CarMax is the largest used car retailer in the United States. This writeup was encouraged by potential catalysts stemming from the coronavirus crisis that did not exist just a month ago. CarMax will be better positioned going forward than if this crisis did not occur due to an aversion to public transportation, weak competitors going out of business, and accelerated adoption of omni-channel initiatives.
Business
CarMax sold 833,000 used cars at retail in the past year, sold another 466,000 at wholesale auctions, and holds 70,000 retail vehicles in inventory. This massive scale provides the company with several important advantages:
- Inventory breadth: With 70,000 used cars to select from that vary by age, color, mileage, and interior packages, consumers are more likely to find the specific car they want at CarMax as compared to smaller dealers. For a fee, customers can have cars transferred to them from the 217 CarMax stores around the country.
- Data advantage: Being involved in ~100,000 used car transactions each month and a strong auction presence gives CarMax critical data on fluctuating used car values and consumer preferences. This data allows for accurate pricing in both buying and selling vehicles and is needed to manage a consistent gross margin. Smaller competitors are unlikely to have an inventory system as robust as CarMax’s due to less complete information, which makes it harder to identify what is in demand and at what price.
- Buying power: With the largest retail distribution network, CarMax is able to buy in size from fleets such as rental car companies and lower its cost per vehicle.
- Brand/trust: While price will outweigh provider in most car decisions, CarMax has established itself as a trustworthy dealer in an industry with blemishes. They pioneered no-haggle prices (for vehicles and loan terms) and have a strict reconditioning process that all retail vehicles go through before being retailed.
Growth & Reinvestment Runway
The used car market is fragmented. CarMax is by far the largest player, yet only commands 4.7% market share. The next handful of competitors each have a fraction of that share. The rest of the market consists of small dealerships around the country. CarMax has gradually taken market share from these competitors due to the advantages listed above complemented by a strong financial position capable of weathering economic storms, such as the current environment.
It is estimated that in its older markets CarMax has achieved 5 to 10% market share. This indicates future market share gains from the current 4.7%, as one-third of CarMax stores are less than five years old and not at full capacity yet. CarMax plans to open 10 to 15 new stores each year in its goal to reach 300 stores, which implies several more years of 5% store count growth. There is a significant opportunity for capital reinvestment and a long runway to take market share. These gains show up in existing store sales growth of 3 to 5% per year, historically. Combined with annual store expansion of 5%, it is reasonable to expect 8 to 10% growth in earnings power for several years.
Capital Allocation
CarMax is a cannibal, aggressively repurchasing its shares with any cash flow that is not used to fund store or IT investments. Since 2013, they have reduced shares outstanding from 226 mil to 163 mil today, a reduction of 28% in total and 4% per year. Free cash flow available to fund buybacks should grow faster than earnings due to slowing new store capital expenditures relative to net income. At a high free cash flow conversion rate north of 85% going forward, it is fair to expect CarMax to buyback 5% of their shares per year given they are typically valued at ~6% earnings yield.
Over time, with 8 to 10%/yr growth in earnings from market share gains and new stores plus 5% reduction in shares each year, there is clearly a path to an above average rate of return for the next decade if CarMax is able to maintain and strengthen their competitive advantages. Now I will make the case for why CarMax will emerge from the COVID19 crisis better positioned for the long-term than if it had not happened.
Coronavirus Catalysts
- Weaker competitors folding will accelerate market consolidation. CarMax just reported that used car sales are down 50% due to the coronavirus shutdown. They have $700m in cash, another $300m in available credit, and own most of their stores plus $2.8 billion worth of inventory that is a source of cash that they can liquidate. CarMax also noted they can cut expenses by 25% in order to slow any cash burn until the economy restarts. CarMax will make it. On the other hand, smaller firms that don’t have access to credit will have limited liquidity while sales are remarkably low. Depending on the length of the shutdown, smaller firms and leveraged firms may close up shop or go bust. In that case, their market share will go to the bigger players like CarMax.
- Reduction in ride share and public transit. Ride sharing results in reduced car ownership and transaction levels which is a headwind to CarMax’s growth. Unfortunately for society, any form of sharing has been halted in the midst of this pandemic. It is hard to forecast the extent of behavioral changes as a result of the COVID19 crisis, but there will be aversion to public transportation and ride sharing as we endure this period of avoiding contact with people and touched surfaces at all costs. This will boost used car ownership because those avoiding public transit still need a cheap alternative to get to work once we resume activity. Of this new base of car owners, some will likely return to public transit once it is safe to resume human contact. Undoubtably, though, some won’t resort to old habits and will prefer to keep the individualism of owning a car. This effect is a positive for the used car market and CarMax.
- Acceleration of omni-channel adoption. In 2019, CarMax gradually rolled out its express pickup and home delivery options to select markets which resulted in significant market share gains in those locations. Now, during a pandemic, curb pickup and home delivery are a critical alternative relative to stores that are either closed or limited to appointment-only visits. In light of this, CarMax has accelerated the program rollout to be available everywhere this year. As a result of COVID19, curb pickup and home delivery adoption should accelerate as consumers have more time to shop cars online and learn about new, convenient ways to buy from CarMax while generally avoiding the stores. The execution and adoption of these programs firm wide should result in substantial market share gains as evidenced by the initial rollout in 2019.
Valuation
I will not spend much time forecasting profits in this unprecedented environment. No doubt, they will be down significantly this year. The qualitative aspects of the business will be the driver of long term results. Nonetheless, in the past three years Carmax earned $888m, $842m, and $644m while total U.S. used car sales were at ~40 mil/year. This is a typical level of sales given U.S. used car sales have averaged 39.6 mil/year since 2000 which includes a severe recession in the data. Assuming corporate tax rates will eventually go back up to at least 27%, CarMax has after-tax earnings power of roughly $830 million based on the past two years pre-tax earnings which had reduced margins from the omni-channel rollout. This number has an element of conservatism and is reasonable. With 163m shares outstanding @ $54, CarMax is valued at $8.8 billion which is around 10.6 times after tax earnings that are set to compound over the next decade. With government bond yields close to zero, this is a very attractive price to pay for a dominant market leader with structural, long-term tailwinds that is positioned to see a boost in market share once the economy resumes normal activity.
An alternative view of the growth algorithm: At a 9.4% earnings yield on 4/6/2020, CarMax can repurchase around 8% of the shares outstanding with a year’s free cash flow once sales recover. With earnings power growing at 8 to 10% per year and shares dropping at 8%/yr, EPS has a very real potential to compound at over 15% from these valuations. That is unlikely to last due to efficient markets, so the stock will rerate higher eventually. Without assigning a price target, I suggest an investor hold this investment for the long term. Let a great business and compounding do the work for you.
Catalysts
-Weaker competitors lead to market share gains
-Reduction in public transit boosts used car ownership
-Increased omni-channel adoption
-Compounding value
Disclosure: I hold a position in KMX stock.
BD Capital 