tenk.htm


 
 

 
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, 2010
 
OR
 
¨  
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period       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

 
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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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes  ¨  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 or a smaller reporting company. See definitions 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 ¨ (do not check if a smaller reporting company)    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

The aggregate market value of the registrant’s common stock held by non-affiliates as of August 31, 2009, computed by reference to the closing price of the registrant’s common stock on the New York Stock Exchange on that date, was $3.8 billion.

On March 31, 2010, there were 223,126,563 outstanding shares of CarMax, Inc. common stock.


DOCUMENTS INCORPORATED BY REFERENCE

Portions of the CarMax, Inc. Notice of 2010 Annual Meeting of Shareholders and Proxy Statement are incorporated by reference in Part III of this Form 10-K.

 
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CARMAX, INC.
 
FORM 10-K
FOR FISCAL YEAR ENDED FEBRUARY 28, 2010
TABLE OF CONTENTS
 

 
 
 
 
Page No.
         
PART I
         
Item 1.
 
Business
 
4
         
Item 1A.
 
Risk Factors
 
11
         
Item 1B.
 
Unresolved Staff Comments
 
14
         
Item 2.
 
Properties
 
14
         
Item 3.
 
Legal Proceedings
 
15
         
Item 4.
 
Reserved
 
15
         
PART II
         
Item 5.
 
Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
16
         
Item 6.
 
Selected Financial Data
 
18
         
Item 7.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
19
         
Item 7A.
 
Quantitative and Qualitative Disclosures about Market Risk
 
39
         
Item 8.
 
Consolidated Financial Statements and Supplementary Data
 
40
         
Item 9.
 
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
 
75
         
Item 9A.
 
Controls and Procedures
 
75
         
Item 9B.
 
Other Information
 
75
         
PART III
         
Item 10.
 
Directors, Executive Officers and Corporate Governance
 
76
         
Item 11.
 
Executive Compensation
 
77
         
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
 
77
         
Item 13.
 
Certain Relationships and Related Transactions and Director Independence
 
77
         
Item 14.
 
Principal Accountant Fees and Services
 
77
         
PART IV
         
Item 15.
 
Exhibits and Financial Statement Schedules
 
78
         
 
 
 Signatures 
 
79

 
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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:

Ÿ  
Our projected future sales growth, comparable store unit sales growth, margins, earnings and earnings per share.
Ÿ  
Our expectations of factors that could affect CarMax Auto Finance income.
Ÿ  
Our expected future expenditures, cash needs and financing sources.
Ÿ  
The projected number, timing and cost of new store openings.
Ÿ  
Our sales and marketing plans.
Ÿ  
Our assessment of the potential outcome and financial impact of litigation and the potential impact of unasserted claims.
Ÿ  
Our assessment of competitors and potential competitors.
Ÿ  
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,” “outlook,” “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 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, Virginia.

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, Virginia.  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, publicly traded company.

CarMax Business.  We are the nation’s largest retailer of used cars, based on the 357,129 used vehicles we retailed during the fiscal year ended February 28, 2010.  As of the end of fiscal 2010, we operated 100 used car superstores in 46 metropolitan markets.  In addition, we sold 197,382 wholesale vehicles in fiscal 2010 through on-site auctions.

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.  The CarMax consumer offer provides 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 customer benefits: low, no-haggle prices; a broad selection; high quality vehicles; and a customer-friendly sales process.  Our strategy is to revolutionize 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.
 
 
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We purchase, recondition and sell used vehicles.  All of the used vehicles we retail are thoroughly reconditioned to meet our high standards, and each vehicle must pass a comprehensive inspection before being offered for sale.  In fiscal 2010, approximately 90% of the used vehicles we retailed were 1 to 6 years old with fewer than 60,000 miles.  We also offer a selection of used vehicles at each superstore that are more than 6 years old or have more than 60,000 miles, if they meet similar quality standards.

We also sell new vehicles at five locations under franchise agreements with four new car manufacturers (Chrysler, General Motors, Nissan and Toyota).  In fiscal 2010, new vehicles comprised 2% of our total retail vehicle unit sales.

We provide 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 financing providers; the sale of extended service plans, guaranteed asset protection 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 generally based on a fixed dollars-per-unit standard, allow 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.  Historically, we have acquired 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.  Vehicles purchased through our in-store appraisal process that do not meet our retail standards are sold to licensed dealers through on-site wholesale auctions.

Our proprietary inventory management and pricing system tracks each vehicle throughout the sales process.  Using the information provided by this system and applying 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, generally more than 99% of the entire used car inventory offered at retail is sold at retail.

Industry and Competition.  The U.S. used car marketplace is highly fragmented and competitive.  According to industry sources, as of December 31, 2009, there were approximately 18,600 franchised automotive dealerships, who sell both new and used vehicles.  In addition, used vehicles were sold by approximately 36,500 independent used vehicle dealers, as well as millions of private individuals.  Our primary competitors are the franchised auto dealers, who sell the majority of late-model used vehicles.  Independent used car dealers predominantly sell older, higher mileage cars than we do.  The number of franchised and independent auto dealers has gradually declined over the last decade.  The rate of dealership closures accelerated in 2008 and 2009 due to the recessionary environment, the sharp decline in industry sales, the challenging credit conditions and the bankruptcies of General Motors and Chrysler.  Despite the recent acceleration in dealership closures, the automotive retail environment remains highly fragmented.

Based on industry data, there were approximately 35 million used cars sold in the U.S. in calendar year 2009, of which approximately 15 million were estimated to be late-model, 1 to 6 year old vehicles.  While we are the largest retailer of used vehicles in the U.S., selling more than two times as many used vehicles as the next largest retailer in calendar 2009, we still represented only approximately 2% of the total late-model used units sold.  Over the last several years, competition has been affected by the increasing use of Internet-based marketing for both used vehicles and vehicle financing.  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 advantages 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 locations of our retail stores.  Upon request by a customer, we will transfer virtually any used vehicle in our nationwide inventory to a local superstore.  Transfer fees may apply, depending on the distance the vehicle needs to travel.  In fiscal 2010, more than 25% of our vehicles sold were transferred at customer request.  Our Certified Quality Inspection assures that every vehicle we offer for sale meets our stringent standards.  We back every vehicle with a 5-day, money-back guarantee and at least a 30-day limited warranty.  Other competitive advantages include our ability to offer or arrange customer financing with 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.
 
 
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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 gross profit on the vehicle being sold.  The sales consultant normally 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 typically receive higher commissions for negotiating higher prices and interest rates, and for steering customers toward vehicles with higher gross profit.

In the new vehicle market, we compete with other franchised dealers.  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.

In our wholesale auctions, we compete with other automotive auction houses.  We believe our principal competitive advantages include our high vehicle sales rate, our conditional announcement and arbitration policies, our broad geographic distribution and our dealer-friendly practices.  Because we own the cars that we auction, we generally sell between 97% and 100% of the vehicles offered, which is substantially higher than the sales rate at most other auto auctions.  Our policy of making conditional announcements, noting mechanical and other issues found during our appraisal process, is also not a typical practice used at other auctions of older, higher mileage vehicles.  Together, these factors make our auctions attractive to dealers, resulting in a high dealer-to-car attendance ratio.

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, Internet search engines and online classified listings.  Television and radio broadcast advertisements are designed to build consumer awareness of the CarMax name, carmax.com and key components of the CarMax offer.  Broadcast and Internet advertisements are designed to drive customers to our stores and to carmax.com.

We continue to adjust our marketing programs in response to the evolving media landscape.  We have customized our marketing program based on awareness levels in each market.  We are building awareness and driving traffic to our stores and carmax.com by listing every retail vehicle on AutoTrader.com, cars.com and usedcars.com.  We believe using these online classified services allows our vehicles to appear on sites that are visited by a majority of buyers of late-model used vehicles who use the Internet in their shopping process.  Our advertising on the Internet also includes 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 each of the thousands of 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 advanced feature-based search capabilities, and sorting and comparison tools that allow consumers to easily compare vehicles.  The site also includes features such as detailed vehicle reviews, payment calculators and email alerts when new inventory arrives.  Virtually any used vehicle in our nationwide inventory can be transferred at customer request to their local superstore.  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 they need to visit the store only to sign the paperwork and pay for and pick up their vehicle.  Our survey data indicates that during fiscal 2010, approximately 75% of customers who purchased a vehicle from us had visited our website first.
 
 
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Suppliers for Used Vehicles.  We acquire used vehicle inventory directly from consumers through our in-store appraisal process and through other sources, including local, regional and online auctions, wholesalers, franchised and independent dealers and fleet owners, such as leasing companies and rental companies.  The supply of used vehicles is influenced by a variety of factors, including the total number of vehicles in operation; the rate of new vehicle sales, which in turn generate used-car trade-ins; and the number of used vehicles sold or remarketed through retail channels, wholesale transactions and at automotive auctions.  According to industry statistics, there are approximately 250 million light vehicles in operation in the U.S.  In recent years, generally between 10 million and 17 million new vehicles and between 35 million and 45 million used vehicles have been retailed annually and between 9 million and 10 million vehicles have been sold at wholesale auction each year.

Our used vehicle inventory acquired directly from consumers through our appraisal process, within our stores and car-buying centers, helps provide an inventory of makes and models that reflects the consumer preferences of each market.  We have replaced the traditional “trade-in” transaction with a process in which a CarMax-trained buyer appraises a customer’s vehicle and provides the owner with a written, guaranteed offer that is good for seven days.  An appraisal is available to every customer free of charge, whether or not the customer 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 to licensed dealers through 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 based on internal and external auction data and market sales, as well as estimated reconditioning costs and, for off-site purchases, transportation costs.  Our buyers, in collaboration with our home office staff, utilize the extensive inventory and sales trend data available through the CarMax information system to decide which inventory to purchase at off-site auctions.  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 profit per unit.

Based on consumer acceptance of the in-store appraisal process, 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 sources of used vehicles will continue to be sufficient to meet our current and future needs.

Suppliers for New Vehicles.  Our new car operations are governed by the terms of the sales, service and dealer agreements.  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.  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. Historically, our business has been seasonal.  Typically, our superstores experience their strongest traffic and sales in the spring and summer quarters.  Sales are typically slowest in the fall quarter, when used vehicles generally experience proportionately more of their annual depreciation.  We believe this is partly the result of a decline in customer traffic, as well as discounts on model year closeouts that can pressure pricing for late-model used vehicles.  Customer traffic generally tends to slow in the fall as the weather changes and as customers shift their spending priorities toward holiday-related expenditures.

Products and Services
Merchandising.  We offer 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 Chrysler, Ford, General Motors, Honda, Hyundai, Kia, 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 $11,000 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 $21,000.

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, cars.com and usedcars.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.
 
