領先汽車配件 (AAP) 2010 Q2 法說會逐字稿

Welcome to the Advance Auto Parts second quarter 2010 Conference Call.

Before we begin, Joshua Moore, Director 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.

I'd like to remind you that our comments today contain forward-looking statements we intend to be covered by, we claim the protection under, the Safe Harbor Provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Forward-looking statements address future events, developments or results, and typically use words such as believe, anticipate, expect, intend, will, plan, forecast, outlook, or estimate; and are subject to risks, uncertainties, and assumptions that may cause our results to differ materially, including competitive pressures, demand for the Company's products, the economy in general, consumer debt levels, dependence on foreign suppliers, the weather, and other factors disclosed in the company's 10-K for the fiscal year ended January 2, 2010, on file with the Securities and Exchange Commission.

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.

The reconciliation of any non-GAAP financial measures mentioned on the call with the corresponding GAAP measures are described in our earnings release and our SEC filings, which can be found on our website at www.advanceautoparts.com.

For planning purposes, our third quarter earnings release is scheduled for Wednesday, November 10, 2010, after market close, and our quarterly conference call is scheduled for the morning of Thursday, November 11, 2010.

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

Darren?

Thanks, Joshua.

Good morning, everyone.

Welcome to our second quarter conference call.

First, I'd like to thank our 51,000 team members for delivering a record performance in our second quarter of 2010.

The team continues to position us for another great year with strong top line and bottom line results, through their focus on execution, and an unwavering commitment to serving our customers.

We remain confident in our team members and our strategies, as they fueled a 6.9% increase in our year-to-date comp store sales.

Our team continues to drive the resurgence of our DIY business, while extending the string of double-digit comp store sales gains in our commercial business.

The favorable market conditions and successful execution of our key initiatives drove a 7.2% increase in total sales, and a record store sales productivity that reached $1.64 million per store, on a trailing four-quarter basis.

Our availability excellence teams continue to shine by expanding our gross profit rate by over 100 basis points, resulting in double-digit operating income growth during the quarter.

The 12% operating margins are a glimpse into the potential of our overall business.

I'm encouraged by our continued improvement in our overall customer satisfaction scores, achieved while delivering a record 16.5% return on invested capital.

Collectively, the strategic and financial progress is evident in our customer experience and our bottom line results.

Similar to the first quarter, we out-performed both our financial and strategic objectives during the second quarter of 2010.

We are pleased with the continued progress of the initiatives that we have previously shared with you.

Jim, Kevin, and Mike will provide updates on some of these initiatives later in the call.

Our team is the most important factor to Advance's success.

Our highly engaged team members have a passion for serving our customers, and are committed to serving our customers better than anyone else.

We continue to assess the engagement of our team through our team calibration survey, and I am encouraged that those scores continue to increase across the Company.

Clearly, we are moving in the right direction.

The economic landscape and our industry vital signs, such as more stable gas prices, and miles driven, along with the increase in average age of vehicles, continue to be favorable and have fueled our market over the first half of the year.

These dynamics, combined with our continued focus on select initiatives, are helping us deliver strong results, yet we are also aware that we will compete with back-to-school and the holiday shopping season for top spot on our customers' priority list in the back half of the year.

Overall, we are encouraged by our good start to the third quarter, and are upbeat as we look to the second half of 2010.

Our focus in the second half will remain on key initiatives, including demand-driven labor, the rollout of our B-to-B website, our commercial customer growth and retention programs, our B-to-C website, and global sourcing.

These initiatives continue to make a difference with our customers, and to our bottom line.

Our confidence is tempered by the fact that our business has benefited from extremely favorable weather conditions in the first half of 2010.

However, weather tends to even out over the course of the year.

Additionally, consumer priorities will have an understandable impact principally in Q4, due to the holiday shopping season.

I would like to take a moment to recognize some members of our team who are driving great outcomes.

Through the second quarter, our biggest improvement has come from our 42% increase in free cash flow, which rose to $407.6 million.

Our record cash flow, along with work on our owned inventory management, are examples how leaders are working hard to transform our business.

Leaders such as Kevin Quinn, our Vice President of Treasury, Jamie Akemann, our Vice President of Merchandise, Jim [Nore] our Vice President of Inventory Management, and team members like Nancy Gupta, John Lambers, and Jim Fannon work diligently to make these goals become reality.

The work of this cross-functional team affected all areas of the business.

We will see benefits of this work for a very long time to come.

This type of work is a testament of the success of Advance's transformation, and it wouldn't be possible without the commitment of these talented and dedicated team members.

We remain committed to maintaining our investment grade metrics, and would like to congratulate this dedicated group on the work they are continuing to do to make this happen.

Now, I'd like to turn the call over to Jim Wade, our President, to provide a progress update on our commercial acceleration in DIY transformation strategy.

Thank you, Darren, and good morning.

I want to add my congratulations and thanks to our store teams, our sales force, and our support sales teams for another strong quarter.

Our team continues to serve our customers through our Company values, and we thank our customers for entrusting us with their vehicle needs.

This quarter was a continuation of the plans we've laid out for you in the past few quarters.

Our team continues to execute our plan very successfully.

In addition, as Darren mentioned, our industry fundamentals remain strong.

These fundamentals are positive to our business, and we believe they will remain positive in the future.

This includes the increase in average age of vehicles, more vehicles entering our industry's sweet spot, dealer closings, and more consumers who need to repair their own vehicles.

