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CarMax, Inc. (NYSE:KMX)

F1Q09 Earnings Call

June 18, 2008 9:00 am ET

Executives

Katharine Kenny - Assistant Vice President, Investor Relations

Thomas J. Folliard - President, Chief Executive Officer, Director

Keith D. Browning - Chief Financial Officer, Executive Vice President, Director

Tom Reedy - Vice President, Treasurer

Analysts

Matthew Fassler - Goldman Sachs

Rexford Henderson - Raymond James

Seth Basham - Credit Suisse

Sharon Zackfia - William Blair

John Fox - Fenimore Asset Management

Edward Yruma - J.P. Morgan

Brian Nagel - UBS

Matt Nemer - Thomas Weisel Partners

Bill Armstrong - C.L. King & Associates

Scott Ciccarelli - RBC Capital Markets

Dan Gelvis - Deutsche Bank

Richard Kwas - Wachovia

Jordan Heimowitz - Philadelphia Financial

Daniel Moore - Aqua Marine Capital

Operator

Good morning. My name is Lisa and I will be your conference operator today. At this time, I would like to welcome everyone to the CarMax first quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Kenny. You may begin your conference.

Katharine Kenny

Good morning. My name is Katharine Kenny and I head investor relations at CarMax. Welcome to our fiscal 2009 first quarter earnings conference call. On the call with me today are Tom Folliard, our President, Chief Executive Officer; Keith Browning, our Executive Vice President and Chief Financial Officer; and Tom Reedy, our Vice President and Treasurer.

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 29, 2008 that’s filed with the SEC.

Also, for your information, Tom will be presenting at an industry conference in Chicago tomorrow morning at 9:10 a.m. If you are unable to attend in person, the presentation is being webcast and we invite you to listen. You can check our website for details.

We also invite you to consider joining us in Richmond, beautiful Richmond, for one of our regular analyst days coming up in July or September. And as always, if you have any questions after today’s conference call, or Tom’s presentation tomorrow, please feel free to contact me or my colleague, Celeste Gunter. Tom, we’ll turn it over to you.

Thomas J. Folliard

Thank you, Katharine. Good morning. Thanks for joining us. As you saw, we had a little bit of a tough quarter, to say the least. The weak economy, the dramatic increase in the price of gas, food, and the resulting decrease in consumer sentiment have all combined to create a challenging marketplace which continues to negatively impact our financial results. This is clearly disappointing to us and to our shareholders.

But even in times as tough as these, we do have some relatively positive things to report. We continue to outperform many of our competitors and from all the data we have, we continue to gain market share. Our comps in the first quarter, while lower than expected, still were positive and while store traffic fell for the first time in several years, our stores were able to partially offset that slowdown with higher conversion rates. Additionally, although we took a sizable CAF evaluation adjustment this quarter related to higher costs in our warehouse facility, it was due to funding costs and not to any material changes in our loss assumptions.

Further, a significant portion of that adjustment was originally expected to occur later in the year and does not represent additional cost. Keith will give you more detail on CAF in a few minutes.

From a fundamental standpoint, we remain confident that the superior CarMax model will facilitate our ability to outperform our competitors in any environment and allows us to continue to focus on our long-term growth proposition. Our exceptionally well-trained and dedicated associates will continue to offer our customers the transparent friendly service and wide selection of vehicles that’s the hallmark of our truly differentiated business.

Now let me go over some of the key financial results. In the first quarter, total sales increased 3% to $2.21 billion, compared with $2.15 billion in the first quarter of fiscal ’08. We opened six new stores during the quarter, two in existing markets, four in new markets, including two in Phoenix, Arizona, one in Charleston, South Carolina and one in Huntsville, Alabama. At the end of the first quarter, we operated 95 stores in 44 U.S. markets.

Used vehicle revenues increased 6% for the quarter due to the combination of a 10% increase in unit sales and a 4% decrease in average selling price. As expected, the decrease in average selling price was primarily due to the continued mix shift that is occurring as a result of the weakened economy and the dramatic increase in gas prices. More consumers are buying cheaper, more fuel-efficient cars, as you would expect.

Wholesale revenues decreased by about 7% as unit sales fell by just 2% but selling price also declined by about 5%. Wholesale units fell due to our lower appraisal purchases, which is a result of less appraisal traffic and as we reported in the fourth quarter of last year, a lower appraisal buy rate, which is partially due to the sharp depreciation in wholesale prices for larger, less fuel-efficient vehicles.

On to gross profit, in the first quarter our total gross profit per unit decreased by $237 compared with the first quarter of last year, due largely to a decline in gross profit per used vehicle. While gross profit per used vehicle did increase sequentially over the fourth quarter, we had hoped to make more progress in recapturing the gross profit we lost at the end of last year. However, we were reluctant to chase margin in a declining sales environment.

The decrease in gross profit was also the result of the aggressive markdowns we took on SUVs and trucks in reaction to the unprecedented marketplace depreciation. Also our normal markdown model marked that segment down quicker, as it always does, which also impacted our margins.

In fact, we’ve seen some dealers completely withdrawing from this segment and refusing to buy any of these vehicles. Despite this and despite the uncertainty surrounding the segment, CarMax continues to deliver on our consumer offer by making a cash offer for all vehicles brought to us by customers. But obviously we are forced to offer less to consumers for these vehicles, which results in fewer accepted offers and reduces our buy rate. As a result, the percentage of retail vehicles we acquired through our appraisal lane fell below 50% for the first time in several years.

Nevertheless, wholesale profit per unit fell by only $16, partially a reflection of the lower risk of depreciation inherent in faster turning inventory, and the continuation of strong dealer to car ratio at our auctions, even in this difficult environment.

