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AutoZone, Inc. (NYSE:AZO)

Q3 2008 Earnings Call

May 20, 2008 10:00 am ET

Executives

Bill Rhodes – President & CEO

William Giles – Executive VP & CFO

Brian Campbell – Vice President & Treasurer

Analysts

Gary Balter – Credit Suisse

Dan Wewer – Raymond James

Colin McGranahan – Sanford Bernstein

Matt Fassler – Goldman Sachs

John Lawrence – Morgan, Keegan & Co.

Matt Nemer – Thomas Weisel Partners

Scott Ciccarelli – RBC Capital Markets

Michael Baker – Deutsche Bank

Operator

Good morning and welcome to the AutoZone conference call. (Operator Instructions) This conference call will discuss AutoZone’s third 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. Before Mr. Rhodes begins, the company has requested that you listen to the following statement regarding forward-looking statements.

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.

Mr. Rhodes, you may now begin.

Bill Rhodes

Good morning and thank you for joining us today for AutoZone’s fiscal 2008 third quarter conference call. With me today are 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 third 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 complimenting 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 for the strong results delivered this past quarter. We are proud to talk to you this morning about a seventh consecutive quarter of double-digit EPS growth particularly in light of what continues to be a difficult macro environment. We certainly are aware and understand the challenges inflation, higher gas prices and dropping home values have on our customers. Operating successfully in this environment requires an organization to execute at a very high level and I appreciate the efforts of all our AutoZoners and what they put forth every day.

Our success this quarter can be directly attributed to executing the initiatives we outlined at the beginning of the fiscal year. These initiatives focus on improving our in-store customer shopping experience, increasing our AutoZoner training efforts, and accelerating our commercial growth strategies. In addition, with our competition continuing to execute their strategies, we know we have to be vigilant in improving our customers’ experience to continue to deliver strong performance.

From those key initiatives, we increased our gross profit margin, managed our operating expenses well, although we deleveraged slightly on a percent of sales basis, continued to affectively manage our capital structure and positioned ourselves appropriately for growth heading into this fourth quarter; our traditionally largest sales quarter.

Let me provide a quick summary of some of our activities during the quarter that contributed to our results. We held a spring sales meeting for our senior field management just after last quarter’s conference call to introduce key tactics and new selling programs heading into the second half of the year. At that meeting, we announced we were adding some additional district managers to reduce the number of stores our DMs support individually. We felt it was and continues to be essential for us to have the right amount of focus on our stores to support customer service.

At this meeting we also announced a commercial reorganization to more effectively drive sales efficiencies and productivity. The new organization leverages our sales leadership team more effectively and improves our ability to execute sales strategies and tactics on a consistent basis. It also provides increased flexibility to add additional feet-on-the-street which is an essential element of our commercial growth strategy.

We held our Annual Vendor Summit here in Memphis to review both past performance as well as future opportunities and challenges. Working closely with our vendors to gain alignment on strategies and tactics is an important element of our future success. With approximately 500 people in attendance the interaction we had with our vendors was very constructive and the feedback we received was very positive.

We continue to add inventory to our stores. While not a new discussion for us on a per-store basis, managed quite affectively we feel additional coverage is making a difference for us. For now and for the future. About two years ago we rolled out a new significantly enhanced merchandise assortment planning process. That tool has allowed us to capture more than ever before lost sales information. Unique to this data capture is our ability to track our [yes] percentage separately between our retailer customers and our commercial customers. Over these two years we’ve learned a lot and continue to further develop and enhance this process.

We’ve learned where many of our shortfalls lie and where many of our excesses exist. Last year we discussed the addition of $70 million in additional inventory we felt was immediate low-hanging fruit. Today, we are on track to add a similar amount of incremental inventory this year. At the same time, we have been diligent in rationalizing excess or non-productive inventory to make room both physically and financially for this incremental inventory.

And fourth, we initiated a robust sales training effort to support or drive to develop a best-in-class commercial field sales organization. We understand we are an organization that grew up with primarily a retail focus. While we recognize that and are very proud of our many industry leading efforts we also need to make sure we are supporting our professional commercial customers with all the requirements they are demanding.

Quickly before we review the specifics of our performance, I’d like to answer a question we expect many will want to ask later in the call. That question is, why do you think your sales performance overall has remained similar to previous quarters while the economy has been undoubtedly challenged by recessionary pressures and while gas prices have reached record levels? We believe our industry provides a valued product to consumers in difficult times. We have had to make sure our stores are well stocked with the right merchandise to help our customers save money.

It’s no surprise that many of our marketing messages have and will continue to be built around saving money and improving fuel mileage for example. We believe we’re executing at the store level better. While we understand these efforts are no guarantee for future results, we believe our formula is the right one for the long term.

