Dueling Fools: AutoZone Bull

To get this Duel started, answer a question for me, please. What is investing?

Is it making money? Is it buying growth stocks whose prices increase? Those aren't bad definitions, but I think they are a bit narrow. I would define investing as allocating capital to the highest returns possible for the least amount of risk.

Part of the problem is that, on a daily basis, the stock market is just a voting mechanism, and prices fluctuate for many reasons. Over the long run, the market is a weighing machine rewarding companies that allocate capital to the highest possible returns.

Again, it's not a great story or growth prospects or rising prices; it's generating the best returns on invested capital (ROIC) that wins over time. And that's why I think automotive parts retailer AutoZone (NYSE:AZO) is misunderstood.

The magic formula
Auto-parts retailers are not, by any stretch of the imagination, in a growth industry. Cars are mature, and there are plenty of competitors like Advance Auto Parts (NYSE:AAP), O'Reilly (NASDAQ:ORLY), and Pep Boys (NYSE:PBY). But AutoZone has a magic formula for creating higher returns than its competitors and for sharing those returns with shareholders. Interested? Here it is:

Management spends time and money on improving stores and operations rather than opening lots of new stores. These investments increase margins. Rising margins (operating margins have improved from 14.5% in 2002 to 17.3% in 2006) and Foolish use of capital increase ROIC. To make sure shareholders receive the benefits of productivity, the company reallocates capital to repurchasing shares. Why? Because AutoZone generates great ROIC. And if you remember from the beginning of this article, investing is all about allocating capital to the highest returns with the least possible risk.

For proof, here's a table comparing ROIC.

AutoZone's fiscal calendar goes from September to September. That's why comparisons only go through FY 2005. However, FY 2006 was another good year for AutoZone, as it generated a return of 27.4%.

My numbers don't make any adjustments for rent expenses associated with operating leases. Fortunately and Foolishly, management provides those numbers in its earnings releases. For the last two fiscal years, adjusted ROIC has been 22.2% and 23.9% respectively. Those returns are still very impressive.

Those great returns are what prompt management to keep allocating free cash flow to share repurchases rather than higher growth. With a huge base of stores already out there, it's operational productivity, not opening lots of new stores, that creates value.

And as you can see from the table above, management is allocating as much capital as it can to repurchasing shares as operational improvements are made. That's because operating improvements create value for shareholders, while share repurchases capture that value for them. Kudos to management for working in the best interest of shareholders!

Can this model continue? As long as there are shares outstanding and people willing to sell out, the answer appears to be yes. What about its debt-to-capital ratio, you ask -- isn't that going to get out of hand? That's a great question. It's already very high -- about 80%. However, the company's interest coverage ratio, EBIT/interest, is very strong at 9.2 over the trailing-12-month period. Let's put it this way: The company is not in much danger of missing any interest payments. And should the debt-to-capital ratio climb back into the 90% range again, management can simply suspend the share buybacks for a bit and pay down its debt.

So we have a mechanism for creating value for shareholders. Are shares attractively priced today? Using a simple thumbnail DCF calculation, the implied rate of growth is 3% forever, assuming the company maintains its share reduction at 6% per year. If the company can average 5% growth, the stock is 25% undervalued.

I am not the only one who finds this model intriguing. Not only is AutoZone an Inside Value selection, the following investors also like the way the company creates value for shareholders: Eddie Lampert, Pzena Investment Management, and Maverick Capital. Trust me, these guys understand that capital should flow to the highest returns for the least amount of risk.

Wait! You're not done. Go back and read the other arguments, then vote for the winner of this week's Duel.

Retail editor and Inside Value team member David Meier is ranked 288 out of 16,877 in CAPS and does not own shares in any of the companies mentioned. You can view his TMF profile here. The Fool takes its disclosure policy very seriously.