Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

We are the nation’s leading retailer, and a leading distributor, of automotive replacement parts and accessories in the United States. We began operations in 1979 and at August 25, 2018, operated 5,618 stores in the United States, including Puerto Rico; 564 stores in Mexico; and 20 stores in Brazil. Each store carries an extensive product line for cars, sport utility vehicles, vans and light trucks, including new and remanufactured automotive hard parts, maintenance items, accessories and non-automotive products. At August 25, 2018, in 4,741 of our domestic stores, we also had a commercial sales program that provides commercial credit and prompt delivery of parts and other products to local, regional and national repair garages, dealers, service stations and public sector accounts. We also have commercial programs in stores in Mexico and Brazil. We also sell the ALLDATA brand automotive diagnostic and repair software through www.alldata.com and www.alldatadiy.com. Additionally, we sell automotive hard parts, maintenance items, accessories and non-automotive products through www.autozone.com, and our commercial customers can make purchases through www.autozonepro.com. We do not derive revenue from automotive repair or installation services.

Executive Summary

For fiscal 2018, we achieved record net income of $1.338 billion, a 4.4% increase over the prior year, and sales growth of $332.4 million, a 3.1% increase over the prior year. Both our retail sales and commercial sales grew this past year, as we continue to make progress on our initiatives that are aimed at improving our ability to say yes to our customers more frequently, drive traffic to our stores and accelerate our commercial growth.

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Our business is impacted by various factors within the economy that affect both our consumer and our industry, including but not limited to fuel costs, wage rates, and other economic conditions. Given the nature of these macroeconomic factors, we cannot predict whether or for how long certain trends will continue, nor can we predict to what degree these trends will impact us in the future.

One macroeconomic factor affecting our customers and our industry during fiscal 2018 was gas prices. During fiscal 2018, the average price per gallon of unleaded gasoline in the United States was $2.67 per gallon, compared to $2.31 per gallon during fiscal 2017. We believe fluctuations in gas prices impact our customers’ level of disposable income. With approximately 12 billion gallons of unleaded gas consumption each month across the U.S., each $1 increase at the pump reduces approximately $12 billion of additional spending capacity to consumers each month. Given the unpredictability of gas prices, we cannot predict whether gas prices will increase or decrease, nor can we predict how any future changes in gas prices will impact our sales in future periods.

We have also experienced accelerated pressure on wages in the United States during fiscal 2018. Some of this is attributed to regulatory changes in certain states and municipalities, while the larger portion is being driven by general market pressures with lower unemployment rates and some specific actions taken in recent years by other retailers. The regulatory changes are going to continue, as evidenced by the areas that have passed legislation to increase their wages substantially over the next few years, but we are still assessing to what degree these changes will impact our earnings growth in future periods.

During fiscal 2018, failure and maintenance related categories represented the largest portion of our sales mix, at approximately 84% of total sales, with failure related categories continuing to comprise our largest set of categories. While we have not experienced any fundamental shifts in our category sales mix as compared to previous years, in our domestic stores we did experience a slight increase in mix of sales of the failure category as compared to last year. We believe the improvement in this sales category was driven by differences in regional weather patterns and improved merchandise assortments due to the products we have added over the last year. Our sales mix can be impacted by severe or unusual weather over a short term period. Over the long term, we believe the impact of the weather on our sales mix is not significant.

Our primary response to fluctuations in the demand for the products we sell is to adjust our advertising message, store staffing and product assortment. In recent years, we closely studied our hub distribution model, store inventory levels and product assortment, which led to strategic tests on increased frequency of delivery to our domestic stores and significantly expanding parts assortment in select domestic stores we call mega hubs. During fiscal 2018, we completed our testing and implemented new frequencies resulting in approximately 25% of our stores, representing 40% of our retail sales volume and nearly 50% of our commercial sales volume, receiving distribution center deliveries three or more times per week.

The two statistics we believe have the closest correlation to our market growth over the long-term are miles driven and the number of seven year old or older vehicles on the road.

Miles Driven

We believe that as the number of miles driven increases, consumers’ vehicles are more likely to need service and maintenance, resulting in an increase in the need for automotive hard parts and maintenance items. While over the long-term we have seen a close correlation between our net sales and the number of miles driven, we have also seen certain time frames of minimal correlation in sales performance and miles driven. During the periods of minimal correlation between net sales and miles driven, we believe net sales have been positively impacted by other factors, including the number of seven year old or older vehicles on the road. Since the beginning of the fiscal year and through July 2018 (latest publicly available information), miles driven in the U.S. increased by 0.5% compared to the same period in the prior year.

Seven Year Old or Older Vehicles

New vehicles sales declined 1.5% during 2018 as compared to the prior year, which is the first year-over-year decrease since 2009. We estimate vehicles are driven an average of approximately 12,500 miles each year. In seven years, the average miles driven equates to approximately 87,500 miles. Our experience is that at this point in a vehicle’s life, most vehicles are not covered by warranties and increased maintenance is needed to keep the vehicle operating.

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According to the latest data provided by the Auto Care Association, as of January 1, 2018, the average age of vehicles on the road was 11.7 years. For the seventh consecutive year, the average age of vehicles has exceeded 11 years.

We expect the aging vehicle population to continue to increase as consumers keep their cars longer in an effort to save money. As the number of seven year old or older vehicles on the road increases, we expect an increase in demand for the products we sell.

Results of Operations

Fiscal 2018 Compared with Fiscal 2017

For the fiscal year ended August 25, 2018, we reported net sales of $11.221 billion compared with $10.889 billion for the year ended August 26, 2017, a 3.1% increase from fiscal 2017. This growth was driven primarily by net sales of $196.5 million from new domestic stores and a domestic same store sales increase of 1.8%. Domestic commercial sales increased $151.4 million, or 7.3%, over domestic commercial sales for fiscal 2017.