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. William Giles will then provide more detail on our earnings performance as well as an overview of both our balance sheet and cash flow statements for this past quarter. Finally, I’ll provide a few closing comments before we go into Q&A.

Regarding the third quarter, for the 12 weeks ended May 3, we reported sales of $1.517 billion, an increase of 3% from last year’s third quarter. Same-store sales for stores open more than one year, were down 0.3% for the quarter. While our retail sales showed a modest deceleration versus the previous quarter, our customer satisfaction surveys continued to confirm that we are improving the customer shopping experience.

Regarding our commercial business we continue to be pleased with the progress we are making. This marks our fourth consecutive quarter of positive sales growth and we are especially pleased to report acceleration in our sales growth as we progress through the year. While our retail business remains our largest most profitable business, we are excited by what commercial can represent for us on a sales growth and profitability basis for many years to come.

In the second quarter gross profit as a percentage of sales was up 32 basis points versus last year’s quarter while operating expenses as a percentage of sales increased by 30 basis points. This resulted in an operating margin of 18%, up approximately two basis points from last year’s quarter. Operating profit increased 3% versus the prior year. Net income for the quarter was $159 million and diluted earnings per share increased 14.7% to $2.49 from $2.17 in the year-ago quarter. Our continued disciplined capital management approach resulted in return on invested capital for the trailing four quarters of 23.3%. This increase showed a slight improvement versus last quarter and a more material increase versus last year’s third quarter.

Return on invested capital is a key measure of our success. We have and 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 physically prudent with our investments while optimizing our earnings per share.

Now I’d like to talk in detail about our DIY sales results. Total domestic retail sales were up 1.5% for the quarter. During the quarter we continued to focus on driving sales and profits for long-term growth. As I’d mentioned earlier, we feel our store execution continues to improve. During the quarter as is customary, we experienced regional discrepancies in our sales performance driven by many factors, both positive and negative. Naturally weather was a contributor to our sales performance as it always is. This quarter the weather was slightly cooler and wetter than the previous year. However, over time the weather impacts tend to balance out.

While the economy continues to challenge our customers’ pocketbooks, we did not see a material shift in sales mix to lower priced point merchandise. We continue to believe we have opportunities to sell our customers on the benefits of our good, better and best assortment to offer the appropriate value proposition to every customer. This is a key component of our AutoZoner training efforts.

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 campaigns. We believe Z-net continues to gain 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. Again we feel we are executing well at the store level; however there is always room for improvement.

In addition we have closely monitored and responded to what our customers are telling us. Through our customer satisfaction surveys our customers are telling us we’re offering them a more compelling shopping experience. Although we are making meaningful progress on our initiatives we are not satisfied with our sales performance this past quarter. We believe we can improve our performance from these levels through several selling opportunities. While there are certainly headwinds our customers are facing as we’ve discussed, we feel if we continue to refine and enhance our product offerings to increase our ability to say yes, we can grow sales from here.

As an example, we have added late model parts coverage to appeal to our commercial customer base and we continue to be pleased by how those parts are being purchased by not only our commercial customers, but our retail customers as well. We will continue to be aggressive on our merchandise category updates.

Now let’s turn to macro trends, during the third quarter unleaded gas prices started out high at $2.96 a gallon and went up from there finishing the quarter at $3.61 a gallon. This 22% increase was the highest this year. However, last year as well experienced high prices finishing at just over $3.00 a gallon. Unfortunately we cannot control the prices of gas at the pump. However with more vehicles on the road than ever before, our ability to grow sales remains strong over the long-term and we believe consumers will ultimately adjust their spending habits to the higher prices. We will continue to develop marketing programs that support our customers’ needs during these high-price times.

For the quarter, gas prices had a negative impact on our sales performance. Regarding miles driven, we saw a decrease in miles driven in January and February; neither March nor April is available yet. However through February, miles driven decreased for four straight months versus the previous year; a decrease that hasn’t been seen in many years. Let me again reiterate the two statistics we’ve always felt had 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 had been challenged recently thereby causing a challenge to our overall business, there has been a positive impact from more registered vehicles seven years old and older on the road; quite frankly more than in our country’s history.

Regarding pricing across the industry, we have not seen any material change in the competitive landscape. Overall consumer price inflation in Q3 remained in the low single-digit range. While we do expect some increase in sales due to the recent financial stimulus checks issued to the American public, we do not expect it to have a material impact on our overall results. For example back in 2001 we could not conclude that the checks issued had a material impact on our sales.

For the trailing four quarters sales per-square-foot were $236. 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 6.3% versus last year’s quarter. We now have the commercial program in 2,233 stores supported by 136 hub stores. We are encouraged by the progress we are making on our commercial initiatives and by the response we are seeing from our customers’ purchasing habits. However there is still much work to be done. With such a small share, approximately 1.5% of the overall market, we believe there is significant opportunity to gain further share.

