O'Reilly Automotive Inc (ORLY) 2004 Q2 法說會逐字稿

Good afternoon everyone, and welcome to the CSK, Inc., second quarter earnings conference call. At this time all lines have been placed on a listen-only mode, and the floor will be opened for questions and comments following the presentation. I would now like to turn the floor over to your host, Mr. Maynard Jenkins. Sir, you may begin.

Thank you. Good afternoon, and thank you all for joining our second quarter conference call. Joining me today on the call is Martin Fraser, our President and Chief Operating Officer, Don Watson, our Chief Financial Officer, and Lon Novatt, our Chief Administrative Officer. At this time I'll turn it over to Lon, and he'll address the forward-looking statements disclosure concerning this call as well as provide an outline for the call. Lon.

Thank you, Maynard. Good afternoon, ladies and gentlemen, and welcome to our second quarter call. Certain statements within this call are forward-looking statements. These statements discuss, among other things, expected growth, store development and expansion strategy, business strategy, future revenues, and future performance. The forward-looking statements are subject to risks, uncertainties, and assumptions, including but not limited to competitive pressures, demand for our product, the overall condition of the economy, timing and number of equity awards issued, factors affecting the import of products, inflation, consumer debt levels, factors impacting consumer spending and driving habits, conditions affecting new store development, weather conditions, and litigation and regulatory matters. Actual results may differ from anticipated results described in these forward-looking statements. Additional information regarding these and other risks is contained in the Company's periodic filings with the SEC. Unless otherwise noted the following financial information is presented on a GAAP basis. Don will include in his remarks, for purposes of assessing the comparability of other financial performance of our -- financial performance with prior periods, a discussion of free cash flow and net debt, which are non-GAAP measures. The corresponding GAAP measures and reconciliations with the non-GAAP numbers are available in the Company's earnings press release issued earlier today which is posted on our Website at www.cskauto.com, under investors, then press releases.

I would like to define a few key terms we will use during the call. Second quarter refers to the 13 weeks of fiscal 2004 ending August 1, 2004. Last year refers to the 13 comparable weeks for the second quarter of fiscal 2003. Year to date refers to the 26 weeks of fiscal 2004 ending August 1, 2004. 2004 refers to the 52 weeks of this current fiscal year. 2003 refers to the 52 comparable weeks of the prior fiscal year. Per share refers to a fully diluted share of our common stock. I would now like to provide you with an outline for today's call. First, Maynard will provide an overview of the second quarter and touch on some of our accomplishments. Next, Martin will discuss key operating results. Third, Don will review our second quarter financial results and address our financial outlook. Maynard will conclude with an update of our 2004 goals and key initiatives. We will then open the call up for your questions. I will now turn the call over to Maynard Jenkins, our Chairman and Chief Executive Officer.

Thanks, Lon. Second quarter was certainly a challenging one for our Company, and the retail industry as a whole. The slower than anticipated sales of heat related replacement product was the main contributor of our sales decline. We believe our sales have been negatively impacted by higher gas prices and a milder summer temperatures in many of our key markets. Despite the challenging sales environment, which resulted in a 2,5% decline in our same-store sales for the second quarter, we achieved some positive results in the quarter and remain optimistic about the long-term prospects of our business. Net income for the second quarter was $13.9 million, or 30 cents per share, which is at the high end of our revised guidance issued on July 7, 2004. Our gross profit rate increased almost 50 basis points year-over-year. Our inventory management process allowed us to effectively control our FIFO inventory in a difficult sales environment with only a slight increase in inventory year-over-year. Our free cash flow generation was strong for the second quarter. We generated 29.3 million of free cash flow for the second quarter and 39.6 million for the year to date.

In addition, we utilized $19.8 million of the $25 million previously authorized by our board of directors to repurchase approximately 1.3 million shares for our common stock during the second quarter. At the end of the second quarter, we operated 1,123 stores compared to 1,108 at the end of the same quarter last year. An increase of 15 stores. During the second quarter we opened nine new stores, relocated two stores, and closed three stores, for a net increase of six stores. We are on track to meet our goal of approximately 45 new or relocated stores for 2004. Consisting of approximately 35 new stores and 10 relocated stores. The Company expects to close approximately 10 stores at or close to their lease expirations in 2004. This will result in a net store increase of approximately 25 stores, or a 2% increase in square footage for 2004. Our long-term objective is to continue to accelerate our activity to open new stores in and around our existing markets. Despite what we believe to be short-term economic and business related challenges, we and others have experienced over the past several months the industry fundamentals remain positive.

