On CarMax's Blowout Third Quarter

CarMax (KMX) reported earnings per share of $0.42 ($45.4 million). The results demonstrate earnings growth of 98% (so nearly double) of what the company earned last year in the fiscal third quarter (when they earned $22.9 million, or $0.22). And the results were far better than the $0.25 ($27 million) that I said the consensus figures were looking for. Full year fiscal 2007 guidance was raised to a range of $1.75 to $1.85 from a range of $1.55 to $1.65

Backing in the $1.45 the company has earned through the first nine months of fiscal 2007, it suggests management is expecting to earn somewhere between $0.30 to $0.40 in the last quarter of the year (4Q07). Analysts (juniors) of course will take the mean of this guidance and come up with a figure close to $0.35, which is already consistent with the consensus estimate for 4Q07 (as published on the CarMax website). I should point out then that the guidance for 4Q07 of $0.35 compares with $0.38 in the fourth quarter of fiscal 2006.

So what’s going on? CarMax is on a tear, or so the 3Q results would suggest (nearly doubling profits), and now management expects earnings in the fourth quarter to be lower than the prior year period. They must be “low balling” the figure? Or so investors might conclude. I encourage investors to go back and listen to the replay of the conference call (or just read it here).

Management was pretty clear that part of the improvement merely reflected the favorable timing of some expenses (that get shifted into the fourth quarter). Specifically, they called out about $2 to $3 million in projected relocation expenses that they thought would hit in 3Q and now will be incurred in 4Q07. Also they said that they have pre-opening expenses for 3 new superstores in 4Q, whereas last year they had none. And finally, management pointed out that last year in the 4Q they had lower health care and property taxes.

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My only point is that investors need to be very careful when they start taking the historical results and try to extrapolate it out into the future. Anyone that thinks nearly 100% year over year earnings growth is sustainable or even a decent picture of future return expectations has another thing coming. In some quarters the company is likely to demonstrate lower (year over year) earnings, as the fourth quarter may very well turn out.

If you’re going to get excited about anything, I think it should be the fiscal 2007 earnings guidance. It represents growth of 39% to 47% from the $1.26 (adjusted for the new stock option expense accounting rules) the company earned in fiscal 2006. Now that is the more impressive figure, and this is what we on Wall Street wrestle with (and why you see such a dramatic reaction in the stock price). What is CarMax’s long-term earnings growth rate? I tend to think it is in the 20% - 30% range (some years higher, some years lower). My math is way over simplified, but basically if you figure 15% to 20% new store (square footage) growth and another 3% to 8% same-store sales growth (a flat to declining industry demand environment offset by market share gains), you should come up pretty close to my earnings growth expectation.

Clearly the wildcard in the long-term growth outlook is what will CarMax’s same-store sales look like on a sustainable basis? I have to admit that we are dealing with rather poor industry data, and so it is tough to get a good gauge of what is really happening in the overall used vehicle market. But in general, until the excess capacity situation is resolved with the domestic auto manufacturers, I think new vehicles will compete (from time to time) with substitute used vehicle products. Combined with average American household budgets continuing to get squeezed (remember consumers spending more than they are earning), I think at best used vehicle demand (over the next several years) is flat, and at worst actually demonstrates year over year declines.

Now whenever industry forces pressure an industry, the more efficient players gain share and prevail. It certainly seems to be what has happened in Europe (check out the stock prices of folks like Pendragon), where franchised territory rules were broken down, escalating the competitive landscape and leaving the larger, more capitalized and sophisticated players to scoop up a ton of business. Perhaps this is what is happening with CarMax? Maybe they have reached that perennial “tipping point?”

The industry reports (based on registration data) tend to suggest the overall used vehicle market has been pretty sluggish. And yet, the larger, better capitalized and more efficient players are gaining considerable traction. CarMax’s used vehicle same- store sales (on a dollar basis) were up 21% (year over year) in the third quarter, benefiting from a 13% increase in same-store used units and a 7% increase in average selling prices (in part reflecting a better mix of SUVs). But when I say the large, capitalized players, I am not just discussing CarMax. By my pencil, the peer group of publicly traded (that means they are on the stock market) franchised auto retailers experienced a 5.2% (dollar) increase in same-store used vehicle sales in the third quarter and an 8.4% improvement in the second quarter (keep in mind these are on a calendar year and CarMax is on a February fiscal year).

So I think we have two things that we need to try to figure out: 1) why do larger players seem to be gaining traction in the market, and 2) why does CarMax seem to be gaining even more traction than everyone else? Is it just this divide of the “haves” versus “have nots” I have been discussing throughout the year now showing up in the results? And is it sustainable?

Let me address the first issue quickly. Quite simply, yes. I think the larger players are gaining traction in the market because they have been investing in systems (information technology) and even more importantly processes (training of employees to use the systems) that are allowing the large players to better stock their stores with the most desirable and profitable used vehicles. “Austin in a box” are what a lot of large auto retailers describe to me (paying homage to CarMax’s retired CEO) as the benefits they are now getting from putting the First Look or American Auto Exchange software into their stores.

