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     car max 2004ar car max 2004ar Document Transcript

    • C A R M A X , I N C . A N N U A L R E P O RT FISCAL YEAR 2004 CARMAX 2003 C4n1
    • THE CARMAX ADVANTAGE COMPELLING MARKET UNIQUE CONSUMER OFFER P R O P R I E TA RY P R O C E S S E S 1 2 3 • Huge • Low, No-Haggle Prices A N D S YS T E M S • Stable • Broad Selection • Information Systems • Non-Commodity • Great Quality • Purchasing and Inventory • Fragmented Competition • Customer-Friendly Service Management • Consumer Need • carmax.com • Reconditioning • Finance Originations See page 4. See page 6. See page 8. S T R O N G R E S U LT S S K I L L E D, D E D I C AT E D P E O P L E S O L I D G R OW T H O P P O RT U N I T Y 4 5 6 • Revenues • Training and Development • Growth Plan • Earnings • Store Management Teams • Defensible Competitive Advantage • Return on Invested Capital • Regional Management Teams • Outlook • Return on Shareholders’ Equity • Corporate Management Team See page 14. See page 11. See page 12. CARMAX MARKETS (as of May 1, 2004) 8 1 Alabama Nevada 1 4 Birmingham Las Vegas (2) 1 1 1 2 California North Carolina 11 1 1 2 Los Angeles (2) Charlotte (2) 2 1 Sacramento Greensboro 11 4 Raleigh 1 Florida 4 Miami (3) South Carolina Orlando (2) Columbia 4 2 Tampa (2) Greenville 2 1 Georgia Tennessee 3 Atlanta (4) Knoxville Memphis Illinois Nashville Chicago (8) U S E D C A R S U P E R S TO R E S Texas Indiana Mid-Sized Markets (17) Dallas/Fort Worth (4) Indianapolis Houston (4) Large Markets (8) San Antonio Kansas 1 Numbers in circles indicate the number Kansas City Virginia of used car superstores in a market. Richmond Kentucky Louisville Washington, D.C./ Baltimore (4) Cover photo: CarMax’s used car superstore in Henderson, Nevada, one of two superstores opened in the Las Vegas market in fiscal 2004.
    • Te n y e a r s a f t e r p i o n e e r i n g t h e u s e d c a r s u p e r s t o r e c o n c e p t i n 1 9 9 3 , C a r M a x , I n c . i s t h e n a t i o n ’s l e a d i n g s p e c i a l t y re t a i l e r o f u s e d c a r s . A t Fe b r u a r y 2 9 , 2 0 0 4 , C a r M a x o p e r a t e d 4 9 u s e d c a r s u p e r s t o re s i n 2 3 m a r ke t s , as well as 12 new car franchises, all of which were integrated or co-located with its used car superstores. C a r M a x s o l d 2 2 4 , 0 9 9 u s e d v e h i c l e s i n f i s c a l 2 0 0 4 , r e p r e s e n t i n g 9 1 % o f t h e t o t a l 2 4 5 , 7 4 0 v e h i c l e s s o l d by t h e company during the year. F I N A N C I A L H I G H L I G H T S (Dollars in millions except per share data) FISCAL YEARS ENDED FEBRUARY 29 OR 28 % CHANGE 2004 2003* 2002* 2001 2000 ’03 TO ’04 Operating Results Net sales and operating revenues 16% $4,597.7 $3,969.9 $3,533.8 $2,758.5 $2,201.2 Net earnings 23% $ 116.5 $ 94.8 $ 90.8 $ 45.6 $ 1.1 Separation costs nm $ — $ 7.8 $ 0.4 $ — $ — Net earnings excluding separation costs 14% $ 116.5 $ 102.6 $ 91.2 $ 45.6 $ 1.1 Per Share Data Diluted earnings 21% $ 1.10 $ 0.91 $ 0.87 $ 0.44 $ 0.01 Separation costs nm $ — $ 0.07 $ 0.01 $ — $ — Diluted earnings excluding separation costs 12% $ 1.10 $ 0.98 $ 0.88 $ 0.44 $ 0.01 Other Information Cash provided by (used in) operating activities 106% $ 148.5 $ 72.0 $ 42.6 $ 18.0 $ (23.6) Used car superstores at end of year 23% 49 40 35 33 33 * Results for fiscal 2003 and fiscal 2002 include costs related to the October 2002 separation of CarMax from Circuit City Stores, Inc. nm = not meaningful REVENUES NET EARNINGS COMPARABLE USED CARS SOLD STORE USED UNIT (In billions) (In millions) SALES 224,099 (Percentage change) $116.5 $4.60 190,135 $3.97 24 $94.8 $90.8 $3.53 164,062 $2.76 $2.20 13 $45.6 132,868 111,247 8 6 $1.1 00 00 01 02 03 04 00 01 02 03 04 00 01 02 03 04 01 02 03 04 (8) Forward-Looking Statements: Statements in this annual report about the company’s future business plans, prospects, and financial performance are forward-looking statements that are made in reliance on the safe harbor provisions of the Private Securities Reform Act of 1995. These statements are based on management’s current knowledge and assumptions about future events and involve risks and uncertainties that could cause actual results to differ materially from anticipated results. For additional information on important factors that could affect expectations, see the company’s Securities and Exchange Commission filings, including “Management’s Discussion and Analysis” contained in this annual report. Separation: On October 1, 2002, CarMax, Inc. was separated from Circuit City Stores, Inc. and became an independent, separately traded public company. Details of the separation are discussed in “Management’s Discussion and Analysis” and the “Notes to Consolidated Financial Statements” contained in this annual report. The consolidated financial statements and related information contained in this annual report are presented as if CarMax existed as a separate entity during all periods presented.
    • TO O U R S H A R E H O L D E R S WHERE WE ARE Austin Ligon In fiscal 2004 we delivered strong earnings growth, up 14% President and Chief Executive Officer excluding the non-deductible separation costs we paid for in fiscal 2003, and up 23% on a net earnings basis. Our earnings growth resulted from an 18% increase in used vehicle unit WHERE WE’VE BEEN During the past year, we’ve celebrated some important mile- sales, driven both by our new store openings and 6% compa- stones that reflect just how far we’ve come since we began. rable store used unit sales growth. With our unique consumer Last July, we sold our 1 millionth car. In late September, we offer and strong store execution, we continued to take market celebrated our 10th anniversary since opening, and on share. We hit our gross margin dollars per used unit target for October 1, our first anniversary as an independent public the year despite a particularly challenging model year company. As we finished the fiscal year, we hit a few other changeover period in the third quarter. Our proprietary buy- impressive milestones: ing and inventory processes and systems continue to help us ■ Over 11 million customers greeted with a smile. “buy right” and “price right.” ■ Over 4.5 million free appraisals and cash offers This earnings growth was achieved while we absorbed to customers. both the penalty that comes with ramping up our store ■ Over 1 million used cars sold. growth and the expected decline in CarMax Auto Finance ■ Over $20 billion in cumulative sales. spreads. As planned, we opened nine used car superstores, ■ Our 3rd consecutive PricewaterhouseCoopers/ compared with five the previous year. Consequently, SG&A Automotive News award for top 3-year shareholder expense reflected appreciably higher preopening expense, as return among auto retailers. well as the significantly higher SG&A ratio of new stores All in all, a pretty good first decade for an organic growth compared with stores at mature sales levels. We also absorbed start-up in the retail industry — all thanks to the extraordinary approximately $13.5 million in incremental costs related to efforts of the 9,500-plus CarMax associates who’ve joined us being a stand-alone company compared with fiscal 2003. along the way and made it all happen. Twenty-six of the Also as expected, CAF income grew a modest 3% for the original 100 associates that were with CarMax the day we year. For more than two years — through the first half of fiscal 2004 — we benefited from much higher than normal spreads at CAF because market rates for consumer auto loans did not fall as fast as our cost of funds. During the second half, spreads returned to more normal ranges. We expect CAF income com- parisons in fiscal 2005 to be challenging for the first two quar- ters, and then they should be on a more comparable basis. WHERE WE’RE GOING We are pleased that CarMax has built a strong foundation for consistent and profitable growth. We have adjusted our longer-term used unit comp store growth expectation to a Founding Associates, September 1993 range of 4% to 8%. We continue to expect to deliver average opened the Richmond store on September 29, 1993, are still annual earnings growth of approximately 20%, once our CAF a part of our team today. They now play a wide variety of income comparisons have cycled around to reflect spreads in roles throughout our organization, and their stories are the the normal range for each period. Our operating cash flow story of CarMax’s growth and development. 2 CARMAX 2004
    • provides more than enough resources for our net capital also taking advantage of data provided by our new electronic spending needs, and we have ready availability of attractively repair order system to improve the quality of our recondition- priced debt financing through our inventory facility and real ing process while reducing the cost and cycle time involved. • Associate Development: To open the 10 stores planned estate financing relationships. We are now past the vast major- ity of disruption and costs associated with separating from our for 2005, we need to generate approximately 140 managers parent company. In fiscal 2005, we expect to incur another from our existing base of approximately 700 store-level $4 million in incremental stand-alone costs, largely related to managers across the sales, purchasing, service operations, outsourcing our payroll systems, and the following year, we and business office teams and replace them with internal expect to incur roughly another $3 million to $5 million as promotions and outside hires. It also means identifying, we outsource our computer operations center. We expect this interviewing, selecting, hiring, and training more than to be the last major SG&A addition related to our separation. 1,000 additional talented associates in the various operating ■ Growth Program. Our growth plan calls for a ramp up departments. To do this smoothly, open the new stores suc- to a 15%–20% annual growth rate of new stores. Our focus for cessfully, and continue to improve operational execution in the first 4 to 5 years of the program is adding satellite fill-in our existing stores is an enormous task. This is, as they say, stores in established markets and standard stores in new mid- Job #1 for CarMax management. sized markets. These represent the lowest risk, highest early We also believe the broad diversity that we’ve been able return opportunities, which help offset the penalties of a growth to achieve in both our overall associate teams and our man- program buildup. At year-end, we had opened 15 new stores agement teams has given us a significant competitive advan- plus one replacement store at our LAX location since resuming tage compared to other auto retailers. We intend to build on growth. Seven of these stores are satellite fill-in stores while the this advantage. • Company Culture: The entrepreneurial culture of other eight are standard stores in new mid-sized markets. This year was the first we’ve grown at a 20% pace, and we service and quality that our associates have built as a team intend to do so again in fiscal 2005 by opening five standard over the last decade has been critical to our success. We’ve superstores and five satellite superstores, including a standard also realized how much fun both we and our customers can and a satellite store in the Los Angeles market. We do not have when you remove all the negatives from the car-buying expect the L.A. stores to initially perform as strongly as our process. Yet our own success and growth can become the regular openings due to a current lack of enough stores to enemy if we’re not careful. We want to sustain an enthusiastic, support TV advertising in L.A. The L.A. stores are intended down-to-earth, non-hierarchical business culture that treats to lay the groundwork for an eventual rollout of the entire every associate and every customer with the respect and per- market. A satellite opening in Richmond is a continuation of sonal attention they deserve. A culture where our stores and our efforts to understand how densely we can store an older, store associates come first. They serve our customers, they higher-market-share market. In 4 to 5 years, we hope to better create the value in the company, and our job is to support understand what our ultimate market share potential might them and help make their jobs easier in every way we can. be, and therefore how many stores we may eventually be able Ultimately, all truly great service and retail companies create a to build nationwide. culture built on similar principles, and they prosper only as ■ Operational Goals. During fiscal 2005, we have three long as they sustain it. ■ Board of Directors Additions. This past year we wel- major internal goals. • Quality: First, we want to continue our efforts at contin- comed Fully Clingman and Tom Stemberg to our board of uous quality improvement throughout our operating processes directors. Fully is the retired president of the H.E. Butt and particularly our reconditioning process. I believe we have Grocery Company, named one of the top three supermarket the best and most consistent inspection, reconditioning, and chains in the nation by the Grocery Manufacturers of certification process in the auto industry — indeed, several America. Tom is the founder and executive chairman of manufacturers have studied our process as the basis for their Staples, Inc. Together they add enormous depth in big-box own certification programs. But we know there are still errors to retail experience to our board. We are delighted to have their eliminate and efficiencies to be gained. This past year, our sen- expertise as we grow. ior operating team studied the quality improvement processes and cultures of top auto manufacturers like Toyota and Nissan. Although I believe we’re among the better specialty retailers in process improvement and significantly ahead of anyone else in Austin Ligon auto retail, our visits to the Toyota and Nissan factories have President and Chief Executive Officer helped us understand how much more can be achieved. We are March 30, 2004 CARMAX 2004 3
    • 1 3 COMPELLING MARKET HUGE STABLE ■ ■ With annual sales of approximately $366 billion, used Only twice in the last two decades has the volume of vehicles comprise nearly half of the U.S. auto retail used unit sales fluctuated by more than 3% from one market, the largest retail segment of the economy. year to the next, far less volatile than the annual change in new car units sold. ■ In 2003, there were an estimated 43.6 million used ■ vehicles sold compared with 16.7 million new vehicles. The market for late-model used cars is almost acyclical. As the economy improves, buyers who move from used ■ CarMax’s primary focus — 1- to 6-year-old vehicles — is cars to new cars are replaced by buyers who can now a market estimated at $265 billion in annual sales and afford a later model used car. 20 million units per year. ■ This stability provides the foundation for CarMax’s ■ The used vehicle market is substantially bigger than other market share growth strategy in both existing and large retail categories such as the school and office new markets. products market ($229 billion in estimated annual sales) and the home improvement market ($212 billion in estimated annual sales). R E TA I L M A R K E T S I Z E U S E D V E H I C L E S A L E S S TA B I L I T Y (In billions) (Percentage change) $366 15 $265 10 $229 $212 5 0 -5 -10 -15 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 School and Home 1- to 6- U.S. Office Improve- Year-Old % Change Used Vehicle Unit Sales Used Car % Change New Vehicle Unit Sales Products ment Used Market Cars Source: Manheim Auctions Source: Manheim Auctions; CarMax estimates; the School, Home and Office Products Association estimates; and the Home Improvement Research Institute estimates 4 CARMAX 2004
    • S TA B I L I T Y P R O V I D E D B Y C O N S I S T E N T FRAGMENTED COMPETITION T U R N O V E R O F V E H I C L E S I N O P E R AT I O N ■ The U.S. used car marketplace is highly fragmented and (Percent annual turnover*) includes 21,700 franchised new car dealers, 54,000 25 independent dealers, and millions of private individuals. ■ 20 Our primary competitors are the 21,700 franchised new car dealers who sell the majority of late-model, 15 1- to 6-year-old vehicles. These dealers focus primarily on 10 new cars and secondarily on financing and service. Used car retailing is often a lower priority business for them. 5 ■ Independent dealers predominantly sell older, higher 0 mileage cars than does CarMax. 93 94 95 96 97 98 99 00 01 02 03 1 out of 5 vehicles in operation in the U.S. changes hands annually. ■ To date, there have been no successful, large-scale attempts * Total used vehicle sales divided by total vehicles in operation to replicate the CarMax used car superstore model. Source: Manheim Auctions NON-COMMODITY CONSUMER NEED ■ Unlike new cars, every used car is unique, reflecting ■ Our consumer research confirms that most consumers differences in mileage, condition, and age. This uniqueness dislike the traditional high-pressure sales tactics employed provides CarMax the opportunity to add value. by many auto retailers. ■ We carefully select the vehicles we offer for retail sale. ■ For more than 20 years, “car salesmen” have ranked last in Our choices are driven by our high quality standards and the annual Gallup survey on the honesty and ethics of our exceptional understanding of consumer buying various professions. preferences at each of our stores. ■ The CarMax customer-friendly consumer offer is unique ■ Every retail vehicle undergoes a rigorous reconditioning in auto retailing. We eliminate the traditional adversarial process to ensure it meets our high quality standards. relationship and let customers shop for cars the same way they shop at other “big-box” retailers. ■ We back our quality promise with a 5-day, 250-mile, no- questions-asked, money-back guarantee and a free 30-day, industry-leading limited warranty. We also sell extended service plans that can provide coverage up to 6 years. CARMAX 2004 5
    • UNIQUE 2 CONSUMER OFFER The CarMax offer is structured around our core equities — BROAD SELECTION those things we offer customers that, taken together, make us ■ A typical CarMax superstore has between 300 and unique in auto retailing. 400 used vehicles for sale compared with approxi- mately 90 used vehicles at the average new car dealer. LOW, NO-HAGGLE PRICES ■ Our primary focus is vehicles that are 1 to 6 years old, with fewer than 60,000 miles. For the most cost- ■ We offer our best price up front and never haggle on any conscious consumer, we also offer older, higher mileage element of the sales transaction. ValuMax cars that meet our same mechanical, electrical, • The price of the vehicle is competitively low and clearly and safety standards. These older vehicles typically posted on the car, in the store, and on carmax.com. comprise approximately 15% of our inventory. • The price of the extended service plan is competitive ■ Each store’s inventory is tailored to the buying and fixed, based primarily on the repair record of preferences of the consumers in that store’s trade area. similar vehicles and the length of coverage. • The price of the financing is competitive, no-haggle, and based on the lender’s assessment of credit risk. GREAT QUALITY Customers see the finance offer as it is made directly ■ Every used vehicle we sell must meet stringent from the lender and, if approved by more than one mechanical, electrical, and safety standards. lender, may choose among competing offers. • The price of the “trade-in” is a written cash offer, ■ Every used vehicle we retail is put through a thorough, based solely on the wholesale value of the vehicle, and 125-point inspection. Needed repairs are made and the our offer is good whether the customer buys from us car is thoroughly detailed inside and out to make it look or not. The offer is good for 7 days or 300 miles. and feel as close to new as possible. ■ Our no-haggle offer streamlines the buying process ■ We stand behind our quality standards with our 5-day, and helps ensure that we create only a comfortable, 250-mile, money-back guarantee and our industry- friendly relationship with customers. leading, 30-day limited warranty. We also offer extended service plans on every vehicle we sell that provide up to 6 years of coverage. 6 CARMAX 2004
