CarMax was founded in 1993 in Richmond, Virginia under the ownership of Circuit City Stores.  In the early 1990s, Circuit City was looking for growth opportunities in different markets outside consumer electronics.  The automotive sector was identified due to its large size, fragmented nature, and a reputation for less than stellar consumer satisfaction.  CarMax was separated from Circuit City and became a publicly traded company in 2002.  The business model turned out to be very successful and the company is now the largest retailer of used cars in the United States, selling 619,936 vehicles at retail in fiscal 2016 along with an additional 394,437 vehicles through wholesale auctions.  Although CarMax is the largest used car retailer, it does not have a dominant share of the market.  In 2015, Over 17 million new cars and 40 million used cars were sold at retail, with an additional 10 million vehicles sold at auction.  The total fleet of light vehicles in the United States was approximately 260 million at the end of 2015.

Purchasing a car has traditionally been a frustrating process for most people.  Unless you are someone who particularly enjoys the negotiating process or derives energy from confrontation, buying a vehicle, especially a used one, is about as pleasant as getting a root canal.  One can choose between going to a dealership or transacting with a private party, but informational asymmetry, the complexity of the product, and financing issues make the transaction inherently difficult.  No one wants to overpay for a lemon or be pressured into making a complex decision in a less than hospitable environment.

The CarMax approach is fundamentally different from the typical auto dealership experience primarily because the “no-haggle pricing” policy removes the most contentious part of the process.  The goal is to provide the customer with the same experience they get at a typical “big box” retailer.  Sales consultants are paid commissions on a fixed dollars-per-unit basis and have no incentives to sell inappropriate financing or extras.  The company also provides a five day money back guarantee which reduces risk to the consumer.

There are other benefits for the customer as well including the ability to sell a trade-in vehicle to CarMax regardless of whether one purchases a vehicle.  Effectively, the trade-in of a customer’s vehicle and the purchase of a CarMax vehicle are completely separate and handled transparently.  CarMax benefits from a stream of inventory coming in from trade-ins that can be obtained for better prices than through other channels.  Vehicles obtained via trade-in are either reconditioned in CarMax production facilities or sold at auction.  CarMax tends to focus on selling newer vehicles through its retail channel, as evidenced by the average selling price of $19,640 over the first nine months of fiscal 2017.  The typical sales price of a vehicle sold at auction was $5,165.

CarMax offers financing to customers either through its CarMax Auto Finance subsidiary or through “Tier 2” and “Tier 3” providers who cater to customers with lower credit scores.  All financing offers include the right to pay off the loan within three days, which allows the customer to refinance through another lender within three days at no charge.  The combination of the three day payoff option and the five day money back guarantee obviously removes quite a bit of anxiety from the process.

Although CarMax is the largest used car retailer in the United States, it has yet to saturate the country geographically.  As of September 28, 2016, the company had 165 locations (increased to 169 locations at the end of Q3 of fiscal 2017 on November 30).  The store count was only 67 units at the end of fiscal 2006 and has increased during every fiscal year except for 2010. The exhibit below shows the location of CarMax stores in the United States along with planned locations through August 2017.

In this article, we will take a look at CarMax in more detail focusing first on the history of its retail and wholesale operations which forms the core of the business.  We then examine the company’s financing unit which is an integral part of the success of its retail operations.

Retail and Wholesale Operations

CarMax offers a broad selection of used vehicles at retail that generally range in price from $12,000 to $35,000.  Although there are some older vehicles listed on the CarMax website, the majority are relatively new and have less than 100,000 miles.  Vehicles are reconditioned to ensure that all vehicles sold at retail qualify as “CarMax Quality Certified” vehicles.  Most routine mechanical maintenance and minor body repairs are handled in-house.  Vehicles that do not qualify for sale at retail are sold at auction.  The typical vehicle sold at a CarMax wholesale auction is 10 years old and has more than 100,000 miles.

The exhibit below shows the CarMax income statement over the past eleven fiscal years as well as for the first three quarters of fiscal 2017 (click on the exhibit for a larger view):

It is important to examine more than the past few years for a company like CarMax given the fact that automobile sales were quite depressed during the financial crisis as well as the early part of the current decade.  Predictably, results were pressured during fiscal year ending on February 28, 2009 which represents the worst of the crisis.  However, the company was still profitable, albeit at a depressed level as reduced revenue was not matched by a reduction in SG&A.  However, the recovery in the years that followed is quite impressive.  Looking at some more granular data helps to illustrate CarMax’s recovery after the financial crisis (click on the exhibit for a larger view):

In terms of used cars sold at retail, the decline from fiscal 2008 to fiscal 2009 was fairly modest at 8.4 percent.  Unit sales recovered slightly in fiscal 2010 before exceeding pre-recession levels in 2011 as store expansion resumed.  Used vehicle gross profit held steady during the worst of the crisis and then exceeded pre-recession levels in 2010.  Average selling price of used vehicles sold at retail increased substantially from fiscal 2009 to fiscal 2013 and has held steady since that time. Store expansion accelerated over the past few years and has driven unit sales higher. As per-unit economics have been maintained, overall profitability has increased with diluted EPS rising from $1.24 in fiscal 2010 to $3.03 in fiscal 2016, a compound rate of 16 percent. EPS growth has also been aided by a repurchase program initiated in fiscal 2013.

