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
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.
has employed a similar tactic, with a
resulting fourfold increase in its stock over the past five years.
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.
More CEOs of stable, underleveraged companies should consider the debt-for-equity swap strategy. The math is elementary. Most CEOs think of deploying cash to dividends, capital expenditures and minor stock buybacks. When they think of hitting investment "home runs," they think of something complicated, such as a major acquisition. They don't consider something as simple as shrinking their share base by one-half.
By the way, while AutoZone is reasonably valued at about $131 per share, my analysis of indicates that rival AutoNation is undervalued at its current level of about $22. Its operating model has significant margin leverage yet to be unleashed. With continued share shrinkage, mid-single-digit sales growth and net profit margins that can increase by 35% to 50%, the ingredients are here for a quote that will double or more over the next three to five years.
Pedal to the Metal
An exceedingly rare investment opportunity exists now in CarMax. My thesis is unchanged since I originally
spoke about the company in 2005; that is, buying CarMax stock today is akin to buying
in the early '80s. This is what a 10-bagger opportunity looks like in the early days.
It's difficult to find companies that have 10 to 15 years of 20% annual growth in front of them, that completely dominate their category, and where growth is organic, not by acquisition. My guess is that fewer than 10 companies meet these criteria.
To understand the CarMax opportunity, you have to understand the model. This is not simply a retailer of used cars. CarMax is a paradigm shift. It is changing the way consumers buy and sell used cars.
Everybody is familiar with how the typical used-car dealer does business. Buyers pay more or less depending on their level of sophistication (i.e., Grandma gets hosed). Dealers maximize profit by low-balling offers for trade-ins, by selling warrantees, by manipulating finance terms and by extending endless offers and counteroffers while you wait, wait, wait.
Consumers understand the value proposition of buying an almost-new, one- or two-year-old used car vs. buying a new car. Until the CarMax model came along, consumers didn't have an easy, efficient way to buy and sell their cars. CarMax offers no-haggle, fixed prices on all of its cars. And CarMax will pay you cash for your used car (a no-haggle offer), whether you buy a car from the company or not.
At the typical used-car dealer, the sales representative is paid a percentage of the profit on each car deal. The incentive is clear: Take care of the dealer by maximizing the dealer's profit. At CarMax, the sales rep is paid a fixed rate for every car sold. A CarMax rep's incentive is different: Take care of the customers by helping them to find the car they want, at the price that they are comfortable with.
Plus, CarMax offers a good selection; its lots have four times the inventory of a typical used-car dealer. CarMax reps have access to the company's entire inventory via CarMax.com. That's 20,000 cars to choose from.
By my calculations, this company will be worth more than $100 per share in three to four years. It recently traded at $53. However, my calculation of value will be adjusted to $50 per share after the company's 2-for-1 stock split in March. CarMax will begin trading on a split-adjusted basis on March 27.
At time of publication, Alsin and/or ACM was long CarMax and Home Depot, although holdings can change at any time.
Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor, and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Alsin appreciates your feedback;
to send him an email.