Carmax is in the business of selling used vehicles… Lots of used vehicles. In FY 2008 (ends Feb 28) the company sold over 1/2 million cars; 337k through their retail stores and 209k through their wholesale auction process. The company had record earnings of $0.92 per share and showed increasing margins.

The primary business for Carmax is selling used cars through their large retail stores. The process is much like buying a big screen TV from Best Buy. Prices are clearly marked taking the guess work and haggling out of the picture. The company prides itself on its customer service, making the car buying experience easy and enjoyable for their customers.

The gross margins is very similar on all their vehicles. This aligns the company’s interest in moving product and best meeting customers needs instead of pushing individual vehicles that are high in profit but may not suit a specific customer. Most vehicles are bought directly from the public as Carmax guarantees they will buy any car regardless of its age or condition. Cars are then inspected and if they do not meet KMX standards, they are sold via a wholesale auction to other dealers. This way KMX can keep their brand name clean by selling quality cars while still offering this valuable service to customers who want to get rid of their old cars.

The company has some interesting accounting processes that have me a bit concerned. They have a fully owned special purpose entity (Carmax Auto Finance – or CAF) that securitizes their loans to their buyers but is supposed to be separate from the overall company if this credit facility were to go bankrupt. I’m not a lawyer, but i have questions as to how KMX would be affected if this entity were to get in trouble. Some analysts I have followed are worried that even if KMX does not have liability, any problems at CAF could detract from the company being able to find financing for customers who need loans to buy. Another analyst mused that KMX may have to increase their loss assumptions which would be detrimental to next quarters earnings.

A second issue that had me concerned was a poison pill i found in reading the fine print of the annual report. Basically if the company is purchased by a 3rd party, convertible stock will be automatically be issued to executives (if i read it right) diluting the overall stock. In today’s market buoyed by takeout firms and private equity, this takes KMX out of that game and mandates a lower multiple than a comparable company fully available for sale at the shareholders discretion.

The stock has begun to reflect some of these concerns as well as the potential for a weakening consumer. While not expensive, the stock isn’t trading at a cheap multiple either, and should the risk become more obvious, shareholders will be more likely to demand a higher expected return for taking that risk (thus pushing current prices lower). I would avoid KMX for now and in our fund, I have taken a short position expecting some of these fears to be realized in the market within the next few months.

KMX notes