Carmax Inc Q2 FY2025 Earnings Call

Thank you, Todd. Good morning, everyone. Thank you for joining our fiscal 2025 second quarter earnings conference call. I'm here today with Bill Nash, our President and CEO; Enrique Mayor-Mora, our Executive Vice President and CFO; and Jon Daniels, our Senior Vice President, CarMax Auto Finance operations. Let me remind you, our statements today that are not statements of historical fact, including statements regarding the company's future business plans, prospects, and financial performance are forward-looking statements we make pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are based on our current knowledge, expectations, and assumptions and are subject to substantial risks and uncertainties that could cause actual results to differ materially from our expectations. In providing projections and other forward-looking statements, we disclaim any intent or obligation to update them. For additional information on important factors and risks that could affect these expectations, please see our Form 8-K filed with the SEC this morning, our Annual Report on Form 10-K for the fiscal year 2024 and our quarterly results on Form 10-Q, previously filed with the SEC. Should you have any follow-up questions after the call, please feel free to contact our Investor Relations Department at 804-747-0422, extension 7865. Lastly, let me thank you in advance for asking only one question and getting back in the queue for more follow-ups. Bill?

Great. Thank you, David. Good morning, everyone, and thanks for joining us. We're pleased with our team's execution in the second quarter, as we achieved positive sales trends, strong margins, cost efficiencies, and EPS growth, while managing through industry-wide auto loan loss pressure. Beyond great execution, our results also reflect the positive impact of delivering associate and customer experience enhancements alongside declining prices and a more stable environment for vehicle valuations. In the second quarter, we grew retail unit volume year-over-year. We delivered strong retail and wholesale GPUs and expanded EPP and service gross profit. We bought more vehicles from dealers, achieving a second quarter record. We maintained stable CAF net interest margin and began to test our new full spectrum underwriting model. We materially leveraged SG&A as a percent of gross profit and we achieved double-digit EPS growth. For the second quarter of FY ‘25, our diversified business model delivered total sales of $7 billion, down 1% compared to last year, reflecting lower retail and wholesale prices, partially offset by higher retail volume. In our retail business, total unit sales increased 5.1% and used unit comps were up 4.3%. Average selling price declined approximately $1,250 per unit or 5% year-over-year. Second quarter retail gross profit per used unit was $2,269, consistent with last year's $2,251. Also, unit sales are down 0.3 versus the second quarter last year and improved sequentially from being down 8.3% in the first quarter of this year. Average selling prices declined approximately $1,150 per unit or 13% year-over-year. Second quarter wholesale gross profit per unit was $975 in line with $963 a year ago. We bought approximately 300,000 vehicles during the quarter, up 3% from last year. We purchased approximately 269,000 vehicles from consumers with more than half of those buys coming through our online instant appraisal experience. With the support of our Edmund sales team, we sourced the remaining approximately 31,000 vehicles through dealers, up 60% from last year. We continue to see increased adoption of our omni-channel retail experience. For our second quarter online metrics, approximately 15% of retail unit sales were online, up from 14% last year. Approximately 57% of retail unit sales were omni-sales this quarter, up from 55% in the prior year. Total revenue from online transactions was approximately 29%, slightly down from last year due to wholesale pricing coming down. All of our second quarter wholesale auctions and sales were virtual and are considered online transactions, which represented 17% of total revenue for the quarter. CarMax Auto Finance or CAF delivered income of $116 million, down 14% from the same period last year. CAF results were pressured by an uptick in losses that are being experienced industry-wide. In a few minutes, Jon will provide more detail on customer financing, the loan loss provision, cap contribution, and our progress on becoming a full credit spectrum lender. But at this point, I'd like to turn the call over to Enrique, who will share more information on our second quarter financial performance.

Thanks, Bill, and good morning, everyone. As Bill noted, we delivered on multiple fronts in the quarter, positive retail unit comps, robust vehicle margins, material growth, and other gross profit per retail unit, maintaining CAF's net interest margin, and strong flow through to the bottom line. Second quarter net earnings per diluted share was $0.85, up 13% versus a year ago. This was despite the increase in our loan loss provision. Total gross profit was $760 million, up 9% from last year's second quarter. Used retail margin of $479 million increased by 6% with higher volume and relatively flat per unit margins. Wholesale vehicle margin of $138 million grew by 1% with margins offsetting a slight decrease in volume. Other gross profit was $144 million, up 33% from a year ago. This was driven primarily by a combination of EPP and service. EPP increased by $20 million as we continued to benefit from the higher MaxCare margins per contract that we previously rolled out. Service delivered $3 million in margin, up $17 million from last year's second quarter. This performance reflected the combined impact of successful efficiency and cost coverage measures and positive sales growth. We expect continued year-over-year improvement for the balance of the year, as governed by sales performance given the leverage-deleverage nature of service. On the SG&A front, expenses for the second quarter were $611 million, up 4%, or $25 million from the prior year's quarter, but leveraged 4 percentage points supported by our continued discipline in spend and investment levels. This SG&A leverage would have been even stronger, if not for two main factors that impacted the second quarter. First, total compensation and benefits increased by $16 million. This was primarily driven by our corporate bonus accrual, which was lowered in last year's second quarter. Second, occupancy costs rose by $7 million, a higher increase in recent trends driven by the timing of store maintenance related spending. I also want to point out two noteworthy items. First, our omnichannel selling model, which includes commissions plus the cost of operating our CECs, continues to be more efficient as we further strengthen our digital progression tools and the optimal use of CEC labor. This quarter, we were more efficient year-over-year and versus pre-omni in the three key metrics, per retail unit, per total unit, and per gross margin dollar. Second, as Bill will discuss further, we continue to evaluate all aspects of our logistics operations to drive efficiencies. This includes equipment and leasing arrangements. As part of this evaluation, we may incur charges that we estimate will be less than $10 million in the near-term that would likely hit the other income expense line. These charges will be more than offset by the efficiencies gained in our logistics operations over time. Regarding capital allocation, during the second quarter we repurchased approximately 1.4 million shares for a total spend of $106 million. As of the end of the quarter, we had approximately $2.15 billion of repurchase authorization remaining. Now I'd like to turn the call over to Jon.

