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CarMax, Inc. (NYSE:KMX)

Q4 2010 Earnings Call

April 1, 2010 9:00 am ET

Executives

Katharine Kenny – VP IR

Tom Folliard – President & CEO

Keith Browning – EVP & CFO

Analysts

Jaison Blair - Rochdale Securities

Sharon Zackfia – William Blair

Simeon Gutman – Credit Suisse

Ivan Holman – RBC Capital Markets

Craig Kennison – Robert W. Baird

[John Nabb – AgriCapital Management]

Matthew Fassler – Goldman Sachs

Rod Lache – Deutsche Bank

Bill Armstrong – CL King & Associates

William Truelove – UBS

Matt Nemer – Wells Fargo Securities

Scott Stember – Sidoti & Company

Operator

Good morning ladies and gentlemen. At this time I would like to welcome everyone to the CarMax fourth quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Katharine Kenny, Vice President Investor Relations, may begin your conference.

Katharine Kenny

Good morning. Thank you all for joining us today. My name is Katharine Kenny, I up Investor Relations at CarMax and this is our fourth quarter earnings conference call. I guess I should also say Happy April Fools Day, but one thing we will not fool you about and that is that this is our last quarter was gain on sale accounting.

On the call with me today are Tom Folliard, our President and Chief Executive Officer and Keith Browning, our Executive Vice President and Chief Financial Officer.

Before we begin let me remind you that our statements today regarding the company’s future business plans, prospects, and financial performance are forward-looking statements that we make pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

These statements are based on management’s current knowledge and assumptions about future events that involve risks and uncertainties that could cause actual results to differ materially from our expectations.

In providing protections and other forward-looking statements, the company disclaims any intent or obligation to update them. For additional information on important factors that could affect these expectations please see the company’s Annual Report on Form 10-K for the fiscal year ended February 28, 2009, filed with the SEC.

Tom Folliard

Good morning everyone, thank you Katharine for that witty introduction. Well despite the challenges we faced this year due to the recession, we’re very pleased to report record fiscal year results for CarMax.

I want to thank all of our associates for their commitment in helping us achieve these results. During the year we had several noteworthy accomplishments and I’d like to list just a few of them. We improved our margins on both retail and wholesale vehicles during the year.

We improved our sales execution or conversion rates so that’s the percentage of customers who walk in the door, how many of those buy a car from us, we improved that during the year. We increased our inventory turns for the full year. At year-end we have now achieved a total sustainable reduction of approximately $200 per car in reconditioning costs.

This includes $100 we previously announced in June. We did that while at the same time improving our quality as measured by our 30-day comeback ratio and our customer surveys. We also aggressively controlled our SG&A expenses and we not only reported a record year at CAF, but we also successfully navigated the most difficult credit environment in our history.

Additionally we increased our market share by over 10%. Now let me talk a little about the fourth quarter, total revenues increased by 25% and comp store used unit sales increased 12% compared a decrease of 26% last year.

Net earnings doubled to $75 million or $0.33 per share compared to $37 million or $0.17 per share in the fourth quarter of 2009. Let me briefly review our key financial results for the quarter in a little more detail.

First in sales, improved traffic and sales execution contributed about equally to the 12% growth in comp used unit sales which was also a reflection of our easiest comparison of the year. The 24% increase in used vehicle revenues was mostly driven by the growth in sales but also a reflection of a 10% increase in average selling price.

On the gross profit, as you saw our used vehicle gross profit per unit has now remained above $2,000 for five consecutive quarters. There are several factors that contribute to our solid fourth quarter gross profit performance. As I mentioned earlier we continue to make progress in decreasing our per vehicle reconditioning cost which obviously helps our ability to achieve margin.

The year over year increase in wholesale valuations continued to provide a gross profit tailwind throughout the year. We’ve talked about that in the past. It’s the most unusual year for appreciation in the wholesale business that we’ve ever seen. Higher wholesale prices positively impacted our appraisal buy ratio which rose above 25% in the quarter and increased our inventory purchasing self-sufficiency which also supports our margin.

These factors going forward will all have impact on gross profit but remember we have direct control on only one of them. The wholesale marketplace for vehicles is uncertain and as we have seen can be very volatile, so we will continue to evaluate the marketplace and assess strategies that will allow us to optimize sales and profitability in the future.

I’ll now turn it over to Keith to review CarMax Auto Finance results.

Keith Browning

Good morning, CAF’s total income this year more than doubled over last year’s fourth quarter primarily due to over $26 million in favorable adjustments related to loans originated in previous periods.

The primary drivers of this quarter’s adjustments included favorable funding for the cost of loans that were refinanced in the term securitization during the fourth quarter, net favorable valuation adjustments including a decrease in the discount rate assumption and mark-to-market write-ups in the value of our retained subordinated bonds, which now have fair value of $249 million.

The mark-to-market write-ups reflect continued narrowing in the automotive ABS spreads that has occurred over the last few months. Cash gained on loans originated and sold totaled nearly $16 million in the fourth quarters of both fiscal 2010 and 2009. This was due to several factors.

Our total loan volume increased for the fourth quarter of 2010 due to higher sales. CAF’s loan penetration which by the way is generally seasonally the lowest in the fourth quarter was approximately 28% in both fourth quarters. However the impact of these higher sales was offset by a decline in the gain percentage in the fourth quarter of 2010.

