Carmax Inc: Form 10-Q for the period ended Nov 30, 2023

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements, the accompanying notes and the MD&A included in our Annual Report on Form 10-K for the fiscal year ended February 28, 2023 (“fiscal 2023”), as well as our unaudited interim consolidated financial statements and the accompanying notes included in Item 1 of this Form 10-Q. Note references are to the notes to unaudited interim consolidated financial statements included in Item 1. All references to net earnings per share are to diluted net earnings per share. Certain prior year amounts have been reclassified to conform to the current year’s presentation. Amounts and percentages may not total due to rounding.

OVERVIEW

CarMax is the nation’s largest retailer of used vehicles. We operate in two reportable segments: CarMax Sales Operations and CarMax Auto Finance (“CAF”). Our CarMax Sales Operations segment consists of all aspects of our auto merchandising and service operations, excluding financing provided by CAF. Our CAF segment consists solely of our own finance operation that provides financing to customers buying retail vehicles from CarMax. Our consolidated financial statements include the financial results related to our Edmunds Holding Company (“Edmunds”) business, which does not meet the definition of a reportable segment. For purposes of our MD&A discussion, amounts related to that business are discussed in combination with our CarMax Sales Operations segment. Separate discussion of these amounts is not considered meaningful for the purpose of gaining an understanding of our business, as the significant drivers of these operations in total are consistent with those of our CarMax Sales Operations segment. Where appropriate, specific amounts related to non-reportable segments have been disclosed for informational purposes.

CarMax Sales Operations

Our sales operations segment consists of retail sales of used vehicles and related products and services, such as wholesale vehicle sales; the sale of extended protection plan (“EPP”) products, which include extended service plans (“ESPs”) and guaranteed asset protection (“GAP”); and vehicle repair service. We offer competitive, no-haggle prices; a broad selection of CarMax Quality Certified used vehicles; value-added EPP products; and superior customer service. Our omni-channel platform, which gives us the largest addressable market in the used car industry, empowers our retail customers to buy a car on their terms – online, in-store or an integrated combination of both.

Our customers finance the majority of the retail vehicles purchased from us, and availability of on-the-spot financing is a critical component of the sales process. We provide financing to qualified retail customers through CAF and our arrangements with industry-leading third-party finance providers. All of the finance offers, whether by CAF or our third-party providers, are backed by a 3-day payoff option.

As of November 30, 2023, we operated 241 used car stores in 109 U.S. television markets.

CarMax Auto Finance

In addition to third-party finance providers, we provide vehicle financing through CAF, which offers financing solely to customers buying retail vehicles from CarMax. CAF allows us to manage our reliance on third-party finance providers and to leverage knowledge of our business to provide qualifying customers a competitive financing option. As a result, we believe CAF enables us to capture additional profits, cash flows and sales. CAF income primarily reflects the interest and fee income generated by the auto loans receivable less the interest expense associated with the debt issued to fund these receivables, a provision for estimated loan losses and direct expenses. CAF income does not include any allocation of indirect costs. After the effect of 3-day payoffs and vehicle returns, CAF financed 43.1% of our retail used vehicle unit sales in the first nine months of fiscal 2024. As of November 30, 2023, CAF serviced approximately 1.1 million customer accounts in its $17.51 billion portfolio of managed receivables.

Management regularly analyzes CAF’s operating results by assessing the competitiveness of our consumer offer, profitability, the performance of the auto loans receivable, including trends in credit losses and delinquencies, and CAF direct expenses.

Revenues and Profitability

The sources of revenue and gross profit from the CarMax Sales Operations segment and other non-reportable segments for the first nine months of fiscal 2024 are as follows:

Net Sales and Operating Revenues Gross Profit

A high-level summary of our financial results for the third quarter and first nine months of fiscal 2024 as compared to the third quarter and first nine months of fiscal 2023 is as follows (1):

(Dollars in millions except per share or per unit data)

(1) Where applicable, amounts are net of intercompany eliminations.

(2) An online retail sale is defined as a sale where the customer completes all four of the following activities remotely: reserving the vehicle; financing the vehicle, if needed; trading-in or opting out of a trade-in; and creating an online sales order.

(3) An omni sale is defined as a sale where customers complete at least one, but not all, of the four activities listed above online.

(4) Revenue from online transactions is defined as revenue from retail sales that qualify as an online retail sale, as well as any related EPP and third-party finance contribution, wholesale sales where the winning bid was taken from an online bid and all revenue earned by Edmunds.

Net earnings per diluted share during the first nine months of fiscal 2024 included a benefit of $0.32 in connection with the receipt of settlement proceeds in a class action lawsuit related to the economic loss associated with vehicles containing Takata airbags. Refer to “Results of Operations” for further details on our revenues and profitability.

Liquidity

Our primary ongoing sources of liquidity include funds provided by operations, proceeds from non-recourse funding vehicles, and borrowings under our revolving credit facility or through other financing sources. In addition to funding our operations, this liquidity has been used to fund the repurchase of common stock under our share repurchase program and our location growth.

Our current capital allocation strategy is to focus on our core business. Given our recent performance and continued market uncertainties, we are taking a conservative approach to our capital structure in order to maintain the flexibility that allows us to efficiently access the capital markets for both CAF and CarMax as a whole. We have taken steps to better align our expenses to sales as well as slowed the rate of our store growth. We resumed our share repurchases during the third quarter of fiscal 2024 after a pause initiated during the third quarter of the prior fiscal year. We believe we have the appropriate liquidity, access to capital and financial strength to support our operations and continue investing in our strategic initiatives for the foreseeable future.

