AutoZone (AZO) is an industry leader in a healthy auto parts retail industry that has a proven track record of generating shareholder value. The company is well positioned to deliver solid EPS gains in the long term. AutoZone capital allocation system is extremely efficient and maximizes the value of their business. AutoZone's ability to drive consistent EPS growth in the long term combined with a reasonably attractive valuation should fuel significant capital appreciation.
Long Term Fundamentals of the Industry
A number of analysts have expressed concerns that the robust new car sales in 2012 pose a threat to auto parts retailers. Statistically, the average age of cars on the road has a much higher correlation to auto retailers' parts sales than new car sales does. Overall, more cars on the road is a net benefit to the industry because it increases the potential for more vehicle repairs. The average age of cars on the road has been increasing significantly over time. This trend was accelerated during the past economic crisis as consumers opted to keep their cars instead of purchasing new ones. Consumers are keeping their cars longer not only because of increased frugality, but also because cars have become more durable.
AutoZone allocates its capital efficiently in a manner that is aligned with shareholder interests. A key part of this strategy is generating a significant amount of free cash flow and then utilizing that robust cash flow in their share repurchase program. AutoZone only invests in projects in which it thinks that it can earn a 15% return on capital. All of the free cash that is produced is used for share repurchases. The company seeks to maximize its free cash in whatever way it can. One way in which it does this is by maximizing accounts payable and reducing inventory. AutoZone has a much lower cash conversion cycle then O'Reily or Advanced Auto Parts. The share repurchase program is a consistent use of free cash in that the company repurchases sizeable amounts of shares every year. There is not a time that the company has halted the program. AutoZone has reduced its diluted share count from 99,268 to 39,625 from 2002 to 2012 which is a reduction of about 60% during that period. The share repurchase program is not a simple mechanism to juice EPS numbers on a given quarter to meet analyst expectations.
AutoZone's strategy regarding debt and capital structure is to maintain a solid investment grade credit profile while retuning as much cash to shareholders as possible. The company targets an adjusted debt/EBIDTAR ratio of 2.5. This is calculated as sum of total debt, capital lease obligations, and annual rents times six; divided by (net income plus interest, taxes, depreciation, amortization, and share-based compensation expense). AutoZone's has a BBB stable rating by Fitch and S&P, and a Baa2 rating with a positive outlook by Moody's. The company has significant operational and financial flexibility and is committed to maintaining the adjusted debt/EBIDTAR ratio of 2.5. As long as the company remains relatively close to this ratio they should maintain their solid investment grade credit rating and have access to low interest rates. Debt climbed from 2,726,900 to 3,768,183 from 2009 to 2012. The adjusted debt/EBIDTAR ratio remained at 2.5 from 2009 to 2012, due to the fact that the EBIDTAR rose during that same period from 1,566,938 to 2,103,502. AutoZone's capital allocation system in which share repurchases play a prominent role create significant shareholder value.
AutoZone is expanding its commercial program aggressively which provides the company with a profitable growth outlet. The commercial business is highly fragmented and AutoZone currently only owns approximately 2 percent of the market. A major reason for the relatively small commercial business has been a small sales force. AutoZone is devoting significant resources to their sales team by enhancing training and proving additional technology to optimize productivity. Currently 65% of domestic stores have commercial store base and fewer than 33% are less than 3 years old. Due to the success of the commercial program AutoZone is rolling out commercial programs at an increased pace. In the last year AutoZone added 394 commercial programs representing a 14.8% growth rate. The commercial business represented 15.6% of AutoZone's total business at the end of 2012, so it is currently much smaller than the DIY segment.
AutoZone has the highest operating margins in its industry. The operating margins at the end of their last fiscal year were 18.9% compared to 15% for O'Reily at the end of their fiscal year and 10.8% for Advanced Auto Part a their end of their fiscal year. As opposed to having fewer centralized large distribution centers like their peers do, AutoZone has many smaller localized distribution centers called hub stores. The company possessed 149 hub stores at the end of fiscal year 2012. A number of advantages of the hub stores are that they allow AutoZone to provide local inventory coverage, optimize merchandise assortment, and increase inventory turns. Operating margin expanded from 17.3% to 18.9% during the period of 2009 to 2012. There have been a number of reasons for the strong operating margins that have been expanding. The improvement in operating margins from 2009 to 2012 can partially be attributable to an increase in sales. Sales grew at an 8.1% CAGR during this period. This sales growth rate may not sound spectacular in isolation, but the 8.1% CAGR from 2009 to 2012 represents an acceleration of the 6.3% 5 year CAGR sales rate and the 5.3% 10 year CAGR sales rate.