 
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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 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.  Some superstores depend upon nearby, typically larger, superstores for reconditioning, which increases efficiency and reduces overhead.

All CarMax used car superstores 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, our information systems and our technician training and development process.  The training and development process and our 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 through on-site wholesale auctions.  As of February 28, 2010, wholesale auctions were conducted at 50 of our 100 superstores and were generally held on a weekly or bi-weekly 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 CarMax 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.  The average auction sales rate was 97% in fiscal 2010.  Dealers pay a fee to us based on the sales price of the vehicles they purchase.

Customer Credit.  We offer 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 35% of our retail vehicle unit sales in fiscal 2010.  Customer credit applications are initially reviewed by CAF and may also be reviewed by a third-party provider.  Customers who are not approved by either CAF or the initial third-party provider may be evaluated by other financial institutions.  Having a wide array of financing sources increases discrete approvals and expands the options for our customers.  To this end, we have tested, and will continue to test, other third-party providers.

Customers applying for financing provide credit information that is electronically submitted by sales consultants through our proprietary information system.  A majority of applicants receive a response within five minutes.  The vehicle financings are retail installment contracts secured by the vehicles financed.  For the majority of the contracts arranged by the third-party providers, we are paid a fixed, prenegotiated fee per vehicle financed.  We have no recourse liability on retail installment contracts arranged with third-party providers.  Customers are permitted to refinance or pay off their contract within three business days of a purchase without incurring any finance or related charges.

Extended Service Plans and Guaranteed Asset Protection.  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 mileage, make and age.  We offer extended service plans at low, fixed prices, which are based primarily on the historical repair record of the vehicle make and model and the length of coverage selected.  All extended service plans that we sell (other than manufacturer programs) have been designed to our specifications and are administered by the third parties through private-label arrangements.  We receive a commission from the administrator at the time the extended service plan is sold.  In fiscal 2010, more than half of the customers purchasing a used vehicle from CarMax also purchased an extended service plan.
 
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Our extended service plan customers have access to vehicle repair service at each CarMax store and to the third-party administrators’ nationwide network consisting of thousands of independent and franchised 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.

In fiscal 2010, we introduced a guaranteed asset protection product (“GAP”) that will pay the difference between the customer’s insurance settlement and the finance contract payoff amount on their vehicle in the case of a total loss or unrecovered theft. We sell this product on behalf of an unrelated third party that is the primary obligor and we have no contractual liability to the customer.  GAP has been designed to our specifications and is administered by the third party through private-label arrangements.  We receive a commission from the administrator at the time of sale.

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 our entire vehicle inventory through our website, carmax.com, and print a detailed listing for any vehicle, which includes the vehicle’s features and specifications and its 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.  A computerized 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 many aspects of store operations, such as inventory management, pricing, vehicle transfers, wholesale auctions and sales consultant productivity.  In addition, our store system provides a direct link to our proprietary credit processing information system to facilitate the credit review and approval process.

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 initial retail price points, as well as 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 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 quickly 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, 2010, we had a total of 13,439 full- and part-time associates, including 10,196 hourly and salaried associates and 3,243 sales associates, who worked on a commission basis.  We employ additional associates during peak selling seasons.  As of February 28, 2010, our location general managers averaged more than nine years of CarMax experience, in addition to prior retail management experience.  We open new stores with experienced management teams drawn from existing stores.

We believe we have created a unique corporate culture and maintain good employee relations.  No associate is subject to a collective bargaining agreement.  We focus on providing our associates with the information and resources they need to offer exceptional customer service.  We reward associates whose behavior exemplifies our culture, and we believe that our favorable working conditions and compensation programs allow us to attract and retain highly qualified individuals.  We have been recognized for the success of our efforts by a number of external organizations.
 
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Training.  To further support our emphasis on attracting, developing and retaining qualified associates, we have made a commitment to providing exceptional training programs.  On average, each store associate completed at least 20 online or classroom courses, totaling more than 44 hours of training per associate in fiscal 2010.  Store associates receive structured, self-paced training that introduces 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 after training.  Most new store associates are also assigned mentors who provide on-the-job guidance and support.

We also provide comprehensive, facilitator-led classroom training courses at the associate and manager levels.  All sales consultants go through a four-week on-boarding process in which they are partnered with a mentor, combining self-paced online training with shadowing and role-playing.  Our Professional Selling Skills training provides sales associates the opportunity to learn and practice customer-oriented selling techniques.  This online training program contains modules on a variety of skill sets, including building confidence, connecting with the customer, and listening and persuasion techniques.  We have also implemented a call recording and review program to provide constructive feedback to associates on how to improve their interactions with customers.  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 1,000 cars before making their first independent purchase.  Business office associates undergo a 3- to 6-month on-the-job certification process in order to be fully cross-trained in all functional areas of the business office.  All business office associates and managers also receive continuous training through facilitated competency-based training courses.  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 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.  New managers attend an intensive week-long workshop at the home office where they meet with senior leaders and learn fundamental CarMax management skills.

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 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 and collection laws, installment finance laws and usury laws.

Claims arising out of actual or alleged violations of law could be asserted against us by individuals or governmental authorities and could expose us to significant damages or other penalties, including revocation or suspension of the licenses necessary to conduct business and fines.

Environmental Laws and Regulations. We are subject to a variety of federal, state and local laws and regulations that pertain to the environment.  Our business involves the use, handling and disposal of hazardous materials and wastes, including motor oil, gasoline, solvents, lubricants, paints and other substances.  We are subject to compliance with regulations concerning the operation of underground and aboveground gasoline storage tanks, aboveground oil tanks and automotive paint booths.

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 (“SEC”).  The contents of our website are not, however, part of this report.
 
 
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In addition, our Corporate Governance Guidelines and Code of Business 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 on 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 reportable waivers of the Code of Business Conduct are promptly disclosed on our website.

Item 1A.  Risk Factors.

We are subject to various risks, including the risks described below.  Our business, results of operations and financial condition could be materially and adversely affected by any of these risks or additional risks not presently known or that we currently deem immaterial.

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, unemployment levels and consumer sentiment about the economy in general.  Any significant changes in economic conditions could adversely affect consumer demand and/or increase costs.

Capital.  Changes in the availability or cost of capital and working capital financing, including the long-term financing to support our geographic expansion and financing of auto loan receivables, 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, results of operations and financial condition.

We use and have historically relied upon a securitization program to fund substantially all of the auto loan receivables originated by CAF.  Initially, we sell these receivables into our warehouse facility.  We periodically refinance the receivables through term securitizations.  Changes in the condition of the asset-backed securitization market have led, and could in the future lead, us to incur higher costs to access funds in this market or we could be required to seek alternative means to finance our loan originations.  In the event that this market ceased to exist and there were no immediate alternative funding sources available, we might be forced to curtail our lending practices for some period of time.  The impact of reducing or curtailing CAF’s loan originations could have a material adverse impact on our business, sales and results of operations.

Disruptions in the capital and credit markets could adversely affect our ability to draw on our revolving credit facility.  If our ability to secure funds from the facility were significantly impaired, our access to working capital would be impacted, our ability to maintain appropriate inventory levels could be affected and these conditions could have a material adverse effect on our business, sales, results of operations and financial condition.

Third-Party Financing Providers.  CarMax provides financing to qualified customers through CAF and a number of third-party financing providers.  In the event that one or more of these third-party providers could no longer, or choose not to, provide financing to our customers, could only provide financing to a reduced segment of our customers or could no longer provide financing at competitive rates of interest, it could have a material impact on our business, sales and results of operations.  Additionally, if we were unable to replace current third-party financing providers upon the occurrence of one or more of the foregoing events, it could also have a material impact on our business, sales and results of operations.

Competition. Automotive retailing is a highly competitive business.  Our competition includes publicly and privately owned new and used car dealers, as well as millions of private individuals.  Competitors 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.  Competition could be affected by the increasing use of the Internet to market and potentially sell used vehicles and obtain vehicle financing.  The increasing use of the Internet in the automotive retailing business could reduce our sales and adversely affect our results of operations.  In addition, CAF is subject to competition from various financial institutions.

Retail Prices.  Any significant changes in retail prices for used and new vehicles could reduce sales and profits.  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 revenue and results of operations and require a change in our operating strategies.
 
 
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Inventory.  A reduction in the availability or access to sources of inventory could adversely affect our business.  A failure to adjust appraisal offers to stay in line with broader market trade-in offer trends, or a failure to recognize those trends, could negatively impact the 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 results of operations.

Regulatory and Legislative Environment.  We are subject to a wide range of federal, state and local laws and regulations, such as licensing requirements and laws regarding advertising, vehicle sales, financing and employment practices.  Our facilities and business operations are also subject to laws and regulations relating to environmental protection and health and safety.  The violation of these laws or regulations could result in administrative, civil or criminal penalties or in a cease-and-desist order against business operations.  As a result, we have incurred and will continue to incur capital and operating expenses and other costs to comply 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, financing 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.

During the past year, there were several proposed, comprehensive federal legislative and regulatory initiatives and reforms, and depending upon the scope of the final legislation, if any, we may experience an increase in expenses or a decrease in revenues.  Certain new laws, including legislation regarding health care, employee relations, and finance and tax reform, could adversely affect our business, results of operations and financial condition.

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 business.  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 could 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 operations, impact sales and results of operations, expose us to customer or third-party claims or result in adverse publicity.

Accounting Policies and Matters. We have identified several accounting policies as being “critical” to the fair presentation of our financial condition and results of operations because they involve major aspects of our business and require management to make judgments about matters that are inherently uncertain.  Materially different amounts could be recorded under different conditions or using different assumptions.

Additionally, the Financial Accounting Standards Board is currently considering various proposed rule changes including, but not limited to, potential changes in accounting for leases.  The SEC is currently considering adopting rules that would require U.S. issuers to prepare their financial statements contained in SEC filings in accordance with International Financial Reporting Standards (“IFRS”), as issued by the International Accounting Standards Board.  The implementation of these or other new accounting requirements or changes to U.S. generally accepted accounting principles could adversely affect our reported results of operations and financial condition.

Confidential Customer Information. In the normal course of business, we collect, process and retain sensitive and confidential customer information.  Despite the security measures we have in place, our facilities and systems, and those of third-party service providers, could be vulnerable to security breaches, acts of vandalism, computer viruses, misplaced or lost data, programming or human errors or other similar events.  Any security breach involving the misappropriation, loss or other unauthorized disclosure of confidential information, whether by us or by third-party service providers, could damage our reputation, expose us to the risks of litigation and liability, disrupt our business or otherwise affect our results of operations.


 
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Growth.  Our inability to acquire or lease suitable real estate at favorable terms could limit our expansion and could adversely affect our business and results of operations.  The expansion of our store base places significant demands on our management team, our associates and our systems.  If we fail to effectively or efficiently manage our growth, it could adversely affect our business, sales and results of operations.

