America's Car-Mart: A Subprime Lender Masquerading As A Car Dealer

| About: America's Car-Mart, (CRMT)

Summary

CRMT's business model introduces investors to undue earnings risk.

The company is in a boom cycle right now that inevitably will end at some point.

Earnings estimates are too high and the current price introduces potentially significant downside risk.

Shares of America's Car-Mart (NASDAQ:CRMT) have been largely range bound for the past year during a tougher macro environment for car sellers. The retailer of low end used cars has produced some bad earnings reports in the past year but most recently, blew away estimates as shares took off higher. After a largely sideways year, are CRMT shares ready to resume their longer term uptrend? In this article, we'll take a look at CRMT's prospects in light of its current valuation.

To do this, I'll use a DCF-type model you can read more about here. The model uses inputs such as earnings estimates, which I've sourced from Yahoo!, dividends, which I've set at zero forever, and a discount rate, which I've chosen to set at the 10 Year Treasury rate plus a risk premium of 7.5%. I've chosen a high discount rate because investors should be compensated for the high risk, high reward business model of CRMT.

2013

2014

2015

2016

2017

2018

2019

Earnings Forecast

Prior Year earnings per share

$2.25

$2.99

$3.46

$3.75

$4.05

$4.39

x(1+Forecasted earnings growth)

32.90%

15.70%

8.25%

8.25%

8.25%

8.25%

=Forecasted earnings per share

$2.99

$3.46

$3.75

$4.05

$4.39

$4.75

Equity Book Value Forecasts

Equity book value at beginning of year

$24.37

$27.36

$30.82

$34.57

$38.62

$43.01

Earnings per share

$2.99

$3.46

$3.75

$4.05

$4.39

$4.75

-Dividends per share

$0.00

$0.00

$0.00

$0.00

$0.00

$0.00

=Equity book value at EOY

$24.37

$27.36

$30.82

$34.57

$38.62

$43.01

$47.76

Abnormal earnings

Equity book value at begin of year

$24.37

$27.36

$30.82

$34.57

$38.62

$43.01

x Equity cost of capital

9.90%

9.90%

9.90%

9.90%

9.90%

9.90%

9.90%

=Normal earnings

$2.41

$2.71

$3.05

$3.42

$3.82

$4.26

Forecasted EPS

$2.99

$3.46

$3.75

$4.05

$4.39

$4.75

-Normal earnings

$2.41

$2.71

$3.05

$3.42

$3.82

$4.26

=Abnormal earnings

$0.58

$0.75

$0.69

$0.63

$0.57

$0.49

Valuation

Future abnormal earnings

$0.58

$0.75

$0.69

$0.63

$0.57

$0.49

x discount factor(0.099)

0.910

0.828

0.753

0.686

0.624

0.568

=Abnormal earnings disc to present

$0.53

$0.62

$0.52

$0.43

$0.35

$0.28

Abnormal earnings in year +6

$0.49

Assumed long-term growth rate

3.00%

Value of terminal year

$7.14

Estimated share price

Sum of discounted AE over horizon

$2.46

+PV of terminal year AE

$4.05

=PV of all AE

$6.51

+Current equity book value

$24.37

=Estimated current share price

$30.88

As we can see the model has produced a fair value of around $31, substantially lower than the current share price. So this would indicate that CRMT is way overvalued and we should avoid shares, right?

Maybe. But first, we need to understand what we're looking at and what is driving the discrepancy so investors can make informed choices. The model produces a fair value and not a price target. The distinction is important because a price target is a projection out into the future of some multiple of earnings. By contrast, the fair value my model has calculated is the price at which CRMT is a good value today, given the inputs I described above. In other words, the present value of the company's future earnings stream is around $31 right now. Obviously, at nearly $43, I think CRMT is overvalued.

To start, I don't like CRMT's business model. Selling low end cars to customers with no credit and then financing their purchases is a recipe for booms and busts like we've seen in the past ten years. This means CRMT is more a consumer lender than a car dealer as the car sales are incidental to the company's real business model of making high risk loans. In other words, I don't really think of CRMT as a car dealership but rather as a subprime lender that uses cars as a conduit to make loans. While CRMT has made it work, this business model isn't for me. It introduces enormous risks that don't appear with car dealerships; this company operates on the razor's edge of credit quality.

To be fair, the company crushed its Q1 earnings and the stock raced higher. CRMT posted huge beats on the top and bottom lines and shares took off around 15% higher. As go the company's collection rates, so go its earnings and with car sales and receivables performing well, earnings took off higher.

This is the problem I've got with CRMT and why I don't like it; its business model lends itself to this kind of earnings volatility and introduces shareholders to undue risk. For instance, CRMT operates its business with less than $300 thousand of cash at any given time. Consider the insanity of that number in relation to the $300 million of receivables or $150 million in current payables; CRMT is relying on consumers to pay their bills each week (that's right, CRMT's customers have to pay each week because they cannot be trusted to pay the bill once a month) to be able to keep the lights on. I have never once in my life seen a company operate with virtually no cash unless it was on the verge of bankruptcy. CRMT is far from bankruptcy but rather, chooses to play chicken with its cash reserves every day and hope for the best.

I find the company's expected earnings estimates to be reasonable enough at around 8% growth annually but when you consider that at some point in the next five years we'll likely have some kind of cycle down in the subprime auto lending market, there will be at least one negative earnings growth year for CRMT in all likelihood. That means that projecting only positive growth in earnings is likely not accurate. The analyst estimates I've highlighted above, in my belief, are going to turn out to be far too high. CRMT will struggle again and I don't think it will be that long until that happens. If you think about the way Wells Fargo (NYSE:WFC) makes its mortgage loans wherein it carefully selects high quality buyers and properties to reduce credit risk, CRMT is the total opposite end of the spectrum. It lends to high risk consumers on depreciating assets they may or may not be able to actually afford. Thus, the boom/bust cycles in earnings and revenue.

I think investors are underestimating the risk in CRMT at current levels. The current price of $43 suggests to me that investors think the boom cycle in subprime auto lending is going to last indefinitely. Maybe it will but I'm willing to bet that it won't because we've seen this play out before. The current price is forecasting earnings that are far too high and also doesn't account for any turn down in the cycle which we know will occur at some point. Even if CRMT can execute for another five years, shares are just a decent value right now with most of the earnings already built in. There isn't a lot of room for upside surprises at this point but a lot of room for downside risk.

The company's business model of being a subprime consumer lender will blow up in its face at some point and the company's complete disregard for its cash balance, I suspect, will become a problem as well. The company has twice as many receivables as payables but keep in mind where those receivables are coming from; how much of the $300 million will the company actually collect? Given the credit quality of its customers, those receivables should be heavily discounted. The bottom line is that CRMT at $43 is already pricing in a rosy future that I do not believe will materialize. Thus, the risk is to the downside and in a potentially big way. Investors should either avoid or short CRMT at these levels.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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