AutoZone Inc (NYSE:AZO) is a US based company which operates in the automotive replacement parts and accessories sector. It sells both directly to consumers through a chain of over 6,500 company owned stores throughout the Americas (including Mexico and Brazil) and it also distributes parts to the automotive industry trade (repair garages, car dealers, service stations, etc).
AutoZone retails products sourced from the leading industry branded suppliers and markets its own branded products (private label) sourced directly from low-cost Asian suppliers. Industry commentators estimate that AutoZone’s private label brands may represent almost 50% of total sales.
The company opened its first store under the Auto Shack brand in 1979 and changed its name to AutoZone in 1987. The company listed on the NYSE in 1991.
At the time of writing this report AutoZone had a market capitalization of $US 3,400 M which makes it the 230th largest company on the S&P 500.
The company does not provide any break-down of its revenues by market segment or by region.
There is reasonable conjecture about the size of the US car parts aftermarket. I have seen estimates as high as $US 281B from AutomotiveAftermarket.org to as low as $US 78B from GrandView Research. I have settled on the numbers presented by Advanced Auto Parts (AAP) because of their close agreement with the estimates published by its competitors.
Source: Advanced Auto Parts: Investor Presentation April 2021.
The US market has seen reasonable growth over many years. The industry participants believe that demand is influenced by the total number of vehicle miles driven and the average age of the car fleet. Both indicators have had favorable tailwinds (excepting for the recent short-term impact of COVID-19):
Source: Federal Reserve Bank of St. Louis
Prior to the impact of COVID-19, the underlying total miles travelled had been growing at close to 1% per year. In the most recent year there was a 13.2% decline in the total miles traveled.
The data is indicating that the average age of the US car fleet is growing older each year. This is expected to continue given the challenging economic conditions.
Industry participants expect that post COVID-19 the market will resume its growth trajectory. The generally accepted view is that the sector’s revenues will grow between 2% to 4% per year for the next 5 years once conditions return to normal.
The market is very fragmented with no one company having a dominate market share.
Source: Genuine Parts Company, Investor Day Presentation 2019.
The major companies in this market include: AutoZone, Genuine Parts Company (GPC), Advanced Auto Parts and O’Reilly Automotive (ORLY). Each company has similar market shares with a total combined market share of just over 30%.
The Auto Aftermarket can be segmented into two main elements:
This segment was estimated to be about $US 65B in size before the impact of the pandemic. The market is dominated by retailers who sell primarily to individuals. The on-line component of this segment is significant but reasonably contained due to its complex customer service requirements (a combination of price, availability and technical support is often required by customers).
This segment was estimated to be about $US 85B in size before the impact of the pandemic. The segment comprises the commercial repair shops, car dealers, etc. The customer requirements for this segment are less price sensitive and more sharply focused on the range, availability and quality of the products.
Over the last few years, the Commercial market has become the competitive battleground as it has provided the greatest opportunity for the major companies (including AutoZone) to grow market share.
AutoZone has adopted a multipronged strategy which has specific elements to grow revenues and defend margins in its key markets. It has used a combination of new technology (data mining IT which has enabled better inventory management and dynamic pricing) and traditional market positioning approaches such as:
It is difficult to directly measure the success of specific AutoZone strategies because the company provides us with no breakdown of revenues and margins by market, so we are forced to look at higher level measures and make some broad conclusions.
We know that AutoZone has been growing its international business. We can draw this conclusion by the number of total stores operated in each market:
Source: Author’s compilation using data from AutoZone’s 10-K filings.
The data indicates that AutoZone’s US store count has been growing at 2.7% for the last 5 years whilst its international store count has been growing at 10% per year. Based on the total stores in Brazil and Mexico I estimate that the total revenues from these locations would be approximately 5% of AutoZone’s revenues.
The data indicates that at this stage the expansion outside of the US is probably not making a material contribution to the company’s profitability, but it is providing some future growth optionality if these markets were to develop over time.
We know that AutoZone’s revenues have been growing faster than the overall market for many years:
Source: Author’s compilation using data from AutoZone’s 10-K filings.
We saw earlier that the total US market has been growing at 3.6% per year. Although the above chart includes revenues from AutoZone’s Mexican and Brazilian operations (where I concluded that their contribution was relatively small) it is reasonable to conclude that AutoZone has been growing significantly faster than its market for many years.
