Tuesday, May 27, 2008

Whats attractive about Carmax

Carmax:
I recently received Carmax annual report and in any investment, few important factors determine it's success. I have tried to distill few important items that may attract you towards further research.

Moat or whats special :

1. Carmax primarily sells automobiles that are 1 to 6 years old. It's main competitor is new car dealer franchise. Independent dealers usually sell cars with average of 100,000 miles or more and are not direct Carmax competitor. In fact Car max auctions off older cars to these independent car dealers.

2. A new car dealer on average sells around 110 new and old cars per month. A Car max location sells around 425 used cars per month. The higher per location sales results in leverage of fixed costs. This results in scale. In addition, customers can choose a car from a different location and transfer it to their site using their website. Overall both these attributes provides much better scale than new car dealers.

3. Carmax's another advantage is no haggle pricing for customer thereby providing a plesant customer experience while buying a car. (Think last time you were in new car dealer.)

4. Car max sales associate's incentives are structured based on volume. They receive the same commision irrespective of whether they sell an expensive car or a economy model. So they do not gain by pushing one car over other or more expensive ones that the customer does not want. In addition, sales associates do not make any money from financing and hence help customer with the plan that suits them best. Overall a pleasant consumer experience.

5. Carmax prides in selling only high quality cars in it's retail outlet. Anyone shopping for used car knows the importance of buying quality cars (think peace of mind!).

6. Carmax has a wide selection of cars of all makes and model. This will easily beat the selection at a new car dealer.

7. One of the competitor that Carmax cannot beat on price is private party transactions. In this case, the customer has to do due diligence (check the vehicle with mechanic), negotiate price and wait for the right vehicle to appear in market. This requires lots of time and patience for both buyer and seller. Other than price, Carmax can compete favorably on other factors (like wide selection, no haggle pricing, high quality vehicles and one stop financing) with private transactions. Having said that, private party transactions will still be a viable competition that will co-exist and the market place is big enough to provide enough opportunities for Carmax.

Management

8. Carmax has won many awards for ethical behavior towards customers, employees and shareholders. This throws light on culture of the place and is less prone to poor management.

9. Management has said that growth will be slowed if performance at stores are reduced. They have done this in the past and is a positive indication of management quality. That is, growth only when it makes sense. (Think what fast growth did to Krispy Kreme.)

Growth Drivers:

10. Carmax currently has 89 superstores. They cover roughly 43% of population now. So at the minimum, they can become slightly more than 2 times their current size. My guess is it can be more than that.

11. Carmax plans to expand 15% per year. So it will be at least 5 years before their growth slows down.

12. New stores mature in 5 years. So same store sales should be robust as stores mature. Management expects 4 to 8% same store sales though it wont be even in all years.

13. In mature markets, Carmax owns 8% market share. It is possible to grow this too!

So growth drivers are new store opening, maturing of recently opened stores and increase market share.

Numbers

14. Return on invested capital is around 10 to 12%. I think this figure understates real return because newer stores mature over 5 years. So after maturity, this figure will be higher.

15. ROE is decent and between 14 to 18% depending on year.

16. Their debt is not much of a concern. Their long term debt to equity is less than 25%. Long term Debt (including other long term debt) to earnings is less than 2 times earnings . Much of the growth is equity financed. They retain all the earnings.

Valuation:

17. Assuming, Carmax rolls out as planned and doubles it's store count in 5 years (likely scenario), then it's earnings will double. Likely it will be more than double due to same store sales growth of newer stores.

Currently for 2009, Carmax is forcasting $.78 eps to $.92 eps. Note that 2009 Fiscal is a slow economy year and hence normal year eps should be higher than this. Lets assume eps in normal year will be $.90. So it is not unreasonable to think that in 5 years it will double it's eps (conservative estimate) due to store count doubling plus same store sales growth of 4% will result in eps of $2.

Lets assume P/E after 5 years will be 18 (which as per DCF would mean free cash flow increases by 3% per year from that point and 10% discount rate). This is reasonable assumption considering newer stores will still be maturing over 5 year period. So valuation after 5 years will be $36. So if Carmax is purchased at around $18, it will result in nice 14% per year return. Note that we have made conservative estimates.

Other

18. Davis advisors own 15%, Berkshire owns 10% and Dodge and cox holds 7%. Never buy because others buy but when all value investors aggregate, it is atleast worth looking further!

Let me know your feedback and if you will be interested in more such writing.

6 comments:

Justin said...

What do you think happens to Carmax business if the Big 3 get bailed out?

Sriram said...

Carmax buys and sells used cars. In the absence of a bail out, if one of the three auto companies file for bankruptcy, Carmax will need to take some write down on their inventory since people are less likely (at least initially) to buy that manufacturer's car. But in long term, Car max will sell cars that are popular among it's buyer's. It does not matter whether it is GM, Ford or Toyota or Honda.

In the short term, bail out is positive. In the long run, it does not matter.

If there is a concern about Carmax, it is about lack of liquidity in the interim. The Car loans are tighter like other loans and Car max cannot easily securatize car loans as it did in past. So I would be worried if the car buying slows for a long time and liquidity issues arise.

I think these risks are not unique to Carmax. I think car purchase can be delayed but not avoided. So even if it takes a year or two, it will do ok in long run. In the mean time, they seem to be positioning for a defensive environment.
Good luck,
keep your comments coming...

Anonymous said...

Why is it that Carmax has twice the ROIC as autonation and penske even though the income statement margins are similar. How exactly is KMX deploying capital better than others. Are they buying cheaper land or are they opening up lots substantially bigger than competitors? What do you think they are doing?

Sriram said...

I will first comment on Autonation vs Carmax in this post. I am not very knowledgeable with Autonation and do not own it. So my thoughts must be taken with a grain of salt.

Lets first look at financial ratio's since your question refers to it. I will use 2007 figures since 2008 is in kind of distressed settings. These figures are from morningstar key ratio's. As you can see, Asset turnover (inventory turns) in Carmax is twice that of Autonation (Carmax - 4.42 VS Autonation - 2.07). Also, do not forget Autonation uses lot of leverage.

From a business standpoint, they both are not exactly in same kind of business. Autonation sells mainly new cars (55% of revenue) plus service and repair. Carmax sells used cars (1 to 6 years old). The increase in productivity of Carmax is acquired by all factors listed in moat section of my blog (culture, no haggle pricing, better buying etc) but in particular, the following may shed light (note : this is not a compariosn with Autonation but a generic statistic).

A new car dealer on average sells around 110 new and old cars per month. A Car max location sells around 425 used cars per month. The higher per location sales results in leverage of fixed costs. This results in scale. In addition, customers can choose a car from a different location and transfer it to their site using their website. Overall both these attributes provides much better scale than new car dealers.

Many of it's competitor sell both used and new cars. Car max sells a very small amount of new cars but mostly it is focussed old cars. This single minded focus I think does help it's business model (better purchase focus, IT system tuned for large number of old car sales, inventory management etc). This is a soft attribute than a hard one.

I hope above helps in some way to explain your question. Also, you may be interested in the retail company evaluation piece in my segment
http://dollarbillsforless.blogspot.com/2009/01/how-to-view-retail-companies.html
Please feel free to leave your comments about response.

Sriram said...

Please check my new blog entry on Carmax update at
http://dollarbillsforless.blogspot.com/2010/09/car-max-update.html

Thanks and leave your comments.

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