Our total comp store sales grew by 5.8% the second quarter, compared to 4.8% during the same quarter last year.

Again this quarter, we achieved an increase in both the number of customer transactions, as well as the average size of each of those transactions.

Each of our geographic areas produced positive comps in DIY and double-digit comps in commercial.

This marks our tenth consecutive quarter of double-digit commercial comps in our Advance Auto Parts stores.

Commercial now represents 34% of our total sales.

Also, we saw solid growth in our DIY business and achieved our fifth quarter of positive DIY comps in the last six quarters.

We continued to gain market share during the quarter.

We are continuing to focus on the initiatives that we previously described for both commercial and DIY.

Our pace of new initiatives is slowing, and we are focused on fully implementing and executing the initiatives that we have rolled out.

This focus is enabling more consistent sales growth, while slowing our level of investment.

Our team is focused on leading through our values, and they are measuring their success with clear goals, and we're proud of their progress.

In terms of initiatives, we remain on schedule with those things that allow us to serve our customers best.

This focus has produced our strong sales results and the highest sales per store in our industry.

We have completed commercial investments in half of our stores with commercial programs.

Those investments are continuing to fuel our commercial growth in 2010, as we look towards extending these investments to the entire chain over the next couple years.

At the same time, we're using what we've learned from those stores and already applying much of it across our entire chain.

Our investments in parts availability continue to benefit both our DIY and commercial business, as we're getting better every quarter at having the parts our customers need when they need them.

We continue to use our commercial customer data as a base from which to develop stronger and deeper relationships with our best customers with the highest potential for growth.

This will be an ongoing focus, and will be key to our growth and customer retention, as well as continuing to increase the productivity of our investments in the commercial business.

To ensure our commercial and DIY customers have team members available when needed, we've implemented the first two phases of our customer-driven staffing model.

We'll continue to increase our staffing effectiveness as we build on this model.

To ensure our store teams have the knowledge-in-field need to help solve our customers problems, we've increased the quality and effectiveness of our training and development programs for our team members.

This includes our on-boarding programs for new hires, product knowledge, and related problem-solving skills, and customer greeting and sales training for all team members.

For the past year, Kevin's team has launched new capabilities in eCommerce that are also benefiting our sales growth.

In DIY, eCommerce is increasing our sales and providing our customers a tool to do research before coming to the store.

Our commercial customers are rapidly signing up to use B-to-B as a tool to facilitate their ordering process.

Kevin will update you further on these initiatives.

We continue to refine our marketing approach, to better target both our highest potential customers and our underserved customer segments.

This new more-targeted approach has allowed us to more than double our marketing effectiveness, while keeping our overall marketing spend roughly in line with last year.

We are very pleased with the returns on the progress of our marketing initiatives.

In addition to sales growth, we're pleased that our customer satisfaction scores have continued to improve in 2010.

We are focusing on those stores where our customers have given us our lowest customer satisfaction rating.

As we build a stronger Advance Auto Parts brand, every store must provide exceptional service consistently.

With these initiatives, the positive industry fundamentals and the positive feedback from our customers, we're excited about our ability to achieve double-digit growth in our commercial business, and grow our DIY business as we look forward.

Lastly, we're also reaching new customers and growing our sales through successful new store openings.

During the second quarter, we opened 36 stores, including 14 auto partner national stores, while closing one store.

As of the end of the second quarter, our total store count was 3,497, including 181 auto part international stores.

Additionally, in the first week of the third quarter, we opened our 3,500th store in Westerly, Rhode Island, marking another significant milestone in our growth story.

In closing, thanks again to our team for another successful quarter, and for achieving those results through commitment to leading inspired teams and providing great customer service.

Now, I'd like to turn the call over to Kevin Freeland, our Chief Operating Officer.

Thanks, Jim, and good morning.

I would also like to congratulate the team for a strong second quarter.

I'll take a moment to highlight a few of our accomplishments during the quarter, as well as update you on our initiatives to strengthen our gross profit rate and improve product availability.

During the second quarter, our gross profit rate increased 111 basis points versus the same quarter last year.

The second quarter improvement was driven by increases both in front-room and back-room categories, resulting from the rollout of our custom mix and price optimization strategy, the strengthening of our merchandising capabilities, and the impact of our rapidly growing global sourcing capabilities.

We continue to be pleased with the strides that we've made in improving our gross profit rate, which has increased over 300 basis points on a two-year basis.

For our custom mix rollout, we completed approximately 180 inventory upgrades during the quarter.

This strategy allows us to improve our in-market availability of parts and accessories, and drives improvement both in sales lift and margin performance.

As a result of our improved availability, the sale of car parts continues to outpace that of our Company average, and is increasing as a percent of total revenue, versus the second quarter of last year.

This increase in sales mix for hard parts and improvement of category margin rate were strong contributors to the 111-basis point expansion and total gross profit rate.

Additionally, we continue to grow sales and expand our margins in accessories, which has benefited greatly from our new global sourcing capability.

In total, global sourcing had a positive impact on gross margin in the second quarter, and we expect the global sourcing benefits will grow over time, to become a material driver of our gross margin performance in 2011 and beyond.

Our adjusted accounts payable to inventory ratio of 72.1% is at an all-time high and compares to 58.4% at the end of second quarter last year.

This significant achievement was primarily driven by more favorable payment terms and the timing of inventory purchases.

We're on pace to achieve our long-term goals and expect to see continued year-over-year improvement in 2010.

