UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended August 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number: 1-31420 CARMAX, INC. (Exact name of registrant as specified in its charter) VIRGINIA 54-1821055 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 4900 COX ROAD, GLEN ALLEN, VIRGINIA 23060 (Address of principal executive offices) (Zip Code) (804) 747-0422 (Registrant's telephone number, including area code) N/A (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----- ----- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No ----- ----- Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes No X ----- ----- Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. Class Outstanding at September 30, 2005 - ------------------------------ --------------------------------- Common Stock, par value $0.50 104,683,265
<TABLE> <S> <C> CARMAX, INC. AND SUBSIDIARIES TABLE OF CONTENTS ----------------- Page No. PART I. FINANCIAL INFORMATION --------------------- Item 1. Consolidated Financial Statements: Consolidated Statements of Earnings - Three Months and Six Months Ended August 31, 2005 and 2004 3 Consolidated Balance Sheets - August 31, 2005, and February 28, 2005 4 Consolidated Statements of Cash Flows - Six Months Ended August 31, 2005 and 2004 5 Notes to Consolidated Financial Statements 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk 25 Item 4. Controls and Procedures 26 PART II. OTHER INFORMATION ----------------- Item 1. Legal Proceedings 27 Item 4. Submission of Matters to a Vote of Security Holders 27 Item 6. Exhibits 27 SIGNATURES 28 - ---------- EXHIBIT INDEX 29 - ------------- Page 2 of 29
PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS CARMAX, INC. AND SUBSIDIARIES ----------------------------- Consolidated Statements of Earnings (Unaudited) (In thousands except per share data) Three Months Ended Six Months Ended August 31 August 31 ---------------------------------------- ----------------------------------------- 2005 %(1) 2004 %(1) 2005 %(1) 2004 %(1) ------ ------- ------- ------- ------- ------- ------- ------- Sales and operating revenues: Used vehicle sales $ 1,236,514 75.7 $ 987,359 74.6 $2,440,319 76.0 $1,972,734 74.5 New vehicle sales 151,922 9.3 137,516 10.4 286,015 8.9 274,281 10.4 Wholesale vehicle sales 190,783 11.7 152,118 11.5 380,275 11.8 308,989 11.7 Other sales and revenues 54,634 3.3 46,514 3.5 105,604 3.3 92,493 3.5 ----------------------------------------- ---------------------------------------- Net sales and operating revenues 1,633,853 100.0 1,323,507 100.0 3,212,213 100.0 2,648,497 100.0 Cost of sales 1,425,269 87.2 1,160,307 87.7 2,805,870 87.4 2,318,067 87.5 ----------------------------------------- ---------------------------------------- Gross profit 208,584 12.8 163,200 12.3 406,343 12.6 330,430 12.5 CarMax Auto Finance income (Notes 3 and 4) 23,824 1.5 20,744 1.6 50,895 1.6 42,560 1.6 Selling, general, and administrative expenses 165,274 10.1 134,726 10.2 324,509 10.1 265,414 10.0 Loss on franchise dispositions, net - - 11 - - - 11 - Interest expense 375 - 324 - 1,569 - 817 - Interest income 191 - 66 - 326 - 119 - ----------------------------------------- ---------------------------------------- Earnings before income taxes 66,950 4.1 48,949 3.7 131,486 4.1 106,867 4.0 Provision for income taxes 25,528 1.6 19,090 1.4 50,246 1.6 41,678 1.6 ----------------------------------------- ---------------------------------------- Net earnings $ 41,422 2.5 $ 29,859 2.3 $ 81,240 2.5 $ 65,189 2.5 ========================================= ======================================== Weighted average common shares (Note 7): Basic 104,528 104,002 104,457 103,933 ============ =========== =========== =========== Diluted 106,217 105,512 106,201 105,643 ============ =========== =========== =========== Net earnings per share (Note 7): Basic $ 0.40 $ 0.29 $ 0.78 $ 0.63 ============ =========== =========== =========== Diluted $ 0.39 $ 0.28 $ 0.76 $ 0.62 ============ =========== =========== =========== (1) Percents are calculated as a percentage of net sales and operating revenues and may not equal totals due to rounding. See accompanying notes to consolidated financial statements. Page 3 of 29
CARMAX, INC. AND SUBSIDIARIES ----------------------------- Consolidated Balance Sheets (In thousands except share data) August 31, 2005 February 28, 2005 --------------- ----------------- (Unaudited) ASSETS - ------ Current assets: Cash and cash equivalents (Note 2) $ 53,800 $ 29,099 Accounts receivable, net 62,037 76,167 Automobile loan receivables held for sale (Note 4) 2,360 22,152 Retained interest in securitized receivables (Note 4) 157,784 147,963 Inventory 585,248 576,567 Prepaid expenses and other current assets 8,418 13,008 ----------- ------------ Total current assets 869,647 864,956 Property and equipment, net 434,835 406,301 Other assets 26,787 21,756 ----------- ------------ TOTAL ASSETS $ 1,331,269 $ 1,293,013 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------ Current liabilities: Accounts payable $ 148,341 $ 170,646 Accrued expenses and other current liabilities 83,929 65,664 Accrued income taxes 12,333 1,179 Deferred income taxes 23,552 26,315 Short-term debt - 65,197 Current portion of long-term debt (Note 9) 106,152 330 ----------- ------------ Total current liabilities 374,307 329,331 Long-term debt, excluding current portion (Note 9) 35,279 128,419 Deferred revenue and other liabilities 28,776 29,260 Deferred income taxes 4,112 5,027 ----------- ------------ TOTAL LIABILITIES 442,474 492,037 ----------- ------------ Commitments and contingent liabilities (Note 6) Shareholders' equity: Common stock, $0.50 par value; 350,000,000 shares authorized; 104,645,141 and 104,303,375 shares issued and outstanding at August 31, 2005, and February 28, 2005, respectively 52,323 52,152 Capital in excess of par value 495,572 489,164 Retained earnings 340,900 259,660 ----------- ------------ TOTAL SHAREHOLDERS' EQUITY 888,795 800,976 ----------- ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,331,269 $ 1,293,013 ============ ============ See accompanying notes to consolidated financial statements. Page 4 of 29
CARMAX, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Unaudited) (In thousands) Six Months Ended August 31 2005 2004 ----------- ----------- Operating Activities: - --------------------- Net earnings $ 81,240 $ 65,189 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 12,194 8,844 Amortization of restricted stock awards 44 51 Gain on disposition of assets (829) (83) Provision for deferred income taxes (3,678) (605) Changes in operating assets and liabilities: Decrease in accounts receivable, net 14,130 2,563 Decrease in automobile loan receivables held for sale 19,792 15,617 (Increase) decrease in retained interest in securitized receivables (9,821) 6,463 Increase in inventory (8,681) (25,950) Decrease in prepaid expenses and other current assets 4,590 3,177 (Increase) decrease in other assets (737) 71 Increase (decrease) in accounts payable, accrued expenses and other current liabilities, and accrued income taxes 10,385 (8,926) Increase in deferred revenue and other liabilities 254 1,313 ---------- ---------- Net cash provided by operating activities 118,883 67,724 ---------- ---------- Investing Activities: - --------------------- Purchases of property and equipment (115,240) (118,624) Proceeds from sales of assets 78,173 43,659 ---------- ---------- Net cash used in investing activities (37,067) (74,965) ---------- ---------- Financing Activities: - --------------------- (Decrease) increase in short-term debt, net (65,197) 198 Issuance of long-term debt 105,229 - Payments on long-term debt (100,411) - Equity issuances, net 3,264 2,007 ---------- ---------- Net cash (used in) provided by financing activities (57,115) 2,205 ---------- ---------- Increase (decrease) in cash and cash equivalents 24,701 (5,036) Cash and cash equivalents at beginning of year 29,099 61,643 ---------- ---------- Cash and cash equivalents at end of period $ 53,800 $ 56,607 ========== ========== See accompanying notes to consolidated financial statements. Page 5 of 29
CARMAX, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------------------------------ (Unaudited) 1. Background ---------- CarMax, Inc. ("CarMax" and "the company"), including its wholly owned subsidiaries, is the largest retailer of used cars and light trucks in the United States. CarMax was the first used vehicle retailer to offer a large selection of quality used vehicles at low, "no-haggle" prices using a customer-friendly sales process in an attractive, modern sales facility. CarMax also sells new vehicles under various franchise agreements. CarMax provides its customers with a full range of related services, including the financing of vehicle purchases through its own finance operation, CarMax Auto Finance ("CAF"), and third-party lenders; the sale of extended service plans; and vehicle repair service. 2. Accounting Policies ------------------- Principles of Consolidation. CarMax's consolidated financial statements conform to U.S. generally accepted accounting principles. The interim period consolidated financial statements are unaudited; however, in the opinion of management, all adjustments, which consist only of normal, recurring adjustments necessary for a fair presentation of the interim consolidated financial statements, have been included. All significant intercompany balances and transactions have been eliminated in consolidation. The fiscal year end balance sheet data were derived from the audited consolidated financial statements included in the company's Annual Report on Form 10-K for the fiscal year ended February 28, 2005. The Notes to Consolidated Financial Statements contained in the Annual Report should be read in conjunction with these consolidated financial statements. Cash and Cash Equivalents. Cash equivalents of $49.2 million at August 31, 2005, and $18.0 million at February 28, 2005, consisted of highly liquid debt securities with original maturities of three months or less. Included in cash equivalents at August 31, 2005, and February 28, 2005, were restricted cash deposits of $17.7 million and $12.0 million, respectively, which were associated with certain insurance deductibles. Stock-Based Compensation. The company accounts for its stock-based compensation plans under the recognition and measurement principles of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. Under this opinion and related interpretations, compensation expense is recorded on the date of grant and amortized over the vesting period only if the market value of the underlying stock on the grant date exceeds the exercise price. No stock option-based employee compensation cost is reflected in net earnings, as options granted under those plans had exercise prices equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net earnings and net earnings per share as if the fair-value-based method of accounting had been applied to all outstanding stock awards in each reported period: Page 6 of 29