    • CUSTOMER-FRIENDLY SERVICE CARMAX.COM ■ ■ We designed the CarMax offer to give consumers what Carmax.com is a valuable marketing and research tool they asked for: no haggling on any aspect of the sale, broad that allows customers to see a car’s photo, price, and selection, high quality, and a customer-friendly process. specifications, as well as to make side-by-side vehicle comparisons, all from the comfort of home. We have ■ To ensure that sales consultant objectives are completely sales consultants dedicated to caring for customers who aligned with those of the customer, we pay our sales contact us through the Internet. consultants a fixed-dollar-per-unit commission. The sales ■ consultant earns the same dollar amount regardless of the Using carmax.com, customers can browse our nationwide price and profit on the vehicle. Consequently, the sales inventory of approximately 20,000 used vehicles. This consultant’s only objective is to help customers find the Web-accessible inventory will continue to expand as we right car for their needs at a price they can afford. grow geographically. ■ ■ Our computerized inventory system makes it easy to Any used vehicle in our nationwide inventory can be search our vehicle inventory. transferred at customer request to a local superstore. Transfers are free within a market; longer-distance ■ There is no hand-off of customers to a finance manager transfers include a charge to cover transportation costs. or sales manager. The sales consultant helps the customer ■ through the entire sales process. Currently, more than 10% of our vehicles sold are transferred at customer request, and approximately 20% of retail sales are initiated through our Internet sales process. CARMAX 2004 7
    • PROPRIETARY 3 PROCESSES AND SYSTEMS INFORMATION SYSTEMS P R O P R I E TA R Y P R O C E S S E S A N D S Y S T E M S ■ We recognized at the very beginning of CarMax’s concept development that management information systems would be critical to success in the complex used car retailing business. Consumer Offer ■ Our systems capture data on every aspect of our business. • Every vehicle purchased is electronically tracked through its CarMax life from purchase through reconditioning and test drives to ultimate sale. Purchasing/ We also capture data on vehicles we wholesale, Inventory helping us track market pricing changes. Management • In addition, we collect data on activities such as: > Customer visits. Finance > Sales consultant/customer engagements. Reconditioning Originations > Appraisals. > Extended service plan sales. IN S EM FO > Financings. T RMA SYS TION ■ This information is continually used to enhance our processes and systems. ■ We believe our processes and systems provide us with a Our business is not unlike an iceberg. Our unique consumer key competitive advantage. These enabling technologies offer is what draws customers to our stores; it is what can have been developed over our more than 10-year history, be seen “above the waterline.” However, our key processes and we are dedicated to their continuous improvement to and systems “below the waterline” are what make our business maintain this competitive edge. successful — sophisticated purchasing and inventory manage- ment, reconditioning, and finance originations, all supported by proprietary information systems. Competitors who have tried to copy our concept have typically failed because they focused only on our consumer concept. They ignored the hidden danger of failing to build strong operating processes early in concept development. 8 CARMAX 2004
    • PURCHASING AND INVENTORY RECONDITIONING MANAGEMENT ■ The majority of our service operation resources are used in vehicle reconditioning, which supports our ■ More than half the cars we retail are purchased directly used vehicle sales. from consumers, an excellent source of quality, high- demand vehicles. Customer vehicle purchases that do not ■ We employ state-of-the-art production techniques, and meet our retail standards are sold at our own in-store we focus on balancing quality, speed, and cost. Our auctions, which are an economic and efficient means of production planning process allows us to match disposal. reconditioning capacity and inventory demand across multiple stores. ■ We have built a team of more than 500 skilled buyers, 150 of whom have each completed more than 10,000 ■ At the end of fiscal 2003, we rolled out our electronic appraisals. Our buyers have online access to data on repair order system (“ERO”), which optimizes the current inventory and recent sales, as well as wholesale sequencing of vehicle reconditioning procedures. ERO industry information. has reduced reconditioning cycle time and is providing the basis for further quality improvements. ■ In our 10 years of operation, we have appraised more than 4.5 million customer vehicles, retailed more than 1 million ■ Over the past five years, we have reduced our reconditioning used cars, and sold nearly 600,000 cars at our auctions. work-in-process cycle time by 50% through our improved Information captured and analyzed on each transaction process and production techniques. allows us to continually refine our complex inventory and ■ Automotive technicians are in short supply in the U.S. pricing models. We are able to attract and retain skilled technicians by ■ Our inventory and pricing models help us: offering a superior working environment, including air • Buy the mix of makes, models, age, mileage, and price conditioned bays, a corporate benefit program, and the points tailored to the buying preferences at each super- opportunity for career advancement. We also have store. developed an extensive in-house apprentice program. • Recommend pricing adjustments based on complex algorithms that take into account factors including sales history, consumer interest, and seasonal patterns. • Optimize inventory turns to help maintain gross mar- gin dollars per unit and minimize the depreciation risk inherent in used cars. CARMAX 2004 9
    • ■ FINANCE ORIGINATIONS This structure reduces or eliminates two of the three risks inherent in used car lending. ■ CarMax has created a unique finance origination structure • The consumer risk — the customer’s willingness and that provides significant customer benefits and competi- ability to pay — is the basic risk borne by all lenders. tive advantages. • The collateral risk — the risk of the vehicle — is mini- • The sales consultant collects the customer’s credit infor- mized by the consistent, high quality of our cars, the mation and electronically submits the loan application to large percentage of vehicles covered by extended service CarMax Auto Finance (“CAF”) and a third-party prime plans, and the consistency of the relationship between lender. If there are no prime offers, the application is auto- wholesale and retail values for CarMax vehicles. CAF matically routed to third-party, non-prime lenders. and our third-party lenders have found they can rely on • Customers see each offer directly from the lender, and, CarMax information to determine true vehicle worth. where multiple offers exist, they may choose the offer • The “intermediary” risk — the risk introduced by the that best suits their needs. person between the customer and the finance source — • We provide a 3-day payoff option, which gives cus- is eliminated at CarMax. There is no commission- tomers up to three business days to replace the loan with driven finance manager to distort the facts on the cash or an alternative lending source, free of penalty or price or quality of the vehicle or the consumer credit interest. information. With the price of all components fixed, • The sales consultant receives no commission on the value-oriented, and non-negotiable at CarMax, both finance process. CAF and third-party lenders benefit from superior information quality in making financing decisions. ■ Having our own finance operation also reduces the sales risk associated with changes in third-party credit availability. 10 CARMAX 2004
    • 4 STRONG RESULTS $4,597.7 REVENUES R E T U R N O N I N V E S T E D C A P I TA L $3,969.9 (In millions) (Unleveraged) $3,533.8 12.7% 12.4% 12.1% $2,758.5 8.5% $2,201.2 $1,607.3 3.5% $950.7 FY95 FY96 FY97 FY98 FY99 $566.7 $327.1 $93.5 (0.5)% (0.8)% FY00 FY01 FY02 FY03 FY04 (0.8)% (4.1%) (5.3)% FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 $116.5 EARNINGS RETURN ON SHAREHOLDERS’ EQUITY (In millions) $94.8 $90.8 20.7% 18.9% 18.2% 12.4% $45.6 $1.1 0.3% FY95 FY96 FY97 FY98 FY99 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 $(4.1) $(5.2) FY02 FY00 FY01 FY03 FY04 $(9.3) $(23.5) (5%) (6.7%) $(34.2) (9.1%) ROE calculations not meaningful for periods prior to fiscal 1997. CARMAX 2004 11
    • CarMax’s success depends on the skilled and dedicated people who deliver our consumer offer and who develop and execute our processes and systems. The integrity and transparency of the CarMax consumer offer allows us to attract managers and associates with much more diverse backgrounds than the traditional auto retailer. With access to the best of a broad range of applicants, we’ve built a team that can consistently deliver superior customer service, strong leadership, and excellent results. The associates pictured on these pages represent the more than 9,500 employees who contribute to our success. SKILLED, 5 DEDICATED PEOPLE ■ TRAINING AND DEVELOPMENT We recruit the majority of our superstore managers from the top big-box retailers across the country, ■ In any complex retail business, the primary challenge focusing on individuals with a broad, general and limitation to growth is in the ability to recruit, train, management background and a successful career and develop people. progression. Our management training program ■ We have formal training programs that span each of our four includes rotations through each functional area. functional areas — sales, service, buying, and business office. ■ Our comprehensive workforce planning process looks The programs include classroom and online training as well forward more than 48 months, considering planned as formal mentoring assignments. Standardized training and store openings and anticipated turnover. processes also facilitate transfers between stores and regions. S TO R E M A N A G E M E N T 12 CARMAX 2004
    • R E G I O N A L M A N AG E M E N T T E A M S C O R P O R AT E M A N A G E M E N T T E A M TEAMS CARMAX 2004 13
    • SOLID GROWTH 6 OPPORTUNITY ■ GROWTH PLAN Satellite stores are being added in under-served trade areas in established multi-store markets and to increase ■ By focusing on used cars, CarMax can grow organically, penetration and market share in established mid-sized unrestrained by new car franchise or manufacturer markets. Satellite stores are highly efficient because they restrictions. are built on smaller sites and require little or no ■ We resumed our growth plan at the end of fiscal 2002, incremental advertising. following a two-year hiatus during which we concentrated ■ In fiscal 2005, we expect to open 10 superstores, on improving sales and profits. We opened two superstores including four standard stores in mid-sized markets, four in fiscal 2002, five superstores in fiscal 2003, and nine satellite stores in established markets, and two additional superstores in fiscal 2004, including a replacement store stores in Los Angeles. The L.A. stores will help provide in Los Angeles. the foundation for an eventual full-market rollout. ■ During the next three years, we plan to open stores at an annual rate of approximately 15%-20% of our used car superstore base, focusing primarily on new mid-sized markets and adding satellite stores in established markets. ■ We define mid-sized markets as those with television viewing populations ranging from 1 million to 2.5 million. These markets are the easiest to enter from a real estate and advertising perspective, and 49 historically they are where we have experienced the fastest store ramp-up and profitability. 40 35 S T O R E E X PA N S I O N 33 33 (Number of used car superstores) 29 18 7 4 2 1 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 14 CARMAX 2004
    • ■ We estimate we have an 8% – 10% market share of late OUTLOOK model, 1- to 6-year-old used cars within the trade areas ■ Over the next several years, we believe we can achieve of our most mature stores. This benchmark implies comparable store used unit growth in the range of 4% a $20 billion to $25 billion sales potential in today’s to 8% per year. dollars as our stores reach maturity and we achieve full ■ In fiscal 2005, we expect comparable store used unit national scope. growth in the range of 3% to 7%, slightly below our ■ Our market share is significantly higher within a 5-to- longer-term expectation due to the exceptionally strong 10-mile radius. We are adding satellite stores in older mid- sales base established over the last three years. We expect sized markets to determine optimal storing density, best total used unit growth in the range of 18% to 22%. storing patterns, and incremental market share ■ We expect fiscal 2005 earnings per share in the range of opportunities. $1.21 to $1.26, up 10% to 15% from fiscal 2004. The benefit of our comparable and new store sales growth is DEFENSIBLE COMPETITIVE expected to be partly offset by the return to more normalized spreads at CAF. ADVANTAGE ■ There have been numerous unsuccessful attempts to replicate the CarMax model. At present, however, we are fortunate to have no similar-format challengers. This advantageous competitive landscape is allowing us to expand on our own timetable, following our own strategic priorities. ■ CarMax has more than a 10-year development advantage over any challenger who attempts to copy our business. Building an organization, developing specialized processes and systems, refining execution…all take time. ■ CarMax intends to stay ahead of any potential competition through relentless attention to people, processes, and execution. CARMAX 2004 15
    • S E L E C T E D F I N A N C I A L D ATA FY04 FY03 FY02 FY01 FY00 FY99 FY98 FY97 FY96 FY95 (Dollars in millions except per share data) Net sales and operating revenues $4,597.7 $3,969.9 $3,533.8 $2,758.5 $2,201.2 $1,607.3 $950.7 $566.7 $327.1 $ 93.5 Net earnings (loss) $ 116.5 $ 94.8 $ 90.8 $ 45.6 $ 1.1 $ (23.5) $ (34.2) $ (9.3) $ (5.2) $ (4.1) Net earnings (loss) per share: Basic $ 1.13 $ 0.92 $ 0.89 $ 0.45 $ 0.01 $ (0.24) $ (0.35) $ (0.10) N/A N/A Diluted $ 1.10 $ 0.91 $ 0.87 $ 0.44 $ 0.01 $ (0.24) $ (0.35) $ (0.10) N/A N/A Total assets $1,037.0 $ 917.6 $ 720.2 $ 711.0 $ 675.5 $ 571.2 $448.3 $427.2 $102.6 $114.3 Long-term debt, excluding current installments $ 100.0 $ 100.0 $ —$ 83.1 $ 121.3 $ 139.7 $ 27.4 $ — $ 78.5 $111.6 Used units sold 224,099 190,135 164,062 132,868 111,247 96,915 56,594 31,701 19,618 5,574 New units sold 21,641 22,360 24,164 20,157 17,775 6,152 4,265 2,799 — — Comparable store used unit growth (%) 6 8 24 13 (8) (5) 6 7 12 19 Comparable store vehicle dollar growth (%) 6 6 28 17 2 (2) 6 23 12 43 Total used unit growth (%) 18 16 23 19 15 71 79 62 252 335 Total sales growth (%) 16 12 28 25 37 69 68 73 250 356 Used car superstores at year-end 49 40 35 33 33 29 18 7 4 2 Retail stores at year-end 52 44 40 40 40 31 18 7 4 2 Associates at year-end 9,355 8,263 7,196 6,065 5,676 4,789 3,605 1,614 903 146 16 CARMAX 2004
    • M A N A G E M E N T ’ S D I S C U S S I O N A N D A N A LY S I S The following Management’s Discussion and Analysis finance operation allows us to limit the risk of reliance on (“MD&A”) is intended to help the reader understand third-party finance sources, while also allowing us to capture CarMax, Inc. MD&A is presented in nine sections: Business additional profit and cash flows. The majority of CAF’s profit Overview; Critical Accounting Policies; Results of Operations; contribution is generated from the spread between the interest Operations Outlook; Recent Accounting Pronouncements; rate charged the customer and our cost of funds. We collect Financial Condition; Contractual Obligations; Market Risk; fixed, pre-negotiated fees from most of the third-party lenders and Cautionary Information About Forward-Looking for each CarMax customer loan they finance. Statements. MD&A is provided as a supplement to, and We sell extended warranties on behalf of unrelated third should be read in conjunction with, our consolidated financial parties who are the primary obligors. Under these third-party statements and the accompanying notes contained elsewhere warranty programs, we have no contractual liability to the in this annual report. customer. Extended warranty revenue represents commissions In MD&A, “we,” “our,” “us,” “CarMax,” and “the from the unrelated third parties. company” refer to CarMax, Inc. and its wholly owned We are still at an early stage in the national rollout of our subsidiaries, unless the context requires otherwise. Amounts retail concept. The primary drivers for future earnings growth and percents in tables may not total due to rounding. will be vehicle unit growth from geographic expansion and comparable store sales increases, and the related expense leverage. We target a roughly similar fixed dollar amount of B U S I N E S S OV E RV I E W gross profit per used unit, regardless of price, making unit General growth our primary focus. During the next two-to-three years, CarMax was formerly a subsidiary of Circuit City Stores, Inc. we plan to focus our store growth primarily on adding standard (“Circuit City”). On October 1, 2002, the CarMax business was superstores to new mid-sized markets, which we define as those separated from Circuit City through a tax-free transaction and with television viewing audiences between 1 million and 2.5 became an independent, separately traded public company. We million people, and satellite fill-in superstores in established pioneered the used car superstore concept, opening our first store markets. In addition, in fiscal 2005 we plan to open two stores in 1993. Over the next six years, we opened an additional 32 in Los Angeles on sites that were purchased prior to suspending used car superstores before suspending new store development to growth in 1999. Following these openings, we will have four focus on improving profitability. After a period of concept stores in Los Angeles, which will provide a foundation for refinement and execution improvement, we resumed used car future expansion in this market. In fiscal 2006 or 2007, we superstore growth in fiscal 2002, adding two stores late in the expect to once again begin entering additional larger, multi- fiscal year, five stores in fiscal 2003, and nine stores in fiscal 2004. store markets. Over the three-year period, we plan to open used At the end of fiscal 2004, we had 49 used car superstores in 23 car superstores at a rate of 15% to 20% of our store base each markets, including 8 large markets and 15 mid-sized markets. year. We also expect used unit comparable store sales increases CarMax is the nation’s leading specialty retailer of used in the range of 4% to 8%, reflecting the multi-year ramp in vehicles. The CarMax consumer offer is unique in the auto sales of newly opened stores as they mature and continued retailing marketplace. It gives consumers a way to shop for cars market share gains at stores that have reached mature sales the same way they shop for items at other “big-box” retailers. levels. On a combined basis, we expect that new store openings Our consumer offer is structured around four core equities, and comparable store used unit increases will drive total used including low, no-haggle prices; a broad selection; high unit growth of approximately 20% annually. quality; and customer-friendly service. We generate revenues, The principal challenges we face in expanding our store income, and cash flows by retailing used and new vehicles and base and meeting our total unit growth targets include: associated items including vehicle financing, extended warranties, and vehicle repair service. In addition, vehicles ■ Our ability to procure suitable real estate at reasonable purchased through our appraisal process that do not meet our costs. Real estate acquisition will be an increasing challenge retail standards are wholesaled at on-site auctions. as we enter large, multi-store markets. Sales of new vehicles represented a decreasing percentage of ■ Our ability to build our management bench strength to our total revenues over the last three years as we divested new support the store growth. car franchises and added used car superstores. While further We staff each newly opened store with an experienced franchise disposals are planned, we expect to keep a small management team, including the location general manager, number of core new car franchises in order to maintain long- operations manager, purchasing manager, and business office term strategic relationships with automotive manufacturers. manager, as well as a number of experienced sales managers We provide prime financing for customers through CarMax and buyers. We must therefore be continually recruiting, Auto Finance (“CAF”) and Bank of America. We also provide training, and developing managers and associates to fill the financing for non-prime customers through three third-party pipeline necessary to support future store openings. If at any lenders. We continue to test additional non-prime lenders, as time we believe that the rate of store growth is causing our well as lenders for sub-prime financing. Having our own performance to falter, we will slow the growth rate. CARMAX 2004 17