The combination of substantially higher margins and significantly lower inventory gave us the opportunity to increase sales for improved inventory availability.

While owned inventory declined, total inventory rose in the quarter.

This resulted in an all-time high in our customer perception of product availability.

In the second quarter, we continue to make significant progress in increasing our availability through the addition of seven hub stores.

Our delivery hub network is at 172, providing multiple deliveries a day to thousands of stores, in addition to our 29 PDQs.

We have driven productivity improvements year-to-date from our engineered standards in the distribution center, on top of a double-digit improvement last year.

We're integrating our southeastern AI supply chain into our Lakeland distribution center, and fully intend to use this as a springboard to supply chain integration nationwide.

We continue to be pleased with our progress for our DIY eCommerce business, and continual increases in all key metrics-- traffic; conversion rates; sales.

As stated last quarter, the DIY eCommerce business is materially contributing to fiscal year 2010 performance.

We were very pleased with our launch of our expanded MyGarage during the DIY site during the quarter.

This new feature site aims to help customers maintain vehicle information in one place.

Consumers can register one or more vehicles, and keep track of service work, receive recall notices and e-mail alerts when a car needs tuneups, brakes, tire rotations, tire replacements.

These free enhancements are giving our customers even more reasons to shop online at Advance Auto Parts and to visit us more often.

On the last call, we discussed the launch of our B-to-B eCommerce capabilities in December.

Based on a successful pilot program, we have moved the full scale rollout of the B-to-B eCommerce, and currently have over 850 stores and thousands of customers using the system successfully.

The system has been well received by our customers, and we see a lift in sales with customers who are on the system.

The store and customer count is growing weekly, as we roll out nationally.

In the second quarter, AI's revenue grew 14.8%, driven by the net addition of 39 new stores over the past 12 months, and a positive comp sales performance.

AI opened 14 new stores in the quarter, bringing their total store count to 181.

Overall, the second quarter was very successful for our team, and I'm thrilled by the strategic and financial progress we've made for availability excellent strategy.

Now, let me turn the call over to our Chief Financial Officer, Mike Norona, to review our financial results.

Thanks, Kevin, and good morning, everyone.

I'd like to start by thanking all of our talented and dedicated team members for the strategic progress and fantastic financial results we delivered during the second quarter.

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

One, provide some financial highlights of our second quarter performance; two, provide an update on the key financial dimensions of our transformation; and three, link our second quarter performance to the balance of 2010.

As you may recall, our fiscal 2009 results included the impact of store divestitures, which decreased diluted EPS by $0.06 during the second quarter last year.

When we speak about our year-over-year results versus 2009 on a comparable operating basis, excluding the impact of the 2009 store divestitures, as that provides more transparent and relevant comparison.

We've provided GAAP financial results, as well as comparable operating results in our earnings release.

Overall, we are pleased with our strong second quarter performance, which built on the momentum from our first quarter.

Our second quarter earnings per diluted share of $1.16 were $0.27 favorable to last year, representing a 30% increase in EPS, excluding the $0.06 impact of store divestitures.

This was on top of last year's 14% EPS increase.

On a GAAP basis, EPS increased 40%, for $0.33 over 2009 second quarter results.

Some highlights for the second quarter include a 5.8% comp store sales increase, fueled by strong DIY performance, and our tenth consecutive quarter of double-digit gains in commercial.

This was on top of a 4.8% comp during the same period last year, representing a 10.6% two-year comp store sales increase.

During the second quarter, our gross profit rate increased 111 basis points versus last year, primarily driven by improved merchandising and pricing capabilities, increased inventory levels and results in supply chain efficiencies, and improved parts availability.

The 111-basis point increase was on top of 189 basis point gross profit rate improvement during the second quarter of 2009.

Our SG&A rate during the quarter decreased 10 basis points, excluding the impact of store divestitures last year, which exceeded our expectations.

The 10-basis point decrease was driven by strong comparable store sales, which resulted in leverage of occupancy costs and a decelerated pace of incremental spending on the Company's strategic capabilities.

We are pleased with the progress we have made to balance growth, while positioning the Company's leverage expenses at lower comp sales levels.

After adjusting for higher variable expenses, as a result of the better-than-expected comp store sales growth and the favorable timing of SG&A spend during the quarter, our SG&A dollar growth continues to be in line with our expectations and our previously shared annual outlook.

Free cash flow through the second quarter was $407.6 million, representing a 42% increase over the same period last year, primarily driven by our strong operating performance, and reduction in our owned inventory.

Our accounts payable to inventory ratio increased to a record 72.1% from 58.4% last year, as a result of our continued focused efforts to reduce our owned inventory.

Our rent adjusted leverage ratio at the end of the second quarter was 2.2 times, which is in line with our internal target and consistent with our financial policy.

Our return on invested capital was 16.5%, representing 160 basis point increase versus last year.

Our performance through our second quarter, as well as our performance over the past two and a half years, reinforces our commitment to accelerate growth, improve profitability, and derive shareholder value.

We will continue to measure our performance based on these three dimensions, and our progress thus far shows we are on the right path.

Turning to growth, we continue to make strides in increasing our productivity.

This is reflected in our 4% growth in our industry-leading sales per store, now at $1.64 million, and a 4% increase in sales per square foot on a trailing four-quarter basis through our second quarter.

Our ability to grow our profitability is marked by continued gross profit expansion and an increase in operating income rate, which grew 111 basis points and 121 basis points, respectively, during the quarter.

