CarMax

CarMax stock rose about 10% in early Sept. 29 trading after reporting fiscal 2027 second-quarter diluted EPS up 81.3% year over year to $1.16, well above the $0.74 LSEG consensus. Comparable store unit volume grew 13%, breaking a four-quarter losing streak and its highest growth in about five years.

Why it matters: The market, in our view, has been in wait-and-see mode given frequent weak sales and new CEO Keith Barr yet to detail his four-pillar strategy, now called Shift into GEAR, which will be detailed virtually on Nov. 3. The 13% growth metric suggests Barr is on the right track. The results were impressive, considering web traffic was down and average retail selling prices increased 6.3% to $27,623. Management reported better sales conversion and a better quality customer more ready to buy than in the past, which offset the lower traffic. CarMax is not raising prices as much as it could to help affordability and is controlling overhead costs per unit (down 8.8%) while also maintaining good gross profit per unit of $2,105 that is only about $110 lower year over year. Operating margin rose 70 basis points to 3%.

The bottom line: We see narrow-moat CarMax's recovery on track, so we are not changing our $96 fair value estimate. We like that management said it will resume modest share repurchases in fiscal third quarter as we see the stock well undervalued. Efforts to revamp the online customer experience to be easier and more relevant to customer needs appear to be working. A simplified extended protection plan menu also helped other revenue grow 19.5%. GEAR stands for great offering, easy experience, add value, and run lean. The company announced a new role, chief digital and customer officer, and has hired Elizabeth Dirgins from Volkswagen Financial. It's also centralizing strategy and data via the promotion of CarMax veteran Jeff Campbell.

When asked for examples of removing friction for shoppers, Barr said the company is trying to offer information in the easiest way possible. CarMax recently modified the car details page to quickly show information customers are looking for more front and center, incorporating monthly payments, and more clearly showing the next steps in the online process. These moves should help conversion and along with overhead cost controls such as recent corporate layoffs should help CarMax avoid simply cutting prices to gain volume at the expense of profitability.

CarMax Auto Finance (CAF) had a good quarter with income up 32.1%, mostly due to the prior-year quarter having a larger-than-normal loan loss provision charge that did not repeat this quarter. Interest margin before loan loss provision was flat at 6.6% and penetration net of 3-day payoffs fell 170 basis points to 40.9% as Tier 1 mix fell since those customers have more financing options to mitigate the rising interest rate environment. CAF continues to help CarMax bring more Tier 2 customer sales by being the largest Tier 2 lender in the quarter at about 22% of the firm's Tier 2 sales versus 10% a year ago. We are not concerned about credit losses. The unit did record a $16.6 million gain on sale of loans, versus securitizing them, but CAF income still rose 16% excluding this gain.

Our CarMax fair value estimate is $96 per share. We see variables such as branding, pricing, web design, real estate footprint, and inventory selection as possible areas of change under new CEO Keith Barr. We have lowered our midcycle EBIT margin by 30 basis points to 5.7% on more competition, and CarMax is likely to cut prices more than in the past to get volume.

We think the recovery cadence for used-vehicle affordability is highly uncertain, though we believe recovery is inevitable as used-vehicle supply grows over the next few years. We expect consumer affordability to weigh on sales in fiscal 2027, though to a lesser degree than in fiscal 2026, as used-vehicle supply improves as the year progresses. Late-model used-vehicle supply (generally vehicles up to 4 years old) has not yet fully recovered from weak new-vehicle sales since spring 2020.

Revenue should face headwinds through at least fiscal 2027 as used-vehicle prices, though declining from recent levels, are still unmaintainably high, in our view. Falling prices, however, also mean cheaper inventory procurement over time, which should help expand margins. Management has said that mid-single-digit comparable-store unit growth can translate into high-teens EPS growth, so strong comp quarters can drive rapid stock price expansion. CarMax may enter new verticals to offset the price decline; possibilities include expanding its vehicle shipping capability, CAF offering wholesale financing to dealers at CarMax auctions, CAF expanding its credit spectrum securitization deals, and CarMax capturing more vehicles that, for now, are sold peer to peer. We consider CarMax a top used-vehicle retailer, so we want to give it plenty of credit for its ability to scale its overhead costs over time as more business moves to omnichannel, which allows for fewer stores. The company in fiscal 2027 will also open more reconditioning centers and auction facilities. Less brick and mortar means less in commissions and probably lower headcount over time, which should enable scaling of costs.

