CarMax: An Excellent Opportunity Now

Christopher is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The performance of the four largest publicly traded companies in the new and used automotive dealership industry have diverged sharply in the past twelve months as the domestic economy slowly recovers. AutoNation (NYSE: AN), CarMax (NYSE: KMX), Penske Automotive Group (NYSE: PAG), and Sonic Automotive (NYSE: SAH), are very sensitive to economic conditions,  particularly the job and housing markets, which have been the laggards in the recovery.  However, because demand for cars was suppressed so significantly during the depths of the financial crisis and immediately thereafter, the recovery in new auto sales outpaced the overall economy, increasing by about 10% in 2011.  As a result, some of the industry players saw their shares rise by more than the general market, while others lagged behind the broader benchmarks.

AutoNation, which is the second largest company in the dealership space with a market capitalization of about $4.7 billion, saw its shares rise by about 4.5% in the past twelve months to a recent price of about $35.  This is about 1% more than the rise in the S&P 500 of about 3.6%.  CarMax is the largest dealership company with a market capitalization of about $7.0 billion and its shares fell by about 16% over the past twelve months to a recent price of about $30. The third and fourth sized players, Penske at about $2.2 billion market capitalization and Sonic at about $913 million market capitalization, fared much better with share price increases of about 16% and 14%, respectively. 

Looking forward, analysts are estimating that earnings growth for CarMax and Penske will be about 8% while the forecast for AutoNation is for earnings growth of about 14% and for Sonic analysts estimate earnings growth of about 16%.  The estimate for CarMax is the most reasonable and perhaps too conservative given that the company has grown its earnings per share by about 16% annually over the last five years and has the highest revenue growth rate at about 5% since 2007.  Also, CarMax has significant scale advantage over Penske and Sonic which should support continued growth.  Penske has a forward earnings growth rate (8%) that is comparable to its historic earnings growth rate of about 5% annually and an expansion is reasonable given the expected economic recovery that will lift all the dealership companies.  The earnings estimate for AutoNation at about 14% annual growth is somewhat stretched considering that earnings per share have grown in the past five years by about only 8% with a significant part of that growth from share repurchases.  Net income has been essentially flat since 2007. 

While the economic recovery will perhaps benefit AutoNation more than its smaller rivals due to its scale advantage, the company has a heavy concentration of about 47% of its sales in California and Florida which mitigates this scale advantage if these states lag the rest of the country in the recovery.  This scenario is possible given California's debt woes and Florida's extreme housing collapse.  Analysts have been the most aggressive with their estimate of Sonic's earnings growth at about 16% as the company has not grown earnings per share at all since 2001 despite a 50% total increase in net income.  The company has increased its share count by about 57% during that time.

At their recent prices, the companies in the new and used dealership industry have price to earnings to growth multiples that range from about 0.66x for Sonic to about 2.0x for CarMax.  AutoNation's price to earnings to growth multiple is at about 1.1x while Penske's multiple is at about 1.6x.  I believe strongly that CarMax is the most likely of the companies to realize its forward growth rate and therefore its multiple is the most robust while the growth rate for Sonic is the most likely to fall short of estimates.  I think the multiple for Penske is very solid given the high likelihood of achieving its estimated growth rate while AutoNation has the most attractive multiple at about 1.1x but has a degree of uncertainty in achieving its growth rate.  Overall, I am most comfortable with CarMax at this current price level even though it has the highest price to earnings to growth multiple because of its scale advantage over all competitors, more diffuse revenue sources compared to its chief rival AutoNation, modest growth expectations compared to its historical averages, and industry leading operating margins which will support cash flow in the event of another economic downturn.

CarMax has had recent positive developments which further support the case for buying its shares versus those of its competitors.  In the most recent quarter ended November 30, 2011, average selling price on used retail vehicles increased by 5.7% to around $19,000, continuing 2011's trend of price increases.  Also, the company announced a stepped up store opening schedule with 10 new store openings in fiscal 2013 compared to previous guidance of 8-10 stores, and disclosed that they will be opening 10-15 stores annually for fiscal 2014 through 2016.  This is achievable because the company has a favorable financial position and can use debt to fund its store growth.  Finally, CarMax has a finance division that is still highly profitable and which contributes nearly 40% of the company's unit sales.

The long term value creation potential of the domestic automotive dealership industry is weak compared to other more dynamic and growing industries due to its intense competition, low returns on invested capital, and low cash flow generation per dollar of revenue.  However, there are pockets of opportunity when the economic cycle moves up and when specific companies are creating value over a period of time.  One such opportunity currently lies with shares of CarMax which is poised to rebound with the economic recovery to a greater degree than its competitors.  And with shares trailing its competitors' shares significantly over the past twelve months, investors in CarMax may be about to reap the double reward of a return to historic relative valuation with an improvement in the company's underlying fundamentals.


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