As mentioned on previous calls, there continues to be a subset of commercial programs, approximately 1,200 supported by additional selling tools. While we do not quantify the difference in results between what these approximately 1,200 programs sell versus the remaining programs, our results encourage us enough to continue to grow this subset of commercial programs. A key element to growing our commercial business is to be able to meet the parts coverage requirements of customers. Many of our customers call several times a day. They expect consistent service. Most importantly, they expect us to carry the parts they request and get them delivered on a timely basis.

We have to make sure we continue to better understand their expectations and work diligently to meet or exceed those expectations every day. First let me address their parts needs. To address this need we expect to add as much new coverage this year as we did last year. As I mentioned earlier on this call, about two years ago we began to track how often we were able to say yes to our customers when ordering parts. We have been tracking those sales and more importantly lost sales separately between commercial and retail. It won’t surprise many to hear our commercial yes percent was and has been lower than our retail percentage.

While not as the same level as retail, we have identified many opportunities to close that gap. Let me step back a moment and explain what some of the historical challenges have been to adding this inventory. For one, the commercial parts life span is shorter than retail. Commercial customers are primarily demanding parts for newer models. At a certain point depending on the vehicle and customer demographics, cars reach that target [OKV] range. It’s at this age where the car owner becomes traditionally a retail customer.

Our category reviews are addressing those needs better than ever before. Lastly we continue to be pleased with the customer feedback we’re getting related to our Duralast and Duralast Gold product offerings. Beginning next month, we will be launching a new product line under the Duralast Gold banner. We are very exciting to be launching the new Duralast Gold [CMax] line of brake pads. This completely new offering of ceramic brake pads has new features and functions that are sure to satisfy the needs of our commercial customers in a product offering they are frequently requesting.

Secondly we have been adding field support for the business. We have also been sharpening our message to our customers, working more diligently with our customers to address gaps in both our parts coverage and service offerings. We are continuing to build a selling culture around taking care of customers that traditionally we have not consistently serviced. With the data we’ve collected over the last two years, we are addressing product needs on a customer-by-customer basis. We have also developed and implemented a number of sales tools and processes over the past year as we continue to improve the quality and effectiveness of our field sales organization. These tools and processes are gaining momentum and improving our performance.

We are not able to communicate with those customers appropriately targeting key categories with individual customers. We are letting our customers and AutoZoners know we care about this businesses future growth. We are committed to putting the resources in place for future growth. Our sales growth has been coming from both existing customers growth their weekly purchasing volumes along with the addition of new customers. Primarily we are focusing on what we have called the up-and-down-the-street customer. They are the one and two-store customers who represent a majority of what our industry association, the AAIA, states is the largest commercial customer segment.

Our focus has been as with retail, on improving our commercial customer service. Frankly we understand at the end of the day, all our commercial customers are doing business at the local level. It is the local shop manager that determines who they’re going to pick up the phone and call when they need a part or a product. We are pleased with the progress to-date, but have significant additional work to do before we reach our goal of developing a world class commercial sales force.

We are in the early stages of growth as we represent a very small market share across an industry that is larger than retail. Finally we remain committed to building this business for the long run. While we are excited about our potential in this business and believe over the long-term we can expand the percentage of stores that operate a commercial program, we will remain committed to developing a sustainable, profitable business model.

We are not interested in driving short-term sales results at the expense of profits. Over time, we believe we can grow sales in the existing commercial stores as well as open additional programs where appropriate. 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.

Let’s turn to Mexico, our Mexico stores continue to perform well. We opened two new stores during the third quarter. We currently have 130 stores in Mexico. Our ongoing commitment remains to prudently and profitably grow the Mexico business.

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

William Giles

Thanks Bill. Gross margin for the quarter was 50.2% of sales, up 32 basis points compared to last year’s third quarter. In the third quarter margins continued to benefit from our ongoing category management initiatives, supply chain efficiencies and our continued focus on lowering our acquisition costs, which include increasing our direct import efforts. Over the last several quarters, these efforts have been partially offset by an increase in product cost, specifically related to oil-based products and other commodities.

We continue to focus on ensuring we offer the right products at 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 providing our customers great value. Our Duralast, Duralast Gold and Valucraft product lines continue to show sales increases for the third quarter.

Our customers continue to recognize the value proposition these high quality brands offer. Going forward, we believe there continues to be opportunity for gross margin expansion albeit at reduced rates. We do not manage to a targeted gross profit margin percentage as our key focus is on increasing absolute gross profit dollars.

