Carmax (KMX), the nation’s largest used car retailer, reported 4th quarter results on Thursday morning.  Just yesterday, many major automakers reported March sales that were extremely ugly: GM down 45%, Ford down 41%, Chrysler and Toyota 39%, and Honda down 36%.  For the quarter, Carmax’s sales were disappointing, but still a little better than those results falling 28%.  Nationwide, auto sales have been extremely weak, but interestingly, Carmax was able to lift earnings 70% from last year.  The company netted 17 cents or $38 million, which far outpaces the analysts expectation of just 2 cents per share.

So, how did Carmax increase earnings 70% while car sales slumped 28%?  They kept costs very low, and also got a large amount of their earnings from the finance arm.  Carmax knew that the next few quarter would be lean when they stopped giving forward looking guidance in June of 2008, and at that point they began cutting costs rapidly.  The company dropped expenses by 10.6%, and thinned out its workforce by more than 20% since last May.  The company is planning to further conserve cash by cutting its capital expenditure budget to $20 million for fiscal 2010 from $185.7 million the year prior. 

The stock is getting a nice boost today, up nearly 10%.  However, we have a Fairly Valued stance on shares at these levels.  The company made 27 cents in fiscal 2009 that just ended and that puts the price to trailing twelve month earnings at over 50x.  The spending environment for autos must improve at some point, but that may not be for the next quarter or two.  The company has cut costs as far as they can, cutting cap. ex. nearly 90%, slashing their workforce, etc.  Carmax management said that same store sales could be down double digits in the year ahead, which is never a good sign.  We are maintaining our stance from the post last June (Consumers Steering Clear of Carmax), that there is still quite a bit of risk in Carmax and there are many better places to invest your money right now. 

The latest developments in the automotive industry continue to be disastrous. As most are now aware, American auto makers will receive a bailout even though Congress was unable to reach agreement on the matter. However, it is not just American automakers that are dealing with the fallout of collapsing worldwide demand. U.S. sales data for the auto industry were released yesterday with cumulative sales plunging 36% in December. The results were abysmal across the board: General Motors (GM) down 31%, Ford (F) down 32%, Honda (HMC) down 35% and Toyota (TM) off 37%. These figures are compared to sales from a year ago and in that time the deterioration in both consumer spending and confidence has been drastic. For the entire year, Toyota’s sales slumped 16%.

Now, Toyota is expecting its first operating loss in its 70 year history. This is certainly not an easy operating environment for automakers, including the world’s largest. As Toyota’s newly-resigned President Katsuaki Watanabe said, “It’s a kind of emergency that we’ve never experienced before. The environment surrounding us is extremely harsh.”

In response to weakening demand in Toyota’s hugely important U.S. market—as well as other markets such as Asia—the company is being forced to tighten its belt. Today, TM came forward with a plan to shut down production for 11 days in February and March for all of its factories in Japan. This is in addition to the three day suspension of operations in January already announced. Clearly, we underestimated the impact that the dramatic dive in demand would have on Toyota–especially in the Asian markets–when we wrote in our July piece that TM would stand to benefit from weakened competitors and gain market share worldwide (Kicking the Tires of Toyota Motors). At that time, gas prices were sky high and we believed that Toyota might have a leg up with its largely fuel efficient line-up.

An interesting piece in the Wall Street Journal by Paul Ingrassia illuminates some of the difficulties facing Toyota. One of the biggest problems facing TM is that they underwent an aggressive expansion a few years back. In retrospect, the timing of this massive expansion was dreadful.  Ingrassia points to greater quality control problems as a symptom of a company expanding too fast and losing focus on its products. We agree with Ingrassia that Toyota now faces a period of substantially scaling back its operations and some plants may be shuttered as others will simply ratchet down production.

Although the company and the industry as a whole (see industry 52-week chart) have fallen on hard times, there is little doubt that Toyota will manage through this slowdown. People will resume buying cars again once the economy improves and Toyota will remain a leader in many classes. Toyota seems to us one of the best run companies in the auto industry and will continue to be one of the strongest global competitors.

As for our Ockham valuation, we continue to rate TM as undervalued because based on historical norms the stock is undeniably cheap. Even as sales have slackened, Toyota’s price-to-sales is currently .40x versus its historically normal range of price-to-sales of .58x to .90x. Likewise, now that TM’s price is $66.37 and its price-to-cash earnings ratio is 3.03 (as of last reporting), we are very positive on its outlook from the cash earnings perspective. In fact, TM is now trading a full 51% below its average historical price-to-cash earnings ratio at these profit per share levels. Of course, we are concerned about the company’s impending slip into negative earnings, but if we are near the bottom in car sales, the stock could rebound nicely in the year ahead.

