tenq.htm
 
 




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

FORM 10-Q

[ X ]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended November 30, 2008

OR

 [    ]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number:  1-31420

CARMAX, INC.
(Exact name of registrant as specified in its charter)

VIRGINIA
54-1821055
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)

12800 TUCKAHOE CREEK PARKWAY, RICHMOND, VIRGINIA
23238
(Address of principal executive offices)
(Zip Code)

 (804) 747-0422
(Registrant's telephone number, including area code)

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

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

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

Large accelerated filer X
Accelerated filer _
Non-accelerated filer _
Smaller reporting company _

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes           
No  X

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class
 
Outstanding as of December 31, 2008
Common Stock, par value $0.50
 
220,399,823
     
A Table of Contents is included on Page 2 and a separate Exhibit Index is included on Page 42.

 
 

 

CARMAX, INC. AND SUBSIDIARIES

TABLE OF CONTENTS

 
Page
No.
PART I.
FINANCIAL INFORMATION
 
       
 
Item 1.    Financial Statements:
 
   
Consolidated Statements of Operations - Three Months and Nine Months Ended November 30, 2008 and 2007
3
   
Consolidated Balance Sheets - November 30, 2008, and February 29, 2008
4
   
Consolidated Statements of Cash Flows - Nine Months Ended November 30, 2008 and 2007
5
   
Notes to Consolidated Financial Statements
6
       
 
Item 2.    Management's Discussion and Analysis of Financial Condition and Results of Operations
21
     
 
Item 3.    Quantitative and Qualitative Disclosures About Market Risk
37
     
 
Item 4.    Controls and Procedures
38
     
PART II.
OTHER INFORMATION
 
     
 
Item 1.    Legal Proceedings
39
     
 
Item 1A.  Risk Factors
39
     
 
Item 6.    Exhibits
40
     
     
SIGNATURES                                                                                                                                     
41
     
EXHIBIT INDEX                                                                                                                                     
42

 






Page 2 of 42
 
 

 


PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS



CARMAX, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
(Unaudited)
(In thousands except per share data)

   
Three Months Ended November 30
   
Nine Months Ended November 30
 
   
2008
      % (1)  
2007
      % (1)  
2008
      % (1)  
2007
      % (1)
Sales and operating revenues:
                                                       
Used vehicle sales        
  $ 1,168,804       80.3     $ 1,514,302       80.3     $ 4,461,969       81.1     $ 4,909,835       79.8  
New vehicle sales     
    57,508       4.0       76,999       4.1       217,396       4.0       294,393       4.8  
Wholesale vehicle sales                   
    176,956       12.2       234,739       12.5       642,552       11.7       761,173       12.4  
Other sales and revenues                
    52,364       3.6       59,260       3.1       181,532       3.3       189,563       3.1  
Net sales and operating revenues
    1,455,632       100.0       1,885,300       100.0       5,503,449       100.0       6,154,964       100.0  
Cost of sales             
    1,256,396       86.3       1,642,417       87.1       4,765,586       86.6       5,339,666       86.8  
Gross profit                      
    199,236       13.7       242,883       12.9       737,863       13.4       815,298       13.2  
CarMax Auto Finance (loss) income
    (15,360 )     (1.1 )     16,347       0.9       (12,682 )     (0.2 )     86,827       1.4  
Selling, general and administrative
                                                               
expenses                                                   
    217,482       14.9       210,508       11.2       685,614       12.5       638,518       10.4  
Gain on franchise disposition                     
                                        740        
Interest expense                        
    1,525       0.1       44             5,060       0.1       3,010        
Interest income                           
    735       0.1       285             1,353             908        
(Loss) earnings before income taxes
    (34,396 )     (2.4 )     48,963       2.6       35,860       0.7       262,245       4.3  
Income tax (benefit) provision    
    (12,522 )     (0.9 )     19,117       1.0       14,170       0.3       102,049       1.7  
Net (loss) earnings                 
  $ (21,874 )     (1.5 )   $ 29,846       1.6     $ 21,690       0.4     $ 160,196       2.6  
                                                                 
Weighted average common shares:
                                                               
Basic                                                   
    217,712               216,301               217,468               215,826          
Diluted                                                   
    217,712               220,558               220,692               220,421          
                                                                 
Net (loss) earnings per share:
                                                               
Basic                                                   
  $ (0.10 )           $ 0.14             $ 0.10             $ 0.74          
Diluted                                                   
  $ (0.10 )           $ 0.14             $ 0.10             $ 0.73          
                                                                 
(1)Percents are calculated as a percentage of net sales and operating revenues and may not equal totals due to rounding.
 
See accompanying notes to consolidated financial statements.
 


Page 3 of 42
 
 

 


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

   
November 30, 2008
   
February 29, 2008
 
ASSETS
           
Current assets:
           
Cash and cash equivalents                                                                                            
  $ 138,144     $ 12,965  
Accounts receivable, net                                                                                            
    45,816       73,228  
Auto loan receivables held for sale                                                                                            
    20,910       4,984  
Retained interest in securitized receivables                                                                                            
    314,995       270,761  
Inventory                                                                                            
    601,506       975,777  
Prepaid expenses and other current assets                                                                                            
    8,885       19,210  
                 
Total current assets                                                                                            
    1,130,256       1,356,925  
                 
Property and equipment, net                                                                                            
    948,106       862,497  
Deferred income taxes                                                                                            
    89,315       67,066  
Other assets                                                                                            
    50,505       46,673  
                 
TOTAL ASSETS                                                                                            
  $ 2,218,182     $ 2,333,161  
                 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable                                                                                            
  $ 177,144     $ 306,013  
Accrued expenses and other current liabilities                                                                                            
    70,783       58,054  
Accrued income taxes                                                                                            
    17,672       7,569  
Deferred income taxes                                                                                            
    14,926       17,710  
Short-term debt                                                                                            
    12,073       21,017  
Current portion of long-term debt                                                                                            
    86,895       79,661  
                 
Total current liabilities                                                                                            
    379,493       490,024  
                 
Long-term debt, excluding current portion                                                                                            
    176,683       227,153  
Deferred revenue and other liabilities                                                                                            
    98,303       127,058  
                 
TOTAL LIABILITIES                                                                                            
    654,479       844,235  
                 
Commitments and contingent liabilities                                                                                            
               
                 
Shareholders’ equity:
               
Common stock, $0.50 par value; 350,000,000 shares authorized;
               
220,411,219 and 218,616,069 shares issued and outstanding
               
as of November 30, 2008, and February 29, 2008, respectively
    110,206       109,308  
Capital in excess of par value                                                                                            
    677,564       641,766  
Accumulated other comprehensive loss                                                                                            
    (337 )     (16,728 )
Retained earnings                                                                                            
    776,270       754,580  
                 
TOTAL SHAREHOLDERS’ EQUITY                                                                                            
    1,563,703       1,488,926  
                 
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
  $ 2,218,182     $ 2,333,161  
See accompanying notes to consolidated financial statements.
 