This was primarily due to the combination of decline in average interest rates charged to consumers and somewhat higher funding costs in our warehouse facility compared to last year. As most of you are aware effective March 1 we adopted new accounting rules for CAF which require us to account for term securitizations as secured borrowings going forward.

In previous years we accounted for these transactions using gain on sale accounting. On March 1 we also amended the terms of our warehouse facility and will as a result consolidate both the term and warehouse securitizations and the related non-recourse debt on our balance sheet.

We expect the cumulative effect of these changes to result in a $3.7 billion increase in total assets and a $3.8 billion increase in total liabilities. In order to assist our shareholders in this initial adoption year, we provided an estimated range of CAF pre-tax contribution in fiscal 2011 of $145 million to $185 million in this morning’s press release.

Our forecast for next year reflects the recently improved interest margin defined as the difference between consumer rates and our ultimate funding cost for our recent term securitizations. For assets currently in the warehouse facility and new originations we are assuming that interest margin begins this fiscal year at current high levels but gradually returns to more normal levels by the end of the year.

We also assume that when we renew the warehouse facility this summer our funding cost, i.e. the benchmark rates plus the spreads, will be more reflective of current market conditions than is now the case. Currently it is more expensive than the public market. In addition we assume the continued stability in the auto ABS market.

Now I’ll turn the call back over to Tom.

Tom Folliard

Thank you Keith, turning to SG&A compared to the fourth quarter of fiscal 2009 SG&A expenses increased only modestly in the fourth quarter of fiscal 2010 despite a 13% increase in total used unit sales. For the full 2010 fiscal year we were successful in significantly reducing our SG&A costs which we considered prudent given the tough environment.

However in the current fiscal year we are actually hopeful that some components of SG&A such as variable selling expenses and advertising will actually increase because this would be reflective of an improving sales and economic environment.

We will also begin to invest again in growth related expenses such as pre-opening and advertising for new stores and rebuilding our bench strength. Also assuming no economic deterioration we also plan to invest in some key initiatives to continue to enhance the CarMax model. Those include continued improvements to CarMax.com as well as several other big IT projects and additional training for all of our associates.

In closing we are pleased also to announce our intention to restart store growth. As I’ve indicated in the past our decision to restart growth would be based on improvements in sales and credit. The credit markets have obviously improved dramatically in the last year and our sales have increased steadily throughout.

While sales are not back to pre-recession levels, the positive turns that we’ve seen and our strong profitability have convinced us that moving forward with a measured plan for store growth over the next few years is the appropriate strategy.

We believe this pace will allow us to maintain the momentum we have achieved with our recent successful initiatives to increase efficiency and reduce waste, while at the same time improving the quality of our consumer offer.

So our plan for this year is to open the three stores we previously announced, those stores in Augusta, Dayton, and Cincinnati, will open in May and June of this year. Our current plan is to follow those openings with three to five stores in fiscal 2012 and five to 10 stores in fiscal 2013.

Lastly I’d like to once again express my thanks to all the CarMax associates for their commitment and for everything they did to help us achieve these phenomenal results. Now Keith and I would be happy to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jaison Blair - Rochdale Securities

Jaison Blair - Rochdale Securities

I was wondering if you could walk us through a little bit of the finer points on the math of the fiscal 2011 CAF income estimate. My understanding is that the net interest cash flows that can ebb and flow based upon the timing of originations, losses in the portfolio, and obviously also your expectations about the interest spread, however generally my understanding was that it could proxy for the cash flows of that portfolio of receivables which had been running about the $95 to $97 million plus interest on the sub bonds at $25 to $26 million plus another let’s say $1 to $2 million which would be the difference between fees and expenses which would get me to about $122 to $125 million CAF pre-tax income, so I’m trying to get a sense of how spreads are relative to a normalized level and how the $145 to $148 would compare with my math.

Katharine Kenny

I think what Jaison is asking is why this number is higher than his expectations.

Keith Browning

Its not an easy explanation, I think the real key is is that if you looked at our last public securitization the funding costs on that were extraordinarily low and yet year over year while our margin to consumers is down slightly it doesn’t nearly come down to the amount that the funding cost have. And so we are near record level spreads that we’ve seen.

And that includes what’s happened in the second half of this year and as I indicated we’re starting at those near record levels and planning them to maybe get to normal by the end of the year. And those spreads have a much larger impact than you might impact on the overall cash flow coming in and therefore the timing of the earnings.

The other thing is is you have to look at the last really five years of originations and the sales going into it along with the combined spreads and I’m sure you tried to develop the last schedule, as we’ve had to actually lay out all the details and the components of it, and the short answer is is there’s not an easy answer but I think that that’s why we gave you a range to kind of drive people to, if you look at the middle of the range that’s our best estimate and there are a lot of varied factors that could cause it to be different which is why we put a fairly large range around it.

Jaison Blair - Rochdale Securities

And if spreads were let’s say in the middle of the normal historical range what do you think that CAF number would be.

Keith Browning

I think that’s probably a level of detail that, we would want to actually do something more formal if we wanted to try to disclose what we thought changes in spreads would do going forward and that’s not out of the realm of a question, its just difficult to do. We obviously know ourselves what a 50 bps change in spreads might do to a year’s earnings, but again that’s, if you think about it again the majority of the earnings are already baked in for prior year’s originations so changes in spreads and sales don’t have the same impact as they would have under gain on sale accounting because they’re spread over the future years.

