AutoZone's Recent Earnings: WITTDTJR in Action

1985: Doc Crain coined the term WITTDTJR, which stands for "What it takes to do the job right." The term reflects our commitment to giving customers the parts and service they need to do the job right the first time.

Source: AutoZone timeline, in the about us section at autozone.com

Yesterday morning AutoZone (AZO) reported 1Q07 earnings and hosted their quarterly conference call. Of course, the world is focused on AutoZone’s “better than expected” earnings of $123.9 million, or $1.73 per share, increases of 8.3% and 16.4% respectively. The results pushed the stock up more than 4%. In part, as you probably saw in the release, AutoZone’s better than expected results could be attributed to a higher gross profit margin of 49.2% from 49% in the prior year period. Let me be very clear what I mean when I say gross profit margin. Gross profit margin simply means (for example) AutoZone sold a part/product for $100, and minus what they paid for said part, they received $49.20 in profit. The $49.20 they earned on the sale of each product/part in the first quarter of this year, was better than the $49 they earned on the sale of each product/part they sold last year in the first quarter.

In the press release you hear common phrases like “category management” and “direct importing” as reasons for the higher “gross profit” (sale minus purchase price). But what the heck do these phrases mean? Let me start with category management. And what it really means is that they did a better job of stocking their shelves with the most profitable parts/products. I still remember when I asked Larry Castellani (former CEO of Advance Auto Parts) what category management was and how it helped aftermarket retailers improve gross profit margins. He explained to me that it is more of a philosophy and daily approach to the business than a simple program to improve gross profit margins. It is, (at its core) as almost every automotive aftermarket retailer emphasizes, trying to have the right part, at the right place, at the right time.

So (for example) instead of selling an exhaust manifold heat shield and exhaust tips separately at $30 and $40, respectively ($70 total), maybe they did a better job of stocking their shelves with a full exhaust kit for something like $100 The customer likely walks away happier because they have a full kit (instead of getting home and getting upset because they realize they also needed exhaust clamps or something), while at the same time (because it added more value to the customer) the sale price versus the purchase price (by AutoZone) is better for the kit, improving overall gross profit margins. Wikipedia.com describes category management as follows:

Category management is a development of the brand management approach to product development, and was developed to take account of the growing power of some retailers. Retail products are broken into like groupings called Categories. These groupings are then managed as business units and will go through business reviews on an ongoing basis to determine growth, profitability, trends and future opportunities.

During the AutoZone conference call, one of the big areas of improvement (ongoing) that CEO Bill Rhodes discussed was the company trying to improve product assortment. Specifically he said they have been gaining data that allows them to have a better idea of true customer demand for hard parts. A couple thoughts on that comment. First, I remember going on road shows with AutoZone’s former CFO Mike Archibold where he used to say one of AutoZone’s big competitive advantages was the company’s national warranty database that allowed them to merge it with store sales data and Polk vehicle registration data in the area and therefore better predict what parts are needed when.

AutZone has an industry leading $243 in sales per square foot (trailing twelve months), so you have to figure they have some sort of competitive advantage. However, when I talked with competitors, they said it is far more difficult to achieve (said predictive analysis) in practice than it sounds. And so maybe Mr. Rhodes comments (about being able to mine the data better) means they have fine tuned this (predictive) process. Incidentally, this emphasis on having the right parts where and when needed resulted in the company’s average inventory per store climbing to $503,000 from $501,000 in last years first quarter.

Another thing that Mr. Rhodes mentioned on the conference call, that may be helping AutoZone stock its shelves better is the customer loyalty card. For those of you that are not familiar with the program, it is similar to my ice cream story (that I told a couple months ago) where after 5 purchases (punches on a card) of $20 or more, you get a gift card for $20 Given my ice cream addiction, if I get 5 punches at Cold Stone Creamery I get a free ice cream (which is really cruel in helping someone “cut the habit”).

