Wednesday, August 6, 2008

Portfolio Pick No. 3: Carmax

My previous two picks, brokerage Merrill Lynch and commercial lender CIT Group, are undervalued because of a variety of economic undercurrents affecting the broad financial-services industry. And though there are a host of compelling buys in that arena, I thought it might be a good idea to take a look a another category.

So let's talk about the auto bidness.

Detroit, as you may have read in the newspapers, has been pulverized roughly to the same degree as, well, newspapers. Auto suppliers have been hit, too. And even though an American public shocked at $4 a gallon gasoline is opting to trade in its Suburban, people are still buying cars and trucks.

Not as many, true. Automakers' July sales, reported earlier this month, are a 16-year low, led by a 27% drop at GM, a 15% falloff at Ford and a 12% drop for Toyota. But people are still buying cars: Automakers are having a helluva time keeping up with demand for hybrids and other fuel-efficient vehicles. Honda, a leader in this area, reported only a 1.6% sales decrease. Overall, Americans will buy an estimated 12.55 million vehicles this year.

If we assume a new car costs an average $20,000, that means the new car side of the auto business alone is still a $251 billion industry. The National Automobile Dealers Association says 19.2 million used cars were sold in 2006, which likely doubles sales to a nice, round $500 billion.

That's a lot of jack.

Which brings us to Carmax.

Carmax sells used cars in 89 "used-car superstores" in 41 metro markets. It had $8.2 billion in revenue last year, which is maybe 3% of the market. Earnings for the past twelve months are 78 cents, which gives the shares an earnings multiple of 18 based on Friday's close of $14.10. The company has relinquished about 20% of its market capitalization this year, with shares ranging from a low of $10.53 in mid-July to a high of $25.55 about a year ago.

I like Carmax for four reasons:

It's independent and nimble.
Other public vehicle retailers have dealerships -- licenses from the automakers to sell their vehicles. If you're a BMW dealer, you carry BMW. If you're a Hummer dealer, you carry Hummer. (You get the idea.) The signs in front of Carmax say -- wait for it -- Carmax. They're not beholden to GM, Ford, Benz or Honda. They can stock what the market is buying and can adjust their inventory far more adroitly than a traditional dealership. Even if you're a high-volume metro Toyota dealer, you're only going to get so many Priuses. Carmax can get as many as it wants.

Smart people own it.
Most shares are held by institutions. Mutual fund managers and other big money players own 95% of the shares. Dodge & Cox is one of its largest shareholders. Its stock fund is a perennial winner whose total returns have beat the S&P by 6.4 points for the past 10 years. When smart money managers with a record like that buy a stock, I'm interested.

Oh yeah: Warren Buffett. He's also a major shareholder, which is nice. In fact, he's even been adding to his stake -- currently 21.3 million shares -- and I'll bet you a Cherry Coke that his next 13F filing will show he added more shares in the second quarter when Carmax's price ebbed. (That filing is due on or about Aug. 15.)

A superlative shopping experience
Carmax is the opposite of every used-car stereotype. It's as orderly, clean and well lit as a Lowe's. The stores are large and have vast inventories, ten times larger than the average used-car lot. It has no-haggle pricing. Financing can be done in house with absolute transparency -- you see the same results the salesman does, and at the same time. Carmax guarantees clean titles. It backs up its vehicles with a five-day return policy and a 30-day warranty. It won't sell flood- or frame-damaged vehicles. Its Web site is the best in the business, and dealers can take advantage of each other's inventory. My favorite: The company recently won the Better Business Bureau's International Torch Award for Marketplace Ethics, which means the exceedingly uptight BBB thinks as highly of Carmax as it does of companies like Kraft and IBM.

It's growing.
Carmax is expanding its footprint, but it's not going gangbusters. It has 89 stores, but it's only opened in 41 cities. It likes to focus on markets and develop them before moving on to the next one. It may take a set of brass umlauts to make money in the stock market, but discretion is the better part of valor when it comes to managing growth. That's a big part of the reason its bankers just increased its credit line from $500 million to $700 million. They've seen the books, they know the company and they are 1) still willing to lend money in a tight credit environment and 2) still willing to lend it to a car dealer. That's nothing short of amazing. Frankly, that's as compelling a buy sign as Buffett.

In 2004, Carmax had $5.2 billion in sales. That rose to $8.2 billion last year, which is a gain of about 58%. But quarterly earnings doubled or very nearly doubled in each quarter. That means the company, even as it grows, is extracting an ever-higher profit from its revenue. That's the ball game in a low-margin business like auto sales.

Carmax has been upfront about its sales outlook, which recently came in lower than analysts expected. But it is still growing, and it can whether the economic downturn. The dollar will gain value, the price of oil will fall and Chevy is unlikely to discontune the Suburban. If you assume Carmax can maintain its average growth, then sales should be at $14.3 billion in 2011 and EPS should come in at about $1.86. At 20 times earnings, that would put Carmax at $37.20, or 163% above its Aug. 1 close.

Carmax has a presence in 41 cities, which means it can more than double in size and still stay within the top 100 metro areas. I'll hold these shares indefinitely. I think it will be the Wal-Mart of used cars.

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