At August 25, 2018, we operated 5,618 domestic stores, 564 in Mexico and 20 in Brazil, compared with 5,465 domestic stores, 524 in Mexico, 14 in Brazil and 26 IMC branches at August 26, 2017. We reported a total auto parts segment (domestic, Mexico, Brazil and IMC through April 4, 2018) sales increase of 4.1% for fiscal 2018.

Gross profit for fiscal 2018 was $5.974 billion, or 53.2% of net sales, a 53 basis point increase compared with $5.740 billion, or 52.7% of net sales for fiscal 2017. The increase in gross margin was attributable to the favorable impact of the sale of two businesses (+34 basis points) and higher merchandise margins, partially offset by higher supply chain costs.

Operating, selling, general and administrative expenses for fiscal 2018 increased to $4.163 billion, or 37.1% of net sales, from $3.660 billion, or 33.6% of net sales for fiscal 2017. The increase in operating expenses, as a percentage of sales, was primarily due to second quarter impairment charges (-172 basis points), and fourth quarter charges related to the termination of our pension plans (-116 basis points). See “Note M – Sale of Assets” and “Note L – Pension and Savings Plan” in the Notes to Consolidated Financial Statements.

Interest expense, net for fiscal 2018 was $174.5 million compared with $154.6 million during fiscal 2017. This increase was primarily due to higher borrowing rates. Average borrowings for fiscal 2018 were $4.997 billion, compared with $5.070 billion for fiscal 2017, and weighted average borrowing rates were 3.2% for fiscal 2018, compared to 2.8% for fiscal 2017.

Our effective income tax rate was 18.3% of pre-tax income for fiscal 2018 compared to 33.5% for fiscal 2017. The lower tax rate resulted primarily from the enactment of Tax Reform during the second quarter ended February 10, 2018 (see “Note D—Income Taxes” in the Notes to Consolidated Financial Statements).

Net income for fiscal 2018 increased by 4.4% to $1.338 billion, and diluted earnings per share increased 10.7% to $48.77 from $44.07 in fiscal 2017. The impact on the fiscal 2018 diluted earnings per share from stock repurchases was an increase of $1.36.

Fiscal 2017 Compared with Fiscal 2016

For the fiscal year ended August 26, 2017, we reported net sales of $10.889 billion compared with $10.636 billion for the year ended August 27, 2016, a 2.4% increase from fiscal 2016. This growth was driven primarily by net sales of $172.5 million from new domestic AutoZone stores and domestic same store sales increase of 0.5%. Domestic commercial sales increased $110.9 million, or 5.7%, over domestic commercial sales for fiscal 2016.

At August 26, 2017, we operated 5,465 domestic AutoZone stores, 524 in Mexico, 14 in Brazil, and 26 IMC branches compared with 5,297 domestic AutoZone stores, 483 in Mexico, eight in Brazil and 26 IMC branches at August 27, 2016. We reported a total auto parts (domestic, Mexico, Brazil and IMC) sales increase of 2.6% for fiscal 2017.

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Gross profit for fiscal 2017 was $5.740 billion, or 52.7% of net sales, a 2 basis point decrease compared with $5.609 billion, or 52.7% of net sales for fiscal 2016. The slight decline in gross margin was attributable to higher supply chain costs (-20 basis points) associated with current year inventory initiatives, partially offset by higher merchandise margins.

Operating, selling, general and administrative expenses for fiscal 2017 increased to $3.660 billion, or 33.6% of net sales, from $3.548 billion, or 33.4% of net sales for fiscal 2016. The increase in operating expenses, as a percentage of sales, was primarily due to deleverage on occupancy costs (-23 basis points) and domestic store payroll driven by higher wage pressure.

Interest expense, net for fiscal 2017 was $154.6 million compared with $147.7 million during fiscal 2016. This increase was primarily due to higher borrowing levels and rates. Average borrowings for fiscal 2017 were $5.070 billion, compared with $4.860 billion for fiscal 2016, and weighted average borrowing rates were 2.8% for fiscal 2017, compared to 2.7% for fiscal 2016.

Our effective income tax rate was 33.5% of pre-tax income for fiscal 2017 compared to 35.1% for fiscal 2016. The decrease in the tax rate was primarily due to the Company’s adoption of the new accounting guidance for share-based payments, which lowered the effective tax rate by 162 basis points.

Net income for fiscal 2017 increased by 3.2% to $1.281 billion, and diluted earnings per share increased 8.3% to $44.07 from $40.70 in fiscal 2016. The impact of the fiscal 2017 stock repurchases on diluted earnings per share in fiscal 2017 was an increase of approximately $1.03.

Seasonality and Quarterly Periods

Our business is somewhat seasonal in nature, with the highest sales typically occurring in the spring and summer months of February through September, in which average weekly per-store sales historically have been about 10% to 20% higher than in the slower months of December and January. During short periods of time, a store’s sales can be affected by weather conditions. Extremely hot or extremely cold weather may enhance sales by causing parts to fail; thereby increasing sales of seasonal products. Mild or rainy weather tends to soften sales, as parts failure rates are lower in mild weather and elective maintenance is deferred during periods of rainy weather. Over the longer term, the effects of weather balance out, as we have locations throughout the United States, Puerto Rico, Mexico and Brazil.

Each of the first three quarters of our fiscal year consists of 12 weeks, and the fourth quarter consisted of 16 weeks in 2018, 2017 and 2016. Because the fourth quarter contains seasonally high sales volume and consists of 16 weeks, compared with 12 weeks for each of the first three quarters, our fourth quarter represents a disproportionate share of the annual net sales and net income. The fourth quarter of fiscal year 2018 represented 31.7% of annual sales and 29.9% of net income; the fourth quarter of fiscal year 2017 represented 32.3% of annual sales and 33.9% of net income; and the fourth quarter of fiscal 2016 represented 32.0% of annual sales and 34.4% of net income.

