KMX

Business Context and Reporting Period

Company: CARMAX, INC.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: August 31, 2006 (Second 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 August 31, 2006. The company utilizes a "no-haggle" pricing model and offers financing through its subsidiary, CarMax Auto Finance (CAF).

Key Financial Metrics

Note: Prior period amounts have been restated to reflect the adoption of SFAS 123(R) regarding share-based compensation.

Material Changes vs. Prior Comparable Period

• Revenue Growth: Net sales increased 18% year-over-year (YoY) in the quarter and 19% for the six-month period, driven primarily by a 23% increase in used vehicle dollar sales.
• Profitability: Net earnings surged 44% YoY in the quarter ($54.3M vs. $37.6M) and 49% for the six-month period ($111.0M vs. $74.6M).
• Unit Sales: Total used vehicle unit sales increased 15% in the quarter, comprising a 7% increase in comparable store sales and growth from new store openings.
• CAF Performance: CAF income increased 53% YoY in the quarter, driven by higher loan origination volume, improved gain spreads (3.9% vs. 3.3%), and favorable valuation adjustments on securitized receivables.
• Expense Management: Selling, General, and Administrative (SG&A) expenses as a percentage of revenue decreased slightly to 10.4% in the quarter, despite a significant increase in share-based compensation costs due to the adoption of SFAS 123(R) and the retirement of the former CEO.
• Cash Flow: Net cash provided by operating activities decreased to $86.8 million for the six months ended August 31, 2006, from $116.6 million in the prior year, primarily due to increased working capital requirements (inventory and retained interest in securitized receivables).

Guidance, Outlook, and Risks

Management Commentary and Guidance

• Revised Fiscal 2007 Outlook: Management increased its expectations for the full fiscal year.
  • Comparable Store Sales: Expected annual growth in used units is now 6% to 8% (previously 2% to 8%).
  • Earnings Per Share: Expected diluted EPS is now $1.55 to $1.65 (previously $1.25 to $1.47).
• Capital Expenditures: Revised full-year CapEx expectation is approximately $215 million, down from a previous estimate of $300 million, due to changes in land purchase timing and increased use of ground leases.
• Store Expansion: Plans to open 10 superstores in Fiscal 2007 (4 opened in the first half; 6 planned for the second half).

Risks and Contingencies

• Legal Proceedings: A putative class action lawsuit was filed in August 2006 in South Carolina alleging violations regarding processing fees. The company intends to defend vigorously but cannot estimate potential losses.
• Accounting Changes: The company is evaluating the impact of upcoming accounting standards (FIN 48 regarding uncertain tax positions and SFAS 157 regarding fair value measurements) to be adopted in future periods.
• Market Risks: Exposure to interest rate fluctuations is managed via swaps; however, changes in rates could impact cash flows. Credit risk is managed through securitization structures with limited recourse.

Investor Verification Checklist

• Restatement Impact: Verify the specific impact of SFAS 123(R) adoption on net income and EPS compared to previously reported figures.
• CAF Valuation Adjustments: Review the $6.1 million "other gain income" in CAF for the quarter, which resulted from lowering loss rate assumptions on securitized receivables.
• Working Capital Trends: Monitor the $64.7 million increase in inventory and $31.5 million increase in retained interest in securitized receivables, which reduced operating cash flow.
• Legal Exposure: Track the status of the South Carolina class action lawsuit regarding processing fees.
• Store Opening Schedule: Confirm the timing of the six planned store openings in the second half of Fiscal 2007, as delays could impact revenue recognition.