領先汽車配件 (AAP) 2006 Q3 法說會逐字稿

Welcome to the Advance Auto Parts Third Quarter 2006 Earnings Conference Call.

Before we begin, Adam Bergman, Vice President of Investor and Media Relations, will make a brief statement concerning forward-looking statements that will be made on this call.

Good morning, and thank you for joining us on today's call.

Certain statements contained in this conference call are forward-looking statements as that term is used in the Private Securities Litigation Reform Act of 1995.

Forward-looking statements discuss, among other things, expected growth and future performance, including new store openings, remodels, relocations, comparable store sales, sales per store, operating margin, return on invested capital, free cash flow, accounts payable ratio, stock option expense, capital expenditures, tax rate, share count and earnings per share for the fourth quarter fiscal year 2006 and fiscal year 2007.

These forward-looking statements are subject to risks, uncertainties and assumptions, including those disclosed in the company's 10-K for the fiscal year ended December 31, 2005, and the 10-Q for the fiscal quarter ended July 15, 2006, on file with the Securities and Exchange Commission.

Actual results may differ materially from anticipated results described in these forward-looking statements.

The company intends these forward-looking statements to speak only as of the time of this conference call and does not undertake to update or revise them as more information becomes available.

Our results can be found in our press release and 8-K filing, which are available on our website at www.advanceautoparts.com.

For planning purposes, our fourth quarter earnings release and conference call are both scheduled for the morning of Thursday, February 15, 2007.

To be notified of the dates of future earnings reports, you can sign up through the Investor Relations section of our website.

One last piece of housekeeping, we will be holding our annual investor conference on Wednesday, November 29, 2006, in New York City.

If you would like to attend and have not already RSVPed, please contact me, so we can add your name to the registration list.

We look forward to seeing many of you there, and for those of you who cannot attend the live event, it will be webcast and available for replay.

With that, let me now turn the call over to Mike Coppola, our Chairman, President and CEO, who will be followed by Jim Wade, EVP of Business Development, and Michael Moore, EVP and Chief Financial Officer.

Mike?

Thanks, Adam.

Good morning, and welcome to our third quarter conference call.

We are pleased that our third quarter operating results met the upper end of our guidance and that we're beginning to see some signs of our business improving.

I would like to take this opportunity to really thank all of our team members for their dedication, customer focus and hard work in helping us achieve these results.

Our third quarter comps were 1.4% on top of the 10% in last year's third quarter.

For the third quarter, our DIY comps were negative 0.6% on top of 6.1% last year, while commercial comps grew a healthy 8.7% on top of 26.5 last year.

We achieved earnings per diluted share of $0.56 for the quarter, which includes a gain of less than $0.01 related to the refinancing of our credit facility.

It also includes stock option expense of $0.03 per share.

In last year's third quarter, earnings per share of $0.55 did not include pro forma stock option expense of $0.02.

The macro economic environment remained challenging throughout the third quarter compared to last year.

The challenges that our low- and middle-income customers have faced have been well documented, with inflation and energy costs, insurance and interest rates causing compression in real wages over the past three years.

The good news is that the future appears somewhat brighter.

Energy costs have moderated over the past several months.

Interest rates have stopped rising.

And a mild hurricane season resulted in far less disruption to our customers' lives.

As well, we believe some of the vehicle maintenance that customers have deferred over the past few quarters is reaching a point where it must be performed.

For example, we are seeing stronger sales in nondiscretionary items like batteries and postponable categories such as motor oil.

And perhaps, just as importantly, a number of the customer service and marketing initiatives that we've discussed in recent calls are also beginning to bear fruit.

Our more recent results suggest our customers have a little more financial confidence and are spending a bit more freely.

As a result, we are projecting 1 to 3% comps for the fourth quarter, and we've been running in the middle of that range for the first few weeks of the fourth quarter.

Particularly encouraging is that our DIY results have been slightly positive over this time.

Our comparisons get a little more difficult in November before easing in December.

These past few quarters certainly have been atypical for us from a macro perspective as well as a sales perspective.

As disappointing as the soft sales environment has been, this helped reinforce a skill set and a culture within our organization of being able to respond to sales and expense challenges.

We have learned a tremendous amount, and we will come out of this a leaner, more tenacious company, providing us with more upside potential in good times and less downside in rough times.

We have also learned just how proud and resilient our organization is.

Our team members have rallied together like never before, determined to drive incremental sales through even better execution and aggressive customer service.

Advance has long been known for its customer service, and over the past few months we've defined that term more precisely so that our store teams know exactly what that means from our customer standpoint.

One source of particular pride for us during the quarter was the opening of Advance's 3,000th corporate store on September 14th in Salina, Kansas.

Some people may view this as just another store, but its opening really puts our company's growth trajectory in perspective.

Just 20 years, on October -- 20 years ago, in October 1986, Advance opened its 100th store.

So we have grown 30 fold in 20 years, an outstanding rate of growth.

As we said, we believe we can add another 1,500 stores within our existing 40-state footprint.

