Katharine W. Kenny - Vice President of Investor Relations Thomas J. Folliard - Chief Executive Officer, President and Director Thomas W. Reedy - Chief Financial Officer and Executive Vice President.

Simeon Gutman - Crédit Suisse AG, Research Division Matthew R. Nemer - Wells Fargo Securities, LLC, Research Division Brian W. Nagel - Oppenheimer & Co. Inc., Research Division Craig R. Kennison - Robert W. Baird & Co. Incorporated, Research Division Matthew J. Fassler - Goldman Sachs Group Inc., Research Division Elizabeth Suzuki James J.

Albertine - Stifel, Nicolaus & Co., Inc., Research Division William R. Armstrong - CL King & Associates, Inc., Research Division David Whiston - Morningstar Inc., Research Division.

Good morning. My name is Susan, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q2 FY '14 conference call. [Operator Instructions] Thank you. Ms. Katharine Kenny, you may begin your conference..

Thank you, Susan, and good morning. Thank you for joining our fiscal 2014 second quarter earnings conference call. As usual, on the call with me today are Tom Folliard, our President and Chief Executive Officer; and Tom Reedy, our Executive Vice President and CFO.

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, 2013, filed with the SEC. [Operator Instructions] Thanks so much.

Tom?.

Thank you, Katharine. Good morning, everyone. Thanks for joining us today. As you saw, used unit comps for the second quarter grew 16% compared to last year, primarily due to better conversion, as well as a modest increase in traffic. Total used unit sales grew by 21% in the quarter.

Total used vehicle gross profit grew by 21%, and used vehicle gross profit per unit of $2,174 was virtually the same as last year. Also, unit sales increased by 10%. This was largely due to a higher buy rates and the growth in our store base.

Total wholesale vehicle gross profit increased by 3%, as the 10% growth in units was partially offset by a decrease of $58 in gross profit per unit. Extended service plan revenues rose 23%, reflecting our sales growth and an increase in penetration. CAF quarterly income increased 12% to $84 million. Tom will give you some details on that in a moment.

Overall, we had a very strong quarter. Net earnings grew 26% to $140 million and net earnings per diluted share rose 29% to $0.62 a share. With that, I'll turn it over to Tom to talk about financing..

Thanks, Tom. Good morning, everybody. In the second quarter, CAF income was up 12% compared to the second quarter of fiscal 2013, while our average managed receivables increased 24% to $6.5 billion.

Consistent with recent experience, the portfolio growth was driven by a continuing strong origination volume, which was supported by the expansion in CAF penetration, CarMax's sales growth and an increase in the average amounts financed.

Managed receivables continue to grow at a faster pace than CAF earnings, as the increase in loan volume was offset by continued compression in the spread between consumer rates and funding costs. Credit losses in the quarter were largely in line with our expectations.

The allowance for loan losses grew to $66 million or approximately 1% of ending managed receivables, compared to 0.9% in Q2 of FY '13. For CAF, net loans originated in the quarter rose 32% to $1.1 billion, and net penetration was 41% compared to 37% in the second quarter of fiscal 2013.

The weighted average contract rate for the quarter's originations was 6.8% compared to 8.1% in last year's second quarter, but that's down only slightly from 7.0% in this year's first quarter.

Similar to the first quarter, we experienced higher applicant flow, higher conversion, arising from both more attractive offers and better in-store execution and also greater retention of our finance customers, as 3-day payouts remain at historical lows. We believe our finance offers continue to optimize overall sales and profits for CarMax.

And as outlined in the press release, we saw third-party subprime providers accounting for about 18% of our sales in the second quarter, compared to 15% in last year's second quarter. Now I'll turn it back over to Tom..

our fifth store in Houston, Texas; and our second store in Sacramento, California. In our press release, we also announced 5 planned superstore openings for next year's second quarter. Four will be in new markets for CarMax, including Madison, Wisconsin; Reno, Nevada; Lynchburg, Virginia; and Portland, Oregon.

We will also open our fifth store in the Dallas market. With that, we'd be happy to take your questions.

Operator?.

[Operator Instructions] Your first question comes from the line of Simeon Gutman with Crédit Suisse..

Tom, one question with maybe 1 or 2 little parts, and I'll say it all upfront. First, regarding the vehicle population, the data is pointing to an inflection point in the 0- to 5-year-old range.

