No. of Recommendations: 21
Down 6% today.
Down 11% last month
Down 55% 1 yr
Heading back towards recent low (55)
20-50% below 5 year average P/E and P/S
Carvana on its way to bankruptcy but Carmax not going away anytime soon
Have we reached peak bearishness?
Seems like a good deal to me. Now trading at $61, i.e. market cap of $10.7b
Earnings, last 4 quarters: $807.4m
Earnings, year ending 2022-02-28: $1.151m
Average annual earnings, 3 prior years: $907.3m
In other words, less than 10 times last year's earnings, and less than 12 times earnings for the last 4 quarters. I am going to say that their true baseline earnings level is more like $1b than their recent results, which represent a lot of supply disruption in the used car market, and very high prices. Remember that they make a fairly fixed amount per car sold (typically about $2000), so there's no reason to think that the last few year's profits were anything particularly exceptional.
In the spirit of the Manlobbi method (according to my understanding of it), the first order of business (A) is to ask whether I can be confident of some minimum value of earnings in 10 years. So the questions I would ask myself are, (i) is the business model vulnerable to obsolence or attack by some new model? (ii) Is it in any danger of bankruptcy or insolvency? (iii) Are they vulnerable to what seems like an inevitable recession? (iv) Can I be confident that management is competent and honest, allowing me as a minority shareholder to participate in its possible success in 10 years?
If I can reassure myself about the above (steadfastness), then I will proceed to (B), what kind of growth do I anticipate over the next 10 years, and what is the current multiple of the market cap over the anticipated earnings is 10 years?
So for A(i), I think the business model of buying and selling used cars at a network of dealers is going to be hard to attack. The troubles of Carvana to show any inklings of profitability tend to confirm this. There will be a role for some online transactions, and Carmax is perfectly capable of integrating this into its business and has been doing so (11% of its sales last quarter), but it is hard to see most people wanting to buy a USED car without seeing and driving it first.
(ii) Carmax has $18b in long-term debt, which seems like a lot, but it is because they finance about 40% of the vehicles they sell, and most of this debt is backed up by the collateral which is the cars that are being financed. Only about $3b in true recourse long-term debt, less than 3x earnings.
(iii) I think they are arguably resistant to recession: people need to drive, and if finances are tight, a used car represents better value for money than a new car. Their earnings did not dip notably in the last 2 recessions.
(iv) I see no reason to doubt management's competency or integrity, except perhaps the roughly $100m a year in stock based compensation. This is about 10% of their total earnings (or, to be more precise, about 9% of their pre-SBC earnings, since those earnings are already removed from the GAAP earnings of $1b), but as long as this is 'only' 10%, is disclosed, is not increasing rapidly, and is successful in retaining key employees that would otherwise need to be paid higher monetary salaries, I can live with it. I in particular like their share repurchase activity, which SEEMS to be sensitive to share prices, something you can't say about all companies with big repurchases in place (I'm thinking of Apple, for instance, as opposed to a company like Berkshire where the repurchases stop when prices get higher.) I hope their Q3 results (out next week, Thursday) will confirm this with more buybacks for the quarter that goes up until the end of November.
Going on to B, what kind of growth is it realistic to expect from Carmax? They currently have 4% of the US used car market, and are aiming at 5% by 2025, which seems realistic, and although they are by far the biggest used car company, there is still lots of room for growth. Revenues and net earnings have tripled in the last 9 years, fairly steadily, and although revenue growth may decline a little, I expect profit margins to improve slightly as they grow, benefiting fro scale and network effects, so my guess is they will have tripled their earnings again in 10 years. If in addition to 3 times the earnings, they are back to a more typical 18x P/E ratio, that should provide a nice return from the current $10.7b market cap. The calculations would be: earnings in 10 years: $3b. Multiple in 10 years: 18. IV in 10 years: $54b. Price today: $10.7b. IV10/price: 5.04. Another way of thinking of this is that I am expecting a 404% return in 10 years from the current price ($10.7b, or $61 per share), which annualizes to ... 15.0% per annum (pre-inflation).
I already had about 2% of my portfolio in this but I've taken that to 5% this week.
Regards, DTB