Strategic Update and Future Outlook

Our omni-channel experience provides a common platform across all of CarMax that leverages our scale, nationwide footprint and infrastructure and empowers our customers to buy a vehicle on their terms, whether online, in-store or through an integrated combination of online and in-store experiences. While we expect our online and omni sales to grow over time, our goal is to provide the best experience whether in-store, online or a combination of the two. As a result, online, omni and in-person sales can vary from quarter to quarter depending on consumer preferences and how they choose to interact with us. We believe consumers in the used car industry will increasingly prefer to have the ability to progress digitally. Approximately 70% of our customers leveraged some or all of our digital capabilities to complete their transactions during the current fiscal year, compared to approximately 40% when we completed our initial omni-channel roll-out at the end of fiscal 2020.

Our diversified business model, combined with our exceptional associates, national scale and unparalleled omni-channel experience, is a unique advantage in the used car industry that firmly positions us to drive profitable market share gains while creating shareholder value over the long-term. Some of the direct benefits that we believe omni-channel has delivered to our business include:

• Omni-channel is driving incremental retail customers to CarMax. Customers who complete an online transaction are 10% more likely to be first-time customers compared with our omni-channel and in-store customers. Online customers are also typically younger, which creates the opportunity to participate in more of their lifetime purchase cycles.
• The annual growth rate for market share in our oldest 15 markets, for which we have not opened new stores since calendar year 2013, doubled in calendar year 2019 compared to the average annual growth rate for the previous five years, and the average annual growth rate for these markets has exceeded their average rate from prior to the omni-channel roll-out through calendar year 2022.
• Instant offer, our online consumer-facing appraisal tool, is significantly driving our vehicle purchases and wholesale sales. We doubled our buys from consumers in the year we launched the online instant offer program, which has enabled us to maintain self-sufficiency over 70%. Additionally, our wholesale volume increased approximately 65% and has remained well above the levels from prior to launching the tool.
• Our omni-channel products are supporting double-digit web traffic growth. Over 80% of our customers use our online finance based shopping tool as they begin the credit process, which has become our number one lead source.
• We continue to show sequential year-over-year improvement in key selling cost efficiency metrics for our omni-channel overhead model. With a more fixed cost structure, we expect to lever more strongly as demand increases.

We expect the impact of our omni-channel capabilities will continue to grow as consumers demand a more personalized car-buying experience.

We purchased approximately 250,000 vehicles from consumers and dealers during the third quarter of fiscal 2024, up 5.1% from the prior year quarter. Approximately 22,000 of these vehicles were purchased through dealers, up 61.7% from the prior year quarter. We leverage the Edmunds sales team to open new markets and sign up new dealers for MaxOffer. We recently launched an appraisal tool for dealer websites that makes instant offers based on our algorithms, which are redeemable via MaxOffer.

Our SG&A expenses in the first nine months of fiscal 2024 decreased from the prior year period, even when excluding the benefits of this year's legal settlements. While SG&A as a percent of gross profit can fluctuate from quarter to quarter depending on variability in gross profit, our initial goal on the path to strengthening our SG&A to gross profit leverage over time is to achieve a rate in the mid-70% range on an annual basis. Achieving this annual rate will require continued efficiency gains in our operating model, gross profit growth and healthier consumer demand. We are on track to outperform the target we set at the beginning of the fiscal year of requiring low single digit gross profit growth to lever SG&A for the full fiscal year, even when excluding the benefits of this year's legal settlements.

Other steps we have taken to support our business for both the short- and long-term include focusing on production efficiencies to align saleable inventory to sales, raising CAF's consumer rates while growing CAF's penetration, tightening CAF's underwriting standards and slowing our planned store growth to provide more capital flexibility. We resumed our share repurchases during the third quarter of fiscal 2024 after a pause initiated during the third quarter of the prior fiscal year.

We expect our diversified model, the scale of our operations, our investments and omni-channel strategy to provide a solid foundation for further growth. Our long-term targets, which were disclosed in our Annual Report on Form 10-K for fiscal 2022, are as follows:

• Sell between 2 million and 2.4 million vehicles through our combined retail and wholesale channels by fiscal 2026.
• Generate between $33 billion and $45 billion in revenue by fiscal 2026.
• Grow our nationwide share of the age 0- to 10-year old used vehicle market to more than 5% by the end of calendar 2025.

The achievement of these targets is dependent on macroeconomic factors that could result in ongoing volatility in consumer demand.

In calendar 2022, we estimate we sold approximately 4.0% of the age 0- to 10-year old vehicles sold on a nationwide basis, consistent with calendar 2021. We estimate we sold approximately 4.8% of the age 0- to 10-year old vehicles sold in the current comparable store markets in which we operate in calendar 2022, consistent with calendar 2021. External title data shows that our market share for the first ten months of calendar 2023 improved compared to our market share for the second half of calendar 2022. Further, market share for the month of October 2023, the latest period for which title data is available, improved year-over-year for the first time this calendar year. Our strategy to continue to increase our market share includes focusing on:

• Delivering a customer-driven, omni-channel buying and selling experience that is a unique and powerful integration of our in-store and online capabilities.
• Utilizing advertising to drive customer growth, educate customers about our omni-channel platform and to differentiate and elevate our brand.
• Hiring, developing and retaining an engaged and skilled workforce.
• Leveraging data and advanced analytics to continuously improve the customer experience as well as our processes and systems.
• Improving efficiency in our stores and CECs and our logistics operations to reduce waste.
• Opening stores in new markets and expanding our presence in existing markets.
• Becoming the leading retailer of used electric vehicles (“EV”) in the market. In support of this goal, Edmunds has launched several research and buying tools, which include providing data on the health and range of EV batteries as well as an evaluation of potential federal and state tax credits and incentives. This will support our business and help CarMax be part of the solution to reduce emissions.

As of November 30, 2023, we had used car stores located in 109 U.S. television markets, which covered approximately 85% of the U.S. population. The format and operating models utilized in our stores are continuously evaluated and may change or evolve over time based upon market and consumer expectations. During the first nine months of fiscal 2024, we opened one store, and during the remainder of the fiscal year we plan to open an additional four stores and our first stand-alone reconditioning center in the Atlanta metro market.