Thanks, Enrique, and good morning, everyone. During the second quarter, CarMax Auto Finance originated approximately $2.2 billion, resulting in sales penetration of 42% net of three-day payoffs, as compared to 42.8% during last year's second quarter. The weighted average contract rate charged to new customers was 11.5% and increased to 40 basis points from a year ago. Third-party Tier 2 penetration in the quarter was 17.7%, down slightly from 18.1% a year ago. And third-party Tier 3 volume accounted for 6.7% of sales, compared to the 6.4% seen in last year's second quarter. The combined third-party penetration of 24.4% remains in line with Q2 FY ‘24. CAF income for the quarter was $116 million, down $19 million from the same period last year, predominantly impacted by a year-over-year provision increase of $23 million. Net interest margin for the quarter was 6.1% in line with last year. The provision for loan losses for the quarter was $113 million and resulted in a reserve balance of $501 million. This compares to a provision of $90 million in last year's second quarter. Included in the $113 million provision is a $52 million, roughly 11% increase in our estimate of lifetime losses on existing loans, which we believe reflects industry-wide credit challenges. Also included in the provision is $61 million for expected losses on current quarter originations. The resulting reserve to receivables ratio was 2.82%, as compared to 2.79% at the end of Q1 and 3.08% from a year ago. Despite the growth in the year-over-year provision, the reserve to receivables percentage only increased 3 basis points, which is a result of credit tightening measures we deployed over the course of the last two years and their growing impact on the near $18 billion portfolio. Regarding the broader credit industry, it has been well cited that a number of auto loan consumers are struggling in this inflationary environment, especially those borrowers who originated contracts in 2022 and 2023, when elevated prices were coupled with high interest rates. To combat these results, lenders have generally tightened underwriting where necessary and have adjusted lifetime loss expectations based on weakening performance. CAF has to some degree experienced similar challenges emerging within the industry. But our customers have largely shown an ability to navigate this added inflationary burden. During this last quarter, we observed additional pressure on the consumer. And as a result, we added to our provision accordingly. Despite the adjustment, these higher ASP originations from 2022 and 2023 remain significantly profitable for CarMax, and it is clear that the material tightening deployed in early 2023 has had a meaningful impact on our vintage-level loss rates. In addition, we observed a pocket of customers generally concentrated at the lower end of the Tier 1 credit spectrum that were of noticeably higher risk, which we addressed through the further tightening of our underwriting strategy for cautionary reasons beginning in April 2024. While the loss allowance was previously adjusted for this pocket in the first quarter as a part of our standard loan loss modeling process, during the second quarter, we observed further deterioration, which necessitated an additional adjustment on the pre-existing receivables. We believe this quarter's provision adequately captures the performance within the quarter and the resulting reserve is our best estimate of the remaining lifetime loss for the portfolio. As always, CAF will continue to balance credit risk, driving CarMax sales, and capturing its optimal share of highly profitable finance contracts. Now I will share an update on CAF's Securitization Program and Full Spectrum Lending Initiative. During the month of June, we successfully executed our first non-prime ABS transaction and followed in July with our first higher prime ABS deal. The success of these transactions reaffirms our belief that these complementary programs will provide significant additional funding capacity to support CarMax growth while giving us the flexibility to capture a larger piece of the Tier 2 and Tier 3 landscape. Also during the second quarter, CAF successfully began testing its new full spectrum credit scoring models and corresponding strategies across both the Tier 1 and Tier 2 spaces. We expect our Tier 3 testing of the new model to begin during the third quarter. Now let's turn the call back over to Bill.