This growth generates significant career potential for our team and helps to make Advance an employer choice in our markets.

Next month we'll celebrate our fifth anniversary as a public company, and next year marks Advance's 75th year of business.

So our team has much to be proud of and much to look forward to.

During the quarter, we also made continued progress opening Autopart International stores, which Jim will talk about further.

They added growth in incremental market share that Advance would not have been able to reach, thus providing an additional platform for our growth.

Let me now speak to SG&A, which remains a high priority for us.

As we have discussed in prior calls, we're working aggressively to lower our cost of doing business.

For example, I am pleased to report that we have rolled out our expedited store end-of-day process that we discussed last quarter, and that program has been very well received.

Likewise, the addition of Energy Management Systems to 1,000 stores continues to proceed as planned.

In addition to the initiatives we discussed in previous calls, which are in various stages of implementation, during the quarter we took the opportunity to further reduce our cost structure by consolidating our call center in Florida into our customer contact center here in Roanoke, which reduced headcount and telecom expense, enhancing our store delivery process to minimize cost, while maintaining industry leading in-stock levels, installing commercial printers that are more efficient and more cost-effective, and taking advantage of three-year lows in natural gas prices to hedge a portion of our consumption with the winter's heating season ahead at favorable rates.

These, as well as other initiatives we are working on, will help us take cost out of our business.

It has been difficult for us to produce SG&A leverage on 1% comps, as we have been faced with for the past two quarters.

Our goal and plan is to leverage SG&A in 2007 and comps in the 3 to 4% range.

We believe we can achieve that, while at the same time not making decisions that jeopardize our long-term growth for the sake of short-term SG&A improvement.

We will continue to make investments in new stores, relocations, remodels and additional commercial programs, which have helped us produce good sales growth, and we believe these programs will help drive our sales long into the future.

Indeed, we all know that the most sustainable way to leverage SG&A is to drive comps, and that is what we're most focused on.

I discussed some of our sales driving initiatives on last quarter's call, and I am pleased to report that a number of them are producing good results.

In addition, many of you may have noticed some of our new programs such as our innovative promotions, like our 10 for $10 sale that we implemented to reinforce our value proposition and drive additional footsteps into our stores in September.

As well, a targeted wiper blade campaign in the month of October.

Our new promotion for November, which just began this past weekend offers similar messaging for headlights, which is especially timely with the changeover from daylight savings time to standard time.

And we even rolled out a small area, such as mini shopping carts to our stores, to make it easier for customers to shop and purchase more.

As with our SG&A initiatives, many of these may seem modest, but collectively they represent a large opportunity for us.

Another opportunity we have noticed is that we can do a better job of providing legendary customer service to our customers and offering premium products and free services wherever appropriate.

We also will be reconfiguring our field staff to be more effective in the near future in order to help improve our store execution and customer service.

Let me now turn to gross margin, which Michael will discuss in greater detail in a few minutes.

We continue to show strong year-over-year improvement in this metric.

Improved procurement costs and a favorable mix compared to last year helped our third quarter results.

As well, our category management process continues to get better and better, turning up many opportunities where we can work with our vendors to improve our sales and our competitiveness while at the same time growing our margin percent.

We also have a significant opportunity to grow our margin through direct importing.

Today, we direct import very few hard parts with the key constraint being quality production.

Through the introduction of greater automation and more sophisticated technology overseas, we are seeing more opportunities to source quality hard parts abroad, which typically provides us with much lower cost than we can achieve domestically.

Direct importing always held its promise for us, but it is now much more in our immediate grasp.

AI's knowledge in this area is helping as well.

Stay tuned for more developments in this area.

Let me conclude by reminding you that our industry dynamics remain strong, with a growing and aging vehicle population in need of replacement parts.

If anything, these vehicles need parts more than ever before, in some cases because customers deferred maintenance that should have been performed already.

In other cases we must continue to educate customers about the value of doing certain maintenance.

Many customers don't know, for example, that a vehicle needs a cabin air filter.

New eye-catching packaging of point-of-purchase signage now highlights this opportunity in our stores.

Other customers don't know the recommended change-out rules for wipers, fluids or headlights, and wait until it's too late before they realize they're in need of these items.

We can continue to help our customers through our customer education program, which touts the benefits of preventive maintenance.

As I said, for the fourth quarter, we are projecting 1 to 3% comps.

We do expect to achieve continued year-over-year gross margin improvements, but not as much as in the third quarter.

At this level of comparable store sales gains, we expect to produce less SG&A de-leverage than we have in the past two quarters.

Accordingly, we are targeting fourth quarter EPS to be in the range of $0.33 to $0.37, inclusive of $0.03 of stock option expense.

That would put our annual results in the range of $2.15 to $2.19.

As always, we remain committed to our -- to developing our people to help us achieve our four key financial goals.

First, increasing average sales per store.

This figure now stands at $1.56 million with much room for additional improvement.

Second, growing operating margin, where we continue to target 11 to 12%.

