The Next Financial Crisis Looms in This Sector

I think it was philosopher George Santayana's cousin who said, "Those who do not learn from history are doomed to lose money in the stock market." 

It's amazing how quickly we forget the mistakes of the past, and now one of the biggest factors that led to the Great Recession is building up again.

A booming housing market and relaxing loan standards led to the worst economic collapse in nearly 80 years. And looking at some recent loan data gave me a serious sense of deja vu. But rather than home loans, this time it is the auto loans market that's headed for trouble.

Auto Loans Headed for a Crash?

Just as larger economic drivers sparked the housing boom, super-low interest rates and falling gasoline prices have caused a spike in car sales over the past five years. New car sales hit a record in 2015, while the average transaction price reached an all-time high of $34,428.

Yet, sluggish wage growth and a stalling economic recovery have threatened the good times. Not wanting to see the party end, car makers and dealers have resorted to relaxing loan standards.

Outstanding motor vehicle loans have increased for 22 consecutive quarters, rising at a 7.6% annualized pace since 2011. That is four times the 1.9% annualized growth in real disposable personal income over the same period. To keep payments low, lenders have extended loan terms, with 29% of new loans in Q4 2015 between 73 and 84 months compared to just 9.6% five years earlier.

And now cracks are now starting to show in the overstretched auto loans market. 

Nearly a third (31.4%) of cars owners owe more than their vehicle is worth, according to a J.D. Power Automotive forum held in March. That number is expected to reach a decade high this year. Already, it's above the easy credit days of 2006, when the negative equity rate stood at 30.7%.

And the percentage of auto loans to subprime borrowers who are late by more than 60 days jumped to 5.2% recently, the highest in 20 years.

The Worst Place to Be a Market Leader

CarMax (NYSE: KMX) is the largest retailer of used cars in the United States, selling more than twice as many cars as the next largest competitor. Used vehicle sales account for more than 80% of revenue, with new vehicles representing just 1% of sales. The company's financial arm, CarMax Auto Finance, had a hand in 42% of sales last year.

Normally, the company's leadership and strong growth would be a positive… but not given the trends we're seeing in the auto loan industry.

Fundamentals are already starting to weaken. Receivables at the finance division jumped to $9.1 billion in fiscal 2016 (ended in February), nearly double the $4.7 billion in 2012, as the company used more financing to sell cars. 

CarMax is expanding its financing at the same time it's making less money per loan. The net interest margin on loans shrunk to 5.9% in the most recent quarter from 7.4% just three years ago, and that is before subtracting for loan losses. Subtracting for the loan loss provision reduces the interest margin to roughly 5% for fiscal 2016.

The company started originating loans to subprime borrowers (Tier 3) in 2014 rather than pass these borrowers on to other credit providers. In the fourth quarter, the company made 15% of its loans within this tier. 

Despite the fast loan growth and weakening credit environment, CarMax has barely increased its loan loss percentage of receivables (0.99%) over the past year. Against the delinquency rate of 5.2% across all subprime borrowers, CarMax's loan loss provision looks inadequate. 

Another fundamental concern is CarMax's debt load, which has doubled over the past two years, rising to 34% of capital versus just 17% in 2014. CarMax has been cash flow negative for the past five years, financing growth through $6.2 billion in additional long-term debt. 

Yet, the company plans on opening 15 new stores this year and up to 16 next year -- an increase of about 10% annually -- even as management noted it faces a "challenging sales environment." 

Turn CarMax's Looming Crisis Into a 78% Profit

CarMax's aggressive growth and loan strategy may become an albatross around its neck. Shares trade for 17.8 times trailing earnings but traded as low as 14.1 times in February.

With KMX trading for $54.04 at the time of this writing, we can buy a KMX Oct 52.50 Put for $3.80 per share. That is a put option with a $52.50 strike price that expires on Oct. 21. Each contract controls 100 shares, costing you $380 per contract. 

The trade breaks even at $48.70 per share ($52.50 strike price minus $3.80 options premium), which is about 10% below the current price.

My downside target for KMX is $45.75. That's 15% below the current price and about 15 times trailing earnings. At this price, our put option would be worth at least $6.75 ($52.50 strike price minus $45.75 stock price) for a 78% gain in about five months. Place a good 'til canceled (GTC) order to sell the option at $6.75 when you open the trade.

Like the housing bubble, the bubble in auto loans may take several years to fully deflate. So if shares of CarMax have not skidded to my price target as expiration nears, consider rolling the position to an option with a later expiration date.

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