車美仕 (KMX) 2011 Q2 法說會逐字稿

Good morning.

I will be your conference Operator today.

At this time I would like to welcome everyone to the second quarter fiscal year 2011 conference call.

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

After the speakers' remarks, there will be a question and answer session.

(Operator Instructions).

Thank you.

I would now like to turn the call over to Ms.

Katharine Kenny.

Ms.

Kenny, you may begin your conference.

Good morning.

It is, in fact, 92 degrees here in Richmond today, and no rain in sight, but otherwise we're really happy here.

Thank you for joining our second quarter fiscal 2011 earnings conference call.

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

And also with us, Tom Reedy, our Senior Vice President of Finance and Treasurer.

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

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

In providing projections and other forward-looking statements, the Company disclaims any intent or obligation to update them.

For additional information on important factors that could affect these expectations, please see the Company's annual report on Form 10-K for the fiscal year ended February 28, 2010, filed with the SEC.

Now I will turn it over to Tom Folliard.

Thank you, Katharine.

Good morning.

We're happy to report another record quarter for CarMax.

Our 4% used unit comps were driven by improved sales conversion which was higher due to continued strong execution and the increase in credit availability compared to last year's second quarter.

While traffic levels were flat compared to the second quarter of last year we view this as a positive considering the spike in traffic caused by the Cash for Clunkers program in July and August of '09.

This quarter's results showed sustained strength in many of our key areas.

Our used vehicle gross profit per unit remained strong and increased by $85 year over year.

The wholesale business also continued to perform well compared to last year's second quarter.

Our wholesale unit sales increased by 20%, again, due to both higher appraisal traffic and an improved buy ratio which was nearly 30%.

And our wholesale vehicle gross profit per unit grew by $32.

And CAF income continues to be a strong contributor to the overall business.

I'll now turn it over to Keith and he'll provide some more detail on CAF.

Keith?

Thank you, Tom, and good morning.

CAF's results are relatively self-explanatory this quarter so I'll just touch on a few points.

Our strong CAF income reflects the historically higher financing spreads we've experienced now for a number of quarters.

The average customer APR for current originations fell below 9% for this quarter due to the reduction in rates we made to some customer segments based on the testing that I mentioned last quarter.

Our loan loss experience was within the range of expectations.

Recall that in last year's second quarter credit availability was somewhat lower because CAF had tightened lending standards and the program with Santander whereby they purchased a large portion of the loans that CAF previously originated was not launched until November of 2009.

Let me give you a current update on our third party lenders and overall credit availability.

While we continue to enjoy one of our strongest banking relationships with Bank of America they will no longer serve as a third-party lender for customers in our stores.

Recently Bank of America's loans to our customers represented roughly 1% of our sales and only in the top end of prime lending where CAF also lends.

After previous testing we believe there will be no adverse impact to sales, CAF originations, or payoffs from this change.

Subprime penetration remains higher than last year at 7% compared to 4%, although we have started to see some increased willingness to test expanding credit to more customers at some of our non prime lenders.

In addition, we have active tests in place with other lenders.

We believe that we now offer through CAF or our third-party relationships approximately the same credit availability that we offered prior to the recession.

Before I turn the conversation back to Tom Folliard, I will ask Tom Reedy to update you on our liquidity.

Thanks, Keith.

At August 31, we had just over $4 billion of total debt with all but $30 million non-recourse debt associated with CAF securitizations.

Our $700 million revolving credit facility was in essence fully available to us as we used cash flow during the quarter to pay down the facility and build a modest cash balance.

As you recall, we now maintain two warehouse facilities for CAF originations, one which expired and was successfully renewed in August, and a second that expires in February of 2011.

During the quarter we increased the capacity of our second facility by $400 million, bringing our total combined capacity to $1.6 billion.

At quarter end we utilized $718 million with $882 million available to us.

While the market for auto ABS has clearly improved over the past year, we believe it is prudent to maintain flexibility in this uncertain environment.

These changes to our warehouse give us greater flexibility and reduce the risk that external forces might compromise our ability to provide financing to our customers.

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

Thanks, Keith, thanks, Tom.

SG&A expenses for the quarter increased by 3% compared to total revenue growth of 13%.

The higher costs related primarily to growth in advertising as well as increases in sales commissions and other variable expenses.

As we reported on our last call, we opened our Dayton and Cincinnati stores early in the quarter.

During the first quarter of fiscal 2012 we plan to open stores in Baton Rouge, Louisiana, and Lexington, Kentucky, both new markets for us.

During the second quarter we also plan to open a store in Escondido, California, which will be our second store in the San Diego market.

And we now expect to open a total of five superstores during fiscal 2012.

And with that I would like to open it up for questions.

Operator?

(Operator Instructions).

Your first question comes from the line of Simeon Gutman with Credit Suisse.

This is Simeon Gutman.

Can you just first touch on the expense dollar growth, what may have changed this quarter?

It was managed extremely well versus where you were last quarter.

I think it was about a 300 basis point difference.

You mean SG&A?

SG&A, yes.

I just thought we did a really good job managing expenses this quarter.

We talked about potentially having SG&A go up during the year.

A couple of reasons we mentioned were, as sales continued to grow, we thought we'd see some growth in our advertising expense as well as our variable selling expenses, and that's really what we saw in the second quarter.

It was about what we thought.

Was there anything, though, that structurally was taken out, just because the dollar growth rate on a year-over-year basis was just meaningfully less than where it was last quarter?

I think in the first quarter we also had pre-opening expenses associated with the new stores.

So all of that is behind us at this point.

Okay.

And then on the same topic, expenses, we've talked about IT spend, and then CarMax.com, even some of the advertising.

Can you talk about the future real-estate costs, the pipeline, realizing that stores will be opened here at a measured pace?

Is the pipeline starting to get refilled, is hiring ramped up?

Where are we in that process?

As you know, at the end of last year we announced the next three years.

Three stores this year, three to five next year, which we've now said will be five, and five to ten the year after, and we're well on pace to deliver that growth plan.

In terms of staffing up our stores, we have a long way to go but we have made some progress and we feel very comfortable about delivering the plan we've laid out.

Lastly on the competitive environment, two parts, first on the lending side.

Are you seeing other lenders become more competitive on APR?

As you mentioned, you were testing some yourself, but besides the tests are there any changes at the margin?

Then the competitive environment as it relates to the used car business.

Any new competition that's got your attention, whether it's traditional retail or via the Internet?

From a lending perspective, I think, the way we really monitor changes in credit availability and consumers' appetite is really on our three-day payoffs.

And at the end of the first quarter we were seeing three-day payoffs actually going up, which caused us to do some testing.

And we found what we believe is the sweet spot in the current environment.

And after testing that and seeing payoffs reduced back to what we believe a normal payoff perspective is, then we rolled that out at the end of the first quarter.

So we had that in existence for the entire second quarter.

But monitoring third-party credit rates is difficult for us since our competitors are negotiating on interest rates, the price of the car, and every other component of the transaction.

I'll comment on the competitive landscape.

Through the recession, actually there were a few concept copiers, as we call them, out there, and most of those have largely gone away.

So in terms of competition, it's the same fragmented set of competitors that we have been competing against since we started in the business.

Although there seems to be more focus, a lot of people are talking about focusing more on used cars, particularly with the big decline in new car sales, I have a lot of confidence in our consumer offer.

I think we've held up really well.

We've performed exceptionally well coming out of the recession, and we had some nice share gains at the end of last year, and I feel really great about our consumer offer and our ability to compete in any environment.

Great.

Thanks.

Great quarter.

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

Good morning, everyone.

My first question is, you mentioned advertising, that you were looking to maybe spend some more, you did spend some more on advertising, but that also most of the sales gain was driven by conversion rather than traffic.

So I was wondering, is there something that you're seeing that convinces you that a little more advertising will drive traffic, or what are you thinking there?

Remember, too, the comparison we had for traffic with Cash for Clunkers.

So even with flat traffic to last year I view that as a positive in terms of delivering traffic to the stores.

Also remember, we cut our advertising pretty significantly through the recession, and even spending some money back, you could argue a lot of that spend is just to continue to get our brand's name out there and build awareness, as well as drive traffic.

And towards the end of the -- I guess the end of the recession, we talked about wanting to get back and spending more ad dollars, and you're seeing us start to do that.

And then secondly, on gross profit per unit, you had a nice performance, but typically you would be up a little bit seasonally from Q1 to Q2.

So I'm just wondering if you can give us some commentary on what you were thinking on pricing during the quarter, if you decided to push a little bit more for comps than profit.

As we've talked about before, we are constantly talking elasticity by moving margins up and down.

During the second quarter, the second quarter was no exception.

We had a number of different pricing tests out there.

As I've said a number of times over the last several quarters, we just haven't seen the type of elasticity that we've seen in the past.

Again, it's always managing a whole bunch of different variables to deliver gross profit per unit and comp sales, but we feel pretty comfortable with where we landed at the end of the quarter with a 4% comp and strong gross profit per unit.

But as far as what that means going forward, it's difficult to tell.

Lastly, you mentioned some process changes in the other line, the extended warranty business.

I'm just wondering if you could comment on what's changed there.

And then also, more broadly, changes you're contemplating making to the customer experience or the process during the year, whether that be on the website or in the stores.

The process -- some of the process change we talked about in the extended warranty business goes along with us over the last couple of years saying that without growth, we're going to continue to focus on improving our existing business.

We've rolled out some additional training around our MaxCare, which is our extended warranty business.

We have updated through technology our screens and how those warranties are presented to the customer, and I think it's just a cleaner look and gives the customer more options, and I think that's allowed us to do a little bit better.

The fact that we're financing more cars this year than we were last year, that helps the customer's ability to finance warranties.

So there's a number of different things that have helped the warranty business but I think it's a reflection of some of the investments that we said we would make in both technology and training actually paying off.

In terms of things coming up in the future, I think I mentioned on the last call, continue to invest in CarMax.com, continuing to invest in allowing the customer to do more and more of the transaction at home, or as much as they want to do at home.

In the third quarter and into the fourth quarter we expect to start testing, although in only a store or so, the ability to do on-line credit applications, the ability for customers to make on-line appointments and the ability for customers to initiate transfers from home using a credit card.

Again, I think we just want to keep moving along with the consumer.

Clearly the consumer wants to do more research and more pieces of the transaction at home, and we want to try to stay out in front of that.

Great, thanks, good quarter.

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

Good morning.

A couple additional questions on gross profit per car.

I know you mentioned the sourcing of cars from consumers was a favorable impact.

I'm wondering if that continued to improve from the May quarter's trend?

It was up a little bit from the May quarter but not significantly.

Remember that number had gotten down.

We had talked about around 30%, 33%, and then I think the May quarter, we were around 40%, and we're similar in this quarter, but it's the year-over-year that helps.

And then on the reconditioning front, I know you continued to chip away there.

Is there anything material that's happened in terms of incremental cost savings?

There's nothing material.

As we've said, when we achieve savings that we believe are sustainable going forward we will talk about those, and over the last two years incrementally each year we've gotten $100, then another $100 that we've committed to.

If we have something to update, we'll update it.

We feel really good about both the progress we've made and our ability to make progress going forward.

Okay.

And then just a few questions on CAF, or actually all of the lending partners that you have.

It sounds like credit availability, then, is up year over year if it's back to pre-recession levels.

Do you have any idea on how that's impacting sales at this point?

It helps.

It helps.

If you will recall, Sharon, a year ago when we had to tighten CAF, we indicated that we thought that that cost us several percentage points in comps.

And so we do believe that, in that spite of going up against the Cash for Clunkers, that that ends up being a net positive of a similar magnitude coming back the other way.

Okay.

And then the test that you are doing at CAF in a few markets of the lower rates targeted for prime customers, what are you seeing on that?

And then separately, do you feel like you need to have a third party prime lender?

Do you expect to replace B of A?

The testing indicated that consumers really don't want that.

The thing that shocked us the most when we tested it was the fact that we thought by having a competitive offer that might have an affect on a consumer's need to go look and search for an alternative.

And payoffs didn't change one bit when we tested just doing CAF only.

So we believe in the prime space, as long as you have a competitive rate, and we can actually monitor our competitiveness through the three-day payoffs, that we don't need a third party in that space.

Keith, I was also referring to, I think you were doing a test of 4% and 5% APR.

Sure.

As Tom said on vehicles, we're always testing, and on CAF we're always testing.

And the results are mixed.

It's difficult to get a read where it actually made a difference in sales.

So then you have to just look at what the economics of the overall transactions, because you have to give a lower rate to everyone.

So we're still evaluating the results, but we don't believe it's having a major impact on sales.

Whether we continue it or not, we may just resort to other APR tests more broadly.

Okay.

And then just lastly, there's been a lot of movement in the third-party lenders over the past few years.

Can you just remind us who you have at this point?

I know some have consolidated, and some have moved on.

We were hoping you could remind us.

That's true.

You'll recall that we used to have Wells, Wachovia, and Citi, all in the non frame space.

And Wells acquired Wachovia so that we have Wells, and then Santander has taken over the Citi book of business.

So Santander is a non prime lender.

So we have Wells, Capital One, and Santander.

Of those lenders, Santander actually does the space for the prime where CAF had to pull back, and also both the non-prime business and the subprime business.

Great, thank you.

Your next question comes from the line of Ryan Brinkman with Goldman Sachs.

Hi, good morning.

Regarding the low credit losses in the quarter, does this change your thought as to the normalized provision rates?

And could you comment on what is allowing your losses to track relatively better than your delinquencies?

Is that purely a function of greater recoveries on repossessions due to higher vehicle prices, or are you doing something different, or are there material changes in your credit quality?

The real key issue, we are getting a benefit currently from higher recovery rates.

The higher wholesale values caused a significant favorable impact on the first quarter, and because that actually was looking out for the next 12 months, we already had, then, baked into other expectations that that same favorability would occur in the second quarter.

They actually ended up fairly much in line with our expectations for the quarter.

But it was really a combination of, I think, the CAF environment and the fact that we had the higher recovery rate.

And one of the things that we've seen throughout the recession is that delinquencies have not translated into losses for us.

So consumers are definitely struggling.

But one of the things we've talked about over the years is that a car is a high priority payment for a consumer, and we work real hard at CAF from servicing it to make sure that the consumer understands that we're very serious, if necessary, that we would repo that car.

And so, while people are delinquent, we draw the line, and they actually step up and pay us more frequently before it goes to a repossession status.

Okay, that's great.

And then just separately, could you talk about how it is that you were able to deliver the same-store increase that you did, given that you commented in the release that you're experiencing similar traffic levels year-over-year?

And is that more attributable to these internal efforts you're been making to improve your close rate or are you just sensing increased confidence on the part of those consumers that do walk into the store?

It's a combination of a couple of things.

I think the training and increased focus on the sales floor is a piece of it but the other piece we mentioned earlier is an increase in credit availability which always has an impact on sales.

So as Keith mentioned, we were probably several points off last year's second quarter.

And as Keith mentioned in our opening, we feel like right now we're about back to where we were pre-recession in terms of credit availability.

So that plays another big role in improving conversion.

Okay.

Thanks.

And congratulations on the quarter.

Your next question comes from the line of John Murphy with Bank of America Merrill Lynch.

Good morning, guys, this is Elizabeth Lane on for John.

Did you notice any trends that stood out in the quarter regarding vehicle mix?

Because the truck segment has been performing so well in the new channel that I'm wondering if you're seeing that in used, as well, and whether those tend to be higher margin sales for you.

Yes, we didn't see much of a mix shift in the second quarter, and that is not the big driver of margin for us so we don't see a change.

Even if we saw a big shift, we wouldn't expect a big shift in margin, but we didn't see much of a change in our mix compared to the first quarter.

Okay.

And secondly, on the past few securitizations, they seem to have been done at very favorable terms.

Do you find that to be encouraging in the condition of the auto ABS market and investor demand?

I think we're -- I hate to use this term but we're still cautiously optimistic.

We've marketed two good deals this year.

We were able to sell all the way through the capital structure.

But as for the future I think we need to see how things play out for a little bit longer.

But, with regard to market, we went through an environment where we saw losses essentially double, and everyone kept getting paid on our deals, including us.

So we feel our program, and auto paper in general, has really demonstrated its mettle over the last couple of years and we hope investors start recognizing that and stay with us, as well.

Great, thank you.

Your next question comes from the line of Scot Ciccarelli with RBC Capital.

Hi, guys, how are you?

Tom, you guys have continued to generate better and better unit economics.

I know some of this is structural, like the drop in your reconditioning costs.

My question at this point is, what, if anything, would derail the levels of unit profitability you currently command?

As I mentioned earlier, we continue to test, and if we saw elasticity that allowed us to lower margin, and we'd get it all back in sales, we would do it in a second.

We just haven't seen it over the last couple of years.

But I think if the economy really starts to turn, if we see the SAR really turn around, and I think that's a big indicator of consumer demand as it relates to the stuff that we sell because we're at the higher end of used cars and almost always require a loan, I think if consumer confidence really started to move, then we might see the ability to really change our sales rates with some movements in margin.

Again, we just haven't really seen that.

You mentioned some of it is structural, and we feel very confident right now that we're providing a great deal to the consumer.

Part of it is that we've lowered our reconditioning costs, and so despite the fact that we're running higher margins, with those lower costs, we feel like we're still passing on great prices.

But, again, we would give up margin for sales.

We just haven't seen that level of response from the consumer in this environment.

One of your great assets over time has just been your information flow.

You buy more, you sell more than anybody else.

If we were to see, let's say, a big spike in new car promotions, would you still be able to control that, or be able to adjust that relatively quickly and maintain the current margin, or would that put some sort of structural pressure on the margin?

I can only comment on what we've seen historically, and we've been at this for quite awhile.

Every time there's been a big new car promotion that has worked, we've benefited, without exception.

If there's a big new car promotion and it really drives demand, we have delivered both strong comps and strong profits during that time.

So I'm hopeful that there's a new car promotion that really drives consumers, because inevitably what happens is they get out in the marketplace, and whatever the offer is they're going towards doesn't always work for them, and invariably they end up deciding they want to get a car anyway, and they come over and see us.

My next question is just regarding pricing.

Obviously the whole industry is dealing with higher used vehicle prices, scarcity value.

We also know that the typical used car buyer has been a monthly payment buyer.

What kind of changes have you seen in consumer behavior as ASPs have continued to rise, whether it's people looking to extend terms, obviously the improvement in credit availability would help that.

But any other changes in consumer behavior as we've continued to see the rising ASPs coupled with what the typical thought process is from the consumer in terms of trying to be a monthly payment buyer?

Not really.

We haven't seen much over the last couple years.

Remember, we offer term all the way out to 72 months, which we didn't do several years ago.

So I think what we have always prided ourselves on is giving the consumer lots of choice.

The program Keith talked about earlier that we just tested at 3.95% was only a 36-month program, and we had that option out there.

And at the same time consumers could pick 72 months, which is the main driver of lowering your monthly payment.

So I just feel like as a retailer we offer the consumer multiple choice.

If they want to take a lower payment, they can.

If they want to pay it off a little faster with a lower interest rate we provide them that option as well.

And we don't push them in any one direction.

Our focus has always been to provide as much choice as possible and it seems to have worked for us.

Great, thanks a lot.

Your next question comes from the line of Himanshu Patel with JPMorgan.

Hi, just a few questions.

Could you first just remind us the magnitude and timing of some of the pre-opening costs that you would incur for the five new stores that are planned for next year?

Pre-opening costs run somewhere between $400,000 and $750,000 per store, depending on whether it be a new store or in a new market.

So obviously we introduced a couple of new markets there, so they will be at the upper end.

We'll start incurring those in the fourth quarter for the first quarter openings, and then the ones that open later in the year will happen next year, predominantly.

Then on the issue of used car prices, we've seen just a sequential stabilization in the Mannheim Index for the last couple months.

Two questions.

One, are you guys seeing a similar sequential stabilization in the 30 younger type of used cars that you're trafficking in?

And number two, I am curious, Tom, if you had some thoughts on why this is stabilizing at this stage.

Do you think this is just, at one stage it's just going to go up forever, or are we bumping into a spread versus new car prices where the spread has gotten so tight now that it's very difficult to see a material rise in used prices at this stage?

I don't have a great answer for that.

I think we have seen some moderation in wholesale pricing here very recently.

That is actually fairly normal.

It used to be normal for this time of year, is that we'd see some seasonality in the fall and some dropping of those prices.

I guess one thing I'd say is it couldn't keep going up forever.

Maybe we've seen some moderation there.

I don't believe there's a much tighter spread in new and used prices.

I think if you look at new car data, new car prices have gone up over the last couple of years, the average new car sold.

So I always have believed that it's a very efficient marketplace and that that gap can't get too tight because consumers won't allow it.

Just lastly on the wholesale business, volumes are obviously pretty strong, but you did see a pretty sizable sequential drop in gross profit dollars per unit for that business.

Was that just seasonal, or did that partly have to do with the sequential stabilization in used car prices as well?

That movement is a pretty small number for us.

And I think if you look back over the last decade we have seen some seasonality in our wholesale margins between first and second quarter.

I would attribute it more to that, and then look at the fact that we still had a year-over-year quarterly increase in margin per car.

Thank you.

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

Good morning, everybody.

I had a couple questions.

First on the CAF business.

You mentioned a few things I was hoping you could sort out for us.

You mentioned, of course, the collateral spreads have been higher over the past few quarters which should imply that the spreads could move higher as some of these older tranches roll off.

And you also mentioned that you are testing some at lower retail rates.

So I was just hoping, digesting that a little bit, how would you expect spreads to play out, just the collateral spreads over the intermediate term?

You're right.

The general momentum, if we didn't change anything we were doing, with the older ones falling and putting in new ones at higher spreads, would absolutely create a positive environment for the future.

However, we are very sensitive to what consumers are telling us through their three-day payoffs.

Because we want them to have a great CarMax experience, we don't want credit to be an issue, thinking I got a great car at a great price, great warranty at a great price, but I feel like I paid too much for credit.

We monitor that very carefully and we will test.

Consumer expectations, if they drop, and payoffs go up, we will adjust our rates through our normal testing process.

So I quite honestly can't tell you whether spreads will maintain at their current level or not.

And then obviously if interest rates, cost of funds increase for any reason, we usually get squeezed when that happens.

Consumer expectations tend to lag.

So a neutral positioning on that, it sounds like, at least in the near term.

Yes.

And then you pointed out that your appraisals are picking up.

I was wondering what you see that as implying for the supply demand dynamic in the market over the next year or so.

And can you remind us at this point what percentage of your vehicles are you sourcing from your own appraisal lanes, and remind us about the difference in economics for you on the internally sourced vehicles?

As I mentioned earlier, around 40% of what we're retailing now we're buying through the appraisal lane, compared to a high of around 50% and a low of around 30%.

So we've made some progress there.

Difference in profitability is several hundred dollars for cars sourced through the appraisal lane.

In terms of what it implies going forward, I think it's almost impossible to read with all the volatility we've seen.

But one thing of note is that our wholesale -- our buy rate and our appraisal traffic had declined for a couple of years prior to the recession, and over the last four quarters we've seen that come back in both those categories, both appraisals per customer and appraisal buy rate.

So it has created a little bit of an easier comparison for wholesale since we had a couple of years of decline there.

We had a 52% increase in wholesale unit sales in the first quarter, and a 20% increase here, so it's outpaced our used unit growth, but I think that's somewhat of a reflection of the easier comparison.

And you see that trend continuing at this point, just based on where used vehicle prices are?

We didn't have much movement from the first quarter to the second quarter in terms of the percent sourced through the appraisal lane.

Remember, that's the retail cars we buy through the appraisal lane.

The other numbers I talked about are wholesale numbers.

It two separate classes of vehicles that we buy through the appraisal lane.

Thank you.

Your next question comes from the line of William Trueblood with UBS.

First, I know you mentioned about pre-opening expenses on some of the stores but what is the capex cash outlays for this, because your capex is running relatively lower, given some of the store increase.

I know you prebuilt and had that land for the initial stores but what's going to be a good run rate for capex spend going forward?

We only talked about capex at the beginning of this year, and we'll update that guidance at the end of this year looking forward.

If you just look sequentially at our growth plan that we've laid out, the three stores this year which didn't require as much capex because they were already built, the five stores next year and five to 10 the year after, I think you'll see a ramping up of capex.

In our peak year when we were building at 15% annualized rate, we were north of $300 million expected capex.

This year I think the guidance we gave was --

The guidance we gave was 90%, but you need to bear in mind that the five stores we'll be opening next year we already control or own the land, so it's going to be building costs only.

We gave guidance of 90% this year, I think you'll see that number sequentially go up as we slowly get back to a growth plan.

Right.

It just concerned me given that you had said 90%, and you're only at 15% for year to date.

There's a disconnect.

I have to be honest, a lot of times capex is somewhat of a guess for us because the timing of acquisition is so long on our stores.

We can get involved in a project, and it might take us three years before the store gets built.

We can get involved in a contract where we don't have to pay on it for 12 or 18 months.

So capex, it's a challenging number for us to peg down, but I can tell you in terms of being able to deliver the number of stores that we committed to, we are 100% confident in our ability to do that and that we're well on track.

Thank you so much for that clarification.

One other question, onto the cash flow statement.

With the increase in auto loans receivables on a net basis, and hence your operating cash flow down now in the second quarter, is the offset of that a net number of the receivables that are sold, that negative $229 million?

Or should we be considering the difference down in the financing activity line which is the issuance less the payments on the nonrecourse payables?

What is the true cash flow metric for the notes receivable versus that are sold?

In the past you used to see the proceeds from securitizations show up in CAF income essentially, and the operating activities of the cash flow statement.

And now because it's on balance sheet you're going to be seeing some of the cash flow that's coming off of those show up in financing as you indicated, as proceeds from securitizations.

So it really should be the difference in the issuance and payments on the nonrecourse notes payable versus the net auto loans receivable?

Is that the way we should look at it?

Auto loans receivable represents the amount the portfolio grew and the difference between the financing and payoffs is how much cash we took in.

I'll probably follow up with you on that.

Thank you.

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

Baird.

Good morning.

Thanks for taking my question.

First question on Cash for Clunkers.

At what point last year do you think sales were not influenced by that program?

I'm sure, for example, in July, ahead of that program, there was a dearth in traffic, and during the program it spiked, and then after the program I'm sure it fell off.

When do you think consumers' behavior was no longer affected?

It's really hard to tell.

If you remember, at the end of last year, what we said was -- at the end of the second quarter last year we said we saw a spike but by the end of the year we don't think it had a whole lot of impact.

Although it creates a little bit of a funky comparison this year, we don't think it will have any impact by the end of this year either.

So we try to look at it longer term instead of month to month.

We're pleased with the results we delivered this quarter.

We're pleased to have a 4% comp even though there clearly was a spike in the second quarter.

But by the end of the year I don't think there was much of an impact last year and I don't think there will be much of an impact on the comparison this year.

Following up on the direct source percentage conversation you've had, what was that level in Q3 and Q4 of last year?

I don't remember.

What was our sourcing, self sufficiency?

Hold on.

Low 40s, (inaudible) to what it is now.

That's helpful.

Thanks and congratulations.

Your next question comes from the line of Justin Maurer with Lord Abbett.

Good morning.

On the Mannheim issue, obviously everybody sees the numbers and sees them at all-time highs and wonders how sustainable it is.

And talk about the new to used, and I appreciate the commentary maybe it's not as narrow as people may think.

But maybe to flip it around in terms of sustainability of used is, if we go into this fall and then into next year where we're going to be rolling off, in some sense of '08 production cliffs, why couldn't we be sustained at a high level for the foreseeable future just in terms of availability, given what happened three years ago and how far production rates dropped off the cliff?

We could.

That's one thesis.

That's very possible that we have higher used car prices for a much longer period of time.

I think so much depends on what happens with the economy and unemployment, and as I mentioned earlier, if the SAR really bounces back.

Right now the SAR is running at below scrappage rate, and I just don't think that's a sustainable number.

So it just depends how big that bounce back is.

I think if it bounces back pretty quickly, I think you'll see prices move back down again because it will start to change the supply/demand dynamic.

Just talking to dealers locally, anecdotally, it seems that there's a dearth of cars, and they're concerned, certainly even in the shorter term window, the next six months.

And then as we move into next year, which I'm somewhat surprised by, again thinking of three years ago, that the market was still pretty good in the fall of '07 where you would be seeing some of these come back, and therefore maybe a dropoff on the next year, but it just doesn't seem to be there for whatever reason.

Yes, but I just still think when we think of big market share numbers for us, there are just a huge number of used cars sold annually, and we still represent a very small percentage of one to six-year-old used cars.

The competitive environment is the same for everybody, and I feel really confident in our ability to get through it.

So even though there might be a shortage, quote/unquote, you guys aren't concerned on the margin about your ability to find what you deem to be adequate cars at adequate prices?

No.

Thank you very much.

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

Good morning.

I was wondering if you could just discuss some drivers of the increased appraisal traffic you're seeing.

I was wondering if any of that had to do with any incentive activity from the manufacturers you might have seen during the quarter.

It's more of a continuation of an increase that we've seen over the last, counting this one now, four quarters.

I don't think that we've seen any significant incentive that has changed any traffic at all.

It certainly hasn't clanged the SAR.

I think it came in at 11.4%.

That number hasn't moved very much over the last few months.

I don't think it has anything to do with anything the manufacturers are doing.

And again, I think, as I mentioned earlier, it's a little bit of an easier comparison, but we've seen a nice improvement over the last four quarters and it was nice to see it continue in the second quarter.

Okay.

Appraisal traffic was up, customer traffic was flat.

I would expect them normally to move in the same direction.

As I said, the appraisal traffic compared to customer traffic had gone down for a couple of years, and it's gone back up over the last four quarters.

So what we saw in the quarter was no different than what we saw over the last three-quarters, in terms of those two metrics.

Right, so appraisals just catching up then.

It looks like service department margins were up.

Is that correct, and if so, what might be driving that?

I actually think that's really a reflection of just continued operating leverage that we're seeing in the service area but no specific program that's driving it.

Just continued leverage.

Okay.

Thank you.

Your next question comes from the line of Scott Stember with Sidoti.

Good morning.

Could you guys talk about service sales?

Obviously people are holding onto their cars longer, and many shops that we cover on our end have been seeing nice gains year-over-year over the course of the last year.

Is there anything you guys have in place to better take advantage of that to maybe drive sales a little bit better in the service department?

That's an area where we feel like we need to make a continued investment to do a better job, to continue to try to do a better job with retail service.

For us, we don't have warranty work, so a lot of times you look at a comparison between our revenues and maybe some of the public new car dealers' revenues, and there's a difference there, and a lot of that difference is driven by warranty revenues.

We've always talked about service as being, if you look at the way we pay our tax and make a return, we always say the best way we could spend a tech's time is to recondition a used car.

The next one is to work on somebody in the first five days since we have a five-day money back guarantee.

The next one after that is when a customer buys a car, they have a 30-day warranty, we take care of that.

The next one after that is if we sold them an extended warranty.

And the last one for us is for-pay retail service.

We've seen a nice pickup in sales over the last couple of quarters, and we've worked real hard to keep up in terms of inventory and staffing.

Service just is not all the way up at the top of the list of priorities for us right now.

All right.

And lastly, just going back to self sufficiency, has there been any concerted effort on CarMax's part to increase traffic coming through, beyond the natural forces which are creating higher traffic?

It is an area where we spend quite a lot of our advertising money.

We do it both on the Internet and with our TV and our creative.

It has become a staple for us.

We never go through a campaign where we build an advertising theme without including, we'll buy your car even if you don't buy ours.

So it just has become more and more part of what we do in terms of the way we advertise.

I think over time we've built a nice brand awareness around the fact that we will make you a cash offer.

So I think it's more of a continued effort as opposed to something we did more recently.

Got you.

That's all I have.

Thank you.

Your next question comes from the line of Mark Mandell with Think Equity.

Thanks.

Good morning, everyone.

Your inventories were up 17.6%.

I see the average selling prices were up about 5% and you have a 3% increase in store count.

What can you attribute the rest of it to?

Is it a voluntary increase?

And how is your balance in inventories?

Our sales are up 13% so it's almost exactly in line with both sales and revenue, and ASP.

And if you remember, too, inventory is always a point in time so that's not an exact science, but I would tell you that our inventories are exactly where we would have expected them.

So if it was 18%, and you took the 5% for ASPs, we had a 13% increase in sales, it happens to line up perfectly.

Fair enough.

And your loan loss provision, around $9 million in the quarter, I know we talked about that earlier, but can you give us any guidance in terms of how we might look at that on a going forward basis?

Obviously we're originating a different back of business, and the loan loss provision really should reflect the fact that related to the new loans we're originating, the additional provision there, if there's no major changes in recovery rates, we wouldn't expect any major changes in the provision.

Got you.

Thanks a lot and good luck.

Your next question comes from the line of Hardy Bowen with Bowen Associates.

Tom, the new units, are they coming in at 60% of average unit volume, or are they coming in less because they're small markets?

Say that again, Hardy.

For the first year, are they headed for 60% of average volumes, or are they coming in less than that because they're small markets?

We only opened them a couple months ago so it's a little early to tell.

We haven't really changed our model in terms of how we estimate sales other than we've lowered all of our sales estimates because of the environment that we're in.

In terms of how they would track to their ultimate maturity, we think that our model is pretty good at predicting that.

As I mentioned at the end of last quarter, we're absolutely contemplating the current sales environment in our growth plans and lowering our sales estimates up-front.

But in terms of growth over time, we both expect and hope that it will get there just as we used to in the past.

How hard has it been to open up the new units and how many people do you have in place to open up the units next year?

And do you think 10% is a hard growth rate to achieve, or not?

All we'll talk about, Hardy, is the growth plan that we've already publicly laid out which is the three stores this year, which were actually fairly easy to open because I have to say, if you --

There were a lot of people.

Just if you were here at CarMax and you were growing the way we were growing for so long, we had some pent up demand for growth and we had some people that were eyeing both Cincinnati, Dayton and Augusta as places.

Augusta -- we have people that live there that were working for us already in Atlanta, so those three stores were pretty easy.

The five stores next year we feel very comfortable that we'll be able to deliver the staffing that we need to, to open those stores effectively.

Keith, as far as financing the new stores, I think the sale and lease-back market is terrible.

Are mortgages something you would consider?

At this point, if you look at our debt position, we would anticipate that we don't have any need to finance it.

So by the time we need financing we'll see whether the sale-leaseback market is available and/or mortgage, or whatever is the most effective means of financing them.

But in the short term we don't foresee any need.

If you were opening 10 stores, I guess you would be mortgaging them?

Or doing something, rather than putting in all equity?

We'll see.

Tell me what sales are going to be.

Hardy, you've followed us for awhile.

We always try to do whatever is the most effective plan for funding our stores at that moment, and we don't try to predict what it's going to look like a year from now.

And again, all we're talking about is five stores next year and five to ten the following.

With that plan laid out, with our current sales and cash flows, we just don't really see much of an issue in terms of having to finance the stores.

I guess after we spend a lot of effort training the sales force, the conversion rates from sales trading aren't going to go any higher.

I'm presuming they're all trained at this point in time?

Is that your feeling?

I think that that's never true, that there's always room for improvement.

Keith and I are still training.

And I think there's always room for improvement.

And I think we feel good about the progress we've made, but we also feel confident that there's much more to be had.

Okay.

And the credit availability from your non prime suppliers, are the credit standards that they're enforcing going down as opposed to the interest rate, in your mind, Keith?

No.

As I indicated, I think what we've experienced is they're actually more willing to test buying at different levels than they were during the peak of the recession.

So one of the things that Tom mentioned, Tom Reedy, was that the credit markets, and the performance through this, has really solidified stability.

And our lenders have learned even more through this environment about the predictability of losses.

And I think there's more willingness and more openness to actually test buying deeper with us when it makes sense, and for them and us.

Okay.

Sounds good.

This will be our last question.

And your last question is from the line of Clint Findley with Davenport.

Good morning, guys.

I saw in the past few days where you've selected a new ad agency.

Should we expect any shift in your strategy here?

I was hoping you could update us on your on-line spend versus your total ad spend and your thoughts going forward.

I don't think we've ever broken down our on-line spend and our total ad spend.

What we have said in the past is we are virtually completely out of the newspaper.

Any money we've spent in the newspaper in the past is almost completely now on-line.

It's a combination of search engine advertising and also just online classified like Cars.com and AutoTrader.com where all of our cars are.

In terms of a new ad agency, we do a combination of internal creative and producing our own ads, which we can do much less expensive, but at the same time we want to always push ourselves to try and find out if there's a better way to deliver the message about the various components of our consumer offer.

We're very excited about having selected a new agency.

It's a little too early to give you any update.

I think we're expecting to get some ads out by the end of this year, beginning of next calendar year from the new agency, and we're very excited about it.

But we think it's an ongoing process for us to continue to try to build our brand.

Tom, lastly, could you discuss the incremental advertising spend on a new store and a new market versus a new store and a pre-existing market?

Are the incremental dollars significant here, and does it impact how you think about where you will open new stores in the next couple of years?

It has no bearing on what we would open.

We're going to open whatever we think is going to work best financially.

And it will probably be what we had done in the past, which is a combination of filling out existing markets and opening up new markets.

There is a difference in ad spend when we go into a new market.

For example, in Augusta, Georgia, we've been in Atlanta for more than ten years and we've spent millions of dollars there building our brand so you don't need to create quite the splash.

But it's not a number that's so significant that it's going to change much in the way we report our numbers.

Thank you, guys.

All right.

Thank you, everyone.

I want to, of course, express my thanks to all of our CarMax associates for all you do every day, and we'll see you next quarter.

Thank you.

This concludes today's conference call.

You may now disconnect.