AutoZone F1Q08 (Qtr End 11/17/2007) Earnings Call Transcript

AutoZone, Inc. (AZO)

F1Q08 Earnings Call

December 4, 2007 10:00 a.m., ET

Executives

William C. Rhodes, III – Chairman, President, Chief Executive Officer

William T. Giles – Chief Financial Officer, Executive Vice President – Finance, Information Technology, and Store Development

Analysts

Tony Cristello – BB&T Capital Markets

Seth Schiesel – Credit Suisse

Gary Balter – Credit Suisse

Matthew Fassler – Goldman Sachs

Danielle Fox – Merrill Lynch

Gregory Melich - Morgan Stanley

John Lawrence – Morgan, Keegan and Company

Dan Wewer – Raymond James

David Cumberland – Robert W. Baird & Company

Matt Nemer – Thomas Weisel Partners

Peter Benedict – Wachovia Capital Markets

Presentation

Operator

(Operator Instructions) This is the conference call to discuss AutoZone’s first quarter financial results. Mr. Bill Rhodes, the company’s chairman, president, and CEO, will be making a short presentation on the highlights of the quarter. The conference call will end promptly at 10:00 a.m. Central Time, 11:00 a.m. Eastern Time.

Before Mr. Rhodes begins, the company has requested that you listen to the following statement regarding forward-looking statements.

Unidentified Speaker

Certain statements contained in this presentation are forward-looking statements. Forward-looking statements typically use words such as “believe,” “anticipate,” “should,” “intend,” “plan,” “will,” “expect,” “estimate,” “project,” “positioned,” “strategy,” and similar expressions. These are based on assumptions and assessments made by our management in light of experience and perception of historical trends, current conditions, expected future developments and other factors that we believe to be appropriate.

These forward-looking statements are subject to a number of risks and uncertainties, including without limitation: competition; product demand; the economy; credit markets; the ability to hire and retain qualified employees; consumer debt levels; inflation; weather; raw material costs of our suppliers; energy prices; war and the prospect of war, including terrorist activity; availability of consumer transportation; construction delays; access to available and feasible financing; and changes in laws or regulations.

Forward-looking statements are not guarantees of future performance and actual results; developments and business decisions may differ from those contemplated by such forward-looking statements, and such events could materially and adversely affect our business. Forward-looking statements speak only as of the date made. Except as required by applicable law, we undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. Actual results may materially differ from anticipated results. Please refer to the Risk Factors section of AutoZone’s Form 10-K for the fiscal year ended August 25, 2007, for more information related to those risks.

In addition to the financial statements presented in accordance with Generally Accepted Accounting Principles, AutoZone has provided metrics in this presentation that are not calculated in accordance with GAAP. For a reconciliation of these metrics, please see AutoZone’s press release in the Investor Relations section at www.autozoneinc.com.

Operator

Mr. Rhodes, you may now begin.

William C. Rhodes, III

Good morning and thank you for joining us today for AutoZone’s fiscal 2008 first quarter conference call. With me today is Bill Giles, Executive Vice President and Chief Financial Officer, Store Development, and IT, and Brian Campbell, Vice President, Treasurer, Investor Relations and Tax.

Regarding the first quarter, I hope you’ve had an opportunity to read our press release and learn about the quarter’s results. If not, the press release, along with slides complementing our comments today, is available on our website, www.autozoneinc.com. Please click on quarterly earnings conference calls to see them.

To begin, I’d like to thank our entire organization, all 55,000 AutoZoners, for their significant efforts that delivered another record earnings quarter. It is their commitment to providing outstanding customer service that leads to our success. While we are proud to say we’re the nation’s leading retailer and a leading distributor of auto parts, that moniker does not come without the hard work and dedication of our AutoZoners.

As we began fiscal 2008 in September it was important for us to build on the initiatives that were implemented in 2007. Specifically, to gain traction on the additional parts coverage addition, our new Z-net electronics parts catalogue, our increased focus on continuous customer service and cultural training, and our increased attention to making sure our stores look great.

We expected sales momentum for these initiatives. We expected traction in both our DIY business and commercial business. In fact, we had just finished a quarter of positive sales growth in commercial – the first one in a couple of years – and, while we were encouraged by the early traction we had made, we knew we had much work to do.

I’m happy to say this morning we have made strides in building upon last year’s momentum. We believe we improved the shopping experience for our customers. We feel we have continued to improve our parts offering and we’re beginning to gain traction in our commercial business. We continue to believe if we remain focused on living our pledge to provide wow customer service every day we’ll continue to succeed well into the future.

I believe we have great brands, a great company and, most importantly, great AutoZoners executing our plans who provide our customers with the trustworthy advice they need to maintain and enhance their vehicles.

We have had numerous inquiries regarding the external challenges facing the U.S. consumer and the potential negative ramifications that has on our business. We have expressed in the past that we have seen a negative impact on our sales when there has been a significant increase in gas prices. That impact has historically been reflected in a low-single-digit percentage impact on our same-store sales.

Additionally, there are certainly other macro-challenges facing the U.S. consumer today, but we want to reiterate that historically we have not been able to develop a statistical correlation between macro-challenges and our sales performance. The two factors that we believe impact our business over the long term the most are the number of vehicles on the road, more specifically the number of seven-year-old and older vehicles and miles driven.

We certainly remain mindful of other developments, but we believe the most important determinant of our future success is our strategies and, more specifically, our execution of those strategies.

For the quarter, our retail sales increase 3.6%. The additional parts coverage we added in 2007 was a key contributor to this increase. We continue to evaluate the decisions we made last year, our first year utilizing this new approach, and continue to refine our decision-making processes to improve our product assortment.

