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 November 30, 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.) 12800 TUCKAHOE CREEK PARKWAY, RICHMOND, VIRGINIA 23238 (Address of principal executive offices) (Zip Code) (804) 747-0422 (Registrant's telephone number, including area code) NA (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 December 31, 2005 ----------------------------- -------------------------------- Common Stock, par value $0.50 104,851,247
<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 Nine Months Ended November 30, 2005 and 2004 3 Consolidated Balance Sheets - November 30, 2005, and February 28, 2005 4 Consolidated Statements of Cash Flows - Nine Months Ended November 30, 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 27 Item 4. Controls and Procedures 28 PART II. OTHER INFORMATION ----------------- Item 1. Legal Proceedings 29 Item 6. Exhibits 29 SIGNATURES 30 - ---------- EXHIBIT INDEX 31 - ------------- Page 2 of 31
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 Nine Months Ended November 30 November 30 ---------------------------------------- ----------------------------------------- 2005 %(1) 2004 %(1) 2005 %(1) 2004 %(1) ------ ------- ------- ------- ------- ------- ------- ------- Sales and operating revenues: Used vehicle sales $ 1,087,097 76.3 $ 926,023 76.2 $ 3,527,416 76.1 $ 2,898,757 75.0 New vehicle sales 113,299 8.0 114,199 9.4 399,314 8.6 388,480 10.1 Wholesale vehicle sales 174,235 12.2 132,669 10.9 554,510 12.0 441,658 11.4 Other sales and revenues 49,349 3.5 42,820 3.5 154,953 3.3 135,313 3.5 ----------------------------------------- ---------------------------------------- Net sales and operating revenues 1,423,980 100.0 1,215,711 100.0 4,636,193 100.0 3,864,208 100.0 Cost of sales 1,246,807 87.6 1,070,265 88.0 4,052,677 87.4 3,388,332 87.7 ----------------------------------------- ---------------------------------------- Gross profit 177,173 12.4 145,446 12.0 583,516 12.6 475,876 12.3 CarMax Auto Finance income (Notes 3 and 4) 27,971 2.0 20,439 1.7 78,866 1.7 62,999 1.6 Selling, general, and administrative expenses 161,727 11.4 137,170 11.3 486,236 10.5 402,584 10.4 Gain on franchise dispositions, net - - 692 0.1 - - 681 - Interest expense 430 - - - 1,999 - 817 - Interest income 262 - 175 - 588 - 294 - ----------------------------------------- ---------------------------------------- Earnings before income taxes 43,249 3.0 29,582 2.4 174,735 3.8 136,449 3.5 Provision for income taxes 16,837 1.2 11,537 0.9 67,083 1.4 53,215 1.4 ----------------------------------------- ---------------------------------------- Net earnings $ 26,412 1.9 $ 18,045 1.5 $ 107,652 2.3 $ 83,234 2.2 ========================================= ======================================== Weighted average common shares (Note 7): Basic 104,727 104,070 104,547 103,978 ============ =========== =========== =========== Diluted 106,442 105,735 106,281 105,673 ============ =========== =========== =========== Net earnings per share (Note 7): Basic $ 0.25 $ 0.17 $ 1.03 $ 0.80 ============ =========== =========== =========== Diluted $ 0.25 $ 0.17 $ 1.01 $ 0.79 ============ =========== =========== =========== (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 31
CARMAX, INC. AND SUBSIDIARIES Consolidated Balance Sheets (In thousands except share data) November 30, 2005 February 28, 2005 ----------------- ----------------- (Unaudited) ASSETS - ------ Current assets: Cash and cash equivalents (Note 2) $ 34,977 $ 29,099 Accounts receivable, net 55,616 76,167 Automobile loan receivables held for sale (Note 4) 1,527 22,152 Retained interest in securitized receivables (Note 4) 158,930 147,963 Inventory 606,366 576,567 Prepaid expenses and other current assets 11,381 13,008 ----------- ------------ Total current assets 868,797 864,956 Property and equipment, net 465,990 406,301 Deferred income taxes 5,869 - Other assets 26,484 21,756 ----------- ------------ TOTAL ASSETS $ 1,367,140 $ 1,293,013 ============ ============ LIABILITIES AND SHAREHOLDERS' EQUITY - ------------------------------------ Current liabilities: Accounts payable $ 173,341 $ 170,646 Accrued expenses and other current liabilities 75,266 65,664 Accrued income taxes 21,571 1,179 Deferred income taxes 19,572 26,315 Short-term debt (Note 9) 4,707 65,197 Current portion of long-term debt (Note 9) 40,042 330 ----------- ------------ Total current liabilities 334,499 329,331 Long-term debt, excluding current portion (Note 9) 85,036 128,419 Deferred revenue and other liabilities 29,322 29,260 Deferred income taxes - 5,027 ----------- ------------ TOTAL LIABILITIES 448,857 492,037 ----------- ------------ Commitments and contingent liabilities (Note 6) Shareholders' equity: Common stock, $0.50 par value; 350,000,000 shares authorized; 104,841,310 and 104,303,375 shares issued and outstanding at November 30, 2005, and February 28, 2005, respectively 52,421 52,152 Capital in excess of par value 498,550 489,164 Retained earnings 367,312 259,660 ----------- ------------ TOTAL SHAREHOLDERS' EQUITY 918,283 800,976 ----------- ------------ TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 1,367,140 $ 1,293,013 ============ ============ See accompanying notes to consolidated financial statements. Page 4 of 31
CARMAX, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (Unaudited) (In thousands) Nine Months Ended November 30 2005 2004 ----------- ----------- Operating Activities: - --------------------- Net earnings $ 107,652 $ 83,234 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 19,193 13,334 Amortization of restricted stock awards 53 79 Gain on disposition of assets (777) (810) Deferred income tax benefit (17,639) (2,163) Changes in operating assets and liabilities: Decrease in accounts receivable, net 20,551 8,664 Decrease in automobile loan receivables held for sale 20,625 15,241 (Increase) decrease in retained interest in securitized receivables (10,967) 14,367 Increase in inventory (29,799) (37,621) Decrease (increase) in prepaid expenses and other current assets 1,627 (598) Increase in other assets (434) (394) Increase (decrease) in accounts payable, accrued expenses and other current liabilities, and accrued income taxes 37,804 (11,500) Increase in deferred revenue and other liabilities 800 1,772 ---------- ---------- Net cash provided by operating activities 148,689 83,605 ---------- ---------- Investing Activities: - --------------------- Purchases of property and equipment (153,490) (176,341) Proceeds from sales of assets 78,217 52,657 ---------- ---------- Net cash used in investing activities (75,273) (123,684) ---------- ---------- Financing Activities: - --------------------- (Decrease) increase in short-term debt, net (60,490) 1,885 Issuance of long-term debt 105,229 - Payments on long-term debt (116,764) - Equity issuances, net 4,487 2,313 ---------- ---------- Net cash (used in) provided by financing activities (67,538) 4,198 ---------- ---------- Increase (decrease) in cash and cash equivalents 5,878 (35,881) Cash and cash equivalents at beginning of year 29,099 61,643 ---------- ---------- Cash and cash equivalents at end of period $ 34,977 $ 25,762 ========== ========== See accompanying notes to consolidated financial statements. Page 5 of 31
