#021 - CarMax

CarMax sells used cars. How exciting! CarMax is the mature company in this space but isn't growing nearly as fast as others, but CarMax is profitable!

CarMax - (NYSE: KMX)

CarMax sells used cars. How exciting! CarMax is the mature company in this space but isn't growing nearly as fast as others, but it’s profitable!

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Industry Overview

Over the past two weeks, I’ve written about Carvana and Vroom. CarMax is another company that has a similar business model of selling used cars. While there are many companies that sell cars online, I still think there can be strategies or companies that stand out from the rest.

I don’t think I have anything major to add to the Industry Overview section of this writeup. I think CarMax is pretty similar to Carvana with some slight differences that I’ll touch on.

Business Overview

CarMax buys used cars and sells these cars to consumers. CarMax separates its business into two reported segments, but really has three different business lines. Selling cars to consumers, selling cars wholesale, and a financing/other side of the business. “CarMax Sales Operations” represents the used vehicle sales (both to consumers and wholesale) and “CarMax Auto Finance” (CAF) represents financing, protection plans, and other revenue of the business.

“Our CAF segment consists solely of our own finance operation that provides financing to customers buying retail vehicles from CarMax.” - CarMax FY2020 10-K

I’ll touch on this later in the Financials section below, but CarMax makes most of its revenue and gross profit from selling used cars to consumers, but it’s profit margins on selling used cars is a lot lower than it’s profit margin on “other” revenue.

There are a handful of difference between CarMax and the rest of the used car retailers.

The first difference is that CarMax offers an omnichannel selling approach. CarMax has both in-person lots and a website consumers can visit to buy a car. Carvana and others don’t offer this and likely won’t offer this in a major way going forward. With CarMax, you can get the comfort of seeing a car in person if that’s what you need to get comfortable buying a car or you can buy online just like any other used car retailers. CarMax has higher fixed costs (due to all the land and lots they own) but this might be an advantage if CarMax can have scale across the country and offer better prices than competitors. Roughly half of CarMax’s stores double as reconditioning centers.

CarMax is different from dealerships because there is no negotiation. CarMax has “no-haggle pricing” which means the price you see is the price you get. Customers may interact with CarMax sales people, but the sales people are compensated a flat rate if they sell you a unit. They are therefore motivated to sell you something, but they want to sell you something that works for you.

“Customers may also interact in-person with our sales consultants who are generally paid commissions on a fixed dollars-per-unit standard, thereby earning the same commission regardless of the vehicle being sold, the amount a customer finances or the related interest rate. These pay structures align our associates’ interests with those of our customers, in contrast to other dealerships where sales and finance personnel may receive higher commissions for negotiating higher prices and interest rates, or steering customers to vehicles with higher gross profits.” - CarMax 10-K

The last major difference between CarMax and others is that CarMax takes a hybrid approach for its lending/financing side of the business. CarMax uses both an in-house financing setup (CAF basically) and relies on third parties to help consumers buy a car. CarMax partners with other parties when CarMax isn’t comfortable lending to certain consumers. There are four different options consumers have for financing needs. First, CarMax customers can use CAF to finance their purchase. Second, CarMax works with “Tier 2” providers who help customers finance a purchase. These Tier 2 providers pay CarMax a fee because CarMax refers business to these providers. “Tier 3” providers works the same way as Tier 2, but CarMax pays these providers a fee for giving customers financing to buy a CarMax vehicle. And then there’s a certain portion of the customer base that either doesn’t use financing or uses financing from a bank or some other financial institution. Close to ~46% of used vehicle financing is performed by CarMax, with the rest being split between Tier 2, Tier 3, and other options. CarMax is in between Carvana and Vroom. Vroom uses 3rd parties whereas Carvana does all of this in house.

Total Addressable Market

If you’ve already read my research on Carvana and Vroom, you know the pitch for this industry. Large fragmented market with no real winner at scale. I think that leads to some warranted concerns such as, “Why doesn’t a scaled winner exist in this space? Is scaling a business even possible in this industry?” On the other hand, it might mean there’s an opportunity for a company like CarMax or Carvana to win this space.

Most estimates have this market pegged at around $750bn+. Which I think is a rationale estimate, but I don’t think the profit will be anywhere close to that given the costs of buying inventory (cars), shipping it around, fixing it up, and then selling it along with protection plans and financing. Profits likely improve with scale, but no where close to regular software or platform businesses.

One of the key questions that I have for companies in this space is how much market share each company can capture. Can the winners in this space realistically capture 10%? 15%? 25% More? CarMax has captured ~3.5% of a segment of the broader market. This is a small number and this leads me to some more questions that can be found below if I were to continue to research CarMax and this overall space.

“On a nationwide basis, we estimate we sold approximately 3.5% of the age 0- to 10-year old vehicles sold in calendar year 2019.” CarMax FY2020 10-K

Competitive Advantages

  • Scale

    My thoughts here on competitive advantage will be very similar to my thoughts about Carvana’s competitive advantage. Used car retailers need a lot more than just a website to sell cars. These retailers need logistics to transport the cars, lots to store the cars, reconditioning space for repairs, and other investments that relate to financing cars, relationships with banks and other credit unions, and other aspects to run this business at scale.

