Document


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 May 31, 2016
 
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 June 30, 2016
Common Stock, par value $0.50
 
191,475,213

Page 1



CARMAX, INC. AND SUBSIDIARIES
 
TABLE OF CONTENTS
 
 
Page
No.
PART I.
FINANCIAL INFORMATION 
 
 
 
 
 
 
Item 1.
Financial Statements:
 
 
 
 
 
 
 
Consolidated Statements of Earnings (Unaudited) –
 
 
 
Three Months Ended May 31, 2016 and 2015
 
 
 
 
 
 
Consolidated Statements of Comprehensive Income (Unaudited) –
 
 
 
Three Months Ended May 31, 2016 and 2015
 
 
 
 
 
 
Consolidated Balance Sheets (Unaudited) –
 
 
 
May 31, 2016 and February 29, 2016
 
 
 
 
 
 
Consolidated Statements of Cash Flows (Unaudited) –
 
 
 
Three Months Ended May 31, 2016 and 2015
 
 
 
 
 
 
Notes to Consolidated Financial Statements (Unaudited)
 
 
 
 
 
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 5.
Other Information
 
 
 
 
 
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 May 31
(In thousands except per share data)
2016
 
%(1)
 
2015
 
%(1)
SALES AND OPERATING REVENUES:
 
 
 
 
 
 
 
Used vehicle sales
$
3,428,974

 
83.1

 
$
3,292,658

 
82.0
Wholesale vehicle sales
567,741

 
13.8

 
576,625

 
14.4
Other sales and revenues
129,671

 
3.1

 
145,605

 
3.6
NET SALES AND OPERATING REVENUES
4,126,386

 
100.0

 
4,014,888

 
100.0
Cost of sales
3,553,749

 
86.1

 
3,471,094

 
86.5
GROSS PROFIT
572,637

 
13.9

 
543,794

 
13.5
CARMAX AUTO FINANCE INCOME
100,758

 
2.4

 
109,108

 
2.7
Selling, general and administrative expenses
380,230

 
9.2

 
349,779

 
8.7
Interest expense
11,088

 
0.3

 
7,103

 
0.2
Other (income) expense
(616
)
 

 
41

 
Earnings before income taxes
282,693

 
6.9

 
295,979

 
7.4
Income tax provision
107,333

 
2.6

 
114,005

 
2.8
NET EARNINGS
$
175,360

 
4.2

 
$
181,974

 
4.5
WEIGHTED AVERAGE COMMON SHARES:
 
 
 
 
 
 
 
Basic
193,531

 


 
208,698

 

Diluted
195,253

 


 
211,652

 

NET EARNINGS PER SHARE:
 
 
 
 
 
 
 
Basic
$
0.91

 


 
$
0.87

 

Diluted
$
0.90

 


 
$
0.86

 

 
 
(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 May 31
(In thousands)
2016
 
2015
NET EARNINGS
$
175,360

 
$
181,974

Other comprehensive income (loss), net of taxes:
 
 
 
Net change in retirement benefit plan
 
 
 
unrecognized actuarial losses
249

 
306

 
 
 
 
Net change in cash flow hedge unrecognized losses
3,122

 
(1,373
)
Other comprehensive income (loss), net of taxes
3,371

 
(1,067
)
TOTAL COMPREHENSIVE INCOME
$
178,731

 
$
180,907

 
  
 


































See accompanying notes to consolidated financial statements.

Page 4



CARMAX, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
(Unaudited)
 
As of May 31
 
As of February 29
(In thousands except share data)
2016
 
2016
ASSETS
 

 
 

CURRENT ASSETS:
 

 
 

Cash and cash equivalents
$
52,575

 
$
37,394

Restricted cash from collections on auto loan receivables
364,156

 
343,829

Accounts receivable, net
102,541

 
132,171

Inventory
1,864,991

 
1,932,029

Other current assets
32,317

 
26,358

TOTAL CURRENT ASSETS
2,416,580

 
2,471,781

Auto loan receivables, net
9,853,368

 
9,536,892

Property and equipment, net
2,234,385

 
2,161,698

Deferred income taxes
152,328

 
161,862

Other assets
133,266

 
127,678

TOTAL ASSETS
$
14,789,927

 
$
14,459,911

LIABILITIES AND SHAREHOLDERS’ EQUITY
 

 
 
CURRENT LIABILITIES:
 

 
 
Accounts payable
$
454,522

 
$
441,746

Accrued expenses and other current liabilities
205,426

 
245,909

Accrued income taxes
89,991

 
2,029

Short-term debt
1,255

 
428

Current portion of finance and capital lease obligations
12,411

 
14,331

Current portion of non-recourse notes payable
319,769

 
300,750

TOTAL CURRENT LIABILITIES
1,083,374

 
1,005,193

Long-term debt, excluding current portion
597,277

 
713,910

Finance and capital lease obligations, excluding current portion
419,875

 
400,323

Non-recourse notes payable, excluding current portion
9,494,180

 
9,206,425

Other liabilities
222,936

 
229,274

TOTAL LIABILITIES
11,817,642

 
11,555,125

 
 
 
 
Commitments and contingent liabilities

 

SHAREHOLDERS’ EQUITY:
 

 
 

Common stock, $0.50 par value; 350,000,000 shares authorized; 192,495,265 and 194,712,234 shares issued and outstanding as of May 31, 2016 and February 29, 2016, respectively
96,248

 
97,356

Capital in excess of par value
1,136,469

 
1,130,822

Accumulated other comprehensive loss
(66,825
)
 
(70,196
)
Retained earnings
1,806,393

 
1,746,804

TOTAL SHAREHOLDERS’ EQUITY
2,972,285

 
2,904,786

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY
$
14,789,927

 
$
14,459,911






See accompanying notes to consolidated financial statements.

Page 5






CARMAX, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
 
Three Months Ended May 31
(In thousands)
2016
 
2015
OPERATING ACTIVITIES:
 
 
 
Net earnings
$
175,360

 
$
181,974

Adjustments to reconcile net earnings to net cash provided by operating activities:
 
 
 
Depreciation and amortization
40,801

 
32,066

Share-based compensation expense
31,437

 
23,409

Provision for loan losses
26,591

 
13,598

Provision for cancellation reserves
18,692

 
20,330

Deferred income tax provision
7,374

 
10,475

Other
268

 
77

Net decrease (increase) in:
 
 
 
Accounts receivable, net
29,630

 
34,027

Inventory
67,038

 
242,797

Other current assets
(4,031
)
 
14,423

Auto loan receivables, net
(343,067
)
 
(390,977
)
Other assets
399

 
57

Net increase (decrease) in:
 
 
 
Accounts payable, accrued expenses and other current
 
 
 
liabilities and accrued income taxes
66,871

 
(31,043
)
Other liabilities
(31,999
)
 
(33,659
)
NET CASH PROVIDED BY OPERATING ACTIVITIES
85,364

 
117,554

INVESTING ACTIVITIES:
 
 
 
Capital expenditures
(97,463
)
 
(59,437
)
Proceeds from sales of assets

 
1,419

Increase in restricted cash from collections on auto loan receivables
(20,327
)
 
(33,932
)
Increase in restricted cash in reserve accounts
(3,101
)
 
(2,972
)
Release of restricted cash from reserve accounts
41

 
1,633

Purchases of money market securities, net
(289
)
 
82

Purchases of trading securities
(2,355
)
 
(3,942
)
Sales of trading securities
244

 
72

NET CASH USED IN INVESTING ACTIVITIES
(123,250
)
 
(97,077
)
FINANCING ACTIVITIES:
 
 
 
Increase (decrease) in short-term debt, net
827

 
(4
)
Proceeds from issuances of long-term debt
1,093,800

 
20,000

Payments on long-term debt
(1,208,800
)
 
(30,000
)
Cash paid for debt issuance costs
(4,680
)
 

Payments on finance and capital lease obligations
(3,040
)
 
(4,652
)
Issuances of non-recourse notes payable
2,259,000

 
3,047,805

Payments on non-recourse notes payable
(1,952,428
)
 
(2,656,311
)
Repurchase and retirement of common stock
(137,989
)
 
(134,226
)
Equity issuances
4,134

 
34,323

Excess tax benefits from share-based payment arrangements
2,243

 
26,680

NET CASH PROVIDED BY FINANCING ACTIVITIES
53,067

 
303,615

Increase in cash and cash equivalents
15,181

 
324,092

Cash and cash equivalents at beginning of year
37,394

 
27,606

CASH AND CASH EQUIVALENTS AT END OF PERIOD
$
52,575

 
$
351,698












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 financing to customers buying retail vehicles from CarMax.
 