Page 4 of 42
 
 

 


CARMAX, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
(In thousands)
   
Nine Months Ended November 30
 
   
2008
   
2007
 
             
Operating Activities:
           
Net earnings                                                                                           
  $ 21,690     $ 160,196  
Adjustments to reconcile net earnings to net cash provided by operating activities:
               
Depreciation and amortization                                                                                     
    41,379       34,168  
Share-based compensation expense                                                                                     
    27,038       25,856  
Loss on disposition of assets                                                                                     
    8,263       35  
Deferred income tax benefit                                                                                     
    (34,604 )     (3,332 )
Net decrease (increase) in:
               
Accounts receivable, net
    27,412       18,644  
Auto loan receivables held for sale, net
    (15,926 )     1,462  
Retained interest in securitized receivables
    (44,234 )     (31,360 )
Inventory
    374,271       (56,112 )
Prepaid expenses and other current assets
    10,317       (5,430 )
Other assets
    177       1,030  
Net (decrease) increase in:
               
Accounts payable, accrued expenses and other current liabilities and accrued income taxes
    (104,495 )     (11,881 )
Deferred revenue and other liabilities
    (4,660 )     25,641  
Net cash provided by operating activities                                                                                           
    306,628       158,917  
                 
Investing Activities:
               
Capital expenditures                                                                                           
    (163,964 )     (192,440 )
Proceeds from sales of assets                                                                                           
    28,355       1,457  
(Purchases) sales of money market securities, net
    (4,009 )     5,000  
Purchases of investments available-for-sale                                                                                           
          (10,000 )
Net cash used in investing activities                                                                                           
    (139,618 )     (195,983 )
                 
Financing Activities:
               
Decrease in short-term debt, net                                                                                           
    (8,944 )     (153 )
Issuances of long-term debt                                                                                           
    487,800       692,200  
Payments on long-term debt                                                                                           
    (531,036 )     (685,011 )
Equity issuances, net                                                                                           
    9,962       13,157  
Excess tax benefits from share-based payment arrangements
    387       5,798  
Net cash (used in) provided by financing activities
    (41,831 )     25,991  
                 
Increase (decrease) in cash and cash equivalents
    125,179       (11,075 )
Cash and cash equivalents at beginning of year                                                                                           
    12,965       19,455  
Cash and cash equivalents at end of period                                                                                           
  $ 138,144     $ 8,380  
 
See accompanying notes to consolidated financial statements.
 

Page 5 of 42
 
 

 

CARMAX, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(Unaudited)
1.  
Background
 
CarMax, Inc. (“we”, “our”, “us”, “CarMax” and “the company”), including its wholly owned subsidiaries, is the largest retailer of used vehicles in the United States.  We were the first used vehicle retailer to offer a large selection of high quality used vehicles at competitively low, no-haggle prices using a customer-friendly sales process in an attractive, modern sales facility.  We also sell new vehicles under various franchise agreements at select locations.  We provide customers with a full range of related products and services, including the financing of vehicle purchases through our own finance operation, CarMax Auto Finance (“CAF”), and third-party lenders; the sale of extended service plans and accessories; the appraisal and purchase of vehicles directly from consumers; and vehicle repair service.  Vehicles purchased through the appraisal process that do not meet our retail standards are sold to licensed dealers through on-site wholesale auctions.
 
2.  
Accounting Policies
 
Basis of Presentation and Use of Estimates.  The accompanying interim unaudited consolidated financial statements include the accounts of CarMax and our wholly owned subsidiaries.  All significant intercompany balances and transactions have been eliminated in consolidation.  The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities.  Actual results could differ from those estimates.  Amounts and percentages in tables may not total due to rounding.  Certain previously reported amounts have been reclassified to conform to the current period presentation.

These consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles for interim financial information.  Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements.  In the opinion of management, such interim consolidated financial statements reflect all normal recurring adjustments considered necessary to present fairly the financial position and the results of operations and cash flows for the interim periods presented.  The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full fiscal year.  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in our Annual Report on Form 10-K for the fiscal year ended February 29, 2008.

Cash and Cash Equivalents.  Cash equivalents of $125.3 million as of November 30, 2008, and $2.0 million as of February 29, 2008, consisted of highly liquid investments with original maturities of three months or less.
 

Page 6 of 42
 
 

 

3.  
CarMax Auto Finance (Loss) Income  
 
   
Three Months Ended
November 30
   
Nine Months Ended
November 30
 
(In millions)
 
2008
   
2007
   
2008
   
2007
 
Gain on sales of loans originated and sold (1)
  $ 11.3     $ 20.9     $ 32.5     $ 57.8  
Other (losses) gains (1)                                                       
    (39.8 )     (14.8 )     (82.6 )     1.0  
Total (loss) gain                                                       
    (28.5 )     6.1       (50.1 )     58.8  
Other CAF income:
                               
Servicing fee income                                                    
    10.4       9.5       31.1       27.6  
Interest income                                                    
    12.6       9.1       34.8       24.7  
Total other CAF income                                                       
    23.0       18.7       65.9       52.4  
Direct CAF expenses:
                               
CAF payroll and fringe benefit expense
    4.8       4.1       14.0       11.5  
Other direct CAF expenses
    5.1       4.3       14.5       12.8  
Total direct CAF expenses                                                       
    9.9       8.4       28.4       24.4  
CarMax Auto Finance (loss) income
  $ (15.4 )   $ 16.3     $ (12.7 )   $ 86.8  
(1)To the extent we recognize valuation or other adjustments related to loans originated in previous quarters of the same fiscal year, the sum of amounts reported for the individual quarters may not equal the year-to-date total.
 

CAF provides financing for qualified customers at competitive market rates of interest.  Throughout each month, we sell substantially all of the loans originated by CAF in securitization transactions as discussed in Note 4.  The majority of CAF income has typically been generated by the spread between the interest rates charged to customers and the related cost of funds.  A gain, recorded at the time of securitization, results from recording a receivable approximately equal to the present value of the expected residual cash flows generated by the securitized receivables.  The cash flows are calculated taking into account expected prepayments, losses and funding costs.

The gain on sales of loans originated and sold includes both the gain income recorded at the time of securitization and the effect of any subsequent changes in valuation assumptions or funding costs that are incurred in the same fiscal period that the loans were originated.  Other losses or gains include the effects of changes in valuation assumptions or funding costs related to loans originated and sold during previous fiscal periods.  In addition, other losses or gains could include the effects of new securitizations, changes in the valuation of retained subordinated bonds and the resale of receivables in existing securitizations, as applicable.

CAF income does not include any allocation of indirect costs or income.  We present this information on a direct basis to avoid making arbitrary decisions regarding the indirect benefit or costs that could be attributed to CAF.  Examples of indirect costs not included are retail store expenses and corporate expenses such as human resources, administrative services, marketing, information systems, accounting, legal, treasury and executive payroll.

4.  
Securitizations
 
We use a securitization program to fund substantially all of the auto loan receivables originated by CAF.  We sell the auto loan receivables to a wholly owned, bankruptcy-remote, special purpose entity that transfers an undivided interest in the receivables to a group of third-party investors.  The investors issue commercial paper supported by the transferred receivables, and the proceeds from the sale of the commercial paper are used to pay for the securitized receivables.  This program is referred to as the warehouse facility.  The return requirements of investors in asset-backed commercial paper may fluctuate significantly depending on market conditions.  In addition, the warehouse facility renews on an annual basis.  At renewal both the cost and structure of the facility could change.  These changes could have a significant impact on our funding costs.

Page 7 of 42
 
 

 


Historically, we have used term securitizations to refinance the receivables previously securitized through the warehouse facility.  In these transactions, a pool of auto loan receivables is sold to a bankruptcy-remote, special purpose entity that in turn transfers the receivables to a special purpose securitization trust.  The securitization trust issues asset-backed securities, secured or otherwise supported by the transferred receivables, and the proceeds from the sale of the securities are used to pay for the securitized receivables.  Depending on the transaction structure and market conditions, refinancing receivables in a term securitization could have a significant impact on our results of operations.  The impact of refinancing activity will depend upon the securitization structure and market conditions at the refinancing date.

The special purpose entity and investors have no recourse to our assets.  Our credit risk is limited to the retained interest.  All transfers of receivables are accounted for as sales.  When the receivables are securitized, we recognize a gain or loss on the sale of the receivables as described in Note 3.

