Form 10-Q
 


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, 2006

OR

o 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 incorporation or organization)
 
(I.R.S. Employer 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)

N/A
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes x
No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
  
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
  
Yes o
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, 2006
Common Stock, par value $0.50
 
107,444,503
 
 


 


CARMAX, INC. AND SUBSIDIARIES

TABLE OF CONTENTS
 
   
Page No.
     
PART I.
 
     
Item 1.
 
     
 
 
3
 
 
4
 
 
5
 
 
6
     
Item 2.
 14
     
Item 3.
25
     
Item 4.
26
     
     
PART II.
 
     
Item 1.
27
 
   
Item 1A.
27
     
Item 6.
28
     
29
   
30
 
Page 2 of 30


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 November 30
 
Nine Months Ended November 30
 
 
 
2006
 
%(1)
 
 2005 
 
%(1)
 
2006 
 
%(1)
 
 2005 
 
%(1)
 
 
 
 
 
 
 
 Restated(2)
 
 
 
 
 
 
Restated(2)
 
Sales and operating revenues:              
                                             
     Used vehicle sales
 
$
1,377,551
   
77.9
 
$
1,087,097
   
76.3
 
$
4,365,409
   
78.2
 
$
3,527,416
   
76.1
 
     New vehicle sales
   
109,940
   
6.2
   
113,299
   
8.0
   
349,579
    6.3    
399,314
   
8.6
 
     Wholesale vehicle sales
   
226,363
   
12.8
   
174,235
   
12.2
   
695,958
    12.5    
554,510
   
12.0
 
     Other sales and revenues
   
54,293
   
3.1
   
49,349
   
3.5
   
171,882
   
3.1
   
154,953
   
3.3
 
Net sales and operating revenues
   
1,768,147
   
100.0
   
1,423,980
   
100.0
   
5,582,828
   
100.0
   
4,636,193
   
100.0
 
Cost of sales
   
1,539,538
   
87.1
   
1,246,807
   
87.6
   
4,852,599
   
86.9
   
4,052,677
   
87.4
 
Gross profit
   
228,609
   
12.9
   
177,173
   
12.4
   
730,229
   
13.1
   
583,516
   
12.6
 
CarMax Auto Finance income
   
31,974
   
1.8
   
27,971
   
2.0
   
100,880
   
1.8
   
78,866
   
1.7
 
Selling, general, and administrative expenses
   
187,318
   
10.6
   
167,351
   
11.8
   
574,333
   
10.3
   
502,517
   
10.8
 
Interest expense
   
167
   
-
   
430
   
-
   
4,449
   
0.1
   
1,999
   
-
 
Interest income
   
406
   
-
   
262
   
-
   
973
   
-
   
588
   
-
 
Earnings before income taxes
   
73,504
   
4.2
   
37,625
   
2.6
   
253,300
    4.5    
158,454
   
3.4
 
Provision for income taxes
   
28,085
   
1.6
   
14,694
   
1.0
   
96,841
   
1.7
   
60,907
   
1.3
 
Net earnings
 
$
45,419
   
2.6
 
$
22,931
   
1.6
 
$
156,459
   
2.8
 
$
97,547
   
2.1
 
 
                                                 
Weighted average common shares:
                                             
     Basic
   
106,511
       
104,727
         
105,895
         
104,547
       
     Diluted
   
108,883
       
106,507
         
107,861
         
106,343
       
 
                                       
Net earnings per share:
                                         
     Basic
 
$
0.43
     
$
0.22
       
$
1.48
       
$
0.93
       
     Diluted
 
$
0.42
     
$
0.22
       
$
1.45
       
$
0.92
       

 

(1)
Percents are calculated as a percentage of net sales and operating revenues and may not equal totals due to rounding.
 
(2)
Prior period amounts have been restated to reflect the impact of share-based compensation expense, as permitted by SFAS 123(R). See Notes 2 and 7 for additional information.

See accompanying notes to consolidated financial statements.


Page 3 of 30


CARMAX, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Unaudited)
(In thousands except share data)

   
November 30,
 
 February 28,
   
2006 
 
 2006
       
  Restated(1)
ASSETS              
Current assets:              
Cash and cash equivalents
 
$
12,352
 
$
21,759
 
Accounts receivable, net
   
53,092
   
76,621
 
Automobile loan receivables held for sale
   
3,145
   
4,139
 
Retained interest in securitized receivables
   
202,594
   
158,308
 
Inventory
   
760,816
   
669,700
 
Prepaid expenses and other current assets
    13,955    
11,211
 
Total current assets
   
1,045,954
   
941,738
 
               
Property and equipment, net
   
585,109
   
499,298
 
Deferred income taxes
   
25,788
   
24,576
 
Other assets
   
47,817
   
44,000
 
TOTAL ASSETS
 
$
1,704,668
 
$
1,509,612
 
               
LIABILITIES AND SHAREHOLDERS’ EQUITY
             
Current liabilities:
             
Accounts payable
 
$
222,205
 
$
188,614
 
Accrued expenses and other current liabilities
   
83,623
   
85,316
 
Accrued income taxes
   
33,275
   
5,598
 
Deferred income taxes
   
10,151
   
23,562
 
Short-term debt
   
2,984
   
463
 
Current portion of long-term debt
   
84,422
   
59,762
 
Total current liabilities
   
436,660
   
363,315
 
               
Long-term debt, excluding current portion
   
34,012
   
134,787
 
Deferred revenue and other liabilities
   
35,090
   
31,407
 
TOTAL LIABILITIES
   
505,762
   
529,509
 
               
Commitments and contingent liabilities
             
               
Shareholders’ equity:
             
Common stock, $0.50 par value; 350,000,000 shares authorized; 107,229,646 and 104,954,983 shares issued and outstanding at November 30, 2006, and February 28, 2006, respectively
   
53,615
   
52,477
 
Capital in excess of par value
   
615,282
   
554,076
 
Retained earnings
   
530,009
   
373,550
 
TOTAL SHAREHOLDERS’ EQUITY
   
1,198,906
   
980,103
 
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
 
$
1,704,668
 
$
1,509,612
 

(1)
Prior period amounts have been restated to reflect the impact of share-based compensation expense, as permitted by SFAS 123(R). See Notes 2 and 7 for additional information.

See accompanying notes to consolidated financial statements.

