CarMax: Let It Pull Back More (NYSE:KMX)

Prepared by Tara, Senior Analyst at BAD BEAT Investing

As a reminder, our team recommended CarMax (KMX) about a year ago at $58 per share, but of course, you will recall that we encouraged our members to lock in gains while letting the house’s money run on a remaining position back before Christmas 2019. As we began to emerge from the depths of the market selloff from COVID-19, we pegged CarMax as a name that would rebound nicely, though it has been a faster bounce off the lows than we were anticipating. CarMax has held its own. The question is whether you should stay in the name, or, if you are on the sidelines, consider entering a new position here? We want you to buy the name, but let it come down. Buy it if the market takes this into the $80s. We think a hold is fine but wait a bit more before considering a new position. The just reported quarter reflected fundamental improvement going forward.

Competitive market but demand for used cars is strong

So, for those who may be unfamiliar, CarMax sells used cars, but not just to consumers. What do we mean? Well, CarMax also sells vehicles that do not meet its retail standards to licensed dealers through on-site wholesale auctions. On top of that, it also sells some new vehicles under special franchise arrangements.

Like many other vehicle sales outlets, the company offers its customers financing alternatives through its own finance operations. High-margin services are also offered, such as appraisal services, vehicle repairs, and extended warranties.

When things are going well, the business is profitable, and sales have been growing over time, but this is a heavily saturated market, and with a consumer economy that is strapped and stretched thin.

Right now, it is tough. Unemployment remains high. Local economies are still reopening. It is going to be tough. Car sales are obviously going to suffer, though used cars are in demand. We do not think you should buy shares here just yet. We are close but let it come down. Make no mistake, the company is competing with major dealerships, local/independent used lots, and even online sales now. Still, CarMax is holding its own as evidenced by its Q2 report.

Revenue surprise to the upside

CarMax’s recently reported earnings and revenues were up from a year ago, with a nice surprise versus estimates. While the pace of sales growth had been slowing somewhat in recent quarters, the economy was simply grinded to a halt thanks to COVID, but the used market is picking up. The company used to put up consistent double-digit sales increases in past years. That said, Q2 revenues were $5.37 billion, beating estimates by $294 million, rising 40% from last year.

The sales beat is welcome, though the quarter was really tough to handicap admittedly, even though fundamentals were improving. Even without COVID, we would argue that the days of rapid growth are behind, but we are happy to see the growth. CarMax has spread across the nation, and so there is a bit of a saturation impact, on top of all the competition.

Key data, all of which we expect to improve into

Total used vehicle unit sales rose 3.9% in the quarter and comparable store used unit sales rose 1.2% versus the prior year’s second quarter. However, that was pretty much in line with what we expected with 0.5%-1.0% increases in comps. We expect Q3 to do well as well. Positive comparable used unit sales in both July and August more than offset the high single-digit negative comps experienced in June. Comparable store sales performance reflected strong conversion, continued support from financing, and growth in web sales. A strengthening used car selling environment also benefited the quarter, and though inventory was a headwind to sales, we returned to targeted inventory levels in September.

We do want to point out that the wholesale business rebounded from Q1. Recall wholesale vehicle unit sales were down 47.6% in Q1. They rebounded in Q2 to be up 5.1% over last year. When we had covered the name previously, sales were flat-to-down, and had recently just started to turn positive. There was a massive decline in appraisal volume, and a defensive reduction in the company’s appraisal buy rate. Turning to the service plans and financing side of the business, revenues were also down 7.2%. Extended protection plan revenues (which includes extended service plans and guaranteed asset protection revenues) grew $5.4%, however.

As far as the top line is concerned, it was overall better than expected. We expect growth on all these lines again in Q3, but anticipate the back half of 2020 to still be questionable. As you can imagine, with these sales gains, the bottom line did well.

Earnings popped but market is pricing in continued growth expectations

Considering basic cost expenses, total gross profit rose 8.5% to $752 million in the quarter. This was a result of profit growth in all segments.

One item we do watch is used vehicle gross profit per unit. This rose versus the prior-year period, up $31 per vehicle thank to pricing adjustments to move inventory. The mean profit per vehicle is a key metric to watch and we expect pressure on it the rest of 2020, but improvement in 2021. Wholesale vehicle gross profit was up 23% driven by volumes, and an increase in per vehicle profit of $158 to $1,086.

Still, we need to look at other lines of expenses. Selling, general and administrative expenses rose 2% to $490 million. Advertising expenses were up 7.7%, as was stock-based compensation expenses. It is worth noting a larger store count led to some inflation in expenses, relative to if store count was stagnant.

With the strong top line and expenses that grew minimally, the bottom line beat consensus expectations. Earnings were a strong $1.79, beating by $0.68 per share. Excellent.

Moving forward

Sales have progressively improved since hitting a trough in early April. Sales have progressively improved since hitting a trough in early April. Comparable store used unit sales got better every week out of June. The fiscal third quarter is off to a good start, but even after the decline in share prices, this performance is priced into shares. Wait for shares to pull back into the $80s, then do some buying.

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Disclosure: I am/we are long KMX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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