LL Flooring Holdings Inc (LL) 2012 Q2 法說會逐字稿

Good morning, ladies and gentlemen. Welcome to the Lumber Liquidators second-quarter earnings call. With us today from Lumber Liquidators is Mr. Rob Lynch, President and CEO, and Mr. Dan Terrell, CFO. As a reminder, ladies and gentlemen, this conference is being recorded and may not be reproduced in whole or in part without permission from the Company.

I would now like to introduce Ms. Ashleigh McDermott. Please go ahead.

Thank you, good morning, everyone. Thank you for joining us today. Before we begin, let me take a moment to reference the Safe Harbor Provisions of the United States securities laws for forward-looking statements.

This conference call contains forward-looking statements that are subject to significant risks and uncertainties including the future operating financial performance of Lumber Liquidators. Although Lumber Liquidators believes that the expectations reflected in these forward-looking statements are reasonable, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct.

Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included in Lumber Liquidators' filings with the SEC. The information contained in the call is accurate only as of the date discussed. Investors should not assume that the statements will remain operative at a later date.

Lastly, Lumber Liquidators undertakes no obligation to update any information discussed in this call.

Now I am pleased to introduce Mr. Rob Lynch, President and CEO of Lumber Liquidators.

Good morning, everyone. I'm here with Dan Terrell, our CFO, and we are pleased to be speaking with you about our second quarter 2012 results. Overall our team continued to execute on our key strategic initiatives and by doing so, we captured market share, expanded operating margin, and delivered record results through the important spring remodeling season.

We continued to demonstrate a commitment to continuous improvement in all that we do and operated with a unified vision. We believe our coordinated efforts strengthened our industry-best value proposition of best price, selection, quality, availability, and people. Through this commitment and focus, we have built solid momentum over the last four quarters including increasing net sales at comparable stores, expanding gross margins, and strengthening control over SG&A expenses.

Highlights of our second quarter in comparison to the prior year include a net sales increase of nearly 20%, comparable store net sales up 12.4%, gross margin increased 330 basis points to 37.3%, operating margin expanded 450 basis points to 9.4%, and net income grew 130%.

We have consistently focused on key strategic initiatives which we first outlined at the start of this year which helped drive our second-quarter success and continued our momentum. To reiterate, our five key initiatives are growing revenue, continuing to improve our sourcing, optimizing our supply chain, driving traffic through advertising reach, and frequency, and developing the best people to serve our customers.

In terms of progress made on these initiatives, we drove consistently strong consumer demand during the second quarter through our efforts to expand the reach and frequency of our advertising. Traditionally our message has more narrowly targeted core DIY customer and as we have previously discussed, in the fourth quarter of 2011, we began testing programs to expand our reach to a more casual consumer. Building upon the success of those tests, we launched these programs on a broader scale to drive demand in the spring remodeling season and we increased the frequency of our call to action message.

Though we had planned our 2012 advertising spend as a percentage of net sales to approximate 2011, we are pleased to have achieved leverage through a strong topline in the second quarter. We are committed to reinvesting our national advertising leverage and programs to drive traffic. We are also focused on increasing the effectiveness of our total advertising spend.

Combined with strong store traffic in the second quarter, our average sale contributed to our topline growth. Our average sale in the second quarter improved more than 6% versus a year ago. We believe the increase is due largely to better servicing of our customers by our world-class sales force, reflecting strides made in our best people initiative.

We have seen higher average retail prices per unit sold, which indicates to us that consumers continue to prefer premium products across a wide range of categories. Further, we have continued to see solid sales of moldings and accessories, a category which includes an expanded assortment of flooring tools.

To update you on our store growth, we are still on track to open a total of 20 to 25 stores in 2012. We opened 10 stores in the second quarter, which brings us to a total of 14 openings in the first half of 2012.

We are pleased to have seen increases in both total market penetration as well as second-quarter comparable store net sales in our cannibalized markets.

In terms of our overall real estate strategy, we continue to utilize our enhanced site selection process and will appropriately balance our mix of new stores, relocations, remodels, and assortment expansions as lease renewals come up. Importantly, we are also developing a store layout of the future that we can roll out to both existing and new stores. We are in the very early stages of this process but we are excited and pleased with our initial progress.

To touch on sourcing, we continue to perform line reviews and consider potential product assortment expansion to align with the evolving needs and preferences of our consumer. Our sourcing initiatives and optimization of our supply chain continue to positively impact and expand gross margin.

Additionally, our close working relationships with our vendor partners worldwide enable us to continue enhancing our sourcing strategies and we remain committed to seeking direct relationships with all of our vendors.

As many of you know, our fall 2011 acquisition provided us with direct relationships with our vendor mills in China. I am pleased that efforts to date in 2012 have brought us closer to fully direct relationships in Brazil and throughout South America. Though we have not acquired any partners and have no plans to do so, we have restructured our sourcing and quality control practices and removed certain third-party distributors to strengthen our relationships in this key area.

All of these initiatives would not be possible without the ongoing development of the Lumber Liquidators team. As we've discussed in the past, we are continually evaluating our talent and are always looking for ways to improve our management team.

In the second quarter, as part of our best people initiative, we revamped our Lumber Liquidators University. We began a roadshow to reach all store personnel and by the end of the year, all store employees will receive in-depth training in enhanced selling skills. All of our store managers will also hear directly from me and other members of the senior team about our shared long-term goals, vision, and objectives for the Company.

