Friday, May 27, 2005
AutoZone: A Tale of Two Companies, Part II
Whatever its current investment merits, AutoZone used to be a great company.
The company’s philosophy was summed up in the acronym “WITTDTJR”—whatever it takes to do the job right—and employees proudly refer to themselves as AutoZoners.
Reflecting the Wal-Mart cultural DNA of its founder, “Pitt” Hyde, who served on Wal-Mart’s board, a gaggle of clean-cut AutoZoners would materialize at investment conferences and wow the audience by doing the AutoZone cheer.
Nowadays, the main corporate cheerleader on the conference circuit is CFO Mike Archbold, a scrappy sort of fellow with a ready answer—no matter how silly—for any question, especially any question that sounds even vaguely critical of the company.
Archbold is probably a very competent CFO, and he certainly is convincing when it comes to explaining the company’s aggressive share repurchase plan and its strict adherence to requiring a 15% internal rate of return on “everything we do.”
But his slide show is often unintentionally funny—such as the slide which shows “$60 billion in unperformed maintenance each year” on U.S. automobiles. The genesis of the notion that there is such an untapped gold mine for the auto parts industry lies in the fact (according to the slide) that there are “25 million activated CHECK ENGINE lights” blinking in U.S. vehicles.
The logic being, apparently, that if everybody actually had their engines checked after the “Check Engine” light went on, it would generate $60 billion in revenue. That would be double the annual sales of the entire do-it-yourself auto aftermarket industry.
As anybody with a car knows, of course, the “Check Engine” light goes on pretty much every time you slam the door too hard. Drivers become trained to ignore the “Check Engine” light until the engine fails to turn over when you turn the key, or sparks start flying out of the dashboard when you press the accelerator.
In fact, there is probably a “Check Engine” light on in the Space Shuttle at this very moment.
But getting to the point here: as we touched on in yesterday’s introduction, AutoZone—the market leader in do-it-yourself auto parts retailing—has been losing market share for more than two years. And nothing in Archbold’s slides get to the heart of the problem.
It was not always this way; in fact, AutoZone used to outperform its peers. Its same-store-sales were consistently higher than other public chains, despite its larger base of stores (3,505 at last count) and longer operating history.
Then, along around late calendar 2002, that began to change. When industry sales softened along with a weak economy, AutoZone’s same-store-sales dropped into negative territory and have lingered in that region, slightly plus or minus, ever since—despite a strong industry recovery beginning in late 2003.
After four or five straight quarters of this widening gap, CFO Archbold—the man with the “Check Engine” slide—began adding another humorous slide to his show, this one depicting how movements in the price of gasoline have affected AutoZone’s sales.
It’s a very pretty chart, with colored lines and lots of data—and Archbold explains it both earnestly and with a straight face. But rising gasoline prices have nothing to do with the reason AutoZone is falling behind its peers. After all, they share the exact same customers.
And, as far as I know, pretty much everybody in America runs their cars on gasoline.
Plus, in the most recent quarter, AutoZone's same-store-sales fell through the floor, down 5%, while its largest competitor's same-stores rose 9%. The gap is widening, gasoline prices or not.
The reason AutoZone has fallen behind its competitors is, I believe, that use-any-spare-cash-to-repurchase-our-stock share buyback program, and the 15% IRR “on everything we do.”
Based on the company’s 10K’s, AutoZone has been paring back on advertising expense as well as maintenance capital spending, reducing inventory per store and adding potato chips and soda displays—all in an effort to either conserve capital or add to sales.
Maintenance capital spending, for example, dropped from an estimated $100,000 per store in the late 1990’s to roughly $20,000 each in recent years, and it shows when you walk into the store.
The disinvestment did not stop there, however. It has reared its head most clearly in the company’s efforts to move vendors to something called “pay-on-scan.”
Two years ago the company began widely touting “pay-on-scan” as a way for AutoZone to dramatically reduce the carrying cost of inventories in stores and enhance the company’s cash flow.
“Pay-on-scan” is, essentially, consignment inventory. A vendor of spark plugs and timing belts would no longer sell that stuff to AutoZone’s Memphis distribution center: the vendor would keep ownership of that stuff until it was sold (scanned) at each store, at which time AutoZone would pay the vendor.
Naturally, this would be a cash flow boon to AutoZone, shifting inventory costs to the point of sale rather than the point of distribution. The company suggested “pay-on-scan” would benefit the vendors, too, because they would have more control over how their products were merchandised and sold.
AutoZone management promoted “pay-on-scan” to Wall Street, and Archbold had another slide for his expanding show. By the end of 2004, the company expected to move $200 million worth of inventory to pay-on-scan.
Last quarter, however, the number was only $141 million, and the program has been a bust, for good reason.
The reason vendors do not want to retain ownership of their spark plugs and timing belts until the time of sale goes beyond the simple cash flow drain of carrying their own inventory longer: it becomes a tax and accounting nightmare.
This is because under a “pay-on-scan” arrangement, the vendor of those spark plugs and timing belts sold through each of AutoZone’s 3,500 stores in all 50 states becomes responsible for reporting to tax authorities in all 50 states.
Furthermore, since those spark plugs and timing belts stay on the vendor’s books while they sit in all 3,500 stores, they become part of the vendor’s inventory, for reporting purposes.
How does the vendor’s auditor verify its client’s inventory valuation when spark plugs and timing belts are spread around 3,500 AutoZone stores? And what CEO and CFO can verify, for Sarbanes-Oxley compliance, a company’s books when inventory is sitting in 3,500 AutoZone stores?
These issues with “pay-on-scan” are not theoretical. I have discussed “pay-on-scan” with a number of executives whose companies sell to retailers like AutoZone. Staples, for one, tried to get its vendors to do “pay-on-scan,” and the vendors refused. Those that have gone along with AutoZone tend to be vendors trying to gain shelf space and dislodge other products.
If 20% of AutoZone’s vendors are doing “pay-on-scan,” as the company reported last quarter, it means, of course, that 80% have refused.
Like the $60 billion of so-called “unperformed maintenance” and the fact that rising gasoline prices only seem to hurt AutoZone stores and not Advanced Auto Parts or CSK or O’Reilly, “pay-on-scan” in my opinion merely represents another distraction away from the heart of the AutoZone problem—its accelerating loss of market share.
The real issue is simple: as a retailer with high margins and low growth opportunities, AutoZone must choose to invest in stores or invest in its own stock, or do some reasonable mix of both. And AutoZone has made its choice.
It will be interesting to see if, and when, the resulting deterioration in sales begins to affect the surplus cash flows that the company depends on to buy back its own stock. In which case the choice will become starker.
Meanwhile, those AutoZoners who used to wow ‘em at investment conferences no longer show up—probably because they don’t generate a 15% internal rate of return, which is too bad.
Corporate culture can’t be measured like the decision on whether to refurbish a hundred old stores or buy back a million shares of stock.
But it shows up every day, behind the counter.
I Am Not Making This Up
The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.
Posted by Jeff Matthews at 9:23 AM