This week’s bullish case for CarMax in Barron’s encouraged me to reopen a CarMax annual report that had been gathering dust on my desk. As the Barron’s article says, CarMax is a differentiated retailer in a very commoditized space – used car sales.
Let’s dig deeper into CarMax’s business model to determine whether or not it has the features of a world class investment, or just another pricey growth story.
CarMax Company Bio
CarMax was founded as a division of the now defunct Circuit City in 1993 and was spun off in 2002. The company owns and operated 108 used car stores as of the latest annual report, and has since added 5 new stores. The business focuses primarily on used cars between zero and 6 years of age, targeting sales prices of $10-$13,000.
CarMax has a very different business model than other used car dealerships. First, its sales team is paid on commission per car, not as a percentage of the total sale – executives also tout its less aggressive sales tactics as a way to build trust with consumers. Secondly, the company will buy any and every car on the spot after a short appraisal, regardless of whether or not the seller intends to buy a car at CarMax.
In contrast to other dealerships, CarMax is more retailer than car dealership. It secures inventory from trade-ins and sales, not auctions, acting primarily as a middleman between individual buyers and sellers of used cars. Consider it a consignment shop of sorts.
CarMax is a growth story in the making. The company has an excellent 10-year revenue growth average of 12% per year, and has grown net income at a 10-year average pace of 16.4%. Revenue and profit growth is primarily driven by new stores, higher volumes, and used car price inflation.
The company also has a hidden business in the auctioning of used cars that are not of the quality standards that the company sells on its own lots. Its auctions, which are closed to the public and accept only dealer bids, provide a mechanism for the company to profit on on-the-spot used car purchases from the public. In 2011, used car auctions grew at an annual clip of 20% to 316,000 vehicles, nearly rivaling the 408,000 vehicles sold at retail in the company’s stores.
Despite impressive growth, the company has hardly exhausted avenues for potential growth. In the annual report, it estimates that the company has less than 3% market share of all sales of used cars 0-6 years old. The company intends to open 50 new stores within the next 4 years at a rate of 10-15 new stores per year, financed all by its own operating cash flows, not debt or stock issuance.
CarMax’s Competitive Edge
What interests me most about CarMax are its numerous competitive advantages including:
- Nationwide Network – Buyers can have any car delivered from one CarMax lot to another, giving buyers an incredible amount of selection on and off the lot. Having a nationwide network allows the company to essentially arbitrage car prices from one area to another. CarMax’s selection of used cars rival that of new car dealers in that CarMax customers can essentially order a used car with the exact trim, color, and year of their choosing.
- Informational Asymmetry – CarMax’s used car auctions to dealers provide it with an interesting look into the business of its closest competitors. CarMax knows just how much dealers pay to buy cars at its auctions, intelligence that it can use to compete.
- Best of Breed Inventory – CarMax retails mostly cars that are less than 6 years old and of the best quality. In selling lightly used vehicles, the company targets the most profitable and “cleanest” segment of the used car business, leaving the scraps for mom and pop competitors to fight over.
- Chain Advantages – Chain stores are excellent for driving and implementing innovation. The company’s 110 stores give it the opportunity to test different marketing and sales methods and then implement successful strategies across its entire chain of stores.
- Inventory Turns – CarMax has the best inventory turnover of any publicly-traded auto retailer. The company posts routine inventory turnover that is 33% faster than AutoNation (AN) and Group 1 Automotive (GPI), companies primarily involved in the sale of new, not used, vehicles. Less inventory on the lot also insulates the company from depreciation.
- Less Cyclicality – Used car sales are not as cyclical as new car sales, allowing the company to safely grow faster than it would if it were involved in the new car segment.
- Psychology – Customers walk into the lot knowing the sales staff is paid per-car, not based on price. Further, the no-hassle, no negotiations policy means that a customer doesn’t spend hours haggling with a sales person who “checks with the manager” at every step along the way. Customers can buy quickly, perhaps on impulse, and they leave happier with a faster sales process.
Catalyst for Upside
CarMax has a catalyst in the expanding supplies for used vehicles. As any recent used car buyer would know, the supply for used cars is incredibly thin mostly due to a slowdown in new car sales in 2008 and 2009. Going forward, CarMax will have more inventory, giving it better opportunities for growth.
The supply of used cars is one to four years old is estimated to be 49 million cars, down from 68 million from 2008. With new car sales in the US coming in at an annualized pace of 14-16 million units going forward, supply of used cars could improve by 20-25% over the next four years. American cars on the road are now the oldest ever at an average of 11 years so it is only a matter of time before pent-up demand comes back into the market for new and used cars.
Organic growth gives CarMax further room for upside. Given that the company's sales total less than 3% of the market for vehicles 0-6 years old, the company’s aggressive new store openings should add to profit growth. It estimates that it has 6% marketshare in cities with existing stores, and management apparently believes there is growth opportunity there, as well. The company is opening new stores in existing markets like Nashville, TN, Los Angeles, CA, and Jacksonville, FL.
All in all, CarMax makes for an interesting long term growth play. It’s well positioned in a growing niche market for vehicles 0-6 years old, and on track to post annual store growth of 8-10% per year for the next five years. And as it grows, the value in the network effect should give it sales growth at existing stores as customers tap its network for cars located all around the country. Of the 50 new stores planned, 35 are in entirely new markets – markets that should help it leverage its network to drive revenue per store.
As a long-term buy and hold, CarMax makes sense at an earnings-multiple less than 20. This growth story is far from over, and deserving of a valuation premium. Compared to the PE of 16 for the broad S&P 500 index, CarMax is cheap.