Description

Summary:

Carmax is an excellent business selling at an attractive price.  A large number of short-term concerns (disappointing comps,affordability, used car depreciation, rapidly rising interest rates/loan losses, corporate investment spending) create an opportunity for long-term investors.  As Peter Lynch famously said, the best places to look for superior ideas are  “under a rock or under a cloud.” My bet is that the clouds over Carmax today will lift.  Even in the very choppy market I anticipate, at 13X trailing earnings it should have very limited downside.  My 2-3 year target (again, not factoring in much, if any, help from the market) is $150—based on $10+ earnings in Fiscal 2026 (2/28 year). This could be quite conservative, as the stock has often commanded a 20+ multiple.  Since almost every reader of this knows something about Carmax–and I am paranoid about being beaten to the punch–this will be a brief report but I am happy to go into more detail in Q&A. Note:  There are four prior VIC reports on the company beginning in 2010:  Two longs and two shorts.  They are worth reading for background.

History and Market:

Carmax was founded in 1993 as a part of Circuit City.  By 2002, it was a totally independent company.  Since 2000 its sales have compounded at 11%/year; earnings have grown at a faster clip.The stated corporate ambition is to “Be the most customer centric and largest online buyer and seller of used cars.” The US used vehicle market is enormous:  Roughly 40MM units/year with 30,000 dealers and online competitors like Carvana.  While  the company was slow in moving to online sales, it has invested aggressively in recent years and now has very robust omni-channel capability.  Notwithstanding the superheated growth of Carvana, its unit sales are less than half of those at Carmax. Without getting into a detailed comparison of the shopping experience offered by the two companies, suffice it to say that Carmax today can offer a customer a totally online experience if she wishes.

Business Analysis:

Carmax is, of course, first thought of as a used car retailer.  In fact, it 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. Of the cars bought, half meet standards to be sold at retail (the company focuses on vehicles 0-10 years old).  Online instant appraisals account for roughly half of total buys from consumers and is a key to very rapid growth in this component of the business.  The volume of cars purchased has had two positive effects:  First, a much bigger wholesale business.  From F18 to F21, annual wholesale units were in a tight band averaging 435.000/year. This jumped to 706K in F22. The company is the 3rd largest wholesaler after Manheim and ADESA (which Carvana is in the process of buying).  Second, it supports the retail business.  Carmax now is 70% self-sufficient versus 40-45% just a couple of years ago-–in other words, 7 out of every 10 cars sold at retail now are bought by the company directly as opposed to at auction.  In the wholesale segment, gross profits/unit average around $1000, which includes a fee paid by the purchasing dealers. Wholesale gross profits were 23% of total gross profits in F22.

Carmax has 235 retail locations and plans on 10 openings in the current year (F23), including its first entry with 3 stores in the greater NYC market. 80% of the US population live within 60 miles of a store.  As mentioned above, Carmax is now a true omnichannel retailer:  Some transactions are totally online, some exclusively in the showroom, but the vast number now include an online component.  In F22, Carmax retailed 924K vehicles, achieving a 4% market share of its served market versus 3.5% the prior year.  Management focuses on gross profit/vehicle, which was $2205 in the year just ended–very consistent with prior years.  The third component of total gross profits (other on the income statement) totals $524/unit, largely derived from service and extended warranties.  

Financing is the third segment. The vast majority of potential customers are offered a loan by Carmax.  Tier One (Prime) loans are warehoused and ultimately securitized by Carmax Auto Finance (CAF). Since 1999, Carmax has had 66 securitizations.  Between 40-45% of retail sales fall in this bucket.  Tier Two (about 20%) are provided by other lenders (Chase, Ally Financial and Capital One, for example), though Carmax is starting to experiment with providing these loans though CAF. The outside lenders pay $400/loan, increased from $300 last year,  to Carmax. Tier Three (clearly sub-prime) are about 10%.  Carmax internalizes 10% of this segment and pays $750, down from $1000 a year ago, to outside lenders to provide these loans.  In the year just ended, CAF earned $$802MM, so it is an important contributor to corporate profitability.  Grant’s Interest Rate Observer (and I’m a fan) has had a number of negative articles over the years about this business, but its track record is excellent.  Note that Carmax does not offer loans longer than 72 months, even though it is a growing trend in the industry.  Also note that CAF does not report any gain on sale income.I 

Near Term Issues:

The company reported disappointing Q4 (2/28) earnings last week. Retail comps were down 6.5%.  Management cited flagging consumer confidence, affordability, Omicron, and lapping the stimulus payments of early 2021, but still noted that the company continued to gain market share in the quarter.  The company plans a meaningful increase in both SG&A (“We expect to require an increase beyond the 5-8% range of gross profit growth to lever [SG&A] in FY23 . . . though we expect our leverage point to go down after FY23”) and capital spending ($500MM plan versus $308MM.  So there are a lot of moving parts, but it is easy to imagine Carmax reporting down earnings this year,even though CEO Bill Nash noted, “We are well positioned to deliver profitable market share gains in any environment.”

Stock Buybacks:

Since 2013 Carmax has committed over $5 billion to share repurchases, retiring 38% of its outstanding shares.  In the year just ended the company bought back 4.55MM shares for $562MM ($124 average price).  Accompanying the Q4 earnings release, management announced an additional $2 billion in the program, bringing the total to $2.7 billion. The company is very cash generative and I expect buybacks to continue at an average pace of $500-600MM/year.

Long Term Objectives (FY26):

These were announced at the Analyst Day in 2021 and raised with recent earnings:

• 2.0-2.4MM retail and wholesale units

• $33-45 billion revenues

• >5% market share (0-10 year old vehicles)

Carvana:

I have no idea whether the company can succeed or not; the VIC commentary on both sides of the issue is fascinating.  But I do believe that Carmax can continue to be very successful even if Carvana can achieve profitability.  If you have read this far and are curious about the competitive dynamics, I would encourage you to pick a couple of late model used cars and comparison shop on each company’s website.

Catalyst

Time; progress on business plan.