Favorable long-term industry growth drivers continue to be: increasing number of total registered vehicles, increasing populations of new licensed drivers, increasing average age of the vehicles, increasing number of miles being driven per vehicle, and a growing number of light trucks and SUVs. Over the long term these growth drivers will continue to result in more customers, rising dollar average tickets, and ultimately more dollars spent on automotive maintenance and repair of accessories and hard good parts for those automobiles. We are optimistic about the enthusiasm and demand by our do-it-yourself and commercial customers for our products given these solid industry fundamentals. Although we are not happy with our second quarter earnings we continue to manage our business toward achievement of our longer term goals and key initiatives. We expect this will result in strong earnings over the long term as the sales momentum returns. We remain committed to debt reduction and improved leverage, maximizing the productivity of our existing stores, maximizing cash flow from operations, and acceleration of our new store growth program. Now I'd like to turn the call over to Martin Fraser, our President and Chief Operating Officer.

Thank you, Maynard, and good afternoon, everyone. As Maynard indicated demand was down significantly in our heat related products such as air conditioning, cooling accessories, batteries, starters, alternators and water pumps. Our financial performance for the second quarter was not what we expected. While the Company has undertaken several initiatives in response to the softness in sales we have maintained our focus on our long-term objectives and have not overreacted to the short-term sales impact. We remain committed to our current merchandising strategies. We have continued to refine our core auto parts product offerings, improving our selection and inventory performance. In addition, based on the success of our new product offerings we will continue to introduce additional items that maximize store productivity. These new items, along with our broader selection of core automotive products enhance the customer experience inside the store giving our customers additional reasons to shop.

We continue to tailor our marketing program to be more customer and community specific through our advertising media and sports sponsorship. During the second quarter we continued with our "We got it" ad campaign which speaks to our broad assortment of replacement parts and accessories. Our extensive print advertising program is supported this year with additional broadcast and outdoor advertising reinforcing the "We got it" message. We've increased the flexibility of our ad plan to take better advantage of local market sales opportunities and seasonal trends which are important to a chain with our geographic range. In addition we continue to implement new advertising initiatives such as the recent introduction of our weekly print advertising being available on our Internite (ph) set, excuse me, our Internet site at cskauto.com. Now the just over 1 million visitors to our Website each month can not only locate the nearest CSK store but can also browse our weekly ads. CSK continues to use motor sports as a way to reach our customers. We are utilizing our major NHRA and NASCAR event sponsorships in a chain-wide consumer sweepstakes to increase store traffic and excitement. We continue to work with the NHRA to address a serious public safety issue. Earlier this year we introduced our "Race on the track, never on the streets" program. In each CSK market visited by the NHRA Championship Series, our drivers visit high schools in association with local law enforcement agencies to speak against illegal and dangerous street racing. The public and media response to this program continues to be extremely positive. We are very proud of this program.

In the short term, as we experience softer sales, our field organization remains focused on superior customer service in an effort to increase customer satisfaction and average ticket. We remain committed to our great customer service program. We continue to encourage and support the synergies between the retail and commercial areas of our business to improve our efficiency, productivity, and overall operating effectiveness as well as enhance our sales approach for both the retail and commercial customers. Commercial sales continue to represent approximately 17% of our total sales. We believe strongly that our offering of a broad assortment of brand-name products represents quality to our commercial installers. We remain committed to enhancing all aspects of our commercial sales program with new and innovative merchandising and marketing programs. We have developed additional marketing and merchandising strategies which recognize the unique needs and expectations of our commercial customers. These strategies include specific targeting of certain product categories designed to improve the commercial customer's business. In addition, our commercial sales organization continues to take the business to our customers, increasingly satisfying their needs for product selection and mix at reasonable prices with maximum convenience.

For example, our updated Website, cskproshop.com allows our customers quick, convenient, on-line shopping with no hassle prompt delivery. And our commercial customers have embraced our new electronic signature capture billing program for its ease of use and convenience. We are committed to partnering with our commercial customers to make their business as productive as possible. Finally, and consistent with our long-term strategy, we continue to experience year-over-year growth in our national accounts business which we believe has been -- has benefited by our enhanced commercial marketing and merchandising strategies and initiatives. In addition, their ability to contribute on a more consistent basis to the Company's commercial sales objectives. Our national account customers generally are in a better position to weather short-term economic uncertainties. Now I'd like to turn the call over to Don Watson, the Company's Chief Financial Officer.

