CarMax Form 10-K - Annual Report



 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION 
WASHINGTON, D.C. 20549
 
 
FORM 10-K
 
x   ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
 
For the fiscal year ended February 28, 2007
 
OR
 
¨    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                     to                      
 
Commission File Number: 1-31420
 
 
CARMAX, INC.
(Exact name of registrant as specified in its charter)
 
 
VIRGINIA
(State or other jurisdiction of incorporation or organization)
 
54-1821055
(I.R.S. Employer Identification No.)
 
12800 TUCKAHOE CREEK PARKWAY, RICHMOND, VIRGINIA
(Address of principal executive offices)
 
23238
(Zip Code)
 
 
Registrant’s telephone number, including area code: (804) 747-0422
 
Securities registered pursuant to Section 12(b) of the Act:
 
Title of each class
Common Stock, par value $0.50
Rights to Purchase Series A Preferred Stock,
par value $20.00
Name of each exchange on which registered
New York Stock Exchange
New York Stock Exchange
 
 
Securities registered pursuant to Section 12(g) of the Act:
 
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes x  No ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
 
Yes ¨  No x
 


 
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   x
 
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
 
The aggregate market value of the registrant’s common stock held by non-affiliates as of August 31, 2006, computed by reference to the closing price of the registrant’s common stock on the New York Stock Exchange on that date, was $4.0 billion.
 
On March 31, 2007, there were 216,045,438 outstanding shares of CarMax, Inc. common stock.
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Portions of the CarMax, Inc. Notice of 2007 Annual Meeting of Shareholders and Proxy Statement are incorporated by reference in Part III of this Form 10-K.
 


 
CARMAX, INC.
FORM 10-K
FOR FISCAL YEAR ENDED FEBRUARY 28, 2007
 
TABLE OF CONTENTS
 
  
 
Page No.
       
  
Business
4
       
 
Risk Factors
11
       
 
Unresolved Staff Comments
12
       
  
Properties
13
       
  
Legal Proceedings
14
       
  
Submission of Matters to a Vote of Security Holders
14
 
 
  
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
15
       
 
Selected Financial Data
17
       
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
18
       
 
Quantitative and Qualitative Disclosures about Market Risk
34
       
 
Consolidated Financial Statements and Supplementary Data
35
       
  
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
61
       
Controls and Procedures
61
       
 
Other Information
61
       
       
  
Directors, Executive Officers and Corporate Governance
62
       
  
Executive Compensation
63
       
  
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
63
       
  
Certain Relationships and Related Transactions, and Director Independence
63
       
  
Principal Accountant Fees and Services
63
       
       
  
Exhibits and Financial Statement Schedules
64
       
 
  
65
 

 


 
PART I
 
In this document, “we,” “our,” “us,” “CarMax,” and “the company” refer to CarMax, Inc. and its wholly owned subsidiaries, unless the context requires otherwise.
 
FORWARD-LOOKING AND CAUTIONARY STATEMENTS
This Annual Report on Form 10-K and, in particular, the description of our business set forth in Item 1 and our Management’s Discussion and Analysis of Financial Condition and Results of Operations set forth in Item 7 contain a number of forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding:
·  
Our projected future sales growth, comparable store unit sales growth, earnings, and earnings per share.
·  
Our expected future expenditures, cash needs, and financing sources.
·  
The projected number, timing, and cost of new store openings.
·  
Our sales and marketing plans.
·  
Our assessment of the potential outcome and financial impact of litigation and the potential impact of unasserted claims.
·  
Our assessment of competitors and potential competitors.
·  
Our assessment of the effect of recent legislation and accounting pronouncements.

In addition, any statements contained in or incorporated by reference into this report that are not statements of historical fact should be considered forward-looking statements. You can identify these forward-looking statements by use of words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “predict,” “should,” “will,” and other similar expressions, whether in the negative or affirmative. We cannot guarantee that we will achieve the plans, intentions, or expectations disclosed in the forward-looking statements. There are a number of important risks and uncertainties that could cause our actual results to differ materially from those indicated by our forward-looking statements. These risks and uncertainties include, without limitation, those set forth in Item 1A under the heading “Risk Factors.” We caution investors not to place undue reliance on any forward-looking statements as these statements speak only as of the date when made. We undertake no obligation to update any forward-looking statements made in this report.
 
Item 1. Business.
 
BUSINESS OVERVIEW
CarMax Background. CarMax, Inc. was incorporated under the laws of the Commonwealth of Virginia in 1996. CarMax, Inc. is a holding company and our operations are conducted through our subsidiaries. Our home office is located at 12800 Tuckahoe Creek Parkway, Richmond, Va.
 
Under the ownership of Circuit City Stores, Inc. (“Circuit City”), we began operations in 1993 with the opening of our first CarMax superstore in Richmond, Va. In 1997, Circuit City completed the initial public offering of a tracking stock, Circuit City Stores, Inc.-CarMax Group common stock, which was intended to track separately the performance of the CarMax operations. On October 1, 2002, the CarMax business was separated from Circuit City through a tax-free transaction, becoming an independent, separately traded public company.
 
CarMax Business. We are the nation’s largest retailer of used cars, based on the 337,021 used vehicles we retailed during the fiscal year ended February 28, 2007. As of the end of fiscal 2007, we operated 77 used car superstores in 36 metropolitan markets. In addition, we sold 208,959 wholesale vehicles in fiscal 2007 through our on-site auctions.
 
We were the first used vehicle retailer to offer a large selection of high quality used vehicles at competitively low, fixed prices using a customer-friendly sales process in an attractive, modern sales facility. The CarMax consumer offer provides our customers the opportunity to shop for vehicles the same way they shop for items at other “big-box” retailers, and it is structured around four core equities: low, no-haggle prices; a broad selection; high quality; and customer-friendly service. Our strategy is to better serve the auto retailing market by addressing the major sources of customer dissatisfaction with traditional auto retailers and to maximize operating efficiencies through the use of standardized operating procedures and store formats enhanced by sophisticated, proprietary management information systems.
 


We purchase, recondition, and sell used vehicles. All of the used vehicles we retail are thoroughly reconditioned to meet high mechanical, electrical, safety, and cosmetic standards, and each vehicle must pass a comprehensive inspection before being offered for sale. Approximately 85% of the used vehicles we retail are one to six years old with fewer than 60,000 miles. We also offer a selection of used vehicles at each superstore that are more than six years old or have more than 60,000 miles, but which meet similar quality standards.
 
We also sell new vehicles at seven locations under franchise agreements with four new car manufacturers. In fiscal 2007, new vehicles comprised 5% of our total retail vehicle unit sales. As planned, new car sales have become a smaller part of our business mix over the past several fiscal years as we have divested 14 new car franchises while aggressively growing our used car business. We may divest additional new car franchises in the future.
 
We provide our customers with a full range of related products and services, including the financing of vehicle purchases through CarMax Auto Finance (“CAF”), our own finance operation, and third-party lenders; the sale of extended service plans and accessories; the appraisal and purchase of vehicles directly from consumers; and vehicle repair service.
 
The CarMax consumer offer enables customers to evaluate separately each component of the sales process and to make informed decisions based on comprehensive information about the options, terms, and associated prices of each component. The customer can accept or decline any individual element of the offer without affecting the price or terms of any other component of the offer. Our “no-haggle” pricing and our commission structure, which is based on a fixed dollars-per-unit standard, allow our sales consultants to focus solely on meeting customer needs.
 
We have separated the practice of trading in a used vehicle in conjunction with the purchase of another vehicle into two distinct and independent transactions. We will appraise a consumer’s vehicle and make an offer to buy that vehicle regardless of whether the owner is purchasing a vehicle from us. We acquire the majority of our retail used vehicle inventory through this unique in-store appraisal process. We also acquire a significant portion of our used vehicle inventory through wholesale auctions and, to a lesser extent, directly from other sources, including wholesalers, dealers, and fleet owners. Those vehicles purchased through our in-store appraisal process that do not meet our retail standards are sold at on-site wholesale auctions.
 
Our inventory management and pricing system tracks each vehicle throughout the sales process. Using the information provided by this system, and applying sophisticated statistical modeling techniques, we are able to optimize our inventory mix, anticipate future inventory needs at each store, evaluate sales consultant and buyer performance, and refine our vehicle pricing strategy. Because of the pricing discipline afforded by the inventory management and pricing system, more than 99% of the entire used car inventory offered at retail is sold at retail.
 
Industry and Competition. With calendar year 2006 sales of approximately $340 billion, used vehicles comprise nearly half of the U.S. auto retail market, the largest retail segment of the economy. In calendar 2006, there were an estimated 42.6 million used vehicles sold in the U.S. compared with approximately 16.6 million new vehicles. Our primary focus, late-model vehicles that are 1 to 6 years old, are estimated at approximately $290 billion in annual sales and 20 million units per year.
 
The U.S. used car marketplace is highly fragmented and competitive and includes approximately 21,800 franchised new car dealers and 44,000 independent dealers, as well as millions of private individuals. Our primary competitors are the franchised new car dealers, who sell the majority of late-model used vehicles. Independent dealers predominantly sell older, higher mileage cars than we do. In both the used and new vehicle markets, we seek to distinguish ourselves from traditional dealerships through our consumer offer, sales approach, and other innovative operating strategies.
 
We believe that our principal competitive factors in used vehicle retailing are our ability to provide a high degree of customer satisfaction with the car-buying experience; our competitively low prices; our breadth of selection of the most popular makes and models available both on site and via our website, carmax.com; the quality of our vehicles; our proprietary information systems; and the location of our retail stores. Upon request by a customer, we will transfer virtually any used vehicle in our nationwide inventory to a local superstore. Transfers are free within a market; longer distance transfers include a charge to cover transportation costs. In fiscal 2007, more than 20% of our vehicles sold were transferred at customer request. Our Certified Quality Inspection assures that every vehicle we offer for sale meets stringent mechanical, electrical, and safety standards. We back every vehicle with a 5-day, money-back guarantee, and at least a 30-day limited warranty. Other competitive factors include our ability to offer
 


 
or arrange customer financing on competitive terms and the comprehensiveness and cost of the extended service plans we offer. We believe that we are competitive in all of these areas and that we enjoy advantages over competitors that employ traditional high-pressure, negotiation-oriented sales techniques.
 
Our sales consultants play a significant role in ensuring a customer-friendly sales process. A sales consultant is paid a commission based on a fixed dollars-per-unit standard, thereby earning the same dollar sales commission regardless of the price or gross margin on the vehicle being sold. The sales consultant receives no commission on the finance process. This ensures that the sales consultant’s primary objective is helping customers find the right vehicles for their needs at prices they can afford. In contrast, sales and finance personnel at traditional dealerships often receive higher commissions for negotiating higher prices and for steering customers toward vehicles with higher gross margins.
 
In the new vehicle market, we compete with other franchised dealers offering vehicles produced by the same or other manufacturers. Historically, the new vehicle market has been served primarily by dealerships employing traditional automotive selling methods. We believe our customer-friendly, low-pressure sales methods are points of competitive differentiation.
 
Marketing and Advertising. Our marketing strategies are focused on developing awareness of the advantages of shopping at our stores and on attracting customers who are already considering buying or selling a vehicle. We use market awareness and customer satisfaction surveys to help tailor our marketing efforts to the purchasing habits and preferences of customers in each market area. Our marketing strategies are implemented primarily through television and radio broadcasts, carmax.com, the Internet, and newspaper advertising. Television and radio broadcast advertisements are designed to build consumer awareness of the CarMax name, carmax.com, and key components of the CarMax offer. Newspaper advertisements promote our broad selection of vehicles and price competitiveness, targeting consumers with immediate purchase intentions. Broadcast, Internet, and newspaper advertisements are designed to drive customers to our stores and to carmax.com.
 
The media landscape is changing rapidly and we are changing our marketing programs in response. We are customizing our marketing program based on awareness levels in each market. In selected markets, we have expanded our use of Internet-based advertising while curtailing our use of newspaper advertising. We are building awareness and driving traffic to our stores and carmax.com by listing every retail vehicle on both AutoTrader.com and cars.com. Through their syndicated networks, AutoTrader.com and cars.com vehicle listings appear on sites that we believe are visited by a majority of late model used vehicle buyers who use the Internet in their shopping process. Our advertising on the Internet also includes banner and key-word advertisements on search engines, such as Google and Yahoo!
 
