Death of a Salesman 

How CarMax attacked the used-car industry — and won.

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They found him working at a used-car dealership in Melbourne, Fla., on an August afternoon in 1991.

Rick Sharp, then chief executive of Circuit City Stores, and two of his top lieutenants, Austin Ligon and Mark O'Neil, had chartered a jet from Richmond to meet the owner of the dealership, Jim Rathman.

When they got there, Rathman had left for an appointment — and they got stuck with the kid wearing sneakers.

The kid was a basketball junkie who'd stumbled into the used-car business by accident, driving cars for a buddy to and from wholesale auctions. Sharp, Ligon and O'Neil were high-powered executives of a multibillion-dollar company working on a new, top-secret business plan.

What a waste of time, Sharp thought.

"We're all in a suit and tie — Austin, Mark and myself — and there's this guy sitting in a chair with high-top tennis shoes, a tank top and a cell phone," Sharp recalls. "The first thought when we first looked at this very young person looking the way he does? 'This was not going to be a very productive trip.'"

They were wrong. Tom Folliard Jr., then 26, wowed them with an analytical primer on the used-car business. Essentially, he showed them how Ratham's dealership group built a highly successful niche by focusing on wholesale cars, which they bought at local auctions, and selling them for a nice profit.

On the plane ride back to Richmond, Sharp says, "we all agreed that we needed to hire this guy."

In 1993, Folliard became the first senior buyer for Circuit City's new business, CarMax. "I took the job because they had benefits — and a gym," Folliard recalls, just moments after CarMax's annual shareholders meeting June 20.

That's the day the 41-year-old became president and chief executive officer of the $6 billion company.

Folliard's unlikely path to the helm of the largest used-car automotive company in the nation, and perhaps the world, was as unlikely as a giant electronics retailer starting a used-car business. Both got their wings at that dealership in Florida, where Circuit City's buttoned-up execs collided with the world of used cars.

CarMax, which started as a subsidiary of Circuit City, was left for dead just six years ago by the best and brightest on Wall Street. In fiscal 2006, five years after being spun off as its own publicly traded company, CarMax reported net earnings of $148 million on $6.26 billion in sales. Its success is not just a business-school study of innovation and survival (see Harvard Business School's "CarMax" by Professor Rajiv Lal and researcher David Kiron, 2005), it's a story of civic pride.

CarMax didn't just beat back the smartest competitors. It built a company that is systematically dismantling an entire industry built on manipulation, deceit and stereotypical smarminess.

Few would say the same of Wal-Mart, often seen as the grim reaper of hundreds of thousands of mom-and-pops in the name of consumer choice — or Kohl's or Home Depot or Target, for that matter.

CarMax, on the other hand, is hurting traditional car dealers.

The company is waging war by using a big-box formula to expose and clean up a marketplace shrouded in smoky business practices and inevitable negotiating. Of the major retail sectors, the car business is the only one that hasn't embraced fixed prices. It's how car salesmen routinely rip off unwitting consumers.

The CarMax story has an unlikely narrator. The concept of the used-car superstore came not from the collective genius at Circuit City, but from an outsider — a consultant who specialized in brainstorming before the days of management gurus and "out-of-the-box" business lectures.

Ron Moore, a consummate entrepreneur, got his start selling computer systems to doctors in the early 1980s. With each $15,000 computer package, he sent a complimentary pack of office supplies — extension cords, floppy disks, ink ribbons, for example — a kind of "thank you" to the customer.

But a funny thing happened. Moore kept getting calls from his customers looking to reorder the supplies. He went to his business partners and pitched the idea to start a retail business selling office supplies.

They didn't bite. So he sold the computer business and in 1986 launched Office America. Within a few years, the business grew to 22 stores and $70 million in sales before the chain was bought out by Staples.

At Circuit City, Sharp hoped to do what Moore had done — just with substantially more financial muscle. With capital to burn at the height of Circuit City's success, long before rival Best Buy was in the picture, Sharp wanted to diversify and use Circuit City's retailing know-how to conquer another industry.

Sharp had met Moore a few years earlier when Circuit City was considering investing in Office America. The courtship was short-lived — Circuit City wanted to buy the concept outright — but Sharp came away impressed with Moore's ability to spot business opportunities others had missed.