Third, growing free cash flow, a metric Michael will discuss in greater detail in a few moments.

And finally, improving our ROIC driven by improving sales, margin, as well as inventory management.

Now I'd like to first turn the call over to Jim to review our sales and store growth in greater detail.

Jim?

Thank you, Mike, and good morning.

I'll further review our sales for the third quarter as well as updating you on some of our growth plans.

Our total sales rose 7.8% compared to last year's third quarter.

This reflects the 1.4% comps and approximately 7% new store growth, including the Auto Part International stores.

As Mike mentioned, our DIY comps were a negative 0.6% compared to a positive 6.1% in last year's quarter, which was our best quarterly result in a strong year.

Our average transaction size continues to be strong, while customer account remains our challenge.

We've taken a number of actions to drive additional foot traffic to our stores, and Mike mentioned several of those, including a greater emphasis on customer service, both on the telephone and in-store, new promotions to increase our traffic, and innovative programs that establish Advance as the market leader for free services, such as windshield wiper, installation, battery installation and others.

Our commercial business continued to expand at a healthy rate in the third quarter, both in our Advance Auto Parts stores and with Auto Part International.

For the quarter, our commercial sales as a percent of our total sales was 25.3%, including AI.

This represented $277.9 million in combined commercial sales, but on an annual basis represents only 2% of the large and growing $58 billion addressable commercial market.

We continue to have significant opportunities to further penetrate this market, and I'll talk in more detail about our plan to maximize these opportunities.

As Mike said, we achieved an 8.7% comp in commercial in our Advance stores during the second quarter, over a 26.5% increase in the same quarter last year.

During the quarter we added 45 new commercial programs, most of which were in our new stores, bringing the total number of Advance stores with commercial programs to 2,398.

Commercial made up 23.3% of sales in our Advance stores compared to 22.3% in the same quarter last year.

Today about 81% of our Advance stores have commercial programs compared to 78% at the same time last year.

We are approaching our goal of having commercial programs in 85% or more of our stores over time.

Yet, we continue to see significant opportunity to grow our commercial business as many of our programs are less than five years old and, therefore, have their best growth potential over the next several years.

Our commercial growth will also require less SG&A investment going forward, as it will principally consist of leveraging our existing programs, fewer startup costs for new program.

Although we fell slightly short of our double-digit comp target for commercial in the second and third quarters, we still see the opportunity to achieve that target on an ongoing basis as consumer spending continues to strengthen.

Auto Part International also continues to grow.

They've now opened 19 new stores since we acquired them in September of 2005, which brings their store count to 80.

For the quarter, AI contributed $27.8 million of sales and did so profitably even as this new store growth rate and the infrastructure needed to support that growth has accelerated significantly.

This ramp-up in new growth had a small negative impact on our total SG&A, which Michael will touch on in his remarks.

As we expected, the AI model continues to be highly complementary to Advance's.

We now have a number of markets where they are operating successfully in the same market as an Advance store without either store cannibalizing the other.

In fact, the two companies are almost mirror images of each other.

Advance focuses on DIY first, whereas AI focuses almost exclusively on commercial.

Within commercial, Advance targets smaller general repair shops, whereas AI primarily targets larger specialty garages.

And in terms of parts coverage, Advance has broader offerings for domestic vehicles, and AI's emphasis is primarily on foreign makes and models.

The stores are using each other as their preferred second source for parts, and together, we can capture a greater share of the commercial market than we would have been able to as just Advance.

The AI team has proven it can open new stores at an accelerated pace, and our goal is to continue ramping up AI store openings.

AI also gives us a broader platform to grow our commercial business, both organically through new AI stores and through tuck-in acquisitions of regional commercial operators.

Based on valuation, ease of integration and the opportunity to improve operations, we continue to be interested in small regional acquisitions to supplement AI's growth over time.

Shifting back to Advance, we continue our progress towards having the newest, freshest store base in the industry, not only with our new store growth, but also through our aggressive remodel and relocation program.

During the quarter, we opened 60 new stores, bringing us up to a total of 162 year-to-date. 52 of these 60 new stores opened as Advanced Auto Parts, and 8 opened as Autopart International.

We closed two stores in the quarter and five year-to-date.

Our pipeline of new stores is strong as we prepare for 2007, and we see great opportunities to open more stores in our existing 40 states.

Our new store productivity remains steady, and this quarter was no exception.

New store productivity benefited this quarter also because of having a full quarter of AI this year, but only five weeks of AI in last year's third quarter.

With the success we're achieving opening new stores, we're comfortable that we'll meet our target of opening 205 to 215 new stores in 2006.

This increase in square footage of 7 to 8% even in a soft sales environment illustrates our commitment to growth for the long term.

We believe this is a sustainable rate of growth for the next several years as well and anticipate owning a similar number of new stores in 2007.

During the quarter, we remodeled 56 Advance stores to our 2010 format and 177 year-to-date.

At the end of the quarter, we had a total of 1,884 stores with the 2010 format, or about 64% of our stores.