While we execute both our short- and long-term strategy, there are trends and factors that could impact our strategic approach or our results in the short and medium term. For additional information about risks and uncertainties facing our company, see “Risk Factors,” included in Part I. Item 1A of the Annual Report on Form 10-K for the fiscal year ended February 28, 2023.

CRITICAL ACCOUNTING ESTIMATES

For information on critical accounting policies, see "Critical Accounting Estimates" in the MD&A included in Item 7 of the Annual Report on Form 10-K for the fiscal year ended February 28, 2023.

RESULTS OF OPERATIONS – CARMAX SALES OPERATIONS AND OTHER NON-REPORTABLE SEGMENTS

NET SALES AND OPERATING REVENUES

(In millions)

(1) Excludes intersegment sales and operating revenues that have been eliminated in consolidation. See Note 16 for further details.

UNIT SALES

AVERAGE SELLING PRICES

COMPARABLE STORE USED VEHICLE SALES CHANGES

(1) Stores are added to the comparable store base beginning in their fourteenth full month of operation. We do not remove renovated stores from our comparable store base. Comparable store calculations include results for a set of stores that were included in our comparable store base in both the current and corresponding prior year periods.

VEHICLE SALES CHANGES

USED VEHICLE FINANCING PENETRATION BY CHANNEL (BEFORE THE IMPACT OF 3-DAY PAYOFFS)

(1) Calculated as used vehicle units financed for respective channel as a percentage of total used units sold.

(2) Includes CAF’s Tier 2 and Tier 3 loan originations, which represent less than 2% of total used units sold.

(3) Third-party finance providers who generally pay us a fee or to whom no fee is paid.

(4) Third-party finance providers to whom we pay a fee.

(5) Represents customers arranging their own financing and customers that do not require financing.

CHANGE IN USED CAR STORE BASE

During the first nine months of fiscal 2024, we opened one store in an existing television market (Winchester, VA).

Used Vehicle Sales. The 7.2% decrease in used vehicle revenues in the third quarter of fiscal 2024 was primarily driven by a 4.6% decrease in average retail selling price, or approximately $1,300, and a 2.9% decrease in used unit sales. The decrease in used units included a 4.1% decrease in comparable store used unit sales. For the first nine months of fiscal 2024, used vehicle revenues decreased 11.2%, driven by a 7.0% decrease in used unit sales and a 4.7% decrease in average selling price, or approximately $1,400. The decrease in used units included an 8.5% decrease in comparable store used unit sales. Online retail sales, as defined previously, accounted for 14% of used unit sales for both the third quarter and first nine months of fiscal 2024, compared with 12% and 11% for the third quarter and first nine months of fiscal 2023, respectively.

During the first nine months of fiscal 2024, we believe persistent vehicle affordability challenges continued to impact our unit sales performance, as headwinds remained due to widespread inflationary pressures, higher interest rates, tightened lending standards and prolonged low consumer confidence. Comparable used unit sales for December 2023 were similar to our third quarter results.

The decrease in average retail selling price in the third quarter of fiscal 2024 reflected lower vehicle acquisition costs. The decrease in average retail selling price in the first nine months of fiscal 2024 reflected lower vehicle acquisition costs as well as shifts in the mix of our sales by vehicle age.

Wholesale Vehicle Sales. Vehicles sold at our wholesale auctions are, on average, approximately 10 years old with more than 100,000 miles and are primarily comprised of vehicles purchased through our appraisal process that do not meet our retail standards. Our wholesale auction prices usually reflect trends in the general wholesale market for the types of vehicles we sell, although they can also be affected by changes in vehicle mix or the average age, mileage or condition of the vehicles being sold.

The 1.1% increase in wholesale vehicle revenues in the third quarter of fiscal 2024 was primarily due to a 7.7% increase in unit sales, partially offset by a decrease in average selling price of 6.7%, or approximately $600. For the first nine months of fiscal 2024, wholesale vehicle revenues decreased 19.3%, driven by a decrease in average selling price of 13.6%, or approximately $1,400, and a 7.3% decrease in unit sales.

The decrease in average selling price during the third quarter of fiscal 2024 was primarily due to shifts in the mix of our sales by vehicle age as well as decreased acquisition costs resulting from steep market depreciation, partially offset by shifts in the mix of our sales by vehicle class. The decrease in average selling price during the first nine months of fiscal 2024 was primarily due to shifts in the mix of our sales by vehicle age as well as decreased acquisition costs resulting from steep market depreciation.

Other Sales and Revenues. Other sales and revenues include revenue from the sale of ESPs and GAP (collectively reported in EPP revenues, net of a reserve for estimated contract cancellations), net third-party finance (fees)/income, advertising and subscription revenues earned by our Edmunds business, and other revenues, which are predominantly comprised of service department sales. The fees we pay to the Tier 3 providers are reflected as an offset to finance fee revenues received from the Tier 2 providers. The mix of our retail vehicles financed by CAF, Tier 2 and Tier 3 providers, or customers that arrange their own financing, may vary from quarter to quarter depending on several factors, including the credit quality of applicants, changes in providers’ credit decisioning and external market conditions. Changes in originations by one tier of credit providers may also affect the originations made by providers in other tiers.

Other sales and revenues increased 1.4% in the third quarter of fiscal 2024. Other sales and revenues decreased 3.4% in the first nine months of fiscal 2024, reflecting a decline in EPP revenue and a decrease in net third-party finance (fees)/income. EPP revenues decreased 4.5%, largely reflecting the decline in our retail unit sales, partially offset by a favorable year-over-year return reserve adjustment. Net third-party finance (fees)/income declined as a result of lower Tier 2 volume, for which we generally receive a fee.

