AZO Q3 Earnings Preview

by Enis September 18, 2012 2:07 pm • Commentary

Update with Correction: AZO reports Wednesday before the open, this post initially said Friday before the open in the first sentence.


Event: AZO reports Q3 earnings Wednesday morning before the open. The options market is implying about a 5% move, which is much higher than the 4 quarter average of 1.5%, and the 8 quarter average of 2.5%.

Sentiment: Wall Street analysts are somewhat bullish on the name, with 15 buys, 8 holds, and no sells. The trading community is relatively bullish as well, with short interest at only 3.5%, near the midpoint of the last year.

Balance Sheet / Fundamentals: AZO is particularly interesting from a fundamental perspective. AZO has produced no free cash flow in the past 5 years. That might be hard to believe when you look at the stock chart, which has basically been a straight line higher since 2009. But all of AZO’s operating free cash flow (after business investment spending) has been used to buy back stock. On top of that, the company has borrowed about $1.7 billion in the debt markets, and used that cash flow to also buy back stock.

In essence, AZO is a much more leveraged version of its 2007 self, with a slightly bigger operation. Its earning per share numbers look much stronger of course, with the lower overall share count, but the operating free cash flow that AZO generates is only about 30% higher than it was 4 years ago. AZO is the classic example of using the company coffer to exit an investment (on the part of Eddie Lampert), as opposed to using the company coffer to invest in the business.

Certainly, it’s been a well-timed move on the part of Mr. Lampert. Here is a chart illustrating his holdings:


As you can see, he disclosed his large stake back in early 2010, and has since sold off most of it as the stock has rallied with the buybacks and the broader market.

Valuation:  AZO is a 16 P/E name, but with a much more leveraged balance sheet than in years past.  Interestingly, the valuation multiple that the market is assigning to AZO is actually higher than it was 5 years ago, which is a bit nonsensical given that AZO’s balance sheet is in worse shape than it was in 2007 because of all of the stock buybacks financed by debt.  Here is the chart of the P/E ratio over the past 5 years:

[caption id="attachment_16833" align="aligncenter" width="502" caption="AZO 5 yr Price to Free Cash Flow from Bloomberg"][/caption]

Price Action:  Even with its modest pullback over the past 4 months, AZO is still solidly up on the year.

The 5 year weekly chart shows that the stock has maintained its long term uptrend, though it’s testing the lower end of its bull-market trend channel:

[caption id="attachment_16834" align="aligncenter" width="490" caption="4 yr AZO chart from Bloomberg"][/caption]


Volatility: September vol is pumped (60’s) with earnings so close to expiration, October is high historically but that’s not saying much as it’s only in the high 20’s. October vol will likely fall after earnings, how much is hard to say, but probably into the low 20’s.

[caption id="attachment_16837" align="aligncenter" width="581" caption="HV vs IV from LiveVol Pro"][/caption]


My View: AZO has been an incredibly strong performer over the past 3 years.  The company has performed well in its underlying business, but not nearly to the extent that the stock would suggest.  I think it is a good example of a savvy investor leaving others to hold the bag after he’s taken his cut.  However, AZO has been a very low mover on earnings historically.  So I would be more inclined to fade the earnings move in Sept, and set up for a bearish play further out.  The Sept / Dec 350 put calendar for around $10 looks interesting as one potential play.