Income Taxes

On December 22, 2017, the U.S. government enacted the Tax Cuts and Jobs Act (“Tax Reform”) into law. Tax Reform contains several key provisions that affected the Company during fiscal 2018. The enacted provisions impacting the current financial statements include a mandatory one-time transition tax on certain earnings of foreign subsidiaries and a permanent reduction of the U.S. corporate income tax rate from 35 to 21%, effective January 1, 2018. As the Company has an August 25th fiscal year-end, the impact of the lower rate will be blended resulting in a U.S. statutory federal tax rate of approximately 25.9% for the fiscal year ending August 25, 2018, and a 21% U.S. statutory federal rate for fiscal years thereafter. Other enacted provisions which may impact the Company beginning in fiscal 2019 include: eliminating U.S. federal taxation of future remitted foreign earnings; other new international provisions requiring current inclusion of certain earnings of controlled foreign corporations; immediate expensing of capital assets; and limitations on other tax deductions such as deductibility of executive compensation, interest expense, lobbying expenses, meals and entertainment expenses, and the domestic production activities deduction.

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The Company has withdrawn its assertion regarding the permanent reinvestment of current and accumulated earnings of non-U.S. subsidiaries, but maintained its permanent reinvestment assertion on other basis differences related to non-U.S. subsidiaries.

The Securities and Exchange Commission (SEC) staff issued Staff Accounting Bulletin No. 118 (SAB 118) to address the application of U.S. GAAP in situations where a registrant does not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of Tax Reform. To the extent that a company’s accounting for certain income tax effects of Tax Reform is incomplete but it is able to determine a reasonable estimate, it must record a provisional estimate in the financial statements. If a company cannot determine a provisional estimate to be included in the financial statements, it should continue to apply ASC 740 on the basis of the provisions of the tax laws that were in effect immediately before the enactment of Tax Reform. The ultimate impact may differ from provisional amounts recorded, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, and additional regulatory guidance that may be issued. The accounting is expected to be completed within one year from the enactment date of Tax Reform.

Based on our current analysis, we recorded a provisional income tax benefit of $131.5 million in our Consolidated Financial Statements for the year ended August 25, 2018. We were able to determine a reasonable estimate for the mandatory one-time transition tax as an increase tax expense of $25.8 million and for the re-measurement of our net U.S. federal deferred tax liability at the lower rate, a reduction to tax expense of $157.3 million. Our analysis of these items is incomplete at this time. We will complete the accounting for these items during the measurement period, which will not extend beyond one year from the enactment date.

Our effective income tax rate was 18.3% of pre-tax income for fiscal 2018 compared to 33.5% for fiscal 2017. The lower tax rate resulted from the $131.5 million provisional amount discussed above, $31.3 million of excess tax benefits from option exercises, and a $119.2 million benefit from the reduction of the U.S. statutory rate from 35% to approximately 25.9%.

Liquidity and Capital Resources

The primary source of our liquidity is our cash flows realized through the sale of automotive parts, products and accessories. Net cash provided by operating activities was $2.080 billion in 2018, $1.571 billion in 2017, and $1.641 billion in fiscal 2016. Cash flows from operations are favorable compared to last year primarily due to the timing of payment of accounts payable and growth in net income due to the benefits of Tax Reform.

Our primary capital requirement has been the funding of our continued new-location development program and the building of new distribution centers. From the beginning of fiscal 2016 to August 25, 2018, we have opened 621 new locations. We opened two distribution centers in fiscal 2017 and one in fiscal 2018. Net cash flows used in investing activities were $521.9 million in fiscal 2018, compared to $553.6 million in fiscal 2017 and $505.8 million in fiscal 2016. We invested $521.8 million in capital assets in fiscal 2018, compared to $553.8 million in fiscal 2017 and $488.8 million in fiscal 2016. The decrease in capital expenditures from fiscal 2017 was primarily attributable to the construction of the one distribution center in fiscal 2018 compared to two distribution centers in fiscal 2017. We had new location openings of 201 for fiscal 2018, 215 for fiscal 2017, and 205 for fiscal 2016. Cash flows were also used in the purchase of other intangibles for $10 million in fiscal 2016. We invest a portion of our assets held by our wholly owned insurance captive in marketable securities. We purchased $104.5 million in marketable securities in fiscal 2018, $85.7 million in fiscal 2017 and $130.2 million in fiscal 2016. We had proceeds from the sale of marketable securities of $69.6 million in fiscal 2018, $83.0 million in fiscal 2017 and $120.5 million in fiscal 2016.

Net cash used in financing activities was $1.632 billion in 2018, $914.3 million in 2017 and $1.117 billion in fiscal 2016. The net cash used in financing activities reflected purchases of treasury stock which totaled $1.592 billion for fiscal 2018, $1.072 billion for fiscal 2017 and $1.452 billion for fiscal 2016. The treasury stock purchases in fiscal 2018, 2017 and 2016 were primarily funded by cash flows from operations. The Company did not issue any new debt in fiscal 2018 compared to $600 million for fiscal 2017 and $650 million for fiscal 2016. In fiscal 2018, we used commercial paper borrowings to repay the $250 million Senior Notes due in August 2018. In fiscal 2017, the proceeds from the issuance of debt were used for the repayment of a portion of our outstanding commercial paper borrowings, which were used to repay the $400 million Senior Notes due in January 2017.

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In fiscal 2016, the proceeds from the issuance of debt were used for general corporate purposes, including for working capital requirements, capital expenditures, store openings and stock repurchases. In fiscal 2016, we used commercial paper borrowings to repay the $300 million Senior Notes due in November 2015 and the $200 million Senior Notes due in June 2016. Net proceeds from the issuance of commercial paper and short-term borrowings for fiscal 2018 were $170.2 million. In 2017, we made net repayments of commercial paper and short-term borrowings in the amount of $42.4 million. Net proceeds from the issuance of commercial paper and short-term borrowings for fiscal 2016 were $149.9 million.

