Robert Leonard (02:25):
Then the subtitle gives us a bit more of a clue on how, but doesn’t quite give us the whole picture. The subtitle says there is a way for investors to use their preexisting knowledge to make money in the market. putting these two concepts together, linking the market, which Lynch did not clearly define, with Wall Street, we can derive that he is referring to the stock market and how individual investors can achieve better returns than professional money managers. Now, the lingering question is how? Lynch explains average investors can become experts in their own field and can pick winning stocks as effectively as Wall Street professionals by doing just a little research. He goes on to say by simply observing business developments and taking notice of your immediate world from the mall to the workplace, you can discover potentially successful companies before professional analysts do.

Robert Leonard (03:21):
One Up on Wall Street was originally published in 1989, so it’s a bit of an older book, but that doesn’t diminish Lynch’s credibility. He was the portfolio manager of the best performing fund in the world, the Fidelity Magellan fund, for 13 years, averaging double the S&P 500 index at the time, a 29.2% annual return. When Lynch took over management of the fund in 1977, it had assets under management, known as AUM, of about $20 million. By the end of his tenure, it grew to $14 billion in AUM. Commonly referred to today as “buy what you know,” how do we actually apply this approach? Think back to your first iPhone. When was it? If I recall correctly, mine was the iPhone 4 in the summer of 2010.

Robert Leonard (04:10):
In the summer of 2010 Apple stock was trading at about $9 per share. What Lynch is advocating is that I could have seen how many people were buying the iPhone in my everyday life, which could have led to me investing in the company. Today, Apple is trading at about $128 per share. Had I invested in Apple stock based on Lynch’s approach in 2010, I ended up investing in 2013, but sold too early, that’s a whole ‘nother story, I would have 14Xed my original investment, a 27.3% annual return. Others who have implemented this strategy have talked about massively successful investments in software companies such as Salesforce, because they used its tools in their day to day work. The same could be said for Amazon if you were an early online bookstore shopper, or Netflix if you were an early online content consumer.

Robert Leonard (05:00):
However, the strategy does not always work like this. You could have known Blackberry, Kodak, Blockbuster, or Circuit City well, leading you to invest, and you’d be in a much different position today than you would have been in the Apple, Salesforce, Amazon, or Netflix situations above. There’s a lot more that goes into an investment thesis and decision than just knowing or liking a company’s products and services. There is a business behind each product and service that you must also understand. However, Lynch’s point holds true. If you find a company like those referenced before before it hits mainstream Wall Street, or if you can understand a business so well that you see value in a piece of the business that most people are missing, you may have a great investing opportunity on your hands.

Robert Leonard (05:48):
Before I started writing this week’s intrinsic value assessment, I wasn’t sure which company I was going to analyze. I was going through the filter feature in the TIP finance tool when I came across a company that I felt I knew quite well, at least as a consumer. My background before finance was, surprisingly, in racing motocross. My dad owns a small business as a mechanic and has been doing it for nearly 30 years. Having been around this industry my whole life, when I saw this company in the TIP finance tool, trading at what appeared to be an attractive valuation on the surface, I instantly thought of Lynch’s strategy, and knew I had to dive in deeper. That company is AutoZone, Inc. Not only does AutoZone fit into Lynch’s strategy for many people, but it also likely satisfies Buffet’s requirement of only investing in companies within your circle of competence. It has consistent and growing cash flows, a great management team, and a positive momentum indicator in the TIP finance tool. Now the question is, at today’s price, is AutoZone’s stock undervalued?

Robert Leonard (06:49):
All right, so that wraps up the newsletter that I wrote this week. I really wanted to bring that to you guys, because I really like Peter Lynch’s strategy of investing in things you understand, and I think it really couples well with Buffet’s strategy or principle of only investing in things within your circle of competence. I talk about that a lot here on the show. So I thought that this newsletter was relevant for you guys, and I thought you would enjoy it. Towards the end of the newsletter I talked about AutoZone, and similar to how we did a deep dive into Square in bonus episode one, we’re going to do a deep dive into AutoZone here in bonus episode number three. So let’s get into the intrinsic value assessment of AutoZone.

