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  Business cycle means rough road ahead for AutoZone

BENJ GALLANDER and BEN STADELMANN

Friday, October 12, 2007

A recent column highlighted the career of hedge fund manager Eddie Lampert and suggested that the strategy that has served him well over the past decade may be having some problems. One of us went a step further and shorted the company that comprises the third-largest holding of Lampert's ESL Investments fund.

AutoZone has been a sizzling success story in the car parts business over the past two decades. Starting out with one store in Arkansas in 1979, the enterprise geared up in 1987, when it changed its name from Auto Shack to AutoZone.

While the name change might seem like a no-brainer, it was actually made due to a lawsuit filed by RadioShack. In any event, the new moniker sounded less like a junkyard, while emphasizing the availability of all the toys the do-it-yourself car enthusiast could ever want.

After going public in 1991 at $5.75 U.S. (split-adjusted), AutoZone rapidly expanded its presence throughout the U.S. and into Mexico. Like Wal-Mart, it seized opportunities in underserved rural and small-city markets. In 1997, Lampert started buying shares at around $20, became a director in 1999, and by 2001 was the corporation's largest shareholder.

At that point, AutoZone sharply shifted its strategy. During the go-go hyper-growth days, prices were kept low to build market share and cash flow was ploughed back into the company to open new stores. But at Lampert's urging, gross margins were widened, expenses cut and cash flow diverted to buy back shares.

From 2002 to 2007, revenue growth slowed to about 3 percent per year, yet operating income powered ahead from $771 million to $1.06 billion. Due to the reduced share count, earnings per share zoomed from $4 to $8.53.

Bulls and bears have been debating AutoZone's fundamentals and the sustainability of its business model for years. Critics point out that the metrics that retailers hold dear — same-store sales, sales per square foot, inventory turnover — all indicate that the company is running out of gas. Proponents point out that cash is king, return on equity is consistently stellar, and in a mature business, it's profits and a beefy stock price that count.

The view from here is that with a reputable brand in a good space with strong economic conditions, many business models are feasible. Take Canadian Tire, for instance. It chose more of a middle road, using strong cash flow to steadily increase dividends, open new and bigger stores, grow revenues and reduce dependence on products associated with the automobile. It also managed to increase EPS from $2.56 in 2002 to $4.35 last year, while the stock price trebled over that period.

But what about when the economy slows down or moves into a full-blown recession — when markdowns are needed to stimulate sales, margins contract and cash flow is reduced? It's conditions like these that really stress the "shock absorbers" of a business model.

In this scenario, AutoZone's heavy debt load, which has risen from $1.2 billion in 2002 to the current $1.9 billion, will suck up cash, leaving much less for buying back shares. And while AutoZone has been diligently squeezing profits out of its franchise by reducing advertising and store maintenance, competitors like O'Reilly Automotive and Advance Auto Parts have been aggressively reinvesting in their businesses, rapidly boosting revenues and grabbing market share.

Shorting a high flyer is always a risky business, especially one as perennially popular as AutoZone. But given that we do not believe that the business cycle has been repealed, this is one that looks particularly vulnerable to the next patch of rough road.


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