Description

AutoZone (AZO) is a distributor and retailer of auto replacement parts.  Company has ~5,850 stores with 5,400 stores in the US and remaining in Mexico and small number in Brazil.  AZO has been widely considered one of the best run businesses in the industry with great capital allocation.  Current CEO, William Rhodes took over AZO in 2005 – prior to becoming CEO, Rhodes worked in pretty much every core division at AZO - EVP Store Operations and Commercial, SVP Supply Chain and IT, VP Stores, SVP Finance and VP Operations Analysis and Support – providing him with the deep experience to be one of the better operators in the business. 

Despite the cyclical nature of the auto industry, AZO is pretty much a steady and consistent business.  Revenues have grown at an annualized rate of ~4% between 2000-2008, a little under 6% between 2009-2014, and ~5% between 2014 and 2016.  Operating income growth per year has been ~8% since 2009 while EPS growth per year has been ~19% over the same period, due primarily to share buybacks.  Company reduced shares from ~55mn in 2009 to ~30mn today. 

Top line growth over this period has been driven by a combination of new store openings and same store sales growth, with equal contribution between the two.  Of the $11bn of revenue generated, ~78% comes from the do-it-yourself side (retail) while remaining 12%, or ~$2bn, comes from the do-it-for-me side (commercial).  Since 2009, DIY revenues have grown at a rate of ~5% while DIFM revenues have grown at a much higher rate of ~14%.  From an individual store point of view, each store is ~6,500 square feet and generates ~$1.8mn in revenues and costs a little over ~$1MM to open each store.  With operating margins of 19%, pre-tax cash on cash returns are a little under ~35% for each store or after tax return of over 20%.  AZO has stated in the past that they are looking at minimum hurdle rates of 15% and all of its investments are designed to drive cash flow, while maintaining or enhancing the 20%-plus return on invested capital that it has generated consistently since the early 2000s. 

The high returns of capital in the business is sustained in part due to best in class inventory systems, with accounts payable to inventory ratio of ~110% resulting in negative working capital.  AZO benefits from its leading market share position and scale relative to the fragmented nature of the aftermarket auto part manufacturing industry.

Stock price decline by ~25% YTD due to concerns of Amazon’s entry into the market as well as decelerating fiscal Q3 comps (management attributed to weather and tax refunds).  Numerous sell-side and press report have highlighted Amazon’s entrance into the auto parts market, citing that the company has struck contracts with largest parts makers in the country.  Given the recent trends in apparel retail, people have jumped to the conclusion that Amazon will have the same negative impact.  While I think Amazon might have some effect on some product lines for auto retailers, a significant part of the business will not be impacted.

The total auto retail is ~150bn, with the DIY segment making  ~$50Bn and commercial remaining $100bn.  Amazon’s revenue is $150bn today, so assuming they gain 10% share on DIY market (most at risk segment), that’s a 3% revenue gain. So in my mind, at least in the short term, unless Amazon is able to gain share very quickly (which is unlikely in my mind for reasons stated below), the actual revenue contribution to Amazon is small, thus probably not a key priority.

Second, purchases in the DIY market are failure or maintenance driven and the retailer success in this sector is driven by quality, speed of delivery, and lastly price.  Per company data, ~84% of sales in the DIY market are driven by failure and maintenance products vs. 16% for discretionary.  48% of products are in the failure category (i.e. AC compressors, batteries, clutches, engine parts, fuel pumps, etc.), 36% of sales are in the maintenance category (i.e. antifreeze, chemicals, oil & transmission fluid, oxygen, sensors, etc.), and remaining 16% categorized as discretionary (i.e. air fresheners, floor mats, mirrors, protectants and cleaners, etc.).  Also, ~40% of the products bought in store are installed by sales associates (value add of going to store); due to complexity, 20-25% of items are returned/exchanged. AZO also said that their top selling days for windshield wipers are when it is raining – ie needs based purchases that require store visits or fast delivery. Also, ~50% of customers who made in-store purchases paid by cash, which reflects demographics of the AZO customer base and probably not in the same cohort as Amazon Prime customers.

Another hurdle for Amazon is that for the most part, auto parts turn over slowly.  The reason for the slow turnover is that stores need to keep a wide range of parts for all occasions and as autos have become more complex, stores need to stock more inventory especially as most customers want the parts ASAP forcing stores to keep large SKUs in store.  Inventory per store has grown by 30% since 2009.  Despite growth in inventory, AZO has done a pretty good job at maintaining the turns relatively constant over the last 8 years at ~1.4x.  But at 1.4x turn, this compares to Amazon’s 9x inventory turn – which implies this business segment is completely WC inefficient vs. Amazon’s other businesses.