We model revenue growing at a compound annual rate of about 2%-3%, which is below the firm's normal mid-single-digit to low-teens rate. Our midcycle margin comes from our expectation that operating margins could be as high as around 7.5% in our bull-case scenario. We are more generous than we otherwise would be with our midcycle margin number, given CarMax’s growth potential as it continues to expand in the US and, perhaps one day, into foreign markets. We model four stores opening in each of fiscal 2027-fiscal 2031.

We think the firm will continue to grow and gain scale by leveraging its selling, general, and administrative expenses once it revamps its strategy and online consumer experience. SG&A per retail unit in fiscal 2026 was flat year over year at $3,087, but is up from $2,540 in fiscal 2022. In the future, management will track SG&A per the combined retail and auction units, which for fiscal 2026 was $1,822, excluding restructuring charges. We believe additional SG&A scaling will occur after fiscal 2027, as revenue eventually expands sufficiently for the market to see the benefits of recent cost-reduction efforts. In September, the company said it's on track to achieve another $200 million in SG&A cuts by the end of fiscal 2027. We model SG&A as a percentage of revenue at about 9% on average during our five-year forecast period. We expect the operating margin to average about 4%. We forecast capital expenditures to average about 1.2% of revenue per year and discount our projected cash flows at a weighted-average cost of capital of 9.4%. We model CAF income at around 2.2% of revenue on average over our forecast period. CAF comprises about 48% of our fair value estimate.

From fiscal 2022 through fiscal 2026, CarMax's gross margin compressed relative to prepandemic levels of over 13% due to high inventory acquisition costs. We don’t model gross margin returning to prepandemic levels until fiscal 2029-30.

We assign CarMax a narrow Morningstar Economic Moat Rating. CarMax is the used-vehicle expert. Since 1993, it has retailed nearly 14 million vehicles, wholesaled almost 9 million, and appraised about 45 million. This expertise allows it to retail about 99% of the vehicles that go on the lot. CarMax has two of the five moat sources in our economic moat framework: intangible assets and cost advantage. Many things about CarMax’s moat are replicable in theory, but we see them as difficult to copy well. CarMax's intangible asset moat source stems from its strong brand equity and valuable cache of historical auto pricing and lending data. CarMax is the largest used-vehicle retailer in the world with a very well-recognized brand that is known for its no-haggle selling process, excellent customer service, superior inventory selection, and convenient financing and delivery options. CarMax's selling process is unique compared with dealers. For example, sales associates are paid a flat commission regardless of the vehicle sold. In our view, this method properly aligns the salesperson's incentives with the needs of the customer. Franchise dealers have tried the no-haggle approach in the past, but have not always been successful because their salespeople pursue deals with high gross profit.

Franchise dealers such as Sonic and Asbury began emulating this format in 2014 but had to start from scratch with stand-alone used-vehicle stores under new brands (EchoPark and Q Auto), so we do not see any new brick-and-mortar player as a formidable threat to CarMax. Asbury terminated its Q Auto brand in 2017, and Lithia Motors' L2 used-only stores did not survive the Great Recession. AutoNation (AutoNation USA) and Penske Automotive Group (CarShop in the US, Sytner Select in the UK, and Penske Select in Australia) have joined the stand-alone used-vehicle store fight with Sonic's EchoPark, but we think the market is fragmented enough that CarMax, the franchise dealers, and digital-only players like Carvana can all find success if they execute right.