AutoZone is expanding margins not just from a top line perspective, but from effective expense control as well. AutoZone effectively varies its SG&A by tying a reasonable amount of compensation to sales. SG&A has been moderately dilutive to operating margins recently as AutoZone has been aggressively opening commercial programs. Despite the headwind that the commercial program presents to margins, AutoZone managed to expand its operating margins in 2012 by 40 basis points to .189 from .185 in 2011. Gross profit margins increased 50 basis points in 2012 to .515 from .510 as a result of successfully leveraging distribution costs and decreasing shrink expense. The company is committed to growing absolute operating profit dollars and increasing ROIC, despite the fact that the commercial programs present an EBIT margin headwind. The overall operating margin impact of opening the commercial programs at this point has been mitigated by other operating efficiencies and margins continue to expand.
EPS Growth Rationale
The two most important drivers in AutoZone's future EPS growth is its continued EBIT growth and share reduction through an opportunistic share repurchase program. It should be achievable for AutoZone to grow its EBIT between 6 to 9% annually. EBIT growth can grow at this rate in the next 3 to 5 years based on a same store comps increase between 2 to 4% annually and a 4% square footage increase annually. Expect operating margins to expand due to operating leverage, and should add approximately 1.5% to 2.5% to EBIT annually. Share repurchases should add 8 to 10 percent annually to EPS. Expect AutoZone to be able to grow its EPS between 14 to 19% in the next 3 to 5 years.
AutoZone currently trades at a trailing P/E ratio of 15.75. 16.5 is the midpoint of the 14 to 19 EPS growth rate estimate. The PEG is approximately .95 assuming the growth estimates are met. The valuation is relatively attractive in this market. Advanced Auto Parts is currently trading at a 12.59 trailing P/E and O'Reily is trading at a 19.36 trailing P/E multiple. Advanced Auto Parts and O'Reily have lower operating margins, returns on capital, and sales per square foot. The free cash flow yield in the trailing year where free cash flow cash flow is defined by (cash flow from operations-capital expenditures)/ (market capitalization) was approximately 6.9%. The share repurchase yield last year was approximately 10% as AutoZone skillfully added incremental debt to repurchase additional shares without hurting their credit profile as they maintained a 2.5 adjusted debt/EBIDTAR ratio.
AutoZone Differentiation Compared to Competitors
One of the biggest differentiators between AutoZone and its competitors is its capital allocation in which share repurchases are a key element. Advanced Auto Parts also repurchases significant amounts of stock, but not with the same consistency of AutoZone. Advanced Auto Parts repurchased significantly less stock in 2008 and 2009 as their stock price stalled only to resume share repurchase in 2010 when their stock price rose significantly. O'Reily utilizes a different strategy than AutoZone. O'Reily is growing its footprint more aggressively than AutoZone. It made a major acquisition of CSK in 2008. O'Reily did not start repurchasing their stock in meaningful sums until 2011.
The same store sales results for AutoZone softened moderately in the fourth quarter of 2012 which raises questions as to whether the slowdown is temporary in nature or a longer term problem. The same store sales increase was 2.1% in Q4 of 2012 compared to a 3.9% increase in Q3, a 4.6% increase in Q1, and a 4.5% increase in Q4 of 2011. AutoZone management cited unusually warm winter weather as one potential culprit for the softer than expected same store sales results. It was noted on the fourth quarter conference call that the northeast, plains, and great lakes regions posted materially weaker comps than the rest of their regions. These regions were particularly affected by the warm winter weather. Advanced Auto Parts and O'Reily reported softer comps in their latest quarter and they also mentioned that the warmer winter was a contributing factor as many of the maintenance jobs that would have occurred in their latest quarter happened in the winter quarter instead. If there is a softening in the fundamentals of the industry sales trends could continue to slow, which could cause a deceleration in same store comps growth. Slowing same store comps growth would challenge AutoZone's momentum of solid EBIT growth and margin expansion.
AutoZone is a well managed company in an industry that has solid fundamentals. The company is well positioned to grow its EPS significantly over time. The valuation is compelling. AutoZone's capital allocation system is transparent and consistent. The stock should rise significantly over time and reward the long term investor.
Disclosure: I am long AZO.