I’m going to move on to CarMax auto finance and I’ll let Keith address the CAF results for the quarter. Keith.

Keith D. Browning

Thanks, Tom. Good morning. While earnings at CAF were down significantly versus the prior year, this was largely due to adjustments we anticipated, although not necessarily all in the first quarter. They included an adjustment of $20 million, or $0.06 per share, primarily related to higher funding costs for loans originated in prior quarters. In addition, CAF revenues decreased due to CarMax's lower-than-expected sales and decreased average selling prices, as well as the reduced gain spread for loans originated during the first quarter.

At the end of our fiscal year, we reported that we anticipated a charge of approximately $14 million related to the $855 million left in the warehouse facility when those loans were resold into the public securitization market. We expected some of that adjustment to be reported in our first quarter securitization and the rest to be recorded when the next securitization, most likely in the second quarter.

As it turned out, our private securitization in May was at $750 million, a little bit larger than we had previously had anticipated, given the reduced market place liquidity, and the spread over LIBOR was somewhat higher than what we expected.

We also were compelled to mark-to-market the remaining funds left in the warehouse facility before the renewal in July, since we were far enough along in our negotiations for the new warehouse to know that, as expected, our cost structure would be higher. So a significant amount of the adjustment we took this quarter represents adjustments that we expected to take later in the year. Instead of taking some of the adjustment in the first quarter and some in future quarters, we’ve now effectively taken all of the expected adjustments now, which should actually reduce earnings volatility for CAF in future quarters.

You’ll note that we’ve added a new chart to our quarterly press release, similar to the one we normally included in our 10-Q and 10-K filings, to assist investors in their understanding of the components that make up CAF’s income. In that chart, you will note that higher funding costs and higher discount rate decreased the gain on sale of loans originated and sold during the quarter to 2.7% compared to 4.2% in the first quarter of last year, although the change in discount rate also resulted in the recognition of more interest income.

In general, as we discussed at the last conference call, the increase in discount rate results in less income in any given quarter but more income in future periods, assuming nothing else changes.

As we also discussed on our last call, we feel comfortable with the current credit standards. We believe that the higher-than-expected cumulative loss assumptions we previously recorded for the most recent securitizations have been due to the stress of the current economic environment. We continue to regularly monitor losses but as Tom mentioned earlier, we did not make any material changes to our loss assumptions for this quarter.

During the first quarter, we did note some slight reduction in loans financed by our third-party partners and this modest pull-back had some minor impact on sales. Our lenders tell us that much of the pull-back during the quarter was inadvertent, as they are tightening on other dealers and yet don’t have a separate scorecard for CarMax.

We continue to be reassured by our third-party lenders that they prefer our loans and that CarMax is an important part of their strategic business plans, and as a result we really don’t expect a significant decline in credit availability to our customers for the balance of the year. However, we approach and test other lenders. Tom.

Thomas J. Folliard

Thanks, Keith. On to SG&A, the SG&A ratio in the first quarter was 11% compared to 10% in the first quarter of last year. This deleverage, most of which was expected, was partially a result of the 1% growth in used unit comps, the decline in our used vehicle average selling price, and costs related to litigation that reduced net earnings by $0.02 per share.

In addition, we remain committed to spending to support our growth plans, although given the current pressures of the external environment, we carefully monitor all of our expenses and reduce our spending wherever appropriate.

Net income decreased to $29.6 million, or $0.13 per share from $65.4 million, or $0.30 a share in last year’s first quarter.

And now looking forward, during fiscal ’09 we are on pace to open 14 stores, including three in the second quarter, two of which have already opened earlier this month, the remaining five in the second half of the year. As you know, our plans are always subject to change due to construction scheduling and we now expect that we will open our first store in the Philadelphia market at the beginning of fiscal 2010. In the fourth quarter of the fiscal year, we intend instead to open Potomac Mills, a non-production store in the Washington, D.C. market.

As we stated on the last conference call, we remain committed to our long-term store growth plans. While current market conditions are proving more difficult and long-lasting than many predicted, we continue to believe that the superior CarMax model will outperform in any market, although it is obvious we are not immune from the effects of a slowdown.

As I’ve already said, we were disappointed in our earnings results for the quarter. Both sales and margins fell below our expectations. Our May sales results were notably slower than projected and sales and traffic trends continued to decline into June.

The depreciation in SUVs and other large vehicles has been dramatic, especially since April. The rapid depreciation across this large product segment has been unlike anything I’ve seen in my career, and the consumer confidence index is at its lowest level since 1992.

Taking these factors into consideration, along with the general uncertainty of current market conditions in both the used vehicle marketplace and global credit markets, we have decided to temporarily suspend guidance until we have greater visibility into future trends. While we know this makes life a little more difficult for our analysts and our investors, we also know that giving guidance with a range as wide as necessary to cover all possible contingencies would not be particularly helpful to anyone.

We hope within a quarter or two to reinstate guidance and we appreciate your understanding until that time. As I stated earlier, I have every confidence that our skilled and dedicated associates are positioned well to help us continue to gain share now and as economic trends improve.

Let me take a moment to thank each and every one of our more than 16,000 CarMax associates for all they do every day, especially in this difficult environment.

To everyone on the call today, thank you for your attention, your patience, and your support of CarMax, and now we’ll open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

A couple of questions, and the first relates to the SUV depreciation and the impact that it has on your VAR rate. Based on your observations of past experiences, but I realize that what’s happening is somewhat unprecedented, at what point in terms of time does the market essentially clear such that consumer expectations are realistic and you can start getting back to the VAR rates to which you are accustomed?

