The Long and Short
Advance Auto Parts downgraded to junk
Meredith Contente | September 15, 2023
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.
S&P’s recent downgrade of Advance Auto Parts (AAP) has caught the market a bit off guard, particularly as its new CEO took the helm on September 11, the day before the downgrade, and will be conducting a strategic review of the business. While AAP’s results have trailed peers the past few quarters, company defined leverage is still within the investment grade realm. AAP still maintains an investment grade rating at Moody’s, but given that it is only rated by two agencies, AAP will fall out of the investment grade index at the end of the month.
The split rating can complicate valuations for the bonds as Investment Grade accounts will be forced sellers and High Yield accounts my not see enough yield to be active buyers. However, AAP spreads are trading in line to wide of the BB+ consumer discretionary curve, depending on the tenor. That said, we see value in short-dated AAP bonds, particularly its 2026-2028 tenors and could see some further spread pressure on its 2030 and 2032 bonds as we move closer to month-end. Importantly, AAP’s 2026 and 2027 bonds mature ahead of the company’s existing revolver.
Exhibit 1. AAP Spreads Relative to BB+ Discretionary Curve
S&P Cuts to BB+
S&P lowered its rating one notch, to BB+ with a stable outlook, reflecting the company’s underperformance as it navigates execution challenges while undergoing its transformation. S&P noted that credit metrics will be weaker than previously forecast and that leverage (S&P adjusted) increased to 4.6x for the most recent quarter. This compares to company defined leverage of 3.1x for the same time period, which would still be considered Investment Grade. S&P believes that adjusted leverage will remain above 4.0x through 2024, given the company’s EBITDA margin erosion, which has largely accelerated over the past few quarters relative to industry peers (Exhibit 2).
Exhibit 2. AAP Quarterly EBITDA Margin Comparison (1Q21-2Q23)
Inventory, product availability and supply chain issues have challenged AAP, which has led to a loss of market share. This is evidenced by the company’s flattish sales while peers are posting revenue growth in the low-teens percentage range. In fact, comparable sales were negative in the past two quarters (on average down 0.5%), while AZO and ORLY have witnessed average comparable sales growth of 3.6% and 9.9%, respectively, over the past two quarters.
Moody’s Maintains a Baa2 Rating
Moody’s continues to rate AAP Baa2 but changed its outlook to negative in June 2023. The negative outlook reflects the profitability declines that the company has witnessed which has put pressure on its leverage metrics. Moody’s believes that improvement will depend on management’s ability to execute on its inventory initiatives, which include improving fulfillment rates of the company’s private label products. Private label carries higher margins relative to national brands, which should help to stabilize the EBITDA margin and is important to the leverage metric.
Moody’s expects AAP to maintain a solid liquidity profile which has been supported in the past by good free cash flow generation. AAP recently cut full year free cash flow guidance to the $150 million – $250 million range, which is well off historical levels. As such, AAP cut the dividend by roughly 83% and has paused share repurchases, to limit cash outflows. The company maintains a $1.2 billion revolver (maturing 11/9/27) that currently has $95 million outstanding. AAP’s next debt maturity is not until 3/9/26, when $300 million comes due.
Revolver Covenant Amended
On 8/21/23, AAP amended its consolidated coverage ratio covenant governing its bank line. Under the amendment, AAP must maintain its LTM coverage ratio above 1.75x for fiscal third quarter and fiscal fourth quarter of 2023. That ratio then steps up to a minimum coverage of 2.0x through the third quarter of 2025. Subsequent to the third quarter of 2025, AAP must maintain a minimum coverage ratio of 2.25x, which was the minimum coverage ratio prior to the amendment. No other covenants were amended, including the leverage ratio covenant, which caps AAP’s LTM leverage ratio at 3.75x. Management noted on its earnings call that the amendment was needed given the higher interest costs associated with its issuance earlier this year. AAP issued 3-year and 5-year notes with coupons of 5.9% and 5.95%, respectively. The amendment provides management with some time to execute on both its inventory and supply chain strategies, which are expected to be implemented under the new CEO.