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

GROSS PROFIT

(In millions)

(1) Amounts are net of intercompany eliminations.

GROSS PROFIT PER UNIT

(1) Amounts are net of intercompany eliminations. Those eliminations had the effect of increasing used vehicle gross profit per unit and wholesale vehicle gross profit per unit and decreasing other gross profit per unit by immaterial amounts.

(2) Calculated as category gross profit divided by its respective units sold, except the other category, which is divided by total used units sold.

(3) Calculated as a percentage of its respective sales or revenue.

Used Vehicle Gross Profit. We target a dollar range of gross profit per used unit sold. The gross profit dollar target for an individual vehicle is based on a variety of factors, including its probability of sale and its mileage relative to its age; however, it is not primarily based on the vehicle’s selling price. Our ability to quickly adjust appraisal offers to be consistent with the broader market trade-in trends and the pace of our inventory turns reduce our exposure to the inherent continual fluctuation in used vehicle values and contribute to our ability to manage gross profit dollars per unit. Gross profit per used unit is consistent across our omni-channel platform.

We systematically adjust individual vehicle prices based on proprietary pricing algorithms in order to appropriately balance sales trends, inventory turns and gross profit achievement. Other factors that may influence gross profit include the wholesale and retail vehicle pricing environments, vehicle reconditioning and logistics costs, and the percentage of vehicles sourced directly from consumers through our appraisal process. Vehicles purchased directly from consumers and dealers generally have a lower cost per unit compared with vehicles purchased at auction or through other channels, which may generate more gross profit per unit. In any given period, our gross profit may also be impacted by the age mix of vehicles sold, as older vehicles are generally more profitable. We monitor macroeconomic factors and pricing elasticity and adjust our pricing accordingly to optimize unit sales and profitability while also maintaining a competitively priced inventory.

Used vehicle gross profit decreased 1.2% in the third quarter of fiscal 2024, driven primarily by the 2.9% decrease in total used unit sales. Used vehicle gross profit decreased 6.6% in the first nine months of fiscal 2024, driven by the 7.0% decrease in total used unit sales. Used vehicle gross profit per unit for both the third quarter and first nine months of fiscal 2024 was relatively consistent with the comparable prior year periods. We continue to focus on striking the right balance between covering cost increases, maintaining margin and passing along efficiencies to consumers to support vehicle affordability. We expect used vehicle gross profit per unit in the fourth quarter of fiscal 2024 to be lower than the prior year record fourth quarter. We expect used vehicle gross profit per unit for the full year fiscal 2024 to be in line with the prior year.

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

Wholesale vehicle gross profit increased 7.2% in the third quarter of fiscal 2024, primarily driven by a 7.7% increase in wholesale unit sales. Wholesale vehicle gross profit decreased 4.4% in the first nine months of fiscal 2024, primarily driven by a 7.3% decrease in wholesale unit sales, partially offset by a $30 increase in wholesale vehicle gross profit per unit. Wholesale vehicle gross profit per unit for the third quarter of fiscal 2024 was in line with the prior year period. We expect wholesale vehicle gross profit per unit in the fourth quarter of fiscal 2024 to be in line with the results for the first nine months of fiscal 2024 and lower than the prior year near record fourth quarter. We expect wholesale vehicle gross profit per unit for the full year fiscal 2024 to be in line with the prior year.

Other Gross Profit. Other gross profit includes profits related to EPP revenues, net third-party finance (fees)/income, advertising and subscription profits earned by our Edmunds business, and other revenues. Other revenues are predominantly comprised of service department operations, including used vehicle reconditioning. We have no cost of sales related to EPP revenues or net third-party finance (fees)/income, as these represent revenues paid to us by certain third-party providers. Third- party finance income is reported net of the fees we pay to third-party Tier 3 finance providers. Accordingly, changes in the relative mix of the components of other gross profit can affect the composition and amount of other gross profit.

Other gross profit increased 55.4% in the third quarter of fiscal 2024, primarily driven by a $33.4 million improvement in service department margins. Other gross profit increased 19.2% in the first nine months of fiscal 2024, primarily driven by a $79.3 million improvement in service department margins, partially offset by a decrease in EPP revenues and a decline in net third-party finance (fees)/income, as discussed above. The increase in service department profits for both the third quarter and first nine months of fiscal 2024 was driven by efficiency and cost coverage measures that we have put in place. We expect year-over-year improvements in service for the full year fiscal 2024 as compared to fiscal 2023.

We do not expect to receive EPP profit-sharing revenues in the fourth quarter of fiscal 2024 due to the inflationary pressures our partners have experienced.

SG&A Expenses

COMPONENTS OF SG&A EXPENSES AS A PERCENTAGE OF TOTAL SG&A EXPENSES

Three Months Ended November 30, 2023 Nine Months Ended November 30, 2023

COMPONENTS OF SG&A EXPENSES COMPARED WITH PRIOR PERIOD (1)

(In millions except per unit data)

(1) Amounts are net of intercompany eliminations.

(2) Excludes compensation and benefits related to reconditioning and vehicle repair service, which are included in cost of sales. See Note 10 for details of share-based compensation expense by grant type.

(3) Includes IT expenses, non-CAF bad debt, preopening and relocation costs, insurance, charitable contributions, travel and other administrative expenses.

SG&A expenses decreased 5.4% in the third quarter of fiscal 2024. Factors contributing to the net decrease include the following:

• $19.9 million decrease in compensation and benefits, excluding share-based compensation expense, driven by our continued focus in our stores and CECs on driving efficiency gains and aligning staffing levels to sales as well as a $5.5 million decrease in bonus compensation expense.
• $19.3 million decrease in other overhead costs driven by improvements in non-CAF uncollectible receivables that reflect improved execution at our stores and home office as well as external partners, and to a lesser degree, reduced technology spend and favorability in staffing-related costs.
• $4.6 million increase in advertising expense driven by the timing of our spend.