These bright and new-looking stores provide a significant point of differentiation to the consumer.

With these remodels, along with our new stores and relocations, approximately two-thirds of our stores will have this format at the end of 2006.

With this level of 2010 stores, we will not need to remodel quite as aggressively in the future, which will help our SG&A and CapEx.

Next year, we expect to remodel approximately 150 stores and will continue remodeling our stores until the entire chain features the 2010 format.

Year-to-date, we've also relocated 31 stores, and we continue to target approximately 50 relocations for the year.

In 2007, we foresee approximately 40 relocations.

With this activity, we ended the quarter with 29 -- 2,949 Advance Auto Parts stores and 80 Autopart International stores for a total store count of 3,029 stores.

Now let me turn the call over to Michael Moore to further review our financial results.

Thanks, Jim, and good morning.

For the quarter, gross margin was 48.2%, a 100 basis point improvement over last year.

This improvement reflects lower procurement costs of favorable merchandise mix compared to third quarter last year, the positive impact of category management and lower logistics expense.

LIFO was an immaterial amount in both this year and last year's quarter.

In the fourth quarter, we expect continued gross margin improvement, but not to the same degree as we experienced in third quarter.

Turning now to SG&A, our SG&A expense rate for the quarter rose 200 basis points compared to last year.

Non-comparable stock option expense represented 42 basis points of the increase.

Also, last year included a $1.8 million gain from the sale of our credit card portfolio, or an 18 basis point impact on SG&A.

De-leverage on fixed expenses due to low comp sales represented a 70 basis point increase.

Other areas of expense de-leverage include higher costs in utilities and insurance programs, including property insurance, workers' compensation and medical, which in total represented roughly a 60 basis point increase.

We have implemented programs to mitigate increases in these expenses, including energy management systems, additional safety programs and insurance coverage initiatives.

And lastly, as Jim mentioned, the ramp-up in new store growth for AI impacted SG&A by about 20 basis points.

Although we de-leveraged SG&A in the quarter, due to soft sales non-comparable items, new store growth, utilities and insurance, we made good progress in reducing many controllable expense lines.

In the quarter, we leveraged travel, hiring and moving, meeting expense, supplies, communications and alarm monitoring expense.

In the third quarter, our SG&A per store grew somewhat faster than it did in the first two quarters of the year, largely due to non-comparable items.

Last year, we owned AI for only the last five weeks of the quarter and, therefore, incurred only five weeks of expenses on its full store comp.

Absent that, our rate of growth in SG&A per store this quarter would have been in the low single digits.

Going forward, as Mike said, we will continue to make investments in new stores, relocations, remodels and additional commercial delivery programs, all of which tend to de-leverage SG&A in the short-term.

However, as Jim mentioned, our commercial growth will require less SG&A investment going forward, and it will primarily consistent of leveraging existing programs versus adding new programs to existing stores.

In addition, the number of remodels as a percent of the total chain will decline, which will favorably impact SG&A leverage.

We expect the combination of expense reduction initiatives and less de-leverage impact from remodels and new commercial programs to enable us to gradually lower our SG&A rate.

Also, we expect to make improvements in expenses that de-leveraged in 2006, such as workers' compensation and insurance costs.

In addition, in 2007, stock option expense will be comparable.

Assuming a 1% to 3% comp increase in fourth quarter, we expect SG&A to de-leverage to a lesser degree than it did in the third quarter.

And for 2007, we have developed a plan to leverage SG&A on comp store increases in the 3 to 4% range.

For the third quarter, operating income was $102.5 million, or 9.3% of sales.

Interest expense net of interest income was $9.1 million in the quarter, versus $7.3 million last year, due to higher interest rates and lower cash balances reflecting our return of capital to shareholders through the payment of $19 million in dividends and $196 million in share repurchases over the last year.

The $9.1 million of interest expense excludes a gain of approximately 1 million, which I will discuss in further detail.

Shortly before the quarter ended, we refinanced our secured credit facility with a new $750 million unsecured revolving facility.

This provides us with additional financial flexibility, increasing our liquidity while reducing interest expense.

Our new facility bears interest at LIBOR plus 75 basis points, which will save us more than $2.5 million annually in interest expense.

We have executed new interest rate swaps that effectively fix our interest rate exposure on approximately 50% of the new debt.

At current rates, our borrowing cost is in the 6% range.

We currently have approximately $450 million drawn on this new facility.

In connection with the refinancing, we recorded a charge of $1.9 million for deferred financing costs, and we recorded a gain of 2.9 million for previously unrealized gains on interest rate swaps, both of these items related to our prior credit facility.

These amounts netted to a pre-tax gain of $1 million, or less than $0.01 per share.

Both of these amounts were recorded in the gain on extinguishment of debt line on the income statement.

Our third quarter income tax rate was 37.6% compared to 38.1% last year.

This reflects the successful completion of several state income tax audits.

Going forward, we continue to expect our tax rate to be in the 38.0 to 32.8% range.

For the fourth quarter, we expect our fully diluted share count to be approximately 106.5 million shares.

