Important Metrics, Quotes From CarMax's Latest Earnings Report, Conference Call

Quote #1: "On the wholesale side. . .what is driving the profitability in that sector?"

Jerry: Why not consider international markets?

Quote #2: "The question is, how did we manage it (inventory mix) through the first quarter with rising gas prices?"

Jerry: I have a great tattoo idea.

Quote #3: "What is your current philosophy on competition?"

Jerry: Either an evolved industry or better stewardship of shareholder resources.

Source: Quotes taken from the CarMax conference call this morning, and Jerry's analysis on why the quotes were so important to investors and industry participants.

CarMax Fiscal 1Q08 earnings
This morning CarMax (KMX) reported earnings for the three months ended May 31, 2007. Here is a snapshot of the results:

What is a fiscal year?
A quarter is simply the year divided into four parts. Most of the time, the quarters are divided into four - three month periods. Many of the companies in the autoretailstocks index divide the quarters so that the year ends on December 31st (we call this a "calendar year").

But some companies (like CarMax) have chosen a different period of time to divide the year up. In CarMax's case, their fiscal (financial) reporting year ends in February. So the results reported by CarMax today represent their first fiscal quarter (a.k.a FY1Q08).

The need CarMax fills
"The way Car Buying Should Be."

• Huge selection (25,000+ new and used vehicles online)
• Low prices (Below invoice prices on new cars, No hassles, no haggling)
• Guaranteed quality (Thoroughly inspected and reconditioned, 5-day money back guarantee, Limited 30-day warranty)

Source: company website

CarMax stock up 10%. And what's really important (competitive position metrics)
The "bear drums" (speculators betting on bad news out of CarMax) were beating pretty hard on this stock over the last few weeks. For example:

RBC Capital Markets analyst Scot Ciccarelli said Thursday that the credit scores of CarMax customers taking loans has leveled. 'The company has found a new 'comfort zone' regarding the credit quality profile it is willing to finance,' said Ciccarelli.

According to Ciccarelli, CarMax weakened credit standards last year, which helped the company chart impressive sales growth. With lending standards stabilizing, however, investors might not get the same performance going forward that they've come to expect. Ciccarelli cut his price target for the company to $23.00 from $26.00 and lowered his first-quarter earnings-per-share expectation to 30 cents from 32 cents.

Source: Andrew Farrell, Forbes, June 14, 2007

And beyond the quote above, speculators were floating around aggregated registration data that suggested CarMax's comps were running shy this quarter.

The stock went down 4% the morning the company reported fiscal 4Q07 results (March 29, 2007) despite reporting +12% used unit comps. Yet today, CarMax reported 6% used unit comps, and the stock went up 10%. So I don't know what a "good comp" or "bad comp" is.

The lesson: don't try to play the momentum game with CarMax.

It's been well documented (at least in this newsletter) that April was pretty rough in the world of auto retail (although I think it might have had something to do with the Easter Holiday shift).

My guess is that speculators were all betting on a bad quarter, particularly since registration data tends to be lagged (so it did not capture second half of May). And so in-line results left the shorts "squeezed" and the financial press trying to explain away why in-line results would cause such a big move in the stock with statements like "management backed its outlook for the year."

But you and I are not interested in the hype, right?

What is really important is CarMax's competitive position. . .

We don't match up on quarters. The rest of the public new car dealers are on a calendar quarter and we are on a fiscal quarter. So we can match it up obviously internally because we can match our months up. I look at it more over the long haul. Over the last five years our average comps have been up 6%, and the average of the public new car dealer (on used cars) has been negative 3%.

Last year the spread was, they were up slightly and we were up 9% so they were up about 1%. So we're just very pleased that we continue to see a spread. It fluctuates a little bit quarter by quarter. But over the long haul, I think there is some real evidence that we continue to gain share.

Source: Thomas Folliard, CEO, CarMax June 20, 2007 (1Q08 conference call)

So gaining market share (profitably) is always a good sign.

And of course, I always think it is important to look at a few key performance metrics, most of which were in a positive direction:

Although the above results suggest to me that store productivity gains are slowing, especially when you factor out some of the noise that tends to happen with CAF. So we're going to need to keep an eye on that (store productivity/profitability.)

Important Conference Call Quotes
Quote #1: "On the wholesale side. . .what is driving the profitability in that sector?" Why not consider international markets?

Seth Basham, Credit Suisse
On the wholesale side, can you give us a little more color on what is driving the profitability in that sector?

Thomas Folliard, CEO, CarMax
As I mentioned. I think it is really just a continued refinement of our processes from really start to finish. From how we buy cars and how we evaluate what we should be offering consumers.

And how we run our wholesale auctions. I've said before I think we run the best auction in the business. We have outstanding attendance. We run very consistent sales and I think we continue to refine that process. We're very pleased we have been able to keep profitability where it's at. And at the same time not sacrifice any other areas of the business. . .

Wholesale does not sit by itself. It is a lever of the other pieces of our business. So it's nice to see all aspects continue to perform well.

Why this quote is important?

While it is a lever, I don't think management should rule out the opportunity for this business (in and of itself).

Specifically, I think there continues to be growing demand in international markets. As I have stated before, CarMax should begin marketing its (very old) wholesale vehicles online to international markets like Copart and Insurance Auto Auctions are doing.

Roughly one out of every two of Copart's vehicles go outside the US and almost one out of every three of Insurance Auto Auction's vehicles are shipped outside the US.

True, most of Copart and Insurance Auto's vehicles are salvage (wrecked vehicles). But they are starting to source more of their vehicles from buy here pay here dealers (Copart is around 15%.) So I think an international strategy would be very complimentary to CarMax Auctions, especially with how well this could fit in with CarMax's experimental used car buying centers.

