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I’ve been tardy in my Competitive Strategy posts – living in a global pandemic really disrupts a routine. The focus of this article is on AutoZone stock which would have been a tremendous winner to buy and hold over time.

AutoZone fits the exact mold for my Competitive Strategy Series: auto parts retailing isn’t a sexy business and it’s competitive, but I wanted to dive into any strategic choices the company has made and why that translated into such strong equity returns.

If I could sum up AutoZone stock in one phrase I would say it is: “perennially underestimated.”

Quick Background

AutoZone started as “Auto Shack” in 1979 and quickly expanded from 1 store in Arkansas, to 23 stores by 1980, to greater than 250 by 1985. The company also sold a majority stake to KKR around this time (which may be part of the firm’s culture of understanding of capital allocation priorities and its capital structure). By 1989 they exceeded $500 million in sales and opened the 500^th store. The company went public in 1991.

Focus on the Customer

AutoZone’s core strategy was to offer low price automotive parts with high quality customer service. Similar to Amazon, it seems as though AutoZone figured out early on if the customer is happy, they’ll keep buying from you, and that will translate into good outcomes for shareholders. In other words, customer interests and shareholder interests are aligned.

AutoZone likely also took cues from Wal-Mart, which focuses on low everyday prices, given the company’s founder sat on the Wal-Mart board several years before starting “Auto Shack”. The Chairman & CEO of AutoZone, William Rhodes III is also a board member at Dollar General. Both tremendous retail equity stories… is it any wonder that AutoZone stock was destined for greatness?

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As a quick aside, seeing these company associations made me think about my own experience of seeing AutoZones. When I drive through a small town I don’t know, there are two stores I typically see front and center… a Dollar General store (or something similar) and an AutoZone. Dollar General specifically targets these towns because a “dollar” store becomes the one-stop shop for many of its consumers. I went back to AutoZone’s original prospectus to see what they said about store strategy. It seems to me that they must also target areas where (i) there are plenty of older vehicles on the road that need maintenance and (ii) a high population of DIY-ers.

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Back in the 1980s, the company began using an electronic catalog to help employees determine which parts were needed for specific vehicles quickly. This system helped pave the way for AutoZone to launch an e-retailing site relatively early on – in 1996.

Second, it trained employees to have general knowledge of cars so that they could answer customers’ questions in an educated way. Then, it would even install some parts for the customer. Think of windshield wipers, or running a diagnostic on the car for free to see what’s wrong without visiting a dealer, or replacing a battery for the customer.

Resilient business driven by aging vehicles on the road

AutoZone is a surprisingly resilient business. If you think about it, this makes sense. There will always be a base group of customers that repair their own cars (either to save money or because of interest in cars).

In a recession, AutoZone probably gains a few more customers that would’ve taken it to a repair shop. People may not buy that new car either in a recession and instead opt for fixing the old one they own. This plays exactly to AutoZone’s benefit:

Here is a graph of the vehicle age over time:

I don’t know of many companies that kept same-store sales growth up during the financial crisis, but you can clearly see they started to quickly grow low-to-mid single digits after that as well (likely because it was a long, slog of a recovery).

Recall, 2009-2011 was a period of high unemployment. People weren’t buying new cars and were repairing existing ones. That could play out again.

Thinking about post-COVID for AutoZone: One thing I am thinking about is that new car sales, pre-COVID, were at record levels for the past few years. AutoZone will likely see a recession benefit post-COVID as well, but then those new cars sold the past few years will start needed repairs. In other words, cars sold in 2015 will start to be 7 years old in 2022, which could buoy results for some period of time.

How has AutoZone warded off competition – isn’t it ripe for Amazon to steal share?

Yes and no. First, AutoZone has been in the online retail business for a while now. As of writing, it doesn’t offer two day, free shipping like Amazon does, but that may not matter right now.

Why? Because when something isn’t functioning on your car (and you are part of AutoZone’s core customer base as a DIY-er) then you probably are going to go fix it soon.

Imagine driving in the rain and one windshield wiper stops working. You pass an AutoZone store and understand from their commercials that they’ll even put on the new one for you. Why wait 2 days and risk getting caught in the rain again, being unable to safely drive? Sure, Amazon is moving closer and closer to same day delivery, but so far that has been AutoZone’s capture. AutoZone has nearly 6,500 stores, so it’s hard to miss one!

Like I said though, AutoZone clearly tries to focus on the customer and this is called out almost upfront in its 10-k.

Another reason: comfort knowing the part will actually work with your car. I’m somewhat of a DIY-er myself and, while AutoZone isn’t perfect either, sometimes you buy a part for a car that ends up not working on your specific model. That’s frustrating. Imagine a similar example to the above but now you need to return the item and buy a new one.