So he hired Moore as a consultant in early 1991. "This was when Circuit City was on top of the world," Moore says. His assignment was to answer the question: "Were there any opportunities to go from startup to $500 million in sales in five years without any acquisitions?"

Moore looked at several industries at Circuit City's direction. But one, the aftermarket auto-supply business, intrigued him. "If I were going to sell windshield wiper blades, how many cars would need windshield wipers," Moore recalls thinking. "That's when I realized that used cars were well over a $100 billion market."

Today, it's closer to $400 billion. And it's a market made up of independent dealers and new-car dealers who sell used cars on the side. In 1991, it was an industry with no national players — and rife with consumer distrust.

Moore met with Sharp and Ligon to present his findings, saving the used-car proposal for last. It was two pages long, he says: One page of industry statistics and analysis, and one page with a caricature — "a scruffy looking guy, a stereotypical cartoon of a car dealer," Moore says. "I said, Here's the industry and here's the competition."

The idea seemed implausible. "They literally laughed at me," Moore says. "They said, 'Yeah, right, Circuit City in the used-car business.'"

After they stopped laughing, Sharp pulled out a calculator and crunched a few numbers. The light bulb went on.

"They sat there and looked at it," Moore says, "and said, 'Holy cow.'"

That Circuit City's board of directors saw gold in a business many would have shunned is remarkable, says George Hoffer, an economics professor at Virginia Commonwealth University who's followed CarMax since its inception.

Just the mention of used cars usually elicits visions of roadside lots lined up along dying retail corridors, such as Jefferson Davis Highway or eastern Midlothian Turnpike. There was another hurdle too: Even with its financial might, Circuit City couldn't use its buying power to purchase cars more cheaply than the independents.

They'd have to buy their cars from the same dealers and auto auctions where most trade-ins, repossessions and damaged vehicles wind up — just like everyone else.

"Can you name any big-box retailer that doesn't get its merchandise for a cheaper price than its smaller competitors?" Hoffer posits.

Circuit City would have no price advantage. To compensate, it would have to build an unbelievably efficient business model. The company was confident it could do so, leaning on its retailing experience.

The idea was to de-slime the car-buying process. Institute fixed prices for customers, taking away the guesswork and haggling. Offer extended warranties and leverage the company's financing arm.

"You get your economic advantages from the other things that you do against your competitors," says Austin Ligon, the company's founding chief executive who stepped down June 20. "We're all going to the same auctions. We're all buying from the same customers. The difference in what gives you competitive distinction is, 'Do you know what inventory you want to have?'"

This is where CarMax excels: inventory control. The company sells 300,000 cars a year at 71 stores and has built a sophisticated database and information system that enables it to track every purchase, test drive and color preference in every demographic and region. The company's car-buying database is far superior to anything else on the market, Ligon insists.

"Remember, our competitors are 22,000 dealers who are trying to figure this out on their own, by themselves," Ligon says. "The real question is, 'What are the 450 ideal cars, if I could buy whatever I wanted, that I'd ideally like to have out here that would sell the best in the next 30 days?' We can answer that question better than anybody else."

That wasn't always the case. In the mid-1990s, CarMax found itself at war with one of the country's most respected entrepreneurs: Wayne Huizenga, of Blockbuster and Waste Management fame, who copied the CarMax model and launched AutoNation USA in 1996, three years after the first CarMax opened.

Huizenga had the backing of Wall Street and had access to considerably more capital than Circuit City's counterpart. The entry of AutoNation also spawned copycats, such as Car America and Driver's Mart, founded by a group of new-car dealers who wanted to protect their turf from the category killers.

It was AutoNation, however, that gave Circuit City the most heartburn. After launching four stores in a deliberate, slow-moving pace of expansion, CarMax suddenly was thrust into an intense turf battle.

It threw out the slow-growth plan and opened stores wherever AutoNation popped up. Both were focusing on the Sun Belt states. Beginning in 1997, CarMax grew from six to 33 stores over 27 months and tapped the public markets to help finance the growth by launching a $400 million public offering (as a tracking stock, the company was still owned by Circuit City).