Robert Leonard (07:32):
AutoZone, Inc., ticker AZO, is a relatively simple business in today’s world. It has brick and mortar retail operations and an e-commerce presence where it sells aftermarket automotive parts, accessories, and tools to commercial and do it yourself customers. It is primarily based in the United States, with 90% of its stores domestically, and the remaining stores spread across Mexico and Brazil, with 9.5% of their stores being in Mexico, just half a percent being in Brazil as of the end of its most recent fiscal year. At the time of writing AutoZone’s market cap is about $26.7 billion, and its revenue and cash flows for the 2020 fiscal year were 12.6 billion and 2.3 billion respectively. Currently trading at $1,205.63, the stock has hit a 52 week low of $684.91, and a 52-week high of $1,297.82.

Robert Leonard (08:32):
I had heard of AutoZone and even shopped there quite a few times as a customer, but I hadn’t really considered it for an investment. Then the other day I was using the TIP filter function in the TIP finance tool as I research for potential investment ideas when I came across AutoZone trading at an attractive TIP multiple, TIP median multiple, and a satisfactory potential yield, all with a green momentum status. This intrigued me and was the catalyst for further research, ultimately resulting in this research report. Now the question is, at today’s price of $1,205.63, is AutoZone’s stock undervalued?

Robert Leonard (09:12):
Intrinsic value of AutoZone, Inc. In our last intrinsic value assessment, or bonus episode number one, I analyze a company that is about as far away from a traditional value pick as you can get. This analysis here is far more similar to the traditional analysis many of you are familiar with. Why is that? Square’s a high growth tech company looking to disrupt an industry by continuing to innovate, whereas AutoZone is a much older company with far more stable and consistent results. Each of these investments can work, but they’re very different strategies and approaches.

Robert Leonard (09:48):
In the analysis about Square, I wrote, “DCF models are often associated with value investing because they can be great to value a more mature company, which historically has been the focus of value investors. However, in the case of a company like Square, which is still growing rapidly and far from maturity, DCF models are far less useful. As investors, we must be a bit more creative in our valuations to accurately model these types of companies. In the case of Square, it is a relatively early stage company making it difficult to use historical data, as well as traditional profitability numbers to forecast its future results.”

Robert Leonard (10:27):
On the other hand, AutoZone fits perfectly into the box for using a DCF model. In the below image, we can see just how stable and consistently growing AutoZone’s free cash flows have been. In the article there is a chart of AutoZone’s free cash flows, and from 2011 to 2017, it grew ever so slightly, very little, very little volatility, pretty steady, and mostly trending up. And then in 2017 to 2020, it is still relatively consistent, but it’s growing significantly. It’s about doubled from 2017 to 2020. If you are listening to this and you’re a little bit more visual and maybe you want to see the graphs that are in the article, you can click the link in the show notes below to get to the actual article. You’ll see all the pictures and graphics and charts that are included in the article.

Robert Leonard (11:17):
And also we’re about to go through the DCF models, there’s three of them, and there’s going to be a lot of numbers. And I know it’s hard to follow necessarily on an audio podcast like this, but I also created a video that’s on YouTube and it’s also included in this article that shows exactly all of these numbers and how I went through them and how I put them into my calculator and what tools I use and all of that. So if you’re looking for a visual, the video is on YouTube. I will put a link to it in the show notes below. It’s also in the article as well. So all of that information, if you want to access, it will be in the show notes below.

Robert Leonard (11:52):
So let’s look at the three potential DCF models for AutoZone. The first DCF model run in our TIP finance tool is by far the most optimistic. It is plausible and based in sound logic, but AutoZone would need to fire on all cylinders with minimal impact from competitors and others risks, which we’ll discuss below, in order to achieve these returns. In this model three potential outcomes for AutoZone’s free cash flow were modeled, each with a different percent chance of occurring to arrive at the expected annual rate of return over the next 10 years at today’s price. For the upper band, a 10% growth rate was assumed with a 15% chance of it occurring. For the most likely, a 6% right growth rate was assumed with a 60% chance of occurring. For the lower band, a 3% growth rate was assumed with a 25% chance of occurring. At today’s price, that results in an expected annual rate of return over the next 10 years of about 11.9%.