Thank you, Martin, and good afternoon everyone. Net sales for the second quarter were 409.1 million compared to 418.5 million last year. This represents a second quarter same-store sales decline of 2.5% which is comprised of 2.5% decline in retail and a 2.6% decline in commercial. The weaker than expected sales have been concentrated in the heat-related products. We were pleased with our continued sales and gross margin increases in our promotional products. Gross profit for the second quarter was 191.3 million, or 46.8% of sales compared to 193.7 million, or 46.3% of sales for the prior year. Gross profit rate for the second quarter increased almost 50 basis points. This increase was achieved through our ongoing ability to negotiate lower acquisition costs of our inventory, improvement in our balance of sales through our category management systems, and reduced inventory shrinkage through the improved procedures and enhanced inventory control system. Operating and administrative expenses for the quarter were 160.4 million or 39.2% of sales compared to 158.5 million or 37.9% of sales last year.

The abrupt change in the business climate during the second quarter did not allow us much opportunity to further leverage our expenses as a component of sales. However, expense control remains a key objective and is reflected by a 1% dollar increase in expenses year-over-year while adding 15 new stores. Our commitment to the ongoing execution of our advertising and merchandising programs even during the difficult -- the current difficult sales and economic climates, reflect our unwillingness to sacrifice long-term goals and objectives. Operating profits for the second quarter were 30.3 million, or 7.4% of sales, compared to 35.2 million, or 8.4% of sales for the prior year. Interest expense for the second quarter decreased by 5.7 million to 7.6 million compared to 13.3 million for the same period last year as a result of our lower outstanding debt and the lower interest rate due to our refinancing late last year. Net income for the second quarter increased by 28% year-over-year to 13.9 million from 10.9 million last year. Earnings per share for the second quarter increased to 30 cents per share on a base of 46.5 million shares as compared to 24 cents on a base of 45.5 million shares for the second quarter last year. This represents earnings per share at the high end of our revised guidance on July 7, 2004.

Net sales year to date were 806.1 million compared to 796 million for the prior year. This represents a year-to-date same-store sales increase of 1.1% which is comprised of 1% increase in the retail same-store sales and a 1.5% increase in the commercial same-store sales. The year to date gross profit was 379.9 million, or 47.1% of sales compared to 368.7 million or 46.3% of sales for the same period last year. On a percentage point basis year to date gross profit increased 80 basis points. Year to date operating and administrative expenses were 319.1 million or 39.6% of sales compared to 307.2 million or 38 -- 38.6% last year. The increase year-over-year is primarily due to the increased store count and the higher payroll rate and benefit related costs. Year to date operating profits were 59.6 million, or 7.4% of sales compared to 61.4 million, or 7.7% of sales for last year. Year to date interest decreased by 11.3 million to 15.8 million compared to 27.2 million for the same period of the prior year. And this was as a result of lower outstanding debt and a lower interest rate that we talked about on the refinancing last year. Year to date net income increased to 26.8 million from 18.3 million last year. This is an increase of 8.5 million, or 46% increase year-over-year. Year to date earnings per share increased to 57 cents per share on a base of 46.7 million shares, as compared to 41 cents per share on a base of 45.3 million shares for the same period last year.

Some of the key financial performance measures for the second quarter as follows: Net debt, which includes cash on hand, decreased by $21 million year-over-year, to 457 million. Free cash flow for the quarter was 29.3 million, and it was 39.6 million for the first half of the year. At the end of the quarter, we had no borrowings under our revolving credit facility. Cash on hand increased by 9 million to 44.6 million compared to last year. And in accordance with our stock repurchase program announced in June we've utilized approximately 19.8 million to repurchase approximately 1.3 million shares of our common stock during the second quarter. This is our reflection of our confidence in the Company's financial strength and overall commitment to the shareholders. We believe that the purchase of our common stock represents a highly effective use of our free cash flow. Accounts payable increased in the quarter by $23 million -- or $23 million as compared to the same period last year. Our accounts payable leverage continues to increase to 36% up from 32% for the same period last year. Consistent with our long-term key initiative to reduce our cost of debt, we obtained a reduction in our term loan interest rate of 25 basis points and an opportunity of an additional 25 basis points reduction in the interest rate achievement of a specified leverage ratio and/or an upgraded credit rating from S&P along with the maintaining the current rating for Moody's Investor Services. We also extended the term loan just over one year to August of 2010.

CSKs Auto outlook is as follows: Based on our current sales trend and in recognition of our 7.8% same-store sales increase in the second half of last year we would expect same-store sales to decline between 2 and 3.5% for the third quarter and to be flat to negative 2% for the fourth quarter. Assuming these results we expect our full-year net income to be in the range of 52 million to 56 million, or approximately $1.13 to $1.22 per share, assuming approximately 46 million shares outstanding. We will expect to end the year with FIFO inventory between 535 and 545 million which will be equal to or a 10% -- or a $10 million improvement over last year, and this is also with an additional 25 stores. This will result in free cash flow for the year of approximately 70 to $80 million. Now I'll turn the call back over to Maynard.