Our gross profit rate expanded 300 basis points on a two-year basis, and significantly contributed to our second quarter operating margin rate of 12.1%.

Our strategic choices, along with our execution and favorable industry dynamics, fueled our growth and profitability in our second quarter, and we continue to expect operating income expansion through improvements in our gross profit rate and more moderate SG&A dollar growth.

As we look at our ability to create value, we are pleased with our year-to-date free cash flow and the improvements in our balance sheet, primarily due to a reduction in our owned inventory of $126.2 million.

Additionally, our disciplined approach to Capital Management is generating strong incremental returns on our investments, as reflected in our 160-basis point improvement in our ROIC versus last year.

Over the past two years, we have been focused on building an integrated service model and investing in our capabilities and team members, in order to fuel our growth and generate both strong operating performance and strong financial returns.

Our progress on these dimensions was recognized in April, when S&P upgraded our credit rating to investment grade status.

We recently moved another step closer to achieving full investment grade status, as Moody's formally announced they are reviewing us for upgrades.

This announcement by Moody's is a direct result of the positive impact our team members are making on growing our business, and I want to personally thank all of our team members for moving us much closer to a historic milestone for our company.

In fact, it is the confidence in our team members, and their ability to drive continued growth, along with our strong free cash flow, that led us to repurchase approximately 3.4 million shares of stock in our second quarter, or 4% of our shares outstanding, for $167.8 million, at an average share price of $49.83.

Through second quarter, we've repurchased approximately 10.3 million shares, at an average share price of $44.31.

We were very aggressive in buying back our stock as a result of our relatively low valuation, and our internal confidence in our Company's ability to grow profitably and to create long-term shareholder value.

As we have stated in our press release, the Company's board of directors authorized a new $300 million share repurchase program.

The new authorization replaces the previous $500 million share repurchase program that was authorized in February 2010, which had approximately $45 million remaining.

We remain committed to managing our rent-adjusted debt to EBITDAR leverage ratio to a maximum 2.5 times, using 6 times capitalized rent.

Next, I'd like to link our second quarter performance to what we see for the balance of the year.

We continue to be on track to open approximately 150 new Advance and auto part international stores, and we remain committed to our previously communicated investment profile.

We are very pleased with our first half performance and have momentum going into the back half of fiscal 2010, given our industry dynamics, previous investments, and confidence in our team's execution.

That said, we do not expect the same level of overperformance that we delivered in the first half, given the seasonality of our business is clearly more heavily weighted towards the first half, and the reality is our back half volume is historically more challenging and volatile, as consumers make trade-offs with respect to back-to-school and the holiday shopping season.

We also estimate our SG&A will run slightly higher than we planned in the back half, due to spending which was anticipated to occur in our second quarter, and due to expenses driven by our higher-than-anticipated first half performance.

As we have shared previously, our practice is not to update our annual outlook unless there is a material factor or factors impacting that annual outlook.

As a result of our first half performance, which exceeded our internal expectations,combined with our significant share repurchase activity, which was not included in our original annual EPS outlook, we believe it is prudent to reflect these material changes and update our previously communicated annual EPS outlook.

We now estimate our fiscal 2010 annual EPS outlook to be in the range of $3.70 to $3.80 per share.

In closing, we are pleased with our strong second quarter financial performance that was driven by our previous strategic investments, fantastic team member execution, and positive industry dynamics.

These factors contributed to our delivering strong top line and bottom line growth, along with record cash flow and returns, as measured by return on invested capital.

Our share repurchases through the second quarter reflect our confidence in our Company's ability to drive further value and to remain committed to driving growth, profitability, and continued shareholder returns through investing in our team members and inspiring them to serve our customers better than anyone else.

Again, I would like to thank all of our talented team members for their meaningful contributions, which drove our second quarter performance, and who continue to help our Company reach new heights.

Operator, we are now ready for questions.

(Operator Instructions) And our first question comes from Dan Wewer with Raymond James.

You may ask your question.

One moment, please.

Go ahead with your question, sir.

Thanks.

Good morning.

Mike, in listing the reasons behind the significant gross margin improvement, I believe the second item was increased inventories and supply chain efficiencies.

Wondered if you could discuss that a bit more.

Wasn't sure if this was alluding to maybe better financing terms from your vendors on the additional inventory, or if you are -- just the capitalization of the distribution costs over your inventory levels.

But if you could just walk through that a bit more?

Yes, Dan, I'll let Kevin take that question.

So, essentially, if you go back to first quarter, we had a wonderful quarter, end of the quarter, leaner in inventories than we would have wanted.

The team and the impact at that point is our product availability and in-stocks were not exactly where we had wanted them to be.

So, the teams essentially moved throughout the quarter and not only corrected that, but as you take a look at the way that we manage inventory, we're proud to have the best inventory turn of our main competitors, and the things that you would look at would be what kind of margin rates do you earn, how much of the inventory do you own, what kind of a list do you get from increases in inventory, what's the risk of obsolescence?

And essentially over the last several years, all of those metrics have gotten materially better.

In addition to getting back into stock, we've added a layer of incremental inventory to go for a higher than, than previously achieved availability, which our customers are reporting back to us that they have noticed and believe that that is a part of the success that we had in sales for the quarter.

In terms of the supply chain, as we have previously announced, we have a program in the main distribution centers to enhance the productivity, created a double-digit improvement in productivity in the quarter on top of a comparable lift last year because of the lion's share our supply chain costs being classed into gross margin, those efficiencies show up in the gross margin line.

Okay, and as a follow-up on the discussion on SG&A, you noted that the deceleration in SG&A growth will not be quite as significant as first anticipated due to some shipping in dollars from 2Q.

Could you discuss the magnitude of those dollars and what SG&A items it relates to?

Sure.

So let me give you a little context.

At the beginning of the year, we came in and said that SG&A dollar growth this year would decelerate.

That actually has happened -- you saw that happen in Q2 where our dollars grew about 6.9%.

I think in comparison abot 10.6% last year.

We are pleased that we leveraged SG&A in the second quarter.

For the year, what we said is our SG&A dollar growth will decelerate and we still anticipate that and the numbers that I've given out there is our SG&A dollar growth this year per store would be in the high end of mid single digits.

And we still think that's the case.

What happens is sometimes you have some things that happen, some timing issues.

We have a little bit of timing that happens, that moves out of Q2 into Q3.

It's not significant.

The other aspect that we have in the back half of the year is things like our long-term incentive program.

You have to do accruals for that.

Those are over three-year periods, but that's as a result of our higher performance.

Our LTI programs are tied to growth in EVA.

Our EVA as a Company is growing because our operating performance and our strong balance sheet performance.

So, it's costs like that, I want to be really clear though, we have not changed our investment profile.

Our investment profile is exactly what we said at the beginning of the year.

I think last year, we spent 50% of our dollar growth was in investments.

This year it's about 20% to 25%.

We're right on task for that.

Yes, so accounting timing.

Okay, great.

Thank you.

Thank you.

Our next question comes from Scot Ciccarelli with RBC Capital Markets.

You may ask your questions.

Hi, guys.

Hi, Scot.

Thank you.

You made several references to what I would call seasonality, back-to-school, holiday season.

It kind of sounds like you guys are suggesting that the seasonal volatility that you're seeing or at least expecting is even greater than what we have seen in the past.

In other words, seasonality is typically captured in a comp figure over time, but it sounds like you're expecting a bit of a change on that front.

Is that the right interpretation?

Yes, I would -- Scott, this is Darren.

I would say that is the right interpretation because there's been -- it's principally Q4.

I would say last year, and we said this publicly in Q4, we did a 2 comp, and we were surprised.

That underachieved our expectations, I think underachieved the market.

But I think what everybody reported, the comps across the industry were lower.

And then when we peer back into it, we really did see a Christmas shopping season, where it appears the behavior is all about prioritization in small periods of time.

And, we're making an assessment that that behavior is sinking in.

If you actually go back almost three years ago now, we saw a trend just after Thanksgiving where we're running 2% DIY comps that literally after Thanksgiving went to almost minus 6.

And they stayed that way all the way through the shopping period.

And when you kind of step back and look at the overall macro trends, you would have to say the consumer is really picking their spots, and they are shopping based on this level of prioritization of their pocketbook.

And maybe we're being a little conservative or maybe what we're doing is actually coming to grips with, this shift in the prioritization of spending, and I think we talked about that in the first quarter where we're the beneficiary of it, certainly in the first quarter, and, you know what, as it's gone into the first half now.

All right.

That's very helpful.

Thanks, guys.

Thank you.

Our next question comes from Tony Cristello with BB&T Capital Markets.

You may ask your question.

Good morning.

This is actually [Alan Hotmenelaus] in for Tony.

My first question relates to improving parts availability.

This has been a key driver to your comp growth in commercial.

At $520,000 in inventory per store in Q2, looks like your investment is continuing.

I guess my question is, one, do you see levels moving higher from here, and two, can we expect this approach to further lift commercial gross margins as you're able to compete more on availability and less so on price?

Yes, Alan, this is Kevin.

What we're doing, and as I mentioned in a previous question, the returns that we're getting in inventory are improving.

The amount that we own is declining.

The lift that we're seeing through the custom mix tool and its ability to discern what to put into the store is improving.

We've identified inventory in the stores that essentially belong someplace else and have an aggressive program of pulling those products out of the stores and getting them into the right markets.

So, for a whole host of reasons, we are improving our availability on the commercial side.

The customer perception of our availability has gone up dramatically in the last year and a half, and I believe that that will continue as we go forward.

An awful lot of that story for the last couple of years has been trading inventory for information.

So, without raising inventory levels, we're raising availability by making it more accurate.

What you saw on the quarter is we're also increasing the total quantity as well.

And as we move forward, we'll continue to evaluate all those factors in figuring out what's the best investment of inventory for the Company.

Okay, and then as a follow-up, what is the seasonally stronger sales quarter?

It looked as if total head count per store ticked down slightly.

Is there an element of timing to this or is this more of a function of the roll-out of your demand-driven staffing model, and if so, exactly where are you in that process and apart from improved customer service levels, are there further net cost savings to be realized?

Alan, this is Darren.

So, yes, a little bit of it is we've been going on a journey that we, call it demand-driven labor.

Our internal language is customer-driven labor.

Over the course of the first half of the year, what you've seen is the first step of that clearly is kicking in, and think about we're able to better put team members, part-time, full-time, in the hours of the day that the customer is showing up.

And there's no doubt that we're seeing that show up in terms of our service levels in stores and we're able to see the benefit in our sales per labor hour.

I would say we're into the next phase of that now.

We're think about tailoring down to a store level based on the type of transactions, distance to commercial customers, in an activity-based way.

We're able to make that next edit in terms of labor at a store level.

