It has to frustrate company executives to deliver a solid quarter only to see investors sell off the stock because results did not meet their overheated expectations. That is the case for CarMax (NYSE:KMX) in the wake of its third quarter earnings report - a report that fine relative to expectations, but not flawless. The stock has still climbed almost 50% for the year, so it is not as though the stock has been unfairly maligned this year.

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Hitting the Growth Accelerator
The economic rebound may be lumpy and uncertain, but CarMax is certainly benefiting from some sort of recovery. Overall revenue jumped 23% this quarter, with same-store sales rising 16% (as measured in units) and 19% (as measured in dollars). Used car sales were up 20%, while wholesale rose 41% (to about 15% of revenue). Not only were these solid results in their own right, they met the highest published analyst estimate for the quarter.

Profitability was apparently where some investors saw trouble. Overall gross profit rose nearly 23% and the company basically maintained its overall corporate gross margin. Details matter though, and the company did report that the per-vehicle gross profit on used cars declined very slightly on an annual basis and about 5% on a sequential basis. Even though sequential declines are normal in this period and the prior quarter's result was exceptionally high, some investors were nevertheless disappointed. Likewise, perhaps a few sellers were spooked by the 11% sequential decline in volume, though again this is not all that exceptional.

Can the Company Drive the Growth that Matters?

CarMax has done well for itself, building a nationwide chain of 100 no-haggle used car superstores, and delivering compound revenue growth of about 13% over the past decade. On the other hand, the company performance in terms of free cash flow has been far less impressive. CarMax's best performance on this metric has been just $79 million, which represented a little more than 1% of revenue that year.

Bulls are going to argue that CarMax has to spend money to build new stores. That's fine and true to a point. The fact remains, though, that investors will not pay multiples like 18x trailing EBITDA if there is no cash flow to ultimately back that up. After all, store expansion is great if a company reaps cash flow from each new store, but is a treadmill to nowhere if it does not. What's more, plenty of well-known racing team owners got their starts in car dealerships, so there has to be cash flow in there somewhere.

It is also worth noting that extreme competition may limit just how much cash flow CarMax can ultimately produce. CarMax stays away from the buy-here/pay-here business of America's Car-Mart (Nasdaq:CRMT), which targets a less-affluent customer base. Likewise, CarMax does not have the reliance on new car sales (which carry low margins) like its rivals Asbury Automotive (NYSE:ABG), AutoNation (NYSE:AN), Group 1 (NYSE:GPI), Lithia Motors (NYSE:LAD) and Sonic Automotive (NYSE:SAH). Still, virtually every one of these companies wants to expand its used car sales and may well decide to compete on price and make it even tougher for CarMax to maintain margins.

The Bottom Line

Assuming that CarMax's valuation has a basis in fundamentals, that basis requires a very substantial improvement in free cash flow production in the coming years. That is not out of the question, assuming that the company can reach some sort of "steady state" store count and then leverage the heck out of that in terms of free cash flow. "Not out of the question" is not the same as easily done, though, nor is it the same as having a clear near-term runway to that free cash flow production. As a result, these shares are unlikely to appeal to conservative investors and are more suitable for aggressive investors willing to bank on that prospective future free cash flow. (To learn more, check out 5 Ways To Buy A Used Car.)