Our commercial business continued to build on last quarter’s modest sales gain and we are encouraged by our 4.3% sales increase in this business during the first quarter. As we transitioned away from our supply chain relationship with Midas, which occurred at the end of June, we were pleased to overcome that headwind and more than offset that loss of business. Our commercial customers have responded positively to the many initiatives we implemented last year and specifically to the substantial improvement in our parts coverage. We believe we can continue to gain sales traction in this business going forward.

This morning we would like to communicate three key things about AutoZone and our business. First, we are encouraged by the progress we are making on our initiatives. We believe that the customer experience in both our retail and commercial businesses is improving and we are well positioned to continue to profitably grow these businesses well into the future.

Second, as I mentioned before, there are certainly macro-challenges that appear to be impacting the U.S. consumer. We are aware of those factors and continually monitor them. Will these factors negatively impact our business? Only time will tell. However, we believe the most important factor that will continue to determine our success is how we manage this business.

Third, we want to reiterate our commitment to managing the business with an eye on continuous improvement. We are committed to investing in our most important assets: our AutoZoners and our stores. We are committed to ongoing training for our AutoZoners, as well as investment in merchandise additions and store presentations to improve our customers’ experience and grow our sales. We measure our efforts through customer surveys and focus group research. Our results continue to confirm and reaffirm that we are on the right path.

For the agenda this morning, I will review our overall financial results and then go into detail regarding our DIY sales initiatives, commercial initiatives, and Mexico. Bill Giles will then provide more detail on our earnings performance, as well as an overview of both our balance sheet and cash flow segments for this past quarter. Finally, I’ll provide a few closing comments.

Regarding the first quarter for the 12 weeks ended November 17^th, we reported sales of $1.456 billion; an increase of 4.5% from last year’s first quarter. Same-store sales or sales for stores open more than one year, were up 1.3% for the quarter. We were pleased with the modest improvement in our sales trends and specifically pleased with the improvement in our commercial performance.

In the first quarter, gross profit as a percentage of sales was up 71 basis points versus last year’s quarter while operating expenses as a percentage of sales increased by 41 basis points. This resulted in an operating margin of 16.3%; up 30 basis points from last year’s quarter. Operating profit increased to 6.4% versus the prior year.

Net income for the quarter was $133 million and diluted earnings per share increased 17.4% to $2.02 from $1.73 in the year ago quarter. Our disciplined capital management approach resulted in return on invested capital for the trailing four quarters of 23.0%. This was a solid increase versus last year’s first quarter. Return on invested capital is a key measure of our success. We have and we will continue to make investments that we believe will generate returns that significantly exceed our cost of capital. We will not deviate from our efforts to optimize shareholder value over the long term. We continue to be fiscally prudent with our investments while optimizing our earnings per share.

Now I’d like to talk about our DIY sales results. Total domestic retail sales were up 3.6% for the quarter. During the first quarter we continued to focus on driving sales and profits for the long term.

During the quarter, as is customary, we experienced regional discrepancies in our sales performance, both positive and negative. However, nothing was material enough to highlight.

Last year we discussed our organizations focus on living the pledge. In fiscal 2008 the theme of our operating plan is customers first; the most important element of the first line of our pledge. We held our national sales meeting back in September. Then for the balance of the quarter we held regional meetings with our store management team and witiger (sic) meetings in all our stores to convey our plans for 2008. Once clear theme of our meeting was “we have what we need to succeed.”

In support of this message, we shared the performance of our President’s Club winners, the top 5% of our store managers. This year we invited all of our President’s Club winners to the national sales meeting and shared how these leaders excelled in virtually every critical measurement we have. From sales to turnover to customer satisfaction scores and more, these leaders delivered superior performance. This evaluation again revealed to us the importance of continually enhancing our AutoZoners leadership capabilities and, as a result, we are enhancing our leadership training.

Secondly, we continue to focus relentlessly on improving our parts assortment. As mentioned before, we are in the second year of using our new parts assortment tool. We have learned a great deal from last year’s implementation, both our successes and our mistakes. During the first quarter we implemented product assortment changes in 11 of our categories. We are encouraged by our results to date and excited by the differences our future enhancements can make. We remain committed to refreshing our product assortment on a routine basis as this is critical to keeping our product assortment relevant to the ever-changing vehicle demographics in each store’s trade area.

Also during the quarter we offered some compelling promotions that we believe contributed to our sales growth. We will continue to focus our marketing efforts on communicating trustworthy advice, great value, and quality products to our customers.

During the quarter we continued to improve the capabilities of our new parts catalogue, Z-Net, and continued to highlight this terrific customer service enhancement in our marketing campaign. We believe Z-net is gaining traction with our customers as we are able to provide better, more comprehensive information to our customers and assist them with their needs more quickly.

Additionally, we continued with our efforts to ensure our stores looked great through improvements in merchandise placement and routine maintenance. We believe the appearance of our stores, both internally and externally, are continuing to show significant improvement.

For the first quarter we experienced a subtle shift towards application or hard parts. We believe weather was a major contributor to this shift. Specifically, certain product categories that respond to wetter or colder weather, like antifreeze and windshield wipers, were below prior year levels, while other hard part related categories benefitted from the warmer, drier weather. We expect these categories will revert to more normalized trends as the seasons change.

Regarding macro-trends, during the first quarter gas prices started out high at $2.75 a gallon and went up from there, finishing the quarter at $3.11 a gallon. Unfortunately, we cannot control the prices of gas at the pump. However, with more vehicles on the roads than ever before our ability to grow sales remain strong over the long run and we believe consumers will ultimately adjust their spending habits for the higher prices. We will continue to develop marketing programs that support our customers’ needs during these high-priced times. For the quarter, gas prices had a modest negative impact on our sales performance.

Regarding miles driven, we saw a slight increase in miles driven in July and August and then a decrease in September. Let me reiterate, the two statistics we’ve always felt have the closest correlation to our market growth: miles driven and the number of seven-year-old and older vehicles on the road. While miles driven have been challenged recently, there are more registered vehicles on the road today than in our country’s history.