Page 4 of 30


CARMAX, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)

   
Nine Months Ended
November 30
 
   
2006
 
2005
 
       
 Restated(1) 
Operating Activities:
        
Net earnings
 
 $
156,459  
$
97,547
 
Adjustments to reconcile net earnings to net cash provided by operating activities:
             
Depreciation and amortization
    25,177    
19,193
 
Share-based compensation expense
    25,548    
15,713
 
Loss (gain) on disposition of assets
    259    
(777
)
Deferred income tax benefit
 
  (14,623 )  
(22,603
)
Changes in operating assets and liabilities:
             
Decrease in accounts receivable, net
    23,529    
20,551
 
Decrease in automobile loan receivables held for sale, net
    994    
20,625
 
Increase in retained interest in securitized receivables
    (44,286 )  
(10,967
)
Increase in inventory
    (91,116 )  
(29,799
)
(Increase) decrease in prepaid expenses and other current assets
    (2,744 )  
1,627
 
Increase in other assets
    (3,817  
(6,184
)
Increase in accounts payable, accrued expenses and other current liabilities, and accrued income taxes
    58,502    
33,371
 
Increase in deferred revenue and other liabilities
    3,683    
800
 
Net cash provided by operating activities
    137,565    
139,097
 
               
Investing Activities:
             
Capital expenditures
    (114,719 )  
(153,490
)
Proceeds from sales of assets
    3,472    
78,217
 
Net cash used in investing activities
    (111,247 )  
(75,273
)
               
Financing Activities:
             
Increase (decrease) in short-term debt, net
    2,521    
(60,490
)
Issuance of long-term debt      –    
105,229
 
Payments on long-term debt
   
(76,115
)   (116,764 )
Equity issuances, net
   
27,449
   
5,108
 
Excess tax benefits from share-based payment arrangements
   
10,420
   
3,221
 
Net cash used in financing activities
   
(35,725
)  
(63,696
)
               
(Decrease) increase in cash and cash equivalents
   
(9,407
)  
128
 
Cash and cash equivalents at beginning of year
   
21,759
   
17,124
 
Cash and cash equivalents at end of period
 
 $
12,352  
$
17,252
 

(1)
Prior period amounts have been restated to reflect the impact of share-based compensation expense, as permitted by SFAS 123(R). See Notes 2 and 7 for additional information.
 
See accompanying notes to consolidated financial statements.

Page 5 of 30

 
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 vehicles 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; the appraisal and purchase of vehicles directly from consumers; and vehicle repair service. Vehicles purchased through the company’s appraisal process that do not meet its retail standards are sold at on-site wholesale auctions.
 
2.
Accounting Policies
 
Basis of Presentation. The accompanying interim unaudited consolidated financial statements include the accounts of CarMax and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation. Certain previously reported amounts have been reclassified to conform with the current period presentation, including restricted cash deposits associated with certain insurance deductibles, which were reclassified from cash and cash equivalents to other assets.
 
The company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”), effective March 1, 2006, applying the modified retrospective method. As a result, prior period amounts have been restated to reflect the adoption of this standard. The impact of the adoption of SFAS 123(R) on net income for the third quarter and first nine months of fiscal 2006 is consistent with the pro forma amounts previously disclosed in the company’s quarterly reports.
 
These consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, such interim consolidated financial statements reflect all normal recurring adjustments considered necessary to present fairly the financial position and the results of operations and cash flows for the interim periods presented. The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full fiscal year. These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in the company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2006.
 
Cash and Cash Equivalents. Cash equivalents of $4.0 million at November 30, 2006, and $6.0 million at February 28, 2006, consisted of highly liquid investments with original maturities of three months or less.
 
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 CAF income is generated by the spread between the interest rates charged to customers and the related cost of funds. A gain, recorded at the time of securitization, 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 prepayments and defaults.

 
 
 
 
Three Months Ended
 
 
Nine Months Ended
 
 
 
November 30 
 
 
November 30 
(In millions)
   
2006
   
2005
   
2006
   
2005
 
Total gain income
 
$
23.7  
$
20.9
 
 $
77.4  
$
58.7
 
                           
Other CAF income:
   
         
   
 
   Servicing fee income
   
8.2
    7.0    
23.5
   
20.5
 
   Interest income
   
6.8
    5.6    
19.2
   
15.7
 
Total other CAF income
   
15.0
    12.6     42.7    
36.2
 
 
   
         
       
Direct CAF expenses:
   
         
       
   CAF payroll and fringe benefit expense
   
3.1
    2.7    
8.8
   
7.6
 
   Other direct CAF expenses
   
3.6
    2.9    
10.4
   
8.4
 
Total direct CAF expenses
   
6.7
    5.6    
19.2
   
16.0
 
CarMax Auto Finance income
 
 $
32.0  
$
28.0  
 $
100.9  
$
78.9
 

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 and corporate expenses such as human resources, administrative services, marketing, information systems, accounting, legal, treasury, and executive payroll.
 
Page 6 of 30


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 routinely 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. Depending on the securitization structure and market conditions, refinancing receivables in a public securitization may or may not have a significant impact on the company’s results.

All transfers of receivables are accounted for as sales in accordance with 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 Ended
 
Nine Months Ended
 
 
 
 November 30
 
 November 30
 
(In millions)
 
2006
 
2005
 
2006
 
2005
 
Net loans originated
   $ 537.9     $ 415.7    $ 1,686.6     $
1,333.8
 
Total loans sold
   $ 538.7   
 $
416.6
   $ 1,728.7     $
1,405.9
 
Total gain income(1)
   $ 23.7   
 $
20.9
   $ 77.4     $
58.7
 
Total gain income as a percentage of total loans sold (1)
 
 
4.4  %  
5.0
%
  4.5  %  
4.2
%

 
(1)
Includes the effects of valuation adjustments, new public securitizations, and the repurchase and resale of receivables in existing public securitizations, as applicable.
 
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,” various reserve accounts, and an undivided ownership interest in the securitized receivables, or “required excess receivables,” as described below. On a combined basis, the reserve accounts 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 fair value of the retained interest was $202.6 million as of November 30, 2006, and $158.3 million as of February 28, 2006. The retained interest had a weighted average life of 1.5 years as of November 30, 2006, and February 28, 2006. 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.
 
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.

Reserve accounts. The company is required to fund 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 original balance of the securitized receivables 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, the 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 on deposit in reserve accounts was $30.4 million as of November 30, 2006, and $29.0 million as of February 28, 2006.

Required excess receivables. The total value of the securitized receivables must 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 required excess receivables are released through the special purpose entity to the company. The unpaid principal balance related to the required excess receivables was $64.8 million as of November 30, 2006, and $52.2 million as of February 28, 2006.

