Description

Autozone (AZO) is the dominant do-it-yourself (DIY) auto parts aftermarket retailer. Nominal growth of the DIY auto parts aftermarket has been about at the rate of inflation for the last few years (no real growth). Most AZO competitors have had declining comp store sales, earnings declines, and increasing debt loads for several years. Bankruptcies and consolidation have occured as a result. AZO acquired some distressed retailers in 1998.

I believe AZO’s stock price is low because investors are discouraged by the lack of industry growth, the time it has taken for AZO to absorb its acquisitions, AZO’s declining ROIC, and AZO’s increasing debt-load (used to finance stock repurchases).

In spite of this tough industry environment and working through several acquisitions, AZO has had remarkably stable profit margins. AZO has a Walmart-like culture of excellence and a financial discipline to match (probably from its KKR LBO past – still has a KKR board member). I won’t repeat AZO details posted by phil19, though I will urge readers who have access to valueline to do side by side comparisons of HD, WMT, and AZO. Notice that despite remarkably similar financial characteristics and histories, HD and WMT have usually traded over 3x AZO’s P/E during the past year. I would imagine this is because WMT and HD are perceived to be in growth industries while AZO is perceived to be in a stagnant industry. It is possible that the next CEO (to be hired within 3 months) will be able to change this perception, or that the company will be LBO’d to be taken public when DIY auto repair companies come back into fashion (note the recent change to the shareholder rights plan).

Due to AZO's fiscal discipline, investment in domestic DIY store growth is declining. AZO stated in their 9/21/00 conference call that they are selective in their new store development, choosing to invest only in stores with excellent locations and adequate projected ROI. AZO DOES have promising growth prospects to supplement declining domestic DIY store growth (in order of AZO's priorities as stated in 9/21/00 conference call):

· Commercial sales - currently at $397 million, AZO goal 1 billion in 4 years - they are #3 in the commercial sales category currently so there is room for growth
· Mexican store growth - 300 stores in 5 years
· ALLDATA diagnostic database is best in industry, licensing continues to grow
· Ecommerce site just launched - more interested in profitability than sales growth
· TruckPro on hold - ROI not yet as good on these stores as AZO stores

In analyzing this company, I found ROE analysis most enlightening and key to understanding why most analysts undervalue AZO. Net margin has been stable, leverage has been rising, and, until several months ago, Asset Turnover has been steadily declining since 1994. Further analysis indicates that the driver of this decrease in asset turnover is lower inventory turns, which dropped from 3.19x in 1993 to 2.28x in 1999, partly as a result of the acquisitions. Inventory turns rose slightly to 2.32x in 2000 (FY ending Aug 26) but this masks the fact that inventory turns were mostly improved in the last quarter and will be around 2.5 (so management stated in the conference call) in FY2001. While ROE is rising due to increased leverage, it will ALSO rise even more due to the higher asset turnover (caused by higher inventory turns), and ROIC will rise as well (management targets 14% ROIC FY 2001, 15% FY2002). Given that the pull replenishment system was implemented around June, 2000, it will take several more quarters to reap the full benefits on AZO's inventory as the slower moving SKUs gradually drop to their new levels.

I trust that AZO management will make wise use of the increased free cash flow, as they have been good stewards of capital in the past. They will either invest in growth projects whose IRR is greater than the cost of capital or they will return the capital to shareholders in the form of share buybacks or dividends.

The ValueLine for AZO dated Nov 17 assumes a very low inventory turn of about 2.2 (based on past few years' trend instead of the future). I derived this by constructing a 5 year proforma for AZO and was only able to match Value line balance sheet projections by making inventory turns drop from last years 2.28 to about 2.18 over the next 4 years. I forced my financial model to match ValueLine's Long Term Debt of $900 million and revenues of 6.85 billion by 2004. Keeping my model the same as value line but changing inventory turns to 2.5, I come up with about the same 2004 net income as ValueLine (435 million), but lower equity due to another 200 million in share buybacks. This brings shares down to 100 million (from Valueline's assumed 107 mil) if the average share price is $28.5/share for future buybacks. Therefore:

435/100 = $4.35 EPS
And the P/E should be higher than 13.5 because ROIC and ROE is increasing. Assuming P/E of 20:

20 X 4.35 = $87/share at the end of FY2004

And this is based on inventory turns of 2.5, which assumes no more improvement from FY2001's projected 2.5 inv turns. If AZO can cause inventory turns to go even higher (perhaps to their former 3.0 turns 6 years ago?), they will generate even more cash and ultimately a higher stock price.

Implicit in both value line's model and my model is an 11% sales growth rate over the next 4 years, a rather conservative assumption.

Some risks worth mentioning:

The entire industry is suffering for some reasons which are permanent (cars better built and more complex) which may cause worse damage to AZO's core DIY business than I anticipate. However, keep in mind that many reasons for the stagnating industry sales are temporary due to the best 5 year economy of the century - more newer cars, more leased cars, and more hiring out of repairs instead of DIY repairs. If the economy slows down to normal levels, or better yet a recession, leasing, new car buying, and hired out repairs will drop, causing DIY sales to grow faster.

Catalyst

1) Inventory Turns (and therefore ROIC) have bottomed out and started rising due to implementation of a pull replenishment inventory system - the cash this generates can be used to reduce debt or buyback stock

2) In the event of an economic downturn, AZO sales and earnings growth are likely to increase due to more people doing their own auto repairs, and lower labor costs.

3) Will be hiring a new CEO within the next 3 months, who they want to bring AZO to "the next level" - to receive the kind of recognition accorded Walmart and Home Depot (whose P/Es are usually 3x AZO's)

4) Lampert (ESL partners), the largest shareholder, has precipitated changes in shareholder rights agreement (10/10/00) which presumably make it easier for AZO to be acquired or LBO'd.