KMX

Business Context and Reporting Period

Company: CARMAX, INC.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: November 30, 2007 (Third Quarter of Fiscal 2008)
Business Overview: CarMax is the largest retailer of used vehicles in the United States, operating 86 used car superstores and six new car franchises as of November 30, 2007. The company generates revenue through the retail sale of used and new vehicles, wholesale vehicle auctions, and financing services via CarMax Auto Finance (CAF).

Key Financial Metrics

Material Changes vs. Prior Comparable Period

• Revenue Growth: Net sales increased 7% in the third quarter and 10% for the nine-month period compared to the prior year, driven primarily by a 9% increase in used vehicle unit sales.
• Profitability Decline: Net earnings decreased 34% in the third quarter ($29.8M vs. $45.4M) and increased only 2% for the nine-month period ($160.2M vs. $156.5M).
• CAF Income Volatility: CAF income dropped 49% in the third quarter to $16.3 million. This was primarily due to a $14.1 million reduction in the valuation of retained interest in loans, caused by increased funding costs in the asset-backed credit markets.
• Comparable Store Sales: Comparable store used unit sales were flat (0%) in the third quarter, a significant slowdown from the 13% growth in the prior year, attributed to declining consumer confidence and industry-wide slowdowns.
• Expense Ratios: The SG&A ratio increased to 11.2% of net sales in the third quarter from 10.6% in the prior year, reflecting flat comparable store sales and continued investment in growth initiatives.

Guidance, Outlook, and Risks

Management Commentary and Guidance

• Revised EPS Guidance: Management reduced fiscal 2008 earnings per share expectations to a range of $0.87 to $0.93 (previously $0.92 to $0.98) due to continued turmoil in asset-backed credit markets and higher funding costs.
• Sales Outlook: Fiscal 2008 comparable store used unit sales growth is now expected to be approximately 2%.
• Capital Expenditures: Expected capital expenditures for fiscal 2008 were revised down to approximately $260 million from $300 million, reflecting changes in the timing of land purchases.
• Store Expansion: The company plans to open approximately 15% to 20% of its store base annually. Three new superstores were planned for the fourth quarter of fiscal 2008.

Risks and Contingencies

• Credit Market Disruption: Unprecedented instability in the asset-backed securities market has increased CAF funding costs and reduced gain percentages on loans sold. The company temporarily increased its warehouse facility limit by $300 million to $1.3 billion in December 2007 to ensure liquidity.
• Legal Proceedings: A putative class action lawsuit was filed in June 2007 alleging improper disclosure of vehicles' prior rental history. The company cannot estimate the potential loss.
• Delinquency Rates: Past due accounts (31+ days) increased to 2.51% of managed receivables in the third quarter, up from 1.93% in the prior year, reflecting worsening economic conditions.

Investor Verification Checklist

• CAF Funding Costs: Verify the sustainability of the $14.1 million valuation adjustment and the impact of rising asset-backed commercial paper spreads on future CAF margins.
• Comparable Store Trends: Monitor the flat comparable store sales growth to determine if the industry-wide slowdown is impacting CarMax's market share gains.
• Liquidity Position: Confirm the status of the temporary $300 million increase in the warehouse facility and the company's ability to refinance or renew securitizations in a volatile market.
• Legal Exposure: Track the status of the Maryland class action lawsuit regarding rental history disclosures.
• Capital Allocation: Review the revised capital expenditure plan ($260M) to ensure it aligns with the reduced store opening schedule and land acquisition timing.