O'Reilly Automotive Inc (ORLY) 2007 Q2 法說會逐字稿

Good morning. My name is Uniki and I will be your conference operator today. At this time, I would like to welcome everyone to O'Reilly Auto Parts 2007 second quarter earnings release conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. (OPERATOR INSTRUCTIONS)

I will now turn the call over to Tom McFall, CFO. Please go ahead, sir.

Thank you, Uniki. Good morning, everyone, and welcome to our conference call. Before I introduce Greg Henslee, our CEO, I'd like to read a brief statement. The Company claims the protection of the Safe Harbor for forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements can be identified by forward-looking words such as expect, believe, anticipate, should, plan, intend, estimate, project, will, or similar words. In addition, statements contained within this press release that are not historical facts are forward-looking statements, such as statements discussing among other things expected growth, store development and expansion strategy, business strategies, future revenues and future performance. These forward-looking statements are based on estimates, projections, beliefs and assumptions that are not guarantees of future events and results. Such statements are subject to risks, uncertainties and assumptions including but not limited to competition, product demand, the market for Auto Parts, the economy in general, inflation, consumer debt levels, governmental approvals, our ability to hire and retain qualified employees, risks associated with integration of acquired businesses, weather, terrorist activities, war, and the threat of war. Actual results may materially differ from anticipated results described or implied in these forward-looking statements. Please refer to the Risk Factors section of the Company's Form 10-K for the year-ended December 31, 2006, for more details. At this time, I'd like to introduce Greg Henslee.

Thanks, Tom. Good morning, everyone and welcome to our Second Quarter 2007 Conference Call. Participating on the call today is Ted Wise, our Chief Operating Officer; and of course Tom McFall, our Chief Financial Officer. David O'Reilly, our Executive Chairman, is also present but he won't be participating in the prepared comments.

I'd like to start off by thanking Team O'Reilly for the great effort in the Second Quarter. Our time continues to offer the highest level of customer service in our business and while none of us were satisfied with our comparable store sales for the Second Quarter, we feel confident that our stores are providing the best combination of service, value, and availability in our business. Second Quarter was a very challenging quarter. In late April, on our First Quarter Conference Call, we discussed how winter weather had returned in many of our markets at the beginning of April, and that business had slowed considerably from the pace we were on in March. With the exception of a few strong weeks during the quarter, that slower pace continued and we ended the quarter with 2% comparable store sales growth and 4.3% through the first six months of the year.

There are a couple of primary factors that we feel presented challenges in growing comparable store sales in the Second Quarter. I hate to talk about how unfavorable weather affects our business, but it can have a significant effect on sales in the short-term. At the end of the day, weather conditions are what they are and over time, periodic favorable or unfavorable weather conditions make little difference to our long term business results, but when looking at a short period of time it can have a meaningful effect. This past quarter, after winter returned to many of our markets in April, we experienced a cycle of much greater than normal rainfall in many of our key markets. This past week, we had our regional Managers in Springfield for our annual mid year meeting and several commented on how the ongoing rain in many markets had negatively affected business, especially our retail business. In the Dallas, Fort Worth area, through the end of June, it had rained every weekend since mid April. Bad weather weekends definitely impact our retail performance. To help define the effect the heavy rains in Texas and Oklahoma had on our overall comparable store sales performance, we calculated our comparable store sales excluding our Texas and Oklahoma regions and the remaining stores in our Company showed a comp store sales growth of 4% even. And that's not considering the other markets that were affected by rain and there were several other markets that were affected by rains pretty seriously also. As I've said, the weather is the weather and maintenance that is not performed today will most likely be performed later, and it all levels out over time.

The other factor of course is fuel prices, which we feel are without question negatively affecting our business. We saw significant increases to record high fuel prices around Memorial Day and then more record highs in some of our markets in late June due to flooding in Kansas brought on by heavy rains which flooded refineries, creating fuel shortages in some areas which drove the price up in the markets serviced by those refineries. Our opinion is that many households are struggling to adjust to the higher cost of gasoline and there is still a significant amount of maintenance that is being deferred, although miles driven continues to look relatively stable. Our most recent information from the Automotive Aftermarket Association shows a slight decrease in miles driven in January and February of this year, and increases in both March and April, which is the most recent period reported.

As we've discussed before, many of the product categories we carry can't be deferred. The customer may decide to save money and buy a value line starter rather than a premium line or a battery with fewer cold cranking amps than they should in order to decrease the cost of the purchase. But if a car needs a starter or a battery or many of the other categories in our business, the component will be replaced if the car is to stay on the road. However, there are categories like accessories that are completely discretionary and application categories like shock absorbers and air-conditioning that can be deferred. This time of year, air-conditioning is a pretty significant category for us, and so far this year, our temperature control business is down 10% on a total sales basis. By that, I mean we're comparing our total sales year-to-date this year to last year and we had about 175 more stores currently open than we had open this time last year.

We have a great air-conditioning program in place this year and feel like we're positioned to capitalize on a seasonal business better than most of our competitors, and we attribute our underperformance to a combination of cooler than normal temperatures in the Second Quarter, all the rainfall we talked about, and the fact that an AC repair can be deferred for some period of time. Recently, with much warmer temperatures in many of our markets, our AC business has improved, and we're hopeful that many of the repairs that have been deferred will be performed as temperatures heat up. With all this said, we're very confident that over time, consumers will better adjust to higher gas prices and they will be built into their household budgets. And weather, as it always does, normalizes in our Company, and our industry will see the benefit of the pent-up demand we feel is being created during this challenging economy.

