10-Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C.  20549
 
FORM 10-Q
 
[ X ]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended August 31, 2015
 
OR
 
 [    ]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 
Commission File Number:  1-31420
 
CARMAX, INC.
(Exact name of registrant as specified in its charter)
 
VIRGINIA
 
54-1821055
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
 
12800 TUCKAHOE CREEK PARKWAY, RICHMOND, VIRGINIA
23238
(Address of principal executive offices)
(Zip Code)
 
(804) 747-0422
(Registrant's telephone number, including area code)
 
N/A
(Former name, former address and former fiscal year, if changed since last report)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes x
 
No ¨
 
Indicate by check mark whether the registrant 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 x
 
No ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):
Large accelerated filer x
 
Accelerated filer ¨
 
 
 
Non-accelerated filer ¨
 
Smaller reporting company ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).
Yes ¨
 
No x
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Class
 
Outstanding as of September 30, 2015
Common Stock, par value $0.50
 
202,634,839

Page 1



CARMAX, INC. AND SUBSIDIARIES
 
TABLE OF CONTENTS
 
 
Page
No.
PART I.
FINANCIAL INFORMATION 
 
 
 
 
 
 
Item 1.
Financial Statements:
 
 
 
 
 
 
 
Consolidated Statements of Earnings –
 
 
 
Three and Six Months Ended August 31, 2015 and 2014
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income –
 
 
 
Three and Six Months Ended August 31, 2015 and 2014
 
 
 
 
 
 
Consolidated Balance Sheets –
 
 
 
August 31, 2015 and February 28, 2015
 
 
 
 
 
 
Consolidated Statements of Cash Flows –
 
 
 
Six Months Ended August 31, 2015 and 2014
 
 
 
 
 
 
Notes to Consolidated Financial Statements
 
 
 
 
 
Item 2.
Management's Discussion and Analysis of Financial Condition and
 
 
 
Results of Operations
 26
 
 
 
 
 
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
 
 
 
 
 
Item 4.
Controls and Procedures
 
 
 
 
PART II.
OTHER INFORMATION
 
 
 
 
 
 
Item 1.
Legal Proceedings
 
 
 
 
 
Item 1A.
Risk Factors
 
 
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
 
 
 
 
 
Item 6.
Exhibits
 
 
 
 
SIGNATURES
 
 
EXHIBIT INDEX


Page 2



PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

CARMAX, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
(Unaudited)
 
 
 
 
Three Months Ended August 31
 
Six Months Ended August 31
(In thousands except per share data)
2015
 
%(1)
 
2014
 
%(1)
 
2015
 
%(1)
 
2014
 
%(1)
SALES AND OPERATING REVENUES:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Used vehicle sales
$
3,150,220

 
81.1
 
$
2,920,165

 
81.1
 
$
6,442,878

 
81.6
 
$
5,980,506

 
81.4
New vehicle sales
60,493

 
1.6
 
69,944

 
1.9
 
120,541

 
1.5
 
139,733

 
1.9
Wholesale vehicle sales
591,774

 
15.2
 
530,270

 
14.7
 
1,168,399

 
14.8
 
1,075,515

 
14.6
Other sales and revenues
82,426

 
2.1
 
78,815

 
2.2
 
167,983

 
2.1
 
153,636

 
2.1
NET SALES AND OPERATING REVENUES
3,884,913

 
100.0
 
3,599,194

 
100.0
 
7,899,801

 
100.0
 
7,349,390

 
100.0
Cost of sales
3,363,543

 
86.6
 
3,135,855

 
87.1
 
6,834,637

 
86.5
 
6,384,320

 
86.9
GROSS PROFIT
521,370

 
13.4
 
463,339

 
12.9
 
1,065,164

 
13.5
 
965,070

 
13.1
CARMAX AUTO FINANCE INCOME
98,279

 
2.5
 
92,574

 
2.6
 
207,387

 
2.6
 
187,189

 
2.5
Selling, general and administrative expenses
330,784

 
8.5
 
297,638

 
8.3
 
680,563

 
8.6
 
611,084

 
8.3
Interest expense
7,450

 
0.2
 
7,351

 
0.2
 
14,553

 
0.2
 
14,952

 
0.2
Other expense
1,593

 
 
283

 
 
1,634

 
 
560

 
Earnings before income taxes
279,822

 
7.2
 
250,641

 
7.0
 
575,801

 
7.3
 
525,663

 
7.2
Income tax provision
107,594

 
2.8
 
96,123

 
2.7
 
221,599

 
2.8
 
201,492

 
2.7
NET EARNINGS
$
172,228

 
4.4
 
$
154,518

 
4.3
 
$
354,202

 
4.5
 
$
324,171

 
4.4
WEIGHTED AVERAGE COMMON SHARES:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
207,249

 

 
218,180

 

 
207,969

 
 
 
219,224

 
 
Diluted
209,648

 

 
221,070

 

 
210,645

 
 
 
222,351

 
 
NET EARNINGS PER SHARE:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
$
0.83

 

 
$
0.71

 

 
$
1.70

 
 
 
$
1.48

 
 
Diluted
$
0.82

 

 
$
0.70

 

 
$
1.68

 
 
 
$
1.46

 
 
 
 
(1)    Percents are calculated as a percentage of net sales and operating revenues and may not total due to rounding.
 
 
 
 
 
 
 
 
 





See accompanying notes to consolidated financial statements.

Page 3




CARMAX, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
(Unaudited)
 
 
 
 
Three Months Ended August 31
 
Six Months Ended August 31
(In thousands)
2015
 
2014
 
2015
 
2014
NET EARNINGS
$
172,228

 
$
154,518

 
$
354,202

 
$
324,171

Other comprehensive income (loss), net of taxes:
 
 
 
 

 

Net change in retirement benefit plan
 
 
 
 

 

unrecognized actuarial losses
339

 
213

 
645

 
426

 
 
 
 
 
 
 
 
Net change in cash flow hedge
 
 
 
 

 

unrecognized losses
(30
)
 
1,096

 
(1,403
)
 
1,378

Other comprehensive income (loss), net of taxes
309

 
1,309

 
(758
)
 
1,804

TOTAL COMPREHENSIVE INCOME
$
172,537

 
$
155,827

 
$
353,444

 
$
325,975

 
  
 


































See accompanying notes to consolidated financial statements.

Page 4



CARMAX, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
 
(Unaudited)
 
 

 
As of August 31
 
As of February 28
(In thousands except share data)
2015
 
2015
ASSETS
 

 
 

CURRENT ASSETS:
 

 
 

Cash and cash equivalents
$
100,477

 
$
27,606

Restricted cash from collections on auto loan receivables
335,075

 
294,122

Accounts receivable, net
100,832

 
137,690

Inventory
1,911,549

 
2,086,874

Deferred income taxes
10,333

 
8,100

Other current assets
45,459

 
44,646

TOTAL CURRENT ASSETS
2,503,725

 
2,599,038

Auto loan receivables, net
9,116,512

 
8,435,504

Property and equipment, net
2,016,520

 
1,862,538

Deferred income taxes
166,669

 
167,638

Other assets
149,139

 
133,483

TOTAL ASSETS
$
13,952,565

 
$
13,198,201

LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 
CURRENT LIABILITIES:
 

 
 
Accounts payable
$
453,864

 
$
454,810

Accrued expenses and other current liabilities
226,371

 
250,307

Accrued income taxes
1,169

 
1,554

Short-term debt
2,122

 
785

Current portion of long-term debt

 
10,000

Current portion of finance and capital lease obligations
21,584

 
21,554

Current portion of non-recourse notes payable
296,867

 
258,163

TOTAL CURRENT LIABILITIES
1,001,977

 
997,173

Long-term debt, excluding current portion
300,000

 
300,000

Finance and capital lease obligations, excluding current portion
357,825

 
306,284

Non-recourse notes payable, excluding current portion
8,856,227

 
8,212,466

Other liabilities
225,552

 
225,493

TOTAL LIABILITIES
10,741,581

 
10,041,416

 
 
 
 
Commitments and contingent liabilities

 

SHAREHOLDERS’ EQUITY:
 

 
 

Common stock, $0.50 par value; 350,000,000 shares authorized; 204,930,606 and 208,869,688 shares issued and outstanding as of August 31, 2015 and February 28, 2015, respectively
102,465

 
104,435

Capital in excess of par value
1,161,678

 
1,123,520

Accumulated other comprehensive loss
(66,149
)
 
(65,391
)
Retained earnings
2,012,990

 
1,994,221

TOTAL SHAREHOLDERS’ EQUITY
3,210,984

 
3,156,785

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
13,952,565

 
$
13,198,201



See accompanying notes to consolidated financial statements.

