Description

Short - CarMax (KMX - $24.60)

How much should an investor pay for two spread businesses disguised as a used car retailer?  Below, we will attempt to show the case for a valuation substantially less than $24.60 and thus we present this idea as a short.

CarMax operates 100 used vehicle superstores primarily in the southern half of the United States.  The company was spun out of Circuit City in 2002 and has been operating a rapid store growth strategy since then (with the exception of FY2010 ending Feb28).  In fact, they've gone from 35 stores back then to the current store base of 100 units.  As you can imagine, sell-side analysts are impressed with the high growth rates.

Bull Case

CarMax has a unique set of competitive advantages because they have scale economics in an industry where the end product is not fungible (every used car is different) and with their small market share they could grow indefinitely.  If you need any proof of the growth obsession, check out the stock price after the latest earnings release in which they announced their planned store growth resumption after a near death experience in FY2009.  Indeed, the Merrill research report after the Q4 earnings was titled "4Q blooms, growth is on the way". 

Growth is great if you have a good business.  In this case, we argue that CarMax is a combination of two mediocre businesses. 

Used Car Business

New car dealers like the used car business because it allows them to make money on several transactions when a customer decides to buy a car.  They make a small profit on the new car, they make a profit on the customer's trade (used car), they line up a customer for the parts & service business, and they typically make money on the F&I business (selling warranties, providing financing, etc.).  CarMax has two of these pieces, they make money on the used car transaction and on financing (I'll discuss the financing later).  The trouble is that without the parts & service annuity that comes by operating a P&S business, selling cars just isn't that great.

Currently, three factors make the used car business look reasonably good.  First, there is an enormous volume lift from the depths of the Great Recession a year ago.  This higher traffic and still low SG&A costs are helping lift margins (SG&A as a % of gross profit dropped several percentage points in FY2010 setting an all-time low).  Second, there has been an increase in used car prices over the past year thanks to Cash for Clunkers.  A third factor driving rising used prices is the radical production cuts made by automakers last year.  Those production decisions have favorably impacted supply though I suspect that will be temporary given the global overcapacity of auto manufacturing.

Manheim Consulting publishes a monthly report on used car prices and they've enjoyed a tremendous spike of late though over time they've not moved much (I can't get the graph to paste -- the index stood at 115 in Feb 2002 and is at 118 now -- though it has risen 12% this past year).

This is important because the weakness of the used car business is the speed at which your inventory declines in value.  During the past year though, it has been a major tailwind.  Used car prices were up 12% in the latest fiscal year for CarMax, so their spread between acquisition cost and sales price has widened recently instead of getting smaller.  Of course the company must replenish their inventory with higher priced vehicles, so this tailwind will become a headwind at some point and will shrink margins.  The recent return of 0% financing among OEMs, and other incentives in the new car market likely provide a sign that used car prices will soon flatten.

The bottom line is that we would argue that the CarMax used car business is simply a spread business between used car acquisition and selling prices.  As such there are precious few long-term competitive advantages to be had in this business.

CarMax Auto Finance (CAF)

The second spread business is in the form of CarMax Auto Finance.  CarMax provides financing to potential customers using their own balance sheet, though they then securitize the loans.  When a customer decides they would like to buy a used car, CarMax takes the credit application and runs it through their internal underwriting platform.  Many customers who need loans are financed that way, with the remaining non-approved applications then farmed out to a group of third-party lenders (not sure exactly why you'd want to pick up the scraps here, but that's a different discussion).  CarMax benefits in two ways - first, the CAF division is incredibly profitable over time.  Second, they provide a way for their customers to fund their car purchase and thus can more easily drive volumes.

Let's spend time on CAF profitability.  Since CarMax was spun out of Circuit City in 2002, CAF has generated $830M of pretax income.  That represents 45% of all CarMax EBIT over that period.  During that same period, CAF has reported $521M of gain on sale income from the securitization of auto loans. (The $521M is included in the $830M figure.  The rest of the income from CAF comes from servicing loans, and from the interest spread between their cost of funds and the loan interest rates).

Over this same period, the average annual managed receivables have jumped from $1.4B to $4.0B (this $4.0B number is one year old since the FY2010 Annual Report has not yet been released, though we do know the FY2010 CAF income figures).  Similarly, the retained interest in the securitizations has risen from $121M to $552M.

What's it worth?

The used car business is mediocre judging by that segment's return on capital.  Since it is impossible to calculate the ROIC with precision, we must make some estimates.  If we assume that the balance sheet, excluding the retained interest, supports the car business than it appears to us as if pretax return on capital is just under 10%.  The CAF business generates much better returns on capital, though with a unique set of risks, risks that took the shares to $6 each in 2008.

We've decided to value the pieces separately despite the fact that CAF wouldn't exist without the car business.  Let's give CarMax the benefit of the doubt and throw out FY2009 (ending Feb 28, 2009) which was an awful year on a number of fronts.  If we use the three years FY2007, FY2008, and FY2010, it appears that the used car business generates average EBIT of $230M, or just north of $1/share of EBIT, or $0.60/share after tax.  CarMax can and will grow revenues with the resumption of their store growth.  However, we believe that the marginal return on capital is not very exciting and thus the company may be economically breaking even, or worse, on new used car stores excluding finance.  Let's be generous and value such a business at 15x earnings or $9/share .

Using that same time period, CAF generated $130M of EBIT on average, or just under $0.60/share per year, roughly $0.40/share after tax.  Clearly, CAF can grow rapidly if CarMax chooses to do so... they clearly have stepped on the accelerator in the past decade.  Also, as they add a handful of stores (they've committed to opening 3 more stores this fiscal year, and between three and five next fiscal year), they can grow the lending business.  The trouble is, we would contend that this type of business isn't worth all that much.  Captive financing companies with wholesale funding sources just don't get valued too highly.   There are dozens of spread businesses in finance with better funding sources than CAF.  That said, since it can grow more quickly than most, let's be generous and say that this business should be valued at 12x earnings or $4.80/share.

Add it up, and we think that CarMax is worth more like $14 than $24.

Catalyst

Change in the direction of used car prices.

Insider selling (CFO just recently made a significant sale)