車美仕 (KMX) 2005 Q1 法說會逐字稿

Good morning.

My name is Amanda and I will be your conference facilitator.

At this time, I would like to welcome everyone to the CarMax first quarter earnings conference call.

All lines have been placed on mute to prevent any background noise.

After the speaker's remarks, there will be a question-and-answer period. (OPERATOR INSTRUCTIONS).

I would now like to turn the conference over to Ms. Dandy Barrett, Assistant Vice President, Investor Relations.

Please go ahead, ma'am.

Good morning.

On the call this morning are Austin Ligon, our President and Chief Executive Officer, and Keith Browning, our Executive Vice President and Chief Financial Officer.

Before we begin, please let me remind you that our statements today about the company's future business plans and prospects are forward-looking statements according to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995.

These statements are based on our current knowledge and assumptions about future events.

Our actual results may differ materially from those indicated in our forward-looking statements as a result of various important factors.

These factors include those discussed in the company's annual report on Form 10-K for the fiscal year ended February 28, 2004, and our quarterly and current reports as filed with or furnished to the SEC.

Now I will turn the call over to Austin.

Thanks very much Dandy.

Good morning.

Let me talk first about earnings.

Despite the disappointing 3 percent decline in comps used unit sales we were pleased as we said in the release that first quarter earnings were 33 cents a share which were in line with our originally projected range for the quarter.

The results reflect solid used car gross margins per unit despite a lower than planned sales, and pricing tests that we undertook during the quarter.

They also reflect higher-than-expected wholesale sales.

They reflect capped gain spreads at more normal levels compared to last year's first quarter.

This year gain spread was at 3.5 versus 5.5 percent last year, and SG&A ratio consistent with last year at 9.9 percent.

We benefited in SG&A from shifts in timing of some plant spending such as relocation and other expenses associated with our store growth program.

The results also included a 1 cent per share benefit from the repurchase of the remaining outstanding receivables of the 2001 public securitization of CarMax Auto Finance.

As is usual in the auto loan securitizations, we exercised our option to call the notes when the receivables reached 10 percent of the original pool balance and the benefit occurred because of the difference between the cost of funds when these notes were originated versus today's funding cost.

As far as our second quarter expectations go, our second quarter expectations assume that for the balance of the quarter, we will continue to experience the kind of sales volatility that we have seen in April, May, and thus far in June.

The sales volatility has been spread broadly across our markets and as we said in our mid-May announcement, can't really be tied to any one factor.

Some of the influences that appear to be having some impact on sales are gas prices, the short-term disruption from manufacture incentives.

In May we saw in particular some short-term disruption in our SUV sales because of heavy discounting by manufacturers in response to gas prices, the increase in mortgage interest rates reducing available cash for big-ticket items from refinancing, the seasonally stronger wholesale prices that have been noted throughout the season, and the increase in negative equity among consumers.

The transparency of CarMax's offer does not hide negative equity from either the consumer or from the finance institution and the fact that we limit negative equity to 10 percent on all but the best credit through cap means that for consumers with very high levels of negative equity, CarMax is and always has been at somewhat of a disadvantage.

And to the degree that negative equity is increased, that has an influence as well.

As a consequence, we're providing much wider ranges than usual in our forecast, and we have chosen not to provide any outlook for the second half of the year until we see a more consistent sales trend that would allow us to issue an updated forecast.

Our second quarter expectations are a range of negative 5 percent to positive 1 percent per used unit comps and an EPS earnings range of 30 to 35 cents.

As far as our growth program, our new store growth program continues to proceed as planned.

We expect to open 9 to 10 stores total for the year.

During the first quarter we opened three standard superstores, two in new midsize markets, one in Indianapolis, Indiana, the other in Columbia, South Carolina, and the third a full size superstore in the Buena Park area of Los Angeles.

During the second quarter, we will open three new stores, a satellite in Winston-Salem, North Carolina which is a satellite of Greensboro, which will grand open tomorrow; a satellite in Fayetteville, North Carolina which is a satellite of Raleigh, which will open in July; and the new midsize market Austin, Texas which will open in August.

With that, I would be glad to take any of your questions.

**********************************

(OPERATOR INSTRUCTIONS) Hardy Bowen (ph) with Arnold Bleichroeder (ph).

That was almost correct.

How are you doing, Austin?

I'm fine, Hardy.

How are you?

Okay.

The number of cars that we are taking in wholesale suggests, I guess, that a greater proportion of our retail inventory is coming from wholesale at this point?

Is that fair to say?

Overall, it's about the same because of the new stores.

The new stores tend to run at a lower percentage of retail purchase because of the lower buy rate in the new stores.

But I think in the comp stores it may be somewhat higher, but it is not dramatically higher.

A lot of that are wholesale cars.

Okay.