    • Fiscal 2004 Highlights and assumptions affecting the reported amounts of assets, In fiscal 2004, net sales and operating revenues increased 16% liabilities, revenues, expenses, and the disclosures of contingent to $4.60 billion from $3.97 billion and net earnings increased assets and liabilities. We use our historical experience and other 23% to $116.5 million, or $1.10 per share, from $94.8 relevant factors when developing our estimates and assumptions. million, or $0.91 per share. Sales and earnings were affected We continually evaluate these estimates and assumptions. Note 2 by the following items: to the company’s consolidated financial statements includes a discussion of significant accounting policies. The accounting ■ We opened nine used car superstores, including five standard- policies discussed below are the ones we consider critical to an sized stores in new markets and four satellite stores in existing understanding of the company’s consolidated financial markets, including one replacement store in Los Angeles. statements because their application places the most significant ■ Total used units increased 18%. demands on our judgment. Our financial results might have ■ Comparable store used units increased 6%. The expected been different if different assumptions had been used or other cannibalization resulting from the addition of satellite stores conditions had prevailed. occurred somewhat faster than originally projected; however, we do not believe the ultimate amount of Calculation of the Fair Value of Retained Interests cannibalization will be higher than originally planned. We in Securitization Transactions are achieving our net incremental sales objectives in the We use a securitization program to fund substantially all of the markets where satellites have been added. automobile loan receivables originated by CAF. The fair value of retained interests in securitization transactions includes the ■ Gross profit benefited from a change in our appraisal cost present value of the expected residual cash flows generated by the recovery methodology, which is allowing us to more fully securitized receivables, the restricted cash on deposit in various recover the cost of our buying and wholesaling operations with reserve accounts, and an undivided ownership interest in the no adverse effect on the acceptance rate for our appraisal offers. receivables securitized through a warehouse facility and certain ■ CarMax Auto Finance income increased 3% in fiscal 2004, public securitizations. The present value of the expected residual as the benefit of the growth in our portfolio of CAF loans cash flows generated by the securitized receivables is determined was largely offset by the return to more normalized spreads by estimating the future cash flows using management’s in the second half of the year. During fiscal 2002, fiscal assumptions of key factors, such as finance charge income, 2003, and the first half of fiscal 2004, CAF benefited from default rates, prepayment rates, and discount rates appropriate the unusually low interest rate environment, with consumer for the type of asset and risk. These assumptions are derived from rates falling more slowly than our cost of funds. historical experience and projected economic trends. ■ Selling, general, and administrative expenses as a percent of Adjustments to one or more of these assumptions may have a sales (the “SG&A ratio”) increased to 10.2% in fiscal 2004 material impact on the fair value of retained interests. The fair from 9.9% in fiscal 2003. Excluding separation costs, the value of retained interests may be affected by external factors, fiscal 2003 SG&A ratio was 9.7%. The increase in the such as changes in the behavior patterns of customers, changes in SG&A ratio reflects both the growth penalty associated the strength of the economy, and developments in the interest with our resumption of geographic expansion and the rate markets. Note 2(C) to the company’s consolidated financial higher costs of being an independent company following statements includes a discussion of accounting policies related to the separation from Circuit City. New stores generally have securitizations. Note 4 to the company’s consolidated financial higher SG&A ratios during the approximately four years it statements includes a discussion of securitizations and provides a takes to reach mature levels of revenues. sensitivity analysis showing the hypothetical effect on the Net cash provided by operations increased to $148.5 million retained interests if there are variations from the assumptions in fiscal 2004 from $72.0 million in fiscal 2003, driven by the used. In addition, see the “CarMax Auto Finance Income” increase in earnings and a slight reduction in inventory, despite section of this MD&A for a discussion of the current year impact adding nine used car superstores during fiscal 2004. The decrease of changing our assumptions. in inventory reflects both higher-than-normal inventories at the Revenue Recognition end of fiscal 2003 resulting from weather-impeded sales in We recognize revenue when the earnings process is complete, February 2003 and the disposal of four new car franchises during generally either at the time of sale to a customer or upon the current fiscal year. During fiscal 2004, we completed three delivery to a customer. The majority of our revenue is generated sale-leaseback transactions covering a total of nine stores for total from the sale of used vehicles. We recognize vehicle revenue proceeds of $107.0 million and we completed two public when a sales contract has been executed and the vehicle has securitizations of CAF receivables totaling $1.11 billion. been delivered, net of a reserve for returns. A reserve for vehicle returns is recorded based on historical experience and trends. CRITICAL ACCOUNTING POLICIES The estimated reserve for these returns could be affected if Our results of operations and financial condition, as reflected in future occurrences differ from historical averages. the company’s consolidated financial statements, have been We also sell extended warranties on behalf of unrelated third prepared in accordance with accounting principles generally parties to customers who purchase a vehicle. Because these third accepted in the United States of America. Preparation of parties are the primary obligors under these warranties, we financial statements requires management to make estimates 18 CARMAX 2004
    • recognize commission revenue on extended warranties at the primarily of marketable equity and debt instruments, are valued time of the sale, net of a provision for estimated warranty using market quotations. Plan obligations and the annual returns. The reserve for returns is based on historical pension expense are determined by independent actuaries using experience and trends. a number of assumptions provided by the company. Key assumptions used to measure the plan obligations include the Income Taxes discount rate, the rate of salary increases, and the estimated Estimates and judgments are used in the calculation of certain future return on plan assets. In determining the discount rate, tax liabilities and in the determination of the recoverability of we use the current yield on high-quality, fixed-income certain deferred tax assets. In the ordinary course of business, investments that have maturities corresponding to the many transactions occur for which the ultimate tax outcome is anticipated timing of the benefit payments. Salary increase uncertain at the time of the transactions. We adjust our income assumptions are based upon historical experience and tax provision in the period in which we determine that it is anticipated future board and management actions. Asset returns probable that our actual results will differ from our estimates. are estimated based upon the anticipated average yield on the Tax law and rate changes are reflected in the income tax plan assets. We do not believe that any significant changes in provision in the period in which such changes are enacted. assumptions used to measure the plan obligations are likely to We evaluate the need to record valuation allowances that occur that would have a material impact on the company’s would reduce deferred tax assets to the amount that will more financial position or results of operations. likely than not be realized. When assessing the need for valuation allowances, we consider future reversals of existing Insurance Liabilities temporary differences and future taxable income. As of We use a combination of insurance and self-insurance for a February 29, 2004, we believe that all of our recorded deferred number of risks including workers’ compensation, general tax assets will more likely than not be realized. However, if a liability, and employee-related health care benefits, a portion of change in circumstances results in a change in our ability to which is paid by our associates. We estimate the liabilities realize our deferred tax assets, our tax provision would increase associated with these risks by considering historical claims in the period when the change of circumstances occurs. experience, demographic factors, and other actuarial In addition, the calculation of our tax liabilities involves assumptions. The estimated liabilities could be affected if future dealing with uncertainties in the application of complex tax occurrences and claims differ from the current assumptions and regulations. We recognize potential liabilities for anticipated tax historical trends. We do not believe that any significant changes audit issues in the U.S. and other tax jurisdictions based on our in assumptions used to estimate insurance liabilities are likely to estimate of whether, and the extent to which, additional taxes occur that would have a material impact on the company’s will be due. If payments of these amounts ultimately prove to be financial position or results of operations. unnecessary, the reversal of the liabilities would result in tax benefits being recognized in the period when we determine the R E S U L T S O F O P E R AT I O N S liabilities are no longer necessary. If our estimate of tax liabilities Certain prior year amounts have been reclassified to conform to proves to be less than the ultimate assessment, a further charge the current year’s presentation. to expense would result in the period of determination. Net Sales and Operating Revenues Total sales increased 16% in fiscal 2004 to $4.60 billion. In Defined Benefit Retirement Plan The plan obligations and related assets of our defined benefit fiscal 2003, total sales increased 12% to $3.97 billion from retirement plan are presented in Note 8 to the company’s $3.53 billion in fiscal 2002. Net sales and operating revenues consolidated financial statements. Plan assets, which consist components are shown in Table 1. TABLE 1 Years Ended February 29 or 28 2004 % 2003 % 2002 % (In millions) Used vehicle sales $3,470.6 75.5 $2,912.1 73.4 $2,497.2 70.7 New vehicle sales 515.4 11.2 519.8 13.1 559.9 15.8 Total retail vehicle sales 3,986.0 86.7 3,431.9 86.4 3,057.1 86.5 Wholesale vehicle sales 440.6 9.6 366.6 9.2 325.6 9.2 Other sales and revenues: Extended warranty revenues 77.1 1.7 68.1 1.7 55.3 1.6 Service department sales 69.1 1.5 58.6 1.5 55.9 1.6 Third-party finance fees 19.6 0.4 16.2 0.4 15.7 0.4 Appraisal purchase processing fees 5.3 0.1 28.5 0.7 24.2 0.7 Total other sales and revenues 171.1 3.7 171.4 4.3 151.1 4.3 Total net sales and operating revenues $4,597.7 100.0 $3,969.9 100.0 $3,533.8 100.0 CARMAX 2004 19
    • Total Retail Vehicle Sales. Total retail vehicle sales increased We continue to be pleased with the success of our new markets 16% in fiscal 2004 to $3.99 billion. In fiscal 2003, total retail and the net sales increases experienced in the markets where we vehicle sales increased 12% to $3.43 billion from $3.06 billion have added satellite superstores. Expected cannibalization of in fiscal 2002. For fiscal 2004 and fiscal 2003, the overall comparable store used unit sales in markets where we have added increase in retail vehicle sales reflects the growth in comparable satellite stores is occurring somewhat faster than originally store used unit sales and the addition of used car superstores projected, which is causing our reported comparable store used not yet in the comparable store base. We opened two used unit growth to be approximately 1% to 2% lower than originally superstores late in fiscal 2002, five in fiscal 2003, and nine in expected. Our analysis of these trade areas reinforces our belief fiscal 2004, including a replacement store in Los Angeles. that the ultimate amount of cannibalization will not be higher Overall, total retail vehicle sales as a percentage of net sales and than initially planned. Because we are achieving the net operating revenues has remained comparable for all fiscal years incremental sales objectives for these markets, the faster rate of presented. The increase in used vehicle sales as a percentage of cannibalization affects only reported comparable store sales net sales and operating revenues offsets the decrease in new growth and does not affect store economics or earnings. vehicle sales. This reflects the fact that we are expanding our Reduced approval rates from our non-prime customer loan used car superstore base and decreasing the number of new car providers had an adverse impact on comparable store used unit franchises that we operate. sales growth during the fourth quarter of fiscal 2003. During Total retail vehicle unit and dollar changes were as follows: fiscal 2004, the approval rates of our non-prime customer loan providers gradually returned to historical levels. Years Ended February 29 or 28 Our new car sales performance was generally in line with 2004 2003 2002 industry performance for the brands we sell. We disposed of Vehicle units: four new car franchises in fiscal 2004, one in fiscal 2003, and Used vehicles 18 % 16 % 24% four in fiscal 2002. The reported new car comparable sales and New vehicles (3)% (7)% 20% units were reduced by the sale of new car franchises at our Total 16 % 13 % 23% Kenosha, Wis., auto mall. Because we have multiple new car franchises within the Kenosha auto mall, we have not adjusted Vehicle dollars: our comparable sales base for the impact of disposing of any Used vehicles 19 % 17 % 30% one franchise at this location. New vehicles (1)% (7)% 23% Wholesale Vehicle Sales. Our operating strategy is to build Total 16 % 12 % 28% customer satisfaction by offering high-quality vehicles. Fewer than half of the vehicles acquired from consumers through the Comparable store used unit sales growth is one of the key appraisal purchase process meet our standards for reconditioning drivers of our profitability. A CarMax store is included in and subsequent retail sale. Those vehicles that do not meet our comparable store retail sales in the store’s fourteenth full month standards are sold at our on-site wholesale auctions. Total of operation. Comparable store retail unit and dollar sales wholesale vehicle units sold at these auctions were 127,168 in changes were as follows: fiscal 2004; 104,593 in fiscal 2003; and 90,937 in fiscal 2002. The fiscal 2004 increase in wholesale vehicle sales as a percentage Years Ended February 29 or 28 of total net sales and operating revenues was due to increased 2004 2003 2002 wholesale appraisal traffic resulting from the expansion of the Vehicle units: company’s store base and increased consumer response to our Used vehicles 6% 8% 24% vehicle appraisal offer. New vehicles (1)% (3)% 21% Other Sales and Revenues. Other sales and revenues include Total 5% 6% 23% extended warranty revenues, service department sales, third- party finance fees, and, through the second quarter of fiscal Vehicle dollars: 2004, appraisal purchase processing fees collected from Used vehicles 7% 8% 30% customers on the purchase of their vehicles. New vehicles 1% (3)% 24% Appraisal purchase processing fees collected from customers Total 6% 6% 28% were designed to cover some of the costs of our appraisal and wholesale operations. During the first quarter of fiscal 2004, we Comparable store used unit growth resulted from strong tested an alternative method for recovering these costs. Based sales execution and the continued benefits of effective on the test results, during the second quarter the appraisal marketing programs, carmax.com, and word-of-mouth purchase processing fees were discontinued across our entire customer referrals. store base leading to the decrease in these fees as a percentage of net sales and operating revenues. Under the revised appraisal cost recovery (“ACR”) method, instead of charging the 20 CARMAX 2004
    • customer the appraisal purchase processing fee, we adjust the Impact of Inflation. Inflation has not been a significant price of our purchase offer to allow for full recovery of our contributor to results. Profitability is based on achieving costs, thereby reducing the acquisition costs of used and specific gross profit dollars per vehicle rather than on average wholesale vehicles and increasing used vehicle and wholesale retail prices. Because the wholesale market for late-model used vehicle gross margins. The intent of changing to this method is cars adjusts to reflect retail price trends, we believe that if the to recover all costs, including the related costs of land where we stores meet inventory turn objectives, then changes in average hold vehicles before their sale at the wholesale auctions. This retail prices will have only a short-term impact on our gross new ACR method also makes our offer more transparent to the margin and thus profitability. consumer by eliminating a fee. Retail Stores. During fiscal 2004, we opened five standard- sized used car superstores and four satellite superstores, including a replacement store in Los Angeles. In Los Angeles, we Supplemental Sales Information. merged what had been two stand-alone new car franchises into one, co-locating it with our new satellite used car superstore. RETAIL UNIT SALES The following tables provide detail on the CarMax retail Years Ended February 29 or 28 stores and new car franchises: 2004 2003 2002 Used vehicles 224,099 190,135 164,062 RETAIL STORES New vehicles 21,641 22,360 24,164 As of February 29 or 28 Total 245,740 212,495 188,226 2004 2003 2002 Mega superstores(1) 13 13 13 Standard superstores(2) 24 19 17 AVERAGE RETAIL SELLING PRICES Satellite superstores(3) 12 8 5 Years Ended February 29 or 28 Co-located new car stores 3 2 2 2004 2003 2002 Stand-alone new car stores — 2 3 Used vehicles $15,379 $15,243 $15,128 New vehicles $23,650 $23,183 $23,128 Total 52 44 40 Total vehicles $16,107 $16,078 $16,155 (1) 70,000 to 95,000 square feet on 20 to 35 acres. (2) 40,000 to 60,000 square feet on 10 to 25 acres. RETAIL VEHICLE SALES MIX (3) 10,000 to 20,000 square feet on 4 to 7 acres. Years Ended February 29 or 28 2004 2003 2002 NEW CAR FRANCHISES Vehicle units: As of February 29 or 28 Used vehicles 91% 89% 87% 2004 2003 2002 New vehicles 9 11 13 Integrated/co-located new car franchises 12 15 15 Total 100% 100% 100% Stand-alone new car franchises — 2 3 Total 12 17 18 Vehicle dollars: Used vehicles 87% 85% 82% New vehicles 13 15 18 Gross Profit Margin The components of gross profit margin and gross profit per Total 100% 100% 100% unit are presented in Table 2. TABLE 2 Years Ended February 29 or 28 2004 2003 2002 % (1) $ per unit (2) % (1) $ per unit (2) % (1) $ per unit (2) Used vehicle gross profit margin 11.3 1,742 10.8 1,648 10.9 1,660 New vehicle gross profit margin 3.7 872 4.0 931 4.5 1,054 Total retail vehicle gross profit margin 10.3 1,666 9.7 1,572 9.7 1,583 Wholesale vehicle gross profit margin 10.4 359 5.5 192 5.6 202 Other gross profit margin 67.7 472 66.5 534 68.3 548 Total gross profit margin 12.4 2,323 11.8 2,201 11.9 2,228 (1) Calculated as a percentage of its respective sales or revenue. (2) Calculated as category gross profit dollars divided by the respective units sold, except the other and total categories, which are divided by total retail units sold. CARMAX 2004 21