Your mix comments alluded to this to some degree, but I'm curious if you can share any anecdotes of whether you're starting to sense or see a change in the complexion of some of the vehicles that are coming through your channel.

And then the second part of that question, is the store pipeline, based on the press release, it looks pretty robust over the next 12 months. I think it's 17 stores.

And so unless the back half of next year is very light, might you end up doing either the high end or a little bit more than the high end of the range of store growth?.

0 to 4 and 5 to 10, there was very little change in our mix between those 2 segments. As I said last quarter, we saw some movement within 0 to 4, but not as a group. So that was very similar this quarter. In terms of the store mix, we've not changed to what our plans are of 10 to 15 stores. Including this year, we said for the next 3 years.

So that's this year and the following 2. What you see in the next 12 months is just a reflection of timing, so it really hasn't changed at all. It's just -- and it will be kind of a higher volume over the next 12 months than the 12-month periods around it -- we haven't changed our projections at all..

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

So I'm just wondering if the mixed compacts and midsized vehicles impacted the gross profit per unit. And then as a follow-up, can you talk about what led to the improved conversion? I'm sure it was lots of little things but maybe just the highlights..

Yes. As we said before, Matt, the mix of vehicles by category really doesn't have much impact on our margins. And our margins were flat and it was only a few points of move within that segment anyway, so very little impact there.

And what was the second part?.

Just factors that led to a better conversion?.

Yes, it's pretty much the same. As we talked about last quarter, we have outstanding execution in our stores. We have some good results coming from improved training programs, but, also, we have better consumer offers from our, not only CAF, but our lending partners as well. So they have a little bit more to work with.

We have approvals at all-time highs, which has not really changed from last quarter of kind of our global approval rate of all applications that we receive in the store. 90% of applicants are receiving an approval from at least one of those lenders. So it's very similar to last quarter.

I think just great execution in the stores, very good offers and our store teams have done a really nice job of getting inventory and getting it ready and getting it up to a very high quality standard, so our customers have a very great selection..

Your next question comes from the line of Brian Nagel with Oppenheimer..

The question I had was really, maybe a couple of parts under the 1 topic, at the subprime. So we're seeing the results there that the subprime remains a contributor to your overall sales growth.

The question I have with respect to subprime, I mean, one, as we look at this, maybe from a high-level perspective, are you managing that growth? Or are you just allowing the market to basically dictate it for you? And as you're thinking -- as you think about this growth, kind of, where's your mind as far as the puts and takes, maybe the risks, the benefit-risk relationship at subprime becomes -- continues to become a bigger piece? And then finally, just as we've started to see interest rates rise a little bit here, is there any shift in the way your subprime providers are financing customers?.

In terms of the mix, it's really -- it's actually as a percentage of sales, it's slightly down from last quarter in terms of how we think about that business. We're not controlling that at all.

Those -- the lenders that are approving those customers are only seeing those applications after they've been declined by CAF and all of our other lending partners. So as I've said in the past, our view is, at that moment, that is a 100% incremental sale.

It's a sale that we wouldn't have gotten otherwise to that consumer did not have an option for credit. So although it's a lower profit deal for us at that moment, we believe it's 100% incremental.

And what's been happening over the last few years, as we've said a number of times, it's just our lending partners, again, more and more comfortable with our origination channel. I think they've been more aggressive with their offers to our applicants, and it's been terrific for sales.

Each individual deal at the moment that it's approved, we think it's a good decision for us. So we really haven't -- we're not at a level that we're uncomfortable with. And as I said, if you compare it to the first quarter, actually down slightly in this quarter. I don't know if Tom can comment some on the interest rate part..

Yes. As far as the rate environment up, during the quarter, we didn't see any change in our subprime partners' behavior, vis-à-vis what they were doing in the Q1 or across the quarter.

But obviously, if we see significant changes in the interest rates, just like with CarMax Auto Finance, it impacts the overall math of their -- the makeup of their returns, so we would expect them to change behavior in some way. How that would be, we can't tell you until it starts to happen.

But at this point, we have no reason to think that they are in the mode of change in their buy behavior..

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

Your SG&A per unit declined nicely, providing some very good operating leverage.

