Growth to the Max Will Return

10/19/2009 11:17 am EST


Paul Larson

Editor, Morningstar StockInvestor

Paul Larson, editor of Morningstar StockInvestor, and analyst David Whitson say car dealer CarMax is poised to start growing again after a brief hiatus.

CarMax (NYSE: KMX) sells, finances, and services used and new cars through a chain of about 100 retail stores.

Used-car sales account for about 80% of revenue, new cars about 4%, and the remaining portion is composed of wholesale, financing, and repair. In fiscal 2009, the company retailed 345,465 used vehicles.

Although CarMax is temporarily slowing store growth, we believe that management will eventually go back to adding stores at a 15% annual growth rate. We believe that this goal is quite realistic, given the size of the market and the fact that the company could take on more debt to fund expansion. We agree with management’s assertion that the company’s current slowdown is entirely related to the weaker macroeconomic environment and the cyclical downturn in auto sales, rather than problems with strategy.

CarMax has one of the best business models around, and once consumer confidence improves, the company should be able to grow internally and by adding stores for many years.

CarMax’s sales have increased at a five-year compound annual rate of about 9% because of the success of customer-friendly sales practices and impressive use of information technology. The firm was the first auto retailer to successfully implement no-haggle pricing across all its stores. CarMax does not hire salespeople from the auto industry, and salespeople receive the same commission regardless of which vehicle the customer buys.

A key growth driver is that more than half of CarMax’s stores are less than five years old. With consumers buying a car every three to five years, comparable-store sales should increase over time as the customer-friendly buying process gives previous customers a reason to go back. The chief executive officer has said he will give any further improvements in operating expenses back to the customer as a price decrease instead of seeking higher margins.

We like this strategy; CarMax’s scale allows it to price below smaller dealerships, and lowering prices should increase sales while keeping competitors away. These factors should keep the company growing for a long time.

Since store growth is currently suspended because of the recession, CarMax cannot increase its advantages for the time being. However, we think that its long-term growth story is intact and that the firm will keep adding scale once new store openings resume.

The firm has no direct competitors at the moment (just traditional dealers who sell new and used vehicles), and with each new location, its pricing database grows more robust and overhead costs are spread over a larger base.

After spying the recent quarterly results, we raised our fair value estimate to $25 per share. (The stock closed below $22 Friday—Editor.) We forecast revenue to increase at a 13.1% compound annual rate during the next seven years, and we expect the operating margin to average 5.3%. We forecast capital expenditures to average 2.8% of revenue per year.

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