CarMax Earnings Shine: Why KMX Is a Buy After 7% Drop

CarMax reported impressive Q2 earnings before the market opened yesterday, with revenue up 19.5% year-over-year and earnings per share up a jaw-dropping 81.2%. The stock initially rose 4.7% on the news but then plummeted 7% the next day, closing at $55.09, below its pre-earnings price.

The company, led by new CEO Keith Barr, has focused on offering more competitive prices for used vehicles by enhancing pricing algorithms. This strategy led to higher unit sales but lower gross profit per unit. Retail unit sales increased 13.8%, while retail gross profit per unit decreased 5% to $2,105. However, the average retail selling price per unit rose 6.3% to $27,623.

The earnings boost was driven by multiple factors: a 32.1% increase in income from auto financing, a $29 million reduction in loan-loss provisions, a $16.6 million gain on the sale of residual financial interests, and a 33.1% growth in extended protection plans and service operations. Additionally, SG&A expenses grew only 4.6%, well below revenue growth, and the company reduced its share count by 3.9%.

CarMax's expansion into Tier 2 lending, where it financed 22% of such sales volume versus 10% a year ago, also contributed to higher profits. The company did not provide forward guidance, but management expects these positive trends to continue.

The market's negative reaction to CarMax's earnings may seem puzzling, but it likely reflects concerns about the sustainability of the company's growth and the broader economic environment. However, the underlying business improvements are significant and could drive long-term value.

CarMax's strategy of competitive pricing and expanding into Tier 2 lending is paying off. The Federal Trade Commission's enforcement of transparent pricing rules is leveling the playing field, benefiting CarMax, which has always practiced transparent pricing. This regulatory change is credited with boosting comparable store sales.

The higher-interest-rate environment is a tailwind for CarMax's financing arm, as it can earn more from loans. The expansion into Tier 2 lending, which offers higher interest rates, is particularly lucrative. Additionally, the growth in extended protection plans and cost control measures are improving profitability.

While the stock has been volatile since the end of the sky-high used-vehicle price era, the company's operational improvements and strategic initiatives position it well for a turnaround. Investors should consider the long-term potential rather than short-term price swings.