The brand does not just help CarMax sell vehicles; it helps the company best source them as well. In fiscal 2022, for example, the number of vehicles CarMax purchased from consumers increased 95.5% from fiscal 2021 to over 1.4 million, with about half of those vehicles purchased online, something we don't think a one- or two-store dealer can do without massive IT investment or a brand as powerful as CarMax's name. The company buys about 900,000-1,000,000 vehicles annually from consumers, plus about 150,000 from dealers. Vehicles purchased from consumers have higher gross profit per unit when retailed than vehicles bought at auctions, and the percentage of CarMax's retail unit sales that it bought from consumers (what it calls its self-sufficiency ratio) is now at record levels of over 70%, up from 30%-40% before the pandemic. We see this increase as the result of online vehicle commerce becoming more common, but also CarMax's digital efforts, such as internet marketing, its instant online appraisal tool, and the firm’s customer experience call centers and AI capabilities.

We view CarMax's big data advantage as an intangible asset, as well. CarMax's sales and appraisal data go back to its founding in 1993 as part of the now-defunct Circuit City. This data cannot be purchased by a competitor. CarMax uses the data to arm its buyers with the best information on vehicle auction pricing and appraisal value. The data is also used to develop a national pricing algorithm, which helps CarMax retail 99% of the vehicles offered through its stores. Since Keith Barr joined as CEO, the company is adding more emphasis in the algorithm to local competitive conditions and individual vehicle types. We believe CarMax's data advantage results in stronger profitability compared with competitors. CarMax posts a higher used-vehicle profit than all of the six publicly traded franchise dealers. We believe its data edge has helped CarMax maintain its gross profit per retail unit at about $2,100-$2,300 despite large upward and downward changes in average selling price.

In our view, CarMax's size and large store base give it an advantage over smaller competitors. Its ability to have customers shop omnichannel could strengthen the moat if the firm can raise the conversion rate of shoppers who start online and then come to a store. A large store base combined with a large digital presence gives CarMax a broader net to grab business versus a large online only competitor. A small used-car lot operation or one- or two-store franchise dealers cannot cost-effectively move inventory around a large geographic area the way CarMax can. In fiscal 2026, about 38% of CarMax's unit volume came from consumers transferring a vehicle, which can be done for no fee if the vehicle is close to the customer or a few thousand dollars if shipped from far away. The ability for CarMax to ship nearly any of its typically over 50,000 (but as many as over 70,000) vehicles in inventory at its over 255 stores to anywhere in the US gives the customer a superior selection versus a small retailer.

We believe CarMax's information systems and captive finance arm differentiate the firm from its competitors, although these capabilities can be replicated, just not at the same scale. In terms of information systems, most dealers use prepackaged software that is geared to the multifaceted operations of a franchise dealer. CarMax developed its own dealer management system software in the 1990s. It is the only large retailer that uses a DMS tailored for a used-vehicle retailer; prepackaged software generally meets the manufacturers' needs.

CarMax does not rely on one brand. The company offers consumers a great selection with more than 50,000 vehicles available nationwide for transfer to any store or delivery if a customer is within 60 miles of a store. An average CarMax store has nearly as many as 350 vehicles on the lot, while a traditional dealer will have just 30-100 vehicles.

We think CarMax is positioned to gain market share in almost any environment. Omnichannel helps this story, as it lets consumers have maximum flexibility in their experience.

We expect continued US market share and revenue growth long-term once the company improves its messaging around online capabilities to customers.

No competitors have successfully duplicated CarMax's business model to the same degree, providing the company with a considerable head start on would-be imitators.

CarMax operates in a cyclical industry, and its strong model is not immune to a recession. Tariffs are not a direct threat, but they will likely mean higher used vehicle prices and squeeze consumers' ability to buy a used vehicle.

CAF's credit spectrum expansion announced in June 2024 could backfire if management does not adequately manage credit risk.

Some of the largest franchise auto dealers are trying to replicate CarMax's success with their own stand-alone used-vehicle stores, and Carvana is formidable competition.