For the quarter we estimate that weather had a modest positive impact on our sales. However, as our footprint is national, any regional differences in weather patterns are muted and weather differences will certainly normalize over the mid to long term.

Regarding pricing across the industry, we have not seen any material change in the competitive landscape. Overall, consumer price inflation in Q1 remained in the low single-digit range.

For the trailing four quarters, sales per square foot were $238. This statistic continues to set the pace for the rest of the industry.

Now let’s turn to commercial. For the quarter, total commercial sales posted an increase of 4.3% versus last year’s quarter. We now have the commercial program in 2,188 stores supported by 133 hub stores. We are in encouraged by the progress we are making on our commercial initiatives and by the initial response we are seeing from our customers’ purchasing habits. However, there is still much work to be done.

Over a year ago we talked about our new test stores. Those stores have continued to experience stronger sales performance than our other commercial programs. We have continued to implement these enhancements in more stores and today we have over 900 stores with additional tools at their disposal. However, we continue to be methodical in our approach, ensuring our activities are improving our customers’ experience and ultimately lead to sustained improvement in our business performance.

What we’ve been doing with this business is relatively straightforward as it has taken time to both maintain and gain traction. It has really been about focusing on profitable growth. To that point we’ve focused on the key drivers. First we identified the customers that we could most effectively and profitably serve. Those within a reasonable distance of our stores.

Second, we focused our efforts on the categories that were most important to our customers and their business success, which is of course hard parts. This included the substantial addition we made to improve our late model inventory coverage. We are still in the early stages of this initiative, but it has clearly made a difference for us. To succeed in this business, we must leverage our strengths to deliver a proposition our customers’ value, and that will continue to be our focus.

Third, we are committed to allocating resources to properly support this business. For example, we have provided compelling professional marketing materials to our sales force. Previously, our efforts on customer communication were primarily locally driven. There were minimal comprehensive, cohesive efforts to develop and deliver a compelling offering and related messaging to our customers. We began implementing this new approach about six months ago and we have received positive feedback from our customers and from our AutoZoners. Additionally, our business has improved in the product categories that have received this additional focus.

As we have significantly improved the basic elements of our offering, we have added focus on developing our sales force. Our heritage as a company has been as a retailer, where our marketing efforts have been primarily focused on media. However, the commercial business requires a different approach. We have to develop a direct sales approach and sales force. Over the last several months we have worked diligently to develop and implement direct sales force training, materials, and processes. We are pleased with the progress to date, but have significant additional progress left before we reach our goal of developing a world-class commercial sales force.

Finally, we remain committed to building this business for the long run. We are not interested in driving short-term sales results at the expense of profits. We believe all the items we’ve been discussing are building momentum. Each of these pieces must work in a cohesive manner for us to not only attract new customers, but improve our penetration with our existing customers.

Now let’s turn to Mexico. Our Mexico stores continue to perform well. We opened one new store during the first quarter. We currently have 124 stores in Mexico. Our ongoing commitment remains to prudently and profitably grow the Mexico business.

Now I’ll turn it over to Bill Giles to discuss the remainder of the income statement, cash flows, and balance sheet. Bill?

William T. Giles

Thank you, Bill. I’m going to start off with the gross margin. The gross margin for the quarter was 49.9% of sales, up 71 basis points compared to last year’s first quarter. In the first quarter margins continued to benefit from our ongoing category management initiatives, direct import efforts, and slight sales shift mix toward higher-margin application parts and away from cold weather-related sales of lower margin products.

Over the last several quarters these efforts have been partially offset by an increase in product costs, specifically related to oil-based products and other commodities. We continue to focus on ensuring we offer the right products as the right prices to our customers. This includes supply chain initiatives, tailoring merchandise mix, and the continued optimization of our good-better-best product lines – all allowing us to price our products appropriately while giving our customers great value. Our Duralast and Duralast Gold product lines continue to show sales increases for the first quarter. Our customers continue to recognize the benefits from buying our better and best merchandise lines.

Going forward, we believe there continues to be opportunity for gross margin expansion, albeit at reduced rates. Our direct import initiative is in its early stages, but we are pleased with the progress our merchandising organization has made to improve margins while pressures on procurement costs continue to exist.

SG&A for the quarter was 33.6% of sales, up 41 basis points from last year. Our deleverage came primarily from continued higher occupancy costs. Specifically, rent and depreciation were approximately 30 basis points higher than last year’s first quarter. We also experienced slight deleverage due to continued investment in our existing store base and in improving our customer service offering. At the same time, we continue to invest in additional marketing efforts and training programs for all AutoZoners in order to improve customer service.

As I have mentioned before, the AutoZone culture of thrift and focus on cost management is an integral part of our ongoing business model. We believe our efforts on improving customer service implemented during the quarter will pay dividends into the future from a sales perspective.

While our expenditures this past quarter were slightly higher than past quarters, we feel very comfortable those dollars were invested in order to harvest future sales growth. Over the long run we continue to believe we can leverage operating expenses on a 1.5% to 2% same-store sales growth rate.

EBIDT for the quarter was $237 million, up 6.4% over last year. Interest expense for the quarter was $28.1 million compared with $27.1 million a year ago.

Debt outstanding at the end of the quarter was $2.161 billion or approximately $300 million more than last year. The increase in interest expense reflects primarily the higher level of debt. We expect interest expense to remain higher than the previous year due to higher debt level. Our adjusted debt level at 2.2 times were higher than our normal guidance of 2.1 times our trailing 12-month EBIDTAR.

Let me take a moment here and discuss our company’s decision to adjust our metric this past quarter. This was purposeful, however not permanent. We expect to return to 2.1 times adjusted debt to EBIDTAR by the end of our fiscal year in August 2008. This effort was driven by opportunistic timing on cost of borrowings, as well as, in our opinion, an attractive stock price. Again, our expectation is to return to our 2.1 times metric by the end of our fiscal year. We purposely manage our capital structure relative to our cash flow in order to maintain our credit ratings at investment grade while optimizing our cost of capital.

