After languishing in flat to low single digit range in FY2018 and FY2019, Carmax’s (KMX) same store used unit sales increased to high single digit range in the first nine months of FY2020. The company’s omnichannel initiative as well as improving consumer confidence, rising wages, low unemployment helped its used car sales. The company is likely to post another good quarter when it reports its fourth quarter results in April. The company’s fourth quarter ended in February and consumers were still doing fine in the U.S. at that time. However, I believe the company’s outlook will be much more important for the stock price than what it reports in Q4 and I am not too optimistic about it.
Used cars are relatively big ticket items and their sales are cyclical in nature. When unemployment is low, wages are increasing and consumers have more purchasing power, their sales benefit. Coronavirus has resulted in shutdown of restaurants, cut in hours for retailers and there were also reports that Steven Mnuchin has warned that without stimulus the U.S. unemployment rate can reach 20%. This paints a bleak macroeconomic picture – even worse than 2008-09 recession – when the unemployment rate peaked near 10%. Also, due to their affordability, used car sales have more exposure towards lower income households and hourly wage earners. I believe these lower income households will be hurt the most due to the shutdown.
Comparisons are also getting tougher for Carmax going into Q1. Last year, there was a delay in processing of tax refunds due to the U.S. Government shutdown. So, a couple of week worth of sales shifted from Q4 2019 to Q1 2020. This benefited the company’s Q1 2020 sales and the company posted a used unit comp growth of 9.5% in Q1 2020. The company is set to lap these comparisons in Q1 2021 when it will take the hardest hit from coronavirus impact. So, the commentary around Q1 2021 outlook and sales may disappoint.
Source: Company filings and estimate is author’s
While Carmax’s omnichannel initiative has helped its sales in the last year, it has also added to the cost. Management expects continued investment in this initiative next year. The company needs mid to high single digit comp sales growth to leverage this investment and maintain its operating margins. Given the weak macroeconomic backdrop and tough comparisons, it is unlikely that the company will be able to post such an increase. There is a good likelihood that if the slowdown persists, we can see a negative comp sales in FY2021 which coupled with incremental cost from omnichannel investment will cause operating margin contraction.
The company’s financial business is also at risk if delinquencies increase or credit market worsens. Carmax Auto Finance business finances ~43% of the company’s used vehicles sales and has ~13.32 billion portfolio of managed receivables. However, one should note that the quality of the loans in the portfolio are relatively good and even at the peak of financial crises of 2008-09, this business was able to breakeven (Carmax Auto Finance income was ~$15.3 mn in FY2009). So, while one can model a reduced profitability, I don’t think there are chances of this business making losses on an annualized basis.
I like Carmax’s execution and their performance last year has been better than investor expectations. I believe the company’s long term market share gain story remains intact and its omnichannel initiative will help it accelerate its share gains. However, the coronvirus outbreak has added significant uncertainty to the near term outlook, and if not contained it can result in a significant decline in comp sales in the current fiscal year. The operational deleverage caused by declining sales and the additional costs from incremental investments in omnichannel initiative are likely to cause operating earnings and EPS to decline at a higher pace than topline. Analysts have still not adjusted their EPS numbers for the next year and I believe them to come sharply down after the company reports its results on April 2, 2020.
So, what to do with the stock?
Although I am bearish on the near term outlook, I am not a believer in “the world is coming to an end” narrative. I have seen it in 2008-09 with Lehman going bankrupt, credit market freezing, significant unemployment rate and S&P 500 correcting more than 50%. But in the end everything turned out to be fine.
If you are a long term investor who won’t be bothered after seeing a sharp drop in the company’s comp sales and margins in Q1 FY2021, hold on. The long term story is still intact and once we are past this crisis/recession the stock will likely outperform. However, if you are a short-term investor trading on quarterly results, it may be best to avoid the stock for the next couple of quarters. I am neutral from a near term perspective.
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.
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