Why CarMax's Hidden Advantage Could Backfire

The following article is exclusive content from The Motley Fool. While this is typically paid content, we are bringing it to you free because we think it is especially pertinent to your ability to invest wisely. CarMax (NYSE: KMX  ) is primarily known for its used-car sales service. Below you will hear from one of our newsletter analysts about how providing auto loans accounts for a huge amount of the company's profit and what needs to happen for that to continue.

You might think of CarMax purely as a used-car retailer. But the company actually gets more than a third of its operating profits from lending customers money to buy cars, selling some of the income from those loans to yield-hungry investors, and pocketing the rest of the interest. That's great business now -- but if investors wise up, CarMax's sweet free ride could come to a screeching halt.

Why car loans beat home loans
Most people in the U.S. depend on their cars for nearly every aspect of their daily lives, making a vehicle pretty hard to live without. But while it can take months or years of legal wrangling for a bank to foreclose on a lapsed mortgage, it's easy to send a tow truck around when someone misses a few car payments. These two factors mean that most people, even low-credit borrowers, are very responsible in making car payments.

Throughout the financial crisis, while people walked away from their houses, their credit cards, and any other type of loan, they rarely walked away from their cars. Investors in notes securitized by auto loans didn't get burned in the financial crisis, while their friends in mortgages took a bath.

Noticing this trend and behavior among consumers, and probably aided by models that are statistically sophisticated but totally backward-looking, yield-seeking investors have developed quite an appetite for auto loans. This has pushed up the price of auto notes, while reducing their yield. For CarMax, this trend has made it easy to sell auto loans to investors at great prices.

Turning Lincolns (and Fords, and Hondas, and...) into Benjamins
When it loans money to customers, CarMax Auto Finance, or CAF, charges them about 8%-9% interest. And CarMax is able to offload packages of car loans on investors at less than a 2% yield . So even after another 2% for expenses and loss provisions, CarMax is earning a net spread of 5%-6% on every loan . It's a really profitable business.

It's also a big business. Roughly 40% of CarMax's customers use CAF to finance their vehicle purchase. Last quarter, that resulted in more than $1 billion of net loans originated. And, based on the most recent quarter, CarMax is managing an average of more than $6.5 billion in managed receivables (i.e., car loans). As a result, the company is on pace to generate $350 million in CAF income this year.

You've got to admit that's a really sweet deal. So what could upset it?

Revenge of the well-informed investors
A 2% interest rate isn't much more than Treasuries offer. A five-year Treasury yields less than 1.4% these days. And the collateral for CAF loans -- the car -- is a rapidly depreciating asset. The longer the loan lasts, the less the car backing it is actually worth. Personally, I wouldn't loan people money to buy cars at less than 2% -- common sense says it's not prudent.

Eventually, investors will come to their senses, and they may demand a 4%-5% return on owning car loans. I don't know what will happen in that case, but it's not clear whether CAF can turn around and charge higher interest rates to its potential buyers to make up the difference.

If consumers won't budge, and CAF has to keep charging the same 8%-9%, its profits will get pummeled as CAF net interest margin compresses. Instead of earning $0.50 per $10 of loans, it will collect something closer to $0.20.

Obviously, that will still be a good business, but it will be worse than the current business. Halving CAF's profits would eliminate more than 15% of the company's total operating profits. Margins would shrink, and the company's net income would suffer even worse.

Why you shouldn't panic just yet
While this interest rate risk is real and major, I still wouldn't let it prevent you from investing in CarMax. The company offers a wonderful, well-run business with plenty of room to grow. Obviously, it will experience bumps on the road, and compressing auto loan spreads could be one. But neither that nor any other challenge I can see look likely to sink the company.

Regardless of the interest rate cycle -- which I refuse to predict -- I feel confident that CarMax will be bigger, better, and generating significantly more profits in 10 years than it does today. I own the stock myself, and I'm hoping to hold it for a decade or more.

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