Page 7 of 30


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, 2006, and a sensitivity analysis showing the hypothetical effect on the retained interest if there were unfavorable variations from the assumptions used. These sensitivities are hypothetical and should be used with caution. In this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in actual circumstances, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.
 
KEY ASSUMPTIONS
 
(In millions)
 
Assumptions
Used
 
Impact on Fair Value of 10% Adverse Change
 
Impact on Fair Value of 20% Adverse Change
Prepayment rate
   
1.35%-1.52%
 
 
$
6.8
 
 
$
13.5
 
Cumulative default rate
   
1.25%-2.30%
 
 
$
5.5
 
 
$
10.9
 
Annual discount rate
   
12.0%
 
 
$
2.9
 
 
$
5.8
 

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. Projected credit losses are estimated using the losses experienced to date, the credit quality of the receivables, economic factors, and the performance history of similar receivables.

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. No servicing asset or liability has been recorded. The company is at risk for the retained interest in the securitized receivables and, if the securitized receivables do not perform as originally projected, the value of the retained interest would be impacted.
 
PAST DUE ACCOUNT INFORMATION
 
   
As of November 30
 
As of February 28
 
(In millions)
 
2006
 
2005
 
2006
 
2005
 
Accounts 31+ days past due
 
$
61.2
 
$
43.3
 
$
37.4
 
$
31.1
 
Ending managed receivables
 
$
3,180.8
 
$
2,710.7
 
$
2,772.5
 
$
2,494.9
 
Past due accounts as a percentage of ending managed receivables
   
1.93
%
 
1.60
%
 
1.35
%
 
1.24
%
 
CREDIT LOSS INFORMATION
 
 
 
Three Months Ended
November 30
 
Nine Months Ended
November 30
 
(In millions)
 
2006
 
 2005
 
2006
 
 2005
 
Net credit losses on managed receivables
   $ 6.7  
$
5.3
   $ 13.7  
$
13.4  
Average managed receivables
   $ 3,147.9  
$
2,705.9
   $ 3,006.4  
$
2,626.6
 
Annualized net credit losses as a percentage of average managed receivables
    0.85 %  
0.78
%
  0.61 %  
0.68
%
Recovery rate
    49.2
%
  48.5 %   50.6
%
  49.3
%

SELECTED CASH FLOWS FROM SECURITIZED RECEIVABLES
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
 November 30
 
 November 30
 
(In millions)
 
2006
 
2005
 
2006
 
2005
 
Proceeds from new securitizations
   $ 445.5   
$
327.0
   $ 1,386.5     $ 1,118.5  
Proceeds from collections reinvested in revolving period securitizations
   $ 264.6   
$
185.7
   $ 777.1     $ 573.9  
Servicing fees received
   $ 8.1   
$
7.0
   $ 23.1     $ 20.3  
Other cash flows received from the retained interest:
         
             
   Interest-only strip receivables
   $ 22.0   
$
20.1
   $ 65.8     $ 62.2  
   Reserve account releases
   $ 1.8   
$
3.2
   $ 10.2     $ 12.3  

Proceeds from new securitizations. Proceeds from new securitizations include proceeds from receivables that are newly securitized in or refinanced through the warehouse facility during the indicated period. Balances previously outstanding in public securitizations that were refinanced through the warehouse facility totaled $41.0 million in the first nine months of fiscal 2007 and $51.5 million in the first nine months of fiscal 2006. There were no balances previously outstanding in public securitizations that were refinanced through the warehouse facility in the third quarter of fiscal 2007 or fiscal 2006.  Proceeds received when the company refinances receivables in public securitizations are excluded from this table as they are not considered new securitizations.

Page 8 of 30

 
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 reserve accounts.
 
Financial Covenants and Performance Triggers. Certain of the securitization agreements include various financial covenants and performance triggers. These agreements require the company to meet financial covenants related to maintaining minimum tangible net worth, maximum total liabilities to tangible net worth ratio, minimum current ratio, and minimum fixed charge coverage ratio. Performance triggers require certain pools of securitized receivables to achieve specified thresholds related to portfolio yields, default rates, and delinquency rates. If these financial covenants and/or thresholds are not met, in addition to other consequences, the company may be unable to continue to securitize receivables through the warehouse facility. At November 30, 2006, the company was in compliance with the financial covenants, and the securitized receivables were in compliance with the performance triggers.
 
5.
Financial Derivatives 
 
The company enters into amortizing fixed-pay interest rate swaps relating to its automobile loan receivable securitizations. Swaps are used to better match funding costs to the fixed-rate receivables being securitized by converting variable-rate financing costs in the warehouse facility to fixed-rate obligations. During the third quarter of fiscal 2007, the company entered into ten 40-month amortizing interest rate swaps with initial notional amounts totaling $480.5 million. The amortized notional amount of all outstanding swaps related to the automobile loan receivable securitizations was $704.6 million at November 30, 2006, and $584.0 million at February 28, 2006. At November 30, 2006, the fair value of swaps totaled a net liability of $2.6 million and was included in accounts payable.  At February 28, 2006, the fair value of swaps totaled a net asset of $1.6 million and was included in prepaid expenses and other current assets.

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.
 
COMPONENTS OF NET PENSION EXPENSE
 
   
Three Months Ended November 30
 
   
Pension Plan
 
 Restoration Plan
 
Total
 
(In thousands)
 
2006
 
 2005
 
 2006
 
 2005
 
 2006
 
2005
 
Service cost
 
$
3,012
 
$
2,332
 
$
103
 
$
172
 
$
3,115
 
$
2,504
 
Interest cost
   
1,024
   
698
   
98
   
64
   
1,122
   
762
 
Expected return on plan assets
   
(737
)
 
(567
)
 
   
   
(737
)
 
(567
)
Amortization of prior service cost
   
9
   
10
    6    
6
   
15
   
16
 
Recognized actuarial loss
   
439
   
241
   
62
   
34
   
501
   
275
 
Net pension expense
 
$
3,747
 
$
2,714
 
$
269
 
$
276
 
$
4,016
 
$
2,990
 
 
 
 
Nine Months Ended November 30
 
 
 
Pension Plan
 
 Restoration Plan
 
Total
 
(In thousands)
 
2006
 
 2005
 
 2006
 
 2005
 
 2006
 
2005
 
Service cost
 
$
9,036  
$
6,584
   $ 309  
$
360
   $ 9,345  
$
6,944
 
Interest cost
    3,072    
2,096
    294    
194
    3,366    
2,290
 
Expected return on plan assets
    (2,211  
(1,553
)
     
