Thursday, May 28, 2009

CarMax (NYSE:KMX): Upgraded to Buy at Deutsche Bank

Deutsche Banks is making a catch-up call in CarMax (NYSE:KMX) raising their rating to Buy from Hold and bumping price tgt to $15 (prev. $10).

Improvement in wholesale funding market has positive implications for CAF
The combination of vastly stronger demand and contracting spreads on Auto ABS deals has mitigated one of our key concerns: That captive (non-bank) finance co's such as Carmax Auto Finance might be structurally impaired. Improving liquidity and lower borrowing costs suggest that this business can once again become an important contributor to KMX earnings (as well as a support to sales).

April deal appears profitable, and the market is now even better
KMX completed its first ABS issuance since early July 2008 on April 9, 2009. The gross collateral spread was 7.3%, which was actually the highest on record. While this number does not account for increased loan loss provisions and credit enhancements, Deutsche Bank still believes that the terms of the securitization imply a $368 per unit profit on CAF originations, a dramatic improvement from early 1Q09 levels, when they estimate market conditions implied a -$106 per unit loss. At today’s spreads, they estimate per-unit profitability at $525 per unit.

And they believe that retail business fundamentals should improve
After historically outperforming the used car market, KMX appears to have underperformed the overall used industry over the past 3 quarters. Firm believes that this was partly attributable to segment mix (lower priced, older vehicles have already begun to recover, and “newer used” vehicles have lagged). While they anticipate near-term volatility, they believe that fundamentals could improve significantly over the next 6-12 months as automaker capacity consolidates, and the new vehicle market shifts from deflationary to inflationary pricing; particularly positive for the type of recent vintage used cars that represent KMX’s specialty.

Carmax has lagged the industry rally, which creates an opportunity
While shares of traditional auto retailers have rallied by 50%-100% since early March, Carmax’s shares remain roughly flat, partially due (in Deutsche Bank's opinion) to structural concerns regarding CAF which they believe are substantially mitigated by ABS market improvements. They estimate that KMX shares could have 40%-50% upside from current levels (to target price of $15) if they apply the average forward multiple for benchmark auto retailers (14x-15x) to 2011 EPS estimate, which the firm sees as conservative. Primary downside risks include deterioration of loan losses, widening of ABS spreads, and lower consumer spending driven by higher unemployment.

Notablecalls: A real ketchup call but it will likely work. After all Deutsche has spent past 3 yrs on Hold.

I suspect the stock can trade towards $11 level if the market continues to hold.

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