Its certainly, a 50 bps change in spread would be several million dollars, that’s probably the best direction I can give you for now.

Jaison Blair - Rochdale Securities

If I could just ask one follow-up if you could talk a little bit about the impact of the Toyota recall in the quarter.

Tom Folliard

At the time of the announcement when Toyota issued their stop sale, we immediately pulled all of that inventory off of our lot. At that time the percentage of our total used inventory that was made up of that product was actually less than 2%. So we do have two Toyota stores and obviously their sales were impacted more dramatically but that impact was not material for the company and then even on the used side, where that was less than 2% of our total inventory, we got those cars out, pulled them out and put them in reconditioning until they were fixed and then put them back out and offered them up for sale.

The net impact in the quarter was immaterial.

Jaison Blair - Rochdale Securities

Even the net impact of let’s say a halo effect on the brand.

Tom Folliard

If you look at some external data and our internal data would confirm that Toyota has absolutely taken a hit and even in the wholesale markets we’ve seen some signs whereas other product has appreciated, Toyota really hasn’t moved very much so we have seen a little slowing there but I think one of the best things about our CarMax model is we’re spread across a whole bunch of different brands and when we look at it in aggregate we don’t really see a material impact for us and more than likely those sales are picked up across lots of the other brands.

So even if we see a slowing of one brand, we’re able to adjust very quickly. As we’ve said in the past we manage our inventory on a weekly basis. If we see one segment slowing and another segment picking up then we adjust our buying accordingly and we were able to do that very effectively in the quarter.

Operator

Your next question comes from the line of Sharon Zackfia – William Blair

Sharon Zackfia – William Blair

You mentioned that your appraisal buy rate went up in the quarter and I guess I’m just curious I know that during the recession your sourcing, a little bit more towards auctions versus the consumer appraisal [land], are you back to over 50% getting sourced from consumers or are we still less than that historical rate.

Tom Folliard

No, we’re not back yet but we’ve seen, that number, that percentage is driven by two things; the appraisal traffic and then the appraisal buy ratio and also really the flow of product whether it comes in as wholesale or retail vehicles.

And what’s been great through the year is we’ve seen a very positive trend in both our traffic and our buy rate and as I mentioned in the opening that number did move during the quarter and we have seen self-sufficiency go up but it is not back to 50% yet. But its moving in the right direction and that feels great.

Sharon Zackfia – William Blair

Do you expect us to get there this year, do you think that’s within the realm of possibility. Its kind of [unclear] how far you dipped.

Tom Folliard

Yes, it’s a little hard for us to tell and again I go back to what I would consider the beauty of the way we manage our inventories, we don’t really have to project that going forward. We would be hopeful that that trend would continue and that we’d see some more normalized movement in the wholesale market but its just really difficult to predict with all the movement and volatility we’ve seen so far.

So we’re hopeful that it will keep moving in that direction but if it doesn’t, I feel confident in our ability to manage through it.

Sharon Zackfia – William Blair

And then separately on SG&A there were a lot of allusions in the press release about resuming growth and reinvesting in the business and so on, what is the right pace of SG&A spend. You used to grow your SG&A in the double-digits on a year over year basis, and I think fiscal 2009 we were a low single and obviously went down last year, are we looking at a low single-digit rate of SG&A spend on a dollar basis or can you give us any kind of guidance for that.

Tom Folliard

As you know we’re kind of out of the guidance business and the allusions you saw in there were intentional. We do expect to get back to spend some of the SG&A dollars that we cut. To be real honest last year we aggressively cut SG&A. When you look back at where we were in November, December, January, of last year, it was pretty scary looking forward and I think we probably cut some areas a little too far.

I mentioned building back bench strength, that’s an area where we went probably a little deeper than we should have. We took a huge amount out of advertising. Our expectation in this year is that we’ll spend more in advertising and we’ll do that and it will generate additional sales. The good thing about advertising is it’s a lever and you can move it up and down throughout the year.

We’re not giving any guidance on SG&A but we had a good year from a profitability standpoint. We intend to start spending some money back on some things that we held off last year. In our IT area we really just maintained where we were last year and we have a lot of things that we think we could spend money on and invest in that will help the business long-term and we’re going to get back to investing in some of those things.

But it would be very difficult to give more specific guidance then that.

Sharon Zackfia – William Blair

And then lastly on reconditioning, where did you get the extra $100 per car, was it a lot of little things and then what do you think the opportunity is from here to continue to improve reconditioning.

Tom Folliard

I think when we started this initiative real aggressively it was about a year and a half to two years ago and we thought there was approximately $300 of savings to be had. I can’t tell you how proud I am of our teams to have achieved what they have in such a short period of time. We thought it would take us four or five years to get to that number.

We’ve now achieved what we are confident is sustainable $200 a car. That’s the other point I want to make on cost, people tend to focus on SG&A, we look at cost in total. And $200 a car across 350,000 cars last year, if you project that forward, its $70 million of sustainable savings and it’s a sustainable margin availability for us that we are now confident we’ve achieved.

In terms of how much is left, we still feel good about that number, approximately $300 but I also believe that we knock off some of the easy stuff early and each incremental $5 or $10 per car is more and more difficult. So I think there’s more to be had but we’ve accomplished a lot in a very short period of time.

