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Fix the Old, Don't Buy the New

03/19/2009 12:00 pm EST


Stephen Biggar

Director, Product Strategy, Argus Research Corporation

Stephen Biggar, global director of equity research for Standard & Poor’s, says an auto parts retailer will profit from the revival of the do-it-yourself trend in America.

Advance Auto Parts (NYSE: AAP) carries Standard & Poor's highest investment recommendation of Five STARS, or Strong Buy. Our positive outlook on the shares reflects our view of strong industry fundamentals, as well as positive [factors] such as a compelling valuation.

While the economic recession has [hurt] the vast majority of consumers and businesses, retailers catering to automotive after-market products have actually benefited from this downturn.

In the fourth quarter of 2008, while most retailers were posting comp-store declines in the mid single-digits (or worse), AAP grew same-store-sales by 3.0%, its best comp performance in the past 11 quarters. Competitors posted strong comps as well.

The US automotive aftermarket industry serves a large and growing market, and we expect industry-wide revenues to advance at about a 4% clip over the next five years. We believe the industry is fragmented and mature.

In our view, improved business conditions for the auto parts retailers are primarily the result of reluctance by consumers to purchase new vehicles [whose] sales have slowed to a crawl. S&P Economics projects that only 9.8 million vehicles will be bought in 2009—and that 2010 will see only a mild rebound in sales, to 11.2 million.

Vehicles currently average 9.9 years, a historical high, and we expect that number to increase further over the next several years. [Also,] each $1.00 decrease at the pump contributes $10 billion in additional spending capacity to consumers, [especially] lower- and middle-income families, the [prime] demographics for auto parts retailers.

[Finally,] it is usually far cheaper [for owners] to repair and maintain their current vehicles than to replace them. [These all] will benefit AAP (and its peers) over the near to medium term.

For 2009, we expect AAP to post sales growth of 4.3%, driven by an increase in square footage of about 2% and comparable-store gains of 3%. We project 2009 earnings at $2.87 per share. For 2010, we forecast sales will rise an additional 6%, driving EPS to $3.13.

Although AAP shares have already risen [more than] 20% thus far in 2009, we think the shares remain a compelling Buy. At 14.3x our 2009 EPS estimate, AAP shares are trading at a modest discount to [its] peers. Furthermore, AAP's P/E ratio represents a modest discount to the 15.6X it has averaged over the past three years.

Our discounted cash flow (DCF) valuation, which assumes a blended weighted average cost of capital of 10.3% and a terminal growth rate of 3.5%, suggests an intrinsic value of $45 for AAP shares. This value, which represents our 12-month target price, is about 10% above [Wednesday’s close of $41] and approximately 16x our 2009 EPS estimate.

Given recent stock market volatility and a lack of earnings visibility for a large number of companies, we think AAP's stable business model and attractive industry fundamentals should present additional appeal to investors.

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