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"In the '70s', people invented hostile takeovers as a way to recapture the approximately 50 percent of the value of American corporations that was being destroyed by its managers with nonoptimal operating policies," asserts Harvard Business School professor Michael Jensen. Jensen, together with the late University of Rochester professor William Meckling, published extensive research purporting to show the positive effect that debt can have on company value. Jensen's main point: A company's operating and investment decisions, and therefore its cash flows, are not independent of its debt-equity ratio.

Of all the real-world reasons that capital structure matters, Jensen's agency-cost argument seems to have taken the firmest hold on the corporate consciousness: witness the rise of stock options to keep managers focused on shareholder value.

Source: CFO Magazine, Dan Gifford, July 1998 "After the revolution - theory on capital structure proposed by professors Franco Modigliani and Merton Miller - includes related article on Modigliani-Miller propositions and their legacy."

Capital Structure (08/20/07)

Suppose I bought a house for $100,000.  If I could get $10,000 in rental revenue (after property management and property taxes), my return on investment would be 10%. 

Or would it?

Sure if I paid the $100,000, my return would be 10%. 

But chances are I only put a small "down payment" (let's say $25,000) toward the house.  This means I have interest expense (let's say another 5,000 a year).   

So I really did not make a $100,000 investment.  I made a $25,000 investment, which is generating $5,000 in rental revenues (after interest and property expenses). And this works out to a 25% "cash on cash" return on investment.

So when you hear analysts discuss price earnings (p/e) multiples, or in my case the earnings yield (which is simply the inverse of the p/e multiple), what we are really discussing is that "cash on cash" return on investment we expect shareholders to receive. 

Based on Friday's closing prices, below are the earnings yields (based on Zack's consensus of analyst estimates) expected in the current and next fiscal (financial) year. 

Company Current Year Estimates Next Year Estimates
Lithia 8.5% 10.3%
Group 1 10.7% 11.9%
Asbury 10.2% 11.3%
Sonic 9.6% 10.6%
Pep Boys 2.3% 3.5%
     
Penske Automotive 7.3% 8.3%
Genuine Parts 6.1% 6.7%
Keystone 4.6% 5.5%
O'Reilly Auto 5.3% 6.2%
Midas 4.3% 4.8%
     
LKQ Corp. 3.1% 3.9%
Monro 4.9% 5.8%
America's Car-Mart 6.7% 9.8%
CarMax 4.8% 5.7%
AutoNation 7.9% 8.8%
AutoZone 7.3% 8.1%
Advance Auto Parts 7.3% 8.3%
CSK Auto 7.8% N/A
Hertz 4.9% 7.0%
Copart 4.7% 5.3%

Source: yahoo finance, Zack's, efficient insights llc

In the example above (where I put $25,000 down for a 100,000 house), I would have a debt/cap ratio of 75%.  My total capitalization ("cap") is $100,000 (total assets or value of the house), I borrowed $75,000, and used another $25,000 of my own cash (representing the equity in the house I own). 

But why did I put down 25%?  Because I grew up in the Midwest and that is what we were taught to do (kidding. . . sort of). 

Chances are I put the $25,000 down because the bank required it.  And the bank came up with that figure because based on historical experience of making loans, putting that much down (in combination with analyzing my income and taking into account any other assets I might own), they determined it constitutes an appropriate risk/reward to make the $75,000 loan to me. 

Now I probably could have put less down, but maybe the bank would have asked for a higher interest rate (to compensate for the higher risk).  And I did not find that very economical (efficient).  

And this same line of thinking is what auto retailer's look at when determining their ideal capital structure.  

Over the last couple weeks I spoke with a number of folks in the industry about this topic what do you look at in determining an ideal capital structure?) 

Below are some of the comments I heard during my conversations with the management teams (probably paraphrased slightly as I did not put a tape recorder to the phone). 

"We run the risk analysis to the downside.  We ask ourselves, what happens in a really bad recession?  And could we still handle our debt levels?" 

Source: John Rickel, CFO, Group 1 Automotive

"We analyzed our cost of capital and found that our cost of debt was not ideal on the efficient frontier.  And so we have been bringing it down." 

Source:  David Cosper, CFO, Vice Chairman, Sonic Automotive

"We like to have considerable flexibility so we can take advantage of share repurchases or acquisitions should the opportunities present themselves." 