Page 5






CARMAX, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
 
Six Months Ended August 31
(In thousands)
2015
 
2014
OPERATING ACTIVITIES:
 
 
 
Net earnings
$
354,202

 
$
324,171

Adjustments to reconcile net earnings to net cash
 
 
 
used in operating activities:
 
 
 
Depreciation and amortization
65,188

 
55,766

Share-based compensation expense
33,506

 
37,778

Provision for loan losses
39,244

 
36,208

Provision for cancellation reserves
42,459

 
38,463

Deferred income tax benefit
(738
)
 
(6,530
)
Loss on disposition of assets and other
1,810

 
917

Net decrease (increase) in:
 
 
 
Accounts receivable, net
36,858

 
(28,936
)
Inventory
175,325

 
(67,531
)
Other current assets
(1,923
)
 
(11,706
)
Auto loan receivables, net
(720,252
)
 
(732,628
)
Other assets
371

 
(313
)
Net decrease in:
 
 
 
Accounts payable, accrued expenses and other current
 
 
 
liabilities and accrued income taxes
(58,705
)
 
(36,052
)
Other liabilities
(52,089
)
 
(46,226
)
NET CASH USED IN OPERATING ACTIVITIES
(84,744
)
 
(436,619
)
INVESTING ACTIVITIES:
 
 
 
Capital expenditures
(145,727
)
 
(135,293
)
Proceeds from sales of assets
1,419

 
5,829

Increase in restricted cash from collections on auto loan receivables
(40,953
)
 
(37,769
)
Increase in restricted cash in reserve accounts
(5,484
)
 
(6,640
)
Release of restricted cash from reserve accounts
1,643

 
1,634

Purchases of money market securities, net
(6,126
)
 
(8,753
)
Purchases of trading securities
(4,355
)
 
(3,107
)
Sales of trading securities
101

 
306

NET CASH USED IN INVESTING ACTIVITIES
(199,482
)
 
(183,793
)
FINANCING ACTIVITIES:
 
 
 
Increase in short-term debt, net
1,337

 
1,647

Proceeds from revolving line of credit and long-term debt
20,000

 

Payments on revolving line of credit and long-term debt
(30,000
)
 

Cash paid for debt issuance costs
(2,981
)
 

Payments on finance and capital lease obligations
(9,741
)
 
(8,712
)
Issuances of non-recourse notes payable
5,106,805

 
3,803,000

Payments on non-recourse notes payable
(4,424,340
)
 
(3,142,735
)
Repurchase and retirement of common stock
(369,210
)
 
(380,149
)
Equity issuances
37,157

 
44,270

Excess tax benefits from share-based payment arrangements
28,070

 
29,790

NET CASH PROVIDED BY FINANCING ACTIVITIES
357,097

 
347,111

Increase (decrease) in cash and cash equivalents
72,871

 
(273,301
)
Cash and cash equivalents at beginning of year
27,606

 
627,901

CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
100,477

 
$
354,600

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION
 
 
 
Cash paid for interest
$
19,992

 
$
15,029

Cash paid for income taxes
$
197,379

 
$
191,401

Non-cash investing and financing activities:
 

 
 

Increase in accrued capital expenditures
$
9,198

 
$
18,173

Increase in finance and capital lease obligations
$
61,312

 
$
5,297

See accompanying notes to consolidated financial statements.

Page 6



CARMAX, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(Unaudited)

1.    Background
 
CarMax, Inc. (“we,” “our,” “us,” “CarMax” and “the company”), including its wholly owned subsidiaries, is the largest retailer of used vehicles in the United States.  We operate in two reportable segments:  CarMax Sales Operations and CarMax Auto Finance (“CAF”).  Our CarMax Sales Operations segment consists of all aspects of our auto merchandising and service operations, excluding financing provided by CAF.  Our CAF segment consists solely of our own finance operation that provides vehicle financing through CarMax stores.
 
We seek to deliver an unrivaled customer experience by offering a broad selection of high quality used vehicles and related products and services at low, no-haggle prices using a customer-friendly sales process in an attractive, modern sales facility.  We provide customers with a full range of related products and services, including the appraisal and purchase of vehicles directly from consumers; the financing of vehicle purchases through CAF and third-party financing providers; the sale of extended protection plan (“EPP”) products, which include extended service plans (“ESP”) and guaranteed asset protection (“GAP”); and vehicle repair service.  Vehicles purchased through the appraisal process that do not meet our retail standards are sold to licensed dealers through on-site wholesale auctions.  At select locations we also sell new vehicles under franchise agreements.
 
2.    Accounting Policies
 
Basis of Presentation and Use of Estimates.  The accompanying interim unaudited consolidated financial statements include the accounts of CarMax and our wholly owned subsidiaries.  All significant intercompany balances and transactions have been eliminated in consolidation.  These consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“GAAP”) for interim financial information.  Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.  In the opinion of management, such interim consolidated financial statements reflect all normal recurring adjustments considered necessary to present fairly the financial position and the results of operations and cash flows for the interim periods presented.  The results of operations for the interim periods are not necessarily indicative of the results to be expected for the full fiscal year.  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and footnotes included in our Annual Report on Form 10-K for the fiscal year ended February 28, 2015.
 
The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities.  Actual results could differ from those estimates.  Certain prior year amounts have been reclassified to conform to the current year’s presentation.  Amounts and percentages may not total due to rounding.
 
Cash and Cash Equivalents.  Cash equivalents of $74.1 million as of August 31, 2015, and $48,000 as of February 28, 2015, consisted of highly liquid investments with original maturities of three months or less.
 
Restricted Cash from Collections on Auto Loan Receivables.  Cash equivalents totaling $335.1 million as of August 31, 2015, and $294.1 million as of February 28, 2015, consisted of collections of principal, interest and fee payments on securitized auto loan receivables that are restricted for payment to the securitization investors pursuant to the applicable securitization agreements.
 
Securitizations.  We maintain a revolving securitization program composed of two warehouse facilities (“warehouse facilities”) that we use to fund auto loan receivables originated by CAF until we elect to fund them through a term securitization or alternative funding arrangement.  We sell the auto loan receivables to one of two wholly owned, bankruptcy-remote, special purpose entities that transfer an undivided percentage ownership interest in the receivables, but not the receivables themselves, to entities formed by third-party investors.  These entities issue asset-backed commercial paper or utilize other funding sources supported by the transferred receivables, and the proceeds are used to finance the securitized receivables.
 
We typically use term securitizations to provide long-term funding for most of the auto loan receivables initially securitized through the warehouse facilities.  In these transactions, a pool of auto loan receivables is sold to a bankruptcy-remote, special purpose entity that, in turn, transfers the receivables to a special purpose securitization trust.  The securitization trust issues asset-backed securities, secured or otherwise supported by the transferred receivables, and the proceeds from the sale of the asset-backed securities are used to finance the securitized receivables.
 

Page 7



We are required to evaluate term securitization trusts for consolidation.  In our capacity as servicer, we have the power to direct the activities of the trusts that most significantly impact the economic performance of the trusts.  In addition, we have the obligation to absorb losses (subject to limitations) and the rights to receive any returns of the trusts, which could be significant.  Accordingly, we are the primary beneficiary of the trusts and are required to consolidate them.
 
We recognize transfers of auto loan receivables into the warehouse facilities and term securitizations (“securitization vehicles”) as secured borrowings, which result in recording the auto loan receivables and the related non-recourse notes payable on our consolidated balance sheets.
 