This ongoing development both at the senior management level and within their departments is enabling our team to commit to one shared strategic plan and set of initiatives.

We believe Lumber Liquidators is successfully navigating through what remains a challenging retail environment particularly for large ticket discretionary purchases. We expect certainty and volatility to continue in the second half and our consumer to remain cautious and price-sensitive. That said, Lumber Liquidators continues to be a very strong company with a value proposition that resonates with consumers.

I have great confidence in our ability to build on our recent success, to continually improve, expand our store base, and further capture market share in the industry. The investments we made are generating immediate dividends and stand to further enhance the Company in the future to grow both net sales and earnings for the remainder of 2012 and beyond.

I would now like to turn the call over to Dan for a detailed review of our financial results and outlook and then I will return with some closing remarks. Dan?

Thank you, Rob. Good morning, everyone. I will provide additional details on our results for the second quarter and then update our outlook for the remainder of 2012. Our references to percentage and basis point changes are in comparison to the second quarter of 2011 unless otherwise noted.

Net sales increased 19.9% to $210.3 million, driven by a $21.7 million increase at comparable stores and a $13.2 million increase at noncomparable stores. As a reminder, we generally consider a store comparable on the first day of the 13th month of operation.

At comparable stores, the net sales increase was 12.4%, which we believe was the result of a 6.3% increase in our average sale and a 5.8% increase in the number of customers invoiced. Our average sale was approximately $1,625, up nearly $100 from the second quarter of 2011 due primarily to the following factors.

First, we saw higher average retail prices per unit sold as customers continued to prefer premium products across a broad range of merchandise categories. In addition, though our April big sale was once again successful in driving incremental demand, a lower level of discounting during the sale preserved a higher average retail price.

Second, we continued to drive increases in the sales mix of moldings and accessories, which now include our flooring tools. These merchandise categories grew to 15.8% of our net sales in the second quarter of 2012, up from 14.4% in the second quarter of 2011.

Finally, we saw slight increases in the volume of flooring per sale primarily measured in square feet.

With respect to the number of customers invoiced, we believe the increase was primarily the result of - greater recognition of our value proposition due to our efforts to expand our advertising reach and frequency.

Fewer noncomparable stores operating in existing markets in comparing 2012 to 2011, at June 30, 2012, we were operating 14 noncomparable stores in markets with at least one comparable store, down from 30 stores at the end of June 2011.

Finally, a greater number of stores in operation for 13 to 36 months when increases in net sales are generally higher than average. A new store generally opens without fanfare and matures in the market as customer awareness of our brand and value proposition grows.

Newer or non-comparable-store locations continue to drive our topline growth. In the first six months of 2012, we have opened 14 new locations including 10 in the second quarter. Combined with the 13 new stores opened in the second half of 2011, we have 27 more stores operating at June 30, 2012 than at the end of June 2011.

Overall, our new stores continue to meet and exceed our estimates. As Rob discussed, we are pleased with our team's coordinated efforts to improve the site selection and total market penetration. This productivity of our non-comparable stores relative to our base of comparable stores has been stronger in 2012 than 2011 even adjusted for maturity.

Our non-comparable stores averaged six months of operations in the second quarter of both 2012 and 2011. In the first quarter of 2012, our non-comparable stores had averaged eight months of operation, much more mature than the five months of operation averaged in the first quarter of 2011.

Turning to gross margin, we saw benefits from improvements in both the cost of product and transportation in the second quarter of 2012. As a result, gross margin improved 330 basis points to 37.3%, matching the first quarter of 2012. As many of you know, our second-quarter gross margin has historically been lower than our first quarter, due in general to heavier promotion in the spring remodeling season particularly during the April Big Sale.

Our 2012 April Big Sale was successful in driving incremental traffic but due to the strong demand throughout the quarter, the sale represented a lower percentage of total net sales in 2012 than in prior years. In addition, we more effectively maintained retail price discipline at the point-of-sale and we believe gross margin was only 20 basis points lower in 2012 due to the incremental net sales from the April event, half the impact of the prior year.

Overall, our cost of product continued to benefit from shifts in our sales mix and the continuing benefit of our sourcing initiatives. Together these benefits drove an improvement of approximately 250 net basis points.

Within our sourcing initiatives, gross margin continued to benefit from the impact of line reviews and the establishment of direct relationships with our vendor mills, particularly in China following our September 2011 acquisition.

Within our sales mix, gross margin benefited from the continuing customer preference for our premium products and the increasing mix or attachment rate of our moldings and accessories.

Within transportation, we believe gross margin benefited by approximately 120 net basis points, due primarily to the following -- lower international container costs, lower domestic fuel costs, more efficient domestic delivery from our warehouses to the first sales floor, and greater control of unit flow and related costs from the first sales floor to the customer.

From a rate perspective, our average international container costs impacting the second quarter was less in 2012 than 2011. Though container rates are generally rising, our average rate is impacted by a combination of East and West Coast deliveries and the utilization mix of 20-foot and 40-foot containers.

We believe investments in our product allocation and distribution teams have more efficiently matched unit flow with customer demand and as a result, we have reduced the units transferred between stores. In addition, our supply chain has worked closely with store operations to control the costs related to customer delivery. Together we believe these initiatives benefited gross margin by approximately 35 basis points.