Thomas J. Folliard

You know, Matt, that’s the, in our case, multi-million dollar question. After Katrina, we had a similar situation that was relatively short-lived and within 30 or 45 days, essentially the market cleared and we were back out buying at a pretty brisk pace, buying that inventory. This has been going on for really since the beginning of the year and has really steepened in the last couple of months. And as of right now, I couldn’t tell you when it’s going to turn.

I fully expect it will turn. I expect the market will clear. I think everything sells at a price. I think the wholesale marketplace has historically been very efficient. This is probably the longest lasting depreciation on any large segment that we’ve ever seen and I don’t know when it will turn.

I can tell you that I think what is most prudent for us is that we continue to chase the offers down along with the depreciation curve. It doesn’t make any sense for us to offer more money for those cars than they are worth, so we are continuing to lower our offers for that segment and we have sent -- we have continued to send guidance out to our own buyers about lowering those offers, and we are going to continue to do it until the market clears. I hope it’s soon but nobody can really tell.

Matthew Fassler - Goldman Sachs

And Tom, just to be clear, is the biggest issue associated with these wholesale price declines for larger cars and trucks simply the mix of store-bought cars versus auction cars, or are you also experiencing margin pressure due to depreciation of the inventory you’ve had in stock over the course of the quarter?

Thomas J. Folliard

It’s both. And you know, we’ve made some -- we talked about making some markdowns. We went into the -- we have a pricing model that has proved to be pretty effective. It’s proved to be pretty responsive to trends and it’s rare that we have to go into our inventory and make additional price cuts because our inventory model doesn’t adjust quick enough. In this case, our inventory model was adjusting quickly and it was applying pressure to the segment, which caused some of the margin miss but additionally on top of that, we had to go in and make additional cuts. And the last time we did that was after Katrina.

Matthew Fassler - Goldman Sachs

And if you look at the state of the inventory now, give us a sense of the mix and your exposure?

Thomas J. Folliard

Well, I feel very good about our inventory, about our response so far and I always feel like it’s the single most important thing that we do is manage our inventory effectively, particularly in a tough sales environment like we are in. And we try to match our inventory levels with our sales and I think -- I feel like we are in pretty good shape right now but there is no telling what’s going to go on with the marketplace.

In terms of our mix, we’re probably still a little bit over on that segment but the way that we move through that is to aggressively lower our prices, which obviously has a margin impact, but I think is the most beneficial thing for us to do long-term.

Matthew Fassler - Goldman Sachs

One other very quick one -- the 2.7% gain on sale that you booked before all the adjustments, how does that feel relative to what you think you will be able to see for the remainder of the year?

Thomas J. Folliard

Keith.

Keith D. Browning

Actually, it feels a little challenging right now, only for the simple reason that while spreads have narrowed in the public markets, which is the good news, unfortunately the base funds, which is the two-year LIBOR swaps, have escalated at an increasing rate, so we don’t know where those are going to be.

So that’s one of the reasons why we said that for the year, we expect it to be well below our normal 3.5 to 4.5. Obviously that’s affected by the discount rate as well but it’s challenging and we’re trying to pass along rate increases as we speak, and not affect sales.

Matthew Fassler - Goldman Sachs

Understood. Thanks, guys.

Operator

Your next question comes from Rex Henderson with Raymond James & Associates.

Rexford Henderson - Raymond James

Good morning. A couple of questions; first of all, new store productivity, I was looking at your total vehicle sales and it looks as if the new store productivity was a little below normal levels. Is that because you are entering new markets, the timing of the openings? Or are you having some -- are we seeing more difficulty getting some of these traction in some of these new markets?

Thomas J. Folliard

You know, Rex, we talked about this the last quarter. It was true again in the first quarter. Our new stores, as well as our existing stores, are down a similar level. So our view is all of these economic factors that are obviously impacting our sales are impacting it across the board, which gives us confidence that continuing to open stores makes sense.

Rexford Henderson - Raymond James

Okay, but you don’t feel like you’re having any more difficult then normal penetrating the market; it’s just that the markets in general are down?

Thomas J. Folliard

That’s right.

Rexford Henderson - Raymond James

Okay. And the $20 million adverse impact on CAF, can you break out how much of that was from securitization, and I assume it’s most of it, and how much of it was from revaluing loans in the warehouse?

Keith D. Browning

I don’t know the exact answer, to be honest with you, Rex, but most of it was from the securitization. But because we booked 750 out of the 855, so my gut says that’s in the neighborhood of $3 million to $4 million unfavorability on that piece of it, and then the balance of the unfavorability is just on the warehouse.

Rexford Henderson - Raymond James

Okay, and finally the percentage of retail that comes from the appraisal lane, you said it’s below 50% for the first time in a very long time. What’s the direction of that? Is that still on a downward trend or are you seeing some stability in that?

Thomas J. Folliard

No, I mean, it’s gone down and that’s one of the other factors that has caused so much uncertainty in the market and so much uncertainty for us. I felt like there was a chance we would turn that around after the fourth quarter. I talk about a declining buy rate, and then this sport utility and large SUV gas guzzler debacle has not allowed us to turn the corner there. So we don’t know what the -- where the end is there and that segment for us is 25% plus of sales and it still was in the first quarter. It’s not like we didn’t sell that product. We just had to sell it at a significantly reduced margin, but that’s had a lot of pressure on the buy-rate and it’s hard to overcome the pressure from that segment when it’s such a big percentage of the total.

Rexford Henderson - Raymond James

And can you give us any sense of what the margin differential is between cars or trucks purchased in the appraisal lane and cars or trucks purchased at auction?

