The Changing Face of the Used Car Biz

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

The car business rebounded back to normalcy in 2012, thanks to artificially low interest rates and pent-up demand from consumers with aging vehicles.  The sales rebound has improved the fortunes of the leading manufacturers, including General Motors and Ford, which reported a combined 6 million in vehicle unit sales and $11.8 billion in net profits in 2012.  However, with rising prices for new models leading to affordability concerns, the used car retailers have been getting customers’ attention and their purchasing power.  So, which companies are the ones to watch?

The industry leader

The used car business is highly fragmented with 17,900 franchised and 37,500 independent dealers selling roughly 39 million vehicles each year.  CarMax (NYSE: KMX) has been bringing order to the business since 1993 through superstores offering no-haggle pricing, quality vehicles, and friendly service.  The company has also been growing a wholesale auction division that sells the portion of its purchased inventory which doesn’t meet its high resale standards.

After retrenching during the financial crisis, CarMax has been getting back into growth mode with new store openings.  In the first nine months of FY2013, the company reported improved results, with increases in revenues and operating income of 8.1% and 2.9%, respectively, versus the prior-year period.  CarMax’s sales benefited from a 6% increase in comparable store sales and an additional nine stores in operation.  In addition, pricing for used vehicles continues to creep slowly higher in general, as consumers recognize their value vis-à-vis expensive new models.

Looking ahead, CarMax is forecasting further sales gains over the next few years, with plans to open roughly ten new stores per year.  As a used car retailer, CarMax finances a large percentage of its customers’ purchases, approximately one third of its used car sales, and finance income has been adding to the company’s bottom line.  More importantly, CarMax is managing its customers’ receivable balances very well, with bad loans accounting for only 3% of the total.  While CarMax is not cheap at a 21 P/E multiple, the company remains a compelling value as it continues to consolidate the industry.

Buy here, pay here

Founded in 1981, America’s Car-Mart (NASDAQ: CRMT) participates in the low end of the used car market, defined as high-mileage vehicles that are between six and 12 years old.  Given the high percentage of “lemons” in this category, America’s Car-Mart utilizes extensive quality checks on its inventory and offers extended service plans on most of its vehicles.  It also emphasizes excellent customer service and affordable payments for its predominantly lower-income customers.

In FY2013, America’s Car-Mart has reported mixed financial results, with a 7.1% increase in revenues and a 1.1% decline in operating income.  The company’s revenue growth benefited from rising comparable store sales, as well as having an additional nine stores in operation.  However, the company’s operating margin was negatively impacted by rising bad debt charges from its loan portfolio.

Looking ahead, the company expects to continue slowly building its network of retail stores in its core markets of the southern region of the U.S.  With annual sales of only roughly 38,000, America’s Car-Mart has plenty of room to expand its business model nationwide.  While rising past due accounts are a concern, the company has made more than adequate provisions for the bad debt and greater geographic diversification should provide an improved mix of customers.  Assuming continued growth in the overall economy, this growing, used car specialist is capable of creating higher profits and intrinsic value for shareholders.

Leveraging the dealer network

Alternatively, investors could consider the franchise dealers that have large exposures to the used car market, like AutoNation (NYSE: AN).  The company is the nation's largest franchise dealer network, selling over 440,000 new and used vehicles each year through 221 retail stores.  While AutoNation's new vehicle inventory gets customers into the door, it earns the majority of its profits from the sale of used vehicles, as well as its service and finance operations.

In FY2012, AutoNation continued its financial momentum, with increases in revenues and operating income of 13.3% and 12.8%, respectively, versus the prior year.  The company's results benefited from higher sales of both new and used vehicles, as well as a strong performance from its service operation.  While the company is at a disadvantage to the used car retailers since it doesn't have in-house financing, AutoNation can use profits from its high-margin service operation to offer customers better vehicle pricing.  With new and used vehicle sales poised for gains in 2013, AutoNation looks ready to win customers to its leading brand.

The bottom line

New vehicles prices are certainly not getting any cheaper, with the industry estimating that the average price of a new car was $30,500 in 2012.  The sector winners will be the companies with great customer service and transparency in their pricing policies.  These three companies have delivered for shareholders over the past five years and look ready to add gains in the future.

rghanley owns shares of America's Car-Mart. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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