AutoZone first store opened in 1979 under the name Auto Shack in Forrest City, Arizona; while, in 1987 the name was changed to Autozone. Autozone implemented the first electronic auto parts catalog for the retail industry. After four years of steady growth, Autozone went public and it was listed in New York Stock Exchange in 1991. By 2012, AutoZone was one of the biggest leading company in retailing and distributing automotive parts and accessories in the United States with more than 65,000 employees and 4,813 stores located in every state contiguous United States, Mexico, Puerto Rico. In fact, AutoZone has performed well in terms of profitability and stock price appreciation over the previous 15 years.
In specific, this case is about Mark Johnson, a portfolio manager of Johnson & Associates, who was reviewing his holdings, including his position in AutoZone. Johnson was concerned that Edward Lampert’s (a prominent shareholder who had begun liquidating his position in AutoZone) reduced position could lead the company to stop using share repurchases as a method of distributing cash flows to shareholders. In this case, students provide an overview of AutoZone’s stock price performed over the previous five years, and how does a stock repurchase work and its impact on EPS and ROIC as well. Moreover, the case lists a number of alternative uses for the free cash flows generated by Autozone if they decided to stop the repurchases program they are undertaking. At the end, recommendation is given to Mark Johnson about his holdings of AutoZone shares and what should he do to deal with it.
How has AutoZone’s stock price performed over the previous five years? What other financial measures can you cite that are consistent with the stock price performance?
Autozone shareholders had enjoyed strong price appreciation since 1997, with an average annual return of 11.5%. The stock price had dramatically increased in the previous five years reaching $348. In 2008, U.S. economy had gone through the worst recession since the great depression, and the recovery that followed had been unusually slow. Strong appreciation of stock price was a result of the recession of the U.S. economy because auto-part business was somewhat a counter cyclical industry. To illustrate more, the company’s growth and stock price are directly related and connected to the economy and to the number of miles driven by a car. When the economy struggled and unemployment was high, fewer new cars were purchased and older cars were kept on the road longer, requiring more frequent repairs. As a result the auto parts retail business enjoyed strong top line growth.By 2012, AutoZone had become the leading retailer of automotive replacement parts and accessories in the United States with more than 65,000 employees and 4,813 stores.
As illustrated in Exhibit 1,the financial statements of Autozone reflect its stock price performance, net sales increased from $6,169,804 to $8,072,973 from 2007 till 2011 which is equal a 30.85% increase. Moreover, cost of sales also increased from $3,105,554 until $3,953,510 in the same period which is equal a 27.430% increase. The increase in cost of sales is lower than the increase in net sales which results in an increase in gross profit from $3,064,250 till $4,119,463 in the previous five years which is equal to 34.4%. Furthermore, Autozone’s operating profit increased by 41.65% ,where it was $1,055,266 in 2007 reaching to $1,494,803 in 2011 indicating the efficiency and the profitability of the company. EPS is strongly related and is a key driver of the stock price for Autozone company. Where basic EPS increase by 130.97% from 2007 till 2011, and the diluted EPS increase by 128.25% through the same period.
AutoZone Income Statements
(in thousands, except per share)
August 29, 2009
August 30, 2008
Cost of sales
Wt. avg. shares for basic EPS
Effect of dilutive stock equivalents
Adj. wt. avg. shares for diluted EPS
Basic earnings per share
Diluted earnings per share
Additionally, Autozone’s management also focused on after tax return on invested capital( ROIC) as the primary way to measure value creation for the company’s capital providers. In 1998, Autozone had restrained capital to its equity investors through share repurchases which is funded through strong operating cash flow and debt issuance. Thus, resulting in reduction of the shares outstanding, which enhanced earning per share. Share outstanding reduction reached 39% from 2007 to 2011, and the shareholders’ equity reached negative 1.2 billion in 2011. The net result was that Autozone’s invested capital had remained fairly constant since 2007, which combined of both increased earning and create attractive ROIC level as shown in exhibit 9 in the case. These two reasons result in the stock price increasing in the previous five years. Autozone cash flow statement in Exhibit 4 shows that net cash provided by operating activities was $1,291,538 in 2011 and the debt is $500,000, showing that the purchases of treasury stock totaling $1,466,802 in 2001 was heavily funded by the free cash flow and by debt as well.