Thanks, Don. Prior to taking any of your questions I'd like to update you on the status of our primary goals and key initiatives which are well underway for 2004. First, we remain focused on reducing our debt while at the same time utilizing our capital to maximize our return on investment. In doing so we expect to redeem the remaining 15 million and 12% notes later this year. Second, we will accelerate our store growth. We are on track to open or relocate approximately 45 stores in 2004, as compared to 25 in 2003. Third, we will continue to strengthen our vendor partnerships to reduce costs from the supply chain and reduce our merchandise inventory. This will provide the ability to improve our merchandise turns and our inventory to payable leverage. Fourth, we'll continue to scrutinize and reduce all expense lines in our business and further reduce our SG&A costs. And finally, we'll continue to focus on our customers' needs through our ongoing improvements in our great customer service program. In closing, I would like to once again stress our commitment to our business strategies and the growth potential of our business. Although we're not pleased with our second quarter results, we believe it is important to let our shareholders know that we will not sacrifice our long-term goals and initiatives. Now we'll open it up for any questions. Nancy.

Thank you. The floor is now open for questions. If you do have a question or a comment, please press star, 1 on your phones at this time. Once again everyone, the floor is now open for questions. If you do have a question or a comment please press star then the number 1 on your phones at this time. Please hold while we poll for questions. Thank you. The first question comes from Matt Nevor (ph) with Thomas Weisel Partners.

Good afternoon gentlemen. The first question is on your SG&A costs in the back half, given that you are expecting a decline in same-store sales, can you -- are there costs that you can take out now in terms of either having people work part-time or reduce some of your advertising to maybe improve the ratio there?

Well, there's two of us that will answer that question. The big question is are we going to reduce our advertising. The appears is no. We think when times are tough, you have to keep yourself committed to your customer and keep yourself in front of the customer, and we just think it's a bad strategy to go out -- our marketing approach, and by saying that we're not saying that we're not going to change things and shift things around a bit, because we are, and that's been in the works for a period of a few weeks for the future rest of the year. I'll let Don answer as far as the other parts of the SG&A question.

Matt, we do look at certain expenses every single week. For example, we'll today forecast payroll at the stores for the next week. So even in light of increasing wages, as far as rate, we would expect year-over-year for SG&A to virtually be flat. But there are things that obviously from when we started the year we've reduced already out of those costs.

Okay. And then the next question is, I'm just wondering, if we look at miles driven, I know you guys have spoken about this before, it seems like it maybe has ticked down in California and a few other states this summer. I'm wondering if you are experiencing the same thing, and what -- maybe just some explanation on what we should expect there and maybe what happened to miles driven, you know, and other times when oil prices have spiked up?

Well, we don't know exactly what the numbers are on miles driven. We take a look at other factors like the information we're getting on mass transit, especially in southern California in the bay area, and in other areas where you have metropolitan areas. We are told that mass transit ridership is up substantially. Now, if there is an issue with what you might call a discretionary dollar going into the gas tank at some point in time deferred maintenance has to be taken care of. And we believe that is going to come to us and to everybody that's in auto parts retailing. Can there be a short-term effect? Absolutely. Can people get other ways to circumvent driving their own vehicle in the short term? Absolutely. We think long term, you know, the maintenance has to be done, and we'll get our share of that maintenance dollar.

Okay. Then the last question is, on the share repurchase, looks like you guys have used most of what was allocated, and I'm just wondering if there's an opportunity to -- if there's an opportunity to increase the share repurchase allocation.

Yeah, Matt, we still have almost $6 million that we can use in the current test as we report the numbers for the second quarter there's another test that says that if your senior debt to EBITDA is 1.5 to 1, then you can buy up to an additional $20 million. But that test is a, you know, an ongoing test, and we first of all, before we could go forward, we will have to go to the board to get authorization to buy that extra -- but, do the extra 20 million.

Okay. Great. Thanks very much.

All right.

Thank you. The next question comes from David Sinel of Gabelli & Company. Please pose your question.

Hi. Good afternoon.

Hi.

Just one question. August, did you see any improvement, particularly in the temp related products, or was it more the same?

More the say. We haven't seen any improvement in our business on heat-related categories.

Okay. And just a quickie, traffic versus ticket in the second quarter.

The -- David, the whole increase in -- has been only in dollar average. There's been a reduction in traffic.

Okay. Thank you very much.

