Alarmed at AutoZone

Investors worry neglect of sales growth is catching up with the retailer.
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The departure of Steve Odland from

AutoZone

(AZO) - Get Report

in March, which coincided with an alarming drop in the retailer's same-store sales, raised red flags on Wall Street.

Now those flags are blowing a little more briskly.

Odland, who became the auto parts chain's chairman and CEO in early 2001, presided over a 300% run-up in AutoZone's stock. Handpicked by shareholder Ed Lampert of ESL Investments, Odland obsessed over profits and growing cash flow through cost control. But critics said he did too little to ensure long-term growth.

Since he left to embark on another cost-cutting mission at

Office Depot

(ODP) - Get Report

, AutoZone's same-store sales, which were flat in 2004, have begun to decline. The stock has shed almost 14%. In its fourth-quarter earnings report, released Wednesday, AutoZone reported a pick-up in selling expenses -- an apparent attempt to stem the sales trend. But the investment has yet to bear fruit, and it's starting to eat into the company's profitability.

AutoZone's earnings fell 1.3% for the quarter from the year-ago period, when the company booked gains from warranty credits. It booked profits totaling $206.6 million, or $2.66 a share, in the quarter, compared with $209.4 million, or $2.53 a share, a year ago (share buybacks accounted for the higher per-share earnings). Its sales rose 2.2% to $1.88 billion, while its same-store sales, or sales at stores open at least a year, declined by 1%.

Analysts on Wall Street were expecting earnings of $2.84 a share on sales of $1.88 billion. Shares of AutoZone were recently trading down $5.40, or 6%, to $84.87.

"The rise in selling costs and the decline in profit margins is the main reason the market is disappointed by this," said Morningstar analyst John Owens.

AutoZone's operating expenses as a percentage of sales rose to 30% from 29.4% a year ago. Capital expenditures rose mroe than 30%, but the company only opened three more new stores than in the same quarter last year. Meanwhile, its operating margin decreased 116 basis points from last year to 18.7%, while operating profit decreased 3.5%.

"The increase in operating expenses reflected efforts to improve the customer shopping experience, from expanding hours of operation to ensuring stores were properly merchandised and well presented," the company said in a statement.

In another troubling sign, the retailer's cash flow before share repurchases was down 28.8%. Credit Suisse First Boston analyst Gary Balter said the drop was a result of AutoZone's underinvestment in infrastructure over the last five years. The decline in cash meant that the company had less money to buy back shares and boost its EPS.

On a conference call with analysts, AutoZone's new CEO Bill Rhodes acknowledged that the results were disappointing, but he stressed that the company would not change its strategy.

"This quarter we experienced some improvement in our sales trends, but we're still not satisfied," Rhodes said. "We have not and will not deviate from our efforts to optimize long-term shareholder value."

AutoZone's focus on cash flow and profitability as a means for generating long-term value is a philosophy brought by Lampert, who employed similar techniques in reviving his biggest investment, Kmart. Now, after orchestrating the merger of Kmart and Sears, the hedge fund guru is expected to work his magic again at the new company,

Sears Holdings

(SHLD)

.

One common thread at Lampert companies, along with growing profit margins and shareholder returns, is sales deterioration and a steady loss of market share -- the very symptom that is now sowing the seeds of doubt at AutoZone.

Investors were impressed by Lampert's ability to restore Kmart to consistent profitability less than a year after it emerged from bankruptcy. But along with improved profits, Kmart posted consistently lower same-store sales as its powerful rivals, like

Wal-Mart

(WMT) - Get Report

and

Target

(TGT) - Get Report

, built market share.

Critics said the situation was unsustainable; nevertheless, Kmart's shares soared. While Lampert's boosters had the last laugh, boasting 500% returns on their investment in less than two years, the argument was never really settled, because Kmart was eventually folded together with Sears, another market-share loser whose shares also were pumped up by real estate speculation.

The jury is out on the resulting $11.5 billion merger, which formed the third-largest retailer in the world. On its face, it makes sense for retailers to seek economies of scale in order to compete with larger rivals. When the deal was announced, Lampert estimated that the merger could produce $500 million annually in profit improvements and $300 million in cost savings.

Still, shares of Sears Holdings continued to be driven by speculation that a series of asset sales will one day unlock hidden value on the company's balance sheet. The stock vaulted to a high of $163.50 in July after CSFB's Balter slapped a $180 price target on the stock. Since then, quarterly earnings reports have served as a grim reminder of the difficulties posed by merging two ailing retailers into one company. The stock has plunged more than 25% since the beginning of August.

Its second-quarter earnings report showed a 0.3% decline in same-store sales at Kmart stores and a 7.4% drop at Sears. Lampert responded by assuming a greater role in the daily operations of the company. He took responsibility for "directing the marketing, merchandising, design, and on-line businesses of Sears Holdings, as well as Lands' End, to ensure that these initiatives are clearly focused on responding to customer needs."

In another sign of dissatisfaction, he replaced Sears' chief executive, Alan Lacy, with Aylwin Lewis, the former chief executive at Kmart.

Unless Lampert unveils long-awaited plans for asset sales soon, Sears investors might get impatient with the company's sales declines amid soaring gasoline prices and fears that consumers face a spending slowdown. Profit margins can improve only so much; eventually, a retailer needs to invest to shore up its competitive position.

Back at AutoZone, Rhodes assured analysts that the company's newfound willingness to invest in the business would eventually pay off.

"Investments that we make into customer service are going to take a while to surface," he said, estimating that AutoZone could demonstrate improvements in six to nine months.

In the meantime, shareholders can find solace in the retailer's profit metrics, which continue to lead the industry.

"It's important to keep in mind that on an underlying basis, AutoZone is delivering 18% operating margins and $248 in sales per square foot," said Morningstar's Owens. "No one else in the industry is anywhere near those metrics. In the long run, AutoZone is still well-positioned to still generate long-term profit."

Still, he said, the company will eventually have to reverse its sales trends. If that never happens, investors may wish they had bolted in March with Odland.