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Autozone Inc. Baker Adhesives Jacqueline Lau Stetson Strifler Tarleton State University FIN-403/505, Spring Semester, Sect. 010 Dr. Omar A. Esqueda April 8, 2013 Table of Contents Executive Summary........................................................................................................ .................3 General Background of Organization..............................................................................................3 Overview of Financial Tools............................................................................................4

Analysis

Stock Repurchases and the Benefits Offer.............................................................................5

They

Alternative Operating Cash Options.......................................................................................6

Flow

Issuing a Dividend.......................................................................................................... .................6

Organic Growth ........................................................................................................................ ......7 Growth by Acquisition...................................................................................................... ...............8 Debt Retirement...................................................................................................... .........................8 Recommendation for Autozone.......................................................................................................9 Recommendation for Mark .............................................................................................10

Johnson

References..................................................................................................... .................................12 Executive Summary Throughout this report, a case analysis will be conducted over the primary topic of share repurchases and dividends, namely concerning Autozone, Inc. (Autozone) and the strategy for the future use of its cash flows. Within this case analysis, we will examine Autozone's stock repurchasing program, as well as the mechanics behind it and the benefits it provides to the firm. Additionally, this report will analyze the alternative operating cash flow options Autozone should consider, detailing the benefits and costs of each option. A comprehensive examination of these operating cash flow alternatives will be presented, allowing for the determination of the most viable alternative for the use of Autozone's operating cash flows. General Background of Organization Founded in 1979 under the name AutoShack, Autozone has grown to become the leading retailer of automotive replacement parts and accessories in the United States, employing nearly 65,000 employees with over 4,800 locations in North America. After changing their name to 1

Autozone in 1987, the company was able to implement the first electronic auto-parts catalogue in the retail industry, helping to establish their dominant position in the market. Because the firm was able to record steady growth for years, it was taken public in 1991, allowing it to be listed on the New York Stock Exchange (NYSE) under the ticker symbol AZO. Along with heavy investments in their retail footprint, Autozone had also developed a refined hub-and-feeder inventory system, keeping in-store inventory levels low while reducing the chance of stock outages. Because of their revolutionary electronic catalogue and their sophisticated inventory system, Autozone was able to develop category leading distribution capabilities, giving them the highest operating margin in the industry. Focusing on return on invested capital (ROIC) as the primary way to measure the firm's valuation, Autozone consistently invests in opportunities that lead to top-line revenue growth, ultimately leading to increased margins. As a way to return capital to their equity investors, Autozone has opted to use a share repurchasing program since 1998. Because of their consistent use of the share repurchasing program since its inception in 1998, there has been a 39% reduction in shares outstanding, reducing shareholder's equity to negative $1.2 billion by 2011. Funded by strong operating cash flows and the issuance of debt, Autozone's share repurchasing program has allowed their invested capital to remain relatively stable, creating an attractive ROIC for the firm (Brenner & Eades, 2012). Overview of Financial Analysis Tools In order to fully understand the value that is generated through a stock repurchasing program, it is important to comprehend the financial ratios that will be discussed in this case analysis. (See Table 1.1) Table 1.1 Financial Ratio | Formula | Use | Return on Total Assets | Net Income available to CS ÷ Total Assets | Measure of how well management is using its assets to generate earnings | Return on Common Equity | Net Income available to CS ÷ Common Equity | Stockholders invest in order to garner a return, this tells how well they are doing in an ing sense | 2

Price/Earnings Ration | Price Per Share ÷ Earnings Per Share | How much investors are willing to pay per dollar of reported profits | Earnings Per Share | (Net Income - Preferred Dividends) ÷ Total Shares Outstanding | Portion of a firm's profits allocated to each outstanding share of common stock, a measure of profitability | Return on Invested Capital | (Net Income - Dividends) ÷ Total Capital | Assesses a company's efficiency at allocating the capital under its control to profitable investments | Stock Repurchases and the Benefits They Offer A stock repurchasing program is when a firm buys back its own shares, either from the open market or through a tenant offer, essentially meaning they are choosing to invest in themselves. While many reasons exist as to why firms would repurchase their own shares, two seem to be the most common, the first of which being when the firm believes the market has discounted their shares too much. If this is the case, the firm will opt to repurchase shares from the open market, or through a tenant offer, because they believe their shares are worth more than what the market has dictated, which represents a good investment for the company as a whole. Secondly, a firm might consider repurchasing their own shares in order to improve their financial rations, such as: earnings per share (EPS), return on assets (ROA), return on equity (ROE), and their price to earnings ratio (P/E). In the case of EPS, when the firm repurchases its own shares, the number of shares outstanding is reduced, which results in an increased EPS. Also, when shares are repurchased, assets on the balance sheet are reduced because cash is considered an asset and is used in purchasing the shares, increasing the ROA. In regards to the ROE, when shares are repurchased there is less outstanding equity for the firm, causing the ROE to increase. As well as increasing the ROE, the repurchasing of shares also helps improve the P/E ratio by lowering it, meaning that the firm is considered a less expensive investment. By initiating a stock repurchasing program, a firm is able to improve all of the aforementioned financial ratios, adding value to the firm in the eyes of potential and current investors. In of ROIC, the stock repurchasing program will likely leave it unchanged, because as the assets are decreasing the debt is increasing, 3