Three Months Ended Six Months Ended August 31 August 31 (In thousands except per share data) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------------- Net earnings, as reported ..................................... $41,422 $29,859 $81,240 $65,189 Total additional stock-based compensation expenses determined under the fair-value-based method for all awards, net of related tax effects ................. 3,770 3,046 6,555 5,653 ----------------------- ------------------------ Pro forma net earnings ......................................... $37,652 $26,813 $74,685 $ 59,536 ======================= ======================== Earnings per share: Basic, as reported.......................................... $ 0.40 $ 0.29 $ 0.78 $ 0.63 Basic, pro forma............................................ $ 0.36 $ 0.26 $ 0.71 $ 0.57 Diluted, as reported........................................ $ 0.39 $ 0.28 $ 0.76 $ 0.62 Diluted, pro forma.......................................... $ 0.36 $ 0.25 $ 0.71 $ 0.56 The pro forma effect on the second quarter and first six months of fiscal 2006 and prior periods may not be representative of the pro forma effects on net earnings and net earnings per share for future periods. Reclassifications. Certain prior year amounts have been reclassified to conform to the current period's presentation. 3. CarMax Auto Finance Income -------------------------- The company's finance operation, CAF, originates prime-rated financing for qualified customers at competitive market rates of interest. Throughout each month, the company sells substantially all of the loans originated by CAF in securitization transactions as discussed in Note 4. The majority of the contribution from CAF is generated by the spread between the interest rate charged to the customer and the related cost of funds. A gain, recorded at the time of each securitization transaction, results from recording a receivable approximately equal to the present value of the expected residual cash flows generated by the securitized receivables. The cash flows are calculated taking into account expected prepayment and default rates. CarMax Auto Finance income was as follows: Three Months Ended Six Months Ended August 31 August 31 (In millions) 2005 2004 2005 2004 -------------------------------------------------------------------------------------------------------------------- Gains on sales of loans................................. $ 17.2 $ 14.9 $ 37.7 $ 30.5 -------------------- --------------------- Other CAF income: Servicing fee income................................. 6.9 6.1 13.5 12.1 Interest income...................................... 5.1 4.4 10.1 9.4 -------------------- --------------------- Total other CAF income.................................. 12.0 10.5 23.6 21.5 -------------------- --------------------- Direct CAF expenses: CAF payroll and fringe benefit expense............... 2.5 2.3 4.9 4.4 Other direct CAF expenses............................ 2.9 2.4 5.5 4.9 -------------------- --------------------- Total direct CAF expenses............................... 5.4 4.7 10.4 9.4 -------------------- --------------------- CarMax Auto Finance income.............................. $ 23.8 $ 20.7 $ 50.9 $ 42.6 ==================== ===================== Amounts in the table above may not total due to rounding. Page 7 of 29
CarMax Auto Finance income does not include any allocation of indirect costs or income. The company presents this information on a direct basis to avoid making arbitrary decisions regarding the indirect benefit or costs that could be attributed to CAF. Examples of indirect costs not included are retail store expenses, retail financing commissions, and corporate expenses such as human resources, administrative services, marketing, information systems, accounting, legal, treasury, and executive payroll. 4. Securitizations --------------- The company uses a securitization program to fund substantially all of the automobile loan receivables originated by CAF. The company sells the automobile loan receivables to a wholly owned, bankruptcy-remote, special purpose entity that transfers an undivided interest in the receivables to a group of third-party investors. The special purpose entity and investors have no recourse to the company's assets. The company's risk is limited to the retained interest on the company's consolidated balance sheets. The investors issue commercial paper supported by the transferred receivables, and the proceeds from the sale of the commercial paper are used to pay for the securitized receivables. This program is referred to as the warehouse facility. The company periodically uses public securitizations to refinance the receivables previously securitized through the warehouse facility. In a public securitization, a pool of automobile loan receivables is sold to a bankruptcy-remote, special purpose entity that in turn transfers the receivables to a special purpose securitization trust. The securitization trust issues asset-backed securities, secured or otherwise supported by the transferred receivables, and the proceeds from the sale of the securities are used to pay for the securitized receivables. Refinancing receivables in a public securitization during a quarter may or may not have a significant impact on the company's results, depending on securitization structures and market conditions. In the first quarter of fiscal 2006, the company recognized a gain of $0.01 per share related to the 2005-1 public securitization. However, this impact may not be representative of the potential impact of future securitizations. The transfers of receivables are accounted for as sales in accordance with Statement of Financial Accounting Standards ("SFAS") No. 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities." When the receivables are securitized, the company recognizes a gain or loss on the sale of the receivables as described in Note 3. Three Months Six Months Ended August 31 Ended August 31 (In millions) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------- Net loans originated......................... $481.5 $369.8 $918.0 $755.8 Loans sold................................... $514.7 $391.8 $989.4 $822.4 Gains on sales of loans...................... $ 17.2 $ 14.9 $ 37.7 $ 30.5 Gains on sales of loans as a percentage of loans sold................. 3.3% 3.8% 3.8% 3.7% Retained Interest. The company retains an interest in the automobile loan receivables that it securitizes. The retained interest, presented as a current asset on the company's consolidated balance sheets, serves as a credit enhancement for the benefit of the investors in the securitized receivables. The retained interest includes the present value of the expected residual cash flows generated by the securitized receivables, or "interest-only strip receivables," the restricted cash on deposit in various reserve accounts, and an undivided ownership interest in the receivables securitized through the warehouse facility and certain public securitizations, or "required excess receivables," as described below. On a combined basis, the cash reserves and required excess receivables are generally 2% to 4% of managed receivables. The special purpose entities and the investors have no recourse to the company's assets. The company's risk is limited to the retained interest on the company's consolidated balance sheets. The fair value of the retained interest may fluctuate depending on the performance of the securitized receivables. Page 8 of 29
The fair value of the retained interest was $157.8 million as of August 31, 2005, and $148.0 million as of February 28, 2005. The retained interest had a weighted average life of 1.4 years as of August 31, 2005, and 1.5 years as of February 28, 2005. As defined in SFAS No. 140, the weighted average life in periods (for example, months or years) of prepayable assets is calculated by multiplying the principal collections expected in each future period by the number of periods until that future period, summing those products, and dividing the sum by the initial principal balance. The following is a detailed explanation of the components of the retained interest. Interest-only strip receivables. Interest-only strip receivables represent ------------------------------- the present value of residual cash flows the company expects to receive over the life of the securitized receivables. The value of these receivables is determined by estimating the future cash flows using management's assumptions of key factors, such as finance charge income, default rates, prepayment rates, and discount rates appropriate for the type of asset and risk. The value of interest-only strip receivables may be affected by external factors, such as changes in the behavior patterns of customers, changes in the strength of the economy, and developments in the interest rate markets; therefore, actual performance may differ from these assumptions. Management evaluates the performance of the receivables relative to these assumptions on a regular basis. Any financial impact resulting from a change in performance is recognized in earnings in the period in which it occurs. Restricted cash. Restricted cash represents amounts on deposit in various --------------- reserve accounts established for the benefit of the securitization investors. In the event that the cash generated by the securitized receivables in a given period was insufficient to pay the interest, principal, and other required payments, the balances on deposit in the reserve accounts would be used to pay those amounts. In general, each of the company's securitizations requires that an amount equal to a specified percentage of the initial receivables balance be deposited in a reserve account on the closing date and that any excess cash generated by the receivables be used to fund the reserve account to the extent necessary to maintain the required amount. If the amount on deposit in the reserve account exceeds the required amount, an amount equal to that excess is released through the special purpose entity to the company. In the public securitizations, the amount required to be on deposit in the reserve account must equal or exceed a specified floor