Basically, I have described AutoZone’s loyalty program as a price incentive. But something that I did not think about (and none of the vendor or auto retail responses to the customer loyalty card topic brought up a couple months ago) is the ability for folks like AutoZone to better track the purchases of their most loyal customers. In fact, when I ran the discussion (that prompted a number of responses from my readers), we all focused on whether or not the programs were cost effective/and or really generated traction with the customers. What we overlooked (in the series) is the ability for retailers like AutoZone to better track the purchases of said consumers and therefore stock their shelves potentially better (and more profitably).

And whether it comes from a loyalty program or hiring a category management “expert,” I think an emphasis on this concept (category management and better mining customer data) is a big area where I think new and used auto retailers as well as collision and repair jobbers have significant opportunities to improve (gross profit margins especially).

Nonetheless, while category management may be the attractive buzzword thrown out almost every time an automotive aftermarket retailer shows an improvement in the gross profit margin line, I suspect a bigger contributor to AutoZone’s results this quarter was this “direct importing” word. Direct importing simply means instead of buying from a supplier here in the United States (who may very well be ordering the parts from overseas), the retailer (like AutoZone) goes directly to the source, and buys (for example) their brakes from a manufacturer in China.

I think the emphasis (or threat) alone from an auto retailer like AutoZone saying they are looking at ordering more parts from China affords significant leverage and is likely why the trend can remain favorable for folks (like AutoZone) that have considerable purchasing leverage.

Some of you may remember when I ran the “Wake up call” series back in October. One of the areas we spent a considerable amount of time discussing was the influence of China on the U.S. (and global) auto retail industry. Importantly, I said we are likely 5 or 10 (+) years out from China having a meaningful impact on vehicle sales here in the United States. But, where we are likely to see the most immediate impact on the auto retail industry (over the next 5 years), is on the automotive aftermarket (retail/jobber) side of the market.

I even talked about a report done by Stephen Cooney, a specialist for Congressional Research Services (Congress’ library basically), where he indicated U.S. imports of auto parts from China has increased from $1.6 billion in 2000 to $5.3 billion in 2005. As lower cost parts are brought into the United States, I said it presents both an opportunity and a challenge.

The opportunity, of course is the ability to lower the overall repair cost of the vehicle. The challenge, however, is how can you create a “just in time” (pull) environment when the lead time (distance) between the manufacturer and is so great? The solution, I said, will likely come from more efficient distribution techniques like cross docking. But it will be interesting that the industry might actually see small “mom and pop” U.S. based generic parts manufacturers (employing non-union based personnel), becoming competitive with large distribution companies as these smaller “mom and pops” eliminate several layers and carrying costs in the chain and are able to directly provide for their local market. The large, heavy infrastructure firms in the U.S., however, will likely continue to get squeezed.

In any case, beyond better gross profit margins at AutoZone (something that I think can continue albeit at a moderated pace), was lower operating expenses. These are basically all of the other operating costs of a store (outside of most financing costs such as interest expense.) Everything from radio, print, and tv advertising, to the accountants at corporate fall into the operating expense category and were 33.2% of total sales versus 33.6% last year (so a 0.4% improvement) in the first quarter. Management said (on the conference call) that the lower operating expenses as a % of sales (from the prior year) was mostly because they took a $2.8 million charge last year (in the operating expense line item) associated with the hurricanes (which comes out to almost 0.2% of sales).

In addition, the company had favorable operating expense comparisons as they invested in a lot of store resets (new paint, etc.) last year. Partially offsetting the favorable comparisons was higher occupancy costs (rent expense), which management indicated on the call was partially due to the company leasing a few more stores than owning them this quarter (leasing stores shows up in ‘rent expense in the operating expense budget, whereas owning the store shows up in the interest expense category as you take on mortgage debt). Finally, management continues to return cash to shareholders in the form of share repurchases (reducing the number of shareholders that get to share in the company’s earnings), purchasing 816,000 shares, and boosting the return to shareholders from an 8% (year over year) improvement in net income to a 16% (increase year over year) in what the shareholder (in theory) can lay claim to.