Thank you, Jon and Enrique. As I mentioned in our last earnings call, I'm proud of the durable actions we've been taking to support our business and further differentiate our offering. We are continuing to refine the experience and realize efficiencies that will support future growth. Some examples include, we've completed the nationwide rollout of our new order processing system across our stores and customer experience centers. As a reminder, this system helps associates guide customers through each step of the buying journey and provides a more seamless experience for customers who prefer to blend self-progression with assistance from associates. We're now focused on customer shopping accounts. These make it even easier for customers to see the steps they have taken on their shopping journey, whether on their own or with help from an associate. These accounts guide next steps and promote MaxCare, our extended service plan offering. We're currently testing in several stores and plan to deploy nationwide later this year. Our data science, CEC, and product teams have recently developed a new knowledge management system that we are testing in our CECs, which leverages generative AI to empower associates with instant access to the information they need. Associates can ask questions through a chatbot and receive an immediate response. We are finding this tool especially helpful for customer questions where the response varies from state to state. This will enable our CEC to be more effective and efficient, and we plan to launch the system across all CECs later this year. For finance-based shopping, we released an enhancement that seamlessly incorporates existing instant appraisal offers into our prequalification offering, giving customers more precise credit terms. And finally, we launched an EV Hub on carmax.com. The hub contains information and research tools that address top questions shoppers have about electric vehicles, including hybrids, and helps consumers determine if an electric vehicle is right for them. As I mentioned last quarter, we're focused on driving down the cost of goods sold by pursuing incremental efficiency opportunities that we have identified across our logistics network and reconditioning operations. This supports affordability as we pass savings on to our customers and also supports our margins. After completing a comprehensive review of our logistics operation, we determine that centralizing some key functions will help us best leverage our network. During the second quarter, we centralized our home delivery, appraisal pickup, and Max offer moves by market. We plan to achieve further efficiencies in upcoming quarters as we roll out our enhanced transportation management system, which provides new planning and execution capabilities. In conclusion, we're encouraged by our second quarter performance, and assuming current market conditions continue, we feel good about our sales in the second half of the year. We're excited about our future and our ability to grow sales and earnings, while continuing to enhance our best-in-class omnichannel experience for our associates and customers, strengthening our competitive mode. With that, we'll be happy to take your questions. Todd?

Thank you. Your first question will come from Seth Basham with Wedbush Securities. Please go ahead; your line is open.

Thanks a lot, and good morning. Great to see the progress on sales. My first question is just if you could give us an update on how unit comps are trending quarter-to-date?

Yes, sure Seth. So first of all, we're pleased with how the sales have progressed. If I look at the comp cadence for the quarter, they actually sequentially got better, which was great to see. For September, with almost one full month into the third quarter, we're trending positive for the quarter in line with the second quarter, but a little bit softer at this point. I would also just point out that September has some heavy day of the week headwinds. One less Friday, one less Saturday, pick up at Sunday, but we get all that back in the quarter.

That's helpful color. And then secondly on task, if you can get some color on your view of the market at this juncture? Does it make sense to push forward with the full spectrum lending given the credit headwinds and do you expect further tightening on your underwriting standards?

Sure. Appreciate the question, Seth. So first on the overall market, again, I think we stated clearly, and I think you've reported this, industry-wide loss rates clearly are out there. It's a stressed consumer. I think that's why we've done the tightening that we've done. April ‘23, we're clearly seeing improvements in losses on those vintages. Mentioned again, further tightening in April ‘24. I'll address your tightening question right now. Right now, we feel good about where we sit. Everything that we've tightened on previously is highly profitable for CarMax, but just moves that we felt we wanted to make proactively on a cautionary basis. But right now we feel good about where we are again, never say never, we'll watch our portfolio very, very closely, but we feel good about what we're originating right now. And with regard to is this the right time for Tier 2 and Tier 3? Well, we're in learning mode and we're really excited about it. We deployed our Tier 2 underwriting model and strategies in the back portion of Q2. We're looking to get into the Tier 3 in probably the back portion of Q3. We're excited to learn and we're going to continue to learn throughout probably the fiscal quarter. We will decide when it makes sense to go in to go after more volume. We think it's great for the customer that there's going to be CAF in there. We know it's great for CarMax that CAF is going to be there. We think there's more opportunity there as we've all stated. So we'll pick the right time but we're excited to learn and we'll move in prudently and when it makes sense.

And Seth, what I'd say is even in this kind of environment, I mean, these are really profitable loans that Jon and team can target and do an excellent job of targeting those loans in origination. So we're really excited about the full credit spectrum. And yes, we'll continue to test in the back half of the year here.

And I'd be remiss if I didn't finish up with you know, and that's what made the securitization program this summer so exciting for us. It really was a great success, both of those issuances, and I think it really sets us up well for the future, both in capacity and flexibility.

Thank you.

Thank you. We'll take our next question from Sharon Zackfia with William Blair. Please go ahead.

Hi, good morning. Thanks for taking the call or question. I guess another question on the finance business. You know, how do we think about the profitability of CAF when you've got the higher losses on the one hand, but we’re also seeing funding costs obviously start to come down. Is this kind of the trough in terms of year-over-year decrease that we should expect? I mean, when do you think CAF can start to grow again in income? Just any kind of perspective around that would be helpful.

