領先汽車配件 (AAP) 2008 Q3 法說會逐字稿

Welcome to the Advance Auto Parts third quarter 2008 conference call.

Before we begin, Judd Nystrom, Vice President of 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 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 10k and its other filings with the Securities and Exchange Commission.

If any of these risks or uncertainties materialize or if any of the underlying assumptions prove incorrect, the Company's actual results may differ materially from the anticipated results discussed 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 8k filing, which are available on our website at www.advanceautoparts.com.

For planning purposes, our fourth quarter earnings release is scheduled for Wednesday, February 18, 2009 after market close and our quarterly conference call is scheduled for the morning of Thursday, February 19, 2009.

To be notified of the dates of the future earnings report, you can sign up through the investor relations section on our website.

Finally a replay of this call will be available on our website for one year.

Now, let me turn the call over to Darren Jackson, our President and CEO, who will be followed by Jim Wade, EVP Customer Development Officer Commercial, Elwyn Murray, EVP Customer Development Officer DIY, Kevin Freeland, EVP Merchandise and Supply Chain and IT, and Michael Norona, EVP and Chief Financial Officer.

Darren?

Thanks, Judd.

Good morning, everyone, and welcome to our 2008 third quarter conference call.

Our third quarter results, like the financial markets, were a roller coaster ride with a number of ups and downs.

The financial results were below our expectations.

On the other hand, our strategic results exceeded our expectations for the quarter.

Our top-line was lower than expected driven by our DIY sales performance.

Our gross profit rate exceeded the forecast.

SG&A was higher than anticipated, because we simply were not able to adjust variable costs to the sharp drop in sales.

Despite the outcomes, I am proud of how our team members consistently served our customers better than anyone else.

Our market share numbers indicate we're able to grow our commercial market share and maintain our DIY market share in a very difficult environment.

Our strategic results were a high point and included the following accomplishments -- Double-digit comps in commercial; double-digit revenue growth for AI; completion of our team member engagement survey; and Companywide customer satisfaction survey.

We also upgraded inventory in approximately 200 stores, launched pilots of custom mix and space optimization and improved our AP ratio.

Overall our year-to-date results are still ahead of expectations we set at the beginning of the year.

I expect the 90-day quarterly results will be volatile as we transform this 76-year-old business.

Our year-to-date results are a better barometer of our transformation progress.

Evaluating the success or failure of a transformation every 90 days is like pulling up a potato every 90 minutes to check on its growth.

Change will be difficult to discern in short quarterly windows.

Jim, Elwyn, Kevin and Mike will cover the changes and results in more detail.

We are taking actions in the fourth quarter to position the business for success in FY '09 and beyond.

Mike will cover some initial thoughts on the upcoming year.

As I look out our largest opportunity continues to be driving our top-line sales per square foot grow.

We are focusing on simple ways to build our top and bottom-line, such as growing the commercial business, improving sales productivity of our inventory and sales floor, while taking costs and work out that the customer's not interested in paying for.

There will continue to be considerable change that we'll be navigating through as we focus on turning the business around.

That change has added more volatility in 2008 as you would expect.

Our third quarter results reinforce the need to realign our business model.

We're making progress on our strategies that are focused on the customer.

The environment is not what we'd like it to be and we don't like it, but we are focused on maximizing what we can while improving our business model for the future.

As a Company, we continue to remain committed to our growth strategies.

During the third quarter we saw sharp decline in sales, yet our costs did not move down fast enough.

We believe it is better to be proactive versus reactive.

As a result, we are resolving to go faster on availability excellence, continue with our capability investments and commercial, and acknowledge the urgency to stabilize and then grow our DIY through a superior experience.

In closing, we remain committed to investing in our strategic initiatives while prudently making the necessary cost adjustments to navigate through the current environment.

We also remain confident in our team members' ability to help our customers navigate through these very challenging times.

I'd like to thank our team for their important role they play in advance of success.

Together, as a team, we are facing change head-on and taking advance to new levels of success.

Jim and Elwyn will both share examples with you today of team members who are embracing change, delivering results and living the advanced values.

Now I'd like to turn the call over to Jim to provide a progress update on commercial.

Thank you, Darren and good morning.

Through our commercial acceleration strategy, we continue to increase sales and gain market share in the third quarter.

With our less than 3% overall market share, there's still room for much growth.

This was our third consecutive quarter of double-digit growth or the 10.8% comp for the quarter.

Our comps are lower than our 13.5% increase in the second quarter, however, we believe the tax stimulus in the last quarter and the more challenging external environment this quarter has some impact on our growth.

However, we don't believe our sales trend is fundamentally changed.

While we remain pleased with our commercial results, we're not totally satisfied.

I'd like to congratulate our commercial team, but as always, we know there's still much work to do.

We remain committed to aggressively growing the commercial business and despite current economic trends, we believe we can continue to achieve double-digit comps.

We'll continue to focus on the basics of our commercial business, increase parts availability, emphasis on key brands, continue team development and strengthening customer relationships with our garages.

A key component of our commercial acceleration strategy is to revolutionize our sales force.

To accomplish this, we're putting in place the leadership, structure and tools to drive our future.

I had the opportunity to attend a meeting of our entire sales force a couple weeks ago and I can't describe the excitement and passion of our team as they prepare for 2009.

