I love the used-car business. In fact, I love all businesses that deal in anything that isn’t considered mainstream or that is somehow considered sub-prime. Why? It usually means high margins and strong profits.
The great thing about used cars versus new cars is that the margins on used vehicles tend to be much higher. Dealers buy used autos from owners at vastly below market price, fix them up and flip them for healthy profits. In addition, many used-car dealers also have in-house sub-prime financing where buyers can finance their cars at interest rates that might run as high as 30% APR.
This should all be good news for CarMax (NYSE:KMX), so the fact that its recent earnings report was not stellar worries me on a couple of levels.
The company did manage a 5% increase in earnings per share on a 10% increase in revenue. Full-year earnings rose 8%. However, this was the fifth straight quarter of declining margins. Same-store sales are also starting to fall, down to 4% against 12% the previous year, and they were only up 1% for the entire fiscal year.
You see, this is one business that actually does better in a soft economy as folks conserve money by purchasing used cars instead of new ones.
With comps backing off, it looks to me as though the company is trying to boost revenue by holding on to more of the loans it makes to customers. Normally, CarMax would sell off a good number of loans to other parties, but now it’s now moving to retain them. The goal is to collect more of the total dollar value of the loan and interest, as opposed to selling it at a discount.
That also means more risk, however, if those loans default. To offset this possibility, CarMax is marketing to higher-FICO-score customers. We’ll see if that works.
This not a development I like. While CarMax’ interest and fee income grew $10 million YOY, it was down as a percentage of receivables, from 9.7% to 9.4%.
The company carries a lot of debt, which is to be expected in this business. In fact, it was able to securitize its auto paper and close a billion-dollar asset-backed securities deal earlier this year. The company is generating a healthy profit and there’s plenty of cash from revenues to pay interest on the debt.
However, the company had negative operating cash flow of $62 million for the year and negative free cash flow of $235 million. That’s not good because it continues a cash-flow trend that’s been in place for several years. Positive FCF of $80 million in FY 2008 dropped to $28 million in FY 2009, went negative — to $93 million — in FY 2010 and is now at the aforementioned -$235 million. This does not bode well for the future.
Even considering a 13% long-term growth rate projected by analysts on FY12 earnings of $1.96, it suggests fair value of $25.50, while the stock is at $31.80.
So CarMax is already arguably overvalued. Add this negative free-cash-flow trend and other operational struggles and I think you should be selling this used stock and buying a new one.
If you want to play in the sub-prime loan space, you can’t do better than pawnshop owners First Cash Financial Services (NASDAQ:FCFS) and EZCorp (NASDAQ:EZPW), both of which are tremendously undervalued.
I’d also take a look at Portfolio Recovery Associates (NASDAQ:PRAA), which buys charged-off debt for next to nothing and does a great job of collecting on it. All three of these are cash-flow machines.
As of this writing, Lawrence Meyers holds shares of FCFS and EZPW.