I'm inferring from what you've said that the April/May sales trend is pretty much what we're reflecting in the midpoint of the range that we are projecting for the next quarter?

Yes, if you take the entire sales trend from the beginning of April through the middle of June, that is what we're reflecting in our forecast, and to call it a trend would be generous.

When we talk about volatility, the challenge that we face right now is it's not a trend.

We have seen strong upward periods and strong downward periods, and that is what has made it so difficult to forecast.

If it were a more consistent trend, we would be more comfortable in making a longer-term forecast, but the volatility that we have seen makes us feel like we have to take the whole period and call it a trend as our best guess for the second quarter.

I'm presuming that SUVs are probably a couple of points lower as a portion of your mix, 92 percent lower as a portion of the mix because of what's been going on with incentives on SUVs related to gasoline prices?

Yes, what we -- rough range, that is probably in the ballpark.

What we saw was, clearly in May, the effect of gas prices on demand for large SUVs led the manufacturers to get very aggressive in incentives.

And as they themselves reported, they got a good month in SUVs, but it was a good month driven by very strong incentives.

That had a negative impact on us, both in sales and in -- not in margins for the quarter, but we have taken discounts on those SUVs that were bought at higher prices.

We've seen the wholesale market fall, so we think that is adjusting as it normally does.

But it's certainly had a negative sales impact on us in the last quarter and will have had a modest margin impact in the first part of June, not something that we would think would influence the quarter overall.

But it's that sort of thing that certainly is creating some of the volatility.

I wonder if Keith would take a shot at how much relocation expense and so forth might show up in later quarters that didn't show up in this past quarter?

There's perhaps somewhere between a penny and two pennies that will show up sometime during the balance of the year.

I won't say definitely that that will impact the second quarter, but we do think that we will catch up based on the anticipated moves and the store openings.

That would already be built into the forecast.

Right, okay.

Sounds good.

Matthew Fassler with Goldman Sachs.

Thanks a lot and good morning.

A couple of questions.

First of all, could you talk about what you are seeing in terms of the market's adjustments to rising cost of funds?

You indicated that there was a bit of a squeeze as you saw some dislocation with increasing cost of funds exceeding the cost in APR.

Is it different from what you typically expect in a rising rate environment, or are some of your competitors being particularly stubborn?

Are you talking about influence on CarMax Auto Finance?

Yes, on cash.

The answer, again, we have seen the market move as soon as the market determines that the cost of funds are stable.

In other words, the market will tend to wait a week or so because there is a lot of volatility in two-year treasuries, which tends to be a good benchmark for us.

But the market has moved upward, and we have moved and actually we feel like we are in as competitive a position as we have ever been relative to the competition and their interest rates.

As you know, a large part of our competition are the dealers who have (indiscernible) managers who are interested in protecting their returns and their margins, so in all likelihood, we sense that they are more aggressive about moving as the buy rates that they get from the individual lenders continue to increase.

Thank you.

My second question relates to your used car gross margins, gross margin rate, which held up quite nicely during the quarter.

If you could talk both about how you made that happen, and also as you look to the second quarter, last year your second- quarter used car gross margin rate was quite strong.

Do you view that as a daunting comparison in any way, and are there any special factors we should be aware of regarding that year-ago number?

Let me -- I will answer the first half of the question and I will let Keith talk about the second half of the question.

As far as the performance in the quarter, one of the things we noted earlier is we know that wholesale prices were stronger through the quarter than they typically are.

One of the things that potentially does is make used cars less competitive with new cars.

We did a fair amount of testing to understand within the bounds of reasonable discounting, should we lower our prices to bring margins down and get a benefit in sales.

What we found was that that was not efficiently beneficial to justify itself, so we were able to hold margins pretty well.

We kept inventory pretty much in line with where we expected it to be, as I noted in my prior answer.

SUVs were somewhat off in May, but we get inventory back in line very quickly any time it is ever out.

So we manage those gross margins very consciously and on a very quick turn basis.

So as long as we get the inventory turn we expect, usually gross margins are going to be in line.

As far as the second quarter, it's a little hard to project.

I will let Keith talk about some of the influences from last year and some of what we come up against, although in general the second quarter tends to be one of our stronger gross margin quarters.

The only thing I was going to add is that one of the positive influences that did occur on gross margins for used cars during the quarter was we did see a higher mix of sales of our ValuMax cars, and as you know, we tend to get similar margins on our ValuMax vehicles, even though average retails are a little bit lower.

So that helped us preserve our aggregate used car margins.

You're talking about the first quarter of this year?

For the first quarter.

And we ended up the quarter slightly ahead of our targeted inventory.

I think we were about 3 or 4 percent higher than we would've expected.

But as Austin indicated, we can adjust and move through that very quickly and feel good about our overall inventory levels and then the resulting margins there.