Operator

Your next question comes from the line of Simeon Gutman – Credit Suisse

Simeon Gutman – Credit Suisse

[inaudible] some lighter frame the discussion on new vehicle incentives, I realize there’s no hard and fast rule to this and we’re still in an unprecedented time, but both from a demand side and then potentially a pricing side, because I think even in the past we’ve said that used vehicle pricing is as much a function of new vehicle sales and I think so, curious if that poses any risk given what we’ve seen last month.

Tom Folliard

You mean, I missed the beginning part of what you said, did you say, what did you say about incentives, we couldn’t hear you.

Simeon Gutman – Credit Suisse

New vehicle incentives, in light of what happened last month with Toyota and some of the other brands.

Tom Folliard

New vehicles, in terms of aggressive new vehicle incentives, we’ve been dealing with that for 15 years. I don’t think this is some wildly unusual period of aggressive manufacturer incentives and as we’ve said multiple times every time there is a big push on incentives and it actually works to drive consumers into the marketplace in the past we have benefited.

We would like to see the [sar] go up, we would like to see new car sales go up because I think it shows that consumers are back in the marketplace and back willing to buy a car and our average retails are north of $17,000, almost always require a loan so I think it’s a similar type customer and although manufacturers get aggressive with incentives, we have found that when consumers go out often times they get real excited about buying a car.

They find out for whatever reason that incentive didn’t work for them and they turn to us, so, we’re not worried about new car incentives. We actually hope that they work in driving consumers into the marketplace.

Simeon Gutman – Credit Suisse

And is there any chance that given that we’ve had an unprecedented rise in used vehicle pricing that if new vehicle sales does grow or does rob some of the growth from used, and I’m saying that’s by chance, that that used vehicle price inflation can be disrupted.

Tom Folliard

You mean that the two would get too close.

Simeon Gutman – Credit Suisse

Yes, or that at some point that it just stops the ongoing price extent that we’ve seen in used if used to some degree take—

Tom Folliard

To me that’s all supply and demand. So that’s all demand driven. I think as I said earlier if the incentives drove a significant amount of consumer demand it would offset the price increase that we’ve seen. I think it’s a pretty efficient marketplace. I think its proven to be over the years and I think it will be going forward.

Simeon Gutman – Credit Suisse

And then can you shed some light on the Santander agreement, I know the expectation that it would at least fill percentage of the loans that CAF had tightened and then that it would drive top line hopefully by several hundred basis points or so and just curious how that went and whether that relationship has been extended.

Keith Browning

We did extend it for another period, for 90 days at more favorable terms and its doing exactly what we had expected is as that you’ll recall in the beginning of the second quarter CAF ended up walking away from that space of loans and they’re actually buying that piece that we walked away from. And CAF is still participating at a small percentage of that.

But Santander is absolutely getting the vast majority of those loans.

Simeon Gutman – Credit Suisse

And then just one last follow-up on the SG&A question, realize the guidance will be limited but is there any differences in timing at which point some of these initiatives may start or may come in or is it steady, just as far as modeling goes.

Tom Folliard

Yes, I couldn’t give you much more in detail. Its really spread throughout the year. When you get into a couple of the components like I talked about a few things around store growth, those obviously will happen as the stores open, the three stores that we currently have this year. But we’ll have some in there towards the end of the year to start preparing for the three to five stores that will open in the next fiscal year.

And another one to think about is as I mentioned is advertising, we can kind of ebb and flow advertising with sales and then with management bench strength build up, that will just go as quickly as we can hire up so that would be spread more throughout the year as well.

Operator

Your next question comes from the line of Ivan Holman – RBC Capital Markets

Ivan Holman – RBC Capital Markets

Congratulations on a nice quarter, I just wanted to ask a quick question at first on the CAF guidance that you gave, just a house cleaning item, that does not include any favorable adjustments such as the ones that were recorded this quarter, correct. Is that just a straight operating number.

Keith Browning

That’s our best forecast that wouldn’t include any adjustments going forward and most of the adjustments we used to have won’t exist under the new accounting. For example we won’t have a mark-to-market issue or other issues that currently exist.

Ivan Holman – RBC Capital Markets

And another question with regards to the store growth, we’ve seen basically this is your third quarter of positive comps essentially and it looks like the store growth is restarting on a good moderate kind of growth trajectory, what do we need to think about in terms of them all, what do you need to see before you start to ramp up that store growth.

Tom Folliard

Well in terms of what we’ll talk about today it’s the stores that we’ve laid out, what we need to see is more sales. So despite the fact that we have seen if you track the last three quarters on comp used unit sales plus 8, plus 8, plus 12, this last 12 is against the negative 26. If you remember back a few years ago whenever we’d get asked where were you to your model, we had said in aggregate we were pretty much at our model.

Well that’s 14% higher sales than what we’re currently seeing. So sales are not back where they used to be and it feels great that we’ve had a good financial quarter. It feels great that we’ve seen some positive sales trends but we’re a long way off of where we were just two years ago.

Ivan Holman – RBC Capital Markets

So I guess to kind of rephrase is there any particular threshold that you would need to pass over in terms of comps either on a two year stack or just normal one year comps that would allow you to I guess to shift gears, pardon the pun, in terms of store growth.