Robert Leonard (12:51):
The second DCF model run in our TIP finance tool is what I would consider to be the most likely scenario. It takes into consideration both the opportunities and risks facing AutoZone with the assumption that it could, but not too significantly, have its business eroded away by competitors. In this model three potential outcomes for AutoZone’s free cash flow were modeled, each with a different percent chance of occurring to arrive at the expected annual rate of return over the next 10 years at today’s price. For the upper band, a 5% growth rate was assumed with a 25% chance of occurring. For the most likely, a 3% growth rate was assumed with a 50% chance of occurring. For the lower band, a 0% growth rate was assumed with a 25% chance of occurring. At today’s price, that results in an expected annual rate of return over the next 10 years of about 8.74%.

Robert Leonard (13:44):
The final DCF model run in our TIP finance tool is what I would consider to be close to, if not the worst case scenario for AutoZone. It gives little value to its opportunities and competitive advantages and heavily leans on the expectations that its business model and industry will be disrupted by competitors and technology. For the upper band, a 0% growth rate was assumed with a 25% chance of occurring. For the most likely, a negative 3% growth rate was assumed with a 50% chance of occurring. For the lower band, a negative 5% growth rate was assumed with a 25% chance of occurring. At today’s price, that results in an expected annual rate of return over the next 10 years of about 5.29%.

Robert Leonard (14:27):
DCF models are often associated with value investing because they can be a great way to value a mature company, which historically has been the focus of value investors. Again, AutoZone fits perfectly into the requirements for input into a valuable DCF model. Why did I use three different DCF models? It’s highly unlikely that my assumptions in one model will prove perfectly accurate. The reality is the future annual rate of return will likely fall within a range. In this case, I’m more confident in saying the annual return of AutoZone over the next 10 years will be between 5.29% and 11.9% than I am saying it’s a specific number for any of these three models.

Robert Leonard (15:09):
AutoZone’s competitive advantages and opportunities. In order for companies to not only maintain their market share, but also grow it, they must have durable, competitive advantage. In the case of AutoZone, there are four competitive advantages that will help them grow over the next 5 to 10 years. Customer service and experience. With many automotive parts being hyper-specific to a vehicle’s make and model, it can often be difficult for customers know exactly which part or tool is needed for their job, but they are cost conscious or DIYers who don’t want to pay full retail for a mechanic shop to do the work for them. That’s where AutoZone steps in and makes a difference.

Robert Leonard (15:49):
AutoZone has a reputation for being very helpful with customers’ questions. They also offer free diagnostic and troubleshooting services, as well as free loan a tool programs, allowing customers to borrow specialty tools for free. They also offer step-by-step guides for nearly all skill levels. There is significant competitive pressure from retailers like Walmart and Amazon, as well as fears of industry disruption, both of which we’ll talk about in the risks section below. However, what Walmart and Amazon can’t or haven’t offered is the one-on-one focused customer service and help that AutoZone has been able to provide. These interactions build brand loyalty and increase customer retention, benefiting AutoZone’s same-store sales.

Robert Leonard (16:35):
Relationships. Other than the typical retail customer relationships we just discussed in the customer service and experience competitive advantage, AutoZone has two additional relationships that are significantly valuable to its business. Vendors and commercial customers. Its relationships with its vendors is quite important and material to its business because it allows AutoZone to manage its working capital efficiently by carrying a large accounts payable balance, meaning it can wait to pay its vendors, while carrying a small accounts receivable balance, meaning it can try to receive cash as quickly as possible from customers. In AutoZone’s Q1 2021 earnings call, management stated, “Historically we have negotiated extended payment terms from suppliers, reducing the working capital required and resulting in a high accounts payable to inventory ratio. We plan to continue leveraging our inventory purchases. Extended payment terms from our vendors have allowed us to continue our high accounts payable to inventory ratio. Accounts payable as a percentage of gross inventory was 114.1% at November 21, 2020, compared to 110.3% at November 23rd, 2019.”

Robert Leonard (17:55):
AutoZone has also been successful in building and maintaining relationships with commercial customers, with nearly 75% of its 2020 revenues coming from commercial customers. As the industry continues to evolve over the coming years, relationships with commercial customers are going to become increasingly important. As it currently stands. AutoZone has been able to derive a competitive advantage from its ability to build and maintain these relationships more than its competitors. While no competitive advantage is set in stone, this is a specific competitive advantage that must continue to be a focus if it wishes to maintain its success with commercial customer relationships.