We're still in the early phases of establishing the necessary foundation to maximize the potential of our commercial business, but we're making great progress every quarter in building the model that will achieve this potential.

To give you an example of what great looks like, I'd like to share a story with you about a member of our commercial team.

Edwin Cologne is an area commercial sales manager and is one of the top performing members of our sales force.

He recently moved his family from Puerto Rico, where he lived his entire life.

When he joined Advance, Edwin could not speak English, but he had a strong desire to move up in our Company, so he committed himself to taking classes at night and learning to speak English.

He lives Advance's values in every action that he takes.

Edwin's committment to serving his commercial customers better than anyone else has produced strong sales increases and he is just at the beginning of the opportunity, as he grows his commercial team of account managers.

In Edwin Cologne we have a 20 year team member that leads his team with passion and integrity.

Thank you, Edwin, and keep up the great work.

During the third quarter, we continue to see our key commercial profitability metrics improve over the prior year.

That included higher parts productivity, increased truck and driver utilization, and a higher balance of parts sales.

I'd also like to recognize the Autopart International team for their accelerated comps from 7.2% in the second quarter to 8.6% this quarter.

AI continues to see success with their business model and we're applying their learnings to help us grow our overall commercial business.

They have also opened 17 new stores year-to-date.

Switching to new store development, in the third quarter we opened 30 stores, including three AI stores, to bring our total for the year to 100.

We also closed three stores and relocated one and for the year closed nine stores and relocated eight.

Our total store count at the end of the third quarter was 3352.

Lastly, we had previously said that we're reviewing our store performance and real estate portfolio.

That review has now been completed and we plan to close approximately nine more stores during the fourth quarter to bring our total closings for 2008 to the low-end of the 20 to 30 range previously communicated.

Now I'd like to turn the call over to Elwyn.

Thank you, Jim, and good morning.

First I would like to acknowledge our disappointment with our third quarter DIY comp.

While encouraged by our negative 0.8% second quarter comp, we now have a brutal reminder that the third quarter is more representative of the continued softness in DIY sales than the second quarter comps.

The macroenvironment clearly impacted the quarter, as consumers are struggling and the DIY business continues to remain in crisis mode.

As tough as the macroeconomic environment is and with customer traffic continuing to be down, we still see a tremendous opportunity to capture more of the business that is walking through our doors every day.

Today I will share insights around this opportunity with you.

During the third quarter we completed a 100 day assessment of our DIY business.

One of our key findings was that only five out of ten customers walking through our doors today were able to purchase everything they need to be successful.

Two out of ten make a partial purchase and three out of ten leave empty handed.

We were able to identify the root causes of these missed opportunities.

Our findings reveal that we have a significant opportunity to grow our business by addressing what I will refer to as a table stakes for our business, parts availability, attachment selling and effective scheduling.

We see pockets around the country where we are winning with the table stakes.

However, we are not getting consistent execution with enough scale to reverse the prevailing DIY trend.

Although we are disappointed with the results of the quarter, we are encouraged by the potential opportunities that are within our control.

To drive towards our full potential now, we must do a better job satisfying the needs of customers who visit our stores today.

That means greeting every customer, understanding their needs and ensuring that they leave with everything required for them to be successful.

Now, I would like to share with you a living example about what good looks like for growing our DIY business.

Paul Braswell is a division manager in eastern Iowa who is bucking the prevailing trend and improving our DIY comp store sales.

Paul and his team are embracing attachment selling, engaging with their customers and drove double-digit DIY comps during the quarter.

His success revolves around developing strong talent with fed in clear goal and providing excellent coaching and recognition for his team.

Paul's team members are celebrated for leading by example and for providing a differentiating customer experience.

They are having fun, while engaging our customers with superior customer service.

Congratulations, Paul, to you and your entire team.

While Paul and his team are taking control and changing their destiny, they were not alone in driving positive DIY comps in the quarter.

In fact, over 20% of our divisions in the Company delivered positive DIY comps during the third quarter.

As part of our journey to full potential, we are beginning to share best practices across the Company by partnering leaders of strong regions with underperforming regions to facilitate learning, tap into their competitive spirit and together drive improved results.

Through our 100 day deep dive into DIY, we also identified a number of new value propositions, many of which are a direct result of team member input and extensive customer research.

We are intrigued by many of these ideas and value propositions that have surfaced and we'll be taking the next step to further explore customer interest and our ability to operationalize and monetize many of these concepts through pilots.

In closing, we are clearly disappointed with our third quarter DIY results, yet from the insight, we see significant potential from things that are well within our control.

We are encouraged by the progress that a number of our divisions are making by embracing the key elements I have discussed and thank them for showing us what good looks like.

We look forward to achieving more consistent execution across the Company through leadership development, best practice sharing, leveraging peer to peer partnership and increased accountability for results.

I would like to personally thank all of the team members that I had the opportunity to work with in our 100-day DIY assessment.

This work helped us see new possibilities and the related keys to realizing our full potential.

There is even more potential than we realized.

By addressing our DIY table stakes, we have the opportunity to significantly improve our customer service and financial results, even during these challenging economic times.

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

Thanks, Elwyn, and good morning.