Partially offsetting these transportation benefits, gross margin was adversely impacted by a reduction in the percentage of units received directly at our stores. The transition of certain products to new vendor mills as a result of line reviews lowered the percentage to 18.6% from 27.7% in the second quarter of 2011. Increasing the percentage of units received directly at our stores remains a strategic goal and we continue to believe that our full year 2012 percentage will exceed the 23% achieved in 2011.

We believe increases in certain other costs reduced gross margin by approximately 40 net basis points including an increase in our inventory reserve for loss and obsolescence, a reserve for reimbursements due from a Brazilian vendor, and our continuing investment in quality control.

Selling, general, and administrative expenses increased approximately $7.6 million or 15% to $58.7 million due primarily to higher net sales and growth in our store base, but as a percentage of net sales fell to 27.9% from 29.1% in the second quarter of 2011.

Salaries, commissions, and benefits increased to 12% of net sales due primarily to an increase in the commission rate paid to our store management, significantly higher accruals from annual management bonuses, and an increase in certain benefit costs.

Our advertising spend increased by approximately $700,000 in comparing the second quarter of 2012 to 2011, but we leveraged that spend 110 basis points due to higher net sales at comparable stores and a larger store base. As Rob discussed, we continue to reinvest in our value proposition by broadening the reach and frequency of our advertising and reallocating our spend to more effective media channels.

Other SG&A expenses for the current quarter include approximately $700,000 to fully reserve notes receivable from a Brazilian supplier. In addition, bank card discount rates were higher due to greater customer preference for extended term promotional financing programs offered through our proprietary credit card.

The effective tax rate was 38.6%, down from 39.5% in the second quarter of 2011 due primarily to lower state income taxes and the timing of certain reserve changes mainly in the prior year.

Net income increased 130% to $12.2 million or $0.43 per diluted share based on approximately 28 million average diluted shares outstanding. Net income for the second quarter of 2011 was $5.3 million or $0.19 per diluted share based on approximately 28.4 million weighted average diluted shares outstanding.

We continued our share repurchase program in the second quarter and through June 30, 2012 had repurchased approximately 1.3 million shares of our common stock on the open market at an average price of $26.34 using approximately $34.3 million of our $50 million authorization.

Cash and cash equivalents totaled $31.5 million at the end of June 2012 compared to $61.7 million at December 31, 2011 and $33.4 million at June 30, 2011. The total inventory balance at June 30, 2012 was $211.6 million and our available inventory per store was $664,000. At June 30, 2011, available inventory per store was $631,000 and at the end of March 2012, it was $578,000.

Available inventory per store as of June 30, 2012 has increased in comparison to prior periods due primarily to the continued supplier transition in certain key merchandise categories subsequent to the completion of several line reviews. Inventory levels were elevated in the laminate, bamboo and engineered hardwood merchandise categories as we transitioned certain existing products to new vendor mills. With these transitions taking place in the important spring remodeling season, elevated inventory levels safeguarded positive trends in net sales.

We expect to complete this transition by the end of October and we continue to target available inventory per store to range from $540,000 to $560,000 at the end of the current year.

Working capital was $163.3 million at June 30, 2012 compared to $157.9 million at June 30, 2011 with the current ratio at 2.8 times and 3.2 times respectively. Capital expenditures totaled approximately $3.5 million for the second quarter of 2012 compared to $4.1 million for the second quarter of 2011 with the decrease primarily due to the fewer new store openings and lower capital expenditure for our integrated information technology solution. We now expect capital expenditures to total between $11 million and $14 million for the full year.

Turning now to our updated outlook for 2012, as Rob indicated, we continue to face a challenging and uncertain retail environment particularly for large ticket discretionary purchases. Though we have seen some year-over-year improvement in certain home-improvement metrics, the levels remain historically low. We continue to expect demand volatility in the second half and our consumer to remain cautious and price-sensitive.

That said, we believe we will continue to capture market share and we remain focused on continuous improvement. As a result, we now expect net sales for the full year in the range of $750 million to $775 million, up from the previous range of $720 million to $750 million, with a mid single-digit increase in net sales at comparable stores.

We continue to expect 20 to 25 new locations in 2012. We now expect 2012 earnings per diluted share in the range of $1.30 to $1.42 based on a diluted share count of approximately 28 million shares exclusive of any future impact of our share repurchase program, up from a previous range of $1.10 to $1.25, which was based on a diluted share count of 28.4 million shares.

I will now turn the call back over to Rob for his closing remarks.

Thanks, Dan. As we look ahead, we remain confident in the strength and positioning of our unique value proposition, profitable store model, our approach to growth, and our emphasis on continuous improvement in everything we do. Our financial position is strong and we look to continue our focus on long-term growth in both net sales and operating margin.

Our team is excited and motivated by the opportunities that lie ahead. Our value proposition continues to resonate well with consumers and we look toward the back half of the year and into the next, we are confident in our ability to continue to drive traffic, improve our operations, expand our operating margin, and grow our footprint.

Before we turn the call over for your questions, I would like to thank all of our associates in the US, Canada, and Shanghai for their dedication and ongoing efforts. Operator, we are now ready for questions.

(Operator Instructions). Budd Bugatch, Raymond James.