Turning to taxes, for the quarter our tax rate was 36.7%, below last year’s rate of 36.8%. We expect to run approximately a 37% tax rate for fiscal 2008.

Net income for the quarter of $133 million was up 7% over the prior year. Our diluted share count of 65.4 million was down approximately 9% from last year. A combination of these factors drove earnings per share for the quarter to $2.02, up 17.4% over the prior year.

I would like to take a moment to remind everyone that our 2008 fiscal year has an extra week in it. Every six years or so our fiscal year has this 53^rd week in the fourth quarter, so at the end of this fiscal year we’ll be talking to you about EPS numbers that include an extra week. So we encourage everyone to model with this extra week taken into account. At the time of reporting we will break out the impact this extra week had on our business.

Relating to the cash flow statement, in the first quarter we generated $171 million of operating cash flow and we repurchased $350 million of AutoZone stock as part of our ongoing stock repurchase program. As stated previously, we remain committed to our targeted adjusted debt to EBIDTAR guidepost as 2.1 times and we expect to return to that metric by the end of the fiscal year.

For the first quarter of this year we reported an industry-leading return on investment capital of 23%. We’re proud to report that this metric continues to improve over last year’s already industry leading rate.

Finally, I’d like to take a moment and update you on our inventory levels in total and on a per-store basis. We reported an inventory balance of $2 billion, up approximately 9% versus the Q1 ending balance last year. This year’s inventory balance includes approximately $60 million in additional inventory carried under our pay-on-scan initiative last year. We have slowly reduced this balance in recent years.

On a per-store basis we reported $507,000 per store versus $503,000 in last year’s first quarter; an increase of less than 1%. Also, keep in mind that we have had added additional parts coverage throughout our category line review and if it had not been for our diligent work on rationalizing certain unproductive inventory we could not have freed up the space that we needed for our additions. This effort on parts additions will continue for the foreseeable future and will allow us to say yes to our customers even more.

Accounts payable as a percent of gross inventory finished the quarter at 90% compared to 88% last year. Total working capital was less than $1 million versus last year’s balance of $110 million. We will continue to focus on minimizing working capital as this past quarter reflects. We are committed to continuing our ongoing focus on increasing cash flow.

Net fixed assets were up 4.4% versus last year. Capital expenditures for the quarter totalled $45 million and reflect the additional expenditures required to open 44 new stores this quarter, maintenance on existing stores, and work on development of our new stores for upcoming quarters. Specifically related to new store openings, our new stores are on track to achieve at least a 15% IRR and we continue to see ample opportunity to open stores in the U.S. at a mid-single-digit growth rate for the foreseeable future.

We opened 40 new stores in the quarter for a total of 3,972 stores in 48 states, the District of Columbia, and Puerto Rico. Our goal remains to open stores more evenly throughout our fiscal year. We also relocated three stores this past quarter and we continue to see opportunities to expand this initiative in the future.

Specifically, we’d like to address the question of self-cannibalization by opening a new AutoZone store near an existing store. We frequently are asked if we caused the most challenged store same-store sales growth. Simply stated, we have not. We calculate our self-cannibalization rate during the evaluation stage of our approval process for all new stores. While certain stores do cannibalize existing stores, the impact of the cannibalization is typically small and this cannibalization impact is excluded from the new store’s sales project to ensure our new store pro forma meets our internal return hurdle rate.

Depreciation totalled $40 million for the quarter; higher than last year due primarily to new stores and the accounting for new capital leases initiated at the beginning of Q1 last year.

AutoZone continues to be one of the few players in our industry to have investment grade debt ratings. Our senior unsecured debt rating from Standard and Poor’s is DDD+ and we have a commercial paper rating of A2. Moodys investor service has assigned us a senior unsecured debt credit rating of DAA2 and a commercial paper rating of T2. We continue to be comfortable with our long-term debt ratings and leverage ratios.

Now I’ll turn it back to Bill.

William C. Rhodes, III

Thank you, Bill. While we are certainly pleased to report record earnings and earnings per share for the quarter, we know we still have substantial opportunities for improvement. We understand our success is driven by our customers’ daily experience with us and we must continue to enhance this experience. We continue to see our customers being more cautious with their buying habits, however we believe if we focus on the basics of our business we will continue to be successful. We believe that we can drive results in this business, even with the macro-challenges our customers are facing.

Our story remains one of steady, profitable sales improvement. We are about staying focused while making methodical improvements in our model so we remain well positioned for the future. We continue to feel confident in our long-range plans. We believe we have significant opportunity for growth in all three key business priorities: retail, commercial, and Mexico.

Two-thousand-eight will be about refining our hard parts assortment to increase our ability to say yes. In fact, we have a tremendous opportunity to increase our yes percentage to both our retail and commercial customers.

This year will also be about testing enhancements to our hub store network to make late model parts coverage more accessible to our stores and customers. We believe this optimization can help us improve the productivity of our inventory while making more merchandise available where it counts – at the store.

Lastly, 2008 will be about growing our commercial business. Customer service will always be our corner stone to improving our customer relationships and our entire company is committed to providing that wow customer service our patrons have grown to expect.

We will focus on improving the trustworthy advice our AutoZoners deliver through enhanced training for our AutoZoners and providing them the tools they need to succeed.

As we continue to demonstrate industry leading financial metrics we remain diligent stewards of our investors’ capital. We continue to remain focused on optimizing long-term shareholder value. We will maintain our cost disciplines while investing incrementally in initiatives that exceed our stated 15% after-tax IRR hurdle rate.