Litigation.  We are subject to various litigation matters, which could adversely affect our business.  Claims arising out of actual or alleged violations of law could 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 business.

Automotive Manufacturers.  Adverse conditions affecting one or more automotive manufacturers could impact our results of operations.  Manufacturer recalls could also have an adverse effect on used vehicle sales or valuations.

Weather.  The occurrence of severe weather events, such as rain, snow, wind, storms, hurricanes or other natural disasters, could cause store closures, adversely affecting consumer traffic, and could adversely affect our results of operations.

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, these conditions could have a disproportionately large adverse effect on our annual results of operations.

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 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 experienced a downturn in economic conditions, it could adversely affect our business and results of operations.

Other Material Events.  The occurrence of certain material events including acts of terrorism, the outbreak of war or other significant national or international events could adversely affect our business, results of operations or financial condition.

 
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Item 1B.  Unresolved Staff Comments.

None.

Item 2.  Properties.

We conduct our used vehicle operations in two basic retail formats – production and non-production superstores.  Production superstores are those locations at which vehicle reconditioning is performed, while non-production superstores do not perform vehicle reconditioning.  In determining whether to construct a production or a non-production superstore on a given site, we take several factors into account, including the anticipated long-term reconditioning needs and the available acreage of this and other sites in that market.  As a result, some superstores that are constructed to accommodate reconditioning activities may initially be operated as non-production superstores until we expand our presence in that market.  As of February 28, 2010, we operated 59 production superstores and 41 non-production superstores.  At that date, we also operated one new car store, which was located adjacent to our used car superstore in Laurel, Maryland.  Our remaining five new car franchises are operated as part of our used car superstores.

Production superstores are generally 40,000 to 60,000 square feet on 10 to 25 acres, but a few range from approximately 70,000 to 95,000 square feet on 20 to 35 acres.  Non-production superstores are generally 10,000 to 25,000 square feet on 4 to 12 acres.

 
Used Car Superstores as of February 28, 2010
   
Total
 
Alabama
    2  
Arizona
    3  
California
    13  
Colorado
    1  
Connecticut
    2  
Florida
    10  
Georgia
    5  
Illinois
    6  
Indiana
    2  
Kansas
    2  
Kentucky
    1  
Maryland
    4  
Mississippi
    1  
Missouri
    1  
Nebraska
    1  
Nevada
    2  
New Mexico
    1  
North Carolina
    8  
Ohio
    2  
Oklahoma
    2  
South Carolina
    3  
Tennessee
    4  
Texas
    12  
Utah
    1  
Virginia
    8  
Wisconsin
    3  
Total
    100  

We have financed the majority of our stores through sale-leaseback transactions.  As of February 28, 2010, we leased 59 of our 100 used car superstores as well as our CAF office building in Atlanta, Georgia.  We owned the remaining 41 stores currently in operation and the 3 superstores that were constructed in fiscal 2009 and which we now plan to open in fiscal 2011.  We also owned our home office building in Richmond, Virginia, and land associated with planned future store openings.

 
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Expansion
Prior to fiscal 2010, we had opened used car superstores at an annual rate of approximately 15% of our used car superstore base for several consecutive years.  As a result of the weak economic and sales environment, in December 2008, we temporarily suspended store growth.  Based on the improvements in our sales and profitability in fiscal 2010, as well as the increasing stability in the credit markets, we plan to resume store growth in fiscal 2011.  We plan to take a measured approach by opening three superstores in fiscal 2011, between three and five superstores in fiscal 2012, and between five and ten superstores in fiscal 2013.  The three superstores that we plan to open in fiscal 2011 were constructed in fiscal 2009, but we chose not to open them until market conditions improved.
 
We continue to 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.
 
For additional details on fiscal 2010, see “Operations Outlook,” included in Part II, Item 7, of this Form 10-K.
 
Item 3.  Legal Proceedings.
 
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 involved: (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 consisted of sales consultants, sales managers, and other hourly employees who worked for the company in California from April 2, 2004, to the present.  On May 12, 2009, the court dismissed all of the class claims with respect to the sales manager putative class.  On June 16, 2009, the court dismissed all claims related to the failure to comply with the itemized employee wage statement provisions.  The court also granted CarMax's motion for summary adjudication with regard to CarMax's alleged failure to pay overtime to the sales consultant putative class.  The plaintiffs have appealed the court's ruling regarding the sales consultant overtime claim.  In addition to the plaintiffs' appeal of the overtime claim, the claims currently remaining in the lawsuit regarding the sales consultant putative class are: (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 (3) unfair competition.  On June 16, 2009, the court entered a stay of these claims pending the outcome of a California Supreme Court case involving related legal issues.  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 these matters.

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.
 
Item 4.  Reserved.
 

 
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PART II

Item 5.  Market for the 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.  We are authorized to issue up to 350,000,000 shares of common stock and up to 20,000,000 shares of preferred stock.  As of February 28, 2010, there were 223,065,542 shares of CarMax common stock outstanding and there were approximately 7,500 shareholders of record.  As of that date, there were no preferred shares outstanding.

The following table presents the quarterly high and low sales prices per share for our common stock for each quarter during the last two fiscal years, as reported on the New York Stock Exchange composite tape.

   
1st
   
2nd
   
3rd
   
4th
 
   
Quarter
   
Quarter
   
Quarter
   
Quarter
 
Fiscal 2010
                       
High
  $ 14.00     $ 17.60     $ 23.07     $ 24.75  
Low
  $ 8.40     $ 11.31     $ 16.64     $ 19.60  
                                 
Fiscal 2009
                               
High
  $ 21.99     $ 19.95     $ 20.70     $ 10.38  
Low
  $ 17.30     $ 10.53     $ 5.76     $ 6.59  

To date, we have not paid a cash dividend on CarMax common stock.  We believe it is prudent to retain our net earnings for use in operations and for geographic expansion, as well as to maintain maximum financial flexibility and liquidity for our business.  Therefore, we do not anticipate paying any cash dividends in the foreseeable future.

During the fourth quarter of fiscal 2010, 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 cumulative total shareholder return (stock price appreciation plus dividends, as applicable) on our common stock for the last five fiscal years with the cumulative total return of the S&P 500 Index and the S&P 500 Retailing Index.  The graph assumes an original investment of $100 in CarMax common stock and in each index on February 28, 2005, and the reinvestment of all dividends, as applicable.
 
 

 

 
16

 

 

Graph
 
 


   
As of February 28 or 29
 
   
2005
   
2006
   
2007
   
2008
   
2009
   
2010
 
CarMax
  $ 100.00     $ 95.21     $ 159.70     $ 111.27     $ 57.15     $ 122.36  
S&P 500 Index
  $ 100.00     $ 108.40     $ 121.38     $ 117.01     $ 66.32     $ 101.88  
S&P 500 Retailing Index
  $ 100.00     $ 111.97     $ 124.14     $ 98.88     $ 66.82     $ 114.87  




 
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Item 6.  Selected Financial Data.

   
FY10
   
FY09
   
FY08
   
FY07
   
FY06
   
FY05
 
Income statement information (In millions)
                                   
Used vehicle sales
  $ 6,192.3     $ 5,690.7     $ 6,589.3     $ 5,872.8     $ 4,771.3     $ 3,997.2  
New vehicle sales
    186.5       261.9       370.6       445.1       502.8       492.1  
Wholesale vehicle sales
    844.9       779.8       985.0       918.4       778.3       589.7  
Other sales and revenues
    246.6       241.6       254.6       229.3       207.6       181.3  
Net sales and operating revenues
    7,470.2       6,974.0       8,199.6       7,465.7       6,260.0       5,260.3  
Gross profit
    1,098.9       968.2       1,072.4       971.1       790.7       650.2  
CarMax Auto Finance income
    175.2       15.3       85.9       132.6       104.3       82.7  
SG&A
    818.7       882.4       858.4       776.2       674.4       565.3  
Earnings before income taxes
    452.5       96.8       297.1       323.3       217.6       165.8  
Income tax provision
    170.8       37.6       115.0       124.8       83.4       64.5  
Net earnings
    281.7       59.2       182.0       198.6       134.2       101.3  
                                                 
Share and per share information (Shares in millions)
                                               
Weighted average shares outstanding:
                                               
Basic
    219.5       217.5       216.0       212.5       209.3       208.1  
Diluted
    222.2       219.4       220.0       216.6       212.8       211.3  
Net earnings per share:
                                               
Basic
  $ 1.27     $ 0.27     $ 0.84     $ 0.93     $ 0.64     $ 0.49  
Diluted
  $ 1.26     $ 0.27     $ 0.82     $ 0.91     $ 0.63     $ 0.48  
                                                 
Balance sheet information (In millions)
                                               
Total current assets
  $ 1,556.4     $ 1,287.8     $ 1,356.9     $ 1,150.5     $ 941.7     $ 853.0  
Total assets
    2,556.2       2,379.2       2,333.2       1,885.6       1,509.6       1,306.3  
Total current liabilities
    477.4       490.8       490.0       512.0       344.9       317.8  
Short-term debt
    0.9       0.9       21.0       3.3       0.5       65.2  
Current portion of long-term debt
    122.3       158.1       79.7       148.4       59.8       0.3  
Long-term debt, excluding current portion
    27.4       178.1       227.2       33.7       134.8       128.4  
Total shareholders’ equity
    1,933.6       1,593.1       1,488.9       1,247.4       980.1       814.2  
                                                 
Unit sales information
                                               
Used vehicle units sold
    357,129       345,465       377,244       337,021       289,888       253,168  
New vehicle units sold
    7,851       11,084       15,485       18,563       20,901       20,636  
Wholesale vehicle units sold
    197,382       194,081       222,406       208,959       179,548       155,393  
                                                 
Percent changes in
                                               
Comparable store used vehicle unit sales
    1       (16 )     3       9       4       1  
Total used vehicle unit sales
    3       (8 )     12       16       15       13  
Total net sales and operating revenues
    7       (15 )     10       19       19       14  
Net earnings
    376       (67 )     (8 )     48       32       (8 )
Diluted net earnings per share
    367       (67 )     (10 )     46       31       (8 )
                                                 
Other year-end information
                                               
Used car superstores
    100       100       89       77       67       58  
Associates
    13,439       13,035       15,637       13,736       11,712       10,815  


 
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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.  All references to net earnings per share are to diluted net earnings per share.  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.  All share and per share amounts for prior periods have been adjusted to reflect our 2-for-1 common stock split in March 2007.

As of March 1, 2009, we adopted new accounting rules related to the treatment of participating securities in the calculation of net earnings per share.  As a result, certain prior year amounts have been restated to reflect the adoption.  See Note 12 for additional information.

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 revolutionize 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 February 28, 2010, we operated 100 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.  In fiscal 2010, we sold 357,129 used cars, representing 98% of the total 364,980 vehicles we sold at retail.

We believe the CarMax consumer offer is distinctive within the auto 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 February 28, 2010, we conducted auctions at 50 used car superstores.  During fiscal 2010, we sold 197,382 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.  As of February 28, 2010, these third parties included Bank of America Dealer Financial Services, Capital One Auto Finance, CitiFinancial Auto, Santander Consumer USA and Wachovia Dealer Services (which changed its name to Wells Fargo Dealer Services in March 2010).  The third-party provider who purchases subprime financings purchases these loans at a discount, and we collect fixed, prenegotiated fees from the majority of the other providers.   We periodically test additional providers.  CarMax has no recourse liability for the financing provided by these third parties.

We sell ESPs on behalf of unrelated third parties who are the primary obligors.  As of February 28, 2010, the used vehicle third-party ESP providers were CNA National Warranty Corporation and The Warranty Group.  We have no contractual liability to the customer under these third-party service plans.  ESP revenue represents commissions from the unrelated third parties.

In fiscal 2010, we introduced a guaranteed asset protection product (“GAP”) that will pay the difference between the customer’s insurance settlement and the finance contract payoff amount on their vehicle in the case of a total loss or unrecovered theft.  We sell GAP on behalf of an unrelated third party who is the primary obligor.  As of February 28, 2010, the third-party GAP provider was Safe-Guard Products International, LLC.  We have no contractual liability to the customer for this product.  GAP revenue represents commissions from the unrelated third party.
 
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Over the long term, we believe the primary drivers for earnings growth will be vehicle unit sales growth, both from new stores and from stores included in our comparable store base, as well as improvements in margins resulting from operational efficiencies.  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 primarily based on the vehicle’s selling price.

Prior to fiscal 2010, we opened used car superstores at an annual rate of approximately 15% of our used car superstore base for several consecutive years.  As a result of the weak economic and sales environment, in December 2008, we temporarily suspended store growth.  This suspension reduced our capital needs and growth-related costs.  Based on the improvements in our sales and profitability in fiscal 2010, as well as the increasing stability in the credit markets, we plan to resume store growth in fiscal 2011.  We plan to take a measured approach by opening three stores in fiscal 2011, between three and five stores in fiscal 2012, and between five and ten stores in fiscal 2013.  We are still at a relatively early stage in the national rollout of our retail concept, and as of February 28, 2010, we had used car superstores located in markets that comprised approximately 45% of the U.S. population.

In the near term, our principal challenges are related to the weak economic conditions and the resulting high unemployment rate and relatively low levels of consumer confidence, all of which have caused a dramatic decline in industry-wide auto sales when compared with pre-recessionary levels.  Longer term, we believe the principal challenges we face will include our ability to build our management bench strength to support our store growth and our ability to procure suitable real estate.  We staff each newly opened store with an experienced management team.  Therefore, we must recruit, train and develop managers and associates to fill the pipeline necessary to support future store openings.

Fiscal 2010 Highlights
·  
Net sales and operating revenues increased 7% to $7.47 billion from $6.97 billion in fiscal 2009, while net earnings increased to $281.7 million, or $1.26 per share, from $59.2 million, or $0.27 per share.
·  
Total used vehicle revenues increased 9% to $6.19 billion versus $5.69 billion in fiscal 2009.  The average used vehicle selling price climbed 5%, primarily reflecting increases in our acquisition costs, which have been affected by a significant year-over-year increase in used vehicle wholesale values.  Total used vehicle unit sales rose 3%, reflecting the combination of a 1% increase in comparable store used unit sales and sales from newer stores not yet included in the comparable store base.
·  
Total wholesale vehicle revenues increased 8% to $844.9 million versus $779.8 million in fiscal 2009, reflecting the combination of a 6% rise in the average wholesale vehicle selling price and a 2% increase in wholesale unit sales.
·  
Total gross profit increased 13% to $1.10 billion compared with $968.2 million in fiscal 2009, primarily because of a significant improvement in total gross profit per unit, which climbed $296 to $3,011 per unit from $2,715 per unit in fiscal 2009.  Several factors contributed to the strength of our gross profit per unit, including our ongoing initiative to reduce waste in the vehicle reconditioning process; the support provided by the appreciation in used vehicle wholesale values; and continued refinements in our proprietary inventory management systems and processes, which allowed us to increase inventory turns.
·  
CAF income climbed to $175.2 million compared with $15.3 million in fiscal 2009.  In both periods, CAF results were affected by adjustments related to loans originated in previous fiscal years.  In fiscal 2010, the adjustments increased CAF income by $26.7 million, or $0.07 per share, while in fiscal 2009, the adjustments reduced CAF income by $81.8 million, or $0.23 per share.  The fiscal 2010 adjustments included $64.0 million of favorable mark-to-market adjustments primarily on retained subordinated bonds and $18.9 million of net favorable valuation adjustments primarily related to decreases in prepayment rate and discount rate assumptions, partially offset by $56.2 million of increased funding costs.  CAF’s gain on loans originated and sold increased to $83.0 million compared with $46.5 million in fiscal 2009.  The increase primarily reflected an increase in CAF’s gain percentage, which improved to 4.5% versus 2.4% in fiscal 2009.
·  
Selling, general and administrative (“SG&A”) expenses were reduced 7% to $818.7 million from $882.4 million in fiscal 2009, despite the increase in unit sales.  The SG&A reduction reflected decreases in advertising expenses and growth-related costs, as well as benefits from a variety of waste-reduction initiatives.  In addition, fiscal 2010 SG&A expenses included the benefit of a favorable litigation settlement, which increased earnings by $0.02 per share, while fiscal 2009 SG&A expenses included various non-recurring items, which in the aggregate reduced earnings by $0.04 per share.  SG&A expenses as a percent of net sales and operating revenues (the “SG&A ratio”), fell to 11.0% from 12.7% in fiscal 2009 due to both the reduction in SG&A expenses and the leverage associated with the increases in unit sales and average selling prices.
·  
Net cash provided by operating activities fell to $50.3 million compared with $264.6 million in fiscal 2009.  The reduction occurred despite the significant improvement in net income in fiscal 2010, and it reflected the use of cash for increases in the retained interest in securitized receivables and inventory in fiscal 2010, and the generation of cash from a significant reduction in inventory in fiscal 2009.  The fiscal 2010 increase in the retained interest in securitized receivables primarily reflected the effects of retaining subordinated bonds in the April 2009 term securitization and the $64.0 million of favorable mark-to-market adjustments.
 
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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 maintain a revolving securitization program (“warehouse facility”) to fund substantially all of the auto loan receivables originated by CAF until they can be funded through a term securitization or alternative funding arrangement.  The securitization transactions are accounted for as sales.  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.  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, various reserve accounts, required excess receivables and retained subordinated bonds.

The present value of the residual cash flows we expect to receive over the life of the securitized 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.  These assumptions are derived from historical experience and projected economic trends.  Adjustments to one or more of these assumptions could have a material impact on the fair value of the retained interest.  The fair value of the retained interest could also 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 and credit 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.  Note 6 includes a discussion on fair value measurements.  In addition, see the “CarMax Auto Finance Income” section of this MD&A for a discussion of the effect of changes in our assumptions.

As discussed in Note 17 and in the “Fiscal 2011 Expectations – CAF Income” section of this MD&A, we will adopt Accounting Standards Updates (“ASUs”) 2009-16 and 2009-17 (formerly Statement of Financial Accounting Standards Nos. 166 and 167, respectively) effective March 1, 2010.  Pursuant to these pronouncements, we will recognize existing and future transfers of auto loan receivables into term securitizations as secured borrowings, which will result in recording the auto loan receivables and the related notes payable to the investors on our consolidated balance sheets.  We will also account for future transfers of receivables into our warehouse facility as secured borrowings.  As of March 1, 2010, we amended our warehouse facility agreement.  As a result, the receivables that were funded in the warehouse facility at that date will be consolidated, along with the related notes payable, at their fair value.  In future periods, CAF income included in the consolidated statements of earnings will no longer include a gain on the sale of loans originated and sold, but instead will reflect the net interest margin generated by the auto loan receivables less direct CAF expenses.

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 results could be affected if future vehicle returns differ from historical averages.
 
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We also sell ESPs and GAP on behalf of unrelated third parties to customers who purchase a vehicle.  Because we are not the primary obligor under these products, we recognize commission revenue at the time of sale, net of a reserve for returns.  The reserve for cancellations is recorded based on historical experience and trends, and results could be affected if future cancellations 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 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.  Note 8 includes information regarding income taxes.

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 available carrybacks, future reversals of existing temporary differences and future taxable income.  Except for a valuation allowance recorded for capital loss carryforwards that may not be utilized before their expiration, we believe that our recorded deferred tax assets as of February 28, 2010, 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.

RESULTS OF OPERATIONS

Net Sales and Operating Revenues

   
Years Ended February 28 or 29
 
(In millions)
 
2010
   
%
   
2009
   
%
   
2008
   
%
 
Used vehicle sales
  $ 6,192.3       82.9     $ 5,690.7       81.6     $ 6,589.3       80.4  
New vehicle sales
    186.5       2.5       261.9       3.8       370.6       4.5  
Wholesale vehicle sales
    844.9       11.3       779.8       11.2       985.0       12.0  
Other sales and revenues:
                                               
Extended service plan revenues
    144.5       1.9       125.2       1.8       132.4       1.6  
Service department sales
    101.1       1.4       101.2       1.5       96.0       1.2  
Third-party finance fees, net
    0.9             15.3       0.2       26.1       0.3  
Total other sales and revenues
    246.6       3.3       241.6       3.5       254.6       3.1  
Total net sales and operating revenues
  $ 7,470.2       100.0     $ 6,974.0       100.0     $ 8,199.6       100.0  
 
 
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Retail Vehicle Sales Changes
 
   
Years Ended February 28 or 29
 
   
2010
   
2009
   
2008
 
Vehicle units:
                 
Used vehicles
    3 %     (8 )%     12 %
New vehicles
    (29 )%     (28 )%     (17 )%
Total
    2     (9 )%     10 %
                         
Vehicle dollars:
                       
Used vehicles
    9 %     (14 )%     12 %
New vehicles
    (29 )%     (29 )%     (17 )%
Total
    7 %     (14 )%     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.