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, as well as through carmax.com and our mobile apps.  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 (“ESPs”) 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.
 
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 29, 2016.
 
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.

In the fourth quarter of fiscal 2016, we reclassified New Vehicle Sales to Other Sales and Revenues and no longer separately present New Vehicle Sales. All periods presented have been revised for this new presentation.
 
Cash and Cash Equivalents.  Cash equivalents of approximately $14.2 million as of May 31, 2016, and $109,000 as of February 29, 2016, consisted of highly liquid investments with original maturities of three months or less.
 
Restricted Cash from Collections on Auto Loan Receivables.  Cash equivalents totaling $364.2 million as of May 31, 2016, and $343.8 million as of February 29, 2016, 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

Page 7



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.
 
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 and defaults, 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 $954.4 million and $925.3 million as of May 31, 2016 and February 29, 2016, 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 $49.7 million as of May 31, 2016, and $46.6 million as of February 29, 2016.
 
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 $66.1 million as of May 31, 2016, and $63.0 million as of February 29, 2016.
 
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.
 

Page 8



We also sell ESP 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 up to 60 months (subject to mileage limitations), while GAP covers the customer for the term of their finance contract. We recognize revenue at the time of sale, net of a reserve for estimated contract cancellations.  Periodically, we may receive additional revenue based upon the level of underwriting profits of the third parties who administer the products.  These additional amounts 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 revenue 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 other 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 certain risks arising from both our business operations 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 the Current Period. In June 2014, the Financial Accounting Standards Board (“FASB”) issued an accounting pronouncement (FASB ASU 2014-12) related to the accounting for share-based payments when the terms of an award provide that a performance target could be achieved after the requisite service period. This pronouncement requires that such performance targets should not be reflected in estimating the grant-date fair value of the award, and that compensation cost be recognized in the period in which it becomes probable that the performance target will be achieved, in an amount that represents the compensation cost attributable to the period for which the requisite service has been rendered. We adopted this pronouncement for our fiscal year beginning March 1, 2016, and it did not have a material effect on our consolidated financial statements.
In January 2015, the FASB issued an accounting pronouncement (FASB ASU 2015-01) related to the disclosure requirements for extraordinary items (FASB ASC Subtopic 225-20). The pronouncement eliminates the concept of extraordinary items on the income statement. We adopted this pronouncement for our fiscal year beginning March 1, 2016, and there was no effect on our consolidated financial statements.
In February 2015, the FASB issued an accounting pronouncement (FASB ASU 2015-02) related to the elimination of guidance that has allowed entities with interest in certain investment funds to follow earlier consolidation guidance and makes changes to both the variable interest model and the voting interest model (FASB ASC 810). This pronouncement requires all entities to re-evaluate consolidation conclusions regarding variable interest entities. We adopted this pronouncement for our fiscal year beginning March 1, 2016, and there was no impact to our consolidation conclusions regarding variable interest entities or on our consolidated financial statements.
In April 2015, the FASB issued an accounting pronouncement (FASB ASU 2015-03) related to the presentation of debt issuance costs (FASB ASC Subtopic 835-30). A clarification to this pronouncement was later issued in August 2015 (FASB ASU 2015-15) related to the presentation of debt issuance costs associated with line-of-credit arrangements. ASU 2015-03 requires 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. These costs will continue to be amortized to interest expense using the effective interest method. ASU 2015-15 clarifies that debt issuance costs related to line-of-credit arrangements may continue to be presented as an asset and be subsequently amortized over the term of the arrangement, regardless of whether there are any outstanding borrowings on the arrangement. We adopted these pronouncements retrospectively for our fiscal year beginning March 1, 2016, and have reclassified all debt issuance

Page 9



costs, except for those associated with our revolving credit facility, from other assets to a reduction of the carrying amount of the related debt liability for the current and all prior periods. See Note 10 for additional information.
In April 2015, the FASB issued an accounting pronouncement (FASB ASU 2015-05), which provides guidance regarding whether a cloud computing arrangement includes a software license (FASB ASC Subtopic 350-40). If a cloud computing arrangement includes a software license, then the entity should account for the software license element of the arrangement consistent with the acquisition of other software licenses. If a cloud computing arrangement does not include a software license, the entity should account for the arrangement as a service contract. The guidance does not change GAAP for an entity’s accounting for service contracts. We adopted this guidance for our fiscal year beginning March 1, 2016, and it did not have a material effect on our consolidated financial statements.
In May 2015, the FASB issued an accounting pronouncement (FASB ASU 2015-07), which eliminates the requirement for entities to categorize within the fair value hierarchy investments for which fair values are measured at net asset value (“NAV”) per share (FASB ASC Subtopic 820-10). This pronouncement also removes the requirement to make certain disclosures for all investments that are eligible to be measured at fair value using the NAV per share practical expedient, instead limiting disclosures to investments for which the entity has elected the expedient. We adopted this pronouncement for our fiscal year beginning March 1, 2016, and it did not have a material effect on our consolidated financial statements.
In March 2016, the FASB issued an accounting pronouncement (FASB ASU 2016-06) related to the embedded derivative analysis for debt instruments with contingent call or put options. This pronouncement clarifies that an exercise contingency does not need to be evaluated to determine whether it relates only to interest rates or credit risk. Instead, the contingent put or call option should be evaluated for possible bifurcation as a derivative in accordance with the four-step decision sequence detailed in FASB ASC 815-15, without regard to the nature of the exercise contingency. We early adopted this pronouncement for our fiscal year beginning March 1, 2016, and it did not have a material effect on our consolidated financial statements.
Effective in Future Periods. In May 2016, the FASB issued an accounting pronouncement (FASB ASU 2016-12), which provided narrow scope improvements and practical expedients related to FASB ASU 2014-09, Revenue from Contracts with Customers. The improvements address completed contracts and contract modifications at transition, noncash consideration, the presentation of sales taxes and other taxes collected from customers, and assessment of collectibility when determining whether a transaction represents a valid contract. The pronouncement has the same effective date as the new revenue standard, which is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2017. We will adopt this pronouncement for our fiscal year beginning March 1, 2018 and do not expect it to have a material effect on our consolidated financial statements.

In June 2016, the FASB issued an accounting pronouncement (FASB ASU 2016-13) related to the measurement of credit losses on financial instruments. The pronouncement changes the impairment model for most financial assets, and will require the use of an “expected loss” model for instruments measured at amortized cost. Under this model, entities will be required to estimate the lifetime expected credit loss on such instruments and record an allowance to offset the amortized cost basis of the financial asset, resulting in a net presentation of the amount expected to be collected on the financial asset. This pronouncement is effective for fiscal years, and for interim periods within those fiscal years, beginning after December 15, 2019. We plan to adopt this pronouncement for our fiscal year beginning March 1, 2020 and are currently evaluating the effect 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.

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.  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.

Page 10



Components of CAF Income

Three Months Ended May 31
(In millions)
2016
 
(1)
 
2015
 
(1)
Interest margin:
 
 
 
 
 
 
 
Interest and fee income
$
184.1

 
7.6

 
$
164.9

 
7.6

Interest expense
(39.4
)
 
(1.6
)
 
(28.1
)
 
(1.3
)
Total interest margin
144.7

 
5.9

 
136.8

 
6.3

Provision for loan losses
(26.6
)
 
(1.1
)
 
(13.6
)
 
(0.6
)
Total interest margin after provision for loan losses
118.1

 
4.8

 
123.2

 
5.7

 
 
 
 
 
 
 
 
Direct expenses:

 

 

 

Payroll and fringe benefit expense
(7.6
)
 
(0.3
)
 
(6.8
)
 
(0.3
)
Other direct expenses
(9.7
)
 
(0.4
)
 
(7.3
)
 
(0.4
)
Total direct expenses
(17.3
)
 
(0.7
)
 
(14.1
)
 
(0.7
)
CarMax Auto Finance income
$
100.8

 
4.1

 
$
109.1

 
5.0

Total average managed receivables
$
9,745.0

 


 
$
8,664.6

 



(1)     Percentage of total average managed receivables (quarterly amounts are annualized).
 