SG&A expenses decreased 10.9% in the first nine months of fiscal 2024. Factors contributing to the net decrease include the following:

• $139.4 million decrease in other overhead costs, which included a $67.2 million benefit in connection with the receipt of settlement proceeds in a class action lawsuit related to the economic loss associated with vehicles containing Takata airbags. Other overhead costs were also positively impacted by improvements in non-CAF uncollectible receivables that reflect improved execution at our stores and home office as well as external partners, a reduction in technology spend and favorability in staffing-related costs.
• $62.5 million decrease in compensation and benefits, excluding share-based compensation expense, driven by our continued focus in our stores and CECs on driving efficiency gains and aligning staffing levels to sales.
• $29.0 million decrease in advertising expense driven by our deliberate efforts to reduce marketing spend to align with sales as well as the timing of our spend.
• $22.5 million increase in stock-based compensation expense, primarily related to cash-settled restricted stock units, as the expense associated with these units was primarily driven by the change in the company's stock price during the relevant periods.

As noted previously, entering the fourth quarter we have now passed the year mark since we initiated our significant cost management efforts. Due to the timing shifts in our advertising spend, we expect our full year spend on a per unit basis to be similar to fiscal 2023. Accordingly, we expect that our advertising spend in the fourth quarter of fiscal 2024 will exceed the per unit spend during the prior year fourth quarter.

Interest Expense. Interest expense includes the interest related to short- and long-term debt, financing obligations and finance lease obligations. It does not include interest on the non-recourse notes payable, which is reflected within CAF income.

Interest expense of $31.3 million and $93.3 million in the third quarter and first nine months of fiscal 2024, respectively, was relatively consistent with $30.2 million and $91.7 million in the third quarter and first nine months of fiscal 2023, respectively.

Other Income. Other income of $0.9 million and $4.7 million in the third quarter and first nine months of fiscal 2024, respectively, was relatively consistent with $0.4 million and $2.3 million in the third quarter and first nine months of fiscal 2023, respectively.

Income Taxes. The effective income tax rate was 25.8% in the third quarter of fiscal 2024 and 25.5% in the first nine months of fiscal 2024 versus 24.8% in the third quarter of fiscal 2023 and 25.0% in the first nine months of fiscal 2023.

RESULTS OF OPERATIONS – CARMAX AUTO FINANCE

CAF income primarily reflects interest and fee income generated by CAF’s portfolio of auto loans receivable less the interest expense associated with the debt issued to fund these receivables, a provision for estimated loan losses and direct CAF expenses. Total interest margin reflects the spread between interest and fees charged to consumers and our funding costs. Changes in the interest margin on new originations affect CAF income over time. Increases in interest rates, which affect CAF’s funding costs, or other competitive pressures on consumer rates, could result in compression in the interest margin on new originations. Changes in the allowance for loan losses as a percentage of ending managed receivables reflect the effect of changes in loss and delinquency experience and economic factors on our outlook for net losses expected to occur over the remaining contractual life of the loans receivable as well as changes in the mix of credit quality originated.

CAF’s managed portfolio is composed primarily of loans originated over the past several years. Trends in receivable growth and interest margins primarily reflect the cumulative effect of changes in the business over a multi-year period. Historically, we have sought to originate loans in our core portfolio, which excludes Tier 2 and Tier 3 originations, with an underlying risk profile that we believe will, in the aggregate, result in cumulative net losses in the 2% to 2.5% range (excluding CECL-required recovery costs) over the life of the loans. Actual loss performance of the loans may fall outside of this range based on various factors, including intentional changes in the risk profile of originations, economic conditions and wholesale recovery rates. Current period originations reflect current trends in both our retail sales and the CAF business, including the volume of loans originated, current interest rates charged to consumers, loan terms and average credit scores. Loans originated in a given fiscal period impact CAF income over time, as we recognize income over the life of the underlying auto loan.

CAF also originates a small portion of auto loans to customers who typically would be financed by our Tier 2 and Tier 3 finance providers, in order to better understand the performance of these loans, mitigate risk and add incremental profits. Historically, CAF has targeted originating approximately 5% of the total Tier 3 loan volume, which we increased to 10% during fiscal 2022 and throughout most of fiscal 2023. In response to the current environment, CAF adjusted its underwriting standards, including, towards the end of the fourth quarter of fiscal 2023, reducing its targeted percentage of Tier 3 volume from 10% to 5%. During the second quarter of fiscal 2024, CAF further adjusted its targeted percentage of Tier 3 volume to less than 5%. Within the Tier 2 space, CAF continues to originate loans on a test basis and we slightly increased our investment in this space during the second quarter of fiscal 2024. Any future adjustments in Tier 2 and Tier 3 will consider the broader lending environment along with the long-term sustainability of the change. These loans have higher loss and delinquency rates than the remainder of the CAF portfolio, as well as higher contract rates.

CAF income does not include any allocation of indirect costs. Although CAF benefits from certain indirect overhead expenditures, we have not allocated indirect costs to CAF to avoid making subjective allocation decisions. Examples of indirect costs not allocated to CAF include retail store expenses and corporate expenses.

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

SELECTED CAF FINANCIAL INFORMATION

(In millions)

(1) Annualized percentage of total average managed receivables.

CAF ORIGINATION INFORMATION (AFTER THE IMPACT OF 3-DAY PAYOFFS)

(1) Vehicle units financed as a percentage of total used units sold.

(2) The credit scores represent FICO® scores and reflect only receivables with obligors that have a FICO® score at the time of application. The FICO® score with respect to any receivable with co-obligors is calculated as the average of each obligor’s FICO® score at the time of application. FICO® scores are not a significant factor in our primary scoring model, which relies on information from credit bureaus and other application information as discussed in Note 4. FICO® is a federally registered servicemark of Fair Isaac Corporation.