Good morning, Rob. Good morning, Dan. Good morning, Ashleigh. It's actually TJ McConville filling in for Budd. Congratulations on the quarter and thank you for taking my question. First question for you folks is sort of on the progression of that impressive comp throughout the quarter. Dan, you sort of hinted at it when you talked about the annual Big Sale but any color you can provide as to sort of the cadence of the sales pace throughout the quarter?

Yes, in a couple of places we mentioned that there was continuously strong demand, so we did have a successful April Big Sale that drove in incremental traffic. We were able to hold our pricing discipline so it didn't have as much impact on margin but we were pleased that the initiatives that we had in place, the expansion of our advertising programs drove consistent demand across the quarter and we finished as strong as we started.

That's good news to hear. On the ticket increase, you talked about the demand for premium goods within category. Are we getting any sense of a switch between categories maybe from the laminates up to the engineereds or the engineereds up to the hardwoods? Are we starting to see that at all yet?

Not of any significance. Still the premium product preference by the consumer is in the lower than average retail price point category, the laminates, the bamboos, and some of the engineered hardwoods. We really haven't seen any kind of the major shift back to the solid hardwood yet.

Okay. The last one for me then, Dan, would be on the expectations for the ad expense leverage throughout the rest of the year. It sounds like the second-quarter sales took you back a little bit but how about the rest of the year? Would you expect that that percentage to be flat in the third and fourth quarters?

TJ, we have said and we are continuing to say that we are going to invest our advertising dollars at roughly the same rate we did last year, rate as a percentage of sales. As you said, we were able to generate more traffic and more sales volume in the second quarter with that investment by broadening the message in the consumer base as well as reallocating some of the dollars to more effective programs and that's going to be our cadence in the second half that will go into each quarter expecting to spend the same percentage of net sales as we did in the previous year.

Congratulations again and thank you for taking the questions.

Brad Thomas, KeyBanc Capital Markets.

Thanks and let me add my congratulations on a great quarter here and some nice momentum. Just a question on the store growth rate. Obviously this is a year where you guys have slowed the rate of growth. With the success that you are having in advertising and some of the in-store initiatives, is this kind of high single digit to 10% unit growth rate the right rate for the next few years or do you think you may want to accelerate that again?

This is Rob. I will take that. What I would reiterate is that we continue to be very excited about our opportunity to expand. We feel that we have a significant opportunity to expand both in our existing stores and our new stores. Hopefully this quarter shows that we have a powerful store model. It throws off a lot of cash. We have short-term leases. It gives us flexibility.

So you know the thing that we did this year was under the umbrella of driving continuous improvement, we slowed that pace down so that we could kind of dig in. We mentioned on the call some of the benefits for the new stores and the improvements in the site selection process. We also talked about our store format of the future.

So what we're doing is we're being really thoughtful about testing and kind of looking under the hood in the other parts of the real estate strategy and that's going to be kind of where our focus is going forward. We are not prepared to talk about any change in the new stores going forward where we feel good about where we are for this year. We are on track to hit that number and again, the short-term focus is really going to be around continuous improvement on the other parts of the real estate strategy, which we are excited about what's going on with the site selection. We are excited very much about how the new stores are doing.

So I think the exciting thing is that we see opportunities as we did this quarter to improve the comp stores as well as the new stores as we go forward and as we come out with that new format.

Great. And Dan, if I could follow up on some of your comments about transportation costs, I think you said that was a 35 basis point benefit this quarter. If memory serves me, it was about a 65 basis point benefit in the first quarter. I know there are a number of kind of puts and takes here. What are you expecting in terms of transportation net impact in the back half of this year?

Brad, we actually had 120 basis points as we group it under transportation for the second quarter so stronger than the first quarter now gives us about 90 basis points of improvement for six months. Within that I'd called out 35 basis points of really what are controlled expenses. Once it's delivered to the first sales floor, we can control transfers between stores and make sure we've got the proper revenue and cost equation for delivery to the customer. We felt that those controls we have put in place benefited us by about 35 basis points in the second quarter.

Transportation from an international container rate perspective is going to continue to increase, at least we believe it will into the third quarter. Whether the overall demand is there to sustain that throughout 2012 will be a question, but right now we are preparing for higher rates to continue into the second half of the year. We think we can mitigate some of those increases through some of our supply chain initiatives including more direct deliveries to the stores, continuing to look for the most efficient route between warehouses and stores.

So we see rising costs. We actually think domestic fuel may actually wind up stable to down just again a function of the macro environment. Expect second-quarter benefit to be the largest of the year but we think we can mitigate rising costs through supply chain initiatives.

Great, if I could just follow up on the earlier question about trends in the quarter, it sounds like your run rate is still very good. Obviously the Company is up against much tougher comparisons in 3Q and 4Q. I think your guidance technically implies about a 2.5% comp in the back half of the year. Why wouldn't we see higher than a 2.5% comp in the back half of the year? Is there anything besides the comparison that you think could slow things down? I'm just trying to get a sense for how you guys are suggesting we model the back half.

Brad, I think it's more of a factor of uncertainty and volatility that we expect from the consumer for large ticket discretionary. As we look at these last months of 2012 with all that's going on in the macro economy, we are a little concerned about what that might do to our consumer. We believe we've still got the ability to take market share. We are in a highly fragmented market, as you know. The initiatives we are putting in place or that we have in place will continue to drive traffic. The sourcing initiatives provide us with the currency to continue to grow operating margin as we drive that traffic, so the guidance is reflective of us continuing to execute but in a very uncertain macro environment.