Thomas J. Folliard

It’s a few hundred bucks. It’s always been a few hundred bucks more through the appraisal lane than it is offsite, but the whole segment is being pressured right now from both sources.

Rexford Henderson - Raymond James

Okay. All right, thank you very much.

Operator

Your next question comes from Seth Basham with Credit Suisse.

Seth Basham - Credit Suisse

Good morning. A couple of quick questions, and I’m sorry if you already said this because I jumped on the call late, but when you think about the SUV and pick-up truck wholesale market going forward, have you see any signs of stabilization in prices or do they continue to fall precipitously?

Thomas J. Folliard

We haven’t seen much in the way of stabilization at all.

Seth Basham - Credit Suisse

Okay, and --

Thomas J. Folliard

It’s really tough. It’s the worst performance of a segment I’ve ever seen.

Seth Basham - Credit Suisse

And when you think about conversion rates on the retail side, how much are they off versus last year and what’s going to turn them around?

Thomas J. Folliard

Conversion rates on the retail side were up in the first quarter over last year. We actually --

Seth Basham - Credit Suisse

They are?

Thomas J. Folliard

Yeah, as I said in the -- I think we said it in our press release as well but it’s one of the things we were very pleased with, is the execution of our stores. We talked about traffic being down, the offset, and the reason we had a 1% comp in the first quarter is because we had strong execution.

Seth Basham - Credit Suisse

Okay, and then given all these pressures in your business, is there an ability to take out a lot of costs or are you pretty much stuck with your cost base?

Thomas J. Folliard

You know, most of our SG&A costs are in the stores and a lot of our year-over-year change in SG&A costs are in our growth and in our growth of our new stores. That doesn’t mean there’s not opportunity to pull costs out but the bulk of our costs are in the stores. So the biggest thing we can do in this kind of environment is manage our inventory effectively, which I feel like we will do, and manage our variable payroll in the stores, which we have done as well.

If you add back the two sets of costs from litigation, our SG&A was actually in line with our expectations.

Seth Basham - Credit Suisse

Understood. Okay, thanks a lot and good luck.

Operator

Your next question comes from Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair

At least the Celtics won, Tom.

Thomas J. Folliard

That was good. You’ve got to be real excited to have me in your conference tomorrow.

Sharon Zackfia - William Blair

We are. Well, a little less excited this morning, but --

Thomas J. Folliard

Yeah, thanks. Thanks a lot.

Sharon Zackfia - William Blair

Yeah, no worries. So a couple of questions on -- obviously you are struggling a little bit with traffic, not unusual in any retail industry at this point but have you had any success in any test in ways to drive traffic into the stores?

Thomas J. Folliard

Our marketing guy is sitting here, so when I say no, I feel bad, but no. And not only that, Sharon, as you said, we actually felt pretty good about our traffic over the course of last year and pretty good in the beginning of this year. It’s been quite the decline in a very short period of time. That’s what’s created all this volatility and all this uncertainty for us. I don’t know if there was a tipping point with the consumers or when we turn the corner through Memorial Day and came into the summer, if people really felt like I don’t know where this is going to end in terms of gas prices, but our traffic has dropped in a way that we haven’t seen in a long, long, long time.

Sharon Zackfia - William Blair

I guess it would be helpful, as we think about the business, I know in the press release you said that the trends worsened as the quarter went on. I mean, how wide of a bandwidth are we talking about in terms of order of magnitude?

Thomas J. Folliard

I won’t get into the order of magnitude but as you know, Sharon, we don’t usually go through the quarter but in this case, we did because I think it’s important for people to understand that as the quarter progressed and deteriorated, it deteriorated at a modest pace, I would say, from the first month all the way -- so what is it, April -- I mean, March, April, and then May. And then at the end of May, particularly as we approached Memorial Day and came out of Memorial Day, that decline was steeper and continued into June. So if you take a -- our visibility, I mean, our looking at the trend over the course of the quarter, if you didn’t add in the last three or four weeks, it isn’t as steep. But it got so steep in the very, very end and into June that it caused us to have all this uncertainty around what we think is going to, what we expect to happen going forward.

Sharon Zackfia - William Blair

Okay, and then a quick question for Keith; I don’t know what the litigation costs were in the quarter. Could you tell us what those were and are there more expected for the rest of the year?

Keith D. Browning

No, they are just accruals based on cases that we have outstanding based on the progress we’ve made to date on negotiating settlements and hopefully there won’t be more but we’re a big company and we are always -- you know, everyone is challenged with ongoing litigation challenges.

Sharon Zackfia - William Blair

All right. We’ll see you guys tomorrow.

Operator

Your next question comes from John Fox with Fenimore Asset Management.

John Fox - Fenimore Asset Management

Keith, I’m wondering if you could clarify a little bit more what you are trying to tell us about CAF when you changed to the new credit facility. Are you saying the $20 million adjustment that you took this quarter, you feel that’s kind of it for the year, will there be further adjustments? I’m not clear on what you are saying.

Keith D. Browning

Well basically, we had anticipated again a large portion of the costs to be in the first quarter but also a significant portion coming in the second quarter. Because we went ahead and booked the new higher cost of our new facility or our estimated higher cost of our new facility since it’s not actually a done deal yet, that brought everything forward into the first quarter. So for the year, the magnitude of miss versus our estimate is really that $6 million, not the $20 million. So if you looked at where we expected CAF to be for the year, it’s only going to be a couple pennies impact and then obviously the real risk to CAF is what happens to CarMax sales and what happens to spreads going forward.

John Fox - Fenimore Asset Management

Okay, but my understanding was the $14 million was the catch-up due to the different pricing between the warehouse and the public securitizations.

Keith D. Browning

And that ended up being a $20 million number instead of a $14 million number.