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 $22.3 million at November 30, 2005, and $18.0 million at February 28, 2005, consisted of highly liquid securities with original maturities of three months or less. Included in cash equivalents at November 30, 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 31
Three Months Ended Nine Months Ended November 30 November 30 (In thousands except per share data) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------------- Net earnings, as reported ...................................... $ 26,412 $18,045 $ 107,652 $ 83,234 Total additional stock-based compensation expenses determined under the fair-value-based method for all awards, net of related tax effects ................. 3,460 2,983 10,015 8,636 ---------------------- ------------------------- Pro forma net earnings ......................................... $ 22,952 $15,062 $ 97,637 $ 74,598 ====================== ========================= Earnings per share: Basic, as reported.......................................... $ 0.25 $ 0.17 $ 1.03 $ 0.80 Basic, pro forma............................................ $ 0.22 $ 0.14 $ 0.93 $ 0.72 Diluted, as reported........................................ $ 0.25 $ 0.17 $ 1.01 $ 0.79 Diluted, pro forma.......................................... $ 0.22 $ 0.14 $ 0.92 $ 0.71 The pro forma effect on the third quarter and first nine 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 Nine Months Ended November 30 November 30 (In millions) 2005 2004 2005 2004 -------------------------------------------------------------------------------------------------------------------- Gains on sales of loans................................. $ 20.9 $ 14.3 $ 58.7 $ 44.8 -------------------- --------------------- Other CAF income: Servicing fee income................................. 7.0 6.2 20.5 18.3 Interest income...................................... 5.6 4.9 15.7 14.3 -------------------- --------------------- Total other CAF income.................................. 12.6 11.1 36.2 32.6 -------------------- --------------------- Direct CAF expenses: CAF payroll and fringe benefit expense............... 2.7 2.3 7.6 6.8 Other direct CAF expenses............................ 2.9 2.7 8.4 7.6 -------------------- --------------------- Total direct CAF expenses............................... 5.6 5.0 16.0 14.4 -------------------- --------------------- CarMax Auto Finance income.............................. $ 28.0 $20.4 $ 78.9 $ 63.0 ==================== ===================== Amounts in the table above may not total due to rounding. Page 7 of 31
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. The company recognized a gain of $0.01 per share in the first quarter of fiscal 2006 related to the 2005-1 public securitization and a gain of $0.01 per share in the third quarter of fiscal 2006 related to the 2005-2 public securitization. These gains 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 Nine Months Ended November 30 Ended November 30 (In millions) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------- Net loans originated......................... $415.7 $346.1 $1,333.8 $1,102.0 Loans sold................................... $416.6 $345.7 $1,405.9 $1,168.2 Gains on sales of loans (1).................. $ 20.9 $ 14.3 $ 58.7 $ 44.8 Gains on sales of loans as a percentage of loans sold (1)............. 5.0% 4.1% 4.2% 3.8% (1) Includes the effects of valuation adjustments, new public securitizations, and the repurchase and resale of receivables in existing public securitizations. 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 Page 8 of 31
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. The fair value of the retained interest was $158.9 million as of November 30, 2005, and $148.0 million as of February 28, 2005. The retained interest had a weighted average life of 1.5 years as of November 30, 2005, and 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 $32.6 million as of November 30, 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. Any remaining cash flows from the excess receivables are released through the special purpose entity to the company. The unpaid principal balance related to the required excess receivables was $51.4 million as of November 30, 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 November 30, 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 November 30, 2005, were not materially different from assumptions used to measure the fair value of the retained interest at the time of securitization. These sensitivity analyses 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 31
Impact on Fair Impact on Fair Assumptions Value of 10% Value of 20% (In millions) Used Adverse Change Adverse Change --------------------------------------------------------------------------------------------------------------------- Prepayment rate........................ 1.42%-1.50% $5.1 $ 10.3 Cumulative default rate................ 1.45%-2.18% $4.5 $ 9.1 Annual discount rate................... 12.0% $2.3 $ 4.5 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 November 30 As of February 28 or 29 (In millions) 2005 2004 2005 2004 ----------------------------------------------------------------------------------------------------------------------- Loans securitized..................................... $ 2,654.6 $ 2,379.9 $2,427.2 $2,200.4 Loans held for sale or investment..................... 56.1 39.3 67.7 48.2 ------------------------------------------------------------ Ending managed receivables............................ $ 2,710.7 $ 2,419.2 $2,494.9 $2,248.6 ============================================================ Accounts 31+ days past due............................ $ 43.3 $ 38.5 $ 31.1 $ 31.4 Past due accounts as a percentage of ending managed receivables........................ 1.60% 1.59% 1.24% 1.40% Three Months Nine Months Ended November 30 Ended November 30 (In millions) 2005 2004 2005 2004 ----------------------------------------------------------------------------------------------------------------------- Average managed receivables............................... $ 2,705.9 $ 2,407.2 $ 2,626.6 $ 2,357.3 Credit losses on managed receivables...................... $ 5.3 $ 5.0 $ 13.4 $ 14.4 Annualized credit losses as a percentage of average managed receivables........................... 0.78% 0.83% 0.68% 0.81% Page 10 of 31
