CarMax Turns Inventory Faster Than Competitors
Summary
- CarMax retailed 832,640 vehicles in the last fiscal year from an inventory of just 80,000.
- Focusing on used vehicles gives CarMax more control over inventory.
- If cars are substantially repriced downward because of Covid-19, then the companies that can get inventory down quickly are advantaged.
Introduction
My thesis is that CarMax (NYSE:KMX) is advantaged relative to competitors with respect to moving inventory quickly. CarMax retails more used cars than anyone in the U.S. and its 4Q20 earnings release (ending February 29, 2019) shows 206,718 units sold. AutoNation (AN) sold 59,022 units in 4Q19 and Carvana (CVNA) sold 50,370. Other competitors include Asbury (ABG), Lithia Motors (LAD), Penske (PAG) and Sonic (SAH).
The latest fiscal year for CarMax is 2020 and it ended February 29th, 2020. We use the word "cars" loosely in this article seeing as the CarMax 3Q20 earnings call stated that SUVs and trucks accounted for about 49% of sales in the quarter.
Covid-19
If cars are substantially repriced downward because of Covid-19, then the companies that can get inventory down quickly are advantaged. The gross profit per unit as opposed to the average selling price is the key to this business. Despite inventory advantages, I think the 1Q21 earnings for CarMax from March to May could be egregious. The 2020 10-K says half the stores are closed and most of the remaining stores are selling 50% of normal or less. 15,500 of the 27,050 associates have been placed on furlough as of April 18th. The 10-K acknowledges there will be pressure on the gross profit per unit as it reduces inventory. And the 10-K gives us reasons to have concerns with CarMax Auto Finance (CAF):
During the second half of March and continuing into April 2020, we have seen an increase in delinquencies and greater demand for payment extensions.
Investors have been honing in on balance sheets during the Covid-19 pandemic but an April 2020 Morningstar report says CarMax's balance sheet looks safe:
The balance sheet looks safe to us should the U.S. enter a long recession in 2020-21. Debt has no balances due until $100 million of senior notes mature in April 2023, but major obligations are not due until June 2024. The June 2024 obligations at March 31 are $1.4 billion, with $1.1 billion coming from the credit line and $300 million from a term loan. In March, CarMax borrowed about $675 million on its revolver and has over $300 million of borrowing available plus about $700 million of cash.
In the short run CarMax and other car retailers face tremendous obstacles. I think most of these retailers will recover to a certain degree in the long run, but the challenges ahead are enormous.
Retail Inventory
This isn't a high-margin business and inventory needs to move somewhat quickly in order to get a decent return on capital. We get some insight into inventory control from the March 2007 Raymond James Institutional Investors Conference. Then CEO Tom Folliard talked about the advantages CarMax has with respect to inventory:
Used cars are more profitable. They're not just more profitable for us. They're more profitable for everybody. You have total control over the inventory that you buy. You're not held captive by what the manufacturers build and have to take that inventory. You can turn your inventory a little bit faster. You're really much more in control of your own destiny with the more used cars you sell.
CarMax's filings show it is true that it moves inventory quickly. The CarMax 2020 10-K ending February 29th shows 832,640 used vehicles retailed from an inventory of just 80,000 vehicles. Vehicle inventory cost for CarMax is determined by specific identification as opposed to LIFO or FIFO. The 2019 10-K filings for companies that retail both new and used vehicles allow us to validate the claims made above by then CEO Folliard. We see that the days supply are higher for new vehicles than used vehicles:
Company | Retail New Days Supply | Retail Used Days Supply |
Asbury | 66 | 29 |
Sonic | 53 | 28 |
Penske | 71 | 52 |
AutoNation | 52 | 39 |
Lithia | 71 | 65 |
Spreadsheet Sources: 2019 10-K filings for Sonic, AutoNation and Lithia along with 4Q19 earnings calls for Asbury and Penske.
Not surprisingly, we see that CarMax turns its inventory faster than competitors:
Company | Inventory | Prior Year Inventory | Average Inventory | Cost of Sales | Inventory Turnover | Days Inv. Outstanding |
CarMax [1] | $2,846 Mn | $2,519 Mn | $2,683 Mn | $17,598 Mn | 6.6 | 59 |
Asbury | $985 Mn | $1,068 Mn | $1,027 Mn | $6,041 Mn | 5.9 | 60 |
Sonic | $1,518 Mn | $1,528 Mn | $1,523 Mn | $8,933 Mn | 5.9 | 62 |
Carvana | $763 Mn | $412 Mn | $588 Mn | $3,433 Mn | 5.8 | 81 |
AutoNation | $3,306 Mn | $3,651 Mn | $3,479 Mn | $17,813 Mn | 5.1 | 68 |
Penske | $4,261 Mn | $4,040 Mn | $4,151 Mn | $19,724 Mn | 4.8 | 79 |
Lithia | $2,434 Mn | $2,365 Mn | $2,400 Mn | $10,719 Mn | 4.5 | 83 |
[1] ended 2/29/20
I define inventory turnover as the cost of sales divided by the average inventory while days inventory outstanding are the cost of sales divided by the current year inventory.