Many years ago I discussed this topic with Thomas Folliard (the company’s CEO) the implementation of new software systems at franchised auto retailers long before he became CEO. He told me that you can have all the technology in the world, but if you don’t put the right processes in place it doesn’t do you much good. I could not agree with him more. And this is why I say the favorable same-store used vehicle sales results coming out of the public franchised auto retailers also reflect better processes and integration going on at those dealer groups.

And this brings us to the second issue: why then does CarMax seem to be doing even better than everyone else? You would think if some of the large dealer groups are now putting in better systems and processes (as third party technology begins to replicate CarMax’s proprietary inventory management software) CarMax would be doing worse, not better than the other large players. I think there are a couple things happening. First, I think there are just a number of less efficient players (independent used dealers and even smaller franchised dealers) that are just closing the doors or taking less inventory risk. So it makes sense that the group (CarMax) furthest along in “merchandising management” and most comfortable with taking the inventory risk (because they know what to stock their lots with) would be able to gain the most amount of share. It is the opportunity that awaits most of the large dealer groups that focus on merchandising versus leaving it up to each independent entrepreneur.

But there is a second element that I also think is allowing CarMax to gain a considerable amount of share, and that is the company’s finance arm. Yesterday I discussed how the company’s captive finance subsidiary created a more efficient and profitable means of financing the vehicle. However, I also cautioned that it can also allow a retailer to “produce” sales. Well, during the conference call, management indicated that they are seeing a modest increase in credit losses. Over the last year or so the company has been recording gains in their finance subsidiary because they had been overly conservative in their loss assumptions. Now those trends are reversing, and while they benefited from favorable funding costs (they had expected rates to move higher), they clearly are not benefiting any more from being able to make adjustments to the loss reserves.

I bring this up, because what all of this really means, and management did not shy away from saying so on the call, is that CarMax has been loosening its credit requirements. Now I said as an analyst, this tends to make you a little nervous. Especially in an era when most lenders are tightening their credit requirements, CarMax seems to be loosening them. Don’t get me wrong, I think it is a smart move. Remember how I discussed yesterday that I wish management teams would actually tighten up their belts (in their budgeting process) when times are good, and spend (hire) more in downturns? Moving against the grain in that regard should allow you to scoop up really good people in downturns and avoid over paying for people when the market is really strong.

This is kind of what I think CarMax is doing; going against the grain. They were obviously too conservative with their lending over the last few years, and now that things have turned, while the rest of the (lending) industry is tightening up, they are loosening their requirements, allowing them to gain considerable share. I don’t think the impact of a more liberal credit scoring should be underestimated when considering CarMax’s same-store sales results this year.

But it is a constant tweaking process. So I think investors need to be prepared that while CarMax is likely benefiting right now from having been conservative in their lending processes, at some point they may find they have gone too far (in easing their lending requirements), and need to reign in the loans again (likely putting pressure on sales). All good companies with a finance arm go through this, and it is not a big deal. However, I just want people to keep this in mind as they look at today’s results, and try to figure out the real same-store sales growth potential. In my mind, the same store used vehicle sales being demonstrated by CarMax in fiscal 2007 are likely on the high end of my expectation for 3% to 8% (management is guiding 8% to 9%).

But I think CarMax’s CEO prefaced it best when he was asked on the conference call what seems to have changed at CarMax? Mr. Folliard said that while externally it appears things have changed, really internally things have not. They continue to improve their process every day, and manage the business for the long term.

I encourage investors to think about CarMax (or any company or stock they invest in) in the same regard. In other words, don’t get caught up in a reactionary mode to these earnings. Nothing has changed with respect to the fundamental direction of where CarMax is headed, and therefore you should treat today’s results as simply that: another data point.

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Correction: In my comments about CarMax above, I pointed out that taking the midpoint of management’s implied 4Q07 earnings guidance you come up with $0.35, which is below the $0.38 the company reported in fiscal 4Q06, suggesting earnings will be lower (on a comparable basis) in 4Q07 of this year versus 4Q06 of last year. Management appropriately pointed out to me that while they reported $0.38 last year in 4Q06, if you adjust for the new stock option expense accounting rules, CarMax really earned $0.35 last year in 4Q06. So on a true comparable earnings basis, I think it is important to note that the mid- point of management’s guidance range really assumes flat earnings (not a decline).

Also management pointed out that in addition to the timing of relocation expenses, new store openings, health care and property taxes, the company also faces tough CarMax Auto Finance [CAF] comparisons when the company benefited from a $0.02 benefit (largely retained interest valuation adjustments). Just another item we should keep in mind when considering the year-over-year earnings growth trends in 4Q07.

See: CarMax F3Q07 (Qtr End 11/30/06) Earnings Call Transcript