The securitized receivables can only be used as collateral to settle obligations of the securitization vehicles.  The securitization vehicles and investors have no recourse to our assets beyond the securitized receivables, the amounts on deposit in reserve accounts and the restricted cash from collections on auto loan receivables.  We have not provided financial or other support to the securitization vehicles that was not previously contractually required, and there are no additional arrangements, guarantees or other commitments that could require us to provide financial support to the securitization vehicles.
 
See Notes 4 and 10 for additional information on auto loan receivables and non-recourse notes payable.

Auto Loan Receivables, Net.  Auto loan receivables include amounts due from customers related to retail vehicle sales financed through CAF.  The receivables are presented net of an allowance for estimated loan losses.  The allowance for loan losses represents an estimate of the amount of net losses inherent in our portfolio of managed receivables as of the applicable reporting date and anticipated to occur during the following 12 months.  The allowance is primarily based on the credit quality of the underlying receivables, historical loss trends and forecasted forward loss curves.  We also take into account recent trends in delinquencies, losses, recovery rates and the economic environment.  The provision for loan losses is the periodic expense of maintaining an adequate allowance.
 
An account is considered delinquent when the related customer fails to make a substantial portion of a scheduled payment on or before the due date.  In general, accounts are charged-off on the last business day of the month during which the earliest of the following occurs:  the receivable is 120 days or more delinquent as of the last business day of the month, the related vehicle is repossessed and liquidated, or the receivable is otherwise deemed uncollectible.  For purposes of determining impairment, auto loans are evaluated collectively, as they represent a large group of smaller-balance homogeneous loans, and therefore, are not individually evaluated for impairment.  See Note 4 for additional information on auto loan receivables.
 
Interest income and expenses related to auto loans are included in CAF income.  Interest income on auto loan receivables is recognized when earned based on contractual loan terms.  All loans continue to accrue interest until repayment or charge‑off.  Direct costs associated with loan originations are not considered material, and thus, are expensed as incurred.  See Note 3 for additional information on CAF income.
 
Property and Equipment.  Property and equipment is stated at cost less accumulated depreciation and amortization of $876.3 million and $822.7 million as of August 31, 2015 and February 28, 2015, respectively.
 
Other Assets.  Other assets includes amounts classified as restricted cash on deposit in reserve accounts and restricted investments.  The restricted cash on deposit in reserve accounts is for the benefit of holders of non-recourse notes payable, and these funds are not expected to be available to the company or its creditors.  In the event that the cash generated by the securitized receivables in a given period was insufficient to pay the interest, principal and other required payments, the balances on deposit in the reserve accounts would be used to pay those amounts.  Restricted cash on deposit in reserve accounts is invested in money market securities and was $46.6 million as of August 31, 2015, and $42.7 million as of February 28, 2015.
 
Restricted investments includes money market securities primarily held to satisfy certain insurance program requirements, as well as mutual funds held in a rabbi trust established to fund informally our executive deferred compensation plan.  Restricted investments totaled $63.2 million as of August 31, 2015, and $52.4 million as of February 28, 2015.
 
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.  As part of our customer service strategy, we guarantee the retail vehicles we sell with a 5‑day, money-back guarantee.  We record a reserve for estimated returns based on historical experience and trends.
 
We also sell ESPs and GAP products on behalf of unrelated third parties, who are the primary obligors, to customers who purchase a vehicle.  The ESPs we currently offer on all used vehicles provide coverage of up to 60 months (subject to mileage limitations), while GAP covers the customer for the term of their finance contract. We recognize commission revenue at the time of sale, net of a reserve for estimated contract cancellations.  Periodically, we may receive additional commissions based upon the level of

Page 8



underwriting profits of the third parties who administer the products.  These additional commissions are recognized as revenue when received.  The reserve for cancellations is evaluated for each product, and is based on forecasted forward cancellation curves utilizing historical experience, recent trends and credit mix of the customer base.  Our risk related to contract cancellations is limited to the commissions that we receive.  Cancellations fluctuate depending on the volume of EPP sales, customer financing default or prepayment rates, and shifts in customer behavior, including those related to changes in the coverage or term of the product.  The current portion of estimated cancellation reserves is recognized as a component of accrued expenses and other current liabilities with the remaining amount recognized in other liabilities.  See Note 7 for additional information on cancellation reserves.
 
Customers applying for financing who are not approved or are conditionally approved by CAF are generally evaluated by third-party finance providers.  These providers generally either pay us or are paid a fixed, pre-negotiated fee per contract.  We recognize these fees at the time of sale.
 
We collect sales taxes and other taxes from customers on behalf of governmental authorities at the time of sale.  These taxes are accounted for on a net basis and are not included in net sales and operating revenues or cost of sales.
 
Derivative Instruments and Hedging Activities.  We enter into derivative instruments to manage exposures that arise from business activities and economic conditions that result in the future known receipt or payment of uncertain cash amounts, the values of which are impacted by interest rates.  We recognize the derivatives at fair value as either current assets or current liabilities on the consolidated balance sheets, and where applicable, such contracts covered by master netting agreements are reported net.  Gross positive fair values are netted with gross negative fair values by counterparty.  The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether we have elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting.  We may enter into derivative contracts that are intended to economically hedge certain risks, even though hedge accounting may not apply or we do not elect to apply hedge accounting.  See Note 5 for additional information on derivative instruments and hedging activities.
 
Recent Accounting Pronouncements.
Effective in Future Periods In July 2015, the Financial Accounting Standards Board (“FASB”) issued an accounting pronouncement (FASB ASU 2015-11) which simplifies the subsequent measurement of inventory by replacing the lower of cost or market test with a lower of cost or net realizable value (“NRV”) test. NRV is calculated as the estimated selling price less reasonably predictable costs of completion, disposal and transportation.  This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2016, and prospective adoption is required.  We will adopt this pronouncement for our fiscal year beginning March 1, 2017.  We are still evaluating the effects of this pronouncement on our consolidated financial statements, but do not expect any such impacts to be material.

In August 2015, the FASB issued an accounting pronouncement (FASB ASU 2015-14), which deferred the effective date of FASB ASU 2014-09, Revenue from Contracts with Customers, for all entities by one year. As a result, that accounting standard is now effective for public business entities for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2017. Based on this amendment, we will adopt FASB ASU 2014-09 for our fiscal year beginning March 1, 2018.
In August 2015, the FASB issued an accounting pronouncement (FASB ASU 2015-15) related to the presentation of debt issuance costs. This standard clarifies the guidance set forth in FASB ASU 2015-03, which required that debt issuance costs related to a recognized debt liability be presented on the balance sheet as a direct deduction from the debt liability rather than as an asset. The new pronouncement clarifies that debt issuance costs related to line-of-credit arrangements could continue to be presented as an asset and be subsequently amortized over the term of the line-of-credit arrangement, regardless of whether there are any outstanding borrowings on the arrangement. We will consider this clarification in conjunction with our adoption of FASB ASU 2015-03, which will occur for our fiscal year beginning March 1, 2016, and do not expect it to have a material impact on our consolidated financial statements.

3.    CarMax Auto Finance
 
CAF provides financing to qualified retail customers purchasing vehicles at CarMax stores.  CAF provides us the opportunity to capture additional profits, cash flows and sales while managing our reliance on third-party finance sources.  Management regularly analyzes CAF's operating results by assessing profitability, the performance of the auto loan receivables including trends in credit losses and delinquencies, and CAF direct expenses.  This information is used to assess CAF's performance and make operating decisions including resource allocation.


Page 9



We typically use securitizations to fund loans originated by CAF, as discussed in Note 2.  CAF income primarily reflects the interest and fee income generated by the auto loan receivables less the interest expense associated with the debt issued to fund these receivables, a provision for estimated loan losses and direct CAF expenses.
 
CAF income does not include any allocation of indirect costs.  Although CAF benefits from certain indirect overhead expenditures, we have not allocated indirect costs to CAF to avoid making subjective allocation decisions.  Examples of indirect costs not allocated to CAF include retail store expenses and corporate expenses such as human resources, administrative services, marketing, information systems, accounting, legal, treasury and executive payroll.  In addition, except for auto loan receivables, which are disclosed in Note 4, CAF assets are not separately reported nor do we allocate assets to CAF because such allocation would not be useful to management in making operating decisions.
 
