AutoNation ( AN) announced a financial restructuring on Tuesday, whereby the nation's largest car dealer offered to repurchase $1.15 billion of stock and $323.5 million of 9% coupon debt. Specifically, the company will commence a tender by March 10 to buy back 50 million shares (19% of the company) at $23 apiece, and it will raise some of the funds by selling $900 million of new long-term notes.

The stock gained 7% Tuesday on the heels of this news, closing at $22.26. It's no wonder, considering that AutoNation said it expects the recapitalization to add 8 to 10 cents a share to annual earnings.

It's also worth noting that ESL Investments, the hedge fund of famed investor Edward Lampert, owns about 29% of the company. Lampert has said the fund will tender all of its 77.1 million shares. Of course, the 50 million shares to be repurchased by the company will be allocated on a pro rata basis, and that means ESL would retain a 29% stake in AutoNation if every investor also tried to sell his shares.

Two questions investors are likely asking themselves: First, how can the company afford this buyback? Second, should I buy AutoNation or view the tender offer as a selling opportunity?

In other words, should I do it?

Let me first say that I never like to see a company borrow money and leverage up its balance sheet to either repurchase stock and/or pay a dividend, as AutoNation is proposing. Even so, there are times when it's acceptable for a company to increase its financial leverage, particularly when operating in a capital-intensive business while interest rates are low. As AutoNation is expecting, this strategy can also improve profit per share, as it will lower the amount of stock outstanding.

According to recent Securities and Exchange Commission filings, AutoNation had $243.8 million of cash on the balance sheet. The company's available financing includes a proposed $300 million term loan and $150 million available under a bank credit line, but the company will need to fill in the funding gap with a new $900 long-term debt offering.

But not everyone was as enthusiastic about the tender offer strategy.

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Bond rating agency Fitch downgraded its ratings on all classes of AutoNation debt Tuesday, to BB+ (junk status) from BBB-. According to Fitch analyst Karen Ghaffari's research note, the company's pro forma debt will rise to about $4 billion. As a result, AutoNation's debt as a percentage of total capital will rise from 10% to about 29%.

Business Outlook

Let's move from AutoNation's balance sheet to its income statement and see if the business fundamentals are strong enough to sustain the added debt.

AutoNation posted fourth-quarter earnings of 31 cents a share, 2 pennies shy of the consensus analyst estimate. One reason for the shortfall was Hurricane Wilma, which management said took about 4 cents of profit out of the quarter. The company operates 346 dealerships in 17 states, and Florida accounts for about 20% of total revenue.

But there's no denying that domestic auto demand has been generally weak over the past several quarters. In fact, for the eighth straight year, U.S. sales are expected to be around 17 million units. Even so, looking ahead to 2006, AutoNation is targeting 8% earnings expansion to $1.56 a share. This would be the company's fastest bottom-line growth in three years, as the company shifts its sales mix to high-margin used cars (23% of total 2005 revenue). With that in mind, I believe the fourth-quarter shortfall will prove to be an anomaly.

Should I Do It?

At current levels, AutoNation is trading at 14.2 times expected 2006 earnings, which compares favorably with its two closest competitors: United Auto Group ( UAG) at 15.7 times and Carmax ( KMX) at 23.8 times, according to CapitalIQ.

So, yes, I believe investors should still consider buying AutoNation around Tuesday's closing price of $22.26. While the stock could trade in a narrow range through the end of the month as management handles the tender offer, I believe the stock could trade up around $26 over the coming quarters, even without a material improvement in overall auto sales.

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David Peltier is a research associate at In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Peltier appreciates your feedback; click here to send him an email.

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