   
Three Months Ended
November 30
   
Nine Months Ended
November 30
 
(In millions)
 
2008
   
2007
   
2008
   
2007
 
Net loans originated                                                                                
  $ 396.8     $ 575.9     $ 1,576.3     $ 1,839.0  
Total loans sold                                                                                
  $ 407.0     $ 575.6     $ 1,608.8     $ 1,891.2  
Total (loss) gain                                                                                
  $ (28.5 )   $ 6.1     $ (50.1 )   $ 58.8  
Total (loss) gain as a percentage of total loans sold
    (7.0 )%     1.1 %     (3.1 )%     3.1 %

Retained Interest.  We retain an interest in the auto loan receivables that we securitize.  The retained interest includes the present value of the expected residual cash flows generated by the securitized receivables, or “interest-only strip receivables,” various reserve accounts, required excess receivables and retained subordinated bonds, as described below.  As of November 30, 2008, on a combined basis, the reserve accounts and required excess receivables were 3.9% of managed receivables.  The interest-only strip receivables, reserve accounts and required excess receivables serve as a credit enhancement for the benefit of the investors in the securitized receivables.

The fair value of the retained interest was $315.0 million as of November 30, 2008, and $270.8 million as of February 29, 2008.  Additional information on fair value measurements is included in Note 6.  The receivables underlying the retained interest had a weighted average life of 1.5 years as of November 30, 2008, and February 29, 2008.  The weighted average life in periods (for example, months or years) of prepayable assets is calculated by multiplying the principal collections expected in each future period by the number of periods until that future period, summing those products and dividing the sum by the initial principal balance.
 
Interest-only strip receivables. Interest-only strip receivables represent the present value of residual cash flows we expect to receive over the life of the securitized receivables.  The value of these receivables is determined by estimating the future cash flows using our assumptions of key factors, such as finance charge income, loss rates, prepayment rates, funding costs and discount rates appropriate for the type of asset and risk.  The value of interest-only strip receivables may be affected by external factors, such as changes in the behavior patterns of customers, changes in the strength of the economy and developments in the interest rate markets; therefore, actual performance may differ from these assumptions.  We evaluate the performance of the receivables relative to these assumptions on a regular basis.  Any financial impact resulting from a change in performance is recognized in earnings in the period in which it occurs.

Reserve accounts.  We are required to fund various reserve accounts established for the benefit of the securitization investors.  In the event that the cash generated by the securitized receivables in a given period was insufficient to pay the interest, principal and other required payments, the balances on deposit in the reserve accounts would be used to pay those amounts.  In general, each of our securitizations requires that an amount equal to a specified percentage of the original balance of the securitized receivables be deposited in a reserve account on the closing date and that any excess cash generated by the receivables be used to fund the reserve account to the extent necessary to maintain the required

Page 8 of 42 
 
 

 

amount.  If the amount on deposit in the reserve account exceeds the required amount, the excess is released through the special purpose entity to the company.  In the term securitizations, the amount required to be on deposit in the reserve account must equal or exceed a specified floor amount.  The reserve account remains funded until the investors are paid in full, at which time the remaining balance is released through the special purpose entity to the company.  The amount on deposit in reserve accounts was $41.0 million as of November 30, 2008, and $37.0 million as of February 29, 2008.

Required excess receivables.  The total value of the securitized receivables must exceed the principal amount owed to the investors by a specified amount.  The required excess receivables balance represents this specified amount.  Any cash flows generated by the required excess receivables are used, if needed, to make payments to the investors.  Any remaining cash flows from the required excess receivables are released through the special purpose entity to the company.  The unpaid principal balance related to the required excess receivables was $117.1 million as of November 30, 2008, and $63.0 million as of February 29, 2008.

Retained subordinated bonds.  In fiscal 2009 and 2008, we retained subordinated bonds issued by securitization trusts.  We receive interest payments on the bonds.  The bonds are carried at fair value and changes in fair value are included in earnings as a component of CAF income.  We base our valuation on observable market prices of the same or similar instruments when available; however, observable market prices are not currently available for these assets due to illiquidity in the credit markets.  Our current valuations are primarily based on an average of three non-binding, current market spread quotes from third-party investment banks. By applying these average spreads to current bond benchmarks, as determined through the use of a widely accepted third-party bond pricing model, we have measured a current fair value.  The value of retained subordinated bonds was $86.6 million as of November 30, 2008, and $43.1 million as of February 29, 2008.

Key Assumptions Used in Measuring the Fair Value of the Retained Interest and Sensitivity Analysis.  The following table shows the key economic assumptions used in measuring the fair value of the retained interest as of November 30, 2008, and a sensitivity analysis showing the hypothetical effect on the retained interest if there were unfavorable variations from the assumptions used.  These sensitivity analyses are hypothetical and should be used with caution.  In this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in actual circumstances, changes in one factor may result in changes in another, which might magnify or counteract the sensitivities.

KEY ASSUMPTIONS
(In millions)
 
Assumptions
Used
   
Impact on Fair
Value of 10%
Adverse Change
   
Impact on Fair
Value of 20%
Adverse Change
 
Prepayment rate                                                
    1.37% - 1.50 %   $ 8.2     $ 15.3  
Cumulative loss rate                                                
    1.39% - 3.90 %   $ 10.8     $ 21.6  
Annual discount rate                                                
    19.00 %   $ 5.3     $ 10.4  
Warehouse facility costs (1)
    2.05 %   $ 2.9     $ 5.8  
(1)Expressed as a spread above appropriate benchmark rates. Applies only to retained interest in receivables securitized through the warehouse facility. As of November 30, 2008, there were receivables of $907.0 million in the warehouse facility.
 

Prepayment rate.  We use the Absolute Prepayment Model or “ABS” to estimate prepayments.  This model assumes a rate of prepayment each month relative to the original number of receivables in a pool of receivables.  ABS further assumes that all the receivables are the same size and amortize at the same rate and that each receivable in each month of its life will either be paid as scheduled or prepaid in full.  For example, in a pool of receivables originally containing 10,000 receivables, a 1% ABS rate means that 100 receivables prepay each month.


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Cumulative loss rate.  The cumulative loss rate, or “static pool” net losses, is calculated by dividing the total projected credit losses of a pool of receivables by the original pool balance.  Projected credit losses are estimated using the losses experienced to date, the credit quality of the receivables, economic factors and the performance history of similar receivables.

Annual discount rate.  The discount rate is the interest rate used for computing the present value of future cash flows and is determined based on the perceived market risk of the underlying auto loan receivables and current market conditions.

Warehouse facility costs.  While receivables are securitized in the warehouse facility, our retained interest is exposed to changes in credit spreads and other variable funding costs.  The warehouse facility costs are expressed as a spread above appropriate benchmark rates.

Continuing Involvement with Securitized Receivables.  We continue to manage the auto loan receivables that we securitize.  We receive servicing fees of approximately 1% of the outstanding principal balance of the securitized receivables.  We believe that the servicing fees specified in the securitization agreements adequately compensate us for servicing the securitized receivables.  No servicing asset or liability has been recorded.  We are at risk for the retained interest in the securitized receivables and, if the securitized receivables do not perform as originally projected, the value of the retained interest would be impacted.

