VALUATION MODEL

Elizabeth Acosta- elizabeth.acosta@ttu.edu

Zack Frewin- zackary.t.frewin@ttu.edu

Reagan Harper- reagan.harper@ttu.edu

Win Johnson- wj.johnson@ttu.edu

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AutoZone Table of Contents Executive Summary……………………..pg.2 Company Overview............................pg.4 Five Forces Model……….....................pg.5 Industry Classification……….………...pg.14 Value Chain Analysis…………………….pg.16 Competitive Advantage Analysis……..pg.18 Key Accounting Policies……………...…pg.20 Accounting Flexibility……………………pg.22 Evaluating Accounting Strategy………pg.25 Evaluating Quality of Disclosure……...pg.27 Identify Potential “Red Flags………….pg.32 Undo Accounting Distortions………....pg.33 Ratio Analysis………………………….….pg.36 SGR & IGR Analysis………………….…..pg.48 Forecasting………………………….……..pg.49 CAPM Model……………………….……….pg.56 WACC…………………………….…………..pg.58 Valuation Models…………….……………pg.59 Analyst Recommendation………………pg.64 Appendix…………………………………....pg.65 Works Cited……………………………......pg.74

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EXECUTIVE SUMMARY

Investment Recommendation: Overvalued, Sell

AZO-NYSE $133.19 EPS Forecast 52 Week Range: $83.81-$137.66 FYE 8/2006 8/2007 8/2008 8/2009Revenue(2006):$5,948,360,000 7.57 9.06 10.16 11.39Market Capitalization: $10.02B Ratio Comparison AZO ORLY AAP Shares Outstanding:75,240,000 Trailing P/E 13 16.47 18.57Dividend Yield- N/A Forward P/E 9.97 14.42 13.973-month Avg Daily Trading Volume:545,025 M/B 14.47 16.93 4.09Percent Institutional Ownership: 90.02% EnterpriseValue/EBITDA 10.23 12.06 9.08Book Value per share(mrq): 7.774 ROE: 146% Valuation Estimates ROA: 13% Actual Price(as of 4/07): $128.98 Estimated 5 yr EPS Growth Rate: 33.3% P/E Trailing: $132.56 Cost of Capital Est. R^2 Beta Ke P/E Forward: $107.41 Ke Estimated 17.40% Enterprise Value: 11.09B 10 Year 0.43770 2.268 17.46% M/B: $65.59

7 Year 0.43772 2.267 17.44%Enterprise Value/EBITDA: $12,166.19

5 Year 0.43771 2.267 17.45% 1 Year 0.43753 2.263 18.54% Intrinsic Valuations 3 Month 0.43757 2.261 18.92% Discount Dividends: N/A Published Free Cash Flows: $143.73 Kd AZO: 6.06% Residual Income: $35.42 WACC AZO: 13.2% Abnormal Earnings Growth:$45.13 Altman Z-Score AZO: 5.88

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Executive Summary

After researching AutoZone and its competitors in the auto parts industry, we

have a knowledgeable understanding of how AutoZone performs and operates.

AutoZone auto parts is one of the largest auto parts retailers in the world.

AutoZone is considered a cost leader and has built a reputation with excellent

customer service in the industry. Their main focus is on customer service to

differentiate themselves from competitors. The main competitors within the auto

parts industry are O’Reilly and Advance Auto Parts. AutoZone satisfies all the key

success factors and highly out performs its competitors in the auto parts industry.

The industry is based on finding innovative techniques that will keep new firms from

entering the industry. The industry is also based on having strong-reliable

relationships with suppliers and brand recognition to survive and compete in the

industry. The auto parts industry carries identical products making it hard to

differentiate the product so mostly competing on price and customer service.

When looking at AutoZone’s accounting policies, we can come to a conclusion

that AutoZone utilizes a mixed accounting strategy while preparing its financial

statements maintaining the generally accepted accounting principles (GAAP).

AutoZone uses a conservative approach by stating higher cost of goods sold and

lower pre-tax income for tax reduction purposes and also uses an aggressive

approach when stating impairments. The key success factors that AutoZone utilizes

are inventory management, keeping low costs by establishing supplier relationships

and investment in brand image in the retail industry. The quality of disclosure on

AutoZone’s financial statements helps analyst understand what is going on in the

company and where the numbers come from in the 10-K. By running the

AutoZone’s sales and expense ratios, we were able to discover any potential “red

flags” in the 10-K. Goodwill has maintained consistency for the past years leading to

a potential problem of overstating assets. Another problem was pertaining to

operating leases and pension plans where AutoZone is underestimating their

liabilities. The affect of using the FIFO method, we believe overstates cost of goods

sold.

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After computing ratios for AutoZone, we gained more knowledge and insight

about the company and how it compares to its competitors in the industry. Overall,

by evaluating AutoZone’s liquidity analysis, they showed to that they are not highly

liquid. The operating efficiency has stayed steady for the past three years, which

may decline in the future due to competitors. All of the profitability ratios decrease

in 2006. Even though the ratios decreased, AutoZone has experienced a positive

effect to the firm’s profitability by taking the total change over the past five years.

Even though AutoZone’s numbers has decreased in the past year (more than likely

due to competitors), they are still better than their competitors in the auto parts

industry.

In our ten year forecasts, we were able to see where AutoZone would be in

the future. Based on our past results and our best forecasted estimates, we were

able to see that AutoZone will have a steady growth in the upcoming years. The

forecasted numbers are important because it is one of the main factors when

valuing the company.

In our analysis of AutoZone, we have come to a conclusion that AutoZone is

an overvalued company. We ran several valuations such as Residual Income Model,

Abnormal Earnings Growth, Free Cash Flows and the Method of Comparables.

AutoZone does not pay dividends so therefore we did not run a Discounted

Dividends Model. The recommendation for the company is to sell. Based on our

observations we found the Abnormal Earnings Growth Model to be the most

accurate. Our share price is $45.13 which is much lower than the $128.98 per share

the current stock is trading for. Overall, we have concluded that AutoZone is an

overvalued company and should sell based on our valuations. The Altman Z-Score

Model helps show the credit worthiness of the company. AutoZone has maintained

a good credit score, which is averaged at a 6.69.

Company Overview:

AutoZone first began in 1979 under the name Auto Shack. In 1987, they

changed their name to AutoZone. They are a specialty retail store of automotive

parts and accessories. The various products that are offered are mainly aimed at

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“do-it-yourself” customers. They have a broad variety of products ranging from

spark plugs to larger auto parts. AutoZone has enjoyed a tremendous amount of

success as being the number one retail store in the auto parts industry for a

consecutive amount of years. The only other name mentioned worthy of

competition is O’Reilly. They have 3,800 AutoZone stores in 48 states and 100 in

Mexico. In the year 2005, AutoZone started expanding across the world by opening

12 stores in Puerto Rico. (www.autozone.com)

Sales growth has been slightly weak the past 5 years averaging only 4.3%

and less than 3% the past three years. However, there is a foreseeable rise in the

near future with operations expanding over the globe in the years to come.

AutoZone is a cost leader, but the piece of the company that they take pride

in is their customer service. They have been innovators in customer service in the

industry by becoming the first firm in the auto parts industry to have electronic

catalogs in computers to provide quick and easy product look-

up.(www.autozone.com) Also, for the past 13 years they have used their own

satellite broadcasting to look up information in other stores and keep parts available

to customers nationwide.

Just in 2004, AutoZone also expanded their marketing techniques by

sponsoring the NASCAR Elite division. AutoZone headquarters are located in

Memphis, Tennessee. AutoZone has expanded in the past few years and looking at

AutoZone’s 10-K it is suppose to grow even more in the upcoming years. This is

represented in the WallStreet Journal that states, “Auto-parts retailer AutoZone Inc.

posted an 8.3% increase in fiscal first-quarter net income, driven mostly by

inventory improvements and merchandise pricing. Same store-sales growth

remained slow.”(www.wsj.com)

Five Forces Model

The five forces model is the basis of analyzing potential profitability within an

industry of which a particular firm is competing. The model is broken down into

intricate components that assess specific areas, such as rivalry among existing firms,

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threat of new entrants and substitute products, and the bargaining power of buyers

and suppliers.

Rivalry Among Existing Firms

Threat of New Entrants

Threat of Substitute Products

Bargaining Power of Buyers

Bargaining Power of Suppliers

Highly Moderate Moderate Moderate High High

Rivalry Among Existing Firms

As the number of competitors in an industry rises, it creates more

competition and intensifies rivalry among existing firms. When rivalry is strong the

demand for products tends to grow slow because of weak differentiation among

similar products and services. Likewise, customers tend to incur low switching costs

when moving from one brand to the next. Eventually, very intense rivalry could

result in continuous negative profit growth.

Industry Growth- Industry growth is a good forecasting tool for industry

performance in the years to come. It shows how well a company is improving

internally to generate sales boosts. There has been a mixed trend in sales growth in

various firms. AutoZone has set the benchmark for other firms in the industry by

growing into the largest auto parts retailer. Although currently the largest, it has

yet to see a substantial growth rate in the past five years. Many of the firms in the

industry have not seen significant or even positive growth rates in the past. This

graph depicts the following growth rates for the top direct competitors in the past

five years.

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Five Year Sales Growth

-5.00%

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

2001 2002 2003 2004 2005

Year

Sale

s G

row

th Pep BoysAdvance Auto PartsO'Reilly Auto PartsAutoZoneCSK Auto

Concentration and Balance of Competitors- The auto parts industry is

crowded with many different kinds of firms involved in the industry. The following

graph shows the asset values of the direct competitors of the industry. Asset value,

often mistaken for the market value of the shares, is the market value of a firm’s

assets on a per share basis. (wikipedia) AutoZone, clearly, has asset values that

exceed its competitors. AutoZone focuses on profits rather than on sales.

Regardless, AutoZone generates more revenue and overall is more productive than

its competitors.

Asset Value

$-

$500,000.00

$1,000,000.00

$1,500,000.00

$2,000,000.00

$2,500,000.00

$3,000,000.00

$3,500,000.00

$4,000,000.00

$4,500,000.00

2001 2002 2003 2004 2005

Years

Ass

et V

alue

(in

Thou

sand

s)

Pep BoysAdvance Auto PartsO'Reilly'sAutoZoneCSK Auto

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The pie chart below illustrates the percentage of market share for the key

players in the retail auto parts industry.

Market Share

41%

16%

32%

11%

AutoZoneO'ReillyAdvanceCSK Auto

Market share has the potential to increase profits as profit leads to more

customers with a higher demand of a particular product. (Wikipedia) Market share is

calculated by taking the total sales revenue divided by total market sales revenue.

We took the AutoZone’s total sales revenue of $ 6.05B divided by the total market’s

revenue of $14.62B to get a market share of 41%. By measuring the market share,

AutoZone can identify how well their company is doing. It also determines their

competitive strength in the auto parts industry compared to its competitors. After

measuring the market share, we can determine that AutoZone is doing better than

the leading competitors in the industry.

Not only do “do-it-yourself” auto parts companies compete with each other,

they also must compete with super center stores such as Wal-Mart and Target.

Both of these firms carry a limited amount of auto accessories inside their store. A

large amount of firms in this industry make it an absolute must to compete on price.

Another kind of player “do-it-yourself” retailers must compete with is the automotive

repair firms. Not only do these firms order parts for their customer, they also install

and do maintenance on the customer’s vehicle so they do not have to do any labor

themselves. A few companies have formed partnerships with these companies by

supplying the parts that they needed for labor. On the other hand, O’Reilly’s Auto

Parts has merged with companies such as Hi/Lo Auto Supply and bought out

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companies such as KarPro Auto Parts, Mid-State Automotive Distributors, Inc, and

Midwest Automotive Distributors, Inc. to eliminate outside competition and expand

their business. With many firms, both direct and indirect competitors are competing

within the industry. The auto parts retail industry’s concentration and balance of

competitors is high.

Degree of Differentiation and Switching Costs- To lower competition in

an industry, firms must try to find a way to differentiate their product. In this

industry, products are generic. You will find the same auto parts and accessories in

AutoZone as you would find in Advanced Auto Parts. This causes switching costs to

be low because now buyers must distinguish products according to price AutoZone

has done a very good job at increasing value brands in the automotive aftermarket

industry that did not start as a high quality brand. They have taken such brands as

Duralast and Valucraft and created a brand image for them. Duralast has brought in

over 1.3 billion dollars in sales and is one of the largest brands in the automotive

aftermarket industry. The crucial element of differentiation is customer service.

The degree of customer service is a crucial factor that can help save customers time

and money. If customers are looking for someone to install or repair a part on their

vehicle, then automotive repair or stores such as Pep Boys would benefit their

wants. If customers are looking for cheap cost then “do-it-yourself” auto part retail

stores are beneficial in the fact that there is no labor wage in purchasing the

product. Although customer service seems to play a key role in this industry, degree

of differentiation and switching costs seem to be low because products seem to be

generic and only compete on the basis of price.

Scale/Learning Economies and the Ratio of Fixed to Variable Costs-

The ratio of fixed to variable cost gives the firm an idea of how changes in output

will affect operating income. To compete in the industry, firms must turn over

excessive amounts of variable costs to cover fixed costs. Companies with lower

fixed costs experience operating revenues that are typically greater and increase

faster than companies with high fixed costs. After analyzing AutoZone and its

competitors’ 10-K financial statements; we have concluded that the retail auto part

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industry as a whole, invests more in fixed costs rather than variable costs. In fact,

two of the biggest competitors in the auto part industry, O’Reilly and Advance Auto

Parts, expense more fixed costs than variable costs; which could be the reason they

seem to have higher overall 5-yr sales growth rates of 18.1% and 13.3%,

respectively. The ratio of fixed to variable costs is high because companies in this

industry are investing more in distribution centers and warehouses to store

inventory.

Exit Barriers and Excess Capacity- The auto part industry has small exit

barriers. It is easy to enter/exit market because it is not based on differentiated

products. There is excess capacity in the auto parts industry; therefore, firms have

to be cost effective and differentiate themselves from each other. In order to

compete in the industry, firms must develop a strict pricing strategy and excellent

customer service. By having larger economies of scale in the auto part industry, it

leaves a huge disadvantage for smaller companies eventually driving the smaller

companies out of the industry. In conclusion, the auto parts industry has low exit

barriers as well as high excess capacity. Overall, rivalry among existing firms is

highly moderate.

Threat of New Entrants

As competition rises, more and more small firms will enter an industry. This

will ultimately reduce profits of existing firms as well as lower their market share.

Existing firms must find innovative techniques to assure that they can keep new

firms at a large disadvantage in competition.

Economies of Scale- Economies of scale are advantages that arise for a

firm because of its larger size and scale of operation in an industry. Economies of

scale are an important factor in determining the optimal capacity of firms, structure

of industries, and the price and output level that is required to be successful in the

auto part industry. The major attraction that attracts new entrants in the industry is

earning abnormal profits. In order for companies to sell large quantities of product,

they have to cumulate large amounts of assets to compete in the retail industry. In

a cost perspective, new entrants will have a disadvantage because the large

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competing firms have a large level of production that brings costs down to the

lowest possible level. This makes it difficult to enter in the market and compete

with large firms such as AutoZone and O’Reilly Auto Parts at the same price level.