    (2,211  
(1,553
)
Amortization of prior service cost
    27    
28
    18    
18
    45    
46
 
Recognized actuarial loss
    1,317    
721
    186    
102
    1,503    
823
 
Net pension expense
 
$
11,241  
$
7,876
   $ 807  
$
674
   $ 12,048  
$
8,550
 
 
The company contributed $7.5 million to the pension plan in the third quarter of fiscal 2007 bringing contributions for the first nine months of fiscal 2007 to $10.7 million. The company does not anticipate making a contribution to the pension plan in the fourth quarter of fiscal 2007.
Page 9 of 30


7.
Share-Based Compensation

Effective March 1, 2006, the company adopted the provisions of SFAS 123(R), which establishes accounting for share-based awards exchanged for employee services. Under the provisions of SFAS 123(R), share-based compensation cost is measured at the grant date, based on the estimated fair value of the award, and is recognized as an expense over the requisite service period (generally the vesting period of the equity grant). Prior to March 1, 2006, the company applied Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations for share-based awards, and provided the pro forma disclosures required by SFAS No. 123, “Accounting for Stock-Based Compensation.” The company elected to apply the modified retrospective application method as provided by SFAS 123(R), and, accordingly, financial statement amounts for the prior periods presented in this Form 10-Q have been restated to reflect the fair value method of expensing share-based compensation on a basis consistent with the pro forma disclosures required for those periods by SFAS 123.
 
In accordance with SFAS 123(R), the company is required to base initial compensation cost on the estimated number of awards expected to vest. Historically, and as permitted under SFAS 123, the company chose to reduce pro forma compensation expense in the periods the awards were forfeited. The cumulative effect on prior periods of the change to an estimated number of awards expected to vest was a $0.6 million reduction of selling, general, and administrative expenses recorded in the first quarter of fiscal 2007.
 
COMPOSITION OF SHARE-BASED COMPENSATION EXPENSE
 
 
 
Three Months Ended
November 30
 
Nine Months Ended
November 30
 
(In thousands)
 
2006
 
2005
 
2006
 
2005
 
 
 
 
 
Restated
 
 
 
Restated
 
Cost of sales
 
 $
327   
$
 
$
1,048
 
$
 
CarMax Auto Finance income
    210          682      
Selling, general, and administrative expenses
    5,582      5,633      24,467     16,334   
Share-based compensation expense, before income taxes
   $ 6,119   
$
5,633   
$
26,197
 
$
16,334   
 
For periods prior to fiscal 2007, all share-based compensation expense has been presented in selling, general, and administrative expenses, as amounts that would have been presented in cost of sales and CarMax Auto Finance income were immaterial. Consistent with the provisions of SFAS 123, the company’s employee stock purchase plan is considered compensatory under SFAS 123(R), and the associated costs of $0.6 million in the first nine months of fiscal 2007 and fiscal 2006 are included in share-based compensation expense. There were no capitalized share-based compensation costs at November 30, 2006 and 2005.
 
IMPACT OF SFAS 123(R) ON FISCAL 2006 CONSOLIDATED FINANCIAL STATEMENTS
 
 
 
Three Months Ended
November 30, 2005
 
Nine Months Ended
November 30, 2005
 
(In thousands, except per share data)
 
As Restated
 
 Previously Reported
 
As Restated
 
 Previously Reported
 
Selling, general, and administrative expenses(1)
 
$
 167,351    
$
161,727
     502,517    
$
486,236
   
Earnings before income taxes
 
$
37,625    
$
43,249
    $  158,454    
$
174,735
   
Net earnings
  $ 22,931    
$
26,412
    $ 97,547    
$
107,652
   
Basic earnings per share
  $  0.22    
$
0.25
    $ 0.93    
$
1.03
   
Diluted earnings per share
  $ 0.22    
$
0.25
    $  0.92    
$
1.01
   
Net cash provided by operating activities(2)
  $  N/A    
$
N/A
    $  139,097    
$
148,689
   
Net cash used in financing activities
  $  N/A    
$
N/A
     63,696    
$
67,538
   
 
(1) Amount previously reported included expenses relating to the amortization of restricted stock of $9 in the third quarter of fiscal 2006 and $53 for the first nine months of fiscal 2006.
(2) As restated amount for the nine months ended November 30, 2005, also includes restricted cash deposits.  See Note 2.
 
   
As of February 28, 2006
   
(In thousands)  
As Restated
 
 Previously Reported
 
Deferred income taxes
 
$
24,576
   
$
4,211
   
Total assets
 
$
1,509,612
   
$
1,489,247
   
Capital in excess of par value
 
$
554,076
   
$
499,546
   
Retained earnings
 
$
373,550
   
$
407,715
   
Total shareholders’ equity
 
$
980,103
   
$
959,738
   
Total liabilities and shareholders’ equity
 
$
1,509,612
   
$
1,489,247
   
 

Page 10 of 30

 
The company maintains long-term incentive plans for management, key employees, and the nonemployee members of the board of directors. The plans allow for the grant of equity-based compensation awards, including nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock awards, stock grants, or a combination of awards.
 
In fiscal 2006 and prior years, the company primarily awarded stock options to employees that received share-based compensation. Beginning in fiscal 2007, the substantial majority of employees receiving awards now receive restricted stock instead of stock options. Senior management continues to receive awards of nonqualified stock options. Nonemployee directors continue to receive awards of nonqualified stock options and stock grants.
 
Stock options are awards that allow the recipient to purchase shares of the company’s stock at a fixed price. Stock options are granted at an exercise price equal to the fair market value of the company's stock price on the grant date. Substantially all of the awards vest annually in equal amounts over periods of three years to four years. These options generally expire no later than ten years after the date of the grant. Restricted stock awards are stock awards that are subject to specified restrictions and a risk of forfeiture. The restrictions typically lapse three years from the grant date. The fair value of a restricted stock award is determined and fixed based on the company’s stock price on the grant date. The company recognizes compensation expense for stock options and restricted stock on a straight-line basis over the requisite service period.

