AutoZone: The Real Cost Of Stock Compensation
AutoZone revealed a stunning fact in its September earnings call:
“We have bought back over 100% of the then outstanding shares of stock since our buyback inception in 1998, while investing in our existing assets and growing our business.”
In 1998, the year AutoZone began its repurchase program, the company had 152 million shares outstanding. AutoZone has since repurchased a total of 154 million shares at an average price of $219, for a total investment of $33.8 billion. Shares outstanding fell 8.2% per year, on average. The average repurchase price is 91% lower than AutoZone’s current $2,500 per share price.
This is incredible from a variety of perspectives. First, it is an example of excellent capital allocation. Second, it implies that AutoZone has been structurally mis-priced for decades. Third, AutoZone’s $46 billion market capitalization shows the true cost of stock compensation.
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Capital Allocation
Since the beginning of 1998, AutoZone has earned $25.6 billion of total net income and spent $33.8 billion on repurchases. The company also grew sales at a 7.0% CAGR and pre-tax earnings at an 8.8% CAGR.
How is that possible?
AutoZone is extremely capital light. Tangible capital employed (TCE) increased $1.9 billion between 1998 and 2023. That supported an increase in pre-tax earnings of $2.6 billion per year.
High incremental returns on invested capital fueled a respectable 8.8% growth rate while leaving virtually all profits available for buybacks.
AutoZone’s steady, non-cyclical cash flows allowed the company to borrow money as it grew to maintain its leverage. Leverage, negative working capital, and low capital intensity allowed AutoZone to grow and while spending nearly 100% of earnings on buybacks.
Structural Mispricing
One rough way I think about the stock market is that most investors expect to earn about 10% per year. This is roughly the S&P 500’s long-term average return. The average business reinvests about half of its profits at a 14% ROE and pays out the other half at a 16x P/E. That’s 7% growth (0.5 x 14%) plus 3% yield (0.5/16) for a 10% total return. Roughly right, if precisely wrong.
In an efficient market, active investors would buy companies priced for higher forward returns and sell companies priced for lower forward returns. Every stock’s forward return would converge toward 10% per year.
Of course the stock market isn’t perfectly efficient. AutoZone has compounded at 19% per year since 1998 despite slight multiple contraction (21x to 17x, 0.8% per year). AutoZone’s growth plus yield has averaged almost 20% per year, double the “fair” market rate.
The only way AutoZone could have managed such stunning growth is if its stock was consistently undervalued. In an efficient market, AutoZone would have traded at a much higher P/E ratio. A higher multiple would have reduced AutoZone’s buyback yield from 8% to 2-3% and reduced the stock’s CAGR from 19% to 10-11%.
The lesson? It is short-sighted to root for multiple expansion if your investments are returning a lot of capital. A low valuation allows for a high yield which can turn a modestly growing business into a serious compounder.
The True Cost Of Stock Compensation
If AutoZone has repurchased 100% of shares outstanding in 1998, then it follows that AutoZone’s $46.5 billion market cap is entirely the result of stock compensation issued since then.
There are a few points I want to make about this. First, stock compensation is a real cost. I don’t think that’s a contentious topic among EPC’s readers, so I won’t belabor the point.
However, it’s still standard practice to present adjusted EBITDA net of stock comp. Even AutoZone does that. Adding stock comp back to EBITDA is okay as a measure of allocatable capital. It’s wrong when it's taken as a measure of earnings.
Second, stock comp is fine when it aligns management with investors. AutoZone’s stock comp has never been egregious. It’s always been tied to ROIC. Good comp metrics need a numerator, like earnings, and a denominator, like invested capital.
Third, despite issuing shares every year, AutoZone still repurchased 8.2% of its shares, net. The repurchases were actually more, but were offset by stock comp. Investors need to look at the net repurchase, not the gross number most companies report.
Alphabet is an example of a company that buys back a lot of stock but also issues a lot of stock. Net, shares outstanding don’t fall much. Shares outstanding peaked in 2018 and have declined 7.6% since, a 2% CAGR. Alphabet spent $159.1 billion for this reduction, which averages out to paying 149.83 per share. That’s near Alphabet’s all-time high. The stock has hardly ever traded there. Most of Alphabet’s buyback program really just pays for its stock comp.
Capital “Leakage”
While I admire AutoZone’s capital allocation and wish more companies followed in its footsteps, I can’t help but imagine where the stock would be if the company didn’t issue stock comp. Companies like Berkshire Hathaway and Constellation Software are remarkable because they have almost not capital allocation “leakage.” They pay their employees in cash so that their share count holds steady.
These are some of the best performing stocks of all time, so I don’t buy the idea that employees need to be paid in stock so that they feel they have skin in the game. Skin in the game is different when you’ve spent your own money on shares versus when you’ve been given shares.
Stock comp may be appear fairly valued on the day it is given or vested but AutoZone shows how expensive even reasonable compensation can become when the company successfully compounds for several decades. Cash compensation would eliminate the leakage from issuing undervalued shares.
Do you have a “stranded” 401(k) from a past job that is neglected and unmanaged? Eagle Point offer separately managed accounts to retail investors, and 401(k) rollovers are often a good fit for our long-term approach. If you would like to invest with Eagle Point Capital or connect with us, please email info@eaglepointcap.com.
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I stopped by an AutoZone the other day since I needed to buy a new taillight assembly for my car and they told me to buy it off Amazon since I’d get it faster and that it would be cheaper as well. They were right it was 120 on Amazon versus 210 at AutoZone, but the delivery timeframe was about the same.
I think part of this is they don’t specialize as much in exterior body stuff like taillight assemblies, but I thought it was an interesting data point. The sample size is one customer transaction at one store so you can’t really draw conclusions, but it did get me wondering about the long-term threat from eCommerce on AutoZone and how this could potentially change their capital allocation strategy.
I’d say as an investor the more uncertainty there is about a companies potential future the more I prefer dividends and special dividends over buybacks as buybacks increase the percentage of the total return that is reliant on the terminal value of the business at the end of the holding period. For many of my midstream investments even if the terminal value of these assets is zero in 2050, I’ll have received so much cash from these assets it doesn’t matter a ton in my opinion.
On a related note I’d love to see a blog post with your thoughts on the midstream sector. The industry seems to be consolidating and there is an increased focus on capital returns with what seems like generally low valuations. There also seem to be barriers to entry in terms of the difficulty combined with a lack of desire for large greenfield pipeline projects combined with what appear to be a decent number of high ROIC incremental expansion opportunities available to many midstream companies.
That EBITDA is shown net of stock compensation is testament to the corporate influence on FASB accounting rules. These rules create cover for self dealing management teams to throw unsophisticated investors off the truth (or under the bus).
That said, Performance based restricted stock awards (RSU’s) should be designed to create incentives for high performing employees to stay. While senior management loves to abuse this by rewarding themselves even in times of mediocrity, RSU’s do encourage retention in the ranks.
From the employee perspective RSU’s are both a form of compensation but also a stake in the continued price appreciation of a companies stock. By nature of their restrictions they also creat a hurdle for competitors to lure away high performing employees and an incentive for low performers to jump to those same competitors.
The takeaway is when evaluating a company it is valuable to understand how stock awards are administered and not simply view them as a line item to adjust. Figuring out how this is administered may be as simple as asking or may be intentionally hidden by management to avoid scrutiny. Companies that use RSU’s to encourage performance and retention are more likely to provide more transparency given that information needs to be disseminated widely among employees to gain the greatest effect.