amount. The reserve account remains funded until the investors are paid in full, at which time the remaining balance is released through the special purpose entity to the company. The amount required to be maintained in the public securitization reserve accounts may increase depending upon the performance of the securitized receivables. The amount on deposit in restricted cash accounts was $31.6 million as of August 31, 2005, and $33.5 million as of February 28, 2005. Required excess receivables. The warehouse facility and certain public ----------------------------- securitizations require that the total value of the securitized receivables exceed, by a specified amount, the principal amount owed to the investors. The required excess receivables balance represents this specified amount. Any cash flows generated by the required excess receivables are used, if needed, to make payments to the investors. The unpaid principal balance related to the required excess receivables was $53.8 million as of August 31, 2005, and $44.3 million as of February 28, 2005. Key Assumptions Used in Measuring the Retained Interest and Sensitivity Analysis. The following table shows the key economic assumptions used in measuring the fair value of the retained interest at August 31, 2005, and a sensitivity analysis showing the hypothetical effect on the retained interest if there were unfavorable variations from the assumptions used. Key economic assumptions at August 31, 2005, were not materially different from assumptions used to measure the fair value of the retained interest at the time of securitization. These sensitivities are hypothetical and should be used with caution. In this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in actual circumstances, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities. Page 9 of 29
Impact on Fair Impact on Fair Assumptions Value of 10% Value of 20% (In millions) Used Adverse Change Adverse Change --------------------------------------------------------------------------------------------------------------------- Prepayment rate........................ 1.43%-1.50% $5.5 $ 10.9 Cumulative default rate................ 1.60%-2.16% $4.7 $ 9.4 Annual discount rate................... 12.0% $2.3 $ 4.6 Prepayment rate. The company uses the Absolute Prepayment Model or "ABS" to --------------- estimate prepayments. This model assumes a rate of prepayment each month relative to the original number of receivables in a pool of receivables. ABS further assumes that all the receivables are the same size and amortize at the same rate and that each receivable in each month of its life will either be paid as scheduled or prepaid in full. For example, in a pool of receivables originally containing 10,000 receivables, a 1% ABS rate means that 100 receivables prepay each month. Cumulative default rate. The cumulative default rate, or "static pool" net ------------------------ losses, is calculated by dividing the total projected credit losses of a pool of receivables by the original pool balance. Continuing Involvement with Securitized Receivables. The company continues to manage the automobile loan receivables that it securitizes. The company receives servicing fees of approximately 1% of the outstanding principal balance of the securitized receivables. The servicing fees specified in the securitization agreements adequately compensate the company for servicing the securitized receivables. Accordingly, no servicing asset or liability has been recorded. The company is at risk for the retained interest in the securitized receivables. If the securitized receivables do not perform as originally projected, the value of the retained interest would be impacted. Supplemental information about the managed receivables is shown in the following tables: As of August 31 As of February 28 or 29 (In millions) 2005 2004 2005 2004 ----------------------------------------------------------------------------------------------------------------------- Loans securitized..................................... $ 2,611.9 $ 2,336.5 $2,427.2 $2,200.4 Loans held for sale or investment..................... 60.6 43.5 67.7 48.2 ------------------------------------------------------------ Ending managed receivables............................ $ 2,672.5 $ 2,380.0 $2,494.9 $2,248.6 ============================================================ Accounts 31+ days past due............................ $ 40.9 $ 35.7 $ 31.1 $ 31.4 Past due accounts as a percentage of ending managed receivables........................ 1.53% 1.50% 1.24% 1.40% Three Months Six Months Ended August 31 Ended August 31 (In millions) 2005 2004 2005 2004 ----------------------------------------------------------------------------------------------------------------------- Average managed receivables............................... $ 2,636.6 $ 2,364.8 $ 2,586.9 $ 2,332.3 Credit losses on managed receivables...................... $ 5.0 $ 5.3 $ 8.1 $ 9.3 Annualized credit losses as a percentage of average managed receivables........................... 0.76% 0.90% 0.62% 0.80% Page 10 of 29
Selected Cash Flows from Securitized Receivables. The table below summarizes certain cash flows received from and paid to the automobile loan securitizations: Three Months Six Months Ended August 31 Ended August 31 (In millions) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------------ o Proceeds from new securitizations............................ $384.0 $297.0 $791.5 $672.5 o Proceeds from collections reinvested in revolving period securitizations......................... $217.0 $167.4 $388.2 $311.4 o Servicing fees received...................................... $ 6.8 $ 6.1 $ 13.3 $ 12.0 o Other cash flows received from the retained interest:.... Interest-only strip receivables.......................... $ 18.1 $ 18.4 $ 42.1 $ 42.0 Cash reserve releases, net............................... $ 0.2 $ 1.1 $ 9.1 $ 10.9 Proceeds from new securitizations. Proceeds from new securitizations ------------------------------------ includes proceeds from receivables newly securitized through the warehouse facility during the period. Proceeds from receivables previously securitized through the warehouse facility that are periodically refinanced in public securitizations are not considered proceeds from new securitizations for this table. Proceeds from receivables repurchased from public securitizations and refinanced through the warehouse facility are included in proceeds from new securitizations and totaled $51.5 million in the first quarter of fiscal 2006 and $51.0 million in the first quarter of fiscal 2005. There were no repurchases in the second quarter of fiscal 2006 or fiscal 2005. Proceeds from collections. Proceeds from collections reinvested in --------------------------- revolving period securitizations represent principal amounts collected on receivables securitized through the warehouse facility that are used to fund new originations. Servicing fees. Servicing fees received represent cash fees paid to the --------------- company to service the securitized receivables. Other cash flows received from the retained interest. Other cash flows -------------------------------------------------------- received from the retained interest represent cash received by the company from securitized receivables other than servicing fees. It includes cash collected on interest-only strip receivables and amounts released to the company from restricted cash accounts. Financial Covenants and Performance Triggers. Certain securitization agreements include various financial covenants and performance triggers. For such agreements, the company must meet financial covenants relating to minimum tangible net worth, maximum total liabilities to tangible net worth ratio, minimum tangible net worth to managed assets ratio, minimum current ratio, minimum cash balance or borrowing capacity, and minimum fixed charge coverage ratio. Certain pools of securitized receivables must meet performance tests relating to portfolio yield, default rates, and delinquency rates. If these financial covenants and/or performance tests are not met, in addition to other consequences, the company may be unable to continue to securitize receivables through the warehouse facility or it may be terminated as servicer under the securitizations. At August 31, 2005, the company was in compliance with these financial covenants, and the securitized receivables were in compliance with these performance triggers. 5. Financial Derivatives --------------------- The company enters into amortizing fixed-pay interest rate swaps relating to its automobile loan receivable securitizations. Swaps are used to better match funding costs to the fixed-rate receivables being securitized by converting variable-rate financing costs in the warehouse facility to fixed-rate obligations. During the second quarter of fiscal 2006, the company entered into seven 40-month amortizing interest rate swaps with initial notional amounts totaling $426.5 million. The amortized notional amount of all outstanding swaps related to the automobile loan receivable Page 11 of 29