I would say our goal is to get the right amount of labor to the right store at the right time.

We're not sitting there in this moment thinking about, boy, that's the best way to take costs out of this system, but it is the best way, candidly, to increase service levels, and move labor around and edit it out in places where the return isn't where it needs to be.

Okay.

That's very helpful.

Thank you.

Thank you.

The next question comes from Chris Furovers with JPMorgan.

You may ask your question.

Thanks, thanks, and good morning.

On the--

Hi, Chris.

How's it going?

Good.

On the gross margin side, earlier this year, you talked about the pace of expansion actually slowing down.

And it accelerated impressively in the second quarter.

So maybe, Kevin, could you speak to what exactly drove that, why do you think it accelerated and then with Mike talk -- speak to how sustainable should we think about that over the back half of this year and into 2011.

Yes, Chris, as we have reported in the past, the way that we're raising the Company's gross margin is on a host of fronts.

So, the fact that the part business is growing disproportionately is positive.

We've gone into global sourcing and the cost of acquisition of goods is declining.

We've developed a relatively sophisticated approach to category management and how we drive category growth and relate to the structure of negotiations with our vendors.

We, through the custom mix program, have substantially reduced the amount of our inventory that is unproductive, which had historically had, for obvious reasons, lower gross margins.

That all said, this is an imprecise set of activities.

It's very broad based.

The teams are working agressively to strike deals to push this forward.

And we were pleased in the quarter, much like we're pleased with earnings in the quarter.

I would say that beyond a shadow of a doubt, those efforts and energies will continue, but I would, I would not expect that it would be reasonable that the level that we saw in the quarter is a sustainable number for the long-term.

Yes, and Chris, it's Mike.

We don't break out the individual components, but I think Kevin has been very clear on where he sees the opportunities to continue to grow gross margin, not in quarters, but as we look out.

And that's what I would tell you.

And we've incorporated what we anticipate for gross margin improvements into our annual outlook.

So, that's factored in.

Right, and there's a little bit of mix benefit.

We're thrilled we're still growing double-digit comps and commercial.

The resurgence of DIY, when DIY is resurging, that's going to help the mix in terms of our overall margin rates as well, Chris.

So, it's a host of things.

So it sounds -- if I were to try to summarize that, it sounds like DIY helped on the mix side and then that's part of the upside surprise.

And then the clearing of unproductive inventory, those two factors helped faster commercial growth?

Yes, and the hard parts mix, too.

That continues to be just the lead business for us in terms of it's taking years to get back into that business.

It's showing up in our inventory investment.

It's showing up both in supporting our DIY resurgence, as well as on commercial business.

So, that part, a little confusing, because I thought historically people would say that commercial side of the house is 300 basis points lower margin rate.

So, how is the hard parts helping there?

The hard parts business is actually, we have a sizable DIY business and over half of that business is on the DIY side.

And, yes, the margins are higher on the retail side than they are on the commercial side.

But again, as we do not break out the individual components, it's difficult to get into solid details.

But as an example, as you went through last year, the largest single category, which we have reported, was price optimization.

With price optimization, exclusively on the DIY side, as we go into the fall of this year for the first time we're rolling out price optimization on the commercial side, which is not in our historical numbers.

So, I think what we can guide you to is that margin rates and the activities that would enhance margins are well under way and are continued to be likely to contribute to gross margin gains in the future.

Just a 301 basis point improvement in the last two years is not likely to be a reasonable number for the next two years.

I got you.

And then one quick followup.

Mike, can you talk about -- you talk about 20%, 25% of the SG&A growth this year is investment dollars.

Can you talk about what that was in the first half of this year?

Yes, primarily in continuing to expand our commercial waves, continuing to invest in capabilities like dot com and global sourcing.

No, I mean in terms of a percentage.

Yes, in the first half, it was about 20% to 25%.

I think that's what I said.

I thought you said that was the year.

Yes, and that's the first half as well.

Okay.

Thanks very much.

Thank you.

Our next question comes from Michael Lasser with Barclays Capital

Good morning.

Thanks for taking my question.

Can you talk about the trend in customer churn over the last few months and how it compared to the last few quarters, and did it have an impact on sales during the second quarter?

Yes, that's an interesting question.

So, Michael, here's what I would say, is that when we look at our DIY business, we wish we could get to that level of detail in terms of we don't have a loyalty card today and different things that some of the tools that would allow us to see that on DIY.

What we're paying attention to is that clearly the growth continues to come out of transactions or traffic is up and customer average is up as well.

On the commercial side, what we can see is that we literally, as we entered this year, one of the things I talked about is how we think about commercial customer retention and growth.

We, literally, this quarter began that process with our organization, and the language we use is our focus customers.

I would say the information isn't stable enough to say whether it's good or whether it's bad in terms of overall trend at this point.

What I am excited about is that we're able to now narrow down from where are our best customers and how are they behaving from a product point of view, how are they behaving in terms of a sales pattern point of view.

I think it would be more appropriate as we're having this call a year from now where the information is stable -- better stabilized across 30 -- 2800 programs that we would be able to talk more thoughtfully about that.

Okay, and on the commercial side, I know in the past you've said that there is a concentration where the top 10% of your customers do a disproportionate amount of business.

So, can you talk about the relative performance of those customers versus the relative performance of the remaining customer group during the second quarter?

This is Jim.

Like a similar answer to what Darren just described, we do have a significant percentage of our volume coming from a relatively small number of our customers, which I don't think is unusual.

