The Week Ahead: Correcting Past Mistakes (CarMax, Hertz, Pep Boys); Sizing Up Sonic's Leadership

I think like an owner and therefore can act quickly and decisively.

- Scott Smith, Chief Operating Officer, Sonic Automotive

A look ahead
There is a lot going on next week otherwise I would have spaced these articles out, or at least saved this email for Monday. The automakers will release March vehicle sales on Tuesday afternoon. Morgan Stanley will be hosting an automotive investor conference in New York on Wednesday and Thursday, And press Days for the New York Auto Show will also be held on Wednesday and Thursday.

Corrections: Hertz, Pep Boys, CarMax
Let me begin with a few corrections. I know it is tough to imagine, but from time to time I make mistakes in the newsletter. I usually try to correct it the next day. But with everything that has been going on over the last couple weeks, a few corrections have "stacked up." So I wanted to provide these corrections/clarifications, and give you a quick thought about CarMax's (KMX) used gross profit figure (and why maybe they should re-think the way they report/account for those gross profits).

I really want to thank all of the readers for doing such a great job of catching my mistakes. It 1) really shows you are paying attention, and 2) helps everyone (including me) better understand the industry. So let me just run through each of the mistakes. . .

Hertz analyst coverage
Hertz (HTZ). On March 16, 2007, I said:

I don't think any of the analysts that are so excited about Hertz today were around writing investment research on the car rental industry back when things were really tough for the industry (2001/2002).

Wrong. Jeffrey Kessler at Lehman Brothers (who follows Hertz now) was assigned Thrifty, Budget, and Agency (insurance replacement) back in 1988. And over the last couple decades Mr. Kessler has covered companies like Avis, Hertz, Dollar Thrifty, and even HFS/Cendant (obviously off and on as these companies were not public the entire time).

Pep Boys gross per bays
Pep Boys (PBY). On March 19, 2007, I said:

Pep Boys has about 6,000 service bays, which means (based on the company's reported $881.3 million in gross profit in the service side of the business), they generated a little less than $150,000 in gross profit dollars per bay ($153k in fiscal 2007, $147k in fiscal 2006).

Wrong. Pep Boys generated $881.3 million in REVENUES (parts and installation) in the service bays in fiscal 2006 (and hence $147k in revenues per bay). And $919.8 million in revenues in the service bays in fiscal 2007 (hence the $153k).

They generated $190.5 million in GROSS profits in fiscal 2007, which is simply the sale of the parts and labor minus what they paid for the part and what they paid the technician to install the part. This works out to roughly $31,800 in gross profit per bay. Still better than the $27,200 in gross per bay they generated in fiscal 2006.

However, when you compare it to the $38,583 in gross per bay being generated at Monro's stores (as I discussed), maybe they do have a bigger problem on the gross side than I originally indicated.

Nonetheless, I still think the focus needs to be on deciding on a direction (purpose) for the company and focusing on all of the costs/profits (so more of an operating figure) than just the gross profit line. I also just really liked being able to use the Saturday Night Live skit "wookin' pa nub."

CarMax operating income per store, floor plan, and re-thinking the way the account for used gross profits
Operating profit per store. It helps if you don't divide by the selling general and administrative expense line. So if I take the company's gross profits of $971.1 million and subtract out selling general and administrative expenses of $776.2 million and divide by 79 stores, I come up with about $2.5 million in operating profit generated per store. If I add the company's finance subsidiary (CAF) to the operating line, I come up with about $4.1 million per store.

Also, in last week's piece on CarMax I said that it is unfortunate that CarMax does not break out floor plan interest expense. Celeste Gunter, Manager of Investor Relations appropriately pointed out to me that they do not have floor plan arrangements with manufacturers, and therefore no floor plan interest to break out. Instead, CarMax funds their used and new inventory with cash generated from operations and borrowings under the company's revolving credit facility.

And a minor point, but I hope you caught the typo in #6, where it is clearly gross per new vehicle, not gross per used unit (again).

Finally, a reader raised an interesting point regarding CarMax's gross profit per used vehicle where I said they made about $1,903 on every used unit they sold (price of the vehicle less any reconditioning, auction and shipping expenses). Due to an accounting difference, this actually comes across as being higher than it really is versus the franchised used vehicle retailers. Let me explain.