The conventional wisdom among analysts was that Huizenga could outlast CarMax with his access to seemingly unlimited resources. But the complexities of the business were too much to overcome. During the battle, CarMax lost $75 million over seven years (the board had approved $50 million over five years to test the concept) — pushing the patience of Circuit City and its board to the brink.

It was "massive indigestion," recalls Circuit City's former vice president and treasurer Edward Villanueva, who served on the board of directors from 1977 to 2000.

"They had a whole lot of systems to develop. They were doing it slowly and trying not to invest too much before they got it right," Villanueva says. "And then [AutoNation] kind of forced CarMax's hands."

It was one of the most trying periods he ever experienced on the board, he says: "It was brutal."

Privately, some people inside the company blamed CarMax's rapid expansion. All told, Circuit City wound up spending $175 million to build CarMax, just as Best Buy Stores began to challenge the electronics chain's market dominance.

Some people blame the distraction of CarMax for Circuit City's slow reaction to Best Buy's challenge. After all, it cost $15 million to $20 million to open each CarMax store, including the overhead and inventory. "How many Circuit Citys could you relocate for $15 million?" Hoffer asks. "The success of CarMax, unequivocally, came at the expense of Circuit City."

Sharp says Circuit City's woes had nothing to do with CarMax. "There was never a capital constraint," he says. Besides, Ligon says CarMax eventually paid off its $175 million debt to Circuit City.

Whatever the cost, CarMax outlasted AutoNation, which got out of the used-car business in December 1999. Ligon remembers the day vividly: "AutoNation closed on or about Dec. 13, 1999, at 9:30 a.m."

How did CarMax prevail? The company had a sizable jump-start in the race to build a functioning information system and simply did a better job of executing its distribution networks and business model, Ligon says. Anyone who was close to the company could look at the numbers and see CarMax was far more efficient than AutoNation, he says, and even during the heat of battle, it continued moving toward profitability.

"In their last year, AutoNation was losing $25 million a month. If you take both their operating losses and their write-offs, they lost a billion dollars in three years," Ligon says. "So, you know, an objective analyst who looked at CarMax and AutoNation's used-car business would have said, 'Geez, these things bear no relationship to one another, because one is modestly unprofitable, and one is clearly an economic black hole.'"

The obstacle that CarMax couldn't overcome was the draining management pool. CarMax simply couldn't churn out capable managers fast enough to keep pace with the growth. Typically, Ligon says, each store is capable of producing only about three new managers a year because the business model is so complex. That allows it to reasonably grow at a pace of about 15 percent to 20 percent a year.

So after AutoNation closed its used-car operation, CarMax slowed its growth to a virtual standstill to lick its wounds and get its management teams up to speed. Because its net margins are so small — about 2.5 percent, the same as Costco, Ligon points out — "you don't have to make much of a mistake before those margins go the wrong direction. You can lose awesome amounts of money in this business very quickly."

CarMax wasn't out of the woods. Ironically, the company reached its "maximum point of pessimism," Ligon says, a few months after AutoNation closed its used-car stores. In the first quarter of 2000, CarMax saw its stock dip to its lowest point ever, at $1.31, as investors began jumping ship and dumping more stock.

"A lot of people assumed that, well, because AutoNation failed, and because CarMax hadn't made a profit yet, therefore CarMax must be failing," Ligon says.

"When our stock was at $1.30, I think everybody was a little nervous," says Folliard.

But there was something most analysts and investors missed.

All they had to do was read the fine print.

Because Circuit City was the guarantor of the leases on CarMax's stores, closing them was next to impossible. Circuit City was solvent, so it would have cost more to pay the rents on the stores than what CarMax lost, Ligon says.

The few investors who read the footnotes were pleasantly surprised. The lease arrangement practically guaranteed CarMax wouldn't be shuttered without bleeding enormous amounts of red ink, to the point where the revenue wasn't even covering rent. Most stores reached some measure of profitability within a year.

Thomas S. Gayner, executive vice president and chief investment officer at Richmond-based Markel Corp., was one of the few who picked up on the lease arrangement. He bought a million shares for Markel shortly after AutoNation closed, when the stock was just under $3. Last week the stock traded at more than $35.

