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The Pep Boys - Manny, Moe & Jack (NYSE:PBY)

F1Q08 Earnings Call

June 10, 2008 8:30 am ET

Executives

Raymond L. Arthur - Chief Financial Officer, Executive Vice President

Michael R. Odell - Interim Chief Executive Officer

Scott A. Webb - Senior Vice President - Merchandising & Marketing

Bernard K. McElroy - Vice President, Chief Accounting Officer, Treasurer

Analysts

Matthew Fassler - Goldman Sachs

Tony Cristello - DB&T Capital Markets

Scot Ciccarelli - RBC Capital Markets

Sid Wilson - Kevin Dan & Partners

Jeff Blaeser - Morgan Joseph & Co.

William Keller - FTN Midwest Securities

Analyst for Grant Jordan - Wachovia

Peter Benedict - Wachovia

Matt Nemer - Thomas Weisel Partners

Operator

Greetings and welcome to The Pep Boys first quarter 2008 conference call. (Operator Instructions) It is now my pleasure to introduce your host, Mr. Ray Arthur, Vice President and Chief Financial Officer for Pep Boys. Thank you, Mr. Arthur. You may begin.

Raymond L. Arthur

Good morning and thank you for participating in Pep Boys' first quarter 2008 conference call. On the call today are Mike Odell, Interim Chief Executive Officer of the company; Scott Webb, SVP Merchandising and Marketing; Bernie McElroy, our Vice President of Finance and Chief Accounting Officer and myself.

The format of the call is similar to those done by Pep Boys in the past. First Mike will provide opening comments regarding the company and the quarter and then I will review the first quarter financial performance, position, and cash flows. We will then turn the call over to the Operator to moderate a question-and-answer session. The call is scheduled to end at 9:30 Eastern Time.

Before we begin, I would like to remind everyone that this conference call is governed by the language at the bottom of our press release concerning forward-looking statements as well as SEC Regulation FD. In compliance with these regulations, we are webcasting the conference call on www.investorcalendar.com. For anyone on the webcast who does not have the financial statements, you can access them on our website, www.pepboys.com.

I will now turn the call over to Mike Odell, our Interim Chief Executive Officer. Mike.

Michael R. Odell 

Thanks, Ray. Good morning, everyone and thank you for joining us this morning. I am very excited by this opportunity to lead Pep Boys during this time of transformation. We are on a mission to rebuild the culture of this great organization and we will build and grow a profitable business model to create shareholder value by returning to our core automotive roots, attending to basic business execution, and most importantly focusing on our customers.

Our vision for Pep Boys is to take our industry-leading position in the automotive services and accessories industry and become the automotive solutions provider of choice for the value-oriented customer. This remains unchanged from what we announced back in November but I am excited to have the opportunity to share with you today how we are approaching our business to achieve this vision.

The first takeaway for you from our vision statement is our commitment to automotive solutions. This is more complete than the offerings of other automotive after-market players. We provide a complete range of repair and maintenance services performed by ASE certified technicians. We support all customers -- VIY and VIFM -- with a huge selection of parts and accessories for their cars and trucks and our commercial business, in addition to providing the same quality parts that we use to repair vehicles, also support these important customers with tires and equipment, so that they too can better serve their customers.

The second takeaway for you from our vision statement is our focus on value-oriented customers. For service, this occupies the vast space between dealers and local mechanics. Our ASE certified technicians are capable of serving customers for most repairs after the warranty expires and dealers lose their appeal due to pricing and convenience. And compared with the local mechanic, we have advantages of convenience, generally priced, and being a large recognized company that stands behind their warranty.

Clearly the economy is on everyone’s mind today. Housing deflation, tighter credit and higher gas prices and obviously our customers are no exception. We do feel the pinch in the discretionary segments of our retail business, as well as the effect of fewer miles driven in our repair business. But customers are also maintaining their vehicles to improve gas mileage and our focus on the value-oriented customer is right for these economic times.

Net income did improve $1.5 million in the first quarter of 2008 to 4.7. This was in line with our plan but only a small step towards our opportunity. Profit improved in our service business, was weaker in our retail business, as we expected, due to our merchandise transition and in a few minutes, Ray Arthur will walk you through those details.

We are leading our turnaround with our profitable service business. Industry trends favor this customer segment and as you know, it is a very fragmented industry with room for growth and consolidation. Sales of tires, maintenance services, and alignments grew in the first quarter. These are the first service categories that we addressed with category reviews and also drive-up service, and we are comfortable with our business model but we need to continue to improve at delivering it consistently.

Drive-up service is intended to support the delivery of fast, expert customer service and to create a more comparable environment for our customers. Repair work, except for brakes, was down for us in the first quarter. We are attacking each category with a complete review, methodically reviewing not just the competitive set and our pricing but also our selling and service process to ensure that it is customer focused and leads to complete solutions for our customers. We intend to leverage our big boxes with improved parts coverage on a store-by-store basis to support service, retail, and commercial customers in the trade areas around our stores.