Our website, carmax.com, is a marketing tool for communicating the CarMax consumer offer in detail, a sophisticated search engine for finding the right vehicle, and a sales channel for customers who prefer to complete a part of the shopping and sales process online. The website offers complete inventory and pricing search capabilities. Information on the more than 25,000 cars available in our nationwide inventory is updated daily. Carmax.com includes detailed information, such as vehicle photos, prices, features, specifications, and store locations, as well as sorting and comparison features that allow consumers to easily compare vehicles. The site also includes features such as detailed vehicle reviews, payment calculators, and an option to estimate trade-in values via a link with Kelley Blue Book. Customers can contact sales consultants online via carmax.com, by telephone, or by fax. Customers can work with these sales consultants from the comfort of home, including applying for financing, and need to visit the store only to sign the paperwork and pick up their vehicle.
 
Suppliers for Used Vehicles. We acquire our used vehicle inventory directly from consumers through our unique in-store appraisal process and through other sources, including local and regional auctions, wholesalers, franchised and independent dealers, and fleet owners, such as leasing companies and rental companies. In calendar 2006, approximately 22 million used vehicles were remarketed in the U.S., of which nearly 10 million were sold at wholesale auction.
 
The majority of our used vehicle inventory is acquired directly from consumers through our appraisal process. The most popular makes and models are more readily available directly from consumers than from other sources. This buying strategy also helps provide an inventory of makes and models that reflects the tastes of each market. In May 2006, we began testing a stand-alone car buying center in the Atlanta market. Our goal for the car buying center is
 


 
to increase appraisal traffic and generate incremental vehicle purchases from individual consumers. We plan to expand this test by opening three additional car buying centers in fiscal 2008.
 
We have replaced the traditional “trade-in” transaction with a process in which a CarMax-trained buyer appraises the vehicle and provides the vehicle’s owner with a written, guaranteed offer that is good for 7 days.  An appraisal is available to every customer free of charge, whether or not the individual purchases a vehicle from us. Based on their age, mileage, or condition, fewer than half of the vehicles acquired through this in-store appraisal process meet our high quality retail standards. Those vehicles that do not meet our retail standards are sold at our on-site wholesale auctions.
 
The inventory purchasing function is primarily performed at the store level and is the responsibility of the buyers, who handle both on-site appraisals and off-site auction purchases. Our buyers evaluate all used vehicles on the basis of their estimated wholesale value and reconditioning costs, and, for off-site purchases, cost of delivery to the store where they will be reconditioned. To decide which inventory to purchase at off-site auctions, our buyers, in collaboration with our home office staff, rely on the extensive inventory and sales trend data available through the CarMax information system. Our inventory and pricing models help the buyers tailor inventories to the buying preferences at each superstore, recommend pricing adjustments, and optimize inventory turnover to help maintain gross margin dollars per unit.
 
Based on consumer acceptance of the in-store appraisal process at existing CarMax stores, our experience and success to date in acquiring vehicles from auctions and other sources, and the large size of the U.S. auction market relative to our needs, we believe that our sources of used vehicles will continue to be sufficient to meet current needs and to support planned expansion.
 
Suppliers for New Vehicles. Our new car operations are governed by the terms of the sales, service, and dealer agreements with DaimlerChrysler, General Motors, Nissan, and Toyota. Among other things, these agreements generally impose operating requirements and restrictions, including inventory levels, working capital, monthly financial reporting, signage, and cooperation with marketing strategies. A manufacturer may terminate a dealer agreement under certain circumstances, including a change in ownership without prior manufacturer approval, failure to maintain adequate customer satisfaction ratings, or a material breach of other provisions of the agreement. In addition to selling new vehicles using our low, no-haggle price strategy, the franchise and dealer agreements generally allow us to perform warranty work on these vehicles and sell related parts and services within a specified market area. Designation of specified market areas generally does not guarantee exclusivity within a specified territory.
 
Seasonality. Our business is seasonal. 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 could have an effect on the overall seasonal pattern of our results.
 
Products and Services
Merchandising. We offer our customers a broad selection of makes and models of used vehicles, including both domestic and imported vehicles, at competitive prices. Our used car selection covers popular brands from manufacturers such as DaimlerChrysler, Ford, General Motors, Honda, Hyundai, Mazda, Mitsubishi, Nissan, Subaru, Toyota, and Volkswagen and luxury brands such as Acura, BMW, Infiniti, Lexus, and Mercedes. Our primary focus is vehicles that are 1 to 6 years old, have fewer than 60,000 miles, and generally range in price from $11,500 to $30,000. For the more cost-conscious consumer, we also offer used cars that are more than 6 years old or have 60,000 miles or more and that generally range in price from $8,000 to $22,000.  
 
We have implemented an everyday low-price strategy under which we set no-haggle prices on both our used and new vehicles. We believe that our pricing is competitive with the best-negotiated prices in the market. Prices on all vehicles are clearly displayed on each vehicle’s information sticker; on carmax.com, AutoTrader.com, and cars.com; and, where applicable, in our newspaper advertising. We extend our no-haggle philosophy to every component of
 


 
the vehicle transaction, including vehicle appraisal offers, financing rates, accessories, extended service plan pricing, and vehicle documentation fees.
 
Reconditioning and Service. An integral part of our used car consumer offer is the reconditioning process. This process includes a comprehensive, Certified Quality Inspection of the engine and all major systems, including cooling, fuel, drivetrain, transmission, electronics, suspension, brakes, steering, air conditioning, and other equipment, as well as the interior and exterior of the vehicle. Based on this quality inspection, we determine the reconditioning necessary to bring the vehicle up to our high quality standards. Our service technicians complete vehicle inspections.  We perform most routine mechanical and minor body repairs in-house; however, for some reconditioning services, we engage third parties specializing in those services. Over the past several years, we have performed an increasing percentage of reconditioning services in-house, and, based on the cost savings realized, we expect this trend to continue. Satellite superstores depend upon nearby mega or standard superstores for reconditioning, which increases efficiency and reduces overhead.
 
All CarMax used car locations provide vehicle repair service including repairs of vehicles covered by our extended service plans. We also provide factory-authorized service at all new car franchises. We have developed systems and procedures that are intended to ensure that our retail repair service is conducted in the same customer-friendly and efficient manner as our other operations.
 
We believe that the efficiency of our reconditioning and service operations is enhanced by our modern facilities, a technician mentoring process, and our information systems. The mentoring process and compensation programs are designed to increase the productivity of technicians,  identify opportunities for cost reduction, and achieve high-quality repairs. Our information systems provide the ability to track repair history and enable trend analysis, which serves as guidance for our continuous improvement efforts.
 
Wholesale Auctions. Vehicles purchased through our in-store appraisal process that do not meet our retail standards are sold at on-site wholesale auctions. At February 28, 2007, wholesale auctions were conducted at 46 of our 77 superstores. Auctions are generally not held at satellite superstores. Auctions are held on a weekly, bi-weekly, or monthly basis. Auction frequency at a given superstore is determined by the number of vehicles to be auctioned, which depends on the number of stores and the market awareness of the company and our in-store appraisal offer in that market. The typical wholesale vehicle is approximately 10 years old and has more than 100,000 miles. Participation in our wholesale auctions is restricted to licensed automobile dealers, the majority of whom are independent dealers. To participate in a CarMax auction, dealers must register with our centralized auction support group, at which time we determine the purchase limit available to each dealer. We make conditional announcements on each vehicle, including those for vehicles with major mechanical issues, possible frame or flood damage, branded titles, salvage history, and unknown true mileage. Professional, licensed auctioneers conduct our auctions. These policies result in an auction sales rate that is generally between 95% and 100%. Dealers pay a fee to the company based on the sales price of the vehicles they purchase.
 
Customer Credit. We offer our customers a wide range of financing alternatives, which we believe enhances the CarMax consumer offer. Before the effect of 3-day payoffs and vehicle returns, CAF financed more than 40% of our used vehicle unit sales in fiscal 2007. Customer credit applications are initially reviewed by CAF, and may also be reviewed by Bank of America. Customers who are not approved by either CAF or Bank of America are evaluated by our core, second-tier finance partners, including AmeriCredit Financial Services, Capital One Auto Finance, CitiFinancial Auto, and Wells Fargo Auto Finance. Customers who are not approved by any of these finance partners are evaluated by our third-tier lenders, which include Triad Financial and Drive Financial Services ("Drive"). Having a wide array of lenders not only expands the choices for our customers, but also increases discrete approvals. To this end, we have tested and will continue to test other third-party finance companies.

Customers applying for financing provide credit information that is electronically submitted by sales consultants through our proprietary information system. Responses from CAF and Bank of America are generally received in less than five minutes. The vehicle financings, or loans, are retail installment contracts secured by the vehicles financed. We have no recourse liability on retail installment contracts arranged with third-party finance companies. Customers are permitted to refinance or pay off their loans within three business days of a purchase without incurring any finance or related charges. Our arrangements with our primary and second-tier, third-party finance companies generally provide for payment of a fee to CarMax at the time of financing, provided the loan is not paid in full within 90 days. Drive purchases customer loans at a discount.
 


 
Extended Service Plan Sales. At the time of the sale, we offer the customer an extended service plan. We sell these plans on behalf of unrelated third parties that are the primary obligors. Under the third-party service plan programs, we have no contractual liability to the customer. The extended service plans have terms of coverage from 12 to 72 months, depending on the vehicle age and make. We offer these extended service plans at low, fixed prices, which are based primarily on the repair record of the vehicle and the length of coverage selected. All extended service plans that we sell (other than manufacturers’ warranties) have been designed to our specifications and are administered by the third parties through private-label arrangements under which we receive a commission from the administrator at the time the extended service plan is sold. In fiscal 2007, more than half of the customers purchasing a used vehicle from CarMax also purchased an extended service plan.
 
Our extended service plan customers have access to our vehicle repair service at each CarMax store and to the third-party administrators’ nationwide network of approximately 14,000 independent service providers. We believe that the quality of the services provided by this network, as well as the broad scope of our extended service plans, helps promote customer satisfaction and loyalty, and thus increases the likelihood of repeat and referral business.
 
Systems
Our stores are supported by an advanced information system that improves the customer experience while providing tightly integrated automation of all operating functions. Using in-store information kiosks, customers can search each store’s vehicle inventory and print a detailed listing for any vehicle, which includes the vehicle’s features and specifications, and a map showing its specific location on the display lot. Our inventory management system tracks every vehicle through its life from purchase through reconditioning and test-drives to ultimate sale. Bar codes are placed on each vehicle and on each parking space on the display lot, and all vehicle bar codes are scanned daily as a loss prevention measure. Test drive information is captured on every vehicle using radio frequency identification devices, linking the specific vehicle and the sales consultant. We also capture data on vehicles we wholesale, which helps us track market pricing. An online finance application process and computer-assisted document preparation ensure rapid completion of the sales transaction. Behind the scenes, our proprietary store technology provides our management with real-time information about every aspect of store operations, such as inventory management, pricing, vehicle transfers, wholesale auctions, and sales consultant productivity.
 
Our inventory management and pricing system allows us to buy the mix of makes, models, age, mileage, and price points tailored to customer buying preferences at each superstore. This system also generates recommended retail price markdowns for specific vehicles based on complex algorithms that take into account factors including sales history, consumer interest, and seasonal patterns. We believe this systematic approach to vehicle pricing allows us to optimize inventory turns, which minimizes the depreciation risk inherent in used cars and helps us to achieve our targeted gross profit dollars per unit.
 
In addition to inventory management, our Electronic Repair Order system (“ERO”) is used by the service department to sequence reconditioning procedures. ERO provides information that helps increase quality and reduce costs, which further enhances our customer service and profitability.
 
Through our centralized systems, we are able to immediately integrate new stores into our store network, allowing the new stores to rapidly achieve operating efficiency. We continue to enhance and refine our information systems, which we believe to be a core competitive advantage. The design of our information systems incorporates off-site backups, redundant processing, and other measures to reduce the risk of significant data loss in the event of an emergency or disaster.
 
Associates
On February 28, 2007, we had a total of 13,736 employees, including 10,394 hourly and salaried associates and 3,342 sales associates, who worked on a commission basis. Sales associates include both full-time and part-time employees. We employ additional associates during peak selling seasons. At February 28, 2007, our location general managers averaged more than 8 years of CarMax experience, in addition to prior retail management experience. Management believes that the company maintains good employee relations. No CarMax associate is subject to a collective bargaining agreement.
 


