Ryan Fuhrmann, CFA
December 13, 2006
My bearish stance on auto-parts retailer AutoZone (NYSE: AZO) can be summarized as follows: I don’t care for the industry, and I think there are more compelling opportunities in the crowded retailing sector, especially with the recent run in the shares. Time to take some chips off the table — some famous investors already have.
Don’t get me wrong, AutoZone excels as the leading auto-parts provider. Only O’Reilly (Nasdaq: ORLY) is worthy of similar consideration, due to lower indebtedness, better industry positioning, and a superior top-line growth track record. But AutoZone is more profitable and has $243 in sales per square foot, versus $220 at O’Reilly and only $208 at another competitor, Advance Auto Parts (NYSE: AAP). It’s clearly doing something right.
Here’s what else I like about AutoZone.
Industry leader and a profitable cash generator
AutoZone is the largest firm in the parts industry as well as the most profitable, with close to 10% net margins and return on invested capital near 30%. It also throws off impressive amounts of cash flow and lately has been posting solid earnings growth as it uses excess capital to repurchase shares.
AutoZone is trading at a reasonable 15 times trailing earnings and 8.5 times trailing EBITDA, even with a near 40% run in the stock price from lows reached in July. The low valuation has piqued the interest of many investors, including those at Motley Fool Inside Value, which recommended the stock in June 2005. But maybe it’s time to lock in some gains, as I think a below-average valuation is warranted for AutoZone.
Anyway, that’s all well and good, but here are some important dislikes I have.
AutoZone’s top-line growth has been anemic. Total sales have grown only 4.3% on average over the past five years, and have averaged less than 3% over the past three years. Same-store trends have also been weak; in the most recent quarter, comps only advanced 0.3%, after an equally uninspiring 0.8% in last year’s quarter. Additionally, although AutoZone throws off impressive operating cash flow, the growth trend has been uneven since 2000, and free cash flow has fallen for three straight years now, as the company must spend to open new stores and keep pace with the competition.
A crowded industry
Speaking of the industry, it’s competitive, seasonal, and cyclical. Retailing in general is very crowded, since the barriers to entry are low in opening a store and selling merchandise. The auto-parts industry is no exception, and it may even be the most fragmented. In addition to the competitors mentioned above, Pep Boys (NYSE: PBY) and CSK Auto (NYSE: CAO) compete in the space. AutoZone has the most stores with about 3,800 total, but the peers listed so far operate a collective 6,300 stores. We can also throw Wal-Mart (NYSE: WMT) into the mix, although it has a more limited auto-parts selection, and don’t forget about the multitude of auto body shops for consumers who don’t have the time or interest to fix their own cars.
Additionally, the industry is seasonal, as most consumers prefer to work on their cars during the warmer summer months. That I can handle, but the auto space is also cyclical and subject to fluctuations in gas prices, consumer sentiment, and the overall health of the auto industry. There’s also concern that technology enhancements could drive do-it-yourselfers into the hands of specialized mechanics. AutoZone is especially geared to the DIY crowd, while O’Reilly serves both consumers and mechanics.
My final bone to pick pertains to AutoZone’s high debt. A debt-to-capital ratio of close to 80% is too much for me, since any unexpected industry downturn or operational miscue could make those hefty interest payments hard to swallow. For comparison purposes, O’Reilly is able to grow just fine with a debt-to-capital mix under 10%. Sure, cash flow generation is strong at AutoZone, but one never knows what lies down the road.
Fool’s final word
Another important consideration has to do with opportunity cost. I think there are better names out there in retailing, including other Motley Fool Inside Value picks such as Wal-Mart and Home Depot (NYSE: HD). These firms have proven so successful that their retail landscapes have been whittled down to two primary leaders, which are better able to enhance cash generation and grow at a decent clip. It’s still not easy, but duopolies make life simpler. Wouldn’t you breathe easier if AutoZone only had O’Reilly to worry about?
Overall, AutoZone is undoubtedly an impressive industry leader with solid cash-flow generating capabilities, but I have to wonder how long that can continue, given the weak top-line growth that comes with operating in a crowded, cutthroat industry. In other words, the investment drawbacks outweigh the positives, especially with the recent run in the shares. And don’t just take my word for it; according to gurufocus.com, of six super-investors listed as having an interest in AutoZone, half have either reduced or eliminated their positions so far this year.
That includes Joel Greenblatt, a renowned value investor who sold a portion of his holdings below $100. There is a point where a low valuation becomes enticing enough to warrant jumping aboard a slow-growing company in a tough industry, but that time has passed for AutoZone for the time being.
AutoZone, Wal-Mart, and Home Depot are Inside Value picks.
Fool contributor Ryan Fuhrmann is long shares of Home Depot, but has no financial interest in any other company mentioned. Feel free to email him with feedback or to discuss any companies mentioned further. The Fool has an ironclad disclosure policy