領先汽車配件 (AAP) 2011 Q3 法說會逐字稿

Welcome to the Advance Auto Parts third-quarter 2011 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, and 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 and 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 the 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, business interruptions and other factors disclosed in the Company's 10-K for fiscal year ended January 1, 2011, 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 AdvanceAutoParts.com.

For planning purposes, our fourth-quarter earnings release is scheduled for Thursday, February 16th, 2012, before the market opens, and our quarterly conference call is scheduled for the morning of Thursday, February 16, 2012.

To be notified of the dates of future earnings reports, you can sign up through the 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 Chief Executive Officer.

Darren?

Thanks, Joshua.

Good morning everyone.

Welcome to our third-quarter conference call.

I'd like to thank our 52,000 Advance team members for delivering record results during the third quarter, through their dedication and service to our customers.

We are pleased with our third quarter results, that included strong growth in our commercial sales, along with incremental improvements in our DIY trends.

During the quarter we generated a 2.2% comparable store sales gain, which was on top of a 9.9% comp gain last year.

It was our best quarterly sales performance in 2011 on a two-year basis.

Our sales performance continues to be driven by our ability to serve our customers and inspire our team members as reflected in our improving customer satisfaction scores and consistent operations execution.

Now, despite the sequential improvement in our sales performance this year, the regional dynamics of our business continue to weigh on our overall sales growth in DIY.

Nearly 90% of our stores are concentrated east of the Mississippi river.

Within those geographies, the pace of industry growth for DIY has slowed by more than 700 basis points versus the rate of growth during the third quarter last year.

Comparatively, industry growth for DIY in the western half of the US outpaced the east by more than 300 basis points in the current third quarter.

This trend has been consistent the entire year, and we anticipate it will continue in the fourth quarter.

However, over the long-term, we believe the impacts of regionality could be much less volatile and the industry fundamentals remain solid across the entire US.

Turning to our profitability, our team materially improved our performance during the quarter, which is reflected in our 20.8% increase in operating income and our 167 basis point increase in our operating income rate.

It was a record 12.1% rate for the third quarter.

Our earnings per share also grew significantly to $1.41, an increase of 37% versus the third quarter last year.

We are delighted by these results, which reflect our ability to drive solid sales growth while improving and accelerating our profitability through leveraging our investments, and adjusting our costs that are not enabling our long-term growth and profitability objectives.

In 2010, we developed a blueprint to help us create a more cost-competitive and efficient organization.

This work continues to help us streamline and simplify our organizational structure to reduce costs and minimize the impact of sales and our service levels.

Overall, our cost management drove our record bottom line results.

It is a delicate balancing act, yet the progress we've made over the past year is encouraging.

Mike will provide more specifics on the financial impact of that work.

The focus of our investments and strategies have been aimed at providing a better and different customer service experience than our competition.

This intense focus on our values and our promise, Service Is Our Best Part, combined with strong industry dynamics, has allowed us to increase our overall return on invested capital to 18.8%.

As a Company, we will continue to be focused on the fundamentals of our business in reaping the rewards of running the business with consistency and excellence.

This year, we began the work to be the leader in service, and putting in place foundational service and operations excellence at every store.

We began that work by increasing the number of district leader positions, to allow for more focused coaching and development within our stores.

We have also begun to roll out tools and training that better enable us to understand both the quantity and the quality of our team members, and appropriately match them with the times of day when our customers shop with us most.

We will continue to prioritize service leadership through accelerating our commercial growth and igniting our talented team members with training and tools to serve our customers better.

We will continue to benefit from our delivery and online ordering capabilities that allow us to fulfill our customers' needs with speed, reliability, and consistency.

Our investment in hub stores and our work to maximize storage capacity for parts in our stores continue to allow us to strengthen our in-market availability while leveraging our larger box sizes.

We also continue to make progress on opening our new Remington DC, which will allow us to create much-needed capacity to fill the demands of our customers.

Selectively, our strategies position us to increase our availability as well as the service level and productivity of every team member through increased customer engagement and service excellence.

Before I close, I want to share a story about a team member who exemplifies what Service Is Our Best Part means to Advance Auto Parts.

[Alice Bodkin], the Assistant General Manager in the store in Staunton, Virginia has been with the Company for over 40 years.

District Leader [Bob Bradsure] says she exemplifies the difference between transactions and interactions, by creating interactions and truly forming relationships with her customers.

Alice's attitude and enthusiasm at work as she serves each and every customer with a smile on her face is very inspiring to her coworkers.

Fellow team members say that they respect Alice for the way in which she takes care of each customer from start to finish and she has set the bar high in store customer service.

Alice backs up her positive personality with extreme parts knowledge, and makes sure she gets enough information from the customer to fully satisfy their needs.

I commend Alice for her personal commitment and passion for service in the store, and in her community, as she strives to live the Advance values every day with every customer.

Congratulations, Alice, and keep up the great work.

Now I'd like to turn the call over to Jim Wade, our President, to discuss our service leadership strategy.

Jim?

Thank you, Darren, and good morning.

I'll start by saying thank you to our team for their record sales and profit results we're reporting this morning.

Our continued commitment to inspiring our teams and serving our customers better than anyone else directly led to our higher sales and higher productivity during the third quarter.