Yes, I appreciate the question, Sharon. So I'll kind of break it down between two of our - yes, obviously our biggest fine items. You mentioned the interest rate aspect. So, right, that's going to show through in our NIM. Obviously, we've been very pleased with how we've managed NIM in this environment. You know, we've said six felt about the right level. We've hovered around that area and we've done that in the face of tightening, which actually is generally going to put pressure on NIM. And obviously, we've been able to capture our share finance contracts while in a raised rate environment. So we've been pleased about how that's operated. Obviously as rates trend down, often there's an opportunity for a lender to enjoy stickier rates and maybe capture a little bit more. But largely, you've got an $18 billion portfolio at the current NIM. It's going to be hard to make a lot of headway against that. But we would hope that would be a tailwind for us. With regard to the loss environment, which is kind of the other end of the spectrum, I really want to point out our provision. Let's talk about that this quarter. Ultimately, if you think about it, when we set our provision and our reserve at the end of a quarter, our goal clearly is to only have to in the successive quarter set a provision for what we newly originated in that quarter. It never happens that way as you're well aware. You're going to have points where sometimes it's going to be you're going to have the ability to release loans, because release provision because performance is excellent. You're going to have in a higher delinquency environment, higher loss environment, which we're operating in right now, we've seen, you know, change that we've had to make in the $10 million, $20 million, $30 million range. Let's make clear, we felt the $52 million adjustment on the existing portfolio was outsized versus previous quarters. It was important we noted that for everyone. And we would hope that obviously we have the provision and the reserve nailed for this quarter, but it's a big deal. So the difference between the $50 million and what I would say is in the last seven, eight quarters, $10 million, $20 million, $30 million on the high side a year ago, you know, I think the $50 million is certainly more than we would hope to do going forward. So again, you've got to gauge what you think our origination volume is, the provision there, and then what the true-up is going to be. But again, I think this is outsized, hopefully, on a go-forward basis.

Yes, I think a way to think about that is, of the $50 million, probably 2025 is probably what we've seen over the past year here, I would say. So you're looking at probably like a $30 million adjustment versus what we typically would have seen on the quarter.

Very helpful. Thank you.

Thank you, Sharon.

Thank you. Our next question will come from John Murphy with Bank of America. Please go ahead.

Good morning. Maybe just to stay on credit here. I mean as you see the trajectory get a bit worse, but it's still, you know, within the bounds of normal and even the lower end of the normal range? I'm just curious how you gauge sort of absolutely how you think about this going forward or sort of the rate of change? Are there specific metrics you guys are looking at internally? I mean you kind of cited tightening in April and then tightening again during the quarter. So it seems like you're moving with this, but I mean, how do you gauge where this may ultimately land?

Yes, I appreciate the question, John. Yes, I'll point to one metric, which is, again, our reserve to receivables, which is 2.82. And I think what that number highlights, quarter-over-quarter, in the face of a provision of $50 million, which we've just said is relatively outsized, is the tightening that we've done, and you mentioned that, the tightening that we've done. We've looked at our portfolio, we've looked at where we originate, highly profitable loans, we feel good about what's on our books, no doubt about that, but we really wanted to pinpoint those receivables and those customers that we felt could sustain or really perform extremely well in a stressed environment like Rian, and we've done that, and we've tightened, and we're seeing the relative performance play through in our vintage level early looks at losses. How bad could it get? Again, hard to say. We feel good about what we have. You've seen a provision that we think really captures where we think losses are headed. We've tightened to the right pockets. It's all very, very profitable. It's the question of what loss rate are we willing to accept provision for accordingly. We have the funding we think in place to really do whatever we want to do going forward. But again, we're going to be cautious and careful and do what we think makes sense in the quarters to go. So hopefully that addresses your question.

And Jon, just to clarify, you mentioned tightening in this quarter. However, we did not implement any tightening during this quarter as we did not find it necessary. We actually tightened in the previous quarter.

Yes, thanks for the clarification. ‘23 April and ‘24 of April, we have not done anything significant since April of ‘24 and don't see anything on the horizon right now.

Okay, that's super helpful. And just one quick follow-up on the sourcing side. I mean, everybody we talk to in the industry is having a tough time finding late model vehicles. It seems like you guys did a really good job in the quarter and actually got the 31,000 out of dealers. So I'm just curious what is changing there, what Edmunds is doing to help you source from dealers, who seem like they have a pretty tight hold on these vehicles and don't want to let them go? And what kind of an impact can that have going forward? Because there is a real shortage, but you did a good job this quarter. So just trying to understand what changed.

I believe the shortage is really highlighted by the off-leash situation. I think it actually reached its lowest point in 2022. There might be a slight decrease in 2025, but then it should begin to improve. The reality is that due to our diverse purchasing strategies, including the increase in our instant appraisal offers and the MaxOffer, the Edmunds team has excelled. Year-over-year, we have about 50% more dealers actively participating than last year. Although leases have never been a major part of our sales, it's interesting that with our instant offers and MaxOffer, we have better access to them now than we did in the past, despite the lower volume. Therefore, supply has not been a significant issue for us.

Got it. Impressive in maintaining grosses. Thank you.

Thank you, John.

Thank you. Our next question will come from Brian Nagel with Oppenheimer. Please go ahead.