The previous chart indicated that AutoZone’s store count was growing below the rate of growth of the total market yet AutoZone’s total revenues were growing faster than the market. This leads me to conclude that AutoZone is gaining market share in the Commercial segment.
Based on these charts (with the margin chart to follow in the next section) I conclude that AutoZone’s strategy seems to be delivering the expected outcomes that were forecast by management.
The biggest strategic issue remains – what will be the impact of electric vehicles (EV) on AutoZone’s business? At this stage management is silent on this issue but at some stage investors will require clarity about this.
AutoZone’s historical revenues and adjusted operating margins are shown in the chart below:
Source: Author’s compilation using data from AutoZone’s 10-K filings.
The operating margins have been adjusted for the impact of :
The chart indicates that AutoZone has not been negatively impacted by COVID-19, in fact, like many large specialty retailers, business has improved. This trend has continued throughout the current year and year on year sales are projected to be over 12% higher in 2021.
AutoZone’s operating margins have been reasonably flat since 2013. The step change to higher margins which happened nearly 10 years ago appears to have been driven at the gross margin level (improved supply chain management). This focus on gross margin continues to drive improvements to this day as shown on the following chart:
Source: Author’s compilation using data from AutoZone’s 10-K filings.
I estimate that AutoZone has sector leading gross margins with O’Reilly Automotive being a close second:
Source: Author’s compilation using data from GuruFocus.
My moat assessment for AutoZone is shown on the following table:
I think that the major sources of moat strength for AutoZone come from its well-regarded brand and from the cost advantages that it has achieved through its supply chain and from its scale.
The strength of AutoZone’s moat can be measured by its return on invested capital which is shown in the chart below:
Source: Author’s compilation using data from AutoZone’s 10-K filings.
Note that I have adjusted the published financial data for:
I estimate that AutoZone’s return on invested capital (ROIC) is the highest in the sector with O’Reilly Automotive a close second with an ROIC of 31.5% in 2020.
This leads me to conclude that AutoZone’s moat is reasonably strong and should be sustained over the medium term provided that the company continues to invest in its value proposition.
I do not have any significant concerns over AutoZone’s capital structure. The following chart shows the shift in the mix of its debt (including operating leases) and market value of equity over time:
Author’s compilation using data from AutoZone’s 10-K filings.
The chart indicates that AutoZone has until recently held its non-operating lease debt levels reasonably steady for several years. In the last 2 years it has begun to slowly raise its debt levels, but it has ensured that it remains in line with its market value of equity. The debt can easily be serviced by its operating cash-flows.
The following table summarizes AutoZone’s cash flows over the last 10 years:
Source: Author’s compilation using data from AutoZone’s 10-K filings.
There is good alignment between AutoZone’s reported Net Income and the net operating cash flows. This gives me confidence that there is probably relatively little management manipulation of the financial statements.
Over the last 10 years AutoZone has generated almost 12% free cash flow to capital from sales (this is significantly higher than companies like Home Depot but very similar to O’Reilly Automotive). AutoZone does not pay a dividend and returns cash to shareholders only through share buybacks. The share buybacks are partially funded by additional debt (about 17% of the debt is used for buybacks) and in a tightening credit environment this would need to be scaled back over time.
In summary, AutoZone is an excellent converter of revenues to free cash flow with relatively modest reinvestment requirements.
Source: Yahoo Finance
The price action for the last few months has been a bit of a roller coaster and I suspect that there was an excellent buying opportunity in June. In summary the stock has performed extremely well since the market bottom in March 2020.
Source: Morningstar
The data from Morningstar indicates that the Specialty Retail sector has had tail-winds relative to the market for the last 3 years. Although AutoZone has out-performed the market it has not out-performed its sector over the last few years. However, for long term investors of AutoZone they have both out-performed the sector and the overall market.
Two of the three key threats to AutoZone’s business are driven by technology – will autonomous vehicles eventually impact the level of personal vehicle ownership and what will be the impact of electric vehicles (EV)?
I believe that the mass introduction of autonomous vehicles is still a long way off (more than 10 years) as the technology / safety challenges have proven to be more difficult than expected. I suspect that autonomous vehicles in the medium term will be restricted to defined routes (highways and inner cities) and this may have a negligible impact on vehicle ownership. Over the long term this assumption will need to be revisited.