Great. Thanks again and congrats on a great quarter. Best of luck.

Peter Keith, Piper Jaffray.

Good morning. Great results. I was hoping to get a little more detail on some timing around the line reviews, so it was my understanding you potentially completed line reviews for laminate, engineereds, and bamboo at this point. I'm curious on how those are rolling in from a timing standpoint as a gross margin benefit. And then if there has been any other line reviews completed beyond those three categories at this point?

What I would say is we are very pleased obviously as you see the margin pick up and how the line reviews are flowing through. And I think we want to reiterate the long-term there that we see this as a multiyear ongoing process that is going to be cumulative. You are pretty close on the percentage of the line reviews that have been completed. They are still flowing through in terms of the ones that have been completed and then we are in the process of scheduling and conducting additional ones so that we complete the entire business as we go forward.

We don't have specific timelines on that but our expectation is to continue to do them one at a time, implement and execute them appropriately.

Peter, I might add that you are probably seeing the full impact of the laminate line review and beginning to see some of the bamboo line review and some of the engineered hardwood line review. The laminate line review is the first we did and I think you need to think about it as we are passing through this percentage of our sales mix the first time, that this isn't a one-time event. We may continue to go back and look at components within the laminate category itself and have many line reviews, if you will.

So as we are going to pass through all the categories we certainly can come back and look at where we may still have opportunities within the assortment.

And I would add to that too, the laminate line was the first one we did and these things are -- they evolve over time so Dan is absolutely right as we get through and complete all the other categories including moldings, including accessories, we are going to go through everything -- we will cycle back around and get back to laminates and based on my experience and our expectations, there absolutely could be continued benefits there as we come back around to that one.

I also mentioned to give you a little more color, we talked about Brazil, getting closer there and more direct. That is -- again that's part of the overall strategy around line reviews and getting closer to our vendor partners and taking more control over our sourcing. That in and of itself will get benefits and actually will lead to line reviews there as well down the road as we get closer to the mills down there and actually look to expand the mill base.

Thanks for that feedback. It's helpful and it's actually a great time for the question I add, which was on the direct sourcing in South America. How should we think about that benefit in the context of what you've gotten with the Sequoia acquisition? Sequoia was probably handling about 40% of your sales. I'm guessing that South America third parties are handling a much smaller percentage but at the same time you're not bringing on additional cost of an acquisition. So how should we think about that benefit relative to what we are currently seeing here with Sequoia?

Peter, you're right in thinking about the size differences between China and South America. Based on the mix right now, South America is maybe a quarter of what China represents. If we see some of the solid hardwood sales mix begin to shift back sometime in the future, that may become a larger percentage of our mix again. But overall, we are pretty excited with the changes that we have made. We are striving to make sure we have got a direct relationship wherever possible. That certainly sets the stage for future line reviews once we have that direct mill relationship.

And the investment in some of the QC/QA in Brazil, we started that some number of years ago. We believe it was top notch and we found a different provider who is also going to provide us with top-notch service there. So the cost structure may change a bit. Going to the mills directly will certainly add some benefit but from a scale perspective, it's about a quarter or even -- the benefit is probably even less than a quarter of what the China benefit was.

Okay. Thanks, Dan. That's helpful. The last question I want to ask was the impressive mix shift you saw in attachments with moldings and in tools, was that driven by -- was there acceleration with molding attachment or are you starting to see some real nice pickup with tools as those came into the store in the second quarter?

This is Rob. What I would say is that has to do -- really it's a benefit out of our drive and focus on continuous improvement. As our Chief Merchant, Bill Schlegel, and his teams have dug in with the vendors and done these line reviews, it's not just been about first cost. It's been about the assortment expanding -- Dan just mentioned expanding one of the most exciting things about Brazil in South America is us getting access on -- from an assortment perspective to an expanded assortment and expanded supplier base both in Brazil and outside Brazil and other countries in South America. That's exciting for us long-term in terms of having the best selection in the industry.

Back to your question on accessories and moldings, it's really about attachment. I think it's also about improved assortments across those categories coming out of the line reviews and that as we've upgraded investment in our merchant team and then I also think it's a nice -- we are getting a nice benefit from our best people initiative and the focus and the training and the improvement in execution at the store level leveraging our SAP system -- reporting and tracking more -- better at the store and associate level on attachments and how we are meeting our customers' needs.

So that's really what it's more about. Tools is a nice add. It's a no-brainer complement for our customers as they need a tool to install a floor but I would say that was partial but more significant were the other two things in terms of the overall general improvement of all the accessory assortments and then our focus in the stores.

Thanks, that's a nice summary. Congrats again and good luck going forward.

David MacGregor, Longbow Research.

Good morning, everyone. Great quarter. Just while we are on moldings and accessories, maybe start there. How much of the improvement was just related to the revised incentives programs at the store level?

Hard to attribute direct relationships between the incentive and the attachment rate, David, but I am right there with Rob in that it's our people, having the right accessory there and presenting them well to the customer and adding flooring tools, which was the natural extension, all makes sense. But it takes the person to make sure that they round out the ticket for the customer so I think the best people initiative is the main driver of the increase.