In addition to record sales and profits, our customer satisfaction scores rose again this quarter.

Our total comp store sales grew by 2.2% in the third quarter, which was on top of our record-setting 9.9% increase during the same quarter last year.

The third quarter represented our toughest comp comparison for the year, and we're pleased with how our team responded to the challenge.

We continue to outperform the market and gain significant market share in our rapidly-growing commercial business which represented 37.2% of our total sales in the third quarter, compared to 34.6% during the third quarter last year.

We continue to see significant potential to grow our commercial business and to gain market share.

We again saw some short-term impact of customers performing only the necessary repairs on their vehicles and delaying maintenance from both a DIY and commercial perspective.

This continues to be driven by the high unemployment rate and high gas prices, which are constraining consumer spending and driving habits.

However, vehicles continue to age, which is creating greater repair needs because of the higher number of average miles per vehicle.

Gas prices have moderated somewhat, and deferred repairs will be performed over time as they always have.

These factors will allow us to continue to grow well into the future.

Our DIY business remained somewhat challenging; however, we continue to see sequential improvement in DIY, and our third-quarter growth was our best thus far this year.

And again, this is on top of our toughest comp comparison for the year.

Our work to provide our store teams more tools to increase their development, coaching and training, our teams' focus and energy to serve our customers better, continued parts availability increases, and refined marketing and advertising initiatives are making a difference.

While we've seen some sequential improvement in DIY, we still have opportunities to grow and improve.

We've shared with you over the last several quarters our work to continue to strengthen our store staffing model.

Our initiatives have been focused on having the right people at the right time to align with the traffic patterns of both our DIY and commercial customers.

The next phase of this work is to ensure we have the highest quality of engagement within each store, during the times when our customers visit and call our stores most.

Our efforts have yielded increases in our productivity and have allowed us to be more flexible and better respond to business demand.

We continue to see great results from this work and will continue to refine it over time to ensure we have both the appropriate quality and quantity of staffing to better serve our customers and achieve higher productivity levels.

Our focus will also continue to be on our training and development, further measuring our progress with respect to our staffing model, increasing our productivity through maximizing our previous investments, and focusing on the consistent execution of those fundamentals that our customers value most.

Lastly, we continue to reach new customers and grow our sales through successful new store openings.

During the third quarter, we opened 20 stores and closed 2 stores.

Year-to-date, we've opened 85 stores.

As of the end of our third quarter, our total store count was 3,645 including 203 Auto Part International stores.

In closing, I'd like to again thank our team as they continue to serve our customers and achieve record sales and profits.

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

Thanks, Jim, and good morning.

I'd also like to thank the team for their hard work in third quarter.

I'll take a moment to update you on our initiatives to support our superior availability strategy, and highlight a few of our accomplishments during the quarter.

Our goal is to provide customers with superior availability, providing the right parts for our customers, our customers' needs, when they need them.

In order to achieve our goal, we've been working to better position our parts inventory to ensure both speedy and accurate deliveries.

Our hub store strategy is key to achieving that goal.

Our work in this space has been two-fold, increasing the number of hubs in the marketplace, as well as providing delivery capability from strategically-positioned hubs.

As a result, we worked to aggressively add our number of hub stores that provide daily deliveries, which now sits at 252, or an increase of 79 since Q3 2010.

During third quarter, we upgraded inventory in 116 stores, and 767 year-to-date.

As a result of our efforts to add hub stores and to maximize store-level capacity, our in-stock levels were up nearly 100 basis points over last year, and are at a record high.

Our inventory positions during the quarter were up 14.7% versus the third quarter of last year.

We continue to expect our total inventory growth to be in the low double-digits for the year.

We continue to work aggressively to manage our increased investment in inventory, and have been able to reduce our owned inventory per store by nearly 5%, due to our work to increase our accounts payable to inventory ratio.

Our work in this space has led to an increase in our AP ratio of roughly 420 basis points versus the third quarter of last year, and now stands at 75.2%.

We are very proud of the accomplishments made and we'll continue to work to expand our AP ratio in the future.

Turning to gross profit, our gross profit rate declined 87 basis points to 49.5%, versus the third quarter of last year.

This anticipated decline was driven by several factors.

First, our gross profit rate continues to be impacted by unfavorable shrink.

Our teams continue to work diligently to get back to the high level of asset protection achieved over the past couple years.

Second, our supply chain costs continue to be a headwind as a result of increased fuel prices, increased hubs, and deliveries.

Finally, our margins were impacted by the commodity price inflation and the related timing of our retail price changes.

Partially offsetting these headwinds were continued improvement in DC productivity, and continued benefits from our merchandising, global sourcing, and pricing capabilities.

We are on pace to open our Remington, Indiana DC during the second quarter of 2002.

The new DC will provide us with much-needed capacity and will be by far our most advanced DC within our distribution network.

Once this new DC is up and running, we'll be able to benefit from additional productivity improvements and continue to increase our overall availability.

Our B2C Internet platform is celebrating its second full year of operations, and we have been absolutely delighted with the progress we've made.

We continue to increase the number of customers who visit the site, and the amount of transactions they generate.

I want to congratulate our e-commerce team on their efforts to build a world-class online shopping experience for our customers.