In the third quarter, while we were in the process of refinancing our debt we did not repurchase any shares.

Year-to-date, however, we have spent $137 million repurchasing 3.7 million shares.

We have $104 million remaining on our existing share repurchase authorization, and we expect to return a significant portion of our future free cash flow in this manner.

However, as we have said before, we do not anticipate levering up significantly to fund share repurchases.

In terms of the key components of our balance sheet and our cash flow statement, we ended the quarter in solid inventory position and managed our inventory appropriately for the sales environment.

Inventory increased 6.3% on a sales increase of 7.8%.

Our accounts payable to inventory ratio was 55.4%, slightly less than last year's 56.6%.

Nonetheless, we continue to expect steady year-over-year improvement in our accounts payable to inventory ratio.

We expect to achieve improved AP to inventory levels primarily through growth in our vendor financing program.

This program currently has $141 million outstanding, a $23 million increase compared to last year.

Let me turn to goodwill on the balance sheet.

As planned, we finalized the purchase price allocation for Auto Part International, which resulted in approximately $28 million of assets being reclassified from goodwill to intangibles.

These include customer relationships, trademarks and trade names and non-compete agreements.

A portion of these will be amortized over their useful life, which will result in approximately $1.1 million of annual amortization expense going forward.

In the third quarter, we recognize 1.1 million of expense to reflect amortization of these assets since our acquisition of AI last year.

On the cash flow statement, our year-to-date CapEx was $201 million as compared to 159 million last year.

This reflects more new stores and remodels as compared to last year, more owned stores and greater investment in IT and logistics.

For 2006, we expect CapEx to be approximately $255 million and free cash flow to be approximately 100 million.

Now I would like to turn the call back over to Mike.

Thanks, Michael.

Before we open the floor to questions this morning, we would like to reiterate our commitment to growing our topline and especially our DIY business, which is our top priority.

We are pleased to see for the past couple of months that our extra efforts and improvements in the macro environment are showing some positive impact.

We will not allow ourselves, however, to become complacent.

Our customers trust us and invite us into their lives by giving us the opportunity to look under their hoods and solve their problem.

We must continually prove that we deserve their trust, and I remind our stores every week that superior customer service is the surest way to secure customers for life.

We are committed to doing exactly that.

We are now ready for questions.

Operator?

Thank you.

[OPERATOR INSTRUCTIONS].

Our first question today comes from Danielle Fox from Merrill Lynch.

Thanks.

Good morning.

Good morning, Danielle.

Could you talk a little bit more between the lag between changes in gas prices and fluctuations in demand?

It seemed like last year for a while higher gas prices didn't have any impact on sales, but then became a drag.

I'm wondering if you'd expect to see sort of the same kind of pattern from lower gas prices with the sales benefit building a few months afterwards.

Well, Danielle, last year again was a little bit different than what happened to us the year prior.

The year prior we felt that gas had impacted us, and in truth, it may have last year.

But we had a number of initiatives that we think may have made up for that as well as, of course, the year-over-year hurricane impact, which created a little bit of difficulty in us really ascertaining what the impact of gasoline is.

That all being said, I think that the issue of gasoline, as well as other energy costs, interest rates, insurance costs and our consumer, and there's disposable income is the real issue.

And although gasoline has gotten better and we're anticipating energy costs being better this winter, these customers are still dealing with a number of issues, some of which will start to annualize themselves as we get into the first quarter.

Okay.

Great.

And then I have a follow-up question for Michael Moore.

Mike, you gave us a lot of very good detail on SG&A -- what hurt you this quarter, what was different from the second quarter.

Can you just tell maybe the one or two main things that will change between the third quarter and the fourth quarter in terms of the magnitude of the SG&A de-leverage?

Is it primarily sales, or is it the lower spending on things like commercial and remodel that will improve the trend sequentially?

Danielle, good morning.

I think it's a few items.

Number one, it is stronger comps.

We're forecasting 1 to 3% comps for the fourth quarter.

Also, many of our SG&A initiatives are starting to take hold and will reduce expense in the fourth quarter.

Also, in the third quarter, we have that 1 million -- 1.08 million credit last year, which will not de-leverage us in the fourth quarter.

And then just final question, on the -- previously, you talked about sort of this 11 to 12% operating margin goal.

I'm wondering if you've updated your thinking at all on that and whether there's been any change in terms of the timetable or the composition, if you have?

And if not, whether we should expect an update at the analyst meeting later in the month?

Thank you

Danielle, that target is still there.

We believe it is very accomplishable.

Obviously, had it not been for this year, we felt we would have been on track for that to happen in '08.

Obviously, we were negatively surprised with particularly the impact of the macro environment, and that slowed our pace toward that goal.

On the other hand, we could be surprised next year.

So I think that right now, we're going to stick to our guns that we're looking for the 11 to 12, although we don't think it will be in '08 right now.

And we'll get a better feel I think as we get into next year, and we'll probably update that guidance on timing as we get through next year.

