領先汽車配件 (AAP) 2008 Q2 法說會逐字稿

Welcome to the Advance Auto Parts second-quarter 2008 conference call.

Before we begin, Judd Nystrom, Vice President, Finance and Investor 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 made during this conference call will contain forward-looking statements that incorporate assumptions based on information currently available to the Company.

Any statements that are not related to historical facts are forward-looking statements as that term is defined in the Private Securities and Litigation Reform Act of 1995.

These forward-looking statements are subject to risks, uncertainties and assumptions, including those listed from time to time in the company's Annual Report on form 10-K and its other filings with the SEC.

If any of these risks or uncertainties materialize or if the underline assumptions prove incorrect the Company's results may differ materially from anticipated results discussed in these forward-looking statements.

The Company intends these forward-looking statements to speak only of the time of the conference call.

It does not undertake or revise them as more information becomes available.

Our results can be found in our press release and 8-K filing which is available on our web site at www.advanceautoparts.com.

For planning purposes, our third-quarter earnings release is scheduled for Wednesday, October 29, after market close, and our quarterly conference call is scheduled for the morning of Thursday, October 30.

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

Finally, a replay of this call will be available on our web site for one year.

Now, let me turn the call over to Darren Jackson, our President and CEO, who will be followed by Elwyn Murray, EVP Customer Development Officer DIY, Jim Wade, EVP, Customer Development Officer commercial, and Mike Norona, EVP and CFO.

Darren?

Thanks, Judd.

Good morning and welcome to our second-quarter 2008 conference call.

I would like to begin by personally thanking our Advance and AIT members for continuing to deliver outstanding customer service and financial results in the second quarter.

The 23% increase in earnings per share reflect the team members' commitment and progress in our four strategies.

We have a saying at Advance, which is "sell more parts, have more fun.

" My view is, "Sell more parts, have more fun" on the conference call, so let's begin.

We are 180 days into our AAP turn around, and we are on track from my perspective.

More importantly, we're beginning to build pockets of momentum.

Our goal is simple, grow to $10 billion in sales in the next five years by focusing on our four key strategies.

Our commercial Acceleration, DIY Transformation, Availability Excellence, and Superior Experience strategies are gaining traction.

To make our turnaround happen, it takes commitment and dedication from every Advance team member to live our Advance values, strive for change, and embrace the future.

Q2 is a great step in our turnaround journey.

Here are a couple of highlights for the quarter: comp store sales increased 2.9%.

What is interesting is this is the first quarter in nine quarters that the comps were positive in all four areas of the country, including Florida.

Our commercial business continues to be the driver.

commercial continues to accelerate with comp sales growth of 13.5% in Q2.

DIY comp sales trends improved as well to negative 0.8% in the quarter, that's up from the past two quarters when DIY comps were down 3%.

Finally our operating income grew 9%, which allowed us to leverage our share repurchase into a 23% EPS increase.

Mike will share with you more about how these results fit into the broader financial picture going forward.

Our strategy is to continue to progress as well.

For example, we conducted a DIY summit that identified key themes and ideas to grow and transform the DIY business.

Now this approach was similar to our parts summit, conducted last year, that led to our parts focus as a company.

More importantly, we are seeking -- actively seeking feedback from the front line team and using it to make improvements to our DIY business.

Elwyn will share with you the progress we're making by focusing on DIY customer needs.

We are pleased to welcome several new field operation leaders in the quarter.

They are Derrick Thomas, Carl Hauck, Dan Peterson and Dave Hamilton, who are firmly engaged in our superior experience strategy.

I am excited about the passion and the experience around customer service and team member engagement these leaders bring to Advance.

Each of these leaders are already making an impact on the business.

Still, this year is proving be too challenging one for customers and team members alike.

The current economic crisis is a constant reminder that our turn around and efforts must go beyond the traditional approach.

More importantly, the changes we need to make are not optional.

Our company must drive change versus being driven by change.

The truth is that we are moving in the right direction.

Even so, we still have a long way to go from our destination.

I remain guarded about the economic environment, which continues to be challenging to navigate with consumer confidence near a 16-year low.

Weakening business and job conditions, along with record high gas prices are a heavy burden for many of our customers.

Our second-quarter results are very encouraging, yet we may have benefited from the economic stimulus which could have accelerated some sales from the second half of this year.

As a result, our outlook remains balanced for the remainder of the year.

We will continue to assess, adjust, and focus our resources to accelerate the execution of our key strategies.

Our new commercial team is a great example of this focus.

Jim will talk about that in a minute.

Our long-term objective remains the same.

We remain committed to a future that is leading, not lagging behind the industry.

We remain committed to a future that is great, not good.

We remain committed to a future that drives change, not one that reacts to it.

Most importantly, we remain committed to winning with superior team members, serving customers better than anybody else, and growing the business and profitability with integrity.

Now I would like to turn the call over to Elwyn Murray to provide a progress update on DIY.

Thank you, Darren, and good morning.

I, too, am encouraged by our second-quarter results and would like to express my thanks and appreciation to our team as well.

I attribute this success to our team and the traction we are gaining on many of our strategic initiatives.

Today, I would like to cover two things: First, update you on the actions we are taking now to turn around our current DIY business trends, and second, provide further visibility to our emerging thinking to strive for full potential in DIY as we know it today and also transform our retail business.

We are making tangible progress in several areas that are impacting our current results.

Specifically we are gaining meaningful traction for our parts inventory investment, the launch of our attachment selling initiatives and their efforts to improve weekend scheduling.

We are in the infancy of addressing our full potential for bilingual staffing, identifying new categories to test and measuring our team member engagement and customer satisfaction.

Our attachment selling strategy is more than pushing items to customers.

It is a sales approach enabling team members to be eager trusted problem-solvers for our customers.

With our help and advice, customers get everything they need on their first visit, saving them time, gas and trouble.