Now I understand management shares a different opinion than me on this issue. And I agree that going into international markets are risky (as I have written about with other companies).

But this isn't really going overseas. It is just establishing a network of rebuilders/resellers of old U.S. vehicles. And old U.S. vehicles in international markets appear to be seeing increased demand. So I'd encourage management to reconsider international markets for their auction business. Or at least talk with a Copart or Insurance Auto Auction about some partnership where they could leverage those companies existing distribution network outside the U.S. to sell some of the CarMax Auction vehicles.

The downside? With demand growing outside the US for older vehicles, it is likely to keep prices moving higher for buy here pay here dealers trying to buy older vehicles and sell them here in the U.S.

For CarMax specifically, this means continued challenges in finding ValueMax vehicles for their lots (the ~20% of the vehicles on CarMax's lots that are over 5 or 6 years old) at affordable prices.

Think about it this way. A 1996 Ford Bronco has a Kelly Blue Book trade in value between $3,000 - $4,000. Chances are it can retail at $6,000 or so in the U.S. But down in Argentina, I am told they sell for $10,000.

Now I am simplifying this a bit and there are some tax implications that need to be factored in. But the dilemma U.S. (old vehicle) used retailers face is trying to compete against people who can buy the car at $3,000 to $4,000 and sell it to a distributor in a foreign market (like Argentina) and get a competitive (if not better) return than if they were trying to sell it in the United States.

Quote #2: "The question is, how did we manage it (inventory mix) through the first quarter with rising gas prices?"

Thomas Folliard, CEO, CarMax
We are managing our inventory on a weekly basis. And I think you know the question is how did we manage it through the first quarter with rising gas prices? I think the answer is really that consumers didn't respond as dramatically as they have in the past. So the requirement to manage it as aggressively really just wasn't there in the first quarter for us anyway.

So we didn't see a big impact in our mix through the quarter. . . We actually sold more SUVs in this year's first quarter than we did in last year's first quarter.

So it hasn't been a drag on us at all. And it has never been a drag on profitability. Because we don't manage, our profits don't come on segment like that, they are driven by a number of other factors. But it's not like we make more or less money on Sport Utilities in and of themselves.

Why this quote is important: "I have a great tattoo idea."

The underlined portion of the quote is a concept I think all of us in the investment community and industry need to tattoo on our foreheads (ok not literally). Although Fortune Magazine on May 28, 2007 ran a story that said more than a third of 18 - 25 year olds surveyed by the Pew Research Center had a tattoo. So a tattoo might go nicely on the forearm (as a permanent reminder).

Here is what it should read:

"We don't manage our profits on the product segment."

Because whenever a retail management team starts talking about mix hurting their results, in my opinion, they have done something wrong. Particularly when it comes to selling cars/light trucks.

For better or worse, dealers price from cost. And any auto retailer (parts distributor or what have you) is simply in the business of matching up the available resources (we call products or services) with the needs and wants of society.

A more sophisticated way of me saying, they're distributors, middle men, or brokers. So the return that a distributor receives should not depend on what (product) they are matching the consumer up with. Because the value proposition the retailer brings is not the product (they don't make it), but the ability to best match it up with those who want it.

If profits (well more importantly return on investment) depend on what is being sold (versus how well they are stocking their shelves/lots and selling it), the retailer needs to go back and re-think the proposition they are delivering in the market place.

Quote #3: "What is your current philosophy on competition?"

Kate Messmer, Thomas Weisel
What is your current philosophy on competition? How do you view the balance between going after real estate that would produce the highest returns for CarMax versus going after a competitor in less attractive markets?

Thomas Folliard, CEO, CarMax
I think it is a case by case decision. Depends on the competition. Depends on how serious a competitive threat they are. Depends on the market. Depends on what the actual return is when we look at it.

So each time we hear about somebody who is going to do what we do, like we do it, we take it very seriously. We gather up as much information as we can, we try to figure out what they're doing and where they're going. And we then evaluate our competitive response.

Kate Messmer, Thomas Weisel
Ok, but you believe there is room in the market for more than one player or are you just trying to be the single player?

Thomas Folliard
Well, I'd rather be the single player. But I think there is enough business out there. . . You know we are never the single player, because there is all the other new car dealers and all the other used car dealers. Even our share numbers reported to date are not what you would see out of home improvement or something like that. So I think there is plenty of room out there for lots of different players to sell used cars obviously.

Why this quote is important: "Either an evolved industry or better stewardship of shareholder resources."

And of course this quote refers to a pretty insightful research note Kate Messmer and Matt Nemer from Thomas Weisel Partners put out about a month ago talking about how CarMax plans to open up a store right next to Lithia's new experimental ("CarMax like") "L2" used vehicle store concept in Colorado.

I think Mr. Folliard hit the nail on the head, however, when he mentioned the home improvement industry. I think Home Depot and Lowe's control something like 40% of the home improvement market. And you know what? Home Depot and Lowe's open up stores side by side. They have become destination locations.

CarMax controls less than 1% of the total used vehicle market and probably no more than 2% of the late model (2 - 5 year old vehicle) market depending on how you define "late model" (age/miles, etc.).

So I look at CarMax opening up a store right next to Lithia's (LAD) experimental concept as the best thing that could happen to Lithia and possibly the industry.

Either Lithia will learn that they do not have a competitive experimental store concept. And therefore not waste valuable shareholder resources (more) on this experiment until they get the first few concept stores right.

Or they will find they can compete head to head with CarMax, in which case I think it creates a similar "destination location" opportunity you see with the home improvement retailers.

KMX 1-yr chart: