This car reseller will report quarterly earnings on April 2. Forecasted EPS is $1.12.
CarMax, Inc. (KMX)
From Investor Advisory Service
CarMax operates a national chain of more than 200 used car superstores. It focuses on the upper end of the used market, vehicles less than six years old, typically with only one previous owner. It wholesales customer trade-ins that do not fit its target profile. Last year, CarMax sold over 750,000 cars to retail customers and wholesaled another 450,000. Trailing 12-month revenue was more than $20 billion.
Uncertain economic conditions are a risk, but disruptions will probably hurt competitors much more than CarMax. With shares down by almost half from recent all-time highs, we see an opportunity to buy a growing market leader at a discount price.
The reputation of the used car business will repel some investors. We’re not in love with the industry either, but it does have some very attractive features. It is big, and while- somewhat cyclical, it sells a necessary product. Almost everybody needs a car.
We view CarMax as an undisputed leader in its market. The company has an increasingly recognizable brand, and its future growth prospects are highly visible as it colonizes more of the country.
The company has been a little slow to respond to a push from online-only competitors. Its e-commerce initiatives are steadily improving, however, and CarMax looks like the long-term leader. Even before this period of economic uncertainty started, online-only competitors were on shaky footing financially. Many companies have tried to push into the space, but most quietly vanished. Only publicly-traded Carvana looks like a long-term survivor. Selling cars is technically complicated and requires a lot of capital. CarMax has been doing it for 25 years.
Like all car dealers, CarMax makes a considerable portion of its overall net income from arranging financing for customers. Somewhere between one-third and one-half of operating income can be attributed to financing, depending on how costs are allocated. Its most credit-worthy customers qualify for advantageous rates through its in-house Consumer Auto Finance (CAF) arm. CarMax issues securities backed by the auto loans from CAF. In a sudden economic downturn like the one we are currently entering, the company may struggle to place its collateralized securities, even at rates that pass most of the borrower interest along to investors. That means financing income is likely to plummet until capital markets stabilize. CarMax may also have to withdraw its CAF offers until it can place old loans with investors. Loans which the company does not match with a CAF offer are referred to an outside lender for a fee. Alternatively, customers can always arrange their own financing through a bank or other lender.
Due to CAF, the company’s balance sheet scares some investors because it looks a little bit like a bank’s. At the end of its most recent quarter, CarMax had about $3.5 billion of debt and other company liabilities, and another $11 billion in interest-bearing securities CAF sold to investors. It also had $13 billion in receivables, including new loans waiting to be packaged and sold.
At first glance, CarMax may appear to have a lot of debt, but netting liabilities against financing receivables reveals a balance sheet with very little leverage. This is why we estimate the company’s true debt $1.5 billion, even when the balance sheet nominally holds close to $16 billion. CarMax has a solid balance sheet which will easily support more store expansion and share buybacks.
The company has repurchased its own stock voraciously at a rate of about 5% per year. It will be interesting to see whether the company can continue repurchasing shares in the current environment. There will be some incremental stress on the balance sheet, but we think the company is going into this downturn on very solid financial footing. 2020 will be a difficult year, but our forecast for 9% EPS growth assumes that the company remains profitable and returns to growth in 2021 and beyond.
A P/E of 20, combined with potential high EPS of $7.94 generates a high price of 159. We are using 44 as a low price, applying a 20% haircut to the recent market price of 55. On that basis, the upside/downside ratio is 9.4 to 1.
Doug Gerlach, www.InvestorAdvisoryService.com, 1-877-33-ICLUB, April 2020