securitizations was $836.7 million at August 31, 2005, and $662.1 million at February 28, 2005. The fair value of swaps included in prepaid expenses and other current assets was a net asset of $0.3 million at August 31, 2005, and $5.4 million at February 28, 2005. The market and credit risks associated with interest rate swaps are similar to those relating to other types of financial instruments. Market risk is the exposure created by potential fluctuations in interest rates. The company does not anticipate significant market risk from swaps as they are used on a monthly basis to match funding costs to the use of the funding. Credit risk is the exposure to nonperformance of another party to an agreement. The company mitigates credit risk by dealing with highly rated bank counterparties. 6. Retirement Plans ---------------- The company has a noncontributory defined benefit pension plan (the "pension plan") covering the majority of full-time employees. The company also has an unfunded nonqualified plan (the "restoration plan") that restores retirement benefits for certain senior executives who are affected by the Internal Revenue Code limitations on benefits provided under the pension plan. The liabilities for these plans are included in accrued expenses and other current liabilities in the consolidated balance sheets. The company uses a fiscal year end measurement date for both the pension plan and the restoration plan. The components of net pension expense were as follows: Three Months Ended August 31 Pension Plan Restoration Plan Total ------------ ---------------- ------------------ (In thousands) 2005 2004 2005 2004 2005 2004 ----------------------------------------------------------------------------------------------------------------------- Service cost............................... $2,126 $1,624 $ 94 $ 80 $2,220 $1,704 Interest cost.............................. 699 538 65 54 764 592 Expected return on plan assets............. (493) (386) -- -- (493) (386) Amortization of prior year service cost........................... 9 9 6 -- 15 9 Recognized actuarial loss.................. 240 184 34 38 274 222 --------------------------------------------------------------------------- Net pension expense........................ $2,581 $1,969 $199 $172 $2,780 $2,141 =========================================================================== Six Months Ended August 31 Pension Plan Restoration Plan Total ------------ ---------------- ------------------ (In thousands) 2005 2004 2005 2004 2005 2004 ----------------------------------------------------------------------------------------------------------------------- Service cost............................... $4,252 $3,308 $188 $160 $4,440 $3,468 Interest cost.............................. 1,398 1,076 130 108 1,528 1,184 Expected return on plan assets............. (986) (738) -- -- (986) (738) Amortization of prior year service cost........................... 18 18 12 -- 30 18 Recognized actuarial loss.................. 480 368 68 76 548 444 --------------------------------------------------------------------------- Net pension expense........................ $5,162 $4,032 $398 $344 $5,560 $4,376 =========================================================================== The company did not make a contribution to the pension plan during the first six months of fiscal 2006. There are no minimum required contributions for fiscal 2006. However, the company expects to contribute at least $4.5 million to the pension plan in the second half of fiscal 2006. Page 12 of 29
7. Earnings per Share ------------------ Reconciliations of the numerator and denominator of basic and diluted earnings per share are presented below: Three Months Six Months Ended August 31 Ended August 31 (In thousands except per share data) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------------- Weighted average common shares.............................. 104,528 104,002 104,457 103,933 Dilutive potential common shares: Options.................................................. 1,671 1,495 1,726 1,695 Restricted stock......................................... 18 15 18 15 ---------------------------- -------------------------- Weighted average common shares and dilutive potential common shares..................... 106,217 105,512 106,201 105,643 ============================ ========================== Net earnings available to common shareholders............... $ 41,422 $ 29,859 $ 81,240 $ 65,189 Basic net earnings per share................................ $ 0.40 $ 0.29 $ 0.78 $ 0.63 Diluted net earnings per share.............................. $ 0.39 $ 0.28 $ 0.76 $ 0.62 Certain options were outstanding and not included in the computation of diluted earnings per share because the options' exercise prices were greater than the average market price of the common shares. As of August 31, 2005, options to purchase 2,009,571 shares of common stock with exercise prices ranging from $28.38 to $43.44 per share were outstanding and not included in the calculation. As of August 31, 2004, options to purchase 3,090,318 shares with exercise prices ranging from $21.49 to $43.44 per share were outstanding and not included in the calculation. 8. Recent Accounting Pronouncements -------------------------------- SFAS No. 123R, "Share-Based Payment," replaces SFAS No. 123, "Accounting for Stock-Based Compensation" and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." This new standard requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost will be recognized over the period during which an employee is required to provide services in exchange for the award (usually the vesting period). In accordance with the revised statement, the company will be required to recognize the expense attributable to stock options effective with the company's 2007 fiscal year, beginning March 1, 2006. The company has not yet determined the impact of adopting SFAS 123R on its financial position, results of operations, or cash flows. 9. Long-Term Debt -------------- In August 2005, CarMax entered into a four year, revolving credit facility (the "credit agreement") with Bank of America, N.A. and various other financial institutions and terminated its $300 million credit facility with DaimlerChrysler Services North America, LLC and Toyota Motor Credit Corporation. The credit agreement is secured by vehicle inventory and contains customary representations and warranties, conditions, and covenants. Borrowings accrue interest at variable rates based on LIBOR, the federal funds rate, or the prime rate, depending on the type of borrowing. The company pays a commitment fee on the unused portion of the available funds. All outstanding principal amounts will be due and payable in August 2009, and there are no penalties for prepayment. The credit agreement provides for aggregate borrowings of up to $450 million. The aggregate borrowing limit includes a $25 million limit on new vehicle swing line loans, a $25 million limit on other swing line loans, and a $30 million limit on standby letters of credit. Borrowings on the each of the swing lines are due on demand and must be repaid monthly or refinanced through other committed borrowings under the credit agreement. Page 13 of 29
As of August 31, 2005, the amount outstanding under the credit agreement was $105.2 million. The entire balance of outstanding borrowings was classified as current portion of long-term debt, based on management's ability and intent to repay the balance within one year of the balance sheet date. We expect that a portion of future borrowings will be used for long-term capital purposes and will remain outstanding more than one year from the balance sheet date. Such amounts will be classified on the company's balance sheets as long-term debt. Obligations under capital leases as of August 31, 2005, consisted of $35.3 million classified as long-term debt, and $0.9 million classified as current portion of long-term debt. 10. Subsequent Event ---------------- In September 2005, the company completed a $525 million public securitization of automobile loan receivables. Page 14 of 29
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS ------------------------------------ OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ------------------------------------------------ The following Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements, the accompanying notes, and the MD&A included in the company's Annual Report on Form 10-K for the fiscal year ended February 28, 2005. In this discussion, "we," "our," "us," "CarMax," "CarMax, Inc.," and "the company" refer to CarMax, Inc. and its wholly owned subsidiaries, unless the context requires otherwise. Amounts and percentages in tables may not total due to rounding. BUSINESS OVERVIEW CarMax is the nation's largest retailer of used vehicles. As of August 31, 2005, we operated 63 used car superstores in 29 markets, including 21 mid-sized markets and eight large markets. We define mid-sized markets as those with television viewing audiences between 1 million and 2.5 million people. We also operated seven new car franchises, all of which were integrated or co-located with our used car superstores. During the twelve month period ended August 31, 2005, we sold 278,178 used cars, representing 93% of the total 299,138 vehicles the company sold at retail during that period. We believe the CarMax consumer offer is unique in the auto retailing marketplace. Our offer gives consumers a way to shop for cars in the same manner that they shop for items at other "big box" retailers. Our consumer offer is structured around four core equities: low, no-haggle prices; a broad selection; high quality; and customer-friendly service. We generate revenues, income, and cash flows primarily by retailing used vehicles and associated items including vehicle financing, extended service plans, and vehicle repair service. A majority of the used vehicles we sell at retail are purchased directly from consumers. Vehicles purchased through our appraisal process that do not meet our retail standards are sold at on-site wholesale auctions. CarMax provides prime-rated financing to qualified customers through CarMax Auto Finance ("CAF") and Bank of America. Nonprime financing is provided through several third-party lenders, and subprime financing is provided through a third-party lender under a program rolled out to our entire store base in August 2004. We periodically test additional third-party lenders. CarMax has no recourse liability for loans provided by third-party lenders. We sell extended service plans on behalf of unrelated third parties who are the primary obligors. We have no contractual liability to the customer under these third-party service plans. Extended service plan revenue represents commissions from the unrelated third parties. Sales of new vehicles represented a decreasing percentage of our total revenues over the last several years as we divested new car franchises and added used car superstores. We are still at an early stage in the national rollout of our retail concept. We believe the primary driver for future earnings growth will be vehicle unit sales growth from comparable store sales increases and from geographic expansion. We plan to open used car superstores at a rate of approximately 15% to 20% of our used car superstore base each year. In fiscal 2006, our plan calls for opening nine used car superstores, representing an approximate 16% increase in our store base. Fiscal 2006 Second Quarter Highlights - ------------------------------------- |X| Net sales and operating revenues increased 23% to $1.63 billion from $1.32 billion in the second quarter of fiscal 2005, while net earnings increased 39% to $41.4 million, or $0.39 per share, from $29.9 million, or $0.28 per share. |X| Total used vehicle units increased 21%, which included a 10% increase in comparable store used unit sales. |X| We added one used car superstore in the second quarter of fiscal 2006, entering the Salt Lake City market with a standard-sized superstore that was opened on the last day of the quarter. Page 15 of 29