During the first quarter, we updated coverage in major hard parts categories like brakes, engine management, ride control, and chassis. We have also updated assortments in 10 of our top 24 sales floor categories, including wash and wax, filters, oil, towing, and fashion and truck accessories.

We expect to substantially complete hard part coverage updates in store by the end of the second quarter and our top 24 sales floor categories by the end of the third quarter.

I do want to take a moment now to thank our store teams for their hard work to make this a reality. This is a major effort that we are in the midst of because we are not just updating planograms but also changing adjacencies throughout the store to make it easier to shop for our customers.

We have also substantially completed the development of our special order warehouse in Indianapolis that provides overnight delivery to any store in the U.S. and we launched two super hub stores that provide same day delivery of [hard to find] late model coverage to stores in the surrounding area.

Parts and car care have been fairly stable categories for us during this difficult economic period and we see on average an 8% change in sales trend when we improve our coverage. We view personalization as preferred categories in our automotive superstore; however, current economic conditions do not favor these categories. During the first quarter, we updated assortments in four categories, resulting in a 4% change in sales trend. We will update assortments of 28 additional personalization categories by the end of the third quarter. Personalization category sales have been softer than we planned but that does not change the need to improve the relevancy of our assortments to serve our customers.

Our biggest declines, double-digit declines, have been in the categories that we have de-emphasized. We have tried a number of tactics to minimize the downside but quite frankly, these are largely discretionary big ticket categories that are most susceptible to the effects of current economic conditions. We will continue to cycle the sales in these categories through the end of the fiscal year and in the fourth quarter, we will cycle the clearance sales, which were significant to the top line but less significant to margin dollars.

That’s the overview of our business trends and some of our current initiatives and now I’ll turn to the execution of our strategic plan.

When we pulled together our company-wide leadership team a few weeks ago for our leadership rally, we realigned and energized the organization around five internal priorities: customers first, inspire and develop the team, create the automotive superstore, margin controls and spending disciplines, and new products, services, and locations.

Customers first is at the forefront as we rebuild our business. We are refreshing our customer research during this period of change in the economy to reevaluate our customers in terms of what they want and how to best reach them. There are so many things that customers want. It is important to be grounded in what’s most important and fits within a business model that aims to serve value-oriented customers.

We fit between the dealer who provides all services for a particular vehicle brand typically during the warranty period and at a higher price and the local mechanic that customers trust once they get to know him. Our niche is between these two positions -- all services, all vehicle brands, lower prices, and national warranty coverage.

Key themes are to do it right and to deliver fast, expert customer service. Do it right for us means quality work and service and it means providing quality products and complete solutions to retail and commercial customers, so that they can do quality work as well. Delivering fast, expert customer service means not just being fast but more importantly respecting our customers’ time, and it puts a premium on how our associates serve our customers.

Our internal metrics for customer satisfaction did reach new highs in both service and retail this quarter but quite frankly, we are only scratching the surface on who we need to become.

An equally important priority is to inspire and develop our associates. We have a committed team of 18,000 associates and they are prepared to help us become the automotive superstore. Key actions under this priority include defining our culture, developing our associates, and using performance-based pay where it can have the most impact. Defining our culture is critical to engaging our associates to achieve a common purpose. Our vision to become the automotive solutions provider of choice for the value-oriented customer. We have a team that wants to win and we will do so by narrowing our focus, simplifying our approach, and focusing on our customers.

Developing our associates is important because we can no longer expect to succeed by merely training associates with our competitors. We will build our business model based on our customers’ needs and build the team accordingly. We will always look to upgrade talent but we will be methodical about how we develop and manage our talent so that we can grow the talent we need from within the company as a competitive advantage. Our people are the key to our success.

Our third priority is to become the automotive superstore. Scott Webb is leading our category update process for service, retail, and commercial. It’s a methodical approach that considers data for customers, the industry, competition, and the category. Of course, we’d love to have it all done now but it takes time to complete the work and then execute. Our store teams have done great work selling through the clearance merchandise and resetting the store and again, it’s not just updating planograms. Many core categories are expanding in space to become dominant in the eyes of our customers. That means lots of moves within the stores, which we expect to complete before the start of the fourth quarter.

As we get this key activity behind us, our focus will then shift to the introduction of our do-it-right sales and service program. Do-it-right will guide our associates’ interactions with our customers so that they leave our stores with complete solutions, whether service, retail, or commercial.

The fourth priority is of course to make money. We have a good profit model for service. We have an improved profit model for commercial and we still need to work on our profit model for retail. Productivity is of course key to profit improvement but we also see more opportunity with margin controls and will never stop paying attention to spending disciplines.

We also continue to market and sell non-productive assets and to adjust our capital structure and as Ray Arthur gets up to speed, he is the one who will be leading these efforts.

And finally, our fifth priority is growth. We continue to pursue new opportunities to leverage our big box with new products and services as long as they are true to our core automotive mission. Caroffer.com has been successfully launched and by the end of June 2008 will be available in over 200 stores. It is still in its infancy and not yet material to our financial statements.

We are also currently pursuing car and truck rentals and will have 16 truck rental programs launched in this quarter next. By focusing on core automotive, we are able to implement these programs with minimal investment and disruption to store merchandising and operations.

We also continue to look for opportunities to add service spokes but have nothing to report at this time.

And finally, we will also be adding commercial operations in 24 current locations this year. Presently, 410 of our 562 stores have commercial operations.

I will now turn this call over to Ray who will walk you through our results.

Raymond L. Arthur

Thanks, Mike. I will now review our results on a GAAP as well as a line of business basis. If you look at the last page of our press release, you can get the line of business information. I will also review relevant balance sheet and cash flow data and update you on our sale leasebacks.

Turning to the GAAP P&L, on a GAAP basis net earnings for continuing operations for the first quarter of 2008 rose to $5.3 million, or $0.10 per share versus $3.1 million or $0.06 per share for the same period last year. The results reflect significantly reduced interest expense due to debt repayments, a gain of $2.8 million from repurchasing bonds at a discount, and the fact that 2007 first quarter interest included almost $900,000 of expense related to a mark-to-market adjustment on a swap that did not qualify for hedge accounting.

Net earnings from continuing operations also benefited from increased gains on the sale of assets resulting from our sale leaseback transactions during the quarter. These benefits were offset by increased income tax expense and a $1.4 million reduction in operating profit as compared to the same period a year earlier.

Consolidated revenue for the first quarter was $498 million, a $41.5 million reduction from revenue of $539.6 million in the same period in 2007. The 7.7% reduction was the result of closing 31 stores, 20 of which remain in continuing operations, whose sales in the first quarter of 2007 were $13 million, and also due to comparable revenue declines of 5.6%.

Merchandise sales were also affected by the de-emphasis on sales of higher ticket but non-core product.

Gross profit declined as a percentage of sales to 25.7% in the first quarter of 2008, as compared to 26.1% in the first quarter of 2007. The decline in gross profit rate is primarily due to continuation of the clearance programs instituted in the last quarter of 2007 and increased occupancy costs as a percentage of sales due to deleveraging sales by de-emphasizing non-core product categories.

Product margin, which is before occupancy costs, increased slightly.

The quarter included sales of clearance products of $5.5 million at 1.6% gross profit, versus sales of the same product categories of $18.3 million in the first quarter of 2007 at a gross margin rate of 33%.

Gross profit dollars declined to $128 million in the first quarter of 2008, from $141 million in the same period in 2007.

For the first quarter of 2007, gross margin of the 20 closed stores, which remained in continuing operations was $2.6 million.

Selling, general, and administrative expenses declined to $119 million in the first quarter of 2008, compared with expenses of $127 million in the first quarter of 2007. As a percent of sales, the expense rate slightly rose in the first quarter of 2008 to 23.9% from 23.6% in the same period a year ago, primarily due to the deleveraging impact of closing stores and the comparable sales reduction.

Net gain from disposition of assets increased to $5.5 million in the first quarter of 2008 as compared to $2.4 million in the same period a year ago, due to the closing of two sale leaseback transactions.

Operating profit was $14.5 million in the first quarter of 2008 compared to $15.8 million in the same period a year ago, as a result of closing stores and the continued clearance program, offset by good spending controls and gains related to the sale leaseback transactions.

Interest expense declined in the first quarter of 2008 to $5.4 million from $12.7 million in the same period a year ago. First quarter 2008 includes a gain from the retirement of debt of $2.8 million and the first quarter of 2007 includes the cost of a mark-to-market for a swap that did not quality for hedge accounting of $900,000.

Income tax expense rose as a percentage of pretax income in the first quarter of 2008 to 43.6% from 40% in the same period a year ago, due to state tax increases and increased profitability of our Puerto Rican operations.

Discontinued operations swung to a loss of $600,000 in the first quarter of 2008 versus a gain of $100,000 a year ago. This change is a result of closing the 11 stores in 2008 compared to operation of these stores in the prior year.

In summary, net earnings per share as a result of the above rose from $0.06 in 2007 to $0.09 in the first quarter of 2008.

On a line of business basis, I will now cover the service business followed by the retail and commercial businesses. The service business, which includes tire and merchandise sales, as well as service labor revenue generated through our service bays, generated revenue of $224.7 million in the first quarter of 2008 versus $228.5 million in the first quarter of last year. Comparable revenue increased by 0.6% in the first quarter of 2008 as compared to the same period a year ago. Sales of maintenance services did well in the quarter -- tire, alignment, brakes, and ride control sales were stable, while most other repair work fell short of prior year.

Service business gross profit for the quarter was up nonetheless to $55 million, or 24.3% of revenue, from $52 million, or 22.7% of revenue in the year-ago period, and this performance was primarily due to improved pricing and realized labor rates.

The retail and commercial businesses generated sales of $273.3 million in the first quarter of ’08, as compared to $311.1 million in the first quarter of ’07. This is a decline of $37.8 million year-on-year or 12.2%. The 2007 results include sales of $7.5 million attributable to the stores that were closed that are not operational for any part of 2008. The results also reflect a reduction in gross sales of $12.8 million of non-core product that the company is de-emphasizing.

