CarMax (KMX) shares have corrected ~23% since making an all-time high in September this year. While the company reported a good second quarter earnings and has been delivering impressive earnings growth over the last few years, its PE multiple has compressed due to increasing concerns about online competition. Trading at less than 13x forward earnings, the stock provides a very interesting buying opportunity as investors seem to be missing market dynamics in used-car space and their worries regarding online competition seem to be overblown. CarMax itself is launching its omni-channel initiative over the next few months which should help ease some of the concerns. Further, comps are getting meaningfully easier over the next two quarters, and the company has increased its buyback authorization by $2 bn, which should provide a downside support.
Market dynamics: What investors are missing?
The US used-car market is highly fragmented with over 43,000 used-car dealerships and the total market share of top 100 used vehicle dealers at ~7%. CarMax is the biggest player accounting for ~ 2% of market share (CarMax sold 196,880 units last quarter versus industry sales of ~10.2 mn). The company is a secular market share gain story in the space and has posted a revenue, net income and EPS CAGR of 8%, 14% and 16%, respectively, over the last decade. However, of late, competition from online players has been a major source of concern for CarMax's investors.
Among the listed online players are TrueCar (TRUE), CarGurus (CARG), Cars.com (CARS) and Carvana (CVNA). While TrueCar, CarGurus, and Cars.com mainly act as a platform to connect brick and mortar dealers with buyers and generate subscription revenues from dealers in the process, Carvana is an online dealer. Traditional brick and mortar players like Lithia Motors (LAD) are also tying up with tech partners and going omnichannel.
I don't consider TrueCar, CarGurus, and Cars.com a threat to CarMax and other brick and mortar retailers. They help brick and mortar retailers generate leads and the deal closure happens offline. So, they are essentially brick and mortar retailers' online partners and not a threat. CarMax has been gaining market share from traditional dealers due to its better service offering and no haggle pricing. As long as it continues to provide better service, source of lead generation (online/offline) won't make much difference to its competitive position.
Carvana, on the other hand, is a different story. The company's online-only model has gained a meaningful traction over the last few years, and its sales have increased from 5,620 units in Q416 to 25,324 units in Q318. While still small as compared to CarMax's 196,880 units sold last quarter, Carvana's over 100% y-o-y revenue growth indicates that it will soon be a major player in the industry. Bears are comparing current scenario to what happened in Amazon (AMZN) versus brick and mortar retail case resulting in the company's depressed valuations. However, I disagree. While I do see Carvana's growth continuing, it doesn't mean an end to CarMax's growth story.
With total annual sales of ~39 mn units, the US used car market is big enough to support both Carvana and CarMax's growth. Rather than Carvana gaining market share at the expense of CarMax, a more likely scenario is both gaining market share against traditional dealers and seeing good growth as they provide better user experience, no haggle pricing and benefit from scale.
Also, unlike what happened in Amazon versus brick and mortar retailers, no pricing war is happening or imminent in used car space in near future. Carvana is focusing on improving its GPU and EBITDA, and its CEO has publicly mentioned management's goal to raise gross profit per unit to $3,000 and turn profitable in the medium term.
Further, CarMax is itself launching its omni-channel initiative later this year, which will help it serve its customers better and help it gain more traction in online space. The company is already testing individual products in some market. It has alternative vehicle delivery options in Charlotte which allow customers to complete most of the vehicle shopping and purchase processes online after which they can decide how they want to receive the car (expedited or express pickup service, home delivery, etc.). It also has an online appraisal estimator in 10 stores and a call center where its consultants help customers until they are ready to either go to the store for pickup or schedule home delivery.
The company plans to combine all of its online products together into one comprehensive offering and provide a seamless omni-channel experience. CarMax plans to launch this integrated omni-channel experience in a major market over the next couple of months and iterate it before scaling it across the entire organization.
As market realizes that the fears regarding online competition impacting CarMax's growth are misplaced and the company launches and scales its omni-channel initiative, the stock can see a re-rating.