Tom Folliard

We don’t have a target number. I’ll just tell you we’re constantly evaluating it. We look at it every month. We look at it every quarter. We look at a whole bunch of different factors, not just, I mentioned sales but as I said there’s sales, there’s credit, there’s our margin management, how much of that can we count on in the model going forward, there’s changes in consumer behavior. I talked about the new car number earlier, the [sar], if that went up, that might be an indication that we think would provide some positive momentum going forward.

So there is no one lever, there’s a combination of several factors.

Operator

Your next question comes from the line of Craig Kennison – Robert W. Baird

Craig Kennison – Robert W. Baird

I’m going to ask sort of the rare long-term question, give you 10 years to think about it, but how many stores can this business model support long-term.

Tom Folliard

Well we have never varied off of our rather wide estimate of 200 to 300 stores. I don’t think anything about this recession or the difficult environment that we’ve just worked through has changed our long-term estimate of what this business can ultimately be. And we still believe that there’s opportunities for us to figure out how to get into smaller markets and figure out how to do some things that prior to the recession we had talked about experimenting more significantly with, which clearly we’re not doing those things now.

So I think it’s a big number. We’re only in 45% of US markets. We have a very small market share of one to six year old used cars. And we’re just as optimistic about our long-term prospects as we were pre-recession.

Craig Kennison – Robert W. Baird

And so given that optimism which with which we would agree actually why not be more aggressive at what seems like the bottom of a cycle.

Tom Folliard

I actually think this is, one of the things that I’d mentioned in my opening was how important we believe it is to maintain momentum in improving efficiencies, lowering costs, the $200 of savings in reconditioning we’ve achieved in the last year and a half is hugely impactful to the model going forward, if we were to take that into margin or if we used it to drive incremental sales.

So we want to make sure that we’re careful that we don’t distract the entire organization by jumping back into 15% growth and losing momentum in those other areas. The other piece is building stores is a pretty long cycle time and when we said at the end of last year that we quit growth, we really quit growth. I mean, we stopped all money and all investment related to store growth and it does take awhile to get that engine back up and running again.

I think this pace is reflective of that but its also reflective as I said earlier of our, how important we think it is to continue to improve our efficiencies in our business.

Craig Kennison – Robert W. Baird

On the strong comps you reported did you see proportional improvement across all credit tiers or did prime compare differently than sub prime.

Tom Folliard

For the fourth quarter specifically, we mentioned that we had a higher percentage of sub prime business than we normally see in the fourth quarter and the fourth quarter is normally our highest percentage of sales in that area anyway due to seasonality, so, I would say its probably a little higher on the lower end.

Craig Kennison – Robert W. Baird

Do you think that’s more a function of traffic at that level or just credit availability at that level.

Keith Browning

I think that’s exactly what happened is, as you recall as our other lenders above the sub prime area had the same economic challenges we did and they had to tighten and so more customers are being now routed to our sub prime provider and then the other element is is our sub prime provider has done a great job of getting comfortable with the CarMax model and I think is also been more aggressive about buying customers.

So the combination of those facts has really moved more to the sub prime and the seasonality this time of the year.

Operator

Your next question comes from the line of [John Nabb – AgriCapital Management]

[John Nabb – AgriCapital Management]

I was just wondering if you could walk through the math behind your statement that you believe you’ve increased market share by 10%.

Tom Folliard

We’ve talked about market share in the past, it’s a, there isn’t great external data out there and the way we measure market share, we buy actual DMV registrations. We take those registrations and we even buy our own data and then we compare those sales in almost all of our markets. I think we’re in 45 markets, we have data in close to 40 of those.

We take that data and we compare only our one to six year old sales compared to the one to six year old sales in that market and then we simply just measure the market share. The reason we went to an annual number is there’s a lot of volatility in that number, the month to month data is, can be very inaccurate but we feel good and we feel confident that over a year’s time it’s a pretty accurate reflection of the changes in the market of one to six year old cars and the changes in our share.

And so for the full year we achieved more than a 10% share gain in one to six year old cars sold in those markets.

Operator

Your next question comes from the line of Matthew Fassler – Goldman Sachs

Matthew Fassler – Goldman Sachs

First question relates to credit, can you try to help us quantify the interest spreads that you’re seeing today and what the components are at least at a high level.

Keith Browning

Meaning what the spread is between what, our current overall [APR] is, its about 10 in if you look at the cost over the last deal, the, let’s go on and we’ll come back to that.

Matthew Fassler – Goldman Sachs

Secondly obviously the reconditioning savings that you’ve generated are bigger than what you had I guess maybe not bigger than what you expected to get but your raise in the level you think is somewhat sustainable do you think that gross profits for car of around $2,000 should essentially be the new benchmark whether or not we see volatility in used car prices.

Tom Folliard

That’s always the multimillion dollar question for us and its really not an easy one for us to answer, I think that as we’ve said before if we could find, if we felt like taking those dollars and reducing our prices by that full amount, would drive the sales, that would more than pay for it, we would rather have the sales.

I talked about the unusual dynamic over the last year and a half where in an appreciating environment aggressively cutting your prices when you have to turn around and go pay more for the same car, didn’t really seem to make a lot of sense. We have tested various pricing, we just think the elasticity around price has been a little different in the last year and a half so I think, as I mentioned, we’ve had some tailwind from margin achievement.