Our gross margin for the quarter came in at 44.7% compared to 44.1% last year, a 60 basis point improvement. We attribute the stronger than anticipated gross margin to a combination of diligent management of distribution costs which resulted in a decrease of these costs as a percent of sales, our category management efforts, and a slightly favorable product mix related to incremental growth in some of our private label lines specifically related to the point I made earlier about many customers managing very challenging household budgets. We continue to be very pleased with the technology investments we're making in our distribution centers, and the positive effect of those investments are having on our distribution center expenses and our productivity. And we look for those investments to continue to stabilize and improve our distribution costs over time.

Operating expenses for the quarter increased 110 basis points to 32% of sales from 30.9% last year simply due to loss of leverage. We continue to focus very intently on providing very high levels of customer service in our stores within the expense control boundaries that we set for each location. We feel like our store scheduling system is improving our ability to manage our store payroll expense more diligently without sacrificing the high levels of service our customers have come to expect. We feel we'll continue to see incremental improvements in our ability to manage both payroll dollars and customer service levels as our managers continue to learn the new tools available in our system.

Operating margin for the quarter came in at 12.7%, down 50 basis points from 13.2% Second Quarter last year, and net margin was 8.1% of sales compared to 8.3% last year. During the quarter, we opened an additional 44 net new stores, bringing our new store openings for the year to 91 on track to meet our plan to open an additional 190 new stores this year. We ended the quarter with 1,731 stores. These additions, along with some duplication of inventory brought about by our relocation of the St. Paul, Minnesota distribution center, brought our inventory investment to $853 million, a 6.7% increase over the Second Quarter last year, supported by the 8.8% increase in sales. We continue to enhance the proprietary inventory management systems that we developed over the years to insure we have the correct coverage in each of our store locations and distribution centers. These systems use a long list of variables and databases that we've developed based on years of experience in the business that include what we believe to be the primary components necessary to accurately deploy and manage a store's inventory based on the vehicles that exist in a given store's market.

Inventory turnover remained equal compared to last year at 1.6 times on a total asset basis and turnover net of payables improved to 3 times from 2.8 times Second Quarter last year due to our ongoing efforts to negotiate the best possible payment terms with our vendors. Our Accounts Payable as a percent of inventory increased 140 basis points from 44.8% last year to 46.2% this year. And looking back at our sales performance so far this year, there's little question in my mind that higher fuel prices are a primary contributor to the more challenging comparable store sales environment. Consumers are spending more at the pump and have less left for several things, one being maintenance of their car and are having to make tough decisions in maintaining their cars, which results in many cases to maintenance and repairs that are either deferred completely or not performed the way they should be in an effort to save money. We feel this is creating significant pent-up demand in our business.

However, it's going to take time for consumers to adjust higher fuel prices into their family budgets and many are struggling with it. We see this manifest itself in consumers that choose to buy the entry level brake pads or entry level belts and hoses and other product lines in which we offer a value line in addition to our higher quality products. In our professional customer shops, you'll hear the shop owners tell you there are a lot of customers today that want to do the bare minimum to get their cars back on the road, obviously trying to save money. Again, our opinion is that over time, consumers will adjust to higher fuel costs and many of the air conditioners that aren't working will be repaired and the shock absorbers that are worn out will be replaced. People have too large of an investment in their cars and depend on them for the livelihood and safety of their family not to maintain them correctly long term.

We also remain very confident that the growing number of vehicles on the road in the U.S. coupled with the fact that the average age of the vehicles are at record highs are going to continue to grow the overall automotive after market business, and that our business strategy of serving both the retail do-it-yourself market and the wholesale do-it-for-me market with equal focus is the right model for our business. We view both sides of the business as growing, but have seen more growth in the do-it-for-me side of the business of late. We don't think this is necessarily an indication of a long term trend and attribute this to some degree to the ability of the typical do-it-for-me customer to more easily incorporate higher fuel prices into their household budget.

With only three weeks of business so far in the third quarter, it's hard to reflect on that short of a period as indicating a trend for the quarter, as we've seen how quickly comparable store sales growth patterns can change. However, I can tell you that we've been relatively pleased with our sales performance over the past few weeks and are comfortable continuing our comparable store sales guidance of 3 to 5% for the third quarter and for the year.

Again, we want to thank Team O'Reilly for the great effort in the Second Quarter under very challenging conditions and want to congratulate every team member on a solid Second Quarter results. To expand a little further on our continued growth plans and other internal initiatives I'll now turn the call over to Ted Wise, our Chief Operating Officer.

Thanks, Greg. Good morning, everyone. In the area of store expansion, as Greg mentioned, we installed 44 new stores this past quarter, giving us a total of 1,731 stores. That brings us to 91 new stores year-to-date, which is slightly short of our goal of being at 95, which is halfway to our expansion goal of the 190 to 195 stores for the year. This was due to the excessive rains across many of our markets and construction schedules having to be shuffled around. So we'll open a few more stores in the second half of the year than in the first. Also to a lesser degree, we are experiencing and adapting to longer permitting times in some of the new markets, especially in the Northern and Eastern markets. So while we would like to be starting the last half of the year with more than -- about 95 new stores, we will have the balance of the stores in the development process and with more normal weather conditions, see no issues with finishing the year on schedule.