Robert Leonard (18:34):
Size and scale. AutoZone currently he has more retail locations than other similar retailers, and this number is continuing to grow. From 2010 to 2020, its store count grew 4% compounded annually from 4,627 stores to 6,549 stores. This provides AutoZone a competitive advantage by giving it a broader reach to connect with DIYers in local communities. As e-commerce in this industry continues to evolve, it will also provide a competitive advantage by allowing these retail locations to act as a distribution hub for online orders, reducing the time for packages to get to customers.

Robert Leonard (19:11):
Management. Many of AutoZone’s executive team have been with the organization for over 15 years, providing significant experience and expertise to the company. The management team has done a masterful job of managing the headwinds its industry and business has faced over the previous decade. While it’s impossible to say, it is my expectation that with a lower quality management team in place, AutoZone likely would have been gone by the wayside, similar to other brick and mortar businesses in competitive narrow moat industries. Think Sports Authority and Blockbuster. AutoZone has opportunities ahead, as we will discuss below, but it won’t be without its fair share of challenges. That said, it is going to be facing those challenges with an experienced and talented management team at the helm. As long as this management team is in place, it provides a competitive advantage for its business.

Robert Leonard (20:02):
Having competitive advantages is critical for any business to have sustainable success. In the case of AutoZone, it is the four main ideas we just discussed previously. However, competitive advantages are not a set it and forget it strategy. There is something that must be deepened by continuing to successfully implement new growth opportunities. Without future growth opportunities, a company’s competitive advantage is likely going to be something of the past. For AutoZone, I see three opportunities that exist for it to continue to expand and grow.

Robert Leonard (20:35):
Expanding distribution. We discussed AutoZone’s focus on opening new stores above. While they have done a good job of this so far, there’s still more room to grow. It’s not always wise to grow just for growth’s sake, but with a talented management team, AutoZone can continue to grow strategically in domestic markets where it’ll be beneficial to the business. This expanded distribution opportunity comes not only from an increased store count, providing more retail opportunities, but also by providing more areas for distribution hubs, further improving AutoZone’s e-commerce presence. International expansion. In addition to the domestic expanded distribution, there is a significant opportunity for AutoZone to expand internationally, both in its existing international markets, as well as in new markets. With only 10% of its stores in two international markets, there’s room to grow at store count significantly in both these markets, learn from scaling in those markets, and then expand to other markets across the world.

Robert Leonard (21:33):
Financial engineering. Financial engineering isn’t so much an opportunity for the business itself, rather it’s an opportunity for investors in AutoZone to potentially benefit from. Over the last decade, one financial engineering lever AutoZone has pulled is that it has bought back nearly half of its stock. Many successful investors have spoken publicly about what this means for investors, but in general, if a company buys it stock back at too high a price, that is eroding shareholder value. Whereas if it purchases stock back at a discount to its intrinsic value, it can increase shareholder’s value. In the case of AutoZone, management has done a satisfactory job to date, which gives me confidence in their ability to continue to do so. In addition to share buybacks, the management team has strategically managed its net working capital, debt, accounts payable, and accounts receivables successfully over the last decade and has the opportunity to continue to do so into the future.

Robert Leonard (22:31):
Risk factors. Although AutoZone has competitive advantages and opportunities ahead, it is not without risks that could potentially negatively impact the company and/or prove our financial models to be inaccurate. The major risks for AutoZone going forward are electric vehicles. The risk of electric vehicles, known as EVs, is one that is widely known for AutoZone and its industry as a whole. The expectations for this risk are likely already priced into the stock, but if the risk is worse than expected by investors currently, AutoZone’s stock could be negatively affected. EVs are a risk to AutoZone because they generally require less maintenance than internal combustion engines. EVs do not have oil changes, fuel filters, spark plugs, timing belts, differential and transmission fluid, and many other parts that traditional cars do.