I want to add to that too, everybody. What I see there too is pushing up a level. The Company is really working well together across departments. We have made significant improvements in -- around again -- I'm going to be on this continuous improvement. Our supply chain teams have stepped up and driven continuous improvement. We invested in expanding our DCs last year. We have invested in our merchant teams.

We have invested in our best people initiative and the training and then leveraging of the SAP system and measuring and incenting -- yes the incentives are part of it too but I would tell you my sense is the overall engine is running better. It's tuned up. From a store -- think about it from a store perspective. The quality of the shipments that are coming, the timeliness, the availability of the product, the improvement in the assortments, the improvement in the advertising and reach and frequency in terms of driving traffic, it's all making the stores jobs easier.

They have -- think about that. You free up an hour for the average associate in the store and that gives them an hour to sell the whole project to attach, to give you everything you need for that floor and not just the floor. I think that's a lot of what we're getting through some real good side benefits from just better executing across the board.

Okay, I guess I wanted to ask you about gross margins in kind of a longer-term perspective here. Rob, since you arrived, you've obviously been a very positive catalyst to the performance of the organization and so a lot of changes have been made. The Company was always kind of a 34%, 35% gross margin generator. Now we're seeing 37%. How do we think about where we are going longer terms in terms of all the initiatives you have underway, where are we going in terms of a more normalized gross margin?

I would tell you not a specific number for you. I would tell you it's all about continuous improvement and reaching our full potential on that. We believe confidently that there -- this is a multiple year benefit and that it would be cumulative and we're going to stay focused on it, so more to come. Stay tuned.

Do we think about it correctly by thinking about expanded gross margin or is the right way to think about it is you are just going to have more resources to take down into advertising and promotion and market share development?

Knock on wood, we are very excited that we have the opportunity to do both. It's not just in the sourcing and in the merchandising team but what Carl Daniels and our supply chain team is doing and supply chain, what the stores are doing in their execution. Dan talked about it and hit on it relative to some of the things the stores are doing to protect the margin. All that adds up and creates a fuel and a currency for us to reinvest and we are excited about that. As we did in this quarter, we see the ability to reinvest in the advertising, in the promotions in some of the margin, but also drive a nice chunk of it into operating margin expansion as well. So I see both those things happening going forward and it's not one or the other.

Okay, last question. You are spending more on advertising, so presumably improving your draw rates. You've improved incentives at the store level, so presumably increasing your conversion rates there as well. What does this all mean for how we should think about new store productivity or productivity in new stores over the first three years going forward?

We've have always targeted the mid-50 range for new store productivity. We certainly saw that increase significantly due to some of the changes in maturity. We have invested in our real estate people as well as our process and we do feel like we are getting better locations. I don't mean just physical locations but locations that are in traffic areas that are appropriate to our value proposition that are laid out well and with the best people in place. So the stores while we haven't changed our advertising strategy around the new store, we are certainly more prepared to open that store and execute well.

Because of that, we have seen new store productivity rise into the mid-60s. We expect that to settle down in our guidance for the second half of the year but while we don't have a specific number I would say the mid-50s are probably going to look low in the periods to come.

Right. Keep up the great work. Good job, guys.

Matt McGinley, ISI.

Good morning. I have a follow-up question on the one that was asked on gross margin. So of the 250 basis points you got in the second quarter as it relates to mix and sourcing, how much was a split of that between what you got for mix and sourcing? It sounds like longer-term you said you thought a lot of these benefits would be sticky and that you could continue to ramp this up over time. But given you ran at 37.3 for the last two quarters and as you said before, the second quarter is typically your lowest quarter for gross margin, would you expect that just mathematically based on the way that the business trends that you would have a higher margin rate in the back half?

Matt, certainly the way the business has trended in the past we would expect Q3 and Q4 to be higher than Q2. Normally, though, we wouldn't have expected Q2 to be at the same as Q1 but that said, where we may see some continued improvement. Certainly on a gross basis but just as we have said in some of the previous discussions, we are going to look at that as a benefit that we are going to reinvest to drive traffic and capture share.

So while we expect that we can still continue to expand gross margin, we're going to keep that option open. We haven't broken out the two drivers within the 250 basis points but I will tell you that there's a significant piece from each. The moldings and accessories capturing more sales mix, drives that cost of product and the sourcing initiatives have just been a continuing cumulative source of benefit.

Got it, thank you. Then on the second question would be on the transport costs, you called out the decline in direct store shipments declining from 27 to 18. I'm not sure if you were talking about that with a 35 basis point impact that you had on that. And if so, I guess when would you cycle through -- when would you expect to get back up to the same kind of direct to store shipment rate and if that 35 basis point is not correct, what was the impact that you had specifically in the quarter? And then how does that cycle through for the rest of the year?

Yes, the 35 basis points was actually related more to our store to store transfers and then store to customer costs. So from the first sales floor all the way to the customer, we put some controls in place, executed at the store level as well within the supply chain to reduce those costs. So we got 35 basis points of benefit there which we think we will be able to maintain in the second half of the year.

The direct-to-store program, rates are lower as a percentage of total receipts as we transition vendor mills. It's -- as you transition a product line from one vendor to another, it is hard to immediately have that vendor mill supply the entire product need. So we bring more of it through the warehouse so it can be allocated out to the stores.