John Fox - Fenimore Asset Management

Right, that’s fine. Now, going forward, because the terms of the warehouse now will be more in line with the public markets, is it fair to say we will not have those types of adjustments going forward?

Keith D. Browning

Well, I would tell you based on what I know today and based on where we see the public market today, it’s possible that we could actually see slight favorable adjustments going forward but we don’t expect to see -- you know, we went a year where we had our warehouse facility that was below market, if you think about it from that perspective. If you look at today, it actually looks like the pricing might be slightly above market and so we’ll end up with a year, potentially, if things didn’t change, of slight favorable adjustments when we go to the public market.

But obviously that’s dependent on what happens to the public market between now and then but we don’t expect the same level of volatility, given the fact that they are very much -- they are closer together, more in line.

John Fox - Fenimore Asset Management

Okay, so if I’m thinking about CAF for the year, I should think about a 2.5% to 2.75% gain on sale, basically no adjustments, minor. The service fee and interest income at a higher rate than last year because of the timing, and the expenses increased a little bit, and that’s what capture looked like. Is that fair?

Keith D. Browning

Well, the only risk to that again is what happens to both LIBOR spreads and then what happens in the public markets. Do those spreads continue to narrow or widen?

John Fox - Fenimore Asset Management

Right, sure.

Keith D. Browning

I think generally speaking, what you are saying makes sense but I can’t tell you what’s going to happen to either of those.

John Fox - Fenimore Asset Management

Right, I understand that. And then on the service fee interest income line, which was 21.3, will that increase quarterly through the year because of the timing difference or is that, can we just annualize that or --

Keith D. Browning

I think it should increase as our portfolio grows using the higher discount rate, so interest income should grow somewhat over the year.

John Fox - Fenimore Asset Management

Okay, thank you.

Keith D. Browning

I don’t have a precise measure for it.

John Fox - Fenimore Asset Management

No, that’s fine. Thank you.

Operator

Your next question comes from Edward Yruma with J.P. Morgan.

Edward Yruma - J.P. Morgan

Can you talk a little bit more about the credit availability, particularly your inability to pass through rate increases on to consumers? Is that really just a by-product if your interest in driving sales, or are other providers making more competitive offers?

Keith D. Browning

It’s really -- it’s hard to tell what the competition is. It’s really primarily us focusing on when we go make a rate change, two things happen, or can happen. And so we absolutely look at what’s the sales impact. And so if we can pass along our rate increase and there’s no sales impact, then the next piece we have to look at is what happens to pay-offs, because all of our customers have the opportunity to pay-off their loan in three days, they tell us very quickly their sensitivity to our rate increases or decreases whenever we make those. And so then we can make the educated choice on to what’s the most favorable economic decision for the company to make. Obviously in this environment, we would hope that pay-offs wouldn’t go up significantly, that sales wouldn’t be impacted, and that we can pass them along. It’s just that the fed has had a series of decreases, so consumer expectations have been moving in the opposite direction of what we’ve actually seen our funds happen. It may be that given that the feds, you know, all indications are that the feds not going to have further decreases, that we can start moving in the right direction for ourselves.

Edward Yruma - J.P. Morgan

And your commentary about the reduction in limited availability for credit, has it impacted your ability to address certain segments? And I know you had the departure of Triad about two months ago.

Keith D. Browning

Well, the good news is that really Triad was a non-event for us because someone else picked up that business segment for us, and that we have a menu of lenders there that are largely picking up the sales that would have been bought at a different rate, perhaps, by the other lenders.

So we’ve seen a minor negative, adverse impact but it’s not material and we’re hoping that no further changes come.

Edward Yruma - J.P. Morgan

Thank you very much.

Operator

Your next question comes from Brian Nagel with UBS.

Brian Nagel - UBS

Good morning. I guess my first question for Keith, with respect to CAF, to what extent are you still looking at alternative funding sources? I know it’s something we discussed in the past and you obviously did the private deal this time but are you still looking out there for other alternative type funding sources?

Keith D. Browning

Well, Tom’s sitting here. The answer is the securitization market still is very good and a lot more liquid now, and the pricing, all indications are moving in the right direction so the onus to secure other sources aren’t as great. We feel good that we have that. We think we do have other sources available to us based on our prior research to this point, should the public market move to the opposite direction. So we think we have an alternative to the public markets if in fact it were to go the wrong way but we are not aggressively pursuing that right now.

Brian Nagel - UBS

The other question for Tom, just to get an idea, a better handle on the psyche of your customer right now, you still have -- as you mentioned before, you still have a lot of your inventory on your lots devoted to the SUV or large VAR category. For the consumer right now, is it a matter of price or are they really avoiding that category altogether because of fuel prices?

Thomas J. Folliard

Well as I said, we sold a lot of that product in the first quarter. Our mix shift is a couple of percentage points. It’s not a gigantic change. But it’s always a matter of price and at some price, all that stuff will sell. And as Matt, to Matt’s question earlier, it’s just a question of when does the market clear and at what price, and we are just still chasing that price down. But my expectation is that it will clear at some price and that segment will come. I’m just -- it makes sense at some price to buy it.

Brian Nagel - UBS

So how many -- as you look at the inventory you have now, how much incremental margin risk do you think is there?

Thomas J. Folliard

Well, it’s hard to say. It depends what happens with the market going forward. We feel like we have mitigated a large portion of that risk and taken a lot of the hit. But as I said earlier, it hasn’t turned and so we could be chasing this down from a while longer and that segment could continue to feel pressure. And the way we relieve the pressure is to cut our prices and sell the cars. And if we have to keep doing that, we’ll keep doing it.