From a B2B Internet standpoint, we continue to perform above expectations and are working diligently to add customers to the site.

This capability allows us to compete more effectively and ultimately provides the convenience and service levels our customers expect.

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 their contributions to the financial outcomes we delivered during our third quarter of 2011.

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

One, provide some financial highlights from our third quarter of 2011.

Two, put our third-quarter results into context with the key financial dimensions that we use to measure our performance.

And three, share with you what we see for the remainder of 2011, and insights into how we are thinking about 2012.

During the third quarter, our revenue increased 4.2%, driven by 105 net new stores over the past 12 months, and a comp store sales increase of 2.2%, which was on top of a 9.9% comp store sales gain during the third quarter last year.

As both Darren and Jim mentioned, we are very pleased with the growth, as our third quarter represented our most challenging comparison for the entire year.

We also experienced strong growth from Auto Part International, which grew 17.4% over the third quarter last year.

As Kevin mentioned, our gross profit rate in the third quarter was 49.5% versus 50.3% in the third quarter last year, or a decrease of 87 basis points.

This was in line with our expectations.

The decline versus prior year was driven by increased shrink, increased supply chain expenses due to investments in hubs, higher fuel costs and commodity price inflation combined with the timing of retail price changes.

Year-to-date, our gross profit rate decreased slightly by 19 basis points to 49.9%.

Our decrease in gross profit rate was in line with our previous outlook provided during our second-quarter conference call.

As previously shared, we anticipate our full-year gross profit rate will be down modestly, compared to last year.

This anticipates our fourth quarter gross profit to be down from prior year, but the decline is expected to be less than the decline in the third quarter.

Turning to our cost structure.

Our SG&A rate was 37.3% during the third quarter versus 39.9% during the third quarter of 2010.

This 254 basis point decrease was primarily due to reduced incentive compensation as a result of our lower comp store sales growth versus last year, productivity improvements from our variable customer-driven labor model, which includes anniversary and investment roll-out expenses, as well as a significant decrease in support cost from our operating model work.

Partially offsetting this was increased investments in areas such as commercial and e-commerce, combined with the timing of some expenses.

Based on our diligent cost management and commitment to building a more competitive cost structure, we now anticipate our SG&A per store to be down slightly for the full year.

All in, our operating income grew 20.8% and our operating income rate increased 167 basis points to 12.1% for the quarter.

This was on top of last year's 32% increase in operating income, and 160 basis point improvement in operating income rate.

Year-to-date, our operating income has increased 10.3%, and on a rate basis, has increased 65 basis points to 11.4%.

Our third-quarter diluted EPS increased 36.9% to $1.41, versus $1.03 last year.

Year-to-date, our diluted EPS is up 24.3% on top of last year's 29.1% comparable EPS increase.

Free cash flow through the third quarter was $354.8 million versus $467.9 million last year.

The decrease in free cash flow was driven primarily by the change in owned inventory this year-to-date, versus last year, as well as higher planned capital expenditures.

Our accounts payable to inventory ratio increased 420 basis points to 75.2%, as of the third quarter of 2011, from 71% versus the same period last year as part of our continued efforts to reduce our net owned inventory.

During the third quarter we repurchased 1.7 million shares of our stock for $100 million, at an average price of $58.81 per share.

Through the third quarter, we have repurchased approximately 9.9 million shares of stock at a cost of $609.6 million, at an average price of $61.51 per share.

These repurchases continue to be reflective of our confidence in our Company's ability to grow profitably and to create long-term shareholder value.

As of the end of the third quarter, we have $200 million remaining under our current $300 million authorized share repurchase program.

Strategically, we continue to position the Company for growth and improved profitability and we are delighted by these financial results as they demonstrate our commitment to growth and improved profitability.

Our performance in our third quarter demonstrates we are on the right path and reinforces our commitment to accelerate growth, improve profitability and drive shareholder value.

We continue to measure our performance based on these three dimensions.

Our commitment to growing our business is reflected by another strong quarter of commercial comp store sales growth.

Our commercial sales per program have grown to $630,000, and over the past three years, have increased 47% or $200,000 per store.

We remain committed to growing our sales per store and improving our operating income rate to 12% over the next few years.

Our third quarter results provide evidence that we can improve our profitability given our 167 basis point improvement in operating income rates to 12.1%, and our year-to-date operating income rate of 11.4%.

On a two-year basis, our operating income rate is up over 325 basis points.

Turning to shareholder value, we continue to maintain our disciplined approach to capital as reflected in our 18.8% return on invested capital, which represents an increase of 147 basis points over the third quarter last year and a 440 basis point improvement over the past three years.

The increase in ROIC is driven by our improved operating performance as well as our continued efforts to reduce our owned inventory.

Next I would like to link our third quarter performance to what we see for the balance of 2011 as well as provide some insights on 2012.

While we are very pleased in our ability to rebound from our difficult start to the year and deliver sequential increases in operating income growth in both the second and third quarters, we certainly do not expect the same level of improvement versus prior year in our fourth quarter.

We are cautiously optimistic about the remainder of the year, given our fourth quarter has a challenging comparison to last year, and historically is the most volatile quarter, given the changes in weather, seasonality shift in the timing of consumer spending, and the tradeoffs consumers make during the holiday shopping season.