Comparable Store Retail Vehicle Sales Changes
 
   
Years Ended February 28 or 29
 
   
2010
   
2009
   
2008
 
Vehicle units:
                 
Used vehicles
    1 %     (16 )%     3 %
New vehicles
    (29 )%     (25 )%     (11 )%
Total
    0 %     (17 )%     2 %
                         
Vehicle dollars:
                       
Used vehicles
    6 %     (21 )%     3 %
New vehicles
    (29 )%     (26 )%     (11 )%
Total
    5 %     (21 )%     2 %

Change in Used Car Superstore Base
 
   
Years Ended February 28 or 29
 
   
2010
   
2009
   
2008
 
Used car superstores, beginning of year
    100       89       77  
Superstore openings
          11       12  
Used car superstores, end of year
    100       100       89  
Openings as a percent of the beginning-of-year store base
    %     12 %     16 %
 
Used Vehicle Sales
Fiscal 2010 Versus Fiscal 2009.  Our 9% increase in used vehicle revenues in fiscal 2010 resulted from a 5% increase in average retail selling price and a 3% increase in unit sales.  The increase in the average retail selling price primarily reflected increases in our vehicle acquisition costs resulting from appreciation in wholesale industry used vehicle values.  After falling sharply in fiscal 2009, wholesale vehicle values climbed during much of fiscal 2010, which we believe in part reflected tight supply conditions that occurred as vehicle trade-in activity slowed in tandem with the decline in new car industry sales.

The 3% unit sales growth reflected a 1% increase in comparable store used unit sales and sales from newer superstores not yet included in the comparable store base.  We experienced a significant improvement in sales execution in fiscal 2010; however, the resulting increase in sales conversion rate was almost fully offset by a decline in customer traffic.  The improvement in sales conversion occurred despite the tightening of lending standards by our third-party finance providers and CAF in fiscal 2010, which we estimate adversely affected our comparable store used unit sales growth by several percentage points.  Continuing weak economic conditions caused our customer traffic to remain below the prior year level, despite the fact that the government’s Consumer Assistance to Recycle and Save Act (“CARS” or “cash for clunkers”) new car incentive program generated a spike in traffic in late July and August 2009.  Similar to our experience with previous successful, broad-based new car incentive programs, we believe this program had a beneficial effect on our used car customer traffic and sales.
 
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Our data indicated that we increased our share of the late-model used vehicle market by more than 10% in fiscal 2010, while the overall market contracted.  We believe our ability to grow market share year after year is a testament to the strength of our consumer offer and the preference for our brand.

Fiscal 2009 Versus Fiscal 2008.  Our 14% decrease in used vehicle revenues in fiscal 2009 resulted from the combination of an 8% decline in unit sales and a 6% decrease in average retail selling price.  The decline in unit sales reflected a 16% decrease in comparable store used units, partially offset by sales from newer superstores not yet in the comparable store base.  The decrease in the average retail selling price was primarily caused by a significant industry-wide drop in wholesale used car prices during the first three quarters of the year, which reduced our inventory acquisition costs.  Early in fiscal 2009, the steep increase in the cost of gasoline caused a temporary shift in consumer demand away from SUVs and trucks, toward more fuel-efficient vehicles.  However, in the latter half of fiscal 2009, the combination of the decline in gasoline prices and the lower, more affordable prices for these less fuel-efficient vehicles caused our sales mix to return to the prior year levels.

We began to see the initial effects of the slowdown in the automotive retail market in the latter part of fiscal 2008.  However, the weakness in the economy and the stresses on consumer spending accelerated in fiscal 2009, causing customer traffic to decline sharply starting in late May 2008.  These stresses included rising unemployment rates, decreases in home equity values and personal wealth, and record low levels of consumer confidence.  For the year, the decline in customer traffic was slightly greater than the decrease in comparable store unit sales.  Despite the more difficult environment, the solid execution by our store teams allowed us to modestly improve our conversion rate compared with fiscal 2008.  While both CAF and our third-party providers tightened lending criteria for some higher-risk customer segments, lack of credit availability was not a major contributor to the reduction in sales in fiscal 2009.  Our data indicated that we modestly gained market share in the late-model used vehicle market in fiscal 2009.

New Vehicle Sales
Fiscal 2010 Versus Fiscal 2009.  New vehicle revenues declined 29% in fiscal 2010.  The decrease was entirely the result of a corresponding decline in unit sales, which primarily reflected the extremely soft new car industry sales trends for the brands we represent.  A reduction in sales volumes at our Chevrolet franchise, which is one of many franchises being terminated by General Motors, also contributed to the decline in new vehicle unit sales.  For the fiscal year ended February 28, 2010, new car manufacturers reported a 15% decline in U.S. new car unit sales.

Fiscal 2009 Versus Fiscal 2008.  New vehicle revenues declined 29% in fiscal 2009.  The decline was the result of a 28% decrease in unit sales and a 1% decrease in average selling price.  New vehicle unit sales primarily reflected the extremely soft new car industry sales trends, as well as the sale of our Orlando Chrysler-Jeep-Dodge franchise in the second quarter of fiscal 2008.  For the fiscal year ended February 28, 2009, new car manufacturers reported a 23% decline in U.S. 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 through on-site wholesale auctions.  Our wholesale auction prices usually reflect the trends in the general wholesale market for the types of vehicles we sell, although they could also be affected by changes in vehicle mix or the average age, mileage or condition of the vehicles wholesaled.

Fiscal 2010 Versus Fiscal 2009.  The 8% increase in wholesale vehicle revenues in fiscal 2010 resulted from a 6% increase in average wholesale vehicle selling price combined with a 2% increase in wholesale unit sales.  The increase in wholesale unit sales was mainly the result of a significant increase in our appraisal buy rate.  We believe the strong industry-wide wholesale vehicle pricing environment and the resulting increases in our appraisal offers had a favorable effect on the buy rate.  The benefit of the improvement in appraisal buy rate was largely offset, however, by a double-digit decline in appraisal traffic, particularly in the first half of the year.  Appraisal traffic was adversely affected by both the slowdown in our customer traffic and by the reduction in new car industry sales and the related used vehicle trade-in activity.

Fiscal 2009 Versus Fiscal 2008.  The 21% decrease in wholesale vehicle revenues in fiscal 2009 resulted from a 13% decrease in wholesale unit sales combined with a 10% decrease in average wholesale vehicle selling price.  The decline in unit sales primarily reflected a decrease in our appraisal traffic and, to a lesser extent, a decline in our appraisal buy rate.  Appraisal traffic was affected by the overall slowdown in customer traffic.  Industry wholesale prices for SUVs, trucks and other less fuel efficient vehicles fell sharply in the first two quarters of fiscal 2009, and prices for virtually all vehicle classes declined at an unprecedented rate during the third quarter, reflecting the weak demand environment.  We believe the significant drop in wholesale market values, which resulted in corresponding decreases in our appraisal offers, contributed to the reduction in our buy rate.
 
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Other Sales and Revenues
Other sales and revenues include commissions on the sale of ESPs and GAP (reported in ESP revenues), service department sales and net third-party finance fees.  The fixed fees paid by third-party finance providers vary by provider, reflecting their differing levels of credit risk exposure.  The third-party provider who purchases subprime financings purchases these loans at a discount, which is reflected as an offset to finance fee revenues received from the other third-party providers.

Fiscal 2010 Versus Fiscal 2009.  Other sales and revenues increased 2% in fiscal 2010.  The increase was comprised of a 15% increase in ESP revenues, largely offset by a 94% decline in third-party finance fees.  ESP revenues benefited from the 3% increase in used unit sales and the successful introduction of GAP in fiscal 2010.  In addition, fiscal 2010 ESP revenues benefited from modifications in pricing made during the second half of fiscal 2009.  The decline in third-party finance fees primarily reflected a mix shift among providers, which increased the percentage of vehicle sales financed by the subprime provider.  The subprime provider financed approximately 6% of our retail unit sales in fiscal 2010 compared with approximately 3% in fiscal 2009.  In addition, during the third quarter of fiscal 2010, we curtailed our temporary strategy of routing a larger percentage of credit applications directly to the third-party finance providers.  We had originally implemented this practice in the third quarter of fiscal 2009 in order to slow the use of capacity in our warehouse facility during a period when the asset-backed securitization markets were severely disrupted.  The warehouse facility is used to provide initial funding for substantially all of the auto loan receivables originated by CAF.

Fiscal 2009 Versus Fiscal 2008.  Other sales and revenues decreased 5% in fiscal 2009.  ESP revenues declined 5%.  Compared with the 8% decrease in total used vehicle unit sales in fiscal 2009, ESP revenues benefited from a slow down in the rate of ESP cancellations, which we believe was the result of the decline in auto industry sales and trade-ins.  Third-party finance fees decreased 42% due to a combination of factors including the reduction in retail vehicle unit sales, a shift in mix among providers and a change in discount arrangements with certain of the providers during fiscal 2009.  Collectively, the third-party providers financed a larger percentage of our retail unit sales in the second half of fiscal 2009, as we chose to route more credit applications to these providers in order to slow the use of capacity in our warehouse facility.

Supplemental Sales Information

Unit Sales

   
Years Ended February 28 or 29
 
   
2010
   
2009
   
2008
 
Used vehicles
    357,129       345,465       377,244  
New vehicles
    7,851       11,084       15,485  
Wholesale vehicles
    197,382       194,081       222,406  

Average Selling Prices

   
Years Ended February 28 or 29
 
   
2010
   
2009
   
2008
 
Used vehicles
  $ 17,152     $ 16,291     $ 17,298  
New vehicles
  $ 23,617     $ 23,490     $ 23,795  
Wholesale vehicles
  $ 4,155     $ 3,902     $ 4,319  



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Retail Vehicle Sales Mix

   
Years Ended February 28 or 29
 
   
2010
   
2009
   
2008
 
Vehicle units:
                 
Used vehicles
    98 %     97 %     96 %
New vehicles
    2       3       4  
Total
    100 %     100 %     100 % 
                         
Vehicle dollars:
                       
Used vehicles
    97 %     96 %     95 %
New vehicles
    3       4       5  
Total
    100     100 %     100 %

As of February 28, 2010, we had a total of six new car franchises representing the Chevrolet, Chrysler, Nissan and Toyota brands.  In June 2009, we were notified by General Motors that our Chevrolet franchise in Kenosha, Wisconsin, will be terminated no later than October 2010.  By this date, we expect to stop selling new General Motors vehicles at this site, where we also have a used car superstore and a Toyota franchise.  We do not expect this franchise termination to have a material effect on sales or earnings.

Between fiscal 2007 and fiscal 2009, we opened five car-buying centers.  These are test sites at which we conduct appraisals and purchase, but do not sell, vehicles.  We will continue to evaluate the performance of these five centers before deciding whether to open additional ones in future years.  These test sites are part of our long-term program to increase both appraisal traffic and retail vehicle sourcing self-sufficiency (equal to the percentage of vehicles sold at retail that were purchased directly from consumers).