August 27, 2011
August 28, 2010
August 29, 2009
August 30, 2008
August 25, 2007
Net cash provided by operating activities
Net cash used in investing activities
Cash flows from financing activities:
Proceeds from issuance of debt
Purchase of treasury stock
How does a stock repurchase work? Why would a company use this tactic? What impact does it have on: EPS? ROIC?
When we talk about free cash flow in a company, the first decision they have to take is whether to retain the cash flow or distribute it to the firm’s capital providers as a return to their investment. If the firm chooses to retain cash flow, it will invest in new projects or add to the cash reserves. If the firm chooses to distribute cash flow, it can do so by repurchasing shares or paying dividends. The way a firm chooses between alternatives ways to pay out cash to shareholders is called Payout policy.
A share repurchase, also known as share buyback, is “the transaction in which the stock issuer buys back its shares from investors”. Once Shares are repurchased, these shares are generally held in the corporate treasury and become treasury shares (or treasury stock). The Accounting transaction that is done to record it is that the dollar amount of the stocks repurchased is debited to the Treasury Stock account and cash is credited. The account of Treasury Stock cannot be considered as an asset/investment, because stocks purchased are from the company’s own shares. Treasury Stock account is a contra-stockholders equity account and it is mainly found in the Balance sheet, specifically stockholders equity section, as a negative item.
So what are the motives and reasons behind repurchasing shares,
· Management signaling that stock is undervalued.
Some companies use buybacks for signaling to the market, in general, that their shares are undervalued. This is possibly because inside information is more positive than the public’s perception about the company’s strength. A large volume of stock buyback in a given time signals that a wide number of stocks in this specific market are undervalued.
· Attaining an advantage of income tax
When a company decide to distribute its cash flow and thus returning part of their cash to shareholders, the option of Share repurchases offer a tax advantage over dividends. In fact, when shareholders receive cash dividends, dividends are treated as ordinary income and the receipts are taxed at the current personal income tax rate in the same year dividends are received. On the other side, when companies buy back their own shares, any capital gains created for the shareholders are not taxed until the gains are realized; also, capital gains are taxed at a much lower rate.
· Offset share increases from executive stock options.
· Maintain the optimal capital structure
One other reason behind stock buybacks comprises the companies’ efforts to maintain the looked-for capital structure. The existence of an optimal capital is believed by many finance experts, which is the correct mix of debt and equity financing that is most advantageous and beneficial for a company. Hence, companies usually use purchasing of treasury stock to alter and maintain such optimum balance of debt and equity levels.
The share buyback is more flexible in nature than payment of dividends. Cash dividends need to be paid immediately, however, the share repurchase program is conducted over extended period of time. Also, the company is under no compulsion to conduct the repurchase program; It can cancel it or modify it according to the company needs. However, a company will never want to stop or cancel dividends payment.
Earnings per Share (EPS)
The most common and also the most important accounting item of measurement for valuing a company is its Earnings per Share (EPS). EPS is figured by dividing the total earnings of a specific period by the number of shares outstanding (stock). For the same level of earnings, if the number of outstanding shares is reduced through stock buyback, the company’s EPS is spontaneously increased without any corresponding increase in total earnings. High EPS companies are regarded as a more favorable option than companies with lower EPS. Therefore, by purchasing shares back, EPS increases and stock prices would probably be on the rise.
Return on Invested capital (ROIC)
Return on Invested capital, one of the best metrics to evaluate corporates performance, is also affected by Share repurchases. Return on Invested capital, one of the best metrics to evaluate corporates performance, is also affected by Share repurchases. When ROIC is calculated non-economic accounting issues and financial leverage impacts are removed. AutoZone’s management management focused on after-tax return on invested capital (ROIC) as primary way to measure value creation for the company’s capital providers. As a result, while Autozone management invested in opportunities that led to top line result revenue growth and increased margins, it also focused on capital stewardship. What resulted was an aggressively managed working capital at the store level through the efficient use of inventory as well as attractive terms from suppliers in 1998. On the balance sheet, a share repurchase will reduce a company’s cash holdings, and thus reduce the total assets and total shareholders’ equity. This is clearly shown in the case of Autozone where there was a significant reduction of both the shares outstanding and equity capital. In particular, shares outstanding had dropped 39% from 2007 to 2011, and shareholders equity had been reduced to a negative $1.2 billion in 2011.
