Time is a Friend
I really like the company AutoZone (AZO). I understand the business model: they sell car parts to people who want to fix up their own cars. I see AutoZone stores everywhere here in Southern California. AZO is currently a member of the S&P 500 index. The lens I use to view AZO is evaluating a business partner for managing an important business venture for me. And I have been impressed by the past 30 years of AZO’s performance. I don’t try to predict AZO’s stock price tomorrow. I don’t try to predict the financial results next quarter (or even next year). I’m not basing my view on any secret hidden information. Everything I like about AZO is based on information out in the open (you can verify everything below).
AZO is one of the most consistently improving companies currently in the S&P 500, based on the past 30 years of performance. Let’s start by looking at the diluted earnings-per-share.
This is my favorite kind of wonderful business: profitable, consistently growing over the long-term, performs well through recessions. Time is clearly a friend to this business.
Time is the friend of the wonderful business, the enemy of the mediocre.Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1989
One reasonable question is “why start by looking at diluted EPS?” Part of me is suspicious of companies that finance earnings growth by diluting the shares outstanding. That’s why I prefer to look at earnings-per-share (EPS), instead of earnings. And diluted EPS is slightly better than basic EPS because it factors in stock options that are in-the-money and can dilute the shares outstanding at some point in the future. In case you are wondering, the earnings history of AZO is beautiful.
Performance During Recessions
It is extremely important the understand how a company performs during recessions. In the two most recent recessions (2001 and 2008), AZO had a split record. AZO grew during the 2007-2009 time period, a once-in-a-lifetime global credit crisis. Only a handful of companies grew during those 3 years. During the 2001 recession, although earnings dropped 34% (from 267 to 175), the following year earnings jumped to 428 and have been growing ever since. I am wary of cyclical companies that look great when the overall economy is growing, but “give back” all of the profits in a recession (financials often follow this pattern). AZO is not a cyclical grower, it’s simply a consistent grower. I’m willing to forgive AZO’s performance in 2001 (it didn’t lose money, it simply earned less than before), given it’s subsequent performance from 2002-2018.
In business, I look for economic castles protected by unbreachable “moats.”Warren Buffett, Berkshire Hathaway Letter to Shareholders, 1995
Recessions are times when mediocre and weak companies are attacked on all sides: attacked by existing competitors, attacked by new entrants, attacked by poor balance sheets, attacked by unsatisfied customers, attacked by new technologies, attacked by new regulations. The strong performance of a company during recessions is an indicator that the company is protected by an economic moat. AZO is an economic castle that has withstood attacks, and is clearly protected by an unbreachable moat.
AZO has been an aggressive buyer of its own shares for many years. Since 2009, AZO has spent over $1B per year on share repurchases. AZO spent over $1.5B on share repurchases in 2018.
Since 1999-2018, AZO spent more on share repurchases than its annual earnings in 17 out of 20 years. The chart below measures annual share repurchases ($M) as a percentage of annual earnings ($M), where a ratio greater than 1 indicates share repurchases exceeded earnings. The ratio was greater than 1 from 1999-2018 with the exception of 3 years: 1999, 2005, 2017. A simple analogy would be if you owned a private business with several co-owners, and every year you took your entire share of the profits to buy some of the ownership stake from your co-owners … overtime you would own much more of the business, and your co-owners would own much less (or none at all). Consistent corporate buybacks every year would indicate the management team has enormous confidence in the future of the business (and an opinion of the valuation of the share price). Of course, I should point out with caution that repeated buybacks of over-priced shares (or mediocre companies) would be a drastic mistake.
