Should the Pullback in Get You into the AutoZone?

Source: Thinkstock

Source: Thinkstock

AutoZone Inc. (NYSE:AZO) has been one of the best performing stocks over the past several years, and there are a couple of reasons for this. The first is that management has steadily grown the company. The second is that it has taken advantage of the low interest rate environment: it has borrowed money inexpensively in order to buy back stock. This combination has been wildly successful because the company has been able to reduce the total number of shares outstanding by over 20 percent over the past three years while growing its net income by around 50 percent, meaning that the company’s earnings per share growth over this time period has been over 20 percent: not bad for a large company in a relatively stable business.

However, recently shares have started to correct. While the stock is still up by over 8 percent for the year, it has met significant resistance at around the $540/share level and have since pulled back to about $520/share. While this isn’t a large pullback, a look at the chart suggests that there is further downside. But is this downside only a temporary blip in a sustainable uptrend, or is there something more serious in the works that would indicate that longer term shareholders should take profits?

The answer isn’t immediately apparent given the nature of the company’s customer base. On the one hand, the growth in AutoZone’s business, and of similar businesses indicates that more people are doing work on their own cars. This reflects the fact that consumers are spending less money and that they are willing to perform basic repairs on their own cars in order to save some money. But this trend may not be sustainable, especially as newer cars become more complicated.

Yet this uncertainty is coupled with AutoZone’s management’s long track record of outperformance and success. The company has shown strong same store sales growth, return on assets, and return on invested capital. It has also used the debt markets to its advantage, and it has bought back an enormous amount of stock. This has clearly paid off as earnings per share have soared. Furthermore, the fact that AutoZone’s management bought back a large amount of stock at prices substantially lower than today’s price reflects management’s understanding of the equity markets and of its own business.

At the same time, however, a quick glance at the company’s balance sheet reveals that it is compromised. The company’s net equity has turned negative as the company has borrowed so much money to buy back stock. This may not be such a bad thing now as earnings are rising and as interest rates are low, but if there is a recession and earnings fall while interest rates rise then AutoZone could face serious trouble.

So I am in large part conflicted by AutoZone. I think there is a significant amount of risk to the downside here in a bear market scenario, but I also think that AutoZone is one of the best ways for investors to play the low interest rate environment. With this in mind, I would be cautiously optimistic. I want to own the stock, but I also want to wait for lower prices, despite the fact that shares trade at just 15 times next year’s earnings estimates (next year starts in September for AutoZone). There is technical support around the $480 – $500/share level, and a decline to this level would reflect a 10 percent to 12 percent correction from the peak, which should be sufficient enough to flush out the speculative money. And unless we are about to see a recession AutoZone will have the earnings power to absorb a lot of stock in the event that the price falls to this level.

With this in mind, I think the risk/reward is favorable on a further $20-$40/share decline. But I wouldn’t make this a long-term holding. I want to keep an eye on economic activity and on interest rates. I also want to use a stop order and I doubt that I would be adding more in the event of a further share price decline, as that would signal that the company’s earnings power is wearing off and that the company doesn’t have enough cash-flow to buy back the shares that are being sold onto the market.

Disclosure: Ben Kramer-Miller no position in AutoZone.

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