Shares of CarMax
Quarterly earnings per share beat analysts' consensus estimate of $0.38 by a penny, but investors were displeased with a 3% decrease in comparable used-car sales, which included weaker sales financed by CarMax Auto Finance. (Robust 12% growth in the year-ago quarter admittedly made comps a tough comparison.)
The market seemed even more concerned by CarMax's lowered fiscal 2007 guidance of $1.25 to $1.47 per share in earnings, and a wide comp guidance range of 2% to 8% due to an uncertain automotive market. CarMax reported strong sales to other dealers in its wholesale market, but that figure is also expected to weaken for 2007. Revenue growth was also strong, up 16% for the quarter and 19% for the year.
So what's a Fool to make of the results and expectations? Brokerage firms aren't currently enthusiastic about the stock, since they only tend to focus on the next 12-18 months. CarMax management admitted that visibility over this time frame is a bit uncertain; the Big Three domestic auto manufacturers are under intense pressure to increase sales and fight through supplier bankruptcies, union woes, and accelerating pension and retirement costs, and this uncertainty trickles down to the used-car guys. Rising interest rates also make cars less affordable to buyers, adversely affecting the financing unit.
From a longer-term perspective, CarMax operates in a highly fragmented market that had estimated overall 2004 sales of $367 billion. With only 67 stores in about 20 states, and 2006 revenue of $6.3 billion, the company could arguably operate at least a couple of hundred stores nationwide before it began to have even the slightest market-share concerns. Indeed, sales have been growing 19% over the past five years, and they are expected to grow at least 15% annually in the near future. Earnings growth is expected to follow a similar path. In addition, the company has a reputation for "revolutionizing" an industry stereotyped as unscrupulous or even corrupt; it offers a no-haggle pricing scheme, a professional, cheery sales staff, and a wide choice of cars due to a large national inventory.
Selling used and new cars is not easy, however, as CarMax's razor-thin net margins of about 2.25% demonstrate. As any Fool familiar with the DuPont identity knows, ROE is driven by three primary factors: Operating efficiency (margins), leverage (use of debt), and asset efficiency (asset turnover). For CarMax, a low-margin business with relatively low levels of debt, ROE is determined by asset turnover -- how quickly it sells cars. The company has been doing a stellar job driving ROE by moving cars off its lots, but domestic industry turmoil will eventually affect the company, whether it's for a quarter or a longer period. With half a billion dollars in inventory currently sitting on the lots, and negligible free cash flow because of an aggressive expansion strategy, any temporary downturn could represent a good share-buying opportunity.
Even with the current hit to the stock, CarMax still trades at a new-car price of about 25 times next year's consensus earnings of $1.36 per share. This implies that growth will remain robust; I currently estimate that earnings will have to grow more than 15% over the next 10 years just to justify the current stock price. Major inputs include a 14% discount rate and 3% terminal growth rate.
Overall, CarMax has a compelling operating model in a fragmented industry, as evidenced by the more than doubling of its stock price since it spun off from Circuit City
Further Foolishness with that new-car smell:
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Fool contributor Ryan Fuhrmann keeps wasting money on new cars but has a good friend who keeps it real by buying used. Ryan has no financial interest in any of the stocks mentioned. Feel free to email him with feedback or to discuss CarMax further.