What were the key factors behind that?.

About 16% comps, similar to last quarter. We've always said that in a growth mode, which we're in, we need, we think, mid- to high-single-digit comps in order to begin to get some leverage. So when -- if we're going to be in the mid to high teens, we would expect some leverage. So it's also very good execution.

You still have to remain very disciplined in the stores with managing your expenses. And, I think, once again, our store teams did an outstanding job..

Your next question comes from the line of Matthew Fassler with Goldman Sachs..

My question also relates to CAF. We are seeing the APR, I guess, the average APR you're offering your consumers through CAF continue to come down, though to your point the decline from Q1 was relatively modest.

Now that we're starting to see your financing cost firm up, along with the overall cost of money, what's your feel within the market, both for your and your competitors' desire to start to lift that APR? And what are consumers' tolerance, you think, to entertain somewhat higher cost to money on the credit front?.

Matt, that as far as consumers' tolerance and our competitors' desire, we're going to have to just keep an eye on that and, through testing and watching our 3-day payoffs and watching what the competitive marketplace is offering, work through that. As far as the funding costs, we've seen them tick up a bit.

I still feel like the ABS market is open to it, and we're doing a good job with securitizing. We've done 3 deals this year. We did see spreads tick up a little bit last deal, but not dramatically.

As far as benchmarks go, that's why we hedge, as we originate our loans and that's why we have CAF, is looking at the market every week and making their pricing decision. So, I mean, I guess, I can just emphasize it. Our plan is to run a competitive and profitable finance business with an overall eye towards maximizing CarMax's profits and sales.

So we can't -- because we're the only person in the Tier 1 space, we can't afford to turn customers off the CarMax at the finance office, so we're always going to make sure that we're competitive. I think we're in a nice position because we are -- we can contest very pretty accurately, because we control our origination channel.

And I think that gives us a competitive advantage and ability to stay on top of the market..

[indiscernible] dramatically is the transparency of our offer to the consumer is, I think, a critical and very important competitive differentiator for us. And since customers -- since we don't negotiate, there are no incentives in our stores for financing. The customer gets a real clear picture of exactly what their rate is.

And if they don't -- if they think they can get better rates, they have 3 days to go pay it off somewhere else. So it's an excellent barometer for us to make sure that we're charging a very competitive rate. But in some regards, we're going to only be able to move as much as the market allows..

Do you think that the market is starting to move at this point?.

Well, it hasn't shown up in our rates yet. So -- but this is -- a lot of times, rates are in a longer cycle. We've seen in the past, as rates have gone up, that the market doesn't move up as much and you tend to see some compression. This is no different than normal.

And when rates -- when cost of funds goes down, oftentimes, the lenders don't go down as quickly, and you tend to see a little widening of the spread. So if you look back over the years for us, this is kind of normal. When rates go up, you see a little compression..

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

This is Elizabeth Suzuki on for John. On store openings, what percentage of the U.S. markets will you be ultimately able to service with your current growth plan? I think the number was somewhere around 50% a little while ago. Just wanted to get an idea of what the target is for the next couple of years..

I haven't really thought of it like that. We're only in half of U.S. markets. When we think about a 3-year growth plan of 10 to 15 stores a year, we said roughly half of those stores will be in building back into existing markets. So I haven't really thought of it that way.

What we're more thinking about is our long-term growth plan, and how to make the CarMax consumer offer available to customers all over the country. So our goal is to go everywhere. I don't really know what percentage we'll achieve in the stated growth plan of 3 years, which -- of which we're in year 1..

Okay.

But there's still plenty of room for growth, obviously?.

Plenty of room for growth..

Your next question comes from the line of James Albertine with Stifel, Nicolaus..

I just wanted to focus very quickly, if I could, on originations. I think last quarter, you gave some good details around sort of your online metrics and some of your app metrics. And I just noticed, looking at your SG&A in a little bit more detail, obviously, advertising sounds significantly year-over-year.

So maybe they're related, maybe they're not related, but I was hoping you could kind of walk us through that. And perhaps, just from a housekeeping standpoint, talk about the buy rate from the appraisal lane..

Yes, I'm not sure what you're referring to there on the app rate. Advertising was down in the quarter. Some of that's driven by a higher comp rate. Some of that is timing, some of that as you expect to get a little leverage on advertising as you continue to grow.

