CHAPTER 10
AutoZone: The Power of Intelligent Share Repurchase
AutoZone serves as a prime example of how a sound strategy and an intelligent stock repurchase plan created enormous value for long-term shareholders.
If one examines AutoZone’s sales from 1999–2018 (Figure 10.1), it would be fair to say that they looked fine but not spectacular at a 5.4% compound annual growth rate (CAGR). Similarly, the company grew its store base by a modest 4.3% CAGR over this time period.
FIGURE 10.1
AutoZone: Modest Sales Growth over Much of the Last Two Decades1
Then how in the world did AutoZone (AZO) produce a 2,445% return relative to 198% for the S&P 500 over this time period? How did AZO earnings per share (EPS) increase from $1.63 in 1999 to $50.34 in 2018?
The AutoZone plan was essentially to grow revenues, open new stores, improve margins, optimize the balance sheet, buy back stock with all available cash, and improve ROIC. The management team and board never wavered from that plan, and as a result they created significant long-term shareholder value for their investors.
WALKING THROUGH THE AZO VALUE-CREATION MATH
AZO grew sales at a 5.4% CAGR from 1999 to 2018 (sales grew from $4 billion to $11 billion). Management improved margins from 10.5% in 1999 to 19% in 2018 (ex-charges), or about 45 bps per year.
Net income and operating cash flow grew at 10.4% and 10.5% respectively. AZO maintained an optimal balance sheet leverage in the low-to-mid-2s (debt to EBITDAR—“r” indicates rent) for most of this period. As EBITDAR grew, AZO was able to carry more debt. Debt increased from $888 million to slightly more than $5 billion in 2018. While debt increased, debt to EBITDAR did not change much over this period, and AutoZone remained an investment-grade company throughout this time.
In addition, AZO leveraged its buying power to achieve improved working capital terms. For most companies, net working capital (inventory + receivables – payables) is a positive number. For a company with positive net working capital, the more the company grows sales, the more net working capital the firm needs to support the growth. For a company with $100 million in sales and 20% net working capital/sales, for every $5 million in sales growth, the firm will need to invest $1 million in working capital. This investment drag negatively impacts ROIC and results in less excess capital to be deployed to create shareholder value.
In 1998, AutoZone’s net working capital was a positive $224.5 million. By the end of 2018, it was a negative $393 million. Over 20 years (see Table 10.2), AZO had grown sales by $7 billion and generated over $600 million in positive FCF from net working capital reductions.
This positive contribution from net working capital is one of the reasons AutoZone was able to generate an attractive 95% FCF conversion rate (FCF/net income) over this stretch, despite heavy capital spending to grow its store base.
Over this period of time, AZO spent $19.4 billion buying back its own shares, as shown in Table 10.1.
TABLE 10.1
AutoZone Buyback Machine2
TABLE 10.2
AutoZone 1999–2018 Capital Deployment3
The magic of the AZO model was modest growth, steadily improving margins, optimization of the balance sheet from a leverage and net working capital investment perspective, and aggressive share repurchase to create significant value for shareholders over the long term.
Now let’s look at AZO through our share repurchase lens:
1. Is the Business Cyclical?
AZO is not cyclical; in fact, it is potentially modestly countercyclical. Sales grew every year, and same-store sales were positive every year with the exception of only two years.
2. Acquisitions Are Not a Viable Alternative
By 1999, AZO was already the largest US retail auto parts company and operated in 39 states. While it is possible AZO could have made small acquisitions that would not have invoked antitrust concerns, it is highly unlikely that the returns from those deals would have been nearly as strong as the returns from buying back stock and opening new stores. AZO’s ROIC expanded dramatically from 12% in 1999 to 32% in 2018. Most acquisitions fail to generate double-digit returns, let alone 30%-plus returns.
3. Mature Business Without Secular Challenges
The auto parts business is a very mature business. While AutoZone and some of its competitors grew faster than the market through share gains, the underlying market was very mature. Until very recently, the business was not viewed as having secular challenges. However, the growth of Amazon and advent of electric cars could put pressure on the business over the long term. While AutoZone’s capital allocation strategy has worked out very well for its long-term shareholders, it might make sense for the company to consider a dividend and/or special dividend going forward.
4. Company in Which the Underlying Stock Price Is Undervalued
The power of the AZO algorithm was aided by the rather consistent low valuation the market awarded AZO over this time period. AutoZone’s average forward multiple during this period was only 13.5x. Despite growing EPS materially faster than the market with earnings and sales that were materially less volatile than the market (and less volatile than most highly valued consumer staples firms), AZO traded at a 10% discount to the S&P 500 average multiple over this time. This oversight by the market allowed AutoZone to buy back more stock at lower prices and generate a higher return on its share repurchases. First year cash-on-cash returns from buying back stock were over 7% on average (13.5x P/E times 95% FCF), and with cash flows growing by double digits annually, AZO’s cash-on-cash returns were in the double digits by year four.
5. Limited Pressure to Pay Out a Dividend
In the late 1990s and the early part of the 2000s, much of retail was still viewed as a growth business. Few, if any retailers issued large dividend payouts. In addition, the return spread from buying back stock and the return its shareholders could receive reinvesting dividends in the market was so wide that it made a tremendous amount of sense for AutoZone management and board to buy back stock, as opposed to paying a dividend.
SHOULD AUTOZONE HAVE INVESTED MORE IN THE BUSINESS?
One question a skeptic of share repurchases might ask is: did AutoZone milk the business?
It is very hard to argue that AutoZone milked the business. Capital expenditures were 1.74x deprecation over this period. This is a very healthy reinvestment rate. The company increased the store base from 2,763 to over 6,000. It expanded in Mexico from 6 stores to over 600 and entered the Brazilian market as well. While AZO was mostly retail-focused, it aggressively expanded into the commercial sector.
In 2008, AZO had 2,200 stores with a commercial program (in which salespeople pursued commercial customers as opposed to purely retail customers), and by 2018, it had 4,700 stores operating a commercial program. The company even made an internet acquisition (Auto Anything) to try to learn more about this distribution channel.
AutoZone is certainly not alone in creating value through share repurchase, but probably no one has done it better over an extended period of time. In addition, there are few companies that more perfectly match the optimal criteria for aggressively buying back stock. Other companies such as Texas Instruments and Fiserv (see Table 10.3) have utilized share repurchase to create significant value for shareholders, despite being more cyclical (in the case of Texas Instruments) or trading for a higher valuation and having more acquisition opportunities (in the case of Fiserv).
TABLE 10.3
Texas Instruments and Fiserv Have Created Substantial Value for Their Shareholders Through Share Repurchase
To embark on a successful share repurchase program, a company does not need to meet all of the aforementioned criteria. In the end, what really matters is that the share repurchase program generates the best risk-adjusted returns relative to other capital allocation alternatives.