Components of CAF Income

Three Months Ended August 31
 
Six Months Ended August 31
(In millions)
2015
 
(1)
 
2014
 
(1)
 
2015
 
(1)
 
2014
 
(1)
Interest margin:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest and fee income
$
169.8

 
7.6

 
$
150.7

 
7.8

 
$
334.6

 
7.6

 
$
297.6

 
7.9

Interest expense
(30.8
)
 
(1.4
)
 
(23.9
)
 
(1.2
)
 
(58.8
)
 
(1.3
)
 
(47.0
)
 
(1.2
)
Total interest margin
139.0

 
6.2

 
126.8

 
6.6

 
275.8

 
6.2

 
250.6

 
6.6

Provision for loan losses
(25.6
)
 
(1.1
)
 
(20.4
)
 
(1.1
)
 
(39.2
)
 
(0.9
)
 
(36.2
)
 
(1.0
)
Total interest margin after

 

 

 

 
 
 
 
 
 
 
 
provision for loan losses
113.4

 
5.1

 
106.4

 
5.5

 
236.6

 
5.4

 
214.4

 
5.7

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Total other expense
(0.1
)
 

 

 

 
(0.1
)
 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Direct expenses:

 

 

 

 
 
 
 
 
 
 
 
Payroll and fringe benefit expense
(7.1
)
 
(0.3
)
 
(6.3
)
 
(0.3
)
 
(13.9
)
 
(0.3
)
 
(12.5
)
 
(0.3
)
Other direct expenses
(7.9
)
 
(0.4
)
 
(7.5
)
 
(0.4
)
 
(15.2
)
 
(0.4
)
 
(14.7
)
 
(0.4
)
Total direct expenses
(15.0
)
 
(0.7
)
 
(13.8
)
 
(0.7
)
 
(29.1
)
 
(0.7
)
 
(27.2
)
 
(0.7
)
CarMax Auto Finance income
$
98.3

 
4.4

 
$
92.6

 
4.8

 
$
207.4

 
4.7

 
$
187.2

 
5.0

Total average managed receivables
$
8,993.9

 


 
$
7,724.5

 


 
$
8,829.3

 
 
 
$
7,557.3

 
 

(1)     Annualized percentage of total average managed receivables.
 
4.    Auto Loan Receivables
 
Auto loan receivables include amounts due from customers related to retail vehicle sales financed through CAF and are presented net of an allowance for estimated loan losses.  We generally use warehouse facilities to fund auto loan receivables originated by CAF until we elect to fund them through a term securitization or alternative funding arrangement.  The majority of the auto loan receivables serve as collateral for the related non-recourse notes payable of $9.15 billion as of August 31, 2015 and $8.47 billion as of February 28, 2015.  See Notes 2 and 10 for additional information on securitizations and non-recourse notes payable.

Page 10



Auto Loan Receivables, Net
 
As of August 31
 
As of February 28
(In millions)
2015
 
2015
Warehouse facilities
$
1,243.0

 
$
986.0

Term securitizations
7,613.2

 
7,226.5

Other receivables (1)
307.8

 
246.2

Total ending managed receivables
9,164.0

 
8,458.7

Accrued interest and fees
36.9

 
31.2

Other
3.4

 
27.3

Less allowance for loan losses
(87.8
)
 
(81.7
)
Auto loan receivables, net
$
9,116.5

 
$
8,435.5


(1)     Other receivables includes receivables not funded through the warehouse facilities or term securitizations.
 
Credit Quality.  When customers apply for financing, CAF’s proprietary scoring models rely on the customers’ credit history and certain application information to evaluate and rank their risk.  We obtain credit histories and other credit data that includes information such as number, age, type of and payment history for prior or existing credit accounts.  The application information that is used includes income, collateral value and down payment.  The scoring models yield credit grades that represent the relative likelihood of repayment.  Customers assigned a grade of “A” are determined to have the highest probability of repayment, and customers assigned a lower grade are determined to have a lower probability of repayment.  For loans that are approved, the credit grade influences the terms of the agreement, such as the required loan-to-value ratio and interest rate.

CAF uses a combination of the initial credit grades and historical performance to monitor the credit quality of the auto loan receivables on an ongoing basis.  We validate the accuracy of the scoring models periodically.  Loan performance is reviewed on a recurring basis to identify whether the assigned grades adequately reflect the customers’ likelihood of repayment.
 
Ending Managed Receivables by Major Credit Grade
 
As of August 31
 
As of February 28
(In millions)
2015 (1)
 
% (2)
 
2015 (1)
 
% (2)
A
$
4,447.3

 
48.5
 
$
4,135.6

 
48.9
B
3,291.4

 
35.9
 
3,055.3

 
36.1
C and other
1,425.3

 
15.6
 
1,267.8

 
15.0
Total ending managed receivables
$
9,164.0

 
100.0
 
$
8,458.7

 
100.0

(1)     Classified based on credit grade assigned when customers were initially approved for financing.
(2)     Percent of total ending managed receivables.

Allowance for Loan Losses
 
Three Months Ended August 31
 
Six Months Ended August 31
(In millions)
2015
 
% (1)
 
2014
 
% (1)
 
2015
 
% (1)
 
2014
 
% (1)
Balance as of beginning of period
$
83.7

 
0.94
 
$
75.4

 
1.00
 
$
81.7

 
0.97
 
$
69.9

 
0.97
Charge-offs
(42.5
)
 

 
(36.9
)
 

 
(76.8
)
 

 
(68.9
)
 

Recoveries
21.0

 

 
18.9

 

 
43.7

 

 
40.6

 

Provision for loan losses
25.6

 

 
20.4

 

 
39.2

 

 
36.2

 

Balance as of end of period
$
87.8

 
0.96
 
$
77.8

 
0.99
 
$
87.8

 
0.96
 
$
77.8

 
0.99

(1)     Percent of total ending managed receivables.
 
The allowance for loan losses represents an estimate of the amount of net losses inherent in our portfolio of managed receivables as of the applicable reporting date and anticipated to occur during the following 12 months.  The allowance is primarily based on the credit quality of the underlying receivables, historical loss trends and forecasted forward loss curves.  We also take into account

Page 11



recent trends in delinquencies and losses, recovery rates and the economic environment.  The provision for loan losses is the periodic expense of maintaining an adequate allowance.
 
Past Due Receivables
 
As of August 31
 
As of February 28
(In millions)
2015
 
% (1)
 
2015
 
% (1)
Total ending managed receivables
$
9,164.0

 
100.0
 
$
8,458.7

 
100.0
Delinquent loans:
 
 
 
 
 
 
 
31-60 days past due
$
180.9

 
2.0
 
$
152.1

 
1.8
61-90 days past due
72.3

 
0.8
 
52.5

 
0.6
Greater than 90 days past due
21.6

 
0.2
 
16.8

 
0.2
Total past due
$
274.8

 
3.0
 
$
221.4

 
2.6

(1)     Percent of total ending managed receivables.
 
5.    Derivative Instruments and Hedging Activities
 
Risk Management Objective of Using Derivatives.  We use derivatives to manage certain risks arising from both our business operations and economic conditions, particularly with regard to future issuances of fixed-rate debt and existing issuances of floating-rate debt.  Primary exposures include LIBOR and other rates used as benchmarks in our securitizations and other debt financing.  We enter into derivative instruments to manage exposures related to the future known receipt or payment of uncertain cash amounts, the values of which are impacted by interest rates.  Our derivative instruments are used to manage (i) differences in the amount of our known or expected cash receipts and our known or expected cash payments principally related to the funding of our auto loan receivables, and (ii) exposure to variable interest rates associated with our term loan, as further discussed in Note 10.
 
We do not anticipate significant market risk from derivatives as they are predominantly used to match funding costs to the use of the funding.  However, disruptions in the credit or interest rate markets could impact the effectiveness of our hedging strategies.
 
Credit risk is the exposure to nonperformance of another party to an agreement.  We mitigate credit risk on our derivative transactions by dealing with highly rated bank counterparties.
 
