2023-04-14 19:06:30 ET
Summary
- The used car industry is about to enter a recession.
- Both AutoNation, Inc. and CarMax, Inc. were reacting to the recession environment and had solid plans for positioning themselves for long-term success.
- We do not believe the return/risk profiles for both stocks are attractive, though, given that the negative risks of normalization can be substantial. We rated both stocks as Neutral.
Investment Thesis
The question is not to ask whether the U.S. will enter a recession or when will the U.S. enter a recession. The used car industry is likely about to enter or is already in a recession.
Our analysis below shows that, from a time standpoint, the normalization of the new car market and the beginning of the used car supply constraint era are fundamentally favorable to CarMax, Inc. (NYSE: KMX ) and unfavorable to AutoNation, Inc. (NYSE: AN ).
Both companies were reacting to the recession environment and had solid plans for positioning themselves for long-term success.
We do not believe the return/risk profiles for both stocks are attractive, though, given that the negative risks of normalization can be substantial. We rated both stocks as Neutral.
Company Profile
AutoNation, Inc. is an automotive retailer that operates in all 50 states and is headquartered in Florida. It was founded in 1996. It sells new and used vehicles under a variety of brands, including Toyota, Chevrolet, Ford, and many others. AutoNation also provides various automotive services, including financing, insurance, and repairs. The company operates over 260 locations across the country and employs more than 26,000 people.
CarMax, Inc. is a used car retailer based in Virginia. It was founded in 1993. CarMax has over 240 stores across the country and employs more than 29,000 people. CarMax offers a wide variety of used vehicles, including cars, trucks, SUVs, and vans. CarMax also offers financing and vehicle appraisal services.
Key Takeaways from CarMax Q4 2023 Earnings
CarMax recently reported its fiscal Q4 2023 earnings for the period ended on Feb 28, 2023. This report gives us an early read into the used car industry trend in 2023.
- CarMax's used and wholesale vehicle unit sales decreased by 12.6% and 19% in Q4 2023, improving from -20% to -36%in Q3 2023.
- ASP of used vehicles and wholesale decreased by 9.3% and 27.8% in Q4 2022, worsening from 1.9% and -6% in Q3 2023.
- Sales of used vehicles and wholesale decreased by 21% and 41% at a similar cadence in Q3 2023.
- Used vehicle gross profit per unit increased by 3.8%, accelerating from 0% in Q3 2023.
- Wholesale vehicle gross profit per unit remained flat, improving from -15% in Q3 2023.
- Other gross profit per unit decreased by 13%, improving from -49% in Q3 2023.
Fiscal 2024 CAPEX Spending Outlook
The company expected capital expenditures in FY2024 at approximately $450 million versus its previous estimate of $500 million. This is an increase from the $320 million CAPEX spent in FY2023, as the result of its investment in omni-channel and production facilities.
The management mentioned in the earnings call that the challenges faced by the used auto industry are due to various macro factors such as inflation, interest rates, lending standards, and low consumer confidence. Despite these challenges, the company reduced SG&A, managed to increase retail and wholesale sales, and adjusted offers to deliver strong wholesale GPU. The company remained focused on achieving profitable market share gains that can be sustained for the long term and plan to continue running extensive price elasticity tests.
We have the following comments:
- The company lowered the sale price to clean the inventory in Q4 2023. The company still faced a challenging environment. The top line and bottom line continued to fall, but its unit economics was improving.
- The company increased its direct purchase from consumers and leveraged its own finance vehicle to lift the gross profit margins. SG&A expense as a percentage of revenues improved from Q3 2023.
- Marketing expenses fell much faster than revenue. This implied that there was a basic demand for used cars.
- We can see the company's cost control effort was working and it had stabilized the bottom line.
Company Fundamentals
AutoNation competes with CarMax in similar geographic areas. Their top 3 states by the number of stores are California, Florida, and Texas.
Different Business Models
Though both companies sell used cars, their business models are quite different. AutoNation used its used car sales as a way to generate traffic leads to grow its operations in new cars, financing, and parts and services. For instance, AutoNation made an average of $1800 from used car sales in Q4 2022 and $5600 and $2700 from new car and loan sales respectively. CarMax , on the other hand, earned $2277 per unit from the sale of used cars and $487 per unit from financing in the fourth quarter of 2022.
Companies Faced Different Dynamics in Used Car and New Car Sectors
On the surface, the new car sales segment appeared to remain stable according to the AutoNation study. However, the supply shortages brought on by COVID in 2020 still remained an impact on the new car sales market. AutoNation's supply of new vehicles as of December 2022 was just 19 days, a major improvement over the 9 days in 2021 but still much below the normal 50–60 days level in the company's history.
