Monday, September 26, 2011

Research: Autozone AZO's Agressive Accounting

Stay away from AZO. First red flag is the Shareholder equity line. Notice that it keeps dropping every year. So question is, how is AZO showing great revenues, low accounts receivable, positive operating cash flow, but declining Shareholder equity? Solution is in the Issuance / retirement of stock. The largest outflow of money from AZO is due to share repurchases, which was supposed to be a good thing but in this case is borderline fraudulent. The enormous amount of money spent on share repurchases is due to the number of options issued to employees that they have been exercising. This money, which is basically a company expense in the form of employee compensation, is able to stay out of the expenses line on the income statement due to accounting rules. Many companies repurchase stock in order to prevent a dilution of stock. When taken to an extreme, companies repurchase A LOT of stock, with total disregard to whether or not the stock is overvalued or undervalued, for the sole purpose of hiding the dilution of the stock.

As mentioned before, AZO's shareholder equity is declining because they are using their cash to repurchase stock. This is my biggest gripe with AZO. Repurchases are supposed to happen when the stock is undervalued. It's questionable if repurchases should even happen at fair value, in terms of whether or not it will benefit the shareholders.

At a 13bn market cap, negative equity, and 16 PE, it is not obvious that AZO is undervalued. There is enough debate where repurchases should be held off until the decision becomes more obvious. NFLX's forceful repurchase of overvalued stock resulted in the destruction of shareholder equity.

If I had to pick only one that I don't like AZO, it would be because this agressive repurchase strategy. (essentially all free cash is used for repurchases). Even the negative equity doesn't bother me as badly because I know it is a result of repurchases.

With negative equity but positive earnings, I can view AZO as a perpetual annuity with a conservative estimate of 0% growth. A PE of 16 would be too expensive if I look at it this way.

One last thing if you're still not convinced about AZO's risk. Notice that Total Assets are lower than Total Liabilities. This company is insolvent in the event of liquidation. In order for AZO to operate like this, they have to make sure that they can continue to refinance their debts after maturity. It makes things a lot more risky.

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