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A steep curve provides opportunity in Advance Auto Parts
admin | May 1, 2020
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Advance Auto Part’s recent 10-year offering has tightened modestly since pricing, but the issue has under-performed both the broader investment grade market and bonds of their closest peer, O’Reilly Automotive. Investors have an opportunity to pick-up considerable yield and take out up to 8 points by switching out of O’Reilly 10-year bonds into the new Advance Auto Parts issue, which are trading wide to fair value.
Advance Auto Parts Inc.’s (Baa2/BBB-) recent 10-year offering has lagged the broader market as the deal is roughly +4 bp tighter from pricing at +320 bp on 4/13/20. Over the same time period, the LUACTRUU Index is roughly +10 bp tighter. While the lag is not that large of a difference, AAP’s closest peer, O’Reilly Automotive (ORLY – Baa1/BBB) has seen considerable tightening in its 10-year issue over the same time period (+32 bp). This has led to a much flatter curve for ORLY. That said, while AAP and ORLY trade roughly 10 bp apart at best in the 3-year part of the cure, a swap out of ORLY 4.20% 2030 bonds into AAP 3.9% 2030 bonds provides for an attractive pick-up of +67 bp (g-spread) while taking out roughly 8 points. Fair value for AAP 3.9% 2030 bonds is approximately +40 bp behind ORLY.
Exhibit 1: BBB Retail Curve (3-year to 10-year)
Source: Bloomberg
Leverage and Liquidity Are Superior
Despite the lower ratings, AAP maintains better leverage than both of its peers providing it with more flexibility under it currents ratings. AAP entered the pandemic with lease-adjusted leverage of 2.0x. Post the new deal, estimated leverage increased to roughly 2.3x. This compares favorably to ORLY who ended its recent quarter with leverage of 2.6x, above its current stated 2.5x target. S&P has noted that its calculation of leverage brings ORLY’s leverage closer to the 3.0x area. Additionally, AAP’s liquidity is roughly $1.7 billion pro forma the new issue giving it ample headroom to navigate the COVID pandemic. AAP also has no debt maturing until 2022. ORLY’s liquidity stood at $1.1 billion as of 3/31/20 and has $800 million of debt maturing in 2021.
Turnaround Bearing Fruit – Likely to Help Offset Some COVID Impact
AAP embarked on a multi-year turnaround program last year in an effort to address the operating margin gap between itself and its peers. The company’s margins have been lagging its peers by nearly 50%. AAP began with increasing profit per store and conducted a footprint optimization strategy which consisted of store closures as well as consolidations. Management also was able to meaningfully reduce lease liabilities through successful lease negotiations. AAP also addressed the long-term optimization of its distribution center footprint which has helped with replenishment issues across its store base. Certain distribution centers could only replenish legacy stores while other distribution centers served its acquired and new store base. Private label investment has helped with material cost optimization efforts as private label typically carries higher margins versus branded items. Lastly, the company has scrutinized the SG&A line and successfully reduced insurance and workers’ compensation costs with improved safety measures that have meaningfully reduced incident reports. As a result, AAP saw its operating margin expand by 106 bp in 4Q19 and 36 bp in FY19. Management has noted that it believes it can achieve 700-to-850 bp of margin expansion over the next five years.
Additional Steps Taken
Since the pandemic, AAP took further steps to reduce costs and preserve financial strength. Management cut capital expenditures for 2020 by over 50% which has helped to reduce professional fees and contract labor costs associated with certain projects. AAP noted that they are currently only choosing to spend on projects that they believe will have the best return on investment. Additionally, the company suspended its share repurchase program. Last year, AAP’s share repurchase program consumed $495 million.
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