|X| Our total gross profit per unit increased to $2,546 from $2,395 in the second quarter of fiscal 2005. Our gross profit per unit rose on used, new, and wholesale vehicles. |X| CAF income increased 15% to $23.8 million from $20.7 million in the second quarter of fiscal 2005, reflecting the growth in total vehicle sales, partially offset by lower gain spreads, as expected. |X| Selling, general, and administrative expenses as a percent of net sales and operating revenues (the "SG&A ratio") declined modestly to 10.1% from 10.2% in the second quarter of fiscal 2005. The overhead leverage provided by the strong sales growth was largely offset by the combination of the rollout of television advertising in Los Angeles in the current year, lower-than normal store and corporate bonuses in the prior year, and the growing proportion of our store base that is comprised of stores not yet at basic maturity. Stores generally have higher SG&A ratios during their first several years of operation. |X| We completed the sale-leaseback of four superstores for total proceeds of $56.0 million. |X| For the first six months of fiscal 2006, net cash provided by operating activities increased to $118.9 million from $67.7 million in fiscal 2005, reflecting the improved net earnings and an increase in cash generated from changes in working capital. FORWARD-LOOKING STATEMENTS The company cautions readers that the statements contained in this MD&A regarding the company's future business plans, operations, opportunities, or prospects, including without limitation any statements or factors regarding expected sales, margins, or earnings, are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based upon management's current knowledge and assumptions about future events and involve risks and uncertainties that could cause actual results to differ materially from anticipated results. For more details on factors that could affect expectations, see the company's Annual Report on Form 10-K for the fiscal year ended February 28, 2005, and its quarterly and current reports as filed with or furnished to the Securities and Exchange Commission. CRITICAL ACCOUNTING POLICIES For a discussion of our critical accounting policies see "Critical Accounting Policies" in Management's Discussion and Analysis included in the CarMax, Inc. 2005 Annual Report to Shareholders, which is included as Exhibit 13.1 to the Annual Report on Form 10-K for the fiscal year ended February 28, 2005. These policies relate to securitization transactions, revenue recognition, income taxes, and the defined benefit retirement plan. RESULTS OF OPERATIONS Reclassifications. Certain prior year amounts have been reclassified to conform to the current period's presentation. Seasonality. CarMax's operations, in common with other retailers in general, are subject to seasonal influences. Historically, our superstores experience their strongest sales in the spring and summer fiscal quarters. The net earnings of any quarter are seasonally disproportionate to net sales since administrative and certain operating expenses remain relatively constant during the year. Therefore, quarterly results should not be relied upon as necessarily indicative of results for the entire fiscal year. Page 16 of 29
Net Sales and Operating Revenues - -------------------------------- Three Months Six Months Ended August 31 Ended August 31 (In millions) 2005 % 2004 % 2005 % 2004 % - ------------------------------------------------------------------------------------------------------------------------------ Used vehicle sales..................... $1,236.5 75.7 $ 987.4 74.6 $2,440.3 76.0 $1,972.7 74.5 New vehicle sales...................... 151.9 9.3 137.5 10.4 286.0 8.9 274.3 10.4 Wholesale vehicle sales................ 190.8 11.7 152.1 11.5 380.3 11.8 309.0 11.7 Other sales and revenues: Extended service plan revenues....... 25.7 1.6 20.7 1.6 50.2 1.6 41.8 1.6 Service department sales............. 24.7 1.5 21.4 1.6 47.4 1.5 41.8 1.6 Third-party finance fees, net........ 4.2 0.3 4.4 0.3 8.0 0.2 8.9 0.3 ------------------------------------------------------------------------------------- Total other sales and revenues......... 54.6 3.3 46.5 3.5 105.6 3.3 92.5 3.5 ------------------------------------------------------------------------------------- Total net sales and operating revenues............................. $ 1,633.8 100.0 $1,323.5 100.0 $3,212.2 100.0 $2,648.5 100.0 ===================================================================================== Retail vehicle sales changes were as follows: Three Months Six Months Ended August 31 Ended August 31 2005 2004 2005 2004 ------------------------------------------------------- Vehicle units: Used vehicles.......................... 21% 4 % 20% 6 % New vehicles........................... 10% (1)% 3% (1)% Total ...................................... 20% 3 % 19% 5 % Vehicle dollars: Used vehicles.......................... 25% 5 % 24% 8 % New vehicles........................... 10% (1)% 4% (1)% Total ...................................... 23% 4 % 21% 7 % Comparable store used unit sales growth is one of the key drivers of our profitability. A CarMax store is included in comparable store sales in the store's fourteenth full month of operation. Comparable store retail sales changes were as follows: Three Months Six Months Ended August 31 Ended August 31 2005 2004 2005 2004 ------------------------------------------------------- Vehicle units: Used vehicles.......................... 10% (7)% 8% (5)% New vehicles........................... 10% 13 % 5% 12 % Total ...................................... 10% (5)% 8% (3)% Vehicle dollars: Used vehicles.......................... 14% (6)% 12% (3)% New vehicles........................... 10% 13 % 6% 12 % Total ...................................... 14% (4)% 11% (1)% Used Vehicle Sales. The 25% increase in used vehicle dollar sales in the second - ------------------- quarter of fiscal 2006 reflects a 21% increase in unit sales and a 3% increase in average retail selling price. The unit sales growth was driven by a 10% increase in comparable store used units, together with sales from newer superstores that are not yet in the comparable store base. The used vehicle unit sales growth reflects a strong increase in store traffic as well as continuing excellent execution by our store teams. We believe the increase in store traffic was helped in part by the domestic new car manufacturers' employee pricing Page 17 of 29
programs. Under the employee pricing programs, introduced in June and July, the manufacturers established specific employee prices for each make and model, which created greater clarity on new car pricing. We believe we benefit from pricing transparency in the marketplace, and our no-haggle consumer offer makes price-comparing easy, giving us a unique advantage as consumers cross-shop. The 10% increase in comparable store used units included approximately 1 percentage point added from sales financed by our subprime finance provider, which was added to our third-party lender group in August 2004 following a nine-month test in selected stores. The 24% increase in used vehicle dollar sales in the first six months of fiscal 2006 reflects a 20% increase in unit sales and a 3% increase in average retail selling price. The unit sales growth reflects an 8% increase in comparable store used units, together with the sales from newer superstores that are not yet in the comparable store base. The increase in comparable store used units was driven by increased store traffic and continuing excellent execution by our store teams, which helped overcome some loss of momentum in our sales pace during April and May 2005. We believe some of the same factors that affected the marketplace in the spring and summer of 2004 put pressure on the market this spring, including an atypical rise in wholesale auction prices and higher gas prices. In response, we did not increase our appraisal offers at the same rate as the steep increase in major public wholesale auction market prices. We believe that doing so helped to keep our retail prices more in line with demand, helping to keep our cars attractive to consumers as they compared their options in the new and used car marketplace. The increase in comparable store used units included approximately 2 percentage points added from sales financed by our subprime finance provider. New Vehicle Sales. We reported strong growth in comparable new vehicle unit - ------------------ sales in both the second quarter and the first six months of fiscal 2006, driven in part by the traffic generated by the employee discount programs. The sales performance for our new car franchises was generally in line with the overall performance of the brands we represent. Wholesale Vehicle Sales. The 25% increase in wholesale vehicles dollar sales in - ----------------------- the second quarter of fiscal 2006 reflects the combination of a 16% increase in wholesale units sold and an 8% increase in average wholesale sales prices. Wholesale unit sales increases reflect a solid increase in appraisal traffic and the growth of our store base as compared with the prior fiscal year. We believe the increased appraisal traffic was due in part to the new car employee pricing programs and in part to an increase in radio advertising over the summer focused on our "we buy cars" message. Even as prices on SUVs and light trucks fell dramatically, CarMax continued to make appraisal purchase offers on all vehicles presented for appraisal by consumers. We believe a portion of the higher appraisal traffic reflected franchised dealers' loss of negotiating ability on trade-ins in connection with the more transparent employee discount price on new cars. Vehicles acquired through the appraisal purchase process that do not meet our retail standards are sold at our on-site wholesale auctions. The 23% increase in wholesale vehicle sales for the first half of fiscal 2006 reflects the combination of a 12% increase in wholesale unit sales and a 10% increase in average selling prices. In the first quarter of fiscal 2006, our in-house wholesale auction prices rose at a higher-than-normal pace, reflecting trends in the general wholesale market. Other Sales and Revenues. Other sales and revenues include extended service plan - ------------------------ revenues, service department sales, and third-party finance fees. Other sales and revenues increased during the second quarter and first six months of fiscal 2006, as extended service plan and service department revenues benefited from the increase in retail sales and the growth in the store base. Third-party finance fees declined, primarily as a result of the August 2004 rollout of a subprime provider. As is customary in the industry, subprime finance contracts are purchased from the company at a discount. We record this discount as an offset to the third-party finance fee revenues received from our prime and nonprime finance providers. Page 18 of 29
