tenq.htm
 



 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549

FORM 10-Q

[ X ]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended August 31, 2007

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)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
Yes  X
No           

 Indicate by check mark whether the registrant is 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 _
Non-accelerated filer _

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes           
No  X
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class
 
Outstanding at September 30, 2007
Common Stock, par value $0.50
 
217,942,376
     
A Table of Contents is included on Page 2 and a separate Exhibit Index is included on Page 35.



CARMAX, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

 
Page
No.
PART I.
FINANCIAL INFORMATION
 
       
 
Item 1.    Financial Statements:
 
   
Consolidated Statements of Earnings -
Three Months and Six Months Ended August 31, 2007 and 2006
 
3
   
Consolidated Balance Sheets -
August 31, 2007, and February 28, 2007
 
4
 
 
Consolidated Statements of Cash Flows -
Six Months Ended August 31, 2007 and 2006
 
5
 
 
Notes to Consolidated Financial Statements
6
       
 
Item 2.    Management's Discussion and Analysis of Financial Condition and
Results of Operations
 
17
     
 
Item 3.    Quantitative and Qualitative Disclosures About Market Risk
30
     
 
Item 4.    Controls and Procedures
31
     
PART II.
OTHER INFORMATION
 
     
 
Item 1.    Legal Proceedings
32
     
 
Item 1A.  Risk Factors
32
     
 
Item 4.    Submission of Matters to a Vote of Security Holders
32
     
 
Item 6.    Exhibits
33
     
     
SIGNATURES                                                                                                                                     
34
     
EXHIBIT INDEX                                                                                                                                     
35
   


 


Page 2 of 35



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 August 31
   
Six Months Ended August 31
 
   
2007
      % (1)  
2006(2)
      % (1)  
2007
      % (1)  
2006(2)
      % (1)
Sales and operating revenues:
                                                       
Used vehicle sales    
  $
1,687,142
     
79.5
    $
1,526,738
     
79.1
    $
3,395,533
     
79.5
    $
2,987,858
     
78.3
 
New vehicle sales       
   
104,779
     
4.9
     
121,231
     
6.3
     
217,394
     
5.1
     
239,639
     
6.3
 
Wholesale vehicle sales       
   
265,282
     
12.5
     
222,299
     
11.5
     
526,434
     
12.3
     
469,595
     
12.3
 
Other sales and revenues       
   
65,327
     
3.1
     
59,274
     
3.1
     
130,303
     
3.1
     
117,589
     
3.1
 
Net sales and operating revenues
   
2,122,530
     
100.0
     
1,929,542
     
100.0
     
4,269,664
     
100.0
     
3,814,681
     
100.0
 
Cost of sales     
   
1,834,336
     
86.4
     
1,676,177
     
86.9
     
3,697,249
     
86.6
     
3,313,061
     
86.9
 
Gross profit    
   
288,194
     
13.6
     
253,365
     
13.1
     
572,415
     
13.4
     
501,620
     
13.1
 
CarMax Auto Finance income          
   
33,412
     
1.6
     
36,512
     
1.9
     
70,480
     
1.7
     
68,906
     
1.8
 
Selling, general, and administrative
                                                               
expenses                                                   
   
214,196
     
10.1
     
200,049
     
10.4
     
428,010
     
10.0
     
387,015
     
10.1
 
Gain on franchise disposition             
   
740
     
     
     
     
740
     
     
     
 
Interest expense             
   
950
     
     
2,335
     
0.1
     
2,966
     
0.1
     
4,282
     
0.1
 
Interest income               
   
245
     
     
300
     
     
623
     
     
567
     
 
Earnings before income taxes       
   
107,445
     
5.1
     
87,793
     
4.5
     
213,282
     
5.0
     
179,796
     
4.7
 
Provision for income taxes     
   
42,450
     
2.0
     
33,529
     
1.7
     
82,932
     
1.9
     
68,756
     
1.8
 
Net earnings                   
  $
64,995
     
3.1
    $
54,264
     
2.8
    $
130,350
     
3.1
    $
111,040
     
2.9
 
                                                                 
Weighted average common shares:
                                                               
Basic                                                   
   
215,891
             
211,831
             
215,592
             
211,181
         
Diluted                                                   
   
220,580
             
215,301
             
220,355
             
214,706
         
                                                                 
Net earnings per share:
                                                               
Basic                                                   
  $
0.30
            $
0.26
            $
0.60
            $
0.53
         
Diluted                                                   
  $
0.29
            $
0.25
            $
0.59
            $
0.52
         
                                                                 
                                                                 

(1) Percents are calculated as a percentage of net sales and operating revenues and may not equal totals due to rounding.
(2) Share and per share amounts have been adjusted for the effect of our 2-for-1 stock split in March 2007.

See accompanying notes to consolidated financial statements.