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 $9.83 billion as of May 31, 2016 and $9.53 billion as of February 29, 2016.  See Notes 2 and 10 for additional information on securitizations and non-recourse notes payable.

Auto Loan Receivables, Net
 
As of May 31
 
As of February 29
(In millions)
2016
 
2016
Term securitizations
$
8,042.6

 
$
7,828.0

Warehouse facilities
1,472.0

 
1,399.0

Other receivables (1)
399.7

 
366.6

Total ending managed receivables
9,914.3

 
9,593.6

Accrued interest and fees
40.3

 
35.0

Other
2.8

 
3.2

Less allowance for loan losses
(104.0
)
 
(94.9
)
Auto loan receivables, net
$
9,853.4

 
$
9,536.9


(1)  
Other receivables includes receivables not funded through the warehouse facilities or term securitizations, including receivables restricted as excess collateral for those funding arrangements.

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.

Page 11



Ending Managed Receivables by Major Credit Grade
 
As of May 31
 
As of February 29
(In millions)
2016 (1)
 
% (2)
 
2016 (1)
 
% (2)
A
$
4,813.2

 
48.6
 
$
4,666.6

 
48.6
B
3,502.5

 
35.3
 
3,400.1

 
35.4
C and other
1,598.6

 
16.1
 
1,526.9

 
16.0
Total ending managed receivables
$
9,914.3

 
100.0
 
$
9,593.6

 
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 May 31
(In millions)
2016
 
% (1)
 
2015
 
% (1)
Balance as of beginning of period
$
94.9

 
0.99
 
$
81.7

 
0.97
Charge-offs
(45.8
)
 

 
(34.3
)
 

Recoveries
28.3

 

 
22.7

 

Provision for loan losses
26.6

 

 
13.6

 

Balance as of end of period
$
104.0

 
1.05
 
$
83.7

 
0.94

(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 recent trends in delinquencies and defaults, 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 May 31
 
As of February 29
(In millions)
2016
 
% (1)
 
2016
 
% (1)
Total ending managed receivables
$
9,914.3

 
100.0
 
$
9,593.6

 
100.0
Delinquent loans:
 
 
 
 
 
 
 
31-60 days past due
$
188.6

 
1.9
 
$
171.0

 
1.8
61-90 days past due
71.7

 
0.7
 
69.1

 
0.7
Greater than 90 days past due
21.0

 
0.2
 
22.7

 
0.2
Total past due
$
281.3

 
2.8
 
$
262.8

 
2.7

(1)     Percent of total ending managed receivables.
 
5.    Derivative Instruments and Hedging Activities
 
We use derivatives to manage certain risks arising from both our business operations and economic conditions, particularly with regard to issuances of 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, and designate these derivative instruments as cash flow hedges for accounting purposes.  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.
 
For the derivatives associated with our securitization program, the effective portion of changes in the fair value is initially recorded in accumulated other comprehensive loss (“AOCL”).  For the majority of these derivatives, the amounts are subsequently

Page 12



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 debt. During the next 12 months, we estimate that an additional $9.1 million will be reclassified from AOCL as a decrease to CAF income.
 
As of May 31, 2016 and February 29, 2016, we had interest rate swaps outstanding with a combined notional amount of $2.60 billion and $2.42 billion, respectively, that were designated as cash flow hedges of interest rate risk.
 
Fair Values of Derivative Instruments
 
As of May 31, 2016
 
As of February 29, 2016
(In thousands)
Assets (1)
 
Liabilities (2)
 
Assets (1)
 
Liabilities (2)
Derivatives designated as accounting hedges:
 
 
 
 
 
 
 
Interest rate swaps
$
2,514

 
(1,442
)
 
$
587

 
$
(8,024
)

(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
 
May 31
(In thousands)
2016
 
2015
Derivatives designated as accounting hedges:
 
 
 
Gain/(Loss) recognized in AOCL (1)
$
2,331

 
$
(4,316
)
Loss reclassified from AOCL into CAF income (1)
$
(2,813
)
 
$
(2,051
)

(1)    Represents the effective 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 and 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 and 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 May 31, 2016
(In thousands)
Level 1
 
Level 2
 
Total
Assets:
 
 
 
 
 
Money market securities
$
477,670

 
$

 
$
477,670

Mutual fund investments
16,456

 

 
16,456

Derivative instruments

 
2,514

 
2,514

Total assets at fair value
$
494,126

 
$
2,514

 
$
496,640

 
 
 
 
 
 
Percent of total assets at fair value
99.5
%
 
0.5
%
 
100.0
%
Percent of total assets
3.3
%
 
%
 
3.4
%
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
Derivative instruments
$

 
$
(1,442
)
 
$
(1,442
)
Total liabilities at fair value
$

 
$
(1,442
)
 
$
(1,442
)
 
 
 
 
 
 
Percent of total liabilities
%
 
%
 
%

Page 14



 
As of February 29, 2016
(In thousands)
Level 1
 
Level 2
 
Total
Assets:
 
 
 
 
 
Money market securities
$
439,943

 
$

 
$
439,943

Mutual fund investments
13,622

 

 
13,622

Derivative instruments

 
587

 
587

Total assets at fair value
$
453,565

 
$
587

 
$
454,152

 
 
 
 
 
 
Percent of total assets at fair value
99.9
%
 
0.1
%
 
100.0
%
Percent of total assets
3.1
%
 
%
 
3.1
%
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
Derivative instruments
$

 
$
(8,024
)
 
$
(8,024
)
Total liabilities at fair value
$

 
$
(8,024
)
 
$
(8,024
)
 
 
 
 
 
 
Percent of total liabilities
%
 
0.1
%
 
0.1
%
 
There were no transfers between Levels 1 and 2 for the three months ended May 31, 2016. As of May 31, 2016 and February 29, 2016 we had no Level 3 assets.
 
7.    Cancellation Reserves
 
We recognize 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 May 31
(In millions)
2016
 
2015
Balance as of beginning of period
$
110.2

 
$
94.4

Cancellations
(16.4
)
 
(14.4
)
Provision for future cancellations
18.7

 
20.3

Balance as of end of period
$
112.5

 
$
100.3

 
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 May 31, 2016 and February 29, 2016, the current portion of cancellation reserves was $56.0 million and $54.4 million, respectively.
 
8.    Income Taxes
 
We had $27.2 million of gross unrecognized tax benefits as of May 31, 2016, and $26.8 million as of February 29, 2016.  There were no significant changes to the gross unrecognized tax benefits as reported for the year ended February 29, 2016, 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
 
We have two frozen 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 they were frozen; however, we have a continuing obligation to fund the pension plan and will continue to recognize net periodic pension expense for both plans for benefits earned prior to being frozen. We use a fiscal year end measurement date for both the pension plan and the restoration plan.


Page 15



Net Pension Expense
 
Three Months Ended May 31
 
Pension Plan
 
Restoration Plan
 
Total
(In thousands)
2016
 
2015
 
2016
 
2015
 
2016
 
2015
Net pension expense
$
82

 
$
186

 
$
120

 
$
114

 
$
202

 
$
300

 
 
 
 
 
 
 
 
 
 
 
 
Net pension expense includes actuarial loss amortization of $0.4 million and $0.5 million for the three months ended May 31, 2016 and 2015, respectively. We made no contributions to the pension plan during the three months ended May 31, 2016, and do not anticipate making any contributions during the remainder of fiscal 2017; however, conditions may change where we may elect to make contributions.  The expected long-term rate of return on plan assets for the pension plan was 7.75% as of February 29, 2016.

