Carmax Gp
/ (Cc) (KMX-NYSE)Current Recommendation / Sell
Prior Recommendation / Hold
Date of Last Change / 10/12/2008
Current Price (03/18/09) / $12.18
Six- Month Target Price / $10.50
OUTLOOK
CarMax continues to face a difficult used-vehicle environment, largely due to aggressive incentives being offered by new vehicle manufacturers. Declining used-car value due to the ongoing weakness in the overall economy and higher funding cost at the CarMax Auto Finance are eroding the margins of the company. The current economic slowdown and reduced consumer spending had a negative impact on the company’s retail business. It is aggressively cutting prices on trucks and SUVs to reduce inventory. A drop in earnings and a higher valuation make us apprehensive about the stock’s performance in the near term. Thus, we rate the stock a Sell and set a six-month target price of $10.50.SUMMARY DATA
52-Week High / $21.9952-Week Low / $5.76
One-Year Return (%) / -40.59
Beta / 1.21
Average Daily Volume (sh) / 3,431,811
Shares Outstanding (mil) / 220
Market Capitalization ($mil) / $2,684
Short Interest Ratio (days) / 13.31
Institutional Ownership (%) / 103
Insider Ownership (%) / N/A
Annual Cash Dividend / $0.00
Dividend Yield (%) / 0.00
5-Yr. Historical Growth Rates
Sales (%) / 14.2
Earnings Per Share (%) / 6.8
Dividend (%) / N/A
P/E using TTM EPS / 39.3
P/E using 2010 Estimate / N/M
P/E using 2011 Estimate / N/M
Zacks Rank / 2
Risk Level / Above Avg.
Type of Stock / Mid-Value
Industry / Ret/Whl-Auto&Tr
Zacks Rank in Industry / 1 of 12
KEY POINTS
Continuing slow sales in the new vehicle market – especially domestic cars – have forced manufacturers and dealers to offer incentives and attractive pricing, filtering down to lower used-vehicle margins.
The values of used cars are continuously falling due to the ongoing weakness in economy.
Incentives on new cars offered by original equipment manufacturers (OEMs) have lowered used-car sales, thereby increasing the used-car inventory.
The company competes primarily in the late-model used-car market, which tends to be more volatile than the overall used-car market. Competition in this segment leads to high advertising costs, which again erodes margins.
CarMax Auto Finance, the finance arm of the company generating about 40% of its total earnings, is expected to report higher funding cost. This is likely to impact earnings in fiscal 2009.
CarMax failed to make any meaningful projections of fiscal 2009 earnings due to the weak economic conditions and the industry-wide slowdown in automobile sales. The company has halted expansion of its used-car superstore base post-fiscal 2009 third quarter until the market revives.
OVERVIEW
CarMax is a holding company which conducts its operations through its wholly owned subsidiaries – CarMax Auto Superstores, Inc., Virginia; CarMax Auto Superstores West Coast, Inc., California; CarMax Auto Superstores California, LLC, California; CarMax Auto Superstores Services, Inc., Virginia; CarMax Business Services, LLC, Delaware; and Glen Allen Insurance Ltd., Bermuda. It is the nation’s largest retailer of used vehicles. Headquartered in Richmond, Virginia, CarMax, Inc. operates as a specialty retailer of used vehicles (96% of sales) such as cars and light trucks as well as of new vehicles (4% of sales). About 85% of the used vehicles that the company retails are 1 to 6 years old, having run less than 60,000 miles. The range of vehicles includes both domestic and imported cars as well as light trucks. As of November 30, 2008, the company operated 99 used-car superstores in 46 markets. Of these, 10 were added in the first three quarters of fiscal 2009. The company acquires its used-vehicle inventory directly from consumers through its in-store appraisal process as well as through other sources including local and regional auctions, wholesalers, franchised and independent dealers, and fleet owners such as leasing and rental companies. The company conducts the in-store appraisal process through its car-buying centers intended to increase appraisal traffic and generate incremental vehicle purchases by individual consumers, but not sale of vehicles. The company sells vehicles, purchased through the in-store appraisal process, that do not meet its retail standard through on-site wholesale auctions. CarMax also operates six new-car franchises, all of which are integrated with or co-located in its used-car superstores. Most of the company’s locations are in the southeastern U.S. However, Chicago, Los Angeles, Houston, Dallas, and WashingtonD.C. are some of the cities where the company has a strong presence.
The company conducts its used-vehicle operations in three basic retail formats: mega, standard, and satellite stores. Mega superstores are approximately 70,000–95,000 square feet, standard superstores are 40,000–60,000 square feet, and satellite superstores are approximately 10,000–20,000 square feet. The company also provides customers with a full range of related services including financing of vehicle purchases and sale of extended warranties, accessories, and vehicle repair services through CarMax Auto Finance (CAF). CarMax’s revenue comprises used vehicle sales (80.4%), wholesale vehicle sales (12%), new vehicle sales (4.5%), and other sales and revenues such as commission on the sale of Extended Service Plans (ESPs), service department sales and third-party finance fees (3.1%).