Page 3 of 35



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

 
August 31, 2007
 
February 28, 2007
 
 
(Unaudited)
     
ASSETS
       
Current assets:
       
Cash and cash equivalents
$
7,589
 
$
19,455
 
Accounts receivable, net
 
56,165
   
71,413
 
Automobile loan receivables held for sale
 
4,464
   
6,162
 
Retained interest in securitized receivables
 
224,334
   
202,302
 
Inventory
 
820,171
   
836,116
 
Prepaid expenses and other current assets
 
19,993
   
15,068
 
             
Total current assets
 
1,132,716
   
1,150,516
 
             
Property and equipment, net
 
755,276
   
651,850
 
Deferred income taxes
 
42,467
   
40,174
 
Other assets
 
47,331
   
43,033
 
             
TOTAL ASSETS
$
1,977,790
 
$
1,885,573
 
             
LIABILITIES AND SHAREHOLDERS’ EQUITY
           
Current liabilities:
           
Accounts payable
$
248,762
 
$
254,895
 
Accrued expenses and other current liabilities
 
63,028
   
68,885
 
Accrued income taxes
 
8,207
   
23,377
 
Deferred income taxes
 
14,680
   
13,132
 
Short-term debt
 
2,672
   
3,290
 
Current portion of long-term debt
 
86,265
   
148,443
 
               
Total current liabilities
 
423,614
   
512,022
 
               
Long-term debt, excluding current portion
 
27,361
   
33,744
 
Deferred revenue and other liabilities
 
115,982
   
92,432
 
               
TOTAL LIABILITIES
 
566,957
   
638,198
 
               
Commitments and contingent liabilities
           
               
Shareholders’ equity:
           
Common stock, $0.50 par value; 350,000,000 shares authorized; 217,879,914 and 216,028,166 shares issued and outstanding at August 31, 2007, and February 28, 2007, respectively
 
108,940
   
108,014
 
Capital in excess of par value
 
617,902
   
587,546
 
Accumulated other comprehensive loss
  (19,303   (20,332 )
Retained earnings
 
703,294
   
572,147
 
               
TOTAL SHAREHOLDERS’ EQUITY
 
1,410,833
   
1,247,375
 
               
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
1,977,790
 
$
1,885,573
 
               
               
See accompanying notes to consolidated financial statements.

Page 4 of 35



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

   
Six Months Ended August 31
 
   
2007
   
2006
 
                 
Operating Activities:
               
Net earnings
 
$
130,350
   
$
111,040
 
Adjustments to reconcile net earnings to net
               
cash provided by operating activities:
               
Depreciation and amortization
   
22,026
     
16,727
 
Share-based compensation expense
   
17,744
     
19,636
 
(Gain) loss on disposition of assets
    (28 )    
86
 
Deferred income tax benefit
    (1,324 )     (18,937 )
Net decrease (increase) in:
               
Accounts receivable, net
   
15,248
     
9,931
 
Automobile loan receivables held for sale, net
   
1,698
     
120
 
Retained interest in securitized receivables
    (22,032 )     (31,512 )
Inventory
   
15,945
      (64,664 )
Prepaid expenses and other current assets
    (4,925 )     (860 )
Other assets
    (4,298 )    
144
 
Net increase (decrease) in:
               
Accounts payable, accrued expenses and
               
other current liabilities, and accrued income taxes
    (26,695 )    
37,442
 
Deferred revenue and other liabilities
   
24,316
     
7,598
 
Net cash provided by operating activities
   
168,025
     
86,751
 
                   
Investing Activities:
               
Capital expenditures
    (132,092 )     (54,317 )
Proceeds from sales of assets
   
1,272
     
3,467
 
Sales of money market securities
   
4,000
     
20,975
 
Purchases of investment securities available-for-sale
    (4,000 )     (20,975 )
Net cash used in investing activities
    (130,820 )     (50,850 )
                   
Financing Activities:
               
(Decrease) increase in short-term debt, net
    (618 )    
1,452
 
Payments on long-term debt
    (62,007 )     (56,871 )
Equity issuances, net
   
9,947
     
13,928
 
Excess tax benefits from share-based payment arrangements
   
3,607
     
7,612
 
Net cash used in financing activities
    (49,071 )     (33,879 )
                   
(Decrease) increase in cash and cash equivalents
    (11,866 )    
2,022
 
Cash and cash equivalents at beginning of year
   
19,455
     
21,759
 
Cash and cash equivalents at end of period
 
$
7,589
   
$
23,781
 


See accompanying notes to consolidated financial statements.


Page 5 of 35


CARMAX, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(Unaudited)
1.  
Background
 
CarMax, Inc. (“we”, “our”, “us”, “CarMax”, and “the company”), including its wholly owned subsidiaries, is the largest retailer of used vehicles in the United States. We were 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. We also sell new vehicles under various franchise agreements.  We provide our customers with a full range of related services, including the financing of vehicle purchases through our 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 our appraisal process that do not meet our 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 our 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 changes in certain retirement plan liabilities, which have been reclassified on our consolidated statements of cash flows from accounts payable, accrued expenses and other current liabilities, and accrued income taxes to deferred revenue and other liabilities.

These consolidated financial statements have been prepared in conformity 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 our Annual Report on Form 10-K  for the fiscal year ended February 28, 2007.

On February 22, 2007, the board of directors declared a 2-for-1 stock split in the form of a common stock dividend for shareholders of record on March 19, 2007, which was distributed on March 26, 2007.  All share and per share amounts included in the consolidated financial statements and accompanying notes have been adjusted to reflect this stock split.

Cash and Cash Equivalents. Cash equivalents of $1.4 million at August 31, 2007, and $1.5 million at February 28, 2007, consisted of highly liquid investments with original maturities of three months or less.
 
3.  
CarMax Auto Finance Income  
 
Our finance operation, CAF, provides financing for qualified customers at competitive market rates of interest. Throughout each month, we sell 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 losses.


