Is the Nation's Largest Used Car Retailer a Buy?

Source: CarMax

CarMax has been one of the best performers in the automotive space for the past decade. It grew its revenues and net income by 10-year CAGRs of 10.6% and 15.5%, respectively, from fiscal 2005 to 2014. For the past five years, CarMax also maintained ROEs in excess of 15% in each of the years. What's the magic formula behind its stellar financial track record?

Companies such as Sonic Automotive and Starbucks offer insights into the competitive advantages that have contributed to Carmax's strong historical financial performance.

One price in the best interest of customers
If you have ever bought any product and subsequent found the same item to be sold at half the price to another customer in a private negotiation, you will have a better appreciation of having a one-price policy in the vehicle market. While no one will negotiate for bargains at dollar stores or groceries, this has been the historical norm at car dealers. CarMax is a company that has broken away from tradition, being the pioneer of the "no-haggle" pricing strategy in the used car market since its inception in 1993.

However, a one-price strategy hasn't worked well for most car dealers because their employees' interests aren't aligned with those of the customers. Under the existing private negotiation model, sales staff are motivated to sell cars at higher prices because that will equate to higher commissions. In contrast, CarMax's sales consultants are compensated on a fixed dollars-per-unit basis, so that they will act in the best interest of customers and not promote higher-priced cars to earn higher commissions.

Imitation is the sincerest form of flattery. CarMax's no-haggle pricing strategy has been validated by the actions of its peer Sonic Automotive. In October 2013, Sonic Automotive announced a new guest experience initiative "One Sonic-One Experience" (OSOE), which will be launched at its pilot store in July this year. OSOE will aim to expedite the car-buying process by reducing the time of the sales and delivery process from three to six hours to one hour. Essentially, OSOE will achieve this by making the car purchase transaction process paperless and limiting the point-of-contact to a single staff.

More significantly, Sonic Automotive will convert all of its stores to one-price selling by 2016 under the OSOE initiative. This is consistent with Sonic Automotive's prior "True Price" strategy, sets vehicle prices within $300 of the company's lowest acceptable transaction price. Besides enhancing transparency and improving customer satisfaction, one-price selling will also help to shorten the vehicle buying process by eliminating price negotiations. The prolonged sales and delivery process and high-pressure sales tactics have traditionally been sources of customer frustration.

CarMax has an edge over Sonic Automotive because it's less susceptible to price competition from other car dealers that are open to negotiations. CarMax's huge selection of inventory (it is largest retailer of used cars in the country, with more than half a million used vehicles sold in fiscal 2014), everyday low-price strategic positioning, and five-day money-back guarantee policy discourage its customers from shopping around for the best deal. It's too early to judge Sonic Automotive's one-price selling strategy, but Sonic Automotive believes that the overall customer experience matters to car buyers than price alone.

Source: CarMax

One-stop shop capturing total customer value
CarMax benefits from a diversified revenue base as a complete solutions provider for used car buyers. It generated 57%, 13%, 14%, and 16% from its fiscal 2014 gross profit from retail, finance, service, and wholesale, respectively.

The car buying process isn't limited to vehicle sales, but involves other critical high-margin components as well. Prior to buying a car, a buyer needs to make sure that he or she can get financing. After making payment for the car, the buyer is concerned about vehicle repair and service plans. CarMax maximizes profitability by being involved in almost every part of the vehicle purchasing value chain.

In addition to retailing cars, CarMax also offers extended service plans offering repair coverage up to three years and car loans via CarMax Auto Finance. CarMax enjoys higher sales for its ancillary businesses through cross-selling and also better margins for these complementary services.

The results speak for themselves. CarMax's gross margins for the core used car sales business are 11%, compared with the aggregated gross margins of 80% for its ancillary financing and services businesses. Consumers are more price sensitive with respect to the actual car purchase and CarMax needs to keep prices attractive to close the sale.

In contrast, CarMax enjoys greater pricing power when it comes to its financing and services businesses. Due to the smaller cash outlay for service plans relative to the vehicle and the follow-on nature of such services, car buyers are less price sensitive. Car buyers are also more receptive to CarMax Auto Finance's higher interest rates and financing costs if they are unable to get third-party financing for their car purchases.

While it might seem strange to compare CarMax with a beverage company, Starbucks shares similarities with CarMax with respect to its business model. Consumers no longer consume only coffee at high-end cafes, and Starbucks now wants to be the brand of choice for all consumers at every beverage occasion and different price points.

To target customers with tight budgets, Starbucks has a separate branded coffee café chain Seattle's Best Coffee, where the price points for its beverage products are lower compared with Starbucks cafes.

On the other hand, not everyone has the luxury of enjoying a cup of latte at a Starbucks café. Some will want a caffeine boost on-the-go, while others insist on having the same premium-grade coffee at home. In response to these consumers' needs, Starbucks has introduced Starbucks VIA, its brand of instant coffee, while Verismo is Starbucks' line of single-serve coffee makers.

Starbuck's multi-channel approach ensures that it captures the entire share of coffee consumption.

Foolish final thoughts
While CarMax is the domestic market leader in used car sales, it still has room for growth. In fact, its current store footprint of 133 superstores in 66 markets only reaches out to 57% of the country's population. Even in its current markets, it estimates that only has approximately 5% market share of used cars sold (which are below 10 years of age.) This suggests that CarMax has the potential to grow in the future by increasing the number of stores and market share gains.

My optimistic view of CarMax is validated by its strong financial performance in the most recent financial year. In fiscal 2014, CarMax grew its net sales and net earnings by 15% and 13% respectively on the back of 13 store openings and a 23% increase in auto loan receivables. Therefore, CarMax is my top pick in the automotive retail space.

Will this stock be your next multi-bagger?
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The article Is the Nation's Largest Used Car Retailer a Buy? originally appeared on

Mark Lin has no position in any stocks mentioned. The Motley Fool recommends CarMax and Starbucks. The Motley Fool owns shares of CarMax and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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