Why CarMax Is a Buy Despite Its Latest Earnings Report

While the holidays are a time of year when most retailers' sales are going through the roof, one exception is the car business, whose sales are pretty consistent throughout the year. There are several ways to play this sector, including car-parts suppliers such as AutoZone (NYSE: AZO  ) and new-car manufacturers such as Ford (NYSE: F  ) , but my favorite way to play the automotive-retail business is through used-car giant CarMax (NYSE: KMX  ) , which is doing incredibly well and still has strong upside potential.

About CarMax
CarMax is the largest retailer of used cars in the U.S. The company has 124 used-car superstores, the average of which carries between 300 and 400 vehicles at any given time, and turns over its inventory eight to 10 times annually. 

The earnings report
CarMax released its latest earnings report on Friday, Dec. 20, and it was less than stellar. As a result, shares dropped more than 9% on the day. However, we Fools like to look at the big picture, and I believe that this one weak report creates a very nice opportunity.

The company only missed the consensus estimates for the quarter by a penny per share, and actually posted revenue that was above predictions at $2.93 billion versus $2.89 billion. The big problem that seems to have scared investors is the fact that more CarMax customers are choosing to finance their loans elsewhere. I see this as a temporary issue and one that is easily fixable. 

In fact, along with its earning results, the company announced a pilot program to start lending to subprime borrowers, which account for about 18% of the company's business. If this program is successful, it could mean a big boost to CarMax's profits, as subprime lending generally produces more interest income and financing charges.

Why it's a good value
At first glance, CarMax may look to be a little expensive at 21 times the current fiscal year's earnings expectations. Nonetheless, this looks pretty reasonable considering the company's revenue and earnings growth, both past and future potential. The company is expected to grow its earnings by around 10% annually for the next few years, with many estimates way above that figure. On its potential to increase its subprime customer base alone, I think these estimates are way too low, but more on that in a second.

Bear in mind that CarMax is still a rapidly growing company, and there is no telling its absolute potential over time. Even though CarMax is the largest used-vehicle retailer, it still makes up just about 2% of the overall used-vehicle market in the U.S. It still has yet to fully capitalize on the subprime market, as up until the aforementioned pilot program was announced, CarMax vehicles were largely inaccessible to subprime buyers.

At just 15 times earnings, AutoZone may look cheaper on the surface, but is not without a much greater risk. AutoZone is much more susceptible to economic conditions such as higher oil prices. People still need cars when gas is expensive, but tend to drive those cars less and therefore need fewer replacement parts. CarMax, on the other hand, benefits greatly in a poor economy or when oil prices rise. People still need cars but will gravitate toward lower-priced used cars during uncertain times. 

Ford is susceptible to lower consumer spending for the same reason. At slightly more than 10 times 2014's earnings, Ford looks the cheapest of the three, but it also has the lowest growth potential and its profit margins are extremely sensitive to global markets and raw-material costs -- two things CarMax doesn't need to worry about.

What the future could hold for the company
CarMax is projected to grow its revenue by about 15% next year on a combination of positive catalysts such as the company's plans to open 10 to 15 new stores, higher average prices of used cars, and a higher operating margin due to the continually improving efficiency of operations as the company grows. 

One of the main reasons that I think CarMax could end up doing even better than expected over the next several years is because of the increasing availability of credit in the marketplace. Nonprime, subprime, and deep subprime loans currently make up 55% of the used-car marketplace, as opposed to just 26% of new-vehicle loans, which is why easier credit could help CarMax even more than new-vehicle dealers. 

As mentioned earlier, subprime customers currently account for just 18% of CarMax's business, which implies that there is a ton of business out there that the new pilot program could capitalize on. Car loan delinquencies are currently very low from a historical standpoint, so there is good reason to believe that credit standards in the industry could get significantly looser over the next few years. 

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