In addition attachment selling helped us grow our sales and margin.

Attachment selling is truly a win-win for our customers and company.

We are currently tracking our attachment rate to allow our leadership teams to better assess their team members' sales skills and identify where training opportunities exist to better serve our customers while growing our sales.

Division manner Kyle Wideman in Buffalo, New York, understands the significance of attachment selling.

His store teams are fully embracing the strategy under his leadership, guidance and support, and are producing some of the highest sales results in recent weeks.

Kyle says the key to attachment selling is simple, serve the customer better than anybody else.

He says his team is passionate about serving the customer having the parts knowledge and selling the complete job.

He is very proud of his team for all their hard work and dedication to help our customers keep the wheels turning and we are very proud of Kyle and his leadership.

We are also in the process of measuring how well we inspire and engage our team members and how well we serve our customers.

Engaged team members bring their best game to work every day, and are deeply committed to the success of our customers, our stores and our company.

Loyal customers repurchase, buy additional items, and refer other customers all of which help grow our sales and margin.

It is no coincidence that is a highly engaged workforce is correlated with great customer service.

That's why it is so important to understand how well we are doing in these two areas.

We are committed to defining what great customer service looks like, to measure it and consistently improve.

We look forward to sharing more information with you about these results and the impact they are making later this year.

Currently, we are approximately 75 days into our 100-day assessment of our DIY business, which is focused on driving to full potential in DIY as we know it today and also transforming our retail business.

In this pursuit, as Darren mentioned, we conducted a DIY summit and DIY growth workshop during the second quarter.

These session produced several key themes and hundreds of ideas straight from the field.

We are prioritizing these opportunities based on customer interest, market attractiveness and proximity to our core.

We anticipate these ideas resulting in pilots and or rollouts, depending on the nature of the idea beginning as early as the fourth quarter.

We are also taking action to enhance the speed and capability of our team in order to accelerate the transformation of our DIY retail space.

We have decided to locate our sales floor merchandising teams, which account for over 50% of our DIY business today, in our regional office in Minneapolis.

This location will allow us to add more talent from nearby retail and consumer goods companies as well as network and benchmarks with other retailers with similar systems and practices.

Approximately 70 positions will be located in Minneapolis as part of the sales floor integrated operating team.

In conclusion I am encouraged by the traction we are gaining and the results we are seeing from the near-term initiatives mentioned.

I am confident that opportunities like bilingual staffing, new product categories and services, and our customer satisfaction and team member engagement initiatives will make meaningful contributions in future quarters as well.

While encouraged by our progress, we recognize that more will be required of us in order to achieve our longer-term vision of a $10 billion company that produces $2.5 million per store comprised of a 50/50 mix of retail and commercial sales.

To that end, we remain committed to optimizing our near-term initiatives as well as developing additional sales ideas in order to transform our DIY business as we know it today.

Now I would like to turn the call over to Jim.

Thanks, Elwyn and good morning.

I want to congratulate our store teams, our commercial sales force and our commercial organization on their 13.5% commercial comp sales increase in the second quarter.

Our team has driven solid sequential comp sales improvements over the last five quarters, and we still only have approximately 3% market share.

There is still great room for accelerated commercial growth.

We are taking actions and building plans to achieve our full potential and significantly grow our market share.

Our commercial sales increases are coming first and foremost from unleashing the enthusiasm and passion of our team and empowering them to do what they do best, which is serve our customers better than anyone else.

I want to share one example of how a commercial team member is living our value and moving our commercial Acceleration strategy forward.

During his time as area commercial sales Manager, Bill Grumof was leader in commercial sales growth with significantly higher results in his region.

Bill is known for developing his commercial sales team and for partnering with the storm team to provide great service to his customers.

Bill was recently promoted to area commercial sales Director.

In his new role, Bill now leads a quarter of our commercial sales force and is using his winning strategies to further accelerate our growth.

Thank you and congratulations, Bill.

Beyond our team, we continue to work very hard on the basics of the business.

We are focusing on our strengths and getting the parts quickly delivered to the garage, so our customers can better grow their businesses.

We are partnering with Availability Excellence team to aggressively add parts to our stores and move them closer to our customers throughout our supply chain.

We are capitalizing on the well-respected brands we have added to our stores over the past year, and we are working to further develop and strengthen our team of parts knowledgeable people.

Lastly, we are focusing on being a reliable partner that the garage can consistently count on.

In addition to the basics, we are making good progress in formalizing our commercial salesforce providing the information they need to focus on our highest potential customers.

We are developing systems to identify both customers where we have the best opportunity to deepen our existing relationships, and grow a share of their purchase while acquiring new customers so we can further accelerate our total growth.

We are also formalizing our processes for targeting customers, tracking our progress, and ensuring we keep them what they are buying from us.

As part of our commercial model development, we continue to pilot several different initiatives that are common within our industry, and to look at other division businesses outside our industry.

The results of these pilots are being built into our commercial model, and rolled out on a larger scale as they are developed.

These pilots include everything from how we allocate resources to how we staff our stores, to how our salesforce targets customers.

This will continue be a key part of our process for developing and improving our commercial model.

Over time, we believe we can develop additional value-added services that will further increase our customer attraction and retention.

We are developing a business model for how we conduct and grow our commercial business while building accountability in a culture where customer service for commercial that is rooted in our Advance value.

At the heart of commercial acceleration is partnership.

Arming our commercial sales force and our store teams with the information and tools they need to keep customers bays turning will be a loyalty.

Today we build strong local partnerships, but the real key to our commercial business success is to put the full power of the Company behind its development.

During the second quarter and in addition to strong commercial sales increases, we continue to see all of of our key profitability metrics grow at the same time, that include higher parts productivity, increase truck and driver utilizations, and the higher balance of parts sales.

I would also like to thank the Autopart International team for a strong second quarter, as they significantly increase sales and profitability.