Page 6 of 35


 
 
 
 
Three Months Ended
August 31
   
Six Months Ended
August 31
 
(In millions)
   
2007
   
2006
   
2007
   
2006
 
Total gain income
   
$
25.0
   
$
28.9
   
$
52.8
   
$
53.7
 
Other CAF income:
                                 
Servicing fee income
     
9.2
     
7.9
     
18.1
     
15.3
 
Interest income
     
7.8
     
6.3
     
15.6
     
12.4
 
Total other CAF income
     
17.0
     
14.2
     
33.7
     
27.7
 
                                     
Direct CAF expenses:
                                 
CAF payroll and fringe benefit expense
     
3.8
     
2.9
     
7.4
     
5.7
 
Other direct CAF expenses
     
4.7
     
3.7
     
8.5
     
6.8
 
Total direct CAF expenses
     
8.5
     
6.6
 
   
16.0
     
12.5
 
CarMax Auto Finance income
   
$
33.4
   
$
36.5
   
$
70.5
   
$
68.9
 

CAF income does not include any allocation of indirect costs or income. We present 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.

4.  
Securitizations
 
We use a securitization program to fund substantially all of the automobile loan receivables originated by CAF. We sell 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 our assets. Our risk is limited to the retained interest on our 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.

We routinely use 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 our results.  The impact of refinancing activity will depend upon the particular securitization structures and market conditions at the refinancing date.

All transfers of receivables are accounted for as sales. When the receivables are securitized, we recognize a gain or loss on the sale of the receivables as described in Note 3.


Page 7 of 35


 
     
Three Months Ended
August 31
   
Six Months Ended
August 31
 
(In millions)
   
2007
   
2006
   
2007
   
2006
 
Net loans originated
   
$
620.9
   
$
582.0
   
$
1,263.2
   
$
1,148.8
 
Total loans sold
   
$
668.5
   
$
630.9
   
$
1,315.5
   
$
1,189.9
 
Total gain income (1)
   
$
25.0
   
$
28.9
   
$
52.8
   
$
53.7
 
Total gain income as a percentage of total loans sold (1)
      3.7 %     4.6 %     4.0 %     4.5 %
                                     
(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. We retain an interest in the automobile loan receivables that we securitize.  The retained interest, presented as a current asset on our 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 our assets.

The fair value of the retained interest was $224.3 million as of August 31, 2007, and $202.3 million as of February 28, 2007.  The retained interest had a weighted average life of 1.6 years as of August 31, 2007, and 1.5 years as of February 28, 2007. 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 that we expect to receive over the life of the securitized receivables. The value of these receivables is determined by estimating the future cash flows using our assumptions of key factors, such as finance charge income, loss 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. We evaluate 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. We are 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 our 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 $32.7 million as of August 31, 2007, and $31.5 million as of February 28, 2007.

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  $61.3 million as  of August 31, 2007, and  $57.0 million  as of February 28, 2007.
 
 
Page 8 of 35

 
 
Key Assumptions Used in Measuring the Retained Interest and Sensitivity Analysis. The following table shows the key economic assumptions used in measuring the fair value of the retained interest at August 31, 2007, and a sensitivity analysis showing the hypothetical effect on the retained interest if there were unfavorable variations from the assumptions used.  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.
 

(In millions)
Assumptions
Used
Impact on Fair
Value of 10%
Adverse Change
Impact on Fair
Value of 20%
Adverse Change
Prepayment rate
1.40%-1.52%
$8.7
$17.1
Cumulative loss rate
1.20%-2.70%
$6.7
$13.5
Annual discount rate
12.00%
$3.4
$6.6
 
Prepayment rate. We use 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 loss rate. The cumulative loss 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. We continue to manage the automobile loan receivables that we securitize. We receive servicing fees of approximately 1% of the outstanding principal balance of the securitized receivables. We believe that the servicing fees specified in the securitization agreements adequately compensate us for servicing the securitized receivables. No servicing asset or liability has been recorded. We are 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 August 31
   
As of February 28
 
(In millions)
   
2007
   
2006
   
2007
   
2006
 
Accounts 31+ days past due
   
$
75.7
   
$
54.2
   
$
56.9
   
$
37.4
 
Ending managed receivables
   
$
3,596.0
   
$
3,068.7
   
$
3,311.0
   
$
2,772.5
 
Past due accounts as a percentage of ending managed receivables
      2.10 %     1.77 %     1.72 %     1.35 %
 
CREDIT LOSS INFORMATION
     
Three Months Ended
August 31
   
Six Months Ended
August 31
 
(In millions)
   
2007
   
2006
   
2007
   
2006
 
Net credit losses on managed receivables
   
$
9.2
   
$
4.2
   
$
14.7
   
$
7.0
 
Average managed receivables
   
$
3,550.6
   
$
3,010.5
   
$
3,481.0
   
$
2,935.6
 
Annualized net credit losses as a percentage of average managed receivables
      1.04 %     0.56 %     0.85 %     0.48 %
Recovery rate
      51.4 %     49.5 %     52.1 %     51.5 %
 
 
Page 9 of 35

 
SELECTED CASH FLOWS FROM SECURITIZED RECEIVABLES
     
Three Months Ended
August 31
   
Six Months Ended
August 31
 
(In millions)
   
2007
   
2006
   
2007
   
2006
 
Proceeds from new securitizations
   
$
542.5
   
$
491.0
   
$
1,031.5
   
$
941.0
 
Proceeds from collections reinvested in revolving period securitizations
   
$
289.5
   
$
264.6
   
$
593.1
   
$
512.5
 
Servicing fees received
   
$
9.1
   
$
7.7
   
$
17.8
   
$
15.0
 
Other cash flows received from the retained interest:
                                 
Interest-only strip receivables
   
$
25.7
   
$
24.8
   
$
47.5
   
$
43.8
 
Reserve account releases
   
$
5.5
   
$
8.2
   
$
5.8
   
$
8.5
 

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 $50.7 million in the second quarter and first half of fiscal 2008 and $41.0 million in the second quarter and first half of fiscal 2007.  Proceeds received when we refinance receivables in public securitizations are excluded from this table as they are not considered new securitizations.

