We also explore why this has been a terrible year for bond funds, and how used-car sticker prices might signal trouble ahead.
Ivanna Hampton: Here’s what’s ahead on this week’s Investing Insights. The strong dollar can pose a threat to earnings season. What investors should know as companies report their results.
Plus, Tesla is falling short of Morningstar’s expectations. What we now think of its stock value.
And, used cars are becoming less affordable. Our analyst weighs in on likely warning signals from the country’s largest used-car dealer.
Welcome to the new Investing Insights. I’m your host, Ivanna Hampton. We’re bringing you a new format with a mix of market news, analyst insights, and personal finance tips. Let’s get started with a look at the Morningstar headlines.
Lower Estimate of Tesla's Stock
Tesla’s dip in deliveries is leading to a dip in our view of its stock value. The electric vehicle company reported lower deliveries than we previously forecasted. Preliminary numbers show just under 344-thousand deliveries in the third quarter. Granted, that’s an all-time high. Reuters reported Tesla aims to produce almost a half a million vehicles in the fourth quarter. But those numbers would leave it short of what we forecasted for the year. The company pointed to logistics issues for deliveries slowing down last quarter. Well, we think it reflects the challenges of ramping up production at two new factories and restarting the plant in Shanghai, China. We see no long-term issues that would affect production. We estimate Tesla’s stock is now worth 250-dollars down from 255-dollars.
Micron Stock: Chipmaker Trims Spending
One of the world’s largest chipmakers is scaling back. Micron reported fiscal fourth-quarter results that suffered from declining memory chip sales for PCs and smartphones. The demand is likely to fall further. The chipmaker is also dealing with an oversupply of inventory. Revenue is falling short of management’s estimates. Micron is cutting its capital expenditure budget for fiscal 20-23 while working to curb output. However, Morningstar remains positive on long-term memory demand growth stemming from trends such as artificial intelligence, 5-G, and electric vehicles. We're also optimistic about Micron's new memory and storage products and their ability to help grow revenue. We lowered our estimate of what we believe Micron’s stock is worth to $70.
Nike Stock: Earnings Top Expectations, but Near-Term Outlook Disappoints
Nike's surplus inventory is taking the steam out of otherwise good sales numbers. The company’s performance in its first quarter of fiscal 20-23 topped Morningstar’s expectations. However, it released a disappointing near-term outlook due to the U.S. dollar’s strength and elevated inventories. Demand has been healthy, but Nike has struggled to manage its product deliveries because of supply chain issues. That’s leading to a surplus of out-of-season items. We expect a relatively quick recovery as Nike appears to have a solid lineup of new products despite the issues. The globe’s largest athletic footwear and apparel brand should get a boost from the upcoming World Cup and other sporting events. September showed strong back-to-school demand and double-digit sales growth. We lowered our estimate of what we think Nike's stock is worth to 129-dollars down from 133-dollars. We still think the shares are undervalued.
Why 2022 Has Been a Terrible Year for Bond Funds
This has been one of the worst years for bond funds since the 90s. That’s according to Peter Marchese. He is a senior manager research analyst for Morningstar Research Services. Inflation has stayed higher than expected in part because of the war in Ukraine. The Fed has also signaled that it may keep raising rates into next year. The biggest losses have come from funds bonds with longer maturities. That makes them the most sensitive to an increase in interest rates. The Federal Reserve met in September. They raised interest rates by point-75-percentage points for an unprecedented third time in a row. The double-digit price declines bond funds have seen may make them more attractive investments now. Marchese says investors might be trying to time when bond funds will start to rebound. You can read more about bond funds’ terrible year. A link is in the show notes.
Used-Car Affordability Slams CarMax's Earnings The current economic environment is making used cars unaffordable for some people. CarMax pointed to high inflation and low consumer confidence for its disappointing earnings results. The nation’s largest used-car dealer appears to be signaling trouble ahead. Dave Whiston is a U.S. autos equity analyst for Morningstar Research Services. He covers CarMax.