Gross Profit
 
   
Years Ended February 28 or 29
 
(In millions)
 
2010
   
2009
   
2008
 
Used vehicle gross profit
  $ 739.9     $ 644.4     $ 708.6  
New vehicle gross profit
    6.7       9.0       15.4  
Wholesale vehicle gross profit
    171.5       162.5       176.7  
Other gross profit
    180.8       152.2       171.8  
Total
  $ 1,098.9     $ 968.2     $ 1,072.4  

Gross Profit per Unit

   
Years Ended February 28 or 29
 
   
2010
   
2009
   
2008
 
   
$ per unit (1)
      % (2)  
$ per unit (1)
      % (2)  
$ per unit (1)
      % (2)
Used vehicle gross profit
  $ 2,072       11.9     $ 1,865       11.3     $ 1,878       10.8  
New vehicle gross profit
  $ 858       3.6     $ 814       3.4     $ 994       4.2  
Wholesale vehicle gross profit
  $ 869       20.3     $ 837       20.8     $ 794       17.9  
Other gross profit
  $ 495       73.3     $ 427       63.0     $ 437       67.5  
Total gross profit
  $ 3,011       14.7     $ 2,715       13.9     $ 2,731       13.1  
 
(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 percentage of its respective sales or revenue.

Used Vehicle Gross Profit
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 primarily based on the vehicle’s selling 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 fluctuation in used vehicle values and contribute to our ability to manage gross profit dollars per unit.  We employ a volume-based strategy, and we systematically mark down individual vehicle prices based on proprietary pricing algorithms in order to appropriately balance sales trends, inventory turns and gross profit achievement.  When customer traffic and sales are consistently strong, we generally take fewer pricing markdowns, which in turn benefits gross profit dollars per unit.  When the sales pace slows, we may initially take more pricing markdowns, which could pressure gross profit dollars per unit.  However, as we are successful in reducing inventories to align them with a slower sales pace, this may allow us to return to target levels of gross profit per unit.  Over the past several years, we have continued to refine our car-buying strategies, which we believe has benefited used vehicle gross profit per unit.
 
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Fiscal 2010 Versus Fiscal 2009.  Our used vehicle gross profit increased by $95.4 million, or 15%, to $739.9 million from $644.4 million in fiscal 2009, reflecting the combination of an 11% improvement in used vehicle gross profit dollars per unit and the 3% increase in used unit sales.  Used vehicle gross profit per unit increased $207 to $2,072 per unit compared with $1,865 per unit in fiscal 2009.  The improvement in gross profit per unit resulted from a combination of factors, including our ongoing initiative to reduce waste in the vehicle reconditioning process.  We estimate that we achieved a sustainable reduction in average reconditioning costs of approximately $200 per vehicle by the end of fiscal 2010.  This reduction was primarily accomplished through our emphasis on the consistent application of our reconditioning standards across our entire store base.  The benefit of the year-over-year appreciation in used vehicle wholesale values also contributed to our used vehicle gross profit.  In addition, we believe continuing refinements to our proprietary inventory management systems and processes were contributing factors, as we were able to increase inventory turns in fiscal 2010, despite our aggressive reductions in inventory in the previous year.  The improvement also reflected the below-average profitability reported early in fiscal 2009 when the initial slowdown in customer traffic and a rapid decline in underlying values of SUVs and trucks put pressure on our used vehicle margins.

Fiscal 2009 Versus Fiscal 2008.  Our used vehicle gross profit decreased by $64.2 million, or 9%, to $644.4 million from $708.6 million in fiscal 2008, primarily as a result of the 8% decline in total used unit sales.  Despite the difficult sales environment in fiscal 2009, gross profit per unit decreased only $13 to $1,865 per unit.  Several factors adversely affected our fiscal 2009 used vehicle gross profit per unit, including a reduction in the percent of vehicles purchased directly from customers and the sharp decrease in wholesale industry prices.  These were largely offset, however, by our success in managing our inventories.

During fiscal 2009, we experienced a decline in both appraisal traffic and our buy rate, which required us to source a larger percentage of our used vehicles at auction.  Vehicles purchased at auction typically generate less gross profit per unit compared with vehicles purchased directly from consumers.  Additionally, wholesale industry prices for mid-sized and large SUVs and trucks declined sharply in the spring and early summer of 2008, and this rapid decline in valuation resulted in margin pressure on this segment of inventory in the first half of fiscal 2009.

We believe that our ability to maintain a generally consistent level of gross profit per unit during fiscal 2009, 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.  In response to the sharp decline in traffic and sales that began in late May 2008, we rapidly reduced our used car inventories, which brought them back in line with the current sales rates and minimized required pricing markdowns in the second half of the fiscal year.  Compared with inventory levels at stores open as of February 29, 2008, we had approximately 16,500 fewer total used vehicle units in inventory as of February 28, 2009, representing a 28% reduction.  Due to the severe decline in customer traffic during fiscal 2009, we generally chose not to reduce our gross profit targets, as we believed doing so in the current economic environment would not have spurred a sufficient increase in sales to offset the reduction in per-unit profitability.

New Vehicle Gross Profit
Fiscal 2010 Versus Fiscal 2009.  Our new vehicle gross profit decreased 25% to $6.7 million from $9.0 million in fiscal 2009.  The reduction primarily reflected the 29% decline in new vehicle unit sales, partially offset by a 5% increase in new vehicle gross profit dollars per unit, which improved to $858 per unit from $814 per unit in fiscal 2009.  The industry-wide reductions in new vehicle inventories and incentives related to the cash for clunkers program benefited the new vehicle gross profit dollars per unit in the second and third quarters of fiscal 2010.

Fiscal 2009 Versus Fiscal 2008. Our new vehicle gross profit decreased 42% to $9.0 million in fiscal 2009 from $15.4 million in fiscal 2008, reflecting the 28% reduction in total new unit sales and a $180 decline in gross profit per unit.  These reductions resulted from the sharp decline in new car industry sales and the resulting increase in competitiveness in the new car market.


 
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Wholesale Vehicle Gross Profit
Our wholesale vehicle gross profit per unit has steadily increased over the last several years, in part, reflecting the benefits realized from improvements and refinements in our car-buying strategies, appraisal delivery processes and 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 initiatives to increase our dealer-to-car ratio, which we believe has allowed us to achieve higher prices.  In addition, the frequency of our auctions, which are generally held weekly or bi-weekly, minimizes the depreciation risk on these vehicles.

Fiscal 2010 Versus Fiscal 2009.  Our wholesale vehicle gross profit increased by $8.9 million, or 5%, to $171.5 million from $162.5 million in fiscal 2009, reflecting the combination of a 4% improvement in wholesale vehicle gross profit per unit and the 2% increase in wholesale unit sales.  Wholesale gross profit per unit increased $32 to $869 per unit compared with $837 per unit in fiscal 2009.  The improvement in the wholesale vehicle gross profit per unit primarily reflected the higher year-over-year wholesale pricing environment.  We also achieved a new record dealer-to-car ratio at our auctions in fiscal 2010, with the resulting price competition among bidders contributing to the strong wholesale gross profit per unit.

Fiscal 2009 Versus Fiscal 2008.  Our wholesale vehicle gross profit decreased by $14.2 million, or 8%, to $162.5 million from $176.7 million in fiscal 2008.  The reduction was driven by the 13% decline in wholesale vehicle unit sales, partially offset by an increase in wholesale gross profit per unit of $43, or 5%, to $837 per unit from $794 per unit in fiscal 2008.  We experienced an improvement in our dealer-to-car ratio at our auctions in fiscal 2009, with the resulting price competition among bidders contributing to the strong wholesale gross profit per unit.  Our wholesale vehicles are predominantly comprised of older, higher mileage vehicles, and we believe the demand for these types of vehicles remained strong from dealers who specialize in selling to credit-challenged customers.

Other Gross Profit
Other gross profit includes profits related to ESP and GAP revenues, net third-party finance fees and service department sales.  We have no cost of sales related to ESP and GAP revenues or net third-party finance fees, as these represent commissions paid to us by the third-party providers.  Accordingly, changes in the relative mix of the other gross profit components can affect the composition of other gross profit.

Fiscal 2010 Versus Fiscal 2009.  Other gross profit increased by $28.6 million, or 19%, to $180.8 million from $152.2 million in fiscal 2009.  Other gross profit per unit increased $68, or 16%, to $495 per unit from $427 per unit in fiscal 2009.  ESP gross profit increased $19.3 million, or 15%, benefiting from the introduction of GAP, the modifications in pricing made during the second half of fiscal 2009 and the 3% increase in used unit sales.  Service department gross profit grew $23.6 million, primarily because our retail vehicle sale growth outpaced fixed service overhead costs.  The increases in ESP and service department gross profit were partially offset by a $14.3 million reduction in net third-party finance fees, which were adversely affected by the mix shift among providers and the termination of our temporary practice of reducing CAF originations by routing more credit applications to our third-party providers.

Fiscal 2009 Versus Fiscal 2008. Other gross profit decreased by $19.6 million, or 11%, to $152.2 million from $171.8 million in fiscal 2008.  This decrease primarily reflected the reductions in used and new retail unit sales and the related impact on ESP revenues and third-party finance fees and a $10 decline in other gross profit per unit in fiscal 2009.  The decline in other gross profit per unit was primarily associated with the increase in mix of other revenues represented by service department sales.

Impact of Inflation
Historically, inflation has not been a significant contributor to results.  Profitability is primarily affected by our ability to achieve targeted unit sales and gross profit dollars per vehicle rather than on average retail prices.  However, increases in average vehicle selling prices benefit the SG&A ratio and CAF income, to the extent the average amount financed also increases.

During fiscal 2010, we experienced a period of strong appreciation in used vehicle wholesale pricing.  We believe the appreciation resulted, in part, from a reduced supply of used vehicles in the market that was caused by the dramatic decline in new car industry sales and the associated slow down in used vehicle trade-in activity.  The appreciation also reflected a rebound in pricing compared with the severe depreciation experienced in the previous year.  The higher wholesale values increased both our vehicle acquisition costs and our average selling prices for used and wholesale vehicles.
 
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During fiscal 2009, the weakness in the economy and the stresses on consumer spending contributed to the industry-wide slowdown in the sale of new and used vehicles and to the unprecedented decline in wholesale market prices for most vehicle classes during the first three quarters of the year.  These lower wholesale values reduced our vehicle acquisition costs and contributed to the decline in our used and wholesale vehicle average selling price.

CarMax Auto Finance Income
CAF provides financing for a portion of our used and new car retail sales.  Because the purchase of a vehicle is often 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 loans, both for CAF and for the third-party financing providers.  Generally, CAF has provided us the opportunity to capture additional profits and cash flows from auto loan receivables while managing our reliance on third-party financing sources.