We've expanded our footprint to 26 states with the addition of three new stores in Ohio last quarter. Texas topped the list with 13 new stores, and the balance of the new stores were spread out evenly in 15 other states. Our experience is that balancing our growth throughout our market is more manageable now that we are growing out of 14 different distribution centers. The recent relocation of the Minneapolis/St. Paul DC to a state-of-the-art 328,000 square foot facility is now complete. After the purchase of Midwest, most of our real estate work has been focused on relocations and upgrades to the original Midwest stores. We now have the majority of this work behind us and with a distribution capacity of this new DC, we will be stepping up our new store growth in Minnesota and Wisconsin markets. Atlanta and Indy DC's have plenty growth capacity as we continue to add new markets and grow to the Northeast. An example is the three new stores we recently put in Ohio and our current expansion into the Jacksonville, Florida market. This can be seen with our 13 new Texas stores last quarter.

Growth in Texas and the surrounding Southwest states continue to be good, and for that reason, we have decided to add a new distribution center in Lubbock, Texas. Our development plan for the new ground up DC calls for completion by January to February of 2009. This third Texas DC located in the western part of the State will be much closer and can more economically service a large number of our stores currently shipped from one of our DC's in Texas and Oklahoma. This in return will allow for additional distribution capacity out of some of these existing DC's that are for the most part reaching full capacity. The obvious reason is the growth opportunity in the markets west of Lubbock, such as El Paso and Eastern New Mexico, that will now be within our service range. So with these new DC expansions and the great job that our real estate team are doing finding and developing good store sites, we continue to see good growth opportunities ahead of us. We also relocated ten stores to new buildings last quarter, which brings us to 16 relocations for the year. On top of these relocations, we did 20 major store renovations. That brings us to 32 renovations year-to-date. We also continue to make progress towards finishing the job of installing the new decor packages in all of our stores that we hope will be finished by the end of this year.

Now, for a quick update on store operations systems, our new LMS system -- or computer based learning management -- is fully implemented in the stores, and we are receiving excellent feedback are from our team members. This training system gives us a tremendous opportunity to better educate our new team members as well as our existing team members. The rollout of our new POS or point-of-sale system is underway and scheduled to be completed by the end of Third Quarter. The combination of a new trained system and our new point-of-sale system creates a much more user friendly and learning based environment for new team members that will convert into higher customer service levels.

In motorsports marketing, we had a very busy spring with sponsorship involvements with five NASCAR events and three NHRA major sponsorships. We were also key sponsors in 12 big car events like Super Chevy Show and Ford Fun Weekend and the largest car show in the country back to the 50's in St. Paul, Minnesota. These are major events that draw hundreds of thousands of car enthusiasts that we feel are key prime customers for O'Reilly. O'Reilly continues to also be involved in many racetrack and car show events at the local store market level. To end my comments on the subject of sales, while we wished our comp sale result of 2% better reflected the outstanding effort made by our team during the quarter -- and it did -- I want to assure you that our culture is not to be content with slow business periods due to weather, high fuel prices, or the economy, and we feel there is significant opportunity to increase our market share in both the DIY and professional installer area. O'Reilly team members know and have what it takes to grow business, which is the best availability of quality parts at competitive prices and most important, O'Reilly team members giving outstanding customer service. That being said, we're also hoping for the rest of the summer to be dry and hot. I'll turn it back to Tom.

Thanks, Ted. On to the numbers. Sales were up 8.8% to $643 million for the quarter with comparable store sales of 2% for stores open greater than 12 months versus 3.5% for the Second Quarter of 2006. Year-to-date sales increased 11.4% to $1.26 billion on comparable store sales of 4.3% versus 3.6 in the prior year. Sales to independent jobbers for the Second Quarter of $12.6 million decreased 6.3% from the prior year. Gross profit was 44.7% of sales for the quarter versus 44.1% in the prior year. Year-to-date gross profit was 44.3% of sales versus 43.8% in the prior year. The improvement was primarily due to improved product mix and distribution efficiencies. SG&A for the quarter was 32.0% of sales versus 30.9% in the prior year. The deleverage was a result of low comp sale levels during the quarter. For the year, SG&A was 31.7% of sales versus 31.1% in the prior year. The decrease -- I'm sorry, the increase as a percent of sales was primarily attributable to higher advertising costs and increased stock option expense. Operating income for the quarter was 12.7% of sales versus 13.2% in the prior year. Year-to-date operating income was 12.6% of sales versus 12.7% in the prior year. The tax provision for the quarter was 37.0% of pre-tax income and the year-to-date tax rate of 37.1% of pre-tax income is flat with last year. Net income for the quarter was $51.9 million, 8.1% of sales, versus $49.3 million, 8.3% of sales in the prior year. Year-to-date net income was $100.3 million versus $89.9 million in the prior year. Year-to-date net income in both years was 8.0% of sales. Diluted earnings per share for the quarter was $0.45 versus $0.43 in the prior year on 116.1 million shares, which is a 5% increase. Year-to-date EPS was $0.87 per share versus $0.78 in the prior year, an 11.5% increase.

Moving on to the balance sheet, inventory was $853 million, up $54 million from June 2006. This represents a 6.7% increase over last year versus an 11% increase in store count over the same period. Total assets were $2.2 billion, a $27O million increase from June 2006. The increase is due to increased cash on hand of $37 million and the growth in fixed assets and inventory related to store and distribution growth. Accounts Payable of $394 million was an increase of $36 million over June 2006. AP to inventory of 46.2 increased from 44.8% at June 2006. The AP to inventory ratio was positively impacted by better vendor terms and improved leverage of inventory at the store level and the newer DC's. Debt levels were $100 million at the end of the quarter versus $101 million in June of 2006. Debt-to-capital of 6.3% with debt to EBITDA 0.3 times. Please note short-term debt increased $25 million this quarter, relating to our private placement note that is due in May 2008. EBITDA for the quarter was $102 million, 15.8% of sales. Year-to-date EBITDA of $197 million is an increase of 11.8% over the prior year.

