Why is AutoZone chasing your clunkers?

Covestor model: Tortoise and the Hare

Disclosure: Long AZO

This is the third in a series on how some businesses can prosper in a stagnating economy. See also: Entertainment Stocks: Selling Dreams to the Have-Nots and Extreme Value Stores: Occupy the Poor in the same series.

Personal injury lawyers are nicknamed “ambulance chasers” because they hear “ka-ching” when someone gets hurt in an accident. For a similar reason, DIY (Do It Yourself) auto shops, which sell you replacement parts, are equally happy to see more of your vehicles break down or in need of repair.

Why do I like to invest in DIY auto shops in this poor economy? Let me first give you two shocking numbers:

(1) The average age of the cars and trucks on U.S. roads hit a record 10.8 years as of July 1, 2011, as worries about job security kept many people from buying new vehicles.

(2) According to Polk, there are 240 million light vehicles on U.S. roads. As less than 14 million new vehicles a year are being sold right now (and about 16.5 million a year in the pre-recession peak), average vehicle age is not declining anytime soon.

In other developed countries, because of high taxes on cars and gasoline, which raise total ownership costs, cars owners tend to come from the more affluent segment of the society. In the US, a car is often a necessity and most cars are driven by poor people as a means to get to work. Therefore, it is reasonable for us to expect that:

(1) They are less likely to purchase a new vehicle in this poor economy. They will hold onto their clunkers and drive on.
(2) They have to maintain their cars and fix them when they break down, otherwise they would not be able to get to work.
(3) Short in cash, people are more likely to DIY than going to a full-service garage shop.

Who's going to benefit from this trend?

I would say the job is cut out for DIY auto shops such as AutoZone (AZO) and Advanced Auto Parts (AAP).

In fact, the sweet spot for the industry is vehicles 4 to 12 years old, that is, too old to be covered by an original warranty but too young to be sent to the scrap yard.  If you happen to own a 7-year-old car, they see dollar signs all over you.

But wait, there's more. I see two near-term catalysts, and two medium-term potential bonus points.

First let me serve you two recent catalysts:

(1) Potential buyout target

On Monday (1/30/2012), full service auto repair shop Pep Boys agreed to sell itself to the Gores Group, that values the company's stock at about $804 million, a 24% premium to Friday's closing price.

The event can draw investors' attention to this sector, and as they scrutinize the sector they may start to realize that Autozone would provide an even better value in this poor economy, because consumers may switch from full service shops such as Pep Boys to DIY shops such as AutoZone in order to save money.

Both AutoZone and Pep Boys count hedge funds as their largest shareholders, and hedge funds are certainly more open to buyout offers. Basically, the Pep Boys buyout is going to bring attention to a company that would love to see more attention from higher bidders.

(2) Motivated sellers

AutoZone's largest owner, Edward Lampert (through ESL Investments,which also is the largest owner of the beleaguered retailer Sears Holdings) has almost cut his stake by half in recent months. He didn't sell much in the open market. Instead, the shares were distributed to his clients as in-kind payments in the closing of one of his investment partnerships and the restructuring of another, as well as to meet year-end redemptions from his main fund, ESL Investments.

Understandably, some of these clients may decide to liquidate the shares they received simply because they don't like to personally manage a stock portfolio. Normally, when we buy a stock, we always have to worry whether the seller knows something negative that we are not aware of, otherwise “why would he sell to me?”

In this case, we know that some of the recent selling pressure comes from “motivated sellers” who do not necessarily have negative views on the company, and we expect that over time the pressure is going to subside. In other words, we feel less suspicious when buying a house from a “motivated seller” who's moving to a different city for work than from someone who's moving to a similar house just two blocks away.

Finally, there are two medium-term bonus points that we can hope for but can't count on:

(1) Decline in gasoline price: People drive more miles when gasoline is cheaper, and more mileages driven lead to increased demand for maintenance and replacement parts. Incidentally, AutoZone can also double as a hedge for those investors with long exposures to the energy sector.

(2) Strengthening US Dollar: If the economic situation in Europe continues to worsen, investors may increasingly place a premium on businesses with less foreign exposures. AutoZone is mostly a domestic operation, with only a small presence in Mexico, and therefore may look attractive to those flight-to-safety investors searching for counter-cyclical assets at home.

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