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 CarMax to service the securitized receivables.

Other cash flows received from the retained interest. Other cash flows received from the retained interest represent cash that we receive from securitized receivables other than servicing fees. It includes cash collected on interest-only strip receivables and amounts released to us from reserve accounts.
 
Financial Covenants and Performance Triggers.  Certain of the securitization agreements include various financial covenants and performance triggers.  These agreements require us to meet financial covenants related to a maximum total liabilities to tangible net worth ratio and a minimum fixed charge coverage ratio.  Performance triggers require certain pools of securitized receivables to achieve specified thresholds related to portfolio yields, loss rates, and delinquency rates. If these financial covenants and/or thresholds are not met, in addition to other consequences, we may be unable to continue to securitize receivables through the warehouse facility.  At August 31, 2007, we were in compliance with the financial covenants, and the securitized receivables were in compliance with the performance triggers.
 
5.  
Financial Derivatives
 
We enter into amortizing fixed-pay interest rate swaps relating to our automobile loan receivable securitizations.  Swaps are used to better match funding costs to the fixed-rate receivables being securitized by converting variable-rate financing costs in the warehouse facility to fixed-rate obligations. During the second quarter of fiscal 2008, we entered into one 40-month amortizing interest rate swap, fourteen 41-month amortizing interest rate swaps, and one 16-month amortizing interest rate swap, with initial notional amounts totaling $557.5 million. The amortized notional amount of all outstanding swaps related to the automobile loan receivable securitizations was $869.3 million at August 31, 2007, and $597.5 million at February 28, 2007.  The fair value of swaps included in accounts  payable totaled  a net liability of $4.0 million at August 31, 2007, and $1.0 million at February 28, 2007.
 
 

 
Page 10 of 35

 
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.  We do not anticipate significant market risk from swaps as they are used to match funding costs to the use of the funding.  Credit risk is the exposure to nonperformance of another party to an agreement.  We mitigate credit risk by dealing with highly rated bank counterparties.
 
6.  
Retirement Plans

We have a noncontributory defined benefit pension plan (the “pension plan”) covering the majority of full-time employees. We also have 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.  We use a fiscal year end measurement date for both the pension plan and the restoration plan.

COMPONENTS OF NET PENSION EXPENSE
   
Three Months Ended August 31
 
   
Pension Plan
   
Restoration Plan
   
Total
 
(In thousands)
 
2007
   
2006
   
2007
   
2006
   
2007
   
2006
 
Service cost
  $
4,173
    $
3,012
    $
201
    $
70
    $
4,374
    $
3,082
 
Interest cost
   
1,639
     
1,024
     
101
     
97
     
1,740
     
1,121
 
Expected return on plan assets
    (1,108 )     (737 )    
     
      (1,108 )     (737 )
Amortization of prior service cost
   
9
     
9
     
6
     
6
     
15
     
15
 
Recognized actuarial loss
   
964
     
440
     
46
     
62
     
1,010
     
502
 
Net pension expense
  $
5,677
    $
3,748
    $
354
    $
235
    $
6,031
    $
3,983
 

   
Six Months Ended August 31
 
   
Pension Plan
   
Restoration Plan
   
Total
 
(In thousands)
 
2007
   
2006
   
2007
   
2006
   
2007
   
2006
 
Service cost                              
  $
7,836
    $
6,024
    $
294
    $
206
    $
8,130
    $
6,230
 
Interest cost                             
   
2,998
     
2,048
     
204
     
196
     
3,202
     
2,244
 
Expected return on plan assets                           
    (1,998 )     (1,474 )    
     
      (1,998 )     (1,474 )
Amortization of prior service cost
   
18
     
18
     
12
     
12
     
30
     
30
 
Recognized actuarial loss
   
1,486
     
878
     
92
     
124
     
1,578
     
1,002
 
Net pension expense
  $
10,340
    $
7,494
    $
602
    $
538
    $
10,942
    $
8,032
 

We made contributions to the pension plan totaling $2.5 million during the second quarter of fiscal 2008.  We expect to contribute approximately $11.4 million to the pension plan in fiscal 2008.
 
7.  
Share-Based Compensation

We maintain long-term incentive plans for management, key employees, and the non-employee members of our 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.  To date, we have awarded no incentive stock options.

Stock options are awards that allow the recipient to purchase shares of our stock at a fixed price. Stock options are granted at an exercise price equal to the fair market value of our stock on the grant date. Substantially all of the stock options vest annually in equal amounts over periods of three to four years, and generally expire no later than ten years after the date of the grant.  Restricted stock awards are subject to specified restrictions and a risk of forfeiture. The restrictions typically lapse three years from the grant date.

In fiscal 2006 and prior years, we 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 stock options.  Non-employee directors continue to receive awards of stock options and stock grants.
 
