CarMax, Inc.’s (NYSE:KMX) revenue growth is expected to remain under pressure in the near term due to adverse macroeconomic conditions which is resulting in lower demand for used vehicles as a result of tight discretionary spending in an inflationary environment and rising interest rates. Moreover, the easing of supply issues in new car production, coupled with higher lending rates for used vehicle loans compared to new car loans should also impact the volume growth ahead.
On the margin front, the company should benefit from a favorable mix and cost-saving measures. This should help offset headwinds from volume deleverage and lower CAF income moving forward. So, the company’s overall prospects remain mixed with near-term revenue concerns and improving margins. This along with higher than historical valuations keeps me on the sideline for now. Hence, I continue to have a neutral rating on the stock.
Revenue Analysis and Outlook
In my previous article, I discussed the concerns regarding CarMax’s revenue growth in the near term due to lower consumer demand for used cars in an inflationary environment. These macroeconomic concerns along with higher-than-historical valuation kept me on the sidelines. The company has reported its first quarter of fiscal year 2024 earnings since then and similar dynamics were seen there as well. The stock price has remained flat, validating my neutral stance.
In the first quarter of fiscal year 2024, the company’s sales growth continued to be negatively impacted by lower consumer demand for used cars due to an inflationary environment where discretionary spending tightens. This led to a decrease in YoY volume generation as retail and wholesale used car units sold, declined. In addition, the sales growth in the quarter was also negatively impacted by a decrease in average selling price as demand continued to normalize. This resulted in a 17.4% YoY decline in net sales to $7.7 billion. This decline included a 14.4% YoY decline (or 16.2% decline on a comparable basis) in Used Vehicle sales and a 28.4% YoY decline in Wholesale Vehicle sales.
Looking forward, I believe the consumer demand in the used car market should remain pressurized in an inflationary environment. Moreover, an increase in new car sales and costlier financing of used cars as compared to new cars should also impact volume growth in the quarters ahead.
In an inflationary environment, demand for discretionary items decreases as consumers become more cautious about their finances and prioritize essential expenses over discretionary purchases like buying vehicles. Many individuals opt to hold onto their existing vehicles for a more extended period and look to repair and remodel their vehicles which is more affordable as compared to buying a new one. This trend has been affecting the volume levels of KMX as consumers continue to adjust to rising interest rates and inflation of staples.
Further, with the central banks raising interest rates to combat inflation, the cost of borrowing for auto purchases and the monthly installments on auto loans have increased. This scenario presents a significant challenge for consumers, as it makes vehicle affordability more difficult. Higher monthly payments strain household budgets, potentially forcing individuals to reconsider their vehicle purchase plans or opt for less expensive models. This should negatively impact the demand in used car markets resulting in lower sales volume.
Additionally, with rising interest rates, the company has been also increasing the weighted average contract rate charged to new customers. In the earning’s call for Q1 FY24, management said that the weighted average contract rate charged to new customers increased by 200 bps YoY and 20 bps sequentially to 11.1% at its CarMax Auto Finance (‘CAF’). On the other hand, the average rate on new car loans is much lower in the mid-single digits according to FRED. This difference in interest rates charged to new and used cars should have a negative impact on the company’s demand as consumer preference shifts toward new cars. This should also adversely impact the sales growth of the company in the coming quarters.
Furthermore, as I mentioned in my previous article, the availability of new cars is increasing. Post-COVID, new car availability took a hit due to supply chain challenges in the production of new cars. This led to increased demand for used cars as consumers looked for alternatives. Now with easing supply chain conditions, production of new cars is increasing as compared to previous years. This should negatively impact volume levels as consumers won’t have to choose used car as an alternative.
So, I am not optimistic about the company’s near-term growth prospects.
Margin Analysis and Outlook
In the first quarter of the fiscal year 2024, the company’s margins benefited from a favorable mix of high-margin old cars (8 years and above), which helped offset the headwinds from volume deleverage. In addition, earlier-than-expected results from the management’s cost-saving measures helped reduce SG&A as a percentage of sales and gross profit as compared to previous years. This along with higher gross profit per unit improved the operating margin. As a result, the gross margin increased 120 bps YoY to 10.6% and the operating margin increased 40 bps YoY to 4%.
Looking forward, I believe the company’s efforts to control costs in line with lower sales volume should support the margins. Over the last couple of quarters, the company has been taking several cost-cutting initiatives like reducing its headcount to improve productivity. Additionally, the company also implemented a hiring freeze in its corporate offices. This helped the company lower SG&A in the first quarter (which was earlier than expected) and should continue to provide cost savings.
In addition to these cost-cutting measures, the company has also been investing in digital technology to enhance efficiency. In the first quarter of fiscal 2024, the company began using its 24/7 virtual assistance, known as Sky. Sky has allowed the company to efficiently assist customers through chat, which has reduced the workload on its Customer Experience Center (‘CEC’) system. This virtual assistant has expanded its capabilities in the first quarter to cover tasks related to finance applications, vehicle transfers, and appointment reservations. It has successfully decreased the volume of work that goes to CEC associates, resulting in quicker responses and lower costs per transaction. KMX plans to add more features to Sky throughout fiscal 2024, which should further enhance efficiency and cost savings.
Furthermore, the company is also seeing the mix of old cars above 8 years increasing as consumers look for affordable options. These old cars tend to be high margin and as a result, the company has been able to increase the gross profit per unit. This should also continue to support margin growth moving forward. I expect these cost-saving measures and improving the high-margin product mix should help it offset the short-term pressure from volume deleverage and lower CAF income due to rising loan loss provisions at CAF, given the inflationary environment and increasing financing rates.
So, management’s ability to execute well in adverse macroeconomic conditions has given me some confidence about the company’s margin growth prospects ahead.
Valuation and Conclusion
CarMax is currently trading at a 25.75x FY24 consensus EPS estimate of $3.04 and a 20.83x FY25 consensus EPS estimate of $3.76. The company is trading at a premium to the historical 5-year average forward P/E of 20.06x, making the valuation look unattractive. While the management has proven its ability to control costs to align with lower sales generation and improve the margin profile, lower consumer demand for used vehicles remains a concern in an inflationary environment. So, the company has mixed prospects moving forward in the year. I would like to wait on the sideline to gain some visibility on improving top-line growth before turning positive on the company. Hence, given the higher-than-historical valuation and mixed growth prospects, I continue to have a neutral rating on the stock.