CarMax Inc. (KMX.N) hopes to improve the used-car buying experience with an efficient website and deals like a five-day return policy. Auto sales and consumer spending have been helped by the Fed’s efforts to keep interest rates low. CarMax has recorded solid profits. However, rising accruals, weak cash flows and softening margins produce a very low score of 5 on the StarMine Earnings Quality (EQ) model. During the last economic crash, CarMax revenues fell 20% in the fiscal year ended February 2009. Should the economy again go south, the used car dealer might be driving towards earnings trouble.
Poor Cash Flows
The charts below illustrates CarMax’s poor cash flows. The two most common measures of cash flow, cash flow from operations (CFO) and free cash flow (FCF) are both firmly negative for five consecutive quarters. In the last reported quarter that ended on February 2013, the company reported CFO and FCF both negative and the lowest in five years at -$279 million and -$330 million respectively, despite net income being positive in the same period. When earnings are not backed by strong cash flows, they tend not to be as sustainable as those backed by strong cash flows.
Source : Datastream Professional/StarMine
Decreasing Operating Efficiency
While the company is experiencing weak cash flows, it is also not using its assets as efficiently as it was five years ago. Net operating asset turnover, one of the inputs into return on net operating assets, has been steadily decreasing since 2008. While asset turnover once exceeded the industry median by a large margin, by this measure it has transitioned to an industry laggard. In the last quarter, the net operating asset turnover was 1.3 compared to the industry median of 4. Asset turnover is a more sustainable source of future returns than profit margins, the other input into return on net operating assets. Not surprisingly, return on net operating assets has fallen to 5.3% from 14.1% just three years ago.
Source : Datastream Professional/StarMine
Rising Inventory Levels
The company has also seen a buildup in inventory levels. While that may be a sign of an expected sales increase, it is probably simply a sign there are more cars in the lots than the company is selling. In 2008, customers held on to their cars for longer, hence the company did not see many cars added to the lots, and it also didn’t experience strong sales. It now seems like customers are buying new cars (as evidenced by rising sales at the carmakers), which may explain why inventory levels are rising at CarMax. In the last quarter, the company reported inventory days of 53 days, the highest in five years.
Source : Datastream Professional/StarMine
The stock does not even appear cheap. In order to justify the current market price of $46, the company will have to grow earnings at 12.5% over the next ten years. We arrived at that number by using a methodology that involves reversing StarMine’s Intrinsic Valuation model instead of solving for fair value, using the current stock price and solving for the growth rate required to justify it (the Market Implied Growth rate). That kind of growth could be challenging even in a robust economy. StarMine adjusts for analyst biases and estimates a slightly more modest estimate for ten-year growth rate of 9.4%. February and March tend to be the strongest months for CarMax, as customers look to spend their tax refunds. It remains to be seen if the U.S. economy remains on its positive trajectory, and if the improving job market buoys the used car market.
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