Description

America's CarMart

Arkansas-based America's Car-Mart sells cheap cars to credit impaired customers in the southern U.S using the buy-here, pay-here model. It but does so with a tested and conservative business model that helps mitigate a degree of the risk encountered in this notoriously difficult industry. It is this business model that has allowed the company to consistently grow revenue and earnings roughly 15% per year (though often more) and generate a roughly 13% ROA and 20% ROE.

Car-Mart has been written up three previous times on this site. One thing stands out about those postings: the write up draws much skepticism from VIC readers, but then the stock proceeds to rise in price. CRMT doubled following the first two write ups (January 2002 and December 2002); after the third write up (December 2003) the stock rose as much as 45% before giving up those gains; however, it still remains up 13% since that third post. The factors that have caused the stock to retrace some of its gains I believe are going to reverse and should allow the stock to make new highs. (Figures based on split-adjusted stock price.)

I believe CRMT stock has the potential to rise approximately 25% to 50% in the next 12 months and that patient investors will see it double again in the next three years.

Assumptions required to meet the low end of my short-term goal are modest: Earnings of $1.70 to $1.75 in FY06 (ending April '06), a number which is slightly above management's guidance of $1.63 to $1.70 and is a 15% increase over FY05. Apply a 15 multiple on those earnings yields a $26.00 stock (15 x $1.73 = ~$26). The stock currently trades at $20.20 and 13.5 times trailing FY05 earnings of $1.49.

Upside to management's guidance is driven by 1) a return to a more normal level of provisioning as poor credit losses from loans on lower (than normal) priced cars cycle out of the portfolio, 2) lower provisioning due the increasing maturity (and thus lower losses) from new lots added in recent years and 3) the execution of 5 to 6 relocations of space (and inventory) constrained sites which should add incremental sales. A planned reduction in year-over-year SOX expenditures in the 2H is likely to help, too. Though I base the low end of my near-term valuation on a 15 multiple, if management does begin to exceed estimates again the stock will likely to return to the high teen multiple it gets when the story is playing out well. Should this occur the stock's 12 month gain is more likely to approach 50% (17 x $1.75 = $29.75).

Looking beyond the current FY the key to the story is a reacceleration of new store openings from FY05's abnormally low 8.6% new store growth back up into the range of 12% to 15%. Management has been and is putting the infrastructure in place to make this happen. Twelve to 15% revenue growth should drive 15%+ annual earnings growth. If FY06 pans out at $1.75 as I project, then 15% growth in FY07 results in $2.01 in earnings. Apply a 15 to 17 multiple to those earnings yields a $35 to $39 stock. Though these are not quick gains, I believe Car-Mart will, on average, achieve this growth for many years to come and thus this stock has the potential to be a long-term holding for those who have an interest.

The Business Model

Given the industry in which it operates, I recognize CRMT will never be for everyone. However, I hope that I can convince some to look beyond the "used car salesman" label and discover what drives the success of this company.

The original Car-Mart was started over 23 years ago in Arkansas by a mom and pop team who sold out to current ownership when the founder became ill back in 1998. The company sells extremely basic transportation at an average selling price currently around $7400. A typical car may be six years old and have 80,000 miles. Newer lots sell cars at a slightly lower average price; older lots sell at a slightly higher average. Customers generally have no credit or bad credit.

What allows Car-Mart to successfully operate with this low-income customer includes the following:

1) Internally Grown Management: All Car-Mart lot managers started as salesman or assistant managers at another Car-Mart lot. This allows management to identify employees which are hardworking, honest and which are a cultural fit with the company. It also means these new managers are intimately familiar with how the customer screening and collection process works. This extended interview and training period is one key to CRMT avoiding many of the problems associated with this business.

