A Few Years From Now, You'll Wish You'd Bought This Undervalued Stock | The Motley Fool (2024)

I believe that car-parts retail chain Advance Auto Parts (AAP -0.32%) will be capable of earning $1 billion in annual profit a few years from now. And the stock is wildly undervalued today, based on my contrarian assumption.

As of this writing, Advance Auto Parts stock is down about 75% from its highs reached in 2021. Many investors overlook it because it's a boring business at best and an outdated, outcompeted business at worst. In short, hardly anyone is considering what the company is doing to position itself for greater profitability a few years from now. That's why this is an opportunity that I want to highlight.

Here's why Advance stock is misfiring

According to research from S&P Global Mobility, cars on U.S. 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 old.

Also consider that U.S. non-housing debt is hitting new highs. It's at $4.9 trillion as of the second quarter of 2024, according to the Federal Reserve Bank of New York. With interest rates still elevated, the time isn't ideal for people to suddenly take on additional debt to buy new cars. In other words, the situation seems ripe to keep that aging fleet of vehicles on the road even longer.

This is where auto-parts retailers such as Advance Auto Parts come in. Despite its lagging stock performance, demand for the company's products is still high. People continue to spend on regular maintenance for their geriatric vehicles. Yes, same-store sales for the company were down less than 1% in the first quarter of 2024, as well as in its fiscal 2023. But this modest decline is off record-high sales numbers.

For what it's worth, Advance's rivals O'Reilly Automotive (ORLY 0.33%) and Autozone (AZO 1.39%) are also experiencing record-high demand -- it's an industry trend.

AAP Revenue (TTM) data by YCharts.

During the past five years, shares of Autozone and O'Reilly have more than doubled the returns of the S&P 500, whereas Advance stock has 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 has slipped well below 1%.

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

AAP Gross Profit Margin data by YCharts.

The chart above shows a sudden drop in the gross profit margin for Advance, coinciding with a big acquisition. Since that acquisition, the company has essentially operated two supply chains, making overall operations quite inefficient, dragging down margins.

Why now is 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 ditching the status quo. The company hired Shane O'Kelly as its new chief executive officer in September. He's a supply chain expert as the former CEO of HD Supply -- it was the express reason he was hired.

The supply chain analysis is already complete. Advance decided it needs 14 distribution centers in one unified system to make everything work optimally. It already has 13 of the 14 it wants, and it's looking for one more optimal facility. For perspective, the company has 38 distribution centers currently -- more than double what it needs.

The planned overhaul clearly illustrates just how inefficient operations have been for Advance. Fortunately, that's about to change. Granted, this transformation will take a number of years to complete. But it should help profit recover.

I believe a revamped Advance could enjoy 10% profit margins. That would still be worse than its peers, so this isn't an impossibly high bar to jump over. For perspective, the company had net sales of more than $11 billion in 2023. If it can keep net sales above $10 billion, then it would have more than $1 billion in annual net income in this scenario.

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

In other words, I believe all of these assumptions are conservative for Advance. It all hinges on correcting its supply chain shortcomings. But I believe this expectation is reasonable, considering that's the specific skillset it sought when it hired its new CEO.