CarMax: A Disrupter Faces Disruption
CarMax shook up automotive retailing in the 1990s. Will the company face disruption by online competitors in the 2020s?
CarMax was founded in 1993 as a subsidiary of Circuit City Stores. Circuit City was looking for growth and diversification opportunities outside consumer electronics. The automotive sector was identified due to its large size, high level of fragmentation, and reputation for low customer satisfaction. By bringing its experience in big box retailing to the used car market, Circuit City intended to disrupt automotive retailing by providing a wide array of inventory and a no-haggle shopping experience.
The initial rollout of CarMax locations was restricted to the southeast. By 1996, CarMax had five retail locations and $305 million in sales.1 Although the venture was weighing on Circuit City’s financial results at the time, management saw enough positive signs to pursue an aggressive national rollout of the CarMax concept.
In 1997, Circuit City created a tracking stock for CarMax and raised $412 million by selling 22.5% of the economic interest in CarMax to the public. Circuit City retained the remaining 77.5% interest in CarMax.2 Five years later, CarMax operated 41 retail locations and reported $3.2 billion of revenue and $91 million of net income.3
On October 1, 2002, CarMax became an independent, separately traded company. Owners of the CarMax tracking stock received one share of the newly independent company for each share of tracking stock they owned while Circuit City shareholders received 0.314 share of CarMax for each share of Circuit City they owned.4
To say that the next several years would not be kind to Circuit City is a major understatement. A series of management missteps followed by the 2008 financial crisis and economic downturn destroyed the business. Circuit City filed for bankruptcy in late 2008 and, despite efforts to arrange a restructuring, all stores were closed by March 2009 in a liquidation. Circuit City stock ended up being worthless.5
The story of CarMax is considerably happier. The company is now the largest retailer of used vehicles in the United States and operates 237 retail locations in 41 states.6 In the four fiscal quarters that ended on May 31, 2022, CarMax sold 1.6 million vehicles, recorded $33.5 billion of revenue, and brought $967 million to the bottom line.7
As the business has performed well over time, so has CarMax stock. The stock price has increased from a split-adjusted $8.15 on October 1, 2002 to $101.59 as of August 12, 2022. This represents a 13.5% annualized return and has outpaced the S&P 500 total return index, as seen in the chart below. CarMax has never paid a dividend. Total market capitalization stands at $16.2 billion.
While CarMax has done very well over the past three decades, it is always hazardous to grow complacent in a competitive business environment. The history of the company’s former parent presents cautionary lessons. While there were many reasons for the downfall of Circuit City, one important factor involved management’s failure to adapt its sales approach to compete with Best Buy:
... Circuit City didn’t see Best Buy as a threat. “We thought we were smarter than anybody,” says Alan Wurtzel, who remained on the board of directors until 2001. “But the time you get in trouble is when you think you know the answers." 8
Alan Wurtzel is the son of the founder of Circuit City and served as the company’s CEO from 1972 to 1986.9 In a 2013 interview, Mr. Wurtzel cited hubris as a significant element in the decline and ultimate fall of Circuit City. In particular, he observed that management did not take the threat of Best Buy seriously because they believed that it was skating on thin ice financially and would likely fail.
It turned out that Best Buy’s retail approach was a better fit for what consumers actually wanted, and Circuit City shareholders paid dearly for the hubris of the company’s management in the long run. Circuit City’s management was simply not paranoid enough to take the threat seriously. This proved to be fatal.
Over the past quarter-century, we have repeatedly seen consumer preferences change in ways that might have initially seemed quite unlikely. Often, new competition comes from industry upstarts that have the funding to sustain operating losses for a considerable period of time while gaining scale and operational experience.
The new kid on the block in automotive retailing is Carvana, an upstart founded in 2013 that sells automobiles entirely online. CarMax has enhanced its online presence significantly in recent years, but the company continues to maintain an extensive network of retail locations. While CarMax management considers this “omni-channel” approach to be a competitive advantage, Carvana has been able to eliminate the significant cost of running a network of dealerships.
CarMax is a highly profitable company with a long history of sound financial results. Carvana, which went public in 2017, is the polar opposite with a history of losses and shaky financials. However, Carvana has been growing rapidly in order to achieve the scale that its management believes will eventually lead to profitability. After years of rapid growth, Carvana became the second largest used car dealer in 2021.10
Andy Grove, the longtime CEO of Intel Corporation, wrote a book entitled Only the Paranoid Survive in which he discussed the importance of management taking aggressive actions to deal with strategic inflection points. Are used car buyers ready to abandon the opportunity to test drive cars at retail dealerships and make purchases entirely online? If so, a network of retail locations might become an albatross for CarMax in the long run, ruining the company’s economics.
This profile of CarMax is divided into the following sections:
Used Vehicle Economics. Discussion of the industry’s size, fragmentation, recent trends, basic economics, and growth opportunities. The Automobile Industry, published on August 4, provides general industry background.
Operating History and Business Model. Review of long-term operating results and recent trends. The CarMax business model involves selling to consumers at retail, liquidating inventory unsuitable for retail sale through a wholesale auction process, and financing retail purchases through CarMax Auto Finance.
Balance Sheet and Capital Allocation. CarMax generates significant free cash flow, much of which has been dedicated to share repurchases, with share count declining by nearly 30% over the past decade. In 2021, CarMax acquired Edmunds, a well-known consumer-oriented vehicle research website.
Growth Opportunities and Risks. Fragmentation of the used car market provides opportunities for further expansion while online-only competitors such as Carvana pose significant risks.