The legislative powers in Washington D.C. believe that they have reached an agreement in principle to a sweeping bailout of the auto industry. Word is that the vote passed in Congress already Wednesday morning with little trouble. The newest iteration of the plan has the government loaning the auto makers $15 billion initially, giving General Motors (GM) and Chrysler time to stave off bankruptcy while a long term restructuring and loan package is determined.  The plan also calls for the initiation of a new “car czar” to oversee the whole process, and this czar will have far reaching authority to lead the restructuring effort. Of course “czar” has been used to describe other leaders at the forefront of government initiatives, but never has it seemed more appropriate than as the head of a quasi-socialist bailout program such as this. The auto bailout should pass with little trouble in the house but could meet significant opposition from Senate Republicans, who are pushing for amendments.

A few significant issues come to mind, not the least of which is the question of how much will this actually change the industry for the better? In the media coverage of this initial $15 billion loan, there has been little discussed about how the companies are going to reign in labor costs: the Achilles heel of the industry. The United Auto Workers union has begun to make statements that they were willing to work with the automakers in order to restore their solvency, but is this simply a ploy in the short term to keep the gravy train from derailing? Also, how will this bill treat emissions standards proposed by the government? Here you have an industry that cannot make it another quarter without a bailout from the government; it’s probably not the time to be implementing emissions standards that will further prohibit profitability. Let’s make sure that the company can survive before we start imposing restrictions on their business.

We continue to be in favor of a Chapter 11 restructuring that would allow a bankruptcy judge the ability to cast away the labor and other contracts that are making these companies uncompetitive. However, now that a bailout (possibly with some additional tweaks) looks inevitable, it might be the automakers not participating in the bailout that truly benefit. As everyone who has followed this saga has undoubtedly heard, if these American automakers were allowed to fail (assuming Chapter 11 could not turn them around), it would cost hundreds of thousands or even millions of jobs throughout the country. The resultant unemployment could worsen the recession into a full blown depression, so the logic goes. It would affect not only plant workers, dealerships, and white collar jobs but also the industries that support these would have to cut back such as maintenance and service shops, parts suppliers, etc. you see the point.

This bailout from the government should serve the purpose of at least ensuring more jobs are safe, which is of course of great importance, but if the American automakers are allowed to remain bloated and ultimately uncompetitive this will only stand to benefit Honda, Toyota, Kia, and other foreign automakers making cars here in the states. Consider the alternatives from the foreign auto company’s perspective; when choosing between feeble competitors in an economy that is weak but unlikely to remain that way forever, or the world’s largest auto market in depression. It makes for an easy choice.

Chrysler and its private equity owners (whose investment is Chrysler and GMAC account for only 7% of their total assets under management) are not turning down the injection of  capital, but they are not willing to open up their books for inspection from lawmakers (link). How can they have it both ways? When news of this spreads, Chrysler will surely catch a lot of heat, as well they should. Interestingly, Ford (F) is not seeking a loan, at least not in this initial package, which could be a brilliant move. This should make them less subject to the car czar’s authority, and also should turn the ire of the many Americans against the bailout away from Ford at least for a while.

At the end of the day, this will hopefully bring to a close the dog and pony show on Capitol Hill replete with public relations stunts from opting for a drive from Detroit to D.C. (switching vehicles in the last few miles to show off the Chevy Volt) instead of time saving corporate jet trips and executives “selflessly” taking $1 salaries this year. It is all a big joke, winning the PR battle has become the battle, instead of figuring out how in the world to make these companies viable competitors in the global auto industry. It appears the CEO’s of the Big 3 have done their jobs securing a bailout. Can any rational observer believe that these executives will be around too much longer after the bailout begins. They did not create the troubles their companies are going through, they inherited this mess and my guess is they will likely move on to greener pastures before the dust settles.

Please pardon the cynicism but government should not be in the business of well, business. After the government’s recent history of botching and reconstituting TARP, we are not convinced that those in leadership are not just making it up as they go along. That is a strategy that has never and will never work in business, even if you can print money with 0% financing from the Fed. 

We have included our ratings charts for both GM and Ford (obviously we do not cover Cerberus), but we must caution you that each one of these stocks receives our “sticky note of death”. We have integrated these post-its on our web reports to help our clients understand that just because something is undervalued compared to historical norms, that does not mean that it makes a suitable investment. Our chart for the entire Automotive sector is on the right and we have highlighted those that receiving this sticky note with a red circle.  Notably not circled in red are Daimler, Nissan, Tata Motors, and Toyota.

