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Executives

Judd Nystrom – Vice President Finance and Investor Relations

Darren R. Jackson – Chief Executive Officer

Jimmie L. Wade – President

Kevin P. Freeland – Chief Operating Officer

Michael A. Norona – Chief Financial Officer

Analysts

Analyst for Gregory Melich – Morgan Stanley

Matthew J. Fassler – Goldman Sachs

Anthony Cristello – BB&T Capital Markets

Dan Wewer – Raymond James

Chris Horvers – JP Morgan

Advance Auto Parts, Inc. (AAP) Q2 2009 Earnings Call August 14, 2009 10:00 AM ET

Operator

Welcome to the Advance Auto Parts second quarter 2009 conference call. Before we begin, Judd Nystrom, Vice President, Finance and Investor Relations, will make a brief statement concerning forward-looking statements that will be made on this call.

Judd Nystrom

Good morning and thank you for joining us on today's call. I would like to remind you that comments today contain forward-looking statements subject to risks and uncertainties that may cause our results to differ materially. The most important of these risks, as well as the reconciliation of any non-GAAP financial measures mentioned on the call and the corresponding GAAP measures are described in our earnings release and our SEC filings. These can be found on our Web site at www.advancedautoparts.com.

For planning purposes, our third quarter earnings release is scheduled for Wednesday, November 11, 2009, after market close and our quarterly conference call is scheduled for the morning of Thursday, November 12, 2009. To be notified of the dates of the future earnings release, you can sign up through the Investor Relations section on our website.

Finally, a replay of this call will be available on our website for one year. Now, let me turn the call over to Darren Jackson, our CEO, who will be followed by: Jim Wade, President; Kevin Freeland, Chief Operator Officer; and Mike Norona, Executive Vice President and Chief Financial Officer.

Darren R. Jackson

Good morning everyone. Welcome to our second quarter conference call. I would like to begin by congratulating the team on another successful quarter. I would like to point out that our positive results continue to be driven by the efforts of our 49,000 Advance team members. We are at the halfway point of fiscal 2009 and we remain on track to deliver a very good year. We are closing in on the end of our turnaround efforts for Part 1, which is the foundation of our story.

The turnaround has been focused on: one, establishing a strategic direction with our core priorities—commercial acceleration, DIY transformation, availability excellence, and superior experience; two, restoring the core values of Advance, which are to inspire, serve, and grow; three, identifying, recruiting, and empowering a world-class leadership team; four, aligning our team around a focused set of meaningful and measureable goals; and finally, five, building positive momentum.

And this is just to highlight a few. Overall, it has been a turnaround in leadership, confidence, and focus versus a simple financial restructuring.

We are now mapping out our transformation to become a customer experience leader in our industry. To date, our strategic progress is in line with our high expectations and we continue to be pleased with our financial outcomes. We are encouraged with the double-digit comparable store sales gains in commercial, coupled with posting our second consecutive quarter of positive DIY comp sales growth. These results are built on our improving customer satisfaction and team member calibration scores.

I am delighted with our team members' focus on profitable growth which has resulted in a dozen general managers being on track to earn $100,000 this year under our new incentive program.

Overall, our bonus-eligible general managers achieved low, double-digit comps in the first half of the year, resulting in a 30% increase in their bonus check.

There are countless areas of the business that I'm excited about that are not readily apparent in our earnings release. Here are some specific examples.

We recently launched a national Performance Dashboard. This new tool is important. It aligns and focuses all stores on the same set of measures and metrics. It also provides visibility for each store to see how they are performing compared to stores in their peer group with similar characteristics, such as store sales potential, competitive sets of inventory levels. This peer-group approach has allowed us to target sales and gross margin opportunities to improve performance and accelerate growth this year.

We have recently launched a dedicated team of field leaders to accelerate our results by improving the speed and consistency, while reducing the variability, of initiatives we implement in the field. We have learned over the past year that our speed and consistency of implementing new initiatives must improve to ensure we deliver the intended benefits in a swift and sustainable manner. This team makes up our implementation factory.

