2023-12-03 06:29:37 ET
Summary
- CarMax's shares have underperformed the broader market due to the normalization of the used car market.
- The company's profit engine is its financing business, but there are pressures as reserve appear low, and the stock's multiple is elevated.
- Used car prices have fallen and there is little reason to expect them to appreciate significantly in the next 6-12 months, which may make rising delinquencies more costly.
Shares of CarMax ( KMX ) have been a mixed performer over the past year, losing about 2% while the broader market has rallied. The company has been impacted by the normalization in the used car market. However while it is known for its car sales, KMX’s profit engine is really its financing business. Here, I see pressures, and given where financial firms trade, I view its 20x multiple extremely elevated. I would avoid shares.
In the company’s fiscal second quarter , it earned $0.75, down from $0.79 last year and $0.03 below consensus . Revenue fell by 13% to $7.1 billion with comparable store unit sales down 9% with 342,000 vehicles sold. At the same time, used vehicles prices were down 4% to $27,500, still over 30% above pre-COVID levels.
By now, the used car pricing dynamics are fairly well known. In large part due to supply chain disruptions that hampered new car manufacturing, used car prices soared in the aftermath of the pandemic, posting 40+% gains. As new car production has recovered and government stimulus has worn off, we have begun to see some normalization. Used car prices have fallen 7.1% from last year, according to the CPI index.
I would note that these dynamics are shared by private-sector measures, and there is no sign of let-up. According to Manheim , used car prices have fallen a further 2% in the first half of November, taking the decline to 6.9% from last year. Given the combination of elevated interest rates, high absolute prices, and normalized supply chains, there is little reason to expect used car prices to return to meaningfully appreciate over the next 6-12 months.
In response to weaker market dynamics, KMX has been taken action. Impressively, management did reduce SG&A expense by 12%, largely keeping pace with the revenue decline, which is not easy when revenue falls double digits. Additionally, inventories are down 19% to $3.8 billion as it purchased 292,000 used cars, down 15% from last year. With inventory declining more quickly than sales, KMX should not need to increase promotional activity to move product.
I think it also important to emphasize that KMX is rolling its inventory over every seven weeks or so. It is not stockpiling inventory on speculation of where used car prices are going to be in 6-12 months. As long as the purchase price of its vehicles are moving in tandem with its sales price, it can be somewhat agnostic about used car price levels in this business activity—it is that spread that matters.
In the third quarter, retail used margins were $2,251. This is an 8.1% margin, up slightly from 7.9% last year. In 2019 , CarMax had a $2,186 gross profit per used vehicle. In 2018. It was $2,175. Today, KMX is making only about $80 more per car than it used to, but back then, its margin was about 10.65% because car prices were meaningfully lower. Given the softening market, I would not expect to see KMX’s gross margins widen over the next year, but it appears that its pricing power has returned to normal, and that benefits from COVID supply chain issues are fully behind the company.
Interestingly, online sales are 14% of total retail unit sales, up from 11% last year. I note this because Amazon ( AMZN ) is dipping its toe into the auto sales market, allowing Hyundai dealers to sell new cars through its site. Amazon’s end-goals here are unclear, and it is not trying to bypass the existing dealer model. In the long-run, perhaps it attempts to construct its own auto marketplace, but that appears to be a fairly long-term risk. More online competition would likely be a headwind for margins. But with margins below pre-COVID levels, it is not clear there is material excess profits left that firms like AMZN would seek to capture.
While car sales account for 90+% of revenue, they drive just 15% of KMX’s pre-tax income. KMX is really a financing company. Because financing is the core source of profits, I am also not certain this is a business Amazon would be as excited about getting aggressively involved with.
Its financing unit saw profits fall 26% to $135 million. It provisioned $90 million for credit losses from $76 million last year. Its net interest margin declined to 6.1% from 7.3% last year, even as its rate on new loans rose to 11.1% from 9.4% because of higher funding costs. With the Fed likely complete its interest rate hiking cycle, net interest margin pressures should abate from here. However, I have credit concerns.
