Tuesday, January 1, 2013

AutoZone, O'Reilly and Advance Auto Parts

I’ve contributed a few articles recently discussing the nature of investing and what investors should look for with stocks. In summary I think our success as investors depends upon the ability to identify the salient factors that move a company’s stock price. AutoZone (NYSE: AZO) is a great example to look at in this respect and I will do so with reference to its latest results. What moves its share price? What are the factors that will govern it in the future?

Autozone’s Strategic End Markets

Strategic simply refers to the governing macro conditions and industry trends. This is usually the most important factor and the starting point. Auto parts retailing has typically been seen as a counter cyclical sector in the last few years and stocks within it have been massive out-performers.

AZO data by YCharts

AutoZone, Advance Auto Parts (NYSE: AAP) and O’Reilly Automotive (NASDAQ: ORLY) are seen as beneficiaries of an ageing US car fleet. As cars get older they are more susceptible to wear and tear and need proportionally more parts and servicing. Indeed, AutoZone monitors the ratio of cars over seven years as a key metric and there is no doubt that the recent recession has helped accelerate the trend towards an ageing fleet.

Moreover even though new car sales haven’t been great in 2008-10 (suggesting that there will be fewer ageing cars in the future) I think the key metric is actually going to be miles driven overall and the age of the cars doing them.  As such AutoZone argued that on a comparable basis the year to September saw miles driven up .6%. This is okay because the fleet continues to age. Indeed it allows AutoZone to pursue its model of low single digit expansion in square footage with mid single digit EBITDA growth. Since it typically converts more than its income into free cash flow it is able to then engage in buybacks which leads to mid-teens EPS growth.

This is fine but what happens if/when the economy recovers, new car sales expand and drivers stop maintaining or driving their older cars? Given the strong US car sales numbers this year I would argue that we are nearing that point.

Here is a graphical representation of the trend in comparable same store sales.

Spot the slowdown?

The Bear case here is that strong new car sales and drivers not maintaining their cars in anticipation of buying a new one, have caused an industry wide slowdown. The Bullish retort is that it is largely weather related as in a mild winter did not stress cars as much as it might have done.

Delving Deeper into AutoZone’s Numbers

I confess I lean towards the Bearish camp here. AutoZone breaks out its product categories into failure, maintenance and discretionary sales. On the conference call management outlined that maintenance sales (usually about 40% of the total) are growing weaker than the other two categories. This could be a consequence of drivers anticipating buying a new automobile in the future. If it was general macro weakness then surely discretionary sales would be trending on a similar track?

Moreover there appears to be regional issues with the Northeast, Midwest and Plains cited as being the primary areas of weakness. Given that AutoZone has invested in new stores in these regions then this bit of ‘color’ is somewhat concerning.

Cash or Credit?

Another trend favoring accelerating new car sales is the increasing willingness of lenders to extend credit. Whenever I look at these things I monitor the Federal Deposit Insurance Corporation (FDIC) updates on conditions and they suggest things are getting better. I also like to look at Equifax (NYSE: EFX) because as a credit bureau it will give a first-hand read on trends in lending. I’ve discussed the company in an article linked here . Similarly as argued here Discover Financial Services (NYSE: DFS) saw credit card loans increasing 4.2% from last year and 3.2% sequentially even while charge off rates fell to new lows.

While Equifax and Discover tend to be conservative with guidance, it is hard not to conclude that conditions are getting better for lending in the US and this will inevitably feed through into new car financing.

Where Next For the Sector?

Turning back to the questions I posed at the start, I think the key factor will be the overall economy, the willingness and ability of vehicle financing. You could make a case that an improving economy will lead to more miles driven. Moreover if gasoline prices continue to fall, the sector will be in a win-win situation. Miles driven will go up and drivers will have more discretionary income to spend.

However, I would suggest caution here. The weakness in maintenance spending and the strength of new car sales in the US are, I believe, the key metrics to follow. I think the sector is worth avoiding until it can at least pick up same store sales growth again.