Ivanna Hampton: CarMax reported fiscal 2023 earnings for the second quarter. The news wasn't good. Can you break down what they released to us?
Dave Whiston: Sure. It was a very ugly day for the stock. It fell 25% that day, which I can understand it to a point because some people just focus on the EPS [earnings per share], for example, and they did miss horribly. It was $0.79 reported versus $1.39 for the Refinitiv Consensus. But, basically, what's going on with CarMax is all ultimately a function of this chip shortage that's been ravaging autos. And it's causing a major, major problem in used-vehicle affordability for consumers to the point frankly where consumers are basically just saying, "I'm done. I'm not paying what you're asking now, and I'm not going to pay more." So that's causing their same-store, or what they call comparable store unit sales, were down over 8% for the quarter, which is a pretty ugly number. Not the worst it's ever been, but it's ugly. And it also means they were down for the third-straight quarter in that metric. That hasn't happened since the great recession, actually, when they were down four-straight quarters. And again, I mentioned affordability, that's what's driving all this. It's not a problem with CarMax's management team and their strategy or anything like that, their business model. It's just that used vehicles are very, very expensive and consumers are staying away a lot more than they did and they're just delaying buying a vehicle. So, average selling prices, or what we call ASPs, they were roughly about $20,500 before the pandemic. And they peaked, hopefully peaked, in fiscal Q4, just a couple quarters ago at over $29,000. And they've been coming down, but not a lot yet. They're still over $28,000. Actually, I think over $28,500 for Q2 that they just reported. So, again, that's causing consumers to stay away, that leads to gross-margin compression. You can't leverage your SG&A costs, your overhead expenses. Free cash flow is still positive, but it gets hurt by this. And then you get an earnings miss, and that leads to the stock having a very ugly day.
CarMax's Response to Inflation and Rising Interest Rates Hampton: It's been a challenge to buy a used car over the last couple of years. You mentioned earlier that there's been parts shortages. Well, there's likely hasn't been a shortage of people looking to buy a car. Well, inflation has entered the picture. What is CarMax's response to all of this?
Whiston: That's the ugly thing here is we've got a lot of used-vehicle inflation because of the chip shortage. There are definitely dealers out there gouging consumers, especially on the new-vehicle side, which is unfortunate. But on the used-vehicle side, CarMax's ASPs have gone up over 40% compared to before the pandemic and before the chip shortage. They're now in the over $28,000. But what ultimately happens here is that this whole process, it needs to reverse itself out, and that's going to take some time. So, right now, to your question, what are they doing? Well, they are raising prices, as I mentioned, with the ASP increase, but they price still to get a gross profit per unit, or GPU. They still want that to be in the low $2,000 range, roughly $2,000 to $2,200 a unit.
And because of their big data expertise, their national pricing algorithm, and just their being very good at what they do in terms of how they procure cars, they can still get that GPU. But I talked to their CEO about this before, he is very passionate about not gouging consumers. Because he believes there's good will being created, we don't gouge them now down the road five years from now when they need another car, even though they'll come back to CarMax because they know they were treated right. Obviously, not everyone feels they're treated right, but that's the business model and they're selling nearly a million used cars a year on the retail side. So, I think they're doing something right. But, yes, prices are going up to consumers. But there's the other side of this, which is procurement costs for CarMax to get that inventory. But you're still getting the same GPU that I mentioned in the low $2,000 unit. So what does that mean? There's math here, something has to give, and that's gross margin. Gross margins just on the used vehicles they retail, they're down several hundred basis points now, right around 8%. They were more like 10.5% to 11.0% before the pandemic. And the overall company gross margins are down over 400 basis points now to about 9% from 13% to 14% previously. So you're getting a lot of margin compression, that hurts earnings, that ultimately again leads to a 25% fall in the stock price, and in my opinion, buying opportunity for the long-term investor. But it's early.
