CarMax, Inc. (KMX) will announce earnings next week as their fiscal first quarter ended on May 31. Despite sagging sales the last three quarters, investors appear optimistic that this report will be a bit stronger. The stock is currently trading near $13 after hitting a low of $5.76 on November 21. Unfortunately, while KMX has been a great success story for 2009, the current stock price appears vulnerable to a sharp decline if the news is anything but spectacular. Analysts are expecting the current year (fiscal 2010 ending February 28) to generate earnings of 23 cents per share leaving the stock with a current PE of 57. Now to be fair, I should also point out that 2011 is expected to generate earnings of $0.49 so the multiple on earnings 2 years out is only 26.5. However, that is still fairly high for such a speculative growth story.
Much of the recent strength has been due to increasing expectations of used car sales, and positive financing data. The logical argument is that as the consumer deals with lower employment and reduced balance sheets, he or she will more likely buy a used car instead of springing for that shiny new set of wheels. And the high profile bankruptcies of the US car manufacturers has certainly not hurt the trend towards buying used cars.
Financing has also gotten a bit looser in past months, but not as much for individuals as it has for KMX lending facilities. It is expected that the financing unit will be able to securtize more of its loans and sell them, leaving more available capital to lend to KMX customers. That certainly could have a positive effect on demand, although standards for making these loans will still be much tighter than we have seen in past years.
One of my major concerns with CarMax is the potential for sharply increasing competition. First, you have many independent dealers who used to traffic in new GM, or Chrysler cars who may now enter the used car market. These guys have the property, staff, and expertise to sell cars but no longer have the privileges associated with the manufacturers. It’s likely that these resources will be used to sell used cars, and compete directly with CarMax.
Secondly, the auto manufacturers will come out of bankruptcy leaner and fighting for their lives. This means a sharply reduced cost structure which will trickle down to significantly reduced prices on new cars. So consumers who may previously have decided to stick with a used purchase may find that the cost of a new car is incrementally attractive.
Currently, the gross profit for the average unit sold at CarMax is about $1,850. It will be interesting to see where this number comes in next week, and which way it is trending. Investors could quickly sour to the company if this gross profit number is not improving.
While CarMax will certainly stay in business, and may in fact benefit from the current automaker debacle, the stock price just seems to reflect too much optimism. I wouldn’t be surprised to see the stock trade back down to 15 times the 2011 estimate of $0.49. That would bring the price to $7.35 – which would be quite a shock to investors.
Shorting the stock is likely the best way to profit from a drop over the period of several months. However, aggressive accounts could consider buying the KMX June $12.50 puts. It’s a very risky play, but you can pick up these contracts for 40 cents as I write. The options expire at the end of the day next Friday, but if KMX announces very poor earnings and the stock drops to $10, you would realize a 525% return on the option. However, if the stock does not trade down sharply, know that you would then lose the entire $0.40 used to purchase the puts. The risk / reward ratio on this trade looks appealing to me for a very small part of your trading portfolio.
FD: Author does not have a position in KMX
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