Overall, they produced a 7.2% comp for the quarter.

They also opened 10 stores, which included the acquisition of a 5-store local parts distributor.

This acquisition provided AI the opportunity to strengthen its presence in the Philadelphia market.

Switching to new store development, in the second quarter, we opened 36 stores bringing our total for the year to 70.

We also closed two stores and relocated four stores.

At the end of the second quarter, our total store count was 3325.

During our first-quarter call, we indicated we would be reviewing our store performance and real estate portfolio.

As a result of our recent review, we anticipate closing approximately 20 to 30 underperforming storing for all of 2008 with majority occurring during the third and fourth quarters.

Over the last six months, we have been testing smaller prototype buildings and different store layouts to improve our new store productivity and reduce occupancy cost while increasing our parts availability.

We started rolling out our 6,000-square-foot prototype as we open new stores in place of our current 7,000-square-foot store.

We continue to measure results and build a prototype that best serves the needs of both our DIY and commercial customers and improving result for our shareholders.

Now I will turn the call over to Mike to review our financial results.

Thanks, Jim, and good morning.

It is enjoyable to share our strong second-quarter results with you.

Clearly, these results are directly attributable to our talented and dedicated team members who are leading change, embracing our turnaround and focusing on serving our customers.

I plan to cover the following topics with you this morning.

One, provide an overview of our second-quarter results.

Two, link the actions we are taking to transform our business to our short-term financial performance.

Three, share our philosophy on our four performance gauges as we look to improve our mid-to-long-term financial performance.

Turning to our second quarter, total revenue increased 5.6% to $1.24 billion, compared to revenue of $1.17 billion in the second quarter of last year.

This revenue increase reflected the net addition of 138 new stores in the past 12 months and a comp sales increase of 2.9% on top of a 1.2% increase last year.

Year to date revenue is $2.76 billion.

The comp sales gain priced of a 13.5% increase in commercial sales, partially offset by a 0.8% decrease in DIY sales.

This compares to a 5.4% increase in commercial and a 0.2% decrease in DIY in the second quarter of last year.

Year to date, our comp sales have increased 1.6%.

Our second-quarter commercial sales represented 29% of our total sales compared to 26% last year.

For the quarter, our total commercial sales were $358 million, resulting in a 17.2% increase over last year.

Currently, 83% of Advance stores have commercial programs as compared to 82% last year.

Clearly, our commercial teams are leading our company with the fantastic growth despite a challenging economic environment.

Our gross profit rate was 48.6% in the second quarter, as compared to 48.1% last year, which reflects a 51-basis point improvement.

This improvement was primarily due to lower supply chain and logistic costs, combined with more effective pricing.

SG&A expenses were 38.3% of sales, compared to 38% last year.

This 23 basis point increase was driven by increased incentive compensation, increased spending on strategic initiatives, and higher gasoline expenses related to commercial deliveries.

Partially offsetting the SG&A increases were cost savings realized from actions taken last year, combined with expense leverage of a solid Q2 comp.

Net interest expense was $7.3 million in the quarter compared to $6.9 million last year.

Our current boring cost remains at approximately 5%.

Earnings per share increase 23% to $0.79 for the quarter as compared to $0.64 for the second quarter last year.

This 23% increase in EPS was primarily driven by a 9% increase in operating income, and the benefit of 13 million shares repurchased over the past year.

For the first half of the year, our EPS has increased 22%.

We are pleased with this increase.

Now I will comment an a few items on our balance sheet and cash flows.

For the quarter, inventory increased 8.1% to $507,000 per store.

As previously communicated, the increase in inventory was driven by our parts availability initiative, as well as initial inventory build up over our new MOOG and Wagner brands, partially offset by our focused plan to improve inventory productivity.

Inventory per store was higher given to prior year given we were refunding the majority of our parts availability initiative through some inventory reduction initiative.

I would personally like to thank Jim North and his team for all the work they are leading on our inventory upgrades and inventory reduction initiatives.

In Q2, our accounts payable to inventory ratio was 61.6% compared to 57.1% last year.

While this increase is primarily driven by our inventory build-up, I am encouraged by the initial progress that our merchant team is making to improve this ratio.

This initiative will have positive impacts to our cash flow in the future.

Operating cash flow for the year increased $70 million to $350 million.

Free cash flow for the year increased 25% to $244.6 million, which reflects a $48.7 million improvement as compared to last year.

This increase is primarily driven by higher net income and lower owned inventory.

Capital expenditures were $106 million for year compared to $115.7 million last year.

This decrease is primarily due to reduction in store development.

To put our Q2 results in context, our sales, margin rate and bottom line exceeded our expectations and our SG&A came in higher given the investments we were making in our strategic initiatives.

I will share more on our SG&A profile later.

Collectively, Q2 was an encouraging step forward in our turn around journey.

All strategies are starting to gain traction with our commercial business leading the way.

Now I would like to link the actions we are taking to transform our business to our short-term financial performance, specifically our cost profile.

Our turnaround involves transforming from primarily a retail business model to an integrated operating model that is focused on both retail and commercial customers.

While this turnaround is absolutely the right thing needed to differentiate our company, it will put strain on our expenses in the short term.

That is because our current capabilities, operating, support mechanisms, systems were primarily built to support a retail model.

Therefore, our work entails performing in-depth assessments of all of the fundamental parts of our business, and transforming them to support the new integrated retail and commercial model.

Realistically these type of changes are not simple on-off switches which means you can not immediately transition from one to the other.

Usually, there is an overlap period, where higher costs results from duplicity.

To illustrate with an example, we have committed $60 million of multiyear capital and expense investments to build new merchandising systems and capabilities.

These investments will enable us to better support both our retail and commercial businesses.

Unfortunately, it takes time to build and implement these new systems and capabilities, and as such, we will have added expenses in the short term as we build the new infrastructure while continuing to run our existing merchandising infrastructure.