I thank you today for letting us share with you our company’s results and touch on our ongoing initiatives. We look forward to keeping you abreast of our results well into the future. Now we’d like to open up the call for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Dan Wewer, Raymond James. Your line is open.

Dan Wewer – Raymond James

Thanks. Bill, the growth in your commercial business does not appear to be impacting your gross margin rate. Could you remind us of the margin differential between do-it-yourself and do-it-for-me segments?

William C. Rhodes, III

Yeah, what we have said over time is that there’s certainly margin, that that business operates at a lower operating margin than the retail business and it does have lower gross margins, but not that drastically lower.

Dan Wewer – Raymond James

Second question. As I recall, you added about $70 million of inventory for the expanded coverage. Have you had a chance to look at the incremental turns and gross margin rate on that added inventory?

William T. Giles

We have. In fact, we feel good about the productivity of that $70 million worth of additions. We think that is contributing in part in addition to excellent customer service to the improvement in overall sales growth. So we continue to monitor it and, as you know, we have a very disciplined approach about how we’re going through our category line reviews, as Bill mentioned during the call, and we’re going to continue that and we expect to continue to expand our parts coverage. At the same time we’re going to continue to be very diligent about rationalizing out our unproductive inventory to keep our inventory overall in check. But so far we’re pleased with the category line reviews that we’ve done, the additional inventory that we’ve added into the stores and into the chain. It’s improving both our commercial business and we think it’s also improving some of our DIY business, as well.

William C. Rhodes, III

And Dan, if you don’t mind me adding on to that, this is the first year that we’ve had this new tool. As I’ve said in the script, we’ve made a lot of good decisions, but we’ve made some bad ones as well. Now that we’re going through the second year of that we’re able to refine those decisions and expect to continue to improve those decision-making processes as we go forward.

Dan Wewer – Raymond James

Let me just say, the last question I had, you just highlighted the weather benefits to margin rate. As that begins to normalize what would be the impact on margin? Or in other words, you know, how much would you guesstimate was the benefit in Q1?

William C. Rhodes, III

Yeah, we quantify specifically other than to say that clearly we had some benefit in gross margin rates from having some of the colder weather lower product margins businesses pushed out a little bit. So that’ll come back to us a little bit in the next quarter.

Dan Wewer – Raymond James

Okay, great. Thanks. Good luck.

Operator

Our next question comes from Gary Balter, Credit Suisse. Your line is open.

Seth Schiesel – Credit Suisse

Good morning. It’s actually Seth Schiesel for Gary.

William T. Giles

We wouldn’t have it any other way.

Seth Schiesel – Credit Suisse

Congratulations on a strong quarter, gentlemen. A couple questions for you on the commercial side. You’ve talked in the past about the number of test programs you have. Can you update us on that? And if you built a better mousetrap now where do you expect that number to go over the course of this year?

William C. Rhodes, III

Seth, as I said in the script, we have over 900 stores that are now on that “test program.” We don’t really view it as much about a test now as those stores are operating with a different model than the other ones.

I also said that we’re going to be methodical about it. One of the things we’ve done in the commercial business is we’ve had some fits and starts over the years since we started this business in 1996. We are very committed to making sure that we continue to stay the course and be methodical with how we roll this out. Over time, you know, we do look to roll this new program and its enhanced tools to more and more stores over time. Will we ever get to all stores? I think that’s yet to be determined.

Seth Schiesel – Credit Suisse

Okay. In terms of the number of feet on the streets, so to speak, the sales force, what kind of numbers are we talking about there now and how much do you expect to expand that?

William C. Rhodes, III

Well, we haven’t quantified the number of people, but it’s directly related to the number of stores that are on the test program. So when we originally started the program we had 300 or so stores on it. Now we’ve tripled that number. So you can assume that we’ve tripled the number of feet on the street since we originally rolled this out.

Seth Schiesel – Credit Suisse

Okay.

Gary Balter – Credit Suisse

Bill. This is Gary.

William C. Rhodes, III

Hey, Gary.

Gary Balter – Credit Suisse

Sorry to the other Bill that I’m on the phone. But can you talk about regional differences? Because you’re obviously nationwide. How bad is California? How bad is Florida right now?

William C. Rhodes, III

You know, Gary, I’m going to go back to what we said in the script that we didn’t see anything, we’ve certainly seen difference – positive and negative – in regional differences. We believe that most of those are driven by what we do. Are there certain parts of the area that are more challenged? Yeah, but I also go back to, we’ve never been able to develop a statistical correlation that says that macro-economic challenges impact our business. So we said a couple, I guess a year and a half ago or so that when Florida went through some of the rebounds after the hurricanes, if there appeared to be an infusion of cash from the FEMA money and we saw some benefits from that and saw some detriments that have lasted. But I don’t want to try and draw a correlation that there’s a statistical correlation between macro-economic trends and our sales performance because we simply haven’t seen it.

Gary Balter – Credit Suisse

Okay. Thank you.

Operator

Our next question comes from Matthew Fassler, Goldman Sachs. Your line is open.

Matthew Fassler – Goldman Sachs

Thanks a lot. Congratulations on the nice showing. My question this morning also focuses on commercial and really trying to hone in on the test stores. If you could just give us any more colour on the differences between those stores and the rest of the commercial stores. Also, what was the cost and time that it takes to roll out those initial measures? They’re in less than half your commercial stores right now and would suggest that if they’re working the opportunity to get additional traction is significant.

William C. Rhodes, III

Well, to that point I’ll start there, Matt. Those additional resources are not that costly if we roll them into our higher volume stores. So the bigger concentration of stores that are on that program are the higher volume commercial stores that have significant growth prospects. So as we go farther down into the penetration it’s more challenging than it was at the beginning of parts. So that’s why we’re being methodical about it. But as we continue to roll it we continue to find more and more success factors.