Economies of scale for the auto part industry are moderate. There is a mixed size of

firms in this industry so only 2-3 companies such as AutoZone, Advanced Auto, and

O’Reilly’s have created large economies of scale to block new entrants from entering

the industry.

First Mover Advantage- First mover advantage can provide an instant

niche in a market that will differentiate one firm from the rest in the industry. The

basis of competition in the auto parts retail industry is price so it is very rare to have

a first mover advantage. Firms in this industry have found different channels of

business by expanding. They have bought out distribution centers to help there

distribution costs decrease. (oreillyauto.com) This can put pressure on companies

to seek faster ways of distributing their product so they can compete at a different

level. Companies also can promote their products to auto retail stores to form

partnerships with automotive repair stores to supply them with the parts they need.

They have reached a customer base that auto parts stores are not exposed to.

(autozone.com) The overall first mover advantage is moderate because there are a

couple large companies that have gained access into different channels of

innovation. They alone put pressure on the smaller firms and new entrants in the

industry. However, there are not a vast amount of companies providing innovative

technique toward themselves.

Access to Channels of Distribution and Relationships- Firms within the

auto part industry have built strong-reliable relationships with suppliers of auto part

merchandise. With the strong relationship existing between firms in the industry; it

gives new entrants a harder ability to steal a potential distributor from an existing

firm in the industry. AutoZone’s merchandise is selected and purchased through

two distribution centers in Tennessee and Mexico. (autozone.com) AutoZone keeps

very few long-term contracts because it is important to have good relationships with

alternative suppliers at a very comparable low cost. Networking with suppliers and

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distributors is very important. New entrants struggle to find a supplier that sells its

products at the lowest possible price to compete with existing firms in the industry.

Access to channels of distributions and relationships is high because it is essential to

maintain low costs from suppliers in order to increase profit and to keep continuous

business with the supplier that provides the lowest cost. If relationships are

maintained, then costs will be low and the supplier will not be disloyal to the firm

purchasing products from them.

Legal Barriers- Barriers to entry are any factor that allows firms in a

relevant market to earn higher profits while keeping other firms from entering and

competing. Economies of scale achieved by firms create an advantage and

determine entry into the market. There are many determinants in which legal

barriers such as patents, copyrights, and brand loyalty constitute barriers to entry.

Brand loyalty alone might constitute a sufficient barrier to entry. In this case, legal

barriers are low due to the fact that it is an easy entry/exit industry.

Overall, the threat of entrants in the auto parts industry is moderate. It is

harder for new firms to enter in the industry because the larger firms have set

higher barriers to enter. AutoZone, O’Reilly, and Advance Auto Parts have set the

high barriers for new entrants to enter in the industry.

Threat of Substitute Products

Substitute products of a different caliber can alter company’s sales in terms of

choosing a product over another. In this industry, most stores have identical

products so they must compete on price. One major factor that plays into substitute

threats is different services that are provided. Pep Boys, for instance, provides

installation and maintenance service. (finance.yahoo.com) AutoZone and O’Reilly, on

the other hand, rely on employee knowledge of the products to explain to the

customer how to use or install the product to “do-it –yourself” customers. If

customers feel the need to have someone else repair or install a part on the vehicle,

they can substitute “do-it-yourself” store service for a full labor job at Pep Boys or

an automotive repair shop. This will affect business depending on consumer

preferences of doing the work themselves or getting it done by a repair store that

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charges a labor fee. Threats of substitute products are moderate due to the fact

that automotive manufacturers are making it harder for ordinary people to repair car

parts on their vehicle.

Bargaining Power of Customers

Bargaining power is the ability to influence the setting of prices.

(photopla.net) Bargaining power of customers creates a situation where firms must

decide whether to differentiate their product so that customers can not influence the

change in price. AutoZone is the leading retailer in the auto parts industry, which is

highly competitive on price. AutoZone operates about 3,700 store in the United

States. (autozone.com) Because of this, according to Morningstar analyst Michelle

Chang, “AutoZone has more power in negotiating lower prices from suppliers [.]”

The other situation derives from the fact that industries have identical, generic

products; therefore they must compete on price to win customers over. This creates

a high bargaining power of customers; however, one person leaving AutoZone for

another competitor will not have a big effect on the firm as a whole.

Price Sensitivity- Price sensitivity effects the decision making of a buyer

when they are looking to buy a product that is sold at the best price. If products

are not differentiated and similar in an industry, customers will choose the firm that

has that product with the best price attached to it. With so many competitors in the

auto parts retail industry that compete on price, it is essential to set the price that is

believed to be fair in the customer’s eyes. If the price is not set according to the

customer’s needs, they have plenty of other options to search. This shows the low

switching cost for a buyer looking for a product in this industry. Price sensitivity in

the auto parts industry is very high.

Relative Bargaining Power- When supply exceeds demand, it is often

hard to sell the product. This creates bargaining power towards the customer

because firms realize their product will not be sold unless they come to an

agreement on price in which the buyer believes is fair. Since there are several auto

part retailers in the industry, there is a lot of supply considering the fact that the

industry is filled with direct and indirect competitors that compete on the same

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products. Customers have influence in the prices set by the firms because firms

want to attract as many customers as they can since this industry is at high

competition on product pricing.

In order to face the problem of price sensitivity and relative bargaining

power, AutoZone offers exquisite customer service. In fact, per Autozone.com,

“‘AutoZoners always put customers first!’ That's the first line of AutoZone's pledge

and it's the most important thing we do.” Similarly, AutoZone offers their customers

online guides and services in the store that save time and money all free of charge.

All these qualities help keep AutoZone the number one retailer as well as minimizing

the effects of bargaining power of customers.

Bargaining Power of Suppliers

Bargaining power is a key factor in price negotiation among suppliers, in

which more bargaining power equals a lower cost of product purchases. In the auto

parts retail industry, AutoZone stands at the top of the companies as the largest by

far. The only semi-close competitor is O’Reilly’s and Advanced Auto, who still are

not as near as large as AutoZone. Wal-Mart also competes with bargaining power

since they are one of the largest corporations in America. Since there are three large

firms in this industry that dominate, new entrants will not have the ability to have a

say in price. This leads to high cost and possible loss. Another benefit that concerns

the leaders in the industry’s size is that it establishes success as a company which

will give suppliers an initiative to do business with companies such as AutoZone and

O’Reilly’s and will be a little more lenient on price negotiation since they will buy in

larger amounts than smaller firms in the industry.

Industry Classification

The retail auto parts industry has become progressively more competitive in

recent years with AutoZone leading the industry in sales followed by Advanced Auto

Parts Inc, CSK Auto Corp., O’Reilly Automotive Inc., and Pep Boys. The

effectiveness of a firm is subjective not only by the industry structure, but also by

the tactical decisions it makes in positioning itself within the industry. Many

consumers in the auto parts retail industry have recently gained more knowledge

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about automotive repair and how to install auto parts on their own vehicle. This

creates an opportunity to gain market share in a competitive industry. More

knowledgeable customers mean more “do-it-yourself” jobs. AutoZone’s pledge is to

“[A]lways put customers first! We know our parts and products. Our stores look

great! We’ve got the best merchandise at the right price.” (autozone.com) By

creating value in business operations and implementing key success factors, to help

compete on price and adapt to technological advances; AutoZone will continue to

strive as the largest firm in the auto parts retail industry.

This graph of the retail auto parts industry compares the past two year stock

growths of the key players in the industry. This comparison shows the ups and

downs of the stock price performance for this competitive industry. From September

2005 to May 2006, the industry did not perform well; the companies in this industry

experienced either negative or sluggish stock growths. Stocks are considered

attractive based on the potential growth by its company. It shows the stock

performance for each company which is growing in earnings or revenue faster than

the overall auto parts industry. With a positive stock growth investors know how

well the company is doing.

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The graph above is an overview of stock growth in the auto part industry for

the past four years. From 2003 to 2005, all firms in the auto part industry had a

slight growth. In 2005, Advance Auto Part’s stock price increased and jumped away

from the firms with O’Reilly not far behind. AutoZone’s stock price has stayed

steady throughout the 4 years.

This industry is mixed due to the fact that it competes on low cost as well as

differentiating customer service. The industry is weighted more towards low cost

since prices are generic, but it is the quality of customer service that separates the

quality of the firms in the industry. The industry is based on competing with

excellent customer service as well as low prices.

Value Chain Analysis

The retail auto parts industry creates value by the following key success

factors for cost leadership strategies: economies of scale and scope, efficient

production, continuous improvement in technology, and low-cost distribution. Firstly,

this competitive industry encompasses large economies of scale, “for new entrants

will initially suffer from a cost disadvantage in competing with existing firms.”

(Palepu, Business Analysis and Valuation (2-3)

Secondly, the retail industry does not produce the products it sells;

therefore, it must utilize an efficient production process by standardizing store

layouts and customer traffic for each firm. This efficient production process is based

on the concept that firm’s stores look and operate the same in all stores; this allows

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for a sense of familiarization for customers. Firms want to operate the same in all

locations from the moment customers enter to when they exit.

Next, firms must focus on the key success factor of implementing advanced

technology that specializes in retail software. These technologies process tons of

useful data that is used to analyze the industry and firm, as well as forecast trends.

This expertise allows for competitive pricing and assurance that the right products

are in the right store.

The last key success factor for cost leadership is low-cost distribution. In this

industry there is low-distribution cost because many firms have maintained long-

termed relationships with their suppliers. These positive relationships allow for more

“supplier friendly” distribution costs because suppliers are more willing to execute

price cuts for firms they readily distribute to. “Cost leaders cannot compete unless

they achieve at least a minimum level on key dimensions on which competitors

might differentiate, such as quality and service.” (Palepu, Business Analysis and

Valuation 2-9)

The retail auto parts industry’s differentiated side is composed of the

following two key success factors: superior customer service and investment in

brand image. Since this is such a competitive industry, firms must excel in customer

service. Having great customer service gives customers reasons to exercise repeat

business; this is one of the key ways companies in this industry encourage customer

loyalty.

Finally, a key success factor is investment in brand image. Brand image for

this industry is not the traditional idea of brand image. Instead, customers focus on

the name of the company instead of the name of the product. Most products are

generic brand and every store carries the same products throughout the industry;

therefore, the retail industry focuses less on product brand image. In this industry

the brand image is the name of the firm and public image that the company’s name

brings, who people can trust to buy their auto parts, and exceed customer

expectations.

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Competitive Advantage Analysis

To gain a competitive advantage, AutoZone must utilize the previously stated

key success factors for cost leadership and differentiation, thus creating value for

AutoZone. In the auto part industry, AutoZone carries a large economy of scale. A

large economy of scale helps keep new entrants from entering into the industry.

This is an important factor for AutoZone when determining price, output level, and

the structure of the auto parts industry.

The efficient production process AutoZone incorporates is based on the

concept of familiarization of their stores. Most AutoZone stores are strategically

designed to be like every other store. Their production process focuses on getting

the customer in and out in a timely manner by focusing on the customer needs.

AutoZone wants customers to be approached by an employee when they enter the

store so that there is no wasted time in their production process. Once an AutoZone

employee determines the customer’s needs, they can direct the customer to where

they need to go. This allows for directing of customer traffic through their store,

ultimately increasing efficiently in production.

AutoZone has progressed in technological advances by acquiring specialized

retail software. Technology can help maintain low operating costs by saving time

and forecast unseen trends to help plan for the future. As of November 14, 2006, it

will become easier than ever to locate the parts you need at AutoZone, for the

number one retailer in auto parts is enhancing its product range by using dominant

SAS retail software. AutoZone uses SAS software to advance performance through

insight into vast amounts of data that result in rapid and more precise business

decisions. Competitive advantage requires more than estimates and educated

guesses, but by using SAS forecasting technologies, AutoZone can accurately

analyze and forecast. This will allow AutoZone to identify trends and anticipate

fluctuations so they can effectively plan for the future. SAS’s answer for retail turns

data about customers, merchandise, and operations into knowledge that provides

greater insight into performance ensuring competitive pricing. AutoZone gains a

competitive advantage with SAS because it makes certain efficient and profitable

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retail operations by recognizing store-by-store which products sell and how to price

their products effectively to keep products moving off the shelves. This helps speed

up the inventory turnover and allows AutoZone to purchase the correct kind of

product and the right quantity from the supplier. If AutoZone can accurately pick

the right product and the quantity of order, this reduces sales returns to the supplier

and will establish a stronger relationship with them. (AutoZone Revs Its Engines

With SAS, www.sas.com)

Since 2002, AutoZone has worked on creating an easier distribution process.

“AutoZoners develop a network of "hub, feeder and satellite" stores to get product

to the customer faster, to eliminate lost sales and to have more products in the

market area while reducing inventory investment.” (autozone.com). By creating

distribution centers that are close relative to the retail stores, this saves AutoZone

time and money by getting the product to the stores faster.

An absolute must for AutoZone to be successful in this industry is to have

superior customer service. Customer service is the most crucial component in

AutoZone’s marketing and merchandising strategy, which is based on consumer

marketing research. AutoZone is devoted to offer customers with advanced services,

value and quality automotive parts. Their high standard of customer service begins

by offering some stores that are open 24 hours a day, and other AutoZone stores

have extended operating hours to 18 hours a day seven days a week. By allowing

stores to stay open longer, this allows a greater chance that AutoZone will be able

to help their customers when they need them the most. (AutoZone 10-K)

Another unique feature presented by AutoZone is their Loan-A-Tool program.

This program permits customers that work on their automobiles or repair shops to

borrow certain specialty tools necessary for numerous one-time repair tasks. This

service is free to the customer; however, they must pay for the tool upon checking it

out from the store but receive a full refund when it is returned. Also, all AutoZone

locations offer complimentary testing of batteries, starters, alternators, voltage

regulators, and control modules. Customers can also bring their used engine oil to

be recycled. Once these consumers realize the free tasks AutoZone offers, they will

20

take advantage of their customer service by becoming loyal customers.

(AutoZone.com)

Lastly, AutoZone gains a competitive advantage with the key success factor

of investment in brand image. AutoZone has created and maintained a highly

recognized brand name, for retail firms derive their brand image not from the

products they sell but from the quality image their company’s name brings.

Given the retail auto parts industry is a cut throat environment, attaining new

and loyal customers can be extremely difficult. AutoZone’s partnerships with key

players in the automotive industry have created value for them by increasing

consumer knowledge about their company. AutoZone has formed a partnership with

CarMax, partnering with 7 out of 45 CarMax stores. AutoZone also has partnered

with the leading automotive repair store, Midas; in which, AutoZone distributes to all

US Midas stores. AutoZone expects these partnerships to help increase their

customer base and support the already existing one.

