Street Watchdog Starts CarMax at Sell Amidst Pricing & Credit Concerns

  Price Target $46.00

Link to News Release
September 28, 2016

Last week, CarMax, Inc. (NYSE:KMX) reported disappointing FY 2017 second quarter earnings of $4 billion, which was about $90 million short of analysts' expectations, and a 5.7% decline in net earnings to $162.4 million.  In looking over the company’s second quarter results, we see multiple headwinds facing the company, and we view these Q2 results as a harbinger of things to come.

A review of CMX’s FY 2017 Q2 results shows the following:

 - Net sales and operating revenues increased by 2.9% this quarter versus an increase of 7.9% during the second quarter of last fiscal year

 - Used unit sales in comparable stores increased by 3.1% this quarter versus an increase of 4.6% during the same quarter last year

 - Total used unit sales rose by 7.0% this quarter versus 9.2% during the same quarter last year

 - Total wholesale unit sales declined by 1.3% this quarter versus an increase of 8.7% during the same quarter last year

 - CarMax Auto Finance (CAF) income declined 2.4% this quarter versus and increase of 6.2% during the same quarter last year

 - Net earnings declined by 5.7% this quarter versus an increase of 11.5% during the same quarter last year

The company did indicate that a calendar shift caused one less Monday this quarter of wholesale auctions.  Had it not been for the calendar shift, wholesale unit sales would have increased by 1.4% during the quarter.  Even so, that does not compare to the 8.7% increase from the same period last year.
By every metric, including a much lower traffic count in showrooms, CarMax’s second quarter FY 2017 results failed to measure up to last year’s numbers.

A chart included in CarMax’s 2016 Annual Report filed with the SEC paints the best picture.  It shows that over the past 5 years, the company has underperformed both the S&P 500 Index and the S&P 500 Retailing Index approximately 80% of the time.

The most important question now is: Where is CarMax heading from here?  Well, first of all, pricing softness has us concerned.  During the second quarter of this fiscal year, the company’s used vehicle average selling price (ASP) fell by 2.3% over the same period last year, while wholesale prices fell even further by 4.1% versus the same period last year.  This softness is expected to continue.  Just this morning, Ford (NYSE:F) CEO Mark Fields expressed some concerns about a slowdown in retail auto sales.

Additionally, the used car market is expected to get even more competitive as a growing amount of off-lease vehicles are expected to hit the market soon: 2.6 million vehicles in 2015, 3.1 million vehicles in 2016, 3.6 million vehicles in 2017, and 4.0 million vehicles in 2018.  Pricing softness will be a concern for years to come.

The runaway subprime lending levels in the subprime auto market also has us concerned.  After seven years of super low interest rates and accommodative monetary policy, defaults are coming as a lot of risk has built up in the system over this period of time.  According to the Associated Press, “A Federal Reserve report published earlier this month showed that U.S. companies, governments, and households have $13 trillion more debt than they did before the 2008 financial crisis, a 39% increase.  Assuming some of the money has helped fuel spending and (helped) the economy recover, how much longer can the boost be expected to last?”  Loans at CarMax have jumped 92% in four years.  CarMax got a brief reprieve with the Federal Reserve’s decision to hold interest rates steady in September, but a rate hike is all but guaranteed in December.

The company has traditionally been trading at a PE ratio in the 16-18 range.  At yesterday’s closing price of $53.70 (and using diluted earnings per share), the company is currently trading at a ratio of 17.4.  Given the softness of this quarter’s numbers and the headwinds facing the company, we believe a PE ratio of 15 is more appropriate, thereby imputing a fair value of $46.20.

Disclosure:  We are short KMX.  We do not have a financial relationship with the company.