If I am a franchised car dealer, I treat the reconditioning work like other service repair work. This means I "mark up" the price of the part and labor. For example, before the vehicle is sold let's suppose the car needs a new set of brake pads. I buy the part for maybe $50, and (for simplification purposes), charge my used vehicle department like I would a regular customer for new brake pads $100, resulting in a 50% gross profit margin (meaning I make $50 for every $100 in parts I sell). It also takes me an hour to install the new brake pad (once again, simplification purposes), where the technician costs $50 an hour, and so I charge $100 in labor.

So all in, just like how I charge a regular customer that walks into my shop, I have charged the used vehicle department $200 (which is recorded as a cost in the used vehicle departments gross profit line) at the franchised dealer, and recorded as $200 in revenues and $100 in gross profits (so 50% margin) in the service departments sales and gross profit figures.

If I am CarMax, I don't have this "mark up" for the service department (like the franchised dealer). I simply record how much it cost me to buy the brake pads (in this example $50), and how much I had to pay the technician to install the brake pads (in this example $50). So for CarMax, their "cost of good sold" for reconditioning this fictional used vehicle is only $100 (so they get a higher gross profit per used) whereas the same work is being recorded as $200 at a franchised car dealer (and so you end up with a lower gross per used unit).

At first blush, you might say CarMax's accounting approach is better, because it shows the real cost in reconditioning the vehicle. But is it really? In finance, we learn about a principle called opportunity costs. I could put $100 in a bank and get $5 every year for letting them use my money (so a 5% return). But this "competes" with other uses/opportunities of my money. Like maybe I could loan it to a friend (not something I recommend) and he/she is offering to give me $10 every year for letting them use the money (so a 10% return).

In the same manner, CarMax needs to fully understand the "opportunity costs" of doing reconditioning work versus doing repair work for customers that come to their bays. If the technician's time is being focused on reconditioning work, what is the "opportunity cost" in service repair work that they are giving up? As you may recall, yesterday I said CarMax saw a 3% decline in service and repair revenues despite roughly a 15% increase in the number of stores. And the reason given on the conference call was that the higher used unit volumes caused the company's technicians to spend more of their time/effort on reconditioning (which does not get recorded as a sale or profit) than service and repair work.

I do not want to say that management is wrong in this decision. But accounting for used vehicle reconditioning repair work (with a service department profit mark up like the franchised auto retailers) just seems to make good sense in helping CarMax's management decide on this resource allocation issue.

Sonic Management Meeting
On Thursday (after the CarMax call), I found myself down in Ft. Myers Florida at the official grand opening for one of Sonic's Mercedes Dealerships. As you may recall, I visited this dealership a few months ago where a simple lunch with the General Manager (Robert Ogust) turned into a kind of all afternoon "shadowing" where I got to see first hand how things work on a day to day basis at a dealership. It was really cool!

But Thursday was a more serious trip (although the little mushroom stuffed crab cake things were really good). As you know, Sonic (SAH) recently lost its President and leader, Jeff Rachor. Sonic's loss is Pep Boys' Gain is how a financial media group (seeking alpha) re-titled one of my writings, and probably best summed up my sentiments on the topic.

So Thursday before the Grand Opening, I sat down with David Cosper, Chief Financial Officer and newly appointed Vice Chairman of the company, Scott Smith, Chief Strategic Officer and the new President and Chief Operating Officer (replacing Jeff Rachor), and Jeff Dyke, newly appointed Divisional Chief Operating Officer of Sonic Automotive, who along with Jim Evans (not present) will share the responsibility with Mr. Smith for the day to operations.

Why I spend so much time talking about management teams
Sonic managements' comments began very similar to what most of us in the investment community hear when a key leader departs: "Jeff was a great leader and he will be missed" (if I can paraphrase a bit from everyone in the rooms comments). "But we have a great team, and we remain focused on building shareholder value." "And all of the initiatives that were started under Jeff, like our used vehicle initiative are going to be seen through. . ."

"I've heard that before," I snapped back (well maybe politely said). "Remember when Craig Monaghan left?" I asked with regards to the departure of AutoNation's (AN) former CFO. As you may remember, Mr. Monaghan, the architect and someone I considered key in rolling out the company's somewhat controversial but in my mind important shared services center initiative left last summer. And AutoNation's management gave me similar statements, saying there is still a great team in place, and the initiatives like the shared services center will be seen through.

Shortly thereafter things at AutoNation really seemed to fall apart, with pre-tax income continuing to erode and selling, general, and administrative (SG&A) cost savings targets getting pushed out. And the shared services center, which for some reason is viewed by most external and perhaps even internal observers at AutoNation as a way to cut SG&A, seems in limbo.