10.    Debt

 
As of May 31
 
As of February 29
(In thousands)
2016
 
2016
Revolving credit facility
$
1,255

 
$
415,428

Term loan
300,000

 
300,000

3.86% Senior notes due 2023
60,000

 

4.17% Senior notes due 2026
120,000

 

4.27% Senior notes due 2028
120,000

 

Finance and capital lease obligations
432,286

 
414,654

Non-recourse notes payable
9,834,322

 
9,527,750

Total debt
10,867,863

 
10,657,832

Less: current portion
(333,435
)
 
(315,509
)
Less: unamortized debt issuance costs
(23,096
)
 
(21,665
)
Long-term debt, net
$
10,511,332

 
$
10,320,658


In connection with our adoption of ASU 2015-03, as discussed in Note 2, we have presented all debt issuance costs, with the exception of those related to our revolving credit facility, as a reduction of the carrying amount of the related debt liability. Prior period amounts have been reclassified to conform to the current year's presentation.

Revolving Credit Facility.    We have a $1.20 billion unsecured revolving credit facility (the “credit facility”) with various financial institutions that expires in August 2020. 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 12 months presented as a component of current portion of long-term debt.  As of May 31, 2016, the unused capacity of $1,198.7 million was fully available to us.
 
Term Loan.    We have a $300 million term loan that expires in August 2020.  The term loan accrues interest at variable rates based on the LIBOR rate, the federal funds rate, or the prime rate and interest is payable monthly.  As of May 31, 2016, $300 million remained outstanding and was classified as long-term debt as no repayments are scheduled to be made within the next 12 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.

Senior Notes. On April 27, 2016, we entered into a note purchase agreement to issue and sell an aggregate of $500 million principal amount of senior unsecured notes in a private placement to certain accredited investors. On April 27, 2016, we issued and sold under this note purchase agreement $300 million of senior unsecured notes. Borrowings under these notes are available for working capital and general corporate purposes. Interest on the notes is payable semi-annually. On June 22, 2016, we issued and sold the remaining $200 million of senior unsecured notes.
 

Page 16



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 2017, finance lease obligations were increased by $20.4 million related to leases that were modified or extended beyond their original lease term. Upon modification, the amortization of the obligation is reset, resulting in more of the lease payments being applied to interest expense in the initial years following the modification.
 
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 May 31, 2016, $8.36 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 November 2022, but may mature earlier, depending upon the repayment rate of the underlying auto loan receivables. 
 
As of May 31, 2016, $1.47 billion of non-recourse notes payable was outstanding related to our warehouse facilities. The combined warehouse facility limit was $2.50 billion, and unused warehouse capacity totaled $1.03 billion.  Of the combined warehouse facility limit, $1.00 billion will expire in August 2016 and $1.50 billion will expire in February 2017.  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.  For the three months ended May 31, 2016 and 2015, we capitalized interest of $2.6 million and $2.8 million, respectively.
 
Financial Covenants.  The credit facility, term loan and senior note 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 May 31, 2016, 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
As of May 31, 2016, our board of directors has authorized the repurchase of up to $3.80 billion of our common stock. At that date, $1.27 billion was available for repurchase under the board's outstanding authorization. On June 28, 2016, our board of directors further authorized the repurchase of up to an additional $750 million of our common stock. At the same time, the board removed the expiration date of the outstanding repurchase authorizations.  
 
Common Stock Repurchases
 
Three Months Ended
 
May 31
 
2016
 
2015
Number of shares repurchased (in thousands)
2,569.6

 
1,776.9

Average cost per share
$
51.39

 
$
67.49

Available for repurchase, as of end of period (in millions)
$
1,266.0

 
$
2,249.3

 
(B) Stock Incentive Plans
We maintain long-term incentive plans for management, certain 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/or restricted stock awards.  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 seven 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 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- or three-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
 
May 31
(In thousands)
2016
 
2015
Cost of sales
$
1,360

 
$
1,048

CarMax Auto Finance income
904

 
157

Selling, general and administrative expenses
29,583

 
22,573

Share-based compensation expense, before income taxes
$
31,847

 
$
23,778

 

Page 18



Composition of Share-Based Compensation Expense – By Grant Type
 
Three Months Ended
 
May 31
(In thousands)
2016
 
2015
Nonqualified stock options
$
13,131

 
$
8,680

Cash-settled restricted stock units
12,376

 
10,873

Stock-settled market stock units
3,650

 
2,896

Stock-settled performance stock units
2,133

 
894

Employee stock purchase plan
410

 
369

Restricted stock awards
147

 
66

Share-based compensation expense, before income taxes
$
31,847

 
$
23,778


Unrecognized Share-Based Compensation Expense – By Grant Type
 
As of May 31, 2016
(Costs in millions)
Unrecognized Compensation Costs
 
Weighted Average Remaining Recognition Life (Years)
Nonqualified stock options
$
51.3

 
2.8
Stock-settled market stock units
18.5

 
1.7
Stock-settled performance stock units
5.1

 
2.3
Restricted stock
1.0

 
2.2
Total
$
75.9

 
2.5
 
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 three months ended May 31, 2016 or 2015.

Stock Option Activity
 
 
 
Weighted Average
 
 
 
 
 
 
 
Remaining
 
Aggregate
 
Number of
 
Exercise
 
Contractual
 
Intrinsic
(Shares and intrinsic value in thousands)
Shares
 
Price
 
Life (Years)
 
Value
Outstanding as of February 29, 2016
7,322

 
$
44.67

 
 
 
 

Options granted
2,155

 
$
51.66

 
 
 
 

Options exercised
(172
)
 
$
24.07

 
 
 
 

Outstanding as of May 31, 2016
9,305

 
$
46.67

 
4.7
 
$
92,616

 
 
 
 
 
 
 
 
Exercisable as of May 31, 2016
4,842

 
$
39.26

 
3.4
 
$
76,609









Page 19



Stock Option Information
 
Three Months Ended May 31
 
2016
 
2015
Options granted
2,154,718

 
1,374,013

Weighted average grant date fair value per share
$
14.19

 
$
20.61

Cash received from options exercised (in millions)
$
4.1

 
$
34.3

Intrinsic value of options exercised (in millions)
$
4.9

 
$
53.0

Realized tax benefits from exercises (in millions)
$
1.9

 
$
21.2

 
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.

Assumptions Used to Estimate Option Values
 
Three Months Ended May 31
 
2016
 
2015
Dividend yield
 
 
0.0
%
 
 
 
0.0
%
Expected volatility factor (1)  
30.4
%
33.9
%
 
27.7
%
31.0
%
Weighted average expected volatility
 

 
30.8
%
 
 
 
30.6
%
Risk-free interest rate (2)     
0.18
%
1.6
%
 
0.02
%
1.9
%
Expected term (in years) (3)  
 
 
4.6

 
 

 
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.
 
Cash-Settled Restricted Stock Unit Activity
 
 
 
Weighted Average
 
Number of
 
Grant Date
(Units in thousands)
Units
 
Fair Value
Outstanding as of February 29, 2016
1,320

 
$
52.70

Stock units granted
632

 
$
51.63

Stock units vested and converted
(428
)
 
$
42.76

Stock units cancelled
(29
)
 
$
54.84

Outstanding as of May 31, 2016
1,495

 
$
55.05


Cash-Settled Restricted Stock Unit Information
 
Three Months Ended May 31
 
2016
 
2015
Stock units granted
631,907

 
418,070

Initial grant date fair value per share
$
51.63

 
$
73.76

Payments (before payroll tax withholdings) upon vesting (in millions)
$
22.9

 
$
32.6

Realized tax benefits from vesting (in millions)
$
9.0

 
$
13.1

 

Page 20



Expected Cash Settlement Range Upon Restricted Stock Unit Vesting
 
As of May 31, 2016
(In thousands)
Minimum (1)
 
Maximum (1)
Fiscal 2018
$
15,901

 
$
42,404

Fiscal 2019
18,770

 
50,053

Fiscal 2020
20,133

 
53,688

Total expected cash settlements
$
54,804

 
$
146,145


(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 29, 2016
543

 
$
60.90

Stock units granted
169

 
$
63.97

Stock units vested and converted
(210
)
 