Robert Leonard (23:24):
There are of course still parts that AutoZone can provide to EV owners. For example, it currently provides struts, break pads, various glass replacements, air filters, windshield wipers, and headlights for Tesla vehicles. However, the issue is the quantity of repairs and parts required. With EVs, it’s likely significantly less than traditional cars. Also, as EVs improve, manufacturer warranties are likely going to lengthen, whether it be in terms of miles or years, with the potential of being forever as a selling point, which could significantly cut into AutoZone’s business. Competition. The risk of competition is also another risk that many market participants are aware of. It’s no secret that Amazon, Walmart, O’Reilly Automotive, Advanced Auto Parts, and many others are competitors to AutoZone. There are ways for AutoZone to potentially beat these competitors, But there is significant competition, and the industry is ripe for destruction.

Robert Leonard (24:23):
Fewer DIYer wires. This can come from a variety of reasons, but one of the most common is millennials. Today, fewer people than ever before are going into trades and learning skills related to those careers. This could translate into fewer and fewer people being able and willing to do automotive repairs themselves. If this trend continues, there would be fewer DIYers buying parts from AutoZone. Also, newer cars are being significantly more complex, making it difficult to work on for everyday people. New vehicles are even hitting a point where it is sometimes difficult for independent repair shops to work on them due to the new technology and computer systems. This does not bode well for the future of automotive DIYers, independent repair shops, and therefore this segment of AutoZone’s business.

Robert Leonard (25:13):
Lack of individuals’ automobile ownership, and travel. There’s no concrete evidence, research, or reports showing that individuals’ automobile travel is or is going to decrease. However, if we remove ourselves from strictly data and think a bit more intuitively, it makes logical sense that as millennials and gen Z become a larger percentage of the population and ride sharing apps like Uber and Lyft become more popular, there is the possibility for there to be less individuals traveling via automobile they own, and therefore being required to fix. In addition, there is the looming possibility that autonomous vehicles will be here in the near future. We will have to Wait and see what those vehicles look like and the maintenance required, but if it leads to less individual vehicle ownership and more commercial ownership, this may not bode well for AutoZone.

Robert Leonard (26:06):
Change in vendor relationships. We discussed previously AutoZone’s ability to extend its accounts payable balances due to its strong relationships with its vendors. This has a large Impact on AutoZone’s business and capital structure. If these relationships deteriorate or change due to reasons outside of its control, such as changes in the economic or financial markets, AutoZone’s business could be materially negatively impacted. Management stated in its Q1 2021 earnings call, “We plan to continue leveraging our inventory purchases. However, our ability to do so maybe limited by our vendors’ capacity to factor their receivables from us. Certain vendors participate in arrangements with financial institutions whereby they factor their AutoZone receivables, allowing them to receive early payment from the financial institution on our invoices at a discounted rate.”

Robert Leonard (27:01):
“The terms of these agreements are between the vendor and the financial institution. Upon request from the vendor, we confirm to the vendor’s financial institution, the balances owed to the vendor, the due date, and agree to waive any right of offset to the confirmed balances. A downgrade in our credit or changes in the financial markets may limit the financial institutions’ willingness to participate in these arrangements, which may result in the vendor wanting to renegotiate payment terms. A reduction in payment terms would increase the working capital required to fund future inventory investments.”

Robert Leonard (27:35):
Summary. AutoZone is a brick and mortar retailer and e-commerce company that sells aftermarket automotive parts, accessories, and tools to commercial and do it yourself customers. It is a relatively stable company that generates strong cash flows, profits, and is growing, but it does not come without significant risks. It is possible that AutoZone successfully expands its distribution network and improves its e-commerce operations by opening new stores, it continues to successfully expand internationally, and management is financially savvy with both its stock and its balance sheet. However, it is also possible that EVs erode AutoZone’s business, competition steals material market share, less individuals and independent repair shops are interested or able to fix vehicles themselves, fewer people own vehicles, and there is a relationship deterioration between AutoZone and its vendors, resulting in a less optimal capital structure and inventory management. This is why investing is more often an art than a science.

Robert Leonard (28:39):
After hearing all of this information, you’re probably wondering, “So do I buy AutoZone’s stock?” Well, It’s not quite that simple, and of course I can not give specific investing advice, but I will walk you through how I am personally thinking about AutoZone as an investment. I have shared a personal story on this podcast many times about how I was so wrongly approaching value investing when I first got started. In short, I thought I was a value investor by strictly buying companies that looked cheap based on DCF models. I assumed if my DCF models said the stock was cheap, it was a buy, and I was buying an undervalued company. I quickly learned This was not true value investing, and that just because I input my assumptions into the DCF model, that didn’t mean they were right or that the market would agree with me.