PAST DUE ACCOUNT INFORMATION
   
As of November 30
   
As of February 29 or 28
 
(In millions)
 
2008
   
2007
   
2008
   
2007
 
Accounts 31+ days past due                                                                        
  $ 136.1     $ 93.0     $ 86.1     $ 56.9  
Ending managed receivables                                                                        
  $ 4,027.3     $ 3,702.6     $ 3,838.5     $ 3,311.0  
Past due accounts as a percentage of ending managed receivables
    3.38 %     2.51 %     2.24 %     1.72 %

CREDIT LOSS INFORMATION
   
Three Months Ended
November 30
   
Nine Months Ended
November 30
 
(In millions)
 
2008
   
2007
   
2008
   
2007
 
Net credit losses on managed receivables
  $ 21.6     $ 10.3     $ 48.5     $ 25.1  
Average managed receivables
  $ 4,076.3     $ 3,683.9     $ 4,019.0     $ 3,548.6  
Annualized net credit losses as a percentage of average managed receivables
    2.11 %     1.12 %     1.61 %     0.94 %
Recovery rate
    42.4 %     50.0 %     44.4 %     51.3 %

SELECTED CASH FLOWS FROM SECURITIZED RECEIVABLES
   
Three Months Ended
November 30
   
Nine Months Ended
November 30
 
(In millions)
 
2008
   
2007
   
2008
   
2007
 
Proceeds from new securitizations
  $ 307.0     $ 469.0     $ 1,314.8     $ 1,500.5  
Proceeds from collections
  $ 176.7     $ 247.7     $ 664.9     $ 840.8  
Servicing fees received
  $ 10.5     $ 9.5     $ 30.9     $ 27.3  
Other cash flows received from the retained interest:
                               
Interest-only strip receivables
  $ 16.3     $ 25.2     $ 72.7     $ 72.6  
Reserve account releases
  $ 0.1     $ 0.3     $ 3.2     $ 6.1  

Proceeds from new securitizations.  Proceeds from new securitizations include proceeds from receivables that are newly securitized in or refinanced through the warehouse facility during the indicated period.  Balances previously outstanding in term securitizations that were refinanced through the warehouse facility totaled $48.4 million in the first nine months of fiscal 2009 and $50.7 million in the first nine months of fiscal 2008.  Proceeds received when we refinance receivables from the warehouse facility are excluded from this table as they are not considered new securitizations.

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Proceeds from collections.  Proceeds from collections represent principal amounts collected on receivables securitized through the warehouse facility that are used to fund new originations.

Servicing fees.  Servicing fees received represent cash fees paid to us to service the securitized receivables.

Other cash flows received from the retained interest.  Other cash flows received from the retained interest represents cash that we receive from the securitized receivables other than servicing fees.  It includes cash collected on interest-only strip receivables and amounts released to us from reserve accounts.
 
Financial Covenants and Performance Triggers.  The securitization agreement related to the warehouse facility includes various financial covenants and performance triggers.  This agreement requires us to meet financial covenants related to a maximum total liabilities to tangible net worth ratio and a minimum fixed charge coverage ratio.  Performance triggers require that the pool of securitized receivables in the warehouse facility achieve specified thresholds related to portfolio yield, loss rate and delinquency rate.  If these financial covenants and/or thresholds are not met, we could be unable to continue to securitize receivables through the warehouse facility.  In addition, the warehouse facility investors could have us replaced as servicer and charge us a higher rate of interest.  Further, we could be forced to deposit collections on the securitized receivables with the warehouse agent on a daily basis, deliver executed lockbox agreements to the warehouse facility agent and obtain a replacement counterparty for the interest rate cap agreement related to the warehouse facility.  As of November 30, 2008, we were in compliance with the financial covenants and the securitized receivables were in compliance with the performance triggers.
 
5.  
Financial Derivatives
 
We utilize interest rate swaps relating to our auto loan receivable securitizations and our investment in retained subordinated bonds.  Swaps are used to better match funding costs to the interest on the fixed-rate receivables being securitized and the retained subordinated bonds and to minimize the funding costs related to certain of our securitizations trusts. During the third quarter of fiscal 2009, we entered into 14 interest rate swaps with initial notional amounts totaling $348.5 million and terms of 41 months.  The notional amounts of outstanding swaps totaled $1,033.9 million as of November 30, 2008, and $898.7 million as of February 29, 2008.  The fair value of swaps included in accounts payable totaled a liability of $23.4 million as of November 30, 2008, and $15.1 million as of February 29, 2008.  Additional information on fair value measurements is included in Note 6.

The market and credit risks associated with interest rate swaps are similar to those relating to other types of financial instruments.  Market risk is the exposure created by potential fluctuations in interest rates.  We do not anticipate significant market risk from swaps as they are predominantly used to match funding costs to the use of the funding.  However, disruptions in the credit markets could impact the effectiveness of our hedging strategies.  Credit risk is the exposure to nonperformance of another party to an agreement.  We mitigate credit risk by dealing with highly rated bank counterparties.
 
6.  
Fair Value Measurements

We adopted Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” ("SFAS 157"), on March 1, 2008.  SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements.  SFAS 157 defines “fair value” as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market, or if none exists, the most advantageous market, for the specific asset or liability at the measurement date (referred to as the “exit price”).  The fair value should be based on assumptions that market participants would use, including a consideration of nonperformance risk.

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We assess the inputs used to measure fair value using the three-tier hierarchy in accordance with SFAS 157 and as disclosed in the tables below.  The hierarchy indicates the extent to which inputs used in measuring fair value are observable in the market.  

Level 1
Inputs include unadjusted quoted prices in active markets for identical assets or liabilities that we can access at the measurement date.  

Level 2
Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets in active markets and observable inputs such as interest rates and yield curves.

Level 3
Inputs that are significant to the measurement that are not observable in the market and include management's judgments about the assumptions market participants would use in pricing the asset or liability (including assumptions about risk).  

Our fair value processes include controls that are designed to ensure that fair values are appropriate.  Such controls include model validation, review of key model inputs, analysis of period-over-period fluctuations and reviews by senior management.

VALUATION METHODOLOGIES

Money market securities. Money market securities are cash equivalents, which are included in either cash and cash equivalents or other assets, and consist of highly liquid investments with original maturities of three months or less.  We use quoted market prices for identical assets to measure fair value.  Therefore, all money market securities are classified as Level 1.

Retained interest in securitized receivables.  We retain an interest in the auto loan receivables that we securitize, including interest-only strip receivables, various reserve accounts, required excess receivables and retained subordinated bonds.  Excluding the retained subordinated bonds, we estimate the fair value of the retained interest using internal valuation models. These models include a combination of market inputs and our own assumptions as described in Note 4.  As the valuation models include significant unobservable inputs, we classified the retained interest as Level 3.

For the retained subordinated bonds, we base our valuation on observable market prices for similar assets when available.  Otherwise, our valuations are based on input from independent third parties and internal valuation models, as described in Note 4.  As the key assumption used in the valuation is currently based on unobservable inputs, we classified the retained subordinated bonds as Level 3.

Financial derivatives.  Financial derivatives are included in either prepaid expenses and other current assets or accounts payable. As part of our risk management strategy, we utilize interest rate swaps relating to our auto loan receivable securitizations and our investment in retained subordinated bonds.  Swaps are used to better match funding costs to the interest on the fixed-rate receivables being securitized and the retained subordinated bonds and to minimize the funding costs related to certain of our securitization trusts.  Our derivatives are not exchange-traded and are over-the-counter customized derivative instruments.  All of our derivative exposures are with highly rated bank counterparties.

We measure derivative fair values assuming that the unit of account is an individual derivative instrument and that derivatives are sold or transferred on a stand-alone basis.  We estimate the fair value of our derivatives using quotes determined by the swap counterparties.  We validate these quotes using our own internal model.  Both our internal model and quotes received from bank


Page 12 of 42
 
 

 

counterparties project future cash flows and discount the future amounts to a present value using market-based expectations for interest rates and the contractual terms of the derivative instruments.  Because model inputs can typically be observed in the liquid market and the models do not require significant judgment, these derivatives are classified as Level 2.

