This Car Company Has an Enviable Moat

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Now defunct Circuit City will never know what it really gave up when it sold off CarMax (NYSE: KMX) in 2002. Since that time CarMax has exploded with a customer-friendly approach to used car shopping that makes it a leader in the space.

CarMax's growing moat

The car shopping experience at CarMax is unlike any other. First, prices are not negotiable, removing all of the time-consuming negotiation that turns shoppers away from most dealerships. Secondly, the company operates as a go-to place to get a cash offer for any car any day of the week. CarMax is the thrift store of the used car market.

These differences do not make CarMax a company with a durable competitive advantage. Rather, it is what customers don't see that makes CarMax special:

  • Nationwide network – Customers who shop at CarMax can shop any of the company's car lots in any state. This network allows CarMax to have a varied selection of used cars in every make, model, and year, making it possible for CarMax to cater to any and all customer tastes. Cars can be delivered cross-country for customers who know exactly what they're looking for.

  • Scale – CarMax is the largest used car dealership chain in the nation. This scale has many natural cost-saving advantages that legacy car lots owned by families in small towns simply cannot match.

  • Informational advantages – The company uses data from its nationwide network to know what cars sell best in what places, at what prices, and to which customers. These informational advantages allow CarMax to move product faster and at higher prices than competitors, generating higher returns on capital.

  • Wide selection – CarMax lots deal in cars of every brand, from Toyota, Ford, General Motors, and others. This allows customers to make CarMax a one-stop shop and trust that if the car can't be found on the lot, their dream car can be found on one of the company's lots somewhere around the country for immediate delivery.

  • Goodwill – CarMax customers naturally trust the company known for no-negotiation pricing. Set prices lead to better customer satisfaction as they leave the lot happy, knowing that no obscure financial speak or negotiation techniques were used to rob their wallets of another dollar.

CarMax is a clearly differentiated company in a fractured space with many competitors. CarMax's qualitative moats can be found in quantitative analysis when compared to its peers.

Why CarMax trumps other auto stocks

Those who want exposure to the cyclical automotive sector have two basic choices: auto manufacturers and part suppliers, or auto retailers.

In the automotive retailing space with the best comparable companies, CarMax is a clear leader. First, CarMax trades at only a slight earnings multiple premium to AutoNation (NYSE: AN) (17.6 vs. 13.3).

However, CarMax wins on all other profitability and asset utilization metrics. CarMax maintained double-digit return on equity nine out of the last ten years. In the trailing twelve month period, CarMax turned its inventory over 7.8 times compared to AutoNation's inventory turnover ratio of 6.3. CarMax also carries an average of 12 days fewer inventory on its lots, proving the efficiency of the model compared to its rival, AutoNation. Higher turnover and lower inventory levels allow for higher returns on capital and faster earnings growth.

Car lots vs. car factories

When it comes to comparisons to automotive manufacturers, CarMax is the clear winner. Its employees are not unionized, its business is less cyclical, and it requires fewer capital investments. And that doesn't even begin to cover the huge disparity in growth potential.

America's cars are old – more than 10 years old – which is good for a car retailing company dealing in...you guessed it, used cars! CarMax is expected to grow EPS by 20% helped by the opening of 50 new dealerships in the next four years, and higher same store sales. The company currently has 110 stores open for more than one year.

Major car manufacturers stand to profit as Americans replace dying cars, but unlike CarMax, manufacturers are exposed heavily to European losses. Ford expects to lose $1.5 billion in Europe this year, while General Motors expects to lose as much as $2 billion.

Neither manufacturer is expected to match CarMax's earnings growth rate. Analysts expect single digit earnings growth from Ford, GM, and Toyota.

CarMax is the best play in the automotive space. It trades for less than its average price-earnings multiple despite above-average growth potential. As Americans trade up to new(er) cars, look for CarMax's low capex, high turnover business model to outperform its peers. 


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