If you think Advance Auto Parts's (NYSE: AAP) 10X valuation and 5% yield are attractive, don’t be fooled because the dividend just got cut, and the stock is heading lower, possibly much lower. The company’s efforts to produce growth were insufficient to offset persistent headwinds, including inventory (cough, cough, supply chain) woes. The news sent shares down more than 30% in pre-market trading to levels not seen since the depths of the pandemic, and lower lows may be on the way.

What this means for the market is yet to be determined, but if these results turn into a trend, the market and the economy are heading for darker times. And it’s not like there haven’t been warnings signals already. Results were mixed across the retail sector (NYSEARCA: XRT), with trends showing rising inflation has consumers cutting out discretionary items in favor of staples and still spending just as much. 

Advance Auto Parts Stuns Market-Cuts Dividend

Advance Auto Parts had such a bad quarter that it was forced to cut the dividend to preserve cash flow, which was no easy decision. The company only recently initiated the distribution and indicated more than once it was aiming for long-term distribution growth. The $3.42 billion in revenue isn’t the problem, that’s up 1.5% compared to last year, and it missed the consensus but only by a slim margin.

The problem is that margins were severely affected by inflation and efforts to mitigate inventory issues that are still underway. However, among the negative details are the drivers of growth. Growth is due 100% to new store openings and offset by a -0.4% decline in comp sales. 

The margin contracted at the gross and operating levels, although there is a 1-off that may impact comparability. That 1-off is the increase in working capital/inventory expected to support sales in coming quarters. Regardless, the gross margin contracted by 162 basis points, and SG&A increased as well. This left the operating margin down 240% at 2.6%, and the news only worsened. 

The company lowered its guidance for the year for revenue to fall -1.0% compared to the prior expectation of up 1% to 2%. The FY margin is expected to be 300 bps less than planned, and free cash flow will be roughly halved. Among the detractors is a plan for fewer store openings which will also impact the long-range forecast. 

The Balance Sheet: Cash Flow Turned Negative

The company’s cash flow turned negative in Q1 and may have remained negative in 2024 without the dividend cut. The company’s outflows are due to increased spending to build inventory and a shift in mix. This led to an 83% dividend cut which has the payout at $0.25 quarterly or $1.00 annually, about 1.2%, with shares trading at their new low.

The cash flow should be positive for the remainder of the year, but a new element of risk in the outlook may not clear up until later. Another detail weighing on the market is the increase in long-term debt. 

The price action may be at the bottom of a long downtrend, but it is too soon to tell. The price action is at a long-term low that has been in place since 2012 and has tested twice so that a solid bounce could form. The question now is if the market starts buying at this level and, if so, if it is more than a dead cat bounce. Either way, Advance Auto Parts shares will unlikely recover their previous levels soon.