CarMax - 10-Q quarterly report FY

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A Table of Contents is included on Page 2 and a separate Exhibit Index is included on Page 36.

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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 CarMax Annual Report on Form 10-K for the fiscal year ended February 28, 2007, as well as our consolidated financial statements and the accompanying notes included in this Form 10-Q.

CarMax is the nation’s largest retailer of used vehicles.  We pioneered the used car superstore concept, opening our first store in 1993.  As of November 30, 2007, we operated 86 used car superstores in 39 markets, comprised of 28 mid-sized markets, 10 large markets and 1 small market.  We define mid-sized markets as those with television viewing populations generally between 600,000 and 2.5 million people.  We also operated six new car franchises, all of which were integrated or co-located with our used car superstores.

We believe the CarMax consumer offer is unique in the automobile 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.  Our website, carmax.com, is a valuable tool for communicating the CarMax consumer offer, a sophisticated search engine and an efficient channel for customers who prefer to conduct their shopping online.  We generate revenues, income and cash flows primarily by retailing used vehicles and associated items including vehicle financing, extended service plans (“ESP”) and vehicle repair service.  A majority of the used vehicles we sell at retail are purchased directly from consumers.

We also generate revenues, income and cash flows from the sale of vehicles purchased through our appraisal process that do not meet our retail standards.  These vehicles are sold at our on-site wholesale auctions.  Wholesale auctions are conducted at the majority of our superstores and are held on a weekly, bi-weekly or monthly basis.  On average, the vehicles we wholesale are approximately 10 years old and have more than 100,000 miles.  Participation in our wholesale auctions is restricted to licensed automobile dealers, the majority of whom are independent dealers and licensed wholesalers.

CarMax provides financing to qualified customers through CarMax Auto Finance (“CAF”), the company’s finance operation, Bank of America and through a number of other third-party lenders.  We collect fixed, prenegotiated fees from the majority of our third-party lenders, and we periodically test additional lenders.  CarMax has no recourse liability for loans provided by third-party lenders.

We sell ESPs 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.

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 target a similar dollar amount of gross profit per used unit, regardless of retail price.  Used unit sales growth is our primary focus.  We plan to open used car superstores at a rate of approximately 15% to 20% of our used car superstore base each year.  Over the long term, we expect comparable store used unit sales increases to average in the range of 4% to 8%, reflecting the multi-year ramp in sales at newly opened stores as they mature, continued market share gains at stores that have reached basic maturity sales levels and underlying industry sales growth.  We estimate that our stores generally reach basic maturity sales levels in their fifth year of operation.

The principal challenges we face in expanding our store base include our ability to build our management bench strength to support store growth and our ability to procure suitable real estate at reasonable costs.  Beginning in the third quarter, we also experienced an unprecedented disruption in the asset-backed securities market that has increased CAF’s funding costs.

For a discussion of our critical accounting policies, see “Critical Accounting Policies” in MD&A included in Item 7 of the Annual Report on Form 10-K for the fiscal year ended February 28, 2007. These policies relate to securitization transactions, revenue recognition, income taxes and the defined benefit retirement plan.

Comparable store used unit sales growth is one of the key drivers of our profitability.  A store is included in comparable store retail sales in the store’s fourteenth full month of operation.

Used Vehicle Sales. We believe the difficult macro-economic conditions have caused an industry-wide slowdown in sales in the automotive retail market in recent months.  The 10% increase in our used vehicle revenues in the third quarter of fiscal 2008 resulted from a 9% increase in unit sales and a 1% increase in average selling price.  The unit sales growth reflected sales from newer superstores not yet in the comparable store base.  Comparable store used unit sales were flat, reflecting the combination of the near-term decline in consumer confidence and a slowing sales pace for the automotive retail industry, as well as the challenging comparison with our 13% increase in last year’s third quarter.  We continued to experience healthy increases in consumer traffic, which we believe benefited from the favorable response to the improvements to carmax.com made during the last several quarters.  However, compared with the prior year period, our sales conversion rate declined as consumers appeared to be more hesitant in committing to big-ticket purchases.  Sales were supported by the continued consistent availability of credit from CAF and our third-party finance providers.  Despite the deceleration in automotive industry sales, our data indicates that we continued to gain share within our existing markets in the late-model used vehicle market.