In our test districts, this team helped cut our battery return rate in half, as an example, which we are now rolling out to the balance of the chain. Kevin will speak about this later.

We also have initiatives underway to test traffic counters and new PDS phone systems to measure customer demand. This is important as our research has shown us that we have very large opportunity to better serve our customers through understanding our in-store and phone traffic patterns.

By measuring this, we will be able to better staff to demand. This will increase transactions, conversion rates, waiver effectiveness, and most importantly, the customer experience.

We are making progress on these initiatives as well as numerous other initiatives such as launching our global sourcing capability, adding ACDelco to our parts assortment, rolling out our new stores learning system, expanding Autopart International's geographic reach, as well as testing AI within an existing AAP stores.

And lastly, we're making terrific progress building out our e-commerce team and site, which we will launch later this year.

The ultimate success of these capabilities comes down to our people. Team calibration is a tool we use to assess our team's engagement levels. As a company, we achieved a 95% participation rate and increased our score from 65 last November to 71 this quarter, an increase of 10%.

This is one of our greatest accomplishments in the quarter. Our turnaround and upcoming transformation is dependent upon the engagement and leadership of the entire Advance team. Clearly we are moving in the right direction.

Collectively, our focus on our customers, team members, growth, and profitability allowed us to increase sales 7%. Comp store sales increased 4.8%, while we delivered a 14% increase in our earnings per share, excluding the $0.06 EPS impact for store divestitures. This is on top of a 22% EPS increase last year during the second quarter.

Our investment profile reflects a commitment to building capabilities to successfully compete and deliver a superior customer experience. Jim, Kevin, and Mike will cover the details of our strategic and financial results later.

The economic environment continues to be fragile. We recognize we have a little bit of a wind at our back in terms of our DIY business and we acknowledge that those winds could shift tomorrow. However, we remain committed in building capabilities to lead in our industry over time, using the customer as our compass and transforming our business model to one that provides for long-term, sustainable growth, profitability, and value creation.

As we round out the second half of 2009 and prepare for 2010, we will take what we've learned and transform our business for our team, our customers, and our shareholders, becoming a customer experience leader as a choice. It just doesn't happen. My time at Advance has taught me that our team has the passion and the conviction to take the lead. Our team continues to show me that their commitment to advancing the experience for our customers is what differentiates Advance. Here's an example:

Last month our Greater Leadership team spent time with 15,000 commercial customers to thank them for their partnership and business. Jim will share more details with you about our Customer Commercial Appreciation Week, but I wanted to share with you some thoughts that came directly from our customers during the week, that I visited with them and our team. Their comments demonstrate we are truly on track with our turnaround and transformation.

I spent some time in Indiana and received terrific feedback about our commercial account manager, Aaron Bickley. The feedback that I heard over and over from our commercial customers was that they were choosing Advance because of our people, from our commercial parts pros to our commercial account managers.

Our custom mix investments, parts pro investments, delivery truck investments, are enabling our teams to do what they do best, serve our customers with confidence and consistency.

More importantly, they are choosing Advance Auto Parts because our team will go above and beyond selling parts to serve customers, like Aaron does routinely. I visited one commercial account district manager who has a large, 21-store district and is proud to support Advance with their entire district.

He told of the above-and-beyond steps that Aaron has taken. For example, he starts by focusing on business, which included facilitating meetings with the customer's managers and the Advance general managers to further develop opportunities in the relationship between the two businesses. By the way, our business with this client is up double digits.

To sum it up, Aaron provides the total Advance experience to commercial customers that he services and proof can be seen in the sales results for his area and through the fantastic relationships and partnerships he has developed in his markets. Thanks to you and your team, Aaron, for serving our customers better than anyone else and growing our business.