Components of CAF Income
 
   
Years Ended February 28 or 29
 
(In millions)
 
2010
   
%
   
2009
   
%
   
2008
   
%
 
Gain on sales of loans originated and sold (1)(2)
  $ 83.0       4.5     $ 46.5       2.4     $ 58.1       2.4  
Other gains (losses) (1)
    26.7               (81.8 )             (9.6 )        
Total gain (loss)
    109.7               (35.3 )             48.5          
Other CAF income: (3)
                                               
Servicing fee income
    41.9       1.0       41.3       1.0       37.4       1.0  
Interest income
    68.5       1.7       48.3       1.2       33.3       0.9  
Total other CAF income
    110.4       2.7       89.6       2.2       70.7       2.0  
Direct CAF expenses: (3)
                                               
CAF payroll and fringe benefit expense
    20.2       0.5       19.2       0.5       15.9       0.4  
Other direct CAF expenses
    24.7       0.6       19.9       0.5       17.4       0.5  
Total direct CAF expenses
    44.9       1.1       39.1       1.0       33.3       0.9  
CarMax Auto Finance income (4)
  $ 175.2       2.3     $ 15.3       0.2     $ 85.9       1.0  
                                                 
Total loans originated and sold
  $ 1,855.3             $ 1,930.2             $ 2,430.8          
Average managed receivables
  $ 4,080.0             $ 4,021.0             $ 3,608.4          
Ending managed receivables
  $ 4,112.7             $ 3,986.7             $ 3,838.5          
                                                 
Total net sales and operating revenues
  $ 7,470.2             $ 6,974.0             $ 8,199.6          

(1)
To the extent we recognize valuation or other adjustments related to loans originated and sold during previous quarters of the same fiscal year, the sum of amounts reported for the individual quarters may not equal the amounts reported for the corresponding full fiscal year.

Percent columns indicate:
(2) Percent of loans originated and sold (“gain percentage”).
(3) Percent of average managed receivables.
(4) Percent of total 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 benefits 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.

CAF provides financing for qualified customers at competitive market rates of interest.  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.  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.  Historically, the gain on loans originated and sold as a percent of loans originated and sold (the “gain percentage”) has generally been in the range of 3.5% to 4.5%.  However, the gain percentage was substantially below the low end of this range in fiscal 2009 and fiscal 2008, primarily as a result of the more challenging economic environment and the disruption in the global credit markets.  These factors caused us to increase the loss and discount rate assumptions that affect the gain recognized on the sale of loans, and they increased our funding costs.
 

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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 term securitizations, changes in the valuation of retained subordinated bonds and the repurchase and resale of receivables in existing term securitizations, as applicable.

Between January 2008 and April 2009, we retained some or all of the subordinated bonds associated with our term securitizations.  We retained these subordinated bonds because, at the applicable issue date, the economics of doing so were more favorable than selling them.  During fiscal 2010, we retained subordinated bonds in connection with the April 2009 securitization of $1.0 billion of auto loans.  These subordinated bonds were issued at a discount and had a fair value of $123.0 million as of February 28, 2010.  Retained subordinated bonds are included in retained interest in securitized receivables on our consolidated balance sheets, and their total fair value was $248.8 million as of February 28, 2010, $87.4 million as of February 28, 2009, and $43.1 million as of February 29, 2008.  Changes in the fair value of the retained subordinated bonds are reflected in CAF income.

Fiscal 2010 Versus Fiscal 2009.  CAF income increased to $175.2 million from $15.3 million in fiscal 2009.  In both periods, CAF results were affected by adjustments related to loans originated in previous fiscal years.  In fiscal 2010, the adjustments increased CAF income by $26.7 million, or $0.07 per share, while in fiscal 2009, the adjustments reduced CAF income by $81.8 million, or $0.23 per share.  The fiscal 2010 adjustments included:
·  
$64.0 million of favorable mark-to-market adjustments primarily on retained subordinated bonds resulting from improvements in credit market conditions and an increase in demand for these securities.
·  
$14.8 million of net favorable valuation adjustments primarily related to decreases in prepayment rate assumptions.
·  
$4.1 million of favorable valuation adjustments related to reducing the discount rate assumption on select pools of loans.
·  
Partly offset by a $56.2 million increase in funding costs largely related to the $1.22 billion of auto loan receivables that were funded in the warehouse facility at the end of fiscal 2009.  The majority of this increase in funding costs was associated with the term securitization completed in April 2009.

Excluding the adjustments from both periods, CAF income increased to $148.6 million from $97.0 million in fiscal 2009.  CAF’s gain on loans originated and sold climbed to $83.0 million from $46.5 million in fiscal 2009.  The increase primarily reflected a significant improvement in the gain percentage, partially offset by a reduction in the volume of loans originated and sold.  The gain percentage increased to 4.5% in fiscal 2010 from 2.4% in fiscal 2009.  Several factors contributed to this improvement.  The spread between the rates charged customers and CAF’s funding costs increased, largely due to lower benchmark rates.  In addition, CAF’s tightening of lending standards had a favorable effect on the expected net loss and discount rate assumptions used to value the related gain income and on the required credit enhancements.   The volume of CAF loans originated and sold declined 4% to $1.86 billion from $1.93 billion in fiscal 2009, mainly reflecting a decline in the percentage of sales financed by CAF.  Net of 3-day payoffs, the number of units financed by CAF as a percentage of total retail unit sales (the “penetration rate”) fell to slightly below 30% from 32% in fiscal 2009, primarily reflecting CAF’s tightening of lending standards.

The increases in servicing fee income and direct CAF expenses in fiscal 2010 were proportionate to the growth in average managed receivables.  The interest income component of other CAF income, which increased to 1.7% of average managed receivables from 1.2% in fiscal 2009, includes the interest earned on the retained subordinated bonds.  This growth in interest income primarily resulted from our increased holdings of retained subordinated bonds and higher yields on the subordinated bonds retained in connection with the April 2009 securitization.
 
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Fiscal 2009 Versus Fiscal 2008.  CAF income declined to $15.3 million from $85.9 million in fiscal 2008.  In both periods, CAF income was reduced by adjustments related to loans originated in previous fiscal years.  In fiscal 2009, these adjustments totaled $81.8 million, or $0.23 per share, and they included:
·  
$32.0 million of mark-to-market write-downs on the retained subordinated bonds.  The size of the write-downs reflected the illiquidity in the credit markets in fiscal 2009, particularly for subordinated bonds.
·  
$31.8 million for increases in cumulative net loss rate assumptions.  The upper end of our cumulative net loss rate assumption range was 4.0% as of the end of fiscal 2009 versus 3.0% as of the end of fiscal 2008.
·  
$18.0 million for increases in funding costs related to loans originated in prior fiscal years.  The majority of this increase related to loans that were securitized in the warehouse facility at the end of fiscal 2008 and which were subsequently resold in term securitizations during fiscal 2009.
·  
$3.8 million for increasing the discount rate assumption to 19% from 17%.
·  
Partly offset by $3.8 million of net favorable adjustments primarily related to reducing our prepayment rate assumptions.

In fiscal 2008, the adjustments related to loans originated and sold in previous fiscal years totaled $9.6 million, or $0.03 per share.  In fiscal 2009, CAF’s gain on sales of loans originated and sold declined to $46.5 million compared with $58.1 million in fiscal 2008.  This decrease was primarily the result of the reduction in CAF loan originations, which were adversely affected by the decreases in our used unit sales and average retail selling price.  In addition, it reflected a decrease in the percentage of sales financed by CAF resulting from our election to slow the use of capacity in our warehouse facility during the second half of fiscal 2009.  The gain percentage was 2.4% in both fiscal 2009 and fiscal 2008.  Compared with the prior year, the effects of using higher loss and discount rate assumptions and higher credit enhancement levels for fiscal 2009 originations were offset by the benefit of a significant drop in our funding cost benchmark rate.

The increases in servicing fee income and direct CAF expenses in fiscal 2009 were proportionate to the growth in average managed receivables.  The interest income component of other CAF income increased to 1.2% of average managed receivables from 0.9% in fiscal 2008, primarily due to the increase in the discount rate assumption used to value the retained interest.  The use of a higher discount rate reduces the gain recognized at the time the loans are sold, but increases the interest income recognized in subsequent periods.  Additionally, the growth in interest income reflected our increased holdings of retained subordinated bonds.

Our term securitizations typically contain an option to repurchase the securitized receivables when the outstanding balance in the pool of auto loan receivables falls below 10% of the original pool balance.  This option was exercised two times in each of fiscal 2010, fiscal 2009 and fiscal 2008.  In each case, the remaining eligible receivables were subsequently resold into the warehouse facility.  These transactions did not have a material effect on CAF income in any of the three fiscal years.  In future periods, the effects of refinancing, repurchase or resale activity could be favorable or unfavorable, depending on the securitization structure and the market conditions at the transaction date.

Past Due Account Information
 
   
As of February 28 or 29
 
(In millions)
 
2010
   
2009
   
2008
 
Loans securitized
  $ 3,946.6     $ 3,831.9     $ 3,764.5  
Loans held for sale or investment
    166.1       154.8       74.0  
Total managed receivables
  $ 4,112.7     $ 3,986.7     $ 3,838.5  
Accounts 31+ days past due
  $ 133.2     $ 118.1     $ 86.1  
Past due accounts as a percentage of total managed receivables
    3.24 %     2.96 %     2.24 %

Credit Loss Information
 
   
Years Ended February 28 or 29
 
(In millions)
 
2010
   
2009
   
2008
 
Net credit losses on managed receivables
  $ 70.1     $ 69.8     $ 38.3  
Average managed receivables
  $ 4,080.0     $ 4,021.0     $ 3,608.4  
Net credit losses as a percentage of average managed receivables
    1.72 %     1.74 %     1.06 %
Average recovery rate
    49.8 %     44.0 %     50.2 %


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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 affected.  Our retained interest was $552.4 million as of February 28, 2010, compared with $348.3 million as of February 28, 2009.

During fiscal 2010 and fiscal 2009, CAF’s net loss and delinquency performance was weaker than historical averages.  We believe this was primarily the result of the weak economic environment, which has adversely affected unemployment and industry trends for losses and delinquencies.  In response, we tightened CAF’s lending criteria in February and June 2009.  In November 2009, one of our third-party finance providers began purchasing a large portion of the loans that CAF would have originated prior to the tightening of lending standards, offsetting the majority of the adverse sales effect of the tightening.

The average recovery rate represents the average percentage of the outstanding principal balance we receive when a vehicle is repossessed and liquidated at wholesale auction.  Historically, the annual recovery rate has ranged from a low of 42% to a high of 51%, and it is primarily affected by changes in the wholesale market pricing environment.