What seems impressive about CarMax is the relative stability of gross margin per unit over time coupled with the company’s expansion potential.  Management expects to open 15 stores in fiscal 2017 (ending on February 28, 2017) and an additional 13 to 16 stores in fiscal 2018.  Some of these stores will serve smaller metropolitan areas using a smaller store format and some stores will serve additional large metropolitan areas.  Looking back at the map of store locations, it is clear that there are major parts of the United States that are yet to be served.  CarMax has a strong brand and is not anywhere near the saturation point.

CarMax Auto Finance

Since the majority of customers shopping for a vehicle cannot pay cash for the purchase, providing easy and competitive financing options is an integral part of operating in the retail channel.  The auto financing industry is comprised of banks, captive finance divisions of new car manufacturers, credit unions, and independent finance companies.  CarMax Auto Finance (CAF) primarily competes with banks and credit unions that offer direct financing to customers who are purchasing used vehicles.  CAF is ranked 8th in market share for used vehicle loans and 14th in market share for all vehicle loans in the United States (as of the 4th quarter of 2015).

All customer application for credit are initially reviewed by CAF.  Applications that are declined or conditionally approved by CAF are then evaluated by third-party finance providers (which includes Santander USA, Wells Fargo Dealer Services, Ally Financial, Exeter Finance Corp, American Credit Acceptance, Capital One Auto Finance, and Westlake Financial Services).  When an application is referred to a third party provider, CAF is either paid or pays a fixed fee per contract.  “Tier 2” providers typically pay a fee to CAF while “Tier 3” providers receive a fee from CAF.  Tier 3 providers serve customers with low credit scores and CAF is willing to pay a fee to facilitate their financing because it provides incremental retail sales that would otherwise not occur.  Regardless of whether a loan is retained or referred to a Tier 2 or Tier 3 provider, CAF services all auto loans it originates.  This includes maintaining contact with delinquent customers and, if necessary, repossessing vehicles securing defaulted loans.  At the end of fiscal 2016, CAF serviced approximately 709,000 customers and the managed receivable portfolio was $9.59 billion.

The exhibit below shows the results of CAF from fiscal 2006 through the first nine months of fiscal 2017.  There was an accounting change that required CarMax to consolidate CAF on the balance sheet starting in fiscal 2011 and this also changed the presentation showing the components of CAF income.  However, for purposes of this article, we will focus mainly on overall CAF income as well as key metrics associated with the loan portfolio.  Click on the exhibit for a larger view.

There are a number of moving parts in the exhibit, but we will focus on the following:

• Total managed receivables is the size of the overall loan portfolio, whether retained by CAF or referred to third-party provider.  We can see that this portfolio of receivables has increased rather dramatically over time and now exceeds $10 billion.
• Net loans originated and vehicle units financed gives us a picture of the percentage of vehicle sales that CarMax is financing through CAF each year and the approximate amount of financing per vehicle.  The Net CAF penetration rate represents the percentage of unit sales that are financed through CAF.  This figure has been trending upward for some time, rising from 30 percent in fiscal 2008 to 44.7 percent for the first three quarters of fiscal 2017.
• The weighted average contract rate line indicates that the interest rate charged on the overall portfolio has held above 7 percent in recent years.  The margin between the weighted average contract rate and CAF’s funding costs for securitizations (discussed below) influences CAF income as a percentage of average managed receivables which was 4.3 percent in fiscal 2016 and 3.8 percent on an annualized basis for the first three quarters of fiscal 2017.
• Credit scores, loan-to-value, and term.  FICO score information is not available for all periods, but we can see that the weighted average credit score is around 700 which is generally considered to represent fair to good credit.  The loan to value ratio is the amount of the loan relative to the value of the vehicle (presumably as represented by the selling price).  The fact that the loan-to-value ratio has been in the mid 90% range for the past few years indicates that CarMax customers typically pay very small down payments.  The typical loan term appears to be slightly more than five years.

Perhaps the most important question regarding CAF is the quality of the loan portfolio and how big of an issue credit losses have been historically.  We can see that the allowance for loan losses has typically been slightly below 1 percent in recent years which has roughly matched net credit losses.  If we look back to the financial crisis and recession, credit losses were predictably much higher, as were past due accounts.  However, CAF was still profitable even in 2009, albeit at much reduced levels.

CAF auto loan receivables are primarily funded through securitization transactions that are structured to legally isolate the auto loan receivables.  Investors in the non-recourse notes have no recourse to CarMax assets beyond the securitized receivables plus the amounts on deposits in reserve accounts and restricted cash held by CAF.  In addition to securitization, CAF has access to warehouse facilities to fund non-recourse notes.  At the end of fiscal 2016, there were $8.13 billion of non-recourse notes payable related to securitizations and $1.4 billion related to warehouse facilities.  The warehouse facility limit was $2.5 billion at the end of the fiscal year.