So it's safe to say that to the extent the inventory increase exceeded the increase in cost of goods by a bit more than has been the case in recent quarters that you've probably worked through that by now?

We think so.

One of the reasons we're being so cautious on our forecast is the spring is usually one of the more dependable quarters, and it was not this year.

So summer being the other dependable quarter, we're taking it with a pretty cautious eye.

But we certainly think most of what we saw in the spring, we've moved through.

Understood.

Thank you so much.

Scot Ciccarelli with RBC Capital Markets.

A couple of questions here.

Can you talk about what size, what was the benefit from the wholesale business?

Obviously, that was up very strong, and I believe this is the time of year where you guys generate a profit.

Can you give us an idea of what the benefit was on the wholesale side?

The benefit in terms of sales or in terms of dollar profit?

Earnings.

I mean, you guys are making money at this time of year, correct?

You mean in the auctions themselves?

Yes, your auctions.

The benefit from the auctions themselves is pretty modest.

The majority of the benefit we got was from the incremental ACR fee that we added last year.

You will recall that we started adding on a fee rather than charging customers directly, and we saw that both on our used car margins and in the wholesale margins for the quarter.

But as far as the absolute level of profit per car sold, other than the ACR, while the volume helped, I'm not sure I can put a --.

But it would be the smallest part of that.

The primary impact is the fact that we try to recover, as you know, full cost on every car that we buy, either for retail or for wholesale, and that cost recovery is most of the benefit.

Part of it is just an accounting shift, but part of it is a real benefit.

Fair enough.

Question number two, I understand that you guys have been experimenting with some additional sub-prime lenders.

Can you give us any kind of update, what the thought process is here, and can that actually help you deal with the negative equity issue that you've been facing in the marketplace?

No, just the opposite.

One sub-prime lender that has been mentioned recently that is true sub-prime that we are testing is Drive (ph), and in that case, the consumer actually has to come up with a higher equity position to really offset all of their challenges that they have had personally in the past.

So that won't help the negative equity situation at all.

As far as the concept behind what are we trying to do, as you know, we feel like we have the prime and the nonprime covered very well.

We have been looking for some time to find somebody to do that next slice of lending below nonprime, what's known as true sub-prime, and Drive is one of a variety of companies that we've tested there.

Ultimately, what we're looking for is to try to find someone who will let us add net incremental sales among those consumers who right now would like to buy a CarMax car, who have the financial capability to buy a car somewhere, but currently can't qualify for any of our lenders.

If we are able at some point to conclude a test that lets us roll something out, we would hope we would get a net benefit out of that, but we're certainly not ready to announce anything yet.

What else can you do to deal with a negative equity issue in the marketplace?

Because obviously, as that continues to grow out of the marketplace, that is siphoning off potential customers from your base.

I would love to tell you there's something we can do about negative equity.

We do all of the negative equity deals that make rational economic sense to do.

The ones that don't make any sense to do, we're going to lose.

I think, to be quite honest, what we have to do is wait for the market to adjust, and the market will adjust.

I have read several analysts' reports from the analysts who are covering the auto industry now, and this is becoming one of their biggest issues because they recognize that these deals don't make any sense for the finance companies.

In many cases, the auto finance companies are a little more, if you will, in the know of what is really going on, but the fact that someone is converting incentive into the equivalent of down payment or the fact that they are doing what we've talked about often in the used car business and using what is known as a cheater car; that is a car with a big difference between wholesale price and the book price that a bank will finance on, to create artificial down payment or to cover negative equity means that a lot of things are taking subquality loans into their portfolio.

And as interest rates rise, the manufacturers are having to subsidize the whole process for us.

So, I think the process starts to be self-limiting in terms of what our competitors can do at some point, but I don't really think there is anything that we're going to be able to do proactively about this and there never has been.

This is not a new issue that has popped up.

It is just a contributor because all of the sources we read say there is more total negative equity out there.

But I would like to tell you there is something we can do about that.

This is probably the issue we can do the least about because the fundamental economics of doing anything about it don't make any sense.

That's fair.

The last question, Austin is, given the volatility that you guys have seen in your sales trends which has obviously been considerable particularly given the pretty wide range of guidance that you're providing, how has that changed your buying process?

Obviously part of your core competency has theoretically been your systems, your know-how, your information flow, but if you have less information flow, if you will, on the sell through, how have you altered your buying patterns?

You don't have less information flow, we still have all of the information flow.

The fundamental thing you are continuously trying to do is adjust to the market.

And for instance, I already talked about on the call the fact that we did not -- we got hurt in SUV's in May by the heavy discounting from the manufacturers.

Now as I have talked about many times, the market will adjust that and we have already seen that in the wholesale market with strong downward movement in mid and full-size SUV prices in the wholesale market.