 
Page 11 of 35

 

COMPOSITION OF SHARE-BASED COMPENSATION EXPENSE
     
Three Months Ended
August 31
   
Six Months Ended
August 31
 
(In thousands)
   
2007
   
2006
   
2007
   
2006
 
Cost of sales
   
$
467
   
$
382
   
$
924
   
$
722
 
CarMax Auto Finance income
     
296
     
256
     
597
     
472
 
Selling, general, and administrative expenses
     
7,960
     
12,506
     
16,876
     
18,884
 
Share-based compensation expense
   
$
8,723
   
$
13,144
   
$
18,397
   
$
20,078
 
 
We measure share-based compensation cost at the grant date, based on the estimated fair value of the award and the number of awards expected to vest. We recognize compensation expense for stock options and restricted stock on a straight-line basis over the requisite service period of the entire award, which is generally the vesting period. Our employee stock purchase plan is considered a liability-classified compensatory plan, and the associated costs of $0.7 million in the first half of fiscal 2008 and $0.4 million in the first half of fiscal 2007 are included in share-based compensation expense.  There were no capitalized share-based compensation costs at August 31, 2007 or 2006.
 
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 at March 1, 2007
     
13,775
   
$
12.39
                 
Options granted
     
1,775
   
$
25.04
                 
Options exercised
      (993 )  
$
10.02
                 
Options forfeited or expired
      (166 )  
$
17.13
                 
Outstanding as of August 31, 2007
     
14,391
   
$
14.06
     
5.9
   
$
124,863
 
Exercisable as of August 31, 2007
     
8,457
   
$
11.46
     
5.3
   
$
92,751
 
 
For the six months ended August 31, 2007 and 2006, we granted to our employees nonqualified options to purchase 1,719,760 and 1,828,200 shares of common stock, respectively.  For the six months ended August 31, 2007 and 2006, we granted to our directors nonqualified options to purchase 55,493 and 68,040 shares of common stock, respectively.  The total cash received from employees as a result of employee stock option exercises, net of payroll taxes withheld, was $9.9 million in the first half of fiscal 2008 and $13.9 million in the first half of fiscal 2007. We settle employee stock option exercises with authorized but unissued shares of our common stock. The total intrinsic value of options exercised was $15.2 million for the first six months of fiscal 2008 and $25.8 million for the first six months of fiscal 2007. We realized related income tax benefits of $5.6 million in the first half of fiscal 2008 and $9.8 million in the first half of fiscal 2007.


 
Page 12 of 35

 
OUTSTANDING STOCK OPTIONS
As of August 31, 2007
 
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
 
$2.44     
473
     
0.5
   
$
2.44
     
473
   
$
2.44
 
$7.02 to $9.30    
2,447
     
5.5
   
$
7.16
     
2,447
   
$
7.16
 
$10.74 to $13.42    
4,890
     
6.2
   
$
13.21
     
2,862
   
$
13.23
 
$14.13 to $15.72    
3,017
     
6.5
   
$
14.70
     
2,214
   
$
14.67
 
$16.33 to $22.29    
1,833
     
5.7
   
$
17.14
     
458
   
$
17.12
 
$24.99 to $25.79    
1,731
     
6.6
   
$
25.04
     
3
   
$
25.67
 
Total
   
14,391
     
5.9
   
$
14.06
     
8,457
   
$
11.46
 

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, such as 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 this reason, we believe that the binomial model provides a fair value that is more representative of actual experience and future expected experience than that value calculated using the Black-Scholes model.  For grants to nonemployee directors, we 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.

The weighted average fair values at the date of grant for options granted during the six month periods ended August 31, 2007 and 2006, were $8.58 and $7.08 per share, respectively.  The unrecognized compensation costs related to nonvested options totaled $32.9 million at August 31, 2007.  These costs are expected to be recognized over a weighted average period of 2.2 years.
 
ASSUMPTIONS USED TO ESTIMATE OPTION VALUES
 
Six Months Ended August 31
 
2007
2006
Dividend yield
0.0%
0.0%
Expected volatility factor(1)
28.0% - 54.0%
29.8% - 63.4%
Weighted average expected volatility
38.8%
47.4%
Risk-free interest rate(2)
4.6% - 5.0%
4.8% - 5.1%
Expected term (in years)(3)
4.2 - 4.4
4.5 - 4.6
 
(1)
Measured using historical daily price changes of our stock for a period corresponding to the term of the option and the implied volatility derived from the market prices of traded options on our stock.
(2)
Based on the U.S. Treasury yield curve in effect at the time of grant.
(3)
Represents the estimated number of years 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, 2007
     
920
   
$
17.20
 
Restricted stock granted
     
904
   
$
24.99
 
Restricted stock vested or cancelled
      (57 )  
$
21.19
 
Outstanding as of August 31, 2007
     
1,767
   
$
21.05
 
 
 
Page 13 of 35


 
For the six month periods ended August 31, 2007 and 2006, we granted to our employees restricted stock of 903,815 shares and 983,500 shares, respectively. The fair value of a restricted stock award is determined and fixed based on the price of our stock on the grant date. The unrecognized compensation costs related to nonvested restricted stock awards totaled $24.6 million at August 31, 2007.  These costs are expected to be recognized over a weighted average period of 2.1 years.
 