During fiscal 2019, we expect to increase the investment in our business as compared to fiscal 2018. Our investments are expected to be directed primarily to new locations, supply chain infrastructure, enhancements to existing locations and investments in technology. The amount of investments in our new locations is impacted by different factors, including such factors as whether the building and land are purchased (requiring higher investment) or leased (generally lower investment), located in the United States, Mexico or Brazil, or located in urban or rural areas. During fiscal 2018, our capital expenditures decreased by approximately 6% compared to the prior year period. In 2017 and 2016, our capital expenditures increased by approximately 13% and 2%, respectively, as compared to the prior year.

In addition to the building and land costs, our new locations require working capital, predominantly for inventories. Historically, we have negotiated extended payment terms from suppliers, reducing the working capital required and resulting in a high accounts payable to inventory ratio. We plan to continue leveraging our inventory purchases; however, our ability to do so may be limited by our vendors’ capacity to factor their receivables from us. Certain vendors participate in financing arrangements with financial institutions whereby they factor their receivables from us, allowing them to receive payment on our invoices at a discounted rate. In recent years, we initiated a variety of strategic tests focused on increasing inventory availability, which increased our inventory per location. Many of our vendors have supported our initiative to update our product assortments by providing extended payment terms. These extended payment terms have allowed us to continue our high accounts payable to inventory ratio. We had an accounts payable to inventory ratio of 111.8% at August 25, 2018, 107.4% at August 26, 2017, and 112.8% at August 27, 2016. The increase from fiscal 2017 to fiscal 2018 was primarily due to more favorable vendor terms.

Depending on the timing and magnitude of our future investments (either in the form of leased or purchased properties or acquisitions), we anticipate that we will rely primarily on internally generated funds and available borrowing capacity to support a majority of our capital expenditures, working capital requirements and stock repurchases. The balance may be funded through new borrowings. We anticipate that we will be able to obtain such financing in view of our credit ratings and favorable experiences in the debt markets in the past.

Our cash balances are held in various locations around the world. As of August 25, 2018, and August 26, 2017, cash and cash equivalents of $98.8 million and $148.4 million, respectively, were held outside of the U.S. and were generally utilized to support liquidity needs in our foreign operations.

For the fiscal year ended August 25, 2018, our after-tax return on invested capital (“ROIC”) was 32.1% as compared to 29.9% for the comparable prior year period. ROIC is calculated as after-tax operating profit (excluding rent charges) divided by invested capital (which includes a factor to capitalize operating leases). For fiscal 2018, after-tax operating profit was adjusted for impairment charges, pension termination charges and Tax Reform’s impact on the revaluation of deferred tax liabilities, net of the repatriation tax. The increase in ROIC is primarily due to the decrease in average debt, along with increased net income due to Tax Reform. We use ROIC to evaluate whether we are effectively using our capital resources and believe it is an important indicator of our overall operating performance. Refer to the “Reconciliation of Non-GAAP Financial Measures” section for further details of our calculation.

Debt Facilities

We entered into a Master Extension, New Commitment and Amendment Agreement dated as of November 18, 2017 (the “Extension Amendment”) to the Third Amended and Restated Credit Agreement dated as of November 18, 2016, as amended, modified, extended or restated from time to time (the “Revolving Credit Agreement”). Under the Extension Amendment: (i) our borrowing capacity under the Revolving Credit Agreement was increased from $1.6 billion to $2.0 billion; (ii) our option to increase the borrowing capacity under the Revolving Credit Agreement was “refreshed” and the amount of such option remained at $400 million;

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the maximum borrowing under the Revolving Credit Agreement may, at our option, subject to lenders approval, be increased from $2.0 billion to $2.4 billion; (iii) the termination date of the Revolving Credit Agreement was extended from November 18, 2021 until November 18, 2022; and (iv) we have the option to make one additional written request of the lenders to extend the termination date then in effect for an additional year. Under the Revolving Credit Agreement, we may borrow funds consisting of Eurodollar loans, base rate loans or a combination of both. Interest accrues on Eurodollar loans at a defined Eurodollar rate, defined as LIBOR plus the applicable percentage, as defined in the Revolving Credit Agreement, depending upon our senior, unsecured, (non-credit enhanced) long-term debt ratings. Interest accrues on base rate loans as defined in the Revolving Credit Agreement. As of August 25, 2018, we had $3.3 million of outstanding letters of credit under the Revolving Credit Agreement.

The Revolving Credit Agreement requires that our consolidated interest coverage ratio as of the last day of each quarter shall be no less than 2.5:1. This ratio is defined as the ratio of (i) consolidated earnings before interest, taxes and rents to (ii) consolidated interest expense plus consolidated rents. Our consolidated interest coverage ratio as of August 25, 2018 was 5.8:1.

As of August 25, 2018, $1.325 billion of commercial paper borrowings and the $250 million 1.625% Senior Notes due April 2019 were classified as long-term in the Consolidated Balance Sheets as we have the ability and intent to refinance on a long-term basis through available capacity in our revolving credit facilities. As of August 25, 2018, we had $1.997 billion of availability under our $2.0 billion revolving credit facility, which would allow us to replace these short-term obligations with long-term financing facilities.

We also maintain a letter of credit facility that allows us to request the participating bank to issue letters of credit on our behalf up to an aggregate amount of $75 million. The letter of credit facility is in addition to the letters of credit that may be issued under the Revolving Credit Agreement. As of August 25, 2018 we had $71.0 million in letters of credit outstanding under the letter of credit facility, which expires June 2019.

In addition to the outstanding letters of credit issued under the committed facilities discussed above, we had $32.5 million in letters of credit outstanding as of August 25, 2018. These letters of credit have various maturity dates and were issued on an uncommitted basis.