Supplemental information related to vehicle sales follows: Retail Unit Sales - ----------------- Three Months Six Months Ended August 31 Ended August 31 2005 2004 2005 2004 ---------------------------- ---------------------------- Used vehicles ............................ 75,616 62,396 149,759 124,749 New vehicles ............................ 6,320 5,756 11,924 11,600 ----------------------------- ----------------------------- Total ...................................... 81,936 68,152 161,683 136,349 ============================= ============================= Average Retail Selling Prices - ----------------------------- Three Months Six Months Ended August 31 Ended August 31 2005 2004 2005 2004 ------------------------------ ------------------------------ Used vehicles............................... $16,204 $15,693 $16,161 $15,678 New vehicles................................ $23,878 $23,706 $23,824 $23,463 Weighted average............................ $16,796 $16,370 $16,726 $16,340 Retail Vehicle Sales Mix - ------------------------ Three Months Six Months Ended August 31 Ended August 31 2005 2004 2005 2004 ---------------------------- ---------------------------- Vehicle units: Used vehicles......................... 92% 92% 93% 91% New vehicles.......................... 8 8 7 9 ---------------------------- ---------------------------- Total....................................... 100% 100% 100% 100% =========================== ============================ Vehicle dollars: Used vehicles......................... 89% 88% 89% 88% New vehicles.......................... 11 12 11 12 ---------------------------- ---------------------------- Total....................................... 100% 100% 100% 100% ============================ ============================ Retail Stores. CarMax opened five superstores in the first half of fiscal 2006. - ------------- In the first quarter, we expanded our presence in the Los Angeles market, adding both a standard and a satellite superstore and bringing to five the total store count in this large market. We also entered the Jacksonville market with a standard superstore, and we added a satellite superstore in the Kansas City market. At the end of the second quarter, we entered the Salt Lake City market with a standard superstore. We have a total of seven new car franchises and expect to maintain long-term strategic relationships with the automotive manufacturers we currently represent. Estimate Retail Store Mix Feb. 28, 2006 August 31, 2005 Feb. 28, 2005 August 31, 2004 - --------------------------------------------------------------------------------------------------------------------------- Mega superstores............................. 13 13 13 13 Standard superstores......................... 34 32 29 28 Satellite superstores........................ 20 18 16 14 -------------------------------------------------------------------------- Total used car superstores................... 67 63 58 55 Co-located new car stores.................... 4 4 3 3 --------------------------------------------------------------------------- Total........................................ 71 67 61 58 =========================================================================== Page 19 of 29
Gross Profit - ------------ Three Months Six Months Ended August 31 Ended August 31 2005 2004 2005 2004 $ per unit(1) %(2) $ per unit(1) %(2) $ per unit(1) %(2) $ per unit(1) %(2) -------------------------------------- --------------------------------------- Used vehicle gross profit.................. 1,856 11.3 1,846 11.7 1,829 11.2 1,855 11.7 New vehicle gross profit................... 1,122 4.7 890 3.7 973 4.1 859 3.6 Wholesale vehicle gross profit............. 578 14.4 406 11.0 604 14.6 423 11.3 Other gross profit......................... 411 61.7 385 56.3 404 61.8 398 58.7 Total gross profit......................... 2,546 12.8 2,395 12.3 2,513 12.6 2,423 12.5 (1)Calculated as category gross profit dollars divided by the respective units sold, except the other and total categories, which are divided by total retail units sold. (2) Calculated as a percentage of its respective sales or revenue. Used Vehicle Gross Profit. Our second quarter fiscal 2006 used vehicle gross - -------------------------- profit per unit rose slightly compared with the prior year's quarter. During the quarter, increasing gasoline costs caused wholesale prices for SUVs and light trucks to plummet, while prices for more gasoline efficient compact cars remained above historical norms. We were able to maintain margins in this environment, despite taking a supplemental markdown in retail SUV valuation at the end of the quarter. Our ability to quickly adjust appraisal offers to stay in line with the broader market trade-in offer trends and our rapid inventory turns, which reduce our exposure to declining prices, contributed to our margin stability. For the six months ended August 31, 2005, used vehicle gross profit per unit declined modestly compared with the prior year, due to an increase in wholesale auction pricing in the first quarter of fiscal 2006. This increase adversely affected used vehicle gross profits, particularly for vehicles obtained through the major public wholesale auctions. New Vehicle Gross Profit. The increase in new vehicle gross profit per unit for - ------------------------ the three months and six months ended August 31, 2005, compared with the same periods in the prior year, was primarily the result of the employee discount pricing programs offered by the domestic new car manufacturers beginning in June and July 2005. We were able to increase our new car prices modestly, as they had generally been below the employee discount pricing. Wholesale Vehicle Gross Profit. For the second quarter and the first six months - ------------------------------ of fiscal 2006, wholesale vehicle gross profit per unit increased from the prior year levels, primarily as a result of the strengthening wholesale vehicle pricing environment. We typically experience our strongest wholesale profits during the spring when wholesale prices are rising, and the atypical rate of increase in the current year added to the profit improvement. Wholesale profits also benefited from our decision not to increase appraisal offers at the same rate as the steep increase in major public wholesale auction market prices in the current year. Other Gross Profit. Compared with the prior year's second quarter and first six - ------------------ months, other gross profit per unit increased slightly, primarily as a result of the growth in our service margin. The service department, which is the only category within other sales and revenues that has an associated cost of sales, reported higher profits reflecting the greater overhead expense absorption that higher vehicle sales and reconditioning volumes provide. The increase in service margins was offset somewhat by a decline in third-party finance fees. The discount at which our subprime lender purchases installment contracts is reflected as an offset to third-party finance fees. CarMax Auto Finance Income - -------------------------- CAF provides prime auto financing for our used and new car sales. Because the purchase of an automobile is traditionally reliant on the consumer's ability to obtain on-the-spot financing, it is important to our business that such financing be available to creditworthy customers. While financing can also be obtained from third-party sources, we believe that total reliance on third parties can create an unacceptable volatility and business risk. Furthermore, we believe that our processes and systems, the transparency of our pricing, and our Page 20 of 29
vehicle quality provide a unique and ideal environment in which to procure high-quality auto loan receivables, both for CAF and for third-party lenders. CAF provides us the opportunity to capture additional profits and cash flows from auto loan receivables while managing our reliance on third-party finance sources. The components of CarMax Auto Finance income were as follows: Three Months Ended August 31 Six Months Ended August 31 (In millions) 2005 % 2004 % 2005 % 2004 % - ------------------------------------------------------------------------------------------------------------------------------ Gains on sales of loans(1)........................ $ 17.2 3.3 $ 14.9 3.8 $ 37.7 3.8 $ 30.5 3.7 ----------------------------------- ----------------------------------- Other CAF income: (2) Servicing fee income......................... 6.9 1.0 6.1 1.0 13.5 1.0 12.1 1.0 Interest income.............................. 5.1 0.8 4.4 0.7 10.1 0.8 9.4 0.8 ----------------------------------- ----------------------------------- Total other CAF income............................ 12.0 1.8 10.5 1.8 23.6 1.8 21.5 1.8 ----------------------------------- ----------------------------------- Direct CAF expenses: (2) CAF payroll and fringe benefit expense....... 2.5 0.4 2.3 0.4 4.9 0.4 4.4 0.4 Other direct CAF expenses.................... 2.9 0.4 2.4 0.4 5.5 0.4 4.9 0.4 ----------------------------------- ----------------------------------- Total direct CAF expenses......................... 5.4 0.8 4.7 0.8 10.4 0.8 9.4 0.8 ----------------------------------- ----------------------------------- CarMax Auto Finance income (3).................... $ 23.8 1.5 $ 20.7 1.6 $ 50.9 1.6 $ 42.6 1.6 =================================== =================================== Loans sold........................................ $ 514.7 $ 391.8 $ 989.4 $ 822.4 Average managed receivables....................... $ 2,636.6 $ 2,364.8 $ 2,586.9 $ 2,332.3 Net sales and operating revenues.................. $ 1,633.9 $ 1,323.5 $ 3,212.2 $ 2,648.5 Ending managed receivables........................ $ 2,672.5 $ 2,380.0 $ 2,672.5 $ 2,380.0 Percent columns indicate: (1) Percent of loans sold. (2) Annualized percent of averaged managed receivables. (3) Percent of net sales and operating revenues. CAF's second quarter income rose 15% in fiscal 2006 compared with the prior year's quarter. CAF income benefited from the growth in total vehicle sales and a modest increase in CAF's loan penetration. The gains on sales of loans increased 15%, as the benefit of the 31% increase in loans sold was partially offset by the decrease in the gain spread to 3.3% from 3.8% in the second quarter of fiscal 2005. CAF income for the first six months of fiscal 2006 increased 19% compared with the same period of the prior year. This increase includes first quarter gains of $0.02 per share resulting from a favorable valuation adjustment and $0.01 per share resulting from the favorable terms of the 2005-1 public securitization in April. In the first quarter of fiscal 2006, we lowered the loss assumptions on previously securitized receivables, reflecting the favorable market conditions and the continued favorable performance of CAF's portfolio. Other income and other direct expenses for the second quarter and first six months of fiscal 2006 increased proportionately to managed receivables. In May 2005, we exercised our option to repurchase the loan balances outstanding in the 2001-2 securitization when the remaining balance of the related auto loans receivable fell below 10% of the original pool balance. These loans were subsequently resold into the warehouse facility. In May 2004, we completed a similar repurchase and resale related to the 2001-1 securitization. In both cases, the loan balances carried relatively high interest rates that, combined with relatively low short-term funding costs, resulted in an earnings benefit for the first quarter of both fiscal years of approximately $0.01 per share. The reported gains on sales of loans of 3.8% in the first six months of fiscal 2006 included the effects of the repurchase and resale of the receivables in the 2001-2 public securitization, the valuation adjustment, and the favorable terms of the 2005-1 public securitization. The reported gains on sales of loans as a percent of all loans sold of 3.7% in the first half of fiscal 2005 included the Page 21 of 29
effect of the repurchase and resale of the receivables in the 2001-1 public securitization. Excluding the impacts of the 2005-1 public securitization, the repurchase and resale of the 2001-2 and 2001-1 public securitizations, and the valuation adjustment, the gains on loans originated and sold was 3.3% in the first six months of fiscal 2006, and 3.8% in the first six months of fiscal 2005. We are at risk for the performance of the managed securitized receivables to the extent that we maintain a retained interest in the receivables. Supplemental information on our portfolio of managed receivables is as follows: As of August 31 As of February 28 or 29 (In millions) 2005 2004 2005 2004 - --------------------------------------------------------------------------------------------------------------------------- Loans securitized.......................................... $ 2,611.9 $ 2,336.5 $ 2,427.2 $ 2,200.4 Loans held for sale or investment.......................... 60.6 43.5 67.7 48.2 ------------------------------------------------------------- Ending managed receivables................................. $ 2,672.5 $ 2,380.0 $ 2,494.9 $ 2,248.6 ============================================================= Accounts 31+ days past due................................. $ 40.9 $ 35.7 $ 31.1 $ 31.4 Past due accounts as a percentage of ending managed receivables................................. 1.53% 1.50% 1.24% 1.40% Three Months Six Months Ended August 31 Ended August 31 (In millions) 2005 2004 2005 2004 - --------------------------------------------------------------------------------------------------------------------------- Average managed receivables................................ $ 2,636.6 $ 2,364.8 $ 2,586.9 $ 2,332.3 Credit losses on managed receivables....................... $ 5.0 $ 5.3 $ 8.1 $ 9.3 Annualized credit losses as a percentage of average managed receivables................................ 0.76% 0.90% 0.62% 0.80% If the managed receivables do not perform in accordance with the assumptions used in determining the fair value of the retained interest, earnings could be impacted. Annualized losses as a percentage of average managed receivables for the second quarter and first six months of fiscal 2006 decreased substantially compared with the same periods in fiscal 2005. We believe the decrease was due to a combination of factors including improved general economic conditions, the implementation of a new credit scorecard in the third quarter of fiscal 2003, and operational efficiencies resulting from system enhancements. The change in performance is reflected in the revaluation of the retained interest during the first quarter, as previously discussed. Selling, General and Administrative Expenses - -------------------------------------------- The SG&A ratio declined modestly to 10.1% in the second quarter of fiscal 2006 compared with 10.2% in the second quarter of the prior fiscal year. The expected leverage of fixed expenses and corporate overhead provided by our strong sales growth was largely offset by a combination of factors. The rollout of marketwide television advertising in Los Angeles in fiscal 2006 and the lower-than-normal store and corporate bonuses in fiscal 2005 both adversely affected the SG&A comparison. In addition, we continue to see a larger percentage of our store base that is made up of newer stores not yet at basic maturity, which we define as four years. Newer stores typically experience higher SG&A ratios. In this fiscal year's second quarter, 46% of our stores were newer stores; in last year's second quarter, that percentage was 38%. For the six month period ended August 31, 2005, the SG&A ratio increased to 10.1% compared with 10.0% for the same period last year. This increase was due to the factors mentioned above combined with a slightly lower sales growth in the first quarter of fiscal 2006. Income Taxes - ------------ The effective income tax rate declined to 38.1% in the second quarter and 38.2% in the first six months of fiscal 2006 from 39.0% in the same periods of fiscal 2005, primarily as a result of a legal entity reorganization in December 2004. The company created a centralized corporate management entity in an effort to obtain operational, legal, and other benefits that also resulted in state tax efficiencies. Page 22 of 29
Operations Outlook - ------------------ For the third quarter of fiscal 2006, we anticipate comparable store used vehicle unit growth in the range of 2% to 8% and net earnings per share in the range of $0.19 to $0.25. We have chosen to provide wider than usual ranges for the third quarter's expectations because market conditions continue to be uncertain and because the model year changeover that coincides with the third quarter typically makes it the most challenging period of the year to forecast. We have continued to see price declines for SUVs and light trucks in September, and as these declines cause us to take supplemental markdowns, we anticipate incremental margin pressure in the third quarter. Now that subprime financing has been available across our full retail store base for 12 months, we do not expect subprime financed sales to provide significant incremental used unit comparable store sales growth in future periods. We expect the CAF gains on sales of loans will be approximately 3.5%, which is at the low end of our normalized range of 3.5% to 4.5%, but is slightly higher than the 3.3% gain spread realized in the second quarter of fiscal 2006. We believe we experienced a slight sales benefit early in the third quarter from replacement vehicle purchases resulting from Hurricane Katrina, despite having no stores in Louisiana or Mississippi. However, because we have no basis that would allow us to predict if and to what extent our sales might continue to benefit, our current third quarter expectations do not include any further anticipated benefit from possible replacement purchases. Hurricane Rita is expected to have a minimal effect on the company's sales and earnings. The four CarMax stores in the Houston market were closed for approximately a week in mid-September due to this hurricane; however, we believe that, as with most weather-related events, we should recover nearly all of the resulting lost sales during the next few months. We do not, however, expect our sales to benefit from Rita as we believe that few Houston customers lost vehicles as a result of the storm. We plan to open four additional superstores during the second half of fiscal 2006. Two of these superstores are satellite additions opened in September in the Miami and Nashville markets. Later in the third quarter, we plan to enter the Virginia Beach and the Wichita markets with one standard superstore in each. During the first half of fiscal 2007, we currently plan to open four standard superstores and one satellite superstore. We plan to enter the Columbus, Ohio, market with one standard superstore and one satellite superstore, and the Hartford, Conn.; Oklahoma City, Okla.; and Fresno, Calif.; markets with one superstore each. RECENT ACCOUNTING PRONOUNCEMENTS For a discussion of recent accounting pronouncements applicable to the company, see Note 8 to the company's consolidated financial statements. FINANCIAL CONDITION Liquidity and Capital Resources - ------------------------------- Operating Activities. Net cash from operations increased to $118.9 million in the first half of fiscal 2006 from $67.7 million in the first half of fiscal 2005. The increase reflects a combination of factors, including a $16.1 million increase in net earnings, $17.3 million due to slower growth in inventory, and $17.8 million associated with other changes in working capital in the first half of fiscal 2006 compared with the same period in the prior year. In the first six months of fiscal 2006, inventory increased by only $8.7 million, despite having opened five superstores since the end of the prior fiscal year. Each year we target having our lowest level of inventory of the year after Labor Day in order to minimize the inherent inventory risk during the fall model year changeover period. At August 31, 2005, our inventories were at target levels. Page 23 of 29
