AZO - AutoZone: Overvalued In Light Of Growing Competitive Pressure

2023-04-22 02:19:54 ET

Summary

• Since 2020, the sharp rise in mechanic repair costs has dramatically increased sales for DIY auto parts retailers.
• AutoZone and its peers have grown tremendously over the past two decades, potentially leading to an increase in price competition over the next decade.
• AZO's stellar momentum has led to its inclusion into most "momentum" ETFs and trading strategies, potentially driving its price to an excessive level.
• AutoZone's valuation is at a record high despite the apparent headwinds that limit its ability to expand at its historical pace.
• AutoZone is trading at a ~25% valuation premium to its five-year averages, indicating its fair value is likely closer to $2,150.

Most aspects of the US retail sector are experiencing headwinds today as tempered economic demand and rising costs cause many to struggle with falling profit margins. The long-term rise of E-commerce has made many, if not most, traditional retail segments are less profitable with lower growth outlooks. However, few sub-segments within the retail space have proven tremendous resilience against the secular and cyclical trends in retail. One example is the auto parts and accessories segment, with retailers like AutoZone ( AZO ) continuing to rise despite broader market challenges. See below:

AutoZone and O'Reilly ( ORLY ) have risen steadily, while Advanced Auto Parts ( AAP ) have underperformed in the broader markets. Compared to AAP, AutoZone and O'Reilly have maintained gross margins despite increasing import costs. Additionally, the latter two companies have continued to expand operations, boasting extremely high returns on invested capital of 90%+. Of course, with tremendous growth, AZO's valuation has risen dramatically, potentially hampering its future performance. Further, despite AutoZone's attractive market environment today, industry shifts could end the auto-parts bull market over the coming years. Overall, while AutoZone has attractive qualities, investors may benefit from taking caution over its seeming overvaluation driven by excess investor exuberance.

Overgrowth Boosts Competitive Pressure

The auto parts sector is generally immune to the rise of E-commerce because customers often require specialized help to purchase unique vehicle parts. Further, the industry has some immunity to economic recessions because more people may pursue DIY vehicle repair instead of mechanics. This factor is significant today because vehicle repair costs have soared incredibly since 2019 due to the mechanic shortage, causing more people to pursue DIY vehicle repair. The rise of free online vehicle repair education (i.e., YouTube) is also a critical factor in increasing DIY repair.

AutoZone and O'Reilly have pursued tremendous expansion over the past decade, benefiting from highly high returns on invested capital. See below:

Undoubtedly, AutoZone has benefited tremendously from these broader "secular" factors that have significantly increased demand for aftermarket vehicle parts. Since the company's secondary competition (mechanics) has become far more expensive, AutoZone has managed to maintain higher prices and margins without sacrificing sales. That said, investors should not expect the gravy train to last forever. Eventually, the rising number of vehicle parts stores should increase the primary competitive pressure amongst retailers, potentially hampering margins. This shift can be seen in the gross margins of the two competitors:

Of course, the numerous events of (and since) 2020 have led to increased purchase costs; however, the fact that these companies have not managed to pass those costs onto consumers implies some lingering competitive pressures in the market. For now, the pressure is not enough to dramatically hamper gross margins. These companies have also slightly decreased operating costs to maintain net profit margins. However, as growth continues and the knock-on benefit from rising mechanic costs slows, these firms may struggle to maintain their high operating margins (around 18-20%).

While a recession may not hamper the overall sales of auto parts, it could increase price discrimination among auto part retailers. Excessive growth could also drive internal competition where AutoZone's stores begin competing due to excessive regional expansion. In the short term, the company should continue to generate strong profit margins. However, in the long run, I believe this competitive pressure will cause strain on its margins, which are very high for a retailer. Further, with the accelerating rise of electric and "smart" vehicles, many new vehicles on the market may not be as repairable DIY, likely tampering with the long-term demand for AutoZone's products. These factors may not be necessary for the short run, but they justify a lower stock valuation.

AutoZone's Overvaluation May Not Remain

I believe AutoZone carries a significant issue of excessive extrapolation of past performance, with less regard for future potentials. The company has undoubtedly managed stellar performance over the past decade. However, this record largely came from numerous successive external factors that increased demand for its products, creating an excellent growth environment. Looking 5-10 years out, demand for AutoZone products should decline (due to EVs), and competition appears likely to hamper its high-profit margins. Although its current returns on capital are solid, a slight change in market dynamics could greatly upset the profitability of many of its stores.

By essentially all measures, AZO is trading at a record valuation today at a high "P/E" of 22X. See below:

By most measures, AutoZone's valuation today is around 25% above its five-year average. Excluding Advanced Auto Parts, the stock is trading within its peer group's normal range, indicating that most of the auto parts retail sector is overvalued today. The industry has indeed had outstanding performance over the past decade, particularly in light of most other retailers' challenges. That said, high valuations are only justified when growth outlooks are strong. AutoZone's historical growth is excellent, but that does not guarantee its future growth, particularly considering excessive growth can eventually create extreme competition.

AutoZone and O'Reilly have a high weighting in momentum ETFs such as MTUM today (particularly compared to their market capitalizations). Many investors and speculators follow the "momentum factor" due to the solid historical outperformance of most high-performing stocks. Of course, as momentum trading gained popularity, it lost its edge with MTUM and peers considerably underperforming most other indices since 2020. This factor is essential for AZO because its valuation may be climbing simply due to momentum trading activity, which can cause prices to rise well-above reasonable valuation levels. Further, once AZO's momentum fades, it could fall quickly as these ETFs (and related) rapidly exit the stock.

The Bottom Line

Overall, I am slightly bearish on AZO today due to overvaluation in light of rising competitive pressures and potential long-term demand declines in the industry. For now, increasing competition and the rise of electric vehicles should not significantly impact AZO's profitability. However, stocks are not valued on their immediate cash flows but on their long-term cash-flow potential. Taking a five-to-ten-year outlook, it seems AutoZone will eventually face moderate headwinds as the forces which benefited auto-parts retailers fade, leaving a potential glut of retailers that drives internal competition and lower margins.

AutoZone is a high-quality company with a strong track record, but that alone does not justify its current valuation in light of the industry's potential long-term negative shift. The stock's valuation seems to rise due to "index inclusion" into momentum trading strategies, particularly considering its resilience against broader stock market pressures. That said, momentum trading has not performed as well as this stock prices to rise excessively above sensible valuations. I firmly believe that AZO is facing this as, to me, its valuation is unreasonably high given its limited capacity to continue to grow at its historical pace.

I am not so bearish on AZO that I believe it is a short opportunity. That said, the stock appears likely to decline once its momentum fades and loses its indexation benefits from momentum trading strategies. Based on its five-year average valuation levels, the stock seems around 25% overvalued today, indicating its "fair value" is likely closer to $2150. Of course, if its profit and growth outlook decline, as I suspect, a lower valuation is probably more justified.

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