Building a Foundation Like Home Depot Did

CarMax

Buying a used car from a dealer is considered by many to be about as enjoyable as going to the dentist. CarMax(KMX Quote) is changing the used-car buying experience on a number of levels. For example, it offers strict, no-haggle prices. Its network of stores is grabbing market share in the heavily fragmented, inefficient used-car marketplace.

I've seen several analyst reports that lavish praise on the business model of CarMax, a company growing organically at a 25%-30% clip. Many of these analysts stop there, though, and don't rate CarMax a buy because it sports a P/E multiple of 26.

I think that's a big mistake. Parse the long-term story at Home Depot and you'll readily see not one, but two levers that created the sevenfold (since 1991) increase in market value. Sales growth is the obvious lever. Margin leverage is the less-obvious lever.

Without exception, every great retailer realizes economies of scale resulting in higher profitability as their story matures: The net profitability of Home Depot increased by 50% from 1991 to today, with net margins growing from 4% to 6%. Selling a commodity product, Dell(DELL Quote) increased its net profitability from 2% to over 6% over a period of years.

By my estimation, CarMax should be able to secure at least 4% net margins as the story matures, up from the current 2%. If I'm right, buyers of CarMax stock at the current quote are paying 13 times normalized earnings at the current quote. That's a cheap price to pay for a retailer that is growing organically at over 25% per year, with huge potential for expansion for years to come.