(3) LTV represents the ratio of the amount financed to the total collateral value, which is measured as the vehicle selling price plus applicable taxes, title and fees.

LOAN PERFORMANCE INFORMATION

(In millions)

(1) The average recovery rate represents the average percentage of the outstanding principal balance we receive when a vehicle is repossessed and liquidated, generally at our wholesale auctions. While in any individual period conditions may vary, over the past 10 fiscal years, the annual recovery rate has ranged from a low of 46% to a high of 71%, and it is primarily affected by the wholesale market environment.

• CAF Income (Decreases of $3.5 million, or 2.3%, and $118.5 million, or 22.0%, in the third quarter and first nine months of fiscal 2024, respectively)
• The decrease in CAF income for the third quarter of fiscal 2024 reflects a decrease in the net interest margin percentage, partially offset by a decrease in the provision for loan losses and an increase in average managed receivables.
• The decrease in CAF income for the first nine months of fiscal 2024 reflects a decrease in the net interest margin percentage and an increase in the provision for loan losses, partially offset by an increase in average managed receivables.
• Total Interest Margin (Decreased to 5.9% and 6.0% in the third quarter and first nine months of fiscal 2024, respectively, from 6.7% and 7.2% in the third quarter and first nine months of fiscal 2023, respectively)
• The decrease in the total interest margin percentage for both the third quarter and first nine months of fiscal 2024 was primarily driven by higher funding costs as well as an unfavorable impact of swaps not designated as hedges for accounting purposes, partially offset by higher customer rates. While total interest margin for the third quarter decreased year-over-year, it was relatively consistent with the second quarter of fiscal 2024 and we believe it will remain relatively stable in the near-term, pending market conditions.
• Provision for Loan Losses
• The provision for loan losses resulted in expense of $68.3 million and $239.0 million in the third quarter and first nine months of fiscal 2024, respectively, compared with expense of $85.7 million and $219.0 million in the third quarter and first nine months of fiscal 2023.
• The decrease in the provision for the third quarter of fiscal 2024 primarily reflected the effect of our previously disclosed tightening of CAF's underwriting standards.
• The increase in the provision for the first nine months of fiscal 2024 was primarily due to the effects of unfavorable loss performance within CAF's portfolio as well as the uncertain macroeconomic environment, partially offset by the effect of the tightening of CAF's underwriting standards, as noted above.
• The allowance for loan losses as a percentage of ending managed receivables was 2.92% as of November 30, 2023, compared with 2.95% as of November 30, 2022 and 3.02% as of February 28, 2023. The decrease in the allowance percentage from February primarily reflects CAF's tightened underwriting standards in response to the current environment, partially offset by unfavorable loss performance as well as CAF's continued investment in the Tier 2 business.
• Loan Origination and Performance
• The decline in net loan originations in the third quarter of fiscal 2024 resulted from decreases in the average amount financed, used unit sales and the net penetration rate.
• The decline in net loan originations in the first nine months of fiscal 2024 resulted from decreases in used unit sales and the average amount financed, partially offset by an increase in the net penetration rate.
• CAF net penetration in the third quarter of fiscal 2024 was relatively in line with the prior year quarter. CAF net penetration increased in the first nine months of fiscal 2024 compared to the prior year period, primarily reflecting changes in the underlying credit mix of customers applying for financing.
• The weighted average contract rate increased to 11.3% and 11.1% in the third quarter and first nine months of fiscal 2024, respectively, compared with 9.8% and 9.4% in the third quarter and first nine months of fiscal 2023, respectively. The increases for both periods were primarily due to higher rates charged to customers in response to the current interest rate environment.
• The year-over-year increase in past due accounts as a percentage of ending managed receivables in the third quarter and first nine months of fiscal 2024 reflects an increase in delinquencies as well as our expansion of Tier 2 and Tier 3 originations within CAF's portfolio. The increase in delinquencies primarily reflects customer hardship in the current economic environment.

PLANNED FUTURE ACTIVITIES

We anticipate opening a total of six locations in fiscal 2024, including two more stores in the New York metro market and one store each in the Los Angeles and Chicago markets, as well as our first stand-alone reconditioning center in the Atlanta metro market. We currently estimate capital expenditures will total approximately $450 million in fiscal 2024. Capital expenditures were $422.7 million in fiscal 2023. Planned capital spending in fiscal 2024 largely reflects spending to support our future long-term growth, including investments in auction, sales and production facilities, as well as our new stores.

FINANCIAL CONDITION

Liquidity and Capital Resources

Our primary ongoing cash requirements are to fund our existing operations, store expansion and improvement, CAF and strategic growth initiatives. Since fiscal 2013, we have also elected to use cash for our share repurchase program. Our primary ongoing sources of liquidity include funds provided by operations, proceeds from non-recourse funding vehicles and borrowings under our revolving credit facility or through other financing sources.

Our current capital allocation strategy is to focus on our core business. Given our recent performance and continued market uncertainties, we are taking a conservative approach to our capital structure in order to maintain the flexibility that allows us to efficiently access the capital markets for both CAF and CarMax as a whole. We have taken steps to better align our expenses to sales as well as slowed the rate of our store growth. We resumed our share repurchases during the third quarter of fiscal 2024 after a pause initiated during the third quarter of the prior fiscal year. We believe we have the appropriate liquidity, access to capital and financial strength to support our operations and continue investing in our strategic initiatives for the foreseeable future.

We have historically targeted an adjusted debt-to-total capital ratio in a range of 35% to 45%. Our adjusted debt to capital ratio, net of cash on hand, was below our targeted range for the third quarter of fiscal 2024. In calculating this ratio, we utilize total debt excluding non-recourse notes payable, finance lease liabilities, a multiple of eight times rent expense and total shareholders’ equity. Generally, we expect to use our revolving credit facility and other financing sources, together with stock repurchases, to maintain this targeted ratio; however, in any period, we may be outside this range due to seasonal, market, strategic or other factors.

