AutoZone Tesla Pair Trade Refresh: Time to Book Profits? (NYSE: AZO) (NASDAQ: TSLA)

MCCAIG

Pair Trade Review

Seeking Alpha challenged contributors in June 2022 to submit articles featuring two actions that share a common thread; one to buy and the other to sell or sell short.

The youthesis I submitted suggested this Auto Area (New York stock market :AZO) the stock would outperform Tesla (NASDAQ:TSLA) stock for several reasons. Both companies are auto-related and are heavily impacted by economic downturns, consumer spending, interest rates and inflation, but in very different ways. I will discuss both stocks in detail below.

After more than four months, AutoZone stock has outperformed Tesla stock by 22%, as shown below. AutoZone also crushed the S&P 500, while Tesla fared roughly evenly.

Chart
Data by Y-Charts

One of the reasons Tesla stock rose in August and September before falling back to Earth was almost certainly due to its planned stock split, as shown below with the split date listed.

Chart
Data by Y-Charts

Upcoming stock splits tend to support stocks with a high level of interest from individual investors, but the hype wears off fairly quickly. Here is what I wrote in the June article:

The upcoming 3 for 1 stock split may provide a small spark, but the effects of stock splits usually don’t last. The stock quickly retreated towards its price on the announcement date after the 2020 stock split, then the stock took off thereafter with the success of the company.

Many things have changed since June. The Federal Reserve raised interest rates twice, both companies reported profits, inflation remained stubborn, and Musk completed the purchase of Twitter, among other things.

AutoZone’s valuation also increased significantly. Is it time to change the thesis?

Why did AutoZone’s stock crash?

In April 2022, I wrote that AutoZone could benefit from inflation. The stock has outperformed the S&P 500 by 26% since then. AutoZone benefits as drastic increases in new and used car prices encourage people to keep their current vehicles longer. That means more parts and more repairs.

The graph below shows the extreme rise in vehicle prices.

Chart
Data by Y-Charts

AutoZone crushed market returns coming out of the Great Recession for this reason, as shown below.

Chart
Data by Y-Charts

AutoZone CEO Bill Rhodes puts it this way:

…over the past 30 years, there have been four major shocks to the economy. In each of these four shocks, our performance and the performance of our industry have taken a significant step forward. During these shocks – recessions and pandemics… our business has grown and never retreated.

Bill Rhodes, Chairman, President and Chief Executive Officer, on the Third Quarter 2022 Earnings Conference Call.

Stellar income

AutoZone’s earnings in the fourth quarter of 2022 were spectacular. Sales increased 9% year-over-year (YOY) and comparable store sales increased 6.2%.

Management has handled rising costs exceptionally well. Gross profit margin declined only nominally from 52.8% in fiscal 2021 to 52.1% in fiscal 2022, and operating margin was even. Diluted earnings per share (EPS) increased 23% from $95.19 to $117.19.

AutoZone spent $4.4 billion on stock buybacks in fiscal 2022, reducing the number of shares by 2.2 million, a reduction of more than 9%. This is exceptional. The stock’s average purchase price was $1,964, well below Friday’s closing price of $2,543. The effect of future redemptions will be less with this high share price.

Is the stock overvalued now?

I still believe in the long-term investment opportunity of AutoZone stocks; however, as of Friday, I no longer own any shares. The valuation is not attractive at this level for three main reasons:

  • Last week’s rally put the stock near its highest price-to-earnings (P/E) ratio in a decade, as shown below.

Chart
Data by Y-Charts

AutoZone is not a growth stock. Therefore, it is easier to evaluate using traditional metrics. The big question is, “would I buy stocks at this level?”. The answer is no.

  • Share buybacks will be weakened. AutoZone relies heavily on stock reduction to increase earnings per share and investment value. I love buyouts. But fewer shares will be repurchased at this level, which could dampen EPS growth in 2023.
  • Management did a wonderful job controlling costs last year. Margins remained impressive despite rising fuel, labor and other costs across the economy. Something has to give. I expect at least moderate pressure on margins in the coming year.

I strongly believe in letting your winners run; however, that doesn’t mean being stubborn when a title gets ahead of itself.

The stock’s momentum may continue, but I expect to be able to return to a lower price in 2023.

And Tesla?

Tesla is a revolutionary company. His rise is meteoric and the company will be very successful for a long time.

But that doesn’t make the stock a buy for me right now. It is essential to separate the company from the stock. Just like above with AutoZone. I like the AutoZone results, but not the stock price.

Tesla’s macroeconomic situation couldn’t be much worse. Brimming with competition, a slowing economy, inflation leading to higher interest rates and the destruction of demand weigh heavily.

We haven’t seen a significant decline in inflation since June, and the Fed seems determined to maintain its current path. There’s talk of a “Fed pivot” away from the rate hike, but many professionals don’t see it until late 2023.

Elon Musk has been a vocal critic of Fed policy for good reason. Rate hikes and demand destruction are bad for Tesla’s business. musk too Express fear that the Fed is risking deflation by continuing with its current policy and asserts that the Fed is looking back rather than forward:

“Fed decisions make sense if you look in the rearview mirror, not if you look out the windshield,” Musk said.

He has a point. There are strong arguments that the battle against inflation should be fought more on the supply side (investing to increase supply, which lowers prices) than by curbing demand. There is a legitimate risk that the Fed will exceed the limits. But don’t expect it to move.

Interest rates and inflation negatively affect Tesla stock in several ways, including lower consumer demand, pressures on margins, and the stock’s valuation model.

Consumer demand

Tesla makes a great product and the stock price is destined for massive growth. However, consumers have already seen nearly two years of rapidly rising prices. Budgets will continue to tighten, and Tesla has raised its funding rate.

Consumer sentiment is the best predictor of future consumer spending and is still below its pandemic and Great Recession lows.

Chart
Data by Y-Charts

Again, something has to give.

Margin pressures

Tesla has margins that most other automakers can only dream of. But they are under pressure. Third-quarter sales increased 55% year-over-year. Such massive growth should lead to efficiency gains. Tesla has done an admirable job of controlling costs, including raising prices, as has AutoZone; however, the trend is downward. Automotive gross margin peaked in the first quarter and has lagged since, as shown below.

Tesla Stock

Data source: Tesla. Table by author.

Unlike AutoZone, Tesla is still a high growth stock and harder to value. Rising interest rates lower the valuation of growth stocks on Wall Street because future cash flows are less valuable. This could put more downward pressure on the stock.

The bottom line

Tesla and AutoZone are quality companies with a bright future. Electric vehicles will soon be the norm rather than the exception. The market will swell, but serious competition is coming from all sides, as well as macroeconomic headwinds.

AutoZone could be a net beneficiary of inflation and has historically outperformed in times of economic weakness. But the stock’s recent rise brings it close to its highest P/E ratio in a decade.

Although each company has a bright future, neither stock is an attractive investment given current conditions and prices.