Declining Profits Challenge the CarMax Value Proposition

Key Points

• CarMax stock is dropping sharply after reporting a steep drop in profits. 
• Consumers are voting with their wallets, which is consistent with the current monetary policy. 
• If the worst is baked in, KMX stock is starting to look properly valued 

The used car dealership CarMax (NYSE:KMX) disappointed investors with a lemon of an earnings report. The company showed softer revenue than expected. But the headline number was the company’s profit decline. The company reported earnings per share (EPS) of 79 cents, nearly 50% below the average analyst estimate for $1.40 per share.  

Not surprisingly, shares of KMX stock are down 23% in mid-day trading following the report. That brings the year-to-date loss down to almost 50% for the stock. This is particularly troublesome because the stock was already performing worse than the broader market. 

But this isn’t a surprise to most investors, and certainly not to most consumers. Used car prices were one of the first indicators of rising inflation. And with inflation likely to remain sticky for some time, consumers are taking matters into their own hands.  

This Could Take Awhile 

Since the earnings report, some analysts are proclaiming the used car boom is over. That may be true. But I’m not sure if that’s going to be much relief for used-car buyers in the near term. Like inflation itself, prices of used cars may not be increasing, but it’s not the same thing as having prices go down. That’s not likely to happen right away. And there are two significant reasons for that.  

First, the auto industry still faces a supply-demand imbalance. Therefore, in situations where buying a new car is a necessity instead of a nice-to-have, consumers are likely to be facing elevated prices for some time to come.  

Second, if you take the Federal Reserve at its word, interest rates are going to continue to rise into 2023. That means that many consumers who are priced out of the market will remain priced out of the market. And unfortunately, it may mean that more consumers will be priced out. 

I’ll offer a bonus reason as well. Individuals who are planning to finance a vehicle may find that, if they can afford it, the difference between a new and a used vehicle (in terms of monthly payments) may make it more cost-effective to buy a new vehicle.  

Is The Worst Over for KMX Stock? 

Investors and consumers need to be careful not to miss the point of CarMax’s earnings. The company has created a more efficient way to sell cars. That’s not going away. But efficiency can’t overcome every purchase obstacle.  

And that efficiency comes at a cost. The company said that its general and administrative expenses increased by 18% in the quarter due, in part, to investments in technology. While those are likely to pay for themselves, the company’s results show that it doesn’t matter how easy it is to buy a car if demand is not there. And price is still the most significant factor. 

That being said, CarMax is still expected to grow revenue over the next five years, albeit at a much slower pace than in the past couple of years. But that is likely to be a drag on earnings which are forecast to have an average decline of around 3% in the next five years.  

I don’t own or plan to own KMX stock. But if I was considering it, that would be the question I’d be asking. If it is, then you could point to an appealing price-to-earnings ratio of around 11x earnings as a reason to look at the stock. However, that’s still higher than AutoNation (NYSE:AN) which has a P/E ratio of around 4x earnings and just saw its quarterly earnings make an all-time high.