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CarMax (NYSE:KMX) is poised to lead the used auto market for many years to come, led by its restructuring of how cars are sold via its “no haggle” philosophy, and investments in omnichannel retailing, where the goal is making the process as easy as possible for the consumer via whatever channel makes the most sense, such as delivering a car directly to the consumer. CarMax benefits from participating in every part of the value chain from purchasing trade-ins, to financing, to of course the actual selling of the vehicle, to selling value-add programs such as extended protection. Mr. Market is extremely frightful of the short-term future for CarMax, where affordability and higher rates converge with a likely recession, leading to a decrease in sales and margin. For about the 10th time in ten years, market prognosticators are once again predicting carnage in auto loans, so we can investigate the bear thesis there. Long-term investors that are interested in buying actual quality businesses at large discounts to intrinsic value would be wise to take advantage of Mr. Market’s pessimism while shares are on sale.
The used car market is highly fragmented, with many competitors owning just a couple of lots, instead of being big chains. CarMax only controls about 4% of the 0-10-year-old used car market, despite being the biggest player. This has opened the door for companies such as CarMax to bring an innovative, uniform, and dynamic retail experience, while expanding across a national footprint. CarMax leverages its industry heft to enhance its offerings and technology, such as Max Offer to appraise cars from other dealers or enhancing logistics on moving over 2 million vehicles per year. CarMax estimates that its internal logistics operation drives about a 20% cost advantage over 3rd party providers, while improving speed and dependability. Ultimately, this allows CarMax to offer lower costs to its customers, which is vital as people come to CarMax expecting a good deal on their vehicle purchase.
Upstarts such as Carvana (CVNA) had been growing like gangbusters, buying cars high and selling them low at terrible gross margins, but with the stock down 95%, a restructuring seems quite likely. Being the strongest company in an industry where many of the competitors will die, should help CarMax come out of the other side of this with a stronger market share and competitive position. Carvana’s growth and technological appeal has made it even more important for CarMax to invest heavily into enhancing its omnichannel capabilities. Simply put, CarMax must be able to appraise, buy and sell cars, in whatever way is the best fit to suit the needs of its customers. Ultimately, as weaker competitors have to pull back from the used car market, gross margins should expand once again, which will lead to higher profits generated in the next cycle.
On December 22nd, CarMax reported an extremely disappointing 3rd quarter, as vehicle affordability and pressure from higher interest rates resulted in a significant decline in sales. Total sales of $6.5B were down 24% YoY, driven by lower retail and wholesale volume. Total unit sales in the retail business declined by 20.8% and used unit comps were down 22.4% YoY. Last year was a very challenging comp given the company had achieved a 15.8% used unit comp, highlighting just how different conditions are now in relation to just 12 months ago. The big difference is that used car prices rose so dramatically on high demand and weak new car supply that they became much less affordable. Then interest rates rose dramatically, and people with good credit show up to buy a car and are now offered 9-10% interest rates, which is just highly unattractive. Predictably sales are starting to decline rapidly in that environment.
Management believes that the company has gained market share year-to-date, but that recently it has been pressured by competitors offloading inventory at cheaper prices, which CarMax hasn’t matched at this point, as its focus is on long-term profitability. In Q3, retail gross profit per used unit was $2,237, which was flat YoY, while unit sales were down 36.7%, due to rapidly changing market conditions, including about $2,000 of depreciation, which was incremental to the roughly $2,500 of depreciation seen in Q2. CarMax has been shifting some older vehicles from wholesale to retail to meet consumer demand for lower priced vehicles. Gross profit per unit was $966, down from a record Q3 a year ago when gross profit per unit was $1,131.
CarMax bought roughly 238,000 vehicles from consumers and dealers in Q3, which was down 40% YoY. Volume was impacted by steep depreciation and management’s decision to slow purchases in reaction to that. 224,000 of those vehicle purchases were from consumers with about half of those buys coming from the company’s online instant appraisal experience. The company also sourced about 14,000 vehicles through Max Offer, which is the company’s digital appraisal product for dealers, which was up 16% YoY. 12% of retail unit sales were online, which was up from 9% from a year ago. 52% of retail unit sales were omni-channel, down from 57% last year.
The company is responding to the disappointing sales results by reducing SG&A spending, selling a higher mix of older lower priced vehicles, slowing vehicle purchases, and driving down total inventory levels. CarMax is increasing the interest rates it charges customers to help offset the rising cost of funds, while also pausing share buybacks to preserve capital flexibility. In addition, the company is slowing its planned store growth over the next fiscal year to just five locations, while keeping some optionality to open more if conditions improve. CarMax stores are big endeavors and investments, so focusing on the simple blocking and tackling of the business during this challenging environment seems intelligent to me.