STOCK OPTION ACTIVITY
 
(Shares and intrinsic value in thousands)
 
Number of Shares
 
 Weighted Average
Exercise Price
 
Weighted Average Remaining Contractual Life (Years)
 
 Aggregate Intrinsic Value
 
Outstanding as of March 1, 2006
   
8,769
     
$
20.55
                     
Options granted
   
953
     
$
34.28
                     
Options exercised
   
(1,847
)  
$
15.73
                     
Options expired or terminated
   
(163
)
 
 
$
26.39
                     
Outstanding as of November 30, 2006
   
7,712
     
$
23.28
      6.1      
$
174,806
   
Exercisable as of November 30, 2006
   
3,940
     
$
18.97
      4.8      
$
106,283
   
 
The total cash received from employees as a result of employee stock option exercises was $41.8 million in the first nine months of fiscal 2007 and $8.9 million in the first nine months of fiscal 2006. The company settles employee stock option exercises with authorized but unissued shares of CarMax common stock. The total intrinsic value of options exercised was $39.3 million for the first nine months of fiscal 2007 and $10.7 million for the first nine months of fiscal 2006. The related tax benefits realized by the company were $15.2 million for the nine-month period ended November 30, 2006, and $4.2 million for the nine-month period ended November 30, 2005.
 
OUTSTANDING STOCK OPTIONS
 
As of November 30, 2006
 
Options Outstanding
 
Options Exercisable
 
(Shares in thousands)
Range of Exercise Prices
 
Number of Shares
 
Weighted Average Remaining Contractual Life (Years)
 
Weighted Average
Exercise Price
 
Number of Shares
 
 Weighted Average
Exercise Price
 
$1.63 to $3.31
   
259
     
0.3
   
$
1.95
     
259
     
$
1.95
   
$4.89
   
630
     
1.3
   
$
4.89
     
630
     
$
4.89
   
$13.25 to $18.60
   
1,419
     
6.3
   
$
14.32
     
1,022
     
$
14.33
   
$20.00 to $26.83
   
2,732
     
6.9
   
$
26.42
     
1,128
     
$
26.54
   
$28.26 to $31.43
   
1,712
     
7.3
   
$
29.43
     
885
     
$
29.26
   
$32.67 to $44.57
   
960
     
6.4
   
$
34.40      
16
     
$
41.84
   
Total
   
7,712
      6.1    
$
23.28
     
3,940
     
$
18.97
   

For all stock options granted prior to March 1, 2006, the fair value was estimated as of the date of grant using a Black-Scholes option-pricing model. For stock options granted to employees on or after March 1, 2006, the fair value of each award is estimated as of the date of grant using a binomial valuation model. In computing the value of the option, the binomial model considers characteristics of fair value option pricing that are not available for consideration under the Black-Scholes model. Similar to the Black-Scholes model, the binomial model takes into account variables such as expected volatility, dividend yield, and risk-free interest rate. However, in addition, the binomial model considers the contractual term of the option, the probability that the option will be exercised prior to the end of its contractual life, and the probability of termination or retirement of the option holder. For these reasons, the company believes that the binomial model provides a fair value that is more representative of actual experience and future expected experience than the value calculated using the Black-Scholes model. For grants to nonemployee directors, the company will continue to use the Black-Scholes model to estimate the fair value of stock option awards due to the comparatively small population of recipients of these awards. Estimates of fair value are not intended to predict actual future events or the value ultimately realized by the recipients of share-based awards.

For the nine months ended November 30, 2006, the company granted nonqualified options to purchase  918,600 shares of common stock to its employees and nonqualified options to purchase  34,020 shares of common stock to its nonemployee directors. There were nonqualified options to purchase  2,428,566 shares of common stock granted during the nine months ended November 30, 2005. The weighted average fair values at the date of grant for options granted during the nine month periods ended November 30, 2006, and November 30, 2005, were $14.16 and $12.18 per share, respectively. The unrecognized compensation costs related to all nonvested options totaled $35.6 million at November 30, 2006.  These costs are expected to be recognized over a weighted average period of 2.2 years.
 
Page 11 of 30

 
ASSUMPTIONS USED TO ESTIMATE OPTION VALUES
 
 
Nine Months Ended
November 30, 2006
 Nine Months Ended
 November 30, 2005
Dividend yield
0.0%
 0.0%
Expected volatility factor(1)
29.8%-63.4%
 51.3%
Weighted average expected volatility
47.4%
51.3%
Risk-free interest rate(2)
4.5%-5.1%
 3.7%
Expected term (in years)(3)
4.5-4.6
 4.5
 
 
(1)
Measured using historical daily price changes of the company’s stock over the respective term of the option.
 
(2)
The risk-free interest rate for periods within the contractual term of the share option is based on the U.S. Treasury yield curve in effect at the time of grant.
 
(3)
The expected term is the number of years that the company estimates, based primarily on historical experience, that options will be outstanding prior to exercise.

RESTRICTED STOCK ACTIVITY
 
(In thousands)
 
Number of Shares  
 
 Weighted Average Grant Date Fair Value 
Outstanding as of March 1, 2006
   
     
$
   
Restricted stock granted
   
492
     
$
34.40
   
Restricted stock vested or cancelled
   
(23
)      
$
34.39
   
Outstanding as of November 30, 2006
   
469
     
$
34.40
   

The unrecognized compensation costs related to nonvested restricted stock awards totaled $11.7 million at November 30, 2006. These costs are expected to be recognized over a weighted average period of 2.4 years.
 
8.
Net Earnings per Share

BASIC AND DILUTIVE NET EARNINGS PER SHARE RECONCILIATIONS
 
 
 
Three Months Ended 
November 30
 
Nine Months Ended 
November 30
 
(In thousands except per share data)
 
2006
 
2005
 
2006
 
2005
 
 
 
 
 
Restated
 
 
 
Restated
 
Net earnings available to common shareholders
  45,419  
$
22,931
 
 $
156,459  
$
97,547
 
 
                 
Weighted average common shares outstanding
    106,511    
104,727
    105,895    
104,547
 
Dilutive potential common shares:
                 
Stock options
    2,246    
1,772
    1,910    
1,782
 
Restricted stock
    126    
8
    56    
14
 
Weighted average common shares and dilutive potential common shares
    108,883    
106,507
    107,861    
106,343
 
                           
Basic net earnings per share
   0.43  
$
0.22
 
 $
1.48  
$
0.93
 
Diluted net earnings per share
  0.42  
$
0.22
 
 $
1.45  
$
0.92
 
 
Certain options were determined to be anti-dilutive and were excluded from the calculation of diluted  earnings  per share. As of November 30, 2006, options to purchase 796,584 shares of common stock with exercise prices ranging from $29.61 to $44.57 per share were outstanding and not included in the calculation. As of November 30, 2005, options to purchase 4,326,697 shares with exercise prices ranging from $14.21 to $43.44 per share were outstanding and not included in the calculation.
 