On April 18, 2017, we issued $600 million in 3.750% Senior Notes due June 2027 under our shelf registration statement filed with the SEC on April 15, 2015 (the “2015 Shelf Registration”). The 2015 Shelf Registration allowed us to sell an indeterminate amount of debt securities to fund general corporate purposes, including repaying, redeeming or repurchasing outstanding debt and for working capital, capital expenditures, new location openings, stock repurchases and acquisitions. Proceeds from the debt issuance were used for general corporate purposes.

On April 21, 2016, we issued $400 million in 3.125% Senior Notes due April 2026 and $250 million in 1.625% Senior Notes due April 2019 under the 2015 Shelf Registration. Proceeds from the debt issuances were used for general corporate purposes.

All senior notes are subject to an interest rate adjustment if the debt ratings assigned to the senior notes are downgraded (as defined in the agreements). Further, the senior notes contain a provision that repayment of the senior notes may be accelerated if we experience a change in control (as defined in the agreements). Our borrowings under our senior notes contain minimal covenants, primarily restrictions on liens. Under our revolving credit facilities, covenants include restrictions on liens, a maximum debt to earnings ratio, a minimum fixed charge coverage ratio and a change of control provision that may require acceleration of the repayment obligations under certain circumstances. All of the repayment obligations under our borrowing arrangements may be accelerated and come due prior to the scheduled payment date if covenants are breached or an event of default occurs.

As of August 25, 2018, we were in compliance with all covenants related to our borrowing arrangements and expect to remain in compliance with those covenants in the future.

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For the fiscal year ended August 25, 2018, our adjusted debt to earnings before interest, taxes, depreciation, amortization, rent and share-based compensation expense (“EBITDAR”) ratio was 2.5:1 as compared to 2.6:1 as of the comparable prior year end. We calculate adjusted debt as the sum of total debt, capital lease obligations and rent times six; and we calculate EBITDAR by adding interest, taxes, depreciation, amortization, rent and share-based compensation expense to net income. For fiscal 2018, net income was adjusted to exclude impairment charges and pension termination charges before tax impact as these charges are not reflective of ongoing operations. We target our debt levels to a specified ratio of adjusted debt to EBITDAR in order to maintain our investment grade credit ratings and believe this is important information for the management of our debt levels.

To the extent EBITDAR continues to grow in future years, we expect our debt levels to increase; conversely, if EBITDAR declines, we would expect our debt levels to decrease. Refer to the “Reconciliation of Non-GAAP Financial Measures” section for further details of our calculation.

Stock Repurchases

During 1998, we announced a program permitting us to repurchase a portion of our outstanding shares not to exceed a dollar maximum established by our Board of Directors (the “Board”). On March 20, 2018, the Board voted to increase the authorization by $1.0 billion. This raised the total value of shares authorized to be repurchased to $19.65 billion. From January 1998 to August 25, 2018, we have repurchased a total of 144.7 million shares at an aggregate cost of $19.418 billion. We repurchased 2.4 million shares of common stock at an aggregate cost of $1.592 billion during fiscal 2018, 1.5 million shares of common stock at an aggregate cost of $1.072 billion during fiscal 2017, and 1.9 million shares of common stock at an aggregate cost of $1.452 billion during fiscal 2016. Considering cumulative repurchases as of August 25, 2018, we had $231.7 million remaining under the Board’s authorization to repurchase our common stock.

For the fiscal year ended August 25, 2018, cash flow before share repurchases and changes in debt was $1.596 billion as compared to $1.018 billion during the comparable prior year period. Cash flow before share repurchases and changes in debt is calculated as the net increase or decrease in cash and cash equivalents less increases in debt plus share repurchases. We use cash flow before share repurchases and changes in debt to calculate the cash flows remaining and available in an effort to increase shareholder value in the form of share repurchases. We believe this is important information regarding our allocation of available capital where we prioritize investments in the business and utilize the remaining funds to repurchase shares, while maintaining debt levels that support our investment grade credit ratings. If we allowed these funds to accumulate on our balance sheet instead of repurchasing our shares, we believe our earnings per share and stock price would be negatively impacted. Refer to the “Reconciliation of Non-GAAP Financial Measures” section for further details of our calculation.

On September 26, 2018, the Board voted to increase the authorization by $1.25 billion. This brings the total value of shares authorized to $20.9 billion. Subsequent to August 25, 2018, we have repurchased 346,979 shares of common stock at an aggregate cost of $263.4 million. Considering the cumulative repurchases and the increase in authorization subsequent to August 25, 2018, we have $1.22 billion remaining under the Board’s authorization to repurchase our common stock.

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Financial Commitments

The following table shows our significant contractual obligations as of August 25, 2018:

		Total Contractual Obligations				Payment Due by Period
(in thousands)		Less than 1 year				Between 1-3 years				Between 3-5 years				Over 5 years
Debt(1)		$	5,025,300			$	1,575,300			$	750,000			$	1,300,000			$	1,400,000
Interest payments(2)			657,250				121,063				224,000				158,687				153,500
Operating leases(3)			2,141,163				300,866				556,305				460,023				823,969
Capital leases(4)			165,686				52,290				89,067				24,329				—
Self-insurance reserves(5)			243,337				88,761				77,557				34,567				42,452
Construction commitments			41,324				41,324				—				—				—
		$	8,274,060			$	2,179,604			$	1,696,929			$	1,977,606			$	2,419,921

(1)	Debt balances represent principal maturities, excluding interest, discounts, and debt issuance costs.

(2)	Represents obligations for interest payments on long-term debt.

(3)	Operating lease obligations are inclusive of amounts accrued within deferred rent and closed store obligations reflected in our Consolidated Balance Sheets.

(4)	Capital lease obligations include related interest.

(5)	Self-insurance reserves reflect estimates based on actuarial calculations. Although these obligations do not have scheduled maturities, the timing of future payments are predictable based upon historical patterns. Accordingly, we reflect the net present value of these obligations in our Consolidated Balance Sheets.