$
52.00

Outstanding as of May 31, 2016
502

 
$
65.65

 
Stock-Settled Market Stock Unit Information
 
Three Months Ended May 31
 
2016
 
2015
Stock units granted
168,681

 
105,529

Weighted average grant date fair value per share
$
63.97

 
$
90.46

Realized tax benefits from vesting (in millions)
$
5.2

 
$
16.3

 
Stock-Settled Performance Stock Unit Activity
 
 
 
Weighted Average
 
Number of
 
Grant Date
(Units in thousands)
Units
 
Fair Value
Outstanding as of February 29, 2016
66

 
$
72.58

Stock units granted
83

 
$
51.63

Outstanding as of May 31, 2016
149

 
$
60.94

 
Stock-Settled Performance Stock Unit Information
 
Three Months Ended May 31
 
2016
 
2015
Stock units granted
83,032

 
66,446

Weighted average grant date fair value per share
$
51.63

 
$
72.58


Page 21



Restricted Stock Awards Activity
 
 
 
Weighted
 
 
 
Average
 
Number of
 
Grant Date
(Units in thousands)
Units
 
Fair Value
Outstanding as of February 29, 2016
17

 
$
68.16

Restricted stock granted
20

 
$
51.63

Outstanding as of May 31, 2016
37

 
$
59.26


Restricted Stock Awards Information
 
Three Months Ended May 31
 
2016
 
2015
Restricted stock granted
19,998

 

Weighted average grant date fair value per share
$
51.63

 
$


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.

Basic and Dilutive Net Earnings Per Share Reconciliations
 
Three Months Ended
 
May 31
(In thousands except per share data)
2016
 
2015
Net earnings
$
175,360

 
$
181,974

 
 
 
 
Weighted average common shares outstanding
193,531

 
208,698

Dilutive potential common shares:
 
 
 
Stock options
1,248

 
2,158

Stock-settled stock units and awards
474

 
796

Weighted average common shares and dilutive potential common shares
195,253

 
211,652

 
 
 
 
Basic net earnings per share
$
0.91

 
$
0.87

Diluted net earnings per share
$
0.90

 
$
0.86

 
Certain options to purchase shares of common stock were outstanding and not included in the calculation of diluted net earnings per share because their inclusion would have been antidilutive.  On a weighted average basis, for the three months ended May 31, 2016 and 2015, options to purchase 2,610,461 shares and 812,356 shares of common stock, respectively, were not included.


Page 22



13.    Accumulated Other Comprehensive Loss
 
Changes in Accumulated Other Comprehensive Loss By Component
 
 
 
 
 
Total
 
Net
 
 
 
Accumulated
 
Unrecognized
 
Net
 
Other
 
Actuarial
 
Unrecognized
 
Comprehensive
(In thousands, net of income taxes)
Losses
 
Hedge Losses
 
Loss
Balance as of February 29, 2016
$
(56,470
)
 
$
(13,726
)
 
$
(70,196
)
Other comprehensive income before reclassifications

 
1,415

 
1,415

Amounts reclassified from accumulated other comprehensive loss
249

 
1,707

 
1,956

Other comprehensive income
249

 
3,122

 
3,371

Balance as of May 31, 2016
$
(56,221
)
 
$
(10,604
)
 
$
(66,825
)
 
Changes In and Reclassifications Out of Accumulated Other Comprehensive Loss
 
Three Months Ended May 31
(In thousands)
2016
 
2015
Retirement Benefit Plans (Note 9):
 
 
 
Actuarial loss amortization reclassifications recognized in net pension expense:
 
 
 
Cost of sales
$
157

 
$
195

CarMax Auto Finance income
9

 
11

Selling, general and administrative expenses
221

 
283

Total amortization reclassifications recognized in net pension expense
387

 
489

Tax expense
(138
)
 
(183
)
Amortization reclassifications recognized in net pension expense, net of tax
249

 
306

Net change in retirement benefit plan unrecognized actuarial losses, net of tax
249

 
306

 
 
 
 
Cash Flow Hedges (Note 5):
 
 
 
Effective portion of changes in fair value
2,331

 
(4,316
)
Tax (expense) benefit
(916
)
 
1,698

Effective portion of changes in fair value, net of tax
1,415

 
(2,618
)
Reclassifications to CarMax Auto Finance income
2,813

 
2,051

Tax expense
(1,106
)
 
(806
)
Reclassification of hedge losses, net of tax
1,707

 
1,245

Net change in cash flow hedge unrecognized losses, net of tax
3,122

 
(1,373
)
Total other comprehensive income (loss), net of tax
$
3,371

 
$
(1,067
)
 
Changes in the funded status of our retirement plans and the effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges are recognized in accumulated other comprehensive loss.  The cumulative balances are net of deferred taxes of $40.2 million as of May 31, 2016, and $42.4 million as of February 29, 2016.
  

Page 23



14.    Supplemental Cash Flow Information

Supplemental disclosures of cash flow information:

 
Three Months Ended May 31
(In thousands)
2016
 
2015
Non-cash investing and financing activities:
 

 
 

(Decrease) increase in accrued capital expenditures
$
(10,634
)
 
$
5,820

Increase in finance and capital lease obligations
$
20,392

 
$


15.    Contingent Liabilities
 
LitigationOn 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; (5) unfair competition; and (6) California’s Labor Code Private Attorney General Act.  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 claims then remaining in the lawsuit regarding the sales consultant putative class were: (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; (3) unfair competition; and (4) California’s Labor Code Private Attorney General Act.  On March 30, 2016, the remaining claims asserted by Fowler were settled for an immaterial amount. The non-Private Attorney General Act claims asserted by Areso are subject to arbitration. Areso's Private Attorney General Act claim is stayed in the California state court, pending the arbitration. Subject to obtaining court approval, the parties have reached a settlement of the state court lawsuit and the arbitration for an immaterial amount. The proposed settlement amount has been accrued. The Areso lawsuit seeks compensatory and special damages, wages, interest, civil and statutory penalties, restitution, injunctive relief and the recovery of attorneys’ fees.

On October 15, 2015, CarMax Auto Superstores California, LLC, and CarMax Auto Superstores West Coast, Inc. were served with a complaint filed on behalf of Mr. Craig Weiss in the Superior Court of California, County of Placer, asserting Private Attorney General Act violations. The Private Attorney General Act action is based on the following allegations with respect to CarMax sales consultants in California: (1) failure to compensate at least the minimum wage for all hours worked; (2) not providing accurate wage statements that showed all wages earned, all hours worked, all applicable pay rates, all applicable piece rates, all units earned, and applicable commission rates; (3) not indemnifying for employment-related expenses, including the cost of using personal cell phones to perform business tasks; (4) not maintaining documentation of the actual hours worked each day, all wages earned and meal breaks taken; and (5) not paying all wages due and owing upon termination of employment. The Weiss lawsuit seeks civil penalties, fines, cost of suit, and the recovery of attorneys’ fees. We are unable to make a reasonable estimate of the amount or range of loss that could result from an unfavorable outcome in this matter.

We are involved in various other legal proceedings in the normal course of business.  Based upon our evaluation of information currently available, we believe that the ultimate resolution of any such proceedings will not have a material adverse effect, either individually or in the aggregate, on our financial condition, results of operations or cash flows.
 
Other Matters.  In accordance with the terms of real estate lease agreements, we generally agree to indemnify the lessor from certain liabilities arising as a result of the use of the leased premises, including environmental liabilities and repairs to leased property upon termination of the lease.  Additionally, in accordance with the terms of agreements entered into for the sale of properties, we generally agree to indemnify the buyer from certain liabilities and costs arising subsequent to the date of the sale, including environmental liabilities and liabilities resulting from the breach of representations or warranties made in accordance with the agreements.  We do not have any known material environmental commitments, contingencies or other indemnification issues arising from these arrangements.