That said, given our strong third quarter, we now anticipate our annual EPS outlook to be $4.90 to $4.95.

Achieving this outcome in 2011 will result in another 20%-plus increase in EPS and over 20% compounded annual EPS growth over the past four years on a comparable basis.

As we look to 2012, we will continue to build on our growth and profit successes over the past several years.

We expect the industry dynamics to remain favorable as a result of the continued increase in the average age of vehicles and an increase in mix of vehicles that are 7 to 10 plus years old.

This gives us confidence to invest in the customer and team member-facing parts of our business to continue to drive growth.

We anticipate continued top line growth, driven by our strong commercial comps, combined with continued new store growth to be at least at 2011 levels.

We expect to continue to build on our progress to achieve our goal of 12% operating margins over the next few years.

We expect the drivers to getting to 12% will primarily come through a more competitive cost structure, and modest gross profit expansion from where we are today.

As we have previously shared, we are delighted by the significant improvements we've made in our gross profit rate over the past three years and firmly believe that the structural drivers of our gross profit rate remain intact.

We continue to see opportunities to improve our gross profit rate, driven by the expansion of our global sourcing business and private label strategy, improvements in our shrink performance, and through future supply chain productivity improvements.

These structural drivers will help offset headwinds as a result of an increasing mix of commercial business, as well as inflationary and competitive pressures.

Turning to our cost structure.

We are focused on building a more efficient, sustainable and competitive cost structure.

As we have shared, our operating model work is multi-year work and reflects the opportunities we see to increase our productivity, reduce our variability of store performance and our continued efforts to reduce support costs furthest away from the customer.

We expect to continue the great progress we made in 2011.

Our growth ambitions will require us to continue to make investments in areas such as commercial, global sourcing and e-commerce, and these investments will be primarily funded through our efforts to improve our cost structure and simplify our operating model.

In closing, our strong results during the third quarter continue to be a reflection of our team's commitment to serve our customers.

Our strategic choices, teams' execution, and favorable industry dynamics continue to fuel our growth and give us confidence about the future.

Again, I would like to thank all of our talented team members for their contributions to our third quarter results and for their unwavering commitment to grow our business through our Service Is Our Best Part promise, while improving our profit model.

Operator, we are now ready for questions.

Thank you.

(Operator Instructions).

Our first question today is from Gary Balter with Credit Suisse.

It's Simeon for Gary.

First, on the commercial business, can you talk about what's happening in terms of account penetration with existing customers, versus adding new accounts?

And then I have a follow-up.

Thanks.

Yes.

This is Jim.

We're seeing a combination of both, and that's over the years that we've grown commercial, that continues to be the trend that we're adding new customers in our markets and at the same time working really hard to retain and increase the penetration in existing customers we have.

So no real change in that trend during this past quarter.

Yes, Simeon, what I would add is, underneath those trends earlier this year, I'd say right at the front end of this quarter, we started to get real traction in our new B2B platform and that B2B platform with our customers, we're seeing three good things happen.

One, as we put those platforms in, retention continues to improve.

We see our gross margins improve.

And we also see returns improve as well.

So as we've said before, in the commercial business, in some respects, we're playing catch-up.

Our B2B platform is now in some of those e-services that go with it so we feel good about the foundation of commercial, as Jim said.

We feel real good about the new customers that we're adding, and we feel good about the fact that we're adding that suite of B2B platform and other e-services that quite frankly we were behind on, and now we feel like we're catching up on.

Okay.

And then my follow-up, maybe for Mike, regarding expenses and incentive comp.

In the Q4, looks like the compare is not so different from where you were in Q3.

So if the sales environment stays the same or marginally improves and you hold other variable constants, should the expense performance in Q4 look similar to the way it did in Q3, or are there any other nuances in terms of year-end expense that we should think about?

The thing you think as you look forward, Q4 is always volatile, because it's a little bit lower sales and with a high fixed cost model, you see a little bit less leverage.

You expect to see a little bit less leverage because of the fixed cost nature.

But typically, and you mentioned incentive comp, as a reminder to you, our bonus program is based on growth and it's uncapped.

And our philosophy has always been that we want to share the success of our team members, and since we've implemented the program, we've had strong growth and in fact, we've had strong bonuses.

And in Q3, if you remember last year, we did a 9.9% comp.

This year we did a 2.2% comp.

Typically you wouldn't expect to see that kind of volatility but because we did, the bonuses we saw a little bit more leverage in Q3 than we historically have.

Thanks.

Thank you.

Our next question is from Greg Melich with ISI.

Hi.

Thanks, guys.

Wanted to follow up a little bit on that, where you are in terms of right-sizing the labor staffing model that you started.

Where are you in that process, and what's the sort of gap or the amount of hours you're able to shift between maybe your top 20% of stores versus your bottom 20%?

Just help us out on that side.

Yes.

So thanks, Greg, it's Mike.

Maybe instead of handling it that way, maybe I'll just give you a higher frame of how we think about labor.

And labor is part of our bigger picture.

If you remember last year, we started our op model work and our op model work was really grounded on building a more efficient, sustainable and competitive cost structure, and part of that we kind of looked at three areas.

One is productivity and efficiency, variability in our store performance, and kind of taking costs out furthest away from the customers.

As we think about labor, we just looked at our labor model and we got in there with a cross-functional team including field leaders and we realized we weren't doing a very good job matching our labor up when customers are shopping.

Last year we put a new labor model in, call it our customer driven labor model.

And since we put that in, and we saw it in Q2 and we saw it again in Q3, our field team is doing a wonderful job taking care of customers, with the right labor matched to when customers are shopping.

And we saw some leverage in that.

And we would expect to continue to improve that over time.

Our goal is not to cut labor.

Our job is to match labor when customers are shopping, and kind of get the right mix of labor when customers are shopping, and the great news is our team members did that during our third quarter.

That's great.

What I'd add, Greg, is that I think your question is a good one.

I think you have to think about it in three phases.

Phase 1 was, as Mike said, can we do a better job just matching the quantity of labor when customers are shopping?

I'd say phase 2 as we have gotten into it, is that even throughout the day we are finding better ways to allocate labor by hour of the day.

I think we still have work to do that -- in terms of our commercial programs, because what we're trying to do is match our business with our customers' hours.

You know what?

I still think we have a better opportunity in terms of making sure we're there to support the commercial customers.

And along those lines, we're spending time understanding, in those hours are we making sure we have all the right ASE Certified and qualified team members in the hours that the customers are shopping, too?

So I don't know that the labor journey's ever done.

But I think the way we think about it is, can we keep improving the service levels, keep improving the training to support our customers?

And can we keep doing a better job supporting our team and customers and getting the right hours to the right store?

Great.

And then a follow-up.

Jim, just wanted to thank you for all your years actively in the business and congratulations on retirement.

He's not retiring.

I appreciate the comments.

I would say that this has been a great opportunity here at Advance.

I'm not going anywhere.

I'm on the Board.

I'm connected.

We have a great team in place here at Advance to lead the Company and I look forward to continuing to be part of that.

That's the set-up.

Darren, how do you do all the stuff that Jim was doing and sort of the reallocation of responsibilities?

We're giving Jim Saturday and Sunday off now, as part of it.

So here's what I would say.

We're fortunate to have a team in terms of our Senior Vice Presidents that include -- and these are just meant to be examples, but there are many, that include Charles Tyson, Bill Carter, Carl Hauch and Greg Johnson, as well as Sarah Powell and others, that as organizations evolve, Greg, what my job is, is to actually get leadership deeper into the organization.

So Donna Broome will be taking over in terms of our HR function.

That will be a growth opportunity for her.

She led our commercial sales, probably one of the more focused customer-centric leaders that we have.

Carl Hauch has spent 20 years in operations, will lead our field team.

Bill Carter came over from Bain and spent five years with us -- in terms of working on commercial in terms of strategy, just a fantastic leader, working with our sales team now.

And Charles Tyson has picked up responsibilities for DIY and marketing.

So organizations go through what I'll call this renewal process, and it's our job as leaders to actually have that next generation of leaders take on more leadership and growth for the organization.

We're fortunate, and you know Judd very well.

Mike's doing that in finance, and so I think it's just as I look at it, I couldn't be more pleased.

If I had to take on the work, we would probably be in trouble.

But the fact that we have a bunch of Senior Vice Presidents coming up underneath, under Kevin's leadership and Mike's leadership, I couldn't be more pleased.

Thank you.

Our next question is from Matthew Fassler from Goldman Sachs.

Thanks a lot and good morning.

I've got a question and then a follow-up on the cost structure.

I guess one of the concerns that we hear relates to managing key members with volatile compensation.

Obviously, there's a lot of merit to paying people based on their performance.

But the movement in incentive comp has been pretty sharp, it seems, if you think about the payout last year and the payouts that are due this year.

How have you worked at communicating that with the field, what kind of feedback do you get as the incentive comp moves around?

If you could also, perhaps in that vein, help us contextualize how much an average store manager or associate's compensation might be moving as a result of the incentive comp?

Yes, so maybe I'll start and then I'm going to turn it to Darren.

A couple of years ago when we moved to this program, and it wasn't a small change for us, but as a reminder, and again, I'm going to say it again.

Our bonus program -- we believe it's competitive.

We always start off, and want to always make sure our programs are competitive, so that's just -- that's foundational.

As a reminder, the program's based on growth and it's uncapped.

I think that's a unique part of our program, and our philosophy is that we want to share the success of our team members, because they're the ones that help us grow.

And we've paid out record bonuses over the last number of years.

When you're looking at a number in Q3, you're actually looking at an average.

So that's true.

We did pay lower bonuses this quarter in relation to last quarter.

But we do have stores that are growing.

We have a number of stores that are still getting paid significant bonuses because of our philosophy around that.

And the program's designed to be market-competitive, and it's also designed to be market-competitive at historical rates at well.

To be honest with you, we typically won't see the kind of swings, at least we haven't historically, when you go from a 10 comp to a 2.2 comp so we wouldn't expect that kind of volatility as we look forward.

So, and then, in terms of communication of the program, I think our field teams under Carl's leadership have done a great job.

We're not going to disclose how much we pay our general managers, because we think that's confidential.

