Shares of automotive aftermarket parts and accessories retailer Autozone (NYSE:AZO) are outracing the broader market so far this year. While the S&P 500 index has tacked on a respectable 11% in the first five months of 2019, Autozone stock has appreciated nearly 25%. 

During the company's fiscal third-quarter 2019 earnings conference call on May 21, CEO Bill Rhodes discussed both near-term success factors and challenges for the remainder of the fiscal year. Below, we'll walk through three quotes from Rhodes' commentary that highlight both opportunities and risks in the months ahead.

Assorted automotive parts on a white background.

Image source: Getty Images.

Sales begin with customer service

It's imperative to remember the high touch nature of this business and the vital role our highly knowledgeable AutoZoners [Autozone employees] play to help our customers maintain and enhance their vehicles.

As a physical store-based retailer with some 6,300 locations, Autozone understands the importance of engaged and knowledgeable customer-facing employees. Superior customer service engenders repeat business while helping to rebuff threats from direct competitors -- and also Amazon.com, which has recently ramped up efforts to gain aftermarket auto parts market share.

Rhodes tied the company's admirable comparable sales growth in the third quarter of nearly 4% to a recent wage adjustment last fall for the company's "most tenured" employees, to ensure that Autozone's compensation was competitive within its market. 

In addition, Rhodes observed that management is focused on increasing the engagement of store teams with customers. This manifests in a directive that has even store managers and district managers making customer service calls, which, Rhodes notes, are also in effect sales calls. 

In essence, in the auto parts and accessories business, healthy sales rely on personalized customer engagement, and Autozone is marshaling resources to ensure that knowledgeable employees maintain close and frequent interactions with retail and commercial customers.

A strategy for dealing with escalating tariffs

Over the course of the last year or so, there has been significant focus on tariffs and inflation. After months of being in a steady state, the United States increased tariffs with China recently. When the first tariffs went active in September, [we were] able to negotiate many of the increases away due to the change in the Chinese currency. As the additional tariffs were just added, it is too early for us to know the implications.

While it may be too early for Autozone to assess the implications of rising tariffs as a consequence of the U.S./China trade dispute, Rhodes made clear during the call that Autozone intends to pass on the impact of rising costs to customers. 

Rhodes explained that Autozone's retail parts prices have increased at mid-single-digit levels over a period of years, due to factors such as better technology or improved components (which make parts last longer).

The company's actual cost inflation, however, has been more muted. New products are initially made in low quantities. With consumer uptake, production scales at greater efficiency, easing the pressure on costs. This bears on both brand-name parts and private-label parts Autozone contracts from manufacturers.

Thus, when you take into account historical retail price inflation for customers and subdued cost inflation on Autozone's books, the inference is that Autozone's total price increases to customers have been within acceptable bounds over the years, and that it has some room to initiate tariff-based price increases.

The company will, of course, have more data in hand over the next couple of quarters, but for now, management appears confident that customers won't react with sticker shock at an initial round of pass-through price escalation.

Network expansion will pave the way for more retail and commercial growth

When we originally launched our mega hub initiative, we said we felt we could open 25 to 40 mega hubs domestically, and as we've said every time we have discussed their performance, they have outperformed our expectations. Today, as a result, we are expanding our expectations for long-term mega hubs to 70 to 90 in the United States.

Along with customer engagement, inventory availability and speed of delivery are pillars of the automotive parts business. Commercial customers especially prize the ability of a parts vendor to place and deliver parts within hours. 

To this point, Autozone has invested aggressively in network expansion to provide a wider variety of inventory to stores. The company now has 174 hub stores as inventory distribution points, as well as 28 "mega hubs." Autozone has opened 8 new hubs this year and plans to open at least 3 more mega hubs before year-end.

By more than doubling the expected number of mega hubs it can open over the long term, Autozone is projecting that it can grab a much larger share of the automotive parts market than the 3% it currently claims. In addition, a more robust network of mega hubs reveals the organization's ambitions to grow its commercial business. Currently, approximately 85% of Autozone's U.S. stores have a commercial program catering to mechanic and repair shops, and this group could benefit from even greater parts variety. 

Finally, beefing up its distribution network helps Autozone protect its business from the looming threat of Amazon by sharpening its delivery edge to commercial customers. In the parts business, swift delivery of items to mechanics is almost as important, and sometimes more important, than price.