KMX

Business Context and Reporting Period

Company: CARMAX, INC.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: August 31, 2007 (Second Quarter of Fiscal 2008)
Business Overview: CarMax is the largest retailer of used vehicles in the United States, operating 81 used car superstores and six new car franchises as of August 31, 2007. 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 10% to $2.12 billion for the quarter and 12% to $4.27 billion for the six-month period compared to the prior year.
• Profitability: Net earnings rose 20% to $65.0 million for the quarter and 17% to $130.4 million for the six-month period. Gross profit per retail unit increased to $2,869 from $2,755 in the prior year quarter.
• Unit Sales: Total used vehicle unit sales increased 11% (quarter) and 13% (six months). Wholesale vehicle unit sales increased 15%. Conversely, new vehicle unit sales declined 15% due to industry trends and the divestiture of a franchise.
• CAF Income: CarMax Auto Finance income decreased 8% to $33.4 million for the quarter, primarily due to the absence of a $6.1 million favorable adjustment recorded in the prior year. Excluding adjustments, CAF income increased 9%.
• SG&A Expenses: The SG&A ratio improved to 10.1% from 10.4% in the prior year quarter. The prior year included $5.4 million in accelerated stock option vesting expenses related to the former CEO's retirement.
• Credit Quality: Past due accounts (31+ days) increased to 2.10% of managed receivables from 1.77% in the prior year. Annualized net credit losses rose to 1.04% from 0.56%.

Guidance, Outlook, and Risks

Revised Guidance

Management revised its fiscal 2008 expectations downward due to a market slowdown and industry-wide sales deceleration:

• Comparable Store Used Unit Sales Growth: Revised to 1% to 3% (previously 3% to 9%).
• Earnings Per Share: Revised to $0.92 to $0.98 (previously $1.03 to $1.14).

Outlook Factors

• CAF Impact: A $500 million public securitization completed in September 2007 is expected to reduce CAF gain income by approximately $8 million in the third quarter due to increased credit spreads and unwinding interest rate swaps.
• Capital Expenditures: Estimated at approximately $300 million for fiscal 2008, reflecting increased real estate purchases.
• Store Expansion: Plans to open 9 superstores in the second half of fiscal 2008 and 8 in the first half of fiscal 2009.

Risks and Contingencies

• Legal Proceedings: A putative class action lawsuit filed in June 2007 alleges failure to disclose prior rental history of vehicles. Management cannot estimate the potential loss.
• Market Risk: Reliance on the asset-backed financing market; deterioration could force curtailment of lending practices.
• Credit Risk: Increased delinquency and loss rates on receivables originated in late 2005 and 2006 compared to earlier years.

Investor Verification Checklist

• Credit Loss Trends: Verify the sustainability of the increased net credit loss rate (1.04% vs 0.56% prior year) and its impact on future CAF income.
• Securitization Costs: Confirm the actual impact of the $8 million CAF gain reduction in Q3 2008 related to the September securitization and credit spreads.
• Comparable Store Growth: Monitor if the revised 1-3% comparable store growth target is achievable given the cited macro-economic headwinds.
• Legal Exposure: Track the status of the Maryland class action lawsuit regarding rental history disclosures.
• Capital Allocation: Assess the return on investment for the increased capital expenditure budget ($300M) relative to the slower sales growth environment.