CarMax Auto Finance delivered income of $152MM, down from $166MM at the same time last year. Interest expense increased to $88.8MM from $53.6MM at the same time last year, while interest and fee income increased to $365.4MM, from $330MM a year ago. CarMax Auto Finance (CAF) penetration was stable at roughly 60%. The credit platform provided approvals for over 95% of the consumers who applied for credit. CAF originated $2.1B within the quarter, resulting in a penetration of 44.4% net 3-day payoffs, up from 42.2% a year ago. The weighted average contract rate charged to new customers was a whopping 9.8%, which was up from 8.3% YoY, and 9.4% sequentially. The loan loss provision was $86MM in the quarter, up from $76MM a year ago, resulting in an ending reserve balance of $491MM, which is 2.95% of managed receivables. The company has slightly increased its reserve balance percentage as it has taken on a bit more Tier-2 and Tier-3 receivables of late. The company targets a loss range of up to 2 to 2.5%. It is very fashionable to predict huge losses in car loans and I’ve seen these dark predictions just about every year since the Financial Crisis. People don’t buy used cars as an investment that they expect to appreciate. The cars serve the purpose of driving people to work or other activities. As long as they are employed, they are likely to keep paying, even if used cars are declining in value more rapidly than expected. While we could very well be in a recession, it is not reflected in the unemployment data currently.
I fully expect unemployment to go higher, as will defaults and delinquencies, from this recent era of exceptional credit results. With that said, auto-lenders such as CarMax and Ally, are getting high-single digit, low double-digit rates on secured lending. Repossessions are very quick, unlike housing for instance, and cars can then be sold via retail or auctions to minimize losses. Pretax preprovision earnings are very high in auto finance, providing a large cushion before any losses are taken, and lenders are constantly adjusting their lending standards and reserve provisioning to account for changes that they are seeing with credit. CarMax could easily double its quarterly loan loss provision and maintain profitability in its auto finance unit. Lastly, loans are underwritten under the assumption of fairly rapid depreciation, as anyone with a basic knowledge of finance understands that the value of a car declines precipitously upon being driven off the lot. Appreciating used car values during the pandemic/lockdowns after the initial decline, was the aberration. Companies will have a tougher time getting access to capital, which will also be more costly, but this should lead to enhanced lending margins for the stronger companies that can make it through the cycle. When people prognosticate massive auto loan losses that will devastate a company, ask for the inputs. What level of defaults, what % of recovery, and how do those numbers weigh against pre provision earnings and the existing loss reserve? When you actually put those numbers into context, the auto lending arena is much less scary than the newsletter promoters would have you believe. I suspect underwriting margins are quite right now as many banks have pulled out of the arena, so risks are being amply compensated for with rate.
Total 3rd quarter net earnings per diluted share were $.24, down from $1.63 YoY. Total gross profit of $577MM was down 31%, while used retail margin of $403MM and wholesale vehicle margin of $115MM, declined 21% and 46%, respectively. In Q3, SG&A expense was actually higher than gross profit, which naturally was a bit disappointing for investors. Analysts and investors seem to want CarMax to reduce SG&A costs more aggressively than they are currently doing, which is layoffs mostly via attrition as opposed to outright reductions in workforce via layoffs. The company is reluctant to do so because most of the additional cost is technicians, which are hard to find, and are key to the company buying and refurbishing cars to ultimately be sold. CarMax is pausing buybacks but still has a $2.45B authorization. Capex for the fiscal year will now be $450MM, down from the previous estimate of $500MM. The company ended the quarter with $680MM in cash on the balance sheet and nothing drawn on its $2 billion revolver, so it is coming into this downturn from a position of strength.
The stock of CarMax is down over 56% from its 52-week high of $131.20. CarMax has averaged roughly $680MM of net income over the last eleven years. Clearly, 2023 is likely to be a weak year for the company, but I certainly don’t see anything that should halt the trajectory for the company to grow in the future. CarMax sells EVs, gasoline powered cars, and hybrids, so they can benefit from whatever people want to drive. With a market capitalization hovering around $9B, CarMax is trading at about 13x normalized earnings, and at about 10x 2019, or 2020 earnings, if you want to strip out the exceptional results earned last year, where the company had net income of $1.151B. CarMax is a pretty good business, consistently generating a high-teens, or low 20% return on equity. Because CarMax is reliant on capital markets via asset-backed securities, and warehouse lines, I think it is very rational for the company to halt buybacks. The big money is going to come from emerging from this downturn in stronger financial health than your competitors, while also enhancing your technological and geographic advantages. I believe CarMax is worth at least $75 per share, with upside far beyond that into the future, so I view any purchase price in the mid-$50’s as being very attractive. We are in a fear-driven market so I fully believe the stock could trade lower and I’d be willing to dollar-cost average, and/or use the selling of puts options to manufacture a cheaper entry price into the stock.
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