Maxing Out at CarMax

CarMax Inc., the “big-box” used car retailer spun out of Circuit City years ago, carries a very fancy p/e ratio of nearly 30-times forward earnings despite the company’s inability to string together more than two up year-over-year quarters in a row since the fall of 2002.

The fancy p/e ratio probably owes itself to the fact that CarMax appears to be a great concept: the Best Buy (or Home Depot or Wal-Mart or whatever category killer you want to name) of the highly fragmented, poorly staffed, consumer-unfriendly used car business. Give people a huge, clean, well lighted store, with a transparent trade-in value and a pleasant buying experience, and the world will beat a path to your door.

At least, that’s the concept. And while the stores are in fact well run, and the buying experience very positive, CarMax has the least consistent earnings pattern of any actual category killing retailer out there.

The reasons CarMax has such a tough gig are several. For one, the company does not have a parts and service business, which is the flywheel in the hugely cyclical auto sector. For another, people don’t shop for a used car every couple of weeks, as they do for groceries or consumer electronics or hardware, so between the time they buy one CarMax vehicle and go back for another, they have to get re-sold on the CarMax value proposition.

And even if a satisfied CarMax customer does decide to buy another used car, they may have moved away in the two or three year gap. So the churn in the customer base is much higher than for the grocery shopper at the Wal-Mart Supercenter, or the building contractor at Home Depot, or the Play Station gamer at Best Buy.

Finally, CarMax’s sales depend on more variables–credit conditions, new car incentives, used car inventory–than any normal retailer. Thus, the company’s results vary both ways–to the good and the bad.

Right now, CarMax is varying to the good: last quarter’s unit comp store sales came in at the high-end of guidance and the company now expects the current quarter’s EPS to top its recently raised guidance by $0.01 a share.

There is–as always with CarMax–a caveat. The caveat to the sales acceleration is that it coincides almost precisely with the company’s rollout of sub-prime financing (called “DRIVE”) to its stores in August of 2004.

Indeed, sub-prime contributed 5% to the recent 12% comps.

Most analysts expect the sales impact from DRIVE to diminish over time. It is hard to imagine how it will not. Meanwhile, the earnings benefit is quite a bit smaller than it might otherwise be, because CarMax has over 100 million shares outstanding–and in a low-margin business like used cars, there’s not much left over for shareholders no matter how big the sales boost.

Analysts seem to love this one, for reasons that escape me, except that some very smart investors own the stock and have played it quite well over the years. That plus management’s open playbook and excellent systems make this an easy name to go back to when the stars are lining up for a couple of good quarters.

But the fact that CarMax is juicing up sales by reaching down the credit curve illustrates the problem here: there is no fundamental franchise in used cars.

Let the buyer beware.

Jeff Matthews I’m Not Making This Up