Well, at least I was happy about it. You may have been questioning my
sanity. Not to worry, though. Here's why we all own CarMax (NYSE:KMX).
Let it be known that in the months before General
Motors went bankrupt, investors in the Tarpon Folio were
happily buying shares of a used car dealership.
First - a point about business models. In the end, General Motors was
essentially a huge pension fund that sold automobiles as a means to
make consumer loans. CarMax has an in-house financing arm that
has contributed a significant portion of the company's past
profits. But I view the company's loan business as a tactical
opportunity, not a strategic imperative like I believe existed at GM.
CarMax sells used autos, first and foremost - and nobody does it
Also, in a sin of
omission, I missed out on an even more compelling price for us by not buying CarMax when trading under $7 last November.
Instead we first bought shares at $11.13 in March. Consciously
or otherwise, I stuck to my telecom roots last year and bought shares
in Amdocs, only to have a change of heart this past March after things
looked more predictable at CarMax due to the Fed's TALF
program. Let the cursing begin.
Used cars account for about half of the automobile
market, the largest
retail segment of the U.S. economy. The market is highly competitive
and fragmented, made of approximately 40,000 independent used car
dealers and millions of private individual sellers. Those circumstances
favor the entry of a well-capitalized, highly efficient operator into
the industry which will have an opportunity to achieve significant
competitive advantages. That company is CarMax.
Is This a Great Business?
CarMax was founded to create a used-car superstore
operated exactly the opposite the way the used car
functioned. The company has no-haggle sale and trade-in prices, clearly
discloses all financing terms, hires all salespeople from
auto industry and pays them a fixed-dollar commission regardless of the
vehicle sold - and no commissions on loans. This
service is working quite well. According to the company, 93% of its
would recommend CarMax to a friend, and the company ranks consistently
magazine's "Best 100 Companies To Work For."
There is no true competitor to CarMax currently
capable of adopting a similar business model. Several years back
Wal-Mart attempted to copy the CarMax model in a trial project in Texas
but abandoned it. AutoNation, a network of predominantly new car
dealers, also once tried the used car superstore idea, but it, too,
walked away. And small newcomer Lithia Motors, which operates in rural
areas, has proven to be a much less efficient business; CarMax
has higher margins and earns 3.5 times the return on invested capital.
The company's advantages are found in two areas.
The first is economies of scale. CarMax can simply sell more cars -
around 335 cars per month, versus 46 per month sold by publicly traded new car
dealers. Every superstore has four to five times the inventory of the
typical used car dealer - and if a particular model is not available
onsite, customers are led to kiosks at the terminal to access the
24,000 listings on CarMax.com. Customer transfers from one store to
another represent 25% of the company's sales.
CarMax's scale allows it to price below smaller
dealerships. By giving any further improvements in operating expenses
back to the customer as a price decrease, as the CEO has said he would
do, the company should also be able to further increase same-store
sales while keeping competitors on the defensive.
CarMax also has an information advantage. Since
1993, the company has appraised almost 10 milion car and trucks
and sold nearly 4 million automobiles. Combining that
info with data from other sources has helped CarMax build a
sophisticated inventory and pricing system that allows the company to
buy trade-ins lower and sell them higher than the competition.
I also should mention that used cars are actually
more profitable than new cars. Because every used car is unique, CarMax
can earn better margins on these differentiated products than a new car
dealer can when selling identical products. It's simply not as easy for
customers to call around and make apples-to-apples comparisons on used
With only 100 superstores in 46 markets, CarMax is
also still early in its growth cycle. It operates in a huge and
underpenetrated market. Despite being the largest retailer of used cars
in the U.S., CarMax commands just 2% of the 19 million unit/$275
billion market for 1-6 year old cars. More amazing is that it has
attained this share with just 100 of the more than 65,000 dealerships
in the country. Furthermore, within markets that it serves, CarMax
estimates its share at 8% to 10%. Clearly it business model has legs.
Plus, the company's long-term goal is for 65% of the population to have
access to a CarMax store. Right now that figure lies at 45%. That
difference translates into hundreds and hundreds more stores, which the
company should be able to easily self-finance through the profits it
I agree with the analyst who believes CarMax is to
used car dealers in 2009 what Home Depot was to hardware stores in the
Is It Cheap?
Forced selling last winter by large institutions
to meet investor redemptions. Soft demand for cars due to the
recession. Inventory management woes caused by consumer
reaction to the spike and then plummet in gasoline prices last year.
Most notable, however, was the turmoil in the credit markets, which
last fall left the financing division of the company - CarMax Auto
Finance or CAF - temporarily dysfunctional.