Thanks very much.

Our next question comes from Gary Balter with Credit Suisse.

Hi, good morning.

It's actually Seth Basham for Gary.

Hi, Seth.

I'll take you off speakerphone.

Could you give us some color around the third quarter sales trends?

Were there any impacts on weather compares versus last year?

Seth, obviously versus last year, we didn't have the hurricane impact.

We think weather was fairly neutral to our sales but did help our mix to a degree.

Okay.

And in terms of gross margin, you mentioned mix being a factor.

Can you just provide more detail on what products were selling faster and which were slower causing that shift?

Well, again, it's typically parts that have higher margin that helped us.

And particularly, batteries, as I mentioned earlier, were very strong, and that's a very high margin category, which helps boost sales and margin.

Are you seeing any sort of trade-down effect lingering?

We still believe there is some, although we're working very hard and we're incentivizing our team members to sell -- upsell and sell more premium problems, and I think we're cutting into that somewhat that's helped our margin this quarter.

Okay.

Great.

And finally, Michael, you mentioned less de-leverage in the fourth quarter.

Could you quantify how much de-leverage you expect on the SG&A line?

It will be less.

But we -- we're not prepared to quantify exactly how much less.

Okay.

Fair enough.

Thank you.

Our next question comes from Alan Rifkin with Lehman Brothers.

Yes.

Couple of questions, if I may.

Mike, you mentioned in your prepared remarks that you're seeing incremental market share in markets where there's both an Advance store and an AI.

Can you maybe just elaborate a little bit on what kind of data the two divisions are sharing and maybe what that incremental boost to market share is?

And then I do have a follow-up.

I think that the point being that we have determined, in analyzing our commercial customer base, that our model only allows us to penetrate a certain segment of that market.

And the AI model, as Jim talked to, allows us to penetrate deeper into the commercial area and pick up other segments that we don't pick up.

Okay.

So going forward, could we expect the growth within the AI division to accelerate and for that to become a more and more important part of this 7 to 8% square footage growth on an annual basis?

Yes.

I think that's what Jim basically alluded to in his comments.

Okay.

Thanks, Mike.

And then, Jim, maybe with respect to the 2010 stores, any sort of color as to how the year-two stores are performing relative to where they were earlier in this year, just for modeling purposes?

In terms of the remodels that were done?

Is that it?

Yes.

In terms of the ramp-up that you're seeing post the conversion and how those stores continue to improve over the first year or two as the program now is almost nearing its two-thirds point.

Yes.

We continue to be pleased with what we're seeing with the sales increases on the remodel stores.

Certainly they have seen some of the same impact with sales in those stores as we have on our overall sales this year.

But we believe that's, as Mike has talked about, more of the macro factor than any change in what we're doing with the remodels themselves.

Okay.

And just one quick question for Michael, please.

You mentioned that your CapEx is rising due to more owned stores.

Where is that percent right now?

Is it around the low 20s to mid 20s?

Yes.

We own -- I don't know the exact percentage, but it's in that low 20s range of our total chain.

Okay.

Thank you all.

Thank you.

Our next question comes from Dan Wewer with Raymond James.

Michael, you and your competitors are doing a terrific job in improving gross margins, really on top of five years of substantial gains.

Are you ever concerned that gross margin rates could become so high that it could attract new competitors in your sector?

That's always a concern for us.

And I think you'll find, if you look over time, a good portion of our margin gain has become -- has come from lower procurement costs, as well as our merchandising efforts.

And we're always looking to maintain our competitiveness.

For example, as we look at mass merchants, for example, we believe we're more competitive than we've ever been against them, and in fact, the auto after market in general is growing share against that class of trade.

You had noted an initiative to increase your direct imports of hard parts.

Will this be of greater use to your do it yourself or to your commercial customers?

Anything we do from the standpoint of procurement really benefits both of our customer bases.

And could you remind me on AI what portion of their business is coming from direct imports of hard parts?

They have a very high percentage of their total purchases coming from direct imports at this time.

And that's relationships that have been built over many years that has done very well for them, and as Mike mentioned, that's an opportunity that we're being able to share information and help Advance achieve some of those savings probably faster than we otherwise would have.

So is the game plan just to let the Advance stores piggyback on the programs that AI already has in place on direct imports?

In some cases, but it's more using the relationships and some of the knowledge that AI has built up over many years because of their focus on foreign car parts as what they've been doing for a long time and using those relationships to help leverage in some cases the same vendors and some cases it's other vendors.

Great.

Thanks a lot.

Thank you.

Our next question comes from Matthew Fassler with Goldman Sachs.

Thanks so much, and good morning.

Hi, Matt.

First question I'd like to ask is just a follow-up on the SG&A front.

In the second quarter, if you look at SG&A per foot before the effective options, you were up in the neighborhood of 2% this quarter.

As you noted, that growth rate accelerated by about 200 basis points.

I'm curious about what, if anything, changed in terms of the cost environment over that period of time.

