CarMax, Inc (NYSE:KMX) is one of America’s largest used-car auto dealers. With its 185 locations and its no hassle business model, KMX stock has always been attractive to me.

Particularly alluring are its generally higher margins, a benefit of selling used cars rather than new ones, with their not-quite-so-fat margins.

And while CarMax stock is facing some near-term headwinds, it is well positioned for long-term growth. The question is when to jump in on the shares.

Market Share Gains

From a long-term perspective, KMX stock has a bright future. The company is selling less than 3% of America’s vehicles in the 0-to -10 years old age range. That leaves a a lot of market share to go after.

And, how CarMax handles the shopping experience is another big advantage to its business. You just walk onto a lot and browse without being badgered by a salesperson. The pushy car salesman is universally regarded as the worst part of the car buying or car leasing experience. CarMax wisely decided to let the consumer do what they’re going to do, and if they need help, they can ask.

CarMax is to the used-car world what FirstCash Inc (NASDAQ:FCFS) is to the pawnshop world. These are sleek, upscale, modern stores. You don’t feel like you’re slumming it. That makes a big difference to a used car buyer.

Painful SG&A Increases

Meanwhile, KMX stock has benefited from consistent modest year-over-year revenue increases. Regrettably, much of this has been offset by large increases in selling, general, and administrative expenses.

Also, despite the business model, the company has been struggling with operational cash flow losses and free cash flow going negative year after year. Free cash flow was in the red to the tune of $900 million in fiscal 2017. In the trailing 12 months, that improved to negative $675 million. Still, that’s a horrific cash burn and it’s one of the big problems with the used-car businesses.

Inventory is only part of the problem. The real trick is the financing arm of the company, and this is where I have concerns.

Financing Foibles

The fortunes of any company that deals in financing are going to rest on its underwriting ability. Relaxing underwriting standards, even a little bit, can result in a catastrophic increase in defaults. The yield spread — that is, the difference between the average financing rate it’s able to charge versus the cost of that financing to CarMax — is about 6%.

So, let’s say a car buyer defaults on 60% of the principal he was loaned. It would take 10 interest-years to make up for that one default. That one default wipes out the interest collected on 10 other vehicles.

The average managed receivables portfolio for the company was $7.86 billion in 2015. It rose to $9.09 billion in 2016, and hit $10.16 billion in 2017. Over those years, however, the allowance for loan losses increase from 0.97% in 2015 to 1.16% in 2017. You’d think that a 19-basis-point increase in loan losses wouldn’t amount to much. But you’d be wrong. It results in an additional $50 million of credit losses.

But Wait, There’s More

There’s also some more bad news, which is that the average recovery rate on losses fell from 54.2% in 2015 to 47.4% in 2017. This is not a trend we want to see.

CarMax finances almost half of the vehicles it sells, and holds a portfolio of almost $11 billion. The good news is that the money for these loans comes from non-recourse notes. The bad news is that CarMax is really burning cash right now, and if credit quality in used cars continues to deteriorate it could end up in big trouble.

This is why I say in the near term, CarMax has problems to sort out. If it manages to do so, KMX stock may make for an intriguing long-term opportunity at 16x fiscal year 2019 earnings.

Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.