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CarMax Could Stall as Risky Loans Rise -- Barrons.com

1 Apr 2017 5:25 am
By Bill Alpert 

On Thursday morning, used-car seller CarMax will report results for its latest fiscal year. The no-haggle pricing pioneer probably will show continued sales growth, but uncomfortable questions may arise about its car loans.

Lately, everyone in the auto industry seems to be wringing their hands about credit problems. Defaults and delinquencies are up. The residual values of used cars are down. CarMax is no exception, judging from the recent monthly reports of its securitized loan pools. And that's a worry because CarMax's captive auto-finance unit contributes almost 40% of the company's operating income. Those finance profits could be pinched if CarMax must make unexpectedly high loan-loss provisions.

The Richmond, Va.--based chain has earned praise in these pages (most recently last year in " CarMax: Ready to Step on the Gas," Nov. 19) for its well-executed growth. But in the past month, its $59.22 stock (ticker: KMX) has become a case study in Wall Street estimate dispersion, with brokers like Goldman Sachs calling it a Buy with a $72 target price, while others, such as Morgan Stanley, advise investors to Underweight the shares and brace for a selloff to $48.

Credit has been an important fuel additive to sales growth at CarMax and its industry. If that boost fades, and investors get unnerved by falling used-vehicle prices and weakening credit quality, CarMax shares could hit the bears' target, down 20%.

CITING ITS QUIET PERIOD, CarMax declined our request to discuss car loans ahead of Thursday's earnings report.

In 20 years, CarMax has expanded to become the nation's largest used-car dealer, with more than 170 locations around the country that retail over 600,000 vehicles a year, while wholesaling another 400,000 at auction. Sales grew to $15 billion in the fiscal year ended in February 2016 from $10 billion in fiscal 2012. Profit growth was even better, thanks to investor-friendly share buybacks. From a fiscal-2012 level of $400 million, or $1.79 a share, earnings rose in fiscal 2016 to $620 million, or $3.03. On Thursday, according to the average of Wall Street forecasts, CarMax should report sales of nearly $16 billion -- and earnings of about $3.30 a share -- for the February 2017 year.

Most of the company's retail sales consist of used cars less than four years old. The supply of such cars coming off-lease is expected to grow 25% in the next couple of years, and CarMax fans have hoped this flood would reduce the company's acquisition costs and boost gross margins.

Unfortunately, there are signs that this supply growth is already outpacing demand for used cars. Ford Motor (F) and Hertz Global Holdings (HTZ) have warned that their earnings will suffer because their fleets of used cars are commanding lower-than-expected prices at auction. The National Automobile Dealers Association Used Vehicle Price Index plunged 8%, year over year, in February -- the sharpest annual drop in almost a decade. Auto lender Ally Financial (ALLY) took note of the NADA reading in its latest conference call.

An oversupply of off-lease cars might not be the only thing weighing on used-car values. Morgan Stanley analyst Adam Jonas predicts that used cars will lose some appeal as manufacturers introduce more models with dramatic new safety technologies.

Unexpected drops in used-car residual values also hurt lenders, and CarMax's Auto Finance unit has been an important part of the company's success. Profits contributed by its captive finance arm rose to more than $390 million in the fiscal year ended February 2016 from $260 million in the year ended February 2012. But that gain could begin to reverse as soon as Thursday's report, says Wedbush Securities analyst Seth Basham in a recent study of CarMax's auto-credit business.

When used-car prices slump, loan portfolios always suffer higher net charge-offs -- that is, loan losses. That's because lenders' auctions of repossessed cars yield a smaller recovery of their gross loan losses. CarMax's recovery rate slipped to 46.2% of gross charge-offs in the November 2016 quarter from 54.8% in the May 2015 quarter -- across all of the loans that the company manages on both its balance sheet and in securitized pools sold to investors -- according to securities filings. Gross charge-offs of managed loans have trended up over the same period to an annualized rate of 2.44% from 1.58%.

LIKE MANY IN THE AUTO INDUSTRY in the past few years, CarMax has pulled in additional sales by offering more loans with extended payment terms and by lending larger amounts in proportion to a car's value.

The company has also made more loans to buyers with lower credit scores. CarMax has its own scale for grading creditworthiness, with "A" loans denoting higher-quality credits than "C" loans. As we show in the chart at left, the low-quality C-grade loans have increased to more than 16% of CarMax-managed receivables in the last-reported quarter, ended November 2016, from less than 10% in 2011. Using the industry-standard FICO credit score, some 30% of CarMax borrowers have subprime scores of less than 650. Indeed, 9% have FICO scores below 600.

The economy is becoming less friendly to used-car buyers. Personal bankruptcies have ticked up in recent months, and interest rates are on the rise. CarMax might find itself underreserved for loan losses.

CarMax seems sure to continue to grow sales by opening new stores. But if the company encounters rude surprises in its loan portfolios, and falling vehicle prices pinch margins, investors could send the stock lower in its historical valuation range.

At 59 bucks, the shares now trade around 16.5 times the consensus estimate for about $3.55 a share in February 2018 year earnings. That multiple is well above the current multiples for CarMax's peers in the auto-dealer and auto-lending industries. The company's own multiple has fallen as low as 13 times earnings at rough parts of the auto sales cycle. Buckle up.

Email: editors@barrons.com

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April 01, 2017 01:25 ET (05:25 GMT)

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