Our tax liability for uncertain tax positions, including interest and penalties, was $16.5 million at August 25, 2018. Approximately $1.1 million is classified as current liabilities and $15.4 million is classified as long-term liabilities. We did not reflect these obligations in the table above as we are unable to make an estimate of the timing of payments of the long-term liabilities due to uncertainties in the timing and amounts of the settlement of these tax positions.

Off-Balance Sheet Arrangements

The following table reflects outstanding letters of credit and surety bonds as of August 25, 2018:

(in thousands)		Total Other Commitments
Standby letters of credit		$	106,773
Surety bonds			23,571
		$	130,344

A substantial portion of the outstanding standby letters of credit (which are primarily renewed on an annual basis) and surety bonds are used to cover reimbursement obligations to our workers’ compensation carriers.

There are no additional contingent liabilities associated with these instruments as the underlying liabilities are already reflected in our Consolidated Balance Sheets. The standby letters of credit and surety bond arrangements expire within one year, but have automatic renewal clauses.

Reconciliation of Non-GAAP Financial Measures

“Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” include certain financial measures not derived in accordance with generally accepted accounting principles (“GAAP”). These non-GAAP financial measures provide additional information for determining our optimum capital structure and are used to assist management in evaluating performance and in making appropriate business decisions to maximize stockholders’ value.

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Non-GAAP financial measures should not be used as a substitute for GAAP financial measures, or considered in isolation, for the purpose of analyzing our operating performance, financial position or cash flows. However, we have presented the non-GAAP financial measures, as we believe they provide additional information that is useful to investors as it indicates more clearly our comparative year-to-year operating results. Furthermore, our management and Compensation Committee of the Board use the above-mentioned non-GAAP financial measures to analyze and compare our underlying operating results and use select measurements to determine payments of performance-based compensation. We have included a reconciliation of this information to the most comparable GAAP measures in the following reconciliation tables.

Reconciliation of Non-GAAP Financial Measure: Cash Flow Before Share Repurchases and Changes in Debt

The following table reconciles net increase (decrease) in cash and cash equivalents to cash flow before share repurchases and changes in debt, which is presented in “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”:

		Fiscal Year Ended August
(in thousands)		2018				2017				2016				2015				2014
Net cash provided by/(used in):
Operating activities(1)		$	2,080,292			$	1,570,612			$	1,641,060			$	1,573,018			$	1,365,005
Investing activities			(521,860	)			(553,599	)			(505,835	)			(567,911	)			(447,968	)
Financing activities(1)			(1,632,154	)			(914,329	)			(1,116,528	)			(944,597	)			(935,328	)
Effect of exchange rate changes on cash			(1,724	)			852				(4,272	)			(9,686	)			585
Net (decrease)/increase in cash and cash equivalents		$	(75,446	)		$	103,536			$	14,425			$	50,824			$	(17,706	)
Less: (Decrease)/increase in debt, excluding deferred financing costs			(79,800	)			157,600				299,900				303,800				156,800
Plus: Share repurchases			1,592,013				1,071,649				1,452,462				1,271,416				1,099,212
Cash flow before share repurchases and changes in debt		$	1,596,367			$	1,017,585			$	1,166,987			$	1,018,440			$	924,706

(1)

The Company adopted the provisions of ASU 2016-09, Compensation – Stock Compensation (Topic 718): Improvement to Employee Share-based Payment Accounting, as of August 28, 2016. We have applied ASU 2016-09 relating to the presentation of the excess tax benefits on the Consolidated Statements of Cash Flows retrospectively. Prior period amounts for net cash provided by operating and financing activities for all years presented above were restated to conform to the current period presentation.

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Reconciliation of Non-GAAP Financial Measure: After-tax ROIC

The following table calculates the percentage of ROIC. ROIC is calculated as after-tax operating profit (excluding rent) divided by invested capital (which includes a factor to capitalize operating leases). For Fiscal 2018, after-tax operating profit was adjusted for impairment charges, pension settlement charges and the impact of the revaluation of deferred tax liabilities, net of repatriation tax_._ The ROIC percentages are presented in “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”:

		Fiscal Year Ended August
(in thousands, except percentages)		2018				2017				2016				2015				2014
Net income		$	1,337,536			$	1,280,869			$	1,241,007			$	1,160,241			$	1,069,744
Adjustments:
Impairment before tax impact			193,162				—				—				—				—
Pension termination charges before tax impact			130,263				—				—				—				—
Interest expense			174,527				154,580				147,681				150,439				167,509
Rent expense			315,580				302,928				280,490				269,458				253,813
Tax effect(1)			(211,806	)			(153,265	)			(150,288	)			(149,483	)			(150,412	)
Deferred tax liabilities, net of repatriation tax			(132,113	)			—				—				—				—
After-tax return		$	1,807,149			$	1,585,112			$	1,518,890			$	1,430,655			$	1,340,654
Average debt(2)		$	5,013,678			$	5,061,502			$	4,820,402			$	4,458,114			$	4,258,796
Average (deficit)(3)			(1,433,196	)			(1,730,559	)			(1,774,329	)			(1,619,596	)			(1,709,778	)
Rent x 6(4)			1,893,480				1,817,568				1,682,940				1,616,748				1,522,878
Average capital lease obligations(5)			156,198				150,066				131,008				126,096				108,475
Invested capital		$	5,630,160			$	5,298,577			$	4,860,021			$	4,581,362			$	4,180,371
ROIC			32.1	%			29.9	%			31.3	%			31.2	%			32.1	%

(1)	The effective tax rate during fiscal 2018 was 24.2% for impairment, 28.1% for pension termination and 26.2% for interest and rent expense. For fiscal 2017, 2016, 2015 and 2014 the effective tax rate was 33.5%, 35.1%, 35.6% and 35.7%, respectively.