Designated Cash Flow Hedges – Securitizations.    Our objectives in using interest rate derivatives in conjunction with our securitization program are to add stability to CAF’s interest expense, to manage our exposure to interest rate movements and to better match funding costs to the interest received on the receivables being securitized. 

To accomplish these objectives, we primarily use interest rate swaps that involve the receipt of variable amounts from a counterparty in exchange for our making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.  These interest rate swaps are hedges of forecasted interest payments in anticipation of permanent funding in the term securitization market.
 
For these derivatives, the effective portion of changes in the fair value is initially recorded in accumulated other comprehensive loss (“AOCL”).  These amounts are subsequently reclassified into CAF income in the period that the hedged forecasted transaction affects earnings, which occurs as interest expense is recognized on those future issuances of fixed-rate debt.  During the next 12 months, we estimate that an additional $6.0 million will be reclassified from AOCL as a decrease to CAF income.
 
In addition, we have issued floating rate notes in connection with our term securitizations.  To manage our exposure to interest rate movements, we have entered into interest rate swaps that involve the receipt of variable amounts from a counterparty in exchange for making fixed-rate payments over the estimated life of the note.  The effective portion of the change in fair value for these derivatives is recorded in AOCL.

Any ineffective portion of these derivatives is recognized directly in CAF income.
 
Designated Cash Flow Hedge – Other Debt.  Our objective in using an interest rate derivative for our term loan is to manage our exposure to interest rate movements.  To accomplish this objective, we use an interest rate swap that involves the receipt of variable amounts from a counterparty in exchange for our making fixed-rate payments during the life of the loan without exchange of the

Page 12



underlying notional amount.  The effective portion of the change in fair value for this derivative is recorded in AOCL.  Any ineffective portion of the change in fair value is recognized in current income. 
 
As of August 31, 2015 and February 28, 2015, we had interest rate swaps outstanding with a combined notional amount of $2.0 billion and $1.40 billion, respectively, that were designated as cash flow hedges of interest rate risk.
 
Fair Values of Derivative Instruments
 
As of August 31, 2015
 
As of February 28, 2015
(In thousands)
Assets
 
Liabilities
 
Assets
 
Liabilities
Derivatives designated as accounting hedges:
 
 
 
 
 
 
 
Interest rate swaps (1)
$
91

 
$

 
$
1,201

 
$

Interest rate swaps (2)

 
(3,482
)
 

 
(1,064
)
Total
$
91

 
$
(3,482
)
 
$
1,201

 
$
(1,064
)

(1)     Reported in other current assets on the consolidated balance sheets.
(2)     Reported in accounts payable on the consolidated balance sheets.
 
Effect of Derivative Instruments on Comprehensive Income
 
Three Months Ended
 
Six Months Ended
 
August 31
 
August 31
(In thousands)
2015
 
2014
 
2015
 
2014
Derivatives designated as accounting hedges:
 
 
 
 
 
 
 
Loss recognized in AOCL (1)
$
(1,955
)
 
$
(271
)
 
$
(6,271
)
 
$
(2,069
)
Loss reclassified from AOCL into CAF income (1)
$
(1,907
)
 
$
(2,076
)
 
$
(3,958
)
 
$
(4,339
)
Loss recognized in CAF Income (2)
$
(102
)
 
$

 
$
(102
)
 
$


(1)    Represents the effective portion.
(2)    Represents the ineffective portion.
 
6.    Fair Value Measurements
 
Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants in the principal market or, if none exists, the most advantageous market, for the specific asset or liability at the measurement date (referred to as the “exit price”).  The fair value should be based on assumptions that market participants would use, including a consideration of nonperformance risk.
 
We assess the inputs used to measure fair value using the three-tier hierarchy.  The hierarchy indicates the extent to which inputs used in measuring fair value are observable in the market.
 
Level 1
Inputs include unadjusted quoted prices in active markets for identical assets or liabilities that we can access at the measurement date.
 
Level 2
Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly, including quoted prices for similar assets in active markets, quoted prices from identical or similar assets in inactive markets and observable inputs such as interest rates and yield curves.
 
Level 3
Inputs that are significant to the measurement that are not observable in the market and include management's judgments about the assumptions market participants would use in pricing the asset or liability (including assumptions about risk).
 
Our fair value processes include controls that are designed to ensure that fair values are appropriate.  Such controls include model validation, review of key model inputs, analysis of period-over-period fluctuations and reviews by senior management.
 

Page 13



Valuation Methodologies
 
Money Market Securities.  Money market securities are cash equivalents, which are included in cash and cash equivalents, restricted cash from collections on auto loan receivables or other assets.  They consist of highly liquid investments with original maturities of three months or less.  We use quoted market prices for identical assets to measure fair value.  Therefore, all money market securities are classified as Level 1.
 
Mutual Fund Investments.  Mutual fund investments consist of publicly traded mutual funds that primarily include diversified investments in large-, mid- and small-cap domestic and international companies.  The investments, which are included in other assets, are held in a rabbi trust established to fund informally our executive deferred compensation plan.  We use quoted active market prices for identical assets to measure fair value.  Therefore, all mutual fund investments are classified as Level 1.
 
Derivative Instruments.  The fair values of our derivative instruments are included in either other current assets or accounts payable.  As described in Note 5, as part of our risk management strategy, we utilize derivative instruments to manage differences in the amount of our known or expected cash receipts and our known or expected cash payments principally related to the funding of our auto loan receivables as well as to manage exposure to variable interest rates on our term loan.  Our derivatives are not exchange-traded and are over-the-counter customized derivative instruments.  All of our derivative exposures are with highly rated bank counterparties.
 
We measure derivative fair values assuming that the unit of account is an individual derivative instrument and that derivatives are sold or transferred on a stand-alone basis.  We estimate the fair value of our derivatives using quotes determined by the derivative counterparties and third-party valuation services.  Quotes from third-party valuation services and quotes received from bank counterparties project future cash flows and discount the future amounts to a present value using market-based expectations for interest rates and the contractual terms of the derivative instruments.  The models do not require significant judgment and model inputs can typically be observed in a liquid market; however, because the models include inputs other than quoted prices in active markets, all derivatives are classified as Level 2.
 
Our derivative fair value measurements consider assumptions about counterparty and our own nonperformance risk.  We monitor counterparty and our own nonperformance risk and, in the event that we determine that a party is unlikely to perform under terms of the contract, we would adjust the derivative fair value to reflect the nonperformance risk.

Items Measured at Fair Value on a Recurring Basis
 
As of August 31, 2015
(In thousands)
Level 1
 
Level 2
 
Total
Assets:
 
 
 
 
 
Money market securities
$
505,039

 
$

 
$
505,039

Mutual fund investments
13,847

 

 
13,847

Derivative instruments

 
91

 
91

Total assets at fair value
$
518,886

 
$
91

 
$
518,977

 
 
 
 
 
 
Percent of total assets at fair value
100.0
%
 
 %
 
100.0
%
Percent of total assets
3.7
%
 
 %
 
3.7
%
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
Derivative instruments
$

 
$
(3,482
)
 
$
(3,482
)
Total liabilities at fair value
$

 
$
(3,482
)
 
$
(3,482
)
 
 
 
 
 
 
Percent of total liabilities
%
 
 %
 
%

Page 14



  
 
As of February 28, 2015
(In thousands)
Level 1
 
Level 2
 
Total
Assets:
 
 
 
 
 
Money market securities
$
380,100

 
$

 
$
380,100

Mutual fund investments
9,242

 

 
9,242

Derivative instruments

 
1,201

 
1,201

Total assets at fair value
$
389,342

 
$
1,201

 
$
390,543

 
 
 
 
 
 
Percent of total assets at fair value
99.7
%
 
0.3
 %
 
100.0
%
Percent of total assets
2.9
%
 
 %
 
3.0
%
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
Derivative instruments
$

 
$
(1,064
)
 
$
(1,064
)
Total liabilities at fair value
$

 
$
(1,064
)
 
$
(1,064
)
 
 
 
 
 
 
Percent of total liabilities
%
 
 %
 
%
 
There were no transfers between Levels 1 and 2 for the three and six months ended August 31, 2015.
 