Page 24



As part of our customer service strategy, we guarantee the used vehicles we retail with at least a 30-day limited warranty.  A vehicle in need of repair within this period will be repaired free of charge.  As a result, each vehicle sold has an implied liability associated with it.  Accordingly, based on historical trends, we record a provision for estimated future repairs during the guarantee period for each vehicle sold.  The liability for this guarantee was $5.5 million as of May 31, 2016, and $6.1 million as of February 29, 2016, and is included in accrued expenses and other current liabilities.
 


Page 25



ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements, the accompanying notes and the MD&A included in our Annual Report on Form 10-K for the fiscal year ended February 29, 2016 (“fiscal 2016”), as well as our consolidated financial statements and the accompanying notes included in Item 1 of this Form 10-Q.  Note references are to the notes to consolidated financial statements included in Item 1.  All references to net earnings per share are to diluted net earnings per share.  Certain prior year amounts have been reclassified to conform to the current year’s presentation.  Amounts and percentages may not total due to rounding.

OVERVIEW
 
CarMax is the nation’s largest retailer of used vehicles.  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 financing to customers buying retail vehicles from CarMax.
 
CarMax Sales Operations
Our sales operations segment consists of retail sales of used vehicles and related products and services, such as wholesale vehicle sales; the sale of extended protection plan (“EPP”) products, which include extended service plans (“ESPs”) and guaranteed asset protection (“GAP”); and vehicle repair service.  GAP is designed to cover the unpaid balance on an auto loan in the event of a total loss of the vehicle or unrecovered theft.  We focus on addressing the major sources of customer dissatisfaction with traditional auto retailers while maximizing operating efficiencies.  We offer low, no-haggle prices; a broad selection of CarMax Quality Certified used vehicles; value-added EPP products; and superior customer service. Our website and related mobile apps are tools for communicating the CarMax consumer offer in detail, sophisticated search engines for finding the right vehicle and sales channels for customers who prefer to initiate the shopping and sales process online. 
 
Our customers finance the majority of the retail vehicles purchased from us, and availability of on-the-spot financing is a critical component of the sales process.  We provide financing to qualified retail customers through CAF and our arrangements with industry-leading third-party finance providers.  All of the finance offers, whether by CAF or our third-party providers, are backed by a 3-day payoff option. 
 
As of May 31, 2016, we operated 160 used car stores in 80 U.S. markets, covering 51 mid-sized markets, 23 large markets and 6 small markets.  We define mid-sized markets as those with television viewing populations generally between 600,000 and 3 million people.  As of that date, we also conducted wholesale auctions at 67 used car stores and we operated 2 new car franchises. 
 
CarMax Auto Finance
In addition to third-party financing providers, we provide vehicle financing through CAF, which offers financing solely to customers buying retail vehicles from CarMax.  CAF allows us to manage our reliance on third-party financing providers and to leverage knowledge of our business to provide qualifying customers a competitive financing option.  As a result, we believe CAF enables us to capture additional profits, cash flows and sales.  After the effect of 3-day payoffs and vehicle returns, CAF financed 43.9% of our retail used vehicle unit sales in the first three months of fiscal 2017.  As of May 31, 2016, CAF serviced approximately 735,000 customer accounts in its $9.91 billion portfolio of managed receivables. 
 
Management regularly analyzes CAF’s operating results by assessing the competitiveness of our consumer offer, profitability, the performance of the auto loan receivables including trends in credit losses and delinquencies, and CAF direct expenses.
 
Revenues and Profitability -- Three Months Ended May 31, 2016
During the first quarter of fiscal 2017, net sales and operating revenues increased 2.8%, net earnings declined 3.6% and net earnings per share increased 4.7% versus the corresponding prior year period.  Our ongoing share repurchase program contributed to our earnings per share growth.
 
Our primary source of revenue and net income is the retail sale of used vehicles.  During the first quarter of fiscal 2017, we sold 171,076 used vehicles, representing 83.1% of our net sales and operating revenues and 65.8% of our gross profit.  Used vehicle unit sales grew 4.0%, including a 0.2% increase in comparable store used units and sales from newer stores not yet included in

Page 26



our comparable store base.  Used vehicle gross profits increased 4.1%, driven by the increase in total used unit sales. Used vehicle gross profit per unit was consistent at $2,202 versus $2,200 in the prior year's first quarter.

Wholesale sales are also a significant contributor to our revenues and net income.  During the first quarter of fiscal 2017, we sold 103,462 wholesale vehicles, representing 13.8% of our net sales and operating revenues and 18.0% of our gross profit.  Wholesale vehicle unit sales grew 1.8%, primarily reflecting the growth in our store base. Wholesale vehicle gross profits declined 1.9%, as the increase in wholesale unit sales was offset by a decrease in wholesale vehicle gross profit per unit to $995 from $1,032 in the prior year's first quarter.
 
During the first quarter of fiscal 2017, other sales and revenues, which include revenue earned on the sale of EPP products, net third-party finance fees, and service department and new vehicle sales, represented 3.1% of our net sales and operating revenues and 16.3% of our gross profit. Other sales and revenues declined 10.9% in the first quarter versus the prior year period. The decline primarily reflected a decrease in new vehicle sales resulting from the disposal of two of our four new car franchises during fiscal 2016. Other gross profit rose 20.9%, reflecting improvements in EPP revenues and net third-party finance fees. The decrease in new vehicle sales did not significantly affect other gross profit.   
 
Income from our CAF segment totaled $100.8 million in the first quarter of fiscal 2017, down 7.7% compared with the prior year period.  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 expenses.  CAF income does not include any allocation of indirect costs.  The decline in CAF income reflected the combination of an increase in the provision for loan losses and a lower total interest margin percentage, partially offset by the effects of an increase in average managed receivables. The increase in the provision for loan losses was due to the combination of favorable loss experience in the prior year's quarter, which reduced last year's provision; some unfavorable loss experience in the current year's quarter; and the growth in managed receivables.

Selling, general and administrative expenses increased 8.7% to $380.2 million, reflecting the 11% increase in our store base since the beginning of the first quarter of fiscal 2016, as well as a $7.0 million increase in share-based compensation expense.
 
Liquidity
Our primary ongoing sources of liquidity include funds provided by operations, proceeds from securitization transactions, and borrowings under our revolving credit facility or through other financing sources.  During the first three months of fiscal 2017, net cash provided by operations totaled $85.4 million. This amount, combined with $306.6 million of net issuances of non-recourse notes payable, resulted in $392.0 million of adjusted net cash provided by operating activities (a non-GAAP measure). This liquidity was primarily used to fund the increase in CAF auto loan receivables, the 2.6 million common shares repurchased under our share repurchase program, payments on outstanding borrowings and our store growth.

When considering cash provided by operating activities, management does not include increases in auto loan receivables that have been securitized with non-recourse notes payable, which are separately reflected as cash provided by financing activities.  For a reconciliation of adjusted net cash provided by operating activities to net cash provided by operating activities, the most directly comparable GAAP financial measure, see “Reconciliation of Adjusted Net Cash from Operating Activities” included in “Financial Condition – Liquidity and Capital Resources.”
 
Future Outlook
Over the long-term, we believe the primary driver for earnings growth will be vehicle unit sales growth from both new stores and stores included in our comparable store base.  We also believe that increased used vehicle unit sales will drive increased sales of wholesale vehicles and ancillary products and, over time, increased CAF income.  To expand our vehicle unit sales at new and existing stores, we will need to continue delivering an unrivaled customer experience in stores and online. We also will need to continue hiring and developing the associates necessary to drive our success, while managing the risks posed by an evolving competitive environment.  In addition, to support our store growth plans, we will need to continue procuring suitable real estate at favorable terms. 
 
We are still in the midst of the national rollout of our retail concept, and as of May 31, 2016, we had used car stores located in markets that represented approximately 68% of the U.S. population.  During the first three months of fiscal 2017, we opened two stores, and during the remainder of the fiscal year, we plan to open thirteen stores.  In fiscal 2018, we plan to open between 13 and 16 stores.   For a detailed list of stores we plan to open in the 12 months following May 31, 2016, see the table included in “Planned Future Activities.”

A significant portion of our used vehicle inventory is sourced from local, regional and online wholesale auto auctions. Wholesale vehicle prices are influenced by a variety of factors, including the supply of vehicles available at auction relative to dealer demand.