Our derivative fair value measurements consider assumptions about counterparty and our own nonperformance risk.  We monitor counterparty and our own nonperformance risk and, in the event that we determine that a party is unlikely to perform under terms of the contract, we would adjust the derivative fair value to reflect the nonperformance risk.

ITEMS MEASURED AT FAIR VALUE ON A RECURRING BASIS
   
As of November 30, 2008
 
(In millions)
 
Level 1
   
Level 2
   
Level 3
   
Total
 
ASSETS
                       
Money market securities
  $ 153.8     $     $     $ 153.8  
Retained interest in securitized receivables
                315.0       315.0  
Total assets at fair value
  $ 153.8     $     $ 315.0     $ 468.8  
                                 
Percent of total assets at fair value
    32.8 %     %     67.2 %     100.0 %
Percent of total assets
    6.9 %     %     14.2 %     21.1 %
                                 
LIABILITIES
                               
Financial derivatives
  $     $ 23.4     $     $ 23.4  
Total liabilities at fair value
  $     $ 23.4     $     $ 23.4  
                                 
Percent of total liabilities
    %     3.6 %     %     3.6 %
                                 

CHANGES IN THE LEVEL 3 ASSETS MEASURED AT FAIR VALUE ON A RECURRING BASIS
(In millions)
 
Retained interest in securitized receivables
 
Balance as of March 1, 2008                                                                                                     
  $ 270.8  
Total realized/unrealized losses (1)                                                                                                
    (54.1 )
Purchases, sales, issuances and settlements                                                                                                
    98.3  
Balance as of November 30, 2008                                                                                                     
  $ 315.0  
         
Change in unrealized losses on assets still held (1)                                                                                                     
  $ (41.2 )
(1)Reported in CarMax Auto Finance (loss) income on the consolidated statements of operations.
 

7.  
Income Taxes

We had $27.8 million of gross unrecognized tax benefits as of November 30, 2008, and $32.7 million as of February 29, 2008.  During the first nine months of fiscal 2009, we settled federal and state liabilities of $7.8 million related to the Internal Revenue Service audit of fiscal years 2003 and 2004.  For the nine-month period ended November 30, 2008, there were no other significant changes to the unrecognized tax benefits as reported for the year ended February 29, 2008, as all other activity was related to positions taken on tax returns filed or intended to be filed in the current fiscal year.


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8.  
Retirement Plans

We have a noncontributory defined benefit pension plan (the “pension plan”) covering the majority of full-time employees.  We also have an unfunded nonqualified plan (the “restoration plan”) that restores retirement benefits for certain senior executives who are affected by Internal Revenue Code limitations on benefits provided under the pension plan.  We use a fiscal year end measurement date for both the pension plan and the restoration plan.

COMPONENTS OF NET PENSION EXPENSE
   
Three Months Ended November 30
 
   
Pension Plan
   
Restoration Plan
   
Total
 
(In thousands)
 
2008
   
2007
   
2008
   
2007
   
2008
   
2007
 
Service cost
  $ 2,368     $ 3,918     $ 203     $ 222     $ 2,571     $ 4,140  
Interest cost
    1,526       1,499       177       147       1,703       1,646  
Expected return on plan assets
    (1,408 )     (999 )                 (1,408 )     (999 )
Amortization of prior service cost
    5       9       14       78       19       87  
Recognized actuarial (gain) loss
    (463 )     743       49       37       (414 )     780  
Pension expense
    2,028       5,170       443       484       2,471       5,654  
Curtailment (gain) loss
    (8,229 )           800             (7,429 )      
Net pension (benefit) expense
  $ (6,201 )   $ 5,170     $ 1,243     $ 484     $ (4,958 )   $ 5,654  

   
Nine Months Ended November 30
 
   
Pension Plan
   
Restoration Plan
   
Total
 
(In thousands)
 
2008
   
2007
   
2008
   
2007
   
2008
   
2007
 
Service cost
  $ 9,252     $ 11,754     $ 631     $ 516     $ 9,883     $ 12,270  
Interest cost
    5,056       4,497       593       351       5,649       4,848  
Expected return on plan assets
    (4,098 )     (2,997 )                 (4,098 )     (2,997 )
Amortization of prior service cost
    23       27       74       90       97       117  
Recognized actuarial (gain) loss
    (175 )     2,229       247       129       72       2,358  
Pension expense
    10,058       15,510       1,545       1,086       11,603       16,596  
Curtailment (gain) loss
    (8,229 )           800             (7,429 )      
Net pension expense
  $ 1,829     $ 15,510     $ 2,345     $ 1,086     $ 4,174     $ 16,596  

We made contributions to the pension plan totaling $15.6 million during the first nine months of fiscal 2009.  We do not anticipate making a contribution to the pension plan in the fourth quarter of fiscal 2009.
 
On October 21, 2008, the board of directors approved amendments to freeze the pension plan and the restoration plan effective December 31, 2008.  No additional benefits will accrue under these plans after that date. On January 1, 2009, we will implement significant enhancements to our 401(k) plan, including both an increased matching component and a company-funded contribution made regardless of associate participation, and a new non-qualified retirement plan for certain senior executives who are affected by Internal Revenue Code limitations on benefits provided under the 401(k) plan.
 
9.  
Debt

Our revolving credit facility expires in December 2011 and is secured by vehicle inventory.  Borrowings under this credit facility are subject to limitation based on a specified percentage of qualifying inventory, and they are available for working capital and general corporate purposes.  As of November 30, 2008, $248.4 million was outstanding under the credit facility and $225.4 million of the remaining borrowing limit was available to us.  The outstanding balance included $12.1 million


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classified as short-term debt, $86.3 million classified as current portion of long-term debt and $150.0 million classified as long-term debt.  We classified $86.3 million of the outstanding balance as of November 30, 2008, as current portion of long-term debt based on our expectation that this balance will not remain outstanding for more than one year.

Obligations under capital leases as of November 30, 2008, consisted of $0.6 million classified as current portion of long-term debt and $26.7 million classified as long-term debt.
 
10.  
Share-Based Compensation

We maintain long-term incentive plans for management, key employees and the non-employee members of our board of directors.  The plans allow for the grant of equity-based compensation awards, including nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock awards, stock grants or a combination of awards.  To date, we have awarded no incentive stock options.

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

COMPOSITION OF SHARE-BASED COMPENSATION EXPENSE
   
Three Months Ended
November 30
   
Nine Months Ended
November 30
 
(In thousands)
 
2008
   
2007
   
2008
   
2007
 
Cost of sales
  $ 582     $ 500     $ 1,585     $ 1,425  
CarMax Auto Finance income
    355       299       784       896  
Selling, general and administrative expenses
    7,227       7,565       25,494       24,441  
Share-based compensation expense, before income taxes
  $ 8,164     $ 8,364     $ 27,863     $ 26,762  

We measure share-based compensation expense at the grant date, based on the estimated fair value of the award and the number of awards expected to vest.  We recognize compensation expense for stock options and restricted stock on a straight-line basis (net of estimated forfeitures) over the requisite service period, which is generally the vesting period of the award.  Our employee stock purchase plan is considered a liability-classified compensatory plan; the associated costs of $0.8 million in the first nine months of fiscal 2009 and $0.9 million in the first nine months of 2008 are included in share-based compensation expense.  There were no capitalized share-based compensation costs as of November 30, 2008 and 2007.