(2)	Average debt is equal to the average of our debt measured as of the previous five quarters.

(3)	Average deficit is equal to the average of our stockholders’ (deficit) measured as of the previous five quarters.

(4)	Rent is multiplied by a factor of six to capitalize operating leases in the determination of pre-tax invested capital.

(5)	Average capital lease obligations is computed as the average of our capital lease obligations over the previous five quarters.

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Reconciliation of Non-GAAP Financial Measure: Adjusted Debt to EBITDAR

The following table calculates the ratio of adjusted debt to EBITDAR. Adjusted debt to EBITDAR is calculated as the sum of total debt, capital lease obligations and annual rents times six; divided by net income plus interest, taxes, depreciation, amortization, rent and share-based compensation expense. For fiscal 2018, net income was adjusted to exclude impairment charges and pension termination charges before tax impact. The adjusted debt to EBITDAR ratios are presented in “Selected Financial Data” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations”:

		Fiscal Year Ended August
(in thousands, except ratios)		2018				2017				2016				2015				2014
Net income		$	1,337,536			$	1,280,869			$	1,241,007			$	1,160,241			$	1,069,744
Add: Impairment before tax impact			193,162				—				—				—				—
Pension termination charges before tax impact			130,263				—				—				—				—
Interest expense			174,527				154,580				147,681				150,439				167,509
Income tax expense			298,793				644,620				671,707				642,371				592,970
EBIT			2,134,281				2,080,069				2,060,395				1,953,051				1,830,223
Add: Depreciation and amortization expense			345,084				323,051				297,397				269,919				251,267
Rent expense			315,580				302,928				280,490				269,458				253,813
Share-based expense			43,674				38,244				39,825				40,995				39,390
EBITDAR		$	2,838,619			$	2,744,292			$	2,678,107			$	2,533,423			$	2,374,693
Debt		$	5,005,930			$	5,081,238			$	4,924,119			$	4,624,876			$	4,323,106
Capital lease obligations			154,303				150,456				147,285				128,167				119,603
Rent x 6			1,893,480				1,817,568				1,682,940				1,616,748				1,522,878
Adjusted debt		$	7,053,713			$	7,049,262			$	6,754,344			$	6,369,791			$	5,965,587
Adjusted debt to EBITDAR			2.5				2.6				2.5				2.5				2.5

Recent Accounting Pronouncements

See Note A of the Notes to Consolidated Financial Statements for a discussion on recent accounting pronouncements.

Critical Accounting Policies and Estimates

Preparation of our Consolidated Financial Statements requires us to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements, reported amounts of revenues and expenses during the reporting period and related disclosures of contingent liabilities. In the notes to our consolidated financial statements, we describe our significant accounting policies used in preparing the Consolidated Financial Statements. Our policies are evaluated on an ongoing basis and are drawn from historical experience and other assumptions that we believe to be reasonable under the circumstances. Actual results could differ under different assumptions or conditions. Our senior management has identified the critical accounting policies for the areas that are materially impacted by estimates and assumptions and have discussed such policies with the Audit Committee of our Board. The following items in our Consolidated Financial Statements represent our critical accounting policies that require significant estimation or judgment by management:

Inventory Reserves and Cost of Sales

LIFO

We state our inventories at the lower of cost or market. Inventory cost has been determined using the last-in, first-out (“LIFO”) method for domestic inventories and the weighted average cost method for Mexico and Brazil inventories. Due to price deflation on our merchandise purchases, we have exhausted our LIFO reserve balance. Our policy is to not write up inventory in excess of replacement cost, which is based on average cost. The difference between LIFO cost and replacement cost, which will be reduced upon experiencing price inflation on our merchandise purchases, was $452.4 million at August 25, 2018.

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Inventory Obsolescence and Shrinkage

Our inventory, primarily hard parts, maintenance items, accessories and non-automotive products, is used on vehicles that have rather long lives; and therefore, the risk of obsolescence is minimal and the majority of excess inventory has historically been returned to our vendors for credit. In the isolated instances where less than full credit will be received for such returns and where we anticipate that items will be sold at retail prices that are less than recorded costs, we record a charge (less than $5 million in each of the last three years) through cost of sales for the difference. These charges are based on management’s judgment, including estimates and assumptions regarding marketability of products and the market value of inventory to be sold in future periods.

Historically, we have not encountered material exposure to inventory obsolescence or excess inventory, nor have we experienced material changes to our estimates. However, we may be exposed to material losses should our vendors alter their policy with regard to accepting excess inventory returns.

Additionally, we reduce inventory for projected losses related to shrinkage, which is estimated based on historical losses and current inventory loss trends resulting from previous physical inventories. Shrinkage may occur due to theft, loss or inaccurate records for the receipt of goods, among other things. Throughout the year, we take physical inventory counts of our stores and distribution centers to verify these estimates. We make assumptions regarding upcoming physical inventory counts that may differ from actual results.

Each quarter, we evaluate the accrued shrinkage in light of the actual shrink results from physical inventory counts. To the extent our actual physical inventory count results differ from our estimates, we may experience material adjustments to our financial statements. Historically, we have not experienced material adjustments to our shrinkage estimates and do not believe there is a reasonable likelihood that there will be a material change in the future estimates or assumptions we use. Over the last three years, there has been less than a 50 basis point fluctuation in our shrinkage rate (shrink loss as a percent of sales).

A 10% difference in our inventory reserves as of August 25, 2018, would have affected net income by approximately $8.6 million in fiscal 2018.

Vendor Allowances

We receive various payments and allowances from our vendors through a variety of programs and arrangements, including allowances for warranties, advertising and general promotion of vendor products. Vendor allowances are treated as a reduction of inventory, unless they are provided as a reimbursement of specific, incremental, identifiable costs incurred by the Company in selling the vendor’s products. Approximately 83% of the vendor funds received are recorded as a reduction of the cost of inventories and recognized as a reduction to cost of sales as these inventories are sold.

