CarMax: Short-Term Headwinds Present Long-Term Opportunity – Seek Alpha | CarTailz

Keith Lance

CarMax (NYSE:KMX) shares had a tough year, falling over 24% after releasing disappointing second-quarter results. Shares are now down nearly 55% over the past year. While near-term conditions are likely to remain challenging, CarMax a long-term market share winner with significant competitive advantages. I see the current price weakness as an opportunity to buy shares in a great company at a bargain price.

overview

CarMax is the leading buyer and seller of used cars in the US with a 3.6% market share. CarMax has 235 sales outlets and also sells vehicles online. 80% of the US population lives within 60 miles of a store. The US used car market is huge, with around 40 million units per year served by over 30,000 dealerships.

mkt sch

market share (CarMax investor presentation)

CarMax buys more cars from consumers than it sells to them: In the year just ended, the company bought 1.4 million cars from consumers versus 924,000 cars sold at retail. About half of the cars CarMax buys meet the standards for retail sale (the company focuses on vehicles 0-10 years old), while the rest are sold to other dealers through wholesale auctions (conducted by CarMax). Wholesale gross profits accounted for 23% of total gross profits in F22.

In addition, CarMax offers direct financing to 40-50% of its customers through CarMax Auto Finance (CAF segment). While CarMax funds its most creditworthy customers directly, it uses partners like Ally Financial (ALLY) to provide financing for customers with higher credit risk. While CarMax provides direct financing to almost half of its customers, the Company securitizes these loans in the Asset Backed Financing (“ABS”) market, relieving CarMax and limiting credit risk and capital requirements.

Short term challenges

2021 was a stellar year for CarMax as a shortage of new cars (supply chain disruption) led to more consumers buying used cars and also prompted an unprecedented increase in the price of used cars. This benefited CarMax’s gross margins, as used cars typically experience modest depreciation while held in inventory. Likewise, rising used car prices reduced loan loss provisions in the CAF segment to practically zero.

2022 has seen a reversal of these favorable (but unsustainable) trends:

1/ The normalization of the supply chain has increased production and deliveries of new cars and reduced demand for used cars.

2/ Gross margins have suffered as the value of used cars in inventory is now declining rather than increasing. The depreciation rate recorded in 2022 is higher than normal given the above-average increase in the value of used cars in 2021.

3/ Loan loss provisions have increased due to both increased vehicle depreciation and a slowing economy.

These headwinds are likely to continue (and potentially intensify) for the remainder of the year and into 2023, especially as the economy weakens. While CarMax earned just under $7 per share in 2021, earnings should come in under $4 per share in 2022.

Long-term competitive advantages

Despite a very difficult short-term environment, CarMax has several significant long-term competitive advantages. The most significant benefit is scale — CarMax operates over 200 stores and buys 1.4 million vehicles a year and retails nearly a million a year (and wholesales nearly a million). Most used car dealers are small operators with fewer than 5 locations. CarMax benefits from a massive economies of scale, allowing it to:

A/ Invest in a leading digital experience. CarMax has invested well over $100 million in e-commerce initiatives. Obviously, small used car dealers don’t have the resources to do this. CarMax customers can complete the entire purchase, sale and financing process online.

B/ Data and scope of the network. With the massive volume of cars being bought and sold, CarMax has a huge advantage when it comes to understanding vehicle prices and regional differences in real-time. This gives CarMax the ability to move cars between locations to get optimal prices – for example, a 4×4 can sell for 5-10% more in locations like the Midwest/Northeast (rain, snow) than in the Sunbelt. CarMax is able to move inventory to markets where greater profits can be made.

Data

Data Benefits (CarMax investor presentation)

C/ Lower car overhaul costs. When you buy a used car, the vehicle goes through a refurbishment process that involves replacing the oil, tires, filters, windshield wipers, and making repairs. CarMax’s size allows for significant savings on purchasing things like tires/filters, while the large volume allows for more efficient use of manpower.

D/ Brand – In its 30 year history, CarMax has built a solid reputation for fair dealing. This is a significant benefit in an industry that typically has reputation issues.

E/ Financial Strength – CarMax has successfully completed almost 70 ABS securitizations (sale process of its used car loan portfolio) even in turbulent times (like the GFC) and enjoys a solid reputation in the capital markets. This gives the company the ability to finance its customers in all economic environments.

In addition, the company has a strong balance sheet with net debt (recourse)/EBITDA of ~2x. CarMax’s biggest competitor, Carvana (CVNA), which pioneered online used car transactions, remains unprofitable and may face financial difficulties, which could limit its expansion plans, which could accelerate CarMax’s market share gains.

Rating & conclusion

EPS over time

Historical snapshot (CarMax investor presentation)

Although CarMax operates in a cyclical industry, as shown above, it has consistently grown revenue and earnings per share by double digits over the past 12 years. Looking ahead, I expect CarMax to earn ~$8 per share in 2025 (year-end February 2026). Here are my guesses:

revenue

30,000

versus the $33 billion target

A

gross margin

13%

B

gross profit

3,900

C=A*B

Selling and Administrative Expenses

2,826

growing 5% per year

D

CAF income

1,000

E

THERE

250

f

interest expense

125

G

profit before taxes

1,699

H=C-D+EFG

Steer

391

at 23%

I

net income

1.308

J=HI

shares outstanding

162

K

eps

8.08

M=J/K

Source: author estimates; All figures in USD millions

While gross margins are currently depressed (9-10%) due to the above factors, I expect gross margins to return to the historical average of 13%. The company will continue to benefit from SG&A efficiencies as it gains market share and leverages fixed costs. Financing returns will increase as market share increases (financing returns follow retail units sold).

CarMax has historically traded at 12x to 20x EPS. Assuming a 15x multiple (just below median), I expect CarMax to be worth $120 a share going 3 years (+87% from current price).

I believe today’s stock price represents a compelling entry point for long-term investors to acquire a company with competitive advantage at a significant discount to my fair value estimate.

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