Hampton: CarMax also finances car purchases, and the Fed is raising interest rates, and that's making car loans more expensive. What is the company doing to address that?
Whiston: They also have a very lucrative finance arm called ... they call it CAF, it stands for CarMax Auto Finance, and it basically relies on the asset-backed securities market, or the ABS market. They're still originating well over $2 billion worth of loans every quarter. The originations are roughly flat though year over year. They are passing along some of the higher interest rates because they have funding costs for what's effectively a bank. On the ABS deals, they are getting what's called the collateral spread, that is getting narrowed. But the interest margin on CAF earnings has gone up before the loan-loss provision.
You've got some higher loan-loss provisions, of course, to normalize things after a lot of erratic accounting that went on when the pandemic first started on estimates for the loan-loss provision. But also macroeconomic conditions have worsened slightly. But they're not heavily reliant on the subprime borrower, for example. So, I don't think you need to worry about a low-quality credit portfolio. But as I mentioned, originations are flat. Some of that is, I think, CarMax is choosing to be just a tad more selective. I haven't heard anything about a massive pullback. But also in the used-vehicle space, there's been a huge increase in penetration by credit union. Customers have the option to go through CAF or other lenders, and some customers are choosing to go to another lender. But I see nothing that makes me say the CAF business is in a lot of trouble.
Our Analyst's View of CarMax's Stock Hampton: All right. So what do you think of CarMax stock value?
Whiston: I do like the stock a lot. It's one of my favorite names, honestly. I've been covering this list for 15 years, and CarMax is definitely up there in terms of great quality and a great business. And as analysts, I'm not allowed to own it unfortunately. And I really wish I were allowed to because it's a great business I'd love to own, especially at a recent price in the mid-$60s. I do stress, though, if we are going to have a recession in the U.S., we haven't experienced the full head-on, brunt of it yet. So, things could certainly get worse with the stock.
I do think for the long-term investor, though, the stock is a very attractive investment, and it's certainly well-undervalued. It's a 5-star stock as of now with a fair value estimate, I believe, of $155, if I'm remembering correctly. So, it's the kind of name, I think, like a lot of things, there's just been so much volatility, [how much do] you want to endure and how patient do you want to be. But on my coverage list, which I admit is a very cyclical one and being autos, but this is definitely one of the higher-quality names I cover and a great business. And I think right now, it's cheap. And frankly, it's really undervalued.
Cheap Stock Picks: Ford, GM, and Gentex Hampton: Are there any other names that you would recommend besides CarMax?
Whiston: So, covering autos, it's good and bad when a recession happens because it hurts, obviously, if you own the stocks and you see things like a stock being down 25% in one day, like CarMax was. That's painful. I invest personally. Again, I don't own my list. I'm not allowed to. But I do own stocks. And when they fall hard, I certainly don't like that. None of us do as human beings. We like to make money. But covering autos with everything is just getting decimated and sold off now because of fears of higher interest rates, fears of U.S. recession, uncertainty around what's going on in Europe because of Ukraine. So, basically, every automotive in my cover is undervalued right now. Again though, it comes down to how much volatility, and how patient you want to be as an investor to see what you like.
High profile names on my list beyond CarMax would, of course, be GM and Ford. They're both 5 stars, I believe, today. They're dealing with higher input costs. But the whole industry for a variety of reasons, such as incentives aren't very high right now because of the chip shortage. The industry, in my opinion, is going into a recession. If we were to have one, I think, at a far healthier state and ability to handle a recession than it normally would be because normally, incentives would be very high right now. We'd have bloated inventories. We have the exact opposite. We have inventories that are way too low. Really, they need to more than double from where they are. They're now about 1.4 million units and they got down to under a million units on the new-vehicle side last September. So if one doesn't like a GM or a Ford, another really high-quality name on my list that perhaps some people don't know about is Gentex, ticker GNTX.