Based on exhibit 9, which shows the relation between share repurchased and ROIC, ROIC improve subsequent to a share repurchase. The chart also shows the strong increase of ROIC after an extensive repurchase program is undergone by Autozone. Together with share repurchase program, the obvious increase in growth of Autozone when the economy recession occurred had a large impact on creating a desirable ROIC. At the end, AutoZone’s ROIC is clearly demonstrating that the company is proposing strong returns for its investors.
How much of AutoZone’s stock price performance should we attribute to the share repurchase program?
The increase in the company’s stock price is somehow directly associated the company repurchase programs. Due to the fact that a company’s repurchase program can result to the following:
· An increase in the price of the stock.
· Created a strong earning per share (EPS)
· The reduction in the number of shares outstanding
The company’s earnings per share is absorbed by investors in order to measure the company’s performance. Furthermore, the company has a total of 43,603 shares outstanding in 2011 compared to 69,844 shares outstanding in 2007 which shows a reduction in number of shares. This reduction in shares outstanding resulted to an increase in diluted earnings per share by 128% through previous five years. Increasing diluted earnings per share from an $8.53 per share in 2007 to $19.47 per share in 2011. Moreover, the AutoZone’s stock price has shown an increase in the same time period from $120 to $298. Thus, the increase of shares outstanding will result to lower the price of the stocks on the other hand, the decrease of price of stocks will result to an increase in number of shares outstanding. However, the stock price performance of Autozone company was linked greatly to the good performance.
Adj. wt. avg. shares for diluted EPS
EPS before share repurchase
EPS after share repurchase
Stock Price contributed by Share Repurchase
Assume that AutoZone is planning to stop its share repurchase program. What would be the best alternative use of those cash flows? Why?
If AutoZone decided to stop its share repurchase program, the company could use its cash flows in several ways. These alternatives include distributing their cash flows through dividends, increasing the number of stores, acquiring other auto-parts retail stores, or retire some of the accumulated debt that the company has made over the years.
After carefully looking at the alternatives, expanding the business using the company’s operational cash flows is considered a good alternative, which could be done in one of two ways; either by initiating new stores (both domestically and nationally) or by acquiring other existing auto-parts retail stores. This expansion or growth is essential for AutoZone in order to maintain the company’s position as the leading auto-parts retailer in the United States and bar its competitors from gaining a foothold in those new markets. AutoZone Inc. already owns several stores abroad (outside the United States), in Puerto Rico as well as Mexico. However, AutoZone’s management must bear in mind the risk associated with such expansion. There is no assurance that the expansion would bring along the same returns that AutoZone is currently witnessing.
Since 1998, AutoZone was able to acquire almost 800 stores from its rivals. Therefore, AutoZone is well-aware of using its operational cash flows in acquiring its rivals’ existing stores as an alternative to the share repurchasing program. These stores would be considered a good investment as it would mean that these stores would become productive and functional faster than initiating new stores (due to the fact that they are already built and available). However, there are a few drawbacks to this strategy as well. The auto-parts market is considered an oversaturated or mature market which means that there are a few competitors to be acquired in the market (fewer targets for acquisition). Moreover, this also indicates that the acquisition action could be blocked by the U.S. Department of Justice (as it would be considered a potential act of monopoly).
Hence, we suggest that AutoZone should not consider using its operational cash flows to grow its business because:
· The auto-part retail market is already mature/oversaturated
· Fewer locations are available for expansion (domestically)
· Overseas expansion is considered risky and uncertain
· Acquisition of a higher proportion of the market would be difficult without violating antitrust policy
Moreover, Autozone could use part or all of its operating cash flows to retire some of the debts that the company had accumulated over the years, where much of the debt had been used to fund the share repurchase. However, with a negative book- equity position and a such a large debt position, it is recommended that Autozone could at least use part of its cash flow to repay debt. This is because of two reasons: the first one is that if Autozone ran into trouble, it could struggle under the strain of making interest payments and rolling over maturing debt. Another point is that Autozone was conceivable to lose its investment grade, which would make future debt financing more difficult to secure and more expensive.