2) Strong Customer Relations and Screening: Car-Mart treats its customers with respect and has a no haggle policy. At mature lots as much as 40% of the customers are repeats and another 10% to 15% are referrals. (Repeat customers get a plaque on the wall noting the number of cars they have purchased.) Managers are trained to screen potential customers to determine their ability to pay. For instance, it is not enough to simply have a job, Car-Mart is looking for customers with jobs that they have held for longer periods and/or are with stable employers. They also shy away from sales to buyers who are new to the area. Names and contact info of references are collected from each customer. References (employer, landlord, friends) are contacted as much to learn what they have to say about the potential customer, as to confirm that the reference is valid and thus can be used for repo purposes if necessary. Car-Mart also works with each customer to put together a personal budget including rent, car payments, food, cigarettes, etc. in order to determine if customer is able to make payments. If the budget looks too tight the company may then steer the customer towards a lower priced car or not sell them one at all. Down payments average 6%. Loans are for around 25 months.

3) Fine-tuned Collections Policy: A typical Car-Mart customers gets paid twice a month and arrives in town to pay his Car-Mart bill, maybe even a Rent-A-Center bill and then is off to Wal-Mart to buy necessities. Car-Mart customers can even cash paychecks at a Car-Mart to help facilitate their payment. They are also free to take popcorn from the in-store popcorn machine. Each customer's payment frequency and due date is based on their payday. A customer that is a day late receives a letter; three days late prompts a phone call and after a week the overdue customer gets a visit from a staff member on the lot. One reason it is important to the lot staff to make credit worthy sales is that when things go bad, they are out making these visits and conducting repos as necessary. Lot manager's pay is directly tied to the collection results at his or her store.

4) Small Town Approach: Car-Marts are mostly located in small cities of 50,000 population or less. Real estate costs are less and the company can more easily track down its overdue and delinquent customers.

5) Policy of Gradual Growth: The company policy is not to grow too fast (goal of 8 to 14% new lots per year). Specifically, they seek to grow no faster then they can train new managers from their existing store base. After an infusion of roughly $300k, new stores are cash flow positive in six to eight months at which point receivables growth is funded from the existing loan base. New lots may sell 15 cars a month; mature lots may sell in excess of 40. Same store sales at new stores can exceed 20% for a number of years. Credit losses at new stores are higher, in the range of 26% for stores open zero to 5 years, but it begins to drop thereafter. Stores open 5 to 10 years drop to the 22% range and stores open over 10 years are in the 16% range. The company has about a 1/3 of its store based beginning to enter the middle category. This should help moderate the provisioning line on the income statement somewhat.

6) Financing/Low Leverage: The company has a loan portfolio totaling $123M and a revolving credit facility with $29M outstanding. They are not exactly pushing the envelope when it comes to debt and allow the company to be self-financing to a large degree. Rates on loans average 10.8%. However, Arkansas usury laws drag this down as the company can only charge a fixed percent above the fed discount rate. Rates on loans outside Arkansas are typically around 19%. 32 of CRMT's 70 lots are in Arkansas and these are their mature lots with the most unit sales. As rates rise, CRMT benefits as it will be able to increase the interest rate charged in Arkansas. Car-Mart does not charge higher prices for the cars to compensate for the lower rates and notes that political considerations keep them from doing so. (Someday Arkansas's U.S. congressional delegation will succeed in passing a law that will override the state law, but this has been the company's hope for years but the bill always gets stalled and dies. The company has never made promises that it would pass.)


A MisStep.

In calendar 2003 the company began selling even lower priced cars than they already do. Unfortunately, the drop in price of just a few hundred dollars (to low $6000's) was enough to upset the credit quality balance. In January '04 they recognized the problem and had to reserve for the bad loans. In that period provisioning was 25% of income as compared to a normal range of 18% to 21%. To their credit management made no excuses for their mistake, took responsibility and sought to fix the problem by increasing the price of the cars. Less discussed is the fact that a lack of middle management contributed to the problem. As the number of new lots increased management did not hire enough headquarter-based staff to oversee their lot-based collectors. As such new collectors, who were suddenly being overwhelmed by the increase in bad loans, also had too little guidance from above. Turnover among collection managers increased which further exacerbated the problem. Since that time CRMT has increased the size of the central staff overseeing the lot level collections team which has helped reduce turnover at the lots.