Now I would like to turn the call over to Jim to provide a progress update on our commercial acceleration and DIY transformation strategies.

Jimmie L. Wade

I would also like to thank our store teams, our commercial sales force, and our support teams for another strong quarter. This morning I will update you on our two core customer strategies.

Through our commercial acceleration strategy, we continued to gain significant market share during the second quarter, demonstrating that our strategy focused on our customers and our team members is continuing to gain traction. With the large commercial market and our low, 3% market share, there continues to be plenty of room for continued growth.

This was our sixth consecutive quarter of double-digit growth in commercial, with a 14.8% increase in comp store sales for the quarter, on top of a 13.5% comp increase during the second quarter of last year. This is the second quarter that our commercial sales mix as a percent of our total sales was over 30%.

We continue to drive towards our goal of a 50% commercial business mix. Our commercial gross profit rate again improved as a result of increase in mix of parts sales and our continued implementation of our value proposition based on customer service. We remain confident in our efforts to aggressively grow the commercial business and we continue to drive towards double-digit comps for the remainder of the year.

In the last few quarters we've discussed our focus areas that are leading our acceleration in our commercial business. We are continuing to make progress in these focus areas: investing in addition parts pros, trucks, drivers, and upgraded inventories in our stores and our markets where we have the greatest potential.

These investments provide our stores the capacities to grow faster and our largest comp growth is coming from these markets. We continue to build on the basics of great customer service at each store through commercial operations initiatives, focus on answering phones quickly, filling the order quickly, and consistently making timely deliveries to our customers.

Additionally, we are revolutionizing our commercial sales force by adding commercial account managers once we have the additional store investments in place and we're ready to execute our value propositions. We continue to build on our database and customer acquisition capabilities that's helped us acquire new customers while increasing our share of existing customer purchases. These capabilities have been critical to focusing our team on where the greatest potential is and identifying more garage customers.

Since we launched our commercial acceleration strategy, our growing number of independent garages and national chains have placed their trust in Advance Auto Parts. We want these customers to view advance as a valued business partner that enables their success by simplifying the running of their business.

Because of this, our commercial customers have rewarded us with strong sales. In recognition of this success, we recently celebrated Commercial Customer Appreciation Week, so we had the pleasure, along with our entire management team, to ride with commercial account managers and visit commercial customers across the country and personally say thanks for their business.

In addition, our regional vice presidents, district managers, and general managers, also visited customers throughout the week. All totaled, we visited with more than 15,000 of our customers.

During each visit we discussed the customers' needs and learned how we can serve them better. These learnings will help us continue to grow our commercial business. We would like to thank our many team members that helped organize and execute this successful and important event, and again, thank our customers for their business.

The Autopart International team turned in another strong performance with a comp store sales increase of 12.4% for the second quarter. AI continues to expand its business rapidly through both strong, organic growth and new store openings.

We recently opened our second AI store in the same building as an existing Advance store. We plan to continue to experiment with this model, allowing us to better meet our customers' needs by increasing our parts availability while leveraging our occupancy costs. We are very pleased with the AI's team year-to-date increases in both revenue and profit and we continue to see AI as a key driver of our future growth.

Now turning to our DIY transformation, we achieved our second consecutive quarter of positive comps. Our team delivered a 0.7% positive comp increase during the second quarter. As you may recall, the comp sales decrease of 0.8% in the second quarter last year was our strongest quarter of the year. Looking at our comps on a two-year basis, our DIY comps were flat, consistent with our first quarter after adjusting for the calendar shift. That said, the results in the second quarter remind us that we still have much work to do to achieve our goal of solid and consistent DIY comp sales increases every quarter.

We believe our industry as a whole has continued to realize better DIY results from increased traffic as consumers are saving money by maintaining their existing vehicles rather than replacing them. This is reflected in our positive comps as compared to last year. Although the industry data indicates that we maintained DIY market share for the first half of 2009, we saw the industry grow slightly faster than us during the second quarter.