Good morning. Thanks for taking my questions. So I have two quick questions. I'll merge them together. First off, with regard to the improving used car unit comps, so first off, congratulations. But is there anything you could really point to in the quarter that sort of say underpins that strengthening what we've seen in prior quarters? And then the second question I have with regard to finance, you know, as you look at this, the higher loan loss provision that you took here in the fiscal second quarter, is that more a reflection of what you're seeing in your portfolio or the inputs that come as a result of your analysis of the overall environment?

All right, so I'll take the first part of that and Jon will tackle the second part. So Brian, on your first part, just kind of improvements and comps, kind of drivers. You know, I talked a little bit about this in my opening remarks. I think it's both internal things that we're doing. I also think there's some macro benefits as well. You know, from an internal standpoint, I'm really pleased with the team and the execution across the board, whether it's finding efficiencies in areas of cost of goods sold, which allow us to do different things with, better conversion in our CECs and stores. The experience, I highlighted that we got order processing. Last quarter I talked about the fact that we were testing that. We had it in some stores. We planned to get it out everywhere by the end of the year. We actually got it all out in this the very next quarter, which we're thrilled about, which really puts all of our stores, the CEC and the customer all on the same format. So it makes it much easier and seamless to go back and forth between assistance and help. So I think that's great. From a macro standpoint. Look, prices continue to come down and I think Enrique hold me on this, but I think this is the seventh quarter in a row of year-over-year price declines in our ASP…

That's right.

…which, you know, certainly they're not back to where they were, but every bit helps and then of course, you know, interest rates the future of interest rates coming down, I think will help that. We were able to source and have for sale more, less than $25,000 cars and more zero to four cars, which I think is great. And then of course, we also in this much more of a stable pricing environment. We've talked about that many times over the last few quarters about what happens when you see big price swings of which we saw two last fiscal year, one the year before. You know, we've got up and down depreciation, but it's much more normal. So I think it's a combination of things.

All right, Brian, and I'll take your second question. Basically, it was, hey, with our larger provision this quarter, but your question was, is it really on our portfolio, or is it the broader economic environment? I'm paraphrasing, but I want to be precise in my answer here. So, for Cecil and for our reserve methodology, we look at economic factors that are out there, as you might imagine, and so we weigh them into our decision. But more specifically, our adjustments are based on the observations that we have on our portfolio and the performance that we believe is broad in the industry. You take banks, obviously the ally banks of the world, other banks, other finance companies, you can see that they're citing similar performance issues. So I think it's occurring on books across the industry. We've observed it on ours. We take into account economic factors, but it's largely on us, like on us on industry performance.

I appreciate the call. Thanks, guys.

Thank you, Brian.

Thank you. Our next question will come from Rajat Gupta with JP Morgan. Please go ahead.

Great. Thanks for taking the question. Just have one clarification and another question. On the September comms, did hear correctly that you're tracking positive year-over-year same-strand basis so far?

Yes, for the September, well, really, I'm talking about the quarter trend is tracking positive for the quarter. It's in line with the second quarter. It's a little bit softer. But again, I want to point out, Rajat, that there is a day of week headwind there for sure with the one less Friday, one less Saturday, picking up at Sunday where a bunch of our stores are closed. All that will square away throughout the quarter.

Oh, so you mean for the quarter you would expect it to be positive still? You know, that was the comment you were making?

That's the current trend of sales, yes.

Okay, got it. And then just on the advertising spending, I was surprised to see a big drop there. Curious, like, is there, what's happening there? I mean, is there like some efficiency you're getting with the advertising spending? I mean, is this the right level for unit spending we should be expecting? Any thoughts there would be helpful. Thanks.

Yes, no, absolutely. I would say that, you know, quarter-to-quarter there's going to be some variation, right? But if you look at the first-half of this year, we're pretty much in line with where we've communicated is our target. And if you take a look at the back half of the year, it's going to be very similar. So I wouldn't read anything into this particular quarter with the marketing spend year-over-year on the total unit basis. It's just, you know, various within a quarter. But again, first-half of the year, pretty much in line with what our expectations are and the back half of the year is in line with what we've communicated.

Understood. Great. Thank you.

Thank you. Our next question will come from David Bellinger with Mizuho. Please go ahead.

Hey, thanks for the questions. First one, just on the worsening trends in the broader auto loan market, you've already got Tier 3 down to about a 7% penetration today. You've tightened up again. Just what's next here? You're beginning to plan the business with any type of contingencies for any potential downshift in volumes over the next few quarters? Maybe just help us think there are any further offsets or cost pullbacks you could have in a weakening credit environment?

Yes, so I guess let's speak about you mentioned the Tier 3 percentage. I think there's a couple things going on in the industry. You've got, again, worsening performance that we've talked about and, you know, CAF cited, you know, tightening. I think, again, there's tightening that has occurred across the industry as well. That's well documented too. So I think we've done a great job of absorbing that tightening. Our lenders on our book of business, we think we have the best credit platform in the industry. We have very loyal partners and they've done some tightening no doubt. Every lender is going to do their own thing, but they've done some tightening just as we have. And we don't know what they're going to do going forward. When we speak to them, they feel like they're in a spot similar to us where they feel good about what they're originating. I want to speak to your Tier 3 comment down to 7%, I think that's maybe less about the tightening. Sure, there's some in there, but a lot of the Tier 2 and Tier 3 volume being down, I think that's really an affordability challenge that we've mentioned repeatedly where the consumer that's looking to purchase that is shopping is just not in a position to pull the trigger given the payments and the situation that occurs. Some of that could be from tightening, no doubt, but if you look at the sheer price point and the monthly payment, I think that's where they're struggling. So I think that's coming from as much the consumer as it is the tightening. So I don't think...

