AutoZone: Continuing On The Path To Success (NYSE:AZO) (2024)

The AutoZone Investment Thesis

After my last article on AutoZone, Inc. (NYSE:AZO) from November 2023 titled: This Is What Investors Should Watch For In The Period Ahead, I wanted to give a quick update and earnings preview.

And I believe that AutoZone is still on the road to success because it looks like the old formula of buying back stock and growing through new stores is still the way to go. As a result, I continue to believe in my previous thesis that AutoZone is a high-quality, shareholder-friendly company with competitive advantages that differentiate it from its peers.

AZO's Balance Sheet

At first glance, the current debt load of $8.6 billion seems impressive, given that the company only has about $304 million in cash and cash equivalents. But more importantly, in my opinion, is how much net income a company generates and how that compares to its debt load and how its interest coverage compares to the market.

And here I have to say that the trend in interest coverage is not to my liking. It is still close to the 10x that most non-financials in the S&P 500 (SPY) have, but should the trend continue to the downside, that would be less than optimal in my view. Thus, both higher interest rates and higher debt burdens appear to be having an impact.

TTM's net income of $2.6 billion may soon fall below the 4x threshold that I usually consider a good ratio of debt to net income. Right now, the ratio is below the threshold, but if debt continues to rise and net income cannot keep up, it would lead to a downgrade in my view of balance sheet strength.

However, at 3.3x, the balance sheet is still solid for now, and over the long term, the ratio tends to stay in this range. In August 2019, for example, it was also at 3.2x.

But still, debt is up 22% year-over-year from Q2/23, when it was only about $7 billion.

AutoZone Q2 Earnings + Call Review

AutoZone's Q2 earnings call was the first for the new CEO, Phil Daniele. And it was pointed out that Q2 is the most volatile quarter due to winter weather and various holidays such as Christmas and New Year, which fell on a Monday last year, and that the second half of the year tends to be the cash flow driver.

And you can also see very nicely that net income only grew 9.1% from 1,016 to 1,108, but diluted EPS grew a very strong 18% due to share repurchases. In addition, the increase in Gross Margin is expected to remain at current levels as inflation and supply chain cost increases have been passed on to customers in the past and supply chain costs have recently recovered, resulting in improved EBIT margins.

The commercial segment fell short of expectations, in part due to the weather, but is expected to be a long-term growth driver due to hubs and mega-hubs and improved lead times for hard-to-find parts. Especially when you consider that they probably have less than a 5% share of what is estimated to be a $100 billion market.

In addition, it appears that people are driving more, slowly returning to pre-pandemic levels, and that cars are being used longer, as new and used car prices are still relatively high. Both things that should be positive for AutoZone.

Another growth driver will be the international stores, which now represent 12% of the store base with a total of 859 stores and which increased their same store sales by 23.9%. And the distribution center in Tepej, Mexico, which was nearing completion, I think will also have a positive impact on the business in Mexico.

When asked about Canada, the answer was that it was an interesting market, but that there was strong competition and that the company would focus on Mexico and Brazil for the time being.

And I think it will be interesting when the strong expansion starts in 2028 and several hundred stores are opened worldwide every year. This could have a very positive impact on growth rates.

And I think those growth opportunities will probably more than outweigh the risks associated with the energy transition and the partial transition to electric cars. But I also believe that even in a time when electric cars dominate, AutoZone will still find plenty of opportunities to sell auto parts. The supplier relationships will remain, and that is a huge competitive advantage.

Peer Comparison With ORLY And AZO

Since I believe that companies with high returns on capital and many growth opportunities will outperform the market over the long term, I pay particular attention to this aspect. And this is where AutoZone and O'Reilly Automotive, Inc. (ORLY) stand out, not only from direct competitors like Advance Auto Parts (AAP), but also from technology companies that are typically known for high ROIC.

The ROICs of ~80% for AutoZone and ~67% for O'Reilly are still well above average, even after adjusting for the WACCs of ~7.5% for AutoZone and ~8.0% for O'Reilly. This results in a ROIC-WACC spread of 72.5% for AutoZone and 59% for O'Reilly. Both are incredible numbers that should convince any shareholder that every dollar invested in growth is a good investment for these two companies.

In addition, both AutoZone's and O'Reilly's gross profit margins, as well as their conversion of gross profit margins to EBIT margins, are significantly higher than those of their competitor, Advance Auto Parts. So I think we can clearly say that these two companies are playing in their own league in this market.

This means that both margins and ROIC clearly demonstrate that AutoZone is an extremely high-quality business with a tremendous competitive advantage due to its excellent capital allocation and distribution network.

Earnings Preview And Outlook

At the next earnings, I will be looking to see if the store growth in Brazil and Mexico continues and how same store sales are performing. If things continue to go well there, I see good odds that the AutoZone success story will continue.

In addition, I will continue to monitor the debt and interest coverage situation. As interest rates have risen compared to previous years and the debt pile is not insignificant, this is something to keep an eye on.

In fact, I could see them accelerating the international openings a little bit in Q3 and Q4 and EPS CAGR continuing to be in the 15% to 20% range due to the high share repurchases. Free cash flow should also be higher than in the first half of the year, as the second half of the year is typically the strongest for cash flow.

Reverse DCF

With TTM diluted EPS of $142.66, we see that the market is currently pricing in 10% EPS growth per year for the next 10 years. So nothing has changed in this area since my last article, as the market priced in 10% then and now.

In addition, the historical EPS growth rates are significantly higher at 21.73% for 3 years, 21.63% for 5 years and 16.96% for 10 years. On a year-over-year basis, the diluted EPS growth rate of 18% in the second quarter was also well above the 10% growth rate priced in.

And given the growth opportunities and the share buybacks, I expect the growth rate going forward to be above 10% and closer to historical growth rates, which is why I think the stock is undervalued.

Capital Allocation

In addition to investing in growth opportunities, AutoZone has a clear focus on repurchasing shares. And the long-term trend in shares outstanding shows a clear direction, giving shareholders who have not sold their shares an increasing stake in the company.

And in 2023, AutoZone again ranked among the top 20 companies with the largest buybacks. In fact, shares were repurchased for $3.6 billion, which represents a change in share count of -6.3%. And I expect them to be on that list again in 2024.

And the combination of modest growth in the core business and aggressive share repurchases, I think, is a good formula for success in the stock market, one that is often used by companies that are in rather boring industries but still manage to generate phenomenal share price growth.

That is why I believe that every dollar invested in share repurchases and growth opportunities domestically and internationally is a good decision in terms of total shareholder return. Because I believe the great strength that keeps AutoZone ahead of the competition has been, and will continue to be, excellent capital allocation.

Conclusion

With a focus on international growth and share repurchases, I believe AutoZone has an excellent future. In addition, their distribution network, long-standing industry relationships, and management team give them a competitive advantage that will allow them to continue to generate superior returns on invested capital.

I also think the EPS growth rates that the market is pricing in are too low, and I think AutoZone should be able to beat them. Of course, there is a new CEO this year, and that usually means changes, but since he has been with the company for many years, I think he knows the success mechanisms from the past and will probably continue to apply them in the future.

Tangerine Tan Capital