Thank you. The next question comes from Jack Baylos of Midwood Research.

Regarding sales, what was the difference in your comp-store sales results between commercial delivery business and your retail DIY business?

As we've stated earlier in those, one was down 2.5 in commercial, and 2.6 in retail, so it was very similar.

Oh, very similar.

Yeah.

H'mm. I would have thought that commercial would be stronger than retail.

As we have stated, the areas that have been most effective have been heat-related items, and the heat-related items such as batteries, air conditioning, starters, alternators, you know, that would even support the case even more because it's not getting fixed at the commercial bay and it's not getting fixed by the DIY.

Okay. In areas where -- that were not weather impacted, what areas were those, and what was the difference in sales in those areas?

We had a more normalized weather pattern in southern California, Los Angeles and San Diego, and they ran the strongest during the quarter.

When you say strongest, were they up, or just not down as much?

They were not down as much. You could take what the heat-related scenario was out of their sales, and that's just about where they pegged. And when we talk about heat related things, you know, we really don't like to talk about weather bin and all the rest the thing, but just let me give you some examples here. In the southwest here, for the entire quarter the temperatures ran five to eight degrees below last year day per day for the entire quarter. Now, we did have a spike in, as an example, get up to the 110-degree temperature one or two days in the quarter in the Phoenix area, but as an example, a year ago it got up to 117, and anybody that's been in this business for a while knows the difference delta of seven degrees in heat breaks a lot more parts, especially rotating electric and batteries.

I would also point out, back to that question of southern California, where there are more moderate temperatures there. If you take southern California and Los Angeles, which are virtually our most competitive market and more normal temperature, those two regions together were actually positive comps.

Oh, so, was that also true for San Diego?

He said the two regions together.

Southern Cal and Los Angeles together we treat it as one region, and that was positive.

Okay. Final question is. In terms of non-hard parts type items, like scooters and so forth, how did those sales do?

We've done very well on the wheel goods category and continue to do well.

Okay. Thank you.

The next question comes from Todd Beckert of Credit Suisse.

Hey, guys, couple questions. FIrst, could you just clarify, will you be eligible for the additional $20 million in buyback? Is your debt to EBITDA ratio there now?

Look, at this share price the Company believes the stock is undervalued, but we also have an obligation to get permission from the board to buy back the extra 20 million. And what it is, is it's a test of senior debt to EBITDA. Right now if I calculated it today, I could use the $6 million we have left from the original 25 million, and as of today could I buy another 5 million in addition to that. As you go through the quarter and generate more cash that could go up. But it's premature to say that we would do that because I don't have the board's permission to do it.

So when will you seek board permission?

We have a board meeting the end of September.

And we have one in two weeks and, you know we, maybe we do it sooner, maybe we do it later, but, you know, look, we were buying stock at 17 and at 14, and we thought it was very good buy at that deal, so you should assume that we would at the lower level.

Okay. And then in terms of gross margins, have you ever discussed how high they could ultimately go?

Run that by me again.

Your gross margins continue to grow as you're getting better vendor terms. Is there a target as to how high gross margins could get?

Well, I think there's probably got to be a ceiling on it, and as we talked about we would expect for the remainder of the year on a sequential basis that the third quarter would be approximately 30 basis points higher than the second quarter and that the fourth quarter would be another 50 basis points higher than the third quarter.

Okay.

Now, you know, we've talked about we would expect to get 40 to 50 basis points every year in operating margin.

Okay. And then last question, could you give out -- I don't know if you computed it, corporate-wide same-store sales for the quarter excluding the heat-related items?

I think that is proprietary information, and I don't think we ought to be giving that out.

Okay. All right. Thanks.

Thank you. The next question comes from Derrick Irwin from Advest.

Hi, guys, how you doing? A couple quick ones for you, most of my questions have been answered. One, just to clarify when you have been talking about SG&A expenses for the remainder -- for the second half of the year with Matt's question you said you expect to be flat with last year. Is that on a quarter by quarter basis or for the whole year?

To be more specific, we'd expect the third quarter to be slightly higher, and the fourth quarter to be slightly lower, but not, you know, much either way.

Okay. That makes sense. Okay. And I guess the question I have is with regard, I guess you've sort of answered my questions on the gross margins, you did a great job there. But if -- given that it seems that you are -- your margins, or, excuse me, your comps are down largely for weather related reasons due to the cooler weather it seems strange -- that it feels like comp guidance is down for the back of the year when it would seem to me that that would be less of a factor.

When you take a look at where we are.

Yeah.