With competition growing, AutoZone will try to distinguish itself from its

leading competitors in the auto part industry. AutoZone’s main focus in the future is

exceeding customer’s expectations. They believe customers are the most crucial

element in building AutoZone’s success in the industry. Another goal is expanding

business in Mexico and Puerto Rico. With 100 stores opened in Mexico and 12 in

Puerto Rico; their main focus is to expand in the industry by growing and remaining

profitable in both markets.

Accounting Analysis

The primary function of an accounting analysis is to assess the level to which

a firm’s accounting captures its underlying corporate reality. The accounting analysis

is composed of a series of steps that guide analysts when evaluating a company’s

accounting quality, which are as follows: identify key accounting policies, assess

accounting flexibility, evaluate accounting strategy, evaluate the quality of the

disclosure, identify potential red flags, and undo accounting distortions. (Business

Analysis & Valuation, Palepu)

21

Key Accounting Policies

AutoZone is in the retail auto parts industry, which requires firms to be cost-

leaders with an emphasis on differentiating by means of superior customer service.

The key success factors that AutoZone utilizes is inventory management, keeping

low costs by establishing and maintaining better supplier relationships, and

investment in brand image or goodwill in the retail industry. AutoZone’s senior

management uses estimations and assumptions in the critical areas of inventory and

cost of sales, operating leases, impairments, and pension expenses.

Inventory management is a crucial accounting policy in the retail business.

The more bulk that a company purchases, the more precise the method must be so

there is not an error of such a large amount. AutoZone used the lower of cost or

market using the LIFO method. Due to price deflation of company inventory,

AutoZone began balancing the inventory under the FIFO method. Vendor

allowances make up another part inventory management under AutoZone. Vendor

allowances constitute a grace from the supplier based on an established relationship

between buyer and seller in which the vendor will give discounts in various forms of

ways to the buyer for buying their products in a large amount. Reductions in cost

such as rebates, allowances, promotional funds, and product returns are used to

compensate AutoZone’s bulk purchasing from vendors in the industry. These forms

of grace are recorded as reductions in cost of goods sold.

Pension plans reflect the compensation employees are given for years of

service at the firm. Before the year 2003, all AutoZone employees were covered by

a defined benefit pension plan. “The benefits under the plan were based on years

of service and the employee’s highest consecutive five-year average compensation.”

(AutoZone 10-K) At the beginning of 2003, all plans were frozen meaning current

participants will receive no new benefits and new employees will not receive any

benefits from this plan. The results of this action was a defined contribution plan,

which is a retirement plan where the employee defers a percentage of their salary

and places the income in a portfolio which makes a return on initial investment.

AutoZone also matches the employee salary deferral which is placed into the

22

portfolio as well. The pension account for AutoZone in 2005 was over 26.8 million,

while in 2006 this account decreased to 9.1 million. Their pension accounts for the

past two years were only a small fraction of their total asset. In 2005 and 2006

AutoZone’s pension account was .6% and .2% of total assets. (AutoZone 10-K)

AutoZone obtains funding for this program by creating a diversified mix of domestic

and international equity portfolios that earn a long-term return that will fill in for

AutoZone’s pension plan obligations. This will be the primary source of funding the

pension assets.

Impairments of goodwill for accounting purposes allow firms to review the

decreasing value of their company’s market value or brand image. AutoZone

executes a yearly test of goodwill to compare the estimated fair value of goodwill to

the carrying amount to conclude if impairments are present. Goodwill for AutoZone

in 2005 was calculated to be 7.13% of their total assets, while in 2006 goodwill

amounted for 6.68% of AutoZone’s total assets. Unless conditions dictate otherwise,

AutoZone completes their yearly impairment assessment in the fourth quarter of

each fiscal year. The impairment of goodwill evaluation requires management to

make assumptions based upon information presented at the time the valuation is

performed, which could be different from actual results. (AutoZone 10-K)

Advertising costs play a heavy influence on brand image. AutoZone

exceeds in strong advertising to increase customer value towards their stores.

AutoZone spends massive amounts of money a year boosting their advertising to

attract a large portion of the general public. A good example of heavy advertising

costs would be the fact that AutoZone sponsors NASCAR’s Elite Division.

Accounting Flexibility

Depending on the accounting policy, firms may be able to adjust the ways

they record accounts on their financial reports. Firms must realize flexibility in

accounting in a way that will benefit them and the shareholder. Also, they must do

this while staying within the boundaries of proper accounting rules.

Inventory management can be very flexible in the sense of method choosing.

Firms are given the freedom to choose between FIFO, LIFO, or average cost.

23

AutoZone used to value inventory at the lower of cost or market using the LIFO

method. This method is used to consistently adjust inventory at the right value to

eliminate large write-offs at vast amounts. It maintains consistent inventory value

over a long period of time. Now, AutoZone values inventory by using the FIFO

method. They use the FIFO method to easily view the physical movement of goods

and to prevent obsolescence of inventory. If the first product that is brought in is

the first product sold, it does not sit in a warehouse for an extended amount of time

up to a point where it becomes obsolete. Depending on the economy, firms are

able to adjust their inventory valuation strategy by changing. Since AutoZone’s

inventory was experiencing a deflation in price, they changed to FIFO method to

state lower cost of goods sold and also understate their assets.

GAAP is flexible when it comes to firms choosing whether they will use

operating or capital leases. Many firms in the retail auto parts industry, including

AutoZone, chose operating leases for use on their properties. Since there is

accounting flexibility when it comes to choosing a firm’s lease holdings, firms may

choose to use operating leases which help understate their liabilities. Under our

assumptions, AutoZone’s operating leases are for 10 years and should be capitalized

and amortized over the 10 years of the lease. Also, we have calculated the discount

rate for AutoZone to be 10.05% and the future values of years 2012 – 2016 using

straight line depreciation. As shown below, we will analyze how much AutoZone is

understating their liabilities via operating leases by calculating the present value of

their operating leases.

24

(in thousand)

Year FV PV Factor PV

2007 $ 147,776.00 0.90867787 $ 134,280.78

2008 $ 133,289.00 0.82569548 $ 110,056.12

2009 $ 113,339.00 0.75029121 $ 85,037.26

2010 $ 94,852.00 0.68177302 $ 64,667.53

2011 $ 77,465.00 0.61951206 $ 47,990.50

2012 $ 101,564.00 0.5629369 $ 57,174.12

2013 $ 101,564.00 0.51152831 $ 51,952.86

2014 $ 101,564.00 0.46481445 $ 47,208.42

2015 $ 101,564.00 0.42236661 $ 42,897.24

2016 $ 101,564.00 0.38379519 $ 38,979.77

$ 680,244.62

implied dep. $ 68,024.46

The chart above reveals that if AutoZone capitalized their operating leases

they would experience an increase in their liabilities by 680 million. This flexibility in

accounting allows AutoZone to underestimate a portion of liabilities that equals

16.76% of their total liabilities. By not having to capitalizing their lease holdings,

AutoZone has been given the ability to lower expenses and increase net income by

not recognizing a substantial amount of liability that exists in their leases. The chart

below illustrates the balance sheet effects of converting operating leases to capital

leases resulting in understated liabilities and assets by 680 million.

Balance Sheet 2006

Assets = $4,526,306,000 Assets = $5,206,551,444

Liabilities = $4,056,778,000 Liabilities = $4,737,023,000

Pension plans vary in flexibility depending on what side is being recorded in

the financial statements. The size of pension assets can vary greatly since there is

only a minimum a company must fund into the account according to the Employee

Without Capital Leases (Before) With Capital Leases (After)

25

Retirement Income Security Act of 1974. This is to make sure that a company can

fulfill its obligation to the plan for the employee. Also, there is flexibility in the

amount in which the employer matches the employee’s contributions. The company

makes matching contributions per pay period so AutoZone can choose what

percentage they want to match depending on performance in that period.

Impairment is determined by the reaction of the market. If fair market value

is less than the current book value, firms must recognize impairment of goodwill.

However, there is a lot of accounting flexibility that allows managers to deem

whether there is a need or no need for impairment of their goodwill. The impairment

evaluations are created and analyzed by a firm’s managers, which gives them the

flexibility to use their assumptions on the impairment of goodwill. For fiscal year

ending 2006, AutoZone has determined goodwill for their company to be over $302

million, with essentially no change from the previous year. As stated earlier their

2006 assessment of goodwill accounts for 6.68% of AutoZone’s total assets.

(AutoZone 10-K) AutoZone evaluates impairments of goodwill on an annual basis.

However, AutoZone’s managers have deemed, through their impairment

evaluations, that there have been no impairment losses over the past three years on

their goodwill account; this flexibility AutoZone utilizes is aggressive accounting.

Unfortunately for AutoZone, there is no flexibility pertaining to capitalization

of advertising costs. According to GAAP, firms cannot capitalize costs related to

advertising, research and development, etc. AutoZone cannot report such a crucial

aspect of their business on their balance sheet which seems to lower the value of

the company solely looking at financial statements.

Evaluating Accounting Strategy

“When managers have accounting flexibility, they can use it either to

communicate their firm’s economic situation or to hide true performance.” (Palepu,

Healy, Bernard, Business Analysis and Valuation: Using Financial Statements)

Individuals can assess manager intentions by comparing the firms accounting

strategies with others within the industry. This will reflect the characteristics of

26

management and show how conservative or aggressive they are towards

accounting.

Because of the flexibility GAAP permits when it comes to choosing inventory

management, AutoZone chooses to use the first-in, first-out method to value

inventory. Since recent deflation has affected retail auto part inventory, AutoZone

receives a higher cost of goods sold since old inventory is the first out. The way

AutoZone has adjusted to the affects of current deflation on the retail industry has

allowed them to support their key success factors for their cost leadership

strategies. They are able to support their key success by lowering their pre-tax

income in essence receiving a reduction on taxes. These savings on taxes will allow

AutoZone to reinvest in their key success factors of continuous improvement in

technology and enhancing their production process. Due to the flexibility GAAP

allows for inventory management, the other two main competitors use the last-in,

first-out method. This shows that Advanced Auto and O’Reilly Automotive state a

higher income before taxes which will result in higher taxable income. AutoZone

uses the conservative approach by stating higher cost of goods sold and lower pre-

tax income for tax reduction purposes. As shown below is a table on O’Reilly that

illustrates the effects of their using LIFO instead of FIFO. (O’Reilly 10-K)

Under FIFO $738,877,000 $628,309,000

Under LIFO $726,390,000 $625,320,000

Also, under the guidance of the Statement of Financial Accounting Standards

No. 142, “Goodwill and Other Intangible Assets”, AutoZone assesses impairments on

goodwill through annual impairment evaluations. This evaluation requires executives

to create certain assumptions based upon information accessible at the time the

impairment test is performed, which could be different from actual results.

AutoZone’s goodwill has not been amortized since 2001, and they have not recorded

impairment losses for the past three years ending August 26, 2006. (AutoZone 10-K)

O’Reilly Automotive Inventory

2005 2004

27

However, AutoZone’s goodwill for 2006 was 9.5% of tangible assets. Being that

AutoZone’s goodwill is a substantial portion of their tangible asset base; AutoZone

should have found some type of impairment loss of goodwill. Another main

competitor in the retail auto parts industry, O’Reilly, shares the same accounting

method, as AutoZone, for their assessments of impairments of goodwill. As stated in

AutoZone’s 2006 10-K, their goodwill has not be impaired since 2001. However, we

were not able locate the impairment amount for goodwill, for AutoZone’s 2001 10-K

does not contain sufficient information. O’Reilly’s has deemed no impairment losses

to their goodwill over the past two years. This reveals that firms in the retail auto

parts industry estimate through their evaluations that losses due to impairment of

goodwill have not been present in recent years. We feel it to be strange that

AutoZone and others in the retail auto parts industry are not ruling impairments on

their goodwill. We believe over the past years firms in this industry should have

calculated some impairments on their goodwill and by not doing so may reveal a

flaw in their yearly assessments of impairments on goodwill.

On January 1, 2003 AutoZone joined their competitors, Advance Auto Parts

and O’Reilly Automotive, in that they established a defined contribution plan which

essentially means pay as you go. By switching to a defined benefits plan AutoZone

no longer has to make interest rate assumptions, for once they make their

contributions it is then up to the employee to invest the money.

Evaluate the Quality of Disclosure

Quality of disclosure helps an individual understand what is going on inside

the company and helps give an understanding of the numbers in the financial

reports. Quality disclosure is based on two aspects: qualitative and quantitative. A

majority of a company’s financial information is found in a company’s 10-K annual

report. Management has control over disclosure quality which is an important part of

a firm’s accounting quality.

Qualitative Assessment - Looking at AutoZone’s 10-K in a qualitative

sense, it seems as though they are not attempting to hide information by distorting

footnotes, disclosure, etc. They give brief summaries on how they handle each

28

account on the financial reports to let the reader know where the number came

from in that year. They also created footnotes that contain information about

financial statements and the different transactions that occur within them. We feel

that AutoZone gives unbiased information in a clear and straightforward manner.

This prevents the reader from getting confused when analyzing the various numbers

in the financial reports.

Quantitative Assessment - Quantitative information can show trends in

the industry and help compare individual firms with the norms that coexist. These

numbers can also show how firms changed their strategy in different years. The

following information shows the different sides of accounting trends from AutoZone

and their largest competitors within industry by using diagnostic ratios in two

different classifications: sales manipulations and core expense manipulations.

Sales Manipulation Diagnostic

Managers may have an incentive to manipulate sales if bonuses are directly

related to number of sales. With multiple ratios that are related to sales, analysts

can evaluate whether the firm made an adjustment in their accounting principles or

simply overstated sales. The following table shows AutoZone’s sales diagnostics the

past five years as well as their two major competitors within the auto parts retail

industry: Advanced Auto Parts and O’Reilly Automotive.

NET SALES / CASH FROM SALES

0.97

0.98

0.99

1.00

1.01

1.02

1.03

2001 2002 2003 2004 2005 2006

YEAR

OUT

PUT AUTOZONE

ADVANCE AUTO PARTSO'REILLY'S

29

Net Sales/Cash from Sales- Over the past five years these firms have experienced an

overall positive effect on their ratio of net sales over their cash from sales. We find

this effect to be positive for these firms, for all of their ratios are right around one.

This informs us that their sales are being supported by cash collections, especially in

AutoZone’s case where they experienced a decrease in this ratio over the past year.

NET SALES / NET ACCOUNTS RECEIVABLE

0.00

50.00

100.00

150.00

200.00

250.00

300.00

1 2 3 4 5 6

YEAR

OUT

PUT AUTOZONE

ADVANCE AUTO PARTSO'REILLYS

Net Sales/Net Receivables- A firm can show strength by having a high net

sales/receivables ratio by showing they do no not sell many dollars worth of product

on account. From 2001 to 2005, AutoZone’s ratio for net sales over net accounts

receivables has drastically decreased, resulting in a negative consequence of their

sales becoming increasingly supported by receivables. However, this significant

decline has brought AutoZone’s ratio approximate to the key competitor’s ratios in

the industry.

NET SALES / INVENTORY

0.001.002.003.004.005.00

2001

2002

2003

2004

2005

2006

YEAR

OU

TPU

T AUTOZONE

ADVANCE AUTOPARTS

O'REILLYS

Net Sales/Inventory- This chart reveals that the three firms have a high ratio of net

sales over inventory, inferring that their sales are not being supported by inventory.