I think the shared services center can be a tremendous tool to help bring efficiency to the store GMs (if done and explained right to the managers). The managers should focus on people maximization/development rather than administrative and accounting headaches. And this is the vision I understood the shared services (resource) center was trying to improve. Today, if there is a clear cut direction for the shared services center, it certainly has not been discussed much or articulated well on the company's earnings conference calls. And the entire focus seems related to an SG&A savings target (the least important aspect of the shared services center in my opinion).

What about when Group 1's (GPI) former CFO Scott Thompson retired? I didn't bring it up, but it is another example of when someone I considered key to the organization left, and after he left, things really seemed to fall apart (for lack of a better expression) as Group 1 acquired something like 20% - 30% of the company's revenues in a given year but the bottom line earnings didn't budge.

Then there are other instances, like Ben Hollingsworth (Group 1's CEO) retiring and being replaced by Earl Hesterberg, where the management transition shifted the company from aggregator to operator and earnings and the direction of the company seem to have dramatically improved. Or CarMax, where the company's founder Austin Ligon retired, and Thomas Folliard was promoted up, and results continue to get better.

I could go on and on about all of the management changes that I have observed over the years. No two have been alike, but my point is that the outcome could turn out to be favorable or negative. In other words, risk (albeit increasing whenever you have a change in leadership) swings both ways (for good or bad).

So sizing up the company's new leadership and the direction of the company is probably the single most important thing an investor can do. Yet I am amazed that over the years, I have not seen a single analyst upgrade or downgrade a stock when a management change is announced (although I suspect that will be my next "correction" as an analyst points out a time they did). For the most part, analysts are quick to react to earnings announcements, and slow to react to what is perhaps the single greatest determinant of future returns: what the new leadership will do with the company. I never did. I just found "subjective" points (like a management change) difficult to get past the supervisory analysts. It was just easier to focus on the quantitative numbers/valuation part.

And sizing up a management team is probably the most difficult thing to do, so maybe analysts don't want to "put themselves on the line." No financial textbook, no chartered financial analyst (CFA) test, no discounted cash flow or "economic value added" formula can teach you how to make qualitative judgements about management's leadership ability.

Yet, I can think of few things that will help determine the future returns investors should expect to receive from their investment more than the course management sets for the company. And even more importantly, management's ability to deliver/execute on said course.

Sizing up Sonic's team
So when I look at the change that has occurred at Sonic, I think you can understand why I get concerned when a dynamic leader like Jeff Rachor leaves. Sonic finally seemed to be gaining momentum as Mr. Rachor focused on increasing associate productivity. "Fewer people making more" is the goal I heard Mr. Rachor articulate and a statement I have probably repeated 30 times or so in these emails. And when you merged Mr. Rachor's "operational excellence" focus with the new addition of David Cosper in 2006 (former Vice Chairman of Ford Credit), who brought a return on capital discipline, I felt it was a force to be reckoned with in the industry.

Not too different from my opinion of AutoNation where I thought you had a great team of Craig Monaghan bringing the return on capital discipline, and Mike Maroone (Chief Operating Officer) bringing the operational focus, with Mike Jackson in the middle balancing the two. And when the balance of power got disrupted (with Mr. Monaghan's departure) that is when the problems really began to surface (in my opinion) at AutoNation.

While at first blush Sonic's loss (of Jeff Rachor) therefore sets up the potential for a similar scenario to what I think is happening at AutoNation, I am becoming more convinced that Sonic will not follow down the AutoNation path, and may even emerge a stronger company.

In AutoNation's case, the company's number 2 finance person (Alex McAllister) was also leaving the company and so they were lucky to even keep him around (signing off on the financial statements) until a new CFO was found (from the outside). Sure, when things have really gotten off track, like in the case of Group 1 after Scott Thompson's departure, maybe you need to bring someone in from the outside. Especially when (like in Group 1's case) when a new direction is needed (shifting from an acquisition oriented company to an operating company). But that is usually a good sign that things have gotten off track (when a company has to look outside).

In Sonic's case, like I said above, things do not appear to be getting "off track." In fact, the productivity momentum seems to be building. Could they get off course? Sure. But you don't see the number 2 operating person leaving. Instead, Sonic promoted up the two key operating individuals Jeff Dyke and Jim Evans to help run the day to day operations along with Scott Smith. Jeff Dyke was a Jeff Rachor hire (from AutoNation), and his vision/thoughts about used vehicle processes (not just the technology) impressed me greatly. And Jim Evans is even moving to the company's corporate headquarters where he will work (almost literally) side by side Scott Smith and Jeff Dyke.

