KMX

Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended November 30, 2002, and the nine months ended on that date. CarMax, Inc. became an independent, separately traded public company effective October 1, 2002, following its separation from Circuit City Stores, Inc. The financial statements are presented on a pro forma basis as if the separation had occurred at the beginning of the periods presented.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net sales increased 10% in the quarter and 13% for the nine-month period compared to the prior year, driven by an 8% increase in comparable store used unit sales and the opening of five new stores.
• Profitability: Net earnings decreased 20% in the quarter to $14.7 million, primarily due to $4.5 million in one-time, non-tax-deductible separation costs. Excluding these costs, earnings would have been 4% higher year-over-year.
• Expense Ratios: Selling, general, and administrative (SG&A) expenses rose to 10.9% of sales in the quarter (from 9.7% prior year) due to separation costs, geographic expansion, and diseconomies of scale.
• Capital Structure: The company entered a $200 million credit agreement in May 2002. As of November 30, 2002, $104.5 million was outstanding. The company also paid a $28.4 million special dividend to Circuit City Stores upon separation.
• Reclassifications: Prior year data was reclassified to conform to current presentation, including moving wholesale vehicle sales to revenue and separating CarMax Auto Finance income from SG&A expenses.

Guidance, Outlook, and Risks

• Fiscal 2003 Guidance: Management anticipates pro forma net earnings of $0.95 to $1.00 per share for fiscal 2003, excluding approximately $0.08 per share of one-time separation costs.
• Store Expansion: The company plans to open two additional superstores in the fourth quarter of fiscal 2003, bringing the total for the year to five. Future plans include opening 6-8 stores annually for fiscal years 2004-2006.
• Auto Finance Outlook: CarMax Auto Finance is expected to contribute more to earnings in the fourth quarter than originally anticipated due to a favorable interest rate environment, though cost of funds is expected to rise beyond fiscal 2003.
• Risks and Contingencies:
  • Securitization Performance: The company retains interests in securitized receivables valued at $140.5 million. Adverse changes in prepayment rates, default rates, or discount rates could materially impact the fair value of these retained interests.
  • Separation Costs: Ongoing expenses related to the separation from Circuit City, including higher insurance and benefit costs, are moderating expense leverage.
  • Market Risk: Substantially all debt is floating rate (LIBOR-based). A 100 basis point increase in rates is not expected to have a material effect on operations.

Investor Verification Checklist

• Verify the impact of the $7.6 million in one-time separation costs on the nine-month net earnings and the adjusted earnings per share.
• Review the retained interests in securitized receivables ($140.5 million) and the sensitivity analysis regarding prepayment and default rate assumptions.
• Confirm the status of the $200 million credit agreement and compliance with financial covenants (current ratio, debt-to-equity, fixed charge coverage).
• Monitor the comparable store used unit sales growth (8% in Q3) as the primary driver of future profitability.
• Assess the wholesale vehicle sales volume and margins, which are sensitive to the broader used car market conditions.