CarMax - Good, Honest Business

| About: CarMax Group (KMX)

Summary

Business practices in the used car industry are a major source of displeasure for car buyers.

CarMax confronts these frustrations by offering a superior, consumer-centered shopping alternative.

These initiatives have enabled the company to achieve top market share through customer preference.

The company utilizes data gleaned from its vast quantity of vehicle sales to gain a deep understanding of consumer behavior, achieve operational efficiencies, and expand on its wide competitive advantages.

Customer loyalty, scale advantages, and data mining capabilities create a virtuous cycle for the company in an industry flush with weak competition.

Conscious Capitalism in Car Selling

The used car industry has long held a reputation for being a bastion of crony capitalism. The stakes are high because, for many, the purchase of a vehicle will be their second largest investment next to their home. Dishonesty, lack of transparency in the sales process, hidden fees, upselling by commissioned sales people, and a general concern by customers that they didn't receive the best deal on their purchase all lead to discontent with automotive dealers and their sales process. Take these negative attributes, coupled with the fact that it's a fragmented market with competitors struggling for market share, and it's evident that the industry is ripe for disruption.

The management of CarMax (NYSE:KMX) shares this displeasure with used car consumers. Over the course of its 22-year history, the company has quickly claimed top market share in the used car industry by confronting customers' dissatisfaction with auto dealers and offering a better alternative. CarMax is an excellent example of a company that profits by pioneering a new way of doing business while raising standards for an entire industry, thereby making its business more beneficial for customers, employees, and shareholders alike.

The Virtuous Cycle

The value proposition offered by CarMax begins with a friendly shopping experience for consumers. Customers can feel comfortable that they are getting the best deal available: pricing is transparent and there is no haggling permitted, so shoppers need only make the simple choice of whether or not to buy at the price offered. If customers like the price but can't find the model they want at a local store, they can gain access to the nationwide inventory by participating in CarMax's transfer program through which 30% of sales were made last year.

To further facilitate the customer-centric process, sales personnel are charged only with facilitating purchases. Their commissions are based on units sold, so there's no economic incentive for them to recommend a vehicle with a higher sales price or profit margin. Instead, the incentive structure is meant to align sales consultants' goals with those of their customers, causing sales personnel to guide customers toward vehicles that best suit the needs of each individual buyer.

While CarMax offers extended protection plans, loan guarantees for totaled vehicles, and related services, customers can clearly see how each element affects the total price. With that knowledge, they can choose to accept or decline any element without changing the terms or price associated with any other single element included in the sales contract. And if something goes wrong, customers are afforded five days to return a purchased vehicle with no questions asked.

The sales process is a breath of fresh air in an industry overdue for change. But in addition to customer preference, CarMax possesses multiple sources of competitive advantages against its rivals, part of which derive from the ever-increasing scale of its operations. CarMax has doubled its store base from 77 in 2007 to 158 at the end of its most recent fiscal year as summarized in the table below.

CarMax Used Car Stores 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007
Store Locations 158 144 131 118 108 103 100 100 89 77
Growth 9.7% 9.9% 11.0% 9.3% 4.9% 3.0% 0.0% 12.4% 15.6% 14.9%
Click to enlarge

Source: CarMax SEC 10-K Annual Reports

The expanding store base and growing customer traffic has enabled the company to move nearly 4.5 million used cars over the past ten years. The high volume of transactions produces a mountain of data about consumers' car-buying behavior. A plethora of factors can go into a car buyer's decision: make, model, price, color, year, geographical location, performance, etc. CarMax has been keen to not let this knowledge slip through its fingers. Its proprietary information systems analyze data collected from historical sales and use it to create algorithms capable of optimizing sales prices and inventory management.

The system is a major asset in its procurement processes. It can be used in the initial appraisal process when CarMax quotes a price at which it will offer to buy a car from a consumer. Similarly, the same information can be used to facilitate superior decision making when buying at auctions, a secondary sourcing channel for the company's used car inventory. Purchasing the right vehicles at the right prices ensures more efficient inventory turnover and reduces the likelihood that a vehicle will go unsold or depreciate in value and pressure margins. Management claims that 99 percent of its vehicles are sold at the retail price offered, which is well above the 85 percent rate achieved by franchise dealers according to Morningstar estimates.