8.  
Income Taxes

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), which establishes a consistent framework for determining the appropriate level of tax reserves to maintain for “uncertain tax positions.” This interpretation of Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes,” uses a two-step approach in which 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 established new disclosure requirements related to tax reserves.  We adopted FIN 48 as of March 1, 2007, recording a decrease of $0.8 million in accrued tax reserves and a corresponding increase in retained earnings.

At March 1, 2007, we had $24.4 million of gross unrecognized tax benefits, $1.5 million of which, if recognized, would affect the company’s effective tax rate.  At August 31, 2007, we had $18.7 million of gross unrecognized tax benefits, $2.2 million of which, if recognized, would affect the company’s effective tax rate.  It is reasonably possible that the amount of the unrecognized tax benefit with respect to certain of our unrecognized tax positions will increase or decrease during the next 12 months; however, we do not expect the change to have a significant effect on our results of operations, financial position, or cash flows.

Our continuing practice is to recognize interest and penalties related to income tax matters in selling, general, and administrative costs.    We had $4.7 million accrued for interest as of March 1, 2007, and $4.2 million as of August 31, 2007.

CarMax is subject to U.S. federal income tax as well as income tax of multiple states and local jurisdictions.  With few insignificant exceptions, we are no longer subject to U.S. federal, state, and local income tax examinations by tax authorities for years prior to fiscal 2003.
 
9.  
Net Earnings per Share
 
BASIC AND DILUTIVE NET EARNINGS PER SHARE RECONCILIATIONS
   
Three Months
Ended August 31
   
Six Months
Ended August 31
 
(In thousands except per share data)
 
2007
   
2006
   
2007
   
2006
 
Net earnings available to common shareholders
 
$
64,995
   
$
54,264
   
$
130,350
   
$
111,040
 
                                 
Weighted average common shares outstanding
   
215,891
     
211,831
     
215,592
     
211,181
 
Dilutive potential common shares:
                               
Stock options                                                                                    
   
4,161
     
3,389
     
4,288
     
3,485
 
Restricted stock                                                                                    
   
529
     
82
     
475
     
41
 
Weighted average common shares and dilutive potential common shares
   
220,580
     
215,301
     
220,355
     
214,706
 
Basic net earnings per share                                                                                       
 
$
0.30
   
$
0.26
   
$
0.60
   
$
0.53
 
Diluted net earnings per share                                                                                       
 
$
0.29
   
$
0.25
   
$
0.59
   
$
0.52
 
 
Certain options were outstanding and not included in the calculation of diluted net earnings per share because the options’ exercise prices were greater than the average market price of our common stock during the respective period.  As of August 31, 2007, options to purchase 1,740,453 shares of common stock with exercise prices ranging from $22.29 to $25.79 per share were outstanding and not included in the calculation.  As of August 31, 2006, options to purchase 2,087,686 shares with exercise prices ranging from $14.13 to $21.72 per share were outstanding and not included in the calculation.
 
 
Page 14 of 35

 
10.  
Long-Term Debt

As of August 31, 2007, $88.5 million was outstanding under our $500 million revolving credit facility, with the remainder fully available to us.  The outstanding balance included $2.7 million classified as short-term debt and $85.8 million classified as current portion of long-term debt.  We classified the outstanding balance at August 31, 2007, as current portion of long-term debt based on our expectation that this balance will not remain outstanding for more than one year.

Obligations under capital leases as of August 31, 2007, consisted of $0.5 million classified as current portion of long-term debt and $27.4 million classified as long-term debt.  During the second quarter, we divested our Orlando Chrysler-Jeep-Dodge new car franchise and terminated the capital lease on the building site.
 
11.  
Accumulated Other Comprehensive Loss

Effective March 1, 2007, changes in the funded status of our retirement plans are recognized in accumulated other comprehensive loss (“AOCL”).  There was no AOCL for the six months ended August 31, 2006.  Changes in each component of AOCL for the six months ended August 31, 2007, net of income taxes, are presented below.

(In thousands)
   
Unrecognized Actuarial Losses
   
Unrecognized Prior Service Cost
   
Total Accumulated Other Comprehensive Loss
 
Balance as of February 28, 2007
   
$
20,094
   
$
238
   
$
20,332
 
Amortization expense
      (1,010 )     (19 )     (1,029 )
Balance as of August 31, 2007
   
$
19,084
   
$
219
   
$
19,303
 

12.  
Contingencies

On June 12, 2007, Ms. Regina Hankins filed a putative class action lawsuit against CarMax, Inc., in Baltimore County Circuit Court, Maryland.  We operate four stores in the state of Maryland.  The plaintiff alleges that, since May 25, 2004, CarMax has not properly disclosed its vehicles’ prior rental history, if any. The plaintiff seeks compensatory damages, punitive damages, injunctive relief, and the recovery of attorneys’ fees.  At this time, we continue to evaluate the allegations and our defenses.  We are unable to make a reasonable estimate of the amount or range of loss that could result from an unfavorable outcome in this matter.

CarMax is subject to various other 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 other actions will not materially affect the financial position or results of operations of CarMax.

 
Page 15 of 35

 
 
13.  
Subsequent Event
 
In September 2007, we completed a $500 million public securitization of automobile loan receivables.  Adverse market conditions drove an increase in asset-backed credit spreads and negatively impacted our hedge effectiveness for this transaction, resulting in a reduction in CAF gain income of approximately $8 million in the third quarter of fiscal 2008.  Approximately $4.7 million of the reduction resulted from increased credit spreads, and a majority of the remaining $3.3 million reduction resulted from unwinding interest rate swaps.
 
