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Advance Auto Parts Pivots Strategy to Compete with Rivals

NEW RICHMOND, WI, USA - DECEMBER 31, 2023:Advanced Auto Parts exterior and trademark logo.

Management at Advance Auto Parts Inc. (NYSE: AAP) is looking to reinvent itself this year, or at least that’s what the first quarter 2024 earnings results suggest. The company aims to compete with the likes of O’Reilly Automotive Inc. (NASDAQ: ORLY) and even AutoZone Inc. (NYSE: AZO).

After reporting its first quarter earnings, Advance Auto Parts' shares have shown little change. They will likely remain within their current $65 to $75 range until investors gain a clearer understanding of the company's true potential. Price action wasn't the company's forte this year, but that's only because markets are focused on more hotshot stories in the vehicle space, such as Carvana Co. (NYSE: CVNA).

However, today’s market demands a return to old-school fundamentals for investment decisions, as this rally is unlike the one in 2020. Understanding the current economic conditions is essential to understanding why Advance Auto Parts is making the right moves.

Market Shifts: Understanding the 2024 Rally vs. COVID-19 Rally

Sure, the S&P 500, NASDAQ, and even the Dow have hit all-time highs recently, but unlike 2020’s COVID-19 rally, not all stocks participate. This time, most of the momentum is driven by the so-called ‘magnificent seven’ stocks, mainly in the technology sector.

These stocks enjoyed the multi-year expansion of the services sector, judged by the ISM services PMI index readings. On the other hand, the manufacturing sector had been contracting for over 15 straight months, so it is no wonder Inc. (NASDAQ: AMZN) made it to the Dow, which is supposed to be industrial only.

A propped-up stock market, pricing in interest rate cuts from the Federal Reserve, hides the fact that the U.S. economy is now suffering from stagflation. Stagflation is defined as low economic growth with high inflation. A 1.6% quarterly GDP growth rate and 3.4% inflation fit the profile.

So, how can investors ensure they don’t get caught up in a market-wide tantrum? Focus on free cash flow, ideally at a good enough discount.

Advance Auto Parts is Flowing Again

After posting a net operating cash flow loss of $382.5 million last year, the automotive parts company reported a positive operating cash flow of $2.6 million in the past quarter. While this is a step closer to the ideal situation, it hasn't yet achieved completely positive free cash flow, which is operating cash flow minus capital expenditures.

However, this isn't necessarily a negative. Management invested $48.9 million in property and equipment, primarily for cost savings. This investment resulted in a $120 million change in inventories and a $280 million improvement in accounts payable.

These changes indicate a more flexible financial position, setting the company up for better profitability once the economy recovers. Although net revenues decreased by 0.3%, selling and general (SG&A) expenses declined by nearly 2%, highlighting the effectiveness of these cost-cutting initiatives.

Knowing that management is shifting the company’s financials in the right direction, analysts at Evercore saw it fit to boost Advance Auto Parts’ valuation to $78 a share, daring it to rally by 11.5% from where it trades today, but that’s not even the best part.

Advance Auto Parts Stock Discount: A Summer Sale for Investors

Not for the store but for the stock itself. While AutoZone and O’Reilly trade at a respective 86% and 82% of their 52-week high prices, Advance Auto Parts has fallen to merely 62% of its 52-week high, and that’s where the discount story is born.

A stock's valuation, particularly the forward P/E ratio, is driven by future expectations. When investors notice that Advance Auto Parts analysts expect earnings per share (EPS) growth of 13.2% this year, the stock's current valuation (a 15.3 times forward P/E) looks reasonably attractive.

O’Reilly is only looking to push out 10.6% EPS growth this year while still trading at a 20.6 times forward P/E, or a 34.3% premium to Advance Auto Parts, despite its superior growth.

AutoZone is a similar story. Although it has only 8% EPS growth, it is still 10% more expensive than Advance Auto Parts due to its 16.8 times forward P/E.

Just as Raymond James & Associates boosted its position in Advance Auto Parts stock by 24.1% this quarter, bringing its net investment up to $10 million, the stock’s short interest also contracted by 2.5% last month, giving bulls a wider path into these improving financials.

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