Selling, General and Administrative Expenses
SG&A expenses primarily include rent and occupancy costs; payroll expenses, other than payroll related to reconditioning and vehicle repair service, which is included in cost of sales; fringe benefits; advertising; and other general expenses.

Fiscal 2010 Versus Fiscal 2009.  SG&A expenses were reduced 7% to $818.7 million from $882.4 million in fiscal 2009, despite the increase in unit sales in fiscal 2010.  Given the weak environment experienced in the last two years, we felt it was prudent to take a particularly cautious approach to SG&A spending during fiscal 2010.  Accordingly, we made significant curtailments in advertising, implemented a wage freeze for all salaried and hourly associates and a hiring freeze at our home office, reduced our management bench strength and deferred developmental and discretionary project spending.  The SG&A expense reduction also reflected decreases in growth-related costs, including pre-opening and relocation costs, resulting from the suspension of store growth, as well as benefits from a variety of waste-reduction initiatives.  The SG&A ratio fell to 11.0% from 12.7% in fiscal 2009 primarily due to the reduction in SG&A expenses and the leverage associated with the increases in average selling prices and unit sales.

The fiscal 2010 SG&A expenses included the benefit of a favorable litigation settlement, which increased net earnings by $0.02 per share, while the fiscal 2009 SG&A expenses included various non-recurring items, which in the aggregate reduced net earnings by a total of $0.04 per share.

Fiscal 2009 Versus Fiscal 2008. SG&A expenses increased 3% to $882.4 million from $858.4 million in fiscal 2008, although we increased our store base by 12% in fiscal 2009.  In response to the decline in sales, we focused on reducing store and corporate overhead costs, including payroll and advertising.  Our total number of associates declined to 13,035 as of the end of fiscal 2009 from a peak of approximately 16,400 in May 2008.  The fiscal 2009 SG&A expenses also reflected reductions in growth-related costs resulting from the suspension of store growth.  The SG&A ratio increased to 12.7% from 10.5% in fiscal 2009 primarily due to the significant declines in comparable store used unit sales and average selling price.

The fiscal 2009 SG&A expenses included a number of non-recurring items, which in the aggregate reduced net earnings by $0.04 per share.  These non-recurring items included severance costs associated with a reduction in our service operations workforce in October 2008, costs for the termination of store site acquisitions resulting from our decision to temporarily suspend store growth, and litigation costs, partially offset by a benefit related to our decision to freeze our pension plan benefits as of December 31, 2008.

Income Taxes
The effective income tax rate was 37.8% in fiscal 2010, 38.8% in fiscal 2009 and 38.7% in fiscal 2008.  The fiscal 2010 effective tax rate was slightly reduced by the favorable settlement of prior year tax audits.

OPERATIONS OUTLOOK

Based upon improvements in our sales and profitability in fiscal 2010 and the increasing stability in the credit markets, we have decided to resume store growth in fiscal 2011.  We plan to take a measured approach by opening three superstores in fiscal 2011, between three and five superstores in fiscal 2012, and between five and ten superstores in fiscal 2013.  This approach allows us to maintain momentum on recent initiatives to reduce waste and increase efficiency while still offering superior quality to customers.  It also allows us to rebuild our store management bench strength and to restart our real estate acquisition activity.
 
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The three superstores we plan to open in fiscal 2011 were constructed in fiscal 2009, but we chose not to open them until market conditions improved.

Fiscal 2011 Planned Superstore Openings

 
Television
Market
Planned
Production
Non-Production
Location
Market
Status
Opening Date
Superstores
Superstores
Augusta, Georgia
Augusta
New market
May 2010
1
Dayton, Ohio
Dayton
New market
June 2010
1
Cincinnati, Ohio
Cincinnati
New market
June 2010
1
Total openings
     
1
2

We currently estimate capital expenditures will total approximately $90 million in fiscal 2011.  Compared with the $22.4 million of capital spending in fiscal 2010, the increase in planned fiscal 2011 expenditures reflects real estate acquisitions and construction costs associated with the resumption of store growth, as well as information technology and reconditioning equipment upgrades.

By the end of fiscal 2010, we had achieved a sustainable reduction in average reconditioning costs of approximately $200 per vehicle.  These savings, together with additional reductions that we believe are achievable, will be available to continue to optimize future sales and profitability.

Although we intend to maintain momentum on our initiatives to reduce waste and increase efficiencies, to the extent the economy and our sales improve, we would expect SG&A spending to increase from the level in fiscal 2010, reflecting the resulting increases in store and overhead spending, including payroll, advertising and other costs.  We also expect the resumption of store growth will result in an increase in growth-related expenses, including preopening costs, advertising for new stores and rebuilding our store management bench strength.  In addition, assuming no economic deterioration, we plan to invest in some key initiatives to continue to enhance the CarMax model.  These include continued improvements to carmax.com and other information technology projects and additional training for associates.

Fiscal 2011 Expectations – CAF Income
As of March 1, 2010, we will adopt ASUs 2009-16 and 2009-17.  Pursuant to these pronouncements, we will recognize existing and future transfers of auto loan receivables into term securitizations as secured borrowings, which will result in recording the auto loan receivables and the related notes payable to the investors on our consolidated balance sheets.  Term securitizations will be consolidated based on the unpaid principal balances, less an appropriate reserve for credit losses.  We will also account for future transfers of receivables into our warehouse facility as secured borrowings.

As of March 1, 2010, we amended our warehouse facility agreement.  As a result, existing transfers of auto loan receivables no longer qualify for sale treatment.  The receivables that were funded in the warehouse facility at that date will be consolidated, along with the related notes payable, at their fair value.

As of March 1, 2010, we expect the cumulative effect of these changes to result in a $3.7 billion increase in total assets (net of a reserve for credit losses of approximately $58 million) and a $3.8 billion increase in total liabilities.

The following unaudited pro forma consolidated balance sheet gives affect to the adoption of ASUs 2009-16 and 2009-17 and the amendment to our warehouse facility agreement.

 
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(Unaudited)
 
   
Actual
   
Proforma Adjustments
   
Pro forma
 
   
February 28,
   
Accounting
   
Amended
   
March 1,
 
(In thousands)
 
2010
   
Change
   
Agreement
   
2010
 
CURRENT ASSETS:
                       
Cash and cash equivalents
  $ 18,278     $     $     $ 18,278  
Restricted cash
          162,608             162,608  
Accounts receivable, net
    99,434       (20,375 )           79,059  
Auto loan receivables held for sale
    30,578       (30,578 )            
Retained interest in securitized receivables
    552,377       (508,631 )           43,746  
Inventory
    843,133                   843,133  
Deferred tax asset
    5,595                   5,595  
Prepaid expenses and other current assets
    7,017                   7,017  
TOTAL CURRENT ASSETS
    1,556,412       (396,976 )           1,159,436  
Auto loan receivables, net(1)
          3,712,595       331,000       4,043,595  
Property and equipment, net
    893,453                   893,453  
Deferred income taxes
    57,234       54,850             112,084  
Other assets
    49,092       43,835             92,927  
TOTAL ASSETS
  $ 2,556,191     $ 3,414,304     $ 331,000     $ 6,301,495  
CURRENT LIABILITIES:
                               
Accounts payable
  $ 253,267     $ 6,544     $     $ 259,811  
Accrued expenses and other current liabilities
    94,557       5,584             100,141  
Accrued income taxes
    6,327                   6,327  
Short-term debt
    883                   883  
Current portion of long-term debt
    122,317                   122,317  
Current portion of non-recourse notes payable(1)
          134,798             134,798  
TOTAL CURRENT LIABILITIES
    477,351       146,926             624,277  
Long-term debt, excluding current portion
    27,371                   27,371  
Non-recourse notes payable(1)
          3,360,612       331,000       3,691,612  
Deferred revenue and other liabilities
    117,887                   117,887  
TOTAL LIABILITIES
    622,609       3,507,538       331,000       4,461,147  
TOTAL SHAREHOLDERS’ EQUITY
    1,933,582       (93,234 )           1,840,348  
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
  $ 2,556,191     $ 3,414,304     $ 331,000     $ 6,301,495  
 
(1)
When presented in our consolidated financial statements beginning in the first quarter of fiscal 2011, the assets and liabilities of the securitization trusts will be separately presented on the face of the consolidated balance sheet, as required by ASU 2009-17, to reflect the fact that trust assets can be used only to settle trust obligations and that the trusts’ creditors (or beneficial interest holders) do not have recourse to the general credit of CarMax.

The pro forma consolidated balance sheet as of March 1, 2010, shown above, includes the following adjustments:

·  
Consolidation of the auto loan receivables and the related non-recourse notes payable funded in existing term securitizations.
·  
Consolidation of the auto loan receivables and the related non-recourse notes payable funded in the warehouse facility as of March 1, 2010.
·  
Recognition of a reserve for credit losses on the consolidated auto loan receivables.
·  
Consolidation of customer loan payments received but not yet distributed by the securitization trusts.  These payments are included in restricted cash.
·  
Reclassification of auto loan receivables held for sale to auto loans receivable.
·  
Reclassification of certain balances previously included in retained interest in securitized receivables that relate to existing term securitizations.
·  
Write-off of the remaining interest-only strip receivables related to term securitizations, previously recorded in retained interest in securitized receivables, and the related deferred tax liability. These write-offs are charged against retained earnings.
·  
Recording of a net deferred tax asset, primarily related to the establishment of the reserve for credit losses.
 
34


 
In future periods, CAF income included in the consolidated statements of earnings will no longer include a gain on the sale of loans originated and sold, but instead will reflect the net interest margin generated by the auto loan receivables less direct CAF expenses.  The net interest margin will include the interest and certain other income associated with the auto loan receivables less a provision for estimated credit losses and the interest expense associated with the non-recourse debt issued to fund these receivables.

Including the effects of these changes, we currently estimate that CAF income will be in the range of $145 million to $185 million in fiscal 2011.  Many factors could affect the actual amount of CAF income recognized, including among others, changes in consumer rates and/or funding costs related to new loan originations, changes in loan loss experience, changes in the volume of CAF loan originations, changes in the value of derivative instruments and potential regulatory changes.

In future periods, because our securitization transactions will be accounted for as secured borrowings rather than asset sales, the cash flows from these transactions will be presented as cash flows from financing activities rather than as cash flows from operating or investing activities.  Notwithstanding this accounting treatment, our securitizations are structured to legally isolate the receivables, and we would not expect to be able to access the assets of our securitization trusts, even in insolvency, receivership or conservatorship proceedings.  We would, however, continue to have the rights associated with our retained interests in these trusts.

RECENT ACCOUNTING PRONOUNCEMENTS

For a discussion of recent accounting pronouncements applicable to CarMax, see Note 17.

FINANCIAL CONDITION