    This also isn’t really a sexy business. There isn’t a line of MIT computer science students trying to break into this industry and win market share.

  • Brand

    I think branding is and will be pretty important for used car retailers. Buying a car is one of your most expensive purchases as a consumer and you want to get it right. Even buying a ~$10k junky used car might be one of your most expensive purchases and you’ll spend plenty of time researching the car, the background of the car, and you want to trust the company that is selling you the car.

    If you have a bad experience buying a car at CarMax or elsewhere, you might never return and you’ll likely spread your experience to friends, colleagues, or rant online. People will read those reviews and these used car retailers will have a bad image of this brand. Brand is something companies can’t really buy (sure, there will be an outlier but who cares).

    "It takes 20 years to build a reputation and five minutes to ruin it.” - Warren Buffett

Financials

CarMax is surprisingly a profitable used car retailer. While it’s not a terrific profit margin, at least it’s something.

2020

  • Used vehicle sales = ~ $17,169

  • Wholesale vehicle sales = ~ $2,500

  • Total other sales and revenues = ~ $650

  • Used vehicles sold = 832,640

  • Wholesale vehicles sold = 466,177

  • Used car stores = 216

  • Gross profit per unit:

    • Used vehicle gross profit = ~ $2,186

    • Wholesale vehicle gross profit = ~ $975

    • Other gross profit = ~ $538

  • Revenue growth:

    • Used vehicles = 13.2%

    • Wholesale vehicles = 4.5%

    • Other = 7.1%

  • Gross profit margin:

    • Used vehicle = 10.6%

    • Wholesale vehicle = 18.2%

    • Other = 68.8%

  • Net earnings margin = 4.4%

2019

  • Used vehicle sales = ~ $15,173

  • Wholesale vehicle sales = ~ $2,393

  • Total other sales and revenues = ~ $607

  • Used vehicles sold = 748,961

  • Wholesale vehicles sold = 447,491

  • Used car stores = 203

  • Gross profit per unit:

    • Used vehicle gross profit = ~ $2,175

    • Wholesale vehicle gross profit = ~ $963

    • Other gross profit = ~ $562

  • Revenue growth:

    • Used vehicles = 5.4%

    • Wholesale vehicles = 9.7%

    • Other = 11.1%

  • Gross profit margin:

    • Used vehicle = 10.7%

    • Wholesale vehicle = 18.0%

    • Other = 69.3%

  • Net earnings margin = 4.6%

2018

  • Used vehicle sales = ~ $14,392

  • Wholesale vehicle sales = ~ $2,181

  • Total other sales and revenues = ~ $547

  • Used vehicles sold = 721,512

  • Wholesale vehicles sold = 408,509

  • Used car stores = 188

  • Gross profit per unit:

    • Used vehicle gross profit = ~ $2,173

    • Wholesale vehicle gross profit = ~ $961

    • Other gross profit = ~ $511

  • Revenue growth:

    • Used vehicles = 8.5%

    • Wholesale vehicles = 4.7%

    • Other = 4.7%

  • Gross profit margin:

    • Used vehicle = 10.9%

    • Wholesale vehicle = 18.0%

    • Other = 67.5%

  • Net earnings margin = 3.9%

What’s Interesting

  • Largest used car retailer?

    Currently, CarMax is the leading used car retailer but competition is slowly creeping up. Other companies like Carvana had extraordinary growth in 2020 due to the pandemic and the rush to buying cars online. CarMax was slow to transition and may have lost a solid opportunity to compete with Carvana. But CarMax does deserve some credit for being the current leader in this space and it has been the leader for some time now.

  • Omnichannel?

    I think for some consumers, they will never buy a car online just because the cost of buying a used car can be so expensive. Many consumers may want to have the option to look at a car in-person (and test drive it) or look at a car online. There are pros and cons to both of these decisions and giving customers the ability to choose may be an important factor in their buying process.

Future Questions

  • Financing?

    Carvana and CarMax both have their financing process in-house. I don’t have a background or any previous knowledge into the financing space, so I think I’d need to learn more about this side of the business to feel more comfortable investing in one of these businesses.

    I tried to read a couple write-ups or just background on this side of the business, but I definitely need to focus on this area of the business more.

  • Market share penetration?

    I still wonder what is and has stopped more mature companies like CarMax from capturing more market share. I understand scaling and building new stores in new locations is likely the biggest problem, but CarMax has more than 200 stores now. Do consumers just rely on other methods of buying a car like buying it from a friend or neighbor? Do consumers buy from other dealerships rather than a CarMax or a Carvana?

    What is the upper limit on how much farther CarMax can go into this market? Is there something stopping them? Is it just issues with scaling?

Conclusion

CarMax is interesting but I worry that Carvana’s revenue growth is just blowing them out of the water. A couple of years ago, Carvana wasn’t even close to CarMax, but no Carvana might surpass CarMax if all goes well.


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