Selected Cash Flows from Securitized Receivables. The table below summarizes certain cash flows received from and paid to the automobile loan securitizations: Three Months Nine Months Ended November 30 Ended November 30 (In millions) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------------ o Proceeds from new securitizations............................ $327.0 $ 294.0 $ 1,118.5 $ 966.5 o Proceeds from collections reinvested in revolving period securitizations......................... $185.7 $ 132.3 $ 573.9 $ 443.7 o Servicing fees received...................................... $ 7.0 $ 6.2 $ 20.3 $ 18.2 o Other cash flows received from the retained interest:........ Interest-only strip receivables.......................... $ 20.1 $ 20.6 $ 62.2 $ 62.6 Cash reserve releases, net............................... $ 3.2 $ 3.0 $ 12.3 $ 13.9 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. The company has the option to repurchase the loan balances outstanding in public securitizations when the remaining balance of the related auto loans receivable falls below 10% of the original pool balance. The company exercised this option in the first quarters of fiscal 2006 and fiscal 2005. No such repurchases occurred in the second or third quarters 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 November 30, 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 Page 11 of 31
fixed-rate obligations. During the third quarter of fiscal 2006, the company entered into six 40-month amortizing interest rate swaps with initial notional amounts totaling $330.0 million. The amortized notional amount of all outstanding swaps related to the automobile loan receivable securitizations was $638.5 million at November 30, 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 $3.4 million at November 30, 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 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 November 30 Pension Plan Restoration Plan Total ------------ ---------------- ------------------ (In thousands) 2005 2004 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- Service cost............................... $2,332 $1,624 $ 172 $ 91 $2,504 $1,715 Interest cost.............................. 698 538 64 62 762 600 Expected return on plan assets............. (567) (392) - - (567) (392) Amortization of prior year service cost........................... 10 9 6 12 16 21 Recognized actuarial loss.................. 241 184 34 37 275 221 -------------------------------------------------------------------------- Net pension expense........................ $2,714 $1,963 $276 $202 $2,990 $2,165 ========================================================================== Nine Months Ended November 30 Pension Plan Restoration Plan Total ------------ ---------------- ------------------ (In thousands) 2005 2004 2005 2004 2005 2004 ---------------------------------------------------------------------------------------------------------------------- Service cost............................... $6,584 $4,932 $360 $251 $6,944 $5,183 Interest cost.............................. 2,096 1,614 194 170 2,290 1,784 Expected return on plan assets............. (1,553) (1,130) - - (1,553) (1,130) Amortization of prior year service cost........................... 28 27 18 12 46 39 Recognized actuarial loss.................. 721 552 102 113 823 665 -------------------------------------------------------------------------- Net pension expense........................ $7,876 $5,995 $674 $546 $8,550 $6,541 ========================================================================== During the third quarter of fiscal 2006, the company made a $4.5 million contribution to the pension plan. The company does not anticipate making a contribution to the pension plan in the fourth quarter of fiscal 2006. Page 12 of 31
7. Earnings per Share ------------------ Reconciliations of the numerator and denominator of basic and diluted earnings per share are presented below: Three Months Nine Months Ended November 30 Ended November 30 (In thousands except per share data) 2005 2004 2005 2004 ------------------------------------------------------------------------------------------------------------------------- Weighted average common shares.............................. 104,727 104,070 104,547 103,978 Dilutive potential common shares: Options.................................................. 1,706 1,649 1,720 1,680 Restricted stock......................................... 9 16 14 15 ---------------------------- -------------------------- Weighted average common shares and dilutive potential common shares..................... 106,442 105,735 106,281 105,673 ============================ ========================== Net earnings available to common shareholders............... $ 26,412 $ 18,045 $ 107,652 $ 83,234 Basic net earnings per share................................ $ 0.25 $ 0.17 $ 1.03 $ 0.80 Diluted net earnings per share.............................. $ 0.25 $ 0.17 $ 1.01 $ 0.79 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 November 30, 2005, options to purchase 1,919,226 shares of common stock with exercise prices ranging from $29.61 to $43.44 per share were outstanding and not included in the calculation. As of November 30, 2004, options to purchase 3,015,740 shares with exercise prices ranging from $26.83 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 the second quarter of fiscal 2006, 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 each of Page 13 of 31
the swing lines are due on demand and must be repaid monthly or refinanced through other committed borrowings under the credit agreement. As of November 30, 2005, $93.8 million was outstanding under the credit facility, with the remainder fully available to the company. The outstanding balance included $4.7 million of swing line loans classified as short-term debt, $39.1 million classified as current portion of long-term debt, and $50.0 million classified as long-term debt. The determination of the amount classified as long-term debt was based on management's intent as to that portion expected to remain outstanding for more than one year from the balance sheet date. Obligations under capital leases as of November 30, 2005, consisted of $35.0 million classified as long-term debt, and $0.9 million classified as current portion of long-term debt. 10. Subsequent Event ---------------- In December 2005, the company completed a $450 million public securitization of automobile loan receivables. Page 14 of 31
