Focus on fundamentals in stormy markets: CarMax (KMX)

As the MOMO, YOLO and BTFD days sink deeper into the past, I remind investors to focus on the fundamentals. Fundamental research may seem boring, but it’s the only way to find companies that generate real profits and have stocks that carry less risk. Boring investments can be very rewarding.


Inc. (KMX) is one of this week’s Long Ideas.

Fundamentals are now as important as ever

Amid economic uncertainty and market volatility, investors need to ensure — now more than ever — their portfolios are filled with companies that generate core earnings and trade at cheap valuations.

After years of putting easy money into popular growth companies, the market can no longer tolerate losses in net profit, no matter how strong the sales growth.

Investors should focus on companies with the following characteristics, regardless of the economic outlook:

  • consistent core profit growth
  • high return on invested capital (ROIC) compared to peers
  • rising economic profit
  • strong free cash flow (FCF)
  • low price/economic book value (PEBV)

CarMax performed 60% better than Carvana

Despite a 42% drop from November 2021 highs, due to concerns about the company’s rising costs, CarMax’s stock has far outperformed rival Carvana’s (CVNA) stock since I went on December 16, 2020. made of CarMax a long idea. CarMax’s share is down 9% compared to a 69% drop for CVNA in the same time. See figure 1.

Figure 1: Price Performance: KMX vs. CVNA Since 16/12/20

While the market may be overly pessimistic about the prospects of the used car industry, it clearly differentiates the performance of companies inside the industry. A strong underlying business positions CarMax to deliver long-term returns and profit growth. The recent drop in stock price provides an entry point to own this quality company at a cheap valuation.

Strong core revenue growth before pandemic

Concerns over the company’s ability to match its impressive core earnings performance in 2022 are looming over the stock. Indeed, core earnings in 4Q22 were 34% below 4Q21 and 31% below 4Q20. Historically low gross margins and rising costs could persist in the near term, pushing CarMax’s core fiscal 2023 revenue below fiscal 2022 levels.

However, CarMax’s consistent earnings growth before the pandemic suggests that core earnings will return to trend growth in the long run. CarMax’s core revenues increased from $281 million in fiscal 2010 to $888 million in fiscal 2020 (FYE 2/29/20), or 12% year over year. Over the past two years, CarMax’s core earnings averaged $931 million, which is 5% above fiscal year 2020 levels.

In contrast, Carvana’s Core Earnings have not been positive since 2015 (early year in my model). The company’s core revenues fell from -$40 million in 2015 to -$127 million in 2021. With a new vehicle shortage driving demand in the used car market to record levels, Carvana’s inability to generate positive core revenues is in stark contrast. contrast with CarMax, which achieved its highest-ever core revenue in fiscal 2022 (FYE ended 2/28/22).

CarMax creates shareholder value while Carvana destroys it

Unlike GAA

P income, economic income is a more accurate representation of the actual underlying cash flows of a company as they take into account changes in the balance sheet and income statement. CarMax’s economic profit grew from $401 million in fiscal 2016 (calendar 2015[1]) to $757 million in fiscal 2022 (Calendar 2021). During that period, CarMax generated cumulative economic revenue of $3.6 billion, while Carvana generated -$2.1 billion in economic revenue.

Figure 2: The cumulative economic profit of CarMax and Carvana since calendar 2015

Market share also improved year on year

CarMax is the largest used car retailer in the US (by volume) and continues to gain market share. According to Figure 3, the company’s share of the used car market aged 10 years or younger (the standard size for the used vehicle market) has grown from 3% in calendar 2017 to 4% in calendar 2021. In calendar 2021 alone, CarMax improved its market share by ~50 basis points and also generated a record core profit.

CarMax emphasized in its fiscal 22nd quarter earnings call that it will focus on increasing its market share while continuing to “invest and innovate to achieve profitable market share growth.” The company’s large footprint, range and competitive pricing should continue to attract customers in a tight used vehicle market. Management expects its target market share to reach 5% by 2025.

Figure 3: CarMax’s Share of US Used Car Sales

Demand for used cars seems strong in the short and long term

While tighter used car supplies and rising labor costs have curbed enthusiasm for the used car industry, used car sales and prices are well above pre-pandemic levels. Given the inability of automakers to meet new car demand in the coming years, used car demand is likely to remain at an all-time high. In fact, Grand View Research expects the global used car market to grow at a compound annual growth rate (CAGR) of 6% through 2030.