Yes, the only thing I would add is David is that look, I think we feel great about the actions we've done. We feel great about the tightening that we've done. Our lenders and having conversations with them, they've already tightened. They feel good about the CarMax book of business. Jon talked about this lower income customer and he's absolutely right, I think where you're seeing the Tier 3 is not because of necessarily tightening. Sure, where there's been tightening, it's just an affordability issue. And when I look at lower income, household income consumers, it's still a fraction of what it used to be. So we actually think at some point that will come back.

Got it. If I could just ask one more on the digital progression tools. You mentioned order processing. I think there's a new functionality where consumers can complete a transaction from home that's stored in stores. Is that something available in every location now? And can you talk about any improvement in conversion that you're seeing early on with this?

Yes, we recently implemented the new order processing system everywhere. You're right, it has made the transition smoother whether someone starts their journey in the store or online. Previously, if a customer began online and interacted with the customer service center, it worked well since our centers were fully equipped. However, if they then visited the store, the process wasn't as smooth because the stores weren't integrated with the new system. Now, it’s uniformly available, allowing for a seamless experience regardless of where the customer starts. This change benefits not only the customers but also store associates, as they can easily see a customer's previous online activity when assisting them. Additionally, the new shopping cart feature enables consumers to view all their activities both in the store and online once they log into their CarMax account. It facilitates a continuous shopping experience and guides them on their next steps. Although it's too soon to precisely quantify the impact on conversion rates, we have seen improvements in conversions both at our service centers and stores. Overall, we believe this enhancement will lead to a better customer experience and generate positive results in the future, as consumers will continue to seek more.

Very good. Thanks, Bill.

Thank you.

Thank you. Our next question will come from Craig Kennison with Baird. Please go ahead.

Hey, good morning. Thanks for taking my question. It's somewhat of a follow-up to the last question. But online sales as a percentage of total sales moved up to 15% from 14%. I think it was stuck around 14% for a while. Where do you think that metric should be in the coming years? And then as you shift to a lower-touch process, should we start to see a benefit in unit profitability because of the low-touch nature of that transaction?

Yes. The online sales percentage increased to 15%, slightly up from 14%, which had remained steady for several quarters. I'm actually more encouraged about the two-point increase in omni-channel engagement, as most customers prefer a combination of online and in-store interactions. Even among the 15% who made purchases online, the majority still chose to pick up their items in-store to discuss details. From an efficiency perspective, encouraging more self-service from customers is a positive development, and I'll let Enrique elaborate on that.

Yes, as I mentioned in my prepared remarks, we're really excited about the progress that we've made on our omni selling model as compared to their pre-omni time period, not only from a year-over-year basis but also relative to pre-omni this quarter, we're actually more efficient on those key metrics, right? So the key metrics that we've been talking about consistently here for a while is on a per total unit basis, on a per gross margin basis. And then also on a per retail unit basis, which we were more efficient. So we had committed to making progress on that and being as efficient and even more efficient and we're delivering on that and that should continue to accelerate here in an environment where sales come back and we should continue to see that flow through. So we're really, really pleased.

And Bill, just to push back on your point, customers that wanted purely digital experience really only have a couple of choices, you and a top competitor. And I would think that your perspective is you should have your fair share of that. Do you think you're getting it?

Yes. I don't have a specific target for whether customers want to shop entirely in-store or a mix of both, which is really the essence of an omnichannel approach. We aim to provide the best process for all three methods. We're flexible regarding how they choose to shop. I'm pleased that 15% prefer that method, but we don't impose a specific way on them. I definitely want our fair share, but I'm also okay if they decide to come in or shop entirely in-store.

That’s fair. Thanks, Bill.

Thank you, Craig.

Thank you. Our next question will come from Scot Ciccarelli with Truist. Please go ahead.

Good morning, guys. Apologies in advance for another finance question. Previously, you guys had been lowering provisions despite higher delinquencies. And I know, Jon, you were talking about a lot of different factors that you guys consider, but was the provision change based primarily on delinquencies increasingly converting into write-offs in your book? And then related to that, with delinquencies hitting 8% rates on your subprime after about three months. What are your initial loss expectations for the subprime pools? Thanks.

Sure. Yes. In response to your first question, our provision is influenced by our origination mix, which varies in its levels of provision over time. There's an additional factor to consider. We have been increasing volume based on the performance we've observed, particularly regarding delinquency levels. In any given month, we had seen our customers managing their delinquency well; they might fluctuate, but they were not defaulting at the historic rates we observed five or ten years ago. This indicated that they were navigating the current environment quite effectively. This quarter, however, we noticed a slight decline in that performance, which is why we made a significant adjustment. Our approach is always informed by the performance we see, alongside external economic factors, although the main driver is the operational performance. We are confident in our current reserve, and while the adjustment was significant, it was necessary to reflect the performance accurately. We believe our tightening measures will help avoid the need for further adjustments in the future.