Other ratios, return on equity 13.7% at the end of the quarter. Return on assets, 9.2%, and return on invested capital of 13%. For other financial information, during the Second Quarter our LIFO reserve decreased by $18.3 million; however, $15.8 million of this decrease relates to a one-time reduction in core costs that did not impact our quarterly gross margin results nor do we expect a change to affect our gross margin results in the future. As you will recall, cores are the portion of certain parts that are sold and then the core cost is refunded when the customer brings back the used part, which is then later remanufactured. The remaining $2.5 million reduction in LIFO reserve had a 40 basis point impact on gross margin for the quarter.

Depreciation for the quarter was $18.6 million and $36 million year-to-date. Capital Expenditures: $76.5 million for the quarter and $140.6 million year-to-date. Interest expense for the quarter was $0.7 million and $1.5 million year-to-date. For the quarter, cash flow from operating activities was $63 million with a negative free cash flow of $13 million. As you recall, our First Quarter cash flow was very strong. Year-to-date cash flow from operating activities was $192 million, which represents a 55% increase over the prior year. Year-to-date free cash flow of $51 million is a $47 million increase over year to date June 2006.

Now on to our guidance. For the third quarter, our same-store comp sale guidance is 3 to 5%, and diluted earnings per share guidance is $0.44 to $0.48 per share versus $0.42 per share in the third quarter of 2006. To update our full year guidance, we expect capital expenditures to come in between $240 million and $250 million, interest expense of $3 million to $4 million for the year, depreciation of $72 million to $78 million, the tax rate to be between 37.0 and 37.3% for the year, free cash flow of $30 million to $40 million for the year. Our gross margin guidance for the year is 44.0 to 44.4%. Revenues, $2.5 billion to $2.6 billion. Our comparable -- excuse me, our same-store sale guidance for the year has been revised to 3 to 5% and diluted earnings per share of $1.70 to $1.77 with stock option expense. At this time, I'd like to ask Uniki the operator to come back and we'll be happy to answer your questions.

(OPERATOR INSTRUCTIONS) Your first question comes from Bill Sims with Citigroup.

Thank you and good morning.

Good morning.

Can you compare the number of new stores that will be opened in new markets this year versus last year, and then comment on the maturity curve of stores, especially on the commercial side of the business in new markets such as Ohio compared to your distant markets? Thank you.

Bill, you're saying, well, okay. If I follow your question right, we'll definitely have more new stores out of new markets this year because of really India (sic) is just really in its first full year of expansion so we're just going into Ohio and more Upper Midwest markets. So I would say it would be somewhat more. Although the year before was Atlanta, so it's probably not much different actually when you stop and think about it.

How should we think about new store productivity? Is there a significant difference in how a new store ramps in a new market versus existing market or is it similar?

It depends on the market, Bill. There's been some markets in Texas where we've decided to do some backfill where we simply had really too much business coming to one store and we were leaving business on the table by not having another store in a strategic location, and in those cases those stores will come on quicker than a new store in a new market. But in many of what we would consider backfill stores that's not the case, and they wouldn't necessarily come on quicker so it's pretty market unique and just depends on the market. You mentioned Ohio specifically, and the stores we've opened up in Ohio so far we've been happy with and they've been on track with what we've done in the past as far as some of all of our new stores' performance. So we don't see much difference with those stores in being in a new market as compared to what our historical performance has been.

Really, the retail is pretty consistent between new markets to new markets. It's the wholesale business. It comes on sometimes quick, sometimes a little slower because you're competing against a local competitor that has the market share, and so it gets back to staffing the store with the right installer, service specialist.

I understand. I appreciate it. Thank you, good luck.

Thanks.

Your next question comes from Armando Lopez with Morgan Stanley.

Hi, good morning, everyone.

Good morning.

Just a couple quick questions. First on the CapEx, I think you said it was $240 million to $250 million which is up a little bit from the old guidance. Could you maybe just talk a little bit about that?

Thanks for the question, Armando, this is Tom. Through the year, we've looked at, and we always look at what the payback on our investments are. Our distribution centers have shown a great ability to use automation to become much more efficient, and when we build the new distribution centers, we look and say -- we try new things. And the things that work and have a good return on investment, we'll roll back to older DC's. So that's a portion of it. The other portion -- we talked a little bit about it in the last conference call -- was we decided to make a major investment in the store computing power and are replacing all the AS400's in all of the stores. So that's a big investment for us. But as we continue to add more tools in the store that are computer based, such as the scheduling system, we have the requirement for some more horsepower there.

Okay, thanks, and then you commented on the comp sales, ex-Texas and Oklahoma, I think. Could you talk a little bit about maybe the trend during the quarter?

The trend was coming out of March, April with winter coming back, it slowed down immediately. April was very slow. It kind of leveled out in the middle of the quarter and then stayed consistent towards the end of the quarter. Around the end of June, first of July, we've had some pick up.

Okay, thanks. And then just one last one. How are you thinking about capital allocation now in terms of like buybacks and dividends?

Our plan right now is to continue using our free cash to grow the Company. At some point, we may change our mind on that. But today we like to have dry powder and are looking to our future growth and the possibility of more consolidation in the industry. So for the time being we're going to continue to use our capital to grow, but we don't rule out the possibility of buying back stock at some point in the future or possibly paying a dividend -- more unlikely on the dividend probably.

Okay, thanks a lot, guys.

Thanks.

Your next question comes from Scot Ciccarelli with RBC Capital markets.

Hi, guys, how are you?

Good, Scot.

Just want to verify something, I guess it's Tom's comments. Basically you guys are talking about slightly lower comps, down a point on each side of the range but basically the same earnings as what you had suggested in your previous commentary given -- I guess this current quarter was a little bit lower than what people were expecting. Is that the right way to view it?

Well, I think our full year guidance is $0.01 lower on the high side and the low side than our original guidance going into the year.

Okay. That was number one. And then you did provide some detail in terms of Oklahoma and Texas, what the comps were doing without those as well as the decline that we had seen in air-conditioning products. Can you help quantify those numbers -- what percentage of sales is Texas and Oklahoma and what percentage of sales is AC during these months?

We don't have those numbers here with us. We just yesterday afternoon decided to cap our comps in different ways considering these rainy markets, and we really didn't quantify that. If you want to call back, we could give you more information about the regions in Texas and Oklahoma. We typically don't like to talk about it by market volume just because it is a little bit of a competitive situation. And then by-product line, I don't have the percentage that air-conditioning represents of our business this time of year.

Okay, but it sounds like it's fair to say that weather had a pretty extreme impact on this particular quarter?

No question about it. Especially in Texas and Oklahoma which are big regions for us. Those are big areas of our market area, and when we talk about rain, I maybe even said it lightly. They had flooding conditions. A lot of markets simply had downpours that flooded various areas and simply shut down business for some period of time and we didn't talk about Kansas very much. I mentioned the refineries that shut down, but those markets out there were also very impacted by flooding conditions. But we chose to take Oklahoma and Texas out simply because those were what we felt to be most impacted by the heavy rains.

Got it. Thanks a lot, guys.

Your next question comes from Mike Baker with Deutsche Bank.

Hi, thanks. So just on that sort of flooding question -- historically, when the weather gets drier, do you see any kind of pick up in demand? In other words, does flooding and the rain, we know that people don't work on their cars when it rains and that's what has hurt your business. But is there any kind of damage that has sustained to automobiles and then does that help to drive comps in subsequent quarters?

Really there's a couple of factors. One like you said people typically don't work on their cars -- especially ones that have to work on them outside -- so there's deferred maintenance, just people that maybe weren't in flooding conditions but because of an extended period of rain when they were off work didn't work on their cars. So there's a little bit of pent-up demand created just from that alone. And we saw it in weekends where we had heavy rainfall in Texas that really slowed the DIY business down. And then from a demand standpoint, created by flood damage, yes, if cars are in flooded areas there's several things that happen. One, the bearings that can be underwater, the wheel bearings and front axle bearings, those of course can sustain damage over time. If the water gets high enough, of course, it gets into the transmission and differentials and transaxles depending on the type of vehicle we're talking about. And those fluids have to be changed and those filters have to be changed and things like that. And then there can be starter motor damage and various things. And we experienced a flood down in Houston back, oh, I think it was in 2000 or 2001, a heavy flood, and we saw a lot of demand in things like transmission filter kits and transmission fluid, where the fluids had to be completely changed. We simply couldn't keep up with the demand. As a matter of fact, all the part stores down there were running out of transmission fluid. We're heavy in Houston and Auto Zone is heavy in Houston and both of us were running out of those products.

So what kind of lag do you see before you start to see that kind of demand? If the same thing plays out that happened in Houston in the past, would that be a Third Quarter or Fourth Quarter benefit?

Well, Houston was an extreme and I use that as an example just to define what can happen in a flood. The positive effect happens pretty much directly following the clearing of the rain because the cars in many cases would be inoperable, so the effect is positive right away for the fluids and so forth. Now, axle bearing damage and stuff like that can be some time down the road. The bearing gets wet, there's rain and water and the bearings are sealed to some degree. So they're made to withstand some exposure to moisture, but over time the bearing gets damaged. So there's some sustained benefit over time because of the bearings being damaged but you may not see that. I don't know depends on how long the car is driven and the extent of the damage, but it could be several months or a year.

Very helpful. One more if I could. Just in the third quarter guidance, and then the full year guidance, what is assumed in terms of leveraging comps if you have a 3 to 5% comp called for at the mid point, do you expect to leverage your SG&A? You didn't in the First Quarter on a 7% comp but I imagine you can pull back on some expenses?

Yes. We feel like 3 to 3.5% in the third quarter -- we will leverage our SG&A percentage.

Great. Thank you very much. Very helpful.

Thanks.

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

Thanks, good morning, gentlemen.

Good morning, Tony.

Greg, you look over the last 12 to 15 months and business is clearly been difficult and you think about the mindset of the consumer as one of deferral. As vehicles age and the replacement of critical parts increases and basically fewer dollars then are spent on more normalized maintenance -- if that deferral approaches more permanent on the part of the consumer, how do you then drive average ticket up and how do you upsell when all of the consumer's thinking about is saving money with respect to automotive repair?

Well, first, it depends on the kind of item that we're talking about. If it's air-conditioning for instance, if a car that maybe is worth I don't know, say $10,000, it's a used car that's got five or six years old and it sold new for $20,000 and it's now worth $10,000, the AC doesn't work. The consumer decides to drive a car without AC and just roll the windows down. At the point they decide to trade cars they really almost have to have the air conditioner fixed or take a huge hit on the trade in values. Cars aren't worth much without the air conditioner working because the AC repairs can be so expensive. So it depends on the type of repair. Over time, cars have to be maintained correctly. If a car isn't maintained correctly, it becomes unsafe. For instance, brake pads. If the brake pads are worn to the point that it damages the rotor -- yes, you can put brake pads back on a rotor that doesn't have a clean surface or the correct kind of surface. But it will wear pads out quicker. So it's going to need brake pads in 15 or 20,000 miles as opposed to maybe 30 or 40,000 miles. And at some point the consumer will decide -- listen, it's ridiculous for me not to replace the rotors and fix this right but I'll do it in better economic times when I have more cash in my pocket. So that's basically my feelings on it.