The 12% increase in used vehicle revenues in the first nine months of fiscal 2008 resulted from an 11% increase in unit sales and a 1% increase in average selling price.  The unit sales growth reflected sales from new superstores not yet in the comparable store base, together with a 3% increase in comparable store used units.  Similar to the third quarter, our comparable store used unit sales growth was supported by increases in traffic and the continued, consistent availability of consumer credit.  We experienced a gradual deceleration in our comparable store sales growth over the course of the first nine months of fiscal 2008 that we believe is largely the result of the increasingly challenging economic environment.

New Vehicle Sales.  Compared with the corresponding prior year periods, new vehicle revenues decreased 30% in the third quarter of fiscal 2008 and 16% in the first nine months of fiscal 2008.  The declines were substantially the result of decreases in unit sales, which fell 29% in the third quarter and 16% in the first nine months of the year.  The declines in new vehicle unit sales reflected soft new car industry sales trends, particularly for the domestic manufacturers that we represent, and the divestiture of our Orlando Chrysler-Jeep-Dodge franchise in the second quarter of fiscal 2008.

Wholesale Vehicle Sales.  Vehicles acquired through our appraisal purchase process that do not meet our retail standards are sold at our on-site wholesale auctions.  The 4% increase in wholesale vehicle revenues in the third quarter of fiscal 2008 resulted from a 2% increase in wholesale unit sales combined with a 2% increase in average wholesale selling price.  The increase in wholesale vehicle unit sales was smaller than the 9% increase in used vehicle unit sales, reflecting the more challenging comparison with the third quarter of the prior year, when wholesale vehicle unit sales climbed 29% compared with an 18% increase in used vehicle unit sales.  In addition, while appraisal traffic remained healthy during the quarter, we experienced a decline in our buy rate (defined as vehicles purchased as a percent of vehicles appraised) as the increased hesitancy of consumers to commit to purchasing vehicles also affected their trade-in activity.  Our wholesale auction prices usually reflect the trends in the general wholesale market for the types of vehicles we sell, although they may also be affected by changes in the average age, miles, make, model or condition of vehicles to be wholesaled.

The 9% increase in wholesale vehicle revenues in the first nine months of fiscal 2008 resulted from an 8% increase in wholesale unit sales combined with a 1% increase in average wholesale selling price.  The wholesale unit sales growth was primarily the result of the expansion of our store base.

Other Sales and Revenues.  Other sales and revenues include commissions on the sale of ESPs, service department sales and third-party finance fees.  Compared with the corresponding prior year periods, other sales and revenues increased 9% in the third quarter of fiscal 2008, and 10% in the first nine months of fiscal 2008.  Extended service plan revenues increased 11% in the third quarter and 14% in the first nine months of the year, driven primarily by our retail unit sales growth.  Net third-party finance fees, which increased 5% in the third quarter and 8% in the first nine months of the year, can be affected by changes in the mix of loan originations by provider.  The fixed fees paid by our third-party finance providers will vary by provider, reflecting their differing levels of credit risk exposure.  We record the discount at which the third-party subprime lender purchases loans as an offset to finance fee revenues from the other third-party lenders.  In the third quarter of fiscal 2008, net third party finance fees increased at a slower rate than our used vehicle unit growth, reflecting an increase in sales financed by the third-party subprime lender.

Seasonality.  Most of our superstores experience their strongest traffic and sales in the spring and summer quarters.  Sales are typically lowest in the fall quarter, which coincides with the new vehicle model-year-changeover period.  In the fall, the new model year introductions and discounts on model year closeouts generally can cause rapid depreciation in used car pricing, particularly for late-model used cars.  Customer traffic also tends to slow in the fall as the weather gets colder and as customers shift their spending priorities toward holiday-related expenditures.  Seasonal patterns for car buying and selling may vary in different parts of the country and, as we expand geographically, these differences may impact the overall seasonal pattern of our results.