And I don't see a sort of "tug of war" developing between finance (David Cosper's department) and operations (Dyke/Evans/Smith). What I did see was operations and finance turning to Scott Smith for quick and decisive leadership. "I think like an owner, and therefore can act quickly and decisively" Scott Smith stated as both Mr. Dyke and Mr. Cosper nodded their heads suggesting there were some very specific recent examples where Mr. Smith took quick and decisive action.

Now Scott Smith being more than a figure head might scare the heck out of some people. "He won't last more than 6 months." And other similar comments are the types of emails I got when Scott Smith was named the Chief Operating Officer of the company. Let's be honest, he is the Chairman's son. Does heredity qualify him to run the third largest U.S. dealer group in the country?

I think he may turn out to surprise everyone. Even after the official meeting as Mr. smith and I strolled around the grand opening of the dealership (and I was spilling coffee and mushroom crab things all over the nice clean floor) Mr. Smith continued to go into all sorts of details about the business. "I've learned the hard way that making big investments into technology before thinking through the processes that need to put in place along with the technology can be very costly." He would just zing at me. Or, "Do you know how Pendragon (largest dealer group in the U.K). does their finance and insurance process? Well, they . . ." (I'll leave that one up to you to find out).

And maybe the thing that impressed me the most, was how intricately familiar he was with where the company was lacking. "Could we do a better job on the human capital side? You bet." Mr. Smith stated. "We've made great strides at reducing employee turnover, but it remains public enemy number one." "And why can't we go green, green, green with the manufacturers?" (An expression/color scheme of how manufacturers "score" dealers). "Those (employee turnover and manufacturer relations) along with continuing our focus on operational excellence are probably my top three priorities as I step into this role." Mr. Smith stated to me on the phone several weeks ago and reiterated in our meeting.

But maybe the critics are right. Maybe Mr. Smith is just good at "talking the game." After all, he grew up in the business. It certainly does not prove he can execute. And I will admit that none of us (including Mr. Smith) will know that answer for a couple years. However, there is one thing that I think is different with Scott Smith's leadership versus most of the other management teams in the auto retail stocks index (although interestingly enough it is very similar to the other companies ranked at the top of my list). It goes back to that statement I said he made about thinking like an owner. "I come before you as a stakeholder, not a steward" Roger Penske (Chairman of UnitedAuto Group) begins with almost every one of his investor presentations.

Thinking like an owner just seems to set companies apart (the Smith family controls more than 50% of all outstanding voting stock). I think the most important byproduct of owners running the company is that egos seem reduced. Don't get me wrong, saying egos do not exist at a corporation just because there is a large family interest/ownership would be misleading. But who is "on top" just seems less important, and the thinking (and decision making) seems to be more focused on the long term.

Think about it from this standpoint. Imagine if you could pay someone who just loved the ice cream business $5 an hour to run an ice cream stand for you. And even after paying them, you would make $100 a day. Or on the flipside, even though you are worse than that individual at running the ice cream stand, you could work all day and go home with $50. What would you do? I can tell you what I would do. I would pay the $5 an hour, and let the person who was better at running the stand work it, while I went out skim boarding all day at the beach (or start a free investment website and try to change the world or something).

And while Mr. Smith probably did not go skim boarding at the beach or start a website (he just changed his role), he has proven a willingness to relinquish control of the operations at Sonic when the right talent came along. Remember, he was Chief Operating Officer of Sonic about 5 years ago. But he found a great leader in Jeff Rachor, and let Mr. Rachor run with it. And if another leader emerges (and I am highly doubtful that would come from the outside), I suspect he would do it again. But for right now, he just seems to be the right person for the job. Mr. Dyke and Mr. Cosper seemed eager to build the business with Mr. Smith. So for now, I have to say that I think there is a unified and enthused management team that is completely aligned with shareholder interest.

Have the risks gone up? You bet. But I look at two favorable factors: 1) I think in a couple years time frame, we may look back and find that people underestimated Mr. Smith's leadership abilities, and 2) even if Mr. Smith does find it difficult to execute his plans, I think the downside is reduced because he would probably be quick to put the right person in place who can execute the corporate vision.

This is how I size up Sonic's leadership position at this point.

Enjoy what is left of the weekend.