Investment Thesis

AutoZone (NYSE:AZO), a leading auto parts and accessories retailer, recently unveiled its fiscal Q3 results. The company delivered strong earnings per share (EPS) growth despite missing analysts’ expectations on revenue.

Financially, AutoZone outperformed analysts estimate for EPS by $1.02, reaching $36.69 per share. Revenue grew 3.6% YoY to $4.24 billion, falling slightly short of expectations. However, profitability showed promise with expanding gross and operating margins reaching 53.5% and 21.3% respectively.

Growth remains a key focus for AutoZone. The company added 45 new stores in Q3, bringing its total network to 7,236 locations. International markers are a bright spot with same-store sales surging by 18.1%. Additionally, AutoZone repurchased a significant number of shares in Q3, totaling $734.7 million.

I believe challenges exist alongside opportunities. Domestic same-store sales remained flat due to the timing of tax refunds and cooler weather. But the rising average age of vehicles on the road supports a long-term increase in demand for replacement parts. AutoZone is well positioned to capitalize on this with its large scale and omnichannel capabilities, potentially gaining market share from smaller competitors.

In this article, I aim to find if AZO is a solid candidate for my value with potential portfolio. To accomplish this, I will explore various factors like Management effectiveness, corporate strategy, and valuation to determine if the recent stock price correction might be a good opportunity. AZO is a well-established company with a proven track record of profitability and growth. While facing some headwinds in the domestic market, its international expansion, strong margins, and commitment to shareholder value makes it an attractive candidate.

Management Evaluation

Philiipe Daniele, III has been with AutoZone for over 30 years and last years he made a transition to the President and CEO role. While his tenure is lengthy, his Glassdoor approval rating is just average, similar to the company’s overall rating. However, his compensation structure with a high percentage in stock of around 85% according to the latest 8K form filed with SEC, suggests a strong alignment with the company long term success.

During the last earnings call, Daniele highlighted the following:

Challenges:

• Weather: unusually cool and wet spring led to lower sales of seasonal categories like AC parts and batteries.
• Inflation: inflation has peaked but still puts pressure on consumers, especially for big ticket items like tires.
• Commercial weakness: segment like buy-here-pay-here and used car centers have seen a slowdown.

Growth Plans:

• Continued store expansion: new stores take time to open but will eventually contribute to sales growth
• Focus on commercial business: investments are underway to improve parts availability, service, and delivery for commercial customers. This is a significant opportunity as AutoZone has low market share in this segment.
• Improved customer service: initiatives like leveraging technology for faster parts delivery are expected to enhance customer experience and drive sales.
• Product mix: as summer approaches, the company expects a better mix of product categories leading to higher average transaction value.

Jamere Jackson, AutoZone CFO since late 2023 brings prior experience from the car industry as he served as Hertz CFO in 2018. I believe he faces the challenging act of balancing aggressive shareholder returns through buybacks, a hallmark of AutoZone’s corporate strategy, with continued company growth at a time of decelerating revenues.

I find that AZO Debt to Free Cash Flow at 17x is at the high end of what I like to see in a retail company, especially for a company that’s aggressively buying back shares through debt issuance. I recently wrote an article on Booking.com (BKNG) which you can read here, where I talk about this. I don’t see it as negative move if you have confidence in the management and the company has strong cash flows. However, as it the case as other companies in the industry, AZO has had declining FCF over the past 3 years at rate of 21%, raising concerns about continuing their aggressive buyback program.

As for profitability, I find AutoZone in line with other companies highlighted above with an ROA sitting at 15% and Return on Total Capital at 34%. However, when compared to its chief competitor O’Reilly, AutoZone looks more levered with a Debt to Free Cash Flow at 17.44x vs 10.88x.

During the earnings call Jackson offered some perspective of the current situation. Here’s a breakdown:

• Gross Margin improvement: negotiating with vendors to offset inflation
• Mega Hub expansion: expanding network of mega hubs to increase parts availability and delivery speed.
• Store growth: accelerating store opening in the US and internationally with a focus on the underpenetrated market.
• Service delivery: improving service speed to win on parts availability

Overall, I find that AutoZone leadership delivered a positive message on their growth plans, but they still have higher leverage than their competitors which is already started to hurt net income and lagging behind in revenue growth versus it’s chief competitor. I have confidence in the new management due to the combination of tenure with the company and experience in the industry but for now as they just started their positions I can’t give them a performance rating yet.

Corporate Strategy

AutoZone and its traditional competitors O’Reilly, AAP, prioritize a brick-and-mortar strategy with extensive store networks for customer convenience. They cater to both DIY mechanics and professional DIFM repair shops. For AutoZone and its competitors their growth plans are centered in expanding their physical footprint, for AutoZone in particular they are attempting to grow their underpenetrated commercial market.

Additionally, AutoZone is also investing in initiatives like mega hubs to improve parts availability, delivery speed, and overall customer service. However, their strategy faces challenges like a sector demand slowdown due to macroeconomic factor impacting consumer spending and a high debt leverage, impacting profitability compared to its competitors. Another key point is their limited focus to online sales, which a niche market and a growing trend.