STOCK OPTION ACTIVITY
(Shares and intrinsic value in thousands)
 
Number of Shares
   
Weighted Average Exercise Price
   
Weighted Average Remaining Contractual Life (Years)
   
Aggregate
Intrinsic
Value
 
Outstanding as of March 1, 2008
    13,648     $ 14.55              
Options granted
    2,220     $ 19.56              
Options exercised
    (788 )   $ 12.67              
Options forfeited or expired
    (146 )   $ 16.79              
Outstanding as of November 30, 2008
    14,934     $ 15.38       5.2     $ 1,017  
Exercisable as of November 30, 2008
    9,509     $ 13.14       4.8     $ 1,017  


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For the nine months ended November 30, 2008 and 2007, we granted nonqualified options to purchase 2,219,857 and 1,775,478 shares of common stock, respectively.  The total cash received as a result of stock option exercises was $10.0 million in the first nine months of fiscal 2009 and $13.2 million in the first nine months of fiscal 2008.  We settle stock option exercises with authorized but unissued shares of CarMax common stock.  The total intrinsic value of options exercised was $5.6 million for the first nine months of fiscal 2009 and $22.0 million for the first nine months of fiscal 2008.  We realized related tax benefits of $2.2 million in the first nine months of fiscal 2009 and $8.7 million in the first nine months of fiscal 2008.

OUTSTANDING STOCK OPTIONS

As of November 30, 2008
   
Options Outstanding
   
Options Exercisable
 
(Shares in thousands)
Range of Exercise Prices
   
Number of Shares
   
Weighted Average Remaining Contractual Life (Years)
   
Weighted Average Exercise Price
   
Number of Shares
   
Weighted Average Exercise Price
 
$
6.62 to $ 9.30
      2,197       4.2     $ 7.16       2,197     $ 7.16  
$
10.74 to $13.42
      4,228       5.1     $ 13.21       3,272     $ 13.21  
$
14.13 to $15.72
      2,847       5.3     $ 14.71       2,729     $ 14.70  
$
16.33 to $22.29
      3,980       5.5     $ 18.61       884     $ 17.14  
$
24.99 to $25.79
      1,682       5.4     $ 25.04       427     $ 25.05  
Total
      14,934       5.2     $ 15.38       9,509     $ 13.14  

For all stock options granted prior to March 1, 2006, the fair value was estimated as of the date of grant using a Black-Scholes option-pricing model.  For stock options granted to employees on or after March 1, 2006, the fair value of each award is estimated as of the date of grant using a binomial valuation model.  In computing the value of the option, the binomial model considers characteristics of fair-value option pricing that are not available for consideration under the Black-Scholes model, such as the contractual term of the option, the probability that the option will be exercised prior to the end of its contractual life and the probability of termination or retirement of the option holder.  For this reason, we believe that the binomial model provides a fair value that is more representative of actual experience and future expected experience than the value calculated using the Black-Scholes model.  For grants to nonemployee directors prior to fiscal 2009, we used the Black-Scholes model to estimate the fair value of stock option awards.  Beginning in fiscal 2009, we used the binomial model.  Estimates of fair value are not intended to predict actual future events or the value ultimately realized by the recipients of share-based awards.

The weighted average fair values at the date of grant for options granted during the nine-month periods ended November 30, 2008 and 2007, was $7.16 and $8.58 per share, respectively.  The unrecognized compensation costs related to nonvested options totaled $23.1 million as of November 30, 2008.  These costs are expected to be recognized over a weighted average period of 2.2 years.

ASSUMPTIONS USED TO ESTIMATE OPTION VALUES
   
Nine Months Ended November 30
 
   
2008
   
2007
 
Dividend yield
    0.0 %     0.0 %
Expected volatility factor (1)
    34.8% - 60.9 %     28.0% - 54.0 %
Weighted average expected volatility
    44.1 %     38.8 %
Risk-free interest rate (2)
    1.5% - 3.7 %     4.6% - 5.0 %
Expected term (in years) (3)
    4.8 - 5.2       4.2 - 4.4  
(1)Measured using historical daily price changes of our stock for a period corresponding to the term of the option and the implied volatility derived from the market prices of traded options on our stock.
(2)Based on the U.S. Treasury yield curve in effect at the time of grant.
(3)Represents the estimated number of years that options will be outstanding prior to exercise.


Page 16 of 42
 
 

 


RESTRICTED STOCK ACTIVITY
(In thousands)
 
Number of Shares
   
Weighted Average Grant Date Fair Value
 
Outstanding as of March 1, 2008
    1,721     $ 21.04  
Restricted stock granted
    1,079     $ 19.82  
Restricted stock vested or cancelled
    (117 )   $ 20.87  
Outstanding as of November 30, 2008
    2,683     $ 20.55  

For the nine months ended November 30, 2008 and 2007, we granted 1,078,580 and 903,815 shares of restricted stock, respectively.  The fair value of a restricted stock award is determined and fixed based on the volume-weighted average fair market value of our stock on the grant date.  The unrecognized compensation costs related to nonvested restricted stock awards totaled $24.0 million as of November 30, 2008.  These costs are expected to be recognized over a weighted average period of 1.4 years.
 
11.  
Net (Loss) Earnings per Share

BASIC AND DILUTIVE NET (LOSS) EARNINGS PER SHARE RECONCILIATIONS
   
Three Months
Ended November 30
   
Nine Months
Ended November 30
 
(In thousands except per share data)
 
2008
   
2007
   
2008
   
2007
 
Net (loss) earnings applicable to common shareholders
  $ (21,874 )   $ 29,846     $ 21,690     $ 160,196  
                                 
Weighted average common shares outstanding
    217,712       216,301       217,468       215,826  
Dilutive potential common shares:
                               
Stock options
          3,667       2,210       4,081  
Restricted stock
          590       1,014       513  
Weighted average common shares and dilutive potential common shares
    217,712       220,558       220,692       220,421  
Basic net (loss) earnings per share
  $ (0.10 )   $ 0.14     $ 0.10     $ 0.74  
Diluted net (loss) earnings per share
  $ (0.10 )   $ 0.14     $ 0.10     $ 0.73  

Options to purchase 14,934,460 shares of common stock were outstanding and not included in the calculation of diluted net (loss) earnings per share for the quarter ended November 30, 2008, because their inclusion would be antidilutive.  Options to purchase 1,782,493 shares of common stock were outstanding and not included in the calculation for the quarter ended November 30, 2007.
 
12.  
Accumulated Other Comprehensive Loss

(In thousands, net of income taxes)
 
Unrecognized Actuarial Losses
   
Unrecognized
Prior Service
Cost
   
Total
Accumulated
Other Comprehensive Loss
 
Balance as of February 29, 2008                                                                    
  $ 15,926     $ 802     $ 16,728  
Amounts arising during the period
    4,512             4,512  
Amortization expense                                                                    
    (68 )     (65 )     (133 )
Curtailment of retirement plans                                                                    
    (20,033 )     (737 )     (20,770 )
Balance as of November 30, 2008
  $ 337     $     $ 337  

The cumulative balances are net of deferred tax of $0.2 million as of November 30, 2008, and $9.8 million as of February 29, 2008.

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13.  
Contingent Liabilities

On April 2, 2008, Mr. John Fowler filed a putative class action lawsuit against CarMax Auto Superstores California, LLC and CarMax Auto Superstores West Coast, Inc. in the Superior Court of California, County of Los Angeles.  Subsequently, two other lawsuits, Leena Areso et al. v.  CarMax Auto Superstores California, LLC and Justin Weaver v. CarMax Auto Superstores California, LLC, were consolidated as part of the Fowler case.  The allegations in the consolidated case involve: (1) failure to provide meal and rest breaks or compensation in lieu thereof; (2) failure to pay wages of terminated or resigned employees related to meal and rest breaks and overtime; (3) failure to pay overtime; (4) failure to comply with itemized employee wage statement provisions; and (5) unfair competition.  The putative class consists of sales consultants, sales managers, and other hourly employees who worked for the company in California from April 2, 2004, to the present.  The lawsuit seeks compensatory and special damages, wages, interest, civil and statutory penalties, restitution, injunctive relief and the recovery of attorneys’ fees. We are unable to make a reasonable estimate of the amount or range of loss that could result from an unfavorable outcome in this matter.

