

Integrating the General Parts acquisition has been more challenging than expected for

While we do not expect Advance to hit its 12.0% 2016 operating margin target, we have a favorable view of its longer-term opportunities to gain efficiencies and close the performance gap with its peers. Although much of the company's lower profitability can be attributed to its reliance on independently owned stores, greater proportion of rented (rather than owned) locations than its peers, and higher proportion of commercial sales, we see ample margin-enhancing opportunities to optimize the distribution network, secure more favorable inventory financing, and drive private-label penetration. We also expect Advance to enjoy the same industry tailwinds as its peers, with structural changes that favor larger-scale chains due to their ability to leverage inventories and distribution networks across a dense store network and extensive sales base.

While industry moves toward higher-frequency store inventory replenishment and greater parts availability carry some expense, we believe they deepen Advance's competitive advantages by creating added brand differentiation versus smaller, regional peers while capitalizing on an infrastructure that only the largest retailers have in place. Availability is a critical metric for commercial clients in particular, and Advance's scale enables it to provide a wider variety of stock-keeping units relatively quickly, allowing Advance's clients to clear service bays efficiently. As the industry is highly fragmented, differentiation from local and regional incumbents offers a significant share growth opportunity and a chance to leverage inventory investments over a larger sales base, enhancing returns over time.

From a do-it-yourself standpoint, retailer-customer relationships are based on trust and service levels against a relatively price-inelastic backdrop. Consequently, differentiating elements like availability, convenience, and in-store services are critical means of drawing customers away from competitors. As a result, Advance's growing distribution capabilities and store network should act to reinforce its brand strength at the expense of smaller competitors that cannot match its investment.

Acquisition Wise, but Not Without Troubles While we believe the 2014 purchase of General Parts was wise given the attractiveness of the dual-market model and Advance's retail-oriented bent, the integration has been difficult, depressing sales as consumers experience disruption while the network is consolidated and converted. Despite short-term disappointment, we believe Advance stands to benefit as the purchase is digested, poised to capture increasing share in a market that should see significant consolidation behind large, national retailers that can leverage a broad distribution network to efficiently provide a high standard of service. Further benefiting Advance is the broader state of the industry, with increased miles driven and an aging vehicle fleet combining with a recovering economy to bolster growth.

While Advance's adjusted returns on invested capital and operating margins (9.3% and 10.2% in 2015, respectively) have lagged peers, we believe the company has ample runway for profitability growth over the years ahead. Its expanded store network should help Advance drive private-label penetration higher from current levels (approximately 40%) while spreading distribution costs over a larger base. Increased reliance on commercial sales requires expensive investments in inventory management to provide services like rapid store inventory replenishment and high availability, which are increasingly de rigueur in the industry. However, we believe such moves offer national players like Advance an opportunity to differentiate themselves from local and regional competition in a relatively price-inelastic industry. Advance's size should also help its acquisition costs and lead its accounts payable/inventory ratio to converge toward industry leaders' over time, improving efficiency as the firm gains cachet with vendors.

We believe the cost advantage associated with the firm's scope, together with the strength of Advance's brand intangible assets, provides a durable competitive advantage that should shine through once the acquisition is fully integrated as Advance's performance gradually moves toward that of its peers.

Strong Brand and Extensive Network Dig a Moat We have assigned Advance a narrow economic moat rating due to its brand intangible assets and the cost advantages afforded by its national presence. The firm has consistently generated returns on invested capital above our 8.3% weighted average cost of capital estimate. While the firm's 9.3% 2015 result (10.5% excluding goodwill) was a dip from its 13.0% average over the previous three years due to the General Parts acquisition, we believe Advance's distribution scope and brand intangible assets should drive economic growth in the years ahead. We foresee returns averaging 11.3% over the next five years, with steady increases throughout our explicit forecasting period.

Advance participates in an industry where differentiated service levels can lead to the formation of strong brands. Consumers are price-inelastic, with parts availability, convenience, and in-store services (in the DIY segment) carrying significant weight. As these consumer benefits are costly to deliver, larger retailers are at an advantage as they can spread service costs as well as inventory holding expenses over a large sales base. Brands are especially significant on the commercial side of the industry, where clients tend to stay with trusted partners as any cost differentials can largely be passed on to vehicle operators. High levels of parts availability enhance retailers' reputations with commercial buyers and are difficult to replicate by regional players with less extensive infrastructure. Commercial customers depend on quickly sourcing necessary parts in order to turn over service bays, making reliable parts availability a key point of customer engagement. Advance augments its relationships through its technician and shop owner training programs and technology solutions, which we believe deepen its engagement with professional clients and strengthen its brand equity.