CarMax is ready to meet the growing demand for used cars. The company increased its inventory in fiscal 2022 and plans to add ten new stores in fiscal 2023.

A proven leader

CarMax is able to achieve what Carvana failed to do: profitable market share growth. CarMax’s wholesale segment is an integral part of the profitability and success of sourcing quality used cars. The wholesaler is enhancing the quality of its retail offerings by providing a channel to profitably offload lower quality vehicles into its auctions. In addition, the wholesaler gives the company real-time insight into pricing and demand in the used car market.

Time will tell whether Carvana’s effort to increase its physical presence and wholesale business through the acquisition of auction house ADESA US will improve the company’s profitability. Meanwhile, CarMax already operates a highly profitable omnichannel wholesale and retail business on an unprecedented scale.

Investors Missing Leading Balance Sheet Efficiency

Analysts are disappointed with CarMax’s declining net operating profit after tax (NOPAT) margins, which fell from 5% in fiscal 2020 to a 13-year low of 4% in fiscal 2022. Passing some of our self-efficiency cost savings to consumers through lower prices,” which appears to be a cautious move given the company’s market share gains in the 2021 calendar.

However, the company’s profitability is stronger than its margins suggest. CarMax’s new instant online appraisal offering contributed to the company’s wholesale unit sales growth of 44% yoy in fiscal 4Q22. Growth in the wholesale segment helped CarMax’s leading invested capital changes (my measure of balance sheet efficiency) soar from 3.3 in fiscal 2020 to 3.8 in fiscal 2022. The company will strive to continue improving its invested capital movements as it focuses on growth wholesale sales through its online channel.

CarMax’s soaring invested capital gains support the company’s high ROIC, which ranks third among its peer group. Carvana’s ROIC, on the other hand, is negative and is second to last. See figure 4.

Figure 4: Profitability of CarMax vs. Competition: TTM

KMX has more than 43% advantage if the consensus is correct

CarMax’s PEBV ratio[2] of 1.1 means the stock is priced for earnings to grow just 10% above its fiscal 2020 level. Such an assumption seems overly pessimistic, as the NOPAT company grew by 13%, compounding annually from fiscal 2010 to 2020.

Below I use my reverse discounted cash flow (DCF) model to analyze two future cash flow scenarios and highlight the upside potential in CarMax’s current stock price.

DCF Scenario 1: To justify the current stock price of $88 per share.

If I assume that CarMax’s:

  • NOPAT margin remains at fiscal 4Q22 level of 2% in fiscal year 2023 – 2024,
  • NOPAT margin increases to 4% (13 year low and equal to fiscal 2022) in fiscal 2025 – 2032 and
  • revenue down 2% (vs fiscal 2023 – 2024 consensus estimate CAGR of +3%) plus yearly from fiscal 2023 – 2032, thereafter

the stock is worth $88 a share today — equal to its current price. In this scenario, CarMax earns $1.1 billion in NOPAT in fiscal 2032, which is only 7% higher than the pre-pandemic NOPAT in fiscal 2020.

DCF Scenario 2: Stocks Are Worth $126 More

If I take CarMax:

  • NOPAT margin remains at fiscal 4Q22 level of 2% in fiscal year 2023 – 2024,
  • NOPAT margin increases to 4% (13 year low and equal to fiscal 2022) in fiscal 2025 – 2032 and
  • revenue grows by 3% from fiscal 2023 – 20232,

the stock is worth $126 a share today — a 43% increase from its current price. In this scenario, CarMax’s NOPAT will grow at just 3% per year for the next decade. For reference, CarMax grew NOPAT at a CAGR of 9% from the 2015-2020 fiscal year before the COVID-19 pandemic. Should CarMax’s NOPAT grow in line with pre-pandemic growth rates, the stock has even more upside potential.

Figure 5 compares the historical NOPAT of CarMax with the implicit NOPAT in each of the above DCF scenarios.

Figure 5: CarMax’s Historical and Implied NOPAT: DCF Valuation Scenarios

Disclosure: David Trainer, Kyle Guske II, and Matt Shuler are not remunerated to write about a specific stock, style, or theme.

[1] For this analysis, I compare the financial data of CarMax for 2015 (financial year ending on 29-2/16) with the financial data of Carvana for 2015 (financial year ending on 31/12/15).

[2] I calculate CarMax’s PEBV ratio using the company’s pre-pandemic fiscal 2020 NOPAT, which represents a more normal level of profit than record profits in fiscal 2022.

Leave a Comment