But when we look at our retention rates and our engagement rates, they continue to be strong.

So we continue to feel confident that our programs are competitive and that they're doing a great job to help grow our Company.

Yes, I think that's important, Matt, that maybe a real simple way to think about it is -- we've said this publicly.

I think there's a lot of great companies out there.

One is Fastenal, and they helped us think about how a growth program might work that they've been employing for 20-plus years.

And so when we built the program, our industry historically, while it grows 3% to 4%, so we said we want to make sure we're paying a market bonus when the business is growing 3% to 4%.

So when it grows more than that, the truth is, we share that upside with our general managers.

I'm confident in saying that we paid the best bonuses in the industry last year.

And that's because of our philosophy to share success all the way down to the general manager and our Commercial Parts Pro.

When it performs under that 3% to 4% our bonuses will be lower.

But it creates, and I think you've seen it in our numbers this year progressively, our third quarter was our best two-year comp.

We saw improving trends in our DIY and I like what I see in terms of our teams' focus in terms of commercial customer visits.

I like what I see in terms of our staffing and being available for the customer.

I like what I see in terms of our customer satisfaction scores in the third quarter.

And you know what?

If I could pay them more bonus, I would.

But if I look at the two years together, I feel very good about how we've shared success with our team.

And the underlying motivations for the bonus, you know what, I would just as soon not talk about bonus in terms of improving our SG&A, but it's just a reality.

I hope we're back on 10% comps again because they're winning, our shareholders are winning and that's what good looks like.

I want to put one exclamation point on that.

One of the things that's embedded in our cost structure is continued investments in areas like commercial, e-commerce, global sourcing.

And the reason we're making those investments is to grow our business and to position our stores to grow.

And then just by way of follow-up.

As you talk about improving cost structure relative to the industry, obviously this year on a per-store basis your dollars are going to be down.

As you envision the journey to 12%, is that cost structure in terms of dollars from here, or is it the sales growing into the dollars per store that you've established to date?

I think it's both.

This is not a cost cutting mission.

This is an efficiency and building a more cost-competitive structure to enable growth.

And you said it.

I mean, we're making the investments I mentioned earlier to grow the business.

So growth, growth gives you leverage.

So if we can keep existing dollars but grow, that gives you -- that will put us on a great path to 12%.

I think the really the only areas that we're taking cost out of our business is in the areas furthest away from the customer.

Areas like professional services, things like occupancy, and our discretionary.

Most of the other things that you saw in the third quarter were leverage.

The last follow-up, as you model out going forward, should one model out some increase in expenses per store in the ordinary course, assuming that you do comp commensurate with kind of that standard that you set, or do you actually think expenses per store can stay flat from here?

I think we can -- it's probably flat to a little bit up.

Got it.

Thank you.

Clearly the variables are going up, Matt.

But I want to reinforce that Mike and team did work over a year ago where we said there are systemic places that we just need to take cost out.

And this isn't a situational exercise, so they will grow with variable expenses for sure.

And we will be taking out cost, systemically, in targeted areas that quite frankly just needs to be part of a healthy organization, too.

Got it.

Thank you.

Thank you.

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

I'm curious about the commentary you made regarding a pretty wide dispersion in terms of geographic differences, and I guess the questions are, have you ever seen such a radical difference?

Because it sounds like it's pretty sharp.

I know you kind of intimated it before, but it sounds like it's greater than it's been in the past.

And then what would you attribute the differences to?

I guess those are the key questions here.

Yes, Scott, that's a great question.

Matter of fact, we didn't -- to be real candid, after our first quarter, we started to study regionally more closely, and when we looked at it we've now gone back a couple years and to be fair, being east of the Mississippi was modestly beneficial last year.

So east of the Mississippi outperformed west of the Mississippi.

And again, nearly 90% of our stores are east of the Mississippi, for those keeping score, that's east of Faribault.

In terms of what we see this year, is that we've just seen a consistent gap, principally in DIY.

I'll give you our best thoughts on why we see that.

That gap in the first quarter was -- in terms of total, it was nearly 3%.

In this quarter, it was nearly 2.5% in total.

But DIY's the driver honestly, and this quarter alone it was nearly 360 basis points.

And when I look back, part of it may be that the east in terms of deferred maintenance has been keeping up.

And the west looks like it has just surged in terms of performance this year.

So as we look out into next year, and I said it in my comments, that I think like weather, those things should even out over time and we're just going through a cycle right now that some of the deferred maintenance spend in the east has been more consistent, is our best hypothesis.

In the west, it looks like it might be catching up a little bit.

But we wouldn't expect that type of gap, again, principally in DIY, to continue beyond the fourth quarter of this year.

So that's what we can see.

And that's, again, using industry data that we can see in NPD.

And that captures, without Walmart, virtually all the big players in the industry.

And have you ever seen this kind of divergence before, Darren?

No, not east to west.

I think if you go back to '09, we do see a gap that favored the east, just looking at it by about 200 basis points in the fourth quarter of '09.

So as I look at last year, the gaps -- if it was a 50 basis point gap, where east benefited over the course of the entire year in DIY, that was about it.

That's what we can see.

Like I said, we only started studying it as we got through the first quarter of this year, but it's helping us better understand.

We just don't think you fall off.