CAF historically relied on securitization to sell
the loans the company made to its customers. It would bundle all loans
up, sell them to big investors, and report income using what's called
"gain on sale" accounting. In addition to those securitization gains,
CAF also made money on servicing fees and interest income.
Now we're getting to the crux of why we didn't buy KMX
shares last year.
The company uses an off-balance sheet
special-purpose entity to "warehouse" the auto loans
it makes before it packages them up and sells them. (If the phrase
"off-balance sheet special-purpose entity" reminds you of Enron, you
can relax - it's all disclosed at CarMax.)
Using what's called a "warehouse facility,"
or a special line of credit, CarMax borrows money on a short-term, revolving basis to
make loans to its customers, and then pays back the borrowed
funds once the bundle of auto loans is sold.
Until the credit bubble burst, that model worked
well. Buyers could get access to credit and CarMax earned a profit.
However, when the credit crisis hit last fall, CarMax was effectively
unable to sell off its loans. Investors stopped buying
securitized loans of any stripe. In fact, the amount of all
securitized consumer loans in the US dropped from $1 trillion a year at
its peak to $8 billion in the last three months of '08.
Without buyers of CarMax's old loans, my concern last fall (shared
by others) was that the capacity to make new loans could disappear
as an increasing amount of unsalable loans consumed the company's extra
borrowing capacity. That would mean the company would eventually be
unable to extend more credit to
its customers...and that would most certainly not be good for the
This spring, the Fed and Treasury eventually
launched the TALF (Term Asset Backed Securities Loan Facility) to
jumpstart the market for securitized lending. It came at the right time
CarMax, which had just $185 million left to loan out of its $1.4
billion borrowing capacity. In early April, the company announced a
securitization that will effectively clear out its warehouse facility
Next, CarMax needs to refinance the warehouse facility itself, and I
suspect TALF will be the best option to do so, too.
So, I think we're done with the drama at CarMax.
Management still has miles to go before they can sleep, mind you, but
the business is back to being reasonably predictable in the long-term.
In case you want to know more about TALF, here's a
summary by The
Wall Street Journal which contained this graphic:
And to be clear - the quality of the loans CarMax originated is not a
huge concern to me. Loans that qualify for TALF must meet strict
criteria, and the vast majority of CarMax loans are eligible.
It Cheap For Temporary Reasons?
Yes. While it clearly will take some time for CAF
to begin functioning normally again, the company's earnings power will
eventually return. Fewer cars sold in the country today means
more pent-up demand later. In the meantime, CarMax is making right
moves to address the headwinds...suspending store growth,
slashing inventory, reducing headcount and completing a securitization
using TALF. Also of note
is that in spite of those headwinds, the company was able to increase
its gross margin in the most recent quarter as it gained modest market
share and generated its first free cash flow in some time due to
inventory liquidation and reduced capital spending.
CarMax is a high fixed-cost business. When
business suffers, profitability quickly does, too. However,
when the economy turns, CarMax will benefit from two levers in its
business - sales growth and, because of the operating leverage in the
business, higher net margins. In other words, once we're over the hump,
profits should increase quicker than sales.
In addition, another key growth driver is that
more than half of CarMax stores are less than five years old. Consumers
historically buy cars every three to five years. So my hunch is that
same-store sales will increase, too, once formerly delighted customers
start to come back.
Hundreds of new and used car dealers are likely to
go out of business by year's end. CarMax will also likely pick up
market share as a result. Another potential catalyst is the pending
"Cash for Clunkers" legislation making its way through D.C. Leaving
aside the political debate about the program, it's hard to argue that
CarMax would stand to benefit greatly if used cars are included. If
not, that's still okay. I'm happy to wait for the economy to recover,
and with it the used car market, too.
Is It Worth?
I believe CarMax is worth $22 a share,
though it could take a few years for industry conditions to normalize
enough to approximate my valuation assumptions. Longer-term, CarMax
could be worth much more.
I did not attempt to value the company's auction
business, which though small in terms of revenue could be another
growth engine for the company. It's the third largest wholesale auction
provider in North America and that scale adds value to the rest of
CarMax's operations, too, by reinforcing that information edge
mentioned above and CarMax's auction business is probably
underappreciated in the market.
I should also note that in the third quarter of
2007, the GEICO subsidiary of Warren Buffett's Berkshire Hathaway
conglomerate purchased shares of CarMax at prices between $21
and $25 per share. And if you presume that Lou Simpson at GEICO also
likes to invest with a big margin of safety, he likely believes shares
were worth significantly more than my $22 estimate. And who
am I to argue?