So operationally, management continues to execute very well, and return excesses to shareholders. Where things are not going as well for the company, remains the sales line. Same store sales were up a mere 0.3%. I hope all of you have heard my difference in opinion about the rather sluggish sales where management blames higher gas prices (and other issues) while I blame a saturated market (too many auto parts stores in the market), So I have no intent to re-hash the debate (today). But I wanted to conclude with how I started (see quote at beginning of article), applauding management for re-focusing on their roots of WITTDTJR (What it takes to do the job right). CEO Bill Rhodes had to mention WITTDTJR at least two or three times during the conference call, and it is a concept (as I opened today’s letter with) that has been a focal point of AutoZone’s operating strategy since 1985 (and they did not get into the auto parts business until 1979).

As you see from above, operationally, and from a cash flow perspective, AutoZone continues to be prudent stewards of shareholder resources (capital). Well aside, from my view that the company (and its shareholders) would be better off not growing more stores in the U.S. Instead, I would like to see management return even more dollars to shareholders (through share repurchases or a dividend) as well as invest in new concepts for the commercial market (I have discussed a number of new ideas in the past that I would like to see the DIY management teams try), and possibly even invest in a better distribution infrastructure in Mexico so they can grow in that highly complimentary market.

But most of you have heard me emphasize for some time that I think the market is relatively saturated and the DIY store concept is pretty mature. And as such, with most mature companies you are faced with one of two options: 1) be a prudent steward of capital, or 2) grow for the sake of growth. Under the prudent steward of shareholder capital approach, you often times find yourself slashing costs, but constantly finding yourself chasing down revenues (and market share). Shareholders can benefit immensely from this approach as you can milk solid cash flowing businesses like this for a long time, only deploying capital when very high return targets are likely. But it is, without a doubt, a very slow death process, and something that is very hard for most management teams and employees to accept (especially when they have grown up in an era of rapid growth).

The flipside, when you become a mature company is to grow for the sake of growth. Meaning you try something risky, to “jump start” growth, re-deploying said capital into new growth initiatives. It is fun, and often times the route management teams choose, because they have only known one approach (growing the business). A few companies have been very successful at this approach, and General Electric comes to top of mind where they have successfully re-deployed cash flows from mature businesses like appliances into new growth avenues like financial services and media. IBM re-focused its approach from a harware provider to consulting, because their emphasis was on helping people with technology (not necessarily in just providing them with a product). Apple became a music company.

But far too often what I think ends up happening is companies take on this risk and it bombs, basically accelerating the death process because they were quite simply trying to grow for the sake of growth. I have articulated a third approach to this conundrum, which is that management teams should approach their business neither trying to do #1 or #2. Instead, they should forget the institution (company) and instead focus on the mission. I know it sounds highly esoteric and very difficult to ingrain in a corporate culture, but if achieved I think it puts everything in the right perspective. And this is why I appreciated Mr. Rhodes going back to the company’s roots and emphasizing WITTDTJR. Whether you agree with me (about the market being saturated) or management that the weakness is due to “macro” factors, I hope that we all can agree, servicing the customer is what matters most (and should ultimately yield economic returns).

The world will survive with or without AutoZone. Shareholders will achieve attractive returns with or without AutoZone (in the market). But what the world (and shareholders) will always need (and benefit from) is some organization that can most cost effectively get an automotive part where it is needed. I often discuss the coming changes I see happening in the automotive aftermarket, shifting from a push to a pull environment as remote vehicle diagnostics are ushered into the service repair shops over the next 20 years or so (so auto parts retailers and jobbers will need to react better in getting the part to where it is needed versus predicting best where it is needed). As a result, I suspect it will require more dramatic changes in the approach than what management is considering right now. But as long as management keeps everyone (from shareholders to employees) focused on doing “what it takes to do the job right” [WITTDTJR] in getting the part to the customer, they (and the company’s shareholders) should end up in good shape.

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