The final key advantage achieved by CarMax through its proprietary management system and data collection capabilities is efficiency in its wholesale operations. Because most vehicles acquired through its appraisal process fail to meet its resale standards, CarMax is also among the largest operators of wholesale auctions in the U.S. While the vehicles purchased may not meet CarMax's standards, the company still earns approximately 45 percent as much gross profit on auction sales as on retail sales and management is careful to ensure they acquire wholesale vehicles that are attractive to other dealers. The table below compares the average gross profit per vehicle received through wholesale operations and used vehicle sales.

Gross Profit Per Unit 2016 2015 2014 2013 2012 2011 2010 2009 2008 2007
Used Vehicles 2,159 2,179 2,171 2,170 2,177 2,156 2,072 1,865 1,878 1,903
Wholesale Vehicles 984 970 916 949 953 908 869 837 794 742
Click to enlarge

Source: CarMax SEC 10-K Annual Reports

CarMax's experience, scale, and historical data analysis have helped the company achieve a 97 percent auction sales rate versus the 60 percent rate achieved by other large auction firms per Morningstar estimates.

The industry is extremely fragmented with ~18,000 franchise dealers and approximately twice as many independent retailers, according to management estimates in its 10-K Annual Report. The competition is fierce and industry participants have found it increasingly difficult to find an edge against rivals. Against this backdrop, the ability of CarMax to develop consumer preference despite facing competitors on practically every street corner bodes well for its business model and indicates that its value proposition is resonating deeply with car buyers. The combination of consumer preference, robust data analysis capabilities, and superior operational efficiency has helped the company forge an industry-leading 5 percent market share in its current geographical areas and approximately 3 percent nationwide among late-model vehicles ranging from zero to ten years old.

Risks

While management warns frequently in its annual report that competitors could emulate portions of its business model to share in its competitive advantages, it's difficult to imagine a sudden change in culture at another auto dealer. Considering the large size of the auto market and CarMax's scale, it's even more difficult to envision this happening to a large enough extent to seriously threaten CarMax's market share in the near future.

However, the automotive industry is subject to significant demand fluctuations between periods of economic recession and expansion. Looking back to the financial crisis, CarMax suffered a 16% drop in same store sales and 13% drop in wholesale sales during its 2009 fiscal year, per the table below.

2016 2015 2014 2013 2012 2011 2010 2009 2008 2007
Comparable Used Vehicle Sales 2.4% 4.4% 12.2% 5.4% 1.3% 10.0% 1.0% -16.0% 3.0% 9.0%
Total Used Vehicle Sales 6.5% 10.5% 17.7% 9.7% 3.0% 11.0% 3.0% -8.0% 12.0% 16.0%
Wholesale Vehicle Sales 4.9% 9.8% 5.5% 2.6% 20.4% 33.0% 2.0% -13.0% 6.0% ----
Click to enlarge

Source: CarMax SEC 10-K Annual Reports

The market has recently been giving indications that it expects the automotive industry to be near a cyclical top, and it's uncertain how the economy might perform in a cyclical downturn given the present state of world economies. Despite the highly competitive nature of the industry, macro issues continue to be the foremost concern with the company.

Conclusion

Due to the macro risks involved and present market conditions, I remain cautious about the near-term prospects of CarMax. For investors who are hesitant to buy shares in an economically-sensitive company potentially near the top of an industry cycle and with stock market valuations at an all-time high, KMX could be a good option to consider buying on a pullback, gradually building a position through a dollar-cost averaging program, or placing on a long-term watch list. Regardless of the strategy chosen, CarMax meets the criteria of a quality long-term business model with multiple sources of competitive advantages that warrants investors' attention.

Author's Note: Investors who valued this analysis and who wish to receive future articles and ideas from The Virtuous Cycle can do so by clicking the "Follow" button at the top of the article and selecting "real-time alerts."

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: All investments involve risks. Investors are encouraged to do their own due diligence prior to making buy or sell decisions.