SG&A for the quarter was 32.2% of sales, up 30 basis points from last year. Our deleverage came primarily from continued higher occupancy costs, specifically rent and depreciation were approximately 17 basis points higher than last year’s second quarter which reflected higher percentage of lease versus owned stores. For the long-term we continue to feel in order to leverage SG&A we’ll need an approximate 1.5% to 2% same-store sales growth. Currently we believe our expenditures toward improving customer service will pay dividends well into the future.

EBIT earnings before interest and taxes for the quarter were $273 million, up 3% over last year. Interest expense for the quarter was $25.3 million compared with $27.1 million a year ago. Debt outstanding at the end of the quarter was $1.932 billion or approximately $7 million less than last year. The decrease in interest expense reflects lower short-term borrowing costs. Our adjusted debt level at 2.1x adheres this quarter to our historical guidance of 2.1x. 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.

For the quarter our tax rate was approximately 36%, below last year’s rate of 36.3%. As this quarter’s rate included the settlement of the relatively small discrete tax event, we expect to return to a more normalized run rate of approximately 37% for the last quarter of 2008.

Net income for the quarter of $159 million was up 4.6% over the prior year. Our diluted share count of 63.8 million was down approximately 9% from last year. The combination of these factors drove earnings per share for the quarter to $2.49, up 14.7% 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 53rd in the fourth quarter. So at the end of this fiscal year we’ll be talking to you about EPS numbers that included an extra week. While we do not provide guidance on an earnings impact this extra week will have on our business, we’d like to remind everyone last time we did report a fourth quarter with an extra 17th week, was fiscal 2002 and we reported and impact of $0.18 per share for that period. At the time of reporting we will breakout the impact this extra week had on our business.

Relating to the cash flow statement in the third quarter we generated $204 million of operating cash flow and we did not repurchase any AutoZone stock. Year-to-date we have repurchased approximately $350 million as part of our stock repurchase program compared to approximately $464 million during the same time period last year. As you recall, we accelerated a portion of our annual purchases during the first quarter. As we stated then, we were committed to getting back to our 2.1x credit metric by the end of the year and we were able to do so by the end of the third quarter.

Let me discuss further how we think about spending our operating cash flow. First we spend appropriately on our existing store base. Second we spend capital on the opening of new stores and finally we return any excess capital to our shareholders. For the third quarter of this year we reported an industry-leading ROIC of 23.3%. 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 $2.1 billion, up approximately 6% versus the Q3 ending balance last year. However last year’s number excluded $31 million in [pay-on-scanned] inventory which was not included in our GAAP numbers. We have slowly reduced our inventory balance held as pay-on-scan over the last several years. Today we have approximately $7 million in inventory on our pay-on-scan program.

Our adjusted inventory including pay-on-scan inventory was up approximately 5% versus the previous year’s quarter. This increase is primarily being driven by our new stores opened over the last year representing approximately 4% more square footage then last year. Therefore on a per-store basis we reported $508,000, up slightly from last year. Also keep in mind we have added additional parts coverage through our category line reviews.

Accounts payable as a percent of gross inventory finished the quarter at 88.9%. Total working capital was $3 million versus last year’s balance of $71 million. We will continue to focus on minimizing working capital as this quarter reflects. We are committed to continuing our ongoing focus of increasing cash flow.

Net fixed assets were up 5.7% versus last year. Capital expenditures for the quarter totaled $58 million and reflected the additional expenditures required to open 37 new stores this quarter along with maintenance on existing stores, work on development of new stores for upcoming quarters and the expected summer opening of our new eighth new distribution center in Hazelton, Pennsylvania. 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 US at a mid single-digit growth rate for the foreseeable future.

We opened 32 new stores in the quarter for a total of 4,032 stores in 48 states, the District of Columbia and Puerto Rico. We also relocated three stores this past quarter and we continue to see opportunities to expand this initiative in the future. Depreciation totaled $38 million for the quarter, higher then last year due primarily to new stores. 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 & Poor’s is BBB plus, and we have a commercial paper rating of A2. Moody’s Investor Service has assigned us a senior unsecured debt credit rating of DAA2 and a commercial paper rating of P2.

Now I’ll turn it back to Bill Rhodes.

Bill Rhodes

Thanks William. While we are certainly pleased to report record earnings and earnings per share for the quarter, we also understand that we must stay focused on growing both retail and commercial sales. We clearly understand our success is driven by our customers’ daily experience with us and we must continue to enhance this experience. As I said earlier, this quarter was about our continued focus on executing our game plan of improving our in-store customer shopping experience, our AutoZoner training efforts, and building momentum on our commercial growth strategies.

These efforts were enhanced by adding new inventory where appropriate. Our story will remain consistent heading into the fourth quarter of this fiscal year; a focus on steady, profitable sales and earnings improvement, refining our inventory assortment, continual training of our AutoZoners, expanding our commercial business and prudent profitable growth in Mexico. While we were pleased with our execution in the quarter we do believe we can grow sales into the future, both retail and commercial sales. We have to continue to enhance our value proposition to our customers. Even as our survey results tell us the AutoZone shopping experience remains appealing we cannot rest on our laurels.