Spreadsheet Sources: 2020 10-K filing for CarMax and 2019 10-K filings for everyone else. The 10-K links were given earlier except for Asbury, Carvana and Penske.
Pretax Earnings
Moving inventory quickly is nice, but it doesn't tell us much about the economic prospects by itself. Suppose it costs me 30 cents to make a lemonade and I sell it for 25. I can move my inventory extremely fast, but I'm not making any money. This brings us to return on capital, but it can get messy when comparing companies with different capital structures. Keeping things simple, I like to look at the ratio of pretax earnings to average inventory for each company and make comparisons. Inventory is the biggest part of working capital and it deserves a great deal of focus:
Company | Average Inventory | Pretax Earnings from cont. ops. | Pretax Earnings/ Average Inventory |
CarMax [1] | $2,683 Mn | $1,161 Mn | 43% |
Asbury | $1,027 Mn | $244 Mn | 24% |
AutoNation | $3,479 Mn | $613 Mn | 18% |
Lithia | $2,400 Mn | $375 Mn | 16% |
Penske | $4,151 Mn | $592 Mn | 14% |
Sonic | $1,523 Mn | $200 Mn | 13% |
[1] ended 2/29/20
Spreadsheet Sources: 10-K filings
We see above that CarMax does an excellent job producing large pretax earnings with a relatively small inventory base.
It is beyond the scope of this article to go down the income statement for all the companies above, but we need to do it for CarMax in order to better understand the prospects of its pretax earnings moving forward. Looking at the $20,320 million in net sales, the biggest components are the $17,169 million in used vehicles and the $2,500 million in wholesale vehicle sales. The total cost of sales is $17,598 million bringing us down to a gross profit of $2,722 million.
We know that the focus on retailing used cars as opposed to new cars is part of the equation for CarMax's success in having large pretax earnings from a relatively small inventory base. It also does well originating loans from CAF as opposed to the old days when it originated loans for other lenders and collected a mere $300 commission per car. The wholesale business is another meaningful part of pretax earnings. The June 2015 Oppenheimer Consumer Conference transcript reveals how it makes money on each car. Then IR VP Katharine Kenny succinctly describes the layered components:
So if you want to think in terms of the average car that we sell, we'll make -- if we buy your car, we'll make $1,000 on it. If we -- if you buy a car from us, we'll make, on average, say, $2,100 to $2,200; plus we sell an extended service plan 60% of the time. So, on average, across our entire store base, that's maybe $400 per car. And then if we finance the business, that's another $1,500 or $1,600 on top of that.
We can tie much of this 2015 layered description above with more recent numbers and see that the figures are still in the same ballpark. The 2020 10-K shows that 466,177 vehicles were sold at wholesale auctions and the gross profit was $454.4 million such that the gross profit per unit was $975. 832,640 used vehicles were retailed and the gross profit was $1,820.1 million such that the gross profit per unit was $2,186. There was also $447.8 million in other gross profit which comes to $538 per unit. This "other" group consists of extended protection plan (EPP) revenues, net third-party finance fees and other revenues. At this point we've covered the $2,722 million gross profit.
It helps to get a little more information on CAF before we try to reconcile what was said by then IR VP Kenny with respect to today's numbers. The transcript from the June 2011 Oppenheimer & Co. Consumer Conference sheds some light on why CAF is preferred to commissions from other lenders. Then CEO Tom Folliard notes that the company would collect about $300 in commission if it originated the loan for another lender. He goes on to say that if it originates the loan at CAF, then the profit is around $1,800 and he talks about the timing nuances:
Remember also we had a change in accounting, so the trade-off there is the $300 we get in commission, we get it immediately into earnings. The $1800 that we make over the life of the loan, we only get 25% of that in the first year and 75% over the life of the loan. So it pushes earnings out but it's a pretty easy decision to go from $300 to $1800 regardless of when you get it, as long as you know you can go out and securitize it.
