Core Concepts: Gear Up With Auto Retailers

This column was originally published on RealMoney on Feb. 28 at 10:34 a.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

For students of the stock market, the retail automotive sector is full of interesting case studies. Leading companies in this segment include AutoNation (AN), AutoZone (AZO) and CarMax (KMX).

Renowned investor Eddie Lampert has put his unmistakable stamp on the capital strategies of AutoNation and AutoZone. Both companies increased debt in conjunction with a massive reduction in the share base. However, these companies aren't unique in using this capital allocation strategy. Energizer (ENR) has employed a similar tactic, with a resulting fourfold increase in its stock over the past five years.

Debt-for-Equity Swaps

The opportunistic use of debt capital is a widely misunderstood and underrated strategy. Think of it this way: If additional debt can be comfortably serviced -- as in the case of stable, underleveraged companies -- shareholders benefit when the company replaces equity capital with debt capital because they end up with a bigger stake.

Total capital does not change when using this strategy, just the mix between debt and equity; some of the equity capital is replaced by debt capital. In the case of AutoNation, AutoZone and Energizer, the companies used borrowed capital to buy back about half of all their shares. As a result, shareholders increased their ownership percentage in a big way. For example, Eddie Lampert's ownership stake in AutoZone rose from 13% in 2001 to 26% by using a debt-for-equity swap.

It is important to understand that AutoNation, AutoZone and Energizer were not forced to take on debt. Each company had the ability to grow and expand using capital generated by free cash flow. For these companies (and many others), debt is preferable to equity because it is less expensive. It makes sense to use someone else's capital (debt) instead of owners' capital (equity) when debt is cheap and the addition of debt does not compromise financial stability.