 
Training. We place special emphasis on attracting, developing, and retaining qualified associates and believe that our favorable working conditions and compensation programs allow us to attract and retain highly qualified individuals in each market that we enter. We accomplish this partly through our commitment to provide exceptional training to associates. Store associates receive structured, self-paced training programs that introduce them to company policies and their specific job responsibilities through KMX University - our proprietary intranet-based testing and tracking system. KMX University is comprised of customized applications hosted within a learning management system that allow us to author, deliver, and track training events, and to measure associate competency before and after training. Most new store associates are also assigned mentors who provide on-the-job guidance and support.
 
We also provide comprehensive, facilitated classroom training courses to sales consultants, buyers, automotive technicians, and managers. All sales consultants receive extensive customer service training both initially and on an ongoing basis. Buyers-in-training undergo a 6- to 18-month apprenticeship under the supervision of experienced buyers, and they generally will assist with the appraisal of more than one thousand cars before making their first independent purchase. We utilize a mix of internal and external technical training programs in an effort to provide a stable future supply of qualified technicians. Reconditioning and mechanical technicians attend in-house training and vendor-sponsored training programs designed to develop their skills in performing repairs on the diverse makes and models of vehicles we sell. Technicians at our new car franchises also attend manufacturer-sponsored training programs to stay abreast of current diagnostic, repair, and maintenance techniques for those manufacturers’ vehicles. Additionally, our management-training program includes rotations through each functional area. We open new stores with an experienced management team drawn from existing stores.
 
Laws and Regulations
Vehicle Dealer and Other Laws and Regulations. We operate in a highly regulated industry. In every state in which we operate, we must obtain various licenses and permits in order to conduct business, including dealer, service, sales, and finance licenses issued by state and certain local regulatory authorities. A wide range of federal, state, and local laws and regulations govern the manner in which we conduct business, including advertising, sales, financing, and employment practices. These laws include consumer protection laws, privacy laws, anti-money laundering laws, and state franchise laws, as well as other laws and regulations applicable to new and used motor vehicle dealers. These laws also include federal and state wage-hour, anti-discrimination, and other employment practices laws. Our financing activities with customers are subject to federal truth-in-lending, consumer leasing, and equal credit opportunity laws and regulations, as well as state and local motor vehicle finance laws, installment finance laws, and usury laws.
 
Claims arising out of actual or alleged violations of law may be asserted against us by individuals or governmental authorities and may expose us to significant damages or other penalties, including revocation or suspension of licenses necessary to conduct business and fines.
 
Environmental, Health, and Safety Laws and Regulations. We are subject to a variety of federal, state, and local laws and requirements that regulate the environment and public health and safety. Our business involves the use, handling, and disposal of hazardous or toxic substances, including motor oil, gasoline, transmission fluid, solvents, lubricants, and other materials. We are subject to compliance with governmental and environmental regulations concerning the past and current operation and/or removal of aboveground and underground storage tanks containing these and other substances.
 
AVAILABILITY OF REPORTS AND OTHER INFORMATION 
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and proxy statements on Schedule 14A, as well as any amendments to those reports, are available without charge through our website, carmax.com, as soon as reasonably practicable after filing or furnishing the material to the Securities and Exchange Commission. The contents of our website are not, however, part of this report.
 
In addition, our Corporate Governance Guidelines and Code of Conduct, as well as the charters of the Audit Committee, Nominating and Governance Committee, and Compensation and Personnel Committee, are available to shareholders and the public through the “Corporate Governance” link of our investor information home page at investor.carmax.com. Printed copies of these documents are available to any shareholder, without charge, upon written request to our corporate secretary at the address set forth on the cover page of this report. Any changes to these documents or waivers of the Code of Conduct are promptly disclosed on our website.
 


 
Item 1A. Risk Factors.
 
We are subject to various risks, including the risks described below. Our business, operating results, and financial condition could be materially and adversely affected by any of these risks. Additional risks not presently known or that we currently deem immaterial may also impair the business and our operations.

Economic Conditions.  In the normal course of business, we are subject to changes in general or regional U.S. economic conditions, including, but not limited to, consumer credit availability, consumer credit delinquency and loss rates, interest rates, gasoline prices, inflation, personal discretionary spending levels, and consumer sentiment about the economy in general. Any significant changes in economic conditions could adversely affect consumer demand and/or increase costs resulting in lower profitability for the company.

Competition. Automotive retailing is a highly competitive business. Our competition includes publicly and privately owned franchised new car dealers and independent dealers, as well as millions of private individuals. Our competitors may sell the same or similar makes of vehicles that we offer in the same or similar markets at competitive prices. Further, new entrants to the market could result in increased acquisition costs for used vehicles and lower-than-expected vehicle sales and margins. CAF is subject to competition from various financial institutions. Additionally, competition on vehicle sales and related financing is increasing, as these products are now being marketed and sold over the Internet. Customers are increasingly using the Internet to compare pricing for cars and related financing, which may further reduce our profitability.

Retail Prices. Any significant changes in retail prices for used and new vehicles could reduce our sales and margins. If any of our competitors seek to gain or retain market share by reducing prices for used or new vehicles, we would likely reduce our prices in order to remain competitive, which could result in a decrease in our sales and profitability and require a change in our operating strategies.

Inventory. A reduction in the availability or access to sources of inventory would adversely affect our business. A failure to adjust appraisal offers to stay in line with the broader market trade-in offer trends, or a failure to recognize those trends, could negatively impact our ability to acquire inventory. Should we develop excess inventory, the inability to liquidate the excess inventory at prices that allow us to meet margin targets or to recover our costs would adversely affect our profitability.

Real Estate. The inability to acquire suitable real estate at favorable terms could limit the expansion of our store base and could have a material adverse affect on our future operating results.

Management and Workforce. Our success depends upon the continued contributions of our store, region, and corporate management teams. Consequently, the loss of the services of key employees could have a material adverse effect on our results of operations. In addition, we will need to hire additional personnel as we open new stores. The market for qualified employees in the industry and in the regions in which we operate is highly competitive and may result in increased labor costs during periods of low unemployment.

Information Systems. Our business is dependent upon the efficient operation of our information systems. In particular, we rely on our information systems to effectively manage sales, inventory, consumer financing, and customer information. The failure of these systems to perform as designed or the failure to maintain and continually enhance or protect the integrity of these systems could disrupt our business, impact sales and profitability, or expose us to customer or third-party claims.

Capital. Changes in the availability or cost of capital and working capital financing, including the availability of long-term financing to support our geographic expansion and the availability of securitization financing, could adversely affect growth and operating strategies. Further, our current credit facility and certain securitization and sale-leaseback agreements contain covenants and/or performance triggers. Any failure to comply with these covenants and/or performance triggers could have a material adverse effect on our business.

Weather. The occurrence of severe weather events, such as rain, snow, wind, storms, hurricanes, or other natural disasters, adversely affecting consumer traffic at our superstores could negatively impact our operating results.


Seasonal Fluctuations. Our business is subject to seasonal fluctuations. We generally realize a higher proportion of revenue and operating profit during the first and second fiscal quarters. If conditions arise that impair vehicle sales during the first or second fiscal quarters, the adverse effect on our revenues and operating profit for the year could be disproportionately large.

Geographic Concentration. Our performance is subject to local economic, competitive, and other conditions prevailing in geographic areas where we operate. Since a large number of our superstores are located in the Southeastern U.S. and in the Chicago, Los Angeles, Houston, Dallas, and Washington, D.C./Baltimore markets, our results of operations depend substantially on general economic conditions and consumer spending habits in these markets. In the event that any of these geographic areas experience a downturn in economic conditions, it could adversely affect our business.

Regulatory Environment. We are subject to a wide range of federal, state, and local laws and regulations, such as local licensing requirements and laws regarding advertising, vehicle sales, financing, and employment practices. Our facilities and operations are also subject to federal, state, and local laws and regulations relating to environmental protection and human health and safety. The violation of these laws and regulations could result in administrative, civil, or criminal penalties, or in a cease and desist order against operations. As a result, we have incurred, and will continue to incur, capital and operating expenditures and other costs in complying with these laws and regulations. Further, over the past several years, private plaintiffs and federal, state, and local regulatory and law enforcement authorities have increased their scrutiny of advertising, sales, and finance and insurance activities in the sale and leasing of motor vehicles. If, as a result, other automotive retailers adopt more transparent, consumer-oriented business practices, our differentiation versus those retailers could be reduced.

Litigation. We are subject to various litigation matters, which, if the outcomes in any significant matters are adverse, could negatively affect our business. Claims arising out of actual or alleged violations of law may be asserted against us by individuals, either individually or through class actions, or by governmental entities in civil or criminal investigations and proceedings. These actions could expose us to adverse publicity and to substantial monetary damages and legal defense costs, injunctive relief, and criminal and civil fines and penalties, including suspension or revocation of licenses to conduct operations.

Accounting Matters. The implementation of new accounting requirements or changes to U.S. generally accepted accounting principles could adversely affect our reported financial position or results of operations. Potential changes currently under consideration by the Financial Accounting Standards Board include, but are not limited to, proposed rule changes relating to the accounting for securitization transactions and potential changes in accounting for leases and pension expense.

Other Material Events. The occurrence of certain material events including natural disasters, acts of terrorism, the outbreak of war, or other significant national or international events could adversely affect our results.
 
Item 1B. Unresolved Staff Comments.
 
None.
 


 
Item 2. Properties.
 
We conduct our used vehicle operations in three basic retail formats - mega, standard, and satellite superstores. Our current growth plan primarily includes the construction of standard superstores and satellite superstores. Standard superstores are generally 40,000 to 60,000 square feet on 10 to 25 acres. Satellite superstores are generally 10,000 to 20,000 square feet on 4 to 10 acres. Mega superstores are approximately 70,000 to 95,000 square feet on 20 to 35 acres.
 
Stores as of February 28, 2007 
 
  Used Car Superstores
 
 
 
Mega
Standard (2)
 Satellite(2)
Co-Located
New Car Stores (1)
Total
Alabama
1
1
California
1
4
3
1
9
Connecticut
1
1
2
Florida
3
4
3
1
11
Georgia
1
2
1
4
Illinois
3
1
2
6
Indiana
1
1
2
Kansas
2
2
Kentucky
1
1
Maryland
1
1
1
1
4
Missouri
1
1
Nevada
1
1
2
New Mexico
1
1
North Carolina
3
3
6
Ohio
1
1
2
Oklahoma
1
1
South Carolina
2
2
Tennessee
3
1
4
Texas
4
4
3
11
Utah
1
1
Virginia
4
2
6
Wisconsin
1
1
2
Total
13
40
24
4
81
(1)
We currently operate seven new car franchises. Two franchises are integrated within used car superstores and do not operate as separate stores. The remaining five franchises are operated from four new car stores that are co-located with used car superstores.
(2)
The Kenosha, Wisc. superstore has been reclassified from a satellite to a standard superstore.
 
We have financed the majority of our stores through sale-leaseback transactions. As of February 28, 2007, we leased 61 of our 81 retail stores and owned the remaining 20 stores. We also own our home office building in Richmond, Va., and land associated with planned future store openings.
 
Expansion
We believe that we are well positioned to succeed in the highly competitive automotive retail industry. We have built a strong foundation for future growth based upon our unique knowledge of the used car market, established presence in key locations, and ability to execute our business plan in a market subject to continuous change. We continue to refine our operating strategies and have grown to be the nation’s largest retailer of used cars. Specifically, we have enhanced our ability to identify profitable markets and determine the appropriate store formats to fit those markets.
 
We plan to open superstores at an annual rate of approximately 15% to 20% of our used car superstore base. In fiscal 2008, we plan to open approximately 13 superstores, including 5 standard-sized superstores and 8 satellite superstores, expanding our store base by 17%. Our fiscal 2008 expansion plans are largely focused on opening standard superstores in new mid-sized markets and satellite superstores in existing markets. We generally define
 


 
mid-sized markets as those with television viewing populations of between 600,000 and 2.5 million people. Historically, mid-sized markets have been the easiest to enter from a real estate and an advertising/awareness building perspective, and they are where we have generally experienced the fastest ramp-up in store sales and profitability. We are also beginning to resume store growth in new large markets.
 