As the result, AutoNation has been enjoying a nice unit economic boost in new car gross profit per unit since 2020. Its GPU increased by 233% from $1783 in 2019 to $5937 in 2022.
CarMax Q4 2022 results suggested continued pressure in the used car industry due to the high-interest rates environment and tightening lending standards. The challenges being faced have a greater impact on the sale of units in the used car market.
Used cars, though, were less impacted by the supply constraint as the purchase costs of used cars were adjusted dynamically based on market price. Dealership typically carried 40-45 days supply. Hence, the unit economics of used cars is less volatile than that of new cars. For instance, AutoNation's used car gross profit per unit only increased by 27% from $ 1409 in 2019 to $1801 in 2022.
AutoNation is Likely at a Peak and CarMax is at a Trough
AutoNation's new car unit sales increased as the supply of new cars increased, but its new car GPU began to drop in Q4 2022. Overall, the eased strain on the supply of new cars increased AutoNation's revenues but began to hurt its profitability.
AutoNation employed its used car as a traffic generator. As the result, in a difficult environment, AutoNation needs to offer more discounts to customers on its used cars in order to maintain its after-sale service business. CarMax, in contrast to AutoNation, has the option to only take lucrative trades. As a result, CarMax, whose unit economics improved in the Q4 report, is probably going to experience a stabilization in its profitability sooner than AutoNation.
Growth Drivers
CarMax:
- CarMax focused on profitable trades to improve its unit economics. The management mentioned the company likely to lose market share in exchange for profits.
External title data shows that the market share gains we achieved during the first-half of the year were offset by share losses during the second-half of the year as we prioritize profitability over near-term market share.
For context, we have lost the market share during prior down cycles. In those cases, we recovered the market share and then continued to grow up to new heights as economic conditions improved. We remain focused on achieving profitable market share gains that can be sustained for the long-term and plan to continue running extensive price elasticity tests.
- CarMax completed its investment in omni-channel and expected to see leverage on SG&A expense once unit economics improves.
Accordingly, our expectation is that we will bend the expense growth curve on our omnichannel investments and our overall SG&A. In FY ‘24, we expect to require low single-digit gross profit growth to lever SG&A, well below the levels we've guided to during the investment heavy phases of our omni transformation.
AutoNation:
- AutoNation hoped to enhance the long-term profitability of its financing and service business through the acquisition.
We acquired CIG Financial creating AutoNation Finance, and establishing an in-house CFS solution for current and future customers. This business in addition to legacy relationships is currently focused on servicing used vehicle buyers at our AutoNation USA stores, but will expand to our franchise stores later this year. Obviously as this business grows, we will have an increasing more recurring revenue stream.
Now this January, we acquired RepairSmith, a mobile automotive repair and maintenance solution. The acquisition expands our range of services and creates meaningful after sales business opportunities, including utilizing another channel to provide service to automation's existing customer base, and introducing additional vehicle owners, who have purchased vehicles outside the AutoNation dealer network.
RepairSmith also gives our AN USA brand a unique service proposition and customer experience offering a range of off the sales products and services that are standalone used car sales competitors, frankly, just do not have. As you know, we've consistently gone after sales business, which is more recurring revenue stream with a high percentage of customers bring their vehicles into service under warranty. The rate decrease is rapidly after the warranty period ends. And RepairSmith now expands our reach and provides a very convenient means for customers to service their off-warranty vehicles.
We have the following comments. Both companies prioritized unit economics and profitability over market share gain. CarMax's approach was already producing positive financial results.
The Q4 2023 results for CarMax pointed to a more difficult consumer traffic profile in the used cars market. Dealership financing business is highly correlated to unit sales. 64% of AutoNation's gross profits in 2022 came from used cars, new cars, and finance.
AutoNation's bottom line is projected to come under greater pressure in the near future as its new car unit economics experienced a large fall as a result of normalization, its used car business is under promotion pressure, and its financing business is impacted by decreased customer traffic.
Industry
Trickle-Down Effect on the Used Car Sector
According to AutoNation , the supply of used cars for two and four years old is now under pressure.
This can be attributed to the new car supply chain constraint, which has had a trickle-down effect on the availability of used cars.
The good news is that the used car market may soon see less pressure as the new car supply chain has recently started to show signs of improvement.
So it's absolutely clear that unless the sales profile has been in the used car market in the United States for years is going to dramatically change. We are entering a period of tight supply on two and three and four-year-old vehicles, which make up the majority of these car sales. And that's going to impact wholesale prices and ultimately retail prices, margins I think are going to be fine.