Our availability excellent strategy is focused on continuing to strive to become the dominant parts provider in our industry through increased brand offerings and product availability.

I am pleased to be here today to provide visibility to the key areas that will drive long-term value.

With regard to merchandising, we will continue to invest in merchandising capabilities, invest in parts and reduce our net owned inventory.

We have restructured the merchandising department into eight cross-functional teams.

The transition to this integrated operating model progressed during the third quarter ahead of schedule.

We have completed phase one of our new category management process and are on track to improve our category performance in FY '09.

We also began the rollout of the new price optimization tool and expect to realize improvements in gross margins in the future.

We are improving the quality of the inventory, as well as the quantity, to drive incremental sales.

In fact, we have upgraded inventory in almost 200 stores during the third quarter and over 700 stores year-to-date.

This represents an investment of approximately $50 million year-to-date To improve the quality of inventory in our stores, we tested a significant enhancement to our custom mix system in two major markets.

These test markets achieved higher sales and gross margins with no incremental inventory investments.

Our custom mix system begins its national rollout in fourth quarter for plan-a-gram recess slated for first quarter 2009.

We anticipate the full rollout will take several years.

We also completed a successful test to improve the accuracy of our store inventory.

The test stores achieved higher true-in stocks, higher sales and lower inventory shrink.

This program is slated to rollout to all stores over the next few quarters.

In our supply chain area, we continue to identify opportunities to drive supply chain efficiencies.

For example, we're on track to complete work on engineered standards in our first DC next quarter and plan to migrate these standards to the balance of our DCs next year.

This project enables us to improve labor productivity in our main distribution centers and reduce distribution expenses over time.

Turning to information technology, we are continuing to leverage IT in support of our business strategies.

As previously announced, we began a multi-year effort to replace our legacy systems with Oracle Core Merchandising system.

Work on this critical system will be brought online in stages beginning in the second quarter of next year.

Now let me turn the call over to Mike to review our financial results.

Thanks, Kevin, and good morning, everyone.

Our third quarter was a challenging financial quarter for our Company, as announced in our release on October 7, 2008.

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

One, provide an overview of our third quarter results.

Two, share the actions we are taking as a result of the current business environment.

And three, connect how these actions will position us for FY '09 and beyond.

Turning to our third quarter, total revenue increased 2.6% to $1.19 billion compared with revenue of $1.16 billion in the third quarter last year.

This revenue increase was driven by the net addition of 124 new stores in the past 12 months.

Year-to-date our revenue is $3.95 billion.

The roughly flat comp was comprised of a 10.8% increase in commercial sales, including Autopart International, offset by a 4.1% decrease in DIY sales.

This compares to a 7.5% increase in commercial and a 1.2% decrease in DIY in the third quarter last year.

Year-to-date our comp sales have increased 1.1%.

For the quarter our total commercial sales were $359 million, resulting in a 14.4% increase over last year.

Currently, 84% of Advance doors have commercial programs as compared to 82% last year.

Commercial sales represented 30% of our total sales for our third quarter, compared to 27% last year.

Clearly our commercial teams are leading our Company with this double-digit growth rate despite a challenging economic environment.

Our gross profit rate was 48.6% in the third quarter as compared to 47.9% last year, which reflects a 65-basis point improvement.

This improvement was primarily driven by more effective pricing, improved shrink rate, and a higher mix of business from Autopart International.

SG&A expenses were 40.5% of sales compared to 39.3% last year.

This 124 basis point increase was primarily due to higher investments in our strategic initiatives, deleverage of the Company's fixed costs resulting from a flat sales comps, and the inability to quickly adjust variable expenses to match the decelerating sales trends from the second quarter.

Partially offsetting these increases were lower medical expenses, reduced advertising expenses and charges incurred during the prior year's third quarter related to asset impairments and severance.

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

Interest expense was $6.7 million in the quarter compared to $8 million last year.

Our current borrowing costs are approximately 5%.

Additionally, we repurchased $53.6 million of stock in Q3, which equated to 1.4 million shares at an average price of $39.09.

In 2008, we have purchased 6.1 million shares in an average price of $35.28.

We currently have $189 million left on the $250 million share repurchase authorization approved by our board of directors in May, 2008.

Our third quarter tax rate was 36.9% as compared to 36.4% last year, primarily due to tax credits received in the third quarter last year.

We anticipate the full year tax rate in 2008 will be consistent with last year.

Earnings per share increased 3.5% to $0.59 for the quarter as compared to $0.57 for the third quarter last year.

This increase was primarily due to less shares outstanding from our share repurchases over the past year.

Through the first three quarters of the year, our EPS has increased 16%.

We are pleased with this year-to-date EPS increase.

Now we'll comment on a few items on our balance sheet and cash flows.

For the quarter, inventory increased 11.5% or approximately $512,000 per store.

As previously communicated, an increase -- this increase in inventory was driven by our parts availability initiative, as well as the initial inventory buildup of our new Mugen Wagner brand, partially offset by our focused plan to improve inventory productivity.

We funded the majority of this increase in inventory by partnering with our vendors to increase our days payable outstanding.

This can be seen in our net owned inventory, which represents inventory less accounts payable and finance vendor accounts payable, which remained relatively flat versus the third quarter last year.