30

O’Reilly and Advance Auto Parts have a net sales over inventory ratio that reveals

that their sales are three times higher than inventory, thus their inventory does not

support sales. Over the past five years AutoZone’s inventory has been supporting

their sales more than the competitors.

Core Expense Manipulation Diagnostic

AutoZone competes in an industry where competing on cost is a crucial

strategy to survive in auto parts retail. Firms in these types of industries may

manipulate their costs in the financial statements to increase revenue and defer

their expenses without matching revenue with cost.

SALES / ASSETS

0.00

0.50

1.00

1.50

2.00

2001

2002

2003

2004

2005

2006

YEARS

OU

TPU

T

AUTOZONE

ADVANCE AUTOPARTS

O'REILLY'S

Sales/Assets- The graph above reveals over the past five years each firm

represented had little change in their sales over asset ratio. In recent years all three

firms had an increase in sales supported by their assets. However, this ratio is still

relatively high for these firms and it should be a growing concern to try to support

their sales more with assets. These high ratios indicate that their assets and

expenses could be understated.

CFFO / OI

-0.4

-0.2

0

0.2

0.4

0.6

0.8

2001 2002 2003 2004 2005 2006

YEARS

OU

TPUT

AUTOZONE

ADVANCE AUTOPARTS

O'REILLYS

31

CFFO/OI- Beginning at 2004, AutoZone and Advance Auto Parts began to show that

they were converting more sales into cash; this increase is represented above. The

decrease O’Reilly is currently experiencing is a sign of potential trouble. O’Reilly

must be concerned that they are not supporting their operating income with cash

flows and may be getting income by not booking certain expenses.

CFFO / NOA

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

2001 2002 2003 2004 2005 2006

Y EA R S

AUTOZONE

ADVANCE AUTOPARTSO'REILLYS

CFFO/NOA- This graph reveals that over the past five years all three firms

experienced a trend for their plant, property, and equipment becoming less

supported by cash flows from operations. The decreases they incurred should have

been a growing concern that items could have been buried in their long-term assets.

In recent years AutoZone and Advance Auto Parts have both moved in the positive

direction with an increasing ratio of cash flows from operations over net operating

assets.

Total Accruals / Changes in Sales

-0.50

0.00

0.50

1.00

1.50

2.00

2.50

1 2 3 4 5 6

Year

Out

put

AUTOZONE

ADVANCEAUTO PARTS

O'REILLYS

Total Accruals/Change in Sales- The chart above illustrates there is a major concern

for Advance Auto Parts due to their steady increase in total accruals over change in

32

sales during the past four years. This implies that sales are not increasing with

accruals, thus expenses could potentially be obscured. AutoZone experienced

fluctuation from 2001 to 2005; however, between 2005 and 2006 they obtained a

constant ratio for the reason that their changes in accruals were supported by

change in sales.

Identify Potential “Red Flags”

Red Flags give alerts to individuals who may have detected an extreme

change in accounting procedure. By running these diagnostic ratios, analysts can

discover abnormalities in constant trends within the industry. Abnormal financial

statement account numbers may pose a threat as well.

Under disclosure of goodwill, the paragraph states that, “No impairment

losses were recorded in the three years ended August 26, 2006.” (AutoZone 10-K)

This is an odd look on the balance sheet. Goodwill has maintained its consistency

within the past years without losing any value. This seems as though there might

be a potential problem with overstating assets since there is no deduction in assets

by impairment. The next potential red flag that appeared was in relation to

AutoZone’s operating leases. After we calculated the present value of AutoZone’s

total operating leases, we became concerned because our calculations reveal that

AutoZone is underestimating their liabilities by 680 million. These leases are non-

cancelable leases indicating that they have an obligation (liability) to pay these

leases on a consistent basis. With the recent acquisitions of numerous small

companies, we find it very concerning that AutoZone has not recognized impairment

in the past three years. We believe that somewhere down the line that some of the

acquisition’s fair market value had to fall below the current book value.

The other potential red flag is that AutoZone recently changed their pension

plan within the past three years. They changed from a defined-benefit plan to

defined contribution at the beginning of 2003. Since the plan changed, the discount

factor has varied in the past three years under the 401-K plan. In 2006, the

discount factor changed from 5.25% to 6.25%. One percentage point is a

significant increase because it will decrease your present value factor which will

33

result in a lower pension liability. Also, AutoZone has a deduction account called,

“Accumulated Other Comprehensive Loss,” which is estimation that we believe that

helps underestimate liabilities.

Another question for concern is what account vendor allowances will affect

under the FIFO method. When vendor allowances are given to AutoZone, they give

an immediate effect on cost of goods sold. However, the new inventory that is

purchased by AutoZone goes into inventory. The allowance that AutoZone is given

under the new incoming inventory does not affect the inventory account; it actually

overstates its cost of goods sold.

Undo Accounting Distortions

When firms make a mistake in accounting practices, it is the auditor’s job to

alert management of the accounting distortion to immediately correct their mistake.

We identified a potential threat in the field of impairment. For the past three years,

AutoZone has not recognized any impairment under goodwill. We found this

strange that they have not recognized any considering the numerous acquisitions in

the past ten years. After looking at the other major competitors in the industry, it

seems as though this is a trend among the other companies. In fact, O’Reilly has

not even recognized impairment of goodwill in the past two years. The major

competitors in this industry need to reevaluate how they test for impairment.

As stated earlier, AutoZone using operating leases is underestimating their

liabilities and overstating their net income by an amount that would be the largest

sub-group under their liabilities. In order to undo this accounting distortion

AutoZone must capitalize their operating leases and amortize over the 10 years of

leases. This will correctly show the amount of liabilities AutoZone is incurring

because of their leases. As shown below, capital leases would be beneficial in the

first two years because operating lease expenses would be greater than capital lease

expenses. However, the next four years shows that capitalizing their operating

leases would create more expenses by 65.76 million. The last four years of the

leases reveals a fluctuating trend that operating lease expenses exceed capital lease

expenses.

34

Beginning Balance Interest Payments Ending Balance implied dep. cap lease exp CL-OL exp

$ 680,244.62 $ 68,364.58 $ 147,776.00 $ 600,833.20 $ 68,024.46 $136,389.05 $(11,386.95)

$ 600,833.20 $ 60,383.74 $ 133,289.00 $ 527,927.94 $ 68,024.46 $128,408.20 $ (4,880.80)

$ 527,927.94 $ 53,056.76 $ 113,339.00 $ 467,645.69 $ 68,024.46 $121,081.22 $ 7,742.22

$ 467,645.69 $ 46,998.39 $ 94,852.00 $ 419,792.09 $ 68,024.46 $115,022.85 $ 20,170.85

$ 419,792.09 $ 42,189.10 $ 77,465.00 $ 384,516.19 $ 68,024.46 $110,213.57 $ 32,748.57

$ 384,516.19 $ 38,643.88 $ 101,564.00 $ 321,596.07 $ 68,024.46 $106,668.34 $ 5,104.34

$ 321,596.07 $ 32,320.40 $ 101,564.00 $ 252,352.47 $ 68,024.46 $100,344.87 $ (1,219.13)

$ 252,352.47 $ 25,361.42 $ 101,564.00 $ 176,149.90 $ 68,024.46 $ 93,385.88 $ (8,178.12) $ 176,149.90 $ 17,703.06 $ 101,564.00 $ 92,288.96 $ 68,024.46 $ 85,727.53 $(15,836.47) $ 92,288.96 $ 9,275.04 $ 101,564.00 $ 0.00 $ 68,024.46 $ 77,299.50 $(24,264.50) $ 0.00

The chart below shows the effect on AutoZone’s balance sheet if they had

used capital leases instead of the operating leases. By capitalizing their operating

leases AutoZone’s assets and liabilities would increase drastically due to their

present value of leases calculated to be over 680 million.

(in thousand) Year FV PV Factor PV Assets 2006 After Capital Leases Liabilities 2006 After Capital Leases

2007 $ 147,776.00 0.90867787 $ 134,280.78 $ 5,206,550.62 $ 4,737,022.62

2008 $ 133,289.00 0.82569548 $ 110,056.12

2009 $ 113,339.00 0.75029121 $ 85,037.26

2010 $ 94,852.00 0.68177302 $ 64,667.53

2011 $ 77,465.00 0.61951206 $ 47,990.50

2012 $ 101,564.00 0.5629369 $ 57,174.12

2013 $ 101,564.00 0.51152831 $ 51,952.86

2014 $ 101,564.00 0.46481445 $ 47,208.42

2015 $ 101,564.00 0.42236661 $ 42,897.24

2016 $ 101,564.00 0.38379519 $ 38,979.77

$ 680,244.62

Assets 2006 = $4,526,306 implied dep. $ 68,024.46 Liabilities 2006 = $4,056,778

35

Under AutoZone’s planned benefit funded status and amounts; AutoZone

misleads the public by increasing their discount rate a whole percentage point from

the previous year, in turn understating their liabilities on planned benefits. It is

stated in this information that as of fiscal year 2006 AutoZone had $154,942 of

benefits paid (liabilities) and only a fair value of plan assets at year end of $126,892.

This reveals that the difference between the liabilities and assets should give a

number of $28,050 worth of net liability recognized; however, through the use of

estimations and assumptions by management, AutoZone has created an account

entitled “Accumulated other comprehensive loss” that essentially hides liabilities. By

using this accounting distortion, AutoZone has been able to hide plan benefits

liabilities of $24,481 thus understating their expenses and overstating net income by

this amount. To correct this accounting misrepresentation AutoZone must first

stabilize the discount rate they use for their benefits plan, for once the discount rate

stops fluctuating significantly from year to year can AutoZone begin to recognize

their liabilities correctly. Also, AutoZone should do away with this plan benefit

account that is based on estimations and assumptions. Once they stop using this

misleading account, AutoZone will correctly represent the net liabilities because they

will not have the ability to add such estimations back into their recognized defined

benefits pension liability resulting in understating their liabilities.

Accounting Analysis Conclusion

Through AutoZone’s key accounting policies of inventory management,

pension plans, impairments, and advertising costs, GAAP allows AutoZone and its

competitors to be flexible when it comes to their critical accounting policies. Firms

can choose what inventory method they want and have the ability to use operating

or capital leases. This flexibility can allow firms to manipulate their balance sheet

and income statement to provide more appealing totals. AutoZone and most

competitors in the industry have experienced negative effects on their sales and

core expense manipulation diagnostics at some time over the past five years.

36

However, in the past two years AutoZone has sustained an overall positive effect of

both the manipulation diagnostics. We feel that AutoZone should undo some of their

account distortions by estimating some impairment of goodwill, changing operating

leases to capital leases, and stabilizing the discount rate used on their benefit plan.

Financial Analysis

“The goal of financial analysis is to use financial data to evaluate the current and

past performance of a firm and to assess its sustainability.” (Palepu, Healy, Bernard)

Forecasting helps firms get a view of how they will perform in the future by using

historical data to accurately predict these numbers. If there are forecasts that firms

do not see as benefiting the company, they can make adjustments to prevent

problems in the forthcoming years. Two major components of financial analysis are

ratio analysis and forecasting.

Ratio Analysis

Ratio analysis not only helps a firm predict the future of itself, it also helps

predict where the industry is going in the upcoming years as well. By running these

sixteen ratios, a firm can compare how it is doing with other major competitors

within the industry.

Liquidity Analysis

A liquidity analysis determines how fast a firm can payoff its current liabilities

using its currents assets. This shows how liquid a company can be and how fast

they can write off liabilities.

AutoZone

2002 2003 2004 2005 2006 Current Ratio 1.00 .98 .95 1.07 1.03

Quick Asset Ratio .1 .08 .08 .11 .08 Accounts Receivable

Turnover 223.93 124.75 82.45 48.29 74.02

Days Supply Receivable 1.64 2.93 4.43 7.56 4.93 Inventory Turnover 2.14 1.95 1.84 1.75 1.63

Days Supply Inventory 170.56 187.18 198.37 208.57 223.93 Working Capital Turnover -117.25 -136.26 1,197.84 48.27 92.42

37

AutoZone does not seem to be highly liquid. Although they do seem to

improve in areas that were disastrous five years ago, some of their 2006 ratios are

still not very solid According to the working capital turnover, in 2002 and 2003 they

had more current liabilities than current assets. In 2002 there was a negative

$45,422,000 working capital. In 2003, there was a negative $40,050,000 working

capital. In 2004, there was actually a positive $4,706,000 working capital which is

a low number. Also in 2004, there was a 3% increase in sales compared to the 2%

in 2003. The turnover eventually lowered but it was still very high. One very

positive note is the fact that AutoZone does not sell a lot of their product on

account. This is mostly due to the fact that they are a retail store; however, they

also do business with automotive repair stores that do purchase in bulk.

Profitability Analysis

The following ratios are the factors in driving profit and help companies

evaluate what they need to do to boost profits in the following years.

2002 2003 2004 2005 2006 Gross Profit

Margin .45 .46 .49 .49 .49

Operating Profit Margin

.14 .17 .18 .17 .17

Net Profit Margin .08 .09 .10 .10 .10 Asset Turnover 1.50 1.45 1.44 1.35 1.31

Return On Assets .12 .15 .15 .15 .13 Return On Equity .49 .75 1.51 3.33 1.46

AutoZone’s gross profit margin has changed 4% over the past five years,

holding constant over the past three years. Starting from 2002 to 2006 net sales

and gross profits for AutoZone have both steadily increased. This 4% increase over

2002 to 2004 is contributed to a higher increase in gross profit per year compared to

the increase in net sales per year. AutoZone’s operating profit margin has increased

by over 2% from the years 2002 to 2006. This increase has a positive affect on

AutoZone’s profitability, for their income from operations has increased with respect

to their sales. The net profit margin for AutoZone has remained constant from 2004

to 2006, but their net profit margin increased 2% over the past five years. This

38

increase reveals that in 2002, $.09 of every sales dollar was retained as profit,

whereas $.10 of every sales dollar was retained as profit in 2004 through 2006.

AutoZone’s asset turnover has decreased over the past five years. Their 2002 asset

turnover ratio shows that each dollar of assets created $1.50 of sales but only $1.31

of sales in 2006, which indicates that their revenue productivity of resources is

negatively affecting profitability. A positive affect on AutoZone’s profitability is that

their return on assets increased over 3% from 2002 to 2004. By 2006, AutoZone’s

return on assets had decreased from 2004 but had experienced a positive affect

because the overall change in return on assets was an increase of over 1%. This

positive affect is attributed to a significant increase in net profit margin even with a

declining asset turnover. The return on equity for AutoZone has experienced a

positive affect on the firm’s profitability. From years 2002 to 2005, their return on

equity had increased drastically over the four year span; however, in 2006

AutoZone’s return on equity deceased by half the ratio from the previous year. Even

with a significant decrease in 2006, the total change over the past five years is

deemed to be almost three times larger than five years ago in 2002. This increase in

return on equity reveals a positive impact on profitability for AutoZone.