7.    Cancellation Reserves
 
We recognize commission revenue for EPP products at the time of sale, net of a reserve for estimated contract cancellations.  Cancellations of these services may result from early termination by the customer, or default or prepayment on the finance contract.  The reserve for cancellations is evaluated for each product, and is based on forecasted forward cancellation curves utilizing historical experience, recent trends and credit mix of the customer base. 
Cancellation Reserves
 
Three Months Ended August 31
 
Six Months Ended August 31
(In millions)
2015
 
2014
 
2015
 
2014
Balance as of beginning of period
$
100.3

 
$
81.1

 
$
94.4

 
$
72.5

Cancellations
(14.4
)
 
(12.5
)
 
(28.8
)
 
(25.0
)
Provision for future cancellations
22.2

 
17.4

 
42.5

 
38.5

Balance as of end of period
$
108.1

 
$
86.0

 
$
108.1

 
$
86.0

 
The current portion of estimated cancellation reserves is recognized as a component of accrued expenses and other current liabilities with the remaining amount recognized in other liabilities. As of August 31, 2015 and February 28, 2015, the current portion of cancellation reserves was $52.1 million and $44.8 million, respectively.
 
8.    Income Taxes
 
We had $27.1 million of gross unrecognized tax benefits as of August 31, 2015, and $25.0 million as of February 28, 2015.  There were no significant changes to the gross unrecognized tax benefits as reported for the year ended February 28, 2015, as all activity was related to positions taken on tax returns filed or intended to be filed in the current fiscal year.
 
9.    Retirement Plans
 
Effective December 31, 2008, we froze both of our noncontributory defined benefit plans: our pension plan (the “pension plan”) and our unfunded, nonqualified plan (the “restoration plan”), which restores retirement benefits for certain associates who are affected by Internal Revenue Code limitations on benefits provided under the pension plan.  No additional benefits have accrued under these plans since that date.  In connection with benefits earned prior to December 31, 2008, we have a continuing obligation to fund the pension plan and will continue to recognize net periodic pension expense for both plans.  We use a fiscal year end measurement date for both the pension plan and the restoration plan.
 

Page 15



Components of Net Pension Expense
 
Three Months Ended August 31
 
Pension Plan
 
Restoration Plan
 
Total
(In thousands)
2015
 
2014
 
2015
 
2014
 
2015
 
2014
Interest cost
$
2,168

 
$
2,008

 
$
108

 
$
113

 
$
2,276

 
$
2,121

Expected return on plan assets
(2,464
)
 
(2,247
)
 

 

 
(2,464
)
 
(2,247
)
Recognized actuarial loss
534

 
340

 
6

 

 
540

 
340

Net pension expense
$
238

 
$
101

 
$
114

 
$
113

 
$
352

 
$
214


 
Six Months Ended August 31
 
Pension Plan
 
Restoration Plan
 
Total
(In thousands)
2015
 
2014
 
2015
 
2014
 
2015
 
2014
Interest cost
$
4,336

 
$
4,016

 
$
216

 
$
226

 
$
4,552

 
$
4,242

Expected return on plan assets
(4,929
)
 
(4,514
)
 

 

 
(4,929
)
 
(4,514
)
Recognized actuarial loss
1,017

 
680

 
12

 

 
1,029

 
680

Net pension expense
$
424

 
$
182

 
$
228

 
$
226

 
$
652

 
$
408

 
We made no contributions to the pension plan during the six months ended August 31, 2015, and do not anticipate making any contributions during the remainder of fiscal 2016.  The expected long-term rate of return on plan assets for the pension plan was 7.75% as of February 28, 2015.
 
10.    Debt
 
 
As of August 31
 
As of February 28
(In thousands)
2015
 
2015
Short-term revolving credit facility
$
2,122

 
$
785

Current portion of long-term debt

 
10,000

Current portion of finance and capital lease obligations
21,584

 
21,554

Current portion of non-recourse notes payable
296,867

 
258,163

Total current debt
320,573

 
290,502

Long-term debt
300,000

 
300,000

Finance and capital lease obligations, excluding current portion
357,825

 
306,284

Non-recourse notes payable, excluding current portion
8,856,227

 
8,212,466

Total debt, excluding current portion
9,514,052

 
8,818,750

Total debt
$
9,834,625

 
$
9,109,252

 
Revolving Credit Facility.    During the second quarter of fiscal 2016, we entered into a new five-year, $1.2 billion unsecured revolving credit facility (the “credit facility”) with various financial institutions that expires in August 2020. The new credit facility replaced our $1.0 billion credit facility that was scheduled to expire in August 2016. Borrowings under the credit facility are available for working capital and general corporate purposes.  Borrowings accrue interest at variable rates based on LIBOR, the federal funds rate, or the prime rate, depending on the type of borrowing, and we pay a commitment fee on the unused portions of the available funds.  Borrowings under the credit facility are either due ‘on demand’ or at maturity depending on the type of borrowing.  Borrowings with ‘on demand’ repayment terms are presented as short-term debt while amounts due at maturity are presented as long-term debt with expected repayments within the next fiscal year presented as a component of current portion of long-term debt.  As of August 31, 2015, the unused capacity of $1,197.9 million was fully available to us.
 
Term Loan.    During the second quarter of fiscal 2016, we extended the maturity of our $300 million term loan from November 2017 to August 2020.  The term loan accrues interest at variable rates based on the LIBOR rate, the federal funds rate, or the prime rate.  As of August 31, 2015, $300 million remained outstanding and no repayments are scheduled to be made within the next 12

Page 16



months.  Borrowings under the term loan are available for working capital and general corporate purposes.  We have entered into an interest rate derivative contract to manage our exposure to variable interest rates associated with this term loan.
 
Finance and Capital Lease Obligations.  Finance and capital lease obligations relate primarily to stores subject to sale-leaseback transactions that did not qualify for sale accounting, and therefore, are accounted for as financings.  The leases were structured at varying interest rates and generally have initial lease terms ranging from 15 to 20 years with payments made monthly.  Payments on the leases are recognized as interest expense and a reduction of the obligations.  We have not entered into any new sale-leaseback transactions since fiscal 2009. During fiscal 2016, finance lease obligations were increased by $61.3 million related to leases that were modified or extended beyond the original lease term.
 
Non-Recourse Notes Payable.  The non-recourse notes payable relate to auto loan receivables funded through term securitizations and our warehouse facilities.  The timing of principal payments on the non-recourse notes payable is based on the timing of principal collections and defaults on the securitized auto loan receivables. The current portion of non-recourse notes payable represents principal payments that are due to be distributed in the following period.
 
As of August 31, 2015,  $7.91 billion of non-recourse notes payable was outstanding related to term securitizations.  These notes payable accrue interest predominantly at fixed rates and have scheduled maturities through March 2022, but may mature earlier, depending upon the repayment rate of the underlying auto loan receivables. 
 
As of August 31, 2015, $1.24 billion of non-recourse notes payable was outstanding related to our warehouse facilities. During the second quarter of fiscal 2016, we increased the combined limit of our warehouse facilities by $200 million to $2.5 billion. As of August 31, 2015, the unused warehouse capacity totaled $1.26 billion.  Of the combined warehouse facility limit, $1.5 billion will expire in February 2016 and $1.0 billion will expire in August 2016.  The return requirements of warehouse facility investors could fluctuate significantly depending on market conditions.  At renewal, the cost, structure and capacity of the facilities could change.  These changes could have a significant impact on our funding costs.
 
See Notes 2 and 4 for additional information on the related securitized auto loan receivables.
 
Capitalized Interest.    We capitalize interest in connection with the construction of certain facilities.  We capitalized interest of $5.6 million in the first six months of fiscal 2016no interest was capitalized in the first six months of fiscal 2015.
 
Financial Covenants.  The credit facility and term loan agreements contain representations and warranties, conditions and covenants.  We must also meet financial covenants in conjunction with certain of the sale-leaseback transactions.  Our securitization agreements contain representations and warranties, financial covenants and performance triggers.  As of August 31, 2015, we were in compliance with all financial covenants and our securitized receivables were in compliance with the related performance triggers.
 