One of the things we have always chosen to do is to not try to out-guess the market because the inherent negative of what we do is that we are lagging the market a little bit.

But our view is that is the only rational thing to do because you will be wrong more often than not if you try to out-guess the market.

So, we think this makes it more challenging, but we plan inventory every seven days and it let's us stay very close to the market.

So even during this period of time that -- we ended up missing sales by quite a bit.

Do inventories get out of balance somewhat?

Yes.

Do we get them back in balance very quickly, both in terms of mix and in terms of total amount?

Yes, we do.

I think the economic results, the profit results for the quarter, give you a sense the fact that we are able to manage pretty well in this volatile environment.

I won't say that it doesn't have any penalties for us, it does.

But I think in fact if anything, I think as I said before, we are probably in a little bit better position than most folks in that that we are able to manage through this environment.

But, it is a challenging environment.

It gives our buyers a few more gray hairs but that's what they get paid for.

Thanks a lot.

Certainly.

Bill Armstrong with C. L. King and Associates.

Good morning, a couple of questions.

What specific steps are you taking to increase your appraisal purchase rate and what is the rationale behind increasing that rate?

Well, in general, philosophically we would like to look at every car for sale in the marketplace, every used car a consumer wants to sell, because we would like to have the maximum information flow and the maximum opportunity to buy the cars that we want for our inventory, because the more we can buy at the store the better.

So, we advertise our appraisal offer very aggressively on television, in the newspaper, on radio and on the Internet.

In addition to that, we made some process changes over the last year in our information system, and the tools that we give our salespeople who are the people who actually deliver the appraisals to customers, and we think those process changes and the information system changes improve the effectiveness with which we present the purchase offer to consumers.

Frankly, we are often the bearer of bad news.

If you made a mistake in what you paid for your last car, or you bought a car that has depreciated tremendously, we are the people who are going to give you the honest facts on the value of the car.

How you do that makes an important difference.

The more information you present, the more effectively you present that appraisal so that somebody understands that it's a true market offer, and the more that you can be sensitive to what some of their concerns may be, particularly in a market where you have seen so many wholesale prices decline, makes a big difference in ultimately their ability to decide yes, I want to go ahead and sell this car to CarMax.

As far as why would we want to increase the appraisal buy rate, the appraisal buy rate is good for us in every way.

It helps us buy retail cars that we want to sell.

It helps us buy cars for our wholesale option.

And what we've learned over time is if you're going to sell cars -- if you're going to buy cars you don't want and resell them, you're better off to have a lot of them than a few of them and we certainly fully recover our costs on that.

It also helps us by creating a customer experience that CarMax is an honest retailer who does something that nobody else will do and it really helps create a lot of word-of-mouth.

So we see it as a very strong positive for CarMax.

Okay.

Another question.

A lot has been written I think recently with the idea that CarMax is at a competitive disadvantage because you have a very small parts and service business, and that your competitors use that to subsidize their car sales.

Do you feel that that is a competitive disadvantage for you, and do you see any opportunities to increase your parts and service business?

I think most of the people that have written that have not done very thoughtful analysis.

If you look at our parts and service business, we do about as much what in the industry is called consumer pay service per store in dollars as the typical dealer does, about $1 million a year in parts and service sales.

We don't have the warranty work they have but the warranty work is the least profitable work.

The difference is we sell a lot more cars than they do.

So, while the dollars that we are getting on customer pay work are pretty good, the sales that we do are so much larger that they overwhelm the service as a percent of our gross margin.

We also are, we don't -- we do our accounting in a straightforward and correct manner.

That is, the way that most dealers do their service accounting, all the service work they do on their own used cars is done at market rate and they transfer profits to their service organization from what are truly used car profit.

We do all of our service work, all our conditioning work at cost so we don't create any artificial profit transfer.

We could create a huge imaginary service profit tomorrow if we did accounting the way the dealers do it, by charging ourselves market rate.

All we do is lower our used car profit margins and increase our service margins.

It is our general experience from the competitive marketplace as we have seen at over the last 10 to 12 years, that new car dealers who are selling used cars are generally focused on the margin they make per car, and with a very few exceptions are more focused on how much they make per car than they are on the total quality of cars they sell.

Obviously if they have a current inventory, they want to sell that inventory.

But if they see a margin squeeze, the general direction they go is to reduce inventory and reduce sales and maintain margins.

That is because many of them support their inventory through their own equity.

So, they view it as a very high-cost, high risk business to be in.

It has not been our experience that dealers subsidize their used car business with sales and service.

It has been our experience that the absolutely do that with new car prices.

That is why new car prices are so competitive.

Most dealers try to support their entire overhead through their sales and service so that they can be very competitive on new car prices because it's a commodity and you have to be.