Brian Nagel - UBS

Okay. Thanks a lot.

Operator

Your next question comes from Matt Nemer with Thomas Weisel.

Matt Nemer - Thomas Weisel Partners

Our first question is on comps; can you just talk to the inventory expansion test and maybe what impact that may have had on the top line?

Thomas J. Folliard

Again, that’s still probably difficult for us to tell because we need to run that test for a long time. And just so everybody knows, we’re still running it in about half the stores now, and although we are aggressively driving our inventory levels down to our sales run-rate, we still -- it’s all relative, so the stores that are on the -- that were carrying extra inventory, it’s extra inventory relative to the amount of inventory we would carry at this sales rate.

Difficult to say what impact it had on comps but right now, we are continuing to run it, we are continuing to read the results, and we feel like it’s in total, in aggregate, positive.

Matt Nemer - Thomas Weisel Partners

Okay, and then just on this SUV/truck topic, what is the customer doing that goes in for an appraisal and it comes in way below their expectations? Are they just holding on to the car? Are they trying to sell it in the private to private market? What’s your sense for what these folks are doing?

Thomas J. Folliard

Well, first they yell at us. Then I don’t know. I think if you -- I think people believe that everybody is just going to run and bail out of their big sport utility and buy a hybrid. It’s just not realistic for people. You know that 80% plus of people who buy a car from us get a loan. A large percentage of people that are driving a car have a loan and in this depreciation market, if you came in four weeks ago and got a car like that appraised with us and then came back in today, you would get a couple thousand dollars less in a four-, five-, six-week period. I mean, we’ve never seen anything like that. If you have a pay-off on a car of $25,000, you get your car appraised at $23,000, you come back six weeks later and it’s $20,000, you’ve got to write a check for the difference.

People just can’t afford to write a multi-thousand dollar check to get out of their sport utility to get into a car that gets better gas mileage. The math doesn’t work, so I think people are ending up holding on.

Matt Nemer - Thomas Weisel Partners

Is there a point, even though it seems like winter is a long way away, where you can buy these cars and ending up making very significant gains on them?

Thomas J. Folliard

Well, just like what happened to us after Katrina, once the market kind of hits bottom, what we did then and what I expect we will do this time is that when we buy those cars at a price that they will then sell, instead of taking that -- you know, we’ll get back to our margin target in that segment but I just expect sales to pick up. We wouldn’t take that opportunity to go and make a whole bunch of extra margin. We’d take the opportunity to sell a whole bunch of extra product.

So once it reaches a lower point, we don’t actually change our margin target necessarily because the product has dropped in the marketplace, particularly in a time like this. So when the market hits bottom and the market clears, my expectation is sales will pick up. And you know, the margin pressure will be relieved and we will be able to hit our target margins but we wouldn’t go and try to make a bunch of extra money. We’d try to sell a bunch of extra cars.

Matt Nemer - Thomas Weisel Partners

Got it. And my last question is in terms of the store labor expense, does the store respond -- how does the store respond to this environment? Are there any -- is it automatic or are there specific changes that you need to make from corporate?

Thomas J. Folliard

It is pretty automatic. We have a staffing model that we use that is based on our sales run-rate, not on our budget. So the stores have an analytical model, which is very similar to the analytical model that we use for inventory planning and that’s how we plan our variable payroll.

So we are looking at very recent sales trends to plan our staffing and like with any retailer, although I feel like our turnover is pretty low compared to other retailers, it’s still a number that can help us manage our staffing down. So through attrition, we can adjust pretty quickly.

We have a lot of seasonality in our business so the stores are used to making these kinds of adjustments, both up and down. Heading into the fall every year, we are decreasing our variable payroll and decreasing our staffing. Heading back into the spring every year, we are increasing it to keep up with rising demands and higher sales, so this is not -- it’s not unusual for the stores to have to move their variable payroll around sales changes.

Matt Nemer - Thomas Weisel Partners

Got it. Thanks very much.

Operator

Your next question comes from Bill Armstrong with C.L. King & Associates.

Bill Armstrong - C.L. King & Associates

Good morning. Your wholesale gross profit per care actually was down only slightly during the quarter. How do you see that versus the performance on the retail side? How did it maintain that profitability?

Thomas J. Folliard

You know, when you turn your inventory as fast as we do in that segment, for example, a good number of our stores -- we run our auctions either once a week or every other week, and every time we run an auction, we sell 98% of everything we have in that auction, so we essentially sell everything. And right after we sell everything, we get immediate feedback on what that product is now worth, and literally that afternoon we can change our offers as it relates to wholesale product.

If our turns were that fast in retail, I would expect we would manage our margins just as tightly in retail. So the fact that we have inventory turns so quick in wholesale allows us to make very quick adjustments in our offers and it’s the reason why, even in a declining wholesale environment, as we’ve seen in the segment we’ve talked about all morning, we are able to keep up with that as it relates to the offers we make to consumers who are selling us cars that are going to run in the auction.

And then, as I’ve always said, our store associates do an absolutely phenomenal job of running an auction. I think we run the best auction in the business and the dealers appreciate it and our attendance ratio, our dealer to car ratio has remained extremely strong, even in this environment.

Bill Armstrong - C.L. King & Associates

And the buy rates at the wholesale auctions, still sticking to that high 90s rate?

Thomas J. Folliard

Yeah, that’s not a buy rate -- that’s our sell rate and the reason it stays at that rate is because we sell everything, even if we lose money. So we are clearing that inventory every week or every other week in every store all the time. It doesn’t matter what the environment is, we are selling all of it. We’re the ones who are making the decisions, so it will always stay that high.

Bill Armstrong - C.L. King & Associates

Got it. Okay, how much did the extra Saturday help your used unit comps during the quarter?