Capital Structure Analysis

Capital Structure shows how acquisitions of assets are financed through debt

and equity. The three ratios that are used are: Debt to Equity, Times Interest

Earned, and Debt to Service Margin. The major concerns in these ratios are: the

amount of debt compared to equity, and the ability to serve principal. (Financial

Statement Analysis Notes)

2002 2003 2004 2005 2006 Debt to Equity Ratio 4.14 9.86 21.83 9.08 8.64

Times Interest Earned

1.12 1.10 1.10 1.11 1.12

Debt to Service Margin N/A 0 1.52 1.23 2.22 As stated in Mark Moore’s financial statement analysis notes, “The capital

structure of a company refers to the sources of financing used to acquire assets and

is shown by the liabilities and owner’s equity section of the balance sheet”.

AutoZone’s debt to equity ratio has fluctuated over the past years with a drastically

39

increase from 2003 to 2004 because of a $200 million decrease in owner’s equity in

2004. The total change in debt equity ratio over the past five years had a negative

affect on AutoZone’s capital structure. The debt to equity ratio for 2002 reveals that

the company has $4.14 of liabilities for every dollar of owner’s equity; however, by

2006 AutoZone has $8.64 of liabilities for every dollar or equity. This increase

indicates that their debt has become a larger proportion of total financing since

2002. Income from operations must be adequate to cover required interest expense

before there can be earnings to the stakeholders of a firm, and the times interest

ratio reveals the capability of income from operations to cover required interest

charges. The times interest earned ratio for AutoZone is the same in 2002 as in

2006. However, from 2002 to 2004 AutoZone’s decrease in times interest earned

signaled a negative impact on their capital structure, for these ratios show an

increasing inadequacy of income from operations to cover interest charges. In 2005

and 2006 their times interest earned ratio made positive movement towards better

covering their interest expenses. For AutoZone, the debt service margin for 2004

shows that $1.52 of cash from operations was generated to service one dollar of

long-term debt that will mature in the next year. The increase in debt service margin

from 1.52 in 2004 to 2.22 in 2006 reveals less pressure on AutoZone to use

operating cash flows for debt service reasons.

The following charts show how AutoZone performs against its competitors

within the industry. These charts will also help further illustrate a trend in the auto

parts retail industry

Current Ratio

00.5

11.5

22.5

33.5

44.5

2002 2003 2004 2005 2006

AutoZoneO'ReillyAdvance

40

The graph above shows that O’Reilly clearly has a higher current ratio than

both AutoZone and Advance. The only negative aspect concerning O’Reilly is that it

has dropped to about half of what it was in 2002. They are the leader in paying off

current liabilities with current assets. Advance shows signs of consistency while

AutoZone shows slight struggles of maintaining higher current assets and lower

current liabilities.

Quick Asset Ratio

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

2002 2003 2004 2005 2006

Aut oZone

O'Reilly

Advance

The quick asset ratio tells us how much assets a firm has on hand for every

dollar of current liabilities; thus the way to calculate this ratio is by adding cash,

securities, and accounts receivable up and dividing that number by the current

liabilities. AutoZone’s quick asset ratio has been pretty steady for the last five years,

which indicates that it does a pretty constant job of liquidating its assets. AutoZone’s

quick asset ratio is slightly lower than Advance but significantly lower than O’Reilly’s.

This simply states that AutoZone, despite its 2003 peak, has a harder time

liquidating its assets as oppose to its competitors.

Receivables Turnover

0

50

100

150

200

250

2002 2003 2004 2005 2006

AutoZoneO'ReillyAdvance

41

Only until 2006, AutoZone has seen a major decline in their receivables

turnover. They still lead the industry in receivables turnover, however there is no

sign of consistency. Sales growth declined while accounts receivable steadily

increased until 2006 when they actually decreased. Both O’Reilly and Advance

stayed fairly consistent over a five year time. AutoZone leads the industry with the

higher turnover, but, they fail to stay consistent over time.

Days Receivable

0

2

4

6

8

10

12

14

2002 2003 2004 2005 2006

AutoZone

O'Reilly

Advance

Over the past five years, there has been diversity in the trend among the

days receivables between the three firms presented above. O’Reilly has experienced

a slight increase in their days receivable from 2002 to 2005; however, this increase

is minimal with little change. From 2002 to 2005, AutoZone experienced a negative

affect on their liquidity, for their days receivables increased 4 times. This drastic

increase reveals that it was taking AutoZone more time each year to collect

receivables, but in 2006 their days receivable made a sharp decline resulting in a

positive affect on their liquidity. The only firm that experienced an overall decline in

their days receivable was Advance Auto, for it dropped by almost 4 days.

42

Inventory Turnover

0

0.5

1

1.5

2

2.5

2002 2003 2004 2005 2006

AutoZoneO'Reilly Advance

O’Reilly Auto Parts and Advance Auto had essentially no change to their

inventory turnover over the past five years. However, AutoZone experienced a

negative affect on their liquidity due to a steady decrease in their inventory

turnover. This decrease was attributed to a larger increase in their inventories year

to year than the increase in cost of goods sold.

Days Supply Inventory

0

50

100

150

200

250

300

2002 2003 2004 2005 2006

AutoZoneO'Reilly Advance

The graph above illustrates the only firm that experienced a positive affect on

their liquidity due to a decrease in days supply inventory was O’Reilly. AutoZone and

Advance Auto both had an increase in days supply inventory; therefore, over the

past five years these firm’s inventories had to be stored longer than in previous

years. AutoZone’s increase in days supply inventory was the largest over the past

five years, with an increase of over 53 days.

43

Working Capital Turnover

-400

-200

0

200

400

600

800

1000

1200

1400

2002 2003 2004 2005 2006

AutoZone

O'Reilly

Advance

Over the past five years all the firms above experienced a positive

affect on their overall liquidity, for all of their working capital turnovers increased

during the five years span. O’Reilly Auto Parts’ working capital turnover has

increased every year from 2002 to 2006. Advance Auto had a slight decrease in

working capital in 2003, and AutoZone experienced a significant decline from 2004

to 2005. This drastic decline in AutoZone’s working capital turnover is due to a

larger increase in sales from 2003 to 2004 as compared to the increase from 2004

to 2005, resulting in a much larger turnover in 2004.

Gross Profit Margin

0.38

0.4

0.42

0.44

0.46

0.48

0.5

2002 2003 2004 2005 2006

AutoZoneO'Reilly Advance

The chart above represents the growth profit margin over the past five years

for AutoZone, O’Reilly, and Advance. Starting from 2002 to 2006, all three of the

firm’s represented in the graph experienced a positive affect on their profitability.

44

This positive affect is attributed to the increase in all of the company’s gross profit

margin. AutoZone’s largest increase from one year to next was 3%, while O’Reilly

and Advance experienced at most a 1% increase.

Operating Profit Margin

00.020.040.060.080.1

0.120.140.160.180.2

2002 2003 2004 2005 2006

AutoZoneO'Reilly Advance

To calculate the operating profit margin, we took each firm’s operating profit

and divided that by their net sales. Over the years represented above, each firm has

had a positive result on their operating efficiency, for all of their operating profit

margins increased. AutoZone and O’Reilly Auto Parts experienced about a 2%

increase in operating profit margin, while Advance Auto had the largest increase of

over 3%.

Net Profit Margin

0%

2%

4%

6%

8%

10%

12%

2002 2003 2004 2005 2006

AutoZoneO'ReillyAdvance

Net Profit Margin lets you know how well the company’s profit is doing. It

tells how much a company’s profit is generated related to sales. Net profit margin is

calculated by dividing net income by sales (revenues). Auto Zone leads the auto

part industry with a ratio at 8% in 2002 and increasing to 10% in 2006. It tells that

$.08 of every sales dollar generates in net income. O’Reilly and Advance Auto parts

45

profit margin are lower than AutoZone’s profit margin but is steadily increasing in

the industry.

Asset Turnover

00.20.40.60.8

11.21.41.61.8

2

2002 2003 2004 2005 2006

AutoZoneO'ReillyAdvance

The asset turnover ratio is calculated by dividing sales divided by total assets.

The higher the asset turnover ratio, the lower the profit margin is. The ratio

measures the total sales for every dollar of assets a company owns. Advance leads

the industry at about 1.7 with AutoZone and O’Reilly trailing behind. AutoZone

generates more sales to assets a company owns keeping it steady in the industry.

Advance Auto Parts has high sales but low assets which is why they have the

highest asset turnover in the auto parts industry.

Return on Assets

0

0.02

0.04

0.06

0.08

0.1

0.12

0.14

0.16

2002 2003 2004 2005 2006

AutoZoneO'Reilly Advance

AutoZone, O’Reilly, and Advance Auto all experienced a positive affect on

their profitability, for their return on assets increased from 2002 to 2006. The

return on assets for Advance Auto and O’Reilly Auto Parts has been increasing

steadily over the past five years. From 2002 to 2004, AutoZone had an increasing

46

return on assets; however, over the past two years their return on assets has

decreased almost 2%.

Return on Equity

0

0.5

1

1.5

2

2.5

3

3.5

2002 2003 2004 2005 2006

AutoZoneO'Reilly Advance

The return on equity has increased from 2002 to 2006 for all of the firms

represented above. This positive affect on their profitability allows for these firms’

profits to increase more as their owners’ equity increases. The return on equity for

O’Reilly increased by about 2%, yet Advance Auto’s return increased almost 12%.

Debt to Equity

0

5

10

15

20

25

2002 2003 2004 2005 2006

AutoZoneO'ReillyAdvance

The debt to equity ratio measures the financial leverage of the company. It

is total liabilities divided by shareholder’s equity. It measures how much a company

can borrow over a period of time. AutoZone has the highest debt to equity ratio

with higher liability number and a lower equity number. Advance has a higher ratio

than O’Reilly auto parts but is steadily decreasing.

47

Time Interest Earned

0

10

20

30

40

50

60

2002 2003 2004 2005 2006

AutoZoneO'ReillyAdvance

The time interest earned ratio measures the company’s ability to make its

interest payments on borrowed loans. It is calculated by dividing operating profit by

interest expense. O’Reilly Auto Parts is leading the industry that is steadily

increasing throughout the years. The ratio is increasing due to generating more

operating income and lowering interest expense. AutoZone has the lowest time

interest earned ratio in the industry.

Debt Service Margin

02000400060008000

100001200014000160001800020000

2002 2003 2004 2005 2006

AutoZoneO'Reilly Advance

The debt service margin is calculated by taking the cash flows from

operations for a firm and dividing it by their current notes payable from the previous

year. AutoZone, O’Reilly, and Advance Auto each had one year where they had zero

current notes payable, resulting in zero margin for the following year. AutoZone has

experienced an increase in their debt service margin from 1.52 in 2004 to 2.22 in

2006. From years 2002 to 2005, Advance Auto had an unfavorable change in their

48

debt service margin, for their margin decreased from 33.29 to 10.26 over this time

span. This decline from 33.29 to 10.26 indicates more pressure to use operating

cash flows for debt service purposes. The drastic increase and decrease in O’Reilly’s

debt service margin is due to a much larger current notes payable in 2001 resulting

in a lower margin for 2002. O’Reilly’s current notes payable drastically decreased in

2002 and decreased even more in 2003 resulting in their debt service margin to

vastly increase.

IGR and SGR Analysis

As stated in The Free Dictionary by Farlex, “The internal growth rate, IGR, is

the highest level of growth achievable for a business without obtaining outside

financing.” However, the sustainable growth rate, SGR, is the rate at which a

company can develop while maintaining its profitability and financial policies

unchanged. SGR is used regularly as a method to evaluate companies’ ratios in a

comprehensive approach. If a firm’s profitability, payout ratio, or financial leverage

changes, that firm could grow at a rate unlike its SGR; therefore, the SGR offers a

benchmark against which a company’s growth plans can be assessed. (Palepu 5-19)

Sustainable Growth Rate & Internal Growth Rate

Ratio 2002 2003 2004 2005 2006

Sustainable Growth Rate (SGR) .49 .75 1.51 3.33 1.46

Internal Growth Rate (IGR) .49 .75 1.51 3.33 1.46

A firm’s IGR is included in their SGR; a firm multiples their IGR by 1 plus the

dividend payout ratio to calculate their SGR. However, AutoZone as a growth

company plans to reinvest in their firm for the near term instead of paying out

dividends. (AutoZone Investor Relations) In the case of AutoZone when a firm does

not pay out dividends their IGR will be the same as SGR and both will equal their

return on equity. Over the past five years, AutoZone has experienced a drastic

increase of nearly 300% in both IGR and SGR. From years 2002 to 2005, there was

a steady increase in AutoZone’s IGR and SGR. However, AutoZone’s IGR and SGR

drastically declined after 2005. This significant reduction was due to considerable

increase on equity in 2005, resulting in a much lower return on equity for 2006.

49

Forecasting

Forecasting shows where a company is headed in the near future. Estimating

what kind of profit a firm will have in the future is a crucial factor in valuing a

company in current times. We ran a forecast of the three financial statements of

AutoZone ten years into the future.

Income Statement Actual Financial Statements

2002 2003 2004 2005 2006Net sales 5,325,510$ 5,457,123$ 5,637,025$ 5,710,882$ 5,948,355$ Cost of sales, including warehouse and delivery expenses 2,950,123 2,942,114 2,880,446 2,918,334 3,009,835

Gross profit 2,375,387 2,515,009 2,756,579 2,792,548 2,938,520 Operating, selling, general, and administrative expenses 1,604,379 1,597,212 1,757,873 1,816,884 1,928,595 Operating profit 771,008 917,797 998,706 975,664 1,009,925 Interest expense, net (79,860) (84,790) (92,804) (102,443) (107,889)

Income before income taxes 691,148 833,007 905,902 873,221 902,036 Income taxes 263,000 315,403 339,700 302,202 332,761

Net income 428,148$ 517,604$ 566,202$ 571,019$ 569,275$ Forecasted Financial Statements

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Net sales 6,379,611 6,842,133 7,338,187 7,870,206 8,440,796 9,052,753 9,709,078 10,412,986 11,167,928 11,977,602

Cost of sales, including

warehouse and delivery expenses 3,195,902 3,392,777 3,601,019 3,821,210 4,053,954 4,299,876 4,559,622 4,833,863 5,123,285 5,428,598

Gross profit 3,183,709 3,449,356 3,737,168 4,048,996 4,386,842 4,752,878 5,149,455 5,579,123 6,044,643 6,549,005

Operating, selling, general, and

administrative expenses 1,984,018 2,024,242 2,044,274 2,309,623 2,599,715 2,629,947 2,627,624 2,583,438 2,966,711 3,386,568

Operating profit 3,183,709 3,449,356 3,737,168 4,048,996 4,386,842 4,752,878 5,149,455 5,579,123 6,044,643 6,549,005Interest expense, net Not Forecastable

Income before income taxes 1,078,108 1,288,548 1,540,065 1,604,646 1,671,935 1,998,286 2,388,340 2,854,529 2,974,230 3,098,951

Income taxes Not Forecastable

Net income 720,312 818,098 873,431 896,611 1,134,494 1,288,508 1,375,658 1,412,165 1,786,833 2,029,406

While reviewing the income statement, we noticed most of the accounts

would have to be forecasted by growth rate patterns based on both the number

income statement and the common size. Sales grew over 100% from 1997-2006.

