Automotive Pair Trade: Sell Tesla, Buy AutoZone Stock (NYSE:TSLA)


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Introduction:

The automotive industry is one of the most sensitive industries to economic upheaval. We saw this in 2009 with multiple reorganizations after the housing market’s collapse, and we’re seeing different effects today. Automakers’ reaction to the pandemic, general inflation, sky-high gas prices, and rising interest rates play roles, and each has a tremendous impact on Tesla (NASDAQ:TSLA) and AutoZone (NYSE:AZO) – but in vastly different ways.

The price of new and used vehicles has risen incredibly fast in the past two years, as shown below.

US Consumer Price Index - New and used motor vehicles
Data by YCharts

Current macroeconomic forces point to difficult times for the automakers. However, automotive parts suppliers could be net beneficiaries. Let’s take a look.

How did we get here?

We first need to look back to March 2020. The pandemic hit the economy like a bomb. The stock market crashed, and many thought it would take years to recover. The chart below shows the major indexes from January 1, 2020, through March 23, 2020.

Major indexes from Jan 2020 to Mar 2020
Data by YCharts

It looked like the economy was in for a long, slow recovery. And the worst part was the uncertainty.

During this time, automakers began to cancel or put on hold orders for semiconductors, or “chips.” They assumed that the demand for new vehicles would plummet due to COVID-19. This seemed like prudent thinking – but it turned out to be a massive miscalculation.

The federal government used a series of tools to stimulate and support the economy, such as enhanced unemployment benefits, fully-forgivable loans to businesses (PPP Loans), direct payments to individuals to support consumer spending, tax credits for employee retention, and others. We also saw just how far we had come in our ability to work from home.

As a result, demand for automobiles actually increased. But so did the demand for consumer electronics and other items that rely upon semiconductors. Automakers who had canceled, delayed, or cut back on their chip orders could no longer source enough to keep up with demand.

The days of haggling with the dealership for a price below the manufacturer’s suggested retail price (MSRP) ended, and new cars began to sell at a premium.

When consumers could not afford or found new vehicles unavailable, they looked to the used car market. This increased demand caused used car prices to hit the moon – rising 40% year-over-year ((YoY)) in early 2022. Prices have leveled off a bit, but the damage has been done in terms of affordability.

How will inflation and a potential recession affect Tesla?

Some basics first:

Tesla has enjoyed quite a ride over the past decade. Shareholders have gained over 775% on their investments in the past five years. However, the stock is down more than 40% year-to-date (YTD), as shown below with Seeking Alpha’s charting tool.

Tesla stock chart

Source: Seeking Alpha

The gains have been driven by awe-inspiring results, including a meteoric rise in revenue, as shown below.

Tesla revenue

Source: Seeking Alpha Tools

Operating income also has spiked recently.

Tesla operating income

Source: Seeking Alpha Tools

Tesla has increased production and deliveries to meet increased demand, as shown below, despite some difficulties in their Shanghai plants caused by COVID-19.

tesla production and deliveries

Data source: Tesla. Chart by author.

Despite these positive results, the stock’s 40% plunge YTD shows that investors have concerns. Many of these concerns are macroeconomic risks.

The risks: Demand destruction, rising supply costs, competition.

In a vacuum, rising gas prices would seem to be a net benefit to an electric vehicle maker. People who see those dollars spinning at the pump will be incentivized to turn to the electric vehicle market. But, nothing exists in a vacuum, and rising gas prices contributing to overall inflation could hurt Tesla – here’s how.

First, the Federal Reserve’s newfound hawkishness threatens to dip the economy into a recession as it seeks to curb inflation by raising interest rates. This means that consumers are less likely to make large purchases. Luxury items are often the first cutbacks, and Tesla vehicles are not cheap. Yes, the affordability comes over time with the savings on gas, but many consumers have barriers to entry.

What’s frightening is that the consumer sentiment index is lower now than at any point during the Great Recession or the peak of the March 2020 crash. This index measures how likely people are to make purchases in the near future. Consumer sentiment is generally thought of as a top predictor of consumer spending.

US index of consumer sentiment
Data by YCharts

Rising interest rates also negatively affect people’s ability to afford new cars.

According to Statista, the average 60-month car loan interest rate has risen from 3.8% at the beginning of the year to nearly 4.5% and is likely to continue climbing.

These macroeconomic forces all point to people keeping their current vehicles for as long as possible, and there is already evidence that this is happening.

While demand is clamped down, supply costs are rising. This could begin to crimp profits. The producer price index looks similar to the consumer price index.

US Producer Price Index - motor vehicle manufacturing
Data by YCharts

Rising prices have not yet caught up with Tesla as margins have risen. This is a positive sign for Tesla stockholders. But can it continue? The company has announced price increases for its vehicles which may help.

It’s a bold move to raise prices during talk of a recession, which tells me that the price increase was probably seen by the company as an absolute necessity to maintain its current profitability. Unfortunately, this will further contribute to the demand destruction.

Below are the gross margin and operating margin for the last several quarters. These will be important metrics to watch over subsequent earnings releases.

Tesla margins

Data source: Seeking Alpha. Chart by author

Will Musk’s Twitter foray bog down Tesla stock?

Elon Musk’s bid to purchase Twitter (TWTR) is still active. I have written in detail about this in an article that can be found here, so I won’t belabor the point. I think it’s doubtful that Musk will purchase Twitter for the agreed-upon price. Whether the deal can be salvaged through renegotiation is unknown. If the deal falls through, expect a wave of litigation to follow.

