CarMax, Inc (NYSE: KMX): RiverPark Is Crazy About It

RiverPark Funds recently published its Q1 Focused Value Fund Investor Letter in which it discussed its investment thesis on CarMax, Inc (NYSE: KMX), a retailer of used vehicles in the U.S. The investment firm initiated a position in CarMax during the first quarter. The investor believes that the company has “a durable business franchise, generates consistent free cash flow, is well managed, and trades at an attractive valuation.” In this article, we’re going to take a look at comments made by RiverPark in the letter.

Here is everything that RiverPark said about CarMax:

KMX is an excellent business with both a differentiated business model and scale advantages that create a barrier to competition. Since its founding, interestingly as part of the now-defunct Circuit City chain, KMX has aimed to deliver a superior customer experience to used car buying and selling, incorporating features such as no-haggle pricing, increased selection, and price/quality guarantees. Consistent with our investment strategy, the company has a durable business franchise, generates consistent free cash flow, is well managed, and trades at an attractive valuation.

In a highly fragmented market that has historically been characterized by aggressive sales techniques, KMX delivers a consumer-friendly approach to each step in the used car experience: Selling a car to KMX; Buying a car from KMX; and Financing and other services.

KMX is able to deliver a superior customer experience and earn attractive returns by virtue of scale advantages. These scale advantages are numerous, including the ability to spread fixed costs across a larger base, hire and retain the best talent, and maintain the largest inventory, leading to greater selection. Perhaps the least well understood, but most important scale advantage is market intelligence. In the last 12 months, KMX bought and sold more than one million used vehicles out of a nationwide market of more than 40 million, far more than any other car dealer. This dominant position provides insight into pricing, supply, and demand that allows KMX to bid more effectively for the cars it buys and efficiently price the cars it sells. The market for used cars is dynamic and influenced by many factors including the behavior of new car manufacturers and rental car companies, the overall economy, interest rates, and gasoline prices. KMX has the broadest reach and the most market knowledge in a fragmented and nontransparent market which provides an enormous advantage over smaller competitors.

KMX profitability comes from four sources: selling used cars to consumers, providing financing to used car buyers, selling other services like extended service plans, and selling used cars at auction. Over the past 15 years, revenue has grown at more than 10% per annum through a combination of new store openings, increased unit sales at existing stores, and modest price appreciation. Operating leverage has driven greater growth in net income (14.5% per annum), and share repurchases, beginning in 2013, have enhanced per share earnings growth to more than 15% per annum. CarMax’s core market is lightly used cars (less than 10 years old). Its markets share is less than 5% in markets where it already operates and less than 3% nationwide, so these growth trends should continue well into the future.

Skeptics of KMX have short-term concerns about the cyclicality of new car sales and longer term concerns about the sharing economy reducing car ownership, internet disruption of used car sales, threats from new car dealers, and used car price deflation. As a result, over the past three years, while earnings per share have grown by more than 40%, the share price has declined by more than 10%, compressing the forward earnings multiple from nearly 20 times to less than 12 times, a post-Global Financial Crisis low. Based on our research, we believe the skeptics’ concerns are overblown and that KMX will continue to grow profitably for many years.

Over the next two years, if KMX, which we believe is a significantly above average business and has historically commanded an above average earnings multiple, can achieve a market average multiple of 15 times, we will make nearly 17% per annum (even without any improvement to the current earnings multiple, we should earn over 11% per annum). If our earnings projections prove to be too conservative or the company becomes more aggressive in share repurchases, there is additional upside potential to these expected returns.

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Richmond, Va.-based CarMax, Inc (NYSE:KMX) is the largest used-car retailer in the U.S., with more than 180 stores across the country. The company offers retail merchandising, wholesale auctions, extended protection plans, reconditioning and service, and customer credit.

As of the end of the fourth quarter of 2017, there were 39 hedge funds in Insider Monkey’s database with positions in the used cars retailer, including Immersion Capital, Giverny Capital, and Markel Gayner Asset Management.