Robert Leonard (29:28):
I also didn’t take into account the momentum of the stock I was considering. Oftentimes I would buy a company in which I thought was undervalued, then the stock would fall, fall, and continue to fall, with negative momentum indicators being clear. I missed the clear negative indicators, causing me to buy into a falling knife situation. As I analyzed AutoZone, it brought me back to those days in my investing career. On paper, AutoZone seems undervalued and like a potentially great investment. If you input certain growth numbers into your DCF models, it can even look significantly undervalued. However, that is purely quantitative and does not take into consideration the future of the business and its qualitative aspects. What I did wrong early in my investing career was exactly that. I did not look at non-financial aspects of the business, nor did I try to think logically about the future of the company and its industry.

Robert Leonard (30:23):
Having learned from those experiences and growing as an investor over the past 8 to 10 years, I am now cautious when considering a business like AutoZone. Quantitatively, I don’t have many reservations about the company, but qualitatively, I am far more skeptical about the future of its industry. In addition, it is not enough to simply analyze a company in a vacuum and make an investment decision. Investors must compare their expected return of one investment to that of another option available. Your dollar can only be invested in one place at a time. Choosing the optimal place for that dollar to be invested is equally as important, if not more important. According to our TIP finance momentum tool, AutoZone is currently green, meaning it has positive momentum. This helps alleviate my concern for a potential falling knife situation.

Robert Leonard (31:13):
However, from a qualitative perspective, I am not convinced that AutoZone will be able to continue to thrive in this industry, nor am I convinced that AutoZone is the best place to invest my dollar. Would our dollar be better invested in our previously analyzed company in bonus episode one? Maybe the S&P 500. Maybe a different asset class altogether. Nearly all companies have a price in which it’s a good buying opportunity. At today’s price, I personally am not purchasing AutoZone stock. However, if the stock declined enough to provide a significant margin of safety to my calculated intrinsic value, without any deterioration to its business or my thesis, I would consider allocating a portion of my portfolio to a position in AutoZone.

Robert Leonard (31:57):
Disclosure. The author, Robert Leonard, that’s me, as of this writing, of the companies mentioned only holds a long position in Square, with no intentions of initiating a position in any other company mentioned in this article or podcast within the next 72 hours. The article was written himself and it expresses his own opinions. He is not receiving compensation for it, other than from The Investor’s Podcast Network. He has no business relationships with any company whose stock is mentioned in this article. The information presented in this article is for informational purposes only, and in no way should be construed as financial advice or recommendation to buy or sell any stock. Robert is not a financial advisor. Please always do further research and do your own due diligence before making any investments.

Robert Leonard (32:42):
All right, guys, so that wraps up my intrinsic value assessment of AutoZone, Inc. Like I said, I received a lot of good feedback about my intrinsic value assessment of Square, so I thought I would do another one here about AutoZone. I will be writing these on The Investor’s Podcast website every two weeks, so unless I hear from you guys that you don’t like this content, I plan to bring you a new intrinsic value assessment about every two weeks or so in a bonus episode. And then when I write a newsletter, which I’m doing every week for The Investor’s Podcast, that I think is relevant to the Millennial Investing show, and I think it provides good value to you guys, I will also include a discussion about that on the podcast as a bonus episode, similar to how we did today.

Robert Leonard (33:30):
As always, I would love to hear your guys’ feedback. Be sure to connect with me on social media. I’d love to hear what you guys think, both about the show in general, the guests, and specifically the show and maybe some of the different things you would like to see the show do so that I can tailor the content to what you guys want to see and really make sure I’m providing the most value for you guys as possible. Thanks again, as always, for checking out this episode of millennial investing. That’s all I had for this week’s episode. We will see you again next week.

Outro (33:58):
Thank you for listening to TIP. Make sure to subscribe to We Study Billionaires by The Investor’s Podcast Network. Every Wednesday we teach you about Bitcoin and every Saturday we study billionaires and the fundamental markets. To access our show notes, transcripts, or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by The Investor’s Podcast Network. Written permission must be granted before syndication or rebroadcasting.