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 condition or results of operations.

14.  
Recent Accounting Pronouncements

In March 2008, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133” (“SFAS 161”), which expands the disclosure requirements about an entity’s derivative instruments and hedging activities.  SFAS 161 requires that objectives for using derivative instruments and related hedged activities be disclosed in terms of the underlying risk that the entity is intending to manage and in terms of accounting designation.  The fair values of derivative instruments and related hedged activities and their gains are to be disclosed in tabular format showing both the derivative positions existing at period end and the effect of using derivatives during the reporting period.  Any credit-risk-related contingent features are to be disclosed and are to include information on the potential effect on an entity’s liquidity from using derivatives.  Finally, SFAS 161 requires cross-referencing within the notes to enable users of financial statements to better locate information about derivative instruments.  These expanded disclosure requirements are required for every annual and interim reporting period for which a balance sheet and statement of operations are presented.  SFAS 161 is effective for any reporting period (annual or quarterly interim) beginning after November 15, 2008, with early application encouraged.  We will be adopting SFAS 161 effective as of the start of the fourth quarter of fiscal 2009.

In October 2008, the FASB issued FASB Staff Position Financial Accounting Standard 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active,” (“FSP FAS 157-3”), which clarifies application of SFAS 157 in a market that is not active.  FSP FAS 157-3 was effective upon issuance, including prior periods for which financial statements have not been issued.  The adoption of FSP FAS 157-3 had no impact on our results of operations, financial condition or cash flows.

In December 2008, the FASB issued FSP FAS 140-4 and FIN 46(R)-8, “Disclosures by Public Entities (Enterprises) about Transfers of Financial Assets and Interests in Variable Interest Entities.”  This disclosure-only FSP improves the transparency of transfers of financial assets and an enterprise’s involvement with variable interest entities, including qualifying special-purpose entities.  This FSP is effective for the first reporting period (interim or annual) ending after December 15, 2008, with earlier application encouraged.  We will be adopting this FSP effective as of the start of the fourth quarter of fiscal 2009. We do not expect the adoption of the FSP will have any impact on our results of operations, financial condition or cash flows.

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SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities – Including an amendment of FASB Statement No. 115” (“SFAS 159”) was effective for our fiscal year beginning March 1, 2008.  SFAS 159 permits entities to measure certain financial assets and liabilities at fair value.  The fair value option may be elected on an instrument-by-instrument basis and is irrevocable.  Unrealized gains and losses on items for which the fair value option has been elected are recognized in earnings at each subsequent reporting date.  We did not elect to apply the fair value option to any of our financial assets or liabilities not already within the scope of SFAS 157.

In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations (revised 2007)” (“SFAS 141(R)”).  SFAS 141(R) replaces SFAS No. 141, “Business Combinations” (“SFAS 141”), but retains the requirement that the purchase method of accounting for acquisitions be used for all business combinations.  SFAS 141(R) expands on the disclosures previously required by SFAS 141, better defines the acquirer and the acquisition date in a business combination and establishes principles for recognizing and measuring the assets acquired (including goodwill), the liabilities assumed and any noncontrolling interests in the acquired business.  SFAS 141(R) also requires an acquirer to record an adjustment to income tax expense for changes in valuation allowances or uncertain tax positions related to acquired businesses.  SFAS 141(R) is effective for all business combinations with an acquisition date in the first annual period following December 15, 2008; early adoption is not permitted.  We will apply the provisions of SFAS 141(R) when applicable.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements – an amendment of ARB No. 51” (“SFAS 160”).  SFAS 160 requires that noncontrolling (or minority) interests in subsidiaries be reported in the equity section of our balance sheet, rather than in a mezzanine section of the balance sheet between liabilities and equity.  SFAS 160 also changes the manner in which the net income of the subsidiary is reported and disclosed in the controlling company's income statement.  SFAS 160 also establishes guidelines for accounting for changes in ownership percentages and for deconsolidation.  SFAS 160 is effective for financial statements for fiscal years beginning on or after December 1, 2008, and interim periods within those years.  As of November 30, 2008, we did not hold any noncontrolling interests in subsidiaries.

In April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”).  FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).  In developing assumptions about renewal or extension, FSP FAS 142-3 requires an entity to consider its own historical experience (or, if no experience, market participant assumptions) adjusted for the entity-specific factors in paragraph 11 of SFAS 142.  FSP FAS 142-3 expands the disclosure requirements of SFAS 142 and is effective for financial statements issued for fiscal years beginning after December 15, 2008, with early adoption prohibited.  The guidance for determining the useful life of a recognized intangible asset shall be applied prospectively to intangible assets acquired after the effective date.  The disclosure requirements shall be applied prospectively to all intangible assets recognized as of, and subsequent to, the effective date.  We believe the adoption of FSP FAS 142-3 will have no material impact on our results of operations, financial condition or cash flows.

In May 2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted Accounting Principles” (“SFAS 162”).  SFAS 162 identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements of nongovernmental entities that are presented in conformity with generally accepted accounting principles (“GAAP”) in the United States (“the GAAP hierarchy”).  SFAS 162 makes the GAAP hierarchy explicitly and directly applicable to preparers of financial statements, a step that recognizes preparers’ responsibilities for selecting the accounting principles for their financial statements, and sets the stage for making the framework of FASB Concept Statements fully authoritative.  The effective date for SFAS 162 is 60 days following the SEC’s approval of the Public Company Accounting Oversight Board’s related amendments to remove the GAAP hierarchy from auditing standards, where it has resided for some

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time.  The adoption of SFAS 162 will have no impact on our results of operations, financial condition or cash flows.

In June 2008, the FASB issued FASB Staff Position Emerging Issues Task Force No. 03-6-1, “Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities” (“FSP EITF 03-6-1”). FSP EITF 03-6-1 addresses whether instruments granted in share-based payment transactions are participating securities prior to vesting, and therefore need to be included in the earnings allocation in computing earnings per share under the two-class method as described in SFAS No. 128, “Earnings per Share.”  Under the guidance of FSP EITF 03-6-1, unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of earnings per share pursuant to the two-class method. Our restricted stock awards are considered “participating securities” because they contain nonforfeitable rights to dividends. FSP EITF 03-6-1 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and all prior-period earnings per share data presented shall be adjusted retrospectively. Early application is not permitted. We are currently evaluating the impact of FSP EITF 03-6-1 on our consolidated financial statements and will adopt FSP EITF 03-6-1 effective March 1, 2009.

In September 2008, the FASB issued exposure drafts that eliminate qualifying special purpose entities from the guidance of SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” and FASB Interpretation 46 (revised December 2003), “Consolidation of Variable Interest Entities - an interpretation of ARB No. 51,” as well as other modifications.  While the proposed revised pronouncements have not been finalized and the proposals are subject to further public comment, the changes could have a significant impact on our consolidated financial statements as we could potentially be precluded from using sales accounting treatment for our securitization transactions, which would change the timing of the recognition of CAF income. In addition, the changes could result in the consolidation of the financial assets and liabilities transferred to our qualified special purpose entities.  The changes would be effective March 1, 2010, on a prospective basis.


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ITEM 2.

MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements, the accompanying notes and the MD&A included in our Annual Report on Form 10-K for the fiscal year ended February 29, 2008, as well as our consolidated financial statements and the accompanying notes included in this Form 10-Q.
 