If you don't know them, they make nearly all the auto-dimming mirrors in the world for your car. They have something like roughly 93% market share. It's got amazing margins for an auto supplier. Op margins are generally in the mid- to high-20% range. In a really bad recession, they've been in the high teens. A typical auto supplier is going to do high single digits to maybe low double digits. Gentex has no debt. So, it's a fortress balance sheet. It has cash and high quality investments, generally blue-chip type investments or bonds that make up, I believe, 19% of their total assets as of June 30 and just under $2 per share. So, you've got a stock that I believe right now is 5 stars with a $36 fair value estimate trading at around $25, $26. So that's another high-quality name to keep in mind if someone wants to do autos, but maybe doesn't want to take the plunge into the deep end of the volatility and the cyclical intensity of a GM or a Ford, for example.
Hampton: All right. Well, thank you for those ideas and your time today, Dave.
Why Is the Dollar Strong Now?
Ivanna Hampton: The U.S. dollar is growing stronger. Its surge is good news for U-S travelers taking international trips but not-so-good news for investors. Here’s Morningstar’s director of content Susan Dziubinski and Dave Sekera, who is the chief U-S market strategist for Morningstar Research Services. He covers CarMax.
Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The U.S. dollar recently hit new two-decade highs after the Federal Reserve raised interest rates in September. Morningstar's chief U.S. market strategist Dave Sekera is here today to discuss what the strong dollar means for investors, company earnings, and stocks. Dave, let's start out talking a little bit about what's been driving the dollar's strength in 2022.
Dave Sekera: Well, there's been a number of different reasons, but first and foremost, from a fundamental point of view, I think it's because inflation in the United States, while we haven't turned the corner yet, at least has stopped going up. And the Federal Reserve here in the U.S. really was one of the first major central banks to really start tightening monetary policy in order to limit inflation. So, I think that from a fundamental point of view is one of the biggest reasons that we've seen the strength of the dollar, especially as inflation has been ramping up in the EU and the U.K. I'd also say, from a more technical point of view, the other thing we've been seeing is that there has been a flight to safety to the U.S. dollar. So, again, while markets have been going down, both in the U.S. as well as internationally, the economic outlook globally has been pretty soft. That flight to safety has also helped push the dollar stronger. Dziubinski: Do you expect the dollar to remain strong for the rest of this year? Sekera: Well, we don't explicitly forecast foreign exchange or the dollar in and of itself. We really stick to analyzing the fundamentals of the companies under our coverage. Now, having said that, I would say that in an environment that as long as inflation in the U.S. doesn't continue to start ramping back up and we do see inflation running hot in those other areas within the world, then yes, the dollar probably will remain strong for the foreseeable future.
Strong Dollar Threatens Company Earnings Dziubinski: In a recent column that you wrote for morningstar.com, you talked a little bit about how a strong dollar can cause a threat to company earnings. Unpack that a little bit. Sekera: Well, specifically, that's going to be for those global companies that have a lot of earnings in foreign jurisdictions, and essentially it's going to be what's called foreign-exchange currency translation, in accounting terms. Essentially that just means that when you have those earnings in a foreign currency generated overseas, when that company translates that back into U.S. dollars, for every amount of foreign currency that you have, you end up getting less dollars back in the United States. And so that will be a headwind to earnings growth for those companies. Dziubinski: Dave, what types of companies tend to suffer the most when the dollar's strong? Sekera: Well, again, as we mentioned earlier, it's those companies that do have a significant portion of their earnings coming from overseas. But from a fundamental point of view, more specifically, I'm also concerned about those companies that might have a mismatch between their revenue and their operating costs. For example, if their operating revenue is in U.S. dollars but then their costs would be in that foreign currency, you can see an expansion in their margins, which of course would be good for the company as the foreign currency is cheaper. Or conversely, if it's the opposite way around, and they're generating the revenue in that foreign currency, but their costs are in U.S. dollars, that then could actually impair and constrict their operating margins, which, of course, fundamentally could reduce the value of that company. Dziubinski: Dave, how should investors be thinking about companies that may see their earnings get nicked by the strong dollar? Is this a reason to sell or are earnings disappointments that are maybe driven by that strong dollar something to sort just gloss over as long as the long-term story's good? How should they think about it? Sekera: Well, I wouldn't say it's a reason to sell. It's certainly going to be a reason to dig in a little bit deeper and really understand how that foreign-currency translation may be impacting the fundamentals of the business of itself. So, we look at that foreign currency translation as an accounting change, which is really just going to be a one-time hit in earnings. Unless you expect that the dollar would continue to keep appreciating at a similar rate, it'll hit that one quarter, but then it really won't hit in the quarters thereafter. However, our equity analyst team, they're really looking at the underlying fundamentals of that company. They would be looking for instances that the fundamentals could change because of the difference in those foreign-exchange valuations. And if that were to actually impair the company, then yes, it could be a reason that it may be enough to push the stock down, and of course, you'd want to sell ahead of that.
