As the single largest used car dealer across the United States, CarMax Group (NYSE:KMX) is exposed to some troubling developments in the sector. With the economic cycle rapidly approaching a turning point, the company has become increasingly sensitive to a number of risk factors including rising loan defaults, reduced recovery rates, and margin compression, thanks to a flood of used vehicles hitting the market. After notching a disappointing performance over the last 52 weeks, investors eager to pounce on value will be hard pressed to find it at the existing valuation despite positive mentions from Barron's highlighting the potential upside. With a host of headwinds and an uphill battle, thanks to the tightening credit conditions, CarMax's investors will assuredly find better value once the economic cycle hits a trough instead of a peak.
Auto Loan Bubble Showing Signs of Stress
While Detroit can thank the insatiable appetite of the American consumer for new toys, the reality is that most of the sales gains in recent years were driven by incentives and more lax lending standards for borrowers. According to the most recently available statistics, financing accounts for an estimated 90% of new vehicle purchases and 55% of used car purchases. Even though the subprime mortgage crisis may finally be behind us, a new crisis is creeping up. With auto loans currently tallying $1.1 trillion after climbing from $700 billion in 2011, with $27 billion of subprime loans packaged into bonds and sold to investors during 2015. Additionally, the vast run-up in securitization efforts closely mimics the lead up to the previous financial crisis as banks eagerly buy, package, and sell securities which are seeing delinquency hit the highest levels in 20 years.
Echoing the ghosts of 2007-2008, the surge in subprime delinquencies is calling into question the sustainability of auto sales and the future for prices. With borrowers in the subprime category 60 or more behind in their loans climbing to 5.16% according to Fitch, levels last seen in 1996. In the event that rising defaults leads to a larger volume of used cars hitting the market, used car dealers like CarMax will face the brunt of the margin compression as increased outstanding supply drives prices lower while denting loan recovery amounts. Additionally, the incoming flood of Volkswagen (OTCPK:VLKPY) vehicles threatens to put more price pressure on the already bloated US used car market. With nearly 500,000 vehicles to be recalled potentially hitting the used car market and steep discounts being offered by manufacturers, margins at CarMax are likely to be squeezed over the medium term until the imbalance subsides.
Falling Turnover & Prices
The glut of cars hitting the used market has seen CarMax's throughput decline rapidly, calling into question the company's target of turning over each used car lot nine times per year after recording turnover of 6.64 for the fiscal year ending February 28th. Aside from lower turnover leading to diminished revenue potential, for repossessed vehicles, recovery rates are also on the tumble as delinquencies rise and the amount of outstanding used cars grows larger. According to Manheim, the globe's largest vehicle auction and remarketing company, used car prices have fallen 2.55% over the last three months from December's reading of 125.7. Furthermore, its data suggests that cars in the price range of $7,000 to $10,000 continue to experience the most pressure.
Owing to the fact that CarMax itself does not finance the vehicles it sells and instead partners with external firms to underwrite the loans, this is raising speculation that if lenders decide to pull back from the automotive sector, CarMax is in a lose-lose position. Borrowing rates would either be climbing higher due to the obvious risks of extending credit to a subprime borrower or customers will be unable to access financing for purchases altogether. Even if CarMax is able to continue selling cars to more high-risk borrowers, the accelerating delinquency rates and falling recovery rates for repossessed cars add to the existing pressures facing the CarMax management team.
After falling by 20.55% over the last 52 weeks, it is easy to understand why certain value investors are eager to get involved. Although headline earnings were viewed as positive and the company made progress on an annualized basis, notably by selling over a million vehicles during the fiscal year, growing earnings per share can be attributed to accounting gimmicks. Outstanding shares have fallen dramatically with only 195.73 million shares outstanding compared to 219 million reported at the end of fiscal 2015. The company repurchased nearly $1 billion worth of stock last year, numbering 16.3 million shares, and is authorized to purchase another $1.40 billion in the coming year. While helping to go ahead and improve earnings per share, the share repurchases have come at the expense of rising long-term debt levels, which climbed from $8.82 billion to $10.34 billion over 12 months.
Cash flow is also a concern, with large capital expenditures and negative free cash flows translating to negative operating cash flow. Even though value investors might be drawn in by the 18.22 price-to-earnings multiple, especially considering the figure trails the comparable S&P 500 figure of 24.11, this is not necessarily indicative of a great value. Aside from the short interest, which currently stands at 17.79% (as of April 15th) in a strong reflection of investor sentiment, gross profits are falling per vehicle as margins are already feeling the squeeze. CarMax may not have a high degree of exposure to subprime borrowers; the overall used car market is still a real concern from both a price and supply perspective. Any future earnings growth is likely to be the products of buybacks instead of organic top- and bottom-line growth.
The Kiss of Death
The recent expose put out in Barron's on the value status of CarMax feels like an indication that the top is in for shares which have further room to fall. Weakening margins and a crumbling backdrop for auto sales should be a warning sign to any potential investors at current share prices. Although the bulls will point to the robust new car sales market as a point of optimism, leases gaining favor could translate to more supply of used cars hitting the market in the coming quarters. With most of the negative headwinds on the approach, there is substantial room for shares to fall lower, namely towards the 52-week lows at $41.25. No dividend and risks to the outlook contribute to a shaky upside thesis while the downside gains steam. While headline earnings figures might be positive in the coming quarters, it is important to remember the buyback math behind these results.
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