In this discussion, “we,” “our,” “us,” “CarMax,” “CarMax, Inc.” and “the company” refer to CarMax, Inc. and its wholly owned subsidiaries, unless the context requires otherwise.  Amounts and percentages in tables may not total due to rounding.  Certain prior year amounts have been reclassified to conform to the current presentation.

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.  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.  As of November 30, 2008, we operated 99 used car superstores in 46 markets, comprised of 34 mid-sized markets, 11 large markets and 1 small market.  We define mid-sized markets as those with television viewing populations generally between 600,000 and 2.5 million people.  We also operated six new car franchises, all of which were integrated or co-located with our used car superstores.  In fiscal 2008, we sold 377,244 used cars, representing 96% of the total 392,729 vehicles we sold at retail.

We believe the CarMax consumer offer is distinctive within the automobile retailing marketplace.  Our offer provides customers the opportunity to shop for vehicles the same way they shop for items at other “big box” retailers.  Our consumer offer is structured around our four customer benefits: low, no-haggle prices; a broad selection; high quality vehicles; and a customer-friendly sales process.  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 (“ESPs”) and vehicle repair service.

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 through on-site wholesale auctions.  Wholesale auctions are generally held on a weekly or bi-weekly basis, and as of November 30, 2008, we conducted auctions at 49 used car superstores.  During fiscal 2008, we sold 222,406 wholesale vehicles.  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 retail customers through CarMax Auto Finance (“CAF”), our finance operation, and a number of third-party financing providers.  We collect fixed, prenegotiated fees from the majority of the third-party providers, and we periodically test additional providers.  CarMax has no recourse liability for the financing provided by these third parties.

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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, and as of November 30, 2008, we had used car superstores located in markets that comprised approximately 45% of the U.S. population.  Prior to August 2008, we had planned to open used car superstores at a rate of approximately 15% of our used car superstore base each year.  In August 2008, we announced that we would temporarily slow our store growth as a result of the weak economic and sales environment.  During the third fiscal quarter conditions further deteriorated, and as a consequence, we decided to temporarily suspend our store growth.  The suspension of store growth will both reduce our capital needs and aid profitability in the near term.

Over the long term, we believe the primary driver for earnings growth will be vehicle unit sales growth, both from new stores and from stores included in our comparable store base.  We target a dollar range of gross profit per used unit sold.  The gross profit dollar target for an individual vehicle is based on a variety of factors, including its anticipated probability of sale and its mileage relative to its age; however, it is not based on the vehicle’s selling price.

Fiscal 2009 Third Quarter Highlights

§  
We believe the weakness in the economy and the stresses on consumer spending continued to adversely affect industry-wide sales in the automotive retail market in the third quarter.
§  
Net sales and operating revenues decreased 23% to $1.46 billion from $1.89 billion in the third quarter of fiscal 2008.  We reported a net loss of $21.9 million, or $0.10 per share, compared with net earnings of $29.8 million, or $0.14 per share, in the prior year period.
§  
Total used vehicle unit sales decreased 17%, reflecting the combination of a 24% decrease in comparable store used unit sales partially offset by growth in our store base.  Wholesale vehicle unit sales decreased 15%, reflecting a decrease in both our appraisal traffic and our appraisal buy rate (defined as the number of appraisal purchases as a percent of vehicles appraised).  New vehicle unit sales declined 26%, primarily reflecting the extremely soft new car industry trends.
§  
We opened one used car superstore in the third quarter, expanding our presence in an existing market.
§  
Our total gross profit decreased by $43.6 million, or 18%, to $199.2 million, primarily because of the significant decline in used and wholesale unit sales.  Despite the difficult sales environment, our total gross profit dollars per retail unit was relatively resilient, decreasing only $24 to $2,699 per unit from $2,723 per unit in the prior year’s third quarter.  We believe our ability to maintain a generally consistent level of gross profit per unit, despite the challenging sales environment and the unprecedented decline in wholesale market prices, was due in large part to the effectiveness of our proprietary inventory management systems and processes and our success in dramatically reducing inventories to align them with sales.
§  
CAF reported a pretax loss of $15.4 million compared with income of $16.3 million in the third quarter of fiscal 2008.  In both periods, CAF results were reduced by adjustments related to loans originated in previous fiscal periods.  The adjustments for the third quarter of fiscal 2009 totaled $39.8 million compared with $14.8 million in the prior year quarter.  In addition, CAF’s gain on loans originated and sold decreased to $11.3 million from $20.9 million in the third quarter of fiscal 2008.  This decline was due to the combination of a decline in CAF’s loan origination volume, higher loss and discount rate assumptions and increased credit enhancement requirements in the warehouse facility in fiscal 2009.
§  
Selling, general and administrative expenses as a percent of net sales and operating revenues (the “SG&A ratio”) increased to 14.9% from 11.2% in the third quarter of fiscal 2008.  The increase in the SG&A ratio was the result of the significant declines in comparable store used unit sales and average selling price, partially offset by a reduction in variable costs.  The fiscal 2009 third-quarter expenses also included a number of non-recurring items, which in the aggregate reduced results by $0.01 per share.

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§  
For the first nine months of the fiscal year, net cash provided by operations increased to $306.6 million compared with $158.9 million in fiscal 2008, primarily reflecting a large reduction in used vehicle inventories in fiscal 2009, partially offset by the decrease in net earnings.
 
CRITICAL ACCOUNTING POLICIES
 
For a discussion of our critical accounting policies, see “Critical Accounting Policies” in MD&A included in Item 7 of the Annual Report on Form 10-K for the fiscal year ended February 29, 2008.  These policies relate to securitization transactions, revenue recognition, income taxes and defined benefit retirement plan obligations.
 
RESULTS OF OPERATIONS
 
NET SALES AND OPERATING REVENUES
   
Three Months Ended
November 30
   
Nine Months Ended
November 30
 
(In millions)
 
2008
   
%
   
2007
   
%
   
2008
   
%
   
2007
   
%
 
Used vehicle sales
  $ 1,168.8       80.3     $ 1,514.3       80.3     $ 4,462.0       81.1     $ 4,909.8       79.8  
New vehicle sales
    57.5       4.0       77.0       4.1       217.4       4.0       294.4       4.8  
Wholesale vehicle sales
    177.0       12.2       234.7       12.5       642.6       11.7       761.2       12.4  
Other sales and revenues:
                                                               
Extended service plan revenues
    25.2       1.7       30.1       1.6       93.5       1.7       97.2       1.6  
Service department sales
    24.7       1.7       23.2       1.2       75.7       1.4       72.6       1.2  
Third-party finance fees, net
    2.5       0.2       5.9       0.3       12.3       0.2       19.7       0.3  
Total other sales and revenues
    52.4       3.6       59.3       3.1       181.5       3.3       189.6       3.1  
Total net sales and operating revenues
  $ 1,455.6       100.0     $ 1,885.3       100.0     $ 5,503.4       100.0     $ 6,155.0       100.0  
 
RETAIL VEHICLE SALES CHANGES
   
Three Months
Ended November 30
   
Nine Months
Ended November 30
 
   
2008
   
2007
   
2008
   
2007
 
Vehicle units:
                       
Used vehicles
    (17 )%     9 %     (4 )%     11 %
New vehicles
    (26 )%     (29 )%     (25 )%     (16 )%
Total
    (17 )%     7 %     (5 )%     10 %
                                 
Vehicle dollars:
                               
Used vehicles
    (23 )%     10 %     (9 )%     12 %
New vehicles
    (25 )%     (30 )%     (26 )%     (16 )%
Total
    (23 )%     7 %     (10 )%     10 %
 
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.


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