I happen to love the used car business. It tends to have higher margins than new cars, and there’s usually financing involved, which increases profitability all the more. Alas, one of the leading used car dealers is struggling with growth and needs a new direction.
CarMax (KMX) came in with decent sales growth, but it isn’t translating to the bottom line. On the surface it looks good, with EPS of 86 cents, up 13.2% from 76 cents a year ago. Except when you get to net income, there’s $182 million of it versus $169.7 million last year, or a 7.2% increase. The EPS looks better because KMX reduced its share count by 5.4% via repurchases.
Let’s drill down and see where the problems lie for KMX stock.
Revenues rose 7.1% year over year to $4 billion. Breaking that down, we see used car revenues increased 7.6% to $3.3 billion, the result of a 9.3% increase in volume. The volume increase was slightly offset by a 1.6% decline in selling price, but that’s not earth-shaking. The problem for KMX is that unit volume rose by double-digits in the last quarter.
I can quibble with comparable store sales, which rose 4.9%. That mid-single digit number is perfectly respectable in a wobbly economy. Alas, it was also 200 basis points lower than last quarter.
Extended protection plan revenues jumped 12.5% to $71.7 million. That’s almost pure profit because dealers rarely have to execute on these plans.
Now for my favorite segment: financing. There’s a delicate balance with financing. KMX needs to underwrite well enough to keep losses contained, but loosely enough that it can charge hefty interest rates. The finance division came in with 15.3% growth to $109 million. KMX said there were lower losses but also lower interest margins, so there we see an example of that balance.
On a gross profit basis, it’s the financing and protection arms that contribute the highest margins — 89% gross margins is pretty amazing. Wholesale delivers 18%, used cars comes in at 11% gross margin, but new car sales only has 1.4% gross margin.
There aren’t any real systemic problems that I can see for KMX stock. Maybe there’s an issue with selling, general and administrative expense (SG&A), as compensation and benefits rose $24 million year over year, and occupancy costs increased $7 million.
If KMX could add $22 million of cuts, it would go to the bottom line, and true net income would have increased 20%.
Over on the balance sheet, we find KMX stock has $352 million in cash, while debt rose to $9.5 billion. Of course, much of that debt is from a facility drawn down to make the car financing deals.
Operating cash flow is fine, with $118 million in the quarter.
So, what exactly is the problem here? From what I can tell, KMX is doing fine. It’s just not doing great. It needs to distinguish itself from the competition. It needs to cut some expenses. It needs to push those protection and financing plans to the max. I’m no expert as far as execution, so I can spout all I want, but that doesn’t mean it can happen.
As for valuation, KMX stock trades at a price-to-earnings ratio of 25. I am not paying that rate for net income increases of 7%. Even if FY16 earnings were to organically grow 14% as estimates suggest (although that includes repurchases), I wouldn’t pay 23. So that’s one problem.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance. As of this writing, he did not hold a position in any of the aforementioned securities. He has 20 years’ experience in the stock market, and has written more than 1,200 articles on investing. He also is the Manager of the forthcoming Liberty Portfolio. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
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