Our accounts payable to inventory ratio was 60.3% in the third quarter compared to 55.1% last year.

This increase was primarily driven by our inventory buildup and approved vendor terms, partially offset by a decrease in the inventory turns.

We expect our accounts payable to inventory ratio to decrease by year-end from its current levels, as we pay for inventory investments made earlier in the year, but to still exceed last year's ratio.

Year-to-date operating cash flow is $375.8 million, which is a $1.9 million lower than last year.

Free cash flow for the year increased $4.8 million from last year to $270.2 million, which was primarily driven by a decrease in working capital.

Capital expenditures are $137 million for the third quarter as compared to $146.5 million last year.

This decrease is primarily due to a reduction in new store development.

To put our third quarter results in context, we are pleased with our double-digit commercial comp sales growth, including an 8.6% comp sales increase Autopart International and our 65 basis point increase in our gross profit rate.

Although we did not expect our -- although we did expect our third quarter sales growth to decelerate versus Q2 due to the absence of the government stimulus checks, we did not expect our DIY sales to decelerate at the pace they did in Q3.

It is easy to point to external factors that have impacted the consumer, such as the challenging economic environment, hurricanes and gas shortages in the southeast, and a decrease in miles driven, to explain the sales decline.

But quite frankly, our DIY sales came in below our expectations and require an urgent approach to reverse the current trend.

Furthermore, we did not adjust our variable expenses fast enough during the quarter to reflect the sharp deceleration in sales resulting in an increase in our SG&A rate.

We are disappointed that we did not do a better job navigating these challenges and taking actions earlier.

Now I would like to share the actions we are taking as a result of the current business environment, specifically around our cost profile.

Our challenge is twofold as it relates to our cost profile.

We must adjust our expenses to the recent trends in our business, as the consumer navigates the challenging economic environment.

And we must also continue to invest in our turnaround, which includes making structural changes to our business model.

This may seem like a paradox to both reduce cost and invest in our future and arguably it's our greatest challenge.

A way to think about it is repurposing existing expenditure dollars to more productive uses.

For example, in 2008, we reduced the amount of new store development capital from 2007 and repurposed it to fund a new merchandising system.

Similarly, we reduced advertising to fund more commercial trucks and labor.

This approach is required for us to close some of the productivity gaps and transform our business.

That said, we have already started to take actions in areas where we can right size expenses.

These areas include improvements to our labor management and deployment at store levels, lowering our marketing and advertising expenditures, and adjusting discretionary spending areas such as travel.

While there are no silver bullets in any of these areas, we believe these adjustments provide us some short-term relief as we navigate the current environment.

At the same time, we have to continue investing in our turn around.

As we have shared, we have some structural and systemic areas that require investments if we are going to differentiate ourselves and win with our customers.

These areas include investments in delivery trucks, parts [pros], inventory upgrades, supply chains, merchandising systems and capabilities, and team member training and development.

These investments are critical delivering long-term value and are paramount to our turnaround.

Next I'd like to share how these actions position us for FY '09 and beyond.

As we have previously shared, our financial performance will not be linear.

This is not an excuse for our third quarter performance, but the reality of the work required to turn around our business.

Our four strategies will differentiate us and deliver long-term shareholder value.

However, they require investments, as we have shared, and the returns on these investments will not always line up with our quarters, especially in the short-term.

Additionally, the economic factors may not always cooperate, which can further magnify earnings volatility.

It is incumbent on us to be prudent and responsible as we make these investments.

To that end, we believe the adjustments we are making to the variable expenses and the continued investments in our strategies will position us to deliver the following in 2009 -- double-digit commercial growth; stabilize our DIY sales trajectory; an integrated store labor model that allows us to seamlessly serve both our retail and commercial customers; new store growth similar in number of stores to FY '08, with less Advance stores and more Autopart International stores, which is more reflective of our commercial potential; a distribution network that enables us to increase market parts availability; enhance merchandising capabilities; and programs that provide improved team member experience.

As a reminder, our fourth quarter contains a 53rd week, which we now estimate will have a $0.07 EPS impact.

This is slightly lower than the $0.10 impact we previously shared in our annual outlook, primarily reflecting the current trends in our business.

In closing, we are disappointed we did not deliver the financial results we expected in our third quarter.

Given these results, we also did not see any meaningful improvement in our four gauges during the quarter.

We are also realistic about the economic challenges facing the consumer and the short-term impact it is having on our business, specifically on our DIY sales.

We believe these trends will continue to put short-term pressure on our earnings growth and taken steps to mitigate the impact.

We remain committed and focused on our four strategies and must make the investments required to transform our business.

We believe these investments are in the best interest of our shareholders, customers and team members.

Most importantly, we are appreciative of our talented team members, who continue to lead us through our turnaround and are helping our customers navigate through the challenging economic environment.

We are now ready for questions.

Operator.

(OPERATOR I INSTRUCTIONS) Our first question today is from Tony Cristello.

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

Hi, good morning.

BB&T.

Good morning, everyone.

Good morning, Tony.

I guess one question I had, and it came up a few times during your commentary, is Autopart International.

Darren, and maybe this is a question for Jim, but it appears that AI is certainly showing some better sales trends and have some modest positive contribution to gross margin.

