Description

Carmax Inc. stock (KMX) is up over 30% YTD yet remains a compelling risk/reward as it is now one of the best-positioned retailers to actually execute on a true omnichannel strategy in a margin-neutral manner.  The company was founded 25 years ago to provide a better customer experience for used car buying based on competitive, no-haggle pricing. Carmax has been a solid long-term compounder throughout most of its history, growing its presence to 206 stores in 42 states and becoming the nation's largest retailer of used vehicles (sold approximately ~750,000 units at retail and another ~450,000 via wholesale auction in CY2018).  The company also operates an in-house financing arm, Carmax Auto Finance, that is well managed and profitable. Despite this success and scale, the company only commands 3.3% market share of the 0- to 10-year-old on a nationwide basis (KMX share is ~4.4% in its current comparable markets) and should enjoy several years of expansion and share gains.  

The company demonstrated its ability for solid growth and share gains from CY2010 through CY2016 with comparable sales growth averaging +5.6% over this timeframe.  However, comp growth slowed over the course of CY2017 (+1.9%) and CY2018 (+0.3%), causing KMX shares to come under pressure. As the business slowed, management said that it was difficult to pinpoint the precise source of the softness.  They foremost cited the narrowing price gap between used cars new cars, as dealer incentives compressed the premium for buying a new car to multi-year lows. While this was no doubt a key factor, Carmax's delay in responding to new online competitors was another major factor that management was initially hesitant to acknowledge.  This rise of online competitors, most notably Carvana, occurred far more rapidly than Carmax management anticipated. The chart below illustrates the magnitude of Carvana's ascent, with Carvana adding a greater number of incremental units versus Carmax over five quarters from 4Q 2017 through 4Q 2018 (~58,000 cumulative versus ~22,000):

Given Carvana was/is showing no signs of slowing down, questions arose if Carmax's would see its traditional business model permanently impaired from online disruption like so many other retailers.  Fortunately, while Carmax initially was slow to anticipate the rise of Carvana and others, its management team has developed a credible omnichannel strategy and been investing heavily behind the following initiatives to meet its customers wherever and whenever they want:

• New web site platform

• Improved digital merchandising (new photos; 360-degree interior viewer)

• Optimized search functionality

• Online finance approval

• Online appraisal

• Expanded free transfer radius

• Home delivery offering

• New marketing campaign

Carmax recently launched a pilot of this entire omnichannel offering in Atlanta in 4Q 2018 and has reported a double-digit lift in this market in each of the subsequent two quarters.  The company recently expanded this offering to most markets in Florida and channel checks indicate a lift there as well. The plan is to continue to roll out this offering a majority of markets over the course of the current year and be in essentially all markets next year.  Carmax is also opening three Customer Experience Centers (CECs), dedicated call centers for the express support of customers on their online journey. Previously, online call support was handled by in-store associates on a part-time basis, which was a sub-optimal experience for Carmax customers.  As the CECs ramp, Carmax customers will have a better experience and the company will be able to run its stores more efficiently with fewer salespeople.   

90% of customers begin their car-buying journey online, and Carmax will soon be at the point where its customers will be able to complete as much or as little of that journey online as they choose.  However, it is also important to note here that buying a car remains a category where consumers still overwhelmingly choose to finish the transaction in person. Even Carvana's growth has accelerated after it began rolling out its physical "vending machine" locations, with its CEO recently noting that 50% of their customers choose to go pick up the car versus having it delivered in markets where Carvana operates a vending machine.  With its 206 stores and growing (stated long-term target of up to 300 locations), and soon coupled with a complete online solution, Carmax will be well positioned to resume its historical growth trajectory. Very few competitors will be able to similarly compete with Carmax or Carvana, so this advantage will likely grow over time.  

Recent trends already show promise.  In 1Q CY2019, Carmax reported an overall comp of +9.5% which is an encouraging result given the omnichannel pilot was only live in the Atlanta market.  Also notable is that they added more incremental units than Carvana for the first time in six quarters (Carmax added ~25,900 versus Carvana at ~18,300).  In addition to these various initiatives, the new/used car pricing gap has improved as off-lease vehicle supply increases, which should help unit sales in at least the near term.  Carmax also has relatively undemanding comps for the balance of the year (lapping average comp of +1.3% over next three quarters). Consensus expectations have moved higher following the 1Q  (roughly +4% give or take over next four quarters), but the company should be well positioned to meet or exceed these levels given the ongoing omnichannel rollout and increasingly favorable pricing backdrop.

The stock is valued at only 15.7x CY2019E and 14.7x CY2020E on consensus numbers.  Over the past five years, Carmax's multiple has ranged from ~12x to ~25x and has averaged ~17.2x.  Given the business quality, long runway for further expansion and demonstrated/credible plans for omnichannel rollout, the stock deserves to re-rate higher.  There are a number of other examples of old-line companies seeing such a re-rating of several turns once they have finally committed to investing in areas where their customers want to go (e.g., WMT now trading for ~22x after buying Jet/Fipkart and demonstrating success with its domestic online grocery rollout; DIS now trading for ~22x after preparing to launch direct streaming offering; etc.).  

A few final notes: The business is highly cash-generative ($1.9 bn in FCF over the last three years) and is buying back stock.  Balance sheet is clean at only ~1.1x net debt to Ebitda. It also owns almost two-thirds of its real estate (owns 129 out of 206 sites). 

Risks:  

• Macro slowdown

• Pricing pressure from CVNA and other online players more severe than we expect over the long term

Catalyst

Ongoing omnichannel rollout / continued execution on strategy