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 November 30, 2005, we operated 67 used car superstores in 31 markets, including 23 mid-sized markets and eight large markets. We define mid-sized markets as those with television viewing audiences generally 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 November 30, 2005, we sold 285,950 used cars, representing 93% of the total 306,820 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 revenues represent 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 a relatively 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 the first nine months of fiscal 2006, we opened nine used car superstores, representing an approximate 16% increase in our store base. No superstore openings are planned for the fourth quarter of fiscal 2006. Page 15 of 31
Fiscal 2006 Third Quarter Highlights - ------------------------------------ |X| Net sales and operating revenues increased 17% to $1.42 billion from $1.22 billion in the third quarter of fiscal 2005, while net earnings increased 46% to $26.4 million, or $0.25 per share, from $18.0 million, or $0.17 per share. |X| Total used vehicle unit sales increased 13%, which included a 3% increase in comparable store used unit sales. |X| We opened four used car superstores in the third quarter of fiscal 2006, entering the Virginia Beach and Wichita markets with standard superstores and adding satellite superstores in the Miami and Nashville markets. |X| Our total gross profit per unit increased to $2,483 from $2,284 in the third quarter of fiscal 2005. Compared with the prior year's third quarter, used vehicle gross profit per unit was similar, new vehicle gross profit per unit declined modestly, and wholesale gross profit per unit increased substantially. The wholesale gross profit benefited from unexpectedly strong wholesale pricing trends. |X| CAF income increased 37% to $28.0 million from $20.4 million in the third quarter of fiscal 2005, reflecting the growth in total vehicle sales and managed receivables, a favorable valuation adjustment, and the favorable effect of a new public securitization completed in September. |X| Selling, general, and administrative expenses as a percent of net sales and operating revenues (the "SG&A ratio") increased slightly to 11.4% from 11.3% in the third quarter of fiscal 2005. The moderate rate of increase in comparable store used unit sales was not sufficient to provide SG&A leverage. The growing proportion of our store base that is comprised of stores not yet at basic maturity and a lower-than-normal corporate bonus expense in the prior year were also contributing factors. Stores generally have higher SG&A ratios during their first several years of operation. |X| For the nine months ended November 30, net cash provided by operating activities increased to $148.7 million from $83.6 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. Page 16 of 31
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. Net Sales and Operating Revenues - -------------------------------- Three Months Nine Months Ended November 30 Ended November 30 (In millions) 2005 % 2004 % 2005 % 2004 % - ------------------------------------------------------------------------------------------------------------------------------ Used vehicle sales..................... $1,087.1 76.3 $ 926.0 76.2 $3,527.4 76.1 $2,898.8 75.0 New vehicle sales...................... 113.3 8.0 114.2 9.4 399.3 8.6 388.5 10.1 Wholesale vehicle sales................ 174.2 12.2 132.7 10.9 554.5 12.0 441.7 11.4 Other sales and revenues: Extended service plan revenues....... 22.6 1.6 19.6 1.6 72.7 1.6 61.5 1.6 Service department sales............. 23.0 1.6 20.0 1.6 70.4 1.5 61.8 1.6 Third-party finance fees, net........ 3.8 0.3 3.2 0.3 11.8 0.3 12.0 0.3 ------------------------------------------------------------------------------------- Total other sales and revenues......... 49.3 3.5 42.8 3.5 155.0 3.3 135.3 3.5 ------------------------------------------------------------------------------------- Total net sales and operating revenues............................. $ 1,424.0 100.0 $1,215.7 100.0 $4,636.2 100.0 $3,864.2 100.0 ===================================================================================== Retail vehicle sales changes were as follows: Three Months Nine Months Ended November 30 Ended November 30 2005 2004 2005 2004 ------------------------------------------------------- Vehicle units: Used vehicles.......................... 13 % 15 % 18% 8 % New vehicles........................... (2)% (6)% 1% (3)% Total ...................................... 12 % 13 % 17% 7 % Vehicle dollars: Used vehicles.......................... 17 % 16 % 22% 10 % New vehicles........................... (1)% (7)% 3% (3)% Total ...................................... 15 % 13 % 19% 9 % 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 Nine Months Ended November 30 Ended November 30 2005 2004 2005 2004 -------------------------------------------------------- Vehicle units: Used vehicles.......................... 3 % 2% 7% (3)% New vehicles........................... (6)% 11% 2% 12 % Total ...................................... 3 % 2% 6% (2)% Page 17 of 31
Three Months Nine Months Ended November 30 Ended November 30 2005 2004 2005 2004 ------------------------------------------------------- Vehicle dollars: Used vehicles.......................... 7 % 3% 10% (1)% New vehicles........................... (5)% 9% 3% 11 % Total ...................................... 6 % 4% 9% 0 % Used Vehicle Sales. The 17% increase in used vehicle dollar sales in the third - ------------------- quarter of fiscal 2006 reflected a 13% increase in unit sales and a 4% increase in average retail selling price. The unit sales growth reflected sales from newer superstores not yet in the comparable store base, together with a 3% increase in comparable store used units. At November 30, 2005, 12 of our 67 superstores were not yet included in the comparable store base. The comparable store used unit sales growth was driven by an increase in store traffic, as well as continuing strong execution by our store teams. We were able to sustain positive momentum in our used car business, even as the cross-shopping benefit from this summer's domestic new car manufacturers' employee pricing programs waned. The new car manufacturers' employee pricing programs ended in late September and early October 2005. The effect on sales from hurricanes occurring during the quarter was slightly positive. As anticipated, we were able to fully recover the sales lost to weather-related store closures in south Florida and in Houston from Hurricanes Wilma and Rita. In addition, we experienced a slight sales benefit from replacement purchases made by consumers displaced by Hurricane Katrina, despite having no CarMax stores in Louisiana or Mississippi. For the first nine months of fiscal 2006, the 22% increase in used vehicle dollar sales reflected an 18% increase in unit sales and a 3% increase in average retail selling price. The unit sales growth reflected sales from newer superstores not yet in the comparable store base, together with a 7% increase in comparable store used units. The