But, the behavior that we have seen historically is quite different in used cars and new cars and we think it is more of an issue in our competition between the used car and the new car business, but over the long-term we don't think it is a fundamental issue.

That is always been there and always will be.

Okay.

Just to get back to a comment you made earlier, why would you want to increase the number of wholesale cars going through the auction, buying cars from consumers that you don't want to resell?

Doesn't that use up resources at the dealership level?

We have a charge on each one of those cars, the ACR fee, that pays for those resources, if you will.

We fully recover our costs on doing that, so in essence we pay for the buyer's time, the auction management team's time, and the cost of running the auction, the cost of holding the cars and the cost of the land that we hold the cars in.

So we basically neutralize any negative costs or resource effect, and from the point of view of consumers, it is a very strong positive to consumers.

It is one of the best ways to create a positive image with consumers is to buy cars from them that nobody else will buy.

We believe we get a tremendous amount of traffic flow in sales out of that.

We definitely think if we didn't have that strength these periods of volatility would be even more challenging for us.

Thank you.

Aram Rubinson with Bank of America securities.

Thanks guys.

A couple of questions.

I know that you are still having a hard time kind of diagnosing exactly what is contributing to the volatility, but I wanted to understand the behavior of the model underneath that volatility?

So, the ramp rate of first year to second year, second year to third year, third year to fourth year, I'm curious how that is evolving during this period, number one.

Number two, also, what the, call it volatility, means for growth going forward in terms of your desire to lay down as much capital and new store resources going forward if there is some uncertainty more so in the business?

The last thing is whether there has been any personnel change I guess to a company, the recent spurt in volatility or if everything is status quo at corporate?

Thanks.

I don't know, maybe at investment banks you get rid of people after 60 or 90 days of bad news, but that is generally now how resellers work, at least not ones that ever succeed.

In terms of, I got two of your three questions, the impact of growth and the impact -- look, this is not something as far as we can tell that has anything to do with failure of execution on our part.

We certainly challenge ourselves every day and we certainly are doing everything we can to overcome the volatility we see in the market.

But certainly there have been no personnel changes as a result of the last 60 days, nor do we expect there will be.

As far as capital goes, we don't -- the current rate of volatility we see certainly makes us unhappy.

It has made us frustrated with first quarter sales.

We are still very profitable, much more profitable than anybody else in the auto business and this won't have any impact on the availability of capital for growth or our attitude towards growth.

As far as the ramp up rates, which I think was your first question on new stores, in general, the sales impact we have seen in the last couple of months has been across all our stores as you would expect it would be, both the new stores and the older stores.

So to the degree that we have seen this volatility, that has affected the new stores too.

There is no indication that it has had any fundamental impact on the way that sales ramp up over time.

Now, if sales are down five percent across all the markets, that obviously would influence the new store, but we don't see that it is changing the character of how new stores develop and grow at all.

My last question has to do with the ability to grow earnings in a flat or down comp period.

Your earnings were essentially flat during a minus 3 comp.

Is that something going forward that there is enough flexibility in the model such that a flat comp or a negative comp, you can still deliver flat earnings?

Are there opportunities that you're finding inside the business given the volatility that can enable you to grow earnings with a weaker comp than you originally thought?

Let me let Keith answer first, then I will add on.

I think being a growth company and the added expenses that we incur as a regular part of our business mean that we would not expect that we could deliver flat earnings with negative comps.

I think really we had some positive occurrences, timing otherwise, year-over-year from growth and how that unfolds.

It allowed us to achieve basically flat earnings as you mentioned, but I don't think that will be a realistic expectation going forward.

As we talked about before, as we cycle around on the normalization of cap earnings, that does give us some benefit and as we go through over the next 24 months and get to the point that we've got a fully loaded growth pipeline, that reduces some of the incremental negative impact of growth.

But I don't think that we look at -- we don't look at this as a long-term phenomenon, but we certainly would not be happy with flat or negative comps in terms of letting us hit our growth target long-term.

Thanks.

Sure.

Sharon Zackfia with William Blair.

Good morning.

I know you monitor traffic trends in the stores and I'm curious as to how that ended up flushing out in the May quarter versus last year?

Was traffic down as well or was that was actually up and it was more of a conversion issue?

Can you give us some color there?

As far as we can tell and we have had more chance to analyze this since the last time we talked.

As far as we can tell, most of the negative impact we are seeing is actually coming from traffic.

That are conversion has actually remained pretty strong and that most of what we are seeing is coming from traffic, which is what you would expect.

As I said, I talked through all of the various factors that we think may be having some impact, but in general, the traffic trends were down for the quarter and particularly in April and May.

We will be, as you would expect we would be, we're running some tests and experiments now and will be through the second quarter, tests that involve pricing tests, tests that involve inventory tests and tests that involve marketing tests, to try to understand what, if anything, we can do that makes economic sense that would affect this.

