CarMax Looks to Get Back on Track

Image source: CarMax.

The car-shopping experience is something that millions of Americans hate, and one of the key aspects of CarMax's (KMX 0.83%) business model is to offer an alternative to the haggling and sales tactics that local dealerships tend to use. Yet even though CarMax has found a core audience that is interested in the way it does business, the company's stock hasn't done well, and part of the reason stems from the uncertainty CarMax has expressed about its future. As CarMax investors prepare for its fiscal first-quarter report on Tuesday, many hope that the company will give a clearer picture of what's to come. Let's take an early look at how CarMax has been doing lately and what investors are likely to see in its report.

Stats on CarMax

Data source: Yahoo! Finance.

Can CarMax drive earnings higher?

In recent months, investors have cut back their expectations about CarMax earnings, reducing their full-year fiscal 2017 projections by a nickel per share. The stock has gone nowhere recently, trading essentially flat from its levels in mid-March.

CarMax's fiscal fourth-quarter results delivered solid performance but left investors with questions about whether the car retailer would be able to continue its past string of success. For the quarter, revenue rose 5.5%, and although net income fell slightly from year-ago levels, earnings per share rose to higher levels than most investors had expected. Yet comparable used-car sales rose just 0.7% in terms of units sold, and CarMax didn't adequately address industry trends toward narrower profit margins and higher discounting activity from traditional dealerships. Expansion plans will likely boost sales, but adding new stores is only sustainable for so long if comparable sales don't show signs of persistent growth.

One concern that the entire industry is dealing with right now involves a recall of airbags manufactured by Takata. CarMax rival AutoNation chose not to sell new or used vehicles that were subject to a safety-based recall, and that posed a substantial problem for the auto retailer in that it accumulated inventory that it wasn't able to sell. AutoNation eventually chose to allow sales of vehicles subject to recalls as long as the recalls were disclosed, but that only changed the nature of the concern to focus on potential lower sales prices for such vehicles. Meanwhile, consumer groups have targeted CarMax in the past, with reports finding that some vehicles that CarMax sold were subject to safety-related recalls despite its claims of having put all vehicles through extensive inspections and certifying their quality.

Another risk factor involves fears that the car-loan market will become the next financial crisis for the U.S. economy. With loans having gotten longer and longer, vehicle owners end up being underwater on their car loans for nearly the entire period of the loan, and that could leave lenders vulnerable if default rates start to rise. For the most part, CarMax has securitized much of its loan portfolio, spreading out the risk and making it less subject to credit risk. Moreover, many of CarMax's securitizations have actually performed better than expected. Moody's recently upgraded seven of the company's series of auto owner trusts, including those for loans made between 2012 and 2014. In the aftermath of the 2008-2009 financial crisis, CarMax included features in these asset-backed securities like overcollateralization and non-declining reserve figures to enhance their credit appeal.

In the CarMax earnings report, investors should watch to see if the company comments on the continuing strength in the auto industry more broadly. Favorable trends have continued into 2016 in the new-car arena, defying skeptics who believed that major automakers would have to suffer declines because of falling sales. If CarMax can demonstrate that its used-car traffic has also kept up the pace, then it will provide a nice contrast to the gloomier outlook that many industry followers have. That in turn could deliver outpaced returns for CarMax and give shareholders some respite from the stock's poor performance recently.