I’d like to mention a subject that has not come up on this call yet and that is industry consolidation and what it means to AutoZone. Frankly we believe it will have a positive impact on our industry over the long run. As one competitor recently has announced the acquisition of another, we are encouraged to see growth coming from replacement and not the addition of new brick-and-mortar. However, let me be very clear. We are determined to maintain and hopefully growth our market position from here. We are not satisfied with sales growth in the low single-digit range. As long as we have opportunities to open stores and commercial programs that exceed our hurdle rate of investment, and we certainly do, you should expect to see us expanding our presence. We continue to feel confident in our long range plans. We believe we have opportunity for growth in all three strategic priorities; retail, commercial and Mexico. Customer service will continue to be our key point of differentiation and AutoZoners across the company are 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 with the tools they need. As we continue to demonstrate industry-leading financial metrics we remain cognizant of our investors’ capital. We continue to remain focused on optimizing long-term shareholder value.

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 I’d like to open up the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from the line of Gary Balter – Credit Suisse

Gary Balter – Credit Suisse

On the commercial side, first you had a lot of inventory into the box to help drive these sales; just trying to get a sense of how much more inventory can you add? How do you look at that going forward?

Bill Rhodes

I think it’s important to note first that we have added quite a bit of inventory, as we mentioned $70 million last year and on track to do a similar amount this year but we’ve been very aggressive in managing out excess and non-productive inventory. As I mentioned we’re focused on making sure that we make room for that new product, both physically and financially and that’s been a big part of our strategy and will continue to be as we go forward.

Also I mentioned that the lifespan of the commercial products is much shorter than it is on the retail side and so it causes us to constantly update even more frequently our product assortment so you’ll see it churning a little bit more then it did historically when we were just focused on retail.

Gary Balter – Credit Suisse

It seems like you’ve sort of struck on the winning formula to grow the commercial business. You still only have programs in about 55 or 70 of your stores. Are you looking to accelerate that penetration?

William Giles

We hope over the long-term to increase that penetration. That is not a key component of what our strategy is today. We are looking every day to add a few programs, but it’s not a big focus. Our big focus is making sure that we improve our value proposition to our customers and do it with the customers that we have today in the programs we have. But that is a component of our long-term strategy.

Gary Balter – Credit Suisse

Just thinking about the business overall, can you give us any color on regional strength and weakness?

Bill Rhodes

We mentioned it in our prepared remarks but we saw some fluctuations on our regional basis. Quite frankly I think the biggest part of our fluctuation we believe comes from us and our execution in those individual markets. We saw nothing material worth highlighting.

Operator

Your next question comes from the line of Dan Wewer – Raymond James

Dan Wewer – Raymond James

Bill, when you’re looking at increasing your yes percentage or your in-stock percentage for commercial and do-it-yourself, do you have a sense to how much that’s adding to your same-store sales growth or your total revenue growth?

Bill Rhodes

We do specifically on specific categories. We can see it. We have not disclosed what that number is but it is clearly a key component of our success in that business and its not only a key component for the sales that you get for that category, but you know, whenever a customer calls you and you don’t have it, then they’re likely to move you down the call list over time if you don’t say yes frequently enough.

Dan Wewer – Raymond James

How would you say the sales benefit from the extra $75 million added in fiscal year ’08 compares to the benefit of the $75 million in 2007?

Bill Rhodes

Clearly last year’s benefit will be bigger than this year’s benefit because as I mentioned we kind of took the low-hanging fruit but we also learned a lot so we feel very confident that the inventory that we’re adding now is also going to be productive.

Dan Wewer – Raymond James

You were able to improve your gross margin rate despite the growing sales mix and commercial, it’s always an assumed that margin rates in commercial programs are lower than do-it-yourself. How much has that gap narrowed?

William Giles

It’s narrowed a little bit. We continue to have opportunities on gross margin both on DIY side and the commercial side and so I think overall there are certain strategies that apply to both sides of the business and I think we’ve been successful in executing them so we feel good about the health of the gross margin overall and we’re pleased that we were able to demonstrate an improvement this quarter.

Dan Wewer – Raymond James

Obviously your initiatives to focus on commercial are working, are there any thoughts about putting together some new programs to stimulate you do-it-yourself penetration or is AutoZone’s do-it-yourself sales productivity so high that further gains would be very difficult to achieve?

Bill Rhodes

No further gains would not be very difficult to achieve, obviously it’s a more mature business for us but it is something that we’re working on very diligently every day. We’re not satisfied with our performance in retail. Obviously there are a lot of influences that are going on today. We’re not dissatisfied with it, but we’re certainly not meeting our aspirational levels. We’re doing a lot of things along with product assortment improvements, we’re spending a lot of time on improving our training in the stores and making sure that our AutoZoners are motivated to give that great trustworthy advice.