11.    Stock and Stock-Based Incentive Plans
 
(A) Share Repurchase Program
In fiscal 2013, our board of directors authorized the repurchase of up to $800 million of our common stock which was exhausted in fiscal 2015.  In fiscal 2015, our board of directors authorized the repurchase of up to an additional $3 billion of our common stock of which $1 billion was exhausted during the quarter ended August 31, 2015, and $2 billion expires on December 31, 2016.
 
Common Stock Repurchases
 
Three Months Ended
 
Six Months Ended
 
August 31
 
August 31
 
2015
 
2014
 
2015
 
2014
Number of shares repurchased (in thousands)
3,878.4

 
4,024.8

 
5,655.3

 
7,866.7

Average cost per share
$
64.40

 
$
49.92

 
$
65.37

 
$
47.68

Available for repurchase, as of end of period (in millions)
$
1,999.6

 
$
907.0

 
$
1,999.6

 
$
907.0

 
(B) Stock Incentive Plans
We maintain long-term incentive plans for management, key employees and the nonemployee members of our board of directors.  The plans allow for the granting of equity-based compensation awards, including nonqualified stock options, incentive stock options, stock appreciation rights, restricted stock awards, stock- and cash-settled restricted stock units, stock grants or a combination of awards.  To date, we have not awarded any incentive stock options.
 

Page 17



The majority of associates who receive share-based compensation awards primarily receive cash-settled restricted stock units.  Senior management and other key associates receive awards of nonqualified stock options, stock-settled restricted stock units and stock-settled performance stock units.  Nonemployee directors receive awards of nonqualified stock options, stock grants and/or restricted stock awards.  Excluding stock grants, all share-based compensation awards, including any associated dividend rights, are subject to forfeiture.
 
Nonqualified Stock Options.  Nonqualified stock options are awards that allow the recipient to purchase shares of our common stock at a fixed price.  Stock options are granted at an exercise price equal to the fair market value of our common stock on the grant date.  The stock options generally vest annually in equal amounts over periods of one to four years.  These options expire no later than ten years after the date of the grant.
 
Cash-Settled Restricted Stock Units.  Also referred to as restricted stock units, or RSUs, these are restricted stock unit awards that entitle the holder to a cash payment equal to the fair market value of a share of our common stock for each unit granted.  Conversion generally occurs at the end of a three-year vesting period.  However, the cash payment per RSU will not be greater than 200% or less than 75% of the fair market value of a share of our common stock on the grant date.  RSUs are liability awards and do not have voting rights.
 
Stock-Settled Market Stock Units.  Also referred to as market stock units, or MSUs, these are restricted stock unit awards with market conditions granted to eligible key associates that are converted into between zero and two shares of common stock for each unit granted.  Conversion generally occurs at the end of a three-year vesting period.  The conversion ratio is calculated by dividing the average closing price of our stock during the final 40 trading days of the three-year vesting period by our stock price on the grant date, with the resulting quotient capped at two.  This quotient is then multiplied by the number of MSUs granted to yield the number of shares awarded.  MSUs do not have voting rights.
 
Stock-Settled Performance Stock Units.  Also referred to as performance stock units, or PSUs, these are restricted stock unit awards with performance conditions granted to eligible key associates that are converted into between zero and two shares of common stock for each unit granted.  Conversion generally occurs at the end of a three-year vesting period.  The conversion ratio is based on the company reaching certain target levels set by the board of directors for cumulative three-year earnings before interest and taxes at the end of the three-year vesting period, with the resulting quotient subject to meeting a minimum 25% threshold and capped at 200%.  This quotient is then multiplied by the number of PSUs granted to yield the number of shares awarded.  PSUs do not have voting rights.
 
Restricted Stock Awards.  Restricted stock awards (RSAs) are awards of our common stock that are subject to specified restrictions that generally lapse after a one year period from date of grant.  Participants holding restricted stock are entitled to vote on matters submitted to holders of our common stock for a vote.  
 
(C) Share-Based Compensation
 
Composition of Share-Based Compensation Expense
 
Three Months Ended
 
Six Months Ended
 
August 31
 
August 31
(In thousands)
2015
 
2014
 
2015
 
2014
Cost of sales
$
17

 
$
1,247

 
$
1,065

 
$
1,574

CarMax Auto Finance income
441

 
961

 
598

 
1,637

Selling, general and administrative expenses
9,977

 
20,493

 
32,550

 
35,209

Share-based compensation expense, before income taxes
$
10,435

 
$
22,701

 
$
34,213

 
$
38,420

 

Page 18



Composition of Share-Based Compensation Expense – By Grant Type
 
Three Months Ended
 
Six Months Ended
 
August 31
 
August 31
(In thousands)
2015
 
2014
 
2015
 
2014
Nonqualified stock options
$
5,590

 
$
6,887

 
$
14,270

 
$
15,007

Cash-settled restricted stock units
525

 
11,074

 
11,398

 
14,221

Stock-settled market stock units
2,641

 
3,472

 
5,537

 
7,593

Stock-settled performance stock units
344

 

 
1,238

 

Employee stock purchase plan
338

 
311

 
707

 
642

Restricted stock awards to non-employee directors
997

 
957

 
1,063

 
957

Share-based compensation expense, before income taxes
$
10,435

 
$
22,701

 
$
34,213

 
$
38,420

 
We recognize compensation expense for stock options, MSUs, PSUs and RSAs on a straight-line basis (net of estimated forfeitures) over the requisite service period, which is generally the vesting period of the award.  The PSU expense is adjusted for any change in management’s assessment of the performance target level that is probable of being achieved.  The variable expense associated with RSUs is recognized over their vesting period (net of estimated forfeitures) and is calculated based on the volume-weighted average price of our common stock on the last trading day of each reporting period.  The total costs for matching contributions for our employee stock purchase plan are included in share-based compensation expense.  There were no capitalized share-based compensation costs as of or for the six months ended August 31, 2015 or 2014.

Stock Option Activity
 
 
 
 
 
Weighted
 
 
 
 
 
Weighted
 
Average
 
 
 
 
 
Average
 
Remaining
 
Aggregate
 
Number of
 
Exercise
 
Contractual
 
Intrinsic
(Shares and intrinsic value in thousands)
Shares
 
Price
 
Life (Years)
 
Value
Outstanding as of February 28, 2015
7,645

 
$
35.59

 
 
 
 

Options granted
1,389

 
$
73.70

 
 
 
 

Options exercised
(1,296
)
 
$
28.68

 
 
 
 

Options cancelled
(1
)
 
$
13.19

 
 
 
 
Outstanding as of August 31, 2015
7,737

 
$
43.60

 
4.5
 
$
152,314

 
 
 
 
 
 
 
 
Exercisable as of August 31, 2015
3,824

 
$
33.63

 
3.5
 
$
104,680

 
During the six months ended August 31, 2015 and 2014, we granted nonqualified options to purchase 1,388,661 and 2,003,238 shares of common stock, respectively.  The total cash received as a result of stock option exercises for the six months ended August 31, 2015 and 2014, was $37.2 million and $44.3 million, respectively.  We settle stock option exercises with authorized but unissued shares of our common stock.  The total intrinsic value of options exercised for the six months ended August 31, 2015 and 2014, was $57.0 million and $85.9 million, respectively.  We realized related tax benefits of $22.8 million and $34.6 million during the six months ended August 31, 2015 and 2014, respectively.
 

