AutoZone
We have studied and admired AutoZone for a number of years and finally got the opportunity to purchase our first shares in March. We continued buying in early April. Our average cost is approximately $760 per share. This amounts to 9.0x pre-tax earnings and 11.4x after-tax earnings. This is a 24% discount to AutoZone's 15-year median after-tax multiple of 15.0x.
You've undoubtedly seen at least one of AutoZone's 6,481 stores. AutoZone sells autoparts to consumers (DIY) and professionals (DIFM). AutoZone's simple retail business model belies its strength. According to ValueLine, since 2003:
Earnings per share compounded at 16.7% annually
Return on total capital averaged 42%
The lowest annual return on total capital was 32% in 2009
Shares outstanding decreased 73%
This extraordinary track record is the product of many subtle but powerful competitive advantages.
Stable and Growing End-Market Demand
AutoZone benefits from a stable and growing end-market. Demand for autoparts is largely a function of two variables:
Miles driven
Vehicles that are at least seven years old
Both of these variables are trending in AutoZone's favor.
Miles Driven
Since 1970 miles driven have increased 2.2% per year, increasing from 1.1 to 3.3 million miles. The more miles driven, the more demand AutoZone sees for its failure and maintenance products, which are 85% of sales.
Source: Federal Reserve Bank of St. Louis
Miles driven are remarkably consistent, but do dip during recessions and when gas prices increase. It's too soon to tell what 2020 and 2021 will look like. Miles driven almost surely decreased in March and will in April. As the country re-opens, cheap gasoline may help while greater unemployment may hurt. Regardless, the long term trend is in AutoZone's favor. Five or ten years from now vehicle miles driven will be higher, not lower.
Vehicle Age
Average vehicle age has trended up for the last twenty five years.
Source: IHS Markit
AutoZone's sales correlate with the number of vehicles age seven or older. The typical vehicle is driven 12,500 miles per year. After seven years, it has 87,500 miles on it. At this point, it is out of warranty and increased maintenance is needed to keep the vehicle operating.
The average age of vehicles on the road today is 11.4 years. Average age is increasing because new cars contain lots of new technology and sensors which make them more expensive. Consumers are driving their existing cars longer to defer a big ticket purchase. This behavior becomes more pronounced during recessions.
Stable End Market
Driving is a way of life in the U.S. People must drive, even in recessions. Without a working car, many can't work. Tough times only encourage drivers to fix their cars themselves, which benefits AutoZone's DIY segment. Earnings per share grew straight through the 2008-2009 financial crisis.
Source: Value Line
This recession may be different, because the population is largely locked down. A few months of light driving won't impair AutoZone's long-term intrinsic value, however. We expect Autozone to grow through most “normal” recessions.
Time Sensitive, Not Price Sensitive
Besides a stable and growing end-market, AutoZone benefits from a somewhat price insensitive consumer. When your car is broken, time is of the essence. Most people can't afford to have their car out of commission for long. Mechanics want to turn the cars in their garage quickly, and largely pass along the cost parts to the customer. They're much more concerned with speed, availability, and service than price.
I wouldn't go so far as to say AutoZone has untapped pricing power, but they do have the ability to raise prices when their costs increase. When tariffs rose last year, they slowly layered in price increases to avoid shocking the consumer, and the strategy worked.
A Focus On Service
Instead of worrying about price, AutoZone worries about speed, availability, and service. AutoZone uses a hub and spoke model to put as much inventory as close to the consumer as possible. Distribution centers replenish mega hub stores and hub stores several times per week. Hubs, in turn, supply stores multiple times per day or at least each night.
A few years ago the market got spooked that Amazon was going to compete with AutoZone. This could happen, but shouldn't be a significant worry. RockAuto has been selling autoparts online since 1999, and has yet to dent AutoZone's growth.
The reason is that AutoZone's stores employ staff trained to help you get the part you need. Many DIY-ers don't know what's wrong with their car or what they need to fix it when the roll up. Employees help them diagnose the issue and buy what they need to fix it for free. The internet cannot replicate this human element.