After 1999, AZO shares outstanding (i.e. number of shares owned by the public) start to drop, from a high in 1998 of 153M shares to a low in 2018 of 27M shares. Over the 20 year period (1998-2018), that represents a shrinkage of 126M shares outstanding. Stated differently, AZO shrunk the shares outstanding by 82% over 20 years. From a compound annual growth rate, AZO shrunk the shares outstanding by over 9% per year, each year, over a 20 year period. AZO reminds me of Henry Singleton’s Teledyne during the period in 1970s when Teledyne shrunk the shares outstanding by 90%. Contrast this approach to some companies that dilute their shares outstanding every year. If you were a shareholder of AZO during this time, the below chart should make you want to stand up and clap.
Share buybacks create shareholder value if valuations are reasonable, because capital is being used to increase the earnings per share. If the valuation is too high, then share buybacks destroy value. Let’s examine both scenarios, and then discuss how to evaluate a company’s track record in share buybacks. (I should note that this discussion is most interesting when applied to consistently improving companies … in my opinion, share buybacks at mediocre or troubled companies are best ignored by the long-term-focused investor. The exception would be buybacks at the beginning of a turnaround situation.)
When a company repurchases its own shares at reasonable valuations, the repurchased shares are “retired”, thereby lowering the shares outstanding, and increasing the earnings per share. The share repurchases create a “price floor” for the stock price, which stabilizes the downside. The share repurchases counteract the effect of any stock dilution from employee stock options and/or stock-based company acquisitions. For the remaining shareholders, share buybacks result in having a larger and larger percentage claim on the earnings of the business. As an illustration, if a shareholder owns 5% of the shares outstanding initially, and then the company repurchases 50% of the shares outstanding, afterwards the same shareholder now owns 10% of the shares outstanding without having taken any action.
Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.Warren Buffett, Berkshire Hathaway Letter to Shareholders, 2016
In economics, price is a function of supply and demand. So if a company aggressively repurchases its own shares, it is simultaneously increasing demand of its shares while decreasing supply. Over time, as long the company is fundamentally sound and the buybacks are at a reasonable valuation, this action must boost the share price.
However if a company repurchases its own shares when valuations are too high, this creates other problems. Since the share price was too high, the company is not able to repurchase as many shares for a given amount of capital, therefore the number of shares outstanding doesn’t shrink as much. But more importantly, the capital used in share repurchases starves the rest of the company from investing capital in internal projects that create shareholder value. For example, instead of the company buying machinery for $10M that will lower expenses, the company spent $10M on stock that was too expensive. Another example, instead of spending $100M on advertising and marketing that will increase revenues, the company spent $100M on stock that was too expensive. In a final example, instead of spending $1B on research and development (or product development), the company spent $1B on stock that was too expensive.
How can an investor evaluate whether share repurchases create value or destroy value? There are two different approaches:
- Compare the “earnings yield” to benchmark interest rates
- Compare the “earnings yield” to internal returns on retained earnings
Most investors understand the concept of price-to-earnings (PE) ratio. This is a ratio where the numerator is the stock price, and the denominator is the earnings per share (EPS). The “earnings yield” is simply the reciprocal of the PE ratio, so that the numerator is the earnings per share (EPS), and the denominator is the stock price.
The below 2 charts show PE ratio and earnings yield, although use approximate figures to illustrate long-term trends. Since 2002, AZO had a PE ratio between 11-19, and an approximate earnings yield at least 5% (PE ratio below 20), during a period of historically low interest rates.
As a general rule: aggressive buybacks create shareholder value if a company meets 3 conditions: (a) the company has good fundamentals and not in deep trouble, (b) the stock price valuation is reasonable, and (c) the company has no other better alternative uses of the capital. In AZO’s case, the first two criteria are definitely met.
For the third criteria, this raises the question whether AZO’s capital might have had a better rate of return with internal projects (instead of share buybacks)? If so, this might suggest AZO should allocate more capital for internal projects in place of share buybacks. I will cover this topic in a future private weekly article.
Long-Term Debt, as a % of Earnings
There’s one more fundamental financial data point to review prior to finishing up with a look at the economic cycle and stock valuation: Long-Term Debt. Many companies finance growth by borrowing long-term debt, so it’s an important final step to verify the future financial stability and resilience of the company.