The simple example can be applied to many aspects of our business that need to change.

Therefore, our challenge is two fold.

We must continue to make the investments required to transform our business.

For example, improving parts availability, investing in training and development of team members, and investing in delivery trucks and parts pros.

While at the same time looking for ways to fund these investments.

It is critical that we do both.

This can be accomplished by appropriately sequencing investments, getting more out of existing resources and eliminating activities, capabilities, and resources that are no longer relevant to our new operating model.

Lastly, I would like to share our focus on our four gauges as we look to improve our medium to long-term financial performance.

We continue to believe these gauges provide a transparent and holistic financial view of our four strategies, and will serve as a barometer of our progress.

We are committed to improving our gauges, but we are not trailing the class of our competitors.

But are realistic that certain gauges will show progress before others.

We anticipate seeing improvement in two of the gauges, sales per square foot, and operating income per team member first.

We believe the positive momentum we have in commercial and focus of our talent in team members to embrace and lead our turnaround will help these gauges.

We also anticipate seeing measured improvement in our incremental ROIC, given our new rigor around investment spending.

That said, the large capital base, it will take time for new investments to move the entire ROIC.

Finally, given our short-term expense needs required to build new new capabilities and transform our business, we anticipate our focus on our S & A per store gauge to be one fluctuating around the current level rather than reducing in the short term.

We think this is prudent and we believe investing in our business today will lead to higher sustained returns in the future.

That said, running a leaner, cost effective operation will always be in our sights.

As a reminder the Company provided an annual outlook at the beginning of the year, and does not provide quarterly guidance.

However, for fiscal year 2008, the Company now anticipates leveraging SG&A at an increase of approximately 2% comparable sales versus the 1% increase previously disclosed.

This increase is primarily driven by investments in merchandising capabilities and systems, e-commerce investments and accelerating some tests in commercial combined with the impact of rising fuel costs.

We expect these increase will constrain profit growth for the balance of the year.

In closing, we are pleased with our second-quarter results and are excited about our long-term prospects given our renewed focus on the customer.

We believe we are focused on the right four strategies and are committed to taking actions and making the necessary investments required to create long-term shareholder value.

While we remain cautiously optimistic about the short-term economic headwinds, we remain vigilant to have our four gauges measure the process.

Most importantly, we are investing in and betting on our talented team members to lead us to our turn around.

We are now ready for questions.

Operator?

Thank you.

(OPERATOR INSTRUCTIONS) our first question today is from Gary Balter.

You may ask your question and please state your company name.

Hey, Seth Basham for Gary.

The first question is housekeeping-wise.

Can you just tell us what the LIFO credit or charge was this quarter.

Hi, Seth, it is Mike Norona.

The -- we didn't experience really any material adjustment to LIFO for the quarter.

Okay.

And going forward, would you expect any of the strong credit from last quarter to reverse?

No.

Okay.

And secondly, I would like to focus on gross margins.

Can you give us a breakdown of, you know, where that margin strength was coming from.

You mentioned supply chain.

You mentioned pricing.

But how much of it was really price and how much was supply chain and how did the addition of the new brands come into play there?

Seth, I will start.

It is Mike Norona.

When you look at our margin rate, 66% of it was related to supply chain and logistics efficiency and the rest of it was attributable to pricing.

Seth, this is Kevin Freeland, the portion that is attributable to the gross margins or product margin side, again, the majority was relatively even split on a mix rate basis we benefited from -- hard categories were up in the quarter, predominantly and they hold a higher -- higher overall rate.

In terms of the new brands, it is too early to tell.

We are transitioning at this point and we think it will be better sense to that next quarter.

Okay.

That's helpful.

Then just the last question on the guidance and I will turn it over.

You talked about constrained profit growth for the back half of the year.

Are you referring to net income growing marginally from here?

How does that factor in the extra week?

Yes.

Let me give you a little bit of context.

We talked about that.

As -- we are looking at the total picture, so if you think about the top line in Q2, we believe it was some impact of stimulus that we weren't able to quantify that would pull sales forward from the back half of the year.

That will be one.

Second is there are investments we have to make in our business and we refer to them as e-commerce, our new Minnesota regional office, pressure from fuel costs and increasing our store closing.

And the third bucket is we continue to make investments in our business, in our capabilities and in our four strategies.

So that's where you are seeing some of the pressure come from.

Okay.

That's understandable, but does that mean that you are expecting minimal net income gross?

How does the extra week fit into that?

No, Seth, the way -- you can look at the first half of the year, and I think Mike put it this way when they framed it in the release.

The truth we are ahead where we thought we would be both in terms of the top line, the margin line.

Expense is what we thought, maybe higher for things we are proud of.

We are paying out bonuses which is terrific.

And we are making some investments to grow the business and I think collectively we're up 22% principally driven by OP income growth and leveraging EPS.

We look to the back half, I have got to tell that you I am trying to sort out just how bumpy this is going to be for the consumer and we know we have to keep investing -- and example that Mike used in terms of the merchandising system so we can grow the business into '09, '10.

We have to make the e-commerce investment part of our words so people don't run away and say the fun half is 20% so the back half should ability least that good.

I think we are trying to reflect it is bumpy from a consumer point of view.

We are going to continue to make the investments and make this business better.

You know what, we are thrilled when we are paying out bonuses.

In fact in Q2, what we are most proud about, every store manager in Q2 got a bonus.

I don't remember the last time that happened.

You have to put it all into context given the environment we are navigating in and the fact we remain committed to making the investments in the second half in order to ensure that we can talk about a good FY '09, a good FY '10 and after that.

That is what is underneath --

That's helpful.

Seth, we previously released -- we anticipate 53rd week to be about $0.10.

Great.

Good quarter, and good luck, guys.

Thanks

Thanks.

Our next questions is from Dan Wewer and please state your company name.

Raymond James.