We have several DIY initiatives that are underway to drive our conversion rate with existing customers as well as increase the consideration rate of potential customers. I want to touch on just a few of those initiatives.

In regard to conversion rate, we know we still have a tremendous opportunity in DIY to fulfill the needs of the customers who are already are visiting or calling our stores each day. In our business, almost all of our customers come to our stores with a specific need or seeking a solution to their problem. They want to make a purchase.

We are installing traffic counters and updated phone systems in stores to accurately measure customer demand, which will help us provide better customer service and improve our conversion rate by store.

To improve our ability to better solve our customers' problems, we are targeting stores with specific R&D efforts to identify sales development opportunities. We are also creating intuitive clusters of stores based on location, customer make-up, and competition, to get more targeted and impactful with our initiatives.

Lastly, we are working on opportunities to better leverage the parts availability and merchandising improvements we are making to our stores.

In regard to consideration rates, we are testing changes and refinements to our marketing plan, including localized marketing where we will address the needs that are tailored to each market by assessing our current market share, the customer base, and the competitive landscape.

All of these initiatives are built on a more focused brand purpose that creates differentiation around a superior customer experience for both our DIY and commercial customers.

As we discussed last quarter, we have a monthly company-wide customer satisfaction survey that allows us to measure our progress on building on this superior customer experience. We are listening closely to what our customers are saying and how they rate our performance. As you have heard, we are measuring satisfaction at every store across the chain. These stores are continuing to increase and are a key measure that will help us to determine how we evolve our value proposition and move it forward.

As more of our customers continue to keep their cars longer, our core value of serving our customers better than anyone else is more important than ever.

Switching to new store developments, during the second quarter we opened 23 stores, including 7 by Autopart International. We also closed 21 stores and relocated 3. Year-to-date we have opened a total of 69 stores, including 18 by AI, which continues us on a path towards our goal of 75 new Advanced stores and 30 AI stores in 2009. Year-to-date we have also closed 30 stores and relocated 6. Our total store count at the end of the quarter was 3,407, including 142 AI stores.

Mike will share more information about the store closings that are a part of our plan we announced during our fourth quarter release, as well as their financial impact.

In closing, thanks again to our team for what each of you are doing each day to serve our customers and drive our results. We continue to believe we are making solid progress in providing both our commercial and DIY customers a superior experience and look forward to keeping you updated as we continue with our initiatives.

Now I would like to turn the call over to Kevin to review our Availability Excellence and Superior Experience strategies.

Kevin P. Freeland

I would also like to congratulate the team on a great quarter. I will briefly highlight our initiatives that include our gross profit rates as well as key focus areas in investment that will continue to drive long-term values.

During the second quarter our gross profit rate increased 189 basis points versus last year. The 189 basis point improvement was primarily due to continued investment in pricing capabilities, merchandising capabilities, a decrease in inventory shrink, and better store execution resulting from our changes to better align team-member incentives.

We continued to roll out our new price optimization process, which favorably impacted our gross profit rate in the quarter. Our retail price optimization strategy has been implemented across the majority of the front-room categories. This was achieved while simultaneously improving our price competitiveness against our major competitors. We will complete our back-room optimization tests in the fourth quarter.

We continue to move quickly to develop a true, direct importing program and believe our opportunities in this area are great. Our Asian sourcing operation has been stamped and we expect this capability to provide a significant margin improvement and allow us to increase our speed to market with products that are aligned with what our customers want and need.

We are rebuilding our order management process to ensure smooth integration of new import sourcing and are finalizing a trade finance program for import ordering.

Our initial orders will arrive next month and we expect the program to grown substantially over the next several years.

Through the outsourcing of our corporate purchasing and expense account payable function, we have identified significant savings that will strengthen our bottom line performance. Although some of the benefits are capitalized or realized over multiple years, we expect the benefits to offset transition expenses in fees this year. However, we expect to drive significant benefits in 2010 and beyond.

