Tuesday, 1 July 2008

Company Focus – CarMax Inc – The Not So Recession-Proof Business Model

Since the age of the Model T the Used Car marketplace was always one of buoyancy. Come economic boom or recession, the demand for used cars by respectively new 'come-of-age' drivers, 2nd/3rd car households or regular thrifty down-scalers. So, even if periodically dealers had to reduce margins and push volume, there was always an essential demand-supply equilibrium.

Through the 1990s the environment tightened as an ever increasing array of new models came to market by old and new VMs, which along with deflationary 'real' pricing and lenient credit terms, meant that the dream for many of owning a new car became a plausible reality.

At this point in the mid-90s the Used Car Trade fought-back. Yes there had been market contraction but a round of retail consolidation bringing forth larger, more professional dealerships helped to rid the trade of the infamous 'back-street' operators. More than ever the influx of new cars eventually fed into 2nd hand showrooms providing the used car customer with a plethora of choice, and dealer groups were able to offer in-house finance deals which also boosted per unit margins.

CarMax rode much of this wave, its expansion based upon the regionalised contraction of used cars, but able to 'stay and play' taking an increasingly larger slice of the diminishing pie thanks to a nationwide network that provided vehicle access (esp used fleet), volume buying power, general efficiencies of scale and via IT systems, professionalism (vs the archetype local used car merchant), and a high proportion of return business with speedy return/turnover rates.

However the first decade of the 21st century has witnessed gradual erosion of the used car trade as the volume manufacturers have waged price and incentive wars to satiate the over-capacity that spewed from high-cost western plants. The vicious circle of forced production to cover high overheads that in turn over-populated the marketplace with vehicles could end in no other manner than ongoing margin erosion and value destruction. In turn the used dealer groups consolidated again, with the added pressure of the internet now allowing a potential buyer to view national availability of a certain vehicle with a certain specification – driving a new Dutch Auction climate.

And with the amazing credit deals made available, new cars became within reach of every socio-economic group...why buy used when new was available? Thus the long-running adage that: “a car dealer doesn't lose, good or bad times, single malt booze” has apparently come to an end.

Perhaps the most visible example is Richmond, Virginia based CarMax Inc, a year after year roll-on success story that appears to finally run our of steam given the ever mounting market and operational headwinds. With Q108 profit of $29.6m vs $65.4m (down by 55%), the senior management team isn't providing a specific revised FY earnings guidance, instead leaving analysts to draw their own conclusions rather than overtly disappoint once again later on.

Many previous new car buyers bought into higher-priced large SUVs, which now have residual values that are now, in the real market, far under their expected, notional re-sale valuations since gas prices hit $4 per gallon on the back of $140 per barrel oil. Those who could avoid being lumbered with their fuel-guzzling follies would have traded them against far more fuel efficient cross-over and passenger cars, thus meaning that CarMax will have in theory and on-paper been making decent margins on smaller vehicle sales, especially through finance, but we suspect that CarMax will have already had a large inventory of large SUVs that were previously selling before the crunch and have had to have been taking on more of these unloved giants to move their smaller vehicle stock.

Thus as we've seen cashflow has been drying-up as unfashionable stock levels increase, a situation that eventually leads to business crunch. In the meantime CarMax may be able to massage its accounts somewhat. The first is specific to valuation of its stock; especially the full-size SUVs and Pick-Ups. If it can convince auditors and authorities that those unwanted vehicles are worth their 'book' then CarMax can at least swell its inventory value and add a cushion of comfort to its Balance Sheet and P&L. And at such economically strained times, the US authorities may well let such legal accounting methods pass without scrutiny to maintain the health of the nation's largest used car dealer group and the inherent employment fall-out ramifications.

[Indeed, if dealer principles have been savvy, they may well have bought those SUVs at well below book and so legitimately shown paper profit per vehicle]

However, this paper based 'inflated' valuation of an out-of-favour stock inventory can't last long, even with compliant external assistance, and as the turnover of sales continues to diminish and stock value falls – and probably quickly - so does the corporation's intrinsic valuation.

Given Warren Buffet's investment in CarMax in November 2007, Berkshire Hathaway obviously saw a brighter long-term outlook for the group as the credit-crunch took hold. But what were his fundamental perspectives? Belief in the used car market's buoyancy? A major turnaround including substantial divestment? Or via full break-up of the company?

Turnaround Advisors, M&A Specialists and Bankers will be keenly eye-ing-up CarMax at the moment, eager to identify how best to move onward from today's down-beat results.

A 'Re-Growth' Turnaround would obviously require massive overhead efficiency, variable cost drives and stock balancing including:

- Staff reduction at each location, scaled back to dealer principle, star sales-people and core administrators.
- Scale-back of low-value operating & maintainance costs eg vehicle valeting occasions & charges
- Reduction of network size via leasehold sites expirations. hard leasehold site contract renewel negotiations and possibly only limited sale of freehold properties given present-day low plot valuations.
- Seriously look at the wholesale export of full-size vehicle stock to Latin America and Middle Eastern destinations where booming economies and low gas prices have created a consumer demand for status 4x4s from Suburbans to Navigators to Blackwoods.
- The purchase of Toyota, Honda, Mitsubishi, Hyundai, Mini, VW, Ford, GM & Chrysler used vehicles en mass from each VM owned dealerships and large regional groups to provide a healthy new portfolio. Also helping to clear their own inventories (esp GM & Ford)

This would dramatically change the 'shape' of the company, reducing its overhead, savings of which could be transferred into vehicle price reductions, or ideally concentrating and improving the purchase experience so that more potential customers are converted into direct sales. And such a mass shipment of vehicles would clear the decks for inventory renewal.

A Break-Up might see investors push for an immediate sell-off of the unfavoured SUV stock, done so at 'fire-sale' prices. But this would once again undermine the nation's used car values, so putting pressure upon Detroit's Big 3 own new car prices – a less than ideal scenario. Instead perhaps better to seek better pricing from foreign shipment ads described above. Of prime worth and concern is the network's dealership spots. Each is typically a sizable plot that may outweigh the immediate needs of today's VMs and independent new car dealer groups.

But looking forward it is far from inconceivable that a VM may wish to own large flagship sites for the expected 2010 economic upturn, ready with new portfolios of consumer friendly fuel efficient vehicles and a more confident, self-rewarding consumer-base – especially so if employment and inflation/interest figures are kept low and stable. By controlling CarMax as a VM's central new & used outlet it may be able to far better control its brand's used residual values and so, in turn, assist its own new car prices.

We believe Buffet has evaluated each possible eventuality, and although the stock, now appreciably down on his November buy price, appears to have tractive potential which ever path the business eventually takes. But the central elements are stock removal/replenishment and network divestment. If Buffett can urge the Board to see beyond simply operational tampering, with the possible sale/sub-leasing to American, Japanese, European or even Chinese majors CarMax could pull back and prosper once again.