In a few years, you’ll wish you had bought this undervalued stock

I think the auto parts retail chain Advance Auto Parts (AAP 0.52%) it will be able to earn an annual profit of one billion dollars in a few years. And the stock is undervalued today, based on my contrary assumption.

At the time of writing, Advance Auto Parts stock is down about 75% from its 2021 highs. Many investors overlook it because it’s a boring business at best and an outdated, outdated business at worst. worst case. In short, almost no one is thinking about what the company is doing to position itself for higher profitability a few years from now. That is why this is an opportunity that I want to highlight.

Here’s why Advance stock is wrong

According to research from S&P Global Mobility, cars on US roads are older than ever. The average car or light truck is 12.6 years old in 2024. The average passenger car is even older at 14 years.

Also consider that US non-housing debt is hitting new highs. It’s at $4.9 trillion by the second quarter of 2024, according to the Federal Reserve Bank of New York. With interest rates still high, the time is not ideal for people to suddenly take on additional debt to buy new cars. In other words, the situation looks set to keep that aging fleet of vehicles on the road even longer.

That’s where auto parts retailers like Advance Auto Parts come in. Despite the stock’s past performance, demand for the company’s products is still strong. People continue to spend on regular maintenance of their aging vehicles. Yes, same-store sales for the company fell less than 1% in the first quarter of 2024 as well as in fiscal 2023. But that modest decline is off a record sales high.

For what it’s worth, Advance’s rivals O’Reilly Automotive (ORLY 1.30%) and Autozone (AZO 1.28%) are also experiencing record demand — it’s a trend in the industry.

AAP Revenue (TTM) data from YCharts.

Over the past five years, shares of Autozone and O’Reilly have more than doubled their returns S&P 500while Advance shares underperformed by a wide margin. It’s not hard to find the reason. Autozone and O’Reilly each have a profit margin of about 15%. In contrast, the profit margin for Advance fell well below 1%.

To be clear, profit margins for Advance have significantly trailed its competitors for more than a decade. And this has a clear explanation: the company has long had a terribly inefficient supply chain, which has pushed its gross profit margin to levels lagging behind the industry. But the chart below shows it was in line with its top rivals years ago.

AAP Gross Margin Data by YCharts.

The chart above shows a sharp drop in Advance’s gross profit margin that coincides with a large acquisition. Since that acquisition, the company has essentially operated two supply chains, making overall operations quite inefficient, dragging down margins.

Why now it’s finally different for Advance stock

You can’t do the same thing and expect different results, which is why I’m happy to report that Advance is finally breaking with the status quo. The company hired Shane O’Kelly as its new chief executive in September. He’s a supply chain expert as the former CEO of HD Supply — that was the express reason he was hired.

The supply chain analysis is already completed. Advance decided it needed 14 distribution centers in one unified system to make everything work optimally. He already has 13 of the 14 he wants and is still looking for an optimal facility. For perspective, the company currently has 38 distribution centers — more than double what it needs.

The planned overhaul clearly illustrates how inefficient operations have been for Advance. Fortunately, that’s about to change. Of course, this transformation will take several years. But it should help recover profits.

I think a refurbished Advance could enjoy 10% profit margins. It would still be worse than its peers, so it’s not an incredibly high bar to jump over. For perspective, the company had net sales of over $11 billion in 2023. If it can maintain net sales over $10 billion, then it would have annual net income of over $1 billion in this scenario.

The market capitalization for Advance stock is just $3.6 billion as of this writing. If it trades at 10 times forward earnings, the stock could triple and still be much cheaper than the average valuation of S&P 500 stocks.

In other words, I think all of these assumptions are conservative for Advance. It all depends on correcting supply chain deficiencies. But I think that expectation is reasonable, given that this is the specific skill set he was looking for when he hired his new CEO.