I understand that SG&A at AI is a bit higher.

Can you update a little there, discuss more on the strategy now that you have for AI as it differs from the core commercial business with Advance?

Any reason beyond perhaps parts availability and the commercial focus that could be behind the positive improvement in sales trends.

Also, how does the profitability of that segment look right now versus how it has in the past?

Yes, Tony, why don't we do this, why don't I have Jim talk a little bit about -- we've seen a wonderful turnaround in AI this year in terms of their business.

You can see it in their comps and their profitability.

I'll have Jim just hum a few bars as to what's different and when's driving the business.

Then I'll come back and give you just a couple sentences on how we're thinking about AI going forward, because clearly three years into it now we see different opportunities with them and how it might shape our overall store portfolio going forward.

Jim.

Yes.

I think, Tony, when you look back at the roughly three years that we've owned AI, at the time we purchased the Company, they had about 60 stores and they were opening two or three or four or five stores a year.

Obviously, as part of the acquisition, we wanted to see the team there accelerate the openings and they did that.

And I think it took us a year, 18 months to get to a point where we had everything in place to be able to accelerate their growth and the great news, I think, over the past year to 18 months is we're now seeing the results of that.

If you look at their roughly 125 stores they have today, literally almost half of those have been opened in the last three years.

So I think we're at a point where the team has a very fundamentally sound new store model in place.

They're leveraging the expertise they have in foreign car parts, which is obviously a part of the business that's growing very quickly these days.

And they are using that to start to drive much better performance.

We're excited about what the team there's accomplished.

I think they're positioned very well to help us grow our total commercial business as we go forward.

And, Tony, what I would build on, as we look forward, you think about the AI purchase, we saw three things.

One, Jim talked about and we received significant benefits to date, is their sourcing capability in foreign car parts.

And learning more about foreign car parts is to look at our overall inventory mix today across Advance Auto Parts, we can see in relation to many of our markets, we're simply under invested and underpenetrated in the foreign car parts business.

We can look out into the future and know that they can potentially help us with that.

An example would be we're putting some of the AI car parts into our Atlanta market to help fill in some of those voids in the mix.

So that's one.

Two, it's interesting that part of the northeast, when we position the stores next to an Advance store, both stores get better.

Part of it, if you think about it, is they become second source partners.

It helps the commercial business in terms of the Advance business and it helps them in terms of some of our domestic parts that we can provide to them.

And as we look out, there could be an opportunity to selectively, and I think you heard in Mike's comments, as we look to next year, we'll continue to throttle back some of the Advance store openings and we will have an uptick in the AI openings.

We'll be selectively putting those in markets where we believe we have densification efforts that will be helpful but also adjacent to some AAP stores in some of our core markets to help both those business.

Last but not least, there is the benefit of the knowledge of foreign car parts that AI has.

How do we use that.

They have a tremendous catalog system in terms of foreign car parts that will be accretive to our own catalog system.

And as we look farther out, I think we're skimming across the surface right now and I think next year it'll be more as more learning as to how those two businesses complement one another in terms of our larger objective in terms of balancing our business in a 50/50 profile.

When you look at the prototype AI store versus the Advance, can you just talk maybe just briefly on the differences from a staffing standpoint, the differences from a square footage standpoint and then also when you think about expansion, is there opportunity to go out and acquire some of these smaller independents or jobbers that are out there?

And are those stores that they typically operate consistent with sort of how an AI store may be limiting sort of the amount of Greenfield that you may need versus what you could go out and actually acquire in the marketplace?

Yes.

I think, Tony, when you look at their model, obviously, their model calls for them to do almost entirely commercial business, so their staff -- to do commercial and they're staffed specifically to have the expertise to sell a much greater portion of foreign vehicle parts.

And I think that is one of the unique parts of their model is that they've been able to define how to do that both in standpoint of the staffing they have in their stores as well as the catalog and the sourcing.

From a square footage stand point, again, they have a lot of flexibility.

They were able to find, in effect, small warehouse type locations very quickly and they have a pretty wide variety of square footage space that they can fit their operations into.

So they were able to get stores up going very quickly.

From the standpoint of the consolidation and fragmentation of the business, I think we all know today that the commercial business is -- remains extremely fragmented across the country in terms of all of the local distributors and jobbers that are out there today and I think over time we'll certainly see consolidation.

And in many cases, AI's in a position to participate more effectively in some of the acquisition of small players.

I don't think we necessarily today see that as being a major part of what we're going to be doing.

But just this year, AI picked up a small acquisition in Philadelphia that allowed them to penetrate the market quicker and get access to customers as well as team members that could help them grow.

So as we look forward, I think, and look at the total commercial business there's no question, as Darren talked about, that we have the ability to leverage off of AI and take what they do really well and help us penetrate markets quicker and more effectively.

Great.

Thanks, guys.

I appreciate it.

Operator, we're ready for the next question.

David Cumberland you may ask your question and please state your Company name.

Hi, with Robert Baird.

Good morning.

Hi, David.

Can you quantify the impact of strategic spending on your expense ratio in the quarter or at least rank it among the factors that caused the higher ratio?

Hi, David, it's Mike Norona.

For the quarter our SG&A was up about 124 basis points and we attribute about two-thirds of that to things that we planned to spend and around our capabilities, new stores.