Continuing slow sales in the new vehicle market, especially domestic cars, have forced manufacturers and dealers to offer incentives and attractive pricing, filtering down to lower used-vehicle margins. Values of used cars are continuously falling due to the ongoing weakness in the overall economy. Incentives on new cars given away by the OEMs have encouraged consumers to trade in their old cars for new cars, which has lowered used-car sales and increased the used-car inventory. Therefore, in a defensive move, the company began lowering the prices of vehicles to reduce high used-car inventory but is facing shrinking margins. On the other hand, the company was constrained to fund increased inventory by raising debt. In fiscal 2008, the company increased total debt by $148.9 million for financing increased inventory and capital expenditures. Consequently, the company expects average outstanding debt to rise in fiscal 2009.
CarMax competes primarily in the late-model used-car market, one that tends to be more volatile than the overall used-car market. Competition in this segment leads to high advertising costs, which again weighs on margins.
In the first quarter of fiscal 2009, the wholesale industry prices for SUVs and trucks declined nearly 25%. This is about four times the company’s expected normal depreciation in the segment over the period and greater than the depreciation expected over a full year. The rapid decline in the wholesale market value for SUVs and trucks has significantly compressed margins in this segment. This has forced CarMax to take supplemental pricing markdowns for these vehicles, a move that has further strained margins. Further declines in prices of used trucks and SUVs would again depreciate the value of bloated inventories. This would trigger a vicious cycle of erosion in profit margins on sales of those vehicles in the used market and additional downward pressure on sales of new trucks and SUVs.
CAF, which generates about 25% of the company’s total earnings, is expected to report higher funding cost. This is likely to affect earnings in fiscal 2009. CarMax's utilization of CAF to keep funding retail sales in a deteriorating credit environment adds further uncertainty to this stream of earnings, which is still significant to its profitability.
CarMax was unable to make any meaningful projections of fiscal 2009 earnings due to the decline in traffic sales and continuing volatility in the asset-backed credit markets.
INDUSTRY OUTLOOK
INDUSTRY OUTLOOK - NEGATIVE
POSITIVES
The industry is very concentrated, with the top 8 global auto companies having more than 90% of global revenues and the top 50 global auto parts companies having 80% of global revenues (the top 4 U.S. tire producers have 75% of the U.S. market). There is a focus on automation and simplifying product lines to lower costs and benefit from economies of scale. The average car now needs only 15-25 man-hours per vehicle and this drops 2% annually. Hybrid/alternative cars represent a source of growth in the future. Market share gains by hybrids/alternatives will be slow, and they are now only 4% of cars on the road.President Bush approved an emergency bailout of the U.S. auto industry, offering $17.4 billion in rescue loans in exchange for tough concessions from the deeply troubled carmakers and their workers. The government will have the option of becoming a stockholder in the companies, in effect partially nationalizing the industry. If the carmakers fail to prove viability by March 31, 2009, they will be required to repay the loans, which they would find all but impossible. A firm will be deemed viable only if it can show positive cash flow and can fully repay the government loans. Under terms of the loan, General Motors (GM) and Chrysler must provide the government with stock warrants giving it the option to buy GM and Chrysler stock at a specific price. In addition, the automakers would be required to agree to limits on executive pay and eliminate some perks such as corporate jets
This is a band-aid, but not the surgery this industry needs. In essence, we see this as the first step towards a long-term solution, which will include the following:
1 - Getting a bankruptcy attorney and filing ASAP -- this measure extends this until March 31. Then healthcare and pension issues can be removed and this would go a long way towards making Detroit competitive with foreign manufacturers.
2 - Separate dealerships from the rest of the company. The parts and service issue can be guaranteed by the U.S. Government and these companies can be separated and recapitalized from the rest of the Big Three. We find it hard to believe that consumers would not buy something from a bankrupt company.
3 - Get a labor attorney and have a nasty confrontation with the UAW while in bankruptcy. This would be the worst labor showdown in out memory and may involve the Supreme Court at some point.
4 - Have the U.S. Government be a DIP [debtor-in-possession] financer, as opposed to writing blank checks to the auto manufacturers. They are there to support -- but not nationalize -- the industry. The challenge will be when to get these companies out of the private sector hospital, which is the U.S. Government.
5 - Focus on only 35+ MPG vehicles. Transition from SUV to AFV (Alternative-Fuel Vehicles).
6 - Remove the top-50 officers of the all of the Big Three and replace them with outsiders. Encourage creative and dynamic thinking.
