Long Thesis On CarMax, Inc (KMX) by Redcards
Capital Structure Considerations
- $300m of long-term debt at 1.6% interest (expiring 11/17) and 0.2x net debt/EBITDA ratio.
Investment Thesis
- Sentiment on the subprime auto ABS market is too bearish. The Street ignores the outperformance of CarMax’s auto loans benefiting from an increasing origination rate driven by consensus expectations of modest retail gross profit expansion as store base grows 45%.
- KMX’s auto loans offer an asymmetric risk/reward opportunity as auto ABS are not capitalized with subprime credit or the Company’s balance sheet. ABS credit metrics have best-in-class risk performance of < 2% net losses and 5% spread capture on an average 7% loan.
- Management is overtly conservative. Overcollateralization reserves are guided at filling 3-4 months after issuance, but are completed sooner at 1.5 months, allowing for quicker net cash flow capture of high quality credit and contributes to a 14% ABS cash flow CAGR.
- A 9.6% average FCF yield is efficiently allocated by management. $2.25b worth of shares will be reacquired through 2016 under current buyback plan, and will drive a low-to-mid teens compounding return over the next 5 years.
Catalysts
- Continuation of share repurchase program beyond 2016P.
- Continued outperformance of ABS vs. subprime competitors.
Key Risks and Mitigants
- Subprime financing test exposes CarMax to bad credit: Subprime auto loans are financed with the Company’s balance sheet and do not threaten securitization performance. Subprime loans make up 1.3% of total receivable balance.
- Cash flow from auto loans is not immediate upon issuance: There is a 1.5-month gap between loan overcollateralization target being filled and net cash flows received on new auto loans – KMX does not book these cash flows until they are received.
- Financing origination is sensitive to interest rate environment: Attractive bank financing rates on securitizations combined with increasing interest rates allows spread capture to remain constant at 5%.
Why Does This Opportunity Exist?
- Financial databases miss CarMax’s cash generation: Cash flow from securitization transactions are recorded as financing cash flow, and is not included in CFO/FCF calculations on automated financial terminals such as Bloomberg, Capital IQ, and FactSet.
- Auto securitization performance is buried in the weeds: The low risk performance details of auto loan securitizations are buried within the fine print of KMX’s complex securitization prospectuses that many investors simply do not take the time to read.
- Market sell-off: KMX is currently trading 15% down from its 52-week high of $73.70 after an analyst comps estimate miss for Q1 earnings prompted an irrational sell-off.
Debunking the Bear Thesis
- Cash flow from securitization issuance is unsustainable: Net cash flow from securitizations is collected up front at the time of transaction with special purpose entity, and is not tied to cash flow from spread capture.
- Time-to-maturity of loans is too long to wait for cash flows: The tiered payout structure of KMX’s auto securitizations results in the 50% payback of a $1.2b loan with a 5.5-year time-to-maturity within the first 24 months.
- Subprime financing test adds too much risk to balance sheet: CarMax gets first look at customer profiles for financing, and can still refer risky subprime customers to bank partners if the risk of loan default is too high for on-balance sheet financing.
CarMax Would Be a Short If…
- CarMax Auto Finance (CAF) was spun off: KMX would lose a strong source of cash flow and revert to lower margin gain on fees from financing referrals to third party banks as well as if the Company abandoned self-financing completely.
- Auto loan spread capture fell below 3%: Loan performance would fall in-line with new car loans and no longer present an attractive return profile compared to the same best-in-class auto loans of Ford and Toyota.
- Auto loan securitizations began capitalizing with subprime credit: KMX’s auto loan securitizations would no longer have a competitive edge in the ABS market if they were capitalized with subprime credit and would lose their asymmetric risk/reward profile.
Valuation
I valued KMX on 2017P FCF. A composite of high quality American and Chinese automotive retailers, manufacturers, lenders, and auctioneers trade at an average 15x FCF. My base case 15x FCF scenario both embeds conservatism and margin of safety into the expected IRR considering KMX currently trades at 10x 2017P FCF.
Appendix I: Thesis and Risk Details
CarMax, Inc. is a growth story the Street has been familiar with for some time. The Company is attractively positioned within its industry to take advantage of scale economics of an end product that is not fungible, and has small market share that could grow indefinitely driving superior returns on invested capital. However, the current KMX thesis is only half-baked and does not fully recognize the value proposition of their self-financing business.
The growth thesis for KMX is fairly straight forward. The Company is the leading consolidator of the used car retail market, and is expected to compound their market share by expanding into untapped markets, while retaining their current customer base due to the unique no-haggle value proposition of the KMX business model.
KMX currently operates 145 stores in 30 states and plans on expanding their store base to over 200 stores nationwide over the next five years.
To drive this potential for growth home, consider the following:
- KMX stores only reach about 63% of the U.S. population, and;
- KMX only captures 3% market share of the used car retail industry.
At only 3% market share capture, KMX has generated $14b in revenue for the most recent year.
In this market, there are few companies with the national scale that CarMax has, including – AutoNation, Group 1 Automotive, Penske Automotive Group, and Sonic Automotive. The industry is highly fragmented because most dealerships are not part of a much larger group.
While there are above 17,000 new car dealerships in the country, the number of used car dealerships is higher toward 35,000.
Despite CarMax’s 3% market share, the Company still sells twice as many vehicles as the next-largest retailer of used cars, AutoNation.
The success of KMX’s business model is driven by the fact that the Company offers consumers a used vehicle purchase process that is fundamentally different from a typical auto retail experience. There is a no-haggle pricing model which removes a universal frustration from consumers, also, KMX sales consultants are paid commissions on a fixed dollars-per-unit basis which means salesmen have no incentive to push consumers toward a higher priced vehicle, or try and pass a higher interest rate by.
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