Operator

Your next question comes from the line of Colin McGranahan – Sanford Bernstein

Colin McGranahan – Sanford Bernstein

Just wanted to follow-up on the commercial programs a little bit, in the 1,200, the subset of programs where you’ve got these modified or different tools and processes, first how would you envision the pace of expanding that to the base of the 2,233 programs now that you’re starting to see some traction and then just a little bit more color and specificity in exactly what some of those different processes are and what some of the different tools are in that subset of programs.

William Giles

The biggest part of the differences in the programs are the sales resources that are provided to that program. Number one they have what we call the territory managers. There’s an outside sales representative that also works with the AutoZoners in the box to make sure they’re delivering great service. That resource would typically have about 10 stores that it supports and the stores that aren’t on that program do not have a territory manager associated with it. Also inside the store, the commercial specialist has incentive compensation. There are a few other elements but those are really the main elements.

As far as how fast are we going to grow, we have been pretty prudent with how we’ve rolled it out over time and would expect us to remain prudent. We are very confident that it’s the right thing for those 1,200 stores but obviously when we picked the 1,200 stores because we were putting new resources incremental cost in there we started them with a higher volume stores. Because they could justify it easier. As we get to the lower volume stores it gets more complicated to justify but as we improve our overall program and performance it gives us the opportunity to continue to expand it and we hope that will continue.

Colin McGranahan – Sanford Bernstein

So is part of that prudence managing the negative margin impact of the higher cost of these programs because the sales traction builds over time?

William Giles

We have a term we use around here, it’s called pay as you go and that’s what we’ve been doing with the rollout of that program. Roll it to the next set of folks, make sure that it pays for itself, get traction in it, provide additional margins and then go roll it again.

Colin McGranahan – Sanford Bernstein

Can you talk about the impact of higher fuel on your distribution costs overall and how you’re hedged at this point?

William Giles

We are not currently hedged. We have not been hedged this fiscal year at all. On hindsight that looks like that was a bad decision but one thing we really haven’t spent a lot of time talking about our supply chain but they have done a phenomenal job over the last three years of continuing to drive incredible efficiencies out of that business and because of that we haven’t had to callout the impact of fuel. Obviously we have a big fuel component on both the outbound distribution processes also we manage most of the inbound freight in our DCs and we’re getting fuel pressures there. And then we also have our commercial fleet where we’re having fuel pressures. But we have a lot of pluses and minuses throughout our business and this is something that we can manage. Now if it goes to $6, $7 which nobody seems to be talking about, then it becomes a bigger component but I think we can manage it over time.

Operator

Your next question comes from the line of Matt Fassler – Goldman Sachs

Matt Fassler – Goldman Sachs

Your SG&A line, you showed excellent expense control over the course of the quarter, year-to-year growth in SG&A dollars moderated on essentially the same store count, can you comment on how proactively you manage the SG&A. Obviously there were some sales volatility in the industry presumably you experienced it as well, you’re quarterly comp was identical to the prior quarter. Just any color on that and whether that represents a tighter expense run rate then you’ve had or then you’d hoped to carry forward or something that’s representative of what you should be doing.

William Giles

I think that the organization did an outstanding job of managing expenses throughout the quarter. I think we got out in front of it. We recognized some of the headwinds from a macro standpoint and we reacted appropriately. We’ve been very careful about trying to make sure that we’re not cutting expenses in areas that are customer-facing and so I think that we’ve been able to find efficiencies just in how we operate the stores on a lot of fronts. But there are a lot of places where we’ve been very successful in reducing expenses and I think that we’ll continue those as we move into the fourth quarter as well.

Matt Fassler – Goldman Sachs

You have been very explicit about you’re leverage caps, from time to time you’ve come quite close to them and bought stock back nonetheless, I’m curious of whether the current credit environment and discerning nature of just today has you sticking a little more rigidly to some of those targets than you might have in the past.

William Giles

I would say no. Obviously we’re cognizant of it but I think that we started out the year and we opportunistically accelerated some of our share repurchases and bought $350 million in the first quarter and we exceeded our 2.1 credit metric and we committed to returning back to our 2.1 credit metric and we were pleased that we were able to do that by the end of the third quarter even though we committed to doing it by the end of the year.

Matt Fassler – Goldman Sachs

You obviously have ramped up your commercial sales effort, one of your other competitors has a similar effort, not identical but a similar effort, I’m wondering if you talked to commercial sales managers our in the field. You’re obviously winning more than your fair share given your market share gains, but are you seeing increased competition to become first call for some of these accounts at this point?