Page 27



Industry sources predict that there will be a continued influx in off-lease vehicles in coming years, which will significantly increase the volume of late-model vehicles available at auction relative to dealer demand. This could reduce wholesale auction prices, our vehicle acquisition costs and CAF recovery rates, although no clear trend in this direction has emerged.
 
For additional information about risks and uncertainties facing our Company, see “Risk Factors,” included in Part I. Item 1A of the Annual Report on Form 10-K for the fiscal year ended February 29, 2016.

CRITICAL ACCOUNTING POLICIES
 
For information on critical accounting policies, see “Critical Accounting Policies” in MD&A included in Item 7 of the Annual Report on Form 10-K for the fiscal year ended February 29, 2016.  These policies relate to financing and securitization transactions, revenue recognition and income taxes.

RESULTS OF OPERATIONS – CARMAX SALES OPERATIONS
 
NET SALES AND OPERATING REVENUES
 
Three Months Ended May 31
(In millions)
2016
 
2015
 
Change
Used vehicle sales
$
3,429.0

 
$
3,292.7

 
4.1
 %
Wholesale vehicle sales
567.7

 
576.6

 
(1.5
)%
Other sales and revenues:
 

 
 

 
 

Extended protection plan revenues
76.2

 
71.7

 
6.3
 %
Third-party finance fees, net
(11.9
)
 
(17.0
)
 
29.8
 %
Other (1)
65.4

 
90.9

 
(28.1
)%
Total other sales and revenues
129.7

 
145.6

 
(10.9
)%
Total net sales and operating revenues
$
4,126.4

 
$
4,014.9

 
2.8
 %
 
(1)
Includes service department and new vehicle sales. In the fourth quarter of fiscal 2016, we reclassified new vehicle sales to other sales and revenues and no longer separately present new vehicle sales. Prior period amounts have been revised for this new presentation.

UNIT SALES
 
Three Months Ended May 31
 
2016
 
2015
 
Change
Used vehicles
171,076

 
164,510

 
4.0
%
Wholesale vehicles
103,462

 
101,630

 
1.8
%
 
AVERAGE SELLING PRICES
 
Three Months Ended May 31
 
2016
 
2015
 
Change
Used vehicles
$
19,858

 
$
19,851

 
0.0
 %
Wholesale vehicles
$
5,268

 
$
5,449

 
(3.3
)%
 
COMPARABLE STORE USED VEHICLE SALES CHANGES
 
Three Months Ended May 31
 
2016
 
2015
Used vehicle units
0.2
%
 
4.9
%
Used vehicle revenues
0.3
%
 
3.4
%
 
Stores are added to the comparable store base beginning in their fourteenth full month of operation. We do not remove renovated stores from our comparable store base, but we have removed a relocated store from our comparable store base. Comparable store

Page 28



calculations include results for a set of stores that were included in our comparable store base in both the current and corresponding prior year periods.

VEHICLE SALES CHANGES
 
Three Months Ended May 31
 
2016
 
2015
Used vehicle units
4.0
 %
 
9.3
%
Used vehicle revenues
4.1
 %
 
7.6
%
 
 
 
 
Wholesale vehicle units
1.8
 %
 
4.7
%
Wholesale vehicle revenues
(1.5
)%
 
5.8
%
 
CHANGE IN USED CAR STORE BASE
 
Three Months Ended May 31
 
2016
 
2015
Used car stores, beginning of period
158

 
144

Store openings
2

 
3

Used car stores, end of period
160

 
147

 
During the first three months of fiscal 2017, we opened two stores, both in new markets, including one in Springfield, Illinois, and one in San Francisco, California.  

Used Vehicle Sales.  The 4.1% increase in used vehicle revenues in the first quarter of fiscal 2017 resulted from a 4.0% increase in used unit sales. The increase in used unit sales included a 0.2% increase in comparable store used unit sales and sales from newer stores not yet included in the comparable store base.  The comparable store used unit sales performance reflected the combination of an improvement in conversion that largely offset a decrease in store traffic. We believe that the decline in traffic was primarily due to a decrease in our Tier 3 sales mix, which fell to 11.9% of used unit sales, before the impact of 3-day payoffs, in the current year's first quarter from 14.7% in the prior year's first quarter. Tier 3 sales include those financed by our Tier 3 third-party finance providers and CAF's Tier 3 loan originations. The decline in Tier 3 sales mix was the result of a combination of lower applicant volume within this credit tier, as well as some observed tightening of lending standards by one of our third-party Tier 3 finance providers. This finance provider has publicly discussed that they are contracting in this segment of the industry. Historically, the Tier 3 rate of conversion of credit applications to sales has been significantly lower than that in other credit tiers. As a result, we believe a decline in Tier 3 sales mix typically represents a disproportionate decline in underlying customer traffic. For the non-Tier 3 customer base, comparable store used unit sales rose 3.6%.

Wholesale Vehicle Sales.    Our wholesale auction prices usually reflect the trends in the general wholesale market for the types of vehicles we sell, although they can also be affected by changes in vehicle mix or the average age, mileage or condition of the vehicles bought through our appraisal process and sold in our auctions. 

The 1.5% decrease in wholesale vehicle revenues in the first quarter of fiscal 2017 resulted from a 1.8% increase in wholesale unit sales that was more than offset by a 3.3% decrease in wholesale vehicle average selling price.  The wholesale vehicle unit sales growth was primarily driven by the growth in our store base.    
 
Other Sales and Revenues.  Other sales and revenues include revenue from the sale of ESPs and GAP (collectively reported in EPP revenues, net of a reserve for estimated contract cancellations), net third-party finance fees, and other revenues, which are predominantly comprised of service department and new vehicle sales. We refer to the third-party finance providers who generally pay us a fee or to whom no fee is paid as Tier 2 providers, and we refer to the providers to whom we pay a fee as Tier 3 providers. The fees we pay to the Tier 3 providers are reflected as an offset to finance fee revenues received from the Tier 2 providers. The mix of our retail vehicles financed by CAF, Tier 2 and Tier 3 providers, or customers that arrange their own financing, may vary from quarter to quarter depending on several factors including the credit quality of applicants, changes in providers’ credit decisioning and external market conditions. Changes in originations by one tier of credit providers may also affect the originations made by providers in other tiers. Our Tier 2 providers financed 17.4% of our used vehicle units, before the impact of 3-day payoffs, in the first quarter of fiscal 2017 compared with 18.0% in the prior year period.
 

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Other sales and revenues declined 10.9% in the first quarter of fiscal 2017, primarily reflecting a decrease in new vehicle sales due to the disposal of two of our four new car franchises in fiscal 2016.  EPP revenues increased 6.3% compared with the prior year’s quarter, largely reflecting improved margins and the growth in our used unit sales. Net third-party finance fees improved 29.8% versus the prior year's quarter primarily due to a reduction in the percentage of our used unit sales financed by Tier 3 finance providers.

Seasonality.  Historically, our business has been seasonal.  Our stores typically experience their strongest traffic and sales in the spring and summer quarters.  Sales are typically slowest in the fall quarter.  We typically experience an increase in traffic and sales in February and March, coinciding with tax refund season.

GROSS PROFIT
 
Three Months Ended May 31
(In millions)
2016
 
2015
 
Change
Used vehicle gross profit
$
376.6

 
$
361.9

 
4.1
 %
Wholesale vehicle gross profit
102.9

 
104.9

 
(1.9
)%
Other gross profit
93.1

 
77.0

 
20.9
 %
Total
$
572.6

 
$
543.8

 
5.3
 %
 
GROSS PROFIT PER UNIT
 
Three Months Ended May 31
 
2016
 
2015
 
$ per unit(1)
 
%(2)
 
$ per unit(1)
 
%(2)
Used vehicle gross profit
$
2,202

 
11.0
 
$
2,200

 
11.0
Wholesale vehicle gross profit
$
995

 
18.1
 
$
1,032

 
18.2
Other gross profit
$
544

 
71.8
 
$
468

 
52.9
Total gross profit
$
3,347

 
13.9
 
$
3,306

 
13.5

(1)  
Calculated as category gross profit divided by its respective units sold, except the other and total categories, which are divided by total used 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 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 the pace of our 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 systematically mark down individual vehicle prices based on proprietary pricing algorithms in order to appropriately balance sales trends, inventory turns and gross profit achievement.  Other factors that may influence gross profit include changes in our vehicle reconditioning costs, changes in the percentage of vehicles sourced directly from consumers through our appraisal process and changes in the wholesale pricing environment.  Vehicles purchased directly from consumers typically generate more gross profit per unit compared with vehicles purchased at auction or through other channels.
 