AZO’s long-term debt has been growing steadily since 1997 when the company had no long-term debt until 2018 when the company had over $5B in long-term debt. But as noted earlier, the annual earnings are also increasing, so the company has increasing resources to pay off the increasing debt. So another way to monitor debt is to compare the annual long-term debt as a multiple of earnings. Or stated another way, how many years of profits would be required to pay off the long-term debt? The chart below shoes that since 2002, the ratio is between 2.8 and 4.2 years of earnings to pay off long-term debt, which feels fairly manageable.
If AZO wanted to pay off the long-term debt in 2018, it could use 3.7 years of profit to do so.
Current Ratio (Short-Term Liquidity)
After checking long-term debt and liquidity, just a quick check to verify that the short-term liquidity seems manageable. For this, worth checking the current ratio that divides current assets (assets that can be sold within 1 year) with current liabilities (liabilities that come due within 1 year). This ratio is around 1.0, which means the company has a manageable short-term liquidity situation.
Interest Rates, Valuation, Yield Curve
When evaluating investments and considering valuations, one of the most important considerations is the benchmark interest rate. Below is a screenshot of the US Treasury Yields for various terms, as of March 22, 2019. The most commonly traded term is usually the 10-year US Treasury Bond, currently yielding 2.44%. The US Treasury Bond is considered a “risk-free” investment, because the US Government can raise funds through many sources such as taxation. Question: does the investment under consideration yield at least twice the 10-year US Treasury Bond?
According to Yahoo Finance (screenshot below), AZO’s PE Ratio (TTM) as of Mar 22, 2019 is 18.31, which taking the reciprocal, implies an earnings yield of 5.46%. AZO’s 5.46% earnings yield is more than twice the 10-year US Treasury yield of 2.44%.
Yield Curves are important because they reveal the current stage in the short-term economic cycle (aka short-term credit cycle). I will save a detailed discussion of yield curves for a future weekly article. But for now I’ll provide a few resources and a few key takeaways. Ray Dalio created an excellent 30-minute video that discusses short-term credit cycle, in the context of how the economy works. Deborah Weir wrote an excellent book called “Timing the Market” that goes into lots of nuanced explanation of yield curves. Also the Federal Reserve has published numerous papers that describe the yield curve as a recession predictor. But we are living through a very interesting time of right now of yield curve flattening, for 3 reasons: (a) the long-end of the yield curve is coming down while the 3 month is staying relatively fixed, (b) the short-end of the curve is already inverted (2s5s, 3mo2s), and (c) the 10s3mo recently inverted. It appears that the long-end is marching steadily towards the short end for inversions at other parts of the curve in the future.
Below is a chart with the same data as above but focusing on 5 US Treasury terms: 3 month, 2 year, 5 year, 10 year, 30 year (during March 2019). March 2019 started with a relatively “normal” (upward sloping) yield curve. The 30-year was above the 10-year; the 10-year was above the 5-year; the 5-year was above the 2-year (barely); the 2-year was above the 3-month. At this point, the key takeaway is that we are nearing the end of the short-term credit cycle, although the actual recession may yet be 1-2 years away from now. I’ll save the detailed analysis on this for a future weekly post.
Autozone (AZO) is one of my favorite companies in the S&P 500. AZO is the first company I have chosen for a monthly article on this new blog. AZO has shown consistent growth over the past 30 years, with a strong history of share buybacks, amidst reasonable valuations, conservative liquidity management, and modest use of debt. AZO’s current valuation is attractive relative to benchmark interest rates, and there is still 1-2 years remaining in the short-term economic cycle. For long-term-focused investors, AZO is worthy of further study.
Disclosure: I own shares in Autozone (AZO) as of publishing this article (March 2019). I have no intention of selling my position in the near future. This article is not a recommendation. Investors should make their own determination of whether or not to buy or sell this stock based upon their specific investment goals, and in consultation with their financial advisor.