So what you refer to in terms of our capability investments fall into that two-thirds bucket.

Great.

Very helpful.

Then on the pricing that you cited as helping gross margin, you've referred to this in the past, did you make further changes in your approach in the quarter and when might you anniversary the bigger adjustments you've made here so far?

Maybe I'll start and then I will turn it over to Kevin Freeland to give you some more insight.

As we said, from a gross margin perspective, about a third was pricing.

A third was mixing more AI in and then a third was some operational elements like shrink.

And maybe I'll have Kevin just talk a little about pricing, what we saw in the quarter.

Yes, this is Kevin Freeland.

We essentially are scrutinizing pricing in three different places.

The pricing of some discretionary items in the front room, the retail business that we do in parts behind the counter and then commercial pricing.

And the lift that we saw in third quarter was predominantly centered on the prices that we scrutinized in the front room.

We believe that there are additional opportunities that should manifest themselves in essentially fourth and first quarter, but are being offset somewhat by some competitive price pressure that we're seeing in some of the products, predominantly oil and batteries, that I think is just a function of the softening in the overall economic environment.

Great.

Thank you.

Wendy, we're ready for the next question.

Thank you.

Dan Wewer, you may ask your question and please state your Company name.

Raymond James.

Following up, if we're seeing better prices in the front room, that would primarily benefit the gross margin rate on the do it yourself segment, is that correct?

Inordinately, the front room is a DIY business.

And then kind of related to that, in looking at the gross margin rate for AI, , is it actually better than your do it yourself business and substantially better than

It's Michael Norona, yes it is.

Yes, because it is virtually all a private label business, Dan.

It's a higher mix of.

So in the future as you grow your sales mix to commercial and then that's going to be disproportionately driven by AI, that negative pressure on gross margin rate probably will not be evident in the future?

Dan, this is Darren.

A frame I might give you to think about it is in commercial pricing I would say our capabilities on a scale of one to ten in the Advance chain.

Jim, you correct me if I'm wrong, are closer to one than ten.

And one of our big efforts next year is we put the merchandising system Oracle (inaudible) is that how do we begin to price our merchandise aligned to a commercial market?

And so I think we believe through commercial pricing capabilities there's an opportunity there.

That's one.

You're right, as we think about AI that becomes a bigger percentage of the mix.

Just a mix benefit helps in terms of where we're going.

We have a void today in our capabilities called global sourcing as a whole.

And we trail Auto Zone by a big percentage.

We're on a journey now to build that global sourcing capability where it makes sense.

That should be helpful.

Now that will be offset because structurally, when we're growing our commercial business at rates of 10% plus, the mix impact is putting pressure.

We would not -- it is structurally a lower gross margin business, no doubt about that.

But we are offsetting that, as we look forward, by these other capability and mix benefits that we're positioning in terms of the overall business.

That make sense?

That is very helpful.

And just one real quick question.

The drop in gasoline prices from $4.20 a gallon to $2.50, any evidence of that benefiting your, particularly your do it yourself business.

It's Michael Norona.

We didn't see anything in Q3 and you've got to remember, I know recently we've seen gas prices fall but they hit the actual peak in Q3.

So we won't -- I don't know if we'll know the evidence of that until further on throughout the fourth quarter.

Great.

Thank you.

Yep.

Thank you.

Wendy, we're ready for the next question.

Matt Fassler, you may ask your question and please state your Company name.

Hi, it's actually [Robert Agenbothen] in for Matt from Goldman Sachs.

First quick question.

Could you give us a sense of how compares changed throughout the third quarter and also how they'll change through the fourth quarter in the DIY business specifically?

When you say compares --

In other words, your compares from last year.

Our comparable store trends this year versus last year?

Correct, exactly.

Mike, maybe you take him through we exit Q2, we start into Q3, how did things change because we saw pretty dramatic changes?

So it's Mike.

Let me calibrate you back to what happened at the end of Q2.

If you remember coming out of Q4 of last year and Q1 of this year, our DIY business was trending about a minus 3.

We go into Q2 and we come out of Q2 and the DIY business is minus 0.8.

So there was a tremendous benefit.

I think we attribute that to the economic stimulus.

I think it pulled some sales out of Q3.

We enter Q3 and we're trailing actually pretty positively.

We get into August, about the third week of August and we saw a, I would say, a material drop of about 400 to 500 basis points in a very short period of time and then it stabilized.

And it pretty well stabilized where we finished the quarter at roughly around a minus 4.1 and today we're seeing it in the minus 2.8 to minus 3.2 range.

Yes, Mike.

As we look forward to the fourth quarter -- when we look back, I think we've got to think about a couple things.

Last year's fourth quarter, I think we started the quarter out relatively strong and one of the things, candidly, we're thinking about is that literally, right after Thanksgiving, it says if we got on a down elevator and I think it was more indicative of how the consumer's living their life today.

And what I mean by that is that if we actually look back to this past third quarter, we'd say a couple things occurred that -- back to school happened candidly and we're asking ourselves, is the consumer so tight that, you now what, we just fell down in the prioritization list and back to school went to the top, because we could see it right in that window.

Now, we knew last year we had a little better business in September and you know what we -- I said when I took this job, I'll never talk about weather because it's indigenous to the industry.

