America’s Car-Mart Stumbles: Can It Stage a Comeback?

Yesterday after the close, America’s Car-Mart (CRMT) announced they expect to report a fiscal second quarter loss of $0.16 to $20 per share (so roughly $1.9 million to $2.4 million after-tax). The results included a $3.3 million ($0.28 per share) charge associated with an increase in the allowance for credit losses, so excluding this charge, earnings per share (eps) are expected to be in a range of $0.08 to $0.12, still significantly lower than the $0.23 in eps the company reported last year in their fiscal 2Q (ended October 31, 2005.)

You should also take note that the company (at the bottom of the release) said they will be in violation of certain covenants under its revolving credit facilities. But management is highly confident (after “extensive conversations” with its lenders) that the company will receive the appropriate waivers before filing their 10Q.

Before I get into the details I wanted to back up for a second. Buy Here Pay Here are used vehicle sales to "high risk" customers, and usually done at a really high interest rate (the more risk the more the reward.) Last night I was talking with a good friend of mine from the hedge fund community. Over the years we have somewhat joked, but somewhat seriously talked about starting or investing in a buy here pay here dealership. I always struggled with the excessive rates charged to customers. He always struggled with the risks. So as we were talking and I mentioned America Car-Mart’s results, he said yeah this certainly is not a good time for that type of business. Interest rates are rising, the low end consumer is getting squeezed, and we are certainly closer to the top than the bottom of an economic cycle.

And from my days on Wall Street where we live and die by the returns I certainly can relate. But then I started to think about it from the standpoint of a private equity firm. I said, sure, for the next year or so, things are probably going to be awful in the buy here, pay here business. However, as I think about the industry three to five years from now, heck, it will probably be a pretty good time for Buy Here Pay Here Dealers.

Sooner or later the rising interest rate environment will have subsided (you just need to catch that window.) In addition, the difficult environment being experienced today likely will have caused serious rationalization in the industry (that means the less efficient players will either be acquired or in this business more likely simply shut their doors.) And perhaps most importantly, most players throughout the industry will likely have “tightened their belts” probably swinging too far in the direction of erring on the side of being conservative with their lending practices. This will likely have the effect of pushing a number of (low income) consumers actually out of the market, creating considerable pent up demand as lending standards once again become more flexible.

So deep pocket players and investors with a little foresight (and appetite for a fair amount of risk) could end up BIG winners three to five years from now if they dabble in the buy here, pay here market. What are you saying Jerry, are you actually giving us “actionable” investment research versus your theories? Careful, I like my theories and stories about Underdog. And no, you should always look before you jump. But what I am saying is that America Car-Mart’s “implosion” yesterday makes this an area that we should begin looking at more closely. And I mean for most of the constituents of this newsletter.

If you are public investor (meaning you invest in securities on the public stock exchanges,) maybe you need to put America’s Car-Mart (CRMT) on the radar screen. True, it’s probably a little early. Although, keep in mind, when I say it’s a little early, I am not trying to “time it” in the traditional sense. I think investors should buy securities when they are attractively valued. It’s the whole “trying to value” thing where I think A LOT of work needs to be done in understanding the cash flow and earnings characteristics of America’s Car-Marts business model. There are a number of moving parts with finance companies such as these (as I discuss more below,) not to mention it appears CRMT also went a little aggressive on the growth side (that they are now digesting.) But I certainly think CRMT begins to move up the interest category among the names in the AutoRetailStocks.com index.

If you are a private equity player, you may want to consider investing/starting up a buy here, pay here group. And if you are a franchised auto retailer, it might not be a bad time to start researching adding a buy here pay here side of the business to your lot. I know this sounds nuts, and I need to emphasize: this is not for everyone. The risks are very high. According to independentdealer.com the failure rate of new entrants in the buy here, pay here business is 70%. And what I am discussing right now is looking into this business more seriously, not pulling the trigger and buying America’s Car-Mart stock or starting up a new buy here pay here group. It takes about 6 – 12 months to work through a business plan, or I think even decide to take a “full position” in a stock. So, this is simply the beginning of that process.