Thomas J. Folliard

Probably around 1%.

Bill Armstrong - C.L. King & Associates

Okay. And what’s the warehouse balance right now?

Thomas J. Folliard

We’ll get back to you on that. We’re probably going to have to do another deal in the next month or so.

Bill Armstrong - C.L. King & Associates

Do you think you’ll be able to --

Thomas J. Folliard

-- warehouse capacity is $1 billion, so --

Bill Armstrong - C.L. King & Associates

Right. Do you think -- I think you mentioned before that the securitization market is starting to look a little more liquid. Do you think you will be able to tap the public markets this time around?

Thomas J. Folliard

We hope so, but we’ll let you know after we do a deal.

Bill Armstrong - C.L. King & Associates

Okay, thanks.

Operator

Your next question comes from Scott Ciccarelli with RBC Capital Markets.

Scott Ciccarelli - RBC Capital Markets

A couple of questions; first of all, since the quarter is now behind us, can you tell us what your comp expectations had been? You said that your sales came in below what you were expecting.

Thomas J. Folliard

No, we’re not going to do that, Scott.

Scott Ciccarelli - RBC Capital Markets

Okay. And it sounds like you are probably seeing more people coming in with negative equity at this point, given the deflation. How big of an inhibitor is that to your overall transactional activity, or is that just another facet?

Thomas J. Folliard

We’ve been answering that question for several quarters. We still don’t see it in the credit apps. We still don’t see any kind of significant change in the amount of negative equity that people are requesting to finance.

What we have speculated on is that there is some self-selection out of the process because of negative equity. We can’t tell what -- we can’t tell how much negative equity somebody has if we appraise their car and then they leave. So again, it’s not showing up in the metrics that are measurable for us, which is when we see a credit app with an appraisal on it, we can actually see -- and then we find out what their pay-off is, we know exactly what the negative equity is.

What we can’t tell is how many people we appraise a car, make them an offer, they’ve got a bunch of negative equity, they see it in the appraisal, and they walk out the door. So I think it’s probably more in that -- that’s probably more where it’s occurring than in terms of the metrics that we see.

Scott Ciccarelli - RBC Capital Markets

So the people that are yelling at you when you make the offer, you never get to the credit app stage?

Thomas J. Folliard

That’s correct.

Scott Ciccarelli - RBC Capital Markets

Okay. And then you had mentioned you had seen some credit tightening from some of your finance vendors. Is that across the board or just one or two of your providers?

Keith D. Browning

That was just a couple of them and quite honestly when we brought it to one of their attention, they worked diligently and brought it back up to similar to levels before. The other ones more recent and all indications are they will be able to do the same. It’s inadvertent, unintentional.

Scott Ciccarelli - RBC Capital Markets

Okay. And then the last question is just on the gross margin side for used; can you kind of rank the impact on the gross margin between cutting price to move the metal and then having a lower buy rate from the consumer level?

Thomas J. Folliard

Probably the biggest impact was our starting point. You know, we talked about being -- and again, our budget for margin in comparison to last year might very well be two different things, but probably our biggest miss was more related to the starting point at the beginning of the quarter. You know, we talked about margins being down at the end of the fourth quarter. At the beginning of that, we said we thought and hoped that we would be able to get to flat margins for the year, which didn’t necessarily mean that we would get the flat margins for the first quarter. But we did feel like we could increase our margins sequentially from the fourth to the first quarter. It actually went up a little over $30, but we thought we could do better than that.

But as sales trends declined, it just doesn’t feel good to be raising margin in that kind of an environment, so that’s probably the biggest impact, is that we didn’t chase the margin up as aggressively as we would have.

And then from there, the sport utility impact in total, so not just the fact that we went in and did markdowns but the fact that our inventory management model is going to aggressively make cuts on product that’s not selling, that was another piece of the impact. And then just the continued pressure and the continued decline in the sales rate, which doesn’t make you feel real good about raising margins. So really it’s kind of that order.

Scott Ciccarelli - RBC Capital Markets

Okay. All right, thanks a lot, guys.

Operator

Your next question comes from Dan [Gelvis] with Deutsche Bank.

Dan Gelvis - Deutsche Bank

Good morning. I was wondering if you could talk a little bit about the market for fuel efficient vehicles. It appears there’s a serious shortage of fuel efficient vehicles, of new fuel efficient vehicles. I’m wondering how aggressive new car dealers are being in acquiring late model used and how that’s affecting your ability to acquire those vehicles?

Thomas J. Folliard

You know, I always talk about being in an efficient marketplace. A great example of that is if you go back to the beginning of the year and talk about the segment we’ve been destroying all morning, SUVs, with the biggest depreciation we’ve ever seen, fuel efficient vehicles have appreciated through the year. They’ve actually gone up in value. But it’s kind of fairly basic economics. It’s supply and demand and the demand is there to support it. So we are having to pay more for the product but the customer is willing to pay more as well, as you would expect.

Dan Gelvis - Deutsche Bank

Where is the supply coming from?

Thomas J. Folliard

The same place it always comes from, from customers who are trading their car in or buying a different car or trading out or getting off lease or -- you know, it almost always relates back to whatever the run-rate in new cars was going back two or three years ago.

Dan Gelvis - Deutsche Bank

But have you seen any reduction in supply of fuel-efficient vehicles? Are people holding on to them longer?

Thomas J. Folliard

I don’t know if we’ve seen a reduction in supply but I just know we have to pay more for it. We’re still appraising cars in the appraisal lane. We’re still buying cars at auction of that segment. We’re just paying more for all of it, and then subsequently the customers as well.