    • Used Vehicle Gross Profit Margin. In fiscal 2004, 2003, percentage of the other category following the elimination of and 2002, we achieved our targets for gross profit dollars per the appraisal purchase processing fee. Compared with the unit. In fiscal 2004, used vehicle gross profit per unit increased prior year, fiscal 2004 service margins improved reflecting as a result of the change in the ACR methodology. The new increased service sales and the benefits of our new electronic ACR methodology allows us to recover the expense of our repair order (“ERO”) system. In fiscal 2003, service sales and appraisal, buying, and wholesale operating processes by costs were adversely impacted by the rollout of the ERO factoring those costs into the purchase offers we make. The system. Third-party warranty commissions and third-party acquisition cost of used vehicles purchased directly from finance fees both benefited from the growth in used car sales. consumers decreased due to the implementation of the new CarMax Auto Finance Income ACR method. Absent the ACR change, we estimate the fiscal CAF’s lending business is limited to providing prime auto loans 2004 gross margin per used unit would have been slightly for our used and new car sales. Because the purchase of an lower than in fiscal 2003. automobile is traditionally reliant on the consumer’s ability to New Vehicle Gross Profit Margin. Achieving our new obtain on-the-spot financing, it is important to our business vehicle target gross profit per unit continues to be a challenge. that such financing be available to creditworthy customers. The decline in new vehicle gross margins reflects increased While financing can also be obtained from third-party sources, competition, which required more aggressive pricing in order to we are concerned that total reliance on third parties can create drive unit sales volume. an unacceptable volatility and business risk. Furthermore, we Wholesale Vehicle Gross Profit Margin. In fiscal 2004, the believe that our processes and systems, the transparency of our wholesale vehicle gross profit margin per unit increased pricing, and our vehicle quality provide a unique and ideal primarily due to the implementation of our new ACR environment in which to procure high-quality auto loan methodology discussed previously. Under the new ACR receivables, both for CAF and for third-party lenders. CAF methodology, the acquisition cost of wholesale vehicles provides us the opportunity to capture additional profits and decreased resulting in higher wholesale vehicle gross margins. cash flows from auto loan receivables while managing our Other Gross Profit Margin. Fiscal 2004 other gross profit reliance on third-party finance sources. margin increased slightly, primarily due to a shift in the mix CAF income does not include any allocation of indirect costs of the underlying components. Prior to implementing the or income. We present this information on a direct basis to new ACR methodology, we had charged customers who sold avoid making arbitrary decisions regarding the indirect benefit us their vehicles an appraisal purchase processing fee, which or costs that could be attributed to CAF. Examples of indirect was included in other revenues at a 100% gross profit margin. costs not included are retail store expenses, retail financing The increases in used vehicle and wholesale vehicle margins commissions, and corporate expenses such as human resources, resulting from the new ACR methodology were partially administrative services, marketing, information systems, offset by the elimination of the appraisal purchase processing accounting, legal, treasury, and executive payroll. fee and its impact on other gross profit margin. Service sales, The components of CarMax Auto Finance income are which are the only category within other sales and revenues presented in Table 3. that do not carry 100% gross margins, became a larger TABLE 3 Years Ended February 29 or 28 2004 % 2003 % 2002 % (In millions) Gains on sales of loans(1) $ 65.1 4.7 $ 68.2 5.8 $ 56.4 6.0 Other income(2): Servicing fee income 21.8 1.0 17.3 1.0 14.0 1.0 Interest income 16.0 0.8 11.5 0.7 7.7 0.6 Total other income 37.8 1.8 28.8 1.7 21.7 1.6 Direct expenses(2): CAF payroll and fringe benefit expense 8.2 0.4 7.0 0.4 5.7 0.4 Other direct CAF expenses 9.7 0.5 7.6 0.4 5.9 0.4 Total direct expenses 17.9 0.9 14.6 0.9 11.6 0.8 CarMax Auto Finance income(3) $ 85.0 1.8 $ 82.4 2.1 $ 66.5 1.9 Loans sold $1,390.2 $1,185.9 $ 938.5 Average managed receivables $2,099.4 $1,701.0 $1,393.7 Net sales and operating revenues $4,597.7 $3,969.9 $3,533.8 Ending managed receivables balance $2,248.6 $1,878.7 $1,503.3 Percent columns indicate: (1) Percent of loans sold. (2) Percent of average managed receivables. (3) Percent of net sales and operating revenues. 22 CARMAX 2004
    • CAF originates automobile loans to CarMax customers at Credit losses as a percentage of average managed receivables competitive market rates of interest. The majority of the profit for fiscal years 2004 and 2003 were comparable. The increase contribution from CAF is generated by the spread between the in losses as a percentage of average managed receivables for interest rate charged to the customer and the cost of funds. fiscal 2003 compared with fiscal 2002 was primarily due to Substantially all of the loans originated by CAF each month are depressed wholesale vehicle values which led to lower recovery sold in securitization transactions as described in Note 4 to the rates on repossessed vehicles. The recovery rate was 42% in company’s consolidated financial statements. A gain, recorded fiscal 2004, 43% in fiscal 2003, and 45% in fiscal 2002. The at the time of the securitization transaction, results from recovery rate represents the average percentage of the recording a receivable equal to the present value of the expected outstanding principal balance CarMax receives when a vehicle residual cash flows generated by the securitized receivables. The is repossessed and liquidated. cash flows are calculated taking into account expected If the managed receivables do not perform in accordance prepayment and default rates. with the assumptions used in determining the fair value of the CarMax Auto Finance income as a percentage of total net retained interests, earnings could be impacted. Past due sales and operating revenues decreased in fiscal 2004. The accounts as a percentage of ending managed receivables were decrease was attributable to spreads returning to more comparable for all fiscal years presented. In fiscal 2004, we normalized levels during the second half of fiscal 2004. During adjusted the cumulative default rate assumptions for certain fiscal 2002, fiscal 2003, and the first half of fiscal 2004, we pools of receivables. We increased the loss rates for two of our benefited from higher than normal spreads due to consumer older pools of receivables to reflect slightly higher losses at the loan rates falling more slowly than our cost of funds. The fiscal end of the pools’ lives. We also increased the loss rate on current 2003 increase in CAF income as a percentage of net sales and originations from 1.85% to 2.00%, reflecting current operating revenues was primarily the result of the $11.8 million economic conditions, including weak recovery rates that increase in the gains on sales of loans and the increase in other stabilized at historically low levels. There was no change in the income related to our managed portfolio. The gains on sales of credit quality of the receivables, which was at the high end of loans increase resulted from an increase in loans sold driven by our historical range. The changes resulted in no material impact a higher sales volume and higher CAF penetration, partially on earnings or the fair value of retained interests. Details offset by a marginal decline in yield spreads. The increase in concerning the assumptions used to value the retained interests other income and total direct expenses was proportionate to the and the sensitivity to adverse changes in the performance of the increase in the managed receivables for all fiscal years presented. managed receivables are included in Note 4 to the company’s We are at risk for the performance of the securitized consolidated financial statements. receivables managed to the extent that we maintain a retained Selling, General and Administrative Expenses interest in the receivables. Supplemental information on our The SG&A ratio was 10.2% of net sales and operating revenues portfolio of managed receivables is shown in the following tables: in fiscal 2004, 9.9% in fiscal 2003, and 9.5% in fiscal 2002. The SG&A ratio for fiscal 2003 and 2002 included one-time As of February 29 or 28 2004 2003 2002 (In millions) costs of $7.8 million and $0.4 million, respectively, associated Loans securitized $2,200.4 $1,859.1 $1,489.4 with the separation of CarMax from Circuit City. Excluding Loans held for sale these costs, the SG&A ratio would have been 9.7% in fiscal or investment 48.2 19.6 13.9 2003 and 9.5% in fiscal 2002. The fiscal 2004 and fiscal 2003 SG&A ratios reflect the Ending managed receivables $2,248.6 $1,878.7 $1,503.3 expected higher level of operating expenses associated with Accounts 31+ days past due $ 31.4 $ 27.6 $ 22.3 being a stand-alone company following the October 1, 2002, Past due accounts as a separation from Circuit City. We estimated stand-alone costs percentage of ending were approximately $13.5 million higher in fiscal 2004 than in managed receivables 1.40% 1.47% 1.48% fiscal 2003, and approximately $9.0 million higher in fiscal 2003 than in fiscal 2002. A majority of these costs related to Years Ended February 29 or 28 employee benefits and insurance. 2004 2003 2002 (In millions) As anticipated, the fiscal 2004 SG&A ratio was adversely Average managed affected by the resumption of our store growth plan and the receivables $2,099.4 $1,701.0 $1,393.7 increase in the number of store openings. New stores typically Credit losses on managed experience higher SG&A ratios than stores with mature sales receivables $ 21.1 $ 17.5 $ 12.9 levels, reflecting the sales ramp that occurs over time. Higher Credit losses as a total pre-opening expenses and costs related to building our percentage of average management team bench strength to support future store managed receivables 1.01% 1.03% 0.93% growth also contributed to the higher current year SG&A ratio. CARMAX 2004 23
    • Selected Quar terly Financial Data (Unaudited) First Quarter Second Quarter Third Quarter Fourth Quarter Fiscal Year (In thousands except 2004 2003 2004 2003 2004 2003 2004 2003 2004 2003 per share data) Net sales and operating revenues $1,172,835 $1,005,803 $1,236,457 $1,080,682 $1,071,534 $936,819 $1,116,865 $946,640 $4,597,691 $3,969,944 Gross profit $ 147,771 $ 122,142 $ 163,105 $ 128,812 $ 126,242 $106,940 $ 133,770 $110,345 $ 570,888 $ 468,239 CarMax Auto Finance income $ 25,748 $ 19,838 $ 22,677 $ 22,110 $ 17,649 $ 19,220 $ 18,889 $ 21,231 $ 84,963 $ 82,399 Selling, general, and administrative expenses $ 115,553 $ 93,037 $ 120,714 $ 97,997 $ 114,282 $101,810 $ 117,825 $ 99,573 $ 468,374 $ 392,417 Separation costs $ —$ 1,871 $ —$ 1,265 $ — $ 4,479 $ —$ 153 $ —$ 7,768 Selling, general, and administrative expenses excluding separation costs $ 115,553 $ 91,166 $ 120,714 $ 96,732 $ 114,282 $ 97,331 $ 117,825 $ 99,420 $ 468,374 $ 384,649 (Gain)/loss on franchise dispositions $ —$ —$ 460 $ —$ (1,207) $ —$ (1,580) $ —$ (2,327) $ — Net earnings $ 35,260 $ 29,238 $ 39,610 $ 31,714 $ 19,053 $ 14,717 $ 22,526 $ 19,133 $ 116,450 $ 94,802 Net earnings excluding separation costs $ 35,260 $ 31,109 $ 39,610 $ 32,979 $ 19,053 $ 19,196 $ 22,526 $ 19,286 $ 116,450 $ 102,570 Net earnings per share: Basic $ 0.34 $ 0.28 $ 0.38 $ 0.31 $ 0.18 $ 0.14 $ 0.22 $ 0.19 $ 1.13 $ 0.92 Diluted $ 0.34 $ 0.28 $ 0.37 $ 0.30 $ 0.18 $ 0.14 $ 0.21 $ 0.18 $ 1.10 $ 0.91 Net earnings per share excluding separation costs: Basic $ 0.34 $ 0.30 $ 0.38 $ 0.32 $ 0.18 $ 0.19 $ 0.22 $ 0.19 $ 1.13 $ 1.00 Diluted $ 0.34 $ 0.30 $ 0.37 $ 0.32 $ 0.18 $ 0.18 $ 0.21 $ 0.18 $ 1.10 $ 0.98 Income Taxes We still plan to sell or return our remaining four Mitsubishi The effective income tax rate was 38.5% in fiscal year 2004, new car franchises. In addition, we plan to sell our Ford 39.5% in fiscal 2003, and 38.0% in fiscal 2002. The fiscal franchise in Kenosha, Wis. The sale or return of integrated new 2003 effective tax rate increased as a result of non-tax- car franchises will create more space for used car sales deductible costs associated with the October 1, 2002, expansion, which is more profitable for us. separation from Circuit City. Fiscal 2005 Expectations The fiscal 2005 expectations discussed below are based on O P E R AT I O N S O U T L O O K historical and current trends in our business and should be read Changes in Store Base in conjunction with the “Cautionary Information About During the fiscal year ending February 28, 2005, we plan to Forward-Looking Statements” section of this MD&A. expand our used car superstore base by approximately 20%, Fiscal 2005 Total Used Unit Growth. Our revenue and opening 10 used car superstores. Planned entries into new mid- earnings growth expectations are based on expanding our store sized markets include Indianapolis, Ind.; Columbia, S.C.; base by 15% to 20% annually, as well as on our comparable Austin, Tex.; and Albuquerque, N.M. Satellite superstore store used unit growth. For fiscal 2005, we expect total used additions are planned for Winston Salem, N.C.; Fayetteville, unit growth in the range of 18% to 22%. Total revenues will N.C.; Miami, Fla.; and Richmond, Va. We also plan to add a also be affected by changes in average retail prices, our standard superstore and a satellite superstore in the Los Angeles dispositions of new car franchises, and the residual effect of the market on sites that were purchased prior to suspending growth new ACR methodology. in 1999. With four stores in the Los Angeles market, we will still lack the critical mass to support television advertising in this market. As a result, we do not expect these Los Angeles stores to perform as strongly as our other newly opened stores in their early years. 24 CARMAX 2004
    • Fiscal 2005 Comparable Store Used Unit Growth. We RECENT ACCOUNTING expect fiscal 2005 comparable store used unit growth in the PRONOUNCEMENTS For a discussion of recent accounting pronouncements range of 3% to 7%. Fiscal 2005 comparable store growth is applicable to the company, see Note 14 to the company’s still challenged, we believe, by the exceptionally strong sales consolidated financial statements. base we established over the past three years, especially following the high levels of customer traffic stimulated by the widespread introduction of 0% financing after the events of FINANCIAL CONDITION September 11, 2001. Operating Activities Fiscal 2005 Earnings Per Share. We expect fiscal 2005 We generated net cash from operating activities of $148.5 pretax earnings growth of 12% to 17%. We anticipate that our million in fiscal 2004, $72.0 million in fiscal 2003, and $42.6 effective tax rate will increase from 38.5% to 39.0% as we million in fiscal 2002. The fiscal 2004 improvement primarily expand our store base into states with higher tax rates. resulted from the increase in net earnings and a slight decrease Consequently our earnings per share growth will be slightly in inventory, despite adding nine used car superstores during lower at 10% to 15%, in the range of $1.21 to $1.26. the year. The decrease in inventory in fiscal 2004 reflects the We expect our gross margin to be favorably impacted by the combined effects of a higher-than-normal inventory balance at growing mix of used car sales, as we add used car superstores the end of fiscal 2003 resulting from weather-impeded sales in and divest new car franchises. In addition, we believe a February 2003 and the disposal of four new car franchises refinement of our ACR methodology will provide an during the current fiscal year. The fiscal 2003 improvement incremental benefit to gross margin. primarily resulted from an increase in net earnings and an In fiscal 2005, we expect CAF’s gain as a percent of loans increase in accounts payable and accrued expenses associated sold to be slightly below the midpoint of our 3.5% to 4.5% with the separation from Circuit City. Prior to fiscal 2003, normalized range. Therefore, we expect CAF income will be certain liabilities such as the workers’ compensation liability relatively flat with fiscal 2004, despite the anticipated increase were recorded through the debt from our former parent and in loan volume. Our fiscal 2005 pretax earnings growth would therefore reflected as financing activities. be expected in the range of 19% to 24% if our CAF spread remained at the 4.7% that it was in fiscal 2004. Investing Activities Net cash used in investing activities was $73.8 million in fiscal In fiscal 2005, we will still be experiencing the growth 2004 and $80.4 million in fiscal 2003. Net cash provided by penalty of opening new stores, which have higher SG&A rates, investing activities was $57.5 million in fiscal 2002. Capital while none of our newer stores will have reached mature levels expenditures were $181.3 million in fiscal 2004, $122.0 of revenue. We believe our corporate overhead expenditures as million in fiscal 2003, and $41.4 million in fiscal 2002. The a percent of sales will remain flat compared with fiscal 2004, increase in capital expenditures reflects the increase in our store even though we expect to absorb approximately $4 million in base associated with the resumption of our growth plan. additional expenses related to being a stand-alone company. Additionally, some of the fiscal 2004 increase is associated with Among these expenses are costs related to outsourcing our the initial expenditures associated with our future corporate payroll systems, which previously had been supplied by Circuit office site in Richmond, Va. City. We also expect another $3 million to $5 million of Capital expenditures are funded through sale-leaseback incremental stand-alone costs in fiscal 2006 when we outsource transactions, short- and long-term debt, and internally our data center, which is now housed at Circuit City. This generated funds. Net proceeds from sales of property and should be the last major incremental stand-alone cost increase equipment totaled $107.5 million in fiscal 2004, $41.6 million we will incur. in fiscal 2003, and $99.0 million in fiscal 2002. The majority of the sale proceeds relate to sale-leaseback transactions. In Longer-Term Expectations The longer-term expectations discussed below are based on fiscal 2004, the company entered into sale-leaseback historical and current trends in our business and should be read transactions involving nine properties valued at approximately in conjunction with the “Cautionary Information About $107.0 million. In fiscal 2003, we entered into a sale leaseback Forward-Looking Statements” section of this MD&A. transaction involving three superstore properties valued at We expect used unit comparable store sales increases in the approximately $37.6 million and in fiscal 2002 we entered into range of 4% to 8% over the next several years, reflecting the a sale leaseback transaction involving nine superstore properties multi-year ramp in sales of newly opened stores as they mature. valued at approximately $102.4 million. These transactions Once CAF income reflects comparative spreads in our were structured as operating leases with initial terms of either normalized range, we expect the combination of unit growth 15 or 20 years with various renewal options. At February 29, and expense leverage to deliver average annual earnings per 2004, we owned a total of four CarMax superstores. share growth of approximately 20%. CARMAX 2004 25
