Still a Lot Under the Hood at CarMax - TheStreet

By all appearances, it's the worst of times for

CarMax

(KMX) - Get Report

, which last week slashed earnings forecasts for the second time in two quarters and has seen its stock plummet 37% in a flat market this year.

Beneath the dents and rust, however, this Virginia-based used-car chain still purrs like a kitten, and it might find itself roaring if the incentive war among the Big Three automakers finally ends. A growing populace on Wall Street considers the stock a bargain.

At $19.09, CarMax stock is nearing its 52-week low of $18.05, set in mid-July (its 52-week high of $39.30 was set close to a year ago), and it is trading at roughly 16 times its 2005 earnings estimates. That's not cheap in comparison with other publicly traded auto dealership chains, which generally sport multiples in the high single- to low double-digits. Still, analysts have long considered the Richmond, Va.-based chain one of the sector's brightest stars, and recent insider buying suggests a bottom is near.

"

CarMax has traded at 30 times earnings in the not-too-distant past, and now it's in the high teens," said Bill Armstrong, an analyst with C.L. King Associates (which has no banking relationship with CarMax and owns none of its shares). "I don't see it going a whole lot lower from here. I think an appropriate multiple is in the mid-20s."

CarMax's travails began May 12 when the company slashed its first-quarter earnings and sales forecasts, sparking a 13% one-day selloff. Sure enough, in June the company reported that rising interest rates had bitten its financing arm, leading to flat earnings and speculation that the company couldn't cope with the Big Three's zero-percent finance incentives.

Last week, CarMax slashed forecasts again, blaming Hurricane Charley and generally weak traffic on its lots. The shortfall spooked investors, who worry that with the economy possibly decelerating, the auto sector is particularly vulnerable, because all of its incentives probably inflated demand to begin with.

"You could certainly argue that with the low interest rates of the last few years, with all the home equity loans and refinancings, coupled with the aggressive financing incentives in the auto market, a lot of sales were pulled forward," said Sharon Zackfia, an analyst with William Blair & Co. "You could also talk about political uncertainty and high oil prices. A confluence of events has created a drag on the market."

Despite this drag, Zackfia, whose firm owns a position in CarMax but does not have an investment banking relationship with it, has an outperform rating on the company and views it as an "aggressive growth" stock. In her view, the used-car industry has hit a "rough patch," but when the market's dynamics stabilize, CarMax is likely to emerge as a "category killer."

Company insiders appear to agree. In early July, William Kellogg, the former chairman and chief executive with

Kohl's

(KSS) - Get Report

who now has a seat on the board of CarMax, reported selling $8.9 million worth of Kohl's shares and buying $525,000 worth of CarMax. Also, Beth Stewart, another director, reported exercising options for 428 shares at $14 apiece, pocketing the shares; and Michael Dolan, a senior vice president at a CarMax subsidiary, reported holding on to 8,600 shares after exercising options for 25,000.

Zackfia said that whatever negative factors are buffeting the company's stock, they are already in the price, and the easiest direction from here is up.

"Look at the way the stock reacted to the preannouncement last week," she said, noting that shares dropped 18 cents to $19.47 on the day of the release, then quickly rallied with the broader markets to $20.18 the following day. "Investors are looking through the near-term environment to the long-term prospects."

CarMax's valuation premium over its sector can be explained in several ways, the most obvious being growth. The company has seen annual revenue increase by roughly 33% over the past five years. By comparison,

Autonation

(AN) - Get Report

, the largest publicly traded car dealership, has seen revenue slip the last three years.

Once a subsidiary of

Circuit City

(CC) - Get Report

, CarMax became its own public entity in 2002. At 10 years old, it is poised to rake in $5 billion in sales this year. Executing a brand-new business model in the used-car industry, which is estimated to produce about $375 billion in sales a year, it has consistently gained market share from its publicly traded competitors.

Although CarMax saw its used-car, same-store sales decline by 3% in its first quarter, other public new- and used-car dealer groups watched theirs decline at an average of 8%. That 5-percentage-point outperformance is consistent with its advantage over other public dealers over the last year.

"I think it has outstanding long-term prospects," Armstrong said. "Their business model has definitely broken new ground in the used car-business, and as everyone knows, that's a market that's been ill-served for the last 100 years."

In a business whose reputation for rip-offs and slick-talking salesmen in bad suits precedes itself, CarMax has seemingly introduced a customer-friendly store model that lifts used-car buying out of its seediness.

Philip Guziec, an analyst with Morningstar, said CarMax is stealing market share from other dealers by creating value for their customers that costs them nothing.

"While the typical used-car buyer always feels a sense that they are getting shafted, CarMax has created a process where the customer feels like they're being treated fairly," Guziec said. "By all my estimates, they are being treated fairly. It takes the disutility of the negotiation out of the process, and that creates a lot of value for the customer."

The company also has a huge inventory pool that is searchable by computer, giving customers the sense that they can get what they want, rather than have something forced on them. There's no haggling over prices, and the incentive structure for salespeople is geared toward selling someone a car regardless of its price.

"People don't feel like they're being pushed around or manipulated, because the salespeople have no incentive to push them around of manipulate them," Guziec said. "Just the opposite, in fact."

There is a risk that a new player could copy the company's business model and eat into its growth prospects. CarMax owns stores throughout the Southeast and Midwest and is just entering the California market, leaving room throughout the country for a competitor, but CarMax is far along on the curve of creating its brand and setting up its infrastructure. It would take years for anyone to imitate it, and by that time, Guziec predicts, CarMax will be a national brand that would be extremely expensive to compete with.

"When I talk to customers of CarMax, every single one says, 'It was so easy. I felt so comfortable. I've bought two cars there, and I'm going to be buying and selling my cars there,'" Guziec said. "That kind of repeat business and word-of-mouth will only build the power of the brand over time."

The economic outlook poses the biggest threat to the company's growth prospects. If a higher interest rate environment doesn't coincide with more vigorous growth in the economy, customers could put off buying cars. If sales continue to slacken and the aggressive incentives persist or even grow in the new-car market, used-car inventories could grow, pushing prices lower.

However, most analysts agree that the price war among automakers

General Motors

(GM) - Get Report

,

Ford

(F) - Get Report

and

DaimlerChrysler

(DCX)

can't go on forever. Those companies will eventually stop raising incentives, or even begin to lower them, making used car pricing a more attractive environment.

While the stock price, at 16 times earnings, may not seem particularly low, Guziec compares the growth prospects at CarMax to those of

Home Depot

(HD) - Get Report

20 years ago.

"Even at 30 times earnings, Home Depot was still a strong buy," he said. "We expect

CarMax to have a similarly long growth horizon, like 10 years or more of significant growth rates."