At best, this is a non-issue for Tesla and its CEO. At worst, it’s an unneeded distraction during a critical moment.

Tesla’s Valuation

Tesla’s valuation is concerning. The current market has punished stocks that have inflated valuation, and the shift from growth to value may continue. Any bad news or missed estimate can cause a substantial downturn when a company is priced for outperformance.

Seeking Alpha’s Quant ratings give Tesla awful valuation ratings, as shown below. However, these grades are relative to car makers that do not have nearly the growth or profitability that Tesla has. The company is not easy to value on traditional metrics.

Tesla Quant Ratings

Seeking Alpha Quant Ratings

Tesla still has a market cap that dwarfs other automakers. As shown below, its market cap is higher than the next seven contenders – combined.

Automakers' market caps

Data source: Seeking Alpha. Chart by author.

Competition continues to increase.

As automakers see that electric vehicles are now inevitable, they have increased investments in an all-out effort to catch up. For instance, Ford (F) is investing more than $22 billion over the next several years to make its fleet more electrified, and Mercedes-Benz (OTCPK:DDAIF) and Volkswagen (OTCPK:VWAGY) are looking for at least 40% of their U.S. sales to be electric by the end of the decade. These are just a few of the many examples. Tesla enjoys a tremendous competitive advantage, but this will not last forever.

The upcoming 3-for-1 stock split may provide a small spark, but the effects of stock splits aren’t typically lasting. The stock quickly retreated toward its announcement date price after the 2020 stock split, and then the stock took off afterward with the company’s success. Some equate the last split with the stock’s massive rise, but that isn’t what happened, as shown below. Other catalysts sent it soaring.

TSLA price Chart
Data by YCharts

The bottom line is numerous risks, and few positive catalysts are on the horizon.

How Will Inflation and a Potential Recession Affect AutoZone?

On the other end of the auto industry spectrum, we have AutoZone, a commercial and DIY automotive parts provider. Like Tesla, AutoZone stock has richly rewarded investors over the past several years.

AZO stock Chart
Data by YCharts

As discussed above, economic conditions like rising prices, falling sentiment, and rising interest rates all point to Americans holding on to their current vehicles for as long as possible. This means more repairs, batteries, brake pads, belts, and other parts.

The stock has a history of outperformance during tough economic times. When Americans tighten their belts, specific sectors of the economy do pretty well. Walmart (WMT) is a terrific example, and AutoZone is another. Below is the total return of AutoZone stock vs. the S&P 500 during the Great Recession and subsequent slow recovery.

AZO vs S&P 500 price
Data by YCharts

Or, as AutoZone CEO Bill Rhodes tells it:

…over the last 30 years, there have been four significant shocks to the economy. In all four of those shocks, our performance and our industry’s performance have made a meaningful step up. During those shocks – recessions and pandemics…our business has gone up, and it’s never stepped back down.

-Bill Rhodes, Chairman, President, and CEO on fiscal Q3 2022 earnings call.

The evidence of this is already being seen with healthy same-store sales growth over the past several periods, which built on the massive increases resulting from stimulus checks in the prior fiscal year.

Below are the gains in revenue and earnings-per-share made over the past several years.

AutoZone selected results

Data source: Seeking Alpha. Chart by author.

What are the risks?

AutoZone may be negatively impacted by rising prices, including fuel costs. Auto parts can be heavy and are not cheap to transport. These supplier costs could be detrimental to margins. Management is well aware of this and has taken steps to increase efficiency, but that can only go so far. Eventually, these costs must be passed on to consumers, or they will eat into profits. Like Tesla, adverse margin effects have not yet materialized. The operating margin for the prior quarter was just over 20% which is typical of AutoZone’s recent profitability. However, this is a primary concern moving forward.

AutoZone’s valuation

It’s much easier to place a value on AutoZone than on Tesla. AutoZone is a mature business in a mature industry. Tesla is posting monstrous growth in a burgeoning sector. Since AutoZone stock is more predictable and easier to value, it has less risk than Tesla stock.

The stock is currently trading in the range of its recent historic valuations based on earnings, cash flow, and EBITDA.

AZO stock valuation
Data by YCharts

If the company can capitalize on an increase in parts demand and efficiently navigate increasing supply costs, the stock price should increase along with EPS.

AutoZone has an ace in the hole.

AutoZone has an extremely generous stock buyback program, which could be its most attractive metric. AutoZone has been buying back its stock since 1998 and authorized over $31 billion over that time. The company’s market cap is just over $39 billion now.

The share buybacks have accelerated over the last several years. $3.4 billion was returned to shareholders this way in fiscal 2021 – over 8% of the current market cap in one year. The trend is going strong this fiscal year, with over $1.8 billion returned through three quarters.

This is a terrific program for shareholders and an excellent tool to use when the stock’s price dips. Share buybacks support stockholders in the market. When the stock falls, management can repurchase more shares for the same investment. This leverages shareholders’ gains over time.

A robust stock buyback program can be an investor’s best friend during market downturns.

The bottom line

The automotive sector is no stranger to economic upheaval, and each subsector can be affected differently. The current macroeconomic climate points to more difficulty for auto manufacturers like Tesla and could offer opportunities for savvy parts suppliers like AutoZone. AutoZone’s propensity to buy back its stock and historical outperformance during recessions are also critical. Because of this, AutoZone stock could outperform Tesla stock in our current economy.



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