The current sales environment, and we mentioned a couple of things, primarily the big hit in our comps was heat related. We expect, as we get into the October time frame, that element to go away. Having said that we don't know exactly for whatever reason gas prices may be affecting the retail business. I think if you take a look at the retail business in general across the country, people have had tougher times the last two quarters than they experienced in 2003. We're not going to sit here and promise something that we don't think we can deliver and we think it's premature to say that we're going to jump back to a 3 or 4% comp in the fourth quarter based off all the existing conditions.

Fair enough. Fair enough. The rest of my questions have been answered. Thanks a lot.

Thanks.

Thank you. The next question comes from Gerry Marks with Raymond James.

Good afternoon.

Afternoon.

Was there a LIFO credit in the quarter?

There was no LIFO credit in the quarter this year.

Okay. And just to kind of follow up on Todd's question, the heat-related products, are they typically a lower margin, so was there any mix impact as well on your gross margins?

I think that there -- the margin on the heat-related products is consistent with what we have in the rest of the business.

You know, there are given items that got lower margin but overall there's not a dramatic difference.

Okay. And sales were down year-over-year but inventories were up year-over-year?

Seams were down slightly, and inventory was up slightly, but you have to remember there's 15 more net new stores in that inventory. So on a per-store basis, inventory year-over-year is actually down.

Oh, okay. Then last, the debt seemed to go up sequentially. Is that because of the share buyback?

Yeah, I mean, we used the free cash flow of $20 million, you know, to actually buy back stock, but I don't understand, you know, I've got total debt at the end of the year was a little -- I got it a little lower. We ended the quarter at 502 million in debt. So -- and we ended the year end at 520 million in debt.

You ended the first quarter at how much?

I don't have that off the top of my head, but it dropped just slightly.

Okay. Thanks.

Thank you. The next question comes from Scott Nesson of Lehman Brothers.

Hey, guys. Can you comment on the trend in sales in the last month versus the first two months preceding your inter quarter update? And how would you characterize the overall promotional environment given the impact of weather and macro issues like higher fuel costs?

Well, the, the -- as we stated earlier, our business hasn't improved. Through the week ending Sunday, as far as the promotional activity there are different competitors doing different things trying to improve their position and where their current business status is. But we haven't foreseen any action towards any type of a price war that -- to drive customers into the stores.

Okay. Final question actually with respect to your long-term plans. How would you sort of rank your initiatives as far as debt reduction, maximizing cash flow, and accelerating your store growth? And possibly what kind of store growth acceleration could we see?

We accelerated 2004 from 25 to 45 to 50. We're not ready to commit for 2005 yet because we still have a lot of things going on, but I think we could at least equal what we're doing in 2004 and exceed that. Now, if our site finders and technical people on the production of profitable auto parts stores come up with 55 stores for 2005, there's nothing to say that we won't do it. It's just a matter of making sure that we're getting class-A locations and that we'll end up making money on everything we open. We want to make sure that our growth is not growth for growth sake but it's profitable growth.

Got it. Thank you very much.

The next question comes from Alan Rifkin of Lehman Brothers.

A couple questions if I may. What was the contribution to the comp from the new product offerings and what proportion of your product would you classify as heat related products?

Well, first of all, we don't disclose by product line what portion is the contributor to the comp, and secondly, when you take a look at the heat related products it's primarily -- and I'm saying "Primarily" with a bit of a caveat here. Rotating electric starters and alternators, all the air conditioning product and heat related product accessories with air conditioning and a very huge category that's heat related is batteries. Now, there are other things that can be affected by the loss of the sales of the heat-related product like rotating electric. Your replacement sales on belts, V-belts and serpentine belts and this kind of stuff, can be affected because generally through great customer service program we're pushing our people to sell the customer a replacement belt when they replace the alternator and/or other type of generator or that type of product. So even though we wouldn't classify belts, fan belts, and serpentine belts, and that kind of stuff as a heat related product there can be some effect there because if you sell less generators and alternators you may sell less replacement belts.

Alan, just to follow up on that, and we've talked about it in the past, the categories, batteries, starters, alternators, air conditioning, air conditioning coolant, radiators amounted to a shortfall year-over-year of almost $20 million which accounted for a negative 4.5% comp.

That's very helpful, Don. One follow-up if I may. I can certainly understand, Maynard, your conservatism for the back half of the year. You know, certainly there have been other periods in the past where we've seen, you know, unusually cool weather. What type of trends do you typically see, you know, as far as pent up demand following, you know, the periods when the weather finally does break and it resumes to more normal levels?