Excluding these closed stores and the clearance sales, the decline was 6% year-on-year. Parts, chemicals, oil and filter sales were stable versus last year and accessories, tools, and non-core sales were weak.

From a gross profit perspective, the retail and commercial business reported $73.4 million in the first quarter of 2008 versus $88.8 million in 2007, a decline of $15.4 million. Included in the 2007 gross profit are $1.7 million generated by closed stores not operational in 2008, a $1.3 million benefit from insurance proceeds related to the Hurricane Katrina, and about $6 million on gross profit on the sales of product we are de-emphasizing.

Gross profit as a percentage of sales declined due to the de-emphasizing of non-core product and a de-leveraging impact of reduced sales. Gross margin before occupancy costs actually increased by 0.4% as compared to last year.

Turning to the balance sheet, you can see that cash balances have risen significantly from last year-end, primarily as a result of the proceeds of the two sale leaseback transactions that we closed in the quarter. We are determining at this point what’s the best use of that cash. As you know, we have our synthetic lease coming due on 27 retail properties and two distribution centers on August 1, 2008. At that time, the company is committed to repurchase the properties for about $116 million and we are also in the process of determining how best to finance this commitment, including if we should refinance the purchase or use existing working capital and credit facilities to accomplish the transaction.

Turning to inventory, at the end of the first quarter it was $561.4 million, up slightly from the $561.2 million at the end of last year. The inventory level at the end of the first quarter reflects the reduction in inventory levels of non-core clearance product offset by increased inventory levels of core automotive product in line with our refocus on that segment.

Property and equipment is the only other asset with a large change versus prior year-end and this is due to the sale leaseback of 41 stores in the quarter.

On the liability side of the balance sheet, payables have declined by $15 million, which reflects normal seasonal changes; debt has declined by $59 million as a result of applying a portion of the sale leaseback proceeds to these balances; and the deferred gain as a result of the sale leaseback program has increased from $86.6 million at year-end to $146.1 million at the end of the first quarter, again as a result of the sale leasebacks.

As we disclosed previously, we believe we have substantial value in our owned real estate. The deferred gains are further evidence of this. We have sold the leaseback to a total of 75 properties, leaving 234 operating stores that are owned and 15 closed stores that are still owned, and we have generated about $304 million in gross proceeds, with resulting recognized and deferred gains totaling $168.4 million.

We indicated in 2007 before we started these sale leaseback transactions that we estimated we had an embedded value in our owned properties of about $1.3 billion. We believe the sale leasebacks completed today confirm our earlier estimates of embedded value of our owned properties and as to future sale leaseback transactions, we will continue to look at them and, if favorable to the company, will pursue them in the future.

Moving on to cash flow for a moment, we generated $66.4 million in cash flow for the first quarter of 2008, again primarily due to the sale leasebacks offset by the pay down of debt.

From a liquidity standpoint prospectively outside of the synthetic lease coming due, we have no significant maturities of debt for the next few years. We expect capital expenditures to remain relative consistent with prior years and do not see any significant cash needs other than normal operating cash flow in the near-term.

Regarding guidance, we will not be providing any. Regardless, when you are looking at our upcoming models and doing -- our upcoming quarters and doing your modeling, please consider the sale leaseback transactions and the clearance programs that had affect on the operating performance.

Okay, I’d like to turn the call back over to the Operator at this point and begin the question-and-answer session.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot. Good morning. My first question relates to one slice of the business -- as best I can tell, if you dissect the different areas of gross profit, if you look at the service business and you back out labor and you get essentially to installed parts, it looks like that gross profit rate on installed parts was up a lot. Now, I’m not sure if I adjusted for some of the restatements that you had versus a year ago but it seems like there might have been a several hundred basis point increase in the gross margin on that product. Is that accurate and if so, where does that come from?

Raymond L. Arthur

It’s accurate. It’s accurate. It comes from pricing.

Matthew Fassler - Goldman Sachs

So when you say pricing, is that a function of pass through of materials pricing or are you just adjusting your pricing on hard parts throughout the mix?

Michael R. Odell 

We constantly look at our pricing really as a total package and that’s part of what you see a little bit in terms of the parts, the merchandise sales versus the labor revenue, and so we are going to make sure that we are competitive in terms of how the customer shops that particular job and in terms of how we found that balance during the first quarter is more through the parts than through the labor.

Matthew Fassler - Goldman Sachs

And was that true in hard parts only in the installed front or was that probably true in the retail mix as well?

Michael R. Odell 

No, that’s more so on the service side. I mean, basically we look at it the way the customer shops us, so when we’re on the DIY counter and we are going to be -- and we have gone through great strides to make sure that we are very competitive in our price on the DIY side. And then when you get over to the service customer again shops us, it’s not for the total package and that’s how we make sure we get priced appropriately.

Matthew Fassler - Goldman Sachs

That’s very helpful. So presumably there’s some legs to that trend.

Michael R. Odell 

We hope so. We work it every day.

Matthew Fassler - Goldman Sachs

And out of curiosity, along those lines, what are you seeing in general from the vendors on down through the supply chain in terms of product price inflation as raw materials prices go up? And is the marketplace in your view kind of drifting higher or is still kind of sticky?

Michael R. Odell 

I’m going to let Scott Webb, who’s here with us, answer that question.

Scott A. Webb

Good morning, Matt. We are seeing pricing pressure from manufacturers in several different product categories. As you know, steel prices and oil prices are the foundation for most of those increases but transportation costs do impact a broad range of suppliers.

Matthew Fassler - Goldman Sachs

And is this -- if you think about, Scott, your history in the business which I know goes back a little ways, and you think about pricing trends, is this the most inflationary you’ve seen it in terms of both pressures and also pass through?

Scott A. Webb

I would say this is one of the most aggressive environments we’ve seen.

Matthew Fassler - Goldman Sachs

Okay, that’s very helpful. And then finally if you could give us just a little more color on the drive-up service initiative, how broad that can get, how you are marketing it differently and what kind of potential that effort has?

Michael R. Odell 

We haven’t started marketing it differently because I want to make sure we are consistent in how we execute it first and that’s really where our challenge is right now. You know, I would call this probably a 25% execution level relative to what our expectations are going to be. And again, it’s about just creating an environment so that instead of the customer walking into the store, figuring out where to go and then waiting in line, that they basically get greeted out at their car by the associate. You know, the biggest constraint, of course, that we have in the execution is the amount of labor that we have in our stores to be able to be out there to greet the customer and that’s where we are constantly fine-tuning, trying to find that right balance. Because I don’t want to lean too far forward with an over-investment, yet at the same time I do want to get the guys off the counter and out to the car with the customer.

Matthew Fassler - Goldman Sachs

Thank you very much.

Operator

Our next question comes from Tony Cristello with DB&T Capital Markets.

Tony Cristello - DB&T Capital Markets

I guess one question I had, when you look at your SG&A, certainly a noticeable improvement sequentially as well as year over year. And how much of what we are seeing now is a situation where you’ve closed stores, you’ve done some things that there’s opportunity to say hey, this is at least a beneficial standpoint. It’s not going to get -- start to see a creep or are there some things that you might do, the commercial additions or some of these other things that we might see SG&A start to climb a bit from levels we saw this quarter?

Raymond L. Arthur

I don’t think that you are going to be seeing SG&A levels climb from where you saw in this quarter. There are always business needs that come up that require some spending but our focus here is actually to see whether we can reduce those costs further and I’ve only been here a short time but I would hope that we would be able to do so as we move forward. So I don’t think it’s appropriate to think they are going to creep up.

Tony Cristello - DB&T Capital Markets

And shifting gears a little bit, when you look at your business, there’s obviously a big concentration on the tire side of things and from an industry standpoint, we’ve seen some soft results in the number of tire shipments and units. Can you maybe give a little bit more color on your tire business, what you are seeing in terms of customer traffic or customer patterns, and how you might be positioning your inventory in what is a softer environment right now and why it may be different than what we are seeing as a whole on the industry more from the tire manufacturers?

Michael R. Odell 

Obviously we track RMA shipments as well and have seen the declines and I can tell you that our performance has been better than what we see in the industry. Part of that is due to the fact that we’ve improved our assortments in our stores and obviously we’ve stayed strong with our buy three, get the fourth tire free message, as well as adding into it the low price tire message. We’ve increased the dominance of tires in our marketing efforts, so we’ve actually been pleased with our performance relative to what we’ve seen in the industry.

In terms of positioning the inventory, we did have a rise in tire inventories because of the assortment improvements that we’ve made but basically tires are fairly easy to manage in terms of the overall inventories because of how quickly they turn for us.

Tony Cristello - DB&T Capital Markets

And I guess on the standpoint from the customer, I mean, have you noticed any -- either from a traffic standpoint or just in their buying patterns, has anything changed too dramatically? I mean, gas prices obviously are much higher now than they were a year ago but the industry as a whole has been experiencing some soft results since 2006 and I’m just wondering, have you seen any discernible trend in your business one way or another from the recent jump in oil on those gasoline prices?

Michael R. Odell 

Clearly miles driven affects our overall business, particularly when it comes to repair. And again, I think on part of that on tires it’s because of the nature of our assortment. I mean, we are very much a value orientation in terms of our tire assortment, which I think is playing well right now, so I hear you, but we’ve been pleased with our tire business.

Tony Cristello - DB&T Capital Markets

Okay, and what about in general in other categories of business? I mean, obviously the deferrals are continuing but have you seen any type of acceleration? Or I should say any type of increased deferral mentality, or is it just hey, we’re to the point where critical parts are -- we’re seeing through and that’s just how business is going to be now.

Michael R. Odell 

A couple of things. I think when we get into -- on the service side when we get into the heavier repair work, that’s where you see some deferral. We definitely on the DIY side in particular, we see customers trading down in terms of, for instance, the types of pads that they would -- brake-pads that they would select for their vehicle. And obviously the part of our business that’s the toughest for us right now is those discretionary products, that personalization or the accessories on the sales floor, where customers can decide to go without it when times are tough. That’s where we feel it the most.

Tony Cristello - DB&T Capital Markets

And how do you balance then wanting to have better in-stocks or fill rates or the right kind of inventory in an environment now where customers might be trading down versus what you think is going to be good for your business over the long-term?

Michael R. Odell 

Obviously we’re not going to go heavy in terms of making any big bets in those categories but we still need to make sure that we are right. I mean basically I think what kind of is happening right now is customers are always looking for the best deal and so we’ve got to be priced right. I don’t think that we’re in an environment where you want to go chasing margins down a hole, right? The customers are either going to -- a large part when it comes to discretionary items, customers are going to buy them or they’re not. So to cut price, while we’ve got to be competitive but to cut price to chase sales is a losing proposition and to chase inventory to chase sales is a losing proposition.

We’ve got to be priced right and we’ve got to play things tight but we’re not going to have out of stocks.

Tony Cristello - DB&T Capital Markets

Great. Thanks, guys. I appreciate it.

Michael R. Odell 

The other comment would be relative to the other things, the other trend that we are seeing is customers, that I mentioned in my comments before, is we are seeing customers look for ways that they could improve their fuel mileage, so whether it’s air filters, oil changes, tire pressure, fuel system treatments, those are the areas where we are seeing favorable sales results as people try to improve their gas mileage.

Operator

Our next question comes from Scot Ciccarelli with RBC Capital Markets.

Scot Ciccarelli - RBC Capital Markets

I had a follow-up on Tony’s question, just a little bit of a clarification -- so what is the right way to think about the balance going forward between retail sales and gross margin percentage? I mean, is there a certain balance you are trying to strike? And if you guys could kind of prioritize the right way to think about it, that might be helpful for all of us.

Scott A. Webb

I think Mike said it earlier -- we are acutely focused on maintaining competitiveness in the marketplace. Certainly in this time where folks are price and value conscious, we have got to be sharp in terms of managing our mix within that good, better, best relationship to drive gross margin improvement, as well as through our category management efforts also to drive gross margin improvement.

Scot Ciccarelli - RBC Capital Markets

But I guess what I’m asking is, is there a priority in terms of you guys are shooting for a certain gross margin goal and the sales will kind of flesh out as they will, or is it --

Michael R. Odell 

No, I think our goal is to see sales increase at good margin rates, but we are not going to sacrifice our profitability to chase sales in a tough economic environment. We’ll be competitive and we’ll be in stock and we’ll provide value but it doesn’t make any sense for us to start lowering prices dramatically to chase sales volume.

Scot Ciccarelli - RBC Capital Markets

Okay. And then switching gears to the service side, I mean, we’ve seen some modest improvements to the service gross margin but it’s still half of what it was a couple of years ago. I guess how are you guys thinking about that business going forward? Is that a reasonable goal, what you had a couple of years ago? Or is the business different enough now and is the industry different enough where that shouldn’t really be the benchmark that you guys are trying to gauge yourselves in?

Michael R. Odell 

Yeah, a lot of that, when you compare back to historical financial statements has to do with before the company was reorganized across lines of business and the way services, costs were allocated between the different businesses. Basically our service business, when we look at the flow-through, the incremental margin on an incremental dollar of sales, it’s healthy. Every line of business that we play in in service is profitable and it’s really -- what deteriorates the externally reported gross margin is the fixed cost base, particularly as it relates to the facility. So it’s really about generating extra volume over that fixed base.

It’s profitable and very easily leveraged to our favor.

Scot Ciccarelli - RBC Capital Markets

So what is a -- I don’t know, how you guys best gauge -- is there a certain capacity rate you are running now and there’s a certain goal you would kind of like to get to?

Michael R. Odell 

That’s a fair question. We haven’t really measured it exactly like that, except to say that we have plenty of capacity in our service business.

Scot Ciccarelli - RBC Capital Markets

All right. Thanks a lot, guys.

Operator

Our next question comes from Sid Wilson with Kevin Dan & Partners.

Sid Wilson - Kevin Dan & Partners

Can you discuss what you are seeing in terms of the decrease in driver shipment SUVs and are you adjusting your services as well as your inventory toward that?

Michael R. Odell 

Yeah, I think some of that is going to play out more over the long-term than the short-term, in terms of obviously the -- you know, and one of the things obviously we assessed in terms of what’s it going to mean to us five years down the road with the shift in the way the new vehicle -- the shift in new vehicle sales and what does that mean to us down the road.

But I think the immediate impact on us would be fairly minor in terms of the effect it would have on the inventory. You know, we model our stores on a regular basis in terms of whether to up the quantities of a particular item in the store by one or down one, and that’s an ongoing way of running our business and the way we would manage that risk or that change in the environment in the short-term, and obviously the longer term, it’s going to change the type of parts that are carried in all the stores.

Sid Wilson - Kevin Dan & Partners

Okay, thanks. And with regard to your private label tires versus your national tires, could you give us a sense in terms of what you are seeing in terms of the sales, breaking it down between those two categories?

Michael R. Odell 

We’re pretty much a private label house and obviously that’s again what we think plays well in this current environment that’s value oriented. We do have some tires that are national branded but they are not really national branded in the way that customers think about it. We are a private label house, by and large.

Sid Wilson - Kevin Dan & Partners

Okay, and with regard to the -- what you are -- and I know you haven’t given any -- you’re not going to give any guidance but any color or any general color in terms of what you may have seen in the month of May?

Raymond L. Arthur

No, not at this point. I mean, I think it’s safe to say that everyone is dealing with the price of gas and the economy as it is and at this point, that’s kind of what we’ve all got to cope with until things start to look differently.

Sid Wilson - Kevin Dan & Partners

Okay, thanks, and my last question is backing out the 5.5, I just want to make sure I got this correctly -- was EPS $0.04 or --

Raymond L. Arthur

Well, that 5.5 is pretax, so you get down to about 3.5 after.

Sid Wilson - Kevin Dan & Partners

Okay, so 3.5, rounding up to $0.04? Okay, thank you very much.

Operator

Our next question comes from Jeff Blaeser with Morgan Joseph.

Jeff Blaeser - Morgan Joseph & Co.

Good morning and thank you. Quickly on the SG&A side, where do you stand on the $90 million annualized reduction target? How far into that are you at this point and what else do you have left to eliminate?

Raymond L. Arthur

I don’t have that data at my fingertips here. I would say that we have a number of ongoing programs with significant opportunity that we continue to pursue to reduce our SG&A spending.

Bernard K. McElroy

I would say we are making very good progress against that target and continue to see the savings go through our SG&A, just like we did in this quarter.

Michael R. Odell 

One of the things I would say is I’m excited to have Ray on board and it’s a fresh set of eyes, and now that he’s kind of got his first 40 days under and as we get behind this earnings release and the annual shareholders’ meeting is next week and those activities, and he’s gotten to know his team, his full force is going to be going through all of our expenses to come up with not just making sure that we’ve captured the existing opportunities but that we identified new opportunities.

Jeff Blaeser - Morgan Joseph & Co.

Okay, and on the synthetic lease, I think you said a cost of $116 million. Do you have a feeling to what the current value of those properties are and do you expect to flip it?

Raymond L. Arthur

We believe that they are in excess of $160 million and we haven’t determined what -- exactly how we are going to treat those properties yet, whether we are going to bring them back on the balance sheet or whether we will do a sale leaseback.

Jeff Blaeser - Morgan Joseph & Co.

Okay, and then the overall market conditions, cap rates still in the 7.5%, 8% range and any feel for timing of any additional sale lease backs?

Raymond L. Arthur

I mean, yeah, I think that’s a fair assumption that it’s somewhere around the eight range. As to timing, I don’t have any feel at the moment.

Jeff Blaeser - Morgan Joseph & Co.

Thank you very much.

Operator

Our next question comes from William Keller with FTN Midwest.

William Keller - FTN Midwest Securities

Good morning. Thank you. First off, just on the clearance inventory, I think you mentioned that you’ve got about $12.5 million left. I thought it was around $8 million at the end of the fourth quarter. Could you just help me understand what changed from the fourth to the first quarter?

Scott A. Webb

Likely what we were talking about, there’s a -- it’s the sales for clearance versus the hard parts clearance. That last time there might have been --

Raymond L. Arthur

I actually think it’s a gross number versus a net number -- the 12 is gross value on-hand today. There’s relatively little book value remaining on that, maybe $1 million, and the number you were looking at at the end of last quarter was the net book value that was still on the books of 8.

William Keller - FTN Midwest Securities

All right. Thank you very much. And then last week, Moody’s actions, I’m wondering if you could just discuss briefly if that has any impact on business going forward.

Raymond L. Arthur

You know, it doesn’t. I was a little disappointed with the action Moody’s took. We believe our financial prospects are good. We’ve got a new team here and maybe it was a little unsettling to Moody’s to see the CEO and CFO change, but in any event we are very bullish on the business and hope to see it doing much better. We do not -- our debt doesn’t have covenants in it related to ratings. Standard & Poor’s has left our rating alone so hopefully what we’ll be able to do as we go forward is convince Moody’s that our story is better than maybe they think it is right now.

William Keller - FTN Midwest Securities

Sounds good, and then last thing on the tire business that has been going well, how much of that is adding expanded tire programs to some stores or how much of that is more of a pure organic performance?

Michael R. Odell 

Say the question one more time.

William Keller - FTN Midwest Securities

If I recall, and please correct me if I’m wrong, you’re adding some -- you’re making some changes in the tire business in either expanding programs or expanding square footage in some of the stores. And as that category is doing well, I’m wondering if you can parse out how much of that is due to some of those efforts and how much of that is a pure -- if the stores are exactly the same, just better sales through the store?

Michael R. Odell 

I’ll tell you there’s a combination of both. Number one, the stores where we are fixing our adjacencies and we are freeing up square footage, as we edit those categories we are backfilling those with a larger tire presence. That’s simply taking sizes and assortment from the racks that are in the back of our stores and putting them out on the sales force so that the customers can shop them along with our associates.