Investing Activities. Net cash used in investing activities was $37.1 million in - -------------------- the first six months of fiscal 2006, compared with $75.0 million in the first half of the prior year. Capital expenditures were $115.2 million in the first half of fiscal 2006, compared with $118.6 million in the first half of fiscal 2005. We plan to open nine superstores in fiscal 2006, equal to the number of stores opened in fiscal 2005. In addition to store construction costs, capital spending includes costs associated with our new home office and the cost of land acquisition for future year store openings. The company generated net proceeds from the sales of assets of $78.2 million in the first half of fiscal 2006, compared with $43.7 million in the first half of fiscal 2005. These proceeds are primarily associated with sale-leaseback transactions. In the first half of fiscal 2006, we completed the sale-leaseback of five superstores, while in the first half of fiscal 2005, we completed the sale-leaseback of three superstores. The sale-leaseback transactions were structured with initial lease terms of either 15 or 20 years with four, five-year renewal options. As of August 31, 2005, we owned six superstores currently in operation, as well as land and construction-in-progress related to several planned superstores. Financing Activities. Net cash used in financing activities was $57.1 million in - -------------------- the first six months of fiscal 2006, compared with net cash provided by financing activities of $2.2 million in the first six months of last fiscal year. In the first half of fiscal 2006, we used cash generated from operations to reduce total debt by $60.4 million. The aggregate principal amount of automobile loan receivables funded through securitizations, which are discussed in Notes 3 and 4 to the company's consolidated financial statements, totaled $2.61 billion at August 31, 2005, and $2.34 billion at August 31, 2004. During the first half of fiscal 2006, the company completed a $617 million public securitization of automobile loan receivables. At August 31, 2005, the unused warehouse capacity totaled $63 million. The warehouse facility matures in July 2006. We anticipate that we will be able to renew, expand, or enter into new securitization arrangements to meet the future needs of the automobile finance operation. In August 2005, we entered into a new, four-year, revolving credit facility secured by vehicle inventory. Concurrently, we terminated our existing $300 million credit agreement. Borrowings under the new credit facility are available for working capital and general corporate purposes, and represent senior secured indebtedness of the company. The credit facility contains customary representations and warranties, conditions, and covenants. All outstanding principal amounts borrowed under the credit facility will be due and payable in August 2009. The credit agreement provides for aggregate borrowings of up to $450 million. The aggregate borrowing limit includes a $25 million limit on new vehicle swing line loans, a $25 million limit on other swing line loans, and a $30 million limit on standby letters of credit. Borrowings on the each of the swing lines are due on demand and must be repaid monthly or refinanced through other committed borrowings under the credit agreement. As of August 31, 2005, $105.2 million was outstanding under the credit facility, with the remainder fully available to the company. The entire balance of outstanding borrowings was classified as current portion of long-term debt, based on management's ability and intent to repay the balance within one year of the balance sheet date. As we continue to execute our growth plan, we expect that a portion of future borrowings will be used for long-term capital purposes and will remain outstanding more than one year from the balance sheet date. Such amounts will be classified on the company's balance sheets as long-term debt. We expect that proceeds from securitization transactions; sale-leaseback transactions; current and, if needed, additional credit facilities; and cash generated by operations will be sufficient to fund capital expenditures and working capital for the foreseeable future. Page 24 of 29
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Automobile Installment Loan Receivables. At August 31, 2005, and February 28, - ----------------------------------------- 2005, all loans in the portfolio of automobile loan receivables were fixed-rate installment loans. Financing for these automobile loan receivables is achieved through asset securitization programs that, in turn, issue both fixed- and floating-rate securities. Interest rate exposure relating to floating-rate securitizations is managed through the use of interest rate swaps. Receivables held for investment or sale are financed with working capital. Generally, changes in interest rates associated with underlying swaps will not have a material impact on earnings. However, changes in interest rates associated with underlying swaps may have a material impact on cash and cash flows. Credit risk is the exposure to nonperformance of another party to an agreement. Credit risk is mitigated by dealing with highly rated bank counterparties. The market and credit risks associated with financial derivatives are similar to those relating to other types of financial instruments. The total principal amount of managed receivables securitized or held for investment or sale as of August 31, 2005, and February 28, 2005, was as follows: (In millions) August 31 February 28 - ---------------------------------------------------------------------------------------------------------------- Fixed-rate securitizations............................................. $ 1,774.9 $ 1,764.7 Floating-rate securitizations synthetically altered to fixed.................................... 836.7 662.1 Floating-rate securitizations......................................... 0.3 0.4 Held for investment (1)............................................... 58.2 45.5 Held for sale (2)..................................................... 2.4 22.2 --------------------------------------- Total................................................................. $ 2,672.5 $ 2,494.9 ======================================= (1) The majority is held by a bankruptcy-remote special purpose entity. (2) Held by a bankruptcy-remote special purpose entity. Interest Rate Exposure. We also have interest rate risk from changing interest - ---------------------- rates related to our outstanding debt. Substantially all of the debt is floating-rate debt based on LIBOR. A 100-basis point increase in market interest rates would not have had a material effect on our results of operations or cash flows for the three months and six months ended August 31, 2005. Page 25 of 29
ITEM 4. CONTROLS AND PROCEDURES The company maintains disclosure controls and procedures ("disclosure controls") that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized, and reported within the time periods specified in the U.S. Securities and Exchange Commission's rules and forms. Disclosure controls are also designed to ensure that such information is accumulated and communicated to our management, including the chief executive officer ("CEO") and the chief financial officer ("CFO"), as appropriate, to allow timely decisions regarding required disclosure. As of the end of the period covered by this report, the company evaluated the effectiveness of the design and operation of its disclosure controls. This evaluation was performed under the supervision and with the participation of management, including our CEO and CFO. Based upon that evaluation, the CEO and CFO concluded that the company's disclosure controls were effective as of the end of such period. There was no change in the company's internal control over financial reporting that occurred during the quarter ended August 31, 2005, that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. Page 26 of 29
PART II. OTHER INFORMATION Item 1. Legal Proceedings CarMax is subject to various legal proceedings, claims, and liabilities that arise in the ordinary course of its business. In the opinion of management, the amount of ultimate liability with respect to these actions will not materially affect the financial position or results of operations of CarMax. Item 4. Submission of Matters to a Vote of Security Holders The company held an annual meeting of shareholders on June 21, 2005. Information on the matters voted upon and the votes cast with respect to each matter was previously reported in the company's Quarterly Report on Form 10-Q for the quarter ended May 31, 2005. Item 6. Exhibits 10.1 Credit Agreement, dated August 24, 2005, among CarMax Auto Superstores, Inc., CarMax, Inc., various subsidiaries of CarMax, various Lenders named therein and Bank of America N.A., as Administrative Agent, filed herewith. Certain non-material schedules and exhibits have been omitted from the Credit Agreement as filed. CarMax agrees to furnish supplementally to the Commission upon request a copy of such schedules and exhibits. 10.2 Security Agreement, dated August 24, 2005, among CarMax, Inc., CarMax Auto Superstores, Inc., various subsidiaries of CarMax named therein, and Bank of America N.A., as Administrative Agent, filed herewith. 10.3 Company Guaranty Agreement, dated August 24, 2005, between CarMax, Inc. and Bank of America, N.A., as Administrative Agent, filed herewith 31.1 Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a), filed herewith. 31.2 Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a), filed herewith. 32.1 Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, filed herewith. 32.2 Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, filed herewith. Page 27 of 29
SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CARMAX, INC. By: /s/ Austin Ligon ------------------------- Austin Ligon President and Chief Executive Officer By: /s/ Keith D. Browning ------------------------- Keith D. Browning Executive Vice President and Chief Financial Officer October 7, 2005 Page 28 of 29
EXHIBIT INDEX 10.1 Credit Agreement, dated August 24, 2005, among CarMax Auto Superstores, Inc., CarMax, Inc., various subsidiaries of CarMax, various Lenders named therein and Bank of America N.A., as Administrative Agent, filed herewith. Certain non-material schedules and exhibits have been omitted from the Credit Agreement as filed. CarMax agrees to furnish supplementally to the Commission upon request a copy of such schedules and exhibits. 10.2 Security Agreement, dated August 24, 2005, among CarMax, Inc., CarMax Auto Superstores, Inc., various subsidiaries of CarMax named therein, and Bank of America N.A., as Administrative Agent, filed herewith. 10.3 Company Guaranty Agreement, dated August 24, 2005, between CarMax, Inc. and Bank of America, N.A., as Administrative Agent, filed herewith 31.1 Certification of the Chief Executive Officer Pursuant to Rule 13a-14(a), filed herewith. 31.2 Certification of the Chief Financial Officer Pursuant to Rule 13a-14(a), filed herewith. 32.1 Certification of the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, filed herewith. 32.2 Certification of the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, filed herewith. Page 29 of 29 </TABLE>