KMX

Business Context and Reporting Period

Company: CARMAX, INC.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: May 31, 2006 (First Quarter of Fiscal 2007)
Business Overview: CarMax is the largest retailer of used vehicles in the United States, operating 71 used car superstores and seven new car franchises as of May 31, 2006. The company utilizes a "no-haggle" pricing model and provides financing through its subsidiary, CarMax Auto Finance (CAF).

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 19% year-over-year, driven by a 21% increase in used vehicle sales and a 31% increase in wholesale vehicle sales. New vehicle sales declined 12% due to strategic margin adjustments and softer industry trends.
• Profitability: Net earnings surged 54% to $56.8 million. Gross profit margin expanded to 13.2% from 12.5%, aided by improved gross profit per unit across all categories.
• Store Expansion: The company opened four new superstores during the quarter, bringing the total to 71. Comparable store used unit sales grew 6%.
• Accounting Change: The company adopted SFAS 123(R) effective March 1, 2006. Prior period amounts were restated to reflect share-based compensation expense, resulting in a $6.9 million expense in the current quarter compared to $4.6 million in the prior year.
• Cash Flow: Operating cash flow decreased to $48.1 million from $63.5 million, primarily due to a $69.0 million increase in inventory to support sales and new store openings.

Guidance, Outlook, and Risks

Management Commentary and Outlook

• Fiscal 2007 Guidance: Management expects comparable store used vehicle unit growth of 2% to 8% and diluted net earnings per share in the range of $1.25 to $1.47. This range includes an estimated $0.18 to $0.20 per share impact from share-based compensation.
• Store Openings: The company plans to open 11 superstores in Fiscal 2007. Seven additional stores are scheduled for the second half of the year, with five expected in the fourth quarter.
• CAF Performance: Management noted that rising interest rates may prevent near-term improvements in the CAF gain spread, as the cost of funds may increase faster than consumer loan rates.

Risks and Contingencies

• Securitization Covenants: The company must maintain specific financial covenants (e.g., tangible net worth, current ratio) to continue securitizing receivables. As of May 31, 2006, the company was in compliance.
• Interest Rate Risk: While swaps are used to manage exposure, a 100-basis point increase in market rates would decrease net earnings per share by less than $0.01.
• Executive Transition: Austin Ligon retired as CEO effective June 20, 2006, and Thomas J. Folliard was elected as the new CEO.

Investor Verification Checklist

• Inventory Levels: Verify the $69.0 million increase in inventory against sales velocity to ensure no obsolescence risk.
• CAF Gain Spread: Monitor the "gain spread" on securitized loans (currently 3.4%) against the 3.5% to 4.5% normalized target, especially given rising interest rates.
• Share-Based Compensation: Confirm the full-year impact of SFAS 123(R) adoption, specifically regarding the accelerated recognition of expenses for the retiring CEO and new CEO grants.
• Store Opening Schedule: Track the opening of the seven remaining planned stores for Fiscal 2007 to assess potential delays impacting revenue recognition.
• Wholesale Pricing: Monitor wholesale auction prices, as moderation in these prices positively impacts used vehicle acquisition costs and gross profit.