Investors in Advance Auto Parts (AAP 0.34%) were left disappointed after S&P Global Ratings downgraded the company’s debt to “junk” status, noting its sales underperformance relative to peers like AutoZone and O’Reilly Automotive in the last year and a half. In addition, S&P Global believes Advance Auto’s “misguided” strategy of trying to hold pricing has led to market share erosion.
The news caused another leg down in a stock that’s now down more than 60% this year as I write. Is it now time to go bargain-hunting for the stock, or is it one to avoid?
S&P Global’s downgrade
S&P Global’s viewpoint seems at odds with Advance Auto Parts management’s, and the difference of opinion may cause investors to exercise caution over the stock. The rating agency is critical of the strategy to keep profit margins high by holding prices, and believes Advance Auto has suffered a weakening in its “competitive standing.”
That’s no minor issue in the auto parts market, not least for the pro market that tends to demand reasonably priced parts available in-store for immediate use. As you can see below, the strategy has yet to do anything for Advance Auto Parts’ revenue growth compared to its peers.
Neither did it do anything for its operating margin progression.
Change is coming
Management acknowledges that it needs to improve performance. A new CEO, Shane O’Kelly, has recently been appointed, with former CEO Tom Greco staying on as an advisor. Management is conducting an operational and strategic review of the business, with O’Kelly’s input included — more on that in a moment.
First, it’s worth noting that Greco’s 2016-2023 tenure was unsuccessful. He failed to close the gap in operational performance with AutoZone and O’Reilly Automotive, despite significant effort and the input of activist investor Starboard Value. So it’s hardly surprising that the debt rating agency downgraded its debt. The chart below shows how Advance’s financial debt to earnings before interest, taxation, depreciation, and amortization (EBITDA) has risen over the last 18 months.
What changes are coming
The debt rating agency’s downgrade points to fundamental issues at the company. In contrast, Advance’s management appears to be taking a more moderate view on matters. For example, on the last earnings call in August, Greco lauded the investments made to improve inventory availability and pricing, and noted a sales improvement in the last four weeks of the quarter and into the current third quarter.
Meanwhile, Interim Executive Chair of the Board of Directors Gene Lee told investors the new strategy was an event of “less than one year,” continuing, “I mean, I think that we should start seeing incremental improvement pretty quickly here.”
A value stock?
It seems unlikely that years of underperformance versus peers will be turned around by a strategy taking place in less than one year. Greco was CEO for seven years, yet Advance Auto Parts continues to lag significantly behind its peers in profit margins, inventory management, and cash conversion.
In addition, management is still discussing better inventory management and in-store parts availability. Moreover, six weeks of sales improvement is scant evidence of any fundamental turnaround in its business — not least as it comes after a period of sustained underperformance compared to its peers.
Management appears to be taking the view that it’s already on the right track, and the strategic review may well turn out to be limited in scope. As such, it makes more sense to see the results of the strategic review of the business before considering buying in because it’s far from clear Advance Auto Parts is on the path to generating value for investors.
Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.