KMX

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended May 31, 2003 (First Quarter of Fiscal 2004) for CarMax, Inc. Following its separation from Circuit City Stores, Inc. effective October 1, 2002, CarMax operates as an independent, publicly traded retailer of used and new vehicles. The company operates a network of superstores and utilizes a securitization program to fund its automobile loan receivables through CarMax Auto Finance (CAF).

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 17% year-over-year, driven by a 10% growth in comparable store used vehicle unit sales and the addition of seven new stores since April 2002.
• Profitability: Net earnings rose 21% to $35.3 million. This was aided by the absence of separation-related expenses incurred in the prior year, despite an increase in operating expenses due to stand-alone operations.
• Margin Expansion: Total gross profit margin improved to 12.6% from 12.1%. Wholesale vehicle gross margin increased significantly (9.5% vs 6.7%) due to testing alternative cost recovery methods, while new vehicle margins declined slightly due to competitive pricing.
• Cash Flow: Operating cash flow surged to $72.6 million from $9.1 million, primarily due to higher net earnings, increased accounts payable, and a decrease in inventory levels.
• Debt Structure: The company reduced short-term debt by $41.5 million during the quarter. It completed a $507 million public securitization using a senior-subordinated structure, marking a shift from third-party insurance support.

Guidance, Outlook, and Risks

Management Commentary and Outlook

• Store Expansion: CarMax plans to open approximately two standard superstores and three prototype satellite stores in Fiscal 2004. It also intends to integrate remaining stand-alone franchises in Los Angeles into a new superstore.
• Financial Guidance: Management reaffirms a forecast of 5% to 9% used unit comparable sales growth for Fiscal 2004 and net earnings in the range of $105 million to $116 million.
• Q2 2004 Forecast: Anticipates used vehicle unit comparable growth of 6% to 8% and diluted EPS of $0.33 to $0.35.
• Cost Structure: The company estimates the full-year incremental cost of being a stand-alone entity to be $20 million to $22 million, with the majority of the remaining $11 million to $13 million expected to be incurred in the first seven months of Fiscal 2004.

Risks and Contingencies

• Securitization Performance: The company retains interests in securitized receivables. If these receivables underperform assumptions regarding prepayment or default rates, earnings could be negatively impacted.
• Interest Rate Risk: While most debt is floating-rate (LIBOR), the company uses interest rate swaps to manage exposure. A 100 basis point increase in rates is not expected to materially affect operations but could impact cash flows.
• Accounting Changes: The company is evaluating the impact of FASB Interpretation No. 46 regarding the consolidation of variable interest entities, though no material impact is currently expected.

Investor Verification Checklist

• Comparable Store Growth: Verify the sustainability of the 10% comparable store used unit sales growth in the context of the broader economic environment.
• Stand-Alone Costs: Monitor the realization of the estimated $20 million to $22 million annual incremental costs associated with operating independently from Circuit City.
• Securitization Assumptions: Review the sensitivity analysis of retained interests (Note 7) to understand the potential earnings impact of adverse changes in prepayment or default rates.
• Wholesale Margin Strategy: Assess the long-term viability of the new wholesale cost recovery method that replaced appraisal purchase processing fees.
• Debt Covenants: Confirm continued compliance with financial covenants related to the $300 million credit agreement and securitization performance tests.