Remember that the remarks from then CEO Folliard were in 2011 while the remarks from then IR VP Kenny were in 2015 when the interest rate environment was different. It is hard to tie to the "$1,500 or $1,600" per car CAF range because this is spread out over several years. We do know that the CAF income for the 2020 year was $456 million and 42.5% of retail vehicles for the year were financed with CAF. Again, we can't do a simple division to get a per car number for CAF because the income is spread out with cars from several years.
The sum of these gross profit and CAF income numbers is $3,178 million and it helps to visualize the components in a pie chart:
Image Source: Author's Google Doc from 2020 10-K filing.
One has to be careful making gross profit per unit comparisons with competitors and I explain the details in my February 2019 article. On the surface it looks like Asbury, Penske, AutoNation and Sonic have lower gross profit per unit, but the reality is that they move the highly profitable reconditioning numbers into a separate parts and services bucket.
We get down to the $1,161 million pretax earnings by starting with the $2,722 million in gross profit plus the $456 million in CAF income to get to the $3,178 million gross profit and CAF income subtotal. Next we subtract $1,940 million selling, general and administrative expenses and $83 million interest expense. Finally, we add $5.7 million other income.
Valuation
The non-recourse CAF debt can cause confusion with respect to the balance sheet and the cash flow statement. The 2020 10-K says the following:
We believe adjusted net cash from operating activities is a meaningful metric for investors because it provides better visibility into the cash generated from operations.
The idea behind its adjusted net cash from operating activities figure is that increases in non-recourse notes payable are included. In the "Reconciliation Of Adjusted Net Cash From Operating Activities" section, it shows that adjusted cash flow from operations is $(236.6) million cash provided by operating activities plus $1,077.9 million net issuances of non-recourse notes payable for a total of $841.3 million.
Calculating free cash flow (FCF), I start with the adjusted net cash from operating activities figure of $841.3 million and subtract stock based compensation (SBC) since I treat it like a cash expense. I also subtract the maintenance portion of the capex. SBC is $109 million and total capex is $332 million. In fiscal 2010 through the end of February 2010, the capex was just $22.4 million at a time when it had 100 stores and it froze growth capex due to the financial crisis. Today it has 102 production stores where vehicle reconditioning is performed plus 114 non-production stores for a total of 216 stores. I estimate the maintenance part of capex is less than $75 million today. Therefore, my adjusted free cash flow is around $657 million or $841.3 million less $109 million less $75 million. This number should be much lower for fiscal 2021 due to Covid-19.
In terms of normalized FCF, we're still not quite there because 2020 was different with respect to inventory. Increases in inventory for 2018, 2019 and 2020 lowered cash provided by operating activities by $130 million, $129 million and $327 million, respectively. If 2020 was more like 2018 or 2019 in this respect, then adjusted FCF would have been about $200 million higher making it closer to $857 million than $657 million.
The normalized number for adjusted FCF is fairly close to the net earnings number of $888.4 million.
The value of any company is the amount of cash that can be pulled out from now until judgment day discounted back to today's dollars. We often use a FCF multiple or an earnings multiple as a shortcut. Given the growth prospects for CarMax when we don't have Covid-19 type recessions, I think it is reasonable to value the company at 15x to 18x net earnings or $13.3 billion to $16 billion.
Enterprise Value
I exclude non-recourse debt when calculating enterprise value:
$12,801 million market cap [1]
$1,779 million long-term debt
$441 million operating leases
$31 million current operating leases
$9 million current portion of long-term debt
$(58) million cash and equivalents
---------------------
$15,003 million
[1] The 2020 10-K says there were 162,574,714 shares outstanding as of March 30th. Multiplying this by the April 29th share price of $78.84 gives us a market cap of $12,801 million.
The enterprise value of $15 billion is within my valuation range so I think CarMax is reasonably priced.
Closing Thoughts
One of the reasons I've reduced my position in CarMax is because it has not moved to the online component of its omni-channel strategy as fast as I would like. The omni-channel experience is available to over 60% of CarMax customers, but the Covid-19 crisis shows that this is not enough. The 10-K says that 93% of CarMax customers visited them online before making a purchase and 34% of the vehicles sold were transferred. It would be nice if CarMax could quicken its online rollout to be more like Carvana.
CarMax has an advantage to competitors with respect to inventory, but maybe this isn't the best time to own any car retailing companies. As capital allocators, investors shouldn't just look for their favorite car companies, they should look for their favorite companies period. I like some attributes of CarMax relative to competitors, but maybe this isn't the best time to be invested in companies selling cars. I think CarMax will work out reasonably well over the next five years, but I've been reducing my position and redeploying the capital to other ideas.
This article was written by
Analyst’s Disclosure: I am/we are long KMX, VOO. 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.
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