And we are focusing on tracking those and we're pleased with what we achieved in the second quarter in terms of overall comp and it occurred from both that group of customers as well as the broader group.

But the real health of the business, as Darren described, is continuing to learn more about those -- those customers and ensure that we in fact are retaining and growing them.

And I think we're on a good road to be able to do that and to talk more about it, more specifically as we go forward.

Sounds great.

Best of luck.

Thank you.

Thank you.

Our next question comes from Alan Rifkin with Bank of America You may ask your question.

Yes, thank you very much.

Question on the commercial side maybe for Jim.

Jim, the double digit comps that you now seem to tank for as running is certainly quite admirable, but would you be able to provide some color on where that growth is from?

Is it new account growth or is it more a function of increasing the penetration of the accounts that had already signed up?

Alan, it's primarily continuing the growth of the business on accounts that we have.

And, again, just to elaborate a little bit on that, we, we do business with a lot of customers.

So, when we're in any given market, we're touching a lot of garages and that varies from having a substantial part of their business to doing a very small part of their business.

So, the growth is coming from primarily from growing the business with existing customers, what our focus is, is continuing to narrow that to a point where we're able to clearly retain and grow with our best customers that have the highest potential.

And, as a follow-up, I Jim, I seem to recall that last year you undertook a program to significantly increase the number of salespeople on the commercial side.

Would you be able to just give us an update on the productivity levels for those people and is this a program that you are happy with and where do we see the program going forward?

Sure.

The -- what we've shared with you over the last couple quarters is that last year, through last year, we had increased our salesforce I think by about 45% of total.

And so as we finished the end of last year, what we had talked about was we felt like at that point we were at a place in terms of our coverage that enabled us to continue to grow the commercial business the way that we're growing it.

So, we were able to narrow the span significantly, really start to focus our team on the customers that were most important.

We gave our team, our salesforce a tremendous number of additional tools to use to do that with.

So, this year we're maintaining basically where we were last year.

And as a result of that, obviously as the sales are growing, the productivity of that team is increasing significantly.

And one last question maybe for Mike.

Where do hard parts stand right now as a percent of your revenues versus--?

We don't -- yes, hi, Alan.

We don't typically break that out.

It's an important part of our business.

I think Kevin's been really clear.

And it's a majority part of our mix.

But, we don't break it out.

Okay.

Thank you all very much.

Thanks, Alan.

Thank you.

Our next question comes from Gregory Melich with ISI.

You may ask your question.

Hi--.

With who?

Hi, guys.

I'm bound to make that mistake in one of these calls so I'm glad you guys--.

First of all, congrats on a great first half.

What a difference six months makes.

Thank you.

Two questions.

One, is Kevin, could you help us understand a little bit more of this inventory and payable dynamic, and how much of it was driven by the growth of global sourcing?

Sometimes you start buying products in Asia and you start taking ownership early or you might be able to expend the payables.

Of that 40% payables growth, how much might have been timing within the quarter as opposed to a more structural shift?

Then I had a follow-up on commercial.

Yes, Greg, first off, the global sourcing program has had a pronounced impact on our gross margin.

It is not a large program today, and it will grow substantially over the next several years.

The programs that we have would actually have that share of our product not materially different in terms of the payable structure of the rest of the business.

So, a combination of its small size and similarity to the whole, that's not what's driving it.

And if you take the two main drivers, which is timing of inventory and the -- just kind of the underlying fundamentals, the lion's share of it is the fundamentals themselves.

And it's just a structural change in the way that we're setting up the relationship with our vendors.

It's a series of efforts that have gone on for years.

To be honest, we were somewhat constrained in the past, just with the rest of the world in the banking industry and the things that have happened globally a year or two ago.

I would say that the program is in place.

The partnership with the finance teams has been magnificent and Charles and his team are carrying forward with the program that I think will play out over the next several years.

Mike, has the upgrade from the rating agencies been a catalyst here?

Yes, it has.

It actually helps us in two respects.

It helps with our -- increase our capacity and, second, it helps with our pricing.

So, it has.

Got it.

And then on the commercial side, I think I caught in the commentary that the commercial B2B is at 850 stores and 2100 accounts, is that right?

Essentially, I think the -- you're directionally correct.

Where we're at right now, is this is a program that is being rolled out nationally.

So, literally that number is changing each and every day and what would be a true statement is, it will have been rolled out to all of our stores by the end of the fourth quarter.

So, can you give us any more insight as to what behavior you're seeing out of the people -- the accounts that do sign up for it.

Is it if you just get a much bigger basket, you become their first or second call as opposed to third or fourth.

Are there any other insights on those early adopters?

What we have right now is, first off, the total number of customers that we deal with is substantial and not all of them are Internet savvy.

So, we've identified a prospect list.

And we are today staying within our existing customer base as we're rolling this program out.

And it is generally -- the behavior that we see is these are customers that are substantial customer of ours, but quite frankly had been requesting the ability to order with us online for a while, and as they move to this program as a whole, as a group, they are up noticeably above the comps that we're reporting externally, and it's in essence, we're allowing them to order from us the way that they would prefer and they are choosing to essentially get closer with us and move higher up on their first call list.

That's great.

You want to define noticeably at all?

Don't believe that we, we have broken that out now.

Great.

Higher.

Congrats, guys.

Thanks.

Thanks, Greg.

Thanks, Greg.

Thank you.

Our next question comes from Matt Fassler with Goldman Sachs.

You may ask your question.