As we complete that transition by the -- we are thinking the end of October of this year, we will be able to return those percentage directs over last year and we still think for the year we can achieve more than the 23% we did last year.

Having called out the specific benefit but you know some of the metrics that go into directs versus through this warehouse mainly with regard to stores west of the Mississippi, certainly on the West Coast, there's significant savings in both transit time, container costs, and as you start to move towards the Mississippi, the benefits decrease. We are in a situation where we have slightly lower domestic fuel costs. All of that to say we are going to see some benefit by seeing those directs go up in the second half of the year.

Was that a material offset to the 120 basis points you got from transportation? This direct to store shipment?

It's important. It's strategic.

Okay, thank you.

John Baugh, Stifel Nicolaus.

Thanks and my congratulations as well. Terrific quarter. Just jump right into it. Maybe approaching this gross margin thing from a slightly different angle, I recall adding up between Sequoia and all the line reviews, 400 to 600 basis points of gross margin potential. And then the question was how much would you reinvest in terms of lower price points or greater promotions to at the time compete with some of the increased competition? I'm just curious whether you could tell us is that amount that you think you're going to have to reinvest less or what are you reinvesting or how do we think about that?

I will start and I will kick it to Dan. What I would tell you is we absolutely -- the gross margin benefit is definitely net of some reinvestments and promotions and driving traffic and that's for us the exciting thing is the opportunity that as we continue to generate these benefits, we would have that flexibility. And it's something that I hope you can understand that given some of the uncertainty out there, it's something that's fluid. It changes real time on you and so the exciting thing is as we have the opportunity.

And our overall goal and objective is to really balance that art and science because you really can't run a model and say this is, John, this is exactly the amount of basis points you should reinvest. It's something that we're looking at on a daily and weekly and monthly basis as we run the business.

Is it fair to say, though, that because your results were good maybe you didn't have to reinvest as much as you thought? Would that be a fair to your balancing act comment?

Yes, possibly, but we did reinvest some. These numbers are net but we are not sharing all the details underneath.

Well, and you shouldn't for competitive reasons. Quickly jumping to advertising, is there -- it's clearly having a positive impact. How are you measuring your reach? You mentioned this casual consumer and I think a more direct focus on your DIY. How do you know other than traffic that it's being successful?

Really it's eyeballs and eardrums. As you take the channels and as we expand in terms of the channels that we are going after, as you go into it, John, what we are doing is we're thoughtfully expanding the initial reach and frequency in terms of the media buys and then absolutely based on our -- based on the way we measure our events and the way we capture customer data, responses to ads, calls for catalogs and samples and as they come into the stores, we absolutely have the ability to compare across different types of these media channels and these different types of events that we are doing and see which ones are most effective.

So we actually have a very good kind of read on what's working, what's not working, and obviously we are continuing to look to improve and do more of what's working and less of what's not working.

The thing I would tell you, too, is we are getting benefit from the reinvestment of the prior national advertising leverage in terms of spending more but we are also getting some nice pick up from the improvement in the ROI and the effectiveness of the core spend because we have not just looked at the incremental. We've gone back and looked at everything we do and we're making -- our marketing team is doing a fabulous job of making all of that more effective as well and you are seeing some of that in the numbers, too.

My follow-up final on advertising, you began to implement the programs, what, the beginning of this year? So we still get a year-over-year kick for the latter two quarters. And then secondly, we are in a battleground state here in Virginia. What do you see for media costs and trying to get the same reach as we head towards the election? Thank you.

We started testing in the fourth quarter, to answer your question specifically. We were testing some limited markets and programs based on those we implemented first quarter, beginning of the year. And then we continued into Q2, as we mentioned and to expand it even further. So yes, I would expect we're going to continue to do it throughout the rest of the year.

Relative to the campaigns and what have you, our teams are -- they do a great job at negotiating and placing our ad. We feel comfortable that we are going to be able to find the median and the reach of frequency that we need the balance of the year based on the programs that we do. We're not concerned about that.

Thank you. Good luck.

Laura Champine, Canaccord Genuity.

This is Jason Smith. I'm on the line for Laura today. Congratulations, guys. My question is just a quick question. If you can give us a sense as to what is embedded for ticket growth in the comp guidance going forward?

Ticket growth?

Yes.

We have come into the year expecting it to be flattish and maybe slightly up, maybe slightly down and for traffic to carry the ball. Haven't changed that dramatically. Certainly we are pleased with the attachment rate increases we have been able to get in moldings and accessories, so I would say we are now looking at probably a slight increase in ticket with the rest carried by traffic.

Okay, great. Thank you very much.

Thanks a lot.

Matthew Fassler, Goldman Sachs.

Thanks a lot. Good morning to you. First question relates to traffic. You obviously have the reported transaction account number, which is up nicely. It was interesting that your advertising dollars were not up dramatically and I wonder what you are seeing in terms of conversion rate in the stores? Obviously over the past couple of years, there had been some distraction associated with SAP and with the supply chain that was a bit stuck in the mud. Do you feel like it's the feet in the door that are going up or your ability to convert the customers that walked in, if you have a way of measuring that?

Matt, I think it's absolutely both to your point. Now that SAP is behind us, it seems we are back at full stride. They've got more time and capacity to close the sale and then we absolutely feel our close rates are improving in the stores based on execution and training and then obviously the advertising reach and frequency is driving footsteps.