comparable store used unit sales growth was driven by a solid increase in store traffic, as well as continuing strong execution by our store teams. We experienced a strong increase in store traffic in the second quarter of fiscal 2006, which we believe was helped in part by the domestic new car manufacturers' employee pricing programs which created greater clarity on new car pricing and increased traffic in the marketplace. Our no-haggle consumer offer makes price comparing easy, and we believe it gives us a unique advantage as consumers cross-shop. The 7% increase in comparable store used units for the nine month period included approximately one percentage point added from sales financed by our subprime finance provider, which was added to our third-party lender group near the end of the second quarter of fiscal 2005. New Vehicle Sales. The 1% decline in new vehicle dollar sales in the third - ------------------- quarter of fiscal 2006 reflected the combination of a 2% decline in unit sales and a 1% increase in average retail selling price. The sales performance of our new car franchises was generally in line with the overall performance of the brands we represent. Industry sales of the domestic new car manufacturers' brands declined significantly following the end of the employee pricing programs in late September and early October 2005. For the first nine months of fiscal 2006, the 3% increase in new vehicle dollar sales reflected a 1% increase in both unit sales and average retail selling price. The unit sales increase reflected the strong second quarter unit sales generated by the employee discount programs, partially offset by the effects of the softer third quarter new vehicle sales and the dispositions, as planned, of five new car franchises in the second half of fiscal 2005. Wholesale Vehicle Sales. The 31% increase in wholesale vehicle dollar sales in - ------------------------ the third quarter of fiscal 2006 reflected a 16% increase in average wholesale selling prices and a 13% increase in wholesale unit sales, which was in line with our increase in retail used unit sales. Overall, this year's autumn wholesale prices did not fall as much as has been typical for the model-year changeover season. The significant drop in wholesale pricing for SUVs and light trucks, brought about, we believe, by lower demand for "gas guzzlers," was offset by stronger demand for more fuel-efficient compact and mid-sized cars. In Page 18 of 31
addition, wholesale pricing was bolstered by the limited supply of 2005 model year closeout vehicles following the success of the domestic manufacturers' new car employee pricing programs. For the first nine months of fiscal 2006, the 26% increase in wholesale vehicle dollar sales reflected 12% increases in both average wholesale selling price and wholesale unit sales. Our in-house wholesale auction prices exhibited unusual aggregate price strength in fiscal 2006, reflecting trends in the general wholesale market. We believe that reduced supplies of off-lease and off-rental cars, as well as the strong demand for smaller, fuel-efficient cars contributed to the pricing strength in the wholesale market. We experienced a particularly strong increase in appraisal traffic in the second quarter of fiscal 2006 that we believe 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 over the summer and early fall, 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. 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 15% in both the third quarter and the first nine months of fiscal 2006, as extended service plan and service department revenues benefited from the increase in retail vehicle sales and the growth in the store base. Third-party finance fees increased in the third quarter of fiscal 2006 consistent with our growth in used vehicle sales; however, these revenues declined modestly for the nine-month period as the result of the August 2004 rollout of a subprime finance 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. Supplemental information related to vehicle sales follows: Retail Unit Sales - ----------------- Three Months Nine Months Ended November 30 Ended November 30 2005 2004 2005 2004 ---------------------------- ---------------------------- Used vehicles ............................ 66,680 58,908 216,439 183,657 New vehicles ............................ 4,675 4,765 16,599 16,365 ---------------------------- ---------------------------- Total ...................................... 71,355 63,673 233,038 200,022 ============================ ============================ Average Retail Selling Prices - ----------------------------- Three Months Nine Months Ended November 30 Ended November 30 2005 2004 2005 2004 ------------------------------ ------------------------------ Used vehicles............................... $16,147 $15,591 $16,157 $15,650 New vehicles................................ $24,081 $23,804 $23,896 $23,562 Weighted average............................ $16,667 $16,205 $16,708 $16,297 Page 19 of 31
Retail Vehicle Sales Mix - ------------------------ Three Months Nine Months Ended November 30 Ended November 30 2005 2004 2005 2004 ---------------------------- ---------------------------- Vehicle units: Used vehicles......................... 93% 93% 93% 92% New vehicles.......................... 7 7 7 8 ---------------------------- ---------------------------- Total....................................... 100% 100% 100% 100% =========================== ============================ Vehicle dollars: Used vehicles......................... 91% 89% 90% 88% New vehicles.......................... 9 11 10 12 ---------------------------- ---------------------------- Total....................................... 100% 100% 100% 100% ============================ ============================ Retail Stores. CarMax opened nine superstores during the first nine months of - ------------- fiscal 2006. During the first two quarters, we opened five superstores. We entered the Jacksonville, Kansas City and Salt Lake City markets with one superstore each, and added two superstores in the Los Angeles market, bringing to five our total store count in this large market. During the third quarter, we opened four superstores. We entered the Virginia Beach and the Wichita markets with a standard superstore in each, and we added satellite superstores in Miami and Nashville. 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 Nov. 30, 2005 Feb. 28, 2005 Nov. 30, 2004 - -------------------------------------------------------------------------------------------------------------------------- Mega superstores............................. 13 13 13 13 Standard superstores......................... 34 34 29 29 Satellite superstores........................ 20 20 16 15 --------------------------------------------------------------------------- Total used car superstores................... 