Due to increase in competition over the past five years, the sales growth declined

slightly. Now with firms starting to exit the industry, we believe that the sales will

start to increase steadily over the next ten years. By increasing annual sales growth

from 2.9% (2002-2006 sales growth per year) to 7.25% for the next ten years,

50

sales will increase 72.5%. We decided to slow it down the next ten years due to the

aging of the industry which means more competition.

To calculate gross profit, we took the average growth rate of the percentage of

gross profit relative to sales over the past three years. Gross profit percentage

increased 1.02% on average a year and this trend is expected to happen throughout

the next ten years. By subtracting forecasted gross profit from forecasted sales, we

were able to come up with forecasted cost of sales. Operating profit was found by

realizing a four year cyclical pattern. We calculated a positive rate from years 2002-

2004 (7.6%) and a negative rate. (-4.2%) The positive rate was used for the first

two years and the negative rate for the following two years. This four year pattern

was continuous until 2016. SG&A was found by subtracting operating profit from

gross profit. Income before taxes was calculated by calculating an average growth

rate of the of the common size account which increased at a rate of 11.44% for

three years. After that, based on a cyclical pattern, we calculated that income

before taxes would decrease by 2.8% for one year. This pattern follows until the

year 2016. Net income also grew at a cyclical pattern. By taking the average

decreasing growth rate on the common size income statement for the years 2004-

2006 (2.35%) and the positive average growth rate for years 2001-2004, (12.06%)

we created a five year cyclical pattern, starting with the positive rate for three years

followed by the negative rate for the following two years. Again, this pattern

continues until the year 2016. Actual Financial Statements

2002 2003 2004 2005 2006100.00% 100.00% 100.00% 100.00% 100.00%

55.40% 53.91% 51.10% 51.10% 50.60%44.60% 46.09% 48.90% 48.90% 49.40%

30.13% 29.27% 31.18% 31.81% 32.42%14.48% 16.82% 17.72% 17.08% 16.98%1.50% 1.55% 1.65% 1.79% 1.81%

12.98% 15.26% 16.07% 15.29% 15.16%4.94% 5.78% 6.03% 5.29% 5.59%8.04% 9.48% 10.04% 10.00% 9.57%

51

Forecasted Financial Statements

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Net sales 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Cost of sales, including

warehouse and delivery expenses 50.10% 49.59% 49.07% 48.55% 48.03% 47.50% 46.96% 46.42% 45.87% 45.32%

Gross profit 49.90% 50.41% 50.93% 51.45% 51.97% 52.50% 53.04% 53.58% 54.13% 54.68%

Operating, selling, general, and

administrative expenses 31.10% 29.58% 27.86% 29.35% 30.80% 29.05% 27.06% 24.81% 26.56% 28.27%

Operating profit 18.81% 20.83% 23.07% 22.10% 21.17% 23.45% 25.97% 28.77% 27.56% 26.40%

Interest expense, net Not Forecastable

Income before income taxes 16.90% 18.83% 20.99% 20.39% 19.81% 22.07% 24.60% 27.41% 26.63% 25.87%

Income taxes Not Forecastable

Net income 11.29% 11.96% 11.90% 11.39% 13.44% 14.23% 14.17% 13.56% 16.00% 16.94%

Statement of Cash Flows Actual Financial Statements

2002 2003 2004 2005 2006Cash flows from operating activities: Net income 428,148$ 517,604$ 566,202$ 571,019$ 569,275$ Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 118,255 109,748 106,891 135,597 139,465 Deferred rent liability adjustment - - - 21,527 - Amortization of debt origination fees 2,283 7,334 4,230 2,343 1,559 Income tax benefit realized 42,159 37,402 24,339 31,828 (10,608) Deferred income taxes 28,483 65,701 44,498 (16,628) 36,306 Income from warranty negotiations - (8,695) (42,094) (1,736) - Share based compensation - - - - 17,370 Changes in operating assets and liabilities: Accounts receivable and prepaid expenses 12,879 (27,468) (26,101) (65,957) 24,379 Merchandise inventories (168,150) (135,732) (119,539) (124,566) (182,790) Accounts payable and accrued expenses (272,123) 164,201 43,612 109,341 184,986 Income taxes payable 13,743 (3,460) 32,118 (67,343) 28,676 Other, net 12,005 (5,828) 4,223 52,658 14,129 Net cash provided by operating activities 736,170 720,807 638,379 648,083 822,747

Forecasted Financial Statements

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Cash flows from operating activities: Net income 720,312 818,098 873,431 896,611 1,134,494 1,288,508 1,375,658 1,412,165 1,786,833 2,029,406 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 146,410 153,702 161,356 169,391 177,827 186,683 195,980 205,740 215,985 226,741 Deferred rent liability adjustment Irrelevant Amortization of debt origination fees Irrelevant Income tax benefit realized Irrelevant Deferred income taxes Irrelevant Income from warranty negotiations Irrelevant Share based compensation Irrelevant Changes in operating assets and liabilities: Accounts receivable and prepaid expenses Irrelevant Merchandise inventories (147,585) (129,978) (135,450) (198,773) (160,489) (141,343) (147,293) (216,153) (174,522) (153,701) Accounts payable and accrued expenses 73,791 185,001 312,985 124,850 313,011 529,552 211,238 529,595 895,969 357,402 Income taxes payable Irrelevant

Other, net Irrelevant

767,129 715,271 817,126 933,485 870,381 811,543 927,107 1,059,127 987,530 920,773

Statement of cash flows was relatively difficult to forecast due to the lack of

pattern in the past years. The net income forecast was based upon the same net

income that we forecasted in our income statement. By looking at depreciation, we

52

noticed that there was a constant increase in growth over the past three years. We

decided to use an average growth rate from 2004-2006 (4.98%) to compute

depreciation for the next ten years. Merchandise inventories and accounts payable

were difficult to determine since there was no constant pattern. We took a 4 year

cyclical pattern with merchandise inventories (-11.93%, 4.21%, 46.75%, -19.26%)

based on 5 year historical statistics. Accounts payable was calculated by a 3 year

cyclical pattern (150.71%, 69.18%, -60.11%) based on the past 4 year historical

statistics. By looking at the net cash from operating activities, we realized that there

was a direct relationship between the actions of merchandise activities and cash

flows from operations. By using the same pattern, but different growth rates (-

6.76% first two years, 14.24% next two years) we were able to forecast the next

ten years for cash flows from operating activities.

Due to the fact that there are too many outside factors in determining cash

flows from investing and financing activities, we did not forecast them because we

believe they are unforeseeable due to variables that are impossible to determine in

the future. There were no real patterns in the historical years so it is apparent that

forecasting these numbers would be near impossible in being accurate. COMMON SIZE STATEMENT OF CASH FLOWS Actual Financial Statements

2002 2003 2004 2005 2006Cash flows from operating activities:

Net income 58.16% 71.81% 88.69% 88.11% 69.19% Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization of property and equipme 16.06% 15.23% 16.74% 20.92% 16.95% Deferred rent liability adjustment 0.00% 0.00% 0.00% 3.32% 0.00% Amortization of debt origination fees 0.31% 1.02% 0.66% 0.36% 0.19% Income tax benefit realized from exercise of options 0.00% -1.21% -6.59% -0.27% 0.00% Deferred income taxes 3.87% 9.11% 6.97% -2.57% 4.41% Income from warranty negotiations 0.00% -1.21% -6.59% -0.27% 0.00% Share based compensation 0.00% 0.00% 0.00% 0.00% 2.11% Changes in operating assets and liabilities: Accounts receivable and prepaid expenses 1.75% -3.81% -4.09% -10.18% 2.96% Merchandise inventories -22.84% -18.83% -18.73% -19.22% -22.22% Accounts payable and accrued expenses -36.96% 22.78% 6.83% 16.87% 22.48% Income taxes payable 1.87% -0.48% 5.03% -10.39% 3.49% Other, net 1.63% -0.81% 0.66% 8.13% 1.72% Net cash provided by operating activities 100.00% 100.00% 100.00% 100.00% 100.00%

53

Forecasted Financial Statements

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Cash flows from operating activities:

Net income 93.90% 114.38% 106.89% 96.05% 130.34% 158.77% 148.38% 133.33% 180.94% 220.40%

Adjustments to reconcile net income to net cash

provided by operating activities:

Depreciation and amortization of property and e 19.09% 21.49% 19.75% 18.15% 20.43% 23.00% 21.14% 19.43% 21.87% 24.63%

Deferred rent liability adjustment

Amortization of debt origination fees

Income tax benefit realized from exercise of options

Deferred income taxes

Income from warranty negotiations

Share based compensation

Changes in operating assets and liabilities:

Accounts receivable and prepaid expenses

Merchandise inventories -19.24% -18.17% -16.58% -21.29% -18.44% -17.42% -15.89% -20.41% -17.67% -16.69%

Accounts payable and accrued expenses 9.62% 25.86% 38.30% 13.37% 35.96% 65.25% 22.78% 50.00% 90.73% 38.82%

Income taxes payable

Other, net

Net cash provided by operating activities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Balance Sheet Actual Financial Statements

Assets 2002 2003 2004 2005 2006Current Assets: Cash and cash equivalents 70,306 93,102 76,852 74,810 91,558 Accounts receivable 23,782 43,746 68,372 118,263 80,363 Merchandise inventories 1,375,584 1,511,316 1,561,479 1,663,860 1,846,650 Other current assets 11,690 19,194 49,054 72,526 100,356

Deferred income taxes 32,574 3,996 0 0 0

Total current assets 1,513,936 1,671,354 1,755,757 1,929,459 2,118,927

Property and equipment, net of depreciation 1,661,728 1,715,753 1,790,089 1,937,615 2,051,308 Goodwill, net of accumulated amortization 305,390 294,348 301,015 302,699 302,645 Deferred income taxes 60,305 25,543 0 32,917 20,643 Other long-term assets 240 59,828 65,704 42,567 32,783

Total long-term assets 2,027,663 2,095,472 2,156,808 2,315,798 2,407,379

Total Assets 3,541,599 3,766,826 3,912,565 4,245,257 4,526,306

Asset Turnover 1.50 1.45 1.44 1.35 1.31

Liabilities and Stockholders' EquityCurrent Liabilities: Accounts payable 1,167,711 1,360,482 1,429,128 1,539,776 1,699,667 Accrued expenses 348,209 310,944 243,816 255,672 280,419 Income taxes payable 43,438 39,978 72,096 4,753 24,378 Deferred income taxes 0 0 6,011 10,958 50,104

Total current liabilities 1,559,358 1,711,404 1,751,051 1,811,159 2,054,568

Long-term debt 1,194,517 1,546,845 1,869,250 1,861,850 1,857,157Other liabilities 98,597 134,819 115,143 181,241 145,053Deferred income taxes 0 0 5,728 0 0

Total long-term liabilities 1,293,114 1,681,664 1,990,121 2,043,091 2,002,210Total liabilities 2,852,472 3,393,068 3,741,172 3,854,250 4,056,778

Stockholders' equity 689,127 373,758 171,393 391,007 469,528

Stockholders' equity (after net income)

Total Liabilities and Stockholders' Equity 3,541,599 3,766,826 3,912,565 4,245,257 4,526,306

54

Forecasted Financial StatementsAssets 2007 2008 2009 2010 2011 2012 2013 2014 2015Current Assets: Cash and cash equivalents Accounts receivable 69,342 77,498 83,116 89,142 95,605 102,537 109,971 117,943 126,494 Merchandise inventories 1,914,368 2,035,739 2,164,805 2,302,053 2,448,004 2,603,207 2,768,250 2,943,757 3,130,392 Other current assets Not Forecastable

Deferred income taxes Irrelevant

Total current assets 2,158,753 2,295,618 2,441,160 2,595,930 2,760,512 2,935,528 3,121,641 3,319,553 3,530,013

Property and equipment, net of depreciation 2,206,968 2,346,890 2,495,683 2,653,909 2,822,167 3,001,093 3,191,362 3,393,694 3,608,854 Goodwill, net of accumulated amortization Not Forecastable Deferred income taxes Not Forecastable Other long-term assets Not Forecastable

Total long-term assets 2,654,521 2,822,817 3,001,784 3,192,097 3,394,476 3,609,685 3,838,540 4,081,903 4,340,696

Total Assets 4,813,274 5,118,435 5,442,944 5,788,027 6,154,988 6,545,214 6,960,181 7,401,456 7,870,708

Asset Turnover 1.33 1.34 1.35 1.36 1.37 1.38 1.39 1.41 1.42

Liabilities and Stockholders' EquityCurrent Liabilities: Accounts payable 1,868,274 2,053,607 2,257,325 2,481,251 2,727,391 2,997,948 3,295,345 3,622,243 3,981,570 Accrued expenses Irrelevant Income taxes payable Not Forecastable Deferred income taxes Irrelevant

Total current liabilities 2,145,549 2,281,577 2,426,229 2,580,052 2,743,627 2,917,573 3,102,547 3,299,249 3,508,421

Long-term debt 2,087,816 2,347,123 2,638,635 2,966,354 3,334,775 3,748,954 4,214,574 4,738,024 5,326,487Other liabilities Not Forecastable Deferred income taxes Irrelevant

Total long-term liabilities 2,153,718 2,290,264 2,435,467 2,589,876 2,754,074 2,928,682 3,114,360 3,311,811 3,521,780Total liabilities 4,299,697 4,572,298 4,862,182 5,170,444 5,498,251 5,846,840 6,217,529 6,611,721 7,030,904

Stockholders' equity 513,576 546,137 580,762 617,582 656,737 698,374 742,651 789,735 839,805

Stockholders' equity (after net income) 1,233,888 1,364,235 1,454,193 1,514,193 1,791,231 1,986,882 2,118,309 2,201,901 2,626,638

Total Liabilities and Stockholders' Equity 4,813,274 5,118,435 5,442,944 5,788,027 6,154,988 6,545,214 6,960,181 7,401,456 7,870,708

The first account taken into factor was the total assets. By taking an average

asset growth rate of 6.93%, we were able to use this four the next ten years. We

supported our information by showing the previous year’s asset turnover and

computing the forecasted asset turnover. There seems to be a pattern that reflects

the actual asset turnover from the years 2002-2006 which supports our reasoning.

Current assets and long-term assets were measured by taking a average of current

assets/total assets and long-term assets/total assets (44.85% current, 55.15% long-

term) every year for ten years. We did this due to the fact we do not believe these

accounts to change over a ten year period. There were two special cases which

were inventories and receivables. Basically, we just took our forecasted sales for

that year and divided by our 5 year average receivables turnover (88.288) to get our

projected receivables amount. Inventory was forecasted in the same way by taking

projected cost of goods sold for that year and dividing it by a 5 year average

inventory turnover. The last asset account, depreciation, was simply forecasted by

taking a five year percentage of total-long-term assets every year.

