Activist hedge funds have racked up big gains by pushing companies to borrow money and buy back stock. But a recent setback at Ed Lampert's AutoZone ( AZO) shows that even leverage may have its limits.

The auto parts retailer got stuck in reverse late last month after its CFO split, just a week after the company reported a weak quarter. Michael Archbold departed to take over as head of finances at Saks ( SKS) shortly after AutoZone posted a steep fourth-quarter earnings shortfall. Lampert, the hedge fund guru who made headlines by orchestrating the merger of Sears and Kmart into Sears Holdings ( SHLD), owns some 35% of AutoZone through his ESL Investments.

The latest same-store sales drop came as no surprise, since AutoZone has failed to deliver an increase in sales at stores open at least a year for four straight quarters. But what distressed some on Wall Street was that AutoZone missed earnings estimates in large part because the company chose to boost spending on its stores -- at the expense of keeping up the pace of its buybacks.

Gimme Credit analyst Carol Levenson says AutoZone could have avoided some of the pain. "Had the company bought back more stock than it did by increasing its debt load, it could have met consensus estimates," Levenson said.

In the past, AutoZone hasn't shied away from using debt to repurchase shares: Its debt load has surged some 58% to $1.9 billion since Lampert took an interest in the company seven years ago, while its share count has dropped by more than half. Investors have reaped the rewards: AutoZone stock has more than tripled since the start of 1998 to a recent $83.

But the recent shortfall suggested to some observers that AutoZone has been underinvesting in its stores. Now, facing a tepid retail environment, the company faces the prospect that increased capital spending could put a lid on stock-bolstering buybacks. AutoZone dropped 5% the day of the report and has continued to fall since.

With interest rates low and share repurchasing at an all-time high, Lampert isn't the only hedge fund maven pressuring public companies to use debt to buy back stock. That's the cornerstone of the argument that Carl Icahn recently brought to Time Warner ( TWX), whose stock has frustrated investors by making little headway lately. Along with Franklin Mutual Advisers, Jana Partners and S.A.C. Capital, Icahn is calling on its management to undertake a whopping $20 billion share-repurchase program by taking on more debt and to spin off its cable operations.

Elsewhere, Bill Ackman's Pershing Square Capital recently scored a big win at Wendy's ( WEN). After months of browbeating during which Pershing scooped up a 9% stake in the company, Wendy's agreed to sell part of its Tim Hortons doughnut chain and authorized a $1 billion share buyback, sending its stock up 12% in one day to an all-time high.

Now, Pershing has turned to Wendy's chief competitor, McDonald's ( MCD). Ackman reportedly wants the burger giant to spin off its company-owned restaurants into a separate, publicly traded entity and then borrow against its untapped real estate assets, returning the money to shareholders through dividends and buybacks.

David Ikenberry, a corporate finance professor with the University of Illinois, said that by encouraging the use of debt to raise money for shareholders, activists like Icahn, Ackman and Lampert are essentially telling companies that their capital structures are flawed.

"If McDonald's is actually a real estate company that owns restaurants, then maybe they have a lot more natural debt capacity then they're using," Ikenberry said. "Therefore, this is a move to make them think more like a real estate company and less like a franchise company in the restaurant business."

With investors increasingly concerned that the bull market that began in 2003 may be nearing its end, capital restructurings that can drum up quick stock returns appear to be on the rise.

"On average, there are a lot of companies out there that are conservatively levered, and research indicates they could actually increase their long-term value by taking on more debt," said Amy Dittmar, a finance professor with the University of Michigan at Ann Arbor. "Theoretically, you want to take on debt until the marginal benefit equals the marginal cost of that debt. So, that one last dollar of debt maximizes the value of the firm. In reality, finding that balance can be tricky."

So far, Time Warner's CEO, Dick Parsons, has rejected Icahn's plan, favoring a spinoff of 16% of the company's cable business and a more modest $5 billion buyback. Likewise, at a recent meeting with analysts, McDonald's unveiled a series of shareholder-friendly measures, including a bigger dividend, an expanded stock buyback and the partial sale of its Mexican food chain, Chipotle Mexican Grill. But it stopped well short of planning anything like what Pershing is proposing.

Executives often resist the radical ideas of hedge funds out of concern that they may be more interested in a quick jump in their company's stock price than the long-term health of the business.

"When companies borrow funds, their credit rating may drop, and that makes borrowing costs increase," Dittmar said. "That reflects more leverage -- more potential for financial distress down the road."

And AutoZone's unwillingness to breach its debt target to please Wall Street's expectations in the fourth quarter shows that there are limits to the amount of long-term debt it will take on in order to maximize shareholder returns now.

AutoZone has said it is willing to use funds raised by issuing debt to repurchase shares as long as it maintains a 2:1 ratio of debt to earnings before interest, taxes, depreciation, amortization and restructuring charges, or Ebitdar. But to increase its buybacks in the fourth quarter, AutoZone would have had to exceed that ratio, largely because its capital expenditures rose more than 30% during the period.

While this latest sign of restraint may have hurt its stock price, Gimme Credit's Levenson said she was heartened by the display of discipline.

"AutoZone has the best credit rating in their industry," Levenson said. "So far, they've been conservative about adding debt for share repurchasing, and I think they can continue to do that if they stick to their targets. My worry is that, given the stock price performance, they're going to feel pressure to go beyond that in the form of higher leverage."

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