Gayner saw what others didn't. Being in Richmond, he visited the stores frequently and witnessed what he considered a thriving business. "There was a real advantage to being around Richmond," he says. "I sure did see a lot of CarMax stickers. Personally, the concept resonated with me."

He thought CarMax just needed time. To him it resembled the story of R.H. Macy, the Quaker who moved his store from Haverland, Mass., to New York City in 1858 and revolutionized retailing by advertising fixed prices on its merchandise. Macy got a similar reception when he first landed in New York — nobody thought it would last.

Even with CarMax's recent success, however, fixed prices have yet to take hold in the car world.

Part of the problem is that the industry is so fractured, says Haywood "Huddy" Hyman Jr., a veteran new-car dealer who's operated six dealerships in the Richmond area during the last 26 years.

He dabbled in all manner of franchises — from Porsche/Audi, Buick, Saab, Peugeot, Lotus and even the Smart Car in Paris — before finally settling on Saturn, the only new-car manufacturer to mandate fixed prices.

In 1990 Hyman opened the first Saturn dealership in the country, on Midlothian Turnpike, just west of Chesterfield Towne Center — before CarMax had opened. CarMax guys would often show up on his lots, snooping for prices with clipboards in hand.

Saturn allows dealers only to sell its cars at fixed prices — the only way such a pricing system can work in the new-car business, Hyman says.

Because the major car manufacturers have thousands of dealers across the country, often with more than one independently owned dealership in each market, it means no one is willing to move to fixed prices by themselves.

For example, if one Toyota dealer offers fixed prices in the West End, it would likely drive customers to visit the other Toyota dealership on South Side before making a decision. That puts the West End dealer at a disadvantage. The dealer who doesn't tip his hat first almost always wins, Hyman says.

Why? Blame it on the four-square approach of car sales. The method is well-ingrained. The typical car salesman approaches each customer with a wish list, which is drawn up on a piece of paper: How much do want to pay a month? How much do you want for the trade-in? How much do you want to pay for the car?

In the fourth square, customers are asked to sign their name next to the amount they are willing to deposit. By measuring the customer's response to each question, the salesmen quickly figures out which square is a hot-button issue for the buyer and immediately takes it off the table. Say the customer isn't willing to budge on the trade-in. The salesman concedes the price, or the square, then looks to make up the difference with the remaining squares, say the extras or the car's list price. The system allows the car salesmen to personalize each negotiation — and have the upper hand.

With fixed prices, there are no four squares. It's something that often startles customers. Hyman recalls the week after he opened his Saturn dealership, when he had to watch customer after customer walk out the door. They were so used to the game, they often felt offended when the salespeople wouldn't play ball.

"I questioned myself, my decision," Hyman says. "It was hard to watch people walk out the door."

But it was critical to the model's success, he says. You can't budge on the price, because customers will quickly see through it — and run immediately to the comfort of the hagglers. But ultimately, those customers will come back for the better price if it's the car they want.

It's the discipline that's the hardest for salesmen, especially for those trained in the tradition of the four-square. "They can't adapt to it," Hyman says.

But it may only be a matter of time. The industry is moving toward fixed pricing, says Robert Goodman, operations manager for Hyman's group of five dealerships. The markup on new cars used to average 20 percent, but now it's closer to between 8 and 11 percent, Goodman says. And with customers doing more and more comparison-shopping on the Internet, it's getting more difficult to play four square successfully.

There's also the success of CarMax to deal with. It's become a living testament to fixed prices. While it owns seven new-car dealerships, Ligon says, it's only a matter of time before CarMax takes on the new-car business full scale. Where CarMax has been able to penetrate, it's succeeded. For example, it currently owns the second-largest Toyota dealership in the country in Laurel, Md.

Imagine, says Ligon, if a new car manufacturer entered the U.S. market in the next decade, say China's Chery Automotive Co. By partnering with CarMax, the manufacturer could create a national distribution of dealerships overnight, with all the efficiencies that CarMax has built into its used-car business. That advantage could mean tremendous cost savings to the manufacturer — and the customer.