Used vehicle gross profit rose 4.1% in the first quarter of fiscal 2017, driven by the 4.0% increase in total used unit sales.  Despite an overall trend reported by publicly traded auto retailers toward lower gross profit per unit sold, our used vehicle gross profit per unit remained consistent with the corresponding prior year period. We believe we can manage to a targeted gross profit per unit dollar range, subject to future changes to our business or pricing strategy.

Wholesale Vehicle Gross Profit.    Our wholesale gross profit per unit reflects the demand for older, higher mileage vehicles, which are the mainstay of our auctions, as well as the continued strong dealer attendance and resulting high dealer-to-car ratios at our auctions.  The frequency of our auctions, which are generally held weekly or bi-weekly, minimizes the depreciation risk on these vehicles.  Our ability to adjust appraisal offers in response to the wholesale pricing environment is a key factor that influences wholesale gross profit. 
 

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The 1.9% decrease in wholesale gross profit in the first quarter of fiscal 2017 reflected the combination of the 1.8% increase in wholesale unit sales and the $37, or 3.6%, reduction in wholesale vehicle gross profit per unit.   
 
Other Gross Profit.  Other gross profit includes profits related to EPP revenues, net third-party finance fees and other revenues, which are predominantly comprised of service department operations, including used vehicle reconditioning, and new vehicle sales.  We have no cost of sales related to EPP revenues or net third-party finance fees, as these represent revenues paid to us by certain third-party providers.  Third-party finance fees are reported net of the fees we pay to Tier 3 finance providers.  Accordingly, changes in the relative mix of the other gross profit components can affect the composition and amount of other gross profit.
 
Other gross profit rose 20.9% in the first quarter of fiscal 2017, primarily reflecting the improvements in EPP revenues and net third-party finance fees discussed above, as well as some favorability in service department profits. The decrease in new vehicle sales did not significantly affect other gross profit.
 
Impact of Inflation.  Historically, inflation has not had a significant impact on results.  Profitability is primarily affected by our ability to achieve targeted unit sales and gross profit dollars per vehicle rather than by changes in average retail prices.  However, changes in average vehicle selling prices impact CAF income, to the extent the average amount financed also changes.
 
Selling, General and Administrative ("SG&A") Expenses

COMPONENTS OF SG&A EXPENSE
 
Three Months Ended May 31
(In millions except per unit data)
2016
 
2015
 
Change
Compensation and benefits (1)
$
216.6

 
$
201.8

 
7.3
%
Store occupancy costs
71.7

 
65.3

 
9.8
%
Advertising expense
34.8

 
33.7

 
3.3
%
Other overhead costs (2)
57.1

 
49.0

 
16.5
%
Total SG&A expenses
$
380.2

 
$
349.8

 
8.7
%
SG&A per used vehicle unit (3)
$
2,223

 
$
2,126

 
$
97


(1)     Excludes compensation and benefits related to reconditioning and vehicle repair service, which are included in cost of sales.
(2)  
Includes IT expenses, insurance, non-CAF bad debt, travel, preopening and relocation costs, charitable contributions and other administrative expenses.
(3)  
Calculated as total SG&A expenses divided by total used vehicle units.
 
SG&A expenses increased 8.7% in the first quarter of fiscal 2017. The increase primarily reflected the 11% growth in our store base since the beginning of last year’s first quarter (representing the addition of 16 stores), a $7.0 million increase in share-based compensation expense, and weather related expenses.  SG&A per retail unit increased $97 in the first quarter of fiscal 2017, of which $36 was attributable to the higher share-based compensation expense.
 
Interest Expense.  Interest expense includes the interest related to short- and long-term debt and finance and capital lease obligations.  It does not include interest on the non-recourse notes payable, which is reflected within CAF income.
 
Interest expense rose to $11.1 million in the first quarter of fiscal 2017, from $7.1 million. The increase reflected the combination of growth in our finance and capital lease obligations, which resulted from the recent extension of select store leases beyond their original term, as well as higher average outstanding debt levels in fiscal 2017 undertaken in an effort to achieve our targeted adjusted debt to total capital ratio. See “Financial Condition – Liquidity and Capital Resources” for further discussion. During the current year's quarter, we entered into a note purchase agreement to sell $500 million of senior unsecured notes, due in 2023, 2026 and 2028, to investors in a private placement. Of this amount, $300 million was sold during the first quarter of fiscal 2017 and the remaining $200 million was sold in the second quarter. The proceeds of the first quarter sale of notes were primarily used to reduce outstanding revolving credit borrowings.

Income Taxes.    The effective income tax rate was 38.0% in the first quarter of fiscal 2017 versus 38.5% in the first quarter of fiscal 2016.    


Page 31



RESULTS OF OPERATIONS – CARMAX AUTO FINANCE
 
CAF income primarily reflects the interest and fee income generated by CAF’s portfolio of 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.
 
CAF’s managed portfolio is composed primarily of loans originated over the past several years. Trends in receivable growth and interest margins primarily reflect the cumulative effect of changes in the business over a multi-year period. We strive to originate loans with an underlying risk profile that we believe will, in the aggregate and excluding CAF's Tier 3 originations, result in cumulative net losses in the 2% to 2.5% range over the life of the loans. Actual loss performance of the loans may fall outside of this range based on various factors, including intentional changes in the risk profile of originations, economic conditions and wholesale recovery rates. Current period originations reflect current trends in both our retail sales and the CAF business, including the volume of loans originated, current interest rates charged to consumers, loan terms and average credit scores. Because we recognize CAF income over the life of the underlying auto loan, loans originated in a given fiscal period generally do not have a significant effect on that period’s financial results.

See Note 3 for additional information on CAF income and Note 4 for information on auto loan receivables, including credit quality. 

SELECTED CAF FINANCIAL INFORMATION
 
Three Months Ended May 31
(In millions)
2016
 
% (1)

 
2015
 
% (1)

Interest margin:
 
 
 
 
 
 
 
Interest and fee income
$
184.1

 
7.6

 
$
164.9

 
7.6

Interest expense
(39.4
)
 
(1.6
)
 
(28.1
)
 
(1.3
)
Total interest margin
$
144.7

 
5.9

 
$
136.8

 
6.3

Provision for loan losses
$
(26.6
)
 
(1.1
)
 
$
(13.6
)
 
(0.6
)
CarMax Auto Finance income
$
100.8

 
4.1

 
$
109.1

 
5.0


(1)     Percentage of total average managed receivables (quarterly amounts are annualized).

CAF ORIGINATION INFORMATION
 
Three Months Ended May 31 (1)
 
2016
 
2015
Net loans originated (in millions)
$
1,443.4

 
$
1,364.7

Vehicle units financed 
75,084

 
70,293

Penetration rate (2)
43.9
%
 
42.7
%
Weighted average contract rate
7.5
%
 
7.4
%
Weighted average credit score (3)
703

 
698

Weighted average loan-to-value (LTV) (4)
94.4
%
 
94.4
%
Weighted average term (in months)
66.0

 
65.8


(1)     All information relates to loans originated net of 3-day payoffs and vehicle returns.
(2)     Vehicle units financed as a percentage of total used units sold.
(3)  
The credit scores represent FICO scores, and reflect only receivables with obligors that have a FICO score at the time of application. The FICO score with respect to any receivable with co-obligors is calculated as the average of each obligor’s FICO score at the time of application. FICO scores are not a significant factor in our primary scoring model, which relies on information from credit bureaus and other application information as discussed in Note 4.  FICO® is a federally registered servicemark of Fair Isaac Corporation.
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