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Morningstar | KMX Updated Star Rating from 26 Sep 2018

CarMax reported good fiscal second-quarter 2019 results that, like first quarter, received a significant boost from buybacks and the new lower tax rate. We see no reason to change our fair value estimate. Revenue increased year over year by 8.6% to slightly beat consensus, while diluted EPS grew 26.5% to $1.24, besting consensus by $0.02. We calculate that excluding buybacks, EPS grew 22.4% to $1.20. We also calculate that the lower tax rate contributed $0.22 to EPS including buybacks. The fiscal fourth and first quarters were the first consecutive quarters posting negative year-over-year same-store unit sales growth in about six years, but this metric rebounded this quarter to 2.1% from improved conversion despite lower store traffic. We calculate that adjusted free cash flow declined by 38% year over year, mostly due to higher capital expenditures and less favorable working capital. Gross profit per unit remained flat at a healthy level of $2,179, but SG&A per unit grew $126 to $2,304 due to higher stock compensation expense and less leverage due to 18 new stores opened since the start of fiscal 2018's second quarter. Operating margin declined 60 basis points to 6.4% and operating margin excluding CarMax Auto Finance (CAF) fell 40 basis points to 4.1%.

CEO Bill Nash gave updates on the call regarding digital platform initiatives. The alternative delivery pilot already in Charlotte expanded to Raleigh. This initiative lets a customer take delivery at home or an expedited pickup in the store after doing most of the shopping online. A customer call center to help web shoppers during the buying process is also new. Management is not ready to talk about profit metrics for digital transactions but did say the majority of its Charlotte customers still come to the store at some point in the process. At the national level Nash said that most CarMax customers still want to test drive the vehicle, which is not surprising given its average price tag of about $20,000.

Most interesting to us on the call is that management expects to roll out the company's integrated digital omnichannel to one large market later this year. As we said in our June 22 note, we look forward to CarMax showing the market that it can take on upstarts such as Carvana at their own game, and we believe CarMax can do that because of its brand and advantage in data, as well as due to an established finance arm. We agree with management that the digital experience needs to be done in a way that is highly customizable for the customer throughout the buying process rather than a single digital experience.

CAF income grew 1.6% to $109.7 million as an 8.6% increase in average managed receivables offset a 10-basis-point decline in interest margin and a 10-basis-point increase in the provision for loan losses. The allowance for doubtful accounts remained flat sequentially at 1.13% of average managed receivables and declined by two basis points year over year. With the Federal Reserve continuing to increase interest rates and CarMax's originations also rising, we expect CAF's results to keep reflecting volume increases that more than offset interest rate margin compression for a while. CAF's penetration as a percentage of total unit sales increased by 40 basis points year over year to 43.9% and is up 70 basis points in the first half of fiscal 2019.

Hurricane Florence appears to not be a major issue going forward as the industry's vehicle losses are reported to be a sliver of those hurricane Harvey destroyed in Houston. Florence did delay the opening of CarMax's new Wilmington, North Carolina, store, but the store opened on Sept. 26.