Bill Rhodes

I hate to disagree with you but when we have approximately 1.5% market share we’re not winning anywhere close to our fair share. I understand your point. It’s still and incredibly fragmented industry. If you roll all the top five players together you’re only talking about 20% market share. So are people taking notice of us in the marketplace more than they have in the past? Yes but we’re still such a small component of it that I don’t think we see increased competition on a material basis.

Operator

Your next question comes from the line of John Lawrence – Morgan, Keegan & Co.

John Lawrence – Morgan, Keegan & Co.

First of all would you comment on the new store performance on the retail side, as you open these stores, how are they doing in this environment and as you look at the pipeline for growth in some of these markets, just comment on that please.

William Giles

I think overall new store performance has been relatively consistent actually over time and so we haven’t really seen any significant gyrations in our new store performance overall. I would categorize it as relatively consistent. From the pipeline perspective we continue to see real estate costs are still relatively firm. We’ve seen some minor decline in construction costs overall and so we continue to find ample opportunities for us to continue to penetrate both existing markets as well as some new markets which would be smaller markets. So we continue to have pretty good breadth of assortment if you will from a real estate portfolio standpoint in both new and existing markets.

John Lawrence – Morgan, Keegan & Co.

If you look the best way to look at going forward with the new productivity you’re getting out of commercial, would you comment that as you look at some of these places as you point out that has to pay as you go, but have you identified some of those customers earlier in the pipeline that could be successful commercial customers than you say did two or three years ago and waiting for that timeframe of when they could be added to the mix?

Bill Rhodes

Most of the customers that we would add would be because we added a new program. When we’re going to a new program we go in and do a very extensive market analysis and so we know who those customers are well before we ever go in and we begin cultivating those relationships prior to opening up that actual commercial program. What we have really been focused on though is rather than expanding our footprint; let’s expand our penetration with our existing customers. Let’s prove to them and prove to ourselves that we have the right value proposition that gives them a compelling reason to pick us instead of somebody else. And so that’s really where the biggest part of our focus has been.

Operator

Your next question comes from the line of Matt Nemer – Thomas Weisel Partners

Matt Nemer – Thomas Weisel Partners

On the commercial program, how much does the change in incentive compensation impact the profitability on an EBIT basis on those programs?

William Giles

I don’t think it really impacts the, we obviously hopes that it improves the profitability from an EBIT standpoint that we’re generating the right kind of behaviors through a compensation program that we think will be more affective overall because again we’re looking to drive business and we’re looking to incentivize people appropriately. So we’re looking at it as a positive impact to EBIT.

Matt Nemer – Thomas Weisel Partners

Can you comment on the impact of inflation on your private label brands and are there any price locks or vendor price increases that might be changing here in the future?

William Giles

Difficult to get too far out into the future, the one thing that we’ve obviously seen a lot of pressure on isn’t on private label but on the commodity based prices. But we also see pressure on steel prices as well and we continue to see and expect that steel prices will continue to have pressure going forward as well. But overall I wouldn’t say that there’s anything from a private label perspective that’s any significantly different than anything else we’re seeing.

Matt Nemer – Thomas Weisel Partners

Are those increases, is the industry passing those on one-for-one at this point?

William Giles

Yes, nothing is absolutely one-for-one but for the most part we’ve been somewhat successful on passing on cost, typically we have.

Operator

Your next question comes from the line of Tony Cristello – BB&T Capital Markets

Tony Cristello – BB&T Capital Markets

When you look at the traction you’re gaining with some of the commercial accounts, is the margin on that incremental business tending to be more positive than what you’ve seen with accounts that you don’t have that level of traction with?

Bill Rhodes

I would say not particularly different. We haven’t seen significant swings one way or the other in our margin, overall net margin in that business. Obviously on an individual store level you can get significant increases in margin as you increase your penetration with those existing customers particularly if they’re within your tight service radius.

Tony Cristello – BB&T Capital Markets

When you look at the incremental inventory that you’re added, has there been a net amount that’s come out of the $70, $75 million or is that sort of the total incremental hard parts edition?

William Giles

I would say that that’s, it’s more of a net amount. I mean what that $70 million represents is more of a freshness from an inventory perspective particularly in later model coverage as Bill mentioned earlier. I think we’ve done a pretty good job on really trying to get some of the bottom end of the inventory out as well which is why on a per-store basis you’ve seen a less than a 1% increase for the quarter in spite of us adding about $70 million worth of inventory.

Tony Cristello – BB&T Capital Markets

How much of that inventory is primarily geared toward commercial or are your DIY sales benefiting as well?

Bill Rhodes

For the most part the focus of putting that inventory in has been generated for the commercial business but because so much of our business is in retail we often find that 50% or more of the sales actually end up on the retail side. That changes from category to category and definitely changes based upon how forward you are with the years, make and models, but still a tremendous amount of that comes through on the retail side.