Well, Matt, as I mentioned in my comments, that that increase in SG&A per store artificially was increased because last year we only owned AI for five weeks, which had five weeks of expense.

But the number of stores that we had the full store comp.

So it was really overstated or distorted by that.

I guess my question--

When you subtract that, we're more in line with where we ended the second quarter.

Wouldn't that have been the case in the second quarter as well, where you had AI for the whole second quarter this year and not at all the second quarter of last year?

No.

No, it would not have been because last year there was no AI expense and there was no AI stores in the second quarter.

This year we had a full quarter of expense and a full quarter of stores.

Fair enough.

This is the only quarter where it's somewhat distorted.

Okay.

And the operating model for AI, should we think about as being a higher gross margin and higher SG&A rate operating model as you open more of these stores going forward?

Generally, that's the case.

It becomes complicated because of the fact that we're growing a significant number of new stores on a pretty small base, which increases their SG&A as well.

But generally what you described is the case, and we would expect that to be until we have a large enough base there that the new stores are not as impactful on their SG&A.

Got you.

And my second question relates to your commercial comps.

Last quarter you were kind enough to give us a comp store sales number that essentially relates to stores that have the commercial program a year ago, which I think is a bit different from the way you've traditionally disclosed comps.

Would you be able to give us that number for this quarter as well?

We don't have that number in front of us, although I would say it's going to be the same type of thing as we saw last quarter, where the underlying stores had the very solid increase relative to the total comp increase.

I think we saw that same thing in the third quarter.

Thanks, Jim.

And then my third and final question, we've heard a lot from retailers about the hurricane and the impact of the hurricane and the premise that tough compares -- the aftermath of the hurricane where business picked up and hurricane-impacted markets are constraint year-to-year sales increases.

I know, Mike, you spoke about the tougher compare -- the easier compare in October, a tougher November, et cetera.

But if you take a bigger picture step back and you think about the impact of the hurricane, are you right now constrained by the hurricane compares that you're facing?

And if that's the case, when do you see those beginning to abate?

Well, I think that's reflected in our comp guidance.

If you look on a two-year basis, third quarter versus fourth quarter, it would appear we're guiding lower.

If you look on a three-year basis, you'll see that we have much stronger compares in the fourth quarter.

So I think that the answer to your question, if I haven't answered it already, is, yes, there is some headwind in the fourth quarter to that, but that's reflected in our guidance.

And Mike, do you think that headwind abates once you get to first quarter, or do you think that you continue to ride that wave a little bit into '06?

We think that will be over once we get to the fourth quarter.

Great.

Thank you very much.

[OPERATOR INSTRUCTIONS]

Our next question comes from Armando Lopez with Morgan Stanley.

Thanks.

Good morning, everyone.

Most of my questions have been asked.

But I guess you mentioned, I think, the reconfiguration of the field staff.

Could you just provide a little bit more color on that and the timing of the rollout?

That's something that we're going to begin implementing toward the end of the fourth quarter and should be fully implemented in the first quarter.

And we're basically looking at reconfiguring to have more line supervision and less staff support in the field, which we think will make us more effective from an execution standpoint and better -- give us better customer service focus in our stores.

Okay.

And then on the lease versus own, you mentioned the CapEx up, I think, a little bit, given a little higher ownership of the stores.

How are you thinking about the lease versus own decision with the store growth going forward?

We anticipate somewhere in that same 20, 25% of our stores being owned and the remainder being leased.

And that's the -- basically the model we've been using for the last couple of years, and we wouldn't anticipate that that's going to change significantly in 2007.

Okay, great.

And then just one last one, as you think about like the comp guidance for the fourth quarter, can you provide any color in terms of how you're thinking about that from like a DIY versus commercial perspective?

Well, obviously, with the comp guidance going up to one to three, we feel that there's a little more upside in the DIY business, as we mentioned in the call that we are seeing some strength particularly last few weeks and now have gone to a positive DIY comp.

So we think we'll see stronger DIY comps than we have seen in the second and third quarter.

Okay, great.

Thanks a lot.

Our next question comes from Anil Chachra with Gabelli.

Good morning.

How are you?

Hi, Anil.

Just a few quick questions.

As part of your commercial push, do you plan to offer parts of the heavy duty market Class A market because I know one of your competitors had talked about that.

Right now we look at our convenience business as an add-on to our DIY business.

And that is not a big category for us in DIY and, therefore, is not a category that we're going to be focusing on in commercial.

Secondly, the Amazon announcement, is there any challenges that will create for you or any response to that as far as entering parts distribution?

Yes.

Again, I think from a parts standpoint, the Internet is probably more beneficial for information, which, you know, we have on our site as well.

Sure.

Unless there is a -- again someone way out in the boondocks that can afford to wait two or three days, it's very rare today.

Of course.

I think that the immediacy of parts needs would preclude that from being a significant factor in the parts area.

From an accessory standpoint, it's something we're looking at as well -- how do we do a better job online.

And we've had PartsAmerica.com website for purchasing for many years and continue to see some growth in that.

So we really think we're in the business.

Again, there's a lot of other people in catalog and Internet businesses.

So we don't foresee a noticeable impact with Amazon joining in.

Okay.

Last one is there any incremental advertising spend that you have to include to make customers more aware of your commercial push?

Well, we have a specific marketing and advertising program oriented toward commercial, which is basically running at the rate it has over the last few years.

So--

It's not increasing anymore.

Well, we've been doing the last few years.

Great.

Thank you very much.

Our next question comes from Cid Wilson from Kevin Dann and Partners.

Hi.

Good morning.

Just two questions.

The first is that can you comment on what you're seeing with the 2010 conversions now compared to previously, just in terms of the productivity given the fact that I think in your statements you said you're now going to be converting about 150 per year now versus previously of 200 and 250.

And is that part of the initiative to cut back on SG&A expenses?

Well, we -- as I said, we are planning to do 150 in 2007, which -- this year we'll do somewhere in the 190 to 200 range.

So it's a reduction in the number to some extent.

It's not a huge reduction, but it's driven more by the fact that we're now two-thirds of the way through our entire chain in terms of remodels.

And as we are starting to look at the markets that are remaining and the age of those markets and the position that we have in those markets, it seems to make sense that a number around 150 is more appropriate now that we're as far into the remodel program as we are.

I mentioned in terms of productivity, certainly this year our remodel stores are seeing some of the same impact as our overall stores relative to the macro factors, but we've remained pleased with what we're seeing in terms of sales increases in those stores.

Okay.

And my last question is, can you comment on your distribution centers and their store capacities and at what point you may consider opening up a new DC?

Well, as we said, you know, we opened our DC in March of last year in Allentown, Pennsylvania.

And basically, that DC is geared to service 500 or 600 stores.

So about every two years to two-and-a-half years, we'll probably be looking to add a DC.

We're not ready to make an announcement on that officially yet.

But that's good news, because that tends to have a very positive impact on our transportation expense.

Okay.

Thank you.

Our next question comes from [Danielio Santiago] with Basswood Capital.

Hi, good morning.

Could you just comment on what you're seeing in terms of pricing competition among the players in the industry?

It appears that pricing, as it's been for many years, is rational in our business.

We're obviously a slow-turn business, and margins are crucial to the success of our formula.

So we really see pretty rational pricing among our competition.

Okay.

And then can you also comment what type of comp sales growth you need to see to eventually stop seeing de-leverage on your SG&A line?

We've got a plan together for 2007, which we believe we can -- we will leverage SG&A on a 3 to 4% comp store increase.

Okay.

Thank you.

And our last question today comes from Gary Balter with Credit Suisse.

Thank you.

I'll ask instead of Seth this time.

Just two questions.

One for each of the Mikes.

On the expense side, when you visited New York in June, you talked about a lot of initiatives that are going to drive down expenses.

And obviously, the comps haven't been there, and that's been one of the issues.

But when you look at where you are now and where you thought you were like three or four months ago, are there some areas where expenses have just been higher than you expected or the ability to reduce it have been lower and it's taking longer?

Or do you think it's all just a comparable store sales?

No, as Michael said earlier, it's obviously impacted by the lack of leverage of sales.

On the other hand, Gary, on a controllable basis where we have controllable expenses, I think we've done a pretty good job.

But there are expenses -- credit card fees, insurance, workman's comp -- those type of expenses that are difficult for us to control.

We're kind of a victim of what's taking place in the macro world or from lack of competition in the credit card business and makes it difficult to leverage unless we get comps up to a higher level.

So it would be to fair to say expenses are running a little bit higher than you expected regardless of comps?

Well, yes, on a controllable basis, I think they're running as good or better.

On the ones that are less controllable, we've had some headwind, yes.

Okay.

And then, on the overall, you mentioned that the customer still doesn't have the money, and that's slowing down and you expect that to get better.

Are you surprised at all by the fact that there hasn't been a bounce back at this stage, given how much gas prices have come down?

Well, again, Gary, as we've said, it's not just gasoline that I think is a factor here.

When we talked about the January, what happened in January last year, with credit card payments doubling, interest rates up, energy costs in general, natural gas prices last year, electrical prices over the summer, it's more than just gasoline that's affecting our consumer.

And again, their real wages are not increasing to any significant extent.

And net of all these expenses, healthcare expenses that they're having to bear a share from their employers.

So it's more than just gasoline alone.

Again, the good news is I think we'll see some of these annualized as we get into the first quarter.

And then also be -- we -- your business has to do well on extremes, and the weather last year was quite mild, I believe, in the winter.

Could that be having an impact, a delayed impact?

We believe, and I've talked to a lot of the veterans in the business, and we really haven't talked much more about the weather other than the first quarter.

But we believe there is some impact of less damage that took place over the winter that's been affecting us as we get into this -- later into this year.

Again, that will annualize itself in January.

Yes.

Okay.

Thank you very much.

Thank you.

And that concludes our call today.

Thank you for joining us.

Thank you, everyone out there.