leaving the ROIC stagnant. Another important benefit offered by a stock repurchasing program is the fact that it is not viewed as "sticky" in the eyes of investors, meaning it is not expected to remain steady or increase from year to year. The implementation of a share repurchasing program allows the firm to vary the amount of shares it repurchases from year to year, making it a more flexible option than the offering of a dividend, which is expected to increase or remain steady from year to year. Because of the perceived benefits offered by a share repurchasing program, they are often used by a firm as an indirect form of dividend that is paid out to shareholders looking to sell their shares (Brenner & Eades, 2012). Alternative Operating Cash Flow Options Although Autozone has typically used their operating cash flow to repurchase their own shares, there are several alternative uses for their operating cash flow they may wish to pursue in the future. In the case of Autozone, they could potentially: distribute their cash flows through cash dividends, use the operating cash flow to increase the number of new stores, use the operating cash flow to acquire other auto-parts retail stores, or they could use the operating cash flow to retire some of the debt they have accumulated over the years. While all of these options presented reasonable alternatives, Autozone could also continue to use their operating cash flow to continue their share repurchasing program, which was viewed by many in the market as an indirect dividend. In order to determine the best available option for the use of Autozone's operating cash flow, the benefits and costs of each alternative need to be examined (Brenner & Eades, 2012). Alternative Operating Cash Flow Options: Issuing a Dividend Although Autozone currently uses a share repurchasing program, they do have the option of distributing some of their operating cash flows in the form of a cash dividend. While share repurchases only offer cash to shareholders who happen to be selling their shares, dividends provide cash to all existing common stock holders. However, although dividends are extended to all existing common stockholders, they are taxed at the shareholder level in the year they are received. In the case of the share repurchasing program, because it has been successfully increasing the 4

share price, it allows the non-selling shareholders to defer paying taxes until they choose to sell the stock. Also, in the eyes of investors, dividends are considered to be "sticky", meaning that they are expected to remain at a steady rate or increase from year to year. Because of this, the increase of a firm's dividend is a positive signal to the market, showing that the firm has enough earning power to continue to pay the dividend in the future. On the other hand, a decrease in the dividend is viewed as a negative signal in the eyes of investors, which forces the stock price to change in accordance with the dividend of the firm. Due to this fact, the issuance of a dividend would only be favorable to Autozone's shareholders if it was able to remain steady or increase each year (Brenner & Eades, 2012). Alternative Operating Cash Flow Options: Organic Growth Another viable option for Autozone's operating cash flow would be to invest in new store openings, allowing them to fund the expansion of the firm. Although Autozone's CEO believes the auto-parts retail industry is far from oversaturated, many analysts have indicated that the industry has already reached a mature level. Regardless of the view, Autozone could use this opportunity to reinvest their operating cash flow into new store openings, allowing them to expand into less profitable territory, potentially barring competitors from ever gaining a foothold in these new markets. However, the expansion of the firm's brick-and-mortar stores comes with a certain level of risk, namely the level of managerial capacity that is required to oversee an even larger number of stores. Also, there is no guarantee that further expansion would bring with it the same level of value and return on investment that Autozone is currently experiencing. As well as risking their currently stellar ROIC, the lack of profitable U.S. retail locations was also a contributing factor to the risk associated with further expansion. Although there were very attractive foreign investment opportunities, the current distribution network would be severely strained by expanding into the overseas market. Because of the aforementioned risks, Autozone would likely have a difficult time investing their operating cash flow into further growth and expansion of their brick-and-mortar stores (Brenner & Eades, 2012). Alternative Operating Cash Flow Options: Growth by Acquisition