Lastly, I’ll provide recent commentary from O’Reilly, another player in the industry, and AZO, on the Amazon threat as they see it from their point of view. 

O’Reilly: “I've spent some time talking to some of our supplier principals who might sell online retailers, which we obviously don't care for that that much. But still some of them that make sense for them to sell online retailers and work to protect the price at which the products are sold and so forth. But, and I think – I've known a lot of these guys for a long time and I have every reason to believe that they would shoot me straight relative to the amount of volume they do with some of these online retailers. I think that most of you would be really disappointed to hear what some of the suppliers that you might think would be major suppliers to online retailers, the amount of volume they're actually doing. And that volume is not on a ramp up that I think some of the commentary would lead people to believe. So while I – there's obviously products, especially accessories and some of the more ancillary products that go on cars, there's obviously a marketplace online that will serve them. But for the majority of our business in hard parts, I don't feel like that we're exposed much to online retailers and I don't see that changing in the short-term.”

AZO: So, look at the DIY customer. And I'll start by saying what is Amazon good at, kind of defining them. They're pretty good at offering a product overnight at a pretty good price. If you can save 10% by buying a TV that's $1,000, that's a pretty nice ticket change, that's $100 you could save, 10%, get it overnight, big deal. They're not really good at returning parts. Customers don't – they don't buy parts that they typically are going to return.

If you've bought a TV, odds are you've probably never taken it back. They also – or they buy – repetition, I'm going to get dog food once a month. I said it two weeks earlier, and somebody said that they must have a big dog. But if you buy dog food or paper towels or whatever, it's repeat purchases. Amazon is pretty good at that. Let's talk about our customer. Our customer on the DIY side, those average ticket transactions are $25 and they typically have two pieces in the transaction. That's kind of what the transaction looks like. So, if you're saving 10%, 15%, 20%, you're talking $2 on the transaction. The bulk of the customers that shop with us – well, the bulk of the population is within three to five miles, 90-plus percent of the population in the U.S. is within three to five miles of an AutoZone.  We've got 40 parking spots in front of our store. It's a 7,000 square foot box, the customer can only shop in about 4,000 square feet of it. You can walk up to the parts counter, get somebody to help you diagnose your car. And you can be done with the transaction in less than five to 10 minutes. And you're probably already passing us taking your child to school or going to work. It's just a different customer the customer that comes into our shop, into our stores.

Also, we're helping them with a lot of the transactions. Again the return rates on DIY are pretty high. They're low double digit. Just people buy the wrong part, they don't know what they're buying, their car is making a noise, they think it's the shock and it comes out to be the control arm. They need help installing the parts. We've got 150 tools in the back of our stores that we will loan to a customer free of charge, helps them facilitate the job.

When you go to buy an alternator or a set of brakes or whatever, there is all these different things that you need to know to get the right part. Our AutoZoners walk outside and help people determine what those are. They look at the alternator and say okay, that's a 95 amp Bosch alternator or that's 110 amp Delco. We help people facilitate all those conversations, and it's very difficult to do that over the web. Will Amazon figure some of that stuff out? Sure, probably. But it's a much different interaction. We do check engine lights.

I akin Amazon to very similar to Walmart. We've been competing with Walmart in the automotive industry for 30 years. At the end of the day, Walmart sells a lot of the product that we sell in the front of our stores at a cheaper price. Go shop them, you're going to find some pretty big savings. Light bulbs are a good example. We sell a light bulb, the exact same brand; they can be substantially cheaper than we are but we offer a differentiated product. You'd be amazed at the share we have on light bulbs because we help people install them, we help them get the right one, we get them the bulb grease, we tell them how to install it. Where we don't have great share is where we don't differentiate, where it's hard to do that. A good example is windshield washer fluid. We really don't add a whole lot of value other than maybe we can help somebody pour it in. But it doesn't – there is not a whole lot of advice that's needed. We can't add anything, any value to washer fluid. The bulk of our products we do though. They got to have a core on an alternative or a starter or a CV shaft, those transactions are tough. We take back used oil. Some of these products can't be put on a plane because of aerosols and things like that. So, it's just a different customer and it's a tougher transaction.”

AZO currently trades at 13.6x and 12.5x 2017/2018 consensus EPS estimates.  Consensus has EPS growing at 9% for 2017 and 2018.  I would argue that sell-side estimates are low and EPS will more likely grow in the low double digits on my conservative base case. But even taking consensus numbers as one’s base case, 12-13x seems to be a decent price to pay for a recession-resistant, cyclical business run by great operators and capital allocators with proven track record.

Catalyst

Valuations re-rate as Amazon threat is re-priced

Continued LSD growth on the top line, HSD operating income growth and LDD EPS growth