67 67 58 57 Co-located new car stores.................... 4 4 3 3 --------------------------------------------------------------------------- Total........................................ 71 71 61 60 =========================================================================== Gross Profit - ------------ Three Months Nine Months Ended November 30 Ended November 30 2005 2004 2005 2004 $ per unit(1) %(2) $ per unit(1) %(2) $ per unit(1) %(2) $ per unit(1) %(2) -------------------------------------- --------------------------------------- Used vehicle gross profit.................. 1,758 10.8 1,765 11.2 1,807 11.1 1,826 11.6 New vehicle gross profit................... 866 3.6 886 3.7 943 3.9 866 3.7 Wholesale vehicle gross profit............. 726 16.8 440 11.8 641 15.3 428 11.4 Other gross profit......................... 374 54.0 339 50.5 395 59.3 379 56.1 Total gross profit......................... 2,483 12.4 2,284 12.0 2,504 12.6 2,379 12.3 (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 third quarter used vehicle gross profit per unit - ------------------------- was similar to our used vehicle gross profit per unit in the prior year's quarter. Increasing gasoline costs caused wholesale prices for SUVs and light trucks to plummet in the summer and early fall, before reaching a price point in the latter part of the third quarter that attracted renewed buying interest. Meanwhile, prices for more gasoline efficient compact cars remained above historical norms. We were able to maintain margins in this environment due to Page 20 of 31
our ability to quickly adjust appraisal offers to stay in line with the broader market trade-in offer trends. In addition, our rapid inventory turns, which reduce our exposure to declining prices, contributed to our margin stability. For the nine months ended November 30, 2005, used vehicle gross profit per unit declined modestly compared with the prior year, due in part 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 decline in new vehicle gross profit per unit for - ------------------------- the third quarter reflects the highly competitive new vehicle market. For the first nine months of fiscal 2006, the increase in the new vehicle gross profit per unit was primarily attributable to an improvement in our new car margins realized during the new car manufacturers' employee discount programs. We were able to modestly increase our new car prices during the employee discount programs, as our pricing had generally been below the employee discount pricing. Wholesale Vehicle Gross Profit. For the third quarter and the first nine months - ------------------------------ of fiscal 2006, wholesale vehicle gross profit per unit increased substantially from the prior year levels, primarily as a result of a stronger-than-normal wholesale vehicle pricing environment. In the first half of fiscal 2006, 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. However, as our in-store auction prices usually reflect the broader wholesale market trends, our wholesale margins expanded. In the third quarter of fiscal 2006, we adjusted our appraisal offers to incorporate the anticipated drop in wholesale pricing that typically occurs in the fall. We were particularly aggressive in our appraisals of SUVs, where prices had continued to fall dramatically through the summer. Our wholesale auctions reflected the more modest price declines in the overall wholesale marketplace, giving us unusually high wholesale gross profit. Other Gross Profit. Compared with the prior year's third quarter and first nine - ------------------ months, other gross profits per unit increased moderately. The improvements were primarily the result of the growth in extended service plan revenues, which have no associated cost of sales, and 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. 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 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. Page 21 of 31
The components of CarMax Auto Finance income were as follows: Three Months Ended Nov. 30 Nine Months Ended Nov. 30 (In millions) 2005 % 2004 % 2005 % 2004 % - ------------------------------------------------------------------------------------------------------------------------------ Gains on sales of loans(1)........................ $ 20.9 5.0 $ 14.3 4.1 $ 58.7 4.2 $ 44.8 3.8 ------------------------------------ ----------------------------------- Other CAF income: (2) Servicing fee income......................... 7.0 1.0 6.2 1.0 20.5 1.0 18.3 1.0 Interest income.............................. 5.6 0.8 4.9 0.8 15.7 0.8 14.3 0.8 ----------------------------------- ----------------------------------- Total other CAF income............................ 12.6 1.9 11.1 1.8 36.2 1.8 32.6 1.8 ----------------------------------- ----------------------------------- Direct CAF expenses: (2) CAF payroll and fringe benefit expense....... 2.7 0.4 2.3 0.4 7.6 0.4 6.8 0.4 Other direct CAF expenses.................... 2.9 0.4 2.7 0.4 8.4 0.4 7.6 0.4 ----------------------------------- ----------------------------------- Total direct CAF expenses......................... 5.6 0.8 5.0 0.8 16.0 0.8 14.4 0.8 ----------------------------------- ----------------------------------- CarMax Auto Finance income (3).................... $ 28.0 2.0 $ 20.4 1.7 $ 78.9 1.7 $ 63.0 1.6 ==================================== =================================== Loans sold........................................ $ 416.6 $ 345.7 $1,405.9 $1,168.2 Average managed receivables....................... $ 2,705.9 $2,407.2 $2,626.6 $2,357.3 Net sales and operating revenues.................. $ 1,424.0 $1,215.7 $4,636.2 $3,864.2 Ending managed receivables........................ $ 2,710.7 $2,419.2 $2,710.7 $2,419.2 Percent columns indicate: (1) Percent of loans sold. (2) Annualized percent of averaged managed receivables. (3) Percent of net sales and operating revenues. CAF income rose 37% in the third quarter compared with the prior year's quarter. In the third quarter of fiscal 2006, CAF's gains on sales of loans benefited from the growth in total vehicle sales, a $0.02 per share favorable valuation adjustment, and a $0.01 per share benefit resulting from the favorable impact of the 2005-2 public securitization completed in September 2005. In the third quarter of fiscal 2005, CAF's gains on sales of loans included a benefit of $0.01 per share resulting from a favorable valuation adjustment. Other CAF income and direct CAF expenses for the third quarter of fiscal 2006 increased proportionately to managed receivables. For the first nine months of fiscal 2006, CAF income increased 25% compared with the same period of the prior year. For the first nine months of fiscal 2006, CAF's gains on sales of loans benefited from the growth in total vehicle sales, a modest improvement in CAF loan penetration, $0.04 per share of favorable valuation adjustments, and $0.02 per share of favorable effects from the public securitizations completed in April and September. For the first nine months of fiscal 2005, CAF's gains on sales of loans included a benefit of $0.01 per share resulting from a favorable valuation adjustment. Other CAF income and direct CAF expenses for the first nine months of fiscal 2006 increased proportionately to managed receivables. The favorable valuation adjustments of $0.04 per share in the first nine months of fiscal 2006 and $0.01 per share in the first nine months of fiscal 2005 resulted primarily from lowering the loss rate assumptions on pools of previously securitized receivables. These pools of receivables continue to experience loss rates lower than our initial expectations, reflecting the favorable economic environment and continued strong performance of CAF's portfolio. Page 22 of 31
