Given the headlines, it’s no wonder Advance Auto Parts (AAP) shares are up a whopping 11% on Wednesday.
Even with the gain, it’s only a fraction of the price a major hedge fund said AAP was actually worth based on the company’s prospects.
There’s just one thing a bit questionable about the bullish call … is this hedge fund actually going to hold out for what it says is its target price on Advance Auto, or is it going to lock in its profits somewhere in between here and there, selling the very stock it’s encouraging others to buy?
In other words, consider the source of the tip, and run AAP stock through the reality wringer.
Advance Auto Parts may not be “all that and a bag of chips” just because a recognizable name said it was.
Advance Auto Parts is Worth What?
On the off chance you’re reading this and haven’t heard yet, hedge fund Starboard Value was very clear this morning that it thinks AAP stock could be worth $350 per share (or more) in light of its growth opportunities.
For those of you keeping score, that’s more than 100% higher than where Advance Auto shares closed on Tuesday.
Starboard was slated to make its bullish case on AAP on Wednesday at the C4K Sohn Canada Conference, but suggested the target price via a public letter to Advance Auto CEO Darren Jackson posted this morning.
Starboard Value’s managing member Jeffrey Smith acknowledges it will take some tweaking to realize such a lofty price. Specifically, he noted:
“We believe that Advance can achieve a share price of more than $350 by implementing a comprehensive margin improvement program, together with additional value creation opportunities, including substantial working capital improvements, realizing the value of Worldpac, and implementing a daily delivery program to drive commercial sales. Moreover, if Advance realizes margins and multiples in line with O’Reilly, which we believe is achievable, its stock could be worth well over $400.”
It’s an exciting premise to be sure — a new idea here, a rework there, and all of a sudden, Advance Auto Parts is firing on all cylinders. The market is understandably excited.
The market also needs to understand, however, that Starboard Value owned $460 million worth of AAP stock as of Tuesday’s close, and that trade was up by $55 million at one point today alone, just because the fund merely floated the idea that the auto parts retailer could be worth more.
Reality Check
This isn’t to say Advance Auto Parts shares can’t double between now and whatever point in time Starboard had in mind (presumably a couple of years, give or take). But for AAP to realize such a value, it’s going to take a stunning overhaul.
The letter to Darren Jackson explicitly noted Advance Auto Parts’ operating margins were 800 to 900 basis points (8 to 9 percentage points) weaker than those of peers like O’Reilly Automotive (ORLY) and AutoZone (AZO).
With that being the case, Advance Auto theoretically could have driven an operating profit of about $1.7 billion last year rather than the $852 million it posted as operational income. All other things being equal, on an after-tax basis, that would have translated into net income of roughly $986 million, or per-share income of roughly $13.40, rather than the $6.71 per share of AAP the company managed to produce.
Yep, that’s more than twice the profits the auto parts retailers has been producing.
Assuming the same math applies going forward, that would suggest Advance Auto Parts is capable — capable — of driving per-share profits near $20 next year rather than the $9.80 per share analysts currently expect.
Valuation-wise, Starboard’s target of $350 divided by per-share earnings of $20 (give or take) leads to a palatable P/E ratio of 17.5.
They’re just back-of-the-envelope numbers, but Starboard Value’s basic premise holds water.
Bottom Line
Saying it is one thing. Doing it is another.
Should Advance Auto Parts aim for the same kind of operating margins its competitors are producing? Probably, though not definitely. It’s entirely possible weaker operating margins are an integral part of the company’s success; perhaps it’s a price leader in certain categories. Or, maybe Advance Auto’s selling and supply costs have a curious quirk that works. It’s hard to say — and it’s also hard for Starboard to say.
See, it’s easy to not realize the unique aspects of a particular business when you’re on the outside looking in, mostly examining accounting statements … statements that don’t tell the whole story. Or, even if Starboard is exactly right, there’s still no assurance long-lived Advance Auto Parts is even capable of making what would clearly be a drastic change.
Sometimes, you’re better off not fixing what’s not clearly broken.
Of course, the proposed changes don’t necessarily have to be implemented and successful for AAP stock to advance. Today’s chatter alone has pushed the stock a tenth of the way to Starboard’s target price.
Whatever is in the cards, current and would-be shareholders should bear in mind that Starboard could sell its AAP stake at any time with no warning, just like it bought it.
Just be sure you’re not being set up to be the one left holding the bag.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities.