What I like to think is as we continue to find ways to save money that we’ll be able to do both, put a little into margin, and put a little towards driving incremental sales and both the consumer would benefit and we would benefit from a margin standpoint as well. So that’s kind of our plan going forward but we don’t really, I don’t really have a target for you to say $2,000 is the way to go going forward.

As I mentioned its five consecutive quarters but I think it’s the only five quarters we’ve ever had at $2,000 margins. And if we see changes in the wholesale marketplace and we see changes in some of the things that have provided those tailwinds then it would be more difficult to achieve.

Matthew Fassler – Goldman Sachs

And is the kind of wholesale pricing environment we’ve had over the past couple of months has been flat or up maybe very fractionally month to month adequate to maintain the status quo or do you think you’d need to see more tailwinds for wholesale prices.

Tom Folliard

The last couple of months aren’t going to really help much with what happens over the course of this next fiscal year. Its really what happens from here forward but I think what we have really shown in the last couple of years is our ability to manage through any appreciation or depreciation environment that the market has and we’ve seen again, the most volatile environment we’ve ever seen in the last year and a half, and I’m real proud that our inventory management model has allowed us to achieve good margins, achieve strong inventory turns, and deliver a great value to the consumer.

I expect to be able to do that going forward, honestly we don’t spend a whole bunch of time trying to figure out what the wholesale market is going to do during the year. If it went back to a normal curve like we’ve seen prior to the last couple of years, it makes it a little bit easier for us just because it’s a little bit more predictable but we’re not worried about how volatile it is in terms of our ability to manage through it.

Keith Browning

In answer to your previous question, the consumer APR was just north of 9% and cost of funds is approximately 2%.

Matthew Fassler – Goldman Sachs

That’s 9% rather than the 10% you had initially—

Keith Browning

Correct, yes, closer to 9% to than it is 10%.

Matthew Fassler – Goldman Sachs

Has that fallen over the last quarter or so.

Keith Browning

Not dramatically.

Operator

Your next question comes from the line of Rod Lache – Deutsche Bank

Rod Lache – Deutsche Bank

I’m just trying to first reconcile this uptick in wholesale comps against a still pretty weak used retail market outside of CarMax, and I was wondering if you had any thoughts on the outlook for volume for you in that wholesale business whether you think you’re sustainably taking market share away from auctions and how should we be thinking about the outlook there.

Tom Folliard

We haven’t put anything out in terms of what we expect for volume for the year. As you know the way our auction runs its simply the result of our consumer offer on the front end where we make a cash offer on every car regardless of whether that customer buys a car from us or not, so built into the, I mean the components that deliver the wholesale volume are the percent of customers who come and get their car appraised that are driving a wholesale car and then our buy rate in that category only.

And as I said earlier we have seen movement, we’ve seen our volumes go up, we’ve seen our buy rate go up, but we haven’t talked any about what our expectations are for the year. We’re hopeful that those two things continue to move and we see an increase in volume for next year but again we haven’t guided around that.

Rod Lache – Deutsche Bank

You’re still seeing weakness outside of CarMax and the whole in the retail used business and that’s why its obviously pretty impressive that your wholesale volumes are up that much. I guess you’re saying that its more of a function of [inaudible] supply than the demand.

Tom Folliard

Well I think its always a function of both, I think one of the reasons our auctions have been so successful is we continue to run pretty much in absolute auctions so when we run our sales we have a 98% sell through rate and I think dealers know if they come to our sale and again you know it’s a dealer only auction, if they come to our sale and they’re the top bidder they’re going to buy the car and I think that’s just become more and more valuable in this marketplace.

We mentioned, I think we mentioned, that our dealer ratio was an all time record for the year so that’s the number of dealers per car that we run at our auction and that obviously can generate some additional enthusiasm so I think we do a great job running the auction. I think we do a really good job with customer service for our dealers.

I think we provide an alternative and I think even if people’s volumes have dropped off, similar to what we’ve talked about with the lenders on the retail side, when people had to pull back on capital they didn’t pull it back from CarMax because they like the way we do business. And I think on the wholesale side hopefully we have some similar effect there whereas dealers even if they pull back on their volume and stop going to auctions, ours isn’t the one that they stop going to.

Rod Lache – Deutsche Bank

And also kind of a longer term question is there any impact on your business model just in the next let’s say long-term being two or three years just given the fact that the supply of these relatively new used vehicles is probably going to be constrained for awhile just given that the new car market in the US has been soft for two years and probably be soft again this year.

Tom Folliard

Well I think we saw evidence of that this year. I think this year with the record appreciation throughout the year was, part of that was not only are those new cars not in the marketplace, but the customer that was out there, if you take the [sar] from 16.5 million down to 10, there’s 6.5 million transactions that are missing and a lot of those involve trade-ins and a lot of those trade-ins we find ourselves in the middle of.

So its not just the product that’s being sold but it’s the trade-in activity around it so I think we’ve worked ourselves through this year where we saw supply constraints like we’ve never seen before. Its very difficult to predict what that will be going forward because so much is dependent on what happens with new car sales from here looking into the future and I think most people are predicting that new car sales will increase from here and we’re hopeful that that happens.

Rod Lache – Deutsche Bank

And just lastly I know you’re reluctant to guide to SG&A but could you quantify perhaps some of the operating expense items that you’ve cut, for example, when you discontinued your store growth what were the savings associated with that, just to sort of give us some perspective on some of the things you’re going to have to re-launch.