The increasing complexity of automotive parts and the infrequency of repairs lead DIY consumers to depend on in-store sales staff for knowledge and advice to find the right product and understand how to complete the installation. The company has deepened this level of engagement by offering tool loans, oil and battery recycling, how-to videos, and simple diagnostics at its stores for free. As replacement of a failed part is often critical to the operability of the vehicle, consumers favor trusted retailers that are likely to have the part needed on hand or can obtain it quickly, aiding larger chains like Advance. For DIY customers who enjoy working on and maintaining their cars, Advance's high level of parts availability and consumer loyalty program help keep them in the fold. A DIY brand and trusted salesforce also enable Advance to drive significant traction for its proprietary brands (approximately 40% of sales).

The retail customer's need for assistance in purchasing the right part should forestall significant entry by nontraditional digital retailers (like Amazon) into the hard parts DIY space for the foreseeable future. Hard parts are increasingly complex and can vary significantly depending on the model year and selected options on any vehicle. The purchase and installation of such products can be daunting, and the support provided by trained in-store sales staff is difficult to replicate though do-it-yourself videos and online assistants. Advance's tool loan offerings add value, as parts installations sometimes require a specialized instrument that is better borrowed than purchased for a single-use application. Also, customers looking to replace a failed critical component often need the part immediately in order to regain reliable use of a car or truck in commuting or business. Few digital retailers are able to combine depth of inventory with speed of delivery. Advance already uses digital online ordering tools with its professional clients, and we believe its extensive and fairly flexible inventory makes disruption less of a concern in the commercial segment. We also expect that a large-scale move by manufacturers in favor of direct shipping is unlikely, due to the infrastructure required, end customers' price inelasticity, and the convenience associated with repair shops ordering parts made by multiple brands from one source.

Advance's extensive store and distribution network forms a durable cost advantage versus smaller peers. With 5,293 stores and 50 distribution centers as of the end of 2015, the company is able to quickly shift inventory to meet customer demand while keeping reserves of slower-moving parts that can rapidly be delivered to stores if needed. This enables Advance to maximize its inventory turnover despite high availability (subject to the constraints of a low-turn industry) by holding slow-moving SKUs at distribution centers and hub stores serving many traditional locations in their vicinity. As its investments in inventory management technology and supply chain automation are spread across a broader pool of sales and stores, the firm's cost profile improves in a way that is difficult for smaller competitors to replicate.

While Advance lags O'Reilly ORLY and AutoZone AZO, its scope has allowed it to mitigate its working capital burden through its 0.77 accounts payable/inventory ratio as vendors agree to generous payment terms for one of the largest parts retailers. Financing inventories through this mechanism offsets the balance sheet cost of providing high availability levels for slow-moving SKUs, enabling a standard of service that is uneconomical for smaller peers.

Integration Risk Remains Integration risk persists as Advance digests General Parts. The company also faces industry-level risks surrounding the key drivers of industry success: miles driven, average vehicle age, and unemployment rates. If today's favorable industry environment deteriorates, particularly before the integration is finished, Advance could suffer. Conversely, a faster-than-expected integration and an acceleration of positive trends could lead the firm to beat our forecasts.

The integration has been more challenging than expected, and the firm's flat 2015 comparable-store sales in a strong market indicates the degree to which the combination has provided an operational distraction. While we believe management is acting prudently to consolidate and convert stores, the firm risks frustrating retail and commercial customers as well as independent owners of Carquest franchises. The risks associated with the integration are double-edged -- the $160 million in proposed annual cost savings may not materialize if the company is insufficiently aggressive in reducing outlays, but a move too far may alienate customers and independent owners if service levels drop.

Favorable industry dynamics have provided some support, with miles driven (up 3.5% in 2015) and vehicle age (11.5 years in 2015 versus 10.6 years in 2010) rising as unemployment falls, increasing the need for vehicle repairs as well as customers' ability to pay for fixes and routine maintenance. Demand could drop if miles gains reverse due to higher fuel prices or unemployment reducing commuter miles driven. Higher scrappage rates could depress parts demand as more reliable, under-warranty products replace older vehicles. Conversely, persistent positive trends could boost Advance.

New CEO Thomas Greco has an admirable record, but we question whether he has the right experience to lead Advance through its present challenges, as he lacks significant retail experience and has not managed a complex, troubled acquisition integration before.