Page 12 of 30

 
9.
Long-Term Debt

As of November 30, 2006, $86.4 million was outstanding under the company’s revolving credit facility, with the remainder fully available to the company. The outstanding balance included $3.0 million of swing line loans classified as short-term debt and $83.4 million classified as current portion of long-term debt. The outstanding balance has been classified as current at November 30, 2006, as management expects the outstanding balance to fluctuate and to be fully paid off at times during the next 12 months. 

The company's revolving credit facility was amended in December 2006. The term of the agreement was extended from August 2009 to December 2011 and aggregate borrowings available under the agreement were increased from $450 million to $500 million.
 
As of November 30, 2006, obligations under capital leases consisted of $34.0 million classified as long-term debt and $1.0 million classified as current portion of long-term debt.
 
10.
Contingencies
 
On August 29, 2006, Heather Herron, et al. filed a putative class action lawsuit against 51 South Carolina automobile dealers, including CarMax Auto Superstores, Inc., in the Court of Common Pleas in Aiken County, South Carolina. As of November 30, 2006, there were over 300 automobile dealers named as defendants in the lawsuit.  The company operated two of its 73 used car superstores in the state of South Carolina. The plaintiffs allege that the defendants are violating South Carolina’s Regulation of Manufacturers, Distributors and Dealers Act by (a) presenting their respective processing fees in a manner that gives consumers the impression that charging the processing fees is required by law and (b) excluding their respective processing fees from the advertised prices of their vehicles. The plaintiffs seek compensatory damages equal to two times actual damages and punitive damages equal to three times actual damages. The complaint, however, does not specify a dollar amount of damages. The plaintiffs alternatively seek equitable relief in the form of a permanent injunction to prevent the defendants from deceptively charging future consumers such processing fees and the disgorgement of all such processing fees collected since August 29, 2002. The plaintiffs also seek to recover their attorneys’ fees.
 
At this time, the lawsuit is in its initial stages and the company is evaluating the allegations and intends to defend itself vigorously.  The company is unable to make an estimate of the amount or range of loss that could result from an unfavorable outcome.
 
11.
Recent Accounting Pronouncements
 
In July 2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation ("FIN") 48, "Accounting for Uncertainty in Income Taxes," which establishes a consistent framework to use to determine the appropriate level of tax reserves to maintain for "uncertain tax positions." This interpretation of SFAS No. 109, "Accounting for Income Taxes," uses a two-step approach wherein a tax benefit is recognized if a position is more likely than not to be sustained. The amount of the benefit is then measured as the highest tax benefit that is greater than fifty percent likely to be realized. FIN 48 also establishes new disclosure requirements related to an entity's tax reserves. The company will be required to adopt FIN 48 as of March 1, 2007. The company is currently evaluating the impact of adopting FIN 48 on its financial position, results of operations, and cash flows.

In September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. The statement does not require new fair value measurements, but is applied to the extent that other accounting pronouncements require or permit fair value measurements. The statement emphasizes that fair value is a market-based measurement that should be determined based on the assumptions that market participants would use in pricing an asset or liability. Companies will be required to disclose the extent to which fair value is used to measure assets and liabilities, the inputs used to develop the measurements, and the effect of certain of the measurements on earnings (or changes in net assets) for the period. CarMax will be required to adopt SFAS No. 157 as of March 1, 2008. The company is currently evaluating the impact of adopting SFAS No. 157 on its financial position, results of operations, and cash flows.
 
In September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R)."  This statement requires the company to fully recognize the over-funded or under-funded status of its postretirement benefit plans as an asset or liability in its financial statements. In addition, the statement eliminates the use of a measurement date that is different than the date of the company's year-end financial statements.  The standard is effective for CarMax's current fiscal year ending February 28, 2007. The company is currently evaluating the impact of adopting SFAS No. 158 on its financial position, results of operations, and cash flows.
 
In September 2006, the SEC staff published Staff Accounting Bulletin (SAB) No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements."  The bulletin addresses quantifying the financial statement effects of misstatements, specifically, how the effects of prior year uncorrected errors must be considered in quantifying misstatements in the current year financial statements.  The bulletin offers a special "one-time" transition provision for correcting certain prior year misstatements that were uncorrected as of the beginning of the fiscal year of adooption.  SAB No. 108 is effective for CarMax's current fiscal year ending February 28, 2007.  The adoption of this statement is not expected to have a material impact on the company's financial position, results of operations, and cash flows.
Page 13 of 30


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 intended to help the reader understand the financial performance of CarMax, Inc. 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, 2006, as well as our consolidated financial statements and the accompanying notes included in this Form 10-Q.
 
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.

The company adopted Statement of Financial Accounting Standards No. 123 (Revised 2004), “Share-Based Payment” (“SFAS 123(R)”), effective March 1, 2006, applying the modified retrospective method. As a result, prior period amounts have been restated to reflect the adoption of this standard. The impact of the adoption of SFAS 123(R) on net income for the third quarter and first nine months of fiscal 2006 is consistent with the pro forma amounts previously disclosed in the company’s quarterly reports.

BUSINESS OVERVIEW
 
General

CarMax is the nation’s largest retailer of used vehicles. As of November 30, 2006, we operated 73 used car superstores in 34 markets, including 26 mid-sized markets and 8 large markets. We define mid-sized markets as those with television viewing populations generally between 600,000 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, 2006, we sold 323,570 used cars, representing 94% of the total 342,482 vehicles we sold at retail.

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, www.carmax.com, is a valuable tool for communicating the CarMax consumer offer, a sophisticated search engine, and an efficient sales channel for customers who prefer to complete part of the shopping and sales process online. 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 is 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 prime-rated financing to qualified customers through CarMax Auto Finance (“CAF”), the company’s finance operation, and Bank of America. Nonprime financing is provided through several third-party lenders. Subprime financing, also provided by a third-party lender, is available in CarMax stores in several states. We periodically test additional third-party lenders. We collect fixed, prenegotiated fees from the third parties that finance prime- and nonprime-rated customers. As is customary in the subprime finance industry, the subprime lender purchases the loans at a discount. CarMax has no recourse liability for loans provided by third-party lenders.

We sell extended service plans on behalf of unrelated third parties who are the primary obligors. We have no contractual liability to the customer under these third-party service plans. Extended service plan revenue represents commissions from the unrelated third parties.