Tom Folliard

I’m not going to give much more details than I already gave. All the items that I already pointed out are the ones that we cut. I talked about store growth, I talked about bench strength, I talked about advertising, variable selling expenses, moves up and down with sales. There’s a number of different components there. We feel like we aggressively managed them throughout the year.

But that’s about all we’re going to say on it. I gave you the big components there but its difficult to give specific dollar amounts.

Operator

Your next question comes from the line of Bill Armstrong – CL King & Associates

Bill Armstrong – CL King & Associates

With wholesale gross profit above $900 a car and the outlook for overall pricing it looks like it will be sustained at least for awhile, do you think that $900 gross profit per car is a sustainable rate that we can expect going forward.

Tom Folliard

I’d say probably not. Again that’s a record ratio for us, dealer attendance, that’s a big driver of price for us. Again we’ve continued to see unusual curves in the wholesale market in terms of appreciation so I’d say probably not.

Bill Armstrong – CL King & Associates

With supply still tight is it fair to assume that you have not seen any decline in the dealers car ratio so far.

Tom Folliard

For when?

Bill Armstrong – CL King & Associates

Recently, up until today.

Tom Folliard

Well, we’re not going to talk about this quarter, we gave you the number through what was it February 28, so we’re not going to [far remove] from that.

Bill Armstrong – CL King & Associates

With reconditioning expenses down $200 and it looks like you might have a little bit more there to go, so does it make sense to do any recon work on your wholesale vehicles and maybe squeeze a little more gross profit out of that.

Tom Folliard

Our experience has been the opposite. We spend money on wholesale cars and you don’t get it back. They’re wholesale cars, our average car in the auction is 10 years old with more than 100,000 miles and less than $4,000. We consider reconditioning on those cars running them through the carwash.

Bill Armstrong – CL King & Associates

I knew that’s how you have operated historical, I was just wondering since you’ve been able to get these costs down if maybe this would have prompted you to take another look at that.

Tom Folliard

A lot of our savings in reconditioning as we’ve talked about come from our cosmetic area and that would be the last thing you do on a wholesale car. We’re not going to put them in the paint booth and slow our turns down.

Bill Armstrong – CL King & Associates

The CAF income that you’re projecting going forward does that roughly approximate your cash income from CAF or would there be some adjustments we would need to make.

Keith Browning

It’s a pretty good approximation.

Bill Armstrong – CL King & Associates

And then finally you’re going to increase ad spend probably going forward, have you already begun to increase ad spend.

Tom Folliard

We had some testing and some increases in the fourth quarter which you may or may not have seen during the Olympics and the Super Bowl, so we have spent up some and we feel good about our results and in terms of our projection for the year going forward, do we expect to spend more on advertising? Yes, but as I mentioned earlier it’s an area where we can lever up or lever down with sales.

Operator

Your next question comes from the line of William Truelove – UBS

William Truelove – UBS

On the CapEx side, I know you’re going to open three stores this year and your CapEx guidance is $90 million versus $22 million last year, but you also mentioned you were going to spend a lot on IT and whatnot, so how much of the $90 million do you think will go towards the three stores that you’re opening and are these three stores that you’re opening going to be production stores or just satellite stores.

Tom Folliard

None of the CapEx will go to the three stores that we’re already opening, those stores were CapEx’ed two years ago. Those stores were built last summer and we just chose not to open them, so all of the expense, or almost all of the expense are on opening those stores this year is straight expense. The CapEx number that we put out is to begin to start build the pipeline to start to build the pipeline again for future growth.

As we’ve said in the past that’s about a three year time table so, we just wanted to put out a number that allowed us to deliver the plan that we just released. There is some maintenance in CapEx and there is some IT spend in CapEx as well.

Operator

Your next question comes from the line of Matt Nemer – Wells Fargo Securities

Matt Nemer – Wells Fargo Securities

My first question is on the topic of reconditioning, could you talk about what changed between the $100 and the $200 in savings, is it still just cosmetic or are you starting to get into the mechanics.

Tom Folliard

The change was approximately $100.

Matt Nemer – Wells Fargo Securities

Right, is there anything different that you’re doing versus what you were doing six months ago.

Tom Folliard

When we talked about this before and I’ve talked with you about this as well, we continue to find ways to get more consistent across the way we recondition cars, whether its paint or touch up or detail, or parts or sublet, there’s lots of different areas of reconditioning and we had some pretty big inconsistencies across our stores.

So its more of a continuation of the things that we had already been working on and as I mentioned a lot of these savings come from cosmetics. And we’re just real pleased with our results but from the beginning of the year to now, its just continued improvements in those same areas.

Matt Nemer – Wells Fargo Securities

And then on the topic of gross profit per unit, obviously the consumer environment seems like just in general its improved a little bit over the last couple of months, do you feel like you’re optimized at this $2,000 plus gross profit level based on what’s happening in March or is there a chance that the optimal level is maybe a little bit lower than $2,000.

Tom Folliard

Again I think there’s so many external factors that go into that, all I can tell you is we’ll continue to test elasticity of pricing and if we thought that going down $100 would pay for itself in sales, we would do it in a second. Again, we haven’t really seen that level of movement over the last five quarters but it all depends on supply and demand and what happens with the consumer and lots of other external factors, but I think we’ll be working on optimizing sales and profitability forever.