But we had a little benefit in Q2 in terms of you can just see it in some the product categories like AC that last year we had it in Q3.

If you put the two quarters together, it's a reasonable window so that the variant becomes, gee, how is the consumer prioritizing their personal spend?

And when they're in these unique windows, what we're trying to understand, back to school and Christmas, do things change because they're so tight?

And one of the things we're sensitive to in managing the business too is we don't want to end up going through a trap door again post Thanksgiving in order to manage the business.

But, you know what, we're going to only know that when we talk to you in 90 days from now.

Got you..

One last question.

When you look at that falloff that began in the third week of August, could you help decompose that into traffic, conversion, ticket, price components.

From Elwyn's comments, it certainly sounded like both conversion and ticket was driving certainly a big part of that pressure, but if you could just help us out with a little more color there?

Yes, Robert, this is Elwyn.

I don't want to harp back on weather, as Darren alluded, but there is no question August and early September was inordinately hot versus the average year.

We clearly saw -- excuse me, cool this year versus the average.

And so we saw in a lot of our AC related refrigerants and parts a pretty precipitous dropoff versus same time year ago.

That clearly was a hard and tangible number that moved.

I would also suggest to you that as the consumer confidence has obviously been shaken, we continue to see softness in these discretionary categories, interior, exterior accessories, appearance, chemical, things of that nature continue to show tremendous softness with our business and across the industry.

Wouldn't you also say, Elwin, one of the things that we didn't necessarily quantify in the release, but if you held our feet to the fire and said did the hurricane -- when we look at weekly trends in the hurricane markets and gas shortage markets, our best guess is a half a point.

But you know what, that is our best guess by looking at the weekly trends and the scores effected.

Those things -- it's like the fourth quarter, we should get a little bit of that back.

They hurt you in one quarter.

You know what, they should come back in another quarter.

That's our best guess in terms of another variant that occurred in the quarter.

But those things happen.

It's a part of running a business.

Got you.

Thank you very much.

Wendy, we're ready for the next question.

Thank you.

Peter Benedict, you may ask your question and please state your Company name.

Wachovia.

Thanks, guys.

Mike, can you talk about the inventory implications of going faster here on availability excellence?

You guys were up 11.5% in dollars in the third quarter.

I think about 7.5% per square foot?

How should we think about that trending towards the end of this year and then for next year?

Let me give you a little context for how we're thinking about the buildup of inventory on our financials and then I'll turn it over to Kevin to give you some insights of why we're doing it and what we expect to get.

When you look at your inventory being up 11.5 and your sales only being up 2.6, you would expect that to pop in your cash flow.

And one of the reasons it didn't is that our net owned inventory only changed about $4 million from Q3 of last year to Q3 of this year, which means we're paying for that increased inventory through better vendor terms and partnering with our vendors.

From a financial perspective, you're not seeing it pop.

One of the key strategic elements and key strategic initiatives of our Company is availability excellence and having the inventory, the right inventory in the right spot.

Maybe I'll turn it over to Kevin to give you some insights as to how that impacts us longer term.

Sure, actually there were several things that comprised the 11.5% increase.

Part of it was our sales were up 4%.

That's largely driven by new stores and you can account for about a third of the difference in additional new stores.

We had or I had disclosed in my portion of the call that we'd put about $50 million year-to-date into upgrades, but the comparison is actually from the same period last year and we did another $20 million in upgrades in fourth quarter of last year, so you add those together and that's another approximate third.

Then we launched the MOOG and Wagner conversion, which basically accounts for the remainder and essentially part of that is a temporary change.

We're in a process of in with new merchandise and it'll take a number of months to make the complete conversion.

And it's a combination of two things, going through the logistical activities of pulling down the replacement merchandise and we also essentially used a certain packaging of product that facilitated getting the product in quickly and efficiently, but was in excess of what we reasonably would stock over time.

That will melt down over the next several quarters.

That essentially is about $20 million beyond what we actually -- what you actually see being offset about $20 million in inventory takeouts through an inventory optimization program we're working on.

Okay, great, that's helpful.

And then Mike, can you talk about your approach to the buyback here?

Obviously with the stock being down, but then the issue's kind of in the credit markets and what not and just the overall volatility in the markets.

How do you guys think about buybacks today versus maybe at the time of the last call?

Yes.

So first of all, if we thought the shares were a good buy in the mid 30s and that's really the average price we paid year-to-date, then obviously we think they're a great buy in the 20s.

I think some of the things that you've heard me say before is share buybacks are one option for us.

And when you are in a turnaround, you have many options.

And as we build out our strategies we have many places we can make investments and Kevin talked about a couple of them, as you look at building out commercial, as we build out our new merchandising systems and things like that.

We have lots of options and we have to measure share buybacks as an option to the other options we have in the Company.

What I would tell you that something that has changed is the -- we're in unprecedented times in the economy right now.

I would say one thing that is materially changed is we want to and as Company preserve our liquidity and make sure that during these times we have a strong balance sheet.

Today we do have a strong balance sheet.

When you look at some of our capital structures, they don't come due until October, 2011, so we feel good about that.

You're going to probably see us be a little bit more guarded on stock buybacks.

As you see, we still have $189 million left on our $250 million share repurchase.

