AZO - AutoZone: Durable And Cheap

2023-08-08 14:07:30 ET

Summary

• AutoZone offers competitive advantages in the auto parts retail space, including customer service, free services, and a streamlined supply chain, which have helped it generate historically high returns.
• The company's capital allocation policy prioritizes reinvestment of cash flow at high rates of return, with leftover cash going to share buybacks, reducing the share count by about 80% over the last three decades.
• AZO's cash flow yield is attractive compared to competitors and risk-free rates, making shares look attractively priced.

I'm interested in businesses that have shown historically to be cash generative. If the company has proven capable of paying a dividend, buyback lots of shares, or acquire assets that return above the cost of capital it signals a business model that has obtained relevance for years if not decades. AutoZone (AZO) has these characteristics. AZO sells at an attractive price when comparing cash flow yield against competitors and risk free rates. The competitive advantages appear to still be in tack after a decade of historical returns.

Quick Background

• 1979 - AutoZone was first called Auto Shack which was a division out of Malone & Hyde, Inc..
• 1984 - A quality control program was established for its parts and is believed to be the first in the auto part retailer space.
• 1985 - First store manager Doc Crain came up with the term WITTDTJR (What It Takes To Do The Job Right), which means exactly what it says.
• 1987 - The company rebranded to AutoZone. As AutoZone they first introduced an electronic catalog which allowed customers and store personnel to look up parts, warranties, and on-hand inventory.
• 1991 - First auto retailer listed on the NYSE.
• 1996 - Purchased Alldata for $56.8 million in stock. Alldata develops and markets software that provides automotive diagnostic and repair information to repair shops nationwide.
• 1998 - First international store opens in Mexico.
• 1999 – Acquired 100 stores from Pep Boys.

Mission Statement/Pledge

“ Autozoners put the customer first! We know are parts and products. Our stores look great! We’ve got the best merchandise at the right price.”

Competitive Advantages

Customer Service

AutoZone has been able to train and hire store staff members with the ability to help customers in a specialized automotive industry. A major advantage against competitors such as Walmart. As such, helping build customer loyalty. Trained staff are able to help with the following and its free:

• Battery testing
• Battery changing
• Tool loan program
• Check engine light readings
• Oil collection and recycling

Supply Chain

Management has done a wonderful job over the years building out their supply chain which drives costs efficiencies and growth. Below are a few data points to give an understanding of scale AZO has created:

• At the end of 2022 AZO had 78 mega hubs and 194 hubs. Hubs carry around 50,000 SKU’s and mega hubs carry between 80,000 and 100,000 SKU’s. Management strategic goals of 200 mega hubs and 300 hubs.
• 6,943 stores globally.
• Average square footage per store 6,688.
• Propriety PoS and store management system.
• Store support centers make all purchases of merchandise. AutoZone has one office in Shanghai for sourcing of Chinese merchandise.

Capital Allocation

Simple capital allocation policy: Prioritize the business for reinvestment of cash flow at high rates of return with leftover cash going straight to share buybacks. Cannibalizing itself by reducing the share count by roughly 80% over the last three decades indicates the business has durability. Share buybacks are one of my favorite capital allocation strategies when done properly.

Vendor Relationships

The company is able to leverage inventory purchasing through negotiations with suppliers for extended payment terms, as such, helping fund growth. Accounts payable will run high against inventory as AutoZone hopes to collect payment on merchandise quickly. From the 10K here is how this dynamic is explained from the vendor’s financial prospective:

“Certain vendors participate in arrangements with financial institutions whereby they factor their AutoZone receivables, allowing them to receive early payment from the financial institution on our invoices at a discounted rate. The terms of these agreements are between the vendor and the financial institution.”

Economics, Strategy, and Industry Dynamics

Standard store formats have roughly 90-99% of square footage as selling space. Stores generate their own traffic as DIYers for car repairs are in need of a part as soon as possible. Most stores are situated by major thoroughfares for easy access. Store placement and layout are key drivers of success and management has a lot of historical data to optimize growth.

Financial Highlights

Across all financial data metrics, the numbers have consistently grown. One metric to highlight is how much the diluted earnings per share have grown. Management has effectively grown sales at a reasonable pace, improved operating margins by 4%, and reduced share count which is why earnings per share has grown significantly faster than sales and earnings.

The operating margin profile has seen growth because of supply chain management. Cost of sales includes warehousing and delivery expenses and is the largest expense line item. Management has been able to maintain leading industry gross profit margins of 51%-53% during an inflationary period.

The industry offers favorable returns on invested capital when managed properly.

Growth aspects of the industry would be miles driven and average age of vehicles on the road.

Consumer reports have found a significant difference in costs between 5 and 10-year-old models, underscoring how cars need more maintenance and repairs over time. This has been a major tailwind for the parts retailer market as the age of cars and trucks continues to increase. As cars are becoming significant purchases for the consumer, they are keeping them longer.

Valuation

AZO cash flow yield: 5.2%

Risk free rate: 4 - 4.5%

With durable companies that have shown longevity, I like to compare the cash flow yield to the risk free rate within the market to have an understanding of if the cash flow yield is at-least yielding around or greater than the risk free rate. With risk free rates being higher than they were a year ago, it has become much more difficult to find durable businesses yielding above the current rates.

Competitor Comparison

From both a comparison of AZO's cash flow yield to the risk free rate and competitors, the company appears to be reasonably valued. When taking into account a reasonable top line growth of 5% and shares outstanding shrinking year after year shares appear cheap.

The company has created a wonderful feedback loop within their strategic policies of buying shares back. With strong cash flow generation, management reduces the share count aggressively year after year as the chart above indicates.

With a conservative 6% growth rate against the current price would be yielding closer to a 6% free cash flow per share basis. The average growth for operating cash flow has been 10% over the last 8 years. Again seems like a reasonable yield for a company that has been durable and showed proper capital allocation management.

Risks

The elephant in the room for investors is electric vehicles taking over the market which require fewer parts and expected lower maintenance costs. The counter points I've found are AutoZone supplies several parts for Tesla’s such as struts, brake pads, rotors, windshield wipers, headlights, cabin air filters, and mirror replacement glass.

In addition, the U.S. auto fleet will continue to sell standard vehicles. JD Power highlights EV sales account for less than 1% of total sales. I think naturally this is a concern and my contrarian view is that the EV push will take much longer to permanently impair AZO's earnings power. There's a reason why sales and earnings continue to grow in 2022 with the increase EV push.

Final Thoughts

I've been thinking about longevity a lot lately when it comes to public market investments. It's easy to look up how long the company has been around and what the revenue/earnings growth has been historically. These might provide somewhat of a signal of the future. Digging a little deeper though will give a broader picture and more data points for future projections. Like how customer service is a key aspect of helping create customer loyalty, understanding store formatting, product pricing/sourcing, and strategically placing hubs and stores all enhance how the company is winning in the market. AZO has been executing on all these aspects for a long time and one could argue anything below a 20x P/E ratio is a reasonable price if not cheap.

Based on historical data from 1981 to 2022 the average P/E ratio was 21.92 within the S&P 500. From a performance standpoint I would think AZO would have to be in the top 10% of the of S&P 500 on total return performance so how is it being valued below the average.

I argue if investors had the opportunity to invest in a guaranteed 5% yield with some growth and shrinking shares outstanding, they would say here, take my money. AZO has proven its longevity, operating now in a consolidated industry at a reasonable purchase price.

For further details see: