AutoZone, Inc.
Q4 2006 Earnings Call Transcript

Published: 19 Sep 2006

[Operator:]

Welcome. This is the conference call to discuss AutoZone's fourth quarter financial results. Bill Rhodes, the Company's President and CEO, will be making a short presentation on the highlights of the quarter. The conference call will end promptly at 10

[Bill Rhodes:]

Good morning and thank you for joining us today for AutoZone's fiscal 2006 fourth quarter conference call. With me is today is Bill Giles, Executive Vice President and Chief Financial Officer; and Brian Campbell, Vice President of Investor Relations and Tax. Regarding the fourth quarter, I hope you've had an opportunity to read our press release and learn about the quarter's results. If not, the press release, along with slides complementing our comments today, are available on our web site, www.autozoneinc.com. Please click on Quarterly Earnings Conference Calls to see them. To begin, I'd like to start by thanking our entire organization for their efforts in continuing to live the AutoZone pledge. I am extremely proud of our AutoZoners and their efforts. The primary initiatives for this fiscal year have been focused on improving the customer shopping experience. A significant point of emphasis has been placed on AutoZoner training. My personal travels to our stores continued to encourage me, from the improvements in the layout of our store interiors to the high level of engagement and commitment to our AutoZoners. I firmly believe we are on the right track to continue to build this incredible company and deliver strong financial performance. I'd also like to take a moment and congratulate the team on completing a very challenging and exciting step in AutoZone's history. We challenged every AutoZoner to improve their customer service efforts this past year and I feel we succeeded. While we will never be satisfied, we accomplished significant successes. For 2007, I'm proud to announce that we're absolutely committed to building on our successes and our AutoZoners have embraced this new year with the same excitement as the last. You won't hear from me today about new visions and paths to success. Simply put, our focus will continue to be on living the pledge in fiscal 2007. It will be about improving our customer shopping experience; it will be about profitably growing commercial sales; it will be about growing operating profit dollars, all while optimizing our return on invested capital. We will continue to be exemplary stewards of capital for our stockholders. As in past quarters, I'll start with comments on our overall financial results and then go into detail regarding our DIY sales initiatives, commercial selling initiatives, and Mexico. Then Bill Giles will provide an update on the balance of the income statement and our balance sheet and cash flow statements for this past quarter and year. Finally, I'll provide a few closing comments. Regarding the fourth quarter, for the 16 weeks ended we reported sales of $1.939 billion, an increase of 3% from last year's fourth quarter. Same-store sales, or sales for stores open greater than a year, were down 0.9% for the quarter. Gross profit as a percentage of sales for the quarter was up 97 basis points, while operating expensing as a percentage of sales increased by 39 basis points. This resulted in an operating margin of 19.2%, up 59 basis points from last year's quarter. Operating profit increased 6.2% versus the prior year. During this year's quarter, we experienced additional expenses associated with the introduction of FASB 123 R, Share-Based Payments at the start of this fiscal year. Excluding this item, operating profit increased 7.7%. Net income for the quarter was $213 million and diluted earnings per share increased 9.6% to $2.92 from $2.66 in the year-ago quarter. Excluding this year's expenses related to option expense recognition and last year's fourth quarter discreet tax benefit of $6 million, net income was up 8.1% while earnings per share increased 14.6% to $2.96 versus last year at $2.59. Our continued disciplined capital management approach resulted in return on invested capital for the trailing four quarters of 22.2%. We have and will continue to make investments in our business that generate returns that significantly exceed our cost of capital. We have not and will not deviate from our efforts to optimize shareholder value over the long term. We continue to be fiscally prudent with our investments while optimizing our earnings per share. Now I'd like to talk about our DIY sales results. Total domestic retail sales were up 2.9% for the quarter. During this quarter, we continued to focus on driving sales and profits over the long term. Our customer research and sales results over the past year continue to reaffirm what we've always known. Our customers shop with us because we provide them with trustworthy advice. Our customers have told us to focus on the basics, which are incorporated within our AutoZone Pledge to both our customers and fellow AutoZoners. I'd like to take a moment and update you on our continuing successes in the quarter, certain challenges, as well as our opinion on the macro selling environment. While we certainly believe the macro environment has been challenging, our customer's share of wallet was impacted by the ever-higher prices of gas at the pump. We continue to generate opportunities to improve sales by refining our selling assortment to be able to say “yes” more than ever before. Based on our pledge at the beginning of this fiscal year, we introduced several customer service initiatives. First, I stress that we worked and will continue to work to improve the customer shopping experience by optimizing the number of both off shelf merchandise placements and sales floor product placements. This included reducing the number of displays to improve customer flow, and placing products on our shelves that are compelling and easily obtained based on the job the customer is planning to do. The results of this initiative continue to be extremely positive. Through the use of an extensive survey network, overall satisfaction scores are now measured. Over the past year, there has been significant improvements in satisfaction versus a year ago. In fact, just this past quarter, our results show all areas of the country having significant gains versus a year ago in satisfaction. As those scores have been disseminated, we learn more, specifically about the helpfulness offer AutoZoners, selection of items, quality of items, the value per price paid, and AutoZone's ability to recommend and provide trustworthy advice. Every one of these metrics has improved as the year finished. In fact, we will study these results for the upcoming year in far more detail on a per-store level, as the sample is that extensive. We realize this information allows us to provide the necessary information to both our AutoZoners and our customers to make the appropriate purchasing decisions. This mission has not, nor will not, change for us in the future. Second, I've talked about adding clarity to our offering by reducing the amount of non-automotive related items in our stores. By and large, the goal of this initiative was to reaffirm to our core DIY customers that we are focused on providing the parts and products they need to maintain and accessorize their vehicles. Focusing on extending, where appropriate, our automotive product offerings will be a key initiative in 2007 and beyond. We believe our store presentation today reaffirms to our customers our commitment to be their vehicle solutions provider. Third, we have continued to focus on providing our customers with the broadest offering of parts and accessories to meet their ever-expanding needs. This includes improving in-stock levels in our stores. Over the last several months, we rolled out a new assortment planning tool to continue to improve our ability to say yes to our customers’ parts request. This effort included both adding new SKUs and removing slower-moving SKUs. As with the implementation of most significant new tools or processes, we made some improvements but we also made some mistakes. We continue to refine this tool, our complementary processes, and improve our team's training to leverage this new asset. Due to those learnings, we slowed the deployment of those key decisions. We have substantially completed those refinements and are now deploying new product assortments for select product categories. We will monitor the performance of those categories, continue to enhance our processes and tools, and over the course of the year enhance our product offerings. As we go forward, we believe we will gain traction throughout the year with the bulk of these enhancements impacting the back half of this new fiscal year. With inventory availability being such a vital part of our business, this effort will be a key focus for us in 2007. Fourth, I discussed the renewed emphasis on training, including a specific emphasis on our culture. During the quarter, we continued to hold what we call WITTDJR meetings, or “What It Takes To Do The Job Right”. The meetings focus on our cultural practices to ensure customer satisfaction. Every one of these meetings begins with the cheer and pledge, of course, and with AutoZoner recognition. This includes recognition for years of service, for extra mile efforts, for shrink busters, and for recognition from our customer letters. Improving the knowledge level, effectiveness and engagement of our AutoZoners is an important element of delivering trustworthy advice. Through this training, we've been able to continue to stress opportunities for good, better, best selling and add-on sales to do the job right. I cannot overstate how important I believe this effort is for our entire organization and our AutoZoner feedback states the same. Fifth, I've mentioned we're continuing to focus on our brands. We continue to expand coverage of merchandise available under the Duralast nameplate. This exclusive brand of high quality parts and products provides us with a key point of differentiation. Along with our efforts around our import initiative, the successes of this program have only just begun. During fiscal 2006, I am happy to announce that the Duralast family of brands represented well in excess of $1 billion in sales, making it an enormous and very important brand in the automotive aftermarket. As I said last quarter, we're continuing to listen to our customers and our 50,000 plus AutoZoners. We are focusing intensely on the basics. 2007 will be no different. Nothing too complicated, simply give our AutoZoners what it takes to do the job right and I know we'll continue to succeed well into the future. During the fourth quarter, gas prices rose approximately 14% from our third quarter's average price as the price of crude oil reached near-record levels. We continue to believe it has been the sequential change in the price of gas that affects our customers most. While changes year-over-year are important, we've seen a higher correlation to our sales results when the price of gasoline changes from one quarter to the next. We believe consumers’ memories appear to be more short-term toward the significant spikes. We, like many retailers, are concerned by the sharp price increases at the pump. These higher expenditures are taking an ever-larger share of our customer's wallet. While AutoZone cannot control gas prices, we believe we have initiatives in place to help offset many of these negative affects. Additionally, we continue to view higher gas prices as an opportunity for us to help provide trustworthy advice on even simple, little things that can improve fuel mileage and save money. Again, while we're not excited about the higher gas prices we experienced in the fourth quarter, we certainly have initiatives in place to help offset their impact. We also believe there comes a point when pent-up demand for certain hard parts drives consumption. We certainly feel with more cars on the road than ever before, our ability to grow sales remains strong over the long run. During the fourth quarter we estimate that weather had a minimal impact on our sales. Regarding miles driven, we've seen four months, April through July, of decreases. We believe this reduced driving trend originated from both high gas prices and general pressure on consumer's disposable incomes. Let me reiterate the two statistics we've always felt have the closest correlation to our market growth

[Bill Giles:]

Thank you, Bill. Gross margin for the quarter was 49.7% of sales, up from 48.7% of sales in the previous year's quarter. We continue to be successful in working with our vendors to offer the right products at the right prices to our customers. This includes supply chain initiatives, tailoring the merchandise mix, continued optimization of good, better, best product lines, all allowing us to price our products appropriately and give our customers great value. Going forward, we believe there continues to be some margin expansion opportunity, albeit at much reduced rates. We continue to work with our vendors to lower our cost and provide the best selection of merchandise for our customers at the right prices. Our initiative to do more direct importing of merchandise from foreign suppliers is well underway. Prior to the start of this fiscal year, we bought virtually all our goods from U.S. vendors who may or may not have been buying from foreign sources. While we are increasing our efforts to reduce our costs by going straight to the manufacturer where appropriate, we are not immune from the overall cost pressures in the macro environment. We are extremely proud of our buying organization for their abilities to improve on margins while pressures on procurement cost continue to exist. Again, our success in managing cost efficiently is something to be proud of, but we cannot let up. We have to keep focusing on cost containment for success in the long run. SG&A for the quarter was 30.4% of sales, up 39 basis points from last year. However, this year included a non-comparable charge for the new expensing of stock options under FAS 123 R. On a comparable basis SG&A went up 12 basis points. The increase was due primarily to occupancy cost increasing. This has come from our continued investment in new stores and maintenance on our existing stores. Second, this past quarter we were able to anniversary investments we made in the business, beginning in last year's fourth quarter. Bill Rhodes discussed in detail many of those initiatives under both the DIY and commercial selling discussions earlier. We are pleased with our progress to date toward managing our expenses and we will continue to do so. EBIT for the quarter was $373 million, up 6.2% over last year. Excluding this year's adoption of FAS 123, EBIT for the quarter was up 7.7% last year. Interest expense for the quarter was $34.9 million compared with $32.8 million a year ago. Debt outstanding at the end of the quarter was $1.857 billion, or approximately $5 million less than last year. The increase in interest expense reflects both the ongoing effort to term out the Company's debt on a long-term basis as well as the year-over-year increase in short-term rates. Our adjusted debt levels were maintained in line with our guidance of 2.1 times our trailing 12-month EBITDAR. We have purposely managed 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 36.9% above last year's rate of 35.1%. However, excluding last year's discreet tax benefit of $6 million, this quarter's rate of 36.9% was 10 basis points under last year's fourth quarter rate of 37%. Over the next several quarters we expect to maintain an approximate 37% effective tax rate. Net income for the quarter of $213 million was up 3.3% over the prior year. However, excluding stock option expense in this fiscal quarter, and a discreet tax benefit of $6 million in last year's fourth quarter, net income was up 8.1%. Earnings per share for the quarter of $2.92 were up 9.6% on 73.1 million diluted shares; but again, excluding this year's share-based option expense and last year's fourth quarter discreet tax benefit, earnings per share were up 14.6% from last year's $2.59 per share. Relating to the cash flow statement, in the fourth quarter we generated $386 million of operating cash flow and we repurchased $340 million of AutoZone stock as part of our ongoing stock repurchase program. We intend to continue to repurchase stock after we have appropriately allocated capital to our existing stores and new store openings, as long as it is accretive to earnings and consistent with our 2.1 times adjusted debt to EBITDAR liquidity target, which we maintained again for the quarter. For the fourth quarter of this year we reported yet another industry-leading return on invested capital of 22.2%. Looking at our inventory levels, inventory per store on the balance sheet plus the excluded pay on scan inventory was $501,000 versus Q4 of last year of $494,000 and this was in line with last third quarter's $495,000 per store. Accounts payable as a percent of gross inventory finished the quarter at 92% compares to 92.5% last year. We continued to manager towards achieving 100% AP to inventory. This quarter we reported a total of $92 million of inventory on POS, which, in accordance with GAAP, is not reflected on the balance sheet. As we have stated previously, POS is about aligning the interest of vendors and AutoZone and is one of the programs we use to achieve our financial goals. Total working capital was at $64 million versus last year's balance of $118 million. We will continue to focus on minimizing working capital, as this reflects our ongoing focus on increasing cash flow. Net fixed assets were up 5.9% versus last year. Capital expenditures for the quarter totaling $81 million and reflected the additional expenditures required to open 84 new stores in this quarter, maintenance on existing stores and work on development of new stores for upcoming quarters. Depreciation totaled $45 million for the quarter. As of May 6, 2006 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+ and we have a commercial paper rating of A2. Moody's Investor Service has assigned us a senior unsecured debt credit rating of BAA2 and a commercial paper rating of P2. We continue to be comfortable with our long-term debt ratings and leverage ratios. Now I'll turn it back to Bill Rhodes.

[Bill Rhodes:]

Thank you, Bill. In retrospect, this has been a solid year for AutoZone. I believe we exit 2006 a much stronger, more engaged organization than we were just 12 short months ago. We accomplished the single largest coordinated store effort in our history

[Operator:]

Our first question comes from Armando Lopez – Morgan Stanley.

[Armando Lopez:]

Thanks. Good morning, everyone. Just a couple of quick questions. First, I was wondering if you could just maybe talk a little bit more about the inventory in the quarter? Looking at inventory, it looks like inventory per square foot was up somewhat and sales per square foot was down. Now it sounds like there's a number of new inventory-type systems implemented. Can you talk a little bit about how you're thinking about inventory going forward and what you need to meet the sales that you're looking for?

[Bill Giles:]

Inventory, you're right. On a per square foot basis, or on a per store basis was up about 1.4%, so it wasn't a significant increase overall. We have initiatives underway to improve what we call superior parts coverage and so there will be some continuing movements in that. Part of that is really just adding SKUs where we need to and also deleting it, so you'll have some ups and downs in the meantime. But we think overall, probably the best way to look at it is our overall inventory at about $501,000 a store is a pretty good level for us. So there may be some little increases or decreases, but that's a pretty comfortable level for us.

[Armando Lopez:]

How are you thinking about the pay on scan inventory in terms of the strategy of managing capital here? I mean it looks like that was down somewhat in the quarter.

[Bill Giles:]

I would say the pay on scan really is, not to use a cliche, it's a tool in the toolbox. It's an opportunity for our vendors to have different terms with us. At the end of the day we're going to negotiate and have the optimal terms with our vendors in order to maximize our capital and we want to make sure that it works for them at the same time as well. Again, it's one of the tools for us as we continue to drive towards an ultimate goal of 100% of AP to inventory, but it's not the only tool.

[Armando Lopez:]

Thank you.

[Operator:]

Our next question comes from Seth Basham - Credit Suisse Securities.

[Seth Basham:]

Hi. It's Seth Basham for Gary Balter from Credit Suisse. Congratulations on a nice quarter. Would you guys care to comment on monthly sales trends? I think it'd be helpful, if possible.

[Bill Giles:]

Historically, we haven't and so therefore, we're not going to break that trend at the moment. So I appreciate the question, but unfortunately, I can't give you much color on that, Seth.

[Seth Basham:]

More specifically, can you comment on how the rollout of the assortment planning tool impacted your sales in the quarter?

[Bill Rhodes:]

We rolled this out on a few select categories and we started rolling those categories into the stores in March, April and May, but we didn't roll a tremendous amount of the categories. We saw that we made some big improvements and we also saw that we made a few mistakes so we stopped the rollout for a period of time; went back and made refinements to both the systems as well as the complementary processes around those systems. And, also had to train our AutoZoners on how to use that new tool. We're just now beginning to roll categories into the store again and we're going to do it the same way. We're going to roll some select categories, monitor them. As they prove their success then we'll expand that. But again, it certainly had some negative impact on our sales in the quarter, but not significant.

[Seth Basham:]

On the commercial side, was the impact greater on the commercial side or the DIY side?

[Bill Rhodes:]

Not necessarily significantly different one place or the other. We are focusing very much on expanding our late model coverage and so that's an improvement when we roll the new categories with improved late model coverage for the commercial side of the business, in particular.

[Seth Basham:]

Lastly, you commented on gas prices declining and not to read too much into that in terms of improved sales trends, but given the fact that you see consumers responding to spikes in gas prices, do you see similar responses to quick declines in gas prices? Why wouldn't that correlation hold?

[Bill Rhodes:]

What we've said over the last couple of times that we've seen it, is we didn't see a drastic response as they quickly dropped. It seems to be much more impactful when it runs up than it does when it runs down. Now over time, I think everybody's going to get their disposable income set and they're going to take care of their cars, their cars are too important to them. But short-term when we see significant spikes -- and we saw it again this time -- as soon as it spiked, we saw a negative impact on our business.

[Seth Basham:]

Thank you.

[Operator:]

Our next question comes from Bill Sims- Smith Barney Citigroup.

[Bill Sims:]

Thank you. Good morning. Congratulations on an impressive quarter. I have three questions. The first question, can you give us a little more color on the drivers of the gross margin improvement? How much of it was driven by working with vendors to improve your cost of goods versus mix during the quarter?

[Bill Giles:]

It's really a combination of both. I wouldn't want to give a percentage of each one per se, but I'm going to repeat your question because in essence those are really the two drivers. The fact of the matter is, our organization has done a pretty good job of continuing to reduce their acquisitions costs from a cost perspective. Direct importing is helpful in that process as well, but negotiating with the vendors and utilizing our leverage is also important. Candidly, as Bill talked about before, we've invested a lot in training our AutoZoners and as part of, that that has helped us overall in our mix of business. So we've been able to educate the AutoZoners to, in essence, explain to the customers the value proposition as they move up from good, better to best and that's also helped to move gross margin as well.

[Bill Sims:]

I know you had an opportunity in the third fiscal quarter to renegotiate many of your supply agreements. Can you give us an idea of, was it minority supply agreements, majority, or where do you stand from that perspective?

[Bill Giles:]

You know, that's an ongoing thing. I mean we negotiate contracts with vendors all the time and so there may have been a significant part of them come due over the last quarter or so. But look

[Bill Sims:]

My second question is surrounding your commercial business model rollout. Assuming you achieve a similar performance to what you saw at the end of the third fiscal quarter in your TAC, how long should we expect that it will take to rollout the new business model to all your commercial programs?

[Bill Rhodes:]

I think we're going to have to continue to test that before we can determine. We need to make sure that we see it in a bunch of different operating environments. We said on this call, we've got it in a few hundred stores. We're continuing to put that in different parts of the country, different-sized volume stores and we're going to continue to watch that. I certainly wouldn't expect a big ramp-up of the program in a bunch of stores as we go into the wintertime. Obviously, it's a seasonal business and that's not the time to be expanding a new program.

[Bill Sims:]

The last and final question regarding your ZNet system. Can you share with us any data from the implementation of ZNet? Have you seen any pickup in average ticket driven from the ZNet system or is it too early to tell?

[Bill Rhodes:]

It's really too early at this point in time, but what we're testing right now is customer transaction times. We are testing related sales, but it's a very small group of stores. The biggest thing we're doing is seeing how usable it is for our AutoZoners and how well it's embraced by our customers and we're very excited about both.

[Bill Sims:]

Very good. Congratulations and good luck.

[Bill Rhodes:]

Thank you, Bill.

[Operator:]

Our next question comes from Matthew Fassler – Goldman Sachs.

[Matthew Fassler:]

Thanks a lot. Good morning and congratulations on a good first year. A couple of questions. First of all, your operating expenses per store when you eliminate the impact of options came down for the first time this year, obviously, against an easier compare as you did start to spend in the year-ago quarter. As you think about some of the expense initiatives, or the initiatives that cost you a bit of money earlier this year, would you say, as you look out to 2007, that you should be cycling those with minimal incremental investment or that you might still have a little bit to go?

[Bill Giles:]

I would say that's a fair way to look at it. I think as we cycle through those and we get into the first half of 2007 and so, we'll probably have some continued minimal incremental investment overall. As you would imagine we're tweaking and fine-tuning our model all the time in order to try to optimize our customer service levels. But I would suspect we'll probably have some minimal incremental investment.

[Matthew Fassler:]

Secondly, you've made some comments about consumer's response to gas prices in the general sense. If you think about the products that you would typically see suffer through deferred maintenance to the extent that people have deferrable initiatives, how did you see, if you could talk to what those categories really are and how you saw those tracking?

[Bill Rhodes:]

I'm not going to get into the specific categories, Matt, because we don't get into specific category or geographical discussions. But can you think through what you can defer versus what you can't. I mean if your car won't start, you have to do something about it. If you're going to extend your oil drain from 3,000 miles to 3,500 miles, we can clearly see it in the specific categories where there is deferrable maintenance.

[Matthew Fassler:]

Fair enough. And those were obviously, I guess you're saying softer through the quarter?

[Bill Rhodes:]

Yes.

[Matthew Fassler:]

Thank you.

[Operator:]

Our next question comes from Dan Wewer – Raymond James.

[Dan Wewer:]

Bill, you had noted that customer satisfaction rates were increasing following the initiatives you launched during the last year, yet it doesn't seem to be generating the kind of same-store sales growth that we would expect. Have you been able to determine what is the missing link in leveraging that higher satisfaction rate into better sales productivity?

[Bill Rhodes:]

I'm not drastically disappointed in our sales performance. We've come a long way over the last 18 months. If you look at our quarter versus quarter sales trends, they've continued to improve. I believe, and we continue to believe, number one, that customer satisfaction is the most critical thing that we can do in this Company. It's the heritage of this Company. Customer satisfaction was here long before Bill Rhodes or anybody else was here. It's what made us special. It's what allowed us to deliver 19.2% operating margins in this quarter. So we know customer service works. We're committed to it, and quite frankly, I've been very surprised and amazed at how significantly we've moved customer satisfaction scores over the year. I certainly hope it's a leading indicator of what the future's going to hold.

[Dan Wewer:]

Do you find that maybe the infrequent nature of customer visits leads to your customers not yet recognizing the changes that have been made in the last year, and that's the reason we're seeing a lag between same-store sales growth and the higher satisfaction rates?

[Bill Rhodes:]

You know, we kind of have a couple of different sets of customers. As you've seen in the stores, we have a loyalty card that requires five visits of purchases greater than $20 per visit to earn an award over a six-month period of time. So we have a group of customers that are coming in quite frequently, but our average customer comes in three to four times a year. Really, I think customer satisfaction, it's as much about eliminating the catastrophic failures as it is about having the good experiences. So by eliminating those catastrophic failures, I think we'll gain benefits over the long-term.

[Dan Wewer:]

Could you just provide an example or two on the assortment planning tool and the kind of mistakes that you had alluded to? I'm just trying to get a better sense of what this is about.

[Bill Rhodes:]

We're just using a tremendous amount of different data than we used before. This business is very different when it comes to assortment planning than others. I mean we're making individual decisions, a specific category may have 1,600 SKUs in that category and our core offering may be 100 SKUs. So we're making individual decisions on where to put the balance of those SKUs in the individual stores. We're using a lot of different data to help forecast the most appropriate way to deploy those SKUs and dollars. Some of the things that we did were working quite well and I'm very pleased with what this is going to do for us for the future, but we did make some mistakes along the way.

[Dan Wewer:]

How quickly did you recognize that the mistakes were made from this change?

[Bill Rhodes:]

I would say a couple of months. The first thing is, you've got to get all the inventory moved around in the system and then we started watching it. We weren't getting some of the benefits that we thought we were going to get. We were getting some, but some of the other ones, we weren't. So we slowed it down and stopped it for a period of time. Went in and did real extensive, deep dives into what was working and what wasn't and had some all-day sessions, all-night sessions trying to make sure that we got this thing right. I think we're generally there. We still have a few refinements to make and we'll continue to learn some more things.

[Dan Wewer:]

Great. Well, thanks and good luck with it.

[Bill Rhodes:]

Thank you.

[Operator:]

Our next question comes from John Lawrence – Morgan Keegan.

[John Lawrence:]

Congratulations, Bill.

[Bill Rhodes:]

Thank you, John.

[John Lawrence:]

Would you just take one more step there on Dan's question and go to the next part of that? The good, better, best opportunity, obviously, you've done a great job with that and your comments about not necessarily going down to opening price point. Can you just dig into that a little further and how much more opportunity do you see to get that value proposition across categories?

[Bill Rhodes:]

I think there's going to continue to be tweaks to it. Over the last couple of years, probably three years, we've significantly increased our abilities to offer choices, good, better, best across a wide variety of categories. We continue to tweak them, but really where we've seen big advantages is in places where we've introduced new coverage. Obviously, we've been out advertising the Duralast and Duralast Gold brands. Those brands, as I mentioned, it's over $1 billion, well over a $1 billion family of brands in the automotive aftermarket. As that continues to gain traction, we continue to think we'll benefit.

[John Lawrence:]

Great. Thanks. Good luck.

[Bill Rhodes:]

Thank you, John.

[Operator:]

Our next question comes from Scott Ciccarelli - RBC Capital Markets.

[Scott Ciccarelli:]

Two quick questions. The first is, you saw some pretty nice gross margin expansion in the quarter. How much of that is coming from taking out the non-core products? I mean are we still seeing the effects of that on the gross margin line or have we cycled through that at this stage?

[Bill Rhodes:]

We've generally cycled through that. The majority of those non-core products were out by March of the preceding fiscal year. So it might be just a little bit of it as we continue to sell through some of the things, but the majority of it was gone.

[Scott Ciccarelli:]

So the margin expansion that we did see during the quarter, that was a function of just working on the good, better, best for the most part, more direct importing? I'm just trying to understand where the margin expansion came from.

[Bill Giles:]

I think it's a combination of lower acquisition costs. Some of that's coming from direct imports, some of that's just coming from working with our vendors and then also probably some improvement on good, better, best as we've focused on that over the last several months.

[Scott Ciccarelli:]

Just one more clarification. It just feels like we've had some cross currents here. It sounds like you do expect positive comps in the commercial business, if I heard you right, but you've also made a lot of investments on the retail side, which should start to bear fruit, but you're also cautious on the environment. Is there anything else you could potentially add to that to kind of help flush it out, Bill?

[Bill Giles:]

I don't think there's too much more to add to that. I mean that's really the focus. Again, we're not in the business of giving guidance so we won’t get much more specific than that. Bill talked about same store sales for the commercial business for the full year. Look, at the end of the day, we're going to try to focus everything on improving customer service and that starts with knowledgeable associates. ZNet's going to be a great opportunity for us. We want to have the right parts in the right stores and have good quality parts; Duralast is a big part of that.

[Scott Ciccarelli:]

Perfect. All right. Thanks a lot, guys.

[Operator:]

Our next question comes from Alan Rifkin – Lehman Brothers.

[Alan Rifkin:]

As you look at the 3,200 stores that you've reset, can you maybe quantify what types of returns you've been seeing overall and should we assume that returns are actually best at the stores that were reset earliest in the program?

[Bill Rhodes:]

No, Alan. First of all, there was only 3,200 of them, because the other ones were already at that set. We've said over time that this was as much about offering a consistent presentation to our customers, getting our stores back to the way that we had them for years, where there’s a centralized planning process which will allow us to make incremental moves in the improvement of the store presentations as we go forward. If we had a four-foot section on a different part of the store and we wanted to combine it with an eight-foot section, we couldn't do that before. This was about getting them all back to one presentation and we can move forward from there. You've got to remember, they also happened over about a 10-week period of time, so you don't see a radical difference between any of them over that short period of time.

[Alan Rifkin:]

Okay. But can we assume, Bill, that the required returns at least met the 15% hurdle rate?

[Bill Rhodes:]

Yeah. I think you can determine that. Also, it has to do with we couldn't do some of the things we were going to want to do before. We will have savings in our planogram efforts as we go forward because we don't have to reset some things that we would have otherwise.

[Alan Rifkin:]

So with that being said, any contemplation on your part to maybe a more continuous program on the reset stage, or do you think that this really gets you to exactly where you want to be?

[Bill Rhodes:]

I think we're exactly where we want to be. I am very, very pleased with the presentation in our stores. I am very pleased with our operations team's ability to significantly improve our store standards in our stores. Now we're continuing to work on maintenance to make sure our stores look great. We'll continue to make minor modifications as we always have in our planograms, but I do not see any major shifts or any major capital initiatives on resetting the stores. Remember these resets that we did cost us about 20 basis points in the first two quarters.

[Alan Rifkin:]

Right. One last question, if I may, Bill. With respect to the direct importing program, would it be correct on our part to assume that maybe the contribution to gross margin for this initiative alone should increase in the next couple of years as this initiative takes even greater hold?

[Bill Giles:]

I think you can assume that we're at the very early stages of a program that we think will build over time. Yes.

[Alan Rifkin:]

Great gentleman, thank you very much.

[Bill Giles:]

Thank you, Alan.

[Bill Rhodes:]

Before we conclude the call, I'd like to take a moment to reiterate that we know we still have much to accomplish. We know the opportunity for future growth is great and we certainly believe we can gain market share. However, I want to stress this has to be about setting the appropriate pace for the future and I believe we're well-situated to have a successful fiscal 2007 and beyond. I thank you very much for participating in today's call.

[Operator:]

Thank you. This concludes today's presentation. Thank you for your participation. You may disconnect at this time.