|Shares Out. (in M):||222||P/E||19.0x||19.0x|
|Market Cap (in $M):||5,460||P/FCF||N/A||N/A|
|Net Debt (in $M):||130||EBIT||455||455|
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.
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.
Change in the direction of used car prices.
Insider selling (CFO just recently made a significant sale)
|Entry||04/09/2010 06:41 PM|
I completely agree with your theoretical valuation of mid teens versus mid 20s but having been short this in the low 20s for a long-time making no money and suffering some squeezes along the way, I think this is a very tough short. Yes, I made a boatload being short in 2008. But it took a financial market meltdown to break this stock. Without the cratering of the equity indices and the closing of the ABS market, which put their very ability to finance themselves and their customer in doubt, this wouldn't have cracked. Slowing growth or bad comps won't be enough, because there are just too many true believers in their open field/long runway for store openings and there are just too few retailers with the organic SQF growth prospects of this company, no matter how low the ROIC on that investment.
The reason I think you are too early is because you are basically betting on multiple contraction on an expensive stock, which is always a tough short thesis. In order to get multiple contraction, you need this company to majorly disapppoint on earnings which can happen if they miss sales or miss margins. They aren't going to miss sales for awhile bc on the margin, the economy is getting better and consumer spending is improving and they have a couple more quarters of easy comps. The way they miss margins is if the Manheim index reverses sharply and they lose money on the carry. Because we are coming off 2 years of depression level SAAR of 9-10 mm (and we haven't truly bounced back yet in 2010 either), there will be a shortage of late model used vehicles for at least two more years. Also, in 2008, many OEMs pulled back from their leasing programs, so there are very few cars coming off lease now and next year, and those off-lease cars are very in demand and a shortage of them should support a high Manheim.
Keep in mind there are really three things that have broken this stock before:
1 - collapse in/complete dislocation of the fixed income market and concerns about funding gaps and running out of warehouse line (not likely to happen again soon)
2 - Manheim pulled down because of glut of used cars (probably 1-2 years away)
3 - High gas prices lead to collapse in demand for SUVs and they get hit one quarter on the carry of SUVs and trucks when you suddenly can't give them away (you might get lucky here but if that's your bet, just buy the USO)
Also, it would seem aggressive incentives on new cars from the OEMs would hurt them but historically it has helped them as it has just juiced up interest in the auto category with consumers.
The one long-term threat to the KMX model which I think is very real but you didn't mention in your piece is other competitors getting better at selling used cars. Only 10% of the new car dealer market is the public companies but AN and SAH are already pretty good about moving used cars around lots, putting them on the internet, shipping them, etc. and other companies that aren't as good like ABG are working hard to get better. Also, HTZ about a year ago started advertising their cars they were disposing directly to consumers on the internet. They realized if they can do $200 or so better on car disposal by cutting out the middleman of the auto auctioneer, they can greatly improve their profitability. This is definitely a long-term threat because the availability of high quality, late model used cars from a reputable seller with high price transparency and lots of choice and no haggling is essentially the KMX value proposition to the consumer.
I don't mean to be harsh and I completely agree with you in theory, but in practive, this is a tough short because you are shorting a much-beloved cult name with high long only loyalty including that of Berkshire Hathaway (although I believe it is owned by Geico and not Buffett). It's a valuation short, and if I was going to take a swing at it, I would wait for 25x not 20x. If it gets to $30, I would take a swing I think.
|Subject||RE: Too early|
|Entry||04/09/2010 09:06 PM|
Thanks for your thoughts... we appreciate the feedback.
We agree with your assessment of the long term threat comments. In our view though, the companies you cited are just getting slightly better at operating what is a very mediocre, or worse, business. That modestly helps the likes of AN, etc. but certainly doesn't help KMX as you point out. As a long term follower of auto retailers, we think that the used business is the worst part of the industry if you think about a customer on an NPV basis over their life (if that makes sense). You have inventory risk, you have tons of competition, there is absolutely no brand for anybody, and you are subject to the whims of the OEMs indirectly without any help from them. We should have communicated those points a little better qualitatively rather than just with the return on capital argument.
One offset to your "too early" comments is that it is a cheap short -- easy to borrow, and no carrying costs. Of course the thesis could be wrong, but it isn't expensive to find out so to speak. We take the being wrong risk with all of our positions though, and so perhaps this is reasonably cheap exposure to protect us against some cracks in the economy.
One last comment -- we have what we believe to be a good source that claims your Berkshire comment is accurate (it's Geico that owns KMX not Warren). In fact, we're told CarMax called Berkshire when they were getting ready to open the Omaha store and asked if he'd honor them with his attendance. We're told he acted as if he didn't realize BRK even owned the stock.