While the mechanics of CAF are relatively complex, we can draw some conclusions based on the data and CarMax’s history over the past several years.  First, it is apparent that CAF is integral to CarMax’s ability to successfully sell cars through the retail channel.  Given the fact that most customers require financing, it is critical to have a financing unit capable of either funding loans directly or referring customers to a third party.  Second, securitized funding is very important to CAF’s operations.  Auto loan receivables have grown significantly in support of the company’s overall expansion and growth plans and funding for these receivables must continue to be available to facilitate future growth.  Third, although CAF weathered the financial crisis and recession relatively well, it is much larger today than it was previously and should be monitored carefully when we enter the next recession.

Cash Flow and Repurchases

CarMax management uses an adjusted figure for operating cash flow to eliminate distortions caused by the activities of CAF.  Cash flow from operating activities reflects changes in auto loan receivables, which have been increasing in recent years, and this results in negative reported operating cash flow.  The offsetting impact of changes in non-recourse notes payable is reflected in cash flows from financing activities.  However, these are really operating cash flows given CAF’s business model.  The exhibit below reconciles reported operating cash flow to adjusted operating cash flow and also shows free cash flow:

We should note that our calculation of free cash flow simply deducts all capital expenditures.  In reality, the majority of capex is attributable to the company’s rapid store expansion program.  However, there is no breakdown of maintenance and expansion capex in the company’s filings.  It is likely that free cash flow at least approximates net income if we were to back out the expansionary capex.

CarMax does not pay a dividend but management initiated a stock repurchase program in fiscal 2013.  From fiscal 2013 through the third quarter of fiscal 2017, the company repurchased $2.9 billion of stock.  This was funded by a combination of free cash flow and additional long-term debt.

Risks to the Business Model

As we have noted, CarMax operates in a highly fragmented industry and has relatively low market share.  The company has room to expand geographically and appears to have a brand that permits it to generate attractive gross margins per unit sold even in difficult economic environments.  Obviously, one potential risk involves the emergence of “copycats” who could seek to replicate parts of the CarMax model such as “no haggle” pricing.  However, it would be difficult to replicate CarMax’s ability to offer quotes for any trade-in regardless of whether a customer actually purchases a vehicle and it would not be easy for a new entrant to match CarMax’s financing operation or its overall scale.

We would regard major disruption in the automobile industry to be a more significant long term risk relative to new entrants.  Currently, the automobile market is undergoing two major shifts.  First, electric vehicles with relatively long ranges have been introduced by Tesla Motors as well as General Motors and many more models will soon enter the market.  Electric vehicles are fundamentally different than vehicles powered by internal combustion engines, especially when it comes to long-term maintenance.  Although there will clearly be a resale market for electric vehicles, the distribution channel could change.  For example, with fewer moving parts, it could be easier to determine the relative “health” of an electric vehicle relative to a gasoline powered vehicle making the process more transparent to buyers and sellers.  This would reduce the value of services such as reconditioning and certifying used vehicles.  However, the competitive advantages of a company operating at large scale will continue in terms of offering wide inventory and attractive financing.

The second major shift involves advances in automated vehicles.  Greater automation, including the ability of a car to drive itself most of time, will dramatically change the way in which individuals interact with vehicles.  It is plausible to believe that private vehicle ownership will decline especially in urban and suburban locations.  Large fleets of automated vehicles could transport people to their destination efficiently.  It would no longer be necessary for individuals to incur the significant cost of vehicle ownership and having an expensive asset sit idle 95 percent of the time.

From the perspective of early 2017, the idea that people will forego personal vehicles may seem to be farfetched.  Even if automated technology advances rapidly, many people will resist change and the overall vehicle fleet will not be automated for an extended period of time.  No one knows when or if automation will change the nature of transportation but this seems like a risk that cannot be ignored when evaluating companies in the automobile industry.

Conclusion

Many readers will be aware that CarMax is the second largest holding in Markel Corporation’s equity portfolio.  We have discussed Markel several times over the past few years and admire Tom Gayner’s stock picking abilities.  At nearly 7 percent of Markel’s portfolio, CarMax is obviously a high conviction investment.  After looking at the company in some detail, it is clear why Mr. Gayner was attracted to the business.  CarMax has demonstrated attractive economics over the past decade and managed through the financial crisis and recession reasonably well.  The unit economics of new stores appears to be very attractive and CarMax is nowhere near saturating the United States.

At a recent price of close to $65, CarMax has a market capitalization of slightly over $12 billion relative to book value of $3 billion as of November 30, 2016.  The stock is trading at close to 20 times likely net income for fiscal 2017 (ending on February 28, 2017).  While it is hard to get too excited about the shares at the current valuation, we would note that CarMax shares were punished quite severely during the 2008-09 recession.  As long as the long run secular risks to the business model described above do not materialize in the near future, CarMax seems likely to weather the next recession relatively well.  Given the attractive economics of the business and Mr. Gayner’s involvement, we would be inclined to put CarMax on a watch list and to take advantage of a stock price decline when a new recession (or fears of a recession) emerges.

Disclosure:  No position in CarMax.