Q&A: Soldier of Misfortune

Is the used-car business, in general, very attractive?

It's a viable product in that the consumer gets the benefit of buying a one-, two- or three-year-old car without suffering the major degradation in value he does when he drives a new car off the lot. The greatest amount of value depreciation comes in a new car's first year, so the value proposition is better with used cars.

Also, if you look at the long-term data, new-car sales oscillate wildly depending on the state of the economy, while used-car sales are amazingly consistent. They change little from year to year and are surprisingly independent of the overall economic environment.

Is the organic growth story intact here?

CarMax is still early in its growth cycle. They're currently in 17 states with a total of only 67 superstores. They generate ample cash to fund organic growth and the current plan is to expand square footage by roughly 17% per year, which they've been executing on. Although their story isn't as widely known as it will be, the existing business is extremely well accepted -- same-store sales grew 10% last quarter year over year.

So if you're conservative and assume even 3% to 4% same-store sales growth while they're opening new superstores, you've got very impressive top-line leverage. They'll do $6.2 billion to $6.3 billion in sales this fiscal year, ending in February, and I expect that to double every four to four-and-a-half years for the foreseeable future.

What about margin improvement?

This is not a business that will mature at a 2.2% net profit margin, which is where they are now. When you look closely at things like how gross margins have evolved and the levels of variable expense, you can understand why operating and net margins have been steadily improving year after year. Certain important expenses won't grow in lockstep with the top line. Just one example: They have four locations in Los Angeles and they're going to grow that base. The L.A. basin has more than 10 million people. When you first go in with two stores, advertising costs a largely fixed amount, which then gets spread across a bigger base of revenue when you go to four, then six, then eight stores. CarMax is easily at least a 4% net-margin company.

At around $28 per share, how are you looking at valuation?

My estimate of CarMax's "margin-equilibrium" rate of earnings is around $2.55-$2.60 per share this year, so the stock is trading at only an 11 times P/E -- remarkably cheap for a company with this potential. This is currently a $3 billion market value company, but over the next four or five years I expect it to be worth $10 billion.

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