55

Liabilities were calculated nearly the same way as the assets were. Both

current and long-term liabilities were calculated as a 5 year average percentage of

liabilities. Total liabilities were calculated as a 5 year average percentage of total

assets. Accounts payable had a 5 yr average growth rate of 9.92% so we decided

to use this rate so accounts payable could grow consistent. To forecast

stockholder’s equity, we took an assumption that AutoZone would not repurchase

any more shares in the near future since they have bought so many shares back in

the past four years. By taking this into factor, we simply took the stockholder’s

equity from the previous year and added net income in from the current year. This

may look inconsistent with other forecasts since stockholder’s equity is growing

extremely large compared to other accounts, but the assumption of no share

repurchases is the primary reason behind this.

Actual Financial Statements2002 2003 2004 2005 2006

AssetsCurrent Assets:

Cash and cash equivalents 1.99% 2.47% 1.96% 1.76% 2.02%

Accounts receivable 0.67% 1.16% 1.75% 2.79% 1.78%

Merchandise inventories 38.84% 40.12% 39.91% 39.19% 40.80%

Other current assets 0.33% 0.51% 1.25% 1.71% 2.22%

Deferred income taxes 1.70% 0.68% 0.00% 0.78% 0.46%

Total current assets 42.75% 44.37% 44.87% 45.45% 46.81%

Property and equipment: 46.92% 45.55% 45.75% 45.64% 45.32%

Goodwill, net of accumulated amortization 8.62% 7.81% 7.69% 7.13% 6.69%

Deferred income taxes 1.70% 0.68% 0.00% 0.78% 0.46%

Other long-term assets 0.01% 1.59% 1.68% 1.00% 0.72%

Total long-term assets 57.25% 55.63% 55.13% 54.55% 53.19%

Total Assets 100.00% 100.00% 100.00% 100.00% 100.00%

Liabilities and Stockholders' Equity

Current Liabilities:

Accounts payable 40.94% 40.10% 38.20% 39.95% 41.90%

Accrued expenses 12.21% 9.16% 6.52% 6.63% 6.91%

Income taxes payable 1.52% 1.18% 1.93% 0.12% 0.60%

Deferred income taxes 0.00% 0.00% 0.16% 0.28% 1.24%

Total current liabilities 54.67% 50.44% 46.80% 46.99% 50.65%

Long-term debt 41.88% 45.59% 49.96% 48.31% 45.78%

Other liabilities 3.46% 3.97% 3.08% 4.70% 3.58%

Deferred income taxes 0.00% 0.00% 0.15% 0.00% 0.00%

Total long-term liabilities 45.33% 49.56% 53.20% 53.01% 49.35%

Total Liabilities 100.00% 100.00% 100.00% 100.00% 100.00%

Stockholders' equity 100.00% 100.00% 100.00% 100.00% 100.00%

Total Liabilities and Stockholders' Equity

56

Forecasted Financial Statements2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

AssetsCurrent Assets:

Cash and cash equivalents

Accounts receivable

Merchandise inventories 39.77% 39.77% 39.77% 39.77% 39.77% 39.77% 39.77% 39.77% 39.77% 39.77%

Other current assets Irrelevant

Deferred income taxes Not Forecasetbale

Total current assets 44.85%

Property and equipment: 45.85% 45.85% 45.85% 45.85% 45.85% 45.85% 45.85% 45.85% 45.85% 45.85%

Goodwill, net of accumulated amortization

Deferred income taxes Not Forecastable

Other long-term assets Not Forecastable

Total long-term assets 55.15% 55.15% 55.15% 55.15% 55.15% 55.15% 55.15% 55.15% 55.15% 55.15%

Total Assets 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Liabilities and Stockholders' Equity

Current Liabilities:

Accounts payable 43.45% 44.91% 46.43% 47.99% 49.60% 51.27% 53.00% 54.79% 56.63% 58.54%

Accrued expenses

Income taxes payable Not Forecastable

Deferred income taxes Not Forecastable

Total current liabilities 49.90% 49.90% 49.90% 49.90% 49.90% 49.90% 49.90% 49.90% 49.90% 49.90%

Long-term debt

Other liabilities

Deferred income taxes

Total long-term liabilities 50.09% 50.09% 50.09% 50.09% 50.09% 50.09% 50.09% 50.09% 50.09% 50.09%

Total Liabilities 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Stockholders' equity 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%

Total Liabilities and Stockholders' Equity

Cost of Equity (Ke)

The cost of equity (Ke) is important and is the rate of return that

shareholders’ requite to identify equity investments in the firm. Cost of equity

reflects the opportunity cost of investment for shareholders. The higher the cost of

equity targets the higher risk industry that should demand a higher return. After

observing market statistics, we were able to solve for Ke by using the CAPM model.

CAPM Model

Ke=Risk Free Rate + Beta*Market Risk Premium

17.4%=4.71%+2.27*5.6%

To compute the cost of equity (Ke), we estimated the risk free rate, market risk

premium, and the systematic risk (Beta) that resulted in our statistical computations.

We ran 24, 36, 48, 60, & 72 months based on historical prices and the monthly

57

market return for the S&P 500. Our estimates were based on monthly percentage

of data of 7-year maturity T-Bills. We chose the 7-year treasury constant maturity

rate divided by one hundred to get the risk free rate of 4.71% because it had the

highest adjusted R-squared compared to the other computations. The beta was 2.27

by basing the regression with the highest adjusted R-squared of 43.77 %.( see table

below) With the beta being greater than one, it implies the asset has more

systematic risk than the overall market. We used a market risk premium of 5.6%,

which is a measure of the excess return on assets to exceed the risk free rate. We

took the average of the market risk premium and added the risk free rate to get the

market risk premium (see appendix). After finding all the variables in the equations

we plugged it in and got a total of 17.4% for the cost of equity. Cost of equity is

the return that stockholders require for AutoZone. AutoZone is expected to have a

17.4% return.

7 Year Months

Beta R^2 Ke

72 0.508928514 0.052045292 0.075682 60 0.676710196 0.111732994 0.085105 48 1.497507192 0.271115141 0.131201 36 1.842932222 0.370525503 0.150601 24 2.267817138 0.437726791 0.174463

Cost of Debt (Kd)

The cost of debt is the rate a company pays on its current debt. To find the

cost of debt, we broke down the liability side and found discount rates for current

and long-term liabilities that were found on the most recent financial statement

located on the 10-K. On the long term liabilities, we took the weighted average of

long term debt rates and calculated a percentage of total liabilities. We added all of

the computed interest rates individually and calculated a total cost of debt (Kd) as

6.06%.

58

Cost of Debt(Ke) % LT % of Interes

t Computed

Total Liabilities

liabilities

Total Liabilities Rates

Interest Rates

Accounts Payable 1699667 41.90% 5.91% 0.0248 Accrued Expenses 280419 6.91% 8.83% 0.0061 Income taxes Payable 24378 0.60% 7.55% 0.0005 Deferred Income Taxes 50104 1.24% 10.94% 0.0014 Total Current Liabilities 2054568 50.65% Long-term Liabilities Long-term debt 1857157 92.76% 45.78% 5.91% 0.0270 Other Liabilities 145053 7.24% 3.58% 2.41% 0.0009 Total Long-term Liabilities 2002210 100.00% 49.35% Total Liabilities 4056778 100.00% 0.0606 WACD

WACC

The weighted average cost of capital (WACC) is the most important measure

when evaluating a company. It is important for capital budgeting purposes.

Investment projects that have a greater return than the company’s WACC, create a

positive net present value for stock owners and should take the project. If the

project earns less than the company’s WACC, the project should be avoided by the

company because it would decrease in stockholder value. It is the basis for

performing evaluations and strategy methods. The WACC is used in measuring the

cost of capital for a firm.

WACC= (Vd/Vf) (Kd) (1-T) + (Ve/Vf) (Ke)

To calculate the weighted average cost of capital we need to find variables

such as the value of debt(Vd), the value of equity(Ve), the value of firm(Vf), cost of

equity(Ke), and the cost of debt(Kd). These variables can be found from the most

recent financial statements. For the value of debt, $4,056,778, we used the total

liabilities from the most recent 10-k. The value of equity was determined by taking

the current stock price times the current shares outstanding which is the market

value of $9,108,477. The value of the firm is based on taking the value of equity

plus the value of debt. The value of the firm is $13,165,255. For AutoZone’s tax

rate, we used the average of the last five years from the financial statements to

come up with a 37% tax rate. To find the cost of debt we took a weighted average

of long-term debt found in the financial statements. After calculating the rates, we

59

summed all the rates together to come up with a total cost of debt (Kd) to be

6.06%. After finding all the parameters to plug into the equation we got 13.2% for

the weighted average cost of capital.

13.2 %=( $4.057m/$13.17m) (6.06%) (1-37%) + ($9.11m/$13.17m) (17.4%)

Intrinsic Valuation Models

For investment purposes, companies must value a firm to indicate whether

they believe the investment is a smart decision or not. By taking various angles of

different valuation models, investors will be able to access which one is the most

reliable. Looking at the values, a company can decide whether the investment is a

good buy or not. We ran four different valuation models in order to see which one

is most reliable and how much we believe that AutoZone is worth. The four models

that we used were: Method of Comparables, Free Cash Flows, Residual Income, and

Abnormal Earnings Growth. Another model that was used to associate

creditworthiness with a company is the Altman’s z-score.

Method of Comparables

O'Reilly Advance AutoZone IndustryAverage ValuationP/B 16.93 4.09 14.47 10.51 65.59

Forward P/E 13.97 14.42 9.97 14.20 107.41Trailing P/E 16.47 18.57 13.00 17.52 132.56Price/Sales 1.69 0.92 0.94 1.31 117.84

Price/EBITDA 0.09 0.07 0.08 0.08 7.12PEG RATIO 0.88 1.13 0.9 1.01 11.93

ENTERPRISE VALUE/EBITDA 12.06 9.08 10.23 10.57 12,166.19The method of comparables valuation model is derived based on other company

statistics and past numbers. We used 7 ratios to determine value of AutoZone. By

taking an industry average of each ratio separately and multiplying it by the

denominator of AutoZone’s ratio, we create a value. Overall, we decided that the

trailing P/E ratio was the most accurate since it was the highest one valuing at

$132.56. The enterprise value/EBITDA was too extreme and was not considered in

this valuation.

Discounted Free Cash Flows

The discounted free cash flows model involves discounting free cash flows

back to the firm by the weighted average cost of capital to come up with an intrinsic

60

valuation in present value form. The first step in this process is to calculate the free

cash flows to the firm. This is done by subtracting cash flows from investing

activities from cash flows from operations. We did this in the year 2006 and all of

the forecasting years. (2007-2015) After that, we needed to find the discount factor

by using the weighted average cost of capital so can find the present value of our

intrinsic valuation. After we found the present value rates for each year, we

multiplied them by the free cash flows to the firm in that year. The sum of those

numbers was used to find the total present value of $5,777,578. The next

computation in this model was to find the continuing terminal value. To find the

terminal value, we took the forecasted value in 2017 and divided the value by the

weighted average cost of capital minus the growth rate of zero. Once we

determined this number of $10,285,497, we discounted it back using the weighted

average cost of capital to come up with the present value of the continuing terminal

value at $9,093,358. Once we added the present value of the forecasted years and

the continuing terminal value and subtracting off the current book value of liabilities

and divided the number by the current shares outstanding, we came up with a value

of $143.73.

Sensitivity AnalysisWACC

0.11 0.12 0.1311 0.145 0.16-0.02 154.38 140.89 127.74 113.45 100.20-0.01 164.73 149.68 135.17 119.57 105.25

0 176.96 159.94 143.73 126.53 110.930.01 191.64 172.06 153.71 134.53 117.370.02 209.58 186.61 165.49 143.81 124.72

0.03 232.01 204.39 179.60 154.69 133.21 Overvalued<$116.08Fairly Valued +/-10%Undervalued>$141.88

Unlike the residual income and abnormal growth rate models, the discounted

free cash flow model uses the weighted average cost of capital (WACC). This

sensitivity analysis shows us that at the WACC we calculated assuming a zero

growth rate we estimated a price of $143.73, which is significantly closer to the

observed price than the RI and AEG models calculated. This model also shows us

61

that if the WACC remains constant, a higher growth rate will increase the price level.

On the other hand, a decrease in the growth rate, holding the WACC constant,

decreases the price level. In this case, the WACC we calculated for AutoZone results

in a fairly valued price at about a -3% and -2% growth rate. However, increasing

the WACC and keeping the growth rate constant decreases the price. Likewise, if

you increase the WACC and increase the growth rate, the price level decreases as

well. For instance, increasing the WACC to 16% and increasing the growth rate to

3% will increase the price level to $133.21. If you keep the growth rate at 3% and

decrease the growth rate to 11% the price rises to $232.01.

Residual Income

The residual income model uses forecasted residual incomes to come up with

an estimated intrinsic value. By finding all of the residual incomes and then

forecasting them back to the present using the cost of equity, firms have a better

understanding of what a company is worth. To find a residual income for each

forecasted year, we took the Earning for the year and subtracted the normal

income, which is the cost of equity times the book value from the previous year,

from the earnings of the current year. After we calculated all of the residual

incomes we discounted all of them back by using the cost of equity. Once the

present value of all the residual incomes was found, we added them together to get

a total present value of $2,105,015. Like the discounted free cash flows model, we

must find a terminal value perpetuity for the final section of our model. To do this,

we simply take our forecasted 2017 residual income, which was $77,964, and divide

it by the cost of equity minus the growth rate of zero. After this we discounted the

terminal value perpetuity by using the cost of equity. We came up with the present

value of the terminal value perpetuity of $90,087. By adding the 2006 book value of

equity, the total present value of residual income and the present value of the

continuing value perpetuity, we came up with an intrinsic value of $35.42. The

problem with this is that the observed share price is $128.80. This is not even close

to our valuation. Upon reviewing all of the different factors that help conclude the

model, we have come to the decision that we value the cost of equity a lot higher

62

than the market does. This could relate to the recent repurchases of shares that

AutoZone has been buying in the past four years. Either way, firms must value

AutoZone’s cost of equity higher so it can relate to intrinsic valuations based on

financial statistics.

Sensitivity AnalysisKe

0.075 0.088 0.091 0.095 0.105 0.1740.00 135.59 108.69 103.60 97.34 83.85 35.420.01 143.74 113.24 107.60 100.71 86.08 35.490.02 154.86 119.12 112.75 104.98 88.82 35.570.03 170.92 127.03 119.52 110.57 92.31 35.670.04 196.17 138.24 128.99 118.18 96.86 35.77

Overvalued<$116.08Fairly Valued +/-10%Undervalued>$141.88

With our cost of equity at 17.4% and a growth rate of 0, we calculated a

price that was not very close to the ending price on April 2nd. We also noticed that

neither an increase nor decrease in the growth, while keeping the original cost of

equity constant, showed much of a change in the calculated price. However, when

we decreased the cost of equity we saw an on average 67% increase in the price,

and finally we were able to conclude that if we increase the growth rate as well as

decrease the cost of equity the price gets closer and closer to the ending price on

April 2nd of $128.98. In fact, when we increased the growth rate to 0.04 and

decreased the cost of equity to 0.091, we got a fairly valued price of $128.99 which

is one cent higher than the observed price. By decreasing the cost of equity while

increasing the growth rate, we decrease the numerator of the residual income

equation. Doing this increases the price as shown in the sensitivity analysis above.