Dan Gelvis - Deutsche Bank

Okay, thanks. One more question on your new stores; is there any plan to explore the sale lease-back model, sale lease-back market in funding any of the new stores? Or are you going to continue on your current path?

Thomas J. Folliard

It’s always in the plans for us. Every store is unique. We make the best funding decision for each store at the time when it’s required to make that funding decision, so we have some stores that we own, we have some stores that are on sale lease-back. Depending on our capital and depending on what the market is at that time, we’ll make each of those decisions at that time. But the sale leaseback market is obviously something that we’re -- we have tapped into and expect to tap into in the future.

Dan Gelvis - Deutsche Bank

Okay, appreciate the time. Thanks.

Operator

(Operator Instructions) Your next question comes from Rich Kwas with Wachovia.

Richard Kwas - Wachovia

Good morning, everyone. Keith, could you comment on recovery rates here for the quarter? I know it was kind of in the mid-40s for the fourth quarter. Where was it for the first quarter and how are you seeing that trending by vehicle segment?

Keith D. Browning

I don’t actually have the data yet for the first quarter with me, so I can answer that after the call.

Richard Kwas - Wachovia

Okay. And I realize you don’t have the data in front of you, but given that the mix of sales over the last six months to a year is still weighted towards trucks, how much of a risk is it to recovery rates, given the decline in valuations here going forward?

Keith D. Browning

I mean, obviously we would see for those that default that we have to actually repossess a vehicle that we are going to have the same impact on CAF recovery rate for that segment and get the benefit on recovery rate on the fuel efficient cars as well. So all in all, I would expect it to be slightly negative but the real risk isn’t in that amount of rate. It’s really in frequency.

Richard Kwas - Wachovia

Right, okay. And then going on that with the rebate checks out now, are you seeing any benefit on the delinquency run?

Keith D. Browning

We actually think we saw a small benefit but not a very material benefit.

Richard Kwas - Wachovia

All right. Thanks so much.

Operator

Your next question comes from Jordan Heimowitz with Philadelphia Financial.

Jordan Heimowitz - Philadelphia Financial

Just two questions; just by variable, going from 12% to 17% reduces the gain margin by what? And going from 2.5% to 3% reduces the gain margin by what? By my calculation, the combined is about 50 to 70 basis points on the gain on sale. Is that right? So the new blended rate, so to speak, would be 2.8 to 3.8?

Keith D. Browning

Could you repeat that again?

Jordan Heimowitz - Philadelphia Financial

Sure. You said your guidance was 3.5% to 4.5% on the gain margin, but that assumed a 12% discount rate, and a 2.5% to 2.75% lifetime loss rate, correct?

Keith D. Browning

Right.

Jordan Heimowitz - Philadelphia Financial

Now we’re using a 17% discount rate and closer to a 3% lifetime loss rate, so I’m just saying -- so just those two variables, it seems to reduce the normalized gain margin about 70 basis points or like 2.8 to 3.8. Is that --

Keith D. Browning

Yep, that makes sense.

Jordan Heimowitz - Philadelphia Financial

Okay. Thank you.

Keith D. Browning

And the other piece of that is we’ll get more income in the back end on it because we have the higher discount rate.

Jordan Heimowitz - Philadelphia Financial

Okay. I just wanted to make sure the math was done correctly.

Operator

Your next question comes from Daniel Moore with Aqua Marine Capital.

Daniel Moore - Aqua Marine Capital

Thanks for taking the question. Two questions quickly; one, given the speed of the deceleration and trends that you described, can you give us a sense for what used car comps were month by month, and any sense where you might be June to date? And second, the one sort of bright spot is that loss assumptions that you had haven’t changed much. Are you surprised by that at all and anymore color that you might have around that would be very helpful. Thank you.

Thomas J. Folliard

On the first part, as you know we’ve been very reluctant to talk about month to month. I don’t think the business actually runs month to month. I think it runs on longer terms and as I said, the quarter came out at 1%. There was a declining trend through the quarter but we’re not going to give anymore detail on a month-to-month basis. I don’t think it’s actually relevant.

And in terms of June, it’s way too early in June. You know, the fact that after Memorial Day, our trends continued to decline is the reason for so much uncertainty from our end but in terms of the comp, two weeks of a comp is virtually meaningless.

And what was the second part of the question?

Keith D. Browning

I’ll answer that. Every quarter when we set the loss rates, we actually try to project the lifetime losses, and so we are not surprised that we didn’t have to make any material adjustments. The longer and the more sustained the adverse economy has been obviously then it changes your outlook, and so I think that we feel real good about our projections for loss rates, assuming that the economy doesn’t continue to deteriorate, let’s put it that way.

Daniel Moore - Aqua Marine Capital

Thank you.

Operator

Sir, are there any closing remarks?

Thomas J. Folliard

In closing, I would just like to thank everybody for listening in today. As I stated earlier, we are as committed as ever to the CarMax consumer model. You know, it’s a very difficult and very challenging environment, both the credit markets, the gas prices, all the uncertainty out there. But in terms of our consumer offer and our model, we have as much confidence as we’ve ever had. We are going to continue to build on our growth plan. We are not going to lose any of our best people. We are going to continue to invest in our strategic initiatives and we are as excited as ever about our prospects going forward. I just think we’re in such a tough environment right now that there’s so much uncertainty in the marketplace. It’s very difficult for us to figure out what’s going to happen for the rest of the year. But again, we are very, very confident in our long-term prospects. Thank you very much and we’ll talk to you next quarter.

Operator

Thank you for participating in today’s conference. You may now disconnect.

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Source: CarMax F1Q09 (Qtr End 5/31/08) Earnings Call Transcript
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