For additional details on fiscal 2008 planned store openings, please see “Operations Outlook,” included in Part II, Item 7, of this Form 10-K.
 
Item 3. Legal Proceedings.
 
On August 29, 2006, Heather Herron, et al. filed a putative class action lawsuit against numerous South Carolina automobile dealers, including CarMax Auto Superstores, Inc., in the Court of Common Pleas in Aiken County, South Carolina. Subject to final judicial approval, we have settled this lawsuit, and we believe the settlement will not materially affect our financial position or results of operations.
 
We are involved in various other legal proceedings in the normal course of business. Based upon our evaluation of information currently available, we believe that the ultimate resolution of any such proceedings will not have a material adverse effect, either individually or in the aggregate, on our financial position, liquidity, or results of operations.
 
Item 4. Submission of Matters to a Vote of Security Holders.
 
No matters were submitted to a vote of security holders during the fourth quarter of fiscal 2007.
 


PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.

Our common stock is listed and traded on the New York Stock Exchange under the ticker symbol KMX.

As of February 28, 2007, there were approximately 6,300 CarMax shareholders of record.

The following table sets forth for the fiscal periods indicated, the high and low sales prices per share for our common stock, as reported on the New York Stock Exchange composite tape as adjusted for the effect of the 2-for-1 stock split in March 2007.

   
First
Quarter
 
Second Quarter
 
Third
Quarter
 
Fourth
Quarter
 
Fiscal 2007
                 
High
 
$
18.20
 
$
18.95
 
$
23.99
 
$
29.44
 
Low
 
$
15.14
 
$
14.85
 
$
18.59
 
$
23.10
 
                           
Fiscal 2006
                         
High
 
$
17.00
 
$
17.12
 
$
16.00
 
$
15.92
 
Low
 
$
12.44
 
$
12.32
 
$
13.00
 
$
13.20
 


To date, we have not paid a cash dividend on the CarMax common stock. We presently intend to retain our net earnings for use in our operations and for geographic expansion and, therefore, we do not anticipate paying any cash dividends in the foreseeable future.

During the fourth quarter of fiscal 2007, we sold no CarMax equity securities that were not registered under the Securities Act of 1933, as amended. In addition, we did not repurchase any CarMax equity securities during this period.
 
Performance Graph
The following graph compares the five-year cumulative total return among CarMax common stock, the S&P 500 Index, and the S&P 500 Retailing Index. The graph assumes an original investment of $100 in our common stock and in each index on February 28, 2002, and the reinvestment of dividends, if applicable. We separated from Circuit City on October 1, 2002. For dates preceding October 1, 2002, the graph reflects information for the Circuit City Stores, Inc.-CarMax Group common stock. 
 


 
 
 
 
 
   
As of February 28 or 29
 
   
2002
 
2003
 
2004
 
2005
 
2006
 
2007
 
CarMax
 
$
100.00
 
$
56.28
 
$
127.15
 
$
123.41
 
$
117.50
 
$
197.08
 
S&P 500 Index
 
$
100.00
 
$
77.32
 
$
107.10
 
$
114.58
 
$
124.20
 
$
139.06
 
S&P 500 Retailing Index
 
$
100.00
 
$
72.39
 
$
113.21
 
$
125.29
 
$
135.97
 
$
149.85
 
 

 





Item 6. Selected Financial Data.

   
FY07
 
FY06
 
FY05
 
FY04
 
FY03
 
FY02
 
Income statement information
(In millions)
                         
Used vehicle sales
 
$
5,872.8
 
$
4,771.3
 
$
3,997.2
 
$
3,470.6
 
$
2,912.1
 
$
2,497.2
 
New vehicle sales
   
445.1
   
502.8
   
492.1
   
515.4
   
519.8
   
559.9
 
Wholesale vehicle sales
   
918.4
   
778.3
   
589.7
   
440.6
   
366.6
   
325.6
 
Other sales and revenues
   
229.3
   
207.6
   
181.3
   
171.1
   
171.4
   
151.1
 
Net sales and operating revenues
   
7,465.7
   
6,260.0
   
5,260.3
   
4,597.7
   
3,969.9
   
3,533.8
 
Gross profit
   
971.1
   
790.7
   
650.2
   
570.9
   
468.2
   
419.4
 
CarMax Auto Finance income
   
132.6
   
104.3
   
82.7
   
85.0
   
82.4
   
66.5
 
SG&A
   
776.2
   
674.4
   
565.3
   
479.3
   
399.5
   
337.0
 
Earnings before income taxes
   
323.3
   
217.6
   
165.8
   
178.4
   
149.6
   
143.9
 
Provision for income taxes
   
124.8
   
83.4
   
64.5
   
68.9
   
59.2
   
54.9
 
Net earnings
   
198.6
   
134.2
   
101.3
   
109.6
   
90.4
   
89.1
 
Share and per share
information (Shares in millions)
                                     
Weighted average shares outstanding:
                                     
Basic
   
212.5
   
209.3
   
208.1
   
207.0
   
206.0
   
204.1
 
Diluted
   
216.7
   
212.8
   
211.3
   
210.6
   
209.1
   
207.8
 
Net earnings per share:
                                     
Basic
 
$
0.93
 
$
0.64
 
$
0.49
 
$
0.53
 
$
0.44
 
$
0.44
 
Diluted
 
$
0.92
 
$
0.63
 
$
0.48
 
$
0.52
 
$
0.43
 
$
0.43
 
Balance sheet information (In millions)
                                     
Total current assets
 
$
1,150.5
 
$
941.7
 
$
853.0
 
$
760.5
 
$
697.3
 
$
577.7
 
Total assets
   
1,885.6
   
1,509.6
   
1,306.3
   
1,055.1
   
921.7
   
721.9
 
Total current liabilities
   
512.0
   
344.9
   
317.8
   
232.2
   
237.7
   
221.1
 
Short-term debt
   
3.3
   
0.5
   
65.2
   
4.4
   
56.1
   
9.8
 
Current portion of long-term debt
   
148.4
   
59.8
   
0.3
   
   
   
78.6
 
Long-term debt, excluding current portion
   
33.7
   
134.8
   
128.4
   
100.0
   
100.0
   
 
Total shareholders’ equity
   
1,247.4
   
980.1
   
814.2
   
688.0
   
558.6
   
487.1
 
Unit sales information
                                     
Used vehicle units sold
   
337,021
   
289,888
   
253,168
   
224,099
   
190,135
   
164,062
 
New vehicle units sold
   
18,563
   
20,901
   
20,636
   
21,641
   
22,360
   
24,164
 
Wholesale vehicle units sold
   
208,959
   
179,548
   
155,393
   
127,168
   
104,593
   
90,937
 
Percent changes in
                                     
Comparable store used vehicle unit sales
   
9
   
4
   
1
   
6
   
8
   
24
 
Total used vehicle unit sales
   
16
   
15
   
13
   
18
   
16
   
23
 
Total net sales and operating revenues
   
19
   
19
   
14
   
16
   
12
   
28
 
Diluted net earnings per share
   
46
   
31
   
(8
)
 
21
   
   
95
 
Other year-end information
                                     
Used car superstores
   
77
   
67
   
58
   
49
   
40
   
35
 
Retail stores
   
81
   
71
   
61
   
52
   
44
   
40
 
Associates
   
13,736
   
11,712
   
10,815
   
9,355
   
8,263
   
7,196
 

All share and per share amounts have been adjusted for the effect of the 2-for-1 stock split in March 2007. Certain prior year amounts have been reclassified to conform to the current year presentation. In fiscal 2007, we adopted SFAS 123(R), applying the modified retrospective method and restating prior period amounts for the effect of the adoption. See Notes 2(A) and 10(C) to the consolidated financial statements in Item 8 of this Form 10-K.


 
Item 7. 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 consolidated financial statements and the accompanying notes presented in Item 8, Consolidated Financial Statements and Supplementary Data. Note references are to the notes to consolidated financial statements included in Item 8. Amounts and percentages in tables may not total due to rounding. Certain prior year amounts have been reclassified to conform to the current year’s presentation.
 
We 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.

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 data included in MD&A have been adjusted to reflect this stock split.
 
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. At February 28, 2007, we operated 77 used car superstores in 36 markets, including 26 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. We also operated seven new car franchises, all of which are integrated or co-located with our used car superstores. In fiscal 2007, we sold 337,021 used cars, representing 95% of the total 355,584 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 our 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 retail 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. In fiscal 2007, we sold 208,959 vehicles at our wholesale auctions. 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, and Bank of America, and through several 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 the 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 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 stores 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 2008, we plan to open 13 superstores, expanding our store base by approximately 17%. 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, which we estimate 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 the store growth and our ability to procure suitable real estate at reasonable costs. We staff each newly opened store with an experienced management team. We must therefore continually recruit, train, and develop managers and associates to fill the pipeline necessary to support future store openings. If at any time we believed that the rate of store growth was causing our performance to falter, we would consider slowing the growth rate.
 
Fiscal 2007 Highlights
·  
Net sales and operating revenues increased 19% to $7.47 billion from $6.26 billion in fiscal 2006, while net earnings increased 48% to $198.6 million, or $0.92 per share, from $134.2 million, or $0.63 per share.
·  
Total used vehicle unit sales increased 16%, reflecting the combination of our 9% increase in comparable store used unit sales and the growth in our store base.
·  
Total wholesale vehicle unit sales increased 16%, consistent with our used vehicle unit sales growth.
·  
We opened ten used car superstores in fiscal 2007, including five standard superstores and five satellite superstores.
·  
Our total gross profit per unit increased to $2,731 from $2,544 in fiscal 2006. We realized improvements in gross profit per unit in all categories, including used vehicles, new vehicles, wholesale vehicles, and other. We believe our 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 economic environment.
·  
CAF income increased 27% to $132.6 million from $104.3 million in fiscal 2006. The improvement reflected the 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. CAF income included a benefit of $13.0 million, or $0.04 per share for favorable items, primarily valuation adjustments of our retained interest, in fiscal 2007, compared with a benefit of $15.2 million, or $0.04 per share in fiscal 2006.
·  
Selling, general, and administrative expenses as a percent of net sales and operating revenues (the “SG&A ratio”) declined to 10.4% from 10.8% in 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 $0.09 per share in fiscal 2007 compared with $0.07 per share in fiscal 2006, as restated. The fiscal 2007 expense includes costs of $0.02 per share resulting from the retirement of our former chief executive officer.
·  
Net cash provided by operations increased to $136.8 million from $117.5 million in fiscal 2006, primarily reflecting the improved net earnings offset by increased investment in working capital.
 
CRITICAL ACCOUNTING POLICIES
 
Our results of operations and financial condition as reflected in the consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles. Preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues, expenses, and the disclosures of contingent assets and liabilities. We use our historical experience and other relevant factors when developing our estimates and assumptions. We continually evaluate these estimates and assumptions. Note 2 includes a discussion of significant accounting policies. The accounting policies discussed below are the ones we consider critical to an understanding of our consolidated financial statements because their application places the most significant demands on our judgment. Our financial results might have been different if different assumptions had been used or other conditions had prevailed.
 
Securitization Transactions
We use a securitization program to fund substantially all of the automobile loan receivables originated by CAF. The securitization transactions are accounted for as sales. A gain, recorded at the time of the securitization transaction,
 


 
results from recording a receivable equal to the present value of the expected residual cash flows generated by the securitized receivables. The fair value of our retained interest in securitization transactions includes the present value of the expected residual cash flows generated by the securitized receivables, cash reserve accounts, and an undivided ownership interest in the receivables.
 
The present value of the expected residual cash flows generated by the securitized receivables is determined by estimating the future cash flows using management’s assumptions of key factors, such as finance charge income, loss rates, prepayment rates, and discount rates appropriate for the type of asset and risk. These assumptions are derived from historical experience and projected economic trends. Adjustments to one or more of these assumptions may have a material impact on the fair value of the retained interest. The fair value of the retained interest may also be affected by external factors, such as changes in the behavior patterns of customers, changes in the economy, and developments in the interest rate markets. Note 2(C) includes a discussion of accounting policies related to securitizations. Note 4 includes a discussion of securitizations and provides a sensitivity analysis showing the hypothetical effect on the retained interest if there were variations from the assumptions used. In addition, see the “CarMax Auto Finance Income” section of this MD&A for a discussion of the effect of changes in our assumptions.
 