    • Off-Balance Sheet Arrangements In fiscal 2005, we anticipate gross capital expenditures of CAF’s lending business is limited to providing prime auto approximately $250 million. Planned expenditures primarily loans for our used and new car sales. We use a securitization relate to new store construction, including furniture, fixtures, program to fund substantially all of the automobile loan and equipment; land purchases associated with future year receivables originated by CAF. We sell the automobile loan store openings; new corporate offices; and leasehold receivables to a wholly owned, bankruptcy-remote, special improvements to existing properties. We expect to open ten purpose entity that transfers an undivided interest in the used car superstores during fiscal 2005, five of which will be receivables to a group of third-party investors. This program satellite superstores. is referred to as the warehouse facility. We periodically use public securitizations to refinance the Financing Activities receivables previously securitized through the warehouse Net cash used in financing activities was $47.6 million in facility. In a public securitization, a pool of automobile loan fiscal 2004. In fiscal year 2003, net cash provided by receivables is sold to a bankruptcy-remote, special purpose financing activities was $39.8 million, compared with net entity that in turn transfers the receivables to a special cash used of $105.7 million in fiscal 2002. In fiscal 2004, we purpose securitization trust. used cash generated from operations to reduce total Additional information regarding the nature, business outstanding debt by $51.6 million. In fiscal 2003, we purposes, and importance of our off-balance sheet increased total outstanding debt by $67.6 million and paid a arrangement to our liquidity and capital resources can be one-time dividend of $28.4 million to Circuit City in found in the “CarMax Auto Finance Income,” “Financial conjunction with the separation transaction. Condition,” and “Market Risk” sections of this MD&A, as The aggregate principal amount of automobile loan well as in Notes 3, 4, and 5 to the company’s consolidated receivables funded through securitizations, which are financial statements. discussed in Notes 3 and 4 to the company’s consolidated financial statements, totaled $2.20 billion at February 29, 2004, $1.86 billion at February 28, 2003, and $1.49 billion MARKET RISK at February 28, 2002. During fiscal 2004, we completed two Automobile Installment Loan Receivables public automobile loan securitizations totaling $1.11 billion. At February 29, 2004, and February 28, 2003, all loans in At February 29, 2004, the warehouse facility limit was the portfolio of automobile loan receivables were fixed-rate $825.0 million and unused warehouse capacity totaled installment loans. Financing for these automobile loan $272.5 million. The warehouse facility matures in June 2004. receivables is achieved through asset securitization programs Notes 2(C) and 4 to the company’s consolidated financial that, in turn, issue both fixed- and floating-rate securities. statements include a discussion of the warehouse facility. We Interest rate exposure relating to floating-rate securitizations anticipate that we will be able to renew, expand, or enter into is managed through the use of interest rate swaps. new securitization arrangements to meet the future needs of Receivables held for investment or sale are financed with the automobile loan finance operation. working capital. Generally, changes in interest rates We maintain a $300 million credit facility secured by vehicle associated with underlying swaps will not have a material inventory. As of February 29, 2004, the amount outstanding impact on earnings. However, changes in interest rates under this credit facility was $104.4 million, with the associated with underlying swaps may have a material impact remainder fully available to the company. See Note 9 to the on cash and cash flows. company’s consolidated financial statements for discussion of Credit risk is the exposure to nonperformance of another expiration, renewals, and covenants associated with this facility. party to an agreement. Credit risk is mitigated by dealing with We expect that proceeds from securitization transactions; highly rated bank counterparties. The market and credit risks sale-leaseback transactions; current and, if needed, additional associated with financial derivatives are similar to those relating credit facilities; and cash generated by operations will be to other types of financial instruments. Refer to Note 5 to the sufficient to fund capital expenditures and working capital for company’s consolidated financial statements for a description the foreseeable future. of these items. C O N T R A C T U A L O B L I G AT I O N S Less than 1 to 3 3 to 5 More than 5 Total 1 Year Years Years Years (In millions) Contractual obligations: Long-term debt $ 100.0 $ — $100.0 $ — $ — Operating leases 893.0 58.2 116.4 115.5 602.9 Purchase obligations 88.4 73.0 6.3 9.1 — Lines of credit 4.4 4.4 — — — Total $1,085.8 $135.6 $222.7 $124.6 $602.9 26 CARMAX 2004
    • The total principal amount of ending managed receivables The company operates in a highly competitive industry and ■ securitized or held for investment or sale was as follows: new entrants to the industry could result in increased wholesale costs for used vehicles and lower-than-expected As of February 29 or 28 vehicle sales and margins. 2004 2003 (In millions) Any significant changes in retail prices for used and ■ Fixed-rate securitizations $1,647.9 $1,385.1 new vehicles could result in lower sales and margins for Floating-rate securitizations the company. synthetically altered to fixed 551.8 473.2 A reduction in the availability or access to sources of ■ Floating-rate securitizations 0.7 0.8 inventory would adversely affect the company’s business. Held for investment(1) 29.4 16.0 Held for sale(2) 18.8 3.6 Should excess inventory develop, the inability to liquidate ■ excess inventory at prices that allow the company to meet its Total $2,248.6 $1,878.7 margin targets or to recover its costs would adversely affect (1) The majority is held by a bankruptcy-remote special purpose entity. the company’s profitability. (2) Held by a bankruptcy-remote special purpose entity. The ability to attract and retain an effective management ■ team in a dynamic environment and the availability of a Interest Rate Exposure suitable work force is vital to the company’s ability to We also have interest rate risk from changing interest rates manage and support its service-driven operating strategies. related to our outstanding debt. Substantially all of the debt The inability to attract such a work-force team or a is floating-rate debt based on LIBOR. A 100-basis point significant increase in payroll market costs would adversely increase in market interest rates would not have had a material affect the company’s profitability. effect on our fiscal 2004 results of operations or cash flows. Changes in the availability or cost of capital and working ■ capital financing, including the availability of long-term C A U T I O N A R Y I N F O R M AT I O N A B O U T financing to support development of the company and the F O R W A R D - L O O K I N G S TAT E M E N T S The provisions of the Private Securities Litigation Reform Act availability of securitization financing, could adversely affect of 1995 provide companies with a “safe harbor” when making the company’s growth and operating strategies. forward-looking statements. This “safe harbor” encourages A decrease in the availability of appropriate real estate ■ companies to provide prospective information about their locations for expansion would limit the expansion of the companies without fear of litigation. The company wishes to company’s store base and the company’s future operating take advantage of the “safe harbor” provisions of the Act. results. Company statements that are not historical facts, including The occurrence of weather events adversely affecting traffic ■ statements about management’s expectations for fiscal 2005 at our retail locations could negatively impact the company’s and beyond, are forward-looking statements and involve operating results. various risks and uncertainties. The occurrence of certain material events including natural ■ Forward-looking statements are estimates and projections disasters, acts of terrorism, the outbreak of war or other reflecting our judgment and involve a number of risks and significant national or international events could adversely uncertainties that could cause actual results to differ materially affect the company’s operating results. from those suggested by the forward-looking statements. Although we believe that the estimates and projections The imposition of new restrictions or regulations ■ reflected in the forward-looking statements are reasonable, our regarding the sale of products and/or services that the expectations may prove to be incorrect. Investors are cautioned company sells, changes in tax or environmental rules and not to place undue reliance on any forward-looking regulations applicable to the company or our competitors, statements, which are based on current expectations. or any failure to comply with such laws or any adverse Important factors that could cause actual results to differ change in such laws could increase costs and affect the materially from estimates or projections contained in our company’s profitability. forward-looking statements include: We are subject to various litigation matters, which, if the ■ In the normal course of business, we are subject to changes ■ outcomes in any significant matters are adverse, could in general U.S. or regional U.S. economic conditions negatively affect the company’s business. including, but not limited to, consumer credit availability, consumer credit delinquency and default rates, interest rates, inflation, personal discretionary spending levels, and consumer sentiment about the economy in general. Any significant changes in economic conditions could adversely affect consumer demand and increase costs resulting in lower profitability for the company. CARMAX 2004 27
    • C O N S O L I D AT E D S TAT E M E N T S O F E A R N I N G S Years Ended February 29 or 28 2004 %(1) 2003 %(1) 2002 %(1) (In thousands except per share data) SALES AND OPERATING REVENUES: Used vehicle sales $3,470,615 75.5 $2,912,082 73.4 $2,497,150 70.7 New vehicle sales 515,383 11.2 519,835 13.1 559,943 15.8 Wholesale vehicle sales 440,571 9.6 366,589 9.2 325,552 9.2 Other sales and revenues 171,122 3.7 171,438 4.3 151,114 4.3 4,597,691 100.0 3,969,944 100.0 3,533,759 100.0 NET SALES AND OPERATING REVENUES Cost of sales 4,026,803 87.6 3,501,705 88.2 3,114,366 88.1 570,888 12.4 468,239 11.8 419,393 11.9 GROSS PROFIT 84,963 1.8 82,399 2.1 66,473 1.9 CARMAX AUTO FINANCE INCOME (NOTES 3 AND 4) Selling, general, and administrative expenses (NOTE 2) 468,374 10.2 392,417 9.9 334,464 9.5 Gain on franchise dispositions, net 2,327 0.1 — — — — Interest expense (NOTE 9) 1,137 — 2,261 0.1 4,958 0.1 Interest income 683 — 737 — 12 — Earnings before income taxes 189,350 4.1 156,697 3.9 146,456 4.1 Provision for income taxes (NOTE 7) 72,900 1.6 61,895 1.6 55,654 1.6 $ 116,450 2.5 $ 94,802 2.4 $ 90,802 2.6 NET EARNINGS Weighted average common shares (NOTE 11): Basic 103,503 102,983 102,039 Diluted 105,628 104,570 104,022 NET EARNINGS PER SHARE (NOTE 11): Basic $ 1.13 $ 0.92 $ 0.89 Diluted $ 1.10 $ 0.91 $ 0.87 Percents are calculated as a percentage of net sales and operating revenues and may not equal totals due to rounding. (1) See accompanying notes to consolidated financial statements. 28 CARMAX 2004
    • C O N S O L I D AT E D B A L A N C E S H E E T S At February 29 or 28 2004 2003 (In thousands except share data) ASSETS CURRENT ASSETS: Cash and cash equivalents (NOTE 2) $ 61,643 $ 34,615 Accounts receivable, net 72,358 56,449 Automobile loan receivables held for sale (NOTE 4) 18,781 3,579 Retained interests in securitized receivables (NOTE 4) 145,988 135,016 Inventory 466,061 466,450 Prepaid expenses and other current assets 8,650 12,636 773,481 708,745 TOTAL CURRENT ASSETS Property and equipment, net (NOTE 6) 244,064 187,158 Deferred income taxes (NOTE 7) 185 — Other assets 19,287 21,714 $1,037,017 $917,617 TOTAL ASSETS LIABILITIES AND SHAREHOLDERS’ EQUITY CURRENT LIABILITIES: Accounts payable $ 145,517 $117,587 Accrued expenses and other current liabilities 55,674 44,682 Accrued income taxes 4,050 — Deferred income taxes (NOTE 7) 32,711 29,783 Short-term debt (NOTE 9) 4,446 56,051 242,398 248,103 TOTAL CURRENT LIABILITIES Long-term debt, excluding current installments (NOTE 9) 100,000 100,000 Deferred revenue and other liabilities 13,866 10,904 Deferred income taxes (NOTE 7) — 4,041 356,264 363,048 TOTAL LIABILITIES SHAREHOLDERS’ EQUITY (NOTES 1 AND 10): Common stock, $0.50 par value; 350,000,000 shares authorized; 103,778,461 and 103,083,047 shares issued and outstanding at February 29, 2004, and February 28, 2003, respectively 51,889 51,542 Capital in excess of par value 482,132 472,745 Retained earnings 146,732 30,282 680,753 554,569 TOTAL SHAREHOLDERS’ EQUITY Commitments and contingent liabilities (NOTES 1, 8, 9, 12, AND 13) — — $1,037,017 $917,617 TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY See accompanying notes to consolidated financial statements. CARMAX 2004 29
    • C O N S O L I D AT E D S TAT E M E N T S O F C A S H F L O W S Years Ended February 29 or 28 2004 2003 2002 (In thousands) OPERATING ACTIVITIES: Net earnings $ 116,450 $ 94,802 $ 90,802 Adjustments to reconcile net earnings to net cash provided by operating activities: Depreciation and amortization 16,181 14,873 16,340 Amortization of restricted stock awards 122 77 100 (Gain) loss on disposition of assets (1,462) 30 — Provision for deferred income taxes (1,298) 8,880 3,162 Changes in operating assets and liabilities: (Increase) decrease in accounts receivable, net (15,909) (6,008) 7,232 (Increase) decrease in automobile loan receivables held for sale (15,202) (1,435) 704 Increase in retained interests in securitized receivables (10,972) (14,333) (46,542) Decrease (increase) in inventory 389 (67,366) (51,947) Decrease (increase) in prepaid expenses and other current assets 3,986 (10,571) 241 Decrease (increase) in other assets 4,647 (845) 1,639 Increase in accounts payable, accrued expenses and other current liabilities, and accrued income taxes 48,570 51,375 19,330 Increase in deferred revenue and other liabilities 2,962 2,488 1,580 148,464 71,967 42,641 NET CASH PROVIDED BY OPERATING ACTIVITIES INVESTING ACTIVITIES: Purchases of property and equipment (181,338) (122,032) (41,417) Proceeds from sales of property and equipment 107,493 41,621 98,965 (73,845) (80,411) 57,548 NET CASH (USED IN) PROVIDED BY INVESTING ACTIVITIES FINANCING ACTIVITIES: (Decrease) increase in short-term debt, net (51,605) 46,211 8,853 Issuance of long-term debt — 100,000 — Payments on long-term debt — (78,608) (112,600) Equity issuances, net 4,014 570 (1,958) Special dividend paid — (28,400) — (47,591) 39,773 (105,705) NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES Increase (decrease) in cash and cash equivalents 27,028 31,329 (5,516) Cash and cash equivalents at beginning of year 34,615 3,286 8,802 $ 61,643 $ 34,615 $ 3,286 CASH AND CASH EQUIVALENTS AT END OF YEAR SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the year for: Interest $ 4,695 $ 3,862 $ 5,336 Income taxes $ 59,987 $ 49,215 $ 42,332 See accompanying notes to consolidated financial statements. 30 CARMAX 2004
    • C O N S O L I D AT E D S TAT E M E N T S O F S H A R E H O L D E R S ’ E Q U I T Y Common Capital in Shares Common Excess of Retained Parent’s Outstanding Stock Par Value Earnings Equity Total (In thousands) — $ — $ — $ — $ 391,503 $391,503 BALANCE AT MARCH 1, 2001 Net earnings — — — — 90,802 90,802 Equity issuances, net — — — — 3,174 3,174 — — — — 485,479 485,479 BALANCE AT FEBRUARY 28, 2002 Net earnings — — — 30,282 64,520 94,802 Equity issuances, net — — — — 2,589 2,589 Special dividend — — — — (28,400) (28,400) Recapitalization due to separation 103,014 51,507 472,681 — (524,188) — Exercise of common stock options 39 20 177 — — 197 Shares purchased for employee stock purchase plan — — (213) — — (213) Shares issued under stock incentive plans 30 15 408 — — 423 Tax benefit from stock issued — — 12 — — 12 Unearned compensation-restricted stock — — (320) — — (320) 103,083 51,542 472,745 30,282 — 554,569 BALANCE AT FEBRUARY 28, 2003 Net earnings — — — 116,450 — 116,450 Exercise of common stock options 693 346 4,176 — — 4,522 Shares purchased for employee stock purchase plan — — (599) — — (599) Shares issued under stock incentive plans 3 2 95 — — 97 Shares cancelled upon reacquisition by the company (1) (1) (13) — — (14) Tax benefit from stock issued — — 5,598 — — 5,598 Unearned compensation-restricted stock — — 130 — — 130 103,778 $51,889 $482,132 $146,732 $ — $680,753 BALANCE AT FEBRUARY 29, 2004 See accompanying notes to consolidated financial statements. CARMAX 2004 31
    • N O T E S T O C O N S O L I D AT E D F I N A N C I A L S TAT E M E N T S BACKGROUND AND BASIS OF S U M M A RY O F S I G N I F I C A N T 1 2 P R E S E N TAT I O N ACCOUNTING POLICIES CarMax, Inc. (“CarMax” and “the company”), including its (A) Principles of Consolidation wholly owned subsidiaries, is the leading specialty retailer of The consolidated financial statements include the accounts of used cars and light trucks in the United States. CarMax was CarMax and its wholly owned subsidiaries. All significant the first used vehicle retailer to offer a large selection of intercompany balances and transactions have been eliminated quality used vehicles at low, “no-haggle” prices using a in consolidation. customer-friendly sales process in an attractive, modern sales facility. CarMax also sells new vehicles under various franchise (B) Cash and Cash Equivalents agreements. CarMax provides its customers with a full range Cash equivalents of $48.9 million and $29.6 million at of related services, including the financing of vehicle February 29, 2004, and February 28, 2003, respectively, purchases through its own finance operation, CarMax Auto consisted of highly liquid debt securities with original Finance (“CAF”), and third-party lenders; the sale of maturities of three months or less. Included in cash equivalents extended warranties; and vehicle repair service. at February 29, 2004, and February 28, 2003, were restricted CarMax was formerly a subsidiary of Circuit City Stores, cash deposits of $13.0 million and $11.5 million, respectively, Inc. (“Circuit City”). Prior to October 1, 2002, Circuit City which were associated with certain insurance deductibles. had two common stock series, the Circuit City Stores, Inc.— Additional restricted cash related to securitized auto loan Circuit City Group (“Circuit City Group”) common stock receivables at February 29, 2004, and February 28, 2003, were and the Circuit City Stores, Inc.—CarMax Group (“CarMax $6.4 million and $2.4 million, respectively. Group”) common stock, which was intended to track (C) Securitizations separately the performance of the CarMax business. On The company uses a securitization program to fund October 1, 2002, the CarMax business was separated from substantially all of the automobile loan receivables originated Circuit City through a tax-free transaction in which each by CAF. The company sells the automobile loan receivables to share of CarMax Group common stock was exchanged for one a wholly owned, bankruptcy-remote, special purpose entity share of CarMax, Inc. common stock. In addition, each that transfers an undivided interest in the receivables to a group holder of Circuit City Group common stock received a of third-party investors. This program is referred to as the distribution of a 0.313879 share of CarMax, Inc. common warehouse facility. stock for each Circuit City Group share. As a result of the The company periodically uses public securitizations to separation, all of the businesses, assets, and liabilities of the refinance the receivables previously securitized through the CarMax Group are held in CarMax, Inc., an independent, warehouse facility. In a public securitization, a pool of separately traded public company. automobile loan receivables is sold to a bankruptcy-remote, In conjunction with the separation, all outstanding special purpose entity that in turn transfers the receivables to a CarMax Group stock options and restricted stock were special purpose securitization trust. replaced with CarMax, Inc. stock options and restricted The transfers of receivables are accounted for as sales in stock with the same terms and conditions, exercise prices, accordance with Statement of Financial Accounting Standards and restrictions as the CarMax Group stock options and (“SFAS”) No. 140, “Accounting for Transfers and Servicing of restricted stock they replaced. Financial Assets and Extinguishments of Liabilities.” The At the separation date, Circuit City and CarMax executed company retains various interests in the automobile loan a transition services agreement and a tax allocation agreement. receivables that it securitizes. The retained interests presented In the transition services agreement, Circuit City agreed to on the company’s consolidated balance sheets include the provide to CarMax services including human resources, present value of the expected residual cash flows generated by payroll, benefits administration, tax services, computer center the securitized receivables, the restricted cash on deposit in support, and telecommunications. The agreement specified various reserve accounts, and an undivided ownership interest initial service periods ranging from six to twenty-four in the receivables securitized through the warehouse facility and months, with varying renewal options. For fiscal 2005, certain public securitizations. Retained interests are carried at Circuit City will provide computer center support and fair value and changes in fair value are included in earnings. See telecommunication services for CarMax pursuant to this Notes 3 and 4 for additional discussion on securitizations. agreement. The tax allocation agreement provided that the pre-separation taxes attributable to the business of each party would be borne solely by that party. 32 CARMAX 2004