Here is a table I created with key differentiators between AZO and some companies in the industry offering similar services:

	AutoZone	O’Reilly (ORLY)	Advanced Auto Parts (AAP)	NAPA Auto Parts (GPC)
Automotive Aftermarket industry Market Share	15-20%	15-20%	10-15%	10-15%
Corporate Growth Strategy	Store network expansion (US & International). Focus on underpenetrated commercial market. Improve parts availability & delivery speed. Enhance customer service.	Expand store footprint. Enhance product assortment & availability. Improve supply chain efficiency. Leverage technology for faster service.	Focus on omnichannel retailing. Strengthen private label brand. Enhance in-store experience. Expand commercial parts & service offerings.	Focus on professional mechanics. Expand products offerings in niche categories. Strengthen parts distribution network. Enhance technical support for repair shops.
Advantages	Strong brand recognition. Large & geographically dispersed store network. Focuses on DIY and growing its commercial DIFM segment. Strong vendor relationships. Offer free services to strengthen DIY relationships.	Strong brand recognition. Large & geographically dispersed store network. Competitive pricing strategy. Focus on a balance approach of DIY & commercial DIFM market	Strong private label portfolio. Growing online presence. Focus on in-store training & experience.	Strong reputation for quality parts & expertise. Extensive product knowledge among staff. Established relationships with professional repair shops.
Disadvantages	Limited focus on online retail. Slower growth on commercial market.	Smaller presence outside the US. Lower brand recognition than AutoZone in the DIY segment. More financial resources spent to strengthen two segments DIY and DIFM instead of one.	Smaller store network compared to ORLY and AutoZone.	Limited presence in DIY market. Smaller store footprint compared to public competitors.

Source: From companies’ website, presentations, SeekingAlpha

Online auto parts providers like Amazon (AMZN), eBay (EBAY), RockAuto (Private), and CarParts.com (PRTS) operate solely online, offering a wider selection of products and potentially lower prices due to lower overhead costs. These platforms are convenient for price comparison and home delivery. However, they lack the customer support, confidence and hands-on experience by physical stores. This can be a disadvantage for DIY customers who might struggle to assess parts quality and gain confidence online.

Additionally, AutoZone has also been compared to LKQ (LKQ); however, this company doesn’t directly compete for DIY customers. They are the largest distributor in North America with a growing presence in collision repair parts and extensive salvage yard network in the B2B market. Further, I see LKQ more of a company with specialization in alternative parts offering recycled and refurbished parts for body shops and collision centers while AutoZone is focused on providing a wide range of parts for DIY, repair shops and professional installers.

Valuation

AZO currently trades at around $2,808.33. The stock is flat since its last reported earnings in mid-May, having hit at an all-time high in mid-March of $3,256. The stock is also up around 8% TR YTD.

Now, to assess its value, I employed a 11% discount rate, this rate reflects the minimum return an investor expects to receive for their investments. Here, I am using a 5% risk free rate, combined with the additional market risk premium for holding stocks versus risk free investments, I’m using 6% for this risk premium. While this could be further refined, lower or higher, I’m using it as a starting point only to get a gauge using unbiased market expectations.

Then, using a simple 10 year two staged DCF model, I reversed the formula to solve for the high-growth rate, that is the growth in the first stage.

To achieve this, I assumed a terminal growth rate of 4% in the second stage. Predicting growth beyond a 10-year horizon is challenging, but in my experience, a 4% rate reflects a more sustainable long-term trajectory for mature companies that should be close to historical GDP growth. Again, these assumptions can be higher or lower, but from my experience I will use a 4% rate as a base case scenario due to the nature of their business. The formula used is:

$2,808 = (sum^10 EPS (1 + "X") / 1+r)) + TV (sum^10 EPS (1+g) / (1+r))

Solving for x = 14.75%

This suggest that the market currently prices AZO EPS to grow at 14.75%. According to Seeking Alpha analyst consensus EPS over the next 3-5 years CAGR at 14.83%. Therefore, it seems that AZO is fair valued on a fundamental basis.

Further, I’ll also look at their forward price earnings to growth (PEG) ratio which sits at 1.26x -versus a sector median of 1.48x- implying the stock price is below the industry. However, their forward price to sales (P/S) ratio seems overvalued at 2.63x -vs 0.89x.

However, when compared to a select group of companies, highlighted below, that are considered leaders in the industry, these mixed signals make more sense, and the company just looks undervalued:

However, I believe this undervaluation is justified as AZO is considered riskier than its chief competitor ORLY due to its higher leverage. However, I do believe AZO has a very solid position in the industry and shareholder friendly with aggressive buybacks. Despite the shares looking fair valued and existing macroeconomic challenges, I still see a lot of growth potential in the long term due to international expansion plans and focus on growing their commercial segment.

Technical Analysis

AZO has been on a positive momentum since they last reported earnings in mid-May. The stock is off around 14% since it hit all-time highs. However, the stock looks appropriately valued, on a technical basis, with its 1-year average RSI in neutral territory at 41 and below its 14-day moving average of 56 indicating the stock price might be changing trends.

AZO has formed a strong support level at around $2,745 and a resistance level at just under $3.015, the stock should move around this band awaiting more news. Next earnings report is estimated to be on August 27.

Takeaway

Despite fair valuation, I find AutoZone an attractive candidate for my value with potential portfolio. Strong leadership, international markets expansion, and a focus on shareholder value through buybacks make AZO a compelling long-term play. While challenges like limited online presence and high leverage exist, the company’s established brand and focus on the underpenetrated commercial segment position it well for future growth. The current correction, which I believe is due to macroeconomic factors like interest rates and inflation, might offer a long-term opportunity. Therefore, considering all factors, I am initiating coverage with a buy.