Advance Auto Parts: Intrinsic Value 24% Below Share Price

Advance Auto Parts, Inc. (NYSE:AAP) has been underperforming the broader market, with its share price down nearly 30% from its March 2024 peak. Despite this decline, the company's fundamentals remain solid, and its intrinsic value may be significantly below its current share price. In this article, we will explore the key factors driving Advance Auto Parts' valuation and discuss potential strategic initiatives to improve its financial performance.

Key Assumptions in the DCF Model
The Discounted Cash Flow (DCF) model is a widely used valuation method that estimates the attractiveness of an investment opportunity by discounting expected future cash flows to their present value. In the case of Advance Auto Parts, the DCF model suggests that the company's intrinsic value is potentially 24% below its current share price. This discrepancy can be attributed to several key assumptions in the DCF model:

1. Discount Rate: The discount rate used in the DCF model is a crucial factor that reflects the riskiness of the investment. A higher discount rate will result in a lower intrinsic value, making the stock appear more expensive. In the case of Advance Auto Parts, the discount rate used in the DCF model is 10% (in the first article) and 11% (in the second article). A lower discount rate would increase the intrinsic value, making the stock appear cheaper.
2. Growth Rate: The growth rate used in the DCF model is based on analyst estimates and ranges from 2.6% to 3.7% for the next ten years. A higher growth rate will increase the terminal value and the intrinsic value of the company, making the stock appear cheaper. Conversely, a lower growth rate will decrease the terminal value and the intrinsic value, making the stock appear more expensive.
3. Free Cash Flow (FCF) Estimates: The DCF model relies on analyst estimates for FCF over the next ten years. If these estimates are inaccurate or overly optimistic, the intrinsic value calculated by the DCF model will be affected. For example, if the actual FCF growth is lower than the estimated growth, the intrinsic value will be lower, making the stock appear more expensive.
4. Terminal Value: The terminal value is calculated using the Gordon Growth formula, which assumes that the company's FCF will grow at a constant rate in perpetuity. If the assumed growth rate for the terminal value is too high or too low, the terminal value will be overestimated or underestimated, respectively. This will significantly impact the intrinsic value calculated by the DCF model.

Strategic Initiatives to Improve Financial Performance
Given the decline in earnings over the past year, Advance Auto Parts can consider implementing the following strategic initiatives and operational improvements to reverse this trend and improve its financial performance:

1. Improve Inventory Management: Efficient inventory management can help reduce costs and improve profitability. Advance Auto Parts could invest in better inventory tracking systems and optimize its inventory levels to minimize waste and maximize sales. This could involve implementing a more sophisticated demand forecasting system or improving the company's supply chain management processes.
2. Expand Online Presence: With the increasing trend of online shopping, Advance Auto Parts could expand its online presence to reach a larger customer base. This could involve improving the company's website, offering more online-only promotions, or even partnering with online marketplaces to sell its products. By increasing its online sales, the company can tap into new revenue streams and potentially reduce its reliance on brick-and-mortar stores.
3. Diversify Product Offerings: Diversifying the company's product offerings can help attract new customers and increase sales. Advance Auto Parts could consider expanding its product line to include more specialty items, performance parts, or even non-automotive products that complement its existing offerings. This could help the company appeal to a broader range of customers and increase its market share.
4. Improve Customer Experience: Enhancing the customer experience can lead to increased customer loyalty and repeat business. Advance Auto Parts could invest in training its employees to provide better customer service, improving the in-store experience, or even offering more personalized shopping experiences through targeted marketing or loyalty programs.
5. Reduce Operating Expenses: Reducing operating expenses can help improve profitability without negatively impacting sales. Advance Auto Parts could consider negotiating better terms with suppliers, reducing waste in its operations, or even consolidating some of its stores to reduce overhead costs. By focusing on cost-cutting measures, the company can improve its bottom line without sacrificing its core business.
6. Invest in Technology: Investing in technology can help Advance Auto Parts improve its operational efficiency and better serve its customers. This could involve implementing new point-of-sale systems, improving the company's data analytics capabilities, or even investing in automated inventory management systems. By leveraging technology, the company can streamline its operations and better meet the needs of its customers.

Conclusion
Advance Auto Parts' intrinsic value is potentially 24% below its current share price, according to the DCF model. This discrepancy can be attributed to key assumptions in the DCF model, such as the discount rate, growth rate, FCF estimates, and terminal value. To improve its financial performance, Advance Auto Parts can consider implementing strategic initiatives such as improving inventory management, expanding its online presence, diversifying product offerings, enhancing the customer experience, reducing operating expenses, and investing in technology. By focusing on these areas, Advance Auto Parts can work to reverse its decline in earnings and improve its overall financial performance.