But moving into an industry when everyone else is getting out and/or tightening their belts can yield serious rewards several years down the road. First of all, when everyone else is exiting, it is easy to hire talent. It’s also easy to acquire stores, likely for asset value or maybe even a little less. And most importantly, unless you really goof things up, you are gaining market share. Now sometimes, this is because you are winning a game no one else wants to play. Like you are buying a copper wire business and fiber optics has just been invented (see the movie “Other Peoples Money with Danny Devito for some more background on this.) Or, to keep the principles automotive, you are buying the leading horse and buggy whip manufacturer right after this dude by the name of Henry Ford came along with a new idea to build automobiles.

I don’t think the buy here pay here business is facing the above mentioned type of challenges. If anything, although it is somewhat sad, lower income and/or credit challenged customers seem to be a growing part of the U.S. population. And as the U.S. continues to become an “exporter of intellectual capital” the widening of the haves versus have nots seems likely to exacerbate, not recede. Education (skilled learning) seems to be the solution, but like I said, from everything I see right now, even if the overall standard of living continues to rise, so does the propensity for American consumers to assume more debt. And here lies the opportunity for buy here pay here dealers to really help credit challenged individuals.

As such, I don’t see the buy here pay here business going away, rather, going through natural progressions (cycles.) Sometimes lending gets “too loose,” and there are too many players (because of low barriers to entry) are in the market. And then the pendulum swings too far in the other direction. Those players that move against the pendulum therefore could be well positioned when it swings back.

So the first thing we need to figure out is if this is an industry problem or an America’s Car-Mart specific problem While America’s Car-Mart is clearly suffering from an overly aggressive growth strategy in Texas (that I discussed in more detail in the September 7, 2006 Auto Retail Informer,) it also seems industry related. I have often commented about the seemingly disparate (different) industry data being reported about the total used vehicle market versus the results reported by “late model” (three or four year old) used vehicle retailers like CarMax or the publicly traded franchised auto retailers. I agree with Manheim’s Chief Economist that the reported industry declines (using registration data) are “likely exaggerated.” But America Car-Mart’s weakness suggests even more so to me that a “bifurcation” (my SAT word of the day that means split or division,) is occurring between players in the used market.

However, I need to come clean and say that maybe I have overly generalized this division (bifurcation,) by saying “the haves,” or those players that have superior systems and processes are gaining considerable share over “the have nots” or those players that lack the systems and processes. When I look across the board from Wal-Mart, to Monro Muffler and Midas, the do-it-yourself [DIY] automotive aftermarket retailers (all retailers that tend to cater to the low income crowd,) while comps ebb and flow from month to month, for the most part over the last six months or so they have been pretty darn sluggish. This is what is a little perplexing. Usually I would expect Car-Max and even franchised auto retailers used vehicle same store sale results to struggle during this time period as well. The divergence could suggest that a further split is occurring among middle to lower middle income consumers. But that is only an initial guess. Importantly, one thing that is becoming rather obvious, is for whatever reason, late model used vehicle demand is proving a lot stronger than older vehicle models. It is a side of the market that I do not think will go away, and therefore can present an opportunity.

For those of you involved in the industry, maybe you can relate to the woes facing the industry (and if not please let me know as that is useful insight for us Wall Street folk.) But I think the President of the National Alliance of Buy Here Pay Here Dealers (NABD’s Kenneth Shilson) appropriately pointed out in a press release last year (in today’s opening quote) the challenge buy here pay here dealers were likely to face in 2006.