In terms of the -- what was the last part? Oh, the buy rate, yes, in terms of the buy rate, it was up for the quarter, compared to last year's second quarter. So that helps contribute to that 10% growth in wholesale.

And we've always talked about that being a balancing act between buying cars through the appraisal lane, does some of those customers, in turn, buy a retail car from us, and you really can't manage one individually. So we're actually very, very pleased with how the -- how it all came out in total.

Nice buy rate increase in, really, what was a depreciating environment, which is a little bit more normal. So if you look at the Manheim index for the summer, we saw some depreciation, which we would normally expect. That we've had a few years where things haven't been the way they normally are.

But -- so to see our buy rate tick up a little for the quarter, we are very pleased with that..

And any update on the online front in terms of any of the metrics that you're willing to share?.

Well, I talked about them earlier, mostly just on hits. 12 million hits to the website, average monthly visits, that's an all-time high.

We obviously continue to see growth through mobile applications, and touchpads, actually, at the end of the quarter, it was the first time for CarMax that more than 50% of all of the hits to the website came from something other than a desktop. So that's a trend that we expect to continue. We don't do a lot of online credit applications.

I'm not sure if that's the question you were asking earlier, but that's a very tiny piece of our total at this time..

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

Tom, so your average selling price actually declined slightly year-over-year for first time since, I think, 2009.

Does that reflect mix? Or are we seeing some impact from lower acquisition cost? Or is it just not big enough of a decrease to even be relevant?.

It's that part, what you just said..

The last part?.

a little bit of mix, a little bit of some depreciation in the quarter, but nothing that we're really spending time thinking about..

So it sounds like your acquisition costs that are not necessarily following along with the Manheim index, which, obviously, has been decreasing..

It's impossible to tell from the ASP, because of all the variation in the mix. I think the easiest way to look at it is our margins were relatively flat to last year. So we have to be tracking somewhat close to the market on a vehicle-by-vehicle basis in order to achieve a flat margin..

Your next question comes from the line of David Whiston with Morningstar..

Can you talk about if you would want to own the new properties you're constructing? Would you want to own them if interest rates were to rise dramatically? And what's your goal for owning your real estate in terms of the percentage over the midterm?.

We really don't look at it as a goal, whether we want to own it or lease it or controlled portfolio.

We look at it as the amount of capital we need to commit to execute our opening plan and our Treasury department's going to look and figure out the best way to fund it from a cost and flexibility perspective, depending on what the market offers at the time that we need the capital.

At this time point, we haven't had to use any external capital to buy our sites. But if you ask me, all else equal, I'd prefer to own rather than lease our real estate, because it allows you to be the master of your own destiny a lot more..

The only thing I'd add there is, we want to get the best site. So there are some cases where maybe the only thing available is a long-term ground lease. And if it's the best site, then we'll look at the cost and we'll make a decision based on that..

So are interest rates a major decision factor for your Treasury department?.

What's that?.

I'm not sure what you're getting at..

You said the Treasury department is evaluating for -- on each deal, so just, from your answer, it just sounded like interest rates were not that high on the decision-making tree for your Treasury department. I just wanted to confirm that..

We look at everything from an overall need-for-capital perspective. So our business generates a certain amount of money. We need a certain amount of liquidity for inventory and working capital, and we need capital to fund our growth.

The last couple of years, we have not needed to go external for that capital as we look forward, to the extent we would need to go external for that capital. But what I was saying is, whether we're leasing or buying the property, is not a fact -- is a factor, but it's not -- the decision point's not based on a preference to own versus lease.

It's based on a preference to get the best cost of fund and most flexibility..

And remember, too, oftentimes, we'll make a decision on moving forward with a certain piece of property and then we won't actually have to fund it for 2 or 3 years. So we're not going to make a decision now, not knowing what the circumstances will be 2 or 3 years from now. So then Tom and his team will make whatever the best decision is at that time..

[Operator Instructions].

All right, seeing no further questions, I want to thank everybody for joining the call today. Thanks for your support and continued interest in CarMax, and thanks to all of our associates, once again, for their dedication and hard work and all they do every day. We'll talk to you next quarter..

This does conclude today's conference call. You may now disconnect..