Advance Auto Parts’ Cash Flow Increases The Safety Of Its Dividend Yield

Recap from December’s Picks

On a price return basis, the Safest Dividend Yields Model Portfolio (+10.1%) outperformed the S&P 500 (+3.0%) by 7.1% from December 21, 2022 through January 17, 2023. On a total return basis, the Model Portfolio (+10.3%) outperformed the S&P 500 (+3.0%) by 7.3% over the same time. The best performing large-cap stock was up 29%, and the best performing small-cap stock was up 17%. Overall, 16 out of the 20 Safest Dividend Yield stocks outperformed their respective benchmarks (S&P 500 and Russell 2000) from December 21, 2022 through January 17, 2023.

This Model Portfolio only includes stocks that earn an Attractive or Very Attractive rating, have positive free cash flow and economic earnings, and offer a dividend yield greater than 3%. Companies with strong free cash flow (FCF) provide higher quality and safer dividend yields because strong FCF is proof they have the cash to support the dividend. I think this portfolio provides a uniquely well-screened group of stocks that can help clients outperform.

Featured Stock for January: Advance Auto Parts

Advance Auto Parts, Inc. (AAP) is the featured stock in January’s Safest Dividend Yields Model Portfolio.

Advance Auto Parts has grown revenue by 3% compounded annually and net operating profit after tax (NOPAT) by 9% compounded annually since 2016. The company’s NOPAT margin has risen from 6% in 2016 to 9% over the trailing twelve months (TTM), while invested capital turns improved from 1.3 to 1.4 over the same time. Rising NOPAT margins and invested capital turns drove return on invested capital (ROIC) from 8% in 2016 to 13% TTM.

Figure 1: Advance Auto Parts’ Revenue & NOPAT Since 2016

Sources: New Constructs, LLC and company filings

Free Cash Flow Supports Regular Dividend Payments

Advance Auto Parts has increased its regular dividend from $0.24/share in 2017 to $3.25/share in 2021. The current quarterly dividend provides a 4.0% annualized dividend yield.

More importantly, Advance Auto Parts’ free cash flow (FCF) easily exceeds its regular dividend payments. From 2017 to 2021, Advance Auto Parts generated $3.1 billion (23% of current enterprise value) in FCF while paying $270 million in dividends. Over the TTM, Advance Auto Parts generated $714 million in FCF and paid out $336 million in dividends. See Figure 2.

Figure 2: Advance Auto Parts’ FCF vs. Regular Dividends Since 2017

Sources: New Constructs, LLC and company filings

As Figure 2 shows, Advance Auto Parts’ dividends are backed by a history of reliable cash flows. Dividends from companies with low or negative FCF are less dependable since the company may not be able to sustain paying dividends.

AAP Is Undervalued

At its current price of $147/share, Advance Auto Parts has a price-to-economic book value (PEBV) ratio of 0.8. This ratio means the market expects Advance Auto Parts’ NOPAT to permanently decline by 20%. This expectation seems overly pessimistic given that Advance Auto Parts has grown NOPAT by 9% compounded annually since 2016 and 6% compounded annually since 2011.

Even if Advance Auto Parts’ NOPAT margin falls to 8% (below its TTM NOPAT margin of 9%) and revenue grows by just 2% compounded annually (below its 6% revenue CAGR since 2011) over the next decade, the stock would be worth $180+/share today – a 22% upside. See the math behind this reverse DCF scenario. In this scenario, Advance Auto Parts’ NOPAT would grow 1% compounded annually through 2031. Should the company’s NOPAT grow in line with historical growth rates, the stock has even more upside.

Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology

Below are specifics on the adjustments I make based on Robo-Analyst findings in Advance Auto Parts’ 10-Ks and 10-Qs:

Income Statement: I made $421 million in adjustments with a net effect of removing $297 million in non-operating expenses (3% of revenue).

Balance Sheet: I made $444 million in adjustments to calculate invested capital with a net decrease of $40 million. The most notable adjustment was $125 million (2% of reported net assets) in asset write-downs.

Valuation: I made $4.3 billion in adjustments, all of which decreased shareholder value. Apart from total debt, one of the most notable adjustments to shareholder value was $434 million in deferred tax liabilities. This adjustment represents 5% of Advance Auto Parts’ market value.

Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Italo Mendonça receive no compensation to write about any specific stock, style, or theme.