KMX has a complicated balance sheet, and it is important to disentangle its financing operations from its corporate activity. It funds its loans via the securitization debt market. These vehicles are collateralized by loans, and KMX earns an interest margin, but it is not responsible for paying back the debt itself. In theory if every auto loan defaulted, it could walk away from these vehicles. Its financing income would effectively fall to $0, but it would not have to pay back the $17 billion in non-recourse notes payable, which are secured by $17.5 billion of net auto loan receivables and restricted cash. KMX itself has corporate cash of $521 million against $1.9 billion of debt.
KMX has $17.3 billion in managed receivables, up from $16.2 billion last year. This is about a 6% increase. During this time, it has increased allowances for losses by nearly 13% to $538 million. As such, it has 3.1% allowance for credit losses coverage of its loans outstanding. During the quarter, there were $2.2 billion in originations with $143 million of charge-offs against $56 million in recoveries.
I believe it is important to see where the charge-offs are occurring. As you can see, KMX has not charged off essentially any fiscal 2024 (starting March 1, 2023) loans yet—this is because it is highly unusual to default within a few months of getting a loan. In 2020-2021, charge-offs are running below 1.5% as consumers benefited from government stimulus. For loans originated in 2022, as things began to normalize, charge-offs are now 2%. It is concerning the 2023 vintage is already up to a 2% charge-off, even though they are younger loans than 2022. This points to ongoing credit and underwriting deterioration.
This has the potential to keep charge-offs elevated. Here, is where there is greater concern about used car prices, KMX has been recovering about 35% of total charge-offs. However, if loans issued when used car prices were 10% higher default and have to be sold in today’s market, there is the potential for each default to have a higher loss. Defaults are more costly in a deteriorating than strengthening market.
That leaves me concerned that KMX’s 3.1% reserve level is light, as losses on defaults could be higher and delinquencies have been rising. 5.5% of loans are 30+ day delinquency rate, up from 5% at the end of February. This is concentrated in the more likely to default 60+ delinquency rate where 2.5% are now past due from 2.1% at the end of February. As the 2020-2021 vintages continue to shrink and its mix of loans shift negatively, this level may continue to rise.
For comparison, Ally ( ALLY ) has a 3.6% allowance ratio with a 3.85% 30+ day delinquency rate on its large book of auto loans. This is an incremental 50bp of loan loss coverage even as its delinquency rate is 165bp lower. Now, it could be that Ally and banks are reserving excessively, and KMX’s reserve levels prove correct. Still, in that case, their earnings would eventually be boosted by reserve releases that KMX would not generate.
If KMX brings reserves to ALLY’s level of 3.6% over the next year, that would reduce earnings by $0.40. If it brought it to 90% of 30+ day delinquencies, similar to Ally, that would reduce go-forward profits by $1.50-$1.65, or about half of its current earnings run-rate. Given its elevated corporate cash position, the company is resuming its buyback program, which may provide some support for shares, and we are likely seeing gross margins on auto sales bottom, but these tailwinds are likely to be dwarfed by pressure on its financing profits. Assuming even modest reserve increases, it will be difficult for KMX to earn more than $3 a share over the next year in my view, making the stock expensive at 22x.
For comparison, banks like Ally have about a 10x P/E. Now, KMX’s securitizations are non-recourse via a bank’s debt, which does reduce downside risk on its financing unit—essentially income can fall to zero but not sustainably go negative. Even at a 15x P/E, reflecting this business model advantage, fair value is in the mid-$40’s. For investors comfortable with credit risk, I think they will find greater upside looking into the financial sector, as KMX’s profits are largely financial in nature, but its valuation is quite high given the likely trajectory of credit losses.
For further details see:
CarMax: Potential Credit Losses Make Shares Unattractive