Cheap Stocks to Consider as the Dollar Strengthens Dziubinski: Lastly, Dave, are there any stocks today whose earnings may be a little vulnerable to this strong dollar but where we have faith in the long-term story and maybe they're undervalued? Sekera: Sure. So a couple of international companies I highlight right now that we think are significantly undervalued, first would be Anheuser-Busch InBev BUD. Again, the largest beer company in the world has sales all across the globe, so they're going to have lots of different types of foreign-currency issues no matter how you look at it. But that stock, we think is significantly undervalued at this point in time. It also plays into a theme that we've talked about before, which is kind of that consumer normalization that we expect as the pandemic recedes. We think that there'll be some benefits for that company going forward as well. The next one I would mention would be SAP SAP, a large German technology company. That one has been under pressure. That one I think has traded off over 40% year to date. So, that's trading well into undervalue territory, in our view. Then lastly, the one that I would mention is GSK GSK, GlaxoSmithKline. That company's actually one of our healthcare team's best picks right now, and it's been under pressure for two different reasons. The first, of course, would be the foreign-currency translation, but I'd also note this is a little bit of a story stock, it does take a little bit of research and due diligence. The company's getting some lawsuits right now for one of their prior products, which was used for heartburn. Those lawsuits are claiming that it might cause cancer, so the market has really sold that stock off. Our healthcare team, they've looked at the situation, they've put together a couple of different scenarios, and they think that the amount that that stock has gone down is several times greater than any potential settlements that they think that company may have to pay out in the future. Dziubinski: Well, Dave, thanks for your time and for your perspective today on what this strong U.S. dollar may mean for earnings, stocks, and investors. We appreciate it. Sekera: All right. Well, thank you, Susan. Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.
Ivanna Hampton: Thanks, Susan and Dave. All of you out there, let us know what you think of the new format of Investing Insights. Email us at podcast-at-morningstar-dot-com. Make sure you subscribe to Morningstar’s YouTube channel, so you don’t miss out! Thanks to podcast producer Jake Vankersen who puts this show together. I'm thanking you for watching Investing Insights. Take care.
Companies mentioned in this episode.
Tesla (TSLA) ; Micron Technology (MU) ; Nike (NKE) ; CarMax (KMX) ; Ford Motor (F) ; General Motors (GM) ; Gentex (GNTX) ; Anheuser-Busch InBev (BUD) ; GSK PLC (GSK) ; and SAP SE (SAP) .
Read about topics from this episode.
Trimming Tesla Fair Value Estimate to $250 Following Lower Q3 Deliveries
Nike’s Brand Value Holds Despite a Tough Near-Term Outlook; Shares Undervalued
Why 2022 Has Been Such a Terrible Year for Bond Funds
Used-Vehicle Affordability Slams CarMax’s Q2, but We See Stock as Attractive for Long Term
Strong U.S. Dollar a Headwind to Earnings Growth
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