Last quarter, the company reported better-than-expected results with used vehicles unit sales increasing +2.1% on a comparable-store basis. Going forward, CarMax is likely to benefit from easing comps in the second half of the current fiscal year, which can help it post mid to high single-digit SSS comps in the back half of this fiscal year.
The company's y-o-y used unit comps are getting easier by 260 bps [= 530-270, see table below] and 1,330 bps [= 530-(-800), see table below] in Q3 and Q4, respectively, as compared to Q2. On a two-year basis, comps are getting easier by 30 bps [= 840-810, see table below] and 770 bps [= 840-70, see table below] in Q3 and Q4, respectively.
Table: CarMax's comparable unit sales growth
Source: Company data, GS Analytics estimates
If we take average of one and two-year trends, we get comps easing by 145 bps [= (260+30)/2] in Q3 and 1,050 bps [(1,330+770)/2] in Q4. Adding them to second quarter's 2.1% comp sales, we get used vehicles unit sales increasing +3.55% in Q3 and 12.60% in Q4 on a comparable-store basis. This equates to ~8.1% (average of 3.55% and 12.60%) increase in comp sales in second half of the current fiscal year. Usually, the company's PE multiple has a positive correlation with its comp sales, and given CarMax's PE multiple is on the lower side of historical range, I see a good possibility of multiple expansion.
Now, some of the readers may find my estimates on the higher side, especially given William Blair analyst Sharon Zackfia's recent report where she has cautioned that the company's Q3 comps can be in 0.5% to 1.0% range. However, I disagree with her analysis. She has used web-scraping data through November 10 to arrive at her estimates. However, if we analyze the company's last year Q3 data, its comps declined from high-single digit in September to modestly negative in November. Ignoring the last 20 days of November, which were the easiest in terms of comparisons, might be leading William Blair analyst to underestimate the company's comparable unit sales.
Where can the stock go?
Over the last five years, CarMax's stock has traded at an average PE multiple of 19.6x, while over the last three years, its average multiple has been 18.6x (Source: YCharts). The stock is currently trading at 13.5x FY19 (ending Feb. 2019) consensus EPS estimates and 12.4x FY20 (ending Feb. 2020) EPS estimates. As the company's comparable sales improve, it launches its omnichannel initiative and some of the noise regarding online threat goes away, I believe the stock can trade at a PE multiple in line with its historical average. Applying an 18.6x PE multiple on FY19 consensus EPS estimate of $4.63, we get a price target of $86 or ~38% upside.
Downside Risks: On the downside, low valuation and significant buyback power (total buyback authorization currently stands at $2.6 bn or ~23% of the market cap) should support the stock. I don't think there is much scope for a further PE contraction from these levels. Other retailers, which are at a significant risk from online players and have flattish top-line growth rate, are trading at low double-digit PE multiples. For e.g., Kohl's (KSS), which is facing significant competition from Amazon (AMZN) and is expected to grow its top-line by just 1.20% next year, is trading at 11.6x current year PE. CarMax, which is expected to grow its top-line by 7% and is facing threat from a much smaller online player - Carvana - deserves better. However, even if we assume CarMax's valuation compresses to a retailer like Kohl's, we get a price target of 53.70 [= 11.6 x 4.63 (current year consensus EPS estimate for CarMax)] implying a 13.7% downside in the worst case scenario.
The other risk I see for the CarMax is the broader macro concerns regarding rising interest rates and its impact on the US economy, consumers and auto sales. Rising interest rates usually have a negative effect on auto sales as customers have to pay higher equated monthly installment for loans, but used-car retailer like CarMax can also benefit as customers look for more affordable alternatives. So far, used-car sales have held up pretty strong increasing 5% in Q3 2018. However, if the pace of interest rate hikes continues and the US economy goes into a recession, it will start impacting consumer confidence and used-car sales as well. If you have a negative view on the US economy, you can consider hedging by shorting index to minimize this risk.
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.