It includes elements, your other question, what elements does it include? It certainly includes an outside sales force. It also includes some incentive compensation for the sales team that’s leading that effort. And additional assets such as additional trucks and some inventory additions, albeit not terribly significant.

Matthew Fassler – Goldman Sachs

And is it fair to say that a lot of that pick up that you saw in commercial sales per store in the quarter related to those 900 units or was it evident more broadly across the company?

William C. Rhodes, III

We saw growth across the board, Matt. Those units are growing faster, but we’ve seen nice improvement across the board. And a lot of the things that we’re working on are going to all the stores. Certainly all the parts coverage additions that we made through our new inventory assortment tool went to all those stores. The other stores are getting significant improvement as well, just not some of the things like an outside sales force.

Matthew Fassler – Goldman Sachs

Understood. Thank you so much.

Operator

Our next question comes from Danielle Fox, Merrill Lynch.

Danielle Fox – Merrill Lynch

Thank you. I have a couple of questions. First, you mentioned that you now see the company achieving leverage on a 1.5% to 2% comp. Can you just remind us what the previous hurdle was for achieving leverage?

William T. Giles

I think it was probably pretty close to the same. We’re going to have variations by quarter, but we think on a long-term basis the 1.5% to 2% same store sales growth should generate leverage on an SG&A basis.

Danielle Fox – Merrill Lynch

Okay. And then you mentioned the occupancy costs. Is that something that you’ll anniversary after a year or does this represent a fundamental change in the business? For example, a decision to lease rather than own locations or something along those lines.

William T. Giles

Yeah, what we’re finding is that we’re getting a higher percentage of lease versus owned stores as we continue to expand the store count overall. So that’s really what’s putting more pressure on SG&A. I mean, at the end of the day it continues to still be profitable, it’s just a question of whether it’s between SG&A or interest. So what we’re seeing is with the slightly higher percentage of lease stores versus owned it puts a little bit of pressure on SG&A from an occupancy cost standpoint.

Danielle Fox – Merrill Lynch

Okay. And then I think there’s been some speculation when industry sales are weak broadly that maybe there was some, customers were delaying maintenance and repair. Do you have any sense that that was the case and that maybe you’re seeing a little bit of that pent up demand hit the sales line or do you think this is more a function of some of the initiatives that you’re putting in place that may be more of a market share gain?

William C. Rhodes, III

I think the biggest determinate of our success, Danielle, is what are we doing in our business? Certainly there can be times of minor pent up demand, but to me it’s not pent up demand, its loss demand. If somebody doesn’t change their brake pads at 20,000 miles and goes to 25,000 miles they’re not going to change them faster the next time. So are we getting to normalized cycles? I don’t know. We don’t really see material changes in the macro-performance of this industry. The industry seems to grow at about a 4% growth rate on the DIY side and about 4.5% on DIFM. Certainly we see periods of time where gas prices appear to negatively impact our business, but that doesn’t seem to last terribly long and, as we mentioned in the script, if we wanted to kind of characterize it, it’s in the single-digit, low-single-digit range. So it’s not a huge determinant of our success. Our point of view is we have to do what’s right for this business over the long term.

Danielle Fox – Merrill Lynch

Thank you.

Operator

The next question is from John Lawrence from Morgan, Keegan.

John Lawrence – Morgan, Keegan and Company

Good morning, guys. Taking that one step further, Bill, could you talk a little bit about going back to the gross margin issue as far as direct imports and give us a little timeline as far as the increase in pressure from cost and how that relates to different categories in terms of direct imports? Are you seeing any shift there? What will we look for going forward there?

William T. Giles

Yeah, I mean, the import program for us is still relatively immature. We continue to make progress and increase in the amount of imports and we think that is (inaudible) our overall product acquisition costs. We see commodity based increases predominantly from an import standpoint on steel. So many of our hard parts, as you can imagine, have that as a component (inaudible) put pressure on it. So that is one tactic that we have, but we’re very much focused on being able to drive down our overall product acquisition costs so that we can continue to add value to our customers on our own term basis. This is something that will take time. I don’t expect this to have dramatic or significant swing improvement on imports. This is something that will take time and it’ll be over the next several years, but we’ll continue to make improvements in gross margins.

John Lawrence – Morgan, Keegan and Company

Thanks. Last question. Bill, would you discuss a little bit, as commercial is getting sort of a better foundation and structure here going forward, how does ALLDATA play into this and are there some synergies there with using ALLDATA as you get further along in that process?

William C. Rhodes, III

Yeah, obviously ALLDATA is a terrific tool for the shops to use. As we move forward we continue to look for ways to leverage ALLDATA with our commercial sales program. There’s some improvements going on there. First, the base product of ALLDATA continues to improve. We’ve also rolled out shop management systems so that we get more engaged with the shop and we’ve created some electronic ordering programs so that our customers can order directly from ALLDATA’s software and order parts from AutoZone. And then ALLDATA has also moved into the collision business, which gives us another avenue for growth. Not that we’re selling collision parts, but in a lot of those collision oriented repairs there are mechanical parts that have to be repaired as well. So that gives us another entry into more customers.

John Lawrence – Morgan, Keegan and Company

Great. Thanks a lot.

William C. Rhodes, III

Thank you.

Operator

The next question is from Tony Cristello of BB&T.

Tony Cristello – BB&T Capital Markets

Thanks. Good morning, gentlemen.

William C. Rhodes, III

Good morning.

Tony Cristello – BB&T Capital Markets

I guess one question I have, can you just give some colour on what your commercial customers themselves may be relaying to you in terms of feedback with some of the recent changes or initiatives you’ve put in place?

William C. Rhodes, III

I think the biggest point of feedback that they continue to give us is that they have noticed a significant improvement in our parts coverage. They also, where two or three years ago we heard a lot of feedback on service and service failures, we hear much less feedback. This is anecdotal, Tony, but much less feedback on service oriented payers. We attribute that to the implementation of our PDAs, which allow us real time information on how our service is actually occurring at the shop. So when we have service failures we’re able to add new resources or correct them in short order. But I think it’s primarily parts coverage and service improvements.

