The New Car Effect Hits CarMax

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Used-car dealer CarMax (NYSE: KMX) reported stellar third-quarter results Thursday morning. Revenue surged 15% year-over-year to a better-than-anticipated $2.6 billion. Earnings also grew 15% year-over-year to $0.41 per share, easily exceeding the consensus estimate. Our fair value estimate is unchanged.

Given how the new-car recovery continues, it may seem surprising that CarMax would see such strong sales gains. Used-car revenues jumped 17% year to $2.06 billion, with total units jumping 16% and comparable store units jumping 12% compared to the same period last year. However, this shouldn’t be too surprising, in our view, given the aging fleet of cars in the US coupled with the better used-car inventory stimulated by the new car recovery. As consumers purchase new cars from Ford (NYSE: F), GM (NYSE: GM), Honda, and Toyota , these buyers put their previous vehicles into the used car market (generating better offerings).

Speaking of auto OEMs, GM announced that it has repurchased a large block of shares from the US government. Though the price GM will pay—approximately $27.50 per share—exceeds the current market value, it is still lower than our median fair value estimate. More importantly, however, it removes the worry (overhang) that the government-owned shares would be dumped on the market, putting downward pressure on the share price. We like the move for both reasons, and we think the repurchase could be highly accretive to GM’s earnings going forward since it reduces shares outstanding by approximately 11%.

Although we ultimately like the move, GM’s execution remains somewhat lackluster, in our view. We believe both Ford and Toyota are doing a significantly better job delivering products that US consumers want. However, GM is refreshing nearly its entire lineup over the next few years, so we think the firm could recover some lost market share. Shares of GM look fairly valued, in our view, and we continue to hold shares of peer Ford in the portfolio our Best Ideas Newsletter. We think Ford has superior management and execution (less Lincoln), as evidenced by its fantastic operating margin expansion in recent years.

For the past several years, this market’s growth has been constrained by tight supply and a general lack of newer used vehicles. Therefore, growth in new car sales should result in a growth in desirable used cars. Since 2007, car sales have been incredibly weak and mostly below replacement rate; thus pricing should hold up relatively well, too.

Though sales jumped significantly, gross margins slipped 10 basis points, to 13.3%. However, CarMax mostly controlled selling costs, which jumped 14% on an absolute basis due to variable sales compensation (commission), but fell 10 basis points to 9.9% of sales. Unfortunately for the firm, one of the negative effects of having better product selection is higher costs and therefore lower margins. Used-car profit per unit fell 1% year-over-year to $2,146—a number that we think has additional downside.

While CarMax does very little in terms of new car sales, it is interesting to note that the figure fell 0.7% compared to the same period last year to $45.7 million. We do not think this is materially representative of the new car market, but profit per unit halved to just $518. Even wholesale units earned higher profit per unit ($923), suggesting the new car market has become more competitive and incentive-laden. Or it could be an aberration—it is difficult to tell with such a small sample size.

A significant portion of CarMax’s sales growth can be attributed to looser credit standards:

CarMax Auto Finance. CAF income increased 16% to $72.5 million compared with $62.6 million in last year[‘]s third quarter. The growth in CAF income was largely attributable to the 15% increase in average managed receivables, which grew to $5.48 billion from $4.77 billion in the prior year period. The increase in average managed receivables reflected the rise in CAF origination volume throughout fiscal 2012 and fiscal 2013 as we transitioned back to our pre-recession origination strategy, higher average amounts financed and the growth in retail unit sales.

We’ve previously noted that subprime lending to auto purchasers is less risky than subprime mortgage lending, though it certainly raises the company’s receivables risk profile.

Overall, we were impressed by CarMax’s strong results. Though the allowance for doubtful accounts receivable increased to 1% (was 0.9%), we think the company’s decision to allow easier credit has propelled revenue in a favorable direction. We believe financing income will grow, and we think buyers should be able to make payments (assuming economic conditions do not substantially deteriorate). Management continues to open new stores (8 out of 10 stores expected to be open in fiscal year 2013 already are), with plans to open an additional 10 superstores in fiscal year 2014. Nevertheless, we believe shares are fairly valued at current levels, and we’d rather play the auto recovery via Ford, which is a member of the portfolio of our Best Ideas Newsletter. Superior is a holding in our Dividend Growth portfolio.

Valuentum holds shares of Ford in its Best Ideas Newsletter and Superior Industries in its Dividend Growth Newsletter. RJ Towner also owns shares of Ford. The Motley Fool owns shares of Ford. Motley Fool newsletter services recommend Ford and General Motors Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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