    • (D) Fair Value of Financial Instruments indefinite useful lives were amortized on a straight-line basis The carrying value of the company’s cash and cash equivalents, over 15 years. The carrying amount of goodwill and other receivables including automobile loan receivables, accounts intangibles was $16.0 million as of February 29, 2004, and payable, short-term borrowings, and long-term debt $21.7 million as of February 28, 2003. approximates fair value. The company’s retained interests in securitized receivables and derivative financial instruments are (J) Defined Benefit Retirement Plan and Insurance Liabilities recorded on the consolidated balance sheets at fair value. Defined benefit retirement plan obligations and insurance liabilities are included in accrued expenses and other current (E) Trade Accounts Receivable liabilities on the company’s consolidated balance sheets. The Trade accounts receivable, net of an allowance for doubtful defined benefit retirement plan obligations are determined by accounts, include certain amounts due from finance companies independent actuaries using a number of assumptions provided and customers, as well as from manufacturers for incentives and by the company. Key assumptions used to measure the plan warranty reimbursements, and for other miscellaneous obligations include the discount rate, the rate of salary receivables. The estimate for doubtful accounts is based on increases, and the estimated future return on plan assets. historical experience and trends. Insurance liability estimates for workers’ compensation, general (F) Inventor y liability, and employee-related health care benefits are Inventory is comprised primarily of vehicles held for sale or determined by considering historical claims experience, undergoing reconditioning and is stated at the lower of cost or demographic factors, and other actuarial assumptions. market. Vehicle inventory cost is determined by specific identification. Parts and labor used to recondition vehicles, as (K) Impairment or Disposal of Long-Lived Assets The company reviews long-lived assets for impairment when well as transportation and other incremental expenses associated circumstances indicate the carrying amount of an asset may not with acquiring and reconditioning vehicles, are included in be recoverable. Impairment is recognized when the sum of inventory. Certain manufacturer incentives and rebates for new undiscounted estimated future cash flows expected to result car inventory, including holdbacks, are recognized as a reduction from the use of the asset is less than the carrying value. to new car inventory when the company purchases the vehicles. Volume-based incentives are recognized as a reduction to new (L) Store Opening Expenses car inventory cost when achievement of volume thresholds are Costs relating to store openings, including preopening costs, determined to be probable. are expensed as incurred. (G) Proper ty and Equipment (M) Income Taxes Property and equipment is stated at cost less accumulated Deferred income taxes reflect the impact of temporary depreciation and amortization. Depreciation and amortization differences between the amounts of assets and liabilities are calculated using the straight-line method over the assets’ recognized for financial reporting purposes and the amounts estimated useful lives. recognized for income tax purposes, measured by applying currently enacted tax laws. A deferred tax asset is recognized if (H) Computer Software Costs it is more likely than not that a benefit will be realized. External direct costs of materials and services used in the development of internal-use software and payroll and payroll- (N) Revenue Recognition related costs for employees directly involved in the The company recognizes revenue when the earnings process is development of internal-use software are capitalized. Amounts complete, generally either at the time of sale to a customer or capitalized are amortized on a straight-line basis over a period upon delivery to a customer. As part of its customer service of five years. strategy, the company guarantees the vehicles it sells with a 5-day or 250-mile, money-back guarantee. If a customer returns (I) Goodwill and Intangible Assets the vehicle purchased within the limits of the guarantee, the SFAS No. 142, “Goodwill and Other Intangible Assets,” company will refund the customer’s money. A reserve for vehicle requires that goodwill and intangible assets with indefinite returns is recorded based on historical experience and trends. useful lives not be amortized, but rather tested for impairment The company sells extended warranties on behalf of at least annually. As of March 1, 2002, the company unrelated third parties. These warranties have terms of performed the required transition impairment tests of coverage from 12 to 72 months. Because these third parties goodwill and other intangible assets and determined that no are the primary obligors under these warranties, commission impairment existed. Additionally, as of February 29, 2004, revenue is recognized at the time of sale, net of a provision for and February 28, 2003, no impairment of goodwill or estimated customer returns of the warranties. The reserve for intangible assets resulted from the annual impairment tests. returns is based on historical experience and trends. Prior to March 1, 2002, goodwill and other intangibles with CARMAX 2004 33
    • (O) Adver tising Expenses The pro forma effect on fiscal 2004 may not be representative All advertising costs are expensed as incurred. Advertising of the pro forma effects on net earnings and net earnings per expense, which is included in selling, general, and share for future years. administrative expenses in the accompanying consolidated For the purpose of computing the pro forma amounts statements of earnings, amounted to $62.4 million in fiscal indicated above, the fair value of each option on the date of grant 2004, $52.4 million in fiscal 2003, and $47.3 million in fiscal was estimated using the Black-Scholes option-pricing model. The 2002. Advertising expense was 1.4% of net sales and operating weighted average assumptions used in the model were as follows: revenues for fiscal 2004 and 1.3% for fiscal 2003 and 2002. Years Ended February 29 or 28 2004 2003 2002 (P) Net Earnings Per Share Basic net earnings per share is computed by dividing net Expected dividend yield — — — earnings by the weighted average number of shares of common Expected stock volatility 78% 76% 79% stock outstanding. Diluted net earnings per share is computed Risk-free interest rates 3% 4% 5% by dividing net earnings by the sum of the weighted average Expected lives (in years) 5 5 4 number of shares of common stock outstanding and dilutive potential common stock. Using these assumptions in the Black-Scholes model, the weighted average fair value of options granted was $9 per share (Q) Stock-Based Compensation in fiscal 2004, $17 per share in fiscal 2003, and $3 per share in The company accounts for its stock-based compensation plans fiscal 2002. under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued (R) Derivative Financial Instruments to Employees,” and related interpretations. Under this opinion In connection with securitization activities through the and related interpretations, compensation expense is recorded on warehouse facility, the company enters into interest rate swap the date of grant and amortized over the period of service only if agreements to manage exposure to interest rates and to more the market value of the underlying stock on the grant date exceeds closely match funding costs to the use of funding. The the exercise price. No stock option-based employee compensation company recognizes the interest rate swaps as either assets or cost is reflected in net earnings, as options granted under those liabilities on the consolidated balance sheets at fair value with plans had exercise prices equal to the market value of the changes in fair value included in earnings as a component of underlying common stock on the date of grant. The following CarMax Auto Finance income. table illustrates the effect on net earnings and net earnings per (S) Risks and Uncer tainties share as if the fair-value-based method of accounting had been CarMax retails used and new vehicles. The diversity of the applied to all outstanding stock awards in each reported period: company’s customers and suppliers reduces the risk that a severe impact will occur in the near term as a result of changes in its Years Ended February 29 or 28 2004 2003 2002 (In thousands except per share data) customer base, competition, or sources of supply. However, Net earnings, as reported $116,450 $94,802 $90,802 management cannot assure that unanticipated events will not have a negative impact on the company. Total additional stock-based The preparation of financial statements in conformity with compensation expenses accounting principles generally accepted in the United States of determined under the America requires management to make estimates and fair-value-based method assumptions that affect the reported amounts of assets, liabilities, for all awards, net of revenues and expenses, and the disclosure of contingent assets related tax effects 6,759 4,391 1,559 and liabilities. Actual results could differ from those estimates. Pro forma net earnings $109,691 $90,411 $89,243 (T) Reclassifications Earnings per share: Certain prior year amounts have been reclassified to conform to Basic, as reported $ 1.13 $ 0.92 $ 0.89 the current year’s presentation. Basic, pro forma $ 1.06 $ 0.88 $ 0.87 Diluted, as reported $ 1.10 $ 0.91 $ 0.87 Diluted, pro forma $ 1.04 $ 0.86 $ 0.86 34 CARMAX 2004
    • investors have no recourse to the company’s assets. The 3 CARMAX AUTO FINANCE INCOME company’s risk is limited to the retained interests on the The company’s finance operation, CAF, originates automobile company’s consolidated balance sheets. The investors issue loans to prime-rated customers at competitive market rates of commercial paper supported by the transferred receivables, and interest. The company sells substantially all of the loans it the proceeds from the sale of the commercial paper are used to originates each month in a securitization transaction discussed in pay for the securitized receivables. This program is referred to Note 4. The majority of the profit contribution from CAF is as the warehouse facility. generated by the spread between the interest rate charged to the The company periodically uses public securitizations to customer and the cost of funds. A gain, recorded at the time of the refinance the receivables previously securitized through the securitization transaction, results from recording a receivable equal warehouse facility. In a public securitization, a pool of to the present value of the expected residual cash flows generated automobile loan receivables is sold to a bankruptcy-remote, by the securitized receivables. The cash flows are calculated taking special purpose entity that in turn transfers the receivables to a into account expected prepayment and default rates. special purpose securitization trust. The securitization trust CarMax Auto Finance income was as follows: issues asset-backed securities, secured or otherwise supported by the transferred receivables, and the proceeds from the sale of Years Ended February 29 or 28 the securities are used to pay for the securitized receivables. The 2004 2003 2002 (In millions) earnings impact of refinancing receivables in a public Gains on sales of loans $65.1 $68.2 $56.4 securitization has not been material to the operations of the company. However, because securitization structures could Other income: change from time to time, this may not be representative of the Servicing fee income 21.8 17.3 14.0 potential impact of future securitizations. Interest income 16.0 11.5 7.7 The transfers of receivables are accounted for as sales in Total other income 37.8 28.8 21.7 accordance with SFAS No. 140. When the receivables are securitized, the company recognizes a gain or loss on the sale of the receivables as described in Note 3. Direct expenses: CAF payroll and Years Ended February 29 or 28 fringe benefit expense 8.2 7.0 5.7 2004 2003 2002 (In millions) Other direct CAF expenses 9.7 7.6 5.9 Net loans originated $1,407.6 $1,189.0 $941.0 Total direct expenses 17.9 14.6 11.6 Loans sold $1,390.2 $1,185.9 $938.5 Gains on sales of loans $ 65.1 $ 68.2 $ 56.4 CarMax Auto Finance income $85.0 $82.4 $66.5 Gains on sales of loans as a percentage of loans sold 4.7% 5.8% 6.0% CarMax Auto Finance income does not include any allocation of indirect costs or income. The company presents Retained Interests The company retains various interests in the automobile loan this information on a direct basis to avoid making arbitrary receivables that it securitizes. The retained interests, presented decisions regarding the indirect benefit or costs that could be as current assets on the company’s consolidated balance sheets, attributed to CAF. Examples of indirect costs not included are serve as a credit enhancement for the benefit of the investors in retail store expenses, retail financing commissions, and the securitized receivables. These retained interests include the corporate expenses such as human resources, administrative present value of the expected residual cash flows generated by services, marketing, information systems, accounting, legal, the securitized receivables, or “interest-only strip receivables,” treasury, and executive payroll. the restricted cash on deposit in various reserve accounts, and an undivided ownership interest in the receivables securitized 4 S E C U R I T I Z AT I O N S through the warehouse facility and certain public The company uses a securitization program to fund securitizations, or “required excess receivables,” as described substantially all of the automobile loan receivables originated by CAF. The company sells the automobile loan receivables to a wholly owned, bankruptcy-remote, special purpose entity that transfers an undivided interest in the receivables to a group of third-party investors. The special purpose entity and CARMAX 2004 35
    • below. The cash reserves and excess receivables are generally 2% the remaining reserve account balance is released through the to 4% of managed receivables. The special purpose entities and special purpose entity to the company. The amount required the investors have no recourse to the company’s assets. The to be maintained in the public securitization reserve accounts company’s risk is limited to the retained interests on the may increase depending upon the performance of the company’s consolidated balance sheets. The fair value of the securitized receivables. The amount on deposit in the restricted retained interests may fluctuate depending on the performance cash accounts was $34.8 million as of February 29, 2004, and of the securitized receivables. $33.3 million as of February 28, 2003. The fair value of retained interests was $146.0 million as of Required Excess Receivables. The warehouse facility and February 29, 2004, and $135.0 million as of February 28, 2003. certain public securitizations require that the total value of the The retained interests had a weighted average life of 1.5 years as securitized receivables exceed, by a specified amount, the of February 29, 2004, and 1.6 years as of February 28, 2003. As principal amount owed to the investors. The required excess defined in SFAS No. 140, the weighted average life in periods receivables balance represents this specified amount. Any cash (for example, months or years) of pre-payable assets is calculated flows generated by the required excess receivables are used, if by multiplying the principal collections expected in each future needed, to make payments to the investors. The unpaid period by the number of periods until that future period, principal balance related to the required excess receivables was summing those products, and dividing the sum by the initial $28.8 million as of February 29, 2004, and $13.4 million as of principal balance. The following is a detailed explanation of the February 28, 2003. components of retained interests. Key Assumptions Used in Measuring Retained Interest-Only Strip Receivables. Interest-only strip Interests and Sensitivity Analysis receivables represent the present value of residual cash flows the The following table shows the key economic assumptions used company expects to receive over the life of the securitized in measuring the fair value of the retained interests at February 29, receivables. The value of these receivables is determined by 2004, and a sensitivity analysis showing the hypothetical effect estimating the future cash flows using management’s on the retained interests if there were unfavorable variations assumptions of key factors, such as finance charge income, from the assumptions used. Key economic assumptions at default rates, prepayment rates, and discount rates appropriate February 29, 2004, are not materially different from for the type of asset and risk. The value of interest-only strip assumptions used to measure the fair value of retained interests receivables may be affected by external factors, such as changes at the time of securitization. These sensitivities are hypothetical in the behavior patterns of customers, changes in the strength and should be used with caution. In this table, the effect of a of the economy, and developments in the interest rate markets; variation in a particular assumption on the fair value of the therefore, actual performance may differ from these retained interests is calculated without changing any other assumptions. Management evaluates the performance of the assumption; in actual circumstances, changes in one factor may receivables relative to these assumptions on a regular basis. Any result in changes in another, which might magnify or counteract financial impact resulting from a change in performance is the sensitivities. recognized in earnings in the period in which it occurs. Restricted Cash. Restricted cash represents amounts on Impact on Impact on deposit in various reserve accounts established for the benefit Fair Value of Fair Value of of the securitization investors. The amounts on deposit in the Assumptions 10% Adverse 20% Adverse Used Change Change (In millions) reserve accounts are used to pay various amounts, including Prepayment rate 1.45%–1.55% $5.4 $10.5 principal and interest to investors, in the event that the cash Cumulative default rate 2.00%–2.50% $4.1 $ 8.1 generated by the securitized receivables in a given period is Annual discount rate 12.0% $2.1 $ 4.2 insufficient to pay those amounts. In general, each of the company’s securitizations requires that an amount equal to a Prepayment Rate. The company uses the Absolute specified percentage of the initial receivables balance be Prepayment Model or “ABS” to estimate prepayments. This deposited in a reserve account on the closing date and that any model assumes a rate of prepayment each month relative to the excess cash generated by the receivables be used to fund the original number of receivables in a pool of receivables. ABS reserve account to the extent necessary to maintain the further assumes that all the receivables are the same size and required amount. If the amount on deposit in the reserve amortize at the same rate and that each receivable in each account exceeds the required amount, an amount equal to that month of its life will either be paid as scheduled or prepaid in excess is released through the special purpose entity to the full. For example, in a pool of receivables originally containing company. In the public securitizations, the amount required to 10,000 receivables, a 1% ABS rate means that 100 receivables be on deposit in the reserve account must equal or exceed a prepay each month. specified floor amount. The reserve account remains at the Cumulative Default Rate. Cumulative default rate or floor amount until the investors are paid in full, at which time “static pool” net losses are calculated by dividing the total projected future credit losses of a pool of receivables by the original pool balance. 36 CARMAX 2004