Supply Chain is the key

You can already start to piece together that the thing that drives Autozone’s business, the reason why people shop there and the reason why they win your sale, actually comes down to having the part and having it for a fair price.

AutoZone has a very efficient supply chain and this is really what keeps other competitors out of the business. In reality, I would venture to say that the do-it-yourself (DIY) market has developed into an oligopoly now – AutoZone, O’Reilly, Advance Auto, NAPA dominating the market, with Amazon also in the works.

AutoZone has an interesting store concept that reminds me of what Fastenal did, which I described in a prior post. They have satellite stores, which carry around ~24k SKUs, as well as “hub stores” which carry 40-60k SKUs and deliver to the satellite stores 3x a day. This ensures if someone orders a “tail-end” SKU, AutoZone can have it available either that day or the next. Lastly, they’ve deloveped “MegaHub” stores, which have ~100k SKUs. These stores deliver to both satellite stores and hub stores.

At this point, AutoZone notes that all of its hubs and satellite stores get touched at least 1x a day so adding more hubs or MegaHubs doesn’t increase coverage…. However, adding more of these stores reduces the amount of time it takes for deliveries to make it to the end customer.

New Growth Focus – Commercial

AutoZone has historically sold mainly to folks like you and me, not garages and professional networks. Now, its new growth strategy is focused on supply garages and local shops with parts using its sophisticated supply chain. The shift is Do it Yourself to Do it for Me.

Think about this from a garage’s perspective: AutoZone will now house the inventory I need to get more jobs done quickly. This solves 2 issues for me: 1) lowers my need to hold inventory and 2) helps me turn customers which should increase my sales.

So far, the company has seen some success. In its earnings call in early March (pre-COVID impacts), it noted:

We also grew our commercial sales per store at mid-single-digit rate versus last year’s second quarter [which was up 12.9% so a tough comp]… We averaged $9,400 in weekly commercial sales per program this past quarter, up 5% over last year. We have grown our sales with mature customers and mature programs at substantially improved growth rate the last 2 years versus previous years, indicating our offerings. Products, coverage, customer service and ability to enhance the customers’ overall shopping experience are improved and have been recognized and rewarded by our customers.

I can’t prove this trend, per se, but it seems to me that the older generations felt more comfortable working on their cars whereas the younger generation would like to “outsource” that work. “Do It For Me” must be what AutoZone is seeing too and I think that is why they are targeting this market.

AutoZone generates a surprisingly high ROIC

We’ve talked through some of the pieces of the business so far, but it is astonishing to me how high of a ROIC AutoZone generates.

Yet despite this high ROIC, resilient business model, I think one reason the stock has performed so well is that it is perennially undervalued and underappreciated.

This will be hard to read (maybe click to expand), but it’s a trailing FCF yield over a long period of time. Consistently in the high single digit range as a % of market cap. The interesting thing is they plowed in excess of 100% of that FCF back into repurchasing stock.

So clearly, that increased debt of the company slightly over time if they’re spending more than 100% of FCF.

But the way I think about it is: high-single return from FCF yield (which was all plowed back into AutoZone stock) + using capex for high-return projects (new stores). That’s the formula for solid returns. Here is a chart of share count over time – they were early in the share buyback game, in my view, buying massive amounts in the 2000s.

What about the competitors in the space? What have their returns been like?

So Pep Boys is no longer public (no owned by Icahn Enterprises), NAPA is owned by Genuine Parts, so we can really only compare O’Reilly, Advance Auto and AutoZone stock now.

What’s interesting is O’Reilly underperformed AutoZone stock up until about the early 2010s (depending on your starting point). Why did they start closing the gap? They started doing massive share-buybacks. Unlike IBM, where buybacks failed, the automotive parts retailing industry clearly has benefitted from doing this.

Advance Auto actually paused share buybacks and you can see the divergence in equity performance there as well.

Now the real question: who has the best jingle? AutoZone or O’Reilly?

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But seriously, I like AutoZone’s business model. It’s a segment of retail that I think will continue to perform well over the next 5 years. I also like AutoZone stock because, compared to peers, management’s decisions have been very consistent over long periods of time. As of writing, its actually a lower multiple as well.

The question from there is obviously electric vehicles. What happens when these auto retailers lose sales related to the internal combustion engine? It’s a million dollar question. I will say, however, that penetration could be overestimated.

Overall, there are 263.6 million registered vehicles in the US. The number of battery electric vehicles sold in the US was 245,000 in 2019 and the total number of cars sold was 16.9 million, which was around cyclical peak.

Let’s say tomorrow, every new car is electric vehicle and each new car replaces an existing vehicle. So 16.9 million is 6.4% of the existing base… that would take ~15.5 years to replace the entire existing fleet.

Sure, we’d have to factor in autonomous cars next, which would drive down car ownership, but I also think that is far off.

If that gets overly priced in to AutoZone stock, I would view it as a buying opportunity.