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Having acquired nearly 800 stores from competitors since 1998, Autozone was aware that another potential use for their operating cash flow was the acquisition of competing auto-parts stores. Although these stores would become more productive at a quicker rate, due to the fact that they don't have to be built like new stores would, there were a number of problems associated with this strategy. Because of the mature nature of the autoparts retailing industry, the secure nature of the industry left little, if any, conceivable takeover targets in the market place. Due to this fact, only a few powerful auto-parts retailers were left, meaning that a merger of such large firms would likely be blocked by the U.S. Department of Justice, because of the potential of a monopoly. Although Autozone might consider this potential alternative for the use of their operating cash flow, the aforementioned risks would make it extremely difficult (Brenner & Eades, 2012). Alternative Operating Cash Flow Options: Debt Retirement The most intriguing alternative for the use of Autozone's operating cash flow would be the retirement of some of its outstanding debt, which had been accumulating over the years. Although a large portion of the share repurchases had been financed by debt, Autozone was currently experiencing a negative book-equity position of negative $1.2 billion. Because of this negative equity position, and the fact that they had built up such a large debt position, the addition of new debt to the balance sheet could negatively impact the firm. If unfortunate circumstances were to arise in the auto-parts retail market, Autozone would find it difficult to make the interest payments on their debt, which could force them to roll over their mature debt. If these circumstances were to occur, Autozone would likely lose their investment grade credit rating, ultimately making it much more difficult for the firm to acquire future debt financing. Because of the aforementioned risks, the retirement of some of Autozone's debt would likely be the best available alternative to the continuation of the stock repurchasing program. Either way, the evidence s the claim that the best alternative use of the firm's operating cash flows would be the retirement of debt, which could potentially allow them to maintain their investment grade credit rating, making it much easier for the firm to acquire future debt financing if needed (Brenner & Eades, 2012).

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Recommendations for Autozone, Inc. After careful consideration of the evidence that was presented within the case, we have determined that the best use of Autozone's operating cash flow would be the continuance of its share repurchasing program. Because the market views their share repurchases as an indirect dividend, Autozone has been able to steadily improve their share price through the implementation of their share repurchasing program. Any movement away from the non-sticky share repurchasing program would likely be taken as a negative signal in the market, causing investors to lose confidence in the firm. If Autozone were to suddenly alter their strategy and issue a cash dividend, they would have to keep the dividend constant or increase it to satisfy investors, due to the sticky nature of dividends. Autozone has demonstrated over several years that their share repurchasing program has steadily improved their ROIC, which has been the primary driver of their appreciating stock price. In regards to the alternative uses of their operating cash flow, the negative aspects and risks associated with expanding their retail footprint, either domestically or internationally, will likely decrease the value of the firm. That being said, the best alternative use of Autozone's operating cash flow would be the retirement of some of their debt, which would allow the firm to keep their investment grade credit rating. Not only would this make future debt financing much easier should it ever be needed, it would also help eliminate some of their outstanding debt, which has been steadily accumulating over the years. Because of the value the share repurchasing program has provided to the firm's stock price, Autozone would best be served by continuing the program. However, if for some reason they were forced to discontinue the share repurchasing program, the best available alternative for the use of their operating cash flow would be the retirement of some of their debt, due in large part to the reasons mentioned previously. Recommendations for Mark Johnson As a portfolio manager, Mark Johnson would be wise to hold onto his current investments in Autozone, due in large part to the continuation of their stock repurchasing program. Because Autozone has posted a 9.9x interest coverage ratio that has remained steady over the past five years, the use of debt to help finance their share repurchasing program is still 7

acceptable. Assuming some of their operating cash flow is directed towards the retirement of some of their debt, Autozone will still possess an investment grade credit rating, allowing them to continue their share repurchasing program. Another reason Johnson should opt to continue his investment in Autozone would be the fact that their ROIC has increased steadily with their share repurchasing program, proving that the firm is capitalizing and reporting strong earnings in regards to the investment of their operating cash flow. Coupled with this fact, the lagging economy is keeping older cars on the road longer, making the countercyclical nature of Autozone's business profitable. All things considered, Mark Johnson should continue to keep his client's money invested with Autozone, primarily because of the effect their stock repurchasing program has had on their appreciating stock price. References Brenner, J., & Eades, K. M. (2012, July 27). Autozone, Inc. In The University of Virgina: Darden School of Business. Retrieved February 19, 2013, from https://store.darden.virginia.edu/business-case-study/autozoneinc-5492 Brigham, E. F., & Erhardt, M. C. (2011). Corporate Finance: A Focused Approach (Fourth ed., pp. 399-417). Mason, OH: Southwestern Cengage Learning.

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