And I guess a follow-up, are you seeing the part of your professional installer base, are they commenting on the life cycle of parts? Are they lasting a little bit longer and is that enabling the consumer to push out repairs as well?

Well, some parts are. If you look at -- say, starters and alternators, for instance, a lot of the cars these days are made with better starters and alternators than they used to have. But at the same time, back when the starters and alternators failed on cars a lot, the cars didn't have all of these sensors that they have on them now that fail. So there's a lot of offset to the various components that now last longer than what they did at one point, because the individual components are better. And that offset is that the cars have much more technology on them today and that technology is driven through a series of sensors that feed the computer data, and those sensors fail. And all of us that are in this business -- us and all of our competitors -- are very much in this sensor and computer system business because they are primary parts of the car today. So to me there's at least a full offset if not a positive offset to some of the components that are lasting longer.

Thanks. Tom, can I just get a point of clarification -- on the core writedown, was that a function of you had core values there that you just weren't collecting the cores for? Or were they core values that were overstated, and you need to bring back to sort of a price that is more reflective of today's prices?

More similar to your second comment. This particular line has become a line that has been heavily imported from China. The Chinese product is not remanufacturable but is comparably priced, so from a demand standpoint and an uncertainty of origin standpoint, the value of the cores to rebuild for new replacement or new remanufactured units has gone down, thus reducing the value of those.

Is this axles?

We don't want to comment on any particular vendor line.

Okay.

Thanks though, Tony.

Okay, thanks, guys.

Thanks.

Your next question comes from Dan Wewer with Raymond James.

Thanks, and Greg for what it's worth, I was in two of your stores in Dallas last Sunday afternoon and they were packed.

Great. We're glad to hear it.

What did you buy?

Two questions. First, in using the publicly available data to measure new store productivity -- that measures has weakened in the last four or five quarters. Obviously a lot of variables can influence that measure, but can you just walk us through the first year of sales volume of a new store and then how that grows in the following year or two?

I'll go ahead and answer that question. Over the last three or four quarters, the business hasn't been what we would like to be in the total, so the new stores are going to perform a little less but we continue to be in a historically -- a historic band of what new performance should be. First year should be around $900,000. Second -- when I say year I mean first 12 months -- should be around $900,000 and second 12 months $1.1 million, third $1.2 million to $1.3 million, fourth, $1.3 million to $1.4 million, and then we hit maturity.

And you're thinking the last three or four quarters the annual run rate has been somewhat below that $900,000?

We look at them at store class and there's a number of different variables. Some of the stores have been above that and some have been below, but pretty close to that average.

And then my follow-up. The inventory per square foot appears to be down about 4% year-over-year, which is remarkable given sales came in below plan. Can you just remind us as to how you tweak that inventory level down, and if there's any risk that your purchase discounts for the year could be in jeopardy given the volume of inventory, your buying is probably less than what you had originally projected.

Well, we recalculate the value of those potential rebates every quarter, so they are trued up quarterly, and we keep those in check. So part of the impact on the quarter for inventory of course was the deflation of the core value to some degree. And then also just we have a lot of confidence as I said in my prepared comments that our inventory systems are improving every day. We put a lot of effort and technology into making sure that we make wise decisions with inventory investment and we put the right inventory in each store. And I talked about this before in the past when we originally implemented it. But we do things like make available to our distribution centers for replenishment inventory in the stores that is not selling or is on the tail end of the demand curve. As things start tailing down, if it's something you have in a lot of stores, rather than buying more from the vendor because the distribution center has run out, we create in our computer system basically a virtual distribution center from which our distribution centers buy from our stores. They ship it, we run trucks five nights a week. They don't come back full from the stores, so we ship merchandise from our stores back to our DC's to rereplenish our distribution centers as inventory starts coming down. That's one of several things that we do to help streamline inventory to make sure we minimize the investment yet maximize the potential for sales. So I give a lot of credit to the guys in the Company that have developed this and continue to enhance it ongoing, as it relies on data relative to the vehicles that exist in the market, demand in similar vehicle demographic areas of the country in which we do business for new stores. And I think it has a very positive effect on our ability to keep our inventory investment down and to grow sales. And I don't think there's any risk of us having rebate issues at the end of the year because of the process we go through and financing to trueup our rebate expectation based on the most recent quarter results.

Right. Thanks and good luck.

Thanks.

Your next question comes from Scott Stember with Sidoti & Company.

Good morning.

Good morning.

Could you maybe talk about the specific areas within Texas that were impacted -- for instance, were your Southern Texas stores impacted by the flooding and the rains or was this more of a Dallas and up in lower Oklahoma deal?

It was Houston, also. I think DFW was impacted a little more than Houston, or at least for a longer term than what Houston was. I think Houston had some really bad weather also from a rain perspective, but I think it was extended from a time perspective more in Dallas Fort Worth and Southern Oklahoma moreso than it was in Southern Texas.

The actual flooding was fairly isolated. It's just a continuous downpour of rain after rain after rain, and the very cool temperatures too. I mean, probably more so than the rain, it was the fact that it's been like the humidity has been great in Texas. People down there think they are in Southern California this year compared to previous years, and there's just been no heat. And heat is what tears up starters and alternators And hoses and --

Batteries.

Everything, so hopefully it's going to warm up now.

And as far as timing goes, it sounds like most is towards the end of June and the bad weather, it sounds like business has bounced back a little bit. Can you quantify that a little bit?