14.  
Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in U.S. 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.  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 157 as of March 1, 2008.  We do not expect the adoption of SFAS 157 to have a material impact on our financial position, results of operations, and cash flows.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115” (“SFAS 159”), which permits all entities to choose to measure many financial instruments and certain other items at fair value and consequently report unrealized gains and losses on these items in earnings.  SFAS 159 will be effective for our fiscal year beginning March 1, 2008.  We do not expect the adoption of SFAS 159 to have a material impact on our financial position, results of operations, and cash flows.


Page 16 of 35


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, 2007, 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.  Certain prior year amounts have been reclassified to conform with the current period presentation.  All share and per share amounts for prior periods have been adjusted to reflect our 2-for-1 common stock split in March 2007.

BUSINESS OVERVIEW
 
General

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 August 31, 2007, we operated 81 used car superstores in 38 markets, comprised of 28 mid-sized markets, 9 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.  At that date, 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.
 
 
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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.

Fiscal 2008 Second Quarter Highlights

● 
Net sales and operating revenues increased 10% to $2.12 billion from $1.93 billion in the second quarter of fiscal 2007, while net earnings increased 20% to $65.0 million, or $0.29 per share, from $54.3 million, or $0.25 per share.
 
Total used vehicle unit sales increased 11%, reflecting the combination of the growth in our store base and a 3% increase in comparable store used unit sales.  Wholesale vehicle unit sales increased 15%.  New vehicle unit sales declined 15%, reflecting a combination of the softer new car industry trends and the sale of one of our new car franchises during the quarter.
We opened one used car superstore during the second quarter, in Torrance, Calif., bringing our store count in the Los Angeles market to seven.
Our total gross profit per retail unit increased $114 to $2,869 from $2,755 in the prior year’s second quarter.  The majority of the increase was attributable to an improvement in the wholesale gross profit per unit.
CAF income decreased 8% to $33.4 million from $36.5 million in the second quarter of fiscal 2007.  In the prior year’s second quarter, CAF income included a benefit of $6.1 million, or $0.02 per share, for favorable items, primarily related to lowering loss rate assumptions on loans originated in 2003, 2004, and 2005.  Excluding the effect of adjustments, CAF income increased 9%, reflecting our retail sales growth, a slight improvement in the gain on loans originated and sold, and an increase in total managed receivables.
Selling, general, and administrative expenses as a percent of net sales and operating revenues (the “SG&A ratio”) improved to 10.1% from 10.4% in the second quarter of fiscal 2007.  In the prior year’s quarter, the SG&A ratio included the effect of $5.4 million of share-based compensation expense related to the accelerated vesting of stock options held by our former chief executive officer upon his retirement.  Excluding the effect of the accelerated vesting, the prior year’s SG&A ratio for the second quarter would also have been 10.1%.
For the first half of the fiscal year, net cash provided by operations increased to $168.0 million compared with $86.8 million in fiscal 2007, primarily reflecting a reduced investment in inventory and the growth in fiscal 2008 net earnings.


CRITICAL ACCOUNTING POLICIES
 
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.

 
Page 18 of 35


RESULTS OF OPERATIONS
 
NET SALES AND OPERATING REVENUES
     
Three Months Ended August 31
   
Six Months Ended August 31
 
(In millions)
   
2007
   
%
   
2006
   
%
   
2007
   
%
   
2006
   
%
 
Used vehicle sales
   
$
1,687.1
     
79.5
   
$
1,526.7
     
79.1
   
$
3,395.5
     
79.5
   
$
2,987.9
     
78.3
 
New vehicle sales
     
104.8
     
4.9
     
121.2
     
6.3
     
217.4
     
5.1
     
239.6
     
6.3
 
Wholesale vehicle sales
     
265.3
     
12.5
     
222.3
     
11.5
     
526.4
     
12.3
     
469.6
     
12.3
 
Other sales and revenues:
                                                                 
Extended service plan revenues
     
33.2
     
1.6
     
29.2
     
1.5
     
67.1
     
1.6
     
58.0
     
1.5
 
Service department sales
     
25.2
     
1.2
     
23.8
     
1.2
     
49.4
     
1.2
     
47.0
     
1.2
 
Third-party finance fees, net
     
6.9
     
0.3
     
6.2
     
0.3
     
13.8
     
0.3
     
12.6
     
0.3
 
Total other sales and revenues
     
65.3
     
3.1
     
59.3
     
3.1
     
130.3
     
3.1
     
117.6
     
3.1
 
Total net sales and operating revenues
   
$
2,122.5
     
100.0
   
$
1,929.5
     
100.0
   
$
4,269.7
     
100.0
   
$
3,814.7
     
100.0
 

RETAIL VEHICLE SALES CHANGES
     
Three Months
Ended August 31
   
Six Months
Ended August 31
 
     
2007
   
2006
   
2007
   
2006
 
Vehicle units:
                                 
Used vehicles
      11 %     15 %     13 %     14 %
New vehicles
      (15 )%     (19 )%     (10 )%     (15 )%
Total
      9 %     12 %     11 %     12 %
                                     
Vehicle dollars:
                                 
Used vehicles
      11 %     23 %     14 %     22 %
New vehicles
      (14 )%     (20 )%     (9 )%     (16 )%
Total
      9 %     19 %     12 %     18 %

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.