Hi, this is Brian Brinkman for Matt Fassler.

How much of the accounts payable ratio improvement in the quarter related to the increase in inventory?

And how should we think about that ratio going forward in the event that inventory growth were to slow, for example?

Yes, this is Kevin.

Brian, the lion's share, or the majority of the lift was unrelated to timing, but the honest answer is, we started the quarter having coming out of first quarter under where we would have preferred to have been, ended the quarter having made an intentional investment in inventory, so there's an element of it that is timing.

As I sat down with Mike, if you just stay where you were for the balance of the year, that number would slightly come down by the end of the year.

But the programs that we're rolling out with our vendors are continuing over the next six months and depending on the status of those negotiations, that ratio could change.

Yes, it's Mike.

I'm comfortable saying -- I think what we said is improving our AP ratio is important to us long-term.

I think Kevin's given the reasons behind that.

I think I've been asked the question what kind of improvement do we expect to see this year.

I think I've kind of leaky ballooned out, that we would expect the same kind of improvement over last year, which we saw like 400 basis points.

So that would take you from 61 to 65.

I'm actually comfortable now saying I think that number at the end of year's maybe closer to 70.

And then really it's tied to the work that Charles and the finance teams are doing to actually work with our vendors, work with our banks.

And the goal of supply chain financing is actually sell more products.

That's what the goal is.

I think Charles and the team are doing a great job in terms of working with the vendors and it's an important part of our partnership with our vendors.

So, very little to do with inventory growth.

Okay, great.

And then can I just ask a quick too.

Is there a minimum leverage ratio that you expect to maintain going forward?

Yes, we said publicly a maximum of 2.5 times.

And that's what we said publicly.

We're at 2.2 times.

That's where we're comfortable.

And that's all we've disclosed.

Okay.

Thanks a lot.

Thank you.

And our final question today comes from Mark Mendel with ThinkEquity.

You may ask your question.

Hi, congratulations.

Thanks, Mark.

I just had a follow-up on the inventory question.

What sort of growth are you anticipating year-over-year by the end of this fiscal year?

Yes, Mark.

I think that the -- what we've seen or what we've produced in the, in the past has been a growth in sales that outstrips the growth in inventory, whereas this quarter was kind of the exception to the rule.

It's unlikely that we'll have this level of growth of inventory over sales for the back half.

But, all of the dynamics that would make inventory a good investment will be there at that point and likely to have improved between now and then.

So, we're going to be looking at opportunities to invest in inventory and in ways that would be showing up in the top line sales number.

Yes, Mark, this is Darren.

It's probably fair to say we've learned a little bit coming out of Q1.

I would have said coming out of Q1 that we experienced this early in the quarter, is that quite frankly, we over-achieved our sales plan.

We've been very clear about that.

We weren't brought to those levels.

So, when we came into the quarter, I would say both our inventory levels -- and we actually started off the quarter in terms of sales, I think our language was they were good.

But they accelerated throughout the quarter in part and we got back in stock.

And so when you look at our sales trend over Q2, part of it is that you have to look into where we were investing in inventory and how we had to get back in stock in a number of key categories, because, quite frankly, the teams did such a nice job in the sales in Q1 and now the inventory teams have done a great job getting us back in stock and that we have seen the benefit of that throughout this second quarter.

Yes, Mark, just a final comment.

We're in a situation where in-stocks are at a record.

The customer perception of availability is at a record.

And while inventory dollars are up, our owned inventory is down substantially in the quarter, which generated cash that we'd use for corporate purposes.

So, you would expect to see inventory growth decelerate, but still exceed the rate of sales growth by year end?

Is that fair?

I would anticipate it to be flat.

If you get to the end of the year, look at our sales growth, we would expect our inventory growth to be roughly flat on a year-over-year basis.

Okay, great.

And then just to shift for a moment to the interest expense and other expense lines.

They were up significantly year-over-year.

To what extent were there non-recurring items in there from the debt refinancing?

Yes, there's a couple of things in there.

I think we shared before with our bond, so that drove a little bit more with that bond.

And that will carry with us, too, because we still have the swaps outstanding until October of 2011.

And then there was an item in there, a -- I don't know if it's reoccurring, but financial markets and the LIBOR markets continue to jump around.

We had roughly a $1.2 million adjustment to the fair market value of our swaps due to LIBOR fluctuations.

And I can't predict that going forward.

Typically, before those fluctuations used to flow through equity, when we did our bond deal, now they flow through the P&L.

I wouldn't anticipate those to continue, but I can't predict what LIBOR is going to do.

That adjustment was an expense then?

Yes, it was expensed.

In Q2.

Okay.

As far as the rates go.

As far as interest expense for the second half of the year, can you give any guidance, or should we just take the debt outstanding and the 5.75% interest rate?

Yes, and just -- what I would do is just -- that's all incorporated in our annual outlook.

Okay.

Okay.

Fair enough.

And then finally, any LIFO numbers to discuss?

You're on LIFO, right?

Yes, you'll see that in our -- I always try to remind folks we're required to break out LIFO.

You'll see that when we do our Q.

LIFO's only one component of our margin, so you'll see that when we release our Q.

Okay, great.

Good luck.

Thanks a lot.

Thanks, Mark.

Thank you.

At this time, I will turn the call back to management for any final comments.

Thank you, Shirley.

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

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

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

That concludes our call.

Thank you.

Thank you.

That does conclude our call today.

You may now disconnect.

Thank you for joining us.