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 remaining 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 include the effects of the valuation adjustments, new public securitizations, and the repurchase and resale of receivables in existing public securitizations. Excluding the effects of such items, the gains on loans originated and sold were 3.6% during the third quarter of fiscal 2006, compared with 3.5% in the prior year quarter, and 3.4% for the first nine months of fiscal 2006, compared with 3.7% in the first nine 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 November 30 As of February 28 or 29 (In millions) 2005 2004 2005 2004 - --------------------------------------------------------------------------------------------------------------------------- Loans securitized.......................................... $ 2,654.6 $ 2,379.9 $ 2,427.2 $ 2,200.4 Loans held for sale or investment.......................... 56.1 39.3 67.7 48.2 ------------------------------------------------------------- Ending managed receivables................................. $ 2,710.7 $ 2,419.2 $ 2,494.9 $ 2,248.6 ============================================================= Accounts 31+ days past due................................. $ 43.3 $ 38.5 $ 31.1 $ 31.4 Past due accounts as a percentage of ending managed receivables.............................. 1.60% 1.59% 1.24% 1.40% Three Months Nine Months Ended November 30 Ended November 30 (In millions) 2005 2004 2005 2004 - --------------------------------------------------------------------------------------------------------------------------- Average managed receivables................................ $ 2,705.9 $ 2,407.2 $ 2,626.6 $ 2,357.3 Credit losses on managed receivables....................... $ 5.3 $ 5.0 $ 13.4 $ 14.4 Annualized credit losses as a percentage of average managed receivables............................. 0.78% 0.83% 0.68% 0.81% 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 third quarter and first nine months of fiscal 2006 decreased 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 favorable adjustments to our loss rate assumptions during the first and third quarters of fiscal 2006, as previously discussed. Selling, General and Administrative Expenses - -------------------------------------------- The SG&A ratio increased slightly to 11.4% in the third quarter of fiscal 2006 from 11.3% in the third quarter of the prior fiscal year. As expected, the moderate rate of increase in comparable store used unit sales was not sufficient to provide SG&A leverage. Having 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, and a lower-than-normal corporate bonus expense in fiscal 2005 were also contributing factors. Newer stores typically experience higher SG&A ratios. At Page 23 of 31
the end of this year's third quarter, 49% of our stores were less than four years old compared with 40% at the end of last year's third quarter. For the first nine months of fiscal 2006, the SG&A ratio increased slightly to 10.5% compared with 10.4% for the same period last year. This increase was attributable to the factors mentioned above, as well as costs associated with the rollout of marketwide television advertising in Los Angeles in the first quarter of fiscal 2006, concurrent with the opening of our fifth superstore in this large market. Income Taxes - ------------ The effective income tax rate was 38.4% in the first nine months of fiscal 2006 compared with 39.0% in the same period of fiscal 2005. The reduced effective tax rate was primarily the 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. The effective tax rate for the third quarter of fiscal 2006 was adjusted to reach the expected annual effective tax rate of 38.4% for the fiscal year, which increased from 38.2% at the end of the second quarter. This adjustment resulted in an effective tax rate of 38.9% for the third quarter. Operations Outlook - ------------------ Comparable Store Sales and Earnings Per Share. For the fourth quarter of fiscal - ---------------------------------------------- 2006, we anticipate comparable store used vehicle unit sales performance in the range of -4% to +2%. The width of this range reflects the degree of short-term sales volatility experienced in recent quarters. This range is built on an assumption of normal winter weather. We achieved 12% comparable store used vehicle unit growth in the fourth quarter of fiscal 2005, making the fourth quarter the most challenging quarterly comparison of fiscal 2006. Last year's comparable store unit sales growth included 5 percentage points attributable to rolling out a new subprime finance provider. We do not anticipate any incremental sales growth from this source in the current year's fourth quarter. We expect fourth quarter earnings per share in the range of $0.25 to $0.31. We expect the fourth quarter CAF gains on loans originated and sold will be approximately 3.5%, which is at the low end of our normalized range of 3.5% to 4.5%, and slightly lower than the 3.7% gain spread realized in the fourth quarter of fiscal 2005. Assuming performance within expected ranges in the fourth quarter, we anticipate full year fiscal 2006 comparable store used vehicle unit growth in the range of 4% to 6% and earnings per share in the range of $1.27 to $1.33, or an increase of 19% to 24% compared with the $1.07 per share earned in fiscal 2005. Planned Superstore Openings. No superstore openings are planned for the fourth - ---------------------------- quarter of fiscal 2006. During the fiscal year ending February 28, 2007, we currently plan to open 11 used car superstores, representing a 16% increase in our store base, which is consistent with our target for used car superstore annual growth in the range of 15% to 20%. Fiscal 2007 planned store openings include: Standard Satellite Total Superstores Superstores Superstores - ----------------------------------------- ----------------------------------- ----------------- ----------------- ---------------- Hartford / New Haven, Conn. New mid-sized market 1 1 2 Columbus, Ohio New mid-sized market 1 1 2 Oklahoma City, Okla. New mid-sized market 1 - 1 Los Angeles, Calif. Existing large market - 2 2 Charlottesville, Va. New small market - 1 1 Fredericksburg, Va. (1) Existing large market 1 - 1 Austin, Tex. Existing mid-sized market - 1 1 Charlotte, N.C. Existing mid-sized market 1 - 1 ----------------- ----------------- ---------------- Total planned openings 5 6 11 ================= ================= ================ (1) Part of the Washington, D.C. television market Page 24 of 31
