CarMax Maxes Out Earnings

CarMax (NYSE:KMX) shares leapt as much as 11% in early trading Monday (ending the day up 8%) on news that the auto retailer/wholesaler had run a monster truck over analyst estimates.

For its fiscal first quarter of 2007, CarMax reported a series of "50s:"

• $56.8 million in net profits
• $0.53 per share
• 54% better profits than last year.

And the numbers underlying those "headliners" look even better. For example, same-store sales grew a strong 6% year over year. Inventory turns came in healthy at 8.8 times -- meaning that over the last year, the company sold out and refilled its inventory nearly three times in each four-month period. And the slight decline in gross margins didn't prevent CarMax from expanding its operating and net margins significantly.

I found this last development the most encouraging. When asked during the earnings conference call to discuss CarMax's efforts to control its costs and increase its operating margins, new CEO Thomas Folliard explained that the firm didn't make any special efforts per se. Instead, aided by that 6% increase in same-store sales, CarMax's margins improved through "fixed leverage."

CarMax has high fixed costs from maintaining its well-stocked car superstores. But once the company has sold enough goods to cover those fixed costs, incremental sales drop quickly to the bottom line, incurring little additional cost along the way. To this Fool, that only confirms the benefits of the company's economies of scale, as cited by Motley Fool Inside Value analyst Philip Durell when he first recommended the stock. In CarMax's case, bigger really is proving to be better.

Detroit wags CarMax
Bigger companies can still make life difficult for CarMax, though, even if they don't compete with it directly. Outgoing CEO Austin Ligon commented that "Ford (NYSE:F) and General Motors (NYSE:GM) need to stop discounting at the rate they have been, because . they can't afford the lower volume and discounts."

Ligon was right in two ways. First, Detroit is having a tough time making a profit by selling fewer cars for less money. (Natch.) Second, the more that Ford and GM -- and to a lesser extent DaimlerChrysler (NYSE:DCX), Toyota (NYSE:TM), Nissan (NASDAQ:NSANY), and Honda (NYSE:HMC) -- discount their new cars, the more they tend to disrupt the market for used cars. When new cars are cheap, used cars must further depress their prices to maintain their distinction.

If Detroit can resist the urge to further "incentivize" sales, Ligon believes that CarMax will be able to breathe easier. Conversely, if Detroit keeps raising cash-back offerings and lowering interest rates, people will be less inclined to buy used cars, which will obviously hurt CarMax's business.

CarMax is a Motley Fool Inside Value pick. Want to find more sweet rides hiding out in Wall Street's junkyard? Join Philip Durell and hundreds of other bargain-hunting Fools with a free 30-day guest pass.

Fool contributor Rich Smith has no interest, short or long, in any company named above.