What is Value Based Managment (VBM)? There are many definitions. But I think Warren Buffett explains it best:
“When managers are making decisions it’s vital that they act in ways that increase per-share intrinsic value and avoid moves that decrease it. This principle may seem obvious but we constantly see it violated
One of our favorite companies is AutoZone (AZO) the autoparts retailer.
AutoZone is doing a great business in this Great Recesssion serving new demand from cost conscious customers looking to maintain their own car. The stock price has responded as well. It’s up +18.5% year to date and +38.5% over the last 12 months.
At a Morgan Stanley Conference, management says that business remains good in Q2, as consumer behavior continues to change towards wanting to take care of their assets so that they last longer.
In general, people are becoming more comfortable doing maintenance on their cars, as they look to save money. Also, the average age of a vehicle is now over 9 years. Cars over 7 years old are in the “sweet spot” for AZO since these cars are typically off warranties, and may be on their 2nd owner.
To the extent that they are seeing a benefit from dealerships closing, with business then shifting towards AZO, management says they haven’t seen a huge change yet, but it is happening slowly. Management sees this as an opportunity going forward.
AZO believes it is in a good position in terms of inventory coverage, having invested over $300 mln in parts over the past few years. On the commercial side of the business, AZO now has 2,200 programs, and continues to focus on growing this side of the business. Mgmt feels that its enhanced parts coverage, its hub programs, and increased sales force position the company to increase penetration.
Why does this company “act in ways that increase per-share intrinsic value and avoid moves that decrease it.” Let’s consider what drives up per share intrinsic value.
Intrinsic Value = Present Value (PV) of Future Cash Flows
PV of Future Cash Flows = Capital invested (which we can observe; debt + equity) +PV of Future Economic Value Added (EVA)
EVA = (Return on Invest Capital (ROIC) – Cost of Capital) * Capital
ROIC = Net Operating after Taxes (NOPAT)/Capital = NOPAT/Sales X Sales/Capital
That’s the math! Simple for accounting and number geeks like me but its also simple for non accounting types because it all boils down to managing short-term and long-term profit margins to increase the dollar amounts of EVA.
1. Profit margin (NOPAT/Sales)
2. Capital (asset) Turnover (Sales/Capital)
3. Capital Growth (aka Capex and Investments)
4. Use of excess cash if any – debt paydown, stock buyback and/or dividend.
To manage for value, then, we need to take actions that maximizes the amount of EVA dollars that we expect to make. Notice we cannot simply maximize our profit margins by minimizing costs or raising prices. We cannot minimize investments or capital expenditures only to maximize our return on invested capital because that might not maximize EVA dollars or Intrinsic value.
Instead the best business models and managment teams optimize each driver of intrinsic value to maximize intrinsic value.
But remember Mr. Buffett implores managers to act to increase per share intrinsic value. After all, unlike him, we own shares of these companies not the whole thing. Ideally, for the long-term I would want a board that monitors increases in intrinsic value (or EVA) but also uses free cash flow that these high return businesses ordinarily generate to buy back stock and shrink the float, thereby increasing our ownership percentage of a growing pie. That’s the formula for excess returns over the long-term and is at the heart of our process.
Let’s look at the drivers for Autozone:
First, let’s look at past and expected economic performance for the last 15 years.
The first thing that strikes us is that the economic profit (same as EVA in dollars) has been positive for the last 15 years. Next, we understand that the EVA has grown for most of the period except during 2007 – 2009 period. Finally, after 2001 is when the EVA growth accelerated to unprecedented highs. This was the period when value investor Eddie Lampert took a large stake in the company and instituted a Value Based Management program where only expenditures that had a high probability of earning 15% pre tax return on capital would be undertaken. This discipline is exactly the discipline that Buffett has said he sees violated everyday. Basically, growth is good but only when it will generate returns well above the cost of its capital – which leads to high and increasing EVA.
How did AZO do it – look at the profit margins and asset turnover below.
The focus in 2001 was to increase margins mostly reducing costs and wasteful spending. To increase EVA the cost structure was dramatically overhauled and took about 2.5 years. Since then the EBITDA margin has been very consistent at industry highs around 19%. This margin is now very stable even as the company has been extremely good at trading off between lower/higher gross margins and lower/higher fixed costs spread over a growing store base.
The other way to increase ROIC is to increase turnover, sales per capital invested. The efficiency is gained when capital growth is slower than sales growth. But just because capital turnover is slightly decreasing above AZO has been able to increase EVA and ROIC because of the aforementioned careful and steady investment in inventory to inrease parts coverage, while at the same time that margins and or sales would increase to cover the higher capital costs.
The strategy as described by the numbers has been extremely successful, and has led to very high excess returns since the beginning of the VBM program.
Please also notice that we have not once talked about share price – management is not managing the stock market price of AZO. No, it’s managing the intrinsic value per share which may or may not at any given time reflect that growing value. Take a look at that growing realization of the increasing value below.
AZO has obviously managed very well through the Great Recesssion and has shot up during the worst part of the panic. But the most impressive part is that since 2001 when the company began its VBM program, the shareowner has made a lot of money.
But wait there is more! Look how the huge excess cash flow enabled the management to buy back oodles of stock so the number of shares outstanding has steadily fallen.
Let’s say we bought 10 million shares in 1998, when the shares outstanding were 152 million. Our share of the ownership of the company will start at 6.9%. If we simply kept the orginal 10 million shares, we would own 18% of the company in 2009! And remember the dollar amount of EVA has been growing the whole time.
That’s why we invest in EVA companies or what we call Value-Aligned companies. Management is not only capable but is aligned with our goal to increase intrinsic value per share by increasing EVA over time and reducing shares.
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