Call the Fed, my favorite burger joint down the street is experiencing distress.  Yeah, I’ll take a double with cheese, hold the TARP.

Not really sure how Detroit sees this all working out.  Does the UAW and the “big” three (two public, one private, all three collapsing) still think that they are entitled to some sort of government intervention?  The new White House Administration has made it clear that they are ready to help Detroit, and Speaker Pelosi can’t be any more vociferous of her own intent.  So the question is, where, oh where, will it end?

The automakers priorities have been out of whack for quite some time now.  You cannot help but laugh when you hear GM is the worlds leading purchaser of Viagra.  The Detroit News reported in 2006 that GM spent $17 million dollars on the “little blue pill”.  Admittedly, this is a relatively small portion of the more than $5.6 billion per year that GM spends on health care for their employees (more than $1500 per car in 2006), but the Viagra problem is a symptom of an overall cost management illness.

Thomas Friedman, Pulitzer Prize winning columnist and author (”The World is Flat“), has some interesting insights into the situation in yesterday’s New York Times.  He first recounts the history of our esteemed car companies and their insatiable appetite for funds to, … uh… innovate:

Last September, I was in a hotel room watching CNBC early one morning. They were interviewing Bob Nardelli, the C.E.O. of Chrysler, and he was explaining why the auto industry, at that time, needed $25 billion in loan guarantees. It wasn’t a bailout, he said. It was a way to enable the car companies to retool for innovation. I could not help but shout back at the TV screen: “We have to subsidize Detroit so that it will innovate? What business were you people in other than innovation?” If we give you another $25 billion, will you also do accounting?

How could these companies be so bad for so long? Clearly the combination of a very un-innovative business culture, visionless management and overly generous labor contracts explains a lot of it. It led to a situation whereby General Motors could make money only by selling big, gas-guzzling S.U.V.’s and trucks. Therefore, instead of focusing on making money by innovating around fuel efficiency, productivity and design, G.M. threw way too much energy into lobbying and maneuvering to protect its gas guzzlers.

This included striking special deals with Congress that allowed the Detroit automakers to count the mileage of gas guzzlers as being less than they really were — provided they made some cars flex-fuel capable for ethanol. It included special offers of $1.99-a-gallon gasoline for a year to any customer who purchased a gas guzzler. And it included endless lobbying to block Congress from raising the miles-per-gallon requirements. The result was an industry that became brain dead.

Nothing typified this more than statements like those of Bob Lutz, G.M.’s vice chairman. He has been quoted as saying that hybrids like the Toyota Prius “make no economic sense.” And, in February, D Magazine of Dallas quoted him as saying that global warming “is a total crock of [expletive].”

These are the guys taxpayers are being asked to bail out.

            - Thomas L. Friedman, NYT, Nov. 11, 2008

Friedman has a great knack for showing readers where we have been in very understandable terms and examples.  He continues on to propose that Steve Jobs take a year off from Apple (AAPL) to come create the first “iCar”, which no doubt will run on MP3’s available only from the iTunes store.  He really may be on to something there.

When looking at our ratings and valuations on companies like Ford and GM, it is really hard to reconcile the realities of Detroit with the opportunities to invest in depressed stocks.  Well, maybe its not that hard.  Right now, on a 13 week basis, GM and Ford are down around 70% each.   The slide for GM has been an unrelenting death march from the high $80’s in 1999 to its present day.  Ford’s decline from 1999 was a high price of $36 and change.  Both companies have failed miserably to innovate or compete with their foreign counterparts.

Looking at the scatter plot chart, it is true that Ford and GM get a “Greatly Undervalued” rating right now from the Ockham methodology.  We won’t drop coverage on them just because we think they are systemically broken (that’s Wall Street research).  Instead, we basically sit here waiting to see if the government will again burn money by throwing it into the Detroit furnace.  Please note, however, that when visiting our site, we slap an “ALERT” sticky note on both Ford and GM to highlight that our ratings can’t be viewed in a vacuum.  While we advise doing a lot of homework on all companies, and think our clients need to look at multiple sources for their research, we also recognize that some truly deserving companies should be pointed out for the complete debacles they have become.

When looking at the major automotive manufacturers, we find Honda (HMC) and Toyota (TM) to be far more interesting (and they don’t get the yellow sticky note of death on our website.)