Financing Inventory
AutoZone's business is inventory intensive. They carry parts for every current and past car model and make every part available in every store within 24 hours. Accordingly, inventory per location is $673,000. AutoZone turns its inventory 1.3x per year. This means the average part sits on AutoZone's shelf for over 9 months.
Fortunately, AutoZone is able to leverage its scale and financial stability to extract long payment terms from its suppliers. By matching payment terms with inventory terms, AutoZone is able to maintain negative working capital. Accounts payable are 112% of inventory which means suppliers finance all of AutoZone's inventory. Accounts payable have exceeded inventory each year for the past ten.
This is a major competitive advantage for AutoZone and a source of its high returns on capital. If AutoZone needed to front the cash for its inventory, it would need to employ substantially more capital, which would dilute returns. AutoZone's smaller competitors don't have the scale or clout to negotiate long payment terms with suppliers. AutoZone can afford to carry a wider and deeper selection of inventory than competitors, which means AutoZone is more likely to have product available.
AutoZone always maintain an investment grade balance sheet (and has succeeded). Fitch recently affirmed AutoZone at BBB despite curtailed store hours and a new debt offering (more on this later). Suppliers offer AutoZone such generous payment terms because they're able to sell their AutoZone receivables to a bank of a modest discount. The bank is willing to take these on because it knows AutoZone is good for the money. The same is not true for mom-and-pop stores.
Capital Allocation
AutoZone’s management are exemplary capital allocators. Their policy is simple: prioritize reinvestment in the business and spend whatever is left over on share buybacks while always maintaining an investment grade rating. Shares outstanding are down 73% over the last 15 years.
Over the last ten years, AutoZone reinvested 16% of its cash flow at a 29% incremental return. The remaining 84% went to buybacks. AutoZone recently paused its buyback program due to uncertainty over the pandemic.
Liquidity
AutoZone recently closed on a new 364-day senior unsecured $750 million revolving credit facility. They also sold $500 million of 3.625% bonds due in 2025 and $750 million of 4.000% bonds due in 2030. These are attractive terms, which is a testament to the reliability of AutoZone's business model .
This cash will help fund an increase in working capital this spring and summer. Lower sales in March and April will force AutoZone to pay for inventory before it sells it. This will require a temporarily increase in working capital. When sales return to normal and AutoZone restocks inventory, working capital will shrink and then normalize at prior levels.
The Future
AutoZone's growth depends on the number of new stores they open or acquire and their existing same store sales growth. Earnings per share will be further affected by stock repurchases.
AutoZone is the largest domestic autoparts company, with about 20% more stores than its next biggest competitor, O'Reilly Autoparts. The autoparts market is highly fragmented. The top four biggest players (AutoZone, O'Reilly, NAPA, and Advanced Autoparts) collectively account for about 50% of the market. The remaining 50% are mom-and-pops. AutoZone will continue to take market share organically from them because it is able to finance inventory cheaper and make more inventory available faster.
AutoZone is also expanding into Mexico (604 stores) and Brazil (35). These markets are even more fragmented and offer tremendous long-term growth potential.
AutoZone also has growth potential in the commercial (DIFM) space. Historically, AutoZone has focused mostly on the consumer DIY space. Today, 85% of domestic stores and the majority of foreign stores offer a commercial parts program. Commercial is growing 8% annually, double the market rate, which signals that AutoZone is gaining share. As AutoZone builds more megahubs, the quality of its commercial offering will increase.
AutoZone opened about 200 stores per year (~3% growth) in each of the last five years. I'd expect this to continue, though 2020 may buck the trend. Same store sales growth will add another couple of percent to this. If AutoZone continues to return 84% of cash flow to shareholders, it will yield 9% at our cost. A multiple re-rating from 11.4x to 15.0x over five years would add about 5% to the stock's annual return. In total, we expect our investment to return 15-20% for the next several years.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.