7 - The U.S. Government should look at tariffs and quotas to protect these companies as they restructure. Also, this would force foreign manufacturers to build plants in the U.S. rather than export, which would make a worker-retraining issue a worker-relocation issue, which is far easier to deal with.
8 - Consumers should be allowed to deduct automotive interest, which would increase demand for autos and alleviate the credit issue that surrounds the industry now. Perhaps this can be for AFVs and 35+ MPG vehicles only. There should be a punitive tax on SUVs which will make them unaffordable for consumers. These tax revenues can fund growth of the AFVs and high MPG vehicles with tax credits.
9 - Global alliances should be forged among the manufacturers to take advantage of global economies of scale. These new "super-car" companies would be able to tap into the Chinese and Indian markets, where the car industry is a growth business and billions of people are screaming for a new car, not just a second hand retread from the U.S. or Europe. Economies of scale/Rationalization and China/India increasing the global baseline demand for cars may permanently increase profitability for the industry and avoid this situation from happening again.
NEGATIVES
Earnings are below expectations and have been for some time.Some of these companies may be bailout candidates, which would leave equity holders with no value. Demand for autos is down 15% due to a weak economy and weakening real estate market.Demand is also hurt by weakening employment. The recent credit crunch is crippling to auto sales, and this has a trickle-down effect throughout the industry. Furthermore, there is a slowdown of SUV sales, which are 55% of sales (cars are 45%). Imports have also been more competitive, as they tend to have better gas mileage. Costs for domestic producers are much higher than seen for foreign producers, and this is creating a loss of market share in the U.S. by the domestic producers. The presence of unions has led to costs being much higher than seen in other countries.Pricing averages -2% in this sector annually. Incentives are increasing as the industry is trying to increase sales. Overcapacity is about 20% in this sector. Pension deficits are rising due to a weak stock market, lower interest rates and less pension funding.
Auto sales were very weak in February, but this is a continuation of an ongoing trend. Overall sales are down 41% and were the worst since 1981. The average incentive was $2900, which is up 8% and was unable to stimulate sales. Ford (F) sales were off 50%, mainly due to a tired product line and weak F-series sales. General Motors (GM) sales were down 53%, with weakness in the SUV part of the product line. Chrysler sales were down 44%, even with average incentives of $5,500, which is 20% of the price of a car. Honda (HMC) sales were off 38%, which is 3% higher that the market and shows why they are the best of the "Big-4" automakers (Honda sources more of its content from the U.S. than even Chrysler). Nissan (NSANY) sales were down 37%. Toyota (TM) sales were off 40%. We suspect sales were weak in the SUV part of the product line. Hyundai continued to buck the trend and had flat sales, which implies that their "return your car if you lose your job" program is having huge success.
BUY/SELL RATINGS
Autoliv is a sell due to the slowdown in the auto market and weak pricing. Autonation is a sell due the slowdown in the auto market and exposure to California. American Axle and Manufacturing is a sell due to the slowdown in the auto market and costs related to the new UAW agreement. Ford and General Motors are sells and bailout candidates that need a major restructuring. Carmax is a sell due the weak auto market and falling prices. Lear is a bankruptcy candidate. TRW Automotive is a sell due to the weak auto market.
INDUSTRY POSITION
The majority of consumers are looking for value, consistent with general retail trends. Incentives offered on new vehicles are attracting buyers and, as a result, pressuring used-vehicle prices and margins. The primary competitive factors in the used-vehicle retailing market are price, breadth of selection including the more popular makes and models, quality of the vehicles, location of retail sites, the ability to offer or arrange customer financing on competitive terms, and the comprehensiveness and cost of extended warranties. The company’s primary competitors are the nation’s roughly 21,500 franchised new car dealers, who sell the majority of late-model used vehicles. In addition, CarMax also competes with independent dealers, rental companies, and private parties. In the new-vehicle market, CarMax competes with franchised dealers, offering vehicles produced by the same and/or other manufacturers, with auto brokers and leasing companies. The company has six new car franchises representing the Chevrolet, Chrysler, Nissan, and Toyota brands.Two franchises are integrated within the used-car superstores, and the remaining four are operated from three facilities that are co-located with select used-car superstores.Moreover, the company’s finance arm, CAF, is subject to competition from various financial institutions. Further, customers are increasingly using the Internet to compare pricing for cars and related financing, which has increased competition and may impact profitability.
CarMax attempts to capture market share through programs such as its Certified Quality Inspection, which assures that every vehicle offered for sale meets rigorous mechanical, electrical, and safety standards. In addition, each sales consultant at CarMax is paid the same fixed dollar-per-unit commission on any vehicle sold, compared to the traditional method of consultants receiving higher commissions for negotiating higher prices and steering customers toward vehicles with greater gross margins.