Revenue Recognition
We recognize revenue when the earnings process is complete, generally either at the time of sale to a customer or upon delivery to a customer. We recognize used vehicle revenue when a sales contract has been executed and the vehicle has been delivered, net of a reserve for returns under our 5-day, money-back guarantee. A reserve for vehicle returns is recorded based on historical experience and trends, and it could be affected if future vehicle returns differ from historical averages.
 
We also sell ESPs on behalf of unrelated third parties to customers who purchase a vehicle. Because these third parties are the primary obligors under these programs, we recognize commission revenue on the ESPs at the time of the sale, net of a reserve for returns. The reserve for ESP returns is recorded based on historical experience and trends, and it could be affected if future returns differ from historical averages.
 
Income Taxes
Estimates and judgments are used in the calculation of certain tax liabilities and in the determination of the recoverability of certain of the deferred tax assets. In the ordinary course of business, transactions occur for which the ultimate tax outcome is uncertain at the time of the transactions. We adjust our income tax provision in the period in which we determine that it is probable that our actual results will differ from our estimates. Tax law and rate changes are reflected in the income tax provision in the period in which such changes are enacted.
 
We evaluate the need to record valuation allowances that would reduce deferred tax assets to the amount that will more likely than not be realized. When assessing the need for valuation allowances, we consider future reversals of existing temporary differences and future taxable income. We believe that all of our recorded deferred tax assets as of February 28, 2007, will more likely than not be realized. However, if a change in circumstances results in a change in our ability to realize our deferred tax assets, our tax provision would increase in the period when the change in circumstances occurs.
 
In addition, the calculation of our tax liabilities involves dealing with uncertainties in the application of complex tax regulations. We recognize potential liabilities for anticipated tax audit issues in the U.S. and other tax jurisdictions based on our estimate of whether, and the extent to which, additional taxes will be due. If payments of these amounts ultimately prove to be unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the liabilities are no longer necessary. If our estimate of tax liabilities proves to be less than the ultimate assessment, a further charge to expense would result in the period of determination.
 
Information regarding income taxes is presented in Note 7.
 
Defined Benefit Retirement Plan
The plan obligations and related assets of our defined benefit retirement plan are presented in Note 8. Plan assets, which consist primarily of marketable equity and debt instruments, are valued using current market quotations. Plan obligations and the annual pension expense are determined by independent actuaries using a number of assumptions provided by the company. Key assumptions used to measure the plan obligations include the discount rate, the
 


 
estimated rate of salary increases, and the estimated future return on plan assets. In determining the discount rate, we use the current yield on high-quality, fixed-income investments that have maturities corresponding to the anticipated timing of the benefit payments. Salary increase assumptions are based upon our historical experience and anticipated future board and management actions. Asset returns are estimated based upon the anticipated average yield on the plan assets. We do not believe that any significant changes in assumptions used to measure the plan obligations are likely to occur that would have a material impact on our financial position or results of operations.
 
RESULTS OF OPERATIONS
 
Net Sales and Operating Revenues
   
Years Ended February 28
 
(In millions)
 
2007
 
%
 
2006
 
%
 
2005
 
%
 
Used vehicle sales 
 
$
5,872.8
   
78.7
 
$
4,771.3
   
76.2
 
$
3,997.2
   
76.0
 
New vehicle sales 
   
445.1
   
6.0
   
502.8
   
8.0
   
492.1
   
9.4
 
Wholesale vehicle sales 
   
918.4
   
12.3
   
778.3
   
12.4
   
589.7
   
11.2
 
Other sales and revenues:
                                     
Extended service plan revenues
   
114.4
   
1.5
   
97.9
   
1.6
   
84.6
   
1.6
 
Service department sales
   
90.6
   
1.2
   
93.4
   
1.5
   
82.3
   
1.6
 
Third-party finance fees, net
   
24.3
   
0.3
   
16.3
   
0.3
   
14.4
   
0.3
 
Total other sales and revenues 
   
229.3
   
3.1
   
207.6
   
3.3
   
181.3
   
3.4
 
Total net sales and operating revenues 
 
$
7,465.7
   
100.0
 
$
6,260.0
   
100.0
 
$
5,260.3
   
100.0
 

Retail Vehicle Sales Changes
   
Years Ended February 28
 
   
2007
 
2006
 
2005
 
Vehicle units:
                   
Used vehicles
   
16
%
 
15
%
 
13
%
New vehicles
   
(11
)%
 
1
%
 
(5
)%
Total
   
14
%
 
14
%
 
11
%
                     
Vehicle dollars:
                   
Used vehicles
   
23
%
 
19
%
 
15
%
New vehicles
   
(11
)%
 
2
%
 
(5
)%
Total
   
20
%
 
17
%
 
13
%

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
   
Years Ended February 28
 
   
2007
 
2006
 
2005
 
Vehicle units:
                   
Used vehicles
   
9
%
 
4
%
 
1
%
New vehicles
   
(11
)%
 
1
%
 
8
%
Total
   
8
%
 
4
%
 
1
%
                     
Vehicle dollars:
                   
Used vehicles
   
16
%
 
8
%
 
3
%
New vehicles
   
(12
)%
 
1
%
 
8
%
Total
   
13
%
 
8
%
 
3
%





Change in Used Car Superstore Base

   
Years Ended February 28
 
   
2007
 
2006
 
2005
 
Used car superstores, beginning of year
   
67
 
 
58
 
 
49
 
Superstore openings:
                   
Standard superstores
   
5
 
 
5
 
 
5
 
Satellite superstores
   
5
 
 
4
 
 
4
 
Total superstore openings
   
10
 
 
9
 
 
9
 
Used car superstores, end of year
   
77
   
67
   
58
 
Openings as a percent of the beginning-of-year store base
   
15
%
 
16
%
 
18
%
 
Used Vehicle Sales
Fiscal 2007 Versus Fiscal 2006. The 23% increase in used vehicle revenues in fiscal 2007 reflected a 16% increase in unit sales and a 6% increase in average retail selling price. The unit sales growth reflected a 9% increase in comparable store used units, together with sales from newer superstores not yet in the comparable store base. Our comparable store used unit sales growth benefited from strong store and Internet traffic and continued strong execution by our store teams. The increase in the average retail selling price was primarily the result of a shift in vehicle mix, as we experienced a resurgence in the sales of SUVs and trucks, which we believe had been adversely affected in the prior year by consumer reaction to higher gasoline prices. The increase in average retail selling price also reflected growth in the percentage of luxury vehicles in our sales mix.
 
Sales financed by Drive Financial Services declined to less than 1% of our used vehicle unit sales in fiscal 2007 from approximately 3% in fiscal 2006. In the fourth quarter of fiscal 2006, this lender implemented program changes in certain states, narrowing the selection of vehicles it would finance, and making this business less economically attractive to us. We chose to curtail our business with Drive in these states to preserve margins and profits. The decline in Drive-financed sales in fiscal 2007 was substantially offset, however, by incremental sales financed by additional lenders added to our third-party lender group in the second half of fiscal 2006.
 
Fiscal 2006 Versus Fiscal 2005. The 19% increase in used vehicle revenues in fiscal 2006 reflected a 15% increase in unit sales and a 4% increase in average retail selling price. The unit sales growth reflected sales from newer superstores not yet in the comparable store base, together with a 4% increase in comparable store used units. The comparable store used unit sales growth was driven by an increase in store traffic, combined with continued strong execution by our store teams. Store traffic and comparable store sales increases were particularly strong during the period from June through September 2005, which coincided with the domestic new car manufacturers’ employee pricing incentive programs. Under these programs, the manufacturers established specific “employee” prices, available to all consumers, for each make and model. These programs created greater clarity on new car pricing and increased traffic in the marketplace, both of which we believe benefited CarMax. Our no-haggle consumer offer makes price comparing easy, and we believe it gives us a unique advantage as consumers cross-shop.
 
Sales financed by Drive, which was added to our third-party lender group in mid-fiscal 2005, remained approximately 3% of total used vehicle unit sales in fiscal 2006 and fiscal 2005. The full-year benefit of adding this lender was offset by the program curtailments made in the fourth quarter of fiscal 2006.
 
New Vehicle Sales
Fiscal 2007 Versus Fiscal 2006. The 11% decline in new vehicle revenues in fiscal 2007 was substantially the result of a decline in unit sales, and in part reflects 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 new vehicle unit sales also reflects the effects of reduced industry new car sales for several of the brands we represent, including Chevrolet, DaimlerChrysler, and Nissan.
 
Fiscal 2006 Versus Fiscal 2005. The 2% increase in new vehicle revenues in fiscal 2006 was due to a 1% increase in unit sales and a 1% increase in average retail selling price. New vehicle unit sales were strong during the domestic new car manufacturers’ employee pricing programs in June through September 2005; however, these increases were substantially offset by the effects of softer industry new car sales in the months following the end of these programs. New vehicle sales were generally in line with industry performance for the core brands we
 


 
represent—Chevrolet, DaimlerChrysler, Nissan, and Toyota. Our disposition of five new car franchises in the second half of fiscal 2005 also affected the change in our new car unit sales.
 
Wholesale Vehicle Sales
Our operating strategy is to build customer satisfaction by offering high-quality vehicles. Fewer than half of the vehicles acquired from consumers through the appraisal purchase process meet our standards for reconditioning and subsequent retail sale. Those vehicles that do not meet our standards are sold at our on-site wholesale auctions.
 
Fiscal 2007 Versus Fiscal 2006. The 18% increase in wholesale vehicle revenues in fiscal 2007 resulted from a 16% increase in wholesale unit sales and a 1% increase in average wholesale selling price. Our wholesale unit sales benefited from a substantial increase in appraisal traffic, primarily spurred by our strong comparable store unit sales growth, and the expansion of our store base. In the first half of fiscal 2007, our average wholesale selling price climbed 6% reflecting, we believe, the residual effects of industry shortages of older, higher-mileage vehicles experienced following Hurricanes Katrina, Rita, and Wilma in the fall of 2005. In the second half of fiscal 2007, our average wholesale selling price was 4% below the prior year level reflecting the challenging comparison with the previous year.
 
Fiscal 2006 Versus Fiscal 2005. The 32% increase in wholesale vehicle revenues in fiscal 2006 reflected a 16% increase in wholesale unit sales and a 14% increase in average wholesale selling price. Our wholesale unit sales growth benefited from a strong increase in appraisal traffic combined with the expansion of our store base. Appraisal traffic was higher throughout fiscal 2006, but it was particularly strong in the second quarter. We believe this increase was due, in part, to the domestic new car manufacturers’ employee pricing programs. In these programs, franchised dealers lost some ability to negotiate on trade-ins due to their inability to negotiate on the published employee discount price on new cars. In addition, the employee pricing programs coincided with a period of rapid decline in wholesale values for SUVs and large trucks as the result of a spike in gasoline prices, making some dealers reluctant to accept these vehicles in trade. These factors created an influx of appraisal traffic at CarMax as we continued to make appraisal purchase offers on all vehicles presented for appraisal. Appraisal traffic also benefited from our focused “We Buy Cars” advertising during fiscal 2006.
 
Our on-site wholesale auctions exhibited unusual aggregate price strength in fiscal 2006, reflecting trends in the general wholesale market. We believe some of the factors that may have contributed to the unusually strong wholesale market pricing environment during various portions of the year included reduced supplies of off-lease and off-rental cars; the strong demand for smaller, fuel-efficient cars in the face of rising gasoline prices; and hurricanes Katrina, Rita, and Wilma, which destroyed an estimated 400,000 to 600,000 vehicles and created a short-term supply/demand imbalance. Wholesale industry price increases were especially strong in older, higher mileage cars that make up the majority of the vehicles we sell at wholesale. Our wholesale prices also benefited from a record level of dealer attendance at our auctions and a record dealer-to-car ratio in fiscal 2006. We believe the high dealer attendance at our auctions reflected the industry shortage of older vehicles as well as our continuing efforts to attract dealers to our auctions.
 
Other Sales and Revenues
Fiscal 2007 Versus Fiscal 2006. Other sales and revenues increased 10% in fiscal 2007. The increase was primarily the result of increased sales of ESPs and an increase in third-party finance fees. The increase in ESP sales was consistent with our increase in used vehicle unit sales. The third-party finance fees benefited from the decline in Drive-financed sales. We record the discount at which this lender purchases loans as an offset to the third-party finance fee revenues. Service department sales declined modestly in fiscal 2007, as the reconditioning activities required to support our strong comparable store used vehicle sales growth limited the service capacity available for customer pay work.
 
