High-Octane Buyback Lifts Spirits at AutoNation

Ed Lampert's love of share buybacks has the engine humming at AutoNation ( AN), the car dealership of which he is the largest owner. But some observers wonder if the fuel will prove too rich.

AutoNation disclosed plans Tuesday to borrow more than $1 billion to buy back about one-fifth of its publicly traded stock, an announcement that lit a fire under the recently moribund shares. Lampert, best known for masterminding the takeover of Sears ( SHLD) by Kmart, said he will sell some of his 77 million AutoNation shares in the deal.

And no wonder: The deal is a good one for shareholders. Under the offer, AutoNation will buy up to 50 million shares for $23 apiece, a 10% premium to Monday's closing price. At the same time, the company will refinance $323.5 million of its 9% senior notes due in 2008 and replace that debt with about $1.35 billion of a bank and bond facility.

The transaction gave shareholders the boost they were looking for. Since the beginning of the year, shares of AutoNation were down about 5%. After Tuesday's announcement, the stock lifted $1.37, or 6.6%, to $22.26 in trading.

But the leveraged share-buyback deal is enough to make some investment bankers wary. The company, though holding little debt now, will increase its net leverage to about $1.5 billion. The deal prompted Fitch to cut AutoNation's debt rating to BB+, or junk status, on Tuesday.

While nobody can say with certainty whose idea the buyback was, Lampert, as the company's biggest holder, must have had a role in the decision. Lampert and his cohorts have two seats on the board, and significant lobbying power when it comes to capital redeployment decisions. His 29% ownership stake certainly helps.

Thursday the company filed a document with the SEC that included a response letter from ESL, Lampert's firm. "ESL agrees to tender all of the shares (without a minimum purchase condition) into the equity tender offer," the note said. Because the company will have to pro-rate its repurchases, Lampert said he expects his percentage stake to remain unchanged.

Analysts, meanwhile, have been calling for this buyback since first quarter last year. Jonathan Steinmetz of Morgan Stanley issued a report about a year ago noting that the company's debt level was low enough to support a share buyback program. His analysis of this deal was positive.

Steinmetz says this transaction will give AutoNation the capital structure that falls in line with its peers. According to his calculations, after the transaction the company will have a net debt-to-capital ratio of about 30%, vs. 5% before the deal. That debt level is appropriate, he says.

Still, he cautioned that Lampert isn't afraid to use capital to push such buybacks further. He notes that AutoZone ( AZO), where Lampert also has a significant stake, spent $3.9 billion in share buybacks over five years. During the same period, AutoZone only generated $2.6 billion in free cash.

Leveraged share buybacks have been Wall Street's latest fancy, providing a way to rapidly alter a company's capital structure. Usually it takes some other catalyst, such as a defunct private-equity transaction or a forceful hedge fund activist, to prompt firms to execute these transactions.

Affiliated Computer ( ACS), for example, announced a similar deal in late January. A few months before the transaction, the company had mulled take-private offers, and later decided that the offered prices didn't value the company to management's liking. Instead, it bought its own shares by issuing debt in order to get the stock boost it was looking for. At the time, ACS said it would spend about $3 billion for the purchase of the outstanding stock.

Meanwhile, shares in ACS have shot up 9.5% since the report of the buyback, with all of that lift coming the day after the company revealed its plans.

Other repurchases have grazed headlines in recent months, and many have had a hedge fund activist somewhere on the sidelines. Phelps Dodge ( PD) was recently under attack by Atticus Capital to commit to share repurchases through debt issuance. Atticus, which owned 10% of Phelps Dodge, said in a letter registered with the Securities and Exchange Commission that Phelps was "significantly overcapitalized" and must "return excess capital to shareholders." At the time, the company fought back by characterizing the prospect as "reckless," saying that Atticus' proposals forced the company to place debt on its balance sheet that its operations couldn't support.

Other recent repurchases financed by debt have consistently had hedge fund activists working behind the scenes. For example, both Mylan Labs ( MYL) and Kerr-McGee ( KMG) did leveraged buybacks last summer as a result of activist campaigns from Carl Icahn.

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