I love anything subprime-related, and I don’t get to write about that sector too often. Even better, many people seriously mistrust used-car salesmen and would love the opportunity to make money off these guys. That’s why I’m kicking the tires of the massive used-car retailer known as CarMax (NYSE:KMX).

CarMax sold almost 400,000 used cars in its fiscal year ending this past February, through its 103 stores across 49 markets. The company doesn’t restrict itself to just retail customers, though. It operates wholesale auctions in which it sold over 260,000 cars in its last fiscal year. Finally, like any good car dealer, it has its own finance arm.

The reason I love businesses like this is because they make a lot of money. You’ve probably heard that used cars offer higher margins than new cars for auto dealers. The financing side of the business tends to be very profitable, because people are less likely to walk in with financing in place, giving the seller the upper hand in negotiating interest rates.

So I’m disappointed to report that CarMax does not have the financials I hoped it would. Its net margins are only 4.15%. All the big automakers have equal or better margins, save Toyota. I was honestly expecting even higher margins, closer to those of payday lenders, which are in the 10%-12% range. Now, this doesn’t mean CarMax is a bad business. It’s just less profitable than I’d hoped. We need to examine the financials to get a solid look at the company.

Stock analysts driving five years out on the earnings highway see 13.7% annualized growth, which is a good, solid growth rate. At a stock price of $23 on FY 2011 earnings of $1.84, the stock presently trades at a P/E of 12.5. AutoNation (NYSE:AN) trades at an 18 P/E, and Penske Automotive Group (NYSE:PAG) trades at 10.5, so CarMax is dead center by comparison.

Now, one thing CarMax has over its peers is that it turned a profit in 2008 during the financial crisis, to the tune of $59 million, while the others saw massive losses. CarMax grew earnings by almost 360% (!) in 2009, 35% in 2010, but is struggling this year. It’s second-quarter profit was flat compared to last year, on a 2% decline in total sales, including an 8% drop in new vehicle sales (it also sells some new cars, but not many). The finance side is doing well, up 21% year-over-year due to higher margins in that segment, and the wholesale side saw a 23% increase in unit sales.

Conclusion

CarMax has some challenges ahead of it, as used-car acquisition prices rise, and questions remain about the health of the economy. Free cash flow is also troubling. The company was negative in this department last year to the tune of $94 million. For the first six months of this year, its showing negative operating cash flow of $81 million, and it also spent $80 million in capital expenditures. Although the company has $154 million in net cash and a $700 million credit line, I don’t like investing in companies that are negative in the free cash flow department, and there are too many other questions surrounding the company right now.

Lawrence Meyers does not own shares of any company mentioned.