Source: Marc Cannon, head of public relations, AutoNation

"What no one wants to talk about is that the banks still have a big influence on an auto retailer's capital structure.  So I have to spend a considerable amount of time educating the bankers and trying to focus their attention on the cash flows versus the assets."

Source: Jeff DeBoer, CFO, Lithia Motors

"We spend a considerable amount of time educating our credit rating agencies, just like we would any major shareholder."

Source: Brian Campbell, Treasurer, AutoZone Inc

I think Jeff and Brian are really onto the key: cash flow analysis. 

Only one hitch, AutoZone was able to convince its credit rating agencies that they have a stable cash flow stream, and therefore able to issue commercial paper (basically bonds/notes in the debt market). 

As a result, when you see AutoZone's "capital structure" (that I show in a moment) it looks excessively risky.  But it is simply because the company's ideal capital structure is determined by cash flows (versus balance sheet assets and liabilities). 

The problem?  Convincing the credit ratings agencies to look at things on a cash flow basis. 

Remember, AutoNation tried several years ago to get investment grade credit, and despite reaching every logical metric that would make them investment credit grade, Moody's for some reason or another would not give them investment grade credit.  "It was a tremendous exercise in inefficiency" AutoNation's CEO Mike Jackson once blurted out on a quarterly earnings conference call about their efforts to achieve investment grade credit status. 

In part 2, we'll look at capital structure from a cash flow perspective.  But for today, I just wanted to show you what each company in the autoretailstocks index capital structure looks like. 

Company Debt/Cap* Debt/Cap (market equity)**
Lithia 48.7% 51.5%
Group 1 56.4% 51.9%
Asbury 61.0% 55.8%
Sonic 62.8% 55.3%
Pep Boys 53.5% 42.7%
     
Penske Automotive 61.4% 52.7%
Genuine Parts 32.2% 13.2%
Keystone 36.5% 17.1%
O'Reilly Auto 19.6% 8.8%
Midas 81.0% 30.3%
     
LKQ Corp. 39.6% 13.6%
Monro 49.5% 27.0%
America's Car-Mart 33.4% 32.4%
CarMax 36.0% 13.2%
AutoNation 34.7% 33.9%
AutoZone 86.9% 26.9%
Advance Auto Parts 65.2% 40.0%
CSK Auto 91.0% 75.9%
Hertz 85.2% 68.5%
Copart 5.8% 2.0%

Source: company reports, efficient insights llc

*Debt/cap is calculated very similar to the example of me putting money down on a house (earlier).  On a company's balance sheet your debt plus your equity equals the total capital (asset) value of a company. 

So I took the long term debt, plus current maturities, minus any cash on the balance sheet provided in the company's most recent 10Q (or in Advance Auto Parts case most recent press release) to come up with "net debt."  Adding net debt to shareholder's equity (similar to your $25,000 down in the house) I come up with a "total cap." 

Where I got a little tricky, however, is that I also counted rent as debt.  I think a company's rent is similar to debt (just like the mortgage payment on a house).  In the 10-k of each company they tell me how much in capital and operating leases they have to pay in the current fiscal year. 

And from the current year rent obligations, I essentially, back into a mortgage equivalent. 

I think someone should be able to make about 12.5% from renting out their property (before property management and taxes).  And this how I determined the company's real estate debt.  At 12.5%, it would take you 8 years to fully pay the value of the property (12,500 x 8 equals $100,000), giving me the equivalent mortgage debt the company would have otherwise had to take out.    

Debt/Cap (market equity)**  The next column is very similar to the first.  Only one change. . . the equity value. 

Sure, if I bought a house for $100,000, borrowed $75,000, my equity in the house would be $25,000 (assets minus liabilities, how shareholder's equity is calculated).  But what about the stock market?  With public companies, I have to buy the stock in the open market.  Leaving the price up to the whim of fickle investors (and weird dudes out on the beach that try to help facilitate market efficiency).

So my equity really isn't the "book" shareholder's equity reported on the balance sheet, but what I paid for the equity (ownership in the company) on the open exchange (stock market).  If you take all of the shares outstanding and multiply it by Friday's closing stock price, you come up with a "market capitalization."  Or "market equity." 

And this is the idea behind this second column.  It just replaces shareholder's equity with market equity when computing debt/cap.

Source: A Look At Expected Earnings Yields and Capital Structures For Auto Retailers