Well, Alan, we are not, in our opinion, going to recuperate the sales that are lost. Once you get past the heat-related months, it's not like somebody is going to say, well, now I'll go out and replace my air conditioner or they're not going to replace the battery in most cases unless it breaks. So going forward, it's not like if we lost X million dollars in heat-related categories in June through August that we're going to recoup half of that back in December on those products. Now the key question for us, again, is with the amount of fuel increases there have been out there is there a question mark on, quote/unquote, discretionary dollars going into the fuel tank, and if there are, and that element existed, which we believe it did to some extent in the second quarter, are we going to be able to recoup that thought process and get people maintaining their vehicles the way they should be maintaining. That's why we're hesitant at this point in time to be more bullish on the last quarter of the year when we think it's prudent to do that.

Maynard, I know this is obviously very hard to decipher but if you had to choose between higher gas prices and a milder temperatures would it be correct on my part to assume that it sounds like milder temperatures actually hurt you more than the higher gas prices?

Absolutely, in this quarter. I think Don stated it before when we gave our warning on the 7th of July, and at that point in time, prior to the end of the second quarter, if we'd have just been comparable with a year ago, just flat on those heat-related categories, we'd have been positive comp.

Okay. Thank you, Maynard.

The next question comes from Zach Bradford of Gates Capital Management.

Hello. Nancy, I think we lost that one.

Next question comes from David Dean of DN Partners.

Hi, Don, how are you doing?

Good, David.

What can you tell me about the promotional sales specifically in the southern California markets where I guess, you know, Pep Boys has been a little more active in those markets and then on a related note, how do you get as comfortable with the inventory in general and specifically the promotional products inventory that you're carrying these days?

I don't think it's prudent to break down promotion versus nonpromotion in California, but we did say in southern California where it's the most competitive and normal temperatures, those were positive comps. So we could assume one leads to the other. The second, on the inventory, our inventory has been managed very well. Like we said earlier, we would expect no more markdowns than has normally happened in our business. We also are still expecting in our current trend to have a reduction of between 5 to $10 million in inventory, and that's with 25 million net new stores. So I'm assuming you are asking if we expected more markdowns, and the answer to that's no.

Okay. Thank you.

All right.

The next question comes from Matthew Fassler, Goldman Sachs.

Thanks a lot. Good afternoon. A lot of my questions have been answered. Just to follow up on a couple, I realize that wheel products and the so-called noncore business are doing well but just out of curiosity have you seen deceleration in those categories albeit to a still high level?

No. We are still very pleased with our wheel goods category and very happy that we had the wheels goods category for the first half of the year. Having said that, we're selling a different product today and large quantities than we sold when we first got into the wheel goods category, and I think that reflects a more sophisticated customer and a trend in buying habits. As an example, you know, two years ago we didn't have any what you call pocket rockets, these small little -- look like motorcycles. There are places that you can ride those off the street and everything else, and we're getting customers in the 18 to 25-year-old age groups that are coming in to buy that product and having a great time with them. So it's -- business is evolving, and we said before that, you know, we'll have a product for six or eight months in a given price range, in a given category, and that may go by the way side and it's replaced by something else based off of the customer's needs and customers wants.

I know I'd never sit on a pocket rocket but I hear you. Second -- second question. Can you talk -- just on the financial side, your depreciation was down pretty sharply. I know it was down in the first quarter but I think the decline was more stark in the second quarter.

Depreciation, Matt, was down about 800,000 quarter over quarter. And if you'll notice, the capital expenditures were up and the reason was is that we made a decision that we took some high cost capital leases that we bought out of, and we bought out of those, you know, does cost you some long-term capital but it reduces a lot of depreciation short-term and that's been the major reduction in depreciation.

Got you. And, Don, what are the actual shares out at the end of the quarter, primary shares out?

45,278,186.

Okay. Thanks so much.

Left one out there too, but.

Thank you. We have a follow-up question from Derek Irwin from Advest.

Hi, guys. Actually, two follow-up questions if I could. One, when you all gave your sales guidance on July 7, you know, saying that comps are running negative 2% and if these trends were to continue you'd get the range that you gave and you hit the high end of the range, congratulations, but just curious, was there anything that you changed or adjustments you made through July that allowed you to hit the high end of that range even though your comps came in below trend?

Well, you know, in the retail business, every once in a while when you hit a tough sales trend you just can't sit out there with your feet in clover and think everything's going to get better so you continue with a tight fist on your expenses, you look for every way you can to improve your position there, and then you take a look at the other spokes of the wheel. And, you know, when we gave our guidance on the 7th of July, we were really expecting the heat-related categories to come back because we had, you know, three or four weeks left in July and we got a lot of stores in the southwest with heat-related product and when you take a look at the California marketplace, generally, you get a lot of days over 100 degrees in the Sacramento valley and everything and that didn't happen this year. So when you take a look at our work on the margin, and where we were going with that and our balance of sale there we were able to do as well as we did because of those factors. Now, if we'd have gotten that heat-related product selling like crazy and we'd have had a few more sales in the till, our results on the bottom line would have been even better than they were.