Fiscal 2006 Versus Fiscal 2005. Other sales and revenues increased 14% in fiscal 2006, as all components benefited from the increase in retail vehicle sales and the expansion of our superstore base.
 


 
Supplemental Sales Information
 
Unit Sales
   
Years Ended February 28
 
   
2007
 
2006
 
2005
 
Used vehicles
   
337,021
   
289,888
   
253,168
 
New vehicles
   
18,563
   
20,901
   
20,636
 
Wholesale vehicles
   
208,959
   
179,548
   
155,393
 
 
Average Selling Prices
   
Years Ended February 28
 
   
2007
 
2006
 
2005
 
Used vehicles
 
$
17,249
 
$
16,298
 
$
15,663
 
New vehicles
 
$
23,833
 
$
23,887
 
$
23,671
 
Wholesale vehicles
 
$
4,286
 
$
4,233
 
$
3,712
 
 
Retail Vehicle Sales Mix
   
Years Ended February 28
 
   
2007
 
2006
 
2005
 
Vehicle units:
                   
Used vehicles
   
95
%
 
93
%
 
92
%
New vehicles
   
5
   
7
   
8
 
Total
   
100
%
 
100
%
 
100
%
                     
Vehicle dollars:
                   
Used vehicles
   
93
%
 
90
%
 
89
%
New vehicles
   
7
   
10
   
11
 
Total
   
100
%
 
100
%
 
100
%
 
Retail Stores
   
As of February 28
 
   
2007
 
2006
 
2005
 
Mega superstores (1)
   
13
   
13
   
13
 
Standard superstores (2) (4)
   
40
   
35
   
30
 
Satellite superstores (3) (4)
   
24
   
19
   
15
 
Total used car superstores
   
77
   
67
   
58
 
Co-located new car stores
   
4
   
4
   
3
 
Total
   
81
   
71
   
61
 
(1)
Generally 70,000 to 95,000 square feet on 20 to 35 acres.
(2)
Generally 40,000 to 60,000 square feet on 10 to 25 acres.
(3)
Generally 10,000 to 20,000 square feet on 4 to 10 acres.
(4)
The Kenosha, Wisc. superstore has been reclassified from a satellite to a standard superstore.
 
We have a total of seven new car franchises. Two franchises are integrated within used car superstores, and the remaining five franchises are operated from four facilities that are co-located with select used car superstores.
 


Gross Profit
   
Years Ended February 28
 
   
2007
 
2006
 
2005
 
   
$ per unit (1)
 
% (2)
 
$ per unit (1)
 
% (2)
 
$ per unit (1)
 
% (2)
 
Used vehicle gross profit
 
$
1,903
   
10.9
 
$
1,808
   
11.0
 
$
1,817
   
11.5
 
New vehicle gross profit
 
$
1,169
   
4.9
 
$
934
   
3.9
 
$
860
   
3.6
 
Wholesale vehicle gross profit
 
$
742
   
16.9
 
$
700
   
16.1
 
$
464
   
12.2
 
Other gross profit
 
$
431
   
66.8
 
$
391
   
58.5
 
$
366
   
55.3
 
Total gross profit
 
$
2,731
   
13.0
 
$
2,544
   
12.6
 
$
2,375
   
12.4
 
(1)
Calculated as category gross profit divided by its respective units sold, except the other and total categories, which are divided by total retail units sold.
(2)
Calculated as a percentageof its respective sales or revenue.
 
Used Vehicle Gross Profit
We target a similar dollar amount of gross profit per used unit, regardless of retail price. Our ability to quickly adjust appraisal offers to be consistent with the broader market trade-in trends and our rapid inventory turns reduce our exposure to the inherent continual depreciation in used vehicle values and contribute to our ability to manage our gross profit dollars per unit. In addition, over the past few years, we have continued to refine our car-buying strategies, which we believe has benefited our used vehicle gross profit per unit.
 
Fiscal 2007 Versus Fiscal 2006. Our used vehicle gross profit increased $95 per unit in fiscal 2007. This increase reflected the benefit of our strong, consistent sales performance throughout the year. We believe several external factors contributed to a greater degree of sales volatility in the prior year, including significant changes in gasoline prices, new vehicle incentives, and interest rates. We did not experience similar variability in these external factors in fiscal 2007, and therefore benefited from a more stable business environment. We employ a volume-based strategy, and we systematically mark down individual vehicle prices based on our proprietary pricing algorithms in order to appropriately balance sales growth, inventory turns, and gross profit achievement. When customer traffic and our sales are consistently strong, we generally take fewer pricing markdowns, which in turn maximizes our gross profit dollars per unit. In addition, our used vehicle gross profit in fiscal 2006 was adversely affected by slowing demand for SUVs and trucks that have lower gas mileage, which resulted in higher pricing markdowns for these vehicles.
 
Fiscal 2006 Versus Fiscal 2005. While our used vehicle gross profit dollars per unit in fiscal 2006 was similar to that achieved in fiscal 2005, our used vehicle gross profits remained under some pressure throughout fiscal 2006. The profit pressure was primarily the result of the combination of the strong wholesale industry pricing and our desire to price our retail cars at competitive levels for consumers comparing options in the new and used car markets. A strong wholesale industry pricing environment increases our cost of acquiring vehicles both in our in-store purchases and at auction. We were able to offset some of the resulting profit pressure through successful refinements in our in-store appraisal strategy. During portions of fiscal 2006, we did not increase our appraisal offers at the same rate as the steep increase in the major public wholesale auction market prices, as we did not believe the price trends at the major public wholesale auctions were reflective of the broader market trade-in offer trends. This belief was reinforced by the fact that we continued to experience strong increases in appraisal traffic while maintaining our ratio of appraisal buys to appraisal offers. This strategy allowed us to keep our retail prices more in line with underlying retail demand, while maintaining gross profit dollars per unit.
 
New Vehicle Gross Profit
Fiscal 2007 Versus Fiscal 2006. Our new vehicle gross profit increased $235 per unit in fiscal 2007. The increase primarily reflected our strategic decision to increase targeted new vehicle gross profit dollars per unit. While this decision contributed to a reduction in new vehicle unit sales, it resulted in an increase in the total gross profit contribution from new vehicles.
 
Fiscal 2006 Versus Fiscal 2005. Our new vehicle gross profit increased $74 per unit in fiscal 2006. The increase was primarily attributable to the higher profits realized during the domestic new car manufacturers’ employee pricing programs. We were able to modestly increase our new car prices during these programs, as our pricing had generally been below the manufacturers’ specified employee discount prices.
 

 
Wholesale Vehicle Gross Profit
Fiscal 2007 Versus Fiscal 2006. In spite of the challenging comparison with the prior year, our wholesale vehicle gross profit increased $42 per unit in fiscal 2007. Our wholesale vehicle profitability has steadily increased over the last several years, reflecting the benefits realized from improvements and refinements in our car-buying strategies, our appraisal delivery processes, and our in-store auction processes. We have made continuous improvements in these processes, which we believe has allowed us to become more efficient. Our in-store auctions have benefited from our initiatives to increase average dealer attendance, which we believe has allowed us to achieve higher prices.
 
Fiscal 2006 Versus Fiscal 2005. Our wholesale vehicle gross profit increased $236 per unit in fiscal 2006. We believe a portion of this increase resulted from the unusually strong wholesale pricing environment in fiscal 2006. In addition, the refinements in our in-store appraisal strategy benefited our wholesale operations, while allowing us to maintain used vehicle gross profit dollars per unit levels in the face of rising vehicle acquisition costs. While we did not increase our appraisal offers at the same rate as the steep increase in the major public wholesale auction market prices, our own wholesale auctions generally reflected the pricing trends of the public wholesale auctions.
 
Our wholesale gross profit was particularly strong in the second half of fiscal 2006 as the result of a combination of factors. The supply/demand imbalance for older, higher mileage cars created by Hurricanes Katrina, Rita, and Wilma resulted in unusually strong demand and price realizations for our wholesale vehicles. In addition, as we normally do in the third quarter, we adjusted our appraisal offers to incorporate the anticipated seasonal drop in wholesale pricing. Wholesale industry pricing typically declines during the fall due to pressure from model year closeout sales and from reduced demand at auction as dealers pare back inventories heading into the slower-volume winter months. We were particularly aggressive in our appraisals of SUVs where wholesale prices had fallen dramatically through the summer following sharp increases in the cost of gasoline. Pricing in the overall wholesale marketplace did not decline as much as anticipated, however, giving us unusually high third quarter wholesale gross profits.
 
Other Gross Profit
Fiscal 2007 Versus Fiscal 2006. Other gross profit increased $40 per unit in fiscal 2007. The improvement was the result of the growth in ESP sales and third-party finance fees, both of which have no associated cost of sales, and an increase in service department margins. Our service department reported higher profits, reflecting the greater overhead expense absorption provided by the significant increase in used vehicles sales and the associated reconditioning volumes.
 
Fiscal 2006 Versus Fiscal 2005. Other gross profit per unit increased $25 per unit in fiscal 2006. The improvement was primarily the result of improved penetration in sales of ESPs and the growth in service profits. The service department, which is the only category within other sales and revenues that has an associated cost of sales, reported higher profits reflecting the greater overhead expense absorption provided by the higher vehicle sales and reconditioning volumes.
 
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. However, CAF income will benefit from an increase in the average amount financed.
 
CarMax Auto Finance Income
CAF provides automobile financing for our used and new car sales. Because the purchase of an automobile is traditionally reliant on the consumer’s ability to obtain on-the-spot financing, it is important to our business that financing be available to creditworthy customers. While financing can also be obtained from third-party sources, we believe that total reliance on third parties can create unacceptable volatility and business risk. Furthermore, we believe that our processes and systems, the transparency of our pricing, and our vehicle quality provide a unique and ideal environment in which to procure high-quality auto finance receivables, both for CAF and for our third-party lenders. CAF provides us the opportunity to capture additional profits and cash flows from auto loan receivables while managing our reliance on third-party finance sources.


 
Components of CAF Income
   
Years Ended February 28
 
(In millions)
 
2007
 
 %
 
2006
 
 %
 
2005
 
 %
 
Total gain income (1)
 
$
99.7
   
4.3
 
$
77.1
   
4.1
 
$
58.3
   
3.8
 
Other CAF income: (2)
                                     
Servicing fee income
   
32.4
   
1.1
   
27.6
   
1.0
   
24.7
   
1.0
 
Interest income
   
26.6
   
0.9
   
21.4
   
0.8
   
19.0
   
0.8
 
Total other CAF income
   
59.0
   
1.9
   
49.0
   
1.8
   
43.7
   
1.8
 
Direct CAF expenses: (2)
                                     
CAF payroll and fringe benefit
expense
   
12.0
   
0.4
   
10.3
   
0.4
   
9.0
   
0.4
 
Other direct CAF expenses
   
14.0
   
0.5
   
11.5
   
0.4
   
10.3
   
0.4
 
Total direct CAF expenses
   
26.0
   
0.9
   
21.8
   
0.8
   
19.3
   
0.8
 
CarMax Auto Finance income (3)
 
$
132.6
   
1.8
 
$
104.3
   
1.7
 
$
82.7
   
1.6
 
Total loans sold
 
$
2,322.7
       
$
1,887.5
       
$
1,534.8
       
Average managed receivables
 
$
3,071.1
       
$
2,657.7
       
$
2,383.6
       
Ending managed receivables
 
$
3,311.0
       
$
2,772.5
       
$
2,494.9
       
Total net sales and operating revenues
 
$
7,465.7
       
$
6,260.0
       
$
5,260.3
       

Percent columns indicate:
(1)
Percent of loans sold.
(2)
Percent of average managed receivables.
(3)
Percent of net sales and operating revenues.

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 this operation. 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.

CAF originates automobile loans to qualified customers at competitive market rates of interest. The majority of the profit contribution from CAF is generated by the spread between the interest rates charged to customers and our cost of funds. Substantially all of the loans originated by CAF are sold in securitization transactions. 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. In a normalized environment, we expect the gains on loans originated and sold as a percent of loans originated and sold (the “gain percentage”) to be in the range of 3.5% to 4.5%.
 