We'll continue to look at them on an opportunistic basis.

Okay, that makes sense.

And lastly, then I'll -- last question just the CapEx plan for this year are we still thinking 170 to 190?

Yes.

Still in that range.

Great, thanks.

Good luck.

Thank you --

Wendy, we ready for the next question.

Gregory Melich, you may ask your question and please state your company name.

Hi, it's Greg Melich with Morgan Stanley What to follow-up on the gross margin and customer mix.

How has that impacted both sales and margins in those test markets?

Essentially, it was a very positive outcome in the test markets, but to be honest, we did an analysis of all the markets in the country and intentionally selected two markets that were least served with the current process and would reasonably show the best results.

So the results are not what we expect to be indicative for the entire chain, but it was a material improvement.

We're pretty excited.

So to give us -- obviously, you picked the low hanging fruit first.

But to give us any sort of order of magnitude, are we talking hundreds of basis of points improvement or ten?

I think it's a little early to tell.

We, as I mentioned, will begin rolling this out literally we're in motion, changing the plan-a-gram changes for early first quarter.

I think we'll have a better sense at the end of first quarter to give you some guidance as this thing has hit a material amount of our product in a material number of stores.

Greg, I think that's right.

I think we need to give it a little more time.

As you know, with many tests what you're trying to sort out in the beginning is how much of it, to Kevin's point, is we did pick some low-hanging fruit.

We saw some opportunities there and there's a little bit of Hawthorne effect that happens when you first went in.

Our learning is, give us a quarter or two to confirm, like we did with the inventory upgrades last year, and we'd be happy to talk to you about just where it's going.

But suffice it to say, if it was -- if the initial results are what we're seeing were applied to the chain, we'd all be thrilled but we need more time to sort out Hawthorne, markets and that.

We know enough to just keep moving forward, at this point pretty ambitious way.

Great.

And on the SG&A side, just to follow-up, if you look at it from a dollar growth perspective, I calculate it was up around 7% year-over-year once you got severance.

Looking at it that way, it looks like the new investments were about half of that 7% growth or maybe a little less?

Am I -- ?

Let me answer the question a little bit of a different way and let me remind you what I said earlier.

About two-thirds of our SG&A increase over last year was made up by things we planned to do, so capability investments, new stores.

And about one third was related to not adjusting variable expenses.

And also some costs that we didn't anticipate such as hurricanes.

We had a little bit of increase in utilities.

But a different way to think about how we're approaching SG&A is last year we were spending about $604,000 per store.

This year we're about $603,000 a store.

So when you -- so that's on a SG&A basis.

Now when you look at total revenue, we actually have the highest revenue per store amongst our competitors.

But it is interesting, when you look at our metric around sales per square foot, we trail the industry.

So we're producing a lot out of a big box but on a square foot basis, we lag.

And we lag by about 14% some our competitors.

So we really have a productivity issue.

So what we're trying to do, and you heard it in my remarks earlier, is how do we take the SG&A that we're spending and repurpose it to more high productive uses.

And I gave a couple of examples of that with how do we back down on advertising and invest in commercial, labor, and trucks where we get a higher return?

How do we maybe slow down our store growth, which we did it from 2000 and 2008?

And how do we actually take that capital and put it into new inventory systems, like merchandising systems, that will give us a high return?

That's how we're approaching SG&A.

That's where you hear us talk about little bit of a repurposing.

We have to invest in the structural parts of our business in order to differentiate us.

And I will also finish (inaudible), we also have to be cautious around the trends in our business around sales.

Our mix of SG&A today is about one quarter variable and three-quarters fixed.

So we don't have a lot of discretion in that variable, so the structural parts of our business we really have to go in and adjust.

That's great.

Thanks.

Wendy, we're ready for the last question.

Thank you.

Our final question today comes from William Keller.

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

Good morning.

We're with FTN Midwest.

Looking at the accounts payable and the financed accounts payable, which was up roughly $30 million it looks like in the quarter.

Can you give us an idea is that all related to the inventory increase or are vendors gravitating more towards that avenue to get paid.

And then also is that a facility capital?

Thank you.

I'll hit your second question first.

Our factoring programs, it's a tough environment out there and we haven't seen too much of an impact.

But obviously, the crisis in the credit markets has put a little bit of pressure on our ability to factor accounts payable, but we didn't see any change of that during the third quarter.

I think your first question was of the AP ratio, what's attributable to inventory and what's attributable to new terms?

What I would tell you is it could be about 50/50.

In terms of -- Kevin talked about our inventory going up and our MOOG and Wagner.

That was about $60 million of our inventory increase.

We're going to have to pay for that at the end of the year.

So to give you the context of the numbers, I think we're trailing along at about 60% right now coming out of Q3.

Last year we finished off the year at 55.

If you split the uprights, we're probably going to be somewhere in-between those two numbers as we finished off the year.

So said differently, half is inventory and half is terms improvement.

Got you.

Thank you.

Thank you.

At this time I would like to turn the call back to management for any final comments.

Thank you, operator, and thanks to our audience for participating on our third quarter earnings conference call.

If you have additional questions, please call Joshua Moore at 952-715-5076.

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

That concludes our call.

Thank you.

This concludes today's conference.

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