Buy This Auto Stock on any Dip

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

CarMax (NYSE: KMX) is a used car retailer with a unique business model. It sells cars at a premium, won't negotiate on pricing, has zero new inventory, and if you so desire, it'll even make you a cash quote to buy your car on a moment's notice.

How's that for different?

What makes CarMax different is what makes its business model superior to the competition. CarMax has quickly become the largest used car retailer in the country. CarMax sold 447,728 used cars in the United States in its last fiscal year through 118 dealerships.

For those without a calculator, that's more than 10 cars per day from every single dealership in 2012.

But that's just the retail business. The company's wholesale and auction services sold 324,779 cars, bringing the total count to 772,507 cars in a single year.

The lightly used car market is off to a fast start

CarMax has outperformed other automotive retailers because of its focus on barely used, 0-6 year old vehicles. In the last fiscal year, 87% of cars the company sold met that criteria. Rival companies are less levered to the fast-growing, barely used car market.

Rival Autonation (NYSE: AN) reported new car revenue double that of used car sales, 57% of revenue came from new cars vs. 24% for used cars. By volume, CarMax's retail used car business is two times larger than AutoNation. Autonation relies on more volume from automakers to drive growth. That supply line is muted by an American auto industry focused first on market share, then on profits. (Read: Autonation's growth faces a direct limit in new car manufacturing. CarMax's does not.)

Geography risk with Autonation deserves particular scrutiny. The company derives nearly half of its revenue from California and Florida, two high cost-of-living states with weak housing markets. Housing recoveries and new construction coupled with fracking in the Midwest is behind the rise in car and truck sales. Automakers and dealerships earn significantly more per truck than they do on sedans and compact cars, but trucks aren't hot sellers in Florida or California given the lull in construction. At 14 times forward earnings, Autonation may seem like a relative bargin, but its exposure to weaker car markets and product mix are the reason behind its relatively low multiple.

Profits are in used cars

Used car sales are much more profitable than new cars. First, used cars are coming off multi-year supply constraints. Large-scale fleet purchases were slowed by American businesses and governments during the great recession. Secondly, a 2009 “Cash for Clunkers” program intended to take old, inefficient used cars off the road led to the destruction of more than a million working automobiles.

Finally, the market for the used car is back. The average American car is 10 years old. Unemployment is still above 7%.

Americans who can't afford the $31,940 average sticker price of a new car in 2013 find a car from 0-6 years old a value that's tough to beat. Fleet sales and so-called “program car” arrangements have picked up since the depths of the great recession, giving CarMax more inventory to move.

At only 118 dealerships and plans for many more, the company is set for years upon years of double-digit growth. Same store sales are growing at a 5% annual pace, which adds to margins as dealerships are a very high fixed-cost business.

Buying growth

CarMax intends to add 13 new stores in 2014, while forecasting new store openings of 10-15 stores in each of fiscal years 2014 and 2015. Given CarMax's market share (estimates say the company sells less than 3% of all late-model used cars in the United States), there is ample room for expansion.

That leads to serious growth, perhaps as much as 10% per year from new store openings on top of 5% growth in same store sales. At that pace, CarMax is an extreme value at less than 20 times earnings.

CarMax is the only way to play a rapidly expanding market for used cars. Unlike car manufacturers that have exposure to Europe, and new car dealerships which are most exposed to new cars, CarMax is the only way to play a purely American rebound in used car sales – and the trend looks better than ever.

In used cars and stocks, buyers shouldn't overpay. At 24 times last year's earnings, investors should wait for a 20% correction to buy this growing auto player at a price sub-20 times earnings. Long-term shareholders will be rewarded for their patience.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends CarMax. 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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