AutoZone: Ripe for Investment at the Right Price

In today’s economic and financial market climate investors have to balance a stock market that is no longer cheap and an economy that has obvious structural damage. The consensus has concluded that below-average economic growth and employment could be with us for at least several more years. Given such circumstances we must be even more careful than usual in selecting companies to invest in.

In my mind, there are four things investors should look for when choosing new investments today. The first, valuation, is the obvious one for me as a value investor. No matter how much you like the story behind a stock, if you do not pay a fair price, the odds are stacked against you if you are trying to beat the market.

With so many economic headwinds, however, investors are likely to find their fair share of inexpensive stocks. Three other factors that I think are important, in no particular order, are:

1. A predictable and stable business outlook

There is no doubt that we are currently experiencing a fragile economic recovery. Any numbers of things could reverse the trend of the last several quarters and undo much of the progress that has been made. As a result, investors should focus on businesses where the outlook is predictable and relatively stable. This will make it fairly unimportant if GDP grows by a lot, a little, or not at all.

2. A strong market position that faces very few, if any, competitive threats in the near to intermediate term

A predictable and stable overall business outlook is great, but if a particular company is unable to successfully navigate and compete in that business, it could still falter. Not only must end demand be predictable, but the company’s own market position within that market is crucial as well.

3. Company management needs to put shareholders’ interests first

Unfortunately, this does not happen as often as it should (which is all of the time). Corporate executives routinely flush capital down the toilet at the expense of shareholders. They seem to all too often forget that they are working for the shareholders, not themselves or their cozy boards of directors. Management teams should have a clear focus on creating shareholder value and have a strong track record of putting shareholders first, ahead of themselves.

A company that I believe fits all of these criteria, and therefore would make an excellent investment in the current economic climate (at the right price, of course), is AutoZone (AZO), the large automobile parts retailer.

In this case, both the industry (automotive repair and maintenance), and the company (one of the largest and most profitable auto parts retailers in the country) epitomize stable and predictable businesses. The auto parts industry is largely non-cyclical, as cars need to be maintained no matter what the economy is doing.

Some may even argue that a weak economy bodes well for auto parts retailers because as new car sales decline, demand should rise for parts needed to keep older cars on the road longer. This is certainly a strong argument, and an incremental positive for the story, but even so AutoZone and their competitors have not seen any meaningful cyclical upswing in sales as the economy has struggled, and I would not expect one to occur going forward.

In addition, AutoZone has a very strong market position (more than 4,000 stores in the U.S. alone) and there is little in the way of new competition in the pipeline. One of the effects of the recession was a dramatic reduction in retail-related new construction and expansion, which had become a staple during the credit bubble.

The most enticing part of the AutoZone story for investors, however, is the shareholder-friendly nature of the company’s management team. Not only does management run a very tight and efficient operation (operating margins for the last fiscal year were 17% — very high for a retailer), but they allocate capital very intelligently.

Unlike some managers who crave growth, AutoZone has grown its store base meagerly in recent years, as it realizes that its industry is mature and population growth and some pricing power are the only real drivers of sales. The company is quite pleased growing sales in the low to mid single digits each year, rather than expanding too much, cannibalizing existing stores, and earning sub-par returns on its capital.

Where does this excess cash flow go? Mostly to share repurchases, which directly translates into value creation for shareholders. In fact, during the last decade AutoZone used free cash flow to buy back huge amounts of stock. Entering fiscal 2000, the company had 150 million shares outstanding. By the end of fiscal 2009 that number had been cut by two-thirds to an astonishing 51 million. Not surprisingly, AutoZone’s share price rose from $24 to $147 during that decade, for a gain of more than 500%.

Too many times managers and investors equate growth with stock price returns, but AutoZone is a perfect example of how you can create massive amounts of  shareholder value without rapid expansion. The company can generate strong double digit earnings growth, while only growing sales in the low to mid single digits, if it allocates capital in shareholder friendly ways. During fiscal 2009 AutoZone’s revenue grew by less than 7% but earnings per share rose by nearly 20%, largely due to an aggressive stock buyback program.

There is no doubt that the company is a strong investment candidate, especially in the current macroeconomic environment. As is always the case, however, investors need to make sure they pay the right price.

Full Disclosure: Peridot Capital was long AutoZone at the time of writing, but positions may change at any time