KMX

Business Context and Reporting Period

Company: CARMAX, INC.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: August 31, 2008 (Second Quarter of Fiscal 2009)
Business Overview: CarMax is the largest retailer of used vehicles in the United States, operating 98 used car superstores and six new car franchises as of August 31, 2008. The company generates revenue through the retail sale of used and new vehicles, wholesale vehicle sales, and financing services via CarMax Auto Finance (CAF).

Key Financial Metrics

Material Changes vs. Prior Comparable Period

• Revenue Decline: Net sales decreased 13% in the quarter and 5% year-to-date compared to the prior year, driven by a 7% drop in used vehicle unit sales and a 24% drop in new vehicle unit sales.
• Profitability Compression: Net earnings plummeted 78% in the quarter ($14.0M vs. $65.0M prior year) and 66% year-to-date ($43.6M vs. $130.4M prior year).
• CAF Loss: CarMax Auto Finance reported a loss of $7.1 million in the quarter, a significant reversal from $33.4 million in income the prior year. This was driven by a $28.2 million charge related to adjustments on loans originated in prior periods (increased loss rate assumptions and mark-to-market reductions on subordinated bonds).
• Margin Pressure: Total gross profit per retail unit decreased $116 to $2,753. Used vehicle gross profit per unit dropped $112 due to lower appraisal traffic and a shift toward auction-sourced inventory.
• SG&A Ratio Increase: The SG&A ratio rose to 12.2% from 10.1% in the prior year quarter due to the significant decline in sales volume, partially offset by cost reduction efforts.

Guidance, Outlook, and Risks

• Guidance Withdrawal: Management stated they are unable to make meaningful projections for fiscal 2009 comparable store sales or earnings due to unprecedented declines in traffic and volatility in asset-backed credit markets.
• Store Growth Slowdown: In response to the economic environment, CarMax announced a temporary slowdown in store growth. Plans were reduced from 14 openings in fiscal 2009 to 10, with fiscal 2010 openings projected between 5 and 10.
• Capital Expenditures: Estimated gross capital expenditures for fiscal 2009 were lowered to $200–$225 million from a previous expectation of $350 million.
• Workforce Reduction: A subsequent event noted a workforce reduction of over 600 service operations associates, with estimated severance costs of $7.0 million to be recognized in the third quarter.
• Key Risks:
  • Credit Market Disruption: Higher funding costs and increased credit enhancement requirements in the warehouse facility have severely impacted CAF margins.
  • Economic Conditions: High gasoline and food costs have reduced consumer spending power, leading to sharp declines in customer traffic and sales.
  • Inventory Valuation: Rapid declines in wholesale values for SUVs and trucks created margin pressure, though inventory levels were aggressively reduced to mitigate markdowns.

Investor Verification Checklist

• CAF Valuation Assumptions: Verify the impact of the increased discount rate (19%) and cumulative loss rate assumptions (up to 3.5%) on future earnings, as these are significant unobservable inputs (Level 3 assets).
• Inventory Turnover: Monitor the effectiveness of inventory reduction strategies and the potential for further markdowns if wholesale values for SUVs/trucks continue to fluctuate.
• Liquidity and Funding: Assess the company's ability to refinance its warehouse facility (expiring July 2009) and term securitizations given the tight credit markets and increased funding costs.
• Comparable Store Sales: Track the recovery of comparable store traffic and unit sales, which declined 17% in the quarter, as this is the primary driver of profitability.
• Legal Proceedings: Monitor the status of the settled class action regarding vehicle rental history disclosure and the new securities class action filed in August 2008.