Abnormal Earnings Growth

Abnormal earnings are net income adjusted for a capital charge computed as

the discount rate multiplied by the beginning book value of equity. “Abnormal

earnings therefore make an adjustment to reflect the fact that accountants do not

recognize any opportunity cost for equity funds used.” (Palepu- Healy- Bernard)

The abnormal earnings growth model starts with taking the earnings and then

63

adding dividends. The dividends are multiplied by the cost of equity to get our

forecasted dividends. Since AutoZone does not pay any dividends, it makes our

forecasted dividends zero. By adding the earnings and dividends together calculates

AutoZone’s cumulative dividend earnings which will equal earnings due to the fact

that AutoZone does not pay dividends. Normal income is the calculated by

multiplying the growing earnings by the cost of equity. Cumulative dividend

earnings are then subtracted from normal income to calculate Abnormal Earnings.

To find the abnormal earnings growth we take the same calculations for the next

nine years. The total present value of the nine years is found by taking the total

amount of residual income and discounting it back to the previous year at the cost

of equity, which is the discount factor. The total present value of abnormal

earnings growth is ($225,159) and is added to the initial earnings of $720,312.

Those two numbers are divided by the shares outstanding to get the total average

earnings of $7.85 and that is divided by the cost of equity .174 to determine a value

of $45.13.

0.119 0.121 0.125 0.130 0.1740.00 132.26 126.30 122.26 105.70 45.130.01 136.94 130.59 126.41 108.72 45.570.02 142.57 135.72 131.38 112.29 46.080.03 149.47 141.99 137.45 116.59 46.65

Overvalued<$116.08Fairly Valued +/-10%Undervalued>$141.88

Similar to the residual income model, the cost of equity is also used to

calculate the abnormal earnings growth. This sensitivity analysis showed us that

using the cost of equity we calculated for AutoZone (17.4%) and a zero growth rate

the estimated price for AutoZone is $45.13. Although it is a little bit higher than the

residual income model, it is still significantly lower than the observed price. As

previously stated, decreasing the cost of equity increases the price level because as

the cost of equity decreases the denominator increases. In this case, the sensitivity

analysis shows that despite no growth, the smaller the cost of equity, the higher the

64

prices get; however, at a growth of 3%, a smaller decrease in the cost of equity

results in a significantly faster rate of increase in the price level.

Altman’s Z-Score

2002 2003 2004 2005 2006 Z-Score 7.54 7.11 6.72 6.20 5.88

The Altman Z-score model takes a look at a company’s credit risk. The value

range is as follows. If the z-score is less than two then companies do not have good

credit worthiness. Lenders will view this score and it will be hard for a company to

receive money. A credit score between 2 and 3 is average credit worthiness and a

credit score greater than three is a good, creditworthy company. AutoZone has

maintained a good credit score the past five years averaging at 6.69. Companies

will take the risk in lending a company like AutoZone money due to good z-scores

and having the nationally respected label on their firm’s name.

Analyst Recommendation

Upon reviewing multiple different valuation models and financial statistics, we

believe AutoZone to be overvalued. The closest method to the current market price

was the method of comparables. However, we believe that model to highly

inaccurate due to the fact that its primary use is obtaining a quick value. Also, our

free cash flows model undervalued AutoZone at $143.73 per share when we believe

it is overvalued based on statistical evidence. Our residual income was valued at

$35.42 which we believe is too low. We believe that the abnormal earnings growth

model is the most accurate due to the fact that it is the highest overvalued number

at $45.13. The key factor in determining our decision is that AutoZone has been

repurchasing stock the past four years. This boosts earnings to attract shareholders

and to increase their observed market price of 128.98. However, this is misleading

since they are distorting their accounting information. If there were more shares

available to the public, the market price would fall and be valued a lot more

accurate.

65

Appendix 1

Financial Ratios (O’Reilly & Advance)

O’Reilly Auto Parts Liquidity Analysis:

Current Ratio 4.28 2.80 2.44 1.88 NA Quick Asset

Ratio .51 .3 3.84 .22 N/A

Accounts Receivable Turnover

28.90 28.94 28.25 27.70 NA

Days Supply Receivable

12.62 12.61 12.92 13.18 NA

Inventory Turnover

1.51 1.58 1.56 1.59 NA

Days Supply Inventory

241.72 231.01 233.97 229.56 NA

Working Capital Turnover

2.71 3.42 3.59 4.81 NA

Profitability Analysis:

2002 2003 2004 2005 2006 Gross Profit

Margin 42% 42% 43% 44% NA

Operating Expense Ratio

.11 .1 .11 .12 N/A

Net Profit Margin

6.25% 6.62% 8.11% 8.03% NA

Asset Turnover 1.30 1.27 1.20 1.19 NA Return On

Assets 8.12% 8.42% 9.74% 9.58% NA

Return On Equity

12.60% 12.76% 14.72% 14.33% NA

Capital Structure Analysis: 2002 2003 2004 2005 2006 Debt to Equity Ratio .55 .51 .51 .50 NA

Times Interest

Earned

14.95 24.08 40.52 49.89 NA

Debt to Service Margin

20.6 2164.56 18,878 0 N/A

66

Advance Auto Parts

Liquidity Analysis:

Current Ratio 1.64 1.44 1.43 1.36 NA Quick Asset

Ratio .16 .11 .16 .96 N/A

Accounts Receivable Turnover

31.24 41.20 36.97 45.04 NA

Days Supply Receivable

11.68 8.86 9.87 8.10 NA

Inventory Turnover

1.69 1.70 1.68 1.65 NA

Days Supply Inventory

215.98 214.70 217.26 221.21 NA

Working Capital

Turnover

6.92 9.38 9.06 10.49 NA

Profitability Analysis:

2002 2003 2004 2005 2006 Gross Profit

Margin 45% 46% 47% 47% NA

Operating Profit

Margin

.06 .08 .09 .1 N/A

Net Profit Margin

2.03% 3.58% 4.99% 5.5% NA

Asset Turnover

1.63 1.76 1.71 1.68 NA

Return On Assets

3.31% 6.3% 8.54% 9.23% NA

Return On Equity

13.88% 19.80% 26.03% 25.52% NA

Capital Structure Analysis:

2002 2003 2004 2005 2006 Debt to

Equity Ratio 3.20 2.14 2.05 1.76 NA

Times

Interest Earned

2.55 7.67 16.38 12.61 NA

Debt to Service Margin

0 33.29 11.87 10.26 N/A

67

Appendix 2- Regression Tables 3 Month Months

Beta R^2 Ke

72 0.507335247 0.051771645 0.082487114 60 0.673807028 0.110966882 0.092622095 48 1.501631898 0.273513577 0.143020961 36 1.834200524 0.369963219 0.163268096 24 2.261161033 0.437574352 0.18926191

6 Month Months

Beta R^2 Ke

72 0.507157921 0.051675892 0.08239496 60 0.673862264 0.110945002 0.09251736 48 1.502790153 0.273761334 0.1428504 36 1.834573882 0.369850802 0.16299653 24 2.261895076 0.437511241 0.18894375

1 Year Months

Beta R^2 Ke

72 0.507454004 0.051710355 0.080752 60 0.674483356 0.111115009 0.09071 48 1.503089054 0.273628528 0.140107 36 1.835856774 0.369864762 0.159945 24 2.263041921 0.437537017 0.185412

5 Year Months

Beta R^2 Ke

72 0.508849693 0.052034675 0.075694 60 0.676554602 0.111719454 0.085118 48 1.49913764 0.27174487 0.131341 36 1.841782282 0.370392514 0.150596 24 2.267201997 0.437710594 0.174501

68

7 Year Months

Beta R^2 Ke

72 0.508928514 0.052045292 0.075682 60 0.676710196 0.111732994 0.085105 48 1.497507192 0.271115141 0.131201 36 1.842932222 0.370525503 0.150601 24 2.267817138 0.437726791 0.174463

10 Year Months

Beta R^2 Ke

72 0.508625981 0.051932453 0.075786 60 0.676534833 0.111625091 0.085223 48 1.496116551 0.270574177 0.131286 36 1.843933919 0.370654607 0.150835 24 2.268169489 0.43770132 0.174678

69

Appendix 3- Method of Comparables

AutoZone Inc. Actual Financial Statements Forecasted Financial Statements2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

PPS 46.20 72.35 91.80 74.06 94.50 90.30EPS 6.66 7.27 7.57 9.06 10.16 11.39 11.45 11.51 12.90 14.47 16.23 16.31 16.39DPS 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00BPS 2.02 4.98 6.24

O'Reilly AdvanceAutoZone IndustryAverage Valuation

P/B 16.93 4.09 14.47 10.51 65.59Forward P/E 13.97 14.42 9.97 14.20 107.41Trailing P/E 16.47 18.57 13.00 17.52 132.56Price/Sales 1.69 0.92 0.94 1.31 117.84

Price/EBITDA 0.09 0.07 0.08 0.08 7.12PEG RATIO 0.88 1.13 0.9 1.01 11.93

ALUE/EBITDA 12.06 9.08 10.23 10.57 12,166.19

70

Appendix 4- Valuation Models

Free Cash Flows

0 1 2 3 4 5 6 7 8 9 102006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Cash flows from operations 767,129 715,271 817,126 933,485 870,381 811,543 927,107 1,059,127 987,530 920,773Cash flows from investing activities -195,128 -198,864 -202,369 -237,900 -240,113 -202,558 -203,791 -205,828 -243,852 -286,569

Free cash flows to the firm 962,257 914,135 1,019,495 1,171,385 1,110,495 1,014,101 1,130,898 1,264,956 1,231,382 1,207,342 1,348,429Discount rate 0.8841 0.7816 0.6910 0.6109 0.5401 0.4775 0.4222 0.3732 0.3300 0.2917

Present value of free cash flows 850,727 714,510 704,502 715,642 599,807 484,256 477,437 472,136 406,335 352,225Total present value of annual cash flows 5,777,578

Continuing (Terminal) Value (assuming no growth) 10,285,497

Present Value of Continuing (Terminal) Value $9,093,358

Value of firm $14,870,936

Book value of liabilities $4,056,778

Estimated price per share 143.73

Number of shares 75,237

71

Residual Income 0 1 2 3 4 5 6 7 8 9 10

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Beginning BVE 469,528 1,189,840 2,007,938 2,881,369 3,777,980 4,912,474 6,200,982 7,576,640 8,988,805 10,775,638Earnings 720,312 818,098 873,431 896,611 1,134,494 1,288,508 1,375,658 1,412,165 1,786,833 2,029,406DPSEnding Book Value 469,528 1,189,840 2,007,938 2,881,369 3,777,980 4,912,474 6,200,982 7,576,640 8,988,805 10,775,638 12,805,044Ke 0.174Normal Income 81,698 207,032 349,381 501,358 657,368 854,770 1,078,971 1,318,335 1,564,052 1,874,961Residual Income 638,614 611,066 524,050 395,252 477,126 433,738 296,687 93,830 222,781 154,445Discount Factor 0.8518 0.7255 0.6180 0.5264 0.4484 0.3819 0.3253 0.2771 0.2360 0.2011PV of Residual Income 543,964 443,355 323,868 208,066 213,940 165,660 96,521 26,001 52,585 31,052Continuation (Terminal) Value 448,067

Beginning BE 469,528Total PV of RI 2,105,015PV of Terminal Value 90,087Estimated Value 35.42

Observed Share Price 128.98

Number of Shares: Basic 75,237Growth 0

72

Abnormal Earnings Growth 0 1 2 3 4 5 6 7 8 9

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016Earnings 569,275$ 720,312 818,098 873,431 896,611 896,611 1,288,508 1,375,658 1,412,165 1,786,833 2,029,406Dividends 0 0 0 0 0 0 0 0 0Drip 0 0 0 0 0 0 0 0 0Cumulative Dividend Income 818,098 873,431 896,611 896,611 1,288,508 1,375,658 1,412,165 1,786,833 2,029,406Normal Income 845,646 960,447 1,025,408 1,052,621 1,052,621 1,512,709 1,615,022 1,657,882 2,097,742Abnormal Earnings Growth (27,548) (87,016) (128,798) (156,010) 235,887 (137,051) (202,857) 128,951 (68,337) 70,493

PV Factor 0.8518 0.7255 0.6180 0.5264 0.4484 0.3819 0.3253 0.2771 0.2360PV Abnormal Earnings Growth (23,465) (63,134) (79,598) (82,126) 105,770 (52,345) (65,995) 35,734 (16,130)

Core EPS 720,312Total PV of AEG (225,159)Continuing (Terminal) Value 405,132PV of Terminal Value 95,628Total Average EPS Perpetuity 7.85Capitalization Rate 0.174Intrinsic Value 45.13Growth 0Basic Shares Outstanding (20 75,237Basic Shares Outstanding (Fe 70,476

Ke 0.174

Observed Share Price 128.98

73

Appendix 5- Altman’s Z-Score 2002 2003 2004 2005 2006

Current Assets 1,513,936 1,671,354 1,755,757 1,929,459 2,118,927Current Liabilities 1,559,358 1,711,404 1,751,051 1,811,159 2,054,568Working Capital (45,422) (40,050) 4,706 118,300 64,359Retained Earnings 974,141 869,739 580,147 559,208 370,276Earnings Before Interest and Taxes 771,008 917,797 998,706 975,664 1,009,925 Book Value of Liabilities 2,852,472 3,393,068 3,741,172 3,854,250 4,056,778Market Value of Equity 7,013,284 7,558,809 7,270,833 7,022,453 8,214,236Sales 5,325,510 5,457,123 5,637,025 5,710,882 5,948,355Total Assets 1,513,936 1,671,354 1,755,757 1,929,459 2,118,927

Component 1 (0.04) (0.03) 0.00 0.07 0.04Component 2 0.90 0.73 0.46 0.41 0.24Component 3 1.68 1.81 1.88 1.67 1.57Component 4 1.48 1.34 1.17 1.09 1.21Component 5 3.52 3.27 3.21 2.96 2.81

2002 2003 2004 2005 2006Z-Score 7.54 7.11 6.72 6.20 5.88

74

Works Cited

Advanced Auto Parts Inc. www.advancedautoparts.com

AutoZone Inc. www.autozone.com

Business Analysis & Evaluation Palepu – Healy – Bernard

Morningstar www.quicktake.morningstar.com

O’Reilly Automotive Inc. www.oreillyauto.com

Pep Boys www.pepboys.com

SAS www.sas.com

Yahoo Finance www.finance.yahoo.com

Free Dictionary www.freedictionary.com

Wall Street Journal www.wsj.com