Total gain income in fiscal 2007, 2006, and 2005 included the effects of retained interest valuation adjustments, new public securitizations, and the repurchase and resale of receivables in existing public securitizations. The following table provides information on the aggregate effect of these items on gain income, loans sold, and the gain percentage.
 


 
Gain Income and Loans Sold
   
Years Ended February 28
 
(In millions)
 
2007
 
2006
 
2005
 
Gains on sales of loans originated and sold
 
$
86.7
 
$
61.9
 
$
54.9
 
Other gain income
   
13.0
   
15.2
   
3.3
 
Total gain income
 
$
99.7
 
$
77.1
 
$
58.3
 
                     
Loans originated and sold
 
$
2,240.2
 
$
1,792.6
 
$
1,483.8
 
Receivables repurchased from public securitizations and
resold
   
82.5
   
94.8
   
51.0
 
Total loans sold
 
$
2,322.7
 
$
1,887.5
 
$
1,534.8
 
Gain percentage on loans originated and sold
   
3.9
%
 
3.5
%
 
3.7
%
Total gain income as a percentage of total loans sold
   
4.3
%
 
4.1
%
 
3.8
%
 
Fiscal 2007 Versus Fiscal 2006. CAF income rose 27% to $132.6 million in fiscal 2007. CAF income benefited from the growth in retail vehicle unit sales, and increases in the gain percentage, average amount financed, and total managed receivables. The gain percentage increased to 3.9% in fiscal 2007 from 3.5% in fiscal 2006, reflecting changes in the interest rate environment. In fiscal 2006, our funding costs were rising faster than rates charged to consumers resulting in a lower gain percentage. In fiscal 2007, the relative stability in our funding cost allowed us to achieve a higher gain percentage. The increases in other CAF income and direct CAF expenses in fiscal 2007 were proportionate to the growth in managed receivables during the year.
 
We recognized other gain income of $13.0 million, or $0.04 per share in fiscal 2007 compared with $15.2 million, or $0.04 per share, in fiscal 2006. In fiscal 2007, substantially all of the other gain income resulted from favorable valuation adjustments. In fiscal 2006, other gain income included $0.03 per share of favorable valuation adjustments, $0.01 per share of favorable effects from new public securitizations, and a favorable effect of less than $0.01 per share from the repurchase and resale of receivables in existing public securitizations. These items are discussed below:
 
·  
Valuation adjustments. The net favorable valuation adjustments in both fiscal 2007 and fiscal 2006 primarily resulted from lowering loss rate assumptions, mostly on pools of receivables securitized in calendar years 2003, 2004, and 2005. We believe these pools of receivables experienced lower-than-expected loss rates as a result of a combination of factors, including better-than-expected performance of our new credit scorecard implemented in calendar year 2002, favorable economic conditions, operating efficiencies resulting from systems enhancements, and an improved recovery rate.
 
·  
New public securitizations. CarMax periodically repurchases receivables from the warehouse facility and refinances them in public securitizations. The impact of refinancing receivables can be favorable or unfavorable depending on the relative economics of funding structures at the time the receivables are refinanced. These transactions did not have a material impact in fiscal 2007. In fiscal 2006, we recognized a benefit of $0.01 per share as we refinanced balances from the warehouse facility into new public securitizations.
 
·  
Repurchase and resale of receivables. Our securitizations typically contain an option to repurchase the securitized receivables when the outstanding balance in a pool of automobile loan receivables falls below 10% of the original pool balance. This option was exercised two times in each of fiscal 2007 and 2006. In each case, the remaining eligible automobile loan receivables were subsequently resold into the warehouse facility. These transactions did not have a material impact in fiscal 2007. In fiscal 2006, the spread between the APR on the loans and the then-current funding cost in the warehouse facility resulted in an earnings benefit.
 
In future years, the effect of refinancing, repurchase, and resale activity could be favorable or unfavorable depending on the securitization structure and market conditions at the transaction date.
 


 
Fiscal 2006 Versus Fiscal 2005. CAF income rose 26% to $104.3 million in fiscal 2006. The fiscal 2006 total gain income benefited from the growth in retail vehicle sales and a substantial increase in other gain income, partially offset by a modest decline in the gain percentage to 3.5% from 3.7% in fiscal 2005. The increases in other CAF income and direct CAF expenses in fiscal 2006 were proportionate to the growth in managed receivables during the year.
 
Other gain income was $15.2 million in fiscal 2006 compared with $3.3 million in fiscal 2005. In fiscal 2005, approximately half of the other gain income related to favorable valuation adjustments, and the remainder primarily resulted from the repurchase and resale of receivables in existing public securitizations.
 
Past Due Account Information
   
As of February 28
 
(In millions)
 
2007
 
2006
 
2005
 
Loans securitized
 
$
3,242.1
 
$
2,710.4
 
$
2,427.2
 
Loans held for sale or investment
   
68.9
   
62.0
   
67.7
 
Total managed receivables
 
$
3,311.0
 
$
2,772.5
 
$
2,494.9
 
Accounts 31+ days past due
 
$
56.9
 
$
37.4
 
$
31.1
 
Past due accounts as a percentage of total managed
receivables
   
1.72
%
 
1.35
%
 
1.24
%
 
Credit Loss Information
   
Years Ended February 28
 
(In millions)
 
2007
 
2006
 
2005
 
Net credit losses on managed receivables
 
$
20.7
 
$
18.4
 
$
19.5
 
Average managed receivables
 
$
3,071.1
 
$
2,657.7
 
$
2,383.6
 
Net credit losses as a percentage of average managed
receivables
   
0.67
%
 
0.69
%
 
0.82
%
Recovery rate
   
51
%
 
51
%
 
46
%
 
We are at risk for the performance of the managed securitized receivables to the extent of our retained interest in the receivables. If the managed receivables do not perform in accordance with the assumptions used in determining the fair value of the retained interest, earnings could be impacted. Past due accounts as a percentage of total managed receivables increased moderately in fiscal 2007. While credit losses as a percentage of averaged managed receivables decreased slightly in fiscal 2007, the decrease was attributable to favorability in the first half of the year, offset by higher losses in the second half of the year. We believe the increase in losses during the second half of the year was the result of a combination of factors, including a gradual shift in credit mix of the portfolio as well as less favorable general economic and industry trends. Receivables originated in calendar years 2003, 2004, and early 2005 have experienced loss rates well below both CAF’s historical averages and our targeted loss rates. We believe this favorability was due, in part, to the credit scorecard we implemented in late 2002. As it became evident that the scorecard was resulting in lower-than-expected loss rates, CAF gradually expanded its credit offers beginning in late 2004. As a result, receivables originated in late 2005 and 2006 have been experiencing higher loss and delinquency rates than receivables originated in those prior years. The changes in loss and delinquency rates were largely anticipated and were incorporated in our initial loss assumptions for these pools.
 
The recovery rate represents the average percentage of the outstanding principal balance we receive when a vehicle is repossessed and liquidated at wholesale auction. We believe the improvement in the recovery rate in fiscal 2006 reflected the stronger wholesale market pricing environment.
 
Selling, General, and Administrative Expenses
Fiscal 2007 Versus Fiscal 2006. The SG&A ratio declined to 10.4% from 10.8% in fiscal 2006. We benefited from the leverage of fixed expenses generated by our strong comparable store sales growth. The improvement in the fiscal 2007 SG&A ratio was partially offset by an increase in share-based compensation costs and by the recognition of an impairment loss totaling $4.9 million, or $0.01 per share. The impairment loss related to the write down of intangible assets associated with one of our new car franchises.
 


 
We recognized $32.7 million, or $0.09 per share, of share-based compensation costs in fiscal 2007, $30.4 million of which was included in SG&A, compared with $22.4 million, or $0.07 per share, in fiscal 2006, all of which was included in SG&A. The increase in share-based compensation cost was driven, in large part, by the accelerated vesting of stock options upon the retirement of our former chief executive officer in August 2006.
 
Fiscal 2006 Versus Fiscal 2005. The SG&A ratio increased slightly to 10.8% from 10.7% in fiscal 2005. The moderate rate of increase in comparable store used unit sales in fiscal 2006 was not sufficient to provide SG&A leverage. The increase in the percentage of our store base that is comprised of newer stores not yet at basic maturity, which generally occurs in the fifth year of operation, also was a contributing factor. Newer stores typically experience higher SG&A ratios during their first four years of operation. On average, 45% of our stores were less than four years old in fiscal 2006 compared with 37% in fiscal 2005. Costs associated with the launch of market-wide television advertising in Los Angeles in fiscal 2006 and the lower-than-normal corporate bonus expense in fiscal 2005 also precluded SG&A leverage.
 
Income Taxes
The effective income tax rate was 38.6% in fiscal 2007, 38.3% in fiscal 2006, and 38.9% in fiscal 2005. The fiscal 2006 decrease resulted primarily from a legal entity reorganization in the fourth quarter of fiscal 2005. We created a centralized corporate management entity in an effort to obtain operational, legal, and other benefits that also resulted in state tax efficiencies.
 
OPERATIONS OUTLOOK
 
Store Openings and Capital Expenditures
During the fiscal year ending February 29, 2008, we plan to expand our used car superstore base by approximately 17%, opening an estimated 13 used car superstores.
 
Fiscal 2008 Planned Superstore Openings
 
Location
 
Television Market
 
Market Status
Standard
Superstores
Satellite
Superstores
Tucson, Ariz.
Tucson
New market
1
-
Milwaukee, Wis.
Milwaukee
New market
-
2
Torrance, Calif.
Los Angeles
Existing market
-
1
Roswell, Ga.
Atlanta
Existing market
-
1
Newport News, Va.
Norfolk / Virginia Beach
Existing market
-
1
Gastonia, N.C.
Charlotte
Existing market
1
-
Kearney Mesa, Calif.
San Diego
New market
-
1
Modesto, Calif.
Sacramento
Existing market
1
-
Riverside, Calif.
Los Angeles
Existing market
-
1
Omaha, Neb.
Omaha
New market
1
-
Jackson, Miss.
Jackson
New market
1
-
Ellicott City, Md.
DC / Baltimore
Existing market
-
1
Total planned openings
5
8
 
We expect to enter five new markets and expand our presence in six existing markets in fiscal 2008. We currently expect to open approximately four superstores in the first half of fiscal 2008 and nine superstores in the second half of the year. However, normal construction, permitting, or other scheduling delays could shift opening dates of stores into the following fiscal year.
 
In fiscal 2008, we also plan to open three additional car buying centers, with one each in the Raleigh, Dallas, and Tampa markets. These sites will expand a test begun in fiscal 2007, when we opened our first car buying center in the Atlanta market. We only conduct appraisals and purchase cars at these sites and do not sell cars. These test stores are part of our long-term program to increase both appraisal traffic and retail vehicle sourcing self-sufficiency.
 
We currently estimate gross capital expenditures will total approximately $300 million in fiscal 2008. Planned expenditures primarily relate to new store construction and land purchases associated with future year store openings. Compared with the approximately $192 million spent in fiscal 2007, the fiscal 2008 capital spending
 


 
estimate reflects more real estate purchases for future development in larger, multi-store markets. In addition, the fiscal 2007 capital spending amount was lower than originally projected, due in part to the acquisition of some store sites pursuant to ground leases.
 
Fiscal 2008 Expectations
The fiscal 2008 expectations discussed below are based on historical and current trends in our business and should be read in conjunction with “Risk Factors,” in Part I, Item 1A of this Form 10-K.
 
Fiscal 2008 Sales. We currently anticipate comparable store used unit growth for fiscal 2008 in the range of 3% to 9%. We also expect wholesale unit sales growth to be consistent with our total used unit sales increase. Total revenues are expected to climb by between 14% and 20%, reflecting our expectations for comparable store used unit growth, new store openings, a modest increase in used vehicle average selling price, and a continued decline in our new vehicle sales.
 
Fiscal 2008 Earnings Per Share. We currently anticipate fiscal 2008 earnings per share in the range of $1.03 to $1.14, representing EPS growth in the range of 12% to 24%. We expect modest improvement in both used vehicle and wholesale gross profits per unit in fiscal 2008, as we continue to refine and improve our car-buying processes.
 
We expect CAF income to increase modestly, but at a pace slower than anticipated sales growth, primarily reflecting the challenging comparison created by the $13.0 million of favorable CAF items reported in fiscal 2007. The CAF gain percentage is anticipated to be slightly above the midpoint of our normalized 3.5% to 4.5% range in fiscal 2008, assuming no significant change in the interest rate environment.
 