    • Continuing Involvement with Securitized Receivables Proceeds from New Securitizations. Proceeds from new The company continues to manage the automobile loan securitizations represent receivables newly securitized through receivables that it securitizes. The company receives servicing the warehouse facility during the period. Receivables initially fees of approximately 1% of the outstanding principal balance securitized through the warehouse facility that are periodically of the securitized receivables. The servicing fees specified in the refinanced in public securitizations are not considered new securitization agreements adequately compensate the company securitizations for this table. for servicing the securitized receivables. Accordingly, no Proceeds from Collections. Proceeds from collections servicing asset or liability has been recorded. The company is at reinvested in revolving period securitizations represent risk for the retained interests in the securitized receivables. If the principal amounts collected on receivables securitized through securitized receivables do not perform as originally projected, the warehouse facility, which are used to fund new originations. the value of the retained interests would be impacted. The Servicing Fees. Servicing fees received represent cash fees assumptions used to value the retained interests, as well as a paid to the company to service the securitized receivables. sensitivity analysis, are detailed in the “Key Assumptions Used Other Cash Flows Received from Retained Interests. Other in Measuring Retained Interests and Sensitivity Analysis” section cash flows received from retained interests represent cash of this footnote. Supplemental information about the managed received by the company from securitized receivables other receivables is shown in the following tables: than servicing fees. It includes cash collected on interest-only strip receivables and amounts released to the company from As of February 29 or 28 restricted cash accounts. 2004 2003 2002 (In millions) Loans securitized $2,200.4 $1,859.1 $1,489.4 Financial Covenants and Performance Triggers Loans held for sale Certain securitization agreements include various financial or investment 48.2 19.6 13.9 covenants and performance triggers, while other securitization agreements, such as public securitizations with a senior- Ending managed receivables $2,248.6 $1,878.7 $1,503.3 subordinated structure, do not include financial covenants or Accounts 31+ days past due $ 31.4 $ 27.6 $ 22.3 performance triggers. For those agreements with financial Past due accounts as a covenants and performance triggers, the company must meet percentage of ending financial covenants relating to minimum tangible net worth, managed receivables 1.40% 1.47% 1.48% maximum total liabilities to tangible net worth ratio, minimum tangible net worth to managed assets ratio, minimum current Years Ended February 29 or 28 ratio, minimum cash balance or borrowing capacity, and 2004 2003 2002 (In millions) minimum fixed charge coverage ratio. Certain securitized Average managed receivables must meet performance tests relating to portfolio receivables $2,099.4 $1,701.0 $1,393.7 yield, default rates, and delinquency rates. If these financial Credit losses on managed covenants and/or performance tests are not met, in addition to receivables $ 21.1 $ 17.5 $ 12.9 other consequences, the company may be unable to continue to Credit losses as a securitize receivables through the warehouse facility or it may be percentage of average terminated as servicer under the securitizations. At February 29, managed receivables 1.01% 1.03% 0.93% 2004, the company was in compliance with these financial covenants, and the securitized receivables were in compliance Selected Cash Flows from Securitized Receivables with these performance triggers. The table below summarizes certain cash flows received from and paid to the automobile loan securitizations: Years Ended February 29 or 28 2004 2003 2002 (In millions) • Proceeds from new securitizations $1,185.5 $1,018.7 $755.7 • Proceeds from collections reinvested in revolving period securitizations $ 514.9 $ 468.9 $452.3 • Servicing fees received $ 21.5 $ 17.0 $ 13.8 • Other cash flows received from retained interests: Interest-only strip receivables $ 74.1 $ 65.4 $ 48.2 Cash reserve releases, net $ 16.6 $ 25.3 $ 15.8 CARMAX 2004 37
    • 5 7 F I N A N C I A L D E R I VAT I V E S I N C O M E TA X E S The company enters into amortizing fixed-pay interest rate The components of the provision for income taxes on net swaps relating to its automobile loan receivable securitizations. earnings were as follows: Swaps are used to better match funding costs to the fixed-rate Years Ended February 29 or 28 receivables being securitized by converting variable-rate 2004 2003 2002 (In thousands) financing costs in the warehouse facility to fixed-rate Current: obligations. The company entered into twenty-two 40-month Federal $65,212 $47,600 $47,389 amortizing interest rate swaps with initial notional amounts State 8,986 5,415 5,103 totaling approximately $1.21 billion in fiscal 2004, one 20- month and twelve 40-month amortizing interest rate swaps Total 74,198 53,015 52,492 with initial notional amounts totaling approximately $1.05 Deferred: billion in fiscal 2003, and twelve 40-month amortizing interest Federal (1,180) 8,614 3,067 rate swaps with initial notional amounts totaling approximately State (118) 266 95 $854.0 million in fiscal 2002. The amortized notional amount of all outstanding swaps related to the automobile loan Total (1,298) 8,880 3,162 receivable securitizations was approximately $551.8 million at Provision for income taxes $72,900 $61,895 $55,654 February 29, 2004, and $473.2 million at February 28, 2003. The fair value of swaps included in accounts payable totaled a net liability of $2.0 million at February 29, 2004, and $2.6 The effective income tax rate differed from the federal million at February 28, 2003. statutory income tax rate as follows: The market and credit risks associated with interest rate swaps are similar to those relating to other types of financial Years Ended February 29 or 28 2004 2003 2002 instruments. Market risk is the exposure created by potential fluctuations in interest rates. The company does not anticipate Federal statutory significant market risk from swaps as they are used on a income tax rate 35.0% 35.0% 35.0% monthly basis to match funding costs to the use of the State and local income taxes, funding. Credit risk is the exposure to nonperformance of net of federal benefit 3.1 3.0 2.9 another party to an agreement. The company mitigates credit Non-deductible items 0.4 1.5 0.1 risk by dealing with highly rated bank counterparties. Effective income tax rate 38.5% 39.5% 38.0% 6 PROPERTY AND EQUIPMENT The tax effects of temporary differences that give rise to a Property and equipment, at cost, is summarized as follows: significant portion of the deferred tax assets and liabilities were as follows: As of February 29 or 28 2004 2003 (In thousands) As of February 29 or 28 Buildings (25 to 40 years) $ 30,985 $ 18,381 2004 2003 (In thousands) Land 25,716 19,418 Deferred tax assets: Land held for sale 3,163 3,354 Accrued expenses $ 9,048 $ 7,220 Land held for development 3,580 8,021 Other 79 120 Construction in progress 116,639 91,938 Furniture, fixtures, and equipment Total gross deferred tax assets 9,127 7,340 (5 to 15 years) 103,787 86,129 Leasehold improvements Deferred tax liabilities: (8 to 15 years) 29,427 21,029 Depreciation and amortization 5,224 5,748 313,297 248,270 Securitized receivables 27,940 29,138 Less accumulated depreciation Inventory 7,607 5,447 and amortization 69,233 61,112 Prepaid expenses 882 831 Property and equipment, net $244,064 $187,158 Total gross deferred tax liabilities 41,653 41,164 Net deferred tax liability $32,526 $33,824 Land held for development represents land owned for future sites that are scheduled to open more than one year beyond the fiscal year reported. 38 CARMAX 2004
    • Based on the company’s historical and current pretax contribute approximately $0.2 million to the pension plan in earnings, management believes the amount of gross deferred tax fiscal 2005. assets will more likely than not be realized through future Projected Benefit Obligations. The projected benefit taxable income and future reversals of existing temporary obligations are the present value of future benefits to differences; therefore, no valuation allowance is necessary. employees, including assumed salary increases. Changes in the company’s projected benefit obligations are presented in 8 Table 1. RETIREMENT PLANS Assets. Assets used in calculating the funded status are The company has a noncontributory defined benefit pension measured at current market values. The restoration plan is plan covering the majority of full-time employees who are at excluded since it is unfunded. Changes in the market value of least 21 years old and have completed one year of service. The the company’s pension plan assets were as follows: cost of the program is being funded currently. Plan benefits generally are based on years of service and average Years Ended February 29 or 28 compensation. The company also has an unfunded nonqualified Pension Plan plan (“restoration plan”) that restores retirement benefits for 2004 2003 (In thousands) Change in plan assets: certain senior executives who are affected by Internal Revenue Fair value of plan assets at Code limitations on benefits provided under the pension plan. beginning of year $ 5,676 $ 5,008 The liabilities for these plans are included in accrued expenses Actual return on plan assets 2,564 (1,095) and other current liabilities in the consolidated balance sheets. Adjustment for separation 606 (478) Funding Policy. For the defined benefit pension plan, the Employer contributions 7,785 2,343 company contributes amounts sufficient to meet minimum Benefits paid (227) (102) funding requirements as set forth in the employee benefit and tax laws plus any additional amounts as the company may Fair value of plan assets at end of year $16,404 $ 5,676 determine to be appropriate. The company expects to TABLE 1 Years Ended February 29 or 28 Pension Plan Restoration Plan Total 2004 2003 2004 2003 2004 2003 (In thousands) Change in projected benefit obligation: Benefit obligation at beginning of year $24,555 $14,868 $2,031 $1,583 $26,586 $16,451 Service cost 5,529 4,021 231 197 5,760 4,218 Interest cost 1,679 1,104 126 99 1,805 1,203 Plan amendments — 367 — (220) — 147 Actuarial loss 3,074 4,297 1,208 372 4,282 4,669 Adjustment for separation 1,308 — — — 1,308 — Benefits paid (227) (102) — — (227) (102) Projected benefit obligation at end of year $35,918 $24,555 $3,596 $2,031 $39,514 $26,586 CARMAX 2004 39
    • Funded Status. The funded status represents the difference between the projected benefit obligations and the market value of the assets. The components of the funded status of the retirement plans were as follows: As of February 29 or 28 Pension Plan Restoration Plan Total 2004 2003 2004 2003 2004 2003 (In thousands) Reconciliation of funded status: Funded status $(19,514) $(18,879) $(3,596) $(2,031) $(23,110) $(20,910) Unrecognized actuarial loss 10,574 13,339 2,024 870 12,598 14,209 Adjustment for separation — (4,055) — — — (4,055) Unrecognized prior service benefit/(cost) 294 331 (1) (2) 293 329 Net amount recognized $ (8,646) $ (9,264) $(1,573) $(1,163) $(10,219) $(10,427) Additional Information. As of February 29 or 28 Pension Plan Restoration Plan Total 2004 2003 2004 2003 2004 2003 (In thousands) Projected benefit obligation $35,918 $24,555 $3,596 $2,031 $39,514 $26,586 Accumulated benefit obligation $21,991 $12,858 $1,553 $ 815 $23,544 $13,673 Fair value of plan assets $16,404 $ 5,676 — — $16,404 $ 5,676 Expense. The components of net pension expense were as follows: Years Ended February 29 or 28 Pension Plan Restoration Plan Total 2004 2003 2002 2004 2003 2002 2004 2003 2002 (In thousands) Service cost $5,529 $4,021 $2,549 $231 $197 $128 $5,760 $4,218 $2,677 Interest cost 1,679 1,104 588 126 99 49 1,805 1,203 637 Expected return on plan assets (892) (617) (424) — — — (892) (617) (424) Amortization of prior year service cost 37 35 (2) — — 31 37 35 29 Amortization of transitional asset — — (3) — — — — — (3) Recognized actuarial loss 647 194 203 53 32 9 700 226 212 Net pension expense $7,000 $4,737 $2,911 $410 $328 $217 $7,410 $5,065 $3,128 Assumptions. Assumptions used to determine benefit obligations were as follows: Years Ended February 29 or 28 Pension Plan Restoration Plan 2004 2003 2002 2004 2003 2002 Weighted average discount rate 6.00% 6.50% 7.25% 6.00% 6.50% 7.25% Rate of increase in compensation levels 5.00% 6.00% 7.00% 7.00% 6.00% 7.00% Assumptions used to determine net pension expense were as follows: As of February 29 or 28 Pension Plan Restoration Plan 2004 2003 2002 2004 2003 2002 Weighted average discount rate 6.50% 7.25% 7.50% 6.50% 7.25% 7.50% Expected rate of return on plan assets 9.00% 9.00% 9.00% — — — Rate of increase in compensation levels 6.00% 7.00% 6.00% 6.00% 7.00% 6.00% 40 CARMAX 2004
    • To determine the expected long-term rate of return on and a $100 million term loan. Principal is due in full at pension plan assets, the company considers the current and maturity with interest payable monthly at a LIBOR-based rate. expected asset allocations, as well as historical and expected The credit agreement is scheduled to terminate on May 17, returns on various categories of plan assets. The company 2005. The termination date of the agreement will be applies the expected rate of return to a market-related value of automatically extended one year each May 17 unless either assets, which reduces the underlying variability in assets to CarMax or either lender elects, prior to the extension date, not which the expected return is applied. to extend the agreement. As of February 29, 2004, the amount Asset Allocation Strategy. The company’s pension plan outstanding under this credit agreement was $104.4 million. assets are held in trust. The asset allocation was as follows: Under this agreement, the company must meet financial covenants relating to minimum current ratio, maximum total As of February 29 or 28 liabilities to tangible net worth ratio, and minimum fixed 2004 2003 charge coverage ratio. The company was in compliance with all Target Actual Actual such covenants at February 29, 2004. Allocation Allocation Allocation The weighted average interest rate on the outstanding short- Equity securities 80% 80% 79% term debt was 3.5% during fiscal 2004, 3.2% during fiscal Fixed income securities 20 20 21 2003, and 4.4% during fiscal 2002. Total 100% 100% 100% The company capitalizes interest in connection with the construction of certain facilities. Capitalized interest totaled $2.5 million in fiscal 2004, $1.0 million in fiscal 2003, and Plan fiduciaries set investment policies and strategies for the $0.5 million in fiscal 2002. pension plan. Long-term strategic investment objectives include preserving the funded status of the trust and balancing COMMON STOCK AND STOCK-BASED risk and return. The plan fiduciaries oversee the investment 10 I N C E N T I V E P L A N S allocation process, which includes selecting investment managers, setting long-term strategic targets, and monitoring (A) Shareholder Rights Plan asset allocations. Target allocation ranges are guidelines, not In conjunction with the company’s shareholder rights plan, limitations, and occasionally plan fiduciaries will approve shareholders received preferred stock purchase rights as a allocations above or below a target range. dividend at the rate of one right for each share of CarMax, Inc. common stock owned. The rights are exercisable only upon the 9 DEBT attainment of, or the commencement of a tender offer to attain, a 15% ownership interest in the company by a person or group. Total debt is summarized as follows: When exercisable, each right would entitle the holder to buy one one-thousandth of a share of Cumulative Participating As of February 29 or 28 2004 2003 (In thousands) Preferred Stock, Series A, $20 par value, at an exercise price of Term loan $100,000 $100,000 $140 per share, subject to adjustment. A total of 120,000 Revolving loan 4,446 56,051 shares of such preferred stock, which have preferential dividend and liquidation rights, have been authorized and designated. Total debt 104,446 156,051 No such shares are outstanding. In the event that an acquiring Less current installments of person or group acquires the specified ownership percentage of long-term debt — — CarMax, Inc. common stock (except pursuant to a cash tender Less short-term debt 4,446 56,051 offer for all outstanding shares determined to be fair by the Total long-term debt, excluding board of directors) or engages in certain transactions with the current installments $100,000 $100,000 company after the rights become exercisable, each right will be converted into a right to purchase, for half the current market price at that time, shares of CarMax, Inc. common stock valued In May 2002, the company entered into a $200 million at two times the exercise price. The company also has an credit agreement secured by vehicle inventory. During the additional 19,880,000 shares of undesignated preferred stock fourth quarter of fiscal 2003, the credit agreement was authorized of which no shares are outstanding. increased from $200 million to $300 million. The credit agreement includes a $200 million revolving loan commitment CARMAX 2004 41
    • (B) Restricted Stock The company’s stock option activity is summarized in Table 2. The company has issued restricted stock under the provisions Table 3 summarizes information about stock options outstanding of the CarMax, Inc. 2002 Stock Incentive Plan whereby as of February 29, 2004. management and key employees are granted restricted shares of common stock. Shares are awarded in the name of the (D) Employee Stock Purchase Plan The company has an employee stock purchase plan for all employee, who has all the rights of a shareholder, subject to employees meeting certain eligibility criteria. Under the plan, certain restrictions or forfeitures. Restrictions on the awards eligible employees may, subject to certain limitations, purchase generally expire three or four years from the date of grant. shares of common stock. For each $1.00 contributed by employees Total restricted stock awards of 228 shares were granted in under the plan, the company matches $0.15. Purchases are limited fiscal 2004. In fiscal 2003, 25,984 restricted shares were to 10% of an employee’s eligible compensation, up to a maximum exchanged in connection with the separation. of $7,500 per year. The 2002 CarMax, Inc. Employee Stock At the date of grant, the market value of all shares granted Purchase Plan allows employees to purchase up to 1,000,000 is recorded as unearned compensation and is a component of shares of common stock. The source of the shares available for equity. Unearned compensation is expensed over the purchase by employees may, at the company’s option, be open restriction periods. The total charge to operations was market purchases or newly issued shares. $121,500 in fiscal 2004; $77,400 in fiscal 2003; and $99,700 At February 29, 2004, a total of 741,847 shares remained in fiscal 2002. Outstanding shares of restricted common stock available under the plan. Shares purchased on the open market on at February 29, 2004, and February 28, 2003, were 25,817 behalf of employees were 161,662 during fiscal 2004; 213,931 and 27,275, respectively. during fiscal 2003; and 183,902 during fiscal 2002. The average (C) Stock Incentive Plans price per share purchased under the plan was $29.97 in fiscal Under the company’s stock incentive plans, nonqualified stock 2004, $19.43 in fiscal 2003, and $17.13 in fiscal 2002. The options may be granted to management, key employees, and company match totaled $598,600 in fiscal 2004; $520,700 in outside directors to purchase shares of common stock. The fiscal 2003; and $384,800 in fiscal 2002. exercise price for nonqualified options is equal to, or greater than, the market value at the date of grant. Options generally (E) 401(k) Plan The company sponsors a 401(k) plan for all employees meeting are exercisable over a period from one to ten years from the certain eligibility criteria. Under the plan, eligible employees can date of grant. The company has authorized 10,100,000 shares contribute up to 40% of their salaries, and the company matches of common stock to be issued as either options, restricted a portion of those associate contributions. The total expense for stock grants, or stock grants. Shares of common stock available this plan was $1.1 million in fiscal 2004, $1.0 million in fiscal for issuance of options, restricted stock grants, or stock grants 2003, and $885,000 in fiscal 2002. totaled 3,661,200 at February 29, 2004. TABLE 2 Years Ended February 29 or 28 2004 2003 2002 Weighted Average Weighted Average Weighted Average Shares Exercise Price Shares Exercise Price Shares Exercise Price (Shares in thousands) Outstanding at beginning of year 4,345 $10.25 3,631 $ 4.81 4,107 $3.16 Granted 2,154 $14.59 1,134 $26.22 1,659 $4.94 Exercised (693) $ 6.53 (285) $ 5.06 (1,941) $1.32 Cancelled (130) $14.88 (135) $ 9.03 (194) $5.95 Outstanding at end of year 5,676 $12.24 4,345 $10.25 3,631 $4.81 Options exercisable at end of year 1,839 $ 8.02 1,440 $ 6.08 821 $6.85 TABLE 3 Options Outstanding as of February 29, 2004 Options Exercisable as of February 29, 2004 Weighted Average Number Remaining Weighted Average Number Weighted Average (Shares in thousands) Range of Exercise Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price $ 1.63 646 3.0 $ 1.63 414 $ 1.63 $ 3.22 to $ 4.89 1,289 4.0 $ 4.82 553 $ 4.78 $ 6.06 to $ 9.19 565 2.1 $ 6.56 565 $ 6.56 $12.94 to $20.00 2,159 8.8 $14.33 59 $14.88 $22.47 to $43.44 1,017 5.1 $27.14 248 $27.71 Total 5,676 5.7 $12.24 1,839 $ 8.02 42 CARMAX 2004