You're not that good, and fall off that quickly.

And we know in the first quarter that some of our own moves in terms of DLs that we've talked about, increases in hubs, took some of our focus off the ball.

But as we look at it now, what we can see is the stabilizing of our DIY trends, and I can virtually explain the entire gap now through regionality.

Interesting.

All right.

Thanks a lot, guys.

Thank you.

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

I guess I'd like to just follow up a little bit on the DIY segment.

I know Mike closed his remarks on talking about investment in commercial and global sourcing and e-commerce, and I want to understand a little bit more on the DIY on the east of the Mississippi.

Do you think you're performing in line, better, or worse than your competitors?

And let's assume that the DIY side of the business is just at a point where it doesn't reaccelerate here.

How do you as a Company with 65% of your business go out and say, you know what, we're going to lead with commercial but DIY is important?

Here's what we're going to do now to take share and to reaccelerate this side of the business.

Yes, so Tony, maybe I'll start and then I'll turn it over to Charles.

We want to be clear.

We see -- the reason we talk about commercial is because the market is bigger and it's -- we were under-penetrated in terms of we've got 5% share and we see a tremendous growth curve around that for our Company.

Two-thirds of our business is our retail business and is extremely important to us, extremely important to us.

One of the reasons -- so Darren can explain the regionally, that just gives us comfort.

Because you look at the comps and just go, why is that?

Because we haven't seen that kind of regionally and we want to compare our comps and making sure it's not something that we're doing.

One of the things, though, that we know can help our DIY comps is number of stores and opening up stores.

So over the last couple years with our focus on commercial, with closing stores like we did in 2009, we've been out-stored a little bit.

So we're going to -- I guess get focused on store growth.

That's a driver.

The other driver is our customer-driven labor model.

We're making investments in that to match up our customers, who are making investments there.

That will help our retail business.

This year we did more advertising, and that's an important dimension and Charles can talk a little bit about how that impacts our products and why we do that.

Also, our e-commerce investments.

That's targeted directly at our retail business, or a big chunk of it is targeted at our retail business, and then our product strategies.

So we've had some real good success in terms of our battery market share for some of the things we're doing including the fact that we install batteries for customers.

I don't want you to get the impression that our retail business -- it's a big focus for us, and it's an important focus for us.

Charles?

Tony, I think there are a couple of areas.

We talk about our investments in global sourcing and where we're seeing our expansion in our private brands and the value proposition that we're driving with those brands.

Clearly -- you and I talked out in Vegas about some of the moves the industry's seeing from premium into mid-tier brands -- and private label is absolutely helping us in our DIY space look from a competitive set.

Around our marketing, we're looking at, what do our core customers react to?

And we've been doing a lot of different testing controls to see how we position ourselves with our radio spend for next year, and focus on traffic generation into our stores.

And we've been collaborating a lot with our field leadership team, with Carl, around our base execution in our stores, and executing our OSPs and our marketing positioning for each period.

So I think there are multiple levels of where we're making investments in the business, so global sourcing, where we're looking at our core execution in the business.

And we're looking at our core value proposition around Service Is Our Best Part.

As Mike talked about, our battery market share growth, taking care of customers with our battery business, and our customers recognizing that our teams in the field are doing an exemplary job, and it's being paid off in market share growth.

So I think there are opportunities for us to continue to develop our DIY customer base and grow our customer base.

Maybe just a quick follow-up.

When you talk about incentive comp, and you talk about participation on the upside, you've done a great job on the commercial side of the business.

Is the employee or the store manager compensated equally with respect to DIY sales as well as commercial sales, or are there different metrics used to compensate?

No, we use the same.

You remember, we said this many times.

We're looking to build an integrated service model.

We treat the dollars the same.

Okay.

Thank you, guys.

Thank you.

Our next question is from Dan Wewer from Raymond James.

Darren, there's a growing divergence in gross margin rate between Advance compared to AutoZone and O'Reilly, suggesting that the pressures at Advance are not really related to changes in competitive behavior in the market.

It appears to be more or less Company-specific.

Do you think that's primarily the fact that inventories are heavier than they should be?

That increases the opportunities for shrink.

It increases the cost of handling the inventory, increases the cost of shipping the inventory.

Are those the primary drivers of this lower gross margin rate that we're currently seeing?

Yes, Dan, that's a fair question.

So when others grow in a quarter, we decline.

What's creating the divergence?

I would say we -- as we put in our press release -- things that are in our control are shrink.

And when I reflect back on the first quarter and our drive to grow our inventories, and we grew them quite rapidly.

And I think as we've said before, we are near capacity in some of our distribution centers, so we had to do some unique things in order to manage through that flow of inventory, coming off of nearly a 10% comp in the fourth quarter of last year, and we had leadership change all the way down the field.

Shrink is something that's owned throughout an enterprise and I would say some of that is on us.

We had driven our shrink down based on our NRF data to just about the best in the industry.

So we have lost some ground on a very good place because shrink was a very important part of us growing our gross margin in a systemic way, and as we said, using outside auditors to look at the whole deal.

We've all been in this business long enough that shrink doesn't cure itself in a quarter but I'm confident the team, in terms of the shrink piece, is working itself out.

Fuel costs, we're all experiencing fuel costs.