And we think part of it will solve itself with some of these shorter-term factors growing out of the market, but we're certainly trying to find anything that we can do that would make economic sense to do and will be doing that through the quarter.

But as I said, most of it appears to be traffic related.

In terms of marketing tests, is that trying to test kind of a different message or maybe a more targeted message rather than just the brand centric message that you normally deliver?

Or is that different kinds of medium?

The answer is, we do a lot of testing on our message, and we certainly since we don't have promotional tools available to us, we don't have $99 TVs and we're not going to -- that just doesn't exist in this type of business.

We certainly have looked at and will look at changes in the message, but I think the message is not a primary issue based on extensive testing that we have done.

We certainly are looking at different ways of delivering the message.

Is there a more efficient way to use TV?

Does radio have a growing advantage that we haven't seen in the past or is there a different way to use it?

What are tools available on the Internet?

The Internet continues to evolve and we try to -- today we're doing a fair amount of Google advertising.

A year ago we didn't do any.

So, we're continuously looking at what are the different channels, particularly as TV gets more fragmented for us and for everybody else, and also just total quantity of advertising.

One of the things we're looking at in some markets is to do a greater amount of advertising in one vehicle or another just to understand, can you get a payback on that.

Okay.

You had talked some and I think it was earlier in mid-May when you preannounced about your marketshare trends in April.

At the risk of bringing this up again, how did that end up trending in May?

Risk is a good word.

Let me start out with the one thing that we have some confidence in which is the quarter as a whole.

As we have said before, we have a fair amount of confidence that we have some understanding of what a ninety-day trend is as the reported DMV data tells us, plus or minus a moderate variation, and we know that the trends for March, April, and May shows that overall for the quarter we gained share.

The data that is out on May so far suggest that we may have lost a small amount of share.

As I've talked about before, the problem with any of that and I realize I cited the share data, so I'm guilty of using it in the middle of May to simply make the point about April, but the problem we cited even at that time, is there can be anywhere from 5 to 40 percent variation between our actual sales and those reported on a monthly basis at the DMV level.

So we may well have lost a little bit of share in May.

We don't know.

That is what the very earliest DMV data would suggest, but overall for the quarter we know we still gained share.

Great.

Thanks.

Charles Grom with J.P. Morgan.

Good morning.

In addition to the factors you suggested for the weak comps, has the rate of cannibalization, I think you've historically said one to two percent, accelerated or has it pretty much remained relatively the same?

Pretty much remain the same, so that hasn't been a factor that we have seen.

Second question is, not to harp on the negative equity issue, but it's obviously a hot button topic.

I was wondering, are you tracking the number of customers that you're essentially turning away because of this issue, and if so what the rate has been?

Yes, it is interesting.

We're tracking that, and frankly we have not seen a big rate in the number of negative equity customers that we turn away.

That sounds somewhat paradoxical because what it suggests is that at the margin, the customer who has negative equity would have to be going to somebody else, not coming to us.

That is consistent with lower traffic, and so one of the reasons we would want to look at various marketing tests is to try to understand, can we get more of those customers in the door because obviously some of those customers will be making a prejudgment that we cannot finance them when we can.

Interestingly enough, the number that we are turning away doesn't appear to have gone up significantly as far as we can tell, although all of the data suggest that the average amount of negative equity in the market has gone up, which is --.

As I say, that suggests to me that part of where we're losing some sales is to, in particular, new car manufacturers based on the structural incentives that they give that allow consumers to use consumer cash to cover negative equity.

But fundamentally, if you step back and look at the banking portfolio that results from that, it is not a pretty picture particularly in a rising rate environment and it is not something that we think will go on for very long-term.

Would you care to share a percentage?

Is it like five percent of traffic?

Of negative equity?

I wouldn't share a percentage, but it's a lot higher than that.

No, no, no, negative equity, when I talk to folks in New York, analysts live in a little bit different world than most of America.

A very significant -- Edmunds said that 30 percent of all new car customers have negative equity.

It has been in the high 20s to 30 for not just recent months, but I mean for several years.

It's a much higher percentage than that.

Last question for Keith.

In terms of the SG&A, obviously that was -- partially drove the upside in the quarter.

What are you guys budgeting for the second quarter and what is implied in your guidance?

I know you said a penny or two, but is it a 10 percent number for the third and fourth quarter that we should be modeling?

Thanks.

We haven't given guidance for the third or fourth quarter, but we said at the beginning of the year that we did expect SG&A to be up mainly due to be continued growth in some of the cycling of the stand-alone expenses.

So we don't expect to be flat in the second quarter.

We do expect SG&A rates to be higher.

Haven't given the guidance specifically about whether that is five percent or ten percent, but it will be higher as a percent of sales.

Great.

Good luck.

Jeff Black with Lehman Brothers.

Good morning.

I just wanted some quick clarification on what you buy at auction versus what you are buying from consumers in terms of acquiring cars and is that changing?

Where would you like to see that going forward?

Right now, if you're talking about percentage, we buy about 55 percent or so, a little north of 50 percent, of all the cars that we sell at retail from consumers at the store.

It has changed over time.

It is gradually increasing, but quite gradually.

I stated that a long-term goal is over the next decade, to move the up to the 60 to 70 percent range.

So, I wouldn't expect to see that moving quickly, but it's something that if we saw half a percent or a percent every year, that would probably get us in the range and that is something we will be working on.

Austin as a follow-up, on the inventory line which still looks high to me, is the comfort that you can reduce inventories quickly within the quarter based on the fact that you can sell cars into the wholesale market and how much?

It is super easy for us -- we sell so many cars that the way we get inventory in line is just don't go to auction this week.

If you think about how quickly we turn inventory, turning total inventory literally roughly nine times a year, if we get out of line in the store, what we do is reduce purchases in the auction because with nearly 50 percent, roughly 45 percent of our purchases coming through the auctions, we always have the opportunity to not go and not buy any cars there.

That allows us to get inventory back in line very quickly, in any individual store that it gets out of line in or in total.

Now in general, this is the time of year that because even those sales levels are somewhat disappointing compared to where we want them to be, they're still very high compared to any other time of year and we have very strong sales right now.

This is the time of year that you are least concerned about relative inventory level for certainly June through July, even up through the early part of August.

But we get inventories in line very quickly simply by not going to auction.

Good.

Thanks a lot.

Mark Johnson (ph) with Bank of America Capital.

Mr. Johnson, your line is open.

I think he went away.

Why don't you go to the next one?

David Campbell with Davenport.

Thank you.

Good morning.

You mentioned that your service margins were down in the quarter.

I was wondering if you might explain why that happened and what your outlook is for service margins going forward?

I will let Keith explain a little bit.

Realistically, the service margins is a result of lower sales that in fact we have to cover our overhead cost there and we're producing cars, and yet not recognizing the overall percentage of sales and getting the fees related to those back to the service organization.

So in other words, the service organization also --.

I think we lost him.

I'm still here.

You're still there?

Yes.

Operator, are you still there? (technical difficulty)

Most of our people and overhead related to the service organization are actually people who work on the reconditioning business, and so that overhead load is -- what Keith was saying, that overhead load is the same and so sales are below budget.

That in effect, it hits the service P&L line even though it is not really a service cost in the way that you might think of a traditional dealer.

So, that has a negative impact on service profitability as we report it just because the cost of our reconditioning overhead is there.

Because of the lower same-store sales?

Because of lower same-store sales and we're not producing as many cars and therefore not, if you will, relieving that overhead.

So the service side of the organization on the P&L has to carry it.

How is the efficiency, or how are the efficiency initiatives progressing in the service area?

Quite well.

I mean we have both quality and efficiency initiatives that we have been undertaking since we put ERO in place and we're happy with both of those.

Okay.

I also had a question about the supply of vehicles.

I understand that crossover vehicles such as a Pacifica for example, are selling a lot better in the current market.

Do you think that CarMax has the supply of those cars available since that is a newer car on the market?

What other cars would you put in a crossover category and then I might -- because obviously the Pacifica is a brand new car.

Pacifica started out very slow, but Pacifica is not big enough.

Give me some other examples of what you would include in what you're calling a crossover category?

An Outback is one that has been around for a while.

I am not an expert on that category of car, but I know that I have seen some of those out there in ads and so forth.

The general answer I can give is if it's available in the used car marketplace, we usually have as good or better supply than anybody because we are so effective at buying from consumers.

If it's a brand-new hot car that is really only available from new car dealers, then we wouldn't.

For instance, if you considered a Honda Pilot, now I consider a Honda Pilot an SUV, but if you consider it a crossover vehicle or a Honda Element is a crossover vehicle, there are fewer of those in the market.

We certainly have probably as many Elements as anybody.

There are some really interesting new cars coming out.

I think the domestic manufacturers are introducing some of the more interesting cars they have done in a while.

There are quite a few interesting cars in the foreign manufacturers, and we don't have any of those when they first come out.

Who knows, that may suck away a little volume, but as soon as they are available in the used car marketplace, we get those as much as anybody.

I have not heard from any of our store or purchasing people that they think that that is a significant issue in terms of a new category that really just isn't available in the used car market.

But since you have raised it, I will ask it.

I'm going to do a steak cookout in Knoxville who had a great month last month, and when I get there I will ask them if they think that is an issue.

Okay.

Thanks Austin.

I look forward to talking to you about that later.