Page 19



Outstanding Stock Options
 
 
 
 
 
 
As of August 31, 2015
 
 
 
 
 
 
Options Outstanding
 
Options Exercisable
 
 
 
 
 
 
 
 
Weighted
 
Weighted
 
 
 
Weighted
 
 
 
 
 
 
 
 
Average Remaining
 
Average
 
 
 
Average
(Shares in thousands)
 
Number of
 
Contractual
 
Exercise
 
Number of
 
Exercise
Range of Exercise Prices
 
Shares
 
Life (Years)
 
Price
 
Shares
 
Price
 
 
$
11.43

-
$
14.49

 
244

 
0.6
 
$
11.81

 
244

 
$
11.81

 
 
$
19.98

-
$
31.76

 
2,078

 
3.2
 
$
30.22

 
1,639

 
$
29.84

 
 
$
32.69

-
$
42.68

 
2,104

 
3.9
 
$
39.24

 
1,430

 
$
37.61

 
 
$
44.96

-
$
49.25

 
1,916

 
5.6
 
$
45.05

 
511

 
$
45.05

 
 
$
67.82

-
$
73.76

 
1,395

 
6.6
 
$
73.68

 

 

Total
 
 
 
 
 
7,737

 
4.5
 
$
43.60

 
3,824

 
$
33.63

 
For stock options, the fair value of each award is estimated as of the date of grant using a binomial valuation model.  In computing the value of the option, the binomial model considers characteristics of fair-value option pricing that are not available for consideration under a closed-form valuation model (for example, the Black-Scholes model), such as the contractual term of the option, the probability that the option will be exercised prior to the end of its contractual life and the probability of termination or retirement of the option holder.  For this reason, we believe that the binomial model provides a fair value that is more representative of actual experience and future expected experience than the value calculated using a closed-form model.  Estimates of fair value are not intended to predict actual future events or the value ultimately realized by the recipients of share-based awards.
 
The weighted average fair value per share at the date of grant for options granted during the six months ended August 31, 2015 and 2014, was $20.60 and $13.21, respectively.  The unrecognized compensation costs related to nonvested options totaled $45.3 million as of August 31, 2015.  These costs are expected to be recognized on a straight-line basis over a weighted average period of 2.5 years.
 
Assumptions Used to Estimate Option Values
 
Six Months Ended August 31
 
2015
 
2014
Dividend yield
 
 
0.0
%
 
 
 
0.0
%
Expected volatility factor (1)  
25.8
%
31.0
%
 
25.2
%
32.7
%
Weighted average expected volatility
 

 
30.6
%
 
 
 
31.9
%
Risk-free interest rate (2)     
0.00
%
2.1
%
 
0.03
%
2.7
%
Expected term (in years) (3)  
 
 
4.7

 
 

 
4.7

 

(1)  
Measured using historical daily price changes of our stock for a period corresponding to the term of the options and the implied volatility derived from the market prices of traded options on our stock.
(2)     Based on the U.S. Treasury yield curve at the time of grant.
(3)     Represents the estimated number of years that options will be outstanding prior to exercise.
 

Page 20



Cash-Settled Restricted Stock Unit Activity
 
 
 
Weighted
 
 
 
Average
 
Number of
 
Grant Date
(Units in thousands)
Units
 
Fair Value
Outstanding as of February 28, 2015
1,530

 
$
39.81

Stock units granted
418

 
$
73.76

Stock units vested and converted
(516
)
 
$
31.88

Stock units cancelled
(52
)
 
$
49.05

Outstanding as of August 31, 2015
1,380

 
$
52.72

 
During the six months ended August 31, 2015 and 2014, we granted 418,281 and 587,511 RSUs, respectively.  The initial fair market value per RSU at the date of grant for the RSUs granted during the six months ended August 31, 2015 and 2014, was $73.76 and $44.96, respectively.  The RSUs are cash-settled upon vesting.  During the six months ended August 31, 2015 and 2014, we paid $32.8 million and $21.2 million, respectively (before payroll tax withholdings), to RSU holders upon the vesting of RSUs. We realized tax benefits of $13.1 million and $8.6 million during the six months ended August 31, 2015 and 2014, respectively.
 
Expected Cash Settlement Range Upon Restricted Stock Unit Vesting
 
As of August 31, 2015
(In thousands)
Minimum (1)
 
Maximum (1)
Fiscal 2017
$
13,909

 
$
37,090

Fiscal 2018
16,093

 
42,914

Fiscal 2019
18,983

 
50,622

Total expected cash settlements
$
48,985

 
$
130,626


(1)     Net of estimated forfeitures.

Stock-Settled Market Stock Unit Activity
 
 
 
Weighted
 
 
 
Average
 
Number of
 
Grant Date
(Units in thousands)
Units
 
Fair Value
Outstanding as of February 28, 2015
774

 
$
48.30

Stock units granted
107

 
$
90.36

Stock units vested and converted
(327
)
 
$
40.91

Stock units cancelled

 
$

Outstanding as of August 31, 2015
554

 
$
60.77

 
During the six months ended August 31, 2015 and 2014, we granted 106,963 and 245,190 MSUs, respectively.  The weighted average fair value per MSU at the date of grant during the six months ended August 31, 2015 and 2014, was $90.36 and $55.37, respectively.  The fair values were determined using a Monte-Carlo simulation and were based on the expected market price of our common stock on the vesting date and the expected number of converted common shares.  We realized related tax benefits of $16.6 million and $7.4 million for the six months ended August 31, 2015 and 2014, respectively, from the vesting of market stock units.  The unrecognized compensation costs related to nonvested MSUs totaled $16.7 million as of August 31, 2015.  These costs are expected to be recognized on a straight-line basis over a weighted average period of 1.4 years.
 

Page 21



Stock-Settled Performance Stock Unit Activity
 
 
 
Weighted
 
 
 
Average
 
Number of
 
Grant Date
(Units in thousands)
Units
 
Fair Value
Outstanding as of February 28, 2015

 
$

Stock units granted
66

 
$
72.58

Stock units vested

 
$

Stock units cancelled

 
$

Outstanding as of August 31, 2015
66

 
$
72.58

 
During the six months ended August 31, 2015, we granted 66,446 PSUs.  No PSUs were granted in fiscal 2015.  The weighted average fair value per PSU at the date of grant for PSUs granted during the six months ended August 31, 2015, was $72.58.  The fair value was the fair market value of a share of common stock on the date of the grant.  The unrecognized compensation costs related to nonvested PSUs totaled $3.6 million as of August 31, 2015.  These costs are expected to be recognized on a straight-line basis over a weighted average period of 2.6 years.

Restricted Stock Awards

 
 
 
Weighted
 
 
 
Average
 
Number of
 
Grant Date
(Units in thousands)
Units
 
Fair Value
Outstanding as of February 28, 2015
23

 
$
51.18

Restricted stock granted
19

 
$
68.16

Restricted stock vested
(23
)
 
$
51.18

Restricted stock cancelled

 

Outstanding as of August 31, 2015
19

 
$
68.16


During the six months ended August 31, 2015 and 2014, we granted 19,070 and 22,860 shares of RSAs, respectively. The fair value per RSA at the grant date for RSAs granted during the six months ended August 31, 2015 and 2014, was $68.16 and $51.18, respectively. We realized related tax benefits of $0.6 million for the six months ended August 31, 2015. No shares vested during fiscal 2015.  The unrecognized compensation costs related to nonvested RSAs totaled $0.3 million as of August 31, 2015. These costs are expected to be recognized on a straight-line basis over a weighted average period of 0.8 years.

12.    Net Earnings per Share
 
Basic net earnings per share is computed by dividing net earnings available for basic common shares by the weighted average number of shares of common stock outstanding.  Diluted net earnings per share is computed by dividing net earnings available for diluted common shares by the sum of weighted average number of shares of common stock outstanding and dilutive potential common  stock.   Diluted net earnings per share is calculated using the “if-converted” treasury stock method.


Page 22



Basic and Dilutive Net Earnings Per Share Reconciliations
 
Three Months Ended
 
Six Months Ended
 
August 31
 
August 31
(In thousands except per share data)
2015
 
2014
 
2015
 
2014
Net earnings
$
172,228

 
$
154,518

 
$
354,202

 
$
324,171

 
 
 
 
 
 
 
 
Weighted average common shares outstanding
207,249

 
218,180

 
207,969

 
219,224

Dilutive potential common shares:
 
 
 
 
 
 
 
Stock options
1,848

 
2,269

 
2,003

 
2,520

Stock-settled stock units and awards
551

 
621

 
673

 
607

Weighted average common shares and dilutive
 
 
 
 
 
 
 
potential common shares
209,648

 
221,070

 
210,645

 
222,351

 
 
 
 
 
 
 
 
Basic net earnings per share
$
0.83

 
$
0.71

 
$
1.70

 
$
1.48

Diluted net earnings per share
$
0.82