Operating Activities. During the first nine months of fiscal 2024, net cash provided by operating activities totaled $149.0 million compared with $1.66 billion in the prior year period.

As of November 30, 2023, total inventory was $3.64 billion, representing a decrease of $87.2 million compared with the balance as of the start of the fiscal year. The decrease was primarily due to a decline in vehicle units, reflecting lower sales volume, partially offset by an increase in the average carrying cost of inventory due to market appreciation at the beginning of the current fiscal year as well as a shift in the mix of vehicles.

Our operating cash flows are significantly impacted by changes in auto loans receivable, which increased $979.1 million in the current year period compared with $1.17 billion in the prior year period. The majority of the changes in auto loans receivable are accompanied by changes in non-recourse notes payable, which are issued to fund auto loans originated by CAF. Net issuances of non-recourse notes payable were $669.3 million in the current year period compared with $770.6 million in the prior year period and are separately reflected as cash from financing activities. Due to the presentation differences between auto loans receivable and non-recourse notes payable on the consolidated statements of cash flows, fluctuations in these amounts can have a significant impact on our operating and financing cash flows without affecting our overall liquidity, working capital or cash flows.

The change in net cash provided by operating activities for the first nine months of the current fiscal year compared with the prior year period primarily reflected the changes in inventory, as discussed above, combined with the prior year decrease in inventory, as well as the net impact of volume and timing-related changes in accounts receivable and accounts payable, partially offset by the changes in auto loans receivable, as discussed above.

Investing Activities. During the first nine months of fiscal 2024, net cash used in investing activities totaled $357.2 million compared with $318.7 million in fiscal 2023. Capital expenditures were $355.4 million in the current year period versus $319.5 million in the prior year period. Capital expenditures primarily included land purchases and construction costs to support our growth capacity initiatives and new store openings as well as investments in technology. We maintain a multi-year pipeline of sites to support our store and capacity growth, so portions of capital spending in one year may relate to locations that we open in subsequent fiscal years.

As of November 30, 2023, 158 of our 241 used car stores were located on owned sites and 83 were located on leased sites, including 27 land-only leases and 56 land and building leases.

Financing Activities. During the first nine months of fiscal 2024, net cash provided by financing activities totaled $517.3 million compared with net cash used in financing activities of $827.0 million in the prior year period. Included in these amounts were net issuances of non-recourse notes payable of $669.3 million compared with $770.6 million in the prior year period. Non-recourse notes payable are typically used to fund changes in auto loans receivable (see “Operating Activities”).

During the first nine months of fiscal 2024, cash provided by financing activities was impacted by net payments on our long-term debt of $108.4 million as well as stock repurchases of $44.3 million. During the first nine months of fiscal 2023, cash used in financing activities was impacted by net payments on our long-term debt of $1.25 billion as well as stock repurchases of $333.8 million.

TOTAL DEBT AND CASH AND CASH EQUIVALENTS

(In thousands)

(1) Interest is payable monthly, with the exception of our senior notes, which are payable semi-annually.

(2) Borrowings accrue interest at variable rates based on SOFR, the federal funds rate, or the prime rate, depending on the type of borrowing.

(3) Total debt excludes unamortized debt issuance costs. See Note 9 for additional information.

Borrowings under our $2.00 billion unsecured revolving credit facility are available for working capital and general corporate purposes, and the unused portion is fully available to us. The credit facility, term loans and senior note agreements contain representations and warranties, conditions and covenants. If these requirements are not met, all amounts outstanding or otherwise owed could become due and payable immediately and other limitations could be placed on our ability to use any available borrowing capacity. As of November 30, 2023, we were in compliance with these financial covenants.

See Note 9 for additional information on our revolving credit facility, term loans, senior notes and financing obligations.

CAF auto loans receivable are primarily funded through our warehouse facilities and asset-backed term funding transactions. These non-recourse funding vehicles are structured to legally isolate the auto loans receivable, and we would not expect to be able to access the assets of our non-recourse funding vehicles, even in insolvency, receivership or conservatorship proceedings. Similarly, the investors in the non-recourse notes payable have no recourse to our assets beyond the related receivables, the amounts on deposit in reserve accounts and the restricted cash from collections on auto loans receivable. We do, however, continue to have the rights associated with the interest we retain in these non-recourse funding vehicles.

As of November 30, 2023, $12.50 billion and $4.53 billion of non-recourse notes payable were outstanding related to asset-backed term funding transactions and our warehouse facilities, respectively. During the first nine months of fiscal 2024, we funded a total of $4.50 billion in asset-backed term funding transactions. As of November 30, 2023, we had $1.07 billion of unused capacity in our warehouse facilities.

We have periodically increased our warehouse facility limit over time, as our store base, sales and CAF loan originations have grown. See Note 9 for additional information on the warehouse facilities.

We generally repurchase the receivables funded through our warehouse facilities when we enter into an asset-backed term funding transaction. If our counterparties were to refuse to permit these repurchases it could impact our ability to execute on our funding program. Additionally, the agreements related to the warehouse facilities include various representations and warranties, as well as covenants and performance triggers related to events of default. If these requirements are not met, we could be unable to continue to fund receivables through the warehouse facilities. In addition, warehouse facility investors could charge us a higher rate of interest and could have us replaced as servicer. Further, we could be required to deposit collections on the related receivables with the warehouse facility agents on a daily basis and deliver executed lockbox agreements to the warehouse facility agents.