Incidentally, we really spent a lot of the last year, a little over a year, we kind of called time out and said we have to get the basics right. Although we’ll never have them perfectly right, we’ve made some significant improvements on doing the things that are critically important to our customers.

Tony Cristello – BB&T Capital Markets

When you look then at wanting to go from 900 stores to however many, ultimately if you choose to get to all the commercial service stores, what type of spend commitment will you see? I guess what I’m asking is, what we saw for investment in training and marketing, some of these investments you made during the quarter that caused a little bit of deleverage, is that just a sort of ongoing expense as you just continue to try to get more out of your business and sort of better match what the demand side is for what you’re trying to provide to your customers?

William C. Rhodes, III

You know, if you look back over the period of time that we rolled these stores out, we have had some quarters of deleverage in SG&A, but primarily that’s been driven by the occupancy expense that Bill discussed earlier. To the extent we continue to lease stores and move that interest cost from below the operating margin into the operating margin, we may well continue to have that negative impact. As we’ve said before, we’re not operating with a fixed operating margin. We’re worried about improving operating profit dollars.

So my point with all that is we continue to roll those programs out and it has never been something that we’ve called out as a material change in what our cost structure has been, so I don’t anticipate it being that case as we move forward.

Tony Cristello – BB&T Capital Markets

Well, and I guess another point to that I would ask is, do you feel like the investments that you’re making, short of the parts assortment, more people or better marketing or training, have that resulted yet in driving the revenue or is that something that ultimately, as you get further down the road, you’ll start to get more traction with?

William C. Rhodes, III

Well, I certainly hope that over time we’ll gain more traction, but certainly because the performance of those stores has exceeded for an extended period of time the performance of our base programs that don’t have those additional resources we think it’s the right thing to do and we think it’s paying out over the long term.

Tony Cristello – BB&T Capital Markets

Okay. And one last question. On the DIY side of the business, how much detail do you have now with respect to tracking the buying patterns of your customer and sort of how loyal they’ve been and sort of the frequency of maybe how much in terms of an oil change intervals might be? Any details you can share with me in terms of what patterns you track.

William T. Giles

Yeah, we implemented an electronic loyalty card program in December of last year. So we are now beginning to compile that information. But it’s the first time we’ve look at it. So interpreting trends out of it is rather difficult so far. But we believe we will be able to do that over the long term.

Specifically oil change intervals, you know, we’ve seen the industry information that says they’ve significantly increased over time. We’re working as hard as we can to convey to our customers that although your owner’s manual may say that you can wait until 7,000 miles or 7,500 miles that that says under normal operating conditions. And severe operating conditions are characterized as things like starting and stopping and, you know, the way most of us drive. So we’re continuing to try to remind our customers that they do need to stick to those shorter intervals and what we believe is 3,000 miles.

Tony Cristello – BB&T Capital Markets

Okay. Great. Thanks, guys.

William C. Rhodes, III

Thank you.

Operator

The next question is from David Cumberland of Robert Baird.

David Cumberland – Robert W. Baird & Company

Good morning. In the commercial business you mentioned overcoming the change with Midas. Can you comment on your progress on converting some of that business to more Hotshot business at Midas?

William C. Rhodes, III

Well, at Midas we continue to focus very much on the Midas franchisees and growing our business with them. One of the things that happened when we came out was we were no longer a “approved” supplier of Midas Hotshot business. But that doesn’t mean that a lot of the Midas shops do not continue to buy with us. So we’ve had headwind both from the supply chain side as well as on the Hotshot side with Midas. But we continue to do very well with many of the Midas dealers and franchisees and hope to continue to build upon our relationship with them.

David Cumberland – Robert W. Baird & Company

Thanks, Bill. Can you also elaborate on the promotions that you mentioned as helping sales? What types of things did you do and also do you plan similar approach going forward?

William C. Rhodes, III

Yeah, we have a normal promotional calendar that we roll out once a period for us or basically once a month. We change the window signs in our stores. A lot of them have focused on oil changes. You will see others in the industry that at times will focus on price points for each individual quarts. We have focused our efforts more on the complete job and trying to convey to them to do the whole job and give them a great reason to come visit our store.

Also on the commercial side we continue to roll out the marketing materials that we talked about in the conference call and have been very excited about what those marketing materials admit to our AutoZoners and their ability to make an effective sales call with our customer. We have great stories to tell and a lot of product categories. As we script that out it helps educate our AutoZoners as well as our customers. We’ve been pleased with that progress.

David Cumberland – Robert W. Baird & Company

Thank you.

Operator

The next question is from Gregory Melich of Morgan Stanley.

Gregory Melich - Morgan Stanley

Thanks, guys. A couple questions. One is, we’ve seen, you’ve mentioned inflation as being lower mid-single digits. How did that trend sequentially, in particularly with lead and a lot of the commodity prices going up for oil and whatnot?

William T. Giles

I would say it probably hasn’t changed dramatically. We continue to see that. I mean, obviously if we looked at it over the last two years it’s obvious you’d have quite a bit. But there’s no question, you know, that the oil based and energy based commodity prices have been there for quite some time, so we continue to see pressure on that. And we continue to see some pressure on lead, maybe a little bit more recently.

Gregory Melich - Morgan Stanley

Okay. So maybe a little bit incremental from lead, but fundamentally from the fourth quarter to the first quarter no shift that’s more than 100 basis points or something like that.

William T. Giles

I would say nothing significant.

Gregory Melich - Morgan Stanley

Okay. And then second is, as you get people off the pay-on-scan do you take the offsetting benefit, do you typically get it in margin or do you get it from payables?