Darren, it sounds like the growth and the number of executives in Minneapolis is accelerating at a fairly rapid rate.

Can you just discuss, you know, what challenges if any and having your team so far away from Roanoke and maybe long term, there there be a gradual relocation of headquarters to Minneapolis.

Yes, let me do the last part.

The answer to are we migrating Roanoke to Minneapolis in terms of all the headquarters for people?

Absolutely not.

I think, Dan, we started with a view that might be 25 executives, maybe up to 40.

I think as we have done the work and we have been out loud with you and internally.

As a matter of fact, we held a number of town hall meetings with everybody at our Corporate support center and said, look, one of the challenges that we have is our DIY and our front room business.

It is not a secret.

It has been challenging for a number years.

When we stepped back and looked at our parts business, that business candidly has been driving terrific outcomes, particularly in the first half of this year and we are very proud of that.

That's not going anywhere.

And as we look at how do we achieve longer term what we are looking to achieve, and how do we source some of that talent and how do we get the best of both communities.

It is clear to us to think -- and Kevin knows this better than I do.

I think there's $200 billion done in the Twin Cities of consumer package and retail products and that is essentially a lot of our front room.

In Roanoke, it is two.

A multiple of 100 to one.

When you look at putting in systems like Retec which I don't want to call it an industry standard or Oracle now, I think our choices in Minneapolis for that very specific part of our business are just much greater.

And so we did make a change.

And we spent time with our team members explaining that change, and what we are trying to do is one where we can take advantage of the talent, where we can take advantage of, hopefully turning this business around.

That's what we are going to do.

Then what about the other part of the question on the challenges of managing the Corporate office in Roanoke from Minneapolis?

Well, you know, I will give you my answer and maybe one of you guys -- maybe El wyn can give a perspective.

The way we are set up with the executive committee, Jim, Elwyn and Keith are headquartered in Roanoke and will stay headquarters in Roanoke.

Kevin, Mike Marolt and I are Minneapolis.

Ken Worth, who runs our stores, is in Chicago.

The field teams tend to be are in the field.

We are down there -- I think I kidded these guys down there five days a week in the first five months every day of the week and I think the last four weeks, three days a week.

I think what we will get to are somewhat of an alternating schedule, Dan, where we are down three days a week one week and Elwyn, Jim and Keith are here a few days a week.

I think you can do that in today's world.

I feel very comfortable doing that given the quality of this leadership team, and I think that has a lot to do with it in terms of the nature of the leaders and the team members there.

So it gives us the opportunity again to use really the talents and the strengths of both communities.

The other question I had, separate question on the acceleration and your commercial growth.

Is that reflecting adding more commercial customers?

Or is it taking your existing customers and getting them to give you a greater number of first calls on hot spot parts?

Dan this is Jim.

A combination of both.

And the -- in the second quarter, we saw a similar type of situation as we did in the first, where we saw both our existing customers buying more as well as we are adding parts and additional availability and taking advantage of the basics of the business.

We are attracting new customers as well and our salesforce is doing a nice job of telling the story about what we are doing in commercial and I think we will see our new customer base continue to grow as well.

Okay, great, thank you.

Thank you, Tony Cristello, you may ask your question and please state your company name.

Thank you.

BB&T.

Good morning, guys.

Hi, Tony.

One question is, when you look at the improvements sequentially on the DIY, was there any one initiative that you would point to, whether it is inventory or advertising or pricing that stood out or perhaps had better traction and the rest?

Thanks for the question, Tony.

It is easy to develop a complex trying to keep pace with Jim on his commercial sales.

So I appreciate the interest.

I would say specifically our traction is strongest around our parts availability.

I don't want the point lost that 50% of our DIY business is still in parts so we are a major beneficiary of these investments that we are making.

I would say the other one that is having the most traction at this point will be our attachment selling initiatives, where we are looking to sell the complete solution to our customer, and we are providing our team with both the business case for doing that, the tools to assist in that, and also visibility to the metrics to let us know how we are dealing in that area.

I would highlight parts availability and attachment selling the top two with expectations of more to come from both of those.

Wouldn't you also say -- do you think -- I can't remember, Keith, our turnover at store level this year is tracking, what 20%-plus down?

Yes, so Tony -- you know those things are hard to put in a spreadsheet, but at store level, one of the things I am most proud about is the store turn over and as Keith pointed out is down 35%.

And when you have more skills parts pros and team members in the store there is a level of consistency that will clearly show up in the numbers.

What do you think is behind the decline?

Obviously is it a function of incentive and a function of hey I can come to work now and better parts availability to sell and I feel more confident dealing with customers.

Something I can point to or just that the job market is tightening and I -- I got a good thing here in Advance.

Tony, there is Ken Worth.

There are a lot of things that you answered that question with.

And the parts availability, and feeling confident that the team member is able to wait on the customer is certainly contributing, I think, to an extent.

Also we are initiating on board processes that we are teaching our new team members too improving the turnover for the new employee, and certainly when team members begin to make more bonuses, they certainly feel good about working with the Company as well.

When you look at -- from a category standpoint, was there -- was there demand or strength on items that could be perceived as mileage enhancers or was strength generated in categories of parts that traditionally will have a more deferability in nature to them or can you tell?

Yes, Tony, this is Elwyn.

I will make a couple of comments on category themes in the quarter.

First with parts.

Generally across the quarter we saw an improvement in the investment that we were making in our enhanced availability.

Specifically to your question we saw nice improvement in performance chemicals which is an area -- things like fuel additives where people are can looking to improve fuel mileage but also to extend performance and to delay ultimate repairs.

We did see movement in categories related to that.

Okay.

One last question.

Sort of a follow-up.

When you look at the -- I know you have added a lot of parts, particularly behind the counter, and maybe you have changed some -- some things in the front of the store.

When you look at sort of the allocation of -- of what is selling square footage might be at the front of the store versus what is around the counter.

