The old joke about the difference between stock buybacks and dividends is that “dividends are like marriages, and stock buybacks are like one-night stands.” All kidding aside, there is a reason why investors usually take dividends more seriously than share buybacks. Dividends typically represent a commitment to shareholders—not only will the company generate enough cash to pay its dividend both now and into the future, but it presumably expects to generate enough cash over the coming years to fund dividend increases as well.
Stock buybacks make no such presumption. Companies can usually end stock buybacks with little fanfare, and when they do, it is not nearly as bad for the company as the prospect of terminating dividend payments. Likewise, companies that pay dividends hope to continue to do so during poor economic times, allowing investors to repurchase shares at lower prices and beef up overall ownership in the firm, which can significantly turbo-charge future returns.
Stock buybacks have a history of being poorly timed—during economic booms when companies are rolling in cash, they use the excess to purchase overvalued shares, thus destroying value. And when the economic pendulum swings the other way, companies have an unfortunate tendency to cancel buybacks during recessionary times, precisely when share buybacks offer the most potential to shareholders.
And of course, sometimes managements dole out extra shares to executives that completely wipe out the benefit of a share buyback program. But there is a way to do share buybacks right, and I think AutoZone (NYSE:AZO) is a successful example of management using buybacks to take care of shareholders. For the past decade, AutoZone has followed a strategy of using cash to retire undervalued shares (without any further dilution), and it has kept on reducing shares, year in and year out, enabling current shareholders to enjoy a proportional increase in ownership of the automotive parts company.
I’ve included a chart of what the increase in ownership earnings would look like for an investor who made a $4,000 investment in AutoZone in 2001, buying 100 shares. At the time of the initial purchase, the 100 shares represented $238 worth of company earnings. Today, ten years later, that $4,000 initial investment now represents $1,970 worth of annual earnings, giving investors an earnings yield of 49.25% relative to initial cost. As AutoZone continues to use excess profit to reduce the share count, the overall ownership of the shares continues to increase, and as the earnings grow, eventually the stock price follows.
AutoZone went public in 1991. It was called AutoShack until the guys at Kohlberg, Kravis, and Roberts (NYSE:KKR) bought it out for $526 million and then arranged for Goldman Sachs to take the company public, selling 14,950,000 shares for a split-adjusted price of $5.75. A $20,000 investment then would now be worth $1.14 million. Heck, a $20,000 investment ten years ago in 2001 would have given you 500 shares at $40 a piece, which would now be worth $164,000. So AutoZone’s strategy of combining high-single-digit to low-double-digit annual growth with an ambitious share buyback program has rewarded shareholders. AutoZone had 109 million shares outstanding in 2001; today it has a little over 40 million shares left. Over a ten year period, AutoZone’s buyback program has effectively more than doubled the ownership stake in the firm of long-term shareholders.
But I do have a concern about AutoZone’s buyback program. Its relentless purchasing of shares has been both a blessing and a curse, because there is no signal from management that the company lets the share price affect the rate of buying back shares, and this strikes me as foolish. Recently, Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) authorized a buyback program with the contingency that shares will only be bought when they’re trading at 110% of book value. This is because buying back overvalued shares is a very poor use of shareholder funds.
Right now, AutoZone has authorized $750 million worth of stock share buybacks under its current buyback program. Shares currently trade at $328, and have traded in a range of $227 to $337 in the past twelve months.
Let’s take a look at the potential effects of the stock price on a buyback program. Over the past twelve months, AutoZone has earned $19.58 per every share of AZO stock outstanding. Before the most recent buyback announcement, AutoZone had about 45 million shares total. If the $750 million buyback purchased shares at $227, this would enable the company to take 3.3 million shares off the market, or 7.3% of shares outstanding. If the $750 million buyback purchased shares at $337, this would enable the company to take 2.2 million shares off the market, or 4.8% of shares outstanding. This is the difference between your share of AutoZone stock representing $21.01 in earnings and $20.52 in earnings.
AutoZone is currently trading at 16.76x earnings, and that is a bit higher than its 12-14x earnings average over the past decade. In fact, 2002 was the last year AutoZone traded at greater than 16x earnings for the majority of the year, and the earnings growth estimates were higher for the company earlier in the decade (2001-2004) than they are now (2011-2014).
There’s an old saying that the perfect is the enemy of the good. Although I would like to see AutoZone use more discretion when repurchasing shares, it has still done an impressive job of rewarding shareholders over the past two decades. AutoZone has been a great business, but the stock price seems a little high for new investors. If you want to get long-term market-beating returns with this company, I would wait for shares to dip below $290.