Is It Time for Investors to Bail on CarMax, Inc.?

By Markets

Image source: CarMax, Inc.

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It hasn't been a pleasant couple of quarters for those invested in some part of the automotive industry. Despite many companies posting strong profits, the U.S. new vehicle sales market plateauing has offered many investors too good a reason to avoid auto companies. Even CarMax, Inc. (NYSE: KMX), which generates a vast majority of its gross profits from used vehicles and wholesale vehicles rather than new vehicles, has slid from its all-time high in 2015. With all of that in mind, and after CarMax's disappointing second-quarter, is it finally time for investors to bail on their investment?

Where art thou, tier 3 consumers?

CarMax's second-quarter wasn't all that bad, but it was certainly a mixed bag of results. The company grew its revenue 2.9% year over year to $4 billion, which just missed consensus estimates of $4.11 billion. Its bottom-line earnings per share managed to hit estimates of $0.88 when excluding equity compensation charges for the recently retired CEO, Tom Folliard.

Further, CarMax's comparable store sales moved 3.1% higher, which was much better than the first-quarter's 0.2% increase, but was below last year's second-quarter 4.6% mark. However, one of the headwinds for CarMax during the second-quarter was a drop-off in its tier 3 customers, which it refers to as subprime. If you exclude the drop-off of its riskier consumers, the comparable store sales of "non-tier 3" customers increased 8.1%.

If you only scratched the surface CarMax's second-quarter didn't seem so bad, but there are a couple of factors that raise a red flag.

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Pricing softness and margin concerns

When looking at CarMax's average selling prices (ASP), there's definitely a little bit of pricing softness. This was inevitable, though. During the second-quarter its used vehicle ASP dropped 2.3% year over year, from $19,983 to $19,530. Wholesale vehicle ASPs were a bit worse, declining 4.1% year over year, from $5,336 to $5,119. However, to be fair, let's look at pricing and gross profit margins in a long-term view.

Chart by author. Information source: CarMax, Inc.

You can see a little bit of softness in recent quarters, but pricing still remains near record highs. Here's a look at gross profit margins.

Chart by author. Information source: CarMax, Inc.

The concern for investors going forward is that if pricing continues to soften, it's going to begin putting serious pressure on its gross profit margins. Thus far, used vehicle gross profit per unit has remained resilient near record highs, but margins have trended nearly a percentage point lower than the 2010 peak. Wholesale vehicle gross profit margins took a hit during the second quarter, moving from $951 per unit down to $870 per unit.

The real margin concern is what might happen next: an inevitable onslaught of late-model used vehicles coming off-lease over the next couple of years. More specifically, according to, industry forecasts are predicting a total of 3.1 million vehicles to have entered the used vehicle market by the time 2016 is done. That's expected to grow to nearly 4 million during 2018, and that amount of supply is likely to put pressure on gross profit margins. CarMax management notes that it hasn't seen a large supply of these off-lease vehicles hitting the market yet, but that means it could get rough over the next couple of years as that scenario unfolds.

Fender bender, or totaled?

Part of the issue is that investors had gotten used to CarMax growing across the board. If you recall from the graphs above, it wasn't until around 2015 that CarMax's used vehicle pricing plateaued. Before that, the company was improving its pricing power significantly over the years. It was also growing its comparable store sales while it improved the efficiency of its newer stores, all while opening new stores that added incremental sales.

Now, as happens with companies when they mature to a certain point, CarMax is likely optimized in terms of vehicle pricing and has only so many more efficiencies to create with its older stores. That doesn't mean its growth story is over, it just means the growth story now focuses on a rising store count. That's not a bad thing, but it's clear the markets are adjusting for this new growth reality.

CarMax's growth story is far from over, but as the U.S. auto industry plateaus, and its pricing power peaks, the company just isn't going to be firing on all cylinders as we've grown accustomed to in years past -- invest accordingly. But is it time to bail? Not yet -- not unless we start seeing a dramatic reverse in gross profit margins when off-lease vehicles join the used vehicle market.

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Daniel Miller has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.