Next I would like to update you on the progress of our Availability Excellence strategy. Availability Excellence enables us to serve our customers better than anyone else by redefining the standards with breadth, depth, and speed of delivery of parts.

During the quarter we added two PDQ, or Parts Delivered Quickly, warehouses and 24 hub stores. With a larger footprint than any standard Advance store, the hub store stocks a wider variety and greater size inventory allowing the hub store to supplement the inventory of other Advance stores in its immediate market.

We also increased store delivery services to provide a wider assortment of parts to our customers. These facilities, combined with the added delivery service, increase our ability to provide car part stores within two hours or less.

In concert with our new custom mix capability, a record-setting 466 inventory upgrades occurred during the quarter. We are establishing a standard for availability in our industry.

We were also able to reassert 22% of our parts plan-o-grams using our new custom mix tool, bringing the total reassortment of 36% of our parts year-to-date.

We continue to work aggressively to remove overstocks of unproductive inventory from our store assortments and adding products with proven demand in that locale.

In Q4 of 2008 we announced a significant change on how we manage slow-moving inventory. During the quarter approximately $20.0 million of slow-moving inventory was disposed of, bringing the total to $26.0 million year-to-date. Our goal is to dispose of the remaining $11.0 million by the end of the year. This will not have any impact on our 2009 financials since we are utilizing the inventory reserves recorded during the fourth quarter of 2008.

A combination of strong gross margin improvements, sales increases, and a reduction in inventory led to a solid increase in gross margin return on inventory. I would like to congratulate the merchandising team on this exceptional performance on the company's largest financial asset.

In addition to Availability of Excellence investments, we continue to identify opportunities to drive efficiencies through our supply chain and logistics functions. During the quarter we implemented engineered standards for order selection within two of our eight distribution centers, bringing to a total of six year-to-date.

This initiative enables us to improve labor productivity in our main distribution centers and reduce distribution expenses substantially in the quarter. We are also on track to deliver the expected financial savings in the outsourcing of our fleet for outbound transportation.

Turning to information technology, we are continuing to invest in IT in support of our business strategy. Last quarter we launched an online inventory lookup site and began building a team of experienced e-commerce professionals. With the strides that we've made so far, we are on track for the B-to-C, or business to consumer site, to go live in Q4 of this year and the business-to-business site to go live in early 2010.

Another initiative we have underway is the implementation of our core merchandising system. I am pleased with our progress thus far. We are currently on track for our initial implementation to begin in the second half of 2009 and to be completed in early 2010. As previously stated, we anticipate we will begin to realize the benefits of the new system and begin to see improved category performance as a result of these new investments.

Next I would like to update you on our Superior Experience strategy. Superior Experience enables us to serve our customers better than anyone else by consistently providing legendary customer service through our relentless focus on execution. Superior Experience translates that goal into specific activities that our team members must perform in order to unlock their full potential, provide significant customer satisfaction improvement, while ultimately accelerating profitable sales growth.

We have launched a new initiative called the Implementation Factory which will establish a new standard of excellence by providing training and coaching programs for specific initiatives that have broad field impact. The Implementation Factory began their journey in Q2 by rolling out the first initiatives, including new battery-warranty procedures, disciplined commercial pricing, and improved shrink controls. We look forward to sharing results from this exciting initiative in future quarters.

Additionally, the Implementation Factory will roll out initiatives that have been fully tested. While the ultimate destination of these tests will be our stores, they will be sponsored by various functions throughout the company. We have many tests underway to improve our conversion rate, enhance our labor scheduling, optimize both pricing and localized assortments. These tests, with their greatest overall impacts, will be prioritized for the fastest deployment through the Implementation Factory.

In closing, I continue to be encouraged with the progress we're making as a result of our investments in Availability Excellence and Superior Experience strategies.