Once again, I know this came up a bit earlier, you talk about reach and frequency, you levered advertising nicely -- your advertising dollars were up substantially less than your growth of stores and obviously less than your growth in sales. So can you just reemphasize what you are allocating away from as you -- as we increase efficiency there?

Yes, we are going through and we're taking a very methodical approach under this continuous improvement philosophy and going through with the marketing teams and looking at really just the ROI of each category of spend and each event within that category, Matt. Then even within things we are continuing to do, we're looking at where is the point of diminishing return where you can reallocate dollars away from that one extra catalog or that one batch of extra postcards and reallocate those dollars to somebody's new programs that are really effective for us.

So that's what we're doing. We're just managing the marketing P&L and going through and reallocating those dollars to be more effective.

Got it. Dan, in the Q and a bit on the transcript you go through a couple different ways of thinking about both young store comps but also cannibalization. I am not sure if the way you framed cannibalization is the way you framed it in prior quarter. So if you could just give us whatever comparable trends you can talk to us about in terms of cannibalization and that impact obviously on same store sales and how that's evolved from Q1 into Q2?

Sure, we calculated it the same way as we had been in previous periods. Just trying to reiterate to that -- the cannibalization is down. Really part of it is the performance of the store, the strategy we have taken from a total market perspective, but also just a decrease in the number of stores we have operating in markets with an existing comp store and that's how we define a cannibal.

We are less than half as far as that standpoint and we have seen the way we calculate cannibalization, which is comp of over the entire chain versus comp without those markets in it. We've seen that drop in half.

This quarter for the first time, we saw comparable stores in those cannibalized markets comp positive and the total performance of the market increased by nearly 33%. So still calculating the same way but very pleased with the results but wanted to make sure everybody understood there is a driver and that is just the number of stores, which kind of goes with the improved performance of the stores.

And then what is the single point cannibalization number Q2 and then Q1 please?

We calculated 130 bps in Q2, so we would have had a 13.7% increase in comparable stores if we remove cannibalized markets. Last year I think we had significantly more. I think it was 380.

Okay and in Q1 of 2012?

Q1 was 160 maybe. I will have to check that. I think the total for the six months is now 170. I don't have the Q1 number.

Got it. And then the final question you talked about Brazil and some of the enhancements there. It seems like there's a couple cents of write down essentially as you cleaned up some of your vendor relationships there. That if anything depressed the number that you reported would've been stronger. I guess those losses are real losses, so can you just remind us where on the P&L those losses would have shown up or did show up so we can kind of adjust them if you will for their exclusion?

That's correct. Two places. There was a vendor relationship that dates back a number of years and as we have challenged some of the relationships and looked at the expansion of mills in Brazil and South America, this was a relationship that was not going to be sustained. There is about $300,000 or so that is in -- adverse to gross margin -- about $670,000, $675,000 in other SG&A.

Thank you so much.

Rick Nelson, Stephens.

Thank you. You said the mix shift toward moldings and tools. I am wondering if you could speak to the tool category specifically, which is relatively new to you how that's performing from a sales and margin standpoint?

Rick, it's very new. It really only had 2, 2 1/2 months while it was out there in most all stores, so it's a little early and I don't want to take anybody in the wrong direction. But as far as complement to the accessories and in the moldings and accessories together. I think Rob's point of the main driver being the overall supply chain, giving the stores what it needs and then the fantastic people in the store increasing the attachment rate. So it's a natural extension of what we do. It certainly makes sense to have it out there for the DIY customer, but it's still a little bit too early to start thinking of that as a driver of the moldings and accessories attachment rate.

And it was also mentioned the development of a new store layout. I am wondering how that might differ from the existing store prototype?

Yes, it's really again continuous improvement. As we enhance the real estate team, added to the committee that drives that with Dan on there, my Chief Merchant on there, my Chief Marketing Officer on there, what we are looking at is how can we evolve that thing and take it to the next level in terms of the mouse trap. So it is taking our store, our showroom and taking it to the next level and looking at what we're doing is we're looking at it from a customer's perspective. How do we lay out the store? How do we present the brands to the marketplace from the outside? As you go into the store, how are these categories laid out? What assortments and categories within the existing box could we expand and/or better present to take better care of the customer and to make it easier for our store associates? So that's kind of what we're looking at doing.

It's early. We are in the strategic planning stages. We are planning as we get it developed to test it obviously in existing stores, new stores and in terms of existing stores, remodels and relocations. I think that again is a focus towards driving continuous improvement in the performance of our existing box.

And how high is that store level productivity on a unit basis at either a new or an existing store? So that's kind of the goal and the approach we are taking. We don't have any dates or timelines on when we are going to get it out there but obviously as soon as we get one that we can show you, we will be happy to take you guys into the store.

If I could ask about the market share gains that you referred to, do you think that's coming from the home centers or the independent chains?

We operate in a very fragmented market as you look at it and there's still 13,000, 14,000 independents out there, so we haven't seen any shift in where the share is coming from?

Thanks a lot and good luck.

Thanks, Rick. Thank you, everybody, for joining us on today's call. We look forward to speaking with you again on our third-quarter earnings call to provide an update on our continued progress in executing our strategy and achieving our long-term objectives.

This concludes today's teleconference. You may now disconnect your lines at this time and thank you for your participation.