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. In fiscal 2007, we plan to open ten superstores, representing an approximate 15% increase in our store base. The fiscal 2007 store openings are primarily comprised of standard superstores in new mid-sized markets and satellite fill-in superstores in established markets. In the fiscal year ending February 28, 2008, we currently expect to open 13 used car superstores, expanding our superstore base by approximately 17%.  For the foreseeable future, we expect used unit comparable store sales increases to average in the range of 4% to 8% per year, 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, which generally occurs in a store’s fifth year of operation, and underlying industry sales growth.

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.

Page 14 of 30


 
Fiscal 2007 Third Quarter Highlights

 
§
Net sales and operating revenues increased 24% to $1.77 billion from $1.42 billion in the third quarter of fiscal 2006, while net earnings increased 98% to $45.4 million, or $0.42 per share, from $22.9 million, or $0.22 per share.
 
§
Total used vehicle unit sales increased 18%, reflecting the combination of a 13% increase in comparable store used unit sales and the growth in our store base.
 
§
Two used car superstores were opened late in the third quarter.
 
§
Our total gross profit per unit increased to $2,736 from $2,483 in the prior year's third quarter. We realized improvements in gross profit per unit in all major categories, including used vehicles, new vehicles, wholesale vehicles, and other. We believe used vehicle gross profit benefited from our strong, consistent sales performance, which resulted in fewer pricing markdowns being made, as well as a more stable underlying environment.
 
§
CAF income increased 14% to $32.0 million from $28.0 million in the third quarter of fiscal 2006 despite the inclusion of $6.1 million of favorable items in last year's quarter.  The improvement reflected growth in retail vehicle sales and managed receivables, an improvement in the gain on loans originated and sold, and an increase in the average amount financed.
 
§
Selling, general, and administrative expenses as a percent of net sales and operating revenues (the "SG&A ratio") decreased to 10.6% from 11.8% in the third quarter of fiscal 2006. We benefited from the leverage of fixed expenses generated by our strong comparable store sales growth.
 
§
As a result of adopting SFAS 123(R) in fiscal 2007, we recognized share-based compensation expense of $0.03 per share in both the third quarter of fiscal 2007 and the third quarter of fiscal 2006, as restated.
 
§
Net cash provided by operations for the nine months ended November 30, 2006, was $137.6 million compared with $139.1 million in the first nine months of fiscal 2006.


CRITICAL ACCOUNTING POLICIES
 
For a discussion of our critical accounting policies, see “Critical Accounting Policies” in MD&A included in the CarMax, Inc. 2006 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, 2006. These policies relate to securitization transactions, revenue recognition, income taxes, and the defined benefit retirement plan.
 
RESULTS OF OPERATIONS
 
Certain prior year amounts have been reclassified to conform to the current year’s presentation.

NET SALES AND OPERATING REVENUES
 
 
 
Three Months Ended November 30
 
Nine Months Ended November 30
 
(In millions)
 
2006
 
 %
 
2005
 
 
2006
 
 
2005
 
 %
 
Used vehicle sales
 
 $
1,377.6
 
 
77.9
 
$
1,087.1
   
76.3
   $ 4,365.4  
 
78.2
 
$
3,527.4
   
76.1
 
New vehicle sales
   
109.9
   
6.2
   
113.3
   
8.0
   
349.6
   
6.3
   
399.3
   
8.6
 
Wholesale vehicle sales
   
226.4
   
12.8
   
174.2
   
12.2
   
696.0
   
12.5
   
554.5
   
12.0
 
Other sales and revenues:
   
   
   
   
   
 
   
   
   
 
Extended service plan revenues
   
27.1
   
1.5
   
22.6
   
1.6
   
85.1
   
1.5
   
72.7
   
1.6
  
Service department sales
   
21.6
   
1.2
   
23.0
   
1.6
   
68.6
   
1.2
   
70.4
   
1.5
 
Third-party finance fees, net
   
5.6
   
0.3
   
3.8
   
0.3
   
18.2
   
0.3
   
11.8
   
0.3
 
Total other sales and revenues
   
54.3
   
3.1
   
49.3
   
3.5
   
171.9
   
3.1
   
155.0
   
3.3
 
Total net sales and operating revenues
 
$
 1,768.1      100.0  
$
1,424.0
   
100.0
   $  5,582.8      100.0  
$
4,636.2
   
100.0
 

RETAIL VEHICLE SALES CHANGES
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
 November 30
 
 November 30
 
 
 
2006
 
2005
 
2006
 
2005
 
Vehicle units:
 
 
 
 
 
 
 
 
 
 
Used vehicles
 
 
18
 %
 
13
 %
  16  %  
18
%
New vehicles
    (3 )%  
(2
)%
  (12 )%  
1
%
Total
    17  %  
12
 %
   14  %  
17
%
 
                 
Vehicle dollars:
                 
Used vehicles
     27  %  
17
 %
   24  %  
22
%
New vehicles
     (3 )%  
(1
)%
  (12 )%  
3
%
Total
     24  %  
15
 %
   20  %  
19
%
        

Page 15 of 30

 
COMPARABLE STORE RETAIL VEHICLE SALES CHANGES
 
Comparable store used unit sales growth is one of the key drivers of our profitability. A CarMax store is included in comparable store sales beginning in the store’s fourteenth full month of operation.

 
 
Three Months Ended
 
Nine Months Ended
 
 
 
 November 30
 
 November 30
 
 
 
2006
 
2005
 
2006
 
2005
 
Vehicle units:
 
 
 
 
 
 
 
 
 
 
Used vehicles
 
 
13
 %
 
3
 %
  8  %  
7
%
New vehicles
    (3 )%  
(6
)%
  (12 )%  
2
%
Total
     12  %  
3
 %
   7  %  
6
%
 
                 
Vehicle dollars:
                 
Used vehicles
     21  %  
7
 %
   16  %  
10
%
New vehicles
    (3 )%  
(5
)%
  (13 )%  
3
%
Total
     19  %  
6
 %
   13  %  
9
%
 
 
Used Vehicle Sales.  The 27% increase in used vehicle dollar sales in the third quarter of fiscal 2007 resulted from an 18% increase in unit sales and a 7% increase in average retail selling price. The unit sales growth reflected the combination of a 13% increase in comparable store used unit sales, together with sales from newer superstores not yet in the comparable store base. Our comparable store used unit growth benefited from strong store and Internet traffic and continued strong execution by our store teams. We believe many factors contributed to the strong customer traffic, including among others, our increased Internet visibility resulting from recent improvements to our www.carmax.com website and the expansion of our Internet classified advertising. The increase in average retail selling price was primarily the result of a shift in vehicle mix, as we continued to experience a resurgence in the sales of SUVs and trucks, which we believe were adversely affected in the prior year by consumer reaction to higher gas prices. Sales of luxury vehicles also continued to comprise an increased percentage of our sales.
 