How has that changed over the last year as you sort of restructured the stores a bit?

This is Kevin.

The allocation between the front and the back room has remained relatively consistent.

Our sales increases are inordinately coming from behind the counter, but that has to do with -- or being led by, as you said the improved availability behind the counter and increase in the commercial business.

As Elwyn and his team defined the changes as we go forward on the DIY side, it is reasonable to expect a comparable turnaround in the front room.

Thanks, guys

Christopher Horvers, state your company name.

Christopher Horvers from JPMorgan.

Darren, I was curious, you mentioned that maybe you saw a benefit from the stimulus.

Is that something you saw on the monthly trend.

Obviously, you don't give out where your monthlies are, but is it something that checks sent out by the government where you saw an ebb and flow in the comp.

It's Mike.

I'll start.

One of the reasons that we make that comment is when your comp jumps from a 0.6 to a 2.9, you know in a tough economic environment, we think the stimulus had something to do with that .

When people walk in the stores they don't necessarily tell how they are funding their purchase

We should look at the weather charts and see how hot it was.

What we were trying to signal there and this is one of the questions I asked Elwyn and his team to go back and look at is how did the overall market grow in Q1.

We knew how we grew and how the overall market grew in Q2, and what you really saw across the board was a little bit of the tide rising in Q2 for everybody.

Led to you believe to Mike's point that, gee, we can go and sit on the call and tell you we are all geniuses and turned from 0.6 to nearly a 3 comp and there are real good things happening in our commercial business and there are good things happening in DIY and attachment selling and good things happening in turnover.

Those all contributed, but you just saw such a jump up and in 15 years of watching retail and watching these tax stimulus packages, they always help.

A year from now we will be on the conference call and if the number is not what we would say, we had tax stimulus.

I think it is fair to have the door swing both -- we are trying to say that the door needs to swing both ways, it helped us in this quarter.

I cannot math it for you but you can look at math years past.

A year from now we will be on the call and know that it probably did.

We had stimulus last year and won't be able to quantify it next either, but it is clearly out there and probably the key things that we said on the call is that sometimes what it does is some -- fast forward some of the purchases that would have happened the balance of the year and the other phenomenal is the consumer is so tight these days that I think whenever they get a little extra money, they see what is at the top of the list.

When you go to the back half of the year, you know you get into the Christmas season.

Christmas moves to the top of the list.

Back to school, there will be moments in there where back to school will move to the top of the list and they are making trade-offs.

I think we benefited in the second quarter with heat, with stimulus.

There was some benefit being on top of the list.

Now that you have GPS in the stores maybe you are a back to school or Christmas destination.

That's right.

We can get you a cell phone too.

No, I am kidding.

Advanced mobile?

Sounds good.

Two follow-up questions.

As you think about guidance and what you are saying for the back half of the year, clearly some SG&A pressure coming.

Is there an element that the gross margin opportunity may be on the pricing and the logistic cost savings is coming down and maybe Mike if you can talk to how much is that -- now we need to lever for 2% comp versus one.

How much of that delta is fuel cost versus spend.

Maybe I will start and I will start with your last one first and then I will turn it over to Kevin.

So, you know, at the beginning of the year we gave an annual outlook.

We are not going to give quarterly guidance, but what we have said is now we are going to leverage on a 2.

Our SG&A versus a 1.

And I want to put that in context to the sensitivity grid I gave you at the beginning of the year.

As a result of the change of going from 1 to 2 on the SG&A leverage.

Our best estimate is that a 1% comp improvement now is about $0.06 EPS and 10 basis point improvement in operating margins will be $0.03 EPS.

And then just some more context.

On the supply chain, we will be annualizing in the fall some of the supply chain efficiencies you have been seeing and showing up in the numbers.

I will let Kevin talk a little bit about this.

This is Kevin.

As Mike said earlier on the call, two-thirds of the pickup were on the supply chain side and we will anniversary much of that in the fall.

It was also partially driven by the $40 million increase in inventory.

The sales were up 5.6.

Inventory up 8.1.

That increasing inventory essentially improves the efficiency of running the distribution centers.

I think it's reasonable that we will continue to make investments through the fall but again, that was a subset of the overall impact in second quarter.

In terms of the product margins which was the smaller portion of this.

I think it is reasonable to expect that the inflationary impact -- that those numbers are sustainable.

Longer term on both fronts though, we are -- as was mentioned we have a pretty material investment at this point going into new systems and new capabilities, and I think as years go by, it would be reasonable to expect we can lever on our supply chain costs and improve the sharpness and accuracy of our pricing.

Operator, we are ready for the next question.

Thank you.

The next question is from Matthew Fassler.

State your company name.

Good morning, Goldman Sachs.

I have two questions.

One on SG&A and the other on gross margin.

First of all on the SG&A side and I think you might have given these numbers at the EPS level a moment ago.

The change you are talking about in terms of the type of comp you will need to lever.

Sounds like that would suggest call it 2% to 2.5% points of incremental growth in SG&A dollars over prior plan.

Is that basically the way to look at it?

I guess we don't really look at it that way, Matt.

What we said is originally we were expecting a leverage of SG&A to one comp.

Now we are saying two.

The primary three drivers around that.

And we have given the reasons.

Professional services to investment capabilities, fuel, and then some of the other spending that we are doing.

And -- I am sorry, go ahead.

And that's how we are thinking about it.

We typically don't break out the details of, you know, the basis points.

Yes, Matt - we are still running the business trying to figure out we spend $600,000, $601,000 in trailing 12 months, how we continue to remain vigilant with the balancing of commercial investments, merchandise systems, and taking costs out of the --

Got you.

Second question.

I guess related to the SG&A line.

How much of what you are talking about on a year-on-year basis a function of the fact that a year ago the Company started making some pretty significant cost cuts.