Matt Nemer – Wells Fargo Securities

And then on to SG&A, is there an easy way to think about the cost of reassembling the growth infrastructure on a per store basis so the employee training and relocation etc. per new store.

Tom Folliard

There is for us, but I don’t know if there is, I don’t know, it’s a little difficult because of the time line and we really haven’t given a lot of detail around the time line because we don’t have more details to give. But it’s a little easier to talk about it when prior to the recession when we were opening say, 10 stores, then 12 stores, then 14 stores, those expenses flowed a little bit more evenly but to try to figure out on a per store basis how its going to impact this year I think would be really tough.

Matt Nemer – Wells Fargo Securities

I guess as a follow-up to that, do you feel like relative to the last time you restarted growth which I think was 2001, maybe 2002, what could be different about this restart versus last time in terms of the dilution of the model.

Tom Folliard

There’s a couple of differences, one we’re going to start slower as a percentage basis. I think another difference is we’re better at it now than we were then, we know how to open stores more efficiently and another piece and I think maybe the most impactful is we have a better, we’re a more efficient company than we were then.

Just take this $200 we’ve talked about a bunch on this call, that’s a big difference between last time when we restarted growth we were actually operating in an environment where every year our reconditioning costs went up and now we’re operating looking forward on sustainable savings going forward.

So I think we’re much better positioned now to restart growth than we were then and we’re going to go at a more reasonable pace. We’re also growing off of a bigger base. Last time when we started growth our base was much smaller and now we have 100 stores and 13,000 employees and it’s a little easier to go off of a bigger base.

Matt Nemer – Wells Fargo Securities

And then just lastly you mentioned investments in IT and CarMax.com, and I’m just wondering if you can give us a sneak preview of how the web experience might change over the next 12 months.

Tom Folliard

I don’t know that it will change dramatically in the next 12 months, when we talked about investments in our future they’re usually a little longer turn than that but I’ll give you an idea of some of the things we’re working on in CarMax.com.

There are a lot of things that the consumer would like to do with us online that we currently don’t have the capability to do. One example is we’ve talked about our transfers before, our transfers represent more than 25% of our total sales, are transferred at a customer’s request. A lot of those require the customer to pay for that transfer. Sometimes they’d like to, we believe the customer would like to initiate those online and be able to pay, maybe pay with a credit card to get the transfer done.

Right now we can’t accept those payments online. A number of other pieces like an online credit application we currently don’t do. So if you break out the various components that go into selling a car and try to visualize us wanting to do as much of the transaction online as the consumer wants to do and then breaking those off into chunks, I think that’s kind of the bigger things that we’re thinking about in the next couple of years.

Operator

Your next question comes from the line of Scott Stember – Sidoti & Company

Scott Stember – Sidoti & Company

You talked about not having any valuation adjustments under the new accounting, could you talk about the mark-to-market on the sub bonds.

Keith Browning

Just the fact that the market got better, its been, its amazing if you think back a year ago if you were to look at our 2009 one securitization, we had to put 17% of the company’s capital in it. This last deal we had to put a quarter of one percent of the company’s capital. I think that reflects just what’s happened to the overall marketplace.

CAF came in for a reason and our last two deals have been without CAF because the ABS market has gotten so much stronger and we actually have to go out and get ratings or adjustments on what the valuation would be, but those are just relatively fine tuning the marks given the strong credit environment.

Scott Stember – Sidoti & Company

So going forward we’re not expecting the material movements we’ve seen over the last few quarters.

Keith Browning

Correct.

Scott Stember – Sidoti & Company

And as far as the new stores that are opening you talked about the flow stores with regards to reconditioning, could you talk about the additional incremental gain that you can see on gross profit dollars as you roll out this new process to your new stores.

Tom Folliard

Well as I think I said this last June when we talked about our savings, the savings we have achieved in reconditioning we have achieved across the whole chain and that’s true in our flow stores and what we call our traditional stores as well, so, but we have also said that all of our stores going forward would be opened under the flow format.

So in terms of the impact to the economics that will be more driven by the savings that we get across the chain. But every store will be opened in the flow format going forward and of these three stores, one is a reconditioning store.

Operator

Your final question is a follow-up from the line of Jaison Blair - Rochdale Securities

Jaison Blair - Rochdale Securities

Is the interest on income on the sub bonds, is that included in the $145 to $185.

Keith Browning

Yes.

Jaison Blair - Rochdale Securities

And then the 9% APR and the roughly 2% cost of funds, that’s on current—

Keith Browning

That’s a reflection of what we expect starting at the beginning of the year, so what’s currently in the warehouse we think that when it goes to the next public deal, it will be financed at somewhere around that 2% cost and that we actually then say that we think that somewhere over the year there’ll be compressions and we’ll get to a more normalized spread.

Jaison Blair - Rochdale Securities

And your more normalized spread is roughly like 4, 4.5%.

Keith Browning

Yes.

Jaison Blair - Rochdale Securities

And your current spread on the portfolio, do you have that.

Keith Browning

On the portfolio the APR is slightly over 10. I don’t know what the, we’ll have to get back to you on that.

Operator

There are no additional questions at this time; I would like to turn it back over to management for any additional or closing comments.

Tom Folliard

Thank you and we’ll talk to you next quarter.

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Source: CarMax, Inc. F4Q10 (Qtr End 02/28/2010) Earnings Call Transcript
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