Yes, and Scot, I mean, I think that's a fine point that I want to make sure I kind of reinforce in that just, because you're lowering the provision in the previous month, it doesn't mean you're not doing true-ups. We were doing true-ups. In just the origination piece just speaks to the tightening that we've been doing. So again, I just want to make sure that point resonates with everyone.

Okay. And then I'll touch on your last question. I think you spoke about the subprime. So let's just talk about the different pockets. And again, it's more of a continuous rather than this sort of discrete the way I'll describe it. But the Tier 1 book of business, obviously, we've cited that as our bread and butter. That is where we have operated historically. It has been that 2% to 2.5% loss range. Obviously, we're excited about getting more full spectrum. We've operated in the Tier 3 space we've said certainly at higher loss level. It's been way back in the day, it was maybe 1% of our portfolio, but 10% of our losses. So you can do the math there on loss level you'd expect. And then Tier 2 is somewhere in between at different continuums. So when we look at a higher delinquency book, it is something that we manage. We believe it's highly profitable. We provide a great credit offer to the customer. I think for an earlier question, we'll go in that space when we think it makes sense and with the volume it makes sense, we're just excited for the flexibility to be able to do it, have the models that we're going to own to be able to do it. And again, we think it's just good business to be a part of.

Great. Thanks a lot, guys.

Thanks, Scot.

Thank you. Our next question will come from Chris Pierce with Needham. Please go ahead.

Good morning. I have two questions. First, do you believe that CDK contributed to the performance this quarter since more independent dealers tend to utilize their software? Second, regarding gross margins, you've mentioned both challenges and benefits. I would like to understand the best way to evaluate these factors moving forward.

Okay. On the CDK, look, I don't think it really had any material impact. I think a lot of dealers had some workarounds plus, if I just look at our comp cadence through the quarter, it got better each month. So August was over July, and I think CDK kind of worked itself out through that point. So that's why I just don't think it had a material impact. And then what was your second question?

Other gross margin.

Other gross margins, yes, it's been trending quite positively. And then we had the EPP tailwinds, but you called out some equipment headwinds I just want to kind of the right way to think about it, if I heard that right.

Yes, absolutely. We are really pleased with our performance, and other gross margin increased by $36 million this quarter, marking a 33% year-over-year rise driven by two main components. Service continues to improve year-over-year, which we committed to at the start of the year. I expect this improvement to continue in the latter half of the year, although it is somewhat dependent on sales due to leverage and deleverage factors. Overall, I anticipate continued year-over-year improvement. As for EPP, we also see ongoing enhancements. I expect this because it involves margins that we established in earlier periods, so we should see an increase in Q3. In Q4, we will begin comparing against some margin testing we conducted last year, but I still anticipate favorable results year-over-year. Therefore, we are optimistic about our other margin performance. In my prepared remarks, I mentioned a potential impact of up to $10 million, which would not be included in gross margin but rather in other income and expenses—specifically, a non-gross margin, non-SG&A effect. This is mainly related to a potential charge as we optimize our logistics network, evaluating both our associates and our trucks. We need to ensure we have the correct number of trucks ourselves and that our dedicated partners also have the appropriate number, and we expect there might be a charge-off involved, though we are still assessing this. This would be a one-time impact, and I wanted to highlight this for the third or fourth quarter.

Perfect. And then just one last one. We've seen strength in the wholesale market kind of non-seasonal strength. I don't think used car retailers have much pricing power right now. So how should we think about GPUs from here? Could there be modest GPU compression around that? Or am I overreading into a month of strength in the wholesale market?

You mean are we thinking that our GPU would come under strain going forward? Is that the question?

Yes, it has become more expensive for used car dealers to purchase cars in the wholesale market, and their pricing power is somewhat limited at the moment due to current affordability conditions.

Our self-sufficiency in purchasing through the appraisal lane and dealers exceeds 70%. This significantly contributes to our ability to secure supply. I'm very pleased with our wholesale business, as the team is performing exceptionally well. Furthermore, the ratio of dealers to cars continues to improve, which is advantageous for managing our margins and providing competitive offers to customers for their vehicles. Therefore, I believe concerns about supply are unfounded since our high level of self-sufficiency has kept us from encountering any issues.

Okay. Perfect. Thank you.

Thank you.

Thank you. Our next question will come from Chris Bottiglieri with BNP Paribas. Please go ahead.

Hey guys. This is Ian Davis on for Chris. Thanks for taking the question. Another one on credit, but hopefully a little bit more high level. One of your peers, online peers has been able to meaningfully expand their credit penetration at a level that we would estimate to be in the mid-80s versus your low-70s today? So acknowledging some of the conditions in the current environment that you've alluded to previously, what are the constraints that prevent you from getting to those levels today? And maybe what could you tell us about the makeup of the other 30% of customers that aren't procuring financing from CarMax for your lending partners?