Yes, the issues we talked about were more, they started out with the winter weather in April, but the rains and so forth were more May and June. They were kind of periodic throughout the quarter. What was the other question?

You indicated that it sounds like things have bounced back a little bit --

And they have. July has been a little stronger and again, I don't want to give you exactly where we're at comp store wise for the quarter at this point because we compare periods a little unevenly with regard to weekends because of our three months equals a quarter type thing and the weekends has such an impact on our business. But if you just compare the individual weeks -- and we've had three weeks pass in the quarter -- if you compare the individual weeks with the three weeks we've had in the quarter, we've had two weeks of strong business at the very upper end of our guidance range and then one week that was a little weaker than that.

Okay and lastly, can you just talk about any competitive pricing issues going on particularly in the DIY side?

Well, it's always competitive, and there's no question that both Advance and Auto Zone are strong competitors of ours from a DIY standpoint. There's been no major changes in the competitive position that we've seen, and we shop a number of items every week to see if there's been a move across categories. And probably the one that we've seen the most moves in over the past three or four years has been motor oils and various kinds of petroleum fluids, but there's been no major change in strategy that we've noticed during the past quarter.

That's all I have. Thank you.

Thanks.

Your next question comes from David Cumberland with Robert Baird.

Good morning. On the LIFO reserve reduction, the $2.5 million part of that, what was the reason for that and do you expect additional reductions in the second half?

Actually, most of that relates to the capitalized portion of wages that are in our inventory. And as we hit the summer months, we become more efficient which creates a LIFO adjustment in the first and fourth quarter where business is slower, we're not quite as efficient as distribution centers -- we see that reverse. But we would expect that our LIFO would be close to zero for the remainder of the year.

Thank you. That's it.

Thanks.

Your next question comes from Matthew Fassler with Goldman Sachs.

Thanks a lot and good morning to you.

Good morning, Matt.

I'd like to focus on gross margins, primarily -- if I look at your guidance, 44.0 to 44.4, it would imply at the high end margins that are up marginally for the second half of the year, much less than you've seen year-to-date. And at the low end, it would factor in some declines. So I'm trying to get a sense of whether there's some core drivers to that view, or whether it's general conservativism ,and as part of that whether that relates to the different tactics you said you pursue this year in terms of thinking about the timing of (inaudible) recognition?

Well, there's a couple things. One, our previous guidance prior to just announcing that our guidance was 44 to 44.4 was 43.8 to 44.2, so we increased it by 20 basis points. Part of that is due to we feel like our margin is expanding a little bit due to product mix like we said. And part of that comes from private label lines where we feel like consumers are opting to buy more private label lines to save some money as opposed to brand new products. Private labels typically have a little better gross margin. Thinking that that trend may change and we constantly try to sell up to the branded products based on the size of the ticket and so forth, and as that changes, that would have -- could have some impact on gross margin. We raised our guidance 20 basis points because of our feeling we can sustain much or all of the benefits we've gained in distribution and that we'll continue to benefit from the investments we've made in distribution and that's the reason for the change. So you can say it's a little bit maybe conservatism but we feel like it's pretty realistic and we're comfortable with 44 to 44.4 for our gross margin guidance.

Is it your sense the marginal business that you think you'll recapture as the trends return to normal would be a lower margin business? I don't know if it's a temperature sensitive business?

Just slightly. Sometimes -- especially a brake pad. You can buy that for $9.99 or you can buy maybe a brake pad for the same car for $36.99. Well, the $9.99 brake pad has a real healthy margin, but it's not a very big ticket. But the 36.99 brake pad maybe doesn't have quite as much margin, but it's a lot more gross profit dollars and a bigger sale. And we sell up to that higher ticket, and I think as the consumers get more -- adapt to the higher fuel prices and those prices get built into the budget, many will make the decision to go ahead and buy the better value product which in many cases is the more expensive product but that product carries a slightly less gross margin.

Gotcha, and then just one quick follow-up. Gas prices have been an issue for some time on a year to year basis, they finally flattened out I guess in the past week or two. I'm not sure if consumers think about sequential trends year to year, if they think about the $3 sticker shock situation. But as you've watched fuel prices -- and I imagine you're watching them more closely than in years past, are you seeing much correlation as those fluctuate or is that too precise of an analysis to look at?

It's a little too precise of an analysis to look at -- in our markets especially where we've had regional swings. Around Memorial Day there was a lot of volatility because of the supply and some markets just got a lot higher faster than other markets. And then this deal out in Kansas happened where the refineries flooded and it shut down the supply line to several markets and gas for no reason. Matter of fact it got higher in some market supplied out there than it was in many places in the country, which gas would typically be a lot higher. And that of course had an impact. So we really don't see an immediate correlation. My thought is that consumers are getting used to the fact that gas prices are high. There's not so much sticker shock, yet the effect that higher gas prices has had on their overall financial condition has been tough and is going to take a little while for most consumers to recover from that.

Great. Thank you, guys.

Thanks.

Your next question comes from Jeff Sonnek with FBR.

Could you just characterize for us traffic versus ticket, any directional trends you want to comment on there?

Well, obviously traffic wasn't as good as we would like and traffic is not as much of a contributor as we would have liked it to have been. Our ticket average continues to incrementally increase -- but again not as much as we would like it to. It's really kind of a hit. We've been kind of increasing it pretty well for the last year or two or three years, and it's hit a little bit of a flatter spot and tickets were lower than we would have liked also.

And then I know weather was the big kind of negative during the quarter, but you also made commentary in your prepared remarks about the air-conditioning business, et cetera. Number one, can you kind of help us think about what influence that had in the Second Quarter and then secondly, describe the kind of air-conditioning comparison in the third quarter?