COMPARABLE STORE RETAIL VEHICLE SALES CHANGES
     
Three Months
Ended August 31
   
Six Months
Ended August 31
 
     
2007
   
2006
   
2007
   
2006
 
Vehicle units:
                                 
Used vehicles
      3 %     7 %     5 %     6 %
New vehicles
      (13 )%     (19 )%     (9 )%     (15 )%
Total
      2 %     5 %     4 %     5 %
                                     
Vehicle dollars:
                                 
Used vehicles
      3 %     15 %     5 %     14 %
New vehicles
      (11 )%     (21 )%     (8 )%     (17 )%
Total
      2 %     11 %     4 %     11 %


Page 19 of 35



CHANGE IN USED CAR SUPERSTORE BASE
     
Three Months
Ended August 31
   
Six Months
Ended August 31
 
     
2007
   
2006
   
2007
   
2006
 
Used car superstores, beginning of period
     
80
     
71
     
77
     
67
 
Superstore openings:
                                 
Production superstores (1)
     
     
     
1
     
3
 
Non-production superstores (2)
     
1
     
     
3
     
1
 
Total superstore openings
     
1
     
     
4
     
4
 
Used car superstores, end of period
     
81
     
71
     
81
     
71
 

(1) Previously referred to as mega and standard superstores, these are stores at which vehicle reconditioning is performed.
(2) Previously referred to as satellite superstores, these are stores that do not have vehicle reconditioning capabilities.

Used Vehicle Sales. The 11% increase in used vehicle revenues in the second quarter of fiscal 2008 resulted from an 11% increase in unit sales.  There was no material change in average selling price as normal price inflation was offset by the effect of a slight shift in sales mix toward compact cars and smaller SUVs.  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.  Our comparable store used unit sales growth was supported by increases in traffic, both in our stores and on our website, and the consistent availability of consumer credit from CAF and our third-party finance providers.  The 3% increase in comparable store used unit sales represented a deceleration in our growth rate compared with recent quarters reflecting, we believe, the difficult current macro-economic conditions and the challenging automotive retail environment over the past few months.  Despite this deceleration, we believe that we continued to gain share within our existing markets in the late-model used vehicle market.

The 14% increase in used vehicle revenues in the first half of fiscal 2008 resulted from a 13% 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 5% increase in comparable store used units.  Similar to the second quarter, our comparable store used unit sales growth was supported by increases in traffic and the consistent availability of consumer credit.

New Vehicle Sales.  Compared with the corresponding prior year periods, new vehicle revenues decreased 14% in the second quarter of fiscal 2008 and 9% in the first half of fiscal 2008.  The declines were substantially the result of decreases in unit sales, which fell 15% in the second quarter and 10% in the first half of the year.  The declines in new vehicle unit sales reflected softer new car industry sales trends, particularly for the domestic manufacturers that we represent, and the divestiture of our Orlando Chrysler-Jeep-Dodge franchise in August 2007.

Wholesale Vehicle Sales.  Vehicles acquired through the appraisal purchase process that do not meet our retail standards are sold at our on-site wholesale auctions.  The 19% increase in wholesale vehicle revenues in the second quarter of fiscal 2008 resulted from a 15% increase in wholesale unit sales combined with a 4% increase in average wholesale selling price.  Our wholesale unit sales growth benefited from the expansion of our store base and strong appraisal traffic.  The increase in wholesale unit sales was somewhat greater than the 11% increase in used vehicle unit sales, reflecting the easier relative comparison with the second quarter of the prior year.  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 12% increase in wholesale vehicle revenues in the first half of fiscal 2008 resulted from an 11% increase in wholesale unit sales combined with a 1% increase in average wholesale selling price.  Similar to the second quarter, the wholesale unit sales growth was the result of the expansion of our store base and strong appraisal traffic.
 
 
Page 20 of 35

 
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 10% in the second quarter of fiscal 2008, and 11% in the first half of fiscal 2008.  The increases were primarily the result of growth in both extended service plan revenues and third-party finance fees.  Extended service plan revenues increased 14% in the second quarter and 16% in the first half of the year, driven primarily by our unit sales growth.  Net third-party finance fees, which increased 11% in the second quarter and 10% in the first half 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 these loans as an offset to finance fee revenues from the other third-party lenders.

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.

Supplemental Sales Information.

UNIT SALES
     
Three Months
Ended August 31
   
Six Months
Ended August 31
 
     
2007
   
2006
   
2007
   
2006
 
Used vehicles
     
96,102
     
86,846
     
192,868
     
171,112
 
New vehicles
     
4,365
     
5,131
     
9,085
     
10,078
 
Wholesale vehicles
     
60,476
     
52,648
     
118,190
     
106,434
 

AVERAGE SELLING PRICES
     
Three Months
Ended August 31
   
Six Months
Ended August 31
 
     
2007
   
2006
   
2007
   
2006
 
Used vehicles
   
$
17,388
   
$
17,399
   
$
17,434
   
$
17,285
 
New vehicles
   
$
23,863
   
$
23,476
   
$
23,787
   
$
23,626
 
Wholesale vehicles
   
$
4,278
   
$
4,120
   
$
4,344
   
$
4,303
 

RETAIL VEHICLE SALES MIX
     
Three Months
Ended August 31
   
Six Months
Ended August 31
 
     
2007
   
2006
   
2007
   
2006
 
Vehicle units:
                                 
    Used vehicles
      96 %     94 %     96 %     94 %
    New vehicles
     
4
     
6
     
4
     
6
 
Total
      100 %