Certainly. We aim to be a full spectrum lender, ensuring all customers have access to credit. This is why we have a diverse range of lenders on our platform, enabling us to provide competitive credit offers across the spectrum. Our intention is to serve all customers, not just those at the lower or higher ends. Consequently, we have more lenders involved, and we believe everyone stands to benefit from CarMax. Our partner lenders also seek volume, and while we see potential for growth, our priority remains offering great options to all customers within the credit spectrum. Regarding what hinders CAF's meaningful growth, we are enthusiastic about growing when it's appropriate, but we don’t want to focus on just one segment. We aim to make offers across Tier 2 and Tier 3 while staying true to our Tier 1 identity. You mentioned customers who choose not to finance through CarMax and opt for third-party options. These customers tend to be higher-end consumers who prefer to pay cash upfront to avoid higher interest rates. Many of them are connected to credit unions, which operate at a cost advantage and are very sensitive to rates. Competing with these options can be challenging for CAF. However, as we continue to target these consumers, we anticipate that more than 30% of our financing this quarter will come from external sources. This percentage should decrease as more lower-income consumers return, ultimately expanding our overall volume and reducing reliance on external financing. I hope that addresses your question comprehensively.

Yes. I'm going to add a little bit more to that answer, which is, look, we could absolutely go there tomorrow. We would just limit the number of partners, we wouldn't allow three-day payoffs, but in reality, when you sell this many cars to the wide spectrum, especially your rate-sensitive customers, having more partners for lots of reasons is a great thing. Now do we have an opportunity to continue to increase our penetration? Absolutely. And we absolutely will over time. But I think you have to do it in a thoughtful way, especially as your volume grows.

Got it. Really appreciate the answers from both of you.

Thank you. We'll take our next question from John Healy with North Coast Research. Please go ahead.

Thanks for taking my question. Just wanted to ask just one big picture type question. You guys have talked about doing some things on the logistics side, which kind of gets you to where you want to be? But I haven't heard a lot of talk about the recon side of things. And I was just curious if you could address that if you're kind of happy with the state and approach to reconditioning and the ability to get a solid margin out of the business? Or are you maybe rethinking or retooling some things there in the background? Thanks.

Yes, John. This is a key area for us, and I mentioned it last quarter. I provided a high-level overview without specific examples, but I’m confident about the initiatives we're implementing in reconditioning. The key distinction between reconditioning and logistics is that reconditioning involves many smaller improvements adding up. We're seeing notable advancements in parts utilization, whether OEM or non-OEM, and making informed decisions on when to replace components. We're also bringing more operations in-house to reduce outsourcing, improving capacity utilization and overall store performance within a reasonable timeframe. All these efforts will contribute to the internal goals we've previously discussed. Last quarter, I noted that we’re targeting several hundred million dollars at the intersection of reconditioning and logistics, which is significant. This progress allows us the flexibility to choose how to allocate those gains, whether to reduce prices for customers or enhance margins. We're optimistic about our advancements in both logistics and reconditioning, and we anticipate further benefits over the next year.

Got it. And just one initial question for me. I think ad expense, advertising expense was actually down year-over-year for you guys and the comps were up. So just kind of wondering if there was some timing thing there or if you guys are maybe holding back or changing the way you're thinking about ad spending? Thanks.

Yes. No, it was purely timing. If you look at the first half of the year, we're pretty much on course for what we had communicated was the target for the year. And so the first half of the year, I expect it's going to be similar to the back half in terms of the per total unit spend. So it was purely some timing in the second quarter.

Great, thank you.

Thank you. We'll take our next question from David Whiston with Morningstar. Please go ahead.

Thanks. Good morning. Wanted to go back to that explanation on the other financing channel. You said that they're very interest rate sensitive consumers, but you also said that they're more able to pay cash. So are most buyers in that bucket? Are they more budget conscious or are they more wealthy or unable to pay cash? In other words, are they borrowing more? Or are they just more cash buyers?

Yes, that consumer is typically our higher-end consumer. They are often coming in with an affinity check from their bank or credit union, and they tend to be very sensitive to rates. However, the majority of their transactions involve cash in some form. This could be through TrueCash, home equity loans, or personal loans. These individuals generally have the financial means to avoid higher interest rates currently available. While you will find such cash users in various interest rate environments, they are particularly sensitive to rates in the present climate.

I'm feeling like we're on the pace that we communicated, and I would expect to continue to see that pace for the balance of the year.

Okay, thank you.

Thank you. At this time, I'm showing no further questions in queue. I'll turn the call back to Bill for any closing remarks.

Great. Thank you, Todd. Listen, I want to thank everybody for joining the call and your questions and your support, obviously. We feel good about our progress. Also, I just want to share my thoughts are definitely with our associates and their families and the communities as Hurricane Helene approaches we have a number of stores in the storm's path, and as always, the safety of our associates is our top priority to those associates and everyone that's been impacted, please stay safe, and we will talk again next quarter. Thank you.

Thank you. Ladies and gentlemen, that concludes the second quarter fiscal year 2025 earnings release conference call. You may disconnect your line at this time and have a wonderful day.