CarMax: Near-Term Headwinds Present Long-Term Opportunity

CarMax (NYSE:KMX) shares have had a rough year, falling over 24% following the release of a disappointing set of 2Q results. Shares are now down nearly 55% over the past year. While near-term conditions are likely to remain difficult, CarMax is a long term market share gainer with meaningful competitive advantages. I see the current share price weakness as an opportunity to buy shares of an excellent business 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 retail locations and also sells vehicles online. 80% of the US population live within 60 miles of a store. The US used car market is massive, with roughly 40MM units per year changing hands, served by over with 30,000 dealers.

CarMax purchases more cars from consumers as it sells to them: In the year just ended, the company bought 1.4MM cars from consumers versus 924,000 cars sold at retail. Roughly half of the cars purchased by CarMax meet standards to be sold at retail (the company focuses on vehicles 0-10 years old) with the remainder sold to other dealers via wholesale auctions (conducted by CarMax). Wholesale gross profits were 23% of total gross profits in F22.

In addition CarMax provides direct financing to 40-50% of its customers via CarMax Auto Finance (CAF segment). While CarMax directly finances its most creditworthy customers, it uses partners like Ally Financial (ALLY) to provide financing for customers with greater credit risk. While CarMax provides direct financing to nearly half its customers, the company securitizes these loans into the asset backed financing market (‘ABS’) which frees CarMax and limits credit risk and capital requirements.

Near-Term Challenges

2021 was a banner year for CarMax as a shortage of new cars (supply chain disruption) lead to more consumers buying used cars and also drove unprecedented used car price appreciation. This benefitted CarMax’s gross margins as used cars typically experience modest depreciation while held in inventory. Similarly, rising used car prices reduced loan loss provisions to virtually zero in the CAF segment.

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

1/ supply chain normalization has increased new car production and deliveries, reducing demand for used cars.

2/ gross margins have suffered as the value of used cars held in inventory is now depreciating rather than appreciating. The rate of depreciation experienced in 2022 is greater than normal given the super-normal used car appreciation achieved in 2021.

3/ loan losses provisions have increased due to both increased vehicle depreciation and a weakening economy.

These headwinds are likely to persist (and may worsen) for the remainder of the year and into 2023, particularly as the economy is softening. While CarMax earned just under $7 per share in 2021, 2022 earnings are likely to come in below $4/share.

Long-Term Competitive Advantages

Despite a very difficult near-term environment, CarMax has several meaningful long-term competitive advantages. The most significant advantage is scale – CarMax operates over 200 stores and buys 1.4 million vehicles per year and sells nearly one million per year at retail (and sells nearly one million wholesale). Most used car dealerships are small operators with less than 5 locations. CarMax benefits from a massive scale advantage which allows 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 do not have the resources to do this. CarMax customers can conduct the entire purchase, sale, and financing transaction entirely online.

B/ Data and scope of network. Given the massive volume of cars bought and sold, CarMax has a tremendous advantage in understanding real-time vehicle pricing and regional differences. This gives CarMax the ability to move cars between locations to achieve optimal pricing – for instance a four-wheel drive SUV may sell for 5-10% more in places like the midwest/northeast (rain, snow) than in the sunbelt. CarMax is able to shift inventory to markets where it can achieve greater profits.

C/ Lower cost to refurbish cars. Upon buying a used car, the vehicle goes through a refurbishment process whereby the oil, tires, filters, wipers are replaced and repairs are made. CarMax’s scale allows for significant savings in procurement of things like tires/filters, while its large volume allows for more efficient use of labor.

D/ Brand – CarMax has developed a strong reputation for fair dealing in its 30-year operating history. This is a significant advantage in an industry which typically has reputational issues.

E/ Financial Strength – CarMax has successfully completed nearly 70 ABS securitizations (process by which it sells its used car loan portfolio) including during turbulent periods (like the GFC) and has a solid reputation in the capital markets. This gives the company the ability to finance its customers in all economic environments.

Further, the company has a strong balance sheet with net debt (recourse)/EBITDA of ~2x. CarMax’s largest competitor, Carvana (CVNA) which pioneered online used car transactions, remains unprofitable and may be in financial difficulty which could curtail its expansion plans which could accelerate CarMax’s market share gains.

Valuation & Conclusion

Despite operating in a cyclical industry, as shown above, CarMax has steadily grown revenue and EPS at a double-digit rates over the past 12 years. Looking forward, I expect CarMax to earn ~$8 per share in 2025 (year end Feb 2026). Here are my assumptions:

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Source: Author Estimates; All figures in USD millions

While gross margins are currently depressed (9-10%) due to the factors cited above, I expect gross margins to revert to historical average of 13%. The company will continue to benefit from SG&A efficiencies as it gains market share and leverages fixed costs. As it gains market share, financing income will expand (financing income follows units sold at retail).

CarMax has historically traded at 12-20x EPS. Assuming a 15x multiple (just below the midpoint), I expect CarMax to be worth $120 per share looking out 3 years (+87% versus the current price).

I believe that today’s share price represents a compelling entry point for long-term investors to own a competitively advantaged business at a deep discount to my estimate of fair value.