Our effective tax rate for fiscal 2008 is expected to be similar to the fiscal 2007 rate. However, our diluted share count is expected to increase by approximately 3%, reflecting the effects of the recent increase in our stock price and option exercises on the weighted average share calculation. The diluted share count for the fourth quarter of fiscal 2007 was 1.4% higher than the average for the full year, accounting for approximately one-half of the anticipated 3% increase.
 
RECENT ACCOUNTING PRONOUNCEMENTS
 
For a discussion of recent accounting pronouncements applicable to the company, see Note 15.
 
FINANCIAL CONDITION
 
Operating Activities
We generated net cash from operating activities of $136.8 million in fiscal 2007, $117.5 million in fiscal 2006, and $41.8 million in fiscal 2005. Cash generated from operating activities was $19.3 million higher in fiscal 2007 compared with fiscal 2006. The $64.4 million increase in net earnings in fiscal 2007 was more than offset by the increased growth in inventories. Inventories increased by $166.4 million in fiscal 2007 compared with a $93.1 million increase in fiscal 2006. The fiscal 2007 inventory increase related to store openings during fiscal 2007 and shortly after the end of the fiscal year, as well as to added vehicle inventory required to support our strong increase in fourth quarter comparable store used unit sales.
 
Cash generated from operating activities was $75.7 million higher in fiscal 2006 compared with fiscal 2005. The increase reflected the $32.9 million increase in net earnings in fiscal 2006 and a $44.6 million reduction in the year-over-year growth in working capital.
 
The aggregate principal amount of automobile loan receivables funded through securitizations, which are discussed in Notes 3 and 4 totaled $3.24 billion at February 28, 2007, $2.71 billion at February 28, 2006, and $2.43 billion at February 28, 2005. During fiscal 2007, we completed three public automobile securitizations totaling $1.87 billion. At February 28, 2007, the warehouse facility limit was $825.0 million and unused warehouse capacity totaled $227.0 million. The warehouse facility matures in July 2007. Note 4 includes a discussion of the warehouse facility. We anticipate that we will be able to renew, expand, or enter into new securitization arrangements to meet CAF’s future needs.


 
Investing Activities
Net cash used in investing activities was $187.2 million in fiscal 2007, $116.1 million in fiscal 2006, and $141.1 million in fiscal 2005. Capital expenditures were $191.8 million in fiscal 2007, $194.4 million in fiscal 2006, and $230.1 million in fiscal 2005. In addition to store construction costs, capital expenditures for all three years included the cost of land acquired for future year store openings. In fiscal 2006 and fiscal 2005, capital expenditures also included costs associated with our new home office, which was completed in October 2005.
 
Historically, capital expenditures have been funded with internally generated funds, short- and long-term debt, and sale-leaseback transactions. Net proceeds from the sales of assets totaled $4.6 million in fiscal 2007, $78.3 million in fiscal 2006, and $89.0 million in fiscal 2005. The majority of the sale proceeds in fiscal 2006 and fiscal 2005 related to sale-leaseback transactions. In fiscal 2006, we entered into sale-leaseback transactions involving five superstores valued at $72.7 million. In fiscal 2005, we entered into sale-leaseback transactions involving seven superstores valued at approximately $84.0 million. These transactions were structured with initial lease terms of either 15 or 20 years with four, five-year renewal options. At February 28, 2007, we owned 20 superstores currently in operation, as well as the company’s home office in Richmond, Virginia. In addition, six store facilities were accounted for as capital leases.
 
Financing Activities
Net cash provided by financing activities was $48.1 million in fiscal 2007, $3.2 million in fiscal 2006, and $67.7 million in fiscal 2005. We used cash generated from operations to reduce total debt by $9.5 million in fiscal 2007 and $6.8 million in fiscal 2006. In fiscal 2005, we increased total debt by $60.2 million primarily to fund increased inventory.
 
In December 2006, we amended our revolving credit facility. The term of the agreement was extended from August 2009 to December 2011, and the aggregate borrowings available under the agreement were increased from $450 million to $500 million. Borrowings under this credit facility are available for working capital and general corporate purposes, and are secured by our vehicle inventory.
 
As of February 28, 2007, $150.7 million was outstanding under the credit facility, with the remainder fully available to us. The outstanding balance included $3.3 million classified as short-term debt, and $147.4 million classified as current portion of long-term debt. We classified the outstanding balance at February 28, 2007, as current portion of long-term debt based on our expectation that this balance will not remain outstanding for more than one year.
 
Cash received on equity issuances, which primarily related to employee stock option exercises, increased to $35.4 million in fiscal 2007 compared with $6.0 million in fiscal 2006 and $4.3 million in fiscal 2005. The increase reflected exercises by the former chief executive officer in connection with his retirement, and other exercises prompted by the significant increase in our stock price in fiscal 2007.
 
We expect that cash generated by operations; proceeds from securitization transactions; and, if needed, additional debt and sale-leaseback transactions will be sufficient to fund capital expenditures and working capital for the foreseeable future.
 
Contractual Obligations
   
As of February 28, 2007
 
   
 
Total
 
Less Than
1 Year
 
1 to 3
Years
 
3 to 5
Years
 
More Than
5 Years
 
Revolving credit agreement (1)
 
$
150.7
  $
 
  $
 
 
$
150.7
 
$
 
 
Capital leases (2)
   
67.0
 
 
4.5
 
 
9.1
   
9.5
 
 
43.9
 
Operating leases (2)
   
963.7
   
71.0
   
144.2
   
145.5
   
603.0
 
Purchase obligations (3)
   
79.0
   
38.5
   
30.8
   
9.7
   
 
Asset retirement obligations (4)
   
1.1
   
   
   
   
1.1
 
Total
 
$
1,261.5
 
$
114.0
 
$
184.1
 
$
315.4
 
$
648.0
 
(1)
See Note 9 to the consolidated financial statements.
(2)
See Note 12 to the consolidated financial statements.
(3)
Includes certain enforceable and legally binding obligations related to the purchase of real property and third-party outsourcing services.
(4)
Represents the present value of costs to retire signage, fixtures, and other assets at certain leased locations.
 
 
 

 
Off-Balance Sheet Arrangements
CAF provides financing for our used and new car sales. 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. This program is referred to as the warehouse facility.
 
We periodically 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.
 
Additional information regarding the nature, business purposes, and importance of our off-balance sheet arrangement to our liquidity and capital resources can be found in the CarMax Auto Finance Income, Financial Condition, and Market Risk sections of this MD&A, as well as in Notes 3 and 4.
 
 

 
 

 
 

 


 
Item 7A. Quantitative and Qualitative Disclosures about Market Risk.
 
Automobile Installment Loan Receivables
At February 28, 2007, and February 28, 2006, all loans in our portfolio of automobile loan receivables were fixed-rate installment loans. Financing for these automobile loan receivables is achieved through asset securitization programs that, in turn, issue both fixed- and floating-rate securities. We manage the interest rate exposure relating to floating-rate securitizations through the use of interest rate swaps. Receivables held for investment or sale are financed with working capital. Generally, changes in interest rates associated with underlying swaps will not have a material impact on earnings. However, changes in interest rates associated with underlying swaps may have a material impact on cash and cash flows.
 
Credit risk is the exposure to nonperformance of another party to an agreement. We mitigate credit risk by dealing with highly rated bank counterparties. The market and credit risks associated with financial derivatives are similar to those relating to other types of financial instruments. Refer to Note 5 for a description of these items.
 
Composition of Automobile Loan Receivables
   
As of February 28
 
(In millions)
 
2007
 
2006
 
Principal amount of:
             
Fixed-rate securitizations 
 
$
2,644.1
 
$
2,126.4
 
Floating-rate securitizations synthetically altered to fixed
   
597.5
   
584.0
 
Floating-rate securitizations 
   
0.6
   
 
Loans held for investment (1)  
   
62.7
   
57.9
 
Loans held for sale (2) 
   
6.2
   
4.1
 
Total
 
$
3,311.0
 
$
2,772.5
 
(1)
The majority is held by a bankruptcy-remote special purpose entity.
(2)
Held by a bankruptcy-remote special purpose entity.
 
Interest Rate Exposure
We also have interest rate risk from changing interest rates related to our outstanding debt. Substantially all of our debt is floating-rate debt based on LIBOR. A 100-basis point increase in market interest rates would have decreased our fiscal 2007 net earnings per share by less than $0.01.
 


 
Item 8. Consolidated Financial Statements and Supplementary Data.
 
 
MANAGEMENT’S ANNUAL REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management is responsible for establishing and maintaining adequate internal control over financial reporting for the company. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles.

Management conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework and criteria established in Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, our management has concluded that our internal control over financial reporting was effective as of February 28, 2007.

KPMG LLP, the company's independent registered public accounting firm, has issued a report on our management's assessment of our internal control over financial reporting. Their report is included herein.

 

 
/s/ Thomas J. Folliard              
THOMAS J. FOLLIARD
PRESIDENT AND CHIEF EXECUTIVE OFFICER
 

 

 
/s/ Keith D. Browning              
KEITH D. BROWNING
EXECUTIVE VICE PRESIDENT AND
CHIEF FINANCIAL OFFICER
 

 
 

 


 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders
CarMax, Inc.:
 
We have audited management's assessment, included in the accompanying Management's Annual Report on Internal Control Over Financial Reporting, that CarMax, Inc. and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of February 28, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of the Company's internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the consolidated financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management's assessment that CarMax, Inc. and subsidiaries maintained effective internal control over financial reporting as of February 28, 2007, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, CarMax, Inc. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of February 28, 2007, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of CarMax, Inc. and subsidiaries as of February 28, 2007 and 2006, and the related consolidated statements of earnings, shareholders' equity, and cash flows for each of the fiscal years in the three-year period ended February 28, 2007, and our report dated April 25, 2007 expressed an unqualified opinion on those consolidated financial statements.
 
/s/KPMG LLP

Richmond, Virginia
April 25, 2007


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Shareholders
CarMax, Inc.:
 
We have audited the accompanying consolidated balance sheets of CarMax, Inc. and subsidiaries (the “Company”) as of February 28, 2007 and 2006, and the related consolidated statements of earnings, shareholders’ equity, and cash flows for each of the fiscal years in the three-year period ended February 28, 2007. In connection with our audits of the consolidated financial statements, we also have audited the financial statement Schedule II - valuation and qualifying accounts as of and for each of the fiscal years in the three-year period ended February 28, 2007. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
 
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CarMax, Inc. and subsidiaries as of February 28, 2007 and 2006, and the results of their operations and their cash flows for each of the fiscal years in the three-year period ended February 28, 2007, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
 
As discussed in Notes 2(A) and 10(C) to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123 (revised 2004) (Statement 123(R)), Share-Based Payment, effective March 1, 2006, using the modified retrospective transition method. As discussed in Note 8(A) to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Pension and Other Postretirement Plans, effective February 28, 2007.
 
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of February 28, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated April 25, 2007, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

/s/KPMG LLP

Richmond, Virginia
April 25, 2007



CONSOLIDATED STATEMENTS OF EARNINGS
 
   
Years Ended February 28
 
(In thousands except per share data)
 
2007
 
%(1)
 
2006
 
%(1)
 
2005
 
%(1)
 
           
Restated (2)
     
Restated (2)
     
SALES AND OPERATING REVENUES:
                         
Used vehicle sales
 
$
5,872,816
   
78.7
 
$
4,771,325
   
76.2
 
$
3,997,218
   
76.0
 
New vehicle sales
   
445,144
   
6.0
   
502,805
   
8.0
   
492,054
   
9.4
 
Wholesale vehicle sales
   
918,408
   
12.3
   
778,268
   
12.4
   
589,704
   
11.2
 
Other sales and revenues
   
229,288
   
3.1
   
207,569
   
3.3
   
181,286
   
3.4
 
NET SALES AND OPERATING REVENUES
   
7,465,656
   
100.0
   
6,259,967
   
100.0
   
5,260,262
   
100.0
 
Cost of sales
   
6,494,594
   
87.0
   
5,469,253
   
87.4
   
4,610,066
   
87.6
 
GROSS PROFIT
   
971,062
   
13.0
   
790,714
   
12.6
   
650,196