Based on our vendor agreements, a significant portion of vendor funding we receive is earned as we purchase inventory. Therefore, we record receivables for funding earned but not yet received as we purchase inventory. During the year, we regularly review the receivables from vendors to ensure vendors are able to meet their obligations. We generally have not recorded a reserve against these receivables as we have not experienced significant losses and typically have a legal right of offset with our vendors for payments owed them. Historically, we have had write-offs less than $1 million in each of the last three years.

Goodwill and Intangibles

We evaluate goodwill and indefinite-lived intangibles for impairment annually in the fourth quarter of each fiscal year or whenever events or changes in circumstances indicate the carrying values exceed the current fair values. We evaluate the likelihood of impairment by considering qualitative factors, such as macroeconomic, industry, market, or any other factors that could impact the reporting unit’s fair value. If these factors indicate impairment, we perform a quantitative assessment to determine if the carrying value exceeds the fair value. Goodwill is evaluated at the reporting unit level and involves valuation methods including forecasting future financial performance, estimates of discount rates and other factors. If the carrying value of the reporting unit’s goodwill exceeds the fair value, we recognize an impairment loss.

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Indefinite-lived intangibles are evaluated by comparing the carrying amount of the asset to the future discounted cash flows that the asset is expected to generate. If the carrying value of the indefinite-lived intangible asset exceeds the fair value based on the future discounted cash flows, we recognize an impairment loss. These impairment analyses require a significant amount of subjective judgment by management, and as a result these estimates are uncertain and our actual results may be different from our estimates.

The carrying value of goodwill and indefinite-lived intangibles at August 25, 2018 was $302.6 million related to our Domestic Auto Parts reporting unit. The carrying value of goodwill and indefinite-lived intangibles at August 26, 2017 was $418.8 million with $302.6 million related to our Domestic Auto Parts reporting unit, $89.8 million relating to our AutoAnything reporting unit and $26.4 million relating to our Interamerican Motor Corporation reporting unit. During the second quarter of fiscal 2018, the Company recorded impairment charges related to its IMC and AutoAnything businesses as the Company determined that the approximate fair value less costs to sell the businesses was significantly lower than the carrying value of the net assets. These businesses were subsequently sold. See “Note M – Sale of Assets” for more information.

Self-Insurance Reserves

We retain a significant portion of the risks associated with workers’ compensation, employee health, general and products liability, property and vehicle liability; and we obtain third party insurance to limit the exposure related to certain of these risks. Our self-insurance reserve estimates totaled $223.0 million at August 25, 2018, and $220.5 million at August 26, 2017. This change is primarily reflective of our growing operations, including inflation, increases in healthcare costs, the number of vehicles and the number of hours worked, as well as our historical claims experience.

The assumptions made by management in estimating our self-insurance reserves include consideration of historical cost experience, judgments about the present and expected levels of cost per claim and retention levels. We utilize various methods, including analyses of historical trends and actuarial methods, to estimate the cost to settle reported claims and claims incurred but not yet reported. The actuarial methods develop estimates of the future ultimate claim costs based on the claims incurred as of the balance sheet date. When estimating these liabilities, we consider factors, such as the severity, duration and frequency of claims, legal costs associated with claims, healthcare trends, and projected inflation of related factors. In recent history, our methods for determining our exposure have remained consistent, and our historical trends have been appropriately factored into our reserve estimates. As we obtain additional information and refine our methods regarding the assumptions and estimates we use to recognize liabilities incurred, we will adjust our reserves accordingly.

Management believes that the various assumptions developed and actuarial methods used to determine our self- insurance reserves are reasonable and provide meaningful data and information that management uses to make its best estimate of our exposure to these risks. Arriving at these estimates, however, requires a significant amount of subjective judgment by management, and as a result these estimates are uncertain and our actual exposure may be different from our estimates. For example, changes in our assumptions about healthcare costs, the severity of accidents and the incidence of illness, the average size of claims and other factors could cause actual claim costs to vary materially from our assumptions and estimates, causing our reserves to be overstated or understated. For instance, a 10% change in our self-insurance liability would have affected net income by approximately $16.6 million for fiscal 2018.

Our liabilities for workers’ compensation, general and product liability, property and vehicle claims do not have scheduled maturities; however, the timing of future payments is predictable based on historical patterns and is relied upon in determining the current portion of these liabilities. Accordingly, we reflect the net present value of the obligations we determine to be long-term using the risk-free interest rate as of the balance sheet date. If the discount rate used to calculate the present value of these reserves changed by 50 basis points, net income would have been affected by approximately $2.2 million for fiscal 2018. Our liability for health benefits is classified as current, as the historical average duration of claims is approximately six weeks.

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Income Taxes

Our income tax returns are audited by state, federal and foreign tax authorities, and we are typically engaged in various tax examinations at any given time. Tax contingencies often arise due to uncertainty or differing interpretations of the application of tax rules throughout the various jurisdictions in which we operate. The contingencies are influenced by items such as tax audits, changes in tax laws, litigation, appeals and prior experience with similar tax positions.

We regularly review our tax reserves for these items and assess the adequacy of the amount we have recorded. As of August 25, 2018, we had approximately $16.5 million reserved for uncertain tax positions.

We evaluate potential exposures associated with our various tax filings by estimating a liability for uncertain tax positions based on a two-step process. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step requires us to estimate and measure the tax benefit as the largest amount that is more than 50% likely to be realized upon ultimate settlement.

We believe our estimates to be reasonable and have not experienced material adjustments to our reserves in the previous three years; however, actual results could differ from our estimates, and we may be exposed to gains or losses that could be material. Specifically, management has used judgment and made assumptions to estimate the likely outcome of uncertain tax positions. Additionally, to the extent we prevail in matters for which a liability has been established, or must pay in excess of recognized reserves, our effective tax rate in any particular period could be materially affected.