    • available to Circuit City as a large retailer at that time. Circuit 11 E A R N I N G S P E R S H A R E City has assigned each of these leases to CarMax. Despite the CarMax was a wholly owned subsidiary of Circuit City during assignment and pursuant to the terms of the leases, Circuit City a portion of the periods presented. Earnings per share for remains contingently liable under the leases. In recognition of fiscal 2003 and 2002 have been presented to reflect the capital this ongoing contingent liability, CarMax made a one-time structure effective with the separation of CarMax from special dividend payment of $28.4 million to Circuit City on Circuit City. All earnings per share calculations have been the October 1, 2002, separation date. computed as if the separation had occurred at the beginning Rental expense for all operating leases was $54.2 million in of the periods presented. fiscal 2004, $48.1 million in fiscal 2003, and $41.4 million in Reconciliations of the numerator and denominator of basic fiscal 2002. Most leases provide that the company pay taxes, and diluted earnings per share are presented below: maintenance, insurance, and operating expenses applicable to the premises. The initial term of most real property leases will Years Ended February 29 or 28 expire within the next 20 years; however, most of the leases 2004 2003 2002 (In thousands except per share data) have options providing for renewal periods of 5 to 20 years at Weighted average terms similar to the initial terms. common shares 103,503 102,983 102,039 As of February 29, 2004, future minimum fixed lease Dilutive potential obligations, excluding taxes, insurance, and other costs payable common shares: directly by the company, were approximately: Options 2,113 1,579 1,950 Restricted stock 12 8 33 Operating Lease Commitments (In thousands) Weighted average common 2005 $ 58,205 shares and dilutive 2006 58,940 potential common shares 105,628 104,570 104,022 2007 57,432 2008 57,641 Net earnings available 2009 57,913 to common shareholders $116,450 $94,802 $90,802 2010 and thereafter 602,902 Basic net earnings per share $ 1.13 $ 0.92 $ 0.89 Diluted net earnings Total minimum lease payments $893,033 per share $ 1.10 $ 0.91 $ 0.87 In fiscal 2004, the company entered into three sale- Certain options were outstanding and not included in the leaseback transactions covering nine superstore properties computation of diluted earnings per share because the valued at approximately $107.0 million. These transactions options’ exercise prices were greater than the average market were structured as operating leases with initial terms of either price of the common shares. Options to purchase 18,364 15 or 20 years with various renewal options. In fiscal 2003, shares of CarMax, Inc. common stock with exercise prices the company entered into a sale-leaseback transaction ranging from $35.23 to $43.44 per share were outstanding covering three superstore properties valued at approximately and not included in the calculation at the end of fiscal 2004; $37.6 million. This transaction was structured with initial 1,053,610 shares with exercise prices ranging from $18.60 to lease terms of 15 years and two 10-year renewal options. All $43.44 per share at the end of fiscal 2003; and 15,364 shares sales-leaseback transactions are structured at competitive with exercise prices ranging from $37.49 to $43.44 per share rates. Gains on sale-leaseback transactions are deferred and at the end of fiscal 2002. amortized over the term of the leases. The company does not have continuing involvement under the sale-leaseback 12 L E A S E C O M M I T M E N T S transactions. In conjunction with certain sale-leaseback The company conducts a substantial portion of its business in transactions, the company must meet financial covenants leased premises. The company’s lease obligations are based relating to minimum tangible net worth and minimum upon contractual minimum rates. CarMax operates 23 of its coverage of rent expense. The company was in compliance sales locations pursuant to various leases under which its former with all such covenants at February 29, 2004. parent Circuit City was the original tenant and primary obligor. Circuit City had originally entered into these leases so that CarMax could take advantage of the favorable economic terms CARMAX 2004 43
    • In December 2003, the FASB issued SFAS No. 132 (revised 13 C O N T I N G E N T L I A B I L I T I E S 2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” This revised statement retains the (A) Litigation disclosures required by the original SFAS No. 132, which In the normal course of business, the company is involved in standardized employers’ disclosures about pensions and other various legal proceedings. Based upon the company’s evaluation postretirement benefits, and requires additional disclosures of the information presently available, management believes concerning the economic resources and obligations related to that the ultimate resolution of any such proceedings will not pension plans and other postretirement benefits. The have a material adverse effect on the company’s financial provisions of the original SFAS No. 132 remain in effect until position, liquidity, or results of operations. the provisions of this revised statement are adopted. This revised statement is effective for fiscal years ending after (B) Other Matters In accordance with the terms of real estate lease agreements, the December 15, 2003. The company has revised its disclosures company generally agrees to indemnify the lessor from certain to meet the requirements under this revised standard for the liabilities arising as a result of the use of the leased premises, financial statements currently presented. including environmental liabilities and repairs to leased In December 2003, the FASB issued FASB Interpretation property upon termination of the lease. Additionally, in (“FIN”) No. 46 (revised December 2003), “Consolidation of accordance with the terms of agreements entered into for the Variable Interest Entities.” This revised interpretation retains sale of our properties, the company generally agrees to the original FIN No. 46 requirements for consolidating indemnify the buyer from certain liabilities and costs arising variable interest entities by the primary beneficiary of the subsequent to the date of the sale, including environmental entity if the equity investors in the entity do not have the liabilities and liabilities resulting from the breach of characteristics of a controlling financial interest or do not have representations or warranties made in accordance with the sufficient equity at risk for the entity to finance its activities agreements. The company does not have any known material without additional subordinated financial support from other environmental commitments, contingencies, or other parties. The revised interpretation adds the requirement for indemnification issues arising from these arrangements. consolidating an entity where the equity investors’ voting rights As part of its customer service strategy, the company are not proportionate to their economic interests and where the guarantees the vehicles it sells with a 30-day limited warranty. A activities of the entity involve or are conducted on behalf of an vehicle in need of repair within 30 days of the customer’s investor with a disproportionately small voting interest. This purchase will be repaired free of charge. As a result of this revised interpretation is effective for all entities no later than guarantee, each vehicle sold has an implied liability associated the end of the first reporting period that ends after March 15, with it. As such, the company records a provision for repairs 2004. However, for reporting periods ending after December 15, during the guarantee period for each vehicle sold based on 2003, a company must apply either the original or this revised historical trends. The liability for this guarantee was $1.4 million interpretation to those entities that are considered to be special- at February 29, 2004, and $1.3 million at February 28, 2003, purpose entities. A company that has already applied the and is included in accrued expenses and other current liabilities original FIN No. 46 to an entity may continue to do so until in the consolidated balance sheets. the effective date of the revised interpretation. The company has applied the revised FIN No. 46, which has not had a material impact on the company’s financial position, results of RECENT ACCOUNTING 14 P R O N O U N C E M E N T S operations, or cash flows. In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The application of the provisions of SFAS No. 150 has not and is not expected to have a material impact on the company’s financial position, results of operations, or cash flows. 44 CARMAX 2004
    • 15 S E L E C T E D Q U A R T E R L Y F I N A N C I A L D A T A (UNAUDITED) First Quarter Second Quarter Third Quarter Fourth Quarter Fiscal Year 2004 2003 2004 2003 2004 2003 2004 2003 2004 2003 (In thousands except per share data) Net sales and operating revenues $1,172,835 $1,005,803 $1,236,457 $1,080,682 $1,071,534 $936,819 $1,116,865 $946,640 $4,597,691 $3,969,944 Gross profit $ 147,771 $ 122,142 $ 163,105 $ 128,812 $ 126,242 $106,940 $ 133,770 $110,345 $ 570,888 $ 468,239 CarMax Auto Finance income $ 25,748 $ 19,838 $ 22,677 $ 22,110 $ 17,649 $ 19,220 $ 18,889 $ 21,231 $ 84,963 $ 82,399 Selling, general, and administrative expenses $ 115,553 $ 93,037 $ 120,714 $ 97,997 $ 114,282 $101,810 $ 117,825 $ 99,573 $ 468,374 $ 392,417 (Gain)/loss on franchise dispositions $ —$ —$ 460 $ —$ (1,207) $ —$ (1,580) $ —$ (2,327) $ — Net earnings $ 35,260 $ 29,238 $ 39,610 $ 31,714 $ 19,053 $ 14,717 $ 22,526 $ 19,133 $ 116,450 $ 94,802 Net earnings per share: Basic $ 0.34 $ 0.28 $ 0.38 $ 0.31 $ 0.18 $ 0.14 $ 0.22 $ 0.19 $ 1.13 $ 0.92 Diluted $ 0.34 $ 0.28 $ 0.37 $ 0.30 $ 0.18 $ 0.14 $ 0.21 $ 0.18 $ 1.10 $ 0.91 CARMAX 2004 45
    • I N D E P E N D E N T AU D I TO R S ’ R E P O RT To the Board of Directors and Shareholders CarMax, Inc.: We have audited the accompanying consolidated balance sheets of CarMax, Inc. and subsidiaries (the “Company”) as of February 29, 2004 and February 28, 2003, and the related consolidated statements of earnings, shareholders’ equity and cash flows for each of the fiscal years in the three-year period ended February 29, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CarMax, Inc. and subsidiaries as of February 29, 2004 and February 28, 2003, and the results of their operations and their cash flows for each of the fiscal years in the three-year period ended February 29, 2004, in conformity with accounting principles generally accepted in the United States of America. RICHMOND,VIRGINIA MARCH 30, 2004 46 CARMAX 2004
    • C O M PA N Y O F F I C E R S S E N I O R M A N AG E M E N T T E A M AUSTIN LIGON JOE KUNKEL ED HILL SCOTT RIVAS President Senior Vice President Vice President Vice President Chief Executive Officer Marketing and Strategy Ser vice Operations Human Resources KEITH BROWNING ANGIE SCHWARZ CHATTIN DOUGLASS MOYERS FRED WILSON Executive Vice President Vice President Vice President Vice President Chief Financial Officer CarMax Auto Finance Real Estate Store Administration TOM FOLLIARD STUART HEATON KIM D. ORCUTT CLIFF WOOD Executive Vice President Vice President Vice President Vice President Store Operations General Counsel Controller Merchandising Corporate Secretar y MIKE DOLAN TOM REEDY Senior Vice President Vice President Chief Information Officer Treasurer C O R P O R AT E A N D F I E L D M A N AG E M E N T T E A M ANU AGARWAL PATTY COVINGTON BARBARA HARVILL MARTY SBERNA Assistant Vice President Assistant Vice President Assistant Vice President Region Vice President Merchandising Deputy General Counsel Management Information Systems Ser vice Operations Atlanta Region ROD BAKER JOHN DAVIS JACK HIGHTOWER Region Vice President Region Vice President Region Vice President RICHARD SMITH Ser vice Development Ser vice Operations Sales Operations Assistant Vice President Florida Region Management Information Systems DAVE BANKS DAN JOHNSTON Assistant Vice President Region Vice President JASON DAY WILLIAM STONE Management Information Systems Region Vice President General Manager Assistant Vice President Merchandising Mid-Atlantic Region Strategy DANDY BARRETT Atlanta Region Assistant Vice President TOM MARCEY LISA VAN RIPER Investor Relations Region Vice President Assistant Vice President LAURA DONAHUE Assistant Vice President Merchandising Public Affairs CHRIS BARTEE Advertising Mid-Atlantic Region Region Vice President TOM VICINI Merchandising Region Vice President EDWARD FABRITIIS BILL MCCHRYSTAL Southwest Region Assistant Vice President Region Vice President General Manager Field Human Resources Merchandising Central Region DAN BICKETT Florida Region Assistant Vice President JON GESKE DONNA WASSEL Construction and Facilities Region Vice President Region Vice President ROB MITCHELL Ser vice Operations Assistant Vice President General Manager JEREMY BYRNES Southwest Region Consumer Finance Atlanta Region Assistant Vice President CarMax Auto Finance TODD GIBBONS JOHN MONTEGARI JOE WILSON Region Vice President Assistant Vice President Region Vice President MIKE CALLAHAN Ser vice Operations Media Merchandising Assistant Vice President Central Region Central Region CarMax Auto Finance BILL NASH Assistant Vice President MICHELLE HALASZ TOM WULF TIM COOLEY Assistant Vice President Auction Ser vices Assistant Vice President Region Vice President Deputy General Counsel Store Operations Ser vice Operations JEFF RUTTEN Mid-Atlantic Region Region Vice President RANDY HARDEN DUGALD YSKA Assistant Vice President General Manager Region Vice President Marketing Southwest Region General Manager Florida Region CARMAX 2004 47
    • B OA R D O F D I R E C TO R S RICHARD L. SHARP AUSTIN LIGON Chairman of the Board President CarMax, Inc. Chief Executive Officer Private Investor CarMax, Inc. Retired Chairman and Chief Executive Officer Circuit City Stores, Inc. MAJOR GENERAL HUGH G. ROBINSON (RET.), P.E. (a consumer electronics specialty retailer) Chairman and Chief Executive Officer Richmond, Virginia Granville Construction & Development Co., Inc. (a low- and moderate-income housing construction firm) Dallas, Texas KEITH BROWNING Executive Vice President Chief Financial Officer THOMAS G. STEMBERG CarMax, Inc. Chairman of the Board Staples, Inc. (an office supply superstore retailer) JAMES F. CLINGMAN, JR. Retired President and Chief Operating Officer Framingham, Massachusetts H.E. Butt Grocery Company (a food retailer) BETH A. STEWART San Antonio, Texas Chairman and Chief Executive Officer Storetrax.com (an Internet real estate listing service) JEFFREY E. GARTEN Dean, Yale School of Management President Yale University Stewar t Real Estate Capital, L.L.C. New Haven, Connecticut (a real estate investment company) Bernardsville, New Jersey W. ROBERT GRAFTON Retired Managing Partner – Chief Executive WILLIAM R. TIEFEL Andersen Worldwide, S.C. Chairman Emeritus (an accounting and professional services firm) The Ritz-Carlton Hotel Company, L.L.C. Potomac, Maryland Retired Vice Chairman Marriott International, Inc. Palm Beach, Florida WILLIAM S. KELLOGG Retired Chairman and Chief Executive Officer Kohl’s Corporation (an apparel and home products retailer) Oconomowoc, Wisconsin B OA R D C O M M I T T E E S COMPENSATION AND NOMINATING AND AUDIT PERSONNEL GOVERNANCE EXECUTIVE W. Robert Grafton, Hugh G. Robinson, William R. Tiefel, Austin Ligon Chairman Chairman Chairman Keith Browning James F. Clingman, Jr. James F. Clingman, Jr. Jeffrey E. Garten Hugh G. Robinson W. Robert Grafton William S. Kellogg Beth A. Stewart William S. Kellogg Thomas G. Stemberg Beth A. Stewart William R. Tiefel 48 CARMAX 2004
    • C O R P O R AT E A N D S H A R E H O L D E R I N F O R M AT I O N C O R P O R AT E O F F I C E T R A N S F E R AG E N T A N D R E G I S T R A R CarMax, Inc. Contact our transfer agent for questions regarding your stock 4900 Cox Road cer tificates, including changes of address, name, or ownership; Glen Allen, Virginia 23060-6295 lost cer tificates; or to consolidate multiple accounts. Telephone: (804) 747-0422 Wells Fargo Shareowner Services P.O. Box 64854 WEB SITE www.carmax.com South St. Paul, Minnesota 55164-0854 Toll free: (800) 468-9716 Hearing impaired: (651) 450-4144 A N N UA L S H A R E H O L D E R S ’ M E E T I N G Tuesday, June 29, 2004, at 10:00 a.m. www.wellsfargo.com/shareownerservices The Richmond Marriott West Hotel 4240 Dominion Boulevard F I N A N C I A L I N F O R M AT I O N Glen Allen, Virginia 23060 For quar terly sales and earnings information, financial repor ts, filings with the Securities and Exchange Commission (including Form 10-K), news releases, and other investor S TO C K I N F O R M AT I O N CarMax, Inc. common stock is traded on the New York Stock information, please visit our investor Web site at Exchange under the symbol “KMX.” Prior to the separation http://investor.carmax.com. Information may also be from Circuit City Stores, Inc. on October 1, 2002, the Circuit obtained from the Investor Relations Depar tment at: City Stores – CarMax Group common stock was traded on the E-mail: investor_relations@carmax.com NYSE under the same symbol. Telephone: (804) 747-0422, ext. 4489 At February 29, 2004, there were approximately 7,100 CarMax Our chief executive officer and chief financial officer have shareholders of record. filed the cer tifications required by Section 302 of the Sarbanes-Oxley Act of 2002 with the Securities and Exchange Commission as exhibits to our Form 10-K for the fiscal year Q UA RT E R LY S TO C K P R I C E R A N G E The following table sets for th by fiscal quar ter the high and ended February 29, 2004. In addition, our chief executive low repor ted prices of the company’s common stock for the officer is required to file a separate annual cer tification with last two fiscal years: the New York Stock Exchange following our annual share- holders’ meeting. First Second Third Fourth Quarter Quarter Quarter Quarter C O R P O R AT E G OV E R N A N C E I N F O R M AT I O N Copies of the CarMax Corporate Governance Guidelines, the Fiscal 2004 Code of Conduct, and the char ters for each of the Audit High $24.10 $38.72 $39.30 $37.10 Committee, Compensation and Personnel Committee, and Nominating and Governance Committee are available from our Low $12.45 $23.08 $30.08 $28.71 investor Web site, at http://investor.carmax.com, under the cor- Fiscal 2003 porate governance tab. Alternatively, shareholders may obtain, without charge, copies of these documents by writing to High $34.00 $26.75 $21.45 $20.47 Investor Relations at the CarMax corporate office. Low $24.75 $13.00 $12.90 $12.94 I N V E S TO R R E L AT I O N S DIVIDEND POLICY Security analysts are invited to contact: To date, CarMax has not paid a cash dividend on its common Dandy Barrett, Assistant Vice President, Investor Relations stock. The company presently intends to retain its earnings for Telephone: (804) 935-4591 use in its operations and for geographic expansion and, there- fore, does not anticipate paying any cash dividends in the fore- G E N E R A L I N F O R M AT I O N seeable future. Members of the media and others seeking general information about CarMax should contact: I N D E P E N D E N T A U D I TO R S Lisa Van Riper, Assistant Vice President, Public Affairs KPMG LLP Telephone: (804) 935-4594 1021 East Cary Street, Suite 2000 Richmond, Virginia 23219-4023 CARMAX 2004 49
    • CARMAX, INC. 4 9 0 0 C OX RO A D G L E N A L L E N V I R G I N I A 2 3 0 6 0 - 6 2 9 5 804.747.0422 W W W. C A R M A X . C O M