"The reason that we have pulled back on new cars is this scarce resource: people," Ligon says. "You can only develop so many management teams each year."

Having weathered AutoNation, CarMax has built on its competitive advantage every year by making its complex business model more exclusive and seemingly impenetrable.

In the beginning CarMax got most of its cars from auctioneers and other dealers. Now it gets about 45 percent of its cars from other dealers and auctions, and 55 percent from customers who sell directly to CarMax.

Like selling its own cars, the company has tried to make it easier for customers to sell to them. CarMax promises to make a written cash offer to buy each and every car brought in for an appraisal.

It's become another strength for CarMax, which can use its buying data for internal use. Eventually, Ligon expects CarMax to increase the number of cars it sells that were bought from customers to "60, 65 — even 70 percent."

The system also allows CarMax to turn over its inventory more quickly than its competitors. There is one great example of the company's inventory mastery, says Hoffer, the VCU economics professor. It's how the company responded to the zero percent financing deals that swept the new-car industry following the terrorist attacks of 9/11. With a glut of trade-ins coming into the market, driving down used-car prices dramatically, Hoffer says, "CarMax should have been bankrupt."

Instead, CarMax actually made more money during the zero percent financing craze, Ligon says.

It accomplished this by turning over its inventory before those lower prices cut into its profit margins. Because it had the most sophisticated information system on used-car sales, it was able to buy and sell used cars when dealers wouldn't risk it.

Most CarMax lots are filled with cars that are less than three years old. Vehicles that don't meet the company's inventory needs are sold off at auctions that the company holds every week — auctions restricted to private dealers.

After 9/11, CarMax lost money on the auctions.

"We'd buy the car last week, and by the time we auctioned it off, it had fallen further in value," Ligon says. "But every other dealer in town — they were getting terrified of taking trades at all, and they were just saying ... 'We'll sell you a car, but you have to take care of your trade on your own.'"

That sent people desperate to unload their vehicles to CarMax.

"And what happened is we had a huge boom in [customers] bringing us their cars," Ligon says. "And it actually led to a sales boom that more than offset what we were losing on the wholesale side of the business, because we were the only people out there willing to buy a car for several weeks."

CarMax has another tremendous advantage. It's been gathering used-car data for 13 years. Cars have a radio frequency identification strip that sends signals to a computer each time they're driven off the lot for a test drive. The company knows how many credit applications are taken out on each car and how many people looked it up on the Internet.

"The idea is capture all the data that you can in the simplest way possible with the least human effort that lets you understand which of my inventory is the most attractive inventory," Ligon says.

Most new-car dealers are moving around prices so often that they "don't actually know what they paid for a used car," Ligon says. "That creates data havoc in terms of understanding what's going on in your business."

For CarMax, the future is bright. It's penetrated only a fraction of the market. To reach full capacity, Ligon says, CarMax could grow to at least 250 to 300 stores nationwide during the next eight to 10 years.

That growth has been left in the hands of a young man originally spotted on a Florida car lot. Folliard appears to have the support of the rank and file. At last month's shareholders' meeting, he stood at the doorway greeting employees. He had an easy, quick-witted rapport with the group as he gave his first speech as president and CEO.

A basketball standout at Florida Tech, Folliard, a shooting guard, holds the school record for three-pointers in a single game (9), which he set during the 1986-87 season. He loves basketball — his father was the team's coach — and remembers working as a graduate assistant for the team when a buddy asked if he wanted to make a few extra bucks driving cars to and from wholesale auctions.

After earning his bachelor's degree in business management, Folliard needed a job while he waited for his then future wife to finish college. He started selling cars. He had no idea he would soon play a vital role in reshaping the entire used-car industry.

In a back room at CarMax's Midlothian store two weeks ago, a group of buyers light up at the mere mention of his name. Folliard, says buyer Veronica Watts, "is one of the nicest guys in the world. He talks with anyone."

Car buyer George A. Rodgers cracks a wide smile at his mention, albeit for a different reason. He says Folliard's biggest problem is his ball-hogging. In pickup games, the chief executive still hasn't learned to pass. "Once he gets the basketball in his hands," Rodgers says, "he won't let go until it's in the basket." S

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