Advance Auto Parts sees Third Point and Saddle Point secure board seats; potential margin improvement plan emerges.

Company: Advance Auto Parts (AAP)

An automotive aftermarket parts provider, Business offers a range of brand names, original equipment manufacturers, and brand-owned automotive replacement parts, accessories, batteries, and maintenance items for various vehicles. It operates approximately 4,770 stores and 316 branches across the United States, Canada, Puerto Rico, and the U.S. Virgin Islands.

Stock Market Value: $4.19B ($70.50 per share)

Activist: Third Point and Saddle Point Management

Percentage Ownership: 8.04% economic exposure

Average Cost: n/a

Third Point, founded by Dan Loeb, is a multi-strategy hedge fund that selectively takes activist positions. Loeb is a pioneer in shareholder activism and has shaped modern-day shareholder activism. He invented the poison-pen letter and transitioned to the power of the argument as times changed. The firm has amicably obtained board representation at companies like Baxter and Disney, but will not hesitate to launch a proxy fight if ignored.

Saddle Point, an investment firm managed by Roy Katzovicz, has joined forces with Third Point to form a group that owns 4,781,557 shares (8.04%) of AAP stock, which is a mix of common stock and derivatives, with the majority being owned by Third Point.

What's happening

On March 11, Advance Auto Parts appointed three directors to its board: Tom Seboldt, Gregory Smith, and Brent Windom. Seboldt is the president of Seboldt Consulting Services and a former executive at O'Reilly Automotive. Smith is EVP, global operation and supply chain of Medtronic and former EVP, supply chain of Walmart. Windom is a former president and CEO of Uni-Select.

Behind the scenes

Advance Auto Parts was not the first stock to have activist campaigns, as Starboard Value had an activist campaign from September 2015 to May 2020 and exited their investment in the first quarter of 2021 when the stock was trading at approximately $185 per share. The stock peaked around $240 a share in late 2021 but fell to about $120 a share by May 2023. After reporting a significant Q1 of 2023 earnings miss of 72 cents per share, 68% lower than the same quarter in 2022, compared to a consensus estimate of $2.57 per share, the stock price plummeted to $72.89 on May 31, 2023. This made it an interesting entry point for investors who had been watching the stock.

Advance Auto Parts has two distinct businesses: its retail auto parts business and Worldpac, its wholesale auto parts distribution business. While both businesses operate in the automotive industry, they have different supply chains and distribution networks. The first opportunity to create value is by selling Worldpac, which is estimated to be worth approximately $1.5 billion based on sell-side estimates. With $2 billion in revenue and high-single digit earnings before interest, taxes, depreciation, and amortization margins, Worldpac could fetch at least $2 billion at a conservative 10x multiple. A sale would allow management to reduce debt, stabilize the company's balance sheet, and upgrade its S&P rating from junk debt.

Advance Auto Parts' 4,770 stores are valued at approximately $1.25 million per store, whereas peers O'Reilly and AutoZone have per store valuations of $11 million and $8 million respectively. While part of this valuation discrepancy is the estimated value of Worldpac and part is the balance sheet issues, the real problem is sales and margins. O'Reilly generates sales of approximately $2.5 million per store versus AAP at $1.8 million. This is not a marketing issue, a pricing issue or a sales personnel issue. Rather, it is a supply chain and stocking issue. There is little, if any, brand loyalty in the auto parts business. Customers go to stores that have the part they need. AAP's biggest problem has been keeping parts in stock for sale, so customers go elsewhere. Solving this problem would not only increase their revenue closer in line with peers, but it will significantly improve their EBITDA margins. With a 50% gross profit margin, virtually half of every incremental sales dollar goes to the bottom line just by having the parts in stock.

Advance Auto Parts has a new CEO who is highly skilled and capable of leading the company. Shane O'Kelly became CEO in September 2023 and has a strong retail background and leadership abilities. However, he lacks industry expertise and support from the board level. To address this, Third Point and Saddle Point have recently settled for board seats for Thomas Seboldt, Gregory Smith, and Brent Windom, all experienced industry executives with a mix of automotive industry and supply chain experience. Seboldt has spent most of his career with O'Reilly Automotive, while Windom is an experienced automotive industry executive who most recently served as president and CEO of Uni-Select. Smith is a supply chain expert with experience at Medtronic, Walmart, and Goodyear. Finding the right directors to support a good CEO is a common strategy used by activists, including Third Point, to create value for portfolio companies. In fact, when Third Point has received three or more board seats in activist campaigns, it has averaged a return of 49.79% versus 37.77% the S&P 500 over the same periods.

Ken Squire is both the founder and president of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of activist 13D investments.