I think what we are seeing in terms of our favorability in tire sales is more towards our overall marketing efforts and the emphasis that we are placing across the business on the tire category itself, rather than specific tactics within specific stores.

William Keller - FTN Midwest Securities

Very good. Thank you very much.

Operator

Our next question comes from Grant Jordan with Wachovia.

Analyst for Grant Jordan - Wachovia

This is Mike in for Grant. On the $2.8 million gain in bond buy-backs, how much was repurchased?

Raymond L. Arthur

It’s about $20.7 million, face value of the bonds.

Analyst for Grant Jordan - Wachovia

Great. That’s all I had. Thanks.

Operator

Our next question comes from Peter Benedict of Wachovia.

Peter Benedict - Wachovia

Coming from the other side of the house here, just a follow-up on the inflation question, actually Matt’s question -- you had mentioned that you are seeing some pass-through on the service counter. I just wanted to make sure I heard you correctly -- you are seeing some pass-through as well on the retail side, just not as much? Or is that not what you are seeing?

Scott A. Webb

Yes, we are seeing pass-through on the retail side.

Peter Benedict - Wachovia

And is it -- in order of magnitude, is it a lot stronger than you had been seeing the last few quarters? Are we starting to see a lot of this stuff start to hit now? Just trying to get a perspective as to when this all started to come through and is it building momentum?

Michael R. Odell 

I would say that there is some momentum that’s being built, especially with the steel and the continued pressure on oil. But I think it actually -- there may be some ahead of us rather than what we are dealing with right this minute.

Peter Benedict - Wachovia

Yeah, sure, that makes sense. Thanks. And then I’m just curious as to how the leadership change is being communicated down to the associates. Is it basically a stay-the-course message? I mean, you outlined the five priorities. Just to whatever degree you guys are comfortable talking about that, how has the whole change been communicated down to the troops?

Michael R. Odell 

Actually, it’s been a big focus for the first -- my first 30, 40 days here to get everybody settled down and focused. And part of the message is about staying the course, part of the message is about simplifying. We felt like we had too many things going on that were starting to fragment people’s focus, and just trying to get things simplified and focused. And the biggest message is to make sure that that focus turned on to our customers. We had a leadership rally where we brought in all of our field leaders, all of our area directors -- I guess it’s been about three weeks now. You know, as you might imagine, as they came into Philadelphia for the session, it was a little tense and when they left, they were fired up and ready to go. And they are in the process now of getting that message out to their teams, first their store leaders and then within the stores. And that’s a big effort for us as we work to inspire and develop our teams, is to get that message across the chain around what we are going to be in terms of an automotive superstore and particularly the message about putting our customers first in everything that we do, and just simplifying the level of activity that we shove down to our stores so that they can maintain that focus on our customers and driving a profitable business.

Peter Benedict - Wachovia

Okay, thanks for that. And then just lastly, any regional tone to the business that you can talk about in the first quarter, whether it’s California, points east that are notable, different from before, something worth calling out?

Michael R. Odell 

Particularly when you look at last year, obviously those areas that were kind of at the forefront of the housing crisis had the biggest impact, and I would say Florida is still pretty tough for us. But throughout the rest of the country, things have kind of I’d say leveled off where things don’t stick out as much. We obviously have weather peaks and valleys when it’s heat or rain and those kinds of things that move geographically. But from an economic tone, Florida kind of sticks out for us and after that, things I think are kind of more level across the country, whereas obviously last year the west in terms of Arizona, California, and Nevada were really hurting, but I think part of it is we are kind of coming across those numbers the second go-round.

Peter Benedict - Wachovia

Great. Well, hopefully this heat in the Northeast is helping a little bit, at least recently. Good luck, guys.

Operator

Our next question comes from Matt Nemer with Thomas Weisel Partners.

Matt Nemer - Thomas Weisel Partners

Good morning, everyone. Just a quick question on the car offer product. I may have missed this but how many stores is that in, how many units have you processed, and what sort of price or profit realization per unit should we be thinking?

Michael R. Odell 

It’s still, as I said, it’s still fairly immaterial. We basically -- our target is to make about $400 per car in terms of the share of the profit. We are a little bit below that. The traffic has been building over the last couple of weeks but it’s still fairly small and as I say, we plan to be up to 200 stores by the end of next quarter.

Matt Nemer - Thomas Weisel Partners

That’s all I’ve got. Thanks.

Raymond L. Arthur

Okay, if that’s all we’ve got --

Operator

Thank you, sir. There is no further time for any questions. I will turn the conference back over to management for closing comments.

Raymond L. Arthur

Okay, well, we appreciate you coming to listen to us today. We are planning on getting up to New York towards the end of the month and making ourselves available to have some meetings, should you have any further questions.

Michael R. Odell 

We appreciate your time today, our chance to tell our story for the first time as a re-energized management team and looking forward to getting to know you all better here over the coming month or so. Have a great day.

Operator

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time. Thank you all for your participation.

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