The major threat to AutoZone’s business is the increasing popularity of electric vehicles (EV). EV’s currently have a low level of market penetration (around 2%) but this is expected to increase over time. EV’s will continue to require many of the replacement parts that AutoZone supplies but obviously those parts associated with the internal combustion system will not be required. I suspect that the gaining of market share by EV’s will be a negative for AutoZone, but I also think that this will be a problem in 10 to 20 years’ time and not in the short to medium term. Nevertheless this makes it imperative that investors are aware of the underlying intrinsic value of the stock.
The final significant risk relates to AutoZone’s ability to source low-cost parts (particularly its private label parts) if the relationship between China and the US were to significantly deteriorate. This would have a material impact on gross margins and the profitability of the business.
My scenario for AutoZone contains two distinct time horizons. I think that the next 10 years will be similar to the past and therefore we can have reasonable confidence about forecasting this period of time. The impact of EV’s on the business make the longer term quite uncertain and riskier.
I expect that the economy will begin to “normalize” in 2022 as we develop a “living with COVID” world. I think that industry’s growth projection of the underlying demand for auto parts to be around 3% per year for the next 5 years is quite reasonable. The long-term mature demand will be around 1.5%.
I expect that the market will continue to consolidate over time as the larger players squeeze out the smaller players (in both the DIY and Commercial markets) and this will allow the larger companies to continue to grow their market-shares and achieve a higher sales growth rate than the sector average.
Although volumes will continue to grow there will be some give back in margins as a result of the competition that comes from growing market-share in a relatively mature market. I expect that margins will be capped at around current levels and there will be no efficiency gains dropping to the bottom line as these potential benefits are competed away.
Given the importance of the brand and the high levels of customer service to AutoZone’s market position I expect that AutoZone’s reinvest will need to increase marginally over time (as a ratio of sales).
At this stage I am not prepared to forecast what the impact of the growth of EV’s may have on AutoZone’s business. I will deal with the uncertainties associated with this by increasing the terminal cost of capital above what it would be under normal circumstances. This will have the effect of applying a higher discount to the long-term cash-flows.
I have not factored in any major deterioration in the relationship between China and the United States.
The output from my DCF model is:
Source: Author’s model
I also developed a Monte Carlo simulation for the valuation based on the range of inputs for the valuation. The output of the simulation was developed after 100,000 iterations.
Source: Author’s model.
The Monte Carlo simulation not only indicates the extremes of the valuation, but it can be used to help understand the major sources of sensitivity:
The simulation shows that there are 2 significant value drivers in AutoZone’s valuation with the dominant one being the operating margin forecast and the minor driver is the revenue growth – these represents the greatest source of risk in the valuation.
The simulation indicates that at a discount rate of 6.7%, the valuation for AutoZone’s equity per share is between $1,255 and $1,796 per share with an expected value around $1,507.
Based on my scenario I conclude that AutoZone’s shares are currently fairly priced.
AutoZone is a leading US brand and as a result of its customer value proposition it has been able to generate high returns on capital. From an investment perspective, long term shareholders have done extremely well and have earned returns well above the market.
The auto parts sector is relatively mature but highly fragmented and this has enabled AutoZone to grow much faster than the sector for a reasonably long period of time as it participated in the sector’s consolidation. There is still more sector consolidation to take place in the US and AutoZone will continue to participate for many years to come. At the same time AutoZone will continue to expand its footprint internationally where it can leverage its value proposition.
Like any investment, if this market thesis is correct, then it is imperative that investors do not over-pay for above trend growth that may not happen.
For each company that I value I also assess what role this company could potentially play in my portfolio. The cornerstone of my portfolio is what I term “Tier 1” companies. These are the companies that I hold for the long term and where I invest most of my cash.
My high-level assessment for AutoZone is:
Source: Author’s assessment.
My assessment is that AutoZone is a marginal Tier 1 company only because the sector is relatively mature and there are some future unknowns however AutoZone’s fundamentals would truly qualify as a strong Tier 1 company.
I believe that AutoZone is a HOLD at today’s prices. My analysis suggests that just a few weeks ago the company was cheap but now the price has run back to fair value. Now is not the time to pull the trigger on this stock but investors should continue to watch this stock closely because it is difficult to find excellent companies which are reasonably priced in this market.
I currently don’t own any AutoZone stock, but I would be a buyer on any pull back below fair value.
Best wishes.
This article was written by
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in AZO over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.