Robust competitive advantage, but mediocre upside potential

Incorporated in 1979, Tennessee-based AutoZone (AZO) retails and distributes automotive replacement parts and accessories.

Although AZO is an excellent, very profitable and shareholder-friendly company, we are neutral on the stock at its current price.

AutoZone’s Competitive Advantage

There are several ways to quantify a company’s competitive advantage using only its income statement. The first method is to calculate the Earning Power Value (EPV).

The earning power value is measured as after-tax adjusted EBIT divided by the company’s weighted average cost of capital, and the breeding value can be measured using the total asset value. If the earning power value is greater than the reproductive value, then a firm is considered to have a competitive advantage.

The calculation is as follows:

EPV = Adjusted Earnings EPV / WACC

$38.7 billion = $3.022 billion / 0.07

Given that AutoZone has a total asset value of around $14 billion, we can say that it has quite a significant competitive edge. In other words, assuming no growth for AutoZone, it would take $14 billion in assets to generate $38.7 billion in value over time.

The second way to determine a competitive advantage is to look at a company’s gross margins, as they represent the premium consumers are willing to pay over the cost of a product or service.

An expanding gross margin indicates that a sustainable competitive advantage is present. If an existing business does not have an advantage, new entrants will gradually take market share, leading to lower gross margins as price wars ensue to stay competitive.

For AutoZone, gross margins have remained stable over the past 10 years, hovering in a very narrow range of 51.5% to 53.7% (currently 52.5%). Therefore, its gross margins indicate that a competitive advantage is also present in this regard.

Efficiency

The company’s competitive advantage has allowed it to operate very efficiently over the past decade.

To measure effectiveness, we will look at cash return on invested capital (calculated as free cash flow divided by invested capital).

Essentially, this measures the free cash flow the company generates for every dollar of capital invested. Over the past 12 months, AZO had a CROIC of 44.4%, which is well above the industry average of 7.3%.

This matches its five-year average of 39.5%. Put simply, for every dollar invested by AZO last year, it earned $0.44 in free cash flow; it’s a pretty amazing comeback.

This free cash flow can be used to return capital to shareholders through large buyouts, as AZO does.

Just recently, AZO announced an additional $2 billion buyback program, which would help boost future earnings per share as the number of shares declines.

The risks of AutoZone

To measure the risk of AutoZone, we first check whether financial leverage is an issue. To do this, we compare its total debt to free cash flow.

Currently, that number is 2.72. Additionally, looking at historical trends, AZO’s debt to free cash flow ratio tends to decline, with the ratio being 5.05 in August 2017 and 3.74 in August 2020.

Overall, we believe debt is not currently a material risk to the business as its interest coverage ratio is 15.8 (calculated as EBIT divided by interest expense).

However, there are other risks associated with the business. According to Tipranks’ risk analysis, AutoZone disclosed 20 risks in its latest earnings report. The highest level of risk came from the Ability to Sell category.

The Taking of Wall Street

As far as Wall Street is concerned, AutoZone has a moderate buy consensus rating, based on seven buys, four holds and no sells assigned over the past three months. The AutoZone average price target of $2,166.36 implies an upside potential of 8.2%.

Final Thoughts

AutoZone is a solid company that has generously rewarded its shareholders in the past. This is no surprise since it has a measurable competitive advantage that allows it to operate much more efficiently than its industry peers. AZO stocks should continue to provide investors with decent long-term returns.

Nevertheless, we remain neutral because the average price target only implies an upside potential of 8.2%, which does not provide us with a sufficient margin of safety.

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