2023-12-05 13:07:24 ET
Summary
- CarMax's declining revenue phase is expected to reverse as year-over-year comparisons become easier in the coming quarters.
- The margin prospects also look good thanks to management's productivity initiatives and potential volume recovery.
- Valuation is reasonable.
Investment Thesis
CarMax's ( KMX ) year-long declining revenue phase should reverse moving forward as the year-over-year comparisons become easier in the coming quarters. Further, a potential reversal in the interest rate cycle and the company's good execution in terms of improving customer experience in its online platforms should help sales in the medium to long term.
On the margin front, the company should benefit from improving volume leverage from sales recovery, and cost-saving measures. So, I believe the company's overall growth prospects are improving. Moreover, the valuation also seems favorable after the recent correction, with the stock trading at a discount to its historical valuation on FY25 (ending February) P/E. I believe this provides a good entry point and hence, I am upgrading my rating to buy.
Revenue Analysis and Outlook
In my previous article , I discussed the near-term concerns with a high interest rate environment affecting the company's demand. Moreover, the valuation was also higher than historical averages and given the tougher end markets, I preferred to stay on the sidelines. The company has reported its Q2 FY23 earnings since then and the stock price has corrected, validating my stance.
In the second quarter of fiscal 2024, the decline in consumer demand for used cars, driven by an inflationary environment with constrained discretionary spending, continued to adversely affect revenue growth, as I anticipated. This resulted in a year-over-year reduction in volumes, seen in both retail and wholesale units of used cars sold. Furthermore, the quarter's sales growth was negatively influenced by a decrease in average selling price. This resulted in a 13.1% YoY decline in net sales to $7.07 billion. This decline included an 11% YoY decline (or 12.5% decline on a comparable basis) in Used Vehicle sales and a 21.8% YoY decline in Wholesale Vehicle sales.
Looking forward, I expect the company's revenue growth to turn positive in the coming quarters as comparisons ease. Further, the likely reversal in the interest rate cycle over the coming years as well as the good execution by KMX in terms of growing its online platform and improving customer engagement should also help its sales.
As I have noted in my previous article, demand in the used car markets has been challenging over the past year due to high interest rates and a tough macroeconomic environment impacting consumer spending. This led to a decrease in price as well as the volume of units sold by the company. If we look at the quarterly revenue growth numbers from last fiscal year, there was a step-down in revenue from Q2FY23 to Q3FY23. While the total revenues were up 2% Y/Y in Q2FY23, they declined 23.7% Y/Y in Q3FY23. So, the comparisons are meaningfully easing from Q3FY24 onwards, which should help Y/Y sales growth in the coming quarters.
Moreover, the high interest rate environment has significantly impacted the company's sales over the last year, but of late there have been some positive data points with inflation trending in the right direction which may result in the Federal Reserve cutting interest rates in the coming year. The analysts at Deutsche Bank recently commented that they see interest rate cuts starting June 2024. This should help the company's sales as it reduces loan EMIs for the customers.
The company's sales growth in the medium to long term should also benefit from its growing online sales and improving customer experience and convenience in buying used cars. In the retail business, CarMax is strategically utilizing data science and artificial intelligence to streamline customer transactions and improve their overall experience. In line with this, the company is actively creating digital tools aimed at guiding customers through the entire buying process, stimulating online sales, and facilitating efficient express pickups.
In the second quarter of fiscal 2024, the company introduced a new system for processing orders in its Customer Experience Centers (CECs). Sales orders initiated through the new system are automatically linked to customers' online accounts and the KMX progression tracker. This tool assists customers throughout each stage of the car-buying process, creating a more seamless experience for those who prefer a combination of self-guided progression and assistance from associates. Additionally, the company is enhancing the capabilities of Skye, KMX's 24/7 virtual assistant. Apart from supporting workflows related to finance applications, vehicle transfers, and appointment reservations, Skye can now provide customers with an instant appraisal offer. Skye assists these customers in completing the next steps for their trade-in, a process previously handled by associates when required.
Additionally, in the wholesale car auction business, KMX is actively experimenting with improvements to its platform, aiming to enhance the data available to dealers for making more informed bids. For example, the company initiated a trial utilizing technology from its collaboration with UVeye, offering more comprehensive information on tire conditions, involving details such as brand, speed, size, and tread depth of each tire. Management reports positive feedback from dealers regarding this feature. I expect these digital enhancements to contribute to an enhanced customer experience, drive growth in online sales, and support overall sales growth in the medium to long term.
Overall, I remain optimistic about the sales recovery prospects ahead and expect revenue declines to reverse in the second half of fiscal 2024 and then show improvement in the medium to long term, helped by the company's good execution and a reversal in the interest rate cycle.
Margin Analysis and Outlook
In the second quarter of fiscal 2024, KMX's margins benefited from a favorable mix of high-margin old cars (8 years and above), which helped offset the headwinds from volume deleveraging. In addition, management's cost-saving measures also helped in reducing SG&A as a percentage of sales and gross profit as compared to previous years. The cost-saving measures included lower non-CAF uncollectible receivables, reduced costs associated with lower staffing levels, and reductions in spending on the company's technology platform. As a result, the gross margin increased by 70 bps YoY to 9.8% and the operating margin increased by 10 bps YoY to 2.6%.
Looking forward, I expect the company's margins to improve. Over the past year, volume deleveraging has negatively affected the company's margin. However, as discussed in the revenue analysis, I expect volume and sales growth to rebound over the coming quarters, which should help margins.
Moreover, management efforts to efficiently manage costs including reducing its headcount to improve productivity and implementing a hiring freeze in its corporate offices should also continue to benefit margins in the coming quarters.
Furthermore, the company is also leveraging AI and automation to enhance productivity. As stated in the revenue analysis, the company launched new capabilities for its 24/7 virtual assistant Skye. These new capabilities automate assistance provided to customers in completing the next steps for their trade-in, a process previously handled by associates when required. These steps should continue reducing the workload of associates and further improving their productivity in the coming quarters, helping margin growth. Hence, I remain optimistic about the company's margin growth prospects ahead.
Valuation and Conclusion
CarMax is currently trading at an 18.53x FY25 (ending February) consensus EPS estimate of $3.64. This is a discount to the historical 5-year average forward P/E of 20.52x. I believe the worst is behind us in terms of fundamentals, and the coming quarters should lay a good long-term growth trajectory for the company. Revenue growth should recover with the help of easing comps, good execution and strength in online offerings, and a potential reversal in the interest rate cycle. The margin outlook is also favorable given cost-saving initiatives and improving productivity. Hence, I am upgrading my rating to buy.
For further details see:
CarMax: Moving To A Buy Rating As Sales Bottom