Is Carmax a Buy After Its Latest Earnings Report?

Yesterday morning, before the market opened, CarMax (NYSE:KMX) reported impressive Q2 earnings, with revenue up 19.5% year-over-year (YOY) and earnings per share up a jaw-dropping 81.2%.

So it was unsurprising that the company's shares were up 4.7% yesterday. But today, the market suddenly seemed to sour on CarMax. Shares plummeted throughout the day, dropping 7% to close at $55.09, below its pre-earnings price.

What on earth happened? Is the company a buy at this price after its earnings report? Here's what investors need to know.

Image source: The Motley Fool.

CarMax's new strategy

CarMax's earnings boost might seem counterintuitive given the company's strategy going into the quarter.

The company is led by new CEO Keith Barr, who is just six months into his tenure. Barr and his management team have focused on offering more competitive prices for CarMax's used vehicles by enhancing its pricing algorithms, and it appears they've succeeded.

CarMax sold more vehicles (or "units") than it did in the year-ago quarter, but recorded lower profits from those sales, as you'd expect. What you might not expect is that the average selling price of each vehicle increased.

On the retail side, unit sales were up 13.8%. Retail gross profit per unit was $2,105, a decrease of $111 (5%) from the prior-year quarter, reflecting more competitive pricing. But the average retail selling price per unit was $27,623, up $1,600 (6.3%) YOY. In other words, CarMax's sales prices went up, but the company trimmed its margins so it made less money per vehicle.

It was a similar story in CarMax's wholesale division, which sold 15.9% more units than in the year-ago quarter. Gross profit per unit dropped $135 (13.6%) to $858, but average wholesale selling price per unit increased by $145 (1.8%) to $8,036.

But those numbers, while a net positive, don't get you to an 81% increase in net income. Where did that come from?

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How CarMax boosted its earnings

CarMax's impressive per-share earnings growth was driven by a series of smaller factors rather than a single big one. The 19.5% YOY revenue boost was one of those things, but there were many others.

Income from auto financing was up 32.1% to $135.6 million, as the company lowered its loan-loss provision by $29 million (20.3%). Meanwhile, the auto financing segment also recognized a $16.6 million gain on the sale of residual financial interests and increased servicing fees by $6.1 million.

Part of this was due to expansion into offering credit to "Tier 2" borrowers. These are borrowers with above-average credit profiles that are below the "prime" Tier 1 borrowers. Previously, CarMax handed these customers off to third-party lenders, but because such borrowers usually pay higher loan rates, CarMax generates more profits from them. CarMax financed 22% of its Tier 2 sales volume in Q2, up from just 10% in the year-ago quarter.

Extended protection plans and other service operations saw robust growth of 33.1%, boosting net income.

The company also managed to lower its selling, general, and administrative (SG&A) expenses across the business. Those expenses rose by only 4.6%, well below overall revenue growth.

Lastly, the company reduced its share count by 3.9% over the year, resulting in fewer outstanding shares and slightly boosting diluted earnings per share.

In other words, the business seems to be showing improvement across the board. Does that mean it's a buy?

Is CarMax a buy at its current share price?

Although CarMax didn't offer any forward guidance, the same factors that helped it succeed in this quarter should continue to help it moving forward.

In particular, the Federal Trade Commission's recent enforcement of transparent pricing rules is now requiring all used car retailers to disclose all hidden fees upfront. CarMax has always done this, but now that its competitors are being forced to do so as well, it's benefiting from the level playing field. Management credits this rule change for boosting the company's comparable store sales.

The higher-interest rate environment and CarMax's expansion into Tier 2 lending should continue to boost income from its financing arm. Increased sales of extended protection plans and lower SG&A expenses should also benefit the bottom line in the long term.

In short, although CarMax's stock has been rocky since the sky-high used-vehicle price era ended, it looks like a much better buy now as a turnaround play.

John Bromels has positions in CarMax. The Motley Fool has positions in and recommends CarMax. The Motley Fool has a disclosure policy.