The timing and amount of stock repurchases are determined based on stock price, market conditions, legal requirements and other factors. Shares repurchased are deemed authorized but unissued shares of common stock. As of November 30, 2023, a total of $4 billion of board authorizations for repurchases was outstanding, with no expiration date, of which $2.41 billion remained available for repurchase. During the third quarter of fiscal 2024, we resumed our share repurchases after a pause initiated during the third quarter of the prior fiscal year. See Note 10 for more information on share repurchase activity.

Fair Value Measurements

We recognize money market securities, mutual fund investments, certain equity investments and derivative instruments at fair value. See Note 6 for more information on fair value measurements.

FORWARD-LOOKING STATEMENTS

We caution readers that the statements contained in this report that are not statements of historical fact, including statements about our future business plans, operations, capital structure, opportunities, or prospects, including without limitation any statements or factors regarding expected operating capacity, sales, inventory, market share, online purchases of vehicles from consumers, gross profit per used unit, revenue, margins, expenditures, liquidity, loan originations, CAF income, stock repurchases, indebtedness, earnings, market conditions or expectations with regards to the continued impact of the COVID-19 pandemic, are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. You can identify these forward-looking statements by the use of words such as “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “on track,” “outlook,” “plan,” “positioned,” “predict,” “target,” “should,” “will” and other similar expressions, whether in the negative or affirmative. Such forward-looking statements are based upon management’s current knowledge, expectations and assumptions and involve risks and uncertainties and assumptions about future events and involve risks and uncertainties that could cause actual results to differ materially from anticipated results. We disclaim any intent or obligation to update these statements. Among the factors that could cause actual results and outcomes to differ materially from those contained in the forward-looking statements are the following:

• Changes in the competitive landscape and/or our failure to successfully adjust to such changes.
• Changes in general or regional U.S. economic conditions, including inflationary pressures, climbing interest rates and the potential impact of international events.
• Changes in the availability or cost of capital and working capital financing, including changes related to the asset-backed securitization market.
• Events that damage our reputation or harm the perception of the quality of our brand.
• Significant changes in prices of new and used vehicles.
• A reduction in the availability of or access to sources of inventory or a failure to expeditiously liquidate inventory.
• Our inability to realize the benefits associated with our omni-channel initiatives and strategic investments.
• Factors related to geographic and sales growth, including the inability to effectively manage our growth.
• Our inability to recruit, develop and retain associates and maintain positive associate relations.
• The loss of key associates from our store, regional or corporate management teams or a significant increase in labor costs.
• Changes in economic conditions or other factors that result in greater credit losses for CAF’s portfolio of auto loans receivable than anticipated.
• The failure or inability to realize the benefits associated with our strategic transactions.
• The effect and consequences of the Coronavirus (“COVID-19”) public health crisis on matters including U.S. and local economies; our business operations and continuity; the availability of corporate and consumer financing; the health and productivity of our associates; the ability of third-party providers to continue uninterrupted service; and the regulatory environment in which we operate.
• Changes in consumer credit availability provided by our third-party finance providers.
• Changes in the availability of extended protection plan products from third-party providers.
• The performance of the third-party vendors we rely on for key components of our business.
• Adverse conditions affecting one or more automotive manufacturers, and manufacturer recalls.
• The inaccuracy of estimates and assumptions used in the preparation of our financial statements, or the effect of new accounting requirements or changes to U.S. generally accepted accounting principles.
• The failure or inability to adequately protect our intellectual property.
• The occurrence of severe weather events.
• Factors related to the geographic concentration of our stores.
• Security breaches or other events that result in the misappropriation, loss or other unauthorized disclosure of confidential customer, associate or corporate information.
• The failure of or inability to sufficiently enhance key information systems.
• Factors related to the regulatory and legislative environment in which we operate.
• The effect of various litigation matters.
• The volatility in the market price for our common stock.

For more details on factors that could affect expectations, see Part II, Item 1A, “Risk Factors” on Page 46 of this report, our Annual Report on Form 10-K for the fiscal year ended February 28, 2023, and our quarterly or current reports as filed with or furnished to the U.S. Securities and Exchange Commission (“SEC”). Our filings are publicly available on our investor information home page at investors.carmax.com. Requests for information may also be made to our Investor Relations Department by email to investor_relations@carmax.com (mailto:relations@carmax.com) or by calling 1-804-747-0422, ext. 7865. We undertake no obligation to update or revise any forward-looking statements after the date they are made, whether as a result of new information, future events or otherwise.

There have been no material changes to our market risk since February 28, 2023. For information on our exposure to market risk, refer to Part II, Item 7A, “Quantitative and Qualitative Disclosures about Market Risk,” contained in our Annual Report on Form 10-K for the fiscal year ended February 28, 2023.

Disclosure. We maintain disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (“Exchange Act”)) that are designed to ensure that information required to be disclosed in our reports filed under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Our disclosure controls and procedures are also designed to ensure that this information is accumulated and communicated to management, including the chief executive officer (“CEO”) and the chief financial officer (“CFO”), as appropriate to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, with the participation of the CEO and CFO, we evaluated the effectiveness of our disclosure controls and procedures. Based upon that evaluation, the CEO and CFO concluded that our disclosure controls and procedures were effective as of the end of the period.

Internal Control over Financial Reporting. During the third quarter of fiscal 2024, we implemented a new enterprise resource planning (“ERP”) system which included accounts receivable, accounts payable, fixed assets, project accounting, general ledger and consolidation applications as well as inventory and order management modules. As a result of this implementation, we modified certain existing internal controls over financial reporting as well as implemented new controls and procedures related to the new ERP system.

Except as noted above, there were no other changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during the quarter ended November 30, 2023, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

In connection with information set forth in this Form 10-Q, the factors discussed under “Risk Factors” in our Form 10-K for fiscal year ended February 28, 2023, should be considered. These risks could materially and adversely affect our business, financial condition, and results of operations. There have been no material changes to the factors discussed in our Form 10‑K.