The Charlottesville superstore represents our first test of the CarMax superstore concept in a small market. Charlottesville has a television viewing audience of approximately 185,000. We will be adjusting our store footprint, inventory, and staffing model in the Charlottesville store as a result of the smaller overall sales opportunities provided by this market. The store's performance over the next few years will help us better understand our longer-term opportunities in small markets. Annual Guidance. Beginning with fiscal 2007, we will no longer issue quarterly - ---------------- guidance. We will issue guidance on comparable store used unit sales and on earnings per share only for the full fiscal year. This decision reflects our continuing focus on longer-term store, sales, and earnings growth and on return on invested capital, as well as our recognition that the performance in shorter-term periods can be more volatile than over the longer term. As we report our quarterly results, we plan to comment on our performance relative to our annual guidance. 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 $148.7 million in - --------------------- the first nine months of fiscal 2006 from $83.6 million in the first nine months of fiscal 2005. The increase reflected a combination of factors, including a $24.4 million increase in net earnings and favorable changes in working capital resulting from the timing of disbursements, partially offset by increases in receivables and inventory. Investing Activities. Net cash used in investing activities was $75.3 million in - -------------------- the first nine months of fiscal 2006, compared with $123.7 million in the first nine months of the prior fiscal year. Capital expenditures were $153.5 million in the first nine months of fiscal 2006, compared with $176.3 million in corresponding period of the prior fiscal year. In addition to store construction costs, capital expenditures included costs associated with our new home office, which was completed in October 2005, and the cost of land acquired for future year store openings. The decrease in capital expenditures in fiscal 2006 compared with the prior year was primarily due to the timing of land purchases for future year store openings. The company generated net proceeds from the sales of assets of $78.2 million in the first nine months of fiscal 2006, compared with $52.7 million in the first nine months of fiscal 2005. These proceeds were primarily associated with sale-leaseback transactions. In the nine months ended November 30, 2005, we completed the sale-leaseback of five superstores, while in the corresponding period of the prior fiscal year, 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 November 30, 2005, we owned ten superstores currently in operation and the company's home office in Richmond, Virginia. Financing Activities. Net cash used in financing activities was $67.5 million in - -------------------- the first nine months of fiscal 2006, compared with net cash provided by financing activities of $4.2 million in the first nine months of fiscal 2005. In the first nine months of fiscal 2006, we used cash generated from operations to reduce total debt by $72.0 million. The outstanding 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 $2.65 billion at November 30, 2005, and $2.38 billion at November 30, 2004. During the first nine months of fiscal 2006, we completed two public securitizations of automobile loan receivables totaling $1.14 billion. Subsequent to the end of the quarter, in December 2005, we completed a third public securitization of automobile loan receivables totaling $450 million. At November 30, 2005, the unused warehouse capacity Page 25 of 31
totaled $186.0 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, $450 million 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. All outstanding principal amounts borrowed under the credit facility will be due and payable in August 2009. 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 November 30, 2005, $93.8 million was outstanding under the credit facility, with the remainder fully available to the company. The outstanding balance included $4.7 million of swing line loans classified as short-term debt, $39.1 million classified as current portion of long-term debt, and $50.0 million classified as long-term debt. The determination of the amount classified as long-term debt was based on management's intent as to that portion expected to remain outstanding for more than one year from the balance sheet date. 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 26 of 31
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Automobile Installment Loan Receivables. At November 30, 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 November 30, 2005, and February 28, 2005, was as follows: (In millions) November 30 February 28 - ---------------------------------------------------------------------------------------------------------------- Fixed-rate securitizations............................................. $ 2,015.6 $ 1,764.7 Floating-rate securitizations synthetically altered to fixed.................................... 638.5 662.1 Floating-rate securitizations.......................................... 0.5 0.4 Held for investment (1)................................................ 54.6 45.5 Held for sale (2)...................................................... 1.5 22.2 --------------------------------------- Total.................................................................. $ 2,710.7 $ 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 or the nine months ended November 30, 2005. Page 27 of 31
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 November 30, 2005, that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. Page 28 of 31
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 6. Exhibits 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 31
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 January 6, 2006 Page 30 of 31
EXHIBIT INDEX 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 31 of 31 </TABLE>