New Car supply not fully recover
AutoNation reported that new car sales increased due to the easing of supply constraints. However, the shortage remained and the market has not fully recovered from the disruptions.
Full -year U.S. industry new vehicle unit sales were 13.9 million in 2022, as compared to 15.1 million in 2021, and 14.6 million in 2020. There continues to be a shortage of available new vehicles for sale as compared to historical inventory levels driven largely by disruptions in the manufacturers’ supply chains. Although new vehicle inventory levels for certain manufacturers improved slightly during the second half of 2022, the demand for vehicles generally continued to exceed supply throughout the year. This demand and supply imbalance continues to result in higher levels of profitability for available new vehicles. The reduced levels of total new vehicle availability is currently expected to continue into 2023; however, there is still significant uncertainty as to the extent to which new vehicle availability will improve, as well as duration and/or degree of the higher levels of profitability being realized during this time.
The latest March 2023 retail sales data supported the above argument that auto sales continued to decline both quarter over quarter from Feb 2023 and year over year from Mar 2033, respectively.
Unit Sale Normalization
According to Fed , it expected the unemployment rate to increase to 4.5%-4.6% in 2023-2025, similar to the level of 2017. We believe that new car unit sales are likely to recover to the 2017 level of 17 million units yearly when taking into account the Fed's unemployment prediction and statistics from the Bureau of Transportation Statistics. Additionally, given that the used car market is more susceptible to interest rate changes than the new car market, we anticipate that used car unit sales will fall below the 39 million unit level of 2017.
Valuation
We won't use cash flow multiple or the discounted cash flow ("DCF") model to value these equities because of the swings in the used vehicle industry's working capital and CAPEX spending.
The P/E ratio for CarMax is trading above its five-year average. We believe that its P/E ratio will drop to a mean level as unit economics continue to improve.
AutoNation's P/E ratio is trading below both the sector median and its five-year average. We think the market expected that AutoNation will start to experience an increase in acquisition costs and a loss in profits in the new car, used car, and financing markets as new car unit economics normalized to pre-pandemic levels and the supply pressure communicated to the used car market.
AutoNation's profits will drop by $1.4 billion if we assume new car sales profit per unit and unit sales normalize to the 2019 level. After this adjustment, its P/E ratio rises to 19.48x, which is higher than its 10-year trend.
Thus, we think neither CarMax's nor AutoNation's stock is cheap at the current level.
Catalyst
Shares buyback
It's noteworthy to note that while CarMax didn't aggressively buy stock, AutoNation did. Additionally, insiders' activities pointed to a different perspective. Unlike the CEO of AutoNation, the CEO of CarMax was purchasing the stock.
During 2022, we invested $1.7 billion reducing our share count by 25% to 47.6 million shares at year-end. Full-year share repurchases totaled 15.6 million shares, 4.6 of which were repurchased in the fourth quarter alone. Thus far in 2023, we have purchased an additional 800,000 shares with more than $1 billion of remaining share repurchase authority.
CarMax :
We continue to pause our share buybacks. Our $2.45 billion authorization remains in place as does our commitment to return capital to shareholders over time.
We believe that timing-wise, the normalization of the new car market and the beginning of the used car supply constraint era are favorable to CarMax and unfavorable to AutoNation.
In the short term, AutoNation realized that the acquisition probably won't do much to boost its bottom line and hence its buyback of shares to enhance shareholder return is reasonable.
On the other hand, we believe that the CEO of CarMax purchased shares in December 2022 to demonstrate his confidence as the company's unit economics began to sequentially improve. This did not imply that the stock had reached its bottom, though.
Risks
Interest rate risk
The current high-interest rate environment and supply constraints within the used car market are expected to limit the volume of pre-owned car sales, potentially keeping them below 2017 levels.
In addition, if the Federal Reserve decides to increase interest rates further, the overall demand for used cars may decline even further, exacerbating the situation.
If this leads to a rise in unemployment rates due to decreased demand, it can create a downward spiral for the car industry.
Summary
We believe that from a time standpoint, the normalization of the new car market and the beginning of the used car supply constraint era are fundamentally favorable to CarMax, Inc. and unfavorable to AutoNation, Inc.
Both companies were reacting to the environment and had solid plans for positioning themselves for long-term success.
We do not believe the return/risk profiles for both stocks are attractive, though, given that the negative risks of normalization can be substantial. We rate both CarMax, Inc. and AutoNation, Inc. stocks as Neutral.
For further details see:
AutoNation Vs. CarMax: The Future Of Dealerships Amid Recession Uncertainty