In calendar 06 these loans should completely roll off the books. The incident provides legitimate fuel for those who dislike this industry. However, I note that even with the charge earnings grew 14.8% in that year. Neither the business model or the balance sheet broke. In fact, the episode may be good evidence of the viability of the model in that it weathered a storm. Note that the higher priced cars have a lower gross margin percentage than lower priced cars, but have make a similar gross margin contribution.

EPS Drivers.

Reaccelerating Same Store Unit Sales: For the past year the company's same store unit sales have been depressed (low single digits on average) because the company was selling higher priced cars while in the previous year they were selling faster moving lower priced cars. The company has completely cycled the rise in price per car sold and the most recent quarter; Q4, the first quarter in which comparisons were high priced cars to high priced cars (such as Car-Mart has high priced cars); same store unit sales were up 7.4%. Should this become a trend the company could begin beating its guidance.

Declining provisioning: The continued rolloff of bad credits from the sales of lower priced cars and the increasing maturity of lots opened in the past five years should bring the provisioning line from just over 20% to just over 19%. Though the company has had lower average annual losses in the past (ranging from 17% to 21% per annum) I do not think it is likely to get to the low end of the range again. (Those earlier numbers occurred at time when more of the store base was lower loss, mature lots and before current ownership ramped up new store openings.) If provisioning was to decline even 50bps that would have added 5 cents to FY05 earnings. ($950k more pretax income), it would add more to '06. I do not think any of this potential is in management guidance.

Declining SOX costs, but not until after the upcoming quarter: The company is likely to see $700K less in pretax SOX costs in FY06. This translates into 3.6c per share net. However, their upcoming Q1 will still show a drag from SOX. (Though SOX will hurt yoy earnings comparisons in Q1, I believe the real factor to watch in the upcoming quarter is what happens with same store unit sales.)

Reaccelerating new store openings: Stablizing credit quality and SOX issues caused management to take the eye off the drive for new store growth. However, another factor limiting this growth was a lack of sufficient infrastructure, in my opinion. The company prides itself on having a lower overhead central HQ, but the growing number of stores (76 at end of 05) and the need to add a higher number each year requires that the company spend more in order to support growth and they are beginning to recognize this fact. For instance, over the past year or so they have increased the ranks of middle managers in order to grow their trainee program and increased compensation for certain headquarters staff so that successful lot managers (who can make $100K) can now come to the central office and earn more helping oversee multiple lots or store openings. Until recently if they became part of HQ they would have had to take a pay cut. They have also hired outside help to quicken the site selection process. Less distractions (like SOX) and steps like these will help get the number of new lots added per year back up to the low teens by FY07. Management has guided to at least 8 lots in FY06. They have already opened four and we are only four months into the new FY year. This frontloading should allow these new lots to contribute to earnings before they FY is out. Without making promises, management hints that they hope to exceed the 8 lot guidance. Five or six lot relocations to larger lots should also help earnings in FY06 as the only thing holding back higher sales at these lots is the ability to hold more inventory.

In the continuing effort to upgrade the ranks of management, CRMT recently hired a new IT director from Wal-Mart and I hear he's doing a great job. The recent retirement of the CFO is also an opportunity to upgrade to a person with more experience.

Risks:
Higher gas prices are a factor for Car-Mart's customer and at some point the company would feel the pinch. In fact, when Wal-Mart mentions their consumer is having a tough time due to energy prices Car-Mart stock price can decline in sympathy. However, Car-Mart's business is usually doing just fine as the Car-Mart/Wal-Mart customer still needs their car and thus makes car payments before spending on the more discretionary merchandise Wal-Mart offers.

Cost to acquire inventory has risen, but has leveled off recently. A material rise in inventory costs could cause margins to suffer. Over the past year the company has implemented an effort to store at least some inventory at central lots. This enables the company to purchase when opportunities arise and to have more inventory available when sales are good, particularly during the tax return season in the early months of a calendar year. Lack of inventory has hurt sales at certain junctures and the company is trying to overcome this problem.

Catalyst

FY06 guidance is too conservative. Projections of a max of 14% earnings growth – though prudent and appropriate – does not reflect any potential good news in the provisioning line or for a recovery of yoy lot unit sales (which is already occurring). A return to a normalized rate of new store openings will drive long-term growth.