CarMax Inc. (KMX, Financial), the largest retailer of used cars in the United States, is now in the second year of its omnichannel strategy, “omnichannel” referring to the integration of online and traditional retailing.
If well executed, the strategy promises a seamless integration between the online experience and the brick-and-mortar experience for customers. For example, consumer product retailers such as Costco (COST, Financial) and Walmart (WMT, Financial) allow customers to order online and pick up their orders at the nearest brick-and-mortar location.
According to its latest 10-K, the strategy allows customers to shop its inventory of more than 80,000 vehicles at its 216 local stores. If a customer expresses an interest, the vehicle can be transferred to the nearest store or even to the customer’s door, for a test drive.
There are several elements in the business model that support omnichannel:
- It has customer experience reps who help online customers through the buying process.
- Pricing at CarMax always has been done on a no-haggle basis, so that element of car buying is removed.
- CarMax reconditions all vehicles it sells and provides short-term warranties.
The objective, of course, is to grow the business; although it is the largest used car retailer in the U.S., its market share is less than 5%. The industry is highly fragmented, providing growth opportunities.
Ruane Cunniff (Trades, Portfolio) & Goldfarb, the firm that runs the Sequoia Fund, thinks the strategy will work. In a message to its fundholders on March 3, the portfolio managers observed: “Although Carmax’s development of omni channel represents the biggest makeover in the company’s history, it has so far managed the transition without diminishing margins. We believe many competitors will struggle to keep up and that omni increases the size of Carmax’s competitive moat.”
Of course, going omnichannel demands a strong balance sheet and an effective management team. Does CarMax have the financial resources and executives to make the most of this challenge?
It has the distinction of being one of just 22 stocks currently on the Buffett-Munger Screener list. We will use the criteria of the screener to analyze the company: predictability of revenue and earnings, a competitive advantage, little or no debt and an undervalued or fairly valued price as measured by the price-earnings to growth (or PEG) ratio.
Predictability
Checking predictability, we see CarMax receives a four out of five-star rating and this 10-year chart shows steady growth of both revenue per share and earnings per share:
Given the integration between online and store sales, the new channel has the potential to generate additional revenue and earnings without cannibalizing its current business.
Competitive advantage
CarMax's decision to pursue sales through online marketing may have been a necessity rather than a choice. At least two online-only used car dealers have made splashes recently. Carvana's (CVNA, Financial) share price has risen more than 10-fold since its initial public offering in the second quarter of 2017. Vroom (VRM, Financial) made its IPO debut last week, and it, too, wants a piece of the business.
Where CarMax has an advantage over the newcomers is in its experience. It has been selling more than a million cars a year, which means it has a wealth of data. To make the most of it, the company is using advanced data science and machine learning. That helps with everything from customer targeting to pricing and buttresses a protective moat.
For the Buffett-Munger Screener, GuruFocus bases its competitive advantage rating on the strength of a company’s margin or margins, noting “It can maintain or even expand its profit margin while growing its business.”
For CarMax, margins have been maintained, but just barely:
What CarMax does have going for it is a well-known brand name that should help distinguish it from its rivals, a physical presence that adds credibility and insights from big data analysis.
Debt
At the end of February, CarMax had almost $15 billion of long-term debt and $441 million of capital lease obligations. This 10-year chart shows their history:
In its 10-K, CarMax reported that it targets an adjusted debt-to-capital ratio in the range of 35% to 45%, adding that it was at the low end of the range at the end of fiscal 2020.
It also noted, “Our primary ongoing cash requirements are to fund our existing operations, store expansion and improvement and CAF. Since fiscal 2013, we have also elected to use cash for our share repurchase program. Our primary ongoing sources of liquidity include funds provided by operations, proceeds from non-recourse funding vehicles and borrowings under our revolving credit facility or through other financing sources.”
Share buybacks over the past three years have averaged 4.4% per year.
Valuation
The PEG ratio, which is based on the price-earnings ratio divided by the five-year Ebitda growth rate, comes in at 1.5. That is above the undervalued and fairly valued marks. A PEG ratio of less than 1.0 shows a stock is undervalued, while a ratio of 1.0 or slightly more would be considered fairly valued. Therefore, a 1.5 is probably pushing the limits of fair valuation and close to overvaluation.
The discounted cash flow (DCF) valuation is less ambiguous:
A 13.03% margin of safety provides a modest degree of protection against errors in analysis and unexpected, external circumstances.
Overall, CarMax has fairly robust predictability status, a medium moat that should help protect its margins, lots of leverage and a modest margin of safety.
Gurus
As of March 31, guru interest amounted to 14 investors. PRIMECAP Management (Trades, Portfolio) held the largest position with roughly 10 and a quarter million shares. Ruane Cunniff held 9,164,102 and Chuck Akre (Trades, Portfolio)'s Akre Capital Management held 8,190,371 shares.
Conclusion
CarMax is in the midst of a major business model transition, trying to add a new layer of sales and marketing to a solid base. In doing so, it is disrupting its own business but also setting itself up to serve a new generation of buyers that demand online, interactive functionality.
Given the growing competition for online auto sales, the company was wise to expand before it was forced to. It appears the management team is more than able to take up the challenge. From the standpoint of financial resources, especially long-term debt, the company appears to be comfortable.
As its presence on the Buffett-Munger Screener list attests, CarMax is a quality company selling at a minor discount. However, few prudent value investors will buy at this time because of the debt load.
Disclosure: I do not own shares in any companies named in this article and do not expect to buy any in the next 72 hours.
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