1 Factor CarMax, Inc. Investors Need to Watch

By Markets Fool.com

It's no secret that consumers looking to get their hands on a new or used vehicle are looking to make the exhausting purchasing process simpler and faster. CarMax, has built its business around selling used cars with a no-haggle pricing promise, and salesmen whose interests are aligned with consumers because they're paid a fixed-commission rate per vehicle rather than having incentive to persuade you into a more-profitable vehicle.

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The thing is, CarMax sells used cars really well, and that's reflected in its financial performance. Its revenue 10-year CAGR is an impressive 10.5%, which is trumped only by its earnings per diluted share 10-year CAGR of nearly 20%.

In addition to CarMax's growing store count and rising units sold at retail, one reason for its impressive revenue growth is the rising prices of used vehicles. In fiscal year 2005, CarMax sold a vehicle at retail for an average price tag of $15,663; in fiscal year 2015, that average price tag had climbed to nearly $20,000.

Higher used-car prices are a bonus for CarMax; but are those prices here to stay? Let's take a look at some recent used-vehicle sales trends, and see how it could impact CarMax's top- and bottom-line growth.

Why it matters
First, investors need some context as to why average transaction prices are a key component of CarMax's success. CarMax's annual gross profit per retail vehicle sale has historically been between 11% and 12% during the past 10 years. (Those margins don't include profit from extended service plans or financing.)

Without consistent gross-profit-margin growth, CarMax depends on higher vehicle transaction prices at its retail stores to drive a fatter bottom-line profit. After all, 11% gross profit from a $20,000 sale is obviously better for total profits than 11% of a $15,000 sale.

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Because retail sales from CarMax stores generate nearly 60% of its gross profits, the rise and fall of used-car prices will have a sizable impact on the top and bottom line. Fortunately, as you can see in the graph below from Edmunds.com, used-car prices have skyrocketed, and don't appear to be slowing down.


Graphic source: Edmunds.com Used Car Pricing Report.

One factor behind the rising used-car prices might surprise you: leases.


Graphic source: Edmunds.com Used Car Pricing Report.

Because leases are generally for a length of three years, and between 10,000 and 15,000 miles annually, the vehicle often returns to the used-car marketplace when the agreement is up. Because nearly new cars command a higher price tag, the recent influx of off-lease vehicles is sending the average used-vehicle price higher. Fortunately, CarMax focuses its retail sales on vehicles between the ages of one and six years, and the rise in prices has been beneficial.

The question investors need to ask themselves is, when will used-car prices peak? There's already some evidence suggesting that prices of newer vehicles of many passenger car segments have peaked.


Graphic source: Edmunds.com Used Car Pricing Report.

There's one critical trend to note for potential CarMax investors. Vehicles less than five years old saw a meager overall increase in prices, albeit at a higher overall price, and five out of six passenger-car segments saw a decline. Meanwhile, vehicles older than five years posted price increases across the board.

It's possible with more and more lease vehicles hitting the used vehicle markets in 2016 and 2017 that newer used-vehicle prices will face more pressure, and could peak or even decline. If that happens, it will have a direct and slimming effect on the total profits CarMax generates from each retail sale.

Don't panic
All is not lost, and even if newer used-car prices peak, or dare I say head lower in the years ahead, CarMax has something up its sleeve. As America's largest used-car dealer, CarMax has pricing, appraisal, and sale information dating all the way back to 1993. That's information that competitors wish they had, and CarMax has used it wisely.

The company created a national pricing algorithm that helps its associates purchase cars from consumers at good prices. It also sets the price tag on its reconditioned retail cars at the right price to move vehicles off store lots effectively and profitably. It's this same pricing information that enables CarMax to find the pricing equillibrium and sell 97% of the wholesale vehicles at its auctions -- wholesale is CarMax's second-largest business segment, albeit far behind its retail segment -- compared to a 60% sell rate at other large competitors, according to Morningstar.

Furthermore,CarMax is the only large dealer that developed its own dealer-management system, or DMS, software that's customized for a used-vehicle retailer rather than generic software that generally is tailored to automotive manufacturers' dealerships.

Investors would be wise to watch the average prices of used cars; but, because CarMax possesses a wealth of knowledge about the used-car market, the company is well poised to thrive and return value to shareholders regardless of when used-car prices peak, or even take a step back.

The article 1 Factor CarMax, Inc. Investors Need to Watch originally appeared on Fool.com.

Daniel Miller has no position in any stocks mentioned. The Motley Fool recommends CarMax. The Motley Fool owns shares of CarMax. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.