Autozone could also distribute its operating cash flows to shareholders through dividends, the company have the choice of distributing the cash through dividend or share repurchases, or some combination of the two. Dividends were seen a way to provide cash to existing shareholders, whereas only those who happened to be selling their shares would receive cash from a share-repurchase program. On the other hand, dividends were taxed at the shareholder level in the year received, whereas if a share-repurchase program succeeded in increasing the share price, the non-selling shareholders could defer paying taxes until they sell the stock. Dividends were also generally considered to be sticky, meaning that the market expected a company to either keep its dividend steady or raise it each year. However, share repurchases were not viewed as sticky by the market because the amount of share repurchase vary every year. Autozone can chose to return shareholder capital through both dividends and share repurchases as some companies do. In most of these cases, the company provided a stable but relatively small cash dividend and then repurchased shares at varying levels according to the circumstances each year. The benefit of this approach was to give shareholders the benefit of a sticky dividend while also receiving the price support of share repurchases.
In conclusion, Autozone should make its mind up to benefit from all these alternative and implement one or more of these alternatives according to the company’s need.
What should Mark Johnson do about his holdings of AutoZone shares?
Mark Johnson has three options on Autozone Shares holdings either sell, buy or hold Autozon’s shares. Each of these options have advantages and disadvantages which are discussed below:
If Mark Johnson sells his holdings, he will be given a chance of getting a higher return before economy growth and became strong because if the economy became strong, the value of Autozone shares would decline which will reduce Mark Johnson return.
Buying Autozone shares have a positive side in case the stock price and the value increase; however, if the stock price and value decline, it will be a loss for him, and it will be also the same case if he hold Autozone shares.
Additionally, if Autozone decided to stop share repurchase, they would have excess cash flow that could be used for expansion, producing new product, or retiring some of their debt. Utilizing this cash very well may affect Autozone positively; however, the stock price and EPS might slightly decrease if the company were able to handle its operations. On the other hand, if the company could not handle its operation very well, the stock price and EPS might drop which will disappoint its investors.
Johnson is one of the largest holdings in Autozone company shares, where Johnson was concerned about the news that Lampert, Autozone’s main shareholder, was rapidly liquidating his stake in the company (Autozone). In addition, Johnson was concerned about the future performance of Autozone’s stock price because he did not know what is the reason behind Lampert liquidating his stake as it might have a negative effect among Autozones’ investors. However, it is not necessary that Lampert liquidating his stake is a bad sign, he might liquidate his Autozones’ stake because he is in need of fund for any other personal causes, or for better investment chances as he is might be a financial buyer seeking a greater return, so we believe that Johnson should remain holdings shares in Autozone. Financial measures of Autozones’ company show that the company is steadily improving, where EPS, ROIC, and stock price which is the most important measures for investors; are at a desirable rate of increasing. As Autozones’ investors had been enjoying the strong appreciation of Autozone’s stock prices, we believe they will continue enjoying this strong appreciation in the future. In fact, Autozones’ financial statement has no sign of a decrease in its shares stock price, where the company created a measured value since long time, we believe that it will continue doing in the future.
Autozone faced bad debt ratio which affect the financial security index and the complex of increase capital in debt to develop or the company will forced to pay higher cost of capital. Additionally, Autozone maintaining policy of using debt is not efficient to repurchase its stock due to its high debt ratio. If Autozone do not have enough capital to maintain such policy, the stock prices would highly dropped. While the policy of repurchasing shares by debt would create demand on securities market, where the company stock price will be higher than instinct value.
Our recommendation to Mark Johnson to hold Autozone share as U.S. suffer a recession and recover from recession need many years to improve its economy. Consequently, as U.S did reach the economy improving, Mark Johnson will enjoy high stock price, high value of Autozone stock resulted in high ESP.
Post analyzing all potential alternatives to managing their operational cash flows, we strongly believe that AutoZone should not consider stopping its share repurchasing program and continue with it. By implementing their share repurchase program/strategy, AutoZone was able to progressively improve the price of their shares (as the market views their share repurchases as indirect dividends). Any alteration away from the company’s repurchasing program could be considered a negative signal by the market, therefore, resulting in the investors’ loss of confidence in the company.
Likewise, if AutoZone happens and decides to change their strategy and instead issue dividends, they will have to keep it constant or increment the dividends amount in order to keep the investors satisfied at all times. Over the years, AutoZone has been able to demonstrate progressively incremental and an enhanced its ROIC. As per the other alternatives for using the company’s operating cash flows, the undesirable facets as well as the risks linked with the expansion plans, whether domestically or nationally, would probably result in a decrement in the company’s value. Consequently, foreseeing a sustained upsurge in the price of AutoZone’s shares, Johnson & Associates ought to retain its position and sturdily deliberate on growing its venture inside the company itself.