AZO - AutoZone: This Is What Investors Should Be Watching For In The Period Ahead

2023-11-29 06:38:25 ET

Summary

• AutoZone operates in the automotive parts and accessories industry, with over 7,000 stores worldwide.
• The company plans to open new locations in Brazil and the U.S., aiming for 10,000 stores in the U.S. in the long term.
• AZO's competitive advantage lies in its capital allocation, well-trained employees, and efficient delivery network. However, barriers to entry are relatively low.

Thesis

AutoZone ( AZO ) is in an interesting situation as it will have a new CEO starting in January 2024. This is a situation that investors need to watch closely as it could change a lot. While the company is in excellent shape, a transition is always something that leads to changes. And even small changes can have significant effects over time that you may not have anticipated. Nevertheless, the shares are attractively valued and offer investors the chance to achieve results that exceed the market average over a longer period of time.

AutoZone Business Overview

Founded in 1979 and rebranded as AutoZone in 1987, AZO operates in the automotive parts and accessories industry. The company's stores offer products for DIY and commercial customers in the Failure, Maintenance and Discretionary product categories. With Failure and Maintenance accounting for 85% of the product mix . The company operates 7140 stores worldwide, of which 6300 are in the USA, 740 in Mexico, and 100 in Brazil.

As we can see from the table above, expansion is well underway both internationally and in the United States, with only 3 store closures in the last 3 years, while 591 new stores were opened during this 3-year period. In addition to the new stores, same-store growth was 3.4% in the U.S. and 17.5% internationally, for a total of 4.6%.

FY23 revenues of $17.5 billion and ROIC in the 50% range with an operating margin of 19.9% represent strong execution in a challenging environment with inflation and cost pressures. The excellent capital allocation by AZO's management team is also reflected in AZO's TSR of 17.9% per annum over the past 20 years, almost twice the return of the S&P 500. On the downside, the CEO transitioned in January 2024 when he moved to a new position as Executive Chairman after serving as CEO from 2005 until the end of 2023, where he was largely responsible for the company's success. But his successor has also been with AutoZone for 30 years.

Additionally, two new distribution centers were added in the U.S., increasing capacity by 20%. As Brazil and Mexico are expected to drive a significant portion of future growth, their current 10% share of total revenue is expected to increase in the future.

AZO's Growth Opportunities

In 2024, they plan to open 40 new locations in Brazil and 500 new locations in the U.S. over the next several years. In the longer term, starting in 2028, the company plans to open 500 new stores per year, 300 in the United States and 200 internationally. Future sales will therefore be driven by same-store sales growth combined with expansion in the U.S. and Mexico, Brazil, and higher prices for the products they sell due to inflation and cost pass-through. Long-term, 10,000 stores in the U.S. and 1.5,000 in Mexico is the first milestone they want to reach.

Do They Have A Competitive Advantage?

AutoZone operates in a highly competitive industry, with O'Reilly and Advance Auto Parts as its closest competitors. However, other major retailers also sell some of the same products. And since DIY customers are a big part of the business, the quality of service is very important. AutoZone's well-trained employees, through its in-house knowledge program and parts expert certification, combined with frequent management visits, ensure a high level of quality. In addition, they have an efficient delivery network that helps them stand out from smaller competitors and their own brands, which are also key differentiators.

However, their greatest competitive advantage is their excellent capital allocation, using debt and cash flow efficiently to invest in growth where it is needed to benefit shareholders. They also have a kind of pricing power over their suppliers, as they are market leaders in the commercial and DIY sectors and can get better prices than the smaller competitors. Nevertheless, barriers to entry are relatively low, and competitors with a well-developed international distribution network could still enter the industry.

Balance Sheet

AutoZone has a heavy LT debt load of $7.7 billion, which is opposed to net income of $2.5 billion in 2023. That is ~3x net income, which is alright, but there is still a small risk. Interest expense has risen from $191 million in FY22 to $306 million in FY23, and is likely to be even higher in FY24. Right now, AutoZone has enough cash flow to service its debt, but as we all know, things can change quickly and the more debt a company has, the more risky it is.

It should also be noted that a good portion of the debt is due in 2024, $1.5 billion, but more than half of the debt is due in 2029 and later. Refinancing in 2024 could therefore lead to even higher interest expenses in the future as the cost of capital has increased.

Risks

The risk that nobody talks about is usually the one that becomes dangerous. So, yes, of course, the transition from ICE to EV could become something that impacts earnings. ICE tends to have more parts, but I think that is one of the reasons why AutoZone is expanding more into Mexico and Brazil. In both countries, the transition will probably take a lot longer than in the US. Another risk that I think could be big is that as cars get more complex, it becomes harder for people without a lot of experience or help from professionals to tinker with them. However, AutoZone has highly trained employees who receive additional training to address the most common issues and provide the best possible assistance to DIYers.

On the other hand, people will always need their cars, so the demand for auto parts will still be there 10 or 15 years from now. And as new cars become more expensive and old cars last longer, AutoZone is in a comfortable position. The current view is that EVs require less maintenance and repair, but we will see how this plays out when we have the first mass-produced EVs that are 10 to 15 years old. First-generation cars are often prone to failure.

Reverse DCF

My favorite tool to see if a company is fairly valued is to see what is priced into the stock price. If we take the diluted EPS share from the last 10k, which is $132.36, and take a hurdle rate of 10%, we get the result that EPS needs to grow 10% over the next 10 years to justify the share price of about $2500.

Over the past 10 years, however, EPS has grown at a CAGR of 20%, twice the required growth rate. Even if AutoZone only achieves 15% going forward, the stock looks massively undervalued. And if the new CEO has the same strong focus on share buybacks as the old one, a 10%-plus CAGR is very likely unless revenue growth completely collapses.

Peer Comparison

On an EV/EBIT basis, AutoZone trades at a 15x multiple, which is fair given the quality of the business and its growth opportunities. Advance Auto Parts, which is slightly worse than AutoZone and O'Reilly, also trades at a slightly cheaper multiple, but I do not think it is large enough to compensate for the quality differences.

AutoZone's ROIC is simply much better, as we saw above, and its EBIT margins are also in a different league than ORL and AutoZone alone are. The world-class capital allocation of the two top dogs, AutoZone and O'Reilly, has really helped make them a phenomenal investment for long-term investors who have been holding these two companies for a long time. And it looks like they have some good years ahead of them. Both have the cash flow and growth opportunities to continue repurchasing shares and returning cash to shareholders.

Conclusion

Superior service and a highly desirable product are the hallmarks of AutoZone, combined with strong capital allocation skills. Since only 16% of their products are directly imported from abroad, their dependence on foreign countries is not that high, although their American suppliers also source a proportion of their products from abroad, so the total is probably higher. However, AutoZone is not a company that must source all of its products from Asia, as is the business model of many other companies.

The most important thing for investors in AutoZone will be to see if the share buybacks continue at the same pace and if the new CEO is as good as the old one as a capital allocator. A new CEO is always a big deal and can lead to very different results. Especially since the old one has done a fantastic job for the last 18 years. It will not be easy to follow in his footsteps. But if he can grow diluted EPS at a CAGR of 15% to 20% over the next 10 years, shareholder returns are likely to be relatively similar. So the new CEO knows what to do because the blueprint is there, all he has to do is execute.

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