Mr. Shilson went on in the release to say that given the challenges:

Some operators will merely change the deal structure of their financings by lengthening the term of the notes or by decreasing markup in order to offset these increased costs. Although lengthening term and lowering markup is a quicker and simpler way, it has some very adverse side effects. First, it increases the dealers “cash in deal” thereby reducing cash flow and increasing the need for more capital. Second, it increases the collection risk on the note itself. Finally, it constitutes a change in the dealer’s business model which alters portfolio performance statistics. (This is important if you ever want to obtain more capital.) Simply stated, dealers should resist taking this easier road.

And this is why it takes a while for problems in the buy here pay here market to really surface. Don’t get me wrong, I am by no stretch am even trying to insinuate (my second SAT word of the day which means imply) that the folks at America’s Car-Mart are playing games with the accounting and financing. If anything, it appears they are taking quick and decisive action to tighten their belt and become more conservative both with their accounting (loss reserves) and lending flexibility.

In America Car-Mart’s release, management said:

Gross profit margins were negatively affected during the quarter by higher wholesale sales levels, resulting from increased repossessions as well as increased repair costs, as the Company worked to keep customers in vehicles.

They also said same-store retail unit comps were down 3.3%, reflecting, “in part, a tightening of the Company's underwriting standards, particularly in the Company's newer stores.” Actual charge offs were something like 28% of sales, compared to 23% in the prior year period, and according to a study by Leedham and Associates published on independentdealer.com, to give you some perspective of industry averages, in 2005, buy here pay here dealers had an average delinquency- contractual of 22.7%.

The company’s CEO, T.J. “Skip” Falgout said:

The increase in charge- offs, coupled with the level of accounts in the 30+ days past-due category, prompted us to increase our allowance for loan losses from 19.2% to 22% of finance receivable principal balances. The higher level of charge-offs was largely the result of weakness in the performance of our portfolio as our customers have had difficulty making payments under the terms of their notes. We are aggressively addressing our underwriting guidelines and practices as well as our payment terms. Additionally, we have supplemented lot sales efforts with the creation of a Sales Specialist position and are in the process of upgrading and increasing our advertising to attract more qualified customers. We have recently hired a seasoned executive to head our Vehicle Purchasing Department, and we are focusing significant efforts on improving the mix and quality of vehicles we sell, which will lead to lower credit losses in the future."

One encouraging part was when Mr. Falgout said:

As we have previously discussed, credit losses at newer stores can approximate 30% of sales compared to 20% at our mature stores, and even in this quarter, our mature stores have generally maintained their historical profitability levels. The underperformance has been far more pronounced in our newer stores, particularly the Texas dealerships. In addition, we believe that some of our local competitors are offering terms that are irrational and not economically viable, and we do not believe that these practices can continue for a long period of time.

I also talked last weekend how it appears America’s Car-Mart is testing with Copart a better (more efficient) way to dispose of wholesale vehicles (vehicles they can’t sell and that run past their aging requirements.) It just seems like they are doing a lot of the right things to correct some of the, well, not so right things they did in the past.

Like I said, the company grew too aggressively in Texas a couple years ago and is paying the piper now. But almost every good retailer that I have observed over the years has, at times, grown too fast, and had to take a step back and digest what they acquired/built. And this is exactly what it seems like America’s Car-Mart is doing. And they could not have been any more clear in the release when Mr. Falgout said: "Our primary focus is to improve the profitability at the store level for our Company. While we are confident in our long-range ability to continue opening stores, we believe that we need to allow our infrastructure time to catch up to our growth. As a result, we are curtailing our new store openings until our new initiatives have a chance to bear fruit, and we are closely evaluating the results of our underperforming lots."

So over expanding and a downward turn in the market all seem to be weighing on America’s Car-Mart stock and has cast a shadow over the buy here pay here market. But like I discussed yesterday, one way to successfully invest is to spot the “ordinary” that can become “extraordinary.” I don’t know if that is the case with America’s Car-Mart, but given all of the woes, and what appears to be an industry that won’t go away (trouble credit consumers), it sure seems worth looking into.

CRMT 1-yr chart: