CARMAX INC (KMX) FY 2023 MD&A

Item 7.  Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided as a supplement to, and should be read in conjunction with, our audited consolidated financial statements and the accompanying notes presented in Item 8. Consolidated Financial Statements and Supplementary Data.  Note references are to the notes to consolidated financial statements included in Item 8.  Certain prior year amounts have been reclassified to conform to the current year’s presentation.  All references to net earnings per share are to diluted net earnings per share.  Amounts and percentages may not total due to rounding.

OVERVIEW

See Part I, Item 1 for a detailed description and discussion of the company’s business.

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

CarMax Sales Operations

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

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

As of February 28, 2023, we operated 240 used car stores in 109 U.S. television markets.

CarMax Auto Finance

In addition to third-party finance providers, we provide vehicle financing through CAF, which offers financing solely to customers buying retail vehicles from CarMax.  CAF allows us to manage our reliance on third-party finance providers and to leverage knowledge of our business to provide qualifying customers a competitive financing option.  As a result, we believe CAF enables us to capture additional profits, cash flows and sales.  CAF income primarily reflects the interest and fee income generated by the auto loans receivable less the interest expense associated with the debt issued to fund these receivables, a provision for estimated loan losses and direct expenses. CAF income does not include any allocation of indirect costs. After the effect of 3-day payoffs and vehicle returns, CAF financed 42.1% of our retail used vehicle unit sales in fiscal 2023.  As of February 28, 2023, CAF serviced approximately 1.1 million customer accounts in its $16.77 billion portfolio of managed receivables.

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

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Revenues and Profitability

The sources of revenue and gross profit from the CarMax Sales Operations segment and other non-reportable segments for fiscal 2023 are as follows:

A high-level summary of our financial results for fiscal 2023 as compared to fiscal 2022 is as follows (1):

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

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

(3)    An omni sale is defined as a sale where customers complete at least one of the four activities listed above online.

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

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Net earnings per diluted share during fiscal 2022 included a one-time benefit of $0.11 in connection with the receipt of settlement proceeds in November 2021 related to a class action lawsuit.

Refer to “Results of Operations” for further details on our revenues and profitability. A discussion regarding Results of Operations and Financial Condition for fiscal 2022 as compared to fiscal 2021 is included in Part II, Item 7 of our Annual Report on Form 10-K for the fiscal year ended February 28, 2022, filed with the SEC on April 14, 2022.

Liquidity

Our primary ongoing sources of liquidity include funds provided by operations, proceeds from non-recourse funding vehicles, and borrowings under our revolving credit facility or through other financing sources. In addition to funding our operations, this liquidity was used to fund the repurchase of common stock under our share repurchase program, our store growth and the Edmunds acquisition, which was completed during the second quarter of fiscal 2022.

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

Strategic Update and Future Outlook

Our omni-channel experience provides a common platform across all of CarMax that leverages our scale, nationwide footprint and infrastructure and empowers our customers to buy a vehicle on their terms. Our omni-channel platform empowers customers to buy a car on their own terms, whether online, in-store or through an integrated combination of online and in-store experiences. Our diversified business model, combined with our exceptional associates, national scale and unparalleled omni-channel experience, is a unique advantage in the used car industry that firmly positions us to drive profitable market share gains while creating shareholder value over the long-term.

During fiscal 2023, we achieved several key milestones as part of our focus on improving the customer experience, including the following:

•We enhanced the omni-channel experience by enabling online self-progression capabilities for all customers and improving eSign functionality to better support the self-progression process.

•We launched self-check-in capabilities for appraisal customers to drive efficiency gains in our stores.

•We completed the nationwide rollout of Finance Based Shopping, our multi-lender pre-qualification product, which over 80% of our customers have chosen to leverage as they begin the credit process.

•We improved our auction experience through the roll out of a modernized vehicle detail page that is mobile friendly and efficiently displays the most relevant information dealers need to preview our wholesale inventory, similar to how consumers shop our retail inventory.

•We expanded MaxOffer, our digital appraisal product for dealers, to approximately 50 markets, which builds on our leading position as a buyer of cars.

As discussed above, all customers are now eligible to complete an online retail sale independently if they choose through online self-progression. In the fourth quarter of fiscal 2023, online retail sales accounted for 14% of retail unit sales, up from 12% in the previous quarter and 11% in the prior year quarter. Omni sales represented approximately 52% of retail sales in the fourth quarter of fiscal 2023, consistent with the previous quarter and down from 55% in the prior year quarter. Online, omni and in-person sales can vary from quarter to quarter depending on consumer preferences and how they choose to interact with us. While we expect our online and omni sales to grow over time, our goal is to provide the best experience whether in-store, online or a combination of the two.

Revenue from online transactions was $1.7 billion, or approximately 30% of net revenues in the fourth quarter of fiscal 2023, up from 28% in the previous quarter and down from 31% in the prior year quarter.

We purchased approximately 262,000 vehicles from consumers and dealers during the fourth quarter of fiscal 2023, down 22% from the prior year quarter and up 10% from the prior quarter. Approximately 15,000 vehicles were purchased from dealers, up 7% from the prior quarter and up 4% from the prior year quarter. We leverage the Edmunds sales team to open new markets and sign-up new dealers for MaxOffer.

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For the fourth quarter of fiscal 2023, our self-sufficiency rate remained above 70%. The success of our online instant appraisal offer continues to strengthen our leadership position as the largest used vehicle buyer from consumers.

Our investments in the near term will focus on initiatives that unlock operational efficiencies and create better experiences for our associates and customers. Examples of these initiatives include:

•Making it simple for customers to choose the express pick-up option through self-progression, which provides customers the ability to complete their transaction at one of our stores in as little as 30 minutes.

•Enhancing online features to help customers feel more confident in completing key transaction steps on their own and to make it easier to go back and forth between assisted help and self-progression.

•Integrating our finance-based shopping capability into our stores and CECs so that all consumers can utilize this product, as well as adding additional third-party finance providers to the finance-based shopping platform.

While we have slowed the pace of our omni-channel and other digital investments, we continue to selectively invest in initiatives that have the potential to activate new capabilities while lowering our costs, including the following:

•Leveraging technology to enhance our transportation logistics capabilities, which we believe will enable us to consolidate loads, increase our mix of full loads and reduce the truck volume in and out of our stores.

•Upgrading our auction experience by deploying a modernized vehicle detail page that is mobile friendly and efficiently displays the most relevant information dealers need to preview our wholesale inventory, similar to how customers shop our retail inventory.

•Updating the MaxOffer product to provide a fully digital, instant offer experience to dealers.

We remain focused on ensuring we are efficient in our spend and are actively taking steps to further align our expenses to our sales levels. During the second half of fiscal 2023, this included reducing staffing in our stores and CECs through attrition, limiting hiring and contractor utilization in our corporate offices and continuing to align marketing spend to sales. While our total and per unit advertising expense decreased from the prior year quarter, our per unit spending for fiscal 2023 was aligned with the prior fiscal year. We anticipate maintaining per unit spend at a similar level during fiscal 2024.

Our SG&A expenses in the fourth quarter of fiscal 2023 decreased from the prior year quarter. While SG&A as a percent of gross profit can fluctuate from quarter to quarter depending on variability in gross profit, our initial goal on the path to strengthening our SG&A to gross profit leverage over time is to achieve a rate in the mid-70% range on an annual basis. Achieving this will require both efficiency gains in our operating model, gross profit growth and healthier consumer demand. In fiscal 2024, we expect to require low single digit gross profit growth to lever SG&A, which is well below the levels we targeted during our omni transformation. We also expect that the beginning of fiscal 2024 will benefit from the cost management actions we took in the second half of fiscal 2023.

Other steps we have taken to support our business for both the short- and long-term include slowing buys in light of steep market depreciation, reducing total inventory while maintaining saleable inventory levels, raising CAF's consumer rates, slowing our planned store growth and pausing share repurchases to provide more capital flexibility.

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

•Sell between 2 million and 2.4 million vehicles through our combined retail and wholesale channels by fiscal 2026.

•Generate between $33 billion and $45 billion in revenue by fiscal 2026.

•Grow our nationwide share of the age 0- to 10-year old used vehicle market to more than 5% by the end of calendar 2025.

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

In calendar 2022, we estimate we sold approximately 4.0% of the age 0- to 10-year old vehicles sold on a nationwide basis, consistent with calendar 2021. We estimate we sold approximately 4.8% of the age 0- to 10-year old vehicles sold in the current comparable store markets in which we operate in calendar 2022, consistent with 2021. External title data shows that the market share gains we achieved during the first half of the year were offset by share losses during the second half of the year as

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we prioritized profitability over share. However, we believe we are well positioned to deliver profitable market share gains. Our strategy to increase our market share includes focusing on:

•Delivering a customer-driven, omni-channel buying and selling experience that is a unique and powerful integration of our in-store and online capabilities.

•Utilizing advertising to drive customer growth, educate customers about our omni-channel platform and to differentiate and elevate our brand.

•Hiring, developing and retaining an engaged and skilled workforce.

•Leveraging data and advanced analytics to continuously improve the customer experience as well as our processes and systems.

•Improving efficiency in our stores and CECs and our logistics operations to reduce waste.

•Opening stores in new markets and expanding our presence in existing markets.

•Becoming the leading retailer of used electric vehicles in the market, which will support our business and help CarMax be part of the solution to reduce emissions.

As of February 28, 2023, we had used car stores located in 109 U.S. television markets, which covered approximately 85% of the U.S. population.  The format and operating models utilized in our stores are continuously evaluated and may change or evolve over time based upon market and consumer expectations. During fiscal 2023, we opened ten stores, and we anticipate opening five stores during fiscal 2024.

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

CRITICAL ACCOUNTING ESTIMATES

Our results of operations and financial condition as reflected in the consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles.  Preparation of financial statements requires management to make estimates and assumptions affecting the reported amounts of assets, liabilities, revenues, expenses and the disclosures of contingent assets and liabilities.  We use our historical experience and other relevant factors when developing our estimates and assumptions.  We regularly evaluate these estimates and assumptions.  Note 1 includes a discussion of significant accounting policies.  The accounting policy discussed below is the one we consider critical to an understanding of our consolidated financial statements because its application places the most significant demands on our judgment.  Our financial results might have been different if different assumptions had been used or other conditions had prevailed.

Allowance for Loan Losses

The allowance for loan losses represents the net credit losses expected over the remaining contractual life of our managed receivables.  Because net loss performance can vary substantially over time, estimating net losses requires assumptions about matters that are uncertain.

The allowance for loan losses is determined using a net loss timing curve, primarily based on the composition of the portfolio of managed receivables and historical gross loss and recovery trends. Due to the fact that losses for receivables with less than 18 months of performance history can be volatile, our net loss estimate weights both historical losses by credit grade at origination and actual loss data on the receivables to-date, along with forward loss curves, in estimating future performance. Once the receivables have 18 months of performance history, the net loss estimate reflects actual loss experience of those receivables to date, along with forward loss curves, to predict future performance. The forward loss curves are constructed using historical performance data and show the average timing of losses over the course of a receivable’s life. The net loss estimate is calculated by applying the loss rates developed using the methods described above to the amortized cost basis of the managed receivables.

The output of the net loss timing curve is adjusted to take into account reasonable and supportable forecasts about the future. Specifically, the change in U.S. unemployment rates and the National Automobile Dealers Association used vehicle price index are used to predict changes in gross loss and recovery rate, respectively. An economic adjustment factor, based upon a single macroeconomic scenario, is developed to capture the relationship between changes in these indices and changes in gross loss and recovery rates. This factor is applied to the output of the net loss timing curve for the reasonable and supportable forecast period of two years. After the end of this two-year period, we revert to historical experience on a straightline basis over a period of 12 months.  We periodically consider whether the use of alternative metrics would result in improved model performance and revise the model when appropriate.  We also consider whether qualitative adjustments are necessary for factors that are not reflected in the quantitative methods but impact the measurement of estimated credit losses. Such

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adjustments include the uncertainty of the impacts of recent economic trends on customer behavior. The change in the allowance for loan losses is recognized through an adjustment to the provision for loan losses.

Determining the appropriateness of the allowance for loan losses requires management to exercise judgment about matters that are inherently uncertain, including the timing and distribution of net losses that could materially affect the allowance for loan losses and, therefore, net earnings. To the extent that actual performance differs from our estimates, additional provision for credit losses may be required that would reduce net earnings. A 10% change in the estimated loss rates would have changed the allowance for loan losses by approximately $50.7 million as of February 28, 2023.

See Notes 1(H) and 5 for additional information on the allowance for loan losses.

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

NET SALES AND OPERATING REVENUES

(1)    Excludes intersegment sales and operating revenues that have been eliminated in consolidation. See Note 20 for further details.

UNIT SALES

AVERAGE SELLING PRICES

COMPARABLE STORE USED VEHICLE SALES CHANGES

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

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VEHICLE SALES CHANGES

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

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

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

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

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

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

CHANGE IN USED CAR STORE BASE

During fiscal 2023, we opened 10 stores, including our entry into the New York metro and Amarillo markets (Edison, NJ; Stockton, CA; Wayne, NJ; East Meadow, NY; Oceanside, CA; Joliet, IL; Asheville, NC; Greenwood, IN; College Station, TX; and Amarillo, TX).

Used Vehicle Sales

Fiscal 2023 Versus Fiscal 2022.  The 5.7% decrease in used vehicle revenues in fiscal 2023 was primarily driven by a 12.6% decrease in used unit sales, partially offset by a 7.8% increase in average retail selling price. The decrease in used units included a 14.3% decrease in comparable store used unit sales. Online retail sales, as defined previously, accounted for 12% of used unit sales in fiscal 2023, compared with 9% in fiscal 2022.

During fiscal 2023, we believe a number of macroeconomic factors impacted our used unit sales performance, including challenges to vehicle affordability that stem from broad inflation, rising interest rates, tightening lending standards and low consumer confidence. We believe our performance was also impacted by transitory competitive responses to the current environment while we maintained our focus on profitable market share gains.

The increase in average retail selling price in fiscal 2023 reflected higher vehicle acquisition costs, partially offset by shifts in the mix of our sales by vehicle age.

Wholesale Vehicle Sales

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

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Fiscal 2023 Versus Fiscal 2022.  The 11.4% decrease in wholesale vehicle revenues in fiscal 2023 was primarily due to a 17.2% decrease in unit sales, partially offset by a 6.9% increase in average selling price. Wholesale volume was negatively impacted by our decision to shift some units from wholesale to retail to meet consumer demand for lower priced vehicles. The net increase in average selling price in fiscal 2023 was primarily due to increased acquisition costs resulting from strong industry valuations in the beginning of fiscal 2023, which continued from the prior fiscal year, offsetting depreciation in the second half of the fiscal year.

Other Sales and Revenues

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

Fiscal 2023 Versus Fiscal 2022.  Other sales and revenues decreased 5.5% in fiscal 2023, reflecting the decrease in EPP revenue and a decline in new vehicle sales, partially offset by the inclusion of twelve months of Edmunds’ revenue in fiscal 2023 compared to nine months of Edmunds’ revenue in fiscal 2022. EPP revenues decreased 11.7%, primarily driven by the decline in our retail unit volume and a decrease in profit sharing revenue recognized in the current year, partially offset by increased margins. The decline in new car sales was driven by the divestiture of our remaining new car franchise in the third quarter of fiscal 2022.

GROSS PROFIT

(1)Amounts are net of intercompany eliminations.

GROSS PROFIT PER UNIT

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

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

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

Used Vehicle Gross Profit

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

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

Fiscal 2023 Versus Fiscal 2022.  Used vehicle gross profit decreased 9.3% in fiscal 2023, driven by the 12.6% decrease in total used unit sales, partially offset by the $83 increase in used vehicle gross profit per unit. We continue to focus on striking the right balance between covering cost increases, maintaining margin and passing along efficiencies to consumers to support vehicle affordability.

Wholesale Vehicle Gross Profit

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

Fiscal 2023 Versus Fiscal 2022.  Wholesale vehicle gross profit decreased 22.9% in fiscal 2023, driven by the 17.2% decrease in wholesale unit sales as well as the $75 decrease in wholesale vehicle gross profit per unit. Our decision to source a higher mix of older vehicles for retail sale also impacted wholesale vehicle gross profit per unit. When those vehicles cannot be reconditioned to our standards for consumer sales, we shift them to wholesale, which often sell at lower margins.

Other Gross Profit

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

Fiscal 2023 Versus Fiscal 2022.  Other gross profit decreased 25.2% in fiscal 2023, primarily driven by an $81.5 million decline in service department margins as well as a decrease in EPP revenues, as discussed above, partially offset by the inclusion of twelve months of Edmunds' gross profit in fiscal 2023 compared with nine months of Edmunds' gross profit in fiscal 2022. The decline in service department profits was driven by deleverage resulting from lower retail unit sales, inflationary pressure and our decision to maintain technician staffing.

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

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

(1)Amounts are net of intercompany eliminations.

(2)Excludes compensation and benefits related to reconditioning and vehicle repair service, which are included in cost of sales. See Note 14 for details of share-based compensation expense by grant type.

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

Fiscal 2023 Versus Fiscal 2022 (Increase of $162.2 million or 7.0%). Factors contributing to the net increase include the following:

•$122.6 million increase in other overhead costs, primarily driven by investments to advance our technology platforms and support our strategic and growth initiatives. The increase also included a $22.6 million one-time benefit in the prior year related to the receipt of settlement proceeds in a class action lawsuit. Other overhead costs were also negatively impacted by a year-over-year increase in non-CAF uncollectible receivables. This increase reflects several factors including, but not limited to, ongoing DMV processing delays, costs associated with our Love Your Car Guarantee program and field execution opportunities stemming from the dynamic operating environment.

•$58.0 million increase in compensation and benefits expense, excluding share-based compensation expense, driven by increased staffing and wage pressures as well as the inclusion of Edmunds for twelve months in the current year compared to nine months in the prior year, partially offset by a $32.8 million decrease in bonus compensation expense.

•$37.4 million increase in store occupancy costs driven by the 9.1% increase in our store base since the beginning of the last fiscal year as well as other growth- and capacity-related costs.

•$37.4 million decrease in advertising expense driven by our deliberate efforts to reduce marketing spend to align with sales.

•$18.4 million decrease in stock-based compensation expense, primarily related to cash-settled restricted stock units, as the expense associated with these units was primarily driven by the change in the company's stock price during the relevant periods.

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Interest Expense

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

Fiscal 2023 Versus Fiscal 2022.  Interest expense increased to $120.4 million in fiscal 2023 versus $94.1 million in fiscal 2022. The increase primarily reflected higher interest rates as well as higher outstanding debt balances in the current fiscal year, including the $700 million term loan issued in October 2021.

Other Income

Other income decreased to $9.4 million in fiscal 2023 compared with $34.6 million in fiscal 2022. The decrease was primarily due to net gains on an equity investment recorded during fiscal 2022.

Income Taxes

The effective income tax rate was 23.9% in fiscal 2023 compared with 22.9% in fiscal 2022. The increase in the effective income tax rate was primarily driven by the change in excess tax benefit related to settlements of share-based awards.

RESULTS OF OPERATIONS – CARMAX AUTO FINANCE

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

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

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

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

See Note 4 for additional information on CAF income and Note 5 for information on auto loans receivable, including credit quality.

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SELECTED CAF FINANCIAL INFORMATION

(1)Percent of total average managed receivables.

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

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

(2)The credit scores represent FICO® scores and reflect only receivables with obligors that have a FICO® score at the time of application.  The FICO® score with respect to any receivable with co-obligors is calculated as the average of each obligor’s FICO® score at the time of application.  FICO® scores are not a significant factor in our primary scoring model, which relies on information from credit bureaus and other application information as discussed in Note 5.  FICO® is a federally registered servicemark of Fair Isaac Corporation.

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

LOAN PERFORMANCE INFORMATION

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

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Fiscal 2023 Versus Fiscal 2022.

•CAF Income decreased $138.1 million, or 17.2%, reflecting an increase in the provision for loan losses and a decrease in the net interest margin percentage, partially offset by an increase in average managed receivables.

•Provision for Loan Losses (Increased to $317.0 million from $141.7 million)

◦The current year provision increase was primarily the result of the previously disclosed expansion of Tier 2 and Tier 3 originations within CAF's portfolio and unfavorable performance within the portfolio as well as the uncertain macroeconomic environment. In addition, the prior fiscal year was positively impacted by a reduced provision coming out of the pandemic from fiscal 2021.

◦The allowance for loan losses as a percentage of ending managed receivables was 3.02% as of February 28, 2023 compared with 2.77% as of February 28, 2022 due to the factors noted above.

•Total interest margin decreased as a percentage of average managed receivables to 6.9% in fiscal 2023 compared with 7.2% in fiscal 2022. The decrease was primarily the result of higher funding costs, partially offset by higher interest and fees from consumers.

•Loan Performance

◦The decrease in net loan originations in fiscal 2023 resulted from a decrease in used unit sales and the net penetration rate, partially offset by an increase in the average amount financed.

◦CAF net penetration for fiscal 2023 declined from the prior year, largely reflecting shifts in the mix of customers utilizing outside financing.

◦The weighted average contract rate increased to 9.7% in fiscal 2023, compared with 8.5% in the prior year. The increase was primarily due to higher rates charged to customers in response to the current interest rate environment. We expect that these significant pricing moves, along with more gradual movements in our cost of funds, should allow our total interest margin to level off in fiscal 2024.

◦The increase in past due accounts as a percentage of ending managed receivables for fiscal 2023 primarily reflects an increase in delinquencies as well as our expansion of Tier 2 and Tier 3 originations within CAF's portfolio. The increase in delinquencies primarily reflects customer hardship in the current economic environment.

PLANNED FUTURE ACTIVITIES

For fiscal 2024, we plan to open five stores, including two more stores in the New York City metro market, as well as our first offsite production location in the Atlanta metro market. We currently estimate capital expenditures will total approximately $450 million in fiscal 2024. Capital expenditures were $422.7 million in fiscal 2023. Planned capital spending in fiscal 2024 largely reflects spending to support our future long-term growth, including investments in auction, sales and production facilities, as well as our new stores.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 1(X) to the consolidated financial statements for information on recent accounting pronouncements applicable to CarMax.

FINANCIAL CONDITION

Liquidity and Capital Resources

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

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

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On June 1, 2021, we completed our acquisition of Edmunds for a total purchase price of $401.8 million, inclusive of our initial investment. The consideration paid at closing included a combination of cash and shares of CarMax common stock. See Note 2 for additional information.

We are party to contractual obligations involving commitments to make payments to third parties. These obligations impact our liquidity and capital resource needs. Our contractual obligations primarily consist of long-term debt and related interest payments, leases, purchase obligations and commitments, income taxes and defined benefit retirement plans. See Notes 13 and 17 for amounts outstanding as of February 28, 2023 related to debt and leases, respectively.

Our contractual obligations related to income taxes represent the net unrecognized tax benefits related to uncertain tax positions. See Note 11 for information related to income taxes. Our contractual obligations related to defined benefit retirement plans represent the funded status recognized as of February 28, 2023. See Note 12 for information related to these plans.

Purchase obligations and commitments consist of certain enforceable and legally binding obligations related to real estate purchases, third-party outsourcing services and advertising. As of February 28, 2023, our purchase obligations and commitments were approximately $407.3 million, of which $246.2 million are due in fiscal 2024. The majority of the remaining purchase obligations and commitments are due within the next three years.

We currently target an adjusted debt-to-total capital ratio in a range of 35% to 45%. At the end of fiscal 2023, our adjusted debt to capital ratio, net of cash on hand, was below our targeted range for the year. In calculating this ratio, we utilize total debt excluding non-recourse notes payable, finance lease liabilities, a multiple of eight times rent expense and total shareholders’ equity. Generally, we expect to use our revolving credit facility and other financing sources, together with stock repurchases, to maintain this targeted ratio; however, in any period, we may be outside this range due to seasonal, market, strategic or other factors.

Operating Activities.  During fiscal 2023, net cash provided by operating activities totaled $1.28 billion, compared with net cash used in operating activities of $2.55 billion in fiscal 2022.

As of February 28, 2023, total inventory was $3.73 billion, representing a decrease of $1.40 billion, or 27.3%, compared with the balance as of the start of the fiscal year. The decrease was primarily due to a decrease in vehicle units reflecting lower sales volume as well as a decline in the average carrying cost of inventory as a result of market depreciation.

Our operating cash flows are significantly impacted by changes in auto loans receivable, which increased $1.37 billion in fiscal 2023 compared with $1.94 billion in fiscal 2022.  The majority of the changes in auto loans receivable are accompanied by changes in non-recourse notes payable, which are issued to fund auto loans originated by CAF. Net issuances of non-recourse notes payable were $893.3 million in fiscal 2023 compared with $1.70 billion in fiscal 2022 and are separately reflected as cash from financing activities. Due to the presentation differences between auto loans receivable and non-recourse notes payable on the consolidated statements of cash flows, fluctuations in these amounts can have a significant impact on our operating and financing cash flows without affecting our overall liquidity, working capital or cash flows.

The change in net cash provided by (used in) operating activities for fiscal 2023 compared with fiscal 2022 reflected the changes in inventory and auto loans receivable, as discussed above, as well as the net impact of volume and timing-related changes in accounts receivable and accounts payable, partially offset by a decrease in net earnings when excluding non-cash expenses, which include depreciation and amortization, share-based compensation expense and the provisions for loan losses and cancellation reserves.

Investing Activities.  Net cash used in investing activities totaled $425.8 million in fiscal 2023 compared with $523.7 million in fiscal 2022.  For fiscal 2022, this included $241.6 million in cash paid in connection with the Edmunds acquisition, net of cash acquired. Capital expenditures were $422.7 million in fiscal 2023 versus $308.5 million in fiscal 2022. Capital expenditures primarily included store construction costs as well as investments in growth capacity initiatives and technology.  We maintain a multi-year pipeline of sites to support our store and capacity growth, so portions of capital spending in one year may relate to stores that we open in subsequent fiscal years.

Financing Activities.  Net cash used in financing activities was $710.2 million in fiscal 2023, compared with net cash provided by financing activities of $3.10 billion in fiscal 2022.  Included in these amounts were net issuances of non-recourse notes payable of $893.3 million compared with $1.70 billion in the prior year. Non-recourse notes payable are typically used to fund changes in auto loans receivable (see “Operating Activities”).

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During fiscal 2023, cash used in financing activities was impacted by stock repurchases of $333.9 million as well as net payments on our long-term debt of $1.25 billion. During fiscal 2022, cash provided by financing activities was impacted by stock repurchases of $576.5 million as well as net borrowings on our long-term debt of $1.93 billion.

TOTAL DEBT AND CASH AND CASH EQUIVALENTS

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

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

(3)Total debt excludes unamortized debt issuance costs. See Note 13 for additional information.

Borrowings under our $2.00 billion unsecured revolving credit facility are available for working capital and general corporate purposes, and the unused portion is fully available to us.  The credit facility, term loans and senior note agreements contain representations and warranties, conditions and covenants.  If these requirements are not met, all amounts outstanding or otherwise owed could become due and payable immediately and other limitations could be placed on our ability to use any available borrowing capacity. As of February 28, 2023, we were in compliance with these financial covenants.

See Note 13 for additional information on our revolving credit facility, term loans, senior notes and financing obligations.

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

As of February 28, 2023, $12.71 billion and $3.65 billion of non-recourse notes payable were outstanding related to asset-backed term funding transactions and our warehouse facilities, respectively.  During fiscal 2023, we funded a total of $7.23 billion in asset-backed term funding transactions. As of February 28, 2023, we had $1.95 billion of unused capacity in our warehouse facilities.

We have periodically increased our warehouse facility limit over time, as our store base, sales and CAF loan originations have grown. See Notes 1(F) and 13 for additional information on the warehouse facilities.

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

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The timing and amount of stock repurchases are determined based on stock price, market conditions, legal requirements and other factors.  Shares repurchased are deemed authorized but unissued shares of common stock.  In April 2022, our board of directors increased our share repurchase authorization by $2 billion. As of February 28, 2023, a total of $4 billion of board authorizations for repurchases was outstanding, with no expiration date, of which $2.45 billion remained available for repurchase. We paused the repurchase of our common stock during the third quarter of fiscal 2023 but may resume share repurchases at any time in the future depending on market conditions and our capital needs, among other factors. We remain committed to returning capital back to our shareholders over time. See Note 14 for more information on share repurchase activity.

Fair Value Measurements.  We recognize money market securities, mutual fund investments, certain equity investments and derivative instruments at fair value.  See Note 7 for more information on fair value measurements.