There are several ways a company could choose to spend its capital. The five major forms of capital allocation are mergers and acquisitions, investing in growth initiatives, repurchase shares, pay down debt, and pay dividends. In this way, most companies do not take a “one-size-fits-all” approach to capital allocation.

Some companies utilize a mix of all five, while others focus on one or two categories. In rarer cases, a company will lean heavily on one particular method of capital allocation. Automotive parts retailer AutoZone, Inc. (AZO) has a relatively unique capital allocation program.

The company is not a frequent acquirer of smaller companies, nor does it pay dividends to shareholders. Instead, AutoZone has resorted heavily to share repurchases over the past 20 years.

Stock buyback programs are not always utilized effectively. But in this case, AutoZone’s buybacks have greatly rewarded shareholders.

Breaking Down AutoZone’s Buybacks

AutoZone is a major U.S. auto parts retailer and distributor. The company has approximately 5,600 stores in all 50 U.S. states, the District of Columbia, and Puerto Rico. It also has over 560 stores in Mexico and 20 stores in Brazil. AutoZone also sells the ALLDATA brand of diagnostic and repair software.

AutoZone has taken a dramatically different approach to capital allocation than its major competitor Genuine Parts Company (GPC), which operates the NAPA brand. Genuine Parts has used its capital for two primary purposes—acquisitions and dividends. For example, Genuine Parts spent $2 billion to acquire European auto parts giant Alliance Automotive Group last year. Genuine Parts has also raised its dividend for over 60 years in a row, making it a member of the exclusive Dividend Kings.

For its part, AutoZone has shied away from making big acquisitions. It also has never paid a dividend. Instead, the company heavily utilizes share repurchases to reward its shareholders. In fact, according to AutoZone’s 2017 annual report, the company has spent more than $1 billion on share repurchases for nine years in a row.

The company has actually accelerated its buybacks to start 2018. On 9/26/18 AutoZone authorized an additional $1.25 billion on top of its existing repurchase plan. Since the inception of the company’s share buyback program in 1998, AutoZone has authorized $20.9 billion in share repurchases, including the most recent announcement.

Why Buy Back Stock Instead Of Paying Dividends?

The rationale for buying back stock instead of paying dividends is fairly straightforward. Stock buybacks, which are also known as stock repurchases, provide companies with a tax-advantaged way to return cash to shareholders. Paying dividends to shareholders creates a taxable event, since dividend income is taxed at a rate of 15%. Buying back stock does not generate tax liability.

The goal of buying back stock is to reduce the number of shares outstanding. With fewer shares outstanding, each remaining share is therefore entitled to a higher percentage of a company’s earnings. This will result in higher earnings-per-share, since the EPS calculation now has a smaller denominator. Typically, higher earnings-per-share results in a higher share price. Therefore, share repurchases can create shareholder wealth just like dividends, but without the tax impact.

It is easy to see that AutoZone’s buybacks have had the desired result. In the past 20 years, the period in which AutoZone launched its buyback program, the stock has returned 19.5% per year on average. By contrast, the S&P 500 Index has returned 7.5% per year. This means AutoZone stock outperformed the broader market index by 12 percentage points per year. Clearly, AutoZone’s buybacks have created substantial wealth for its shareholders.

Whether the buyback will continue to generate outperformance, is less clear. As a company’s share price rises, each dollar it spends buys back fewer shares. In other words, the higher the price a company pays for its own stock, the less bang-for-the-buck it gets. If a company’s stock becomes drastically overvalued, utilizing large amounts of capital for share buybacks could negatively impact shareholders. This is particularly true if that money could have been spent better elsewhere.

Final Thoughts

When it comes to capital allocation, there is no right answer. Ultimately, the right way for a company to spend its capital should be judged on a case-by-case basis. AutoZone’s capital allocation policy might not appeal to all types of investors. For example, income investors such as retirees might prefer to buy Genuine Parts stock, because of its 2.9% dividend yield and 60+ consecutive years of dividend increases. However, investors who don’t mind foregoing dividends have been rewarded with AutoZone’s superior total returns over the past 20 years.

Ben Reynolds is CEO of Sure Dividend. Sure Dividend helps individual investors build high quality dividend growth stock portfolios for the long run.