# AutoZone: Skewed Probability Towards The Upside

Based on our discounted Economic Value model, our Monte Carlo simulation suggests AutoZone's (NYSE:AZO) share price has a skewed probability towards the upside (Figure 1.1), where a long position would be more likely to generate a return than a short position (as of December 2, 2011).

Figure 1.1
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Our Monte Carlo simulation provides a range of 1,000 scenarios to determine the probability associated with making a minimum return of 20%, as well as the probability of taking a loss through either a short or long position (Figure 1.2).

Figure 1.2
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For each scenario, a random value is generated for the unknown inputs in our discounted Economic Value model. These random values are based on reasonable ranges derived from 10 year historical distributions of company and peer data. While point estimates are often "precisely wrong", range estimates provide a more realistic view of market variability and have a greater chance of the actual outcome falling within the estimated range. Additionally, we scrutinize the inputs of our Monte Carlo simulation through our Economic Value (also known as Economic Profit, Economic Value Added, or EVA) calculation, where adjustments are made to accounting statements to more accurately reflect the economics of each driver.

For AutoZone, the probabilities associated with making a 20% return or higher are as follows (Table 1.1):

- Long: 70% chance.

- Short: 3% chance.

The probabilities associated with losing under the following scenarios are as follows :

- Long: 12% chance.

- Short: 88% chance.

Table 1.1
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Shareholder / Management Alignment

We share Warren Buffett's sentiment that "executive performance should be measured by profitability, after profits are reduced by a charge for the capital employed in the relevant business or earnings retained by it." Our definition of the optimal incentive plan is one that requires managers to generate sustainable returns to shareholders that exceed the Cost of Capital. In other words, long-term improvement in Economic Value (also known as, Economic Profit, EVA, Economic Value Added, or any other name that expresses the same concept) is the only measure that the executive team should be focused on.

Based on AutoZone's Schedule 14A (Figure 1.3), they know what ultimately drives value. Instead of the traditional piecemeal approach to incentive compensation of dispensing arbitrary weights to the drivers of Economic Value, AutoZone uses Economic Value as the arbiter for balancing the tradeoffs between income and capital investment.

Figure 1.3
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As a result, it's no surprise that AutoZone dominates in delivering long-term value to shareholder's (Table 1.2). \$14 billion in Market Value Added (MVA) has been created, which is approximately \$7 billion more than the nearest competitor. Even adjusting for size and standardizing by capital invested, AutoZone has generated \$4.43 in additional market value for shareholders for every \$1 of capital invested. In comparison, the next closest peer has generated a respectable \$2.10, which goes to show how clearly AutoZone dominates in maximizing long-term shareholder value.

Table 1.2
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Even when we look at the rate of returns to shareholders over relatively short-time period, AutoZone has clearly out performed the S&P 500 over 1, 2, 3, 4 and 5 years (Figure 1.4).

Figure 1.4
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One might conclude that this is a function of AutoZone's revenue size or growth. However, this speaks to the company's understanding that growth for growth sake is not what drives shareholder returns, but rather revenue growth coupled with a return on capital that exceeds the cost of capital.

Although AutoZone is not the best in terms of the size or growth in revenue, it is the best in what matters, generating a return on capital that exceeds the cost of capital - in a word, economic value.

AutoZone's 9% revenue growth may be considered average, however the quality of growth is anything but average (Table 1.3). With return on capital of 28%, which exceeds its cost of capital by 20%, the company is strongly positioned to compete against the largest company.

Table 1.3
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In fact, the largest company which is approximately twice the size of AutoZone in revenue with faster growth has generated only 1/7th the MVA. It so happens this other company's incentive plan is based on "simple" allocations towards two separate metrics of which may drive shareholder value, everything held constant, but may in fact conflict with one another which often creates unnecessary confusion and can lead to conflicts of management and shareholder interests.

Disclosure: I am long AZO.