More of a question of cycling that cost cuts or more a question of the incremental dollars.

Maybe I will start that question.

So last year we actually made moves to take $70 million out of the business in terms of cost.

$20 million showed up last year.

$35 million of that was annualized this year, and then 20 of that were new initiatives that would hit this year.

Those have been planned this year and we are achieving those.

Great.

The other question on gross margin.

I think you touch on it with the last question but I heard some static on the line.

That relates to product -- rather price increase and cost of price inflation.

It sounds like pricing is leading to actual gross margin rate improvement.

So presumably to the extent there is any increase in product costs due to raw materials or have you, you are getting back at least that month on the pricing front.

How do you see that balance playing out over the course of the year?

Do you feel like product en nation, cost inflation is at a run rate that you can more than manage or an issue still to come.

Matt, this is Elwyn.

I agree with your assessment.

We monitor price indices for both our sales floor as well as our parts department and feel good with our positioning there.

Many of the cost increases we have incurred we have been able to pass along as has the market.

So I wouldn't anticipate any downward pressure from those cost increases given the ability to pass those through, but we do want to make sure that we remain competitive as we consider each increase.

Yes, thanks so much, appreciate it.

Thanks, Matt.

Thanks, Matt.

Next question

Scott Ciccarelli, ask your question and please state your company's name.

Scott Ciccarelli, RBC

Hi, Scott.

Another question on SG&A and sorry if it is repetitive.

Can you help me understand.

You talk about increasing threshold on SG&A for a 2% comp where you show leverage.

We just saw almost a 3% comp and we delevered by several tens of basis point.

Can you help us understand if there is acceleration in spending or something else in there?

Hey, Scott.

This is Judd.

When Mike made that comment, we are looking at it on an annual basis.

We aren't looking at it on a quarterly basis.

Part of our driver in Q2 is increase incentive compensation and that is a component as well as rising fuel prices, specifically on unleaded gasoline for our commercial delivery.

So Mike's actual frame is for the full year and not a quarterly basis.

We will see ebbs and flows in our spending as we progress through the fiscal year.

Okay.

That is kind of what the annual target is.

Yes.

Okay.

Another question.

In terms of use of cash.

You guys look to have paid down $100 million of debt in the quarter.

A couple of quarters prior to that, buybacks for the primary use of your cash flow.

Now it seems like you are increasing spending or investment in the business.

Can you help us understand how you are going to help to allocate the future cash flow?

The big part of our cash flow is obviously going in the inventory.

We talked about that.

That was the big driver.

We don't comment about the other things like share buybacks.

Most of the share buybacks were done at the beginning of this year and I think we've said that we would look at the share buyback on an opportunistic basis and consistent with past practices we don't comment until we buy the shares.

So a couple of drivers.

Yes, maybe if I can build on that a little bit.

I think as we look out, Mike is right.

I think we are real early in the commercial work, and, you know, we are excited about what we are learning with some of results.

The comps are quite ahead of where we thought we would be at this time and as we get in and test different kinds of ways to continue to try to sustain that growth in commercial, I think we will see different ways that we can put stores together and prototypes together and grow the business.

That doesn't mean run away and put 200 stores in your spreadsheet tomorrow, but I am asking where can we deploy some of that capital.

Because if you look at our debt to adjusted EBITDA, 2.6.

2.6.

Yes, that is a reasonable leverage ratio, so we paid down a little debt this quarter.

The thing that is going to actually get this company where we need to go is if we continue to see ways to take that capital and invest it and grow -- I guess principally going to be in the commercial area as we have been talking about for a while.

We are just not at a point where we can line up and say this is the new store prototype or here is the other specific that relates to commercial parts investment, but what we are seeing at least early on is, you know, we are going to have other opportunities to invest that capital beyond, making opportunistic purchases in terms of stock buybacks.

Okay.

Thanks a lot, guys.

Thanks, Scott.

Next question

Thank you, our next question could from Colin McGranahan.

You may ask your question and state your company name.

The Company is Sanford Bernstein.

Two quick questions.

On the gas and fuel.

I know you are 80% hedged on diesel fuel.

So outbound freight.

Seems like the pressure really is on unleaded gasoline and delivery to customers.

When do the hedges roll off on the fuel that you have already hedged.

Can you quantify what you think the impact is on total gas and diesel inflation this year and how you are thinking about that going forward?

This is Kevin.

The inordinate portion of fuel that we purchase operates the trucks in our store and our delivery vehicles and as you mentioned that is not hedged.

The minority factors and diesel fuels and tractor-trailers.

Essentially what we do is we hedge a major portion of that diesel fuel on an annual basis, so we can give annual guidance.

We would intend to hedge again for next year prior to giving to that guidance, so essentially we are insulated from that portion imbedded in margin for any one fiscal year.

Okay, quantify the gasoline impact basis points and SG&A.

Colin, we never do that, come on.

Okay.

You know -- you are consistent though.

I love that.

I am just asking, Darren.

You are were helpful in an earlier question.

I thought maybe you had turned over a leaf here.

Hey, Colin, it is Mike Norona.

One of the other things, since we can't give that you, maybe we will give you something else, because I know you were prodding at the SG&A, the other items that we haven't talked about so far was the impact on store closings.

You know last year I think we closed roughly at 15 stores.

This year as Jim mentioned, we -- we have reassessed that I think at the beginning of the year, we were thinking 10 to 20 and now taking it up to 20 to 30.

As I look at the impact for -- compared to last year, I think last year's impact was $0.05 to $0.06 and this year $0.09 to $0.10.

More on the first half and more on the second half.

The bulk of that expense is coming in the second half this year.

And your preference is not to break that out as a charge.

No.

Normal recurrence.

That just part of our regular business.