William T. Giles

It’s more from payables. I mean, this is really a financing tool. And again, we’re to some extent indifferent as to how the vendors want to finance it, whether we want to be on pay-on-scan or whether we want to negotiate it through terms. So yeah, we’re committed on a long-term basis to get to 100% A/P’d inventory and we believe that we can get there. So pay-on-scan is simply one metric that we can use and obviously we’ve been unwinding that. So if that’s beneficial to the vendors we’re going to continue to do that. But we’ll negotiate it back on terms.

Gregory Melich - Morgan Stanley

Okay, great. So that did not have an influence on gross margin?

William T. Giles

No.

Gregory Melich - Morgan Stanley

Okay. Great. Thanks.

William T. Giles

Thank you.

Operator

The next question is from Matt Nemer from Thomas Weisel Partners. Matt Nemer, your line is open.

Matt Nemer – Thomas Weisel Partners

Good morning. Sorry about that. My first question is on the weather-related product mix shift. Could you quantify or talk to the impact on traffic ticket and the gross margin rate in the quarter?

William C. Rhodes, III

We haven’t really specifically quantified it as much. I mean, we have certainly set on a longer-term basis that certainly much of our same-store sales is driven a little bit by overall average ticket versus traffic.

Matt Nemer – Thomas Weisel Partners

Okay. And then secondly, following up on the last question, the government data shows a pretty significant increase in inflation in your product category this quarter versus last quarter. I’m just wondering kind of why your experience would be different than that. Is it the composition of the basket?

William T. Giles

Sorry, when you say that, I mean, we’re talking really about product acquisition. So it takes time for that to roll in, etcetera. I mean, we’ve been dealing with increased inflationary prices on product for some period of time and expect to continue to do so. So again, that puts more emphasis on us to continue to try to reduce our product acquisition costs to the extent that we can pass those prices on or the market place passes those prices on and we will continue to do so. So I appreciate the clarification because I don’t want you to think as though we’re immune from it. We continue to receive significant pressure, I just mention that we didn’t see anything in the individual quarter that was significant versus what we have been seeing.

Matt Nemer – Thomas Weisel Partners

And is there a way to quantify the pass-on rate to consumers? Have you been able to pass on 90% of that or is there any way to put some numbers around that?

William T. Giles

Yeah, we haven’t really quantified it. It’s a fair question. I would say that the majority of it has been passed on, is probably the simplest way to say. I wouldn’t give you an exact percentage, but certainly a majority of it has been passed on.

Matt Nemer – Thomas Weisel Partners

Okay. That’s helpful. And then lastly, your late model coverage parts that you’ve added in commercial, can you talk to the take rates or the interest in that product set on the DIY side of the business?

William C. Rhodes, III

Yeah, that’s a great question. We see significant amount of the sales. Obviously 85% of our business is in retail. A significant amount of the sales of that late model inventory is still on the DIY side. It’s a higher percentage on the commercial than our normal products, but it’s still a significant amount that goes into DIY sales.

Matt Nemer – Thomas Weisel Partners

And which is a bit of a departure I think from what we’ve kind of heard from companies in this space over the years that your core segment is older model vehicles. Why do you think you’re having so much success with late model parts?

William T. Giles

I think it depends on the category. Obviously if it’s a part that’s warrantied then we’re not selling those parts. They’re in the three- or four-year cycle. But in places like filtration, batteries, brakes, where they’re not under warranty we still get the opportunity to sell them to those folks that maintain their vehicles themselves.

Matt Nemer – Thomas Weisel Partners

Got it. That’s helpful. Thank you.

William C. Rhodes, III

Thank you.

Operator

The next question is from Peter Benedict of Wachovia.

Peter Benedict – Wachovia Capital Markets

Hey, guys, thanks for taking the call. Most of my questions have been already asked here. But just, Bill, when we think about the inventory going forward and the growth, should we think these first quarter trends are somewhat representative of what we should think will play out over the balance of the year? Could you just give us a little more insight into how you see inventory?

William T. Giles

Yeah, I think from an overall inventory level standpoint, again, we’re going to continue to, because we have good leverage from an A/P’d inventory standpoint we’re going to continue to make sure that we make appropriate investments in our inventory and as part of our category line reviews where we identify opportunities to add additional inventory to ensure that we can improve our late model coverage in order to say yes, we’re going to do so. At the same time we’re going to work hard at rationalizing out our own productive inventory. So I think these inventory levels overall are, feel good to us where we are and as we go forward we expect to stay similar to that with probably some slight investments.

Peter Benedict – Wachovia Capital Markets

Yeah, that’s fair. And just one quick one on the buy back and the understanding that you’re spending is operations dependent. Assuming a similar operating environment balance of the year, I mean, you spend about $700 million or $800 million last year on the buy back. Any reason why we shouldn’t expect something at least in that ball park for this year?

William C. Rhodes, III

Well, what I would tell you is that we’re committed to getting back to our 2.1 times debt EBIDTAR metric by the end of fiscal 2008.

Peter Benedict – Wachovia Capital Markets

Perfect. Fair enough. Thanks.

William C. Rhodes, III

Thank you, Peter.

Operator

And now I’ll turn the call back over to Bill Rhodes for closing remarks.

William C. Rhodes, III

Thank you. Before we conclude the call I’d like to take a moment to reiterate that we are excited about our growth prospects for the remainder of our fiscal 2008. We understand we have to earn those sales every day. We have a solid game plan, but I want to stress that this is a marathon and not a sprint. While the macro-environment remains challenging our focus is on our critical success factors. While we have an incredible business model built from a strong foundation of disciplined processes focused on delivering great customer service, we understand we cannot take anything for granted. As we continue to focus on the basics and never take our eye off of optimizing long-term shareholder value we are confident we will continue to be incredibly successful.

We thank you very much for participating in today’s call and I want to wish everyone happy holidays. Thank you.

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