The used car business faces a handful of industrywide challenges that are too serious to ignore.
Used car middleman Carvana (CVNA -0.79%) will report its second-quarter results at the end of this month. Given the stock's continued rally from November's low, investors appear to anticipate good news. Perhaps they'll get it.
If the numbers from rival CarMax's (KMX 3.61%) fiscal 2025 first quarter are any indication, however, Carvana bulls might want to rethink any lofty expectations they have for the upcoming report.
Here's a rundown of the three biggest red flags from CarMax's prior quarter that could -- and probably do -- apply to Carvana as well.
The used car market really is weakening
Most people broadly sense it, but CarMax just verified it -- the used car market is weakening. Last quarter's sales of 211,132 cars to consumers, plus another 147,685 wholesale vehicles, were down 3.1% and 8.3% year over year, respectively. This dip is despite lower vehicle prices, too. Last quarter's average per-car retail price fell 2.7% to $26,526, while its average wholesale per-car price fell 10.3% to $8,094.
If this was the first time we'd seen such a headwind, it might be dismissable. It's not the first time, though. Unit sales, as well as average prices, have been waning for over a year now as supply and demand have stabilized. Economic headwinds have also prompted people to rethink their potential purchases of new (used) vehicles.
Data source: CarMax Inc. Chart by author. Note: The Q1 uptick in unit sales is common, stemming from tax refund checks.
There's not much meaningful relief on the horizon, either. Industry analytics outfit Cox Automotive predicted early this year that the United States' used automobile market was only set to grow 1% in 2024.
Operating costs are rising
Like most other businesses, CarMax isn't immune to the effect of lingering inflation. However, this effect is particularly pronounced for the company. Despite last quarter's 7.5% top-line dip, the used car dealer's general and administrative expenses grew from $560 million a year ago to nearly $639 million (up 14% year over year) for the three-month stretch ended May 31.
Stock-based compensation accounted for the entire increase with total compensation expense growing 2.5% to $375.2 million last quarter. In the meantime, "other overhead costs" like IT expenses, certain types of bad debt, insurance, and preopening and relocation costs also edged upward, even though the company's now doing less business.
Costs are costs, however, regardless of their nature and reason. Oh, and by the way ... it's the second quarter in a row the company's costs have grown, even though its top line is shrinking.
More auto loans are lower-quality, subprime loans
Last but not least, although CarMax touted the fact it "launched its inaugural non-prime public asset-backed securitization deal" during the fiscal first quarter, this development may actually be a red flag.
Used car middlemen like CarMax and Carvana don't just make money selling used cars. They also make money by extending loans to car buyers and then selling bundles of these loans to investors. Profits on the sale of these loans can be surprisingly healthy, too. Of Carvana's first-quarter gross profit of $6,432 per car sold to retail consumers, roughly one-third of that figure stemmed from the sale of these loans to yield-seeking investors.
To date, the majority of these loans have been so-called "prime" loans made to the most creditworthy of borrowers at relatively low interest rates, but a shift is underway. Rising delinquencies and defaults forced conventional banks to raise their standards for all car loans during the first quarter of this year. More automobile loan applications are now being denied as a result.
Subprime (or non-prime) lenders stepped up to fill the void, but their loans are hitting the same performance wall. Fitch Ratings reports the subprime auto loan delinquency rate reached 5.23% in April -- the highest April reading of the past nine years -- while February's reading of 6.39% was the highest of any month going back 20 years.
Data by YCharts.
A growing unwillingness to make ever-riskier auto loans might not only crimp demand for used cars, but it could also undermine a key profit center for both companies.
CarMax and Carvana are too connected to ignore this
CarMax and Carvana aren't carbon copies of one another, for the record. Carvana's arguably responding to the industrywide headwind better than CarMax is. For example, as a percentage of its revenue, Carvana spent less on marketing in the first quarter than it had in any year since 2016. Administrative expenses are also near multi-year lows (again, as a percentage of its top line).
Image source: Carvana's Q1 2024 shareholder letter.
Carvana and CarMax are more alike than different, however. Even if not to the same extent, Carvana is certainly facing the same challenges as CarMax.
Investors will see just how resilient Carvana is after the market closes on July 31. That's when the company's scheduled to release its second-quarter results. It may well end up driving the stock higher. But given that shares of Carvana are already up 142% year to date and trading well above analysts' consensus price target of $109.97, you might want to remain on the sidelines for the time being.
James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CarMax. The Motley Fool has a disclosure policy.