Thanks a lot, David.

Matt Nemer with Thomas Weisel Partners.

Good morning.

Two quick questions.

The first one is, you mentioned that gas prices, you have seen some impact on SUV sales, and I guess we are getting some kind of mixed color on that from different parts of the industry.

But I'm wondering if you're having any luck replacing those vehicles with hybrids or very high gas mileage type vehicles?

Do you see hybrids at the Manheim auctions?

Are you able to get any of that inventory?

Let me go back to the first part of your question because I think you have -- certainly the new car manufacturer said that they didn't see any weakness in SUVs at all in May, and that is absolutely consistent with the weakness that we did see because the reason we saw weakness is because what they did is, they put huge incentives to ensure they didn't have weakness.

They saw weakness in April and they addressed it with enormous incentives and they had a great month in SUVs in May because of very heavy discounting.

That very heavy discounting had a negative impact on our used SUV business.

But the other thing it did is it also had a big impact on the wholesale prices of SUVs in the marketplace.

We saw a big drop in wholesale SUV prices during May.

So that as we are out in the market now, we think that those have adjusted enough.

If gas prices don't change more, that that should come back.

So, I don't want you to think that what I'm saying about SUVs being soft for us is inconsistent with what the new car guys are saying.

It is actually driven by what they did.

As far as hybrids go, there are just not enough hybrids available for that to be consequential to us.

We have put in a process so that we can sell hybrids going forward in every store, but there are just very few of them out there.

I think someone just told me that Toyota is actually -- I believe this may be true, not taking orders on their new Prius hybrid right now because they have so much more demand than they have supply.

I think hybrids are a significant vehicle for the future but there are just not enough of them out there to count for anything right now.

I will be glad when they are because the certainly seem to have a big consumer attraction.

The second question was coming just on the other sales and revenue line, I'm just trying to understand what percent of that would be customer pay parts and service versus sort of reconditioning, which I understand you report at cost?

The reconditioning would not be in the other sales category.

It is actually loaded into the actual cost of the vehicle, and then to the extent we don't cover the costs because we're not producing enough vehicles, as we mentioned that might impact overall service profitability, but it is not in sales at all, as far as the other category.

So what percent of that other category is actually customer pay?

Is actually service?

Yes.

I think the largest percent isn't it?

Is there anything you can do to, I guess, increase your exposure in that business?

If you listened earlier on the call, the answer is marginally we could, but to think that that would be a primary thing we would want to focus on would be a misunderstanding of the business.

That is not a primary growth or profit opportunity in the business.

If you look at service business, it has high fixed costs and high variable costs.

And when you look at the profitability as dealers report it, our view is that profitability is almost always overstated compared to its true cost and it is not a scalable business, not easily scalable.

But if I was to add a unit of service business you have to add, literally you would have to add a bay.

Since most people will only do service during the daytime, you would have to add a bay to add a tech.

In fact, you would have to add a day and a half to add a tech.

So you have to add physical capacity and physical resources at a much higher rate on service.

And most dealers don't attribute any of that rent when they report to you what their service profits are.

We don't see that as a primary area where we would want to increase our exposure.

We think that the way that traditional dealers report that leads to a huge degree of misunderstanding of how big an opportunity that is.

I think the best way to understand that is if service were that great a business, then Pep Boys, Firestone and Goodyear would be three of the top growth retailers in America.

It is not as good a business as dealer accounting makes it seemed to be.

Don't get me wrong, it's a business that a dealer should do and it is absolutely important if you're a small auto retailer to securing your future in a downturn because it protects you from failure.

But the upside in terms of how you can grow it at any physical location, particularly if you are a large volume retailer like us, is very limited.

I was just thinking about it in terms of -- from a volatility standpoint.

Have you noticed any volatility in that side of your business or does it tend to be a lot more stable?

It's very stable, but it's just -- it's very stable, and by its very nature it has to be very stable, because you cannot just turn on techs.

You're existing salesforce can probably sell twice as many cars if the opportunity were there.

Your existing techs would be lucky to do 10 or 15 percent more business.

It was about 40 percent of the other category for the quarter.

Great.

Thanks very much.

Thank you.

Aram Rubinson with Bank of America Securities.

Must be the end of the line.

What other stores had cookouts?

I'm just curious?

Is this is a publicly reported item?

You can find it out.

So, I think Gulf Freeway had a cookout and our Laurel Toyota store was the number two Toyota new car retailer in the United States for the month.

They had a pretty good month and we're doing a cookout for them.

I think we're doing a cookout in Columbia, South Carolina, one of our new stores.

If you want to do the cookout index, we had four good stores during the month.

Thanks, I'll think about it.

Thanks very much.

I appreciate you joining us.

This concludes today's CarMax first quarter earnings conference call.

You may now disconnect.