CarMax Breakdown A Bad Sign For Entire Auto Industry

Investors have mostly looked past automotive industry challenges. That may be changing, with big implications for the shares of the largest car resellers.

Executives at CarMax (KMX) said last Month that demand for used vehicles is slowing as consumers face affordability challenges. Shares promptly plummeted 25%. Then Moody’s downgraded the entire sector.

Aggressive investors should consider new bearish CarMax bets. Let me explain.

The automotive business is in a state of flux. In addition to the transition to electrification and away from internal combustion engines, most of the world’s biggest vehicle makers are still crippled by supply chain shortages. Investors have been willing to look past these challenges. The bet was pent up demand and relatively flush consumers would lead to big sales gains going forward.

Analysts at J.D. Power and LMC Automotive noted that retail sales in September are expected to reach 958,948 units, up 5.4% from a year ago, according to a press release at Business Wire. The researchers found that sales promotions, a normal September occurrence, were non-existent. And despite rising short term interest rates, transaction prices continued to rise, suggesting pricing power.

Cox Automotive — the publisher of auto industry staples like Autotrader, Kelly Blue Book, and Manheim — wrote in September that overall third quarter vehicle sales are expected to reach 3.4 million units. Despite higher rates chipping away at demand, researchers still expect big gains at General Motors (GM), Ford (F), and Tesla (TSLA).

The CarMax news is a game changer.

The Richmond, Va.-based company is the latest retailer of used vehicles in the United States, with 220 super stores, and combined unit sales of 1.6 million in fiscal 2022.

Bill Nash, chief executive officer said last week that used car prices fell slightly in August month-over-month, yet remain 7.8% higher versus a year ago. Nash notes that the larger problem is that unit sales are falling, leading to a 50% decline in profits from a year ago. He says buyers are now prioritizing spending as rates rise.

Following the CarMax results Moody’s downgraded the entire global auto industry, according to a report at Auto.com. The firm changed its outlook to negative from stable, noting higher production costs, diminishing consumer demand, and most importantly, higher interest rates that make loans and lease rates less attractive to buyers.

The latter is going to be a big problem for CarMax, and its CarMax Auto Finance unit. CAF, and its lending partners are used by approximately 80% of CarMax buyers. That astonishing figure is a concern because CAF has no minimum credit score or credit history requirement. The company says it makes vehicles accessible to customers across the entire credit spectrum, even buyers with FICO credit scores below 630. These buyers may have trouble getting loans elsewhere.

There is a cost for borrowers with poor credit scores. Their loans will come with much higher annual percentage rates of interest. These borrowers are also most vulnerable to weakening macroeconomics, such as surging inflation and rising unemployment. Unfortunately for loan originators like CAF, delinquency rates for car loans are rising, especially among subprime borrowers.

Cox researchers found in July that 60-day delinquent rates rose 3.9% versus June, and were up 32.1% from a year ago. Also, in July 1,56 of auto loans were severely delinquent, the highest rate in five months.

Investors in the auto industry have been preoccupied by the transition to electric vehicles, and the idea that car sales will rebound sharply once carmakers get supply chain challenges sorted out. Few investors are focused on demand destruction due to higher interest rates, or industry exposure to surging bad loans for vehicles. The CarMax news is the first clue both factors will be a concern moving forward.

CarMax shares fell 25% on Thursday to their lowest level since April 2020. Business prospects then were much better. The Federal Reserve was cutting interest rates to zero, and pledging to keep them there for three years. The opposite is true now. The Fed wants to raise rates to 4.25% in early 2023, even as loan delinquency rises.

At the Friday closing price of $66.02, CarMax shares trade at 13.4x forward earnings and 0.3x sales. While these metrics may seem low it is important to note the forward numbers do not yet reflect sales declines. Nor do they account for worsening profitability in 2023 as delinquency rates rise.

A share price of $48.20 is more appropriate given near term changes. A decline that level would yield a profit of 27% for bearish bets.

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