Petsmart 2007 Annual Report Download - page 38

and we did not experience the same level of obsolescence expense in 2006. We also capitalized more costs into
ending inventory as a percentage of revenue in 2006 compared to 2005.
Operating, General and Administrative Expenses
Operating, general and administrative expenses increased as a percentage of net sales to 23.3% for 2006 from
22.9% for 2005.
Net expenses resulting from legal settlements reflected a year-over-year increase. Fiscal 2006 included a
$3.4 million expense to accrue for an ongoing legal proceeding while 2005 included reductions in expenses from an
$8.5 million legal settlement gain and a $2.8 million credit card settlement gain. Fiscal 2005 also included a
reduction in expense due to a correction in stock-based compensation.
We accelerated into 2006 several initiatives, which include strengthening our distribution processes, improv-
ing our information systems and investing in our associates and their education, originally planned for 2007 and
2008. Also contributing to the increased expenses was the review of a potential acquisition we ultimately chose not
to pursue. Other professional fees also increased as we invested in projects to continue to improve our supply chain
and information technology infrastructure.
The increased expenses described above were partially offset by several factors. We saw a decrease in
advertising expense due to higher expenses for our “Mart to Smart” advertising initiative in 2005. We have also
allocated more of our marketing spending to PetPerks promotional offers in 2006, which are recorded as a reduction
of sales. Depreciation expense in 2006 was lower as a percentage of revenue compared to 2005, as a significant asset
reached the end of its depreciable life in 2006. Stock compensation expense was lower as a percentage of revenue in
2006 compared to 2005 due to higher forfeitures in 2006 as well as a change in forfeiture assumptions for the
unvested options and restricted stock.
Interest Income
Interest income increased to $10.6 million during 2006 compared to $9.0 million during 2005 primarily due to
higher rates of return on our investments in auction rate securities.
Interest Expense
Interest expense increased to $42.3 million for fiscal 2006, from $31.2 million for 2005 primarily due to an
increase in capital lease obligations in 2006.
Income Tax Expense
In 2006, the $105.0 million income tax expense represents an effective tax rate of 36.2%, compared with 2005
income tax expense of $106.7 million, which represents an effective tax rate of 36.9%.
During 2006, we settled an audit with the Internal Revenue Service. This included settlement of an affirmative
issue we raised during 2005 with respect to the characterization of certain losses. The settlement resulted in an
overall benefit of $3.4 million. We also recorded tax benefits of approximately $3.0 million primarily due to the
expiration of the statute of limitations for certain tax positions and additional federal and state tax credits.
During 2005, we recorded a reduction to income tax expense of approximately $6.1 million as the period of
assessment, during which additional tax may be imposed for years prior to 2002, expired for several jurisdictions.
As a result, we determined that approximately $6.5 million of tax contingency reserves were no longer required,
with approximately $0.4 million as an increase to additional paid-in-capital. We also recorded additional tax
expense of approximately $4.3 million resulting from corrections of our deferred tax assets.
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