Got you. Okay. And, you know, other than the wheeled items that you've talked about what about the other big ticket stuff, like power washers and compressors? Do they continue to sell well?

Yeah, and to that point, the merchandise mix there is not the same as it was a year ago when we talked on this same conference call. You know, we've evolved the merchandise mix there and what's available and we'll continue to look at that category and many of the items in that category, the power washers and even some of the power tools have been regular stocking SKUs rather than, just quote/unquote, promotional merchandise as we would look at it maybe two years ago. And that's because the customer says, I want to buy it from you.

Fair enough. Thanks a lot.

Thank you. The next question comes from (INAUDIBLE, BACKGROUND NOISE)

Hi. How are you? I have a question on your guidance. I think that, Don, you were talking earlier about the gross margins and it sounds like you were indicating basically in the back half of the year, you know, maybe we can make our own assumptions but the growth margins are going to be up year-over-year. Is that a safe assumption?

No, what I said was, is that sequentially from the second quarter to the third quarter I would expect gross profit margins to be up about 30 basis points, and from the third quarter to the fourth quarter, another 50 basis points. I didn't do a comparison to the prior year because there's a lot of factors that go into year-over-year gross profit dollars.

That would -- wouldn't that imply that the gross margin in the fourth quarter would be down significantly year-over-year?

The answer to that question is the fourth quarter year-over-year would be down, and the reason it would be down is obviously when you get into volume-related rebates you're not going to get the step-ups that you would get historically because of the sales increases.

That would kind of imply that the margins would kind of be down two percentage points, something along those lines.

That would be about what it would be, you're right.

Yeah. Okay. That seems quite large. All right. I guess those are the only -- you said that the SG&A is going to be up a little bit in dollars in the third quarter but down in dollars in the fourth quarter, is that right?

I said slightly up in the third, slightly down in the fourth, but less than a million either way.

Okay. Then finally, how is it that you're continuing to open stores but it looks to me that basically your rent expense that you're giving, you've put in your, kind of the MD&A is kind of flattish, and you kind of presume that you're opening stores and tow is you're renewing leases at higher rates, that that would kind of have a -- a negative impact on your ramp but it kind of almost seems like it's been kind of a favorable swing factor. What is that attributable to?

I think you need to look at the the timing of the closing of the stores in the prior year and the opening of stores in this year. You know, you don't always open the stores at the beginning of the quarter. They could be at the end of the quarter. But, you know, I don't have the rent expense for the second quarter for the Q, but I would expect year-over-year and actually they just gave it to me, year-over-year it actually is going to be up. So, I mean, I think it was a timing. When you look at the first quarter of the stores that were closed at the back half of last year.

Right. And then finally, on this volume rebate, can you just give me a little more insight? Because two percentage points is quite a bit of money, and I guess I'm trying to understand how -- is it from one person, or -- because your inventory isn't really that much different year-over-year. Why -- how is there such a large swing? That's kind of, you know, on the estimated sales in the fourth quarter, kind of $7 million or so, which seems like a large figure.

I mean, if you look at the sales increases year-over-year, you can't always assume that everything you buy has a lot of rebates. I mean, the Company does an awful lot of importing overseas which doesn't come with rebates, and as I've stated many, many times, that over the next couple years you would see some moderation in the gross profit rate, but increase the gross profit dollars per item, and that trend has continued, and as we gave guidance early on in the year we totally expected that the full year gross profit was actually going to be flat year-over-year. And we substantially beat the first quarter, substantially beat the second quarter, so you can't continue to just ramp up and ramp up on gross profit. What it is, it's our reflection to get some of these rebates earlier on in the year versus later on in the year. So it's more of a straight line. And that continued in '02, to '03, and we stated on our last call that it would continue in '04. I think you have to look at, you know, the full year margins.

Great. Thank you.

Again, everyone, the floor is now open for questions. If you do have a question or comment please press star, 1 on your phones at this time. Once again everyone, that's star, 1 on your phones at this time. Mr. Jenkins, we have no further questions at this time.

Okay. If there are no further questions, we will terminate the call. Thank you all for participating, and we'll talk to you on the next quarter call. Thanks a lot.

Thank you, everyone. This does conclude today's teleconference. You may disconnect all lines at this time, and have a wonderful night.