As anticipated, the curtailment of subprime sales in CarMax stores located in certain states beginning in the second half of fiscal 2006 had a slightly adverse effect on third quarter used unit sales compared with the prior year's quarter. This adverse effect was largely offset by incremental sales financed by two new third-party nonprime finance providers added in the second half of fiscal 2006.
 
The 24% increase in used vehicle dollar sales in the first nine months of fiscal 2007 resulted from a 16% increase in unit sales and a 7% increase in average retail selling price. The unit sales growth reflected an 8% increase in comparable store used unit sales, together with sales from newer superstores not yet in the comparable store base. Our comparable store used unit growth benefited from strong store and Internet traffic and continued strong execution by our store teams. Similar to our experience in the third quarter, the increase in average retail selling price for the nine-month period reflected a return to a more normalized mix of SUV and truck sales compared with the prior year when sales of these types of vehicles were adversely affected by rising gasoline prices. The increase in average retail selling price also reflected the growing percentage of luxury vehicles in our sales mix.
 
New Vehicle Sales.  Compared with the corresponding prior year periods, new vehicle dollar sales declined by 3% in the third quarter of fiscal 2007 and 12% in the first nine months of fiscal 2007. The declines were substantially the result of decreases in unit sales, and in part they reflect our strategic decision in fiscal 2007 to increase targeted gross profit dollars per unit on new vehicles. We had anticipated that this decision would result in some reduction in new vehicle unit sales. The decline in unit sales in the first nine months of fiscal 2007 also reflected the challenging comparison with the prior year period, which benefited from unusually large new car sales generated by the domestic new car manufacturers’ employee pricing programs in the summer of fiscal 2006.

Wholesale Vehicle Sales. The 30% increase in wholesale vehicle dollar sales in the third quarter of fiscal 2007 was principally the result of an increase in wholesale unit sales. Our wholesale unit sales benefited from a substantial increase in appraisal traffic, in part spurred by our strong increase in third quarter used vehicle sales, together with the growth in our store base. Vehicles acquired through the appraisal process that do not meet our retail standards are sold at our on-site wholesale auctions.

The 26% increase in wholesale vehicle dollar sales in the first nine months of fiscal 2007 reflected a 20% increase in wholesale unit sales and a 4% increase in average wholesale selling price. Similar to the third quarter, wholesale sales for the first nine months of the year benefited from increases in our appraisal traffic and from the expansion in our store base.

Other Sales and Revenues. Other sales and revenues include commissions on the sale of extended service plans, service department sales, and third-party finance fees. Compared with the corresponding prior year periods, other sales and revenues increased 10% in the third quarter of fiscal 2007 and 11% in the first nine months of fiscal 2007. The increases were primarily the result of increased sales of extended service plans and an increase in third-party finance fees. Extended service plan sales benefited from the growth in used unit sales, and third-party finance fees benefited from the decline in subprime-financed sales. We record the discount at which the subprime lender purchases these sales as an offset to third-party finance fee revenues.
 
Page 16 of 30

 
Impact of Inflation. Inflation has not been a significant contributor to results. Profitability is based on achieving targeted unit sales and gross profit dollars per vehicle rather than on average retail prices.

Seasonality. Most of our superstores experience their strongest traffic and sales in the spring and summer fiscal quarters. Sales are typically lowest in the fall quarter, which coincides with the new vehicle model-year-changeover period. In the fall quarter, 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 CarMax expands geographically, these differences could have an effect on the overall seasonal pattern of the company’s results.

Supplemental Sales Information.

UNIT SALES
 
 
 
Three Months Ended
 
Nine Months Ended
 
   
November 30 
 
November 30 
 
 
 
2006
 
2005
 
2006
 
2005
 
Used vehicles
 
 
79,009
 
 
66,680
    250,121      216,439  
New vehicles
     4,532    
4,675
    14,610       16,599  
Wholesale vehicles
     51,833     40,228     158,267      132,357  
 
AVERAGE SELLING PRICES
 
 
 
Three Months Ended
 
Nine Months Ended
 
   
 November 30
 
 November 30
 
 
 
2006
 
2005
 
2006
 
2005
 
Used vehicles
 
$
17,247
 
 $
16,147  
 $
17,273   
 $
 16,157  
New vehicles
 
$
24,118
 
 $
24,081  
 $
23,779   
 $
 23,896  
Wholesale vehicles
 
$
4,258
 
 $
4,247  
 $
4,288   
 $
4,105  
 
RETAIL VEHICLE SALES MIX
 
 
 
Three Months Ended
 
Nine Months Ended
 
 
 
November 30 
 
November 30 
 
 
 
2006
 
2005
 
2006
 
2005
 
Vehicle units:
 
 
 
 
 
 
 
 
 
 
Used vehicles
 
 
95
%
 
93
%
  94 %    93 %
New vehicles
    5    
7
 
  6      7  
Total
   
100
%
 
100
%
 
100
%
 
100
%
 
                   
Vehicle dollars:
                   
Used vehicles
    93 %  
91
%
  93 %  
 90
%
New vehicles
    7    
9
%
  7      10  
Total
   
100
%
 
100
%
 
100
%
 
100
%

Retail Stores. We opened two superstores late in the third quarter of fiscal 2007, including a satellite superstore in the Los Angeles market, and a standard superstore in Fredericksburg, Va., which is part of the Washington, D.C., market. In the first half of the year, we entered the Hartford, Conn., market with a standard superstore; the Columbus, Ohio, market with a standard and a satellite superstore; and the Oklahoma City, Okla., market with a standard superstore. The opening in Hartford represented our first superstore in the Northeast. We plan to open four additional superstores in the fourth quarter, including our first small market format store in Charlottesville, Va., which opened in December, bringing total superstore openings in fiscal 2007 to ten.
 
Late in the first quarter of fiscal 2007, we opened our first CarMax Car Buying Center, which focuses on appraisals and vehicle purchases. This test site in the Atlanta market is part of a long-term effort to increase appraisal traffic and retail vehicle sourcing self-sufficiency.
 
 
Page 17 of 30

 
RETAIL STORES
 
   
  Estimate
February 28, 2007
 
November 30, 2006
 
February 28, 2006
 
November 30, 2005
 
February 28, 2005
 Mega superstores(1)
 
 
 13
   
13
   
13