I think in the last conference call, Colin, people asked, well, you said it won't be linear, this and that but the problem is we are looking at everything, from our supply chain to how we do DIY and how we change commercial to our store portfolio and I think we said, look, these are upwards of 30 stores that -- 30 stores are all the stores we ever make a mistake on, we'll go to the Hall of Fame and let's get it behind us and that getting behind us will happen in the second half of the year by and large and I don't think people are processing that through.

We are not going to give quarterly guidance and that is somewhat of a change.

Colin, it is important to also state -- I think it has always been an important part of our business but may be a more important aspect of our business as our business transforms now from a retail model to a retail and commercial model and our lenders are changing.

I think we need to continue to go back and reassess those stores, because a store that may not have been that profitable as far as retail may really be good when we balance it, and the -- the converse could be true as well.

Okay, that's helpful.

The second question a little more broadly.

Fairly aspirational goal to be 50/50 commercial-retail.

I know you are still fully into the process of looking at the entire supply chain, but if you think about a store that runs 2700 distribution square foot per store.

You are running closer to the 1500.

How are you thinking about the supply chain investments, needs, infrastructure, capabilities going forward and when might you have more visibility on what those investments will be.

Colin, it is Kevin.

You are correct.

It will reasonably take a shift in supply chain strategy to support the work that Jim and his team are undertaking at this point.

In the test markets, we are also testing supply chain changes.

Part of the $60 million investment that Mike referred to earlier in the call is involved in studying effectiveness of different parts of the merchandising supply chain area including a network study.

So we are currently under way, looking at the way the supply chain network laid out.

We have not completed that work, and don't have conclusions at this point and will get back to you at a future point.

Who is your external partner on that?

We will leave that to your imagination, Colin.

Okay.

Yes.

But you could probably guess.

Thank you.

Thank you.

Our final question today is from Alan Rifkin.

You may ask your question and state your company name.

Alan Rifkin from Merrill Lynch.

Most of my questions from the current quarter have been answered but I just have one.

Welcome back.

Thank you very much.

Nice to be back.

What would the commercial comps have been without the inclusion of AI and without the additional desks that you rolled out year after year?

Our commercial comp would have been 14.1 at Advance -- Advance stores without AI.

Okay.

I am pretty intrigued by, Darren, the statement $10 billion of revenues in five years.

If we do quick math, that implies a 15% CAGR in top line and if you assume 50% commercial, commercial growing from $1.5 billion at the end of this year to $5 billion five years from now which is almost a 30% annual rate.

Can you maybe just provide a little more color of how you get to those top-line numbers?

Yes, Alan.

Here is what I would say.

The framework I gave you is think about an artist's rendering versus a detailed blueprint.

There are a couple of things go into that artist rendering.

One, it starts with -- when we look at the commercial business in terms of its structural industry, Jim will correct me if I'm wrong, but see an industry out there that in terms of addressable for us that is not less than $40 billion and arguably could be $45 billion.

It is growing, I think in terms of its own organic growth, 4%, could be as high as 6 depending on whose numbers you watch.

When we do our own math remember 2.5% market share and doesn't seem to be any one dominant.

There are good players out there and taking nothing away from that and nothing away from O'Reilly but you can see as we position our business mod we will such small market share the ability to leverage our structural -- I would say structural benefit that we have are those store locations being real close to many of our commercial partners, and trying to think about simply how do we simply take advantage of that benefit, and how do we participate in a very vibrant market.

One assumption is to play in that market you have some wind at your back, develop the capability.

It is going to take some time and the road map look to in order to get to that 50% mark.

Others might argue that it will be in light of the structural economics of the commercial market.

On the DIY side, conversely, the good news is I say our heritage is where it is harder to make any headway and enjoy double-digit market share there.

Structurally, it's got a little better economics.

Elwyn will probably tell us that we are doing a lot of business today, $3-plus billion in that business and that probably doesn't even equal half of what comes in our door every year.

And so how do we start by using simple types of techniques -- we talked about attachment selling.

We didn't talk about weekend scheduling and getting those basics right, and how do we start to think about new product categories that are happening in the DIY space.

I think someone was kidding to me about GPS.

Depending on whose numbers, I think GPS this year will approach $4 billion.

That is about as big as our company.

And I think when we look at the greater things that sit around the car, we can see addressable markets today of $22 billion.

If you stretch your imagination, correct me if I'm wrong, Elwyn, if you throw out fuel, throw out a bunch of stuff we can see ten times the number we are participating in today, Alan.

But the truth is, we don't have it figured out as to which ones given our capabilities will be most be a department at being able to anticipate it.

We can tell you in the quarter that partly what is baked into the quarter is the funeral expenses for Big Poppa Pickle so we're leaving pickles behind and trying to find things that are more adjacent to the business and part of that will require a culture change to us.

But the size of those markets, what, our team members desire to get growing again has us focused as the leadership team and we could argue that's goal for us but I don't know how else to drive an organization without setting a real big goal out there because we need to break through where we are today.

Okay.

Just to follow-up, Darren.

I mean, holistically can you triple your commercial revenues over the next five years without a major, major shift in the distribution structure as you look at it today?

Focusing on commercial?

Well, I would say this.

If we don't make investments in supply chains, merchandising systems and, candidly how we do commercial to be more of a sales driven culture and more of a distribution culture, I think that would be -- the answer is -- the answer is no.

And so part of what you are hearing from us is, yes, we are making investments in merchandising systems.

Yes we are making investments in supply chains.

Yes, we are going to make investments in CRM systems for our team and could this business go from $1 billion to $3 billion over the next five years, it better because that's part of our growth plan as a company.

Okay.

Thanks a lot, Darren.

Good to talk to you.

Yep, good to talk to you.

Thank you, Wendy.

And thanks to our audience for participating in our second-quarter conference call.

If you have additional questions, please contact Joshua Moore at 540-561-8307 (corrected by company after the call).

Reporters, please contact Shelly Whitaker at 540-561-8452.

That concludes our call.

Thank you.

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This concludes today's conference.

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