Ours get a little exaggerated, given the number of hubs we put in.

So when we put in hubs we put in additional in-market delivery which causes a little bit more of a year-over-year headwind, given our -- what is it, 57 new hubs this year, too, in terms of what we're experiencing.

And as it relates to inflation and LIFO, I don't want to get into a LIFO conversation, but inflation is going to affect our Company.

It is going to affect everybody.

How that processes through the accounting and stuff will be different timing for different companies at different points in time.

But when I look at the underlying parts of our business in terms of the structural things that drive our margins, and as we look forward, the global sourcing as Kevin said many times, that will continue to be a -- in terms of a tailwind for us.

Remington is something that we're going to open in the second quarter of next year.

That's a, I think, a unique headwind for us in the industry, and when you get down to the actual core of it -- I think Mike said this in our comments -- that we're going to actually start to see those declines in margins moderate as we go into the fourth quarter of this year.

Did I miss anything, Kevin or Mike?

I guess the only thing I would add, Dan, at the highest level, and we get this question a lot.

We're delighted with the improvements we've made over the last three years under Kevin and Charles' leadership from areas, the structural drivers like global sourcing, supply chain availability and merchandising capabilities, and we're comfortable that our margin rate isn't going to be in that 50% range.

This year we said there's going to be a little bit of headwinds because of some of the things that Darren talked about, and we said to get to 12%, we'll probably see modest upside from that as well, but we're comfortable in that 50% range.

Longer term, short-term, there's going to be a little bit of headwinds this year as we said, and they'll be modestly down from that.

Mike, just as a follow-up, in your commentary did you disclose how much of the 254 basis points of SG&A leverage was derived from lower bonuses compared to store labor scheduling, which might be a more sustainable source of expense cuts?

No, we didn't.

We didn't do that.

But one of the largest components was our incentive comp, the variable nature.

But over 50% was productivity, and some of the cost work we did.

Over 50% out of 250 BP leverage is the sustainable sources of expense.

Yes, productivity, cost, those things.

That's helpful.

Thank you.

Thank you.

Our final question today is from Alan Rifkin with Barclays.

Thank you very much.

First question for Mike, and then I have a follow-up.

Mike, your CapEx year-over-year has gone up about $60 million despite about 40 fewer stores opened, which would imply that a greater investment is certainly going towards the supply chain and hubs.

When do you think that incremental investment may subside a little bit?

Will we see a little of that in 2012?

We still expect that we're going to have supply chain investments in 2012.

I think we've got a multi-year supply chain strategy that I'll have Kevin kind of comment on.

But we want to continue to invest in the business.

What we said this year is, our capital this year will be up roughly $100 million more than last year, primarily $75 million to $100 million, primarily driven by our supply chain investments.

Remember, we're building a new DC that goes into place the first half of next year.

More importantly, we're putting a new WMS system in that's going to transform our supply chain, give us supply chain efficiency down the road, but it's multi-year.

Our supply chain investments will be multi-year.

The only thing I would add is you can account for our entire capital budget between new stores, supply chain and IT.

And I think IT will, as a percent of the capital budget, will hit its peak year next year, and moderate in the years ahead.

I think the real estate component of it will expand as we move beyond the current pace of NSOs.

And you're likely to see a similar component for supply chain, as Mike said, as we go through the conversion over the next few years.

Okay.

And one follow-up for Darren, if I may.

This isn't the first time that you've spoken about the disparity between the eastern and western portion of the United States.

With only 10% of the current store base west of the Mississippi, and in your quest to continue to grow as a growth Company, when might we see a more concerted effort to having an increase in new store openings west of the Mississippi, which may balance out some of the geographic effects that you've spoken about?

It won't -- when we look at it, Alan, as we look across our current geography, I would think about our growth in terms of what we can see right now on our organic growth between AAP and AI.

Then we'll continue to maintain our focus and we have been pushing -- we've been edging west, principally in our Denver markets, a little bit in our Texas markets.

But, I must tell you, what we continue to see, and we saw this with our expansion of AI last year, and we've seen this in our core markets like Chicago.

There's just still so much opportunity to fill out some of the core markets, our northeastern market, and when we're doing it in terms of where we have strength, we're able to leverage the team in terms of our field teams, in terms of getting the right people to staff those stores while we'll continue to make those investments to the west.

But I would say as I look into next year, given what I know right now, that it's more likely that we'll continue to edge west as we go into next year for sure.

But as Kevin said, we're spending time right now thinking about -- we know one of the things that's challenging our DIY share right now is that 83% of customers choose a DIY location based on convenience.

And so when our store growth runs at a rate less than our competitors, almost by definition, you're going to give up a little share.

So internally, we're spending time as we look at the back half of 2012 and 2013 in terms of upping those store counts, both in terms of AI and AAP because we like how those models work together in a market and we think it allows us to look at new geographies differently too, in terms of how we might go into them.

Thank you very much.

Thank you.

This concludes the question-and-answer session.

I will now turn the call back to management for any final comments.

Thank you, Wendy, and thanks to our team for -- to our audience for participating in our third-quarter conference call.

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

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

That concludes our call.

Thank you.

That concludes our call today.

You may now disconnect.

Thank you for joining us.