During the third quarter of fiscal 2008, we opened five used car superstores, including one production superstore in Charlotte, North Carolina, and four non-production superstores in Atlanta, Georgia; Newport News, Virginia; and Los Angeles and San Diego, California.  This represented our first store in the San Diego market.

During the first nine months of the year, in addition to the third quarter store openings, we entered the Tucson, Arizona, market with a production superstore and the Milwaukee, Wisconsin, market with two non-production superstores.  We also opened a non-production superstore in the Los Angeles, California market.  Vehicle reconditioning for the Milwaukee stores is provided by our production superstore in Kenosha, Wisconsin, which had available capacity.

During the first nine months of the year, we expanded our car-buying center test with the opening of buying centers in the Raleigh, North Carolina, and Tampa, Florida, markets, expanding the test we began in Atlanta in fiscal 2007.  At these locations, we conduct appraisals and purchase cars, but do not sell vehicles.  These test centers are part of our long-term plan to increase both appraisal traffic and retail vehicle sourcing self-sufficiency.

As ofNovember 30, 2007, we had a total of six new car franchises representing the Chevrolet, Chrysler, Nissan and Toyota brands.  Two franchises are integrated within used car superstores, and the remaining four franchises are operated from three facilities that are co-located with select used car superstores.  During the second quarter of fiscal 2008, we sold our Orlando Chrysler-Jeep-Dodge franchise.

Used Vehicle Gross Profit.  Compared with the corresponding prior year periods, used vehicle gross profit per unit decreased $12 in the third quarter and increased $7 in the first nine months of fiscal 2008.  We target a similar dollar amount of gross profit per used unit, regardless of retail price.  Our ability to quickly adjust appraisal offers to be consistent with the broader market trade-in trends and our rapid inventory turns reduce our exposure to the inherent continual depreciation in used vehicle values and contribute to our ability to manage our gross profit dollars per unit.  In addition, over the past few years, we have continued to refine our car-buying strategies, which we believe has benefited our used vehicle gross profit per unit.

Compared with the second quarter of fiscal 2008, our third quarter used vehicle gross profit per unit declined by $96.  We expect gross profits to decrease sequentially from the second quarter to the third quarter, reflecting the normal seasonal slowdown in traffic, the higher vehicle depreciation that typically occurs during the model-year changeover period and our resulting lower margin targets.

New Vehicle Gross Profit.  Compared with the corresponding prior year periods, new vehicle gross profit per unit decreased $65 in the third quarter and $128 in the first nine months of fiscal 2008, in part reflecting the lower dealer incentives offered by certain of the domestic manufacturers that we represent.

Wholesale Vehicle Gross Profit.  Compared with the corresponding prior year periods, wholesale vehicle gross profit per unit increased $32 in the third quarter and $69 in the first nine months of fiscal 2008.  Wholesale vehicle profitability has steadily increased over the last several years, reflecting the combined benefits of refinements in our appraisal offer and appraisal delivery processes and the continued strong dealer attendance at our auctions.

Other Gross Profit.  Compared with the corresponding prior year periods, other gross profit per unit decreased $13 in the third quarter and $2 in the first nine months of fiscal 2008.  The changes in profit per unit reflected the change in the mix of extended service plan revenues and third-party finance fees, both of which have no associated cost of sales, relative to service department sales.  A small increase in the percentage of sales financed by the third-party subprime lender reduced net third party finance fees.  A decline in the gross margin on service department sales resulted, in part, from our flat comparable store sales growth, which reduced our ability to leverage service and reconditioning overhead expenses.

Impact of Inflation.  Inflation has not been a significant contributor to our results.  Profitability is based on achieving targeted unit sales and gross profit dollars per vehicle rather than on average retail prices.  However, CAF income will benefit from an increase in the average amount financed.

CAF provides automobile 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 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 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 automobile loan receivables, both for CAF and for our third-party lenders.  CAF provides us the opportunity to capture additional profits and cash flows from automobile loan receivables while managing our reliance on third-party finance sources.