Well, I mentioned earlier that I don't have the numbers on or I can't really quantify the air-conditioning impact on our overall financials. I can tell you that typically would be a product category that would grow in line with our overall growth. And this year, not on a comp store basis but on a total sales basis, it's down a little bit over 10%, and it's a discretionary product. And I can't quantify that any further because I don't have the byline numbers with me in order to quantify that. But it has some -- it has a meaningful impact on our comparable store sales for a couple reasons. One, we missed the air-conditioning sale but typically with an air-conditioning sale there's other things that go along with it. There's maybe belts, could be cooling system issues with hoses and things like that. So the air-conditioning repairs are good sales and big tickets and this time of year when you're comparing to periods when air-conditioning business was normal, you take a little bit of a hit by not doing as much as what you've done in previous periods which is the case right now.

Okay, and then just finally can you just make some comments -- just get us up-to-date on where we're at with all of these new distribution center processes, Voice Activated Pick, slotting, etc?

Well, it's all going real well. We continue to rollout Voice Activated Pick and we have it in about half our distribution centers, which all of our distribution centers don't have the base operating system that would allow them to have Voice Activated Pick. And we still have some distribution centers that operate on a paper based system and those distribution centers don't have Voice Activated Picking alone until we make the decision to switch them over to the other system. So we continue to see good results of that, and we're very happy that this past quarter, even with diesel prices being as high as they were and energy prices for utilities continuing to be high, we had a decrease in our distribution expense which was a contributor to a portion of our gross margin gain. On the slotting, we continue to use that. That's another one that continues to generate benefits along with the computer systems that we put on the trucks that allow us to monitor the behavior of the drivers and the idle times, the ship patterns and all the things that allow us to incentivize our drivers to be more conservative with fuel. And that's generated positive returns, so we continue to look for things in distribution. Matter of fact, the distribution center we just relocated in St. Paul, we put some technology in there that we've used in one or two other DC's but it wouldn't be common. Things like carousels where the pick is brought to the picker as opposed to the picker going to the part. This machine rotates and brings parts to people which creates a lot of efficiency. We use a lot of carton flow in our newer distribution centers. So we continue to look for ways to leverage technology to improve productivity and to date we're very happy with all of the investments that we've made and are looking for new investments to make in the future.

Great. Well, best of luck.

Thanks.

Your next question comes from Sharon Zackfia with William Blair.

Hi, good morning.

Good morning, Sharon.

I was hoping to get more detail on the results so far from the new labor scheduling system that you implemented around the end of last year. What have you been seeing there and what impact if any are you seeing at the top line in customer service?

Sharon, the time of the year it's kind of difficult to measure the result. Summer and of course a little bit flatter sales than what we would have liked to have had and you don't start pulling back labor when any time things can change. Plus you're in the middle of vacation time, and so we're using it very conservatively right now again, more of an offense of looking for opportunities to improve our customer service level. And definitely, where we have stores that are on the higher side of what payroll they should have, we're moving payroll around. Managers are becoming much more comfortable using it and believing in it. It's totally new to them. And so we hope this fall, as we start changing our scheduling models to prepare for winter business, it will really come into play and there will be much more at ease using it.

And when you talk about that in the fall, do you think about that more as an opportunity to offer better customer service and get incremental sales or to rightsize labor to the sales trend?

Definitely store by store. It depends on where that individual store is in their sales maturity and what their current payroll is and what we think it should be. When you put new stores in, we definitely let them have plenty of payroll to get to that second, third, fourth year sales volume maturity, so it will depend on the store and the market and how the sales are growing.

Okay, thanks. I hope it gets hot in Texas.

Thanks, Sharon.

Your next question comes from Gary Balter with Credit Suisse.

Hi, good morning. It's actually Seth Basham for Gary. A few quick questions for you, as most of ours have been answered. First, just to clarify -- for the first three weeks of this quarter, the markets of Texas and Oklahoma, are they running higher than the Company average in terms of comps?

I didn't bring that.

We didn't bring that with us to tell you the truth. One of the weeks I know for sure they had that I didn't bring the spreadsheet with me that shows all of the consolidated.

Okay. Fair enough. And then finally, I think Ted and Greg, you guys have talked about in the past how when times get tough in this industry it leads to potential shakeout. More competitors might go out of business and lead to potential for more consolidation. Is that still your frame of mind and do you see more positions potentially on the horizon?

Yes. We feel like that over time, some of the companies that are still out there, most of them are good companies. They are companies that have weathered a lot of consolidation and a lot of competition. But our feeling is that long term, some of those companies will be consolidated into other companies and yes, we would -- part of our growth strategy is to periodically try to digest a sizeable acquisition. And with Midwest now digested, we would, if we ran across one that was a good opportunity for us, with would certainly be interested taking a look at it.

Yes, there seems to be quite a few more independent stores closing down this year. We've had a chance and we've looked at a lot of them and we're more opportunistic and if a store is ready to close down that's probably not a very good acquisition. So we've been real selective on a lot of these singles this year, and for that reason, we really haven't done a lot of acquisitions on just a store by store basis.

Great. Thank you, gentlemen. Good luck.

Thanks, Seth.

Ladies and Gentlemen, we have reached the end of the allotted time for question and answers. Are there any closing remarks?

Thanks, everyone, for your attention on the call, and like I said earlier, we're hoping for a hot remainder of the summer and we'll talk to you at the end of the Third Quarter.

This concludes today's O'Reilly Auto Parts 2007 Second Quarter Earnings Release Conference Call. You may now disconnect.