CarMax Shares Should Kick Into Gear

 | Jun 20, 2017 | 11:00 AM EDT
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While the stock market roars ahead, the auto industry has been stuck in a ditch. Can CarMax (KMX) nonetheless shift into overdrive?

Shares of CarMax have been spinning their wheels, with the stock of the big used-car retailer down 4% year to date. By contrast, General Motors (GM) has barely budged, down 1.4% YTD, while Ford (F) is stuck in reverse, down 7% so far this year. Meanwhile the S&P 500 is up more than 7%.

CarMax reports first-quarter results on Wednesday, June 21, before the market open. Analysts expect earnings per share of $0.99 on $4.452 billion in sales.

Despite the wreckage in the auto sector, I think shares of CarMax can move into overdrive.

First, the volume of used cars is about to explode. The auto cycle clearly peaked last year. This year, analysts expect U.S. auto sales to decline 2%-3%. Auto sales hit 17.5 million units in 2016.

According to estimates by Manheim Consulting, auto leasing makes up about 25% of all auto sales. Historically, the percentage of vehicles on lease has been much, much lower, around 15%. That means cars leased around 2013-14 are starting to come off lease. In the next three years, Merrill Lynch estimates 12 million used cars could flood the market.

Second, as cars come off lease, millions of consumers will be forced to make a decision -- lease another car, buy a new car or buy a used car. The Federal Reserve has raised interest rates since 2013, so car payments and lease payments will be materially higher than they were in 2013, when consumers first got into a new car.

In an effort to find an affordable car, consumers could be forced into the used-car market. With a flood of used cars in the marketplace, used-car prices are expected to plummet. CarMax is perfectly positioned to pick off the best cars at great prices and capture more market share as consumers seek an affordable solution.

When CarMax reported its fourth-quarter results, management said average used retail vehicle prices declined 1.6% to $19,435, but the gross profit per used vehicle increased $25 to $2,134. Gross margin rose to 10.9% from 10.6% last year. In other words, despite lower car prices, CarMax is very savvy when it comes to buying and selling cars. It is able to turn its inventory quickly and keep its margins intact.

Furthermore, CarMax is planning to open 15 stores in 2017 and another 15 next year. With all the new locations CarMax should be able to take market share from local used-car lots.

CarMax has invested millions in its IT infrastructure. The company is able to capture buyers through the Internet and mobile apps, long before the local used-car dealer has a shot. CarMax also has a gigantic storehouse of used-car data. Since its founding, the company has sold more than 10.5 million vehicles, appraised 25.5 million and had more than 65 million customer contacts. CarMax really knows the used-car market and can use its technology to its advantage.

Just like Domino's Pizza (DPZ) and Starbucks (SBUX) have been able to capture sales through technology, CarMax is doing the same thing.

Back in January, I thought the stock could drive higher, but since then, the stock has stalled. Investors have been concerned about the company's financing arm and are worried about the possibility of increasing default rates as interest rates move higher. In the fourth quarter, the company increased its credit losses by $15.4 million. In addition, there is some concern that higher interest rates will squeeze the spread between what CarMax pays for money and the rate at which it lends. I would keep an eye on credit quality, as it would wreck my thesis.

I don't think CarMax will drive off a cliff. Right now, analysts are looking for earnings of $3.52 a share for fiscal 2018 and $3.83 a share the following year. This year, revenue is expected to come in at $16.8 billion (up 6.3%) and increase 7% the next year. Simply using a 20 times multiple on next year's estimates, the stock should be able to reach the mid $70s; it currently is in the low $60s.

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