Tony Cristello – BB&T Capital Markets

You talked about shrink being up a little bit, is that a function of the economy or is it a function of something that’s going on as you’re adding more inventory or maybe just a little clarification on that.

William Giles

I think it’s always hard to know exactly but I certainly would give some credit to the fact that the economy is down and I suspect that usually, if you look over time, that has some bit of a correlation but we’re going to work hard at making sure we reduce shrink again. That’s one of those non-customer facing expenses that we have opportunity to reduce.

Tony Cristello – BB&T Capital Markets

How has your turnover been at the store level?

William Giles

Actually pretty good, our turnover rate, we work hard at it, our field organization, HR organization has worked hard at it through both training and other aspects and our turnover rate is actually down a little bit.

Bill Rhodes

It’s down double-digits year-to-date so they’ve done a great job and it’s been a very specific focus by our HR and operations teams.

Operator

Your next question comes from the line of Scott Ciccarelli – RBC Capital Markets

Scott Ciccarelli – RBC Capital Markets

We’ve seen pretty much industry wide now and yourselves included that commercial has continued to outperform the retail segment and I understand its more of an area you can control whereas retail people are either walking in or not walking in. Do you believe that’s purely an economic impact or could we really, are we starting to see a shift in the marketplace starting to take hold in terms of more people just turning to the commercial side of the business?

Bill Rhodes

We don’t see any major shift between retail and commercial from an overall sales performance basis. In fact if you look at our sales performance over time it hasn’t changed that materially over the last three years on what’s going on on the retail side. Clearly there has been some softness in the market. Our take on that is that those retail customers are more influenced or impacted by the increase in gas prices and obviously we talked about how much gas prices went up in the last quarter so we think that’s clearly putting a headwind out there. But we don’t see anything material in the macroeconomic that changed.

Scott Ciccarelli – RBC Capital Markets

So really just cyclical or economic impact.

Bill Rhodes

The other side of it is our retail business is much more mature than our commercial business and we see incredibly bright prospects for the long-term in retail. We have a huge growth opportunity in commercial.

Scott Ciccarelli – RBC Capital Markets

Is there much of a difference between the mix between brand of product and private label in the commercial as opposed to the retail segment?

Bill Rhodes

No, at least not in our shop because we don’t carry different products. We tried, four or five years ago bringing in some specific commercial brands and what we found was the customers would try them for a little while and then they’d realize the value proposition of our brands, Duralast and Duralast Gold primarily, and they would switch over to them. And so we don’t have any specific commercial brands. There are a few categories where we have made the decision that we think it’s very important to have a name brand in that category. In those categories we have it but it doesn’t change between retail and commercial.

Operator

Your next question comes from the line of Michael Baker – Deutsche Bank

Michael Baker – Deutsche Bank

Some of your metrics like gross margins, gross profit dollars, EBIT dollars, etc. they increased but maybe at a slower rate than year-to-date, particularly in the gross margin, is that more a function of higher commodity prices or the weak economy or just the increased commercial business and if it’s the latter, as commercial continues to grow more, should that impact our expectations for gross margin growth?

William Giles

I think it’s probably a mix of some of those things overall and I think we’ve done some good things to improve our gross margin rates by lowering acquisition costs etc. But clearly commodity prices have a little bit of an impact on it as well to the extent that some of those prices can be carried on. I think quite frankly obviously we had about a 70 basis point improvement in gross margin in Q1 and Q2 and I think at that point we indicated that we expected the gross profit margin rates to moderate a little bit and so I guess the quick answer is that this is pretty much where we expected to be so we’re not surprised by where we are.

Michael Baker – Deutsche Bank

Is it pretty much where you expect to be on the SG&A as well as long as you maintain this about flattish comp level, in other words, flattish operating margins is reasonable.

William Giles

… 1.5% to 2% in order to leverage SG&A and I think we did a pretty good job this quarter at managing our expenses, [inaudible] down by about 30 basis points

Operator

I’d now like to turn it back to Mr. Rhodes for closing comments.

Bill Rhodes

Before we conclude the call I’d like to take a moment to reiterate that we understand both the opportunities we have for future growth and the challenges our customers face every day. We cannot take anything for granted as we understand we have to earn our customers’ business each and every day. Again I want to thank all our AutoZoners for their efforts and dedication to us achieving our goals. We have a solid plan and a culture that is second-to-none. But I want to stress that this is a marathon and not a sprint. Our focus is on our critical success factors as we continue to focus on the basics and never take our eye of off optimizing long-term shareholder value, we are confident we will continue to be incredibly successful. Thank you very much for participating in today’s call.

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Source: AutoZone, Inc. F3Q08 (Qtr End 05/03/08) Earnings Call Transcript
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