Now let me turn the call over to Mike to review our financial results.

Michael A. Norona

I would like to start by thanking all of our talented and dedicated team members for the results we achieved this quarter. Despite being up against a challenging comparison from second quarter last year, due to the positive impact of the economic stimulus, our team again delivered a strong financial quarter.

I plan to cover the following topics with you this morning: one, provide some financial highlights of our 2009 second quarter; two, share with you the progress we are making on the key financial dimensions of our transformation around growth, profit, and value creation; and three, share what we see for the balance of the year.

Overall, we are pleased with our second quarter financial results that were primarily driven by the 189 basis point increase in our gross profit rate versus prior year as a result of our continued strategic investments. Our comp store sales increase of 4.8% was in line with our expectations and consistent with our first quarter comp store sales performance on a two-year basis after adjusting for the approximate 100 basis point impact of the calendar shift.

Our second quarter earnings per diluted share of $0.83 included $0.06 related to store divestitures. Excluding the impact of the store divestitures, our earnings per share of $0.89 versus the consensus of $0.83, increased 14% on top of a 22% increase in EPS last year.

On a year-to-date basis, our earnings per share increased 17% on top of a 21% increase in EPS last year, excluding the $0.10 impact of store divestitures.

Some highlights of the quarter include a 4.8% comp store sales increase comprised of a 14.8% increase in commercial and a 0.7% increase in DIY. Our commercial comp was comprised of a 15.2% increase at Advanced stores and a 12.4% increase from Autopart International.

All in, our revenue during the quarter grew at 7% versus the remainder of the total market growth of approximately 3%. Clearly, our solid top line performance resulted in market share gains.

During the second quarter our gross profit rate increased 189 basis points versus last year, primarily due to the continued investments in pricing capabilities, merchandising capabilities, parts availability, decreased inventory shrink, and better store execution resulting from the impact of previous changes to better align key member incentives.

We are realizing the benefits from the investments we've made over the past year, in terms of both our pricing and merchandising capabilities, as well as decreased inventory shrink. These new capabilities are allowing us to be more targeted with respect to our commercial and retail pricing strategies and better positioned from a cost standpoint.

Additionally, our store team members continue to respond remarkably to our new incentives structure. Overall, we are extremely pleased with our 158 basis point year-to-date increase in gross profit rate.

During the second quarter our SG&A rate increased 136 basis points, excluding the impact of store divestitures. 136 basis point increase was driven by higher incentive compensation, higher mix of fixed commercial labor, continued strategic capability investments to improve the company's gross profit rate and accelerate the commercial business, and increased medical expenses.

These increases were partially offset by lower advertising expenses and occupancy expense leverage as a result of our 4.8% comp store sales increase.

All in, our operating margin increased 53 basis points during the second quarter after removing the impact of the incremental store divestures.

We have previously shared that 2009 would be another year marked by investments, required as part of our turnaround and transformation. This continued to manifest itself in our second quarter and first half SG&A rate.

Free cash flow through the second quarter was $287.0 million, or an 18% increase, over prior year's first two quarters, primarily driven by an increase in operating income. With this free cash flow we have decreased our total bank debt outstanding by $173.0 million over the past year.

Our accounts payable to inventory ratio decreased to 58.4% from 61.6% at the end of the second quarter last year, primarily driven by the impact of the move in Wagner inventory build up at the end of the second quarter of 2008. We expect that this is strictly a timing impact and will remain on track to improve our AP ratio this year.

As proof of our improved inventory management, our inventory actually decreased 3% over last year, even though our sales were 7%.

Our rent-adjusted leverage ratio at the end of second quarter was 2.4x, which was in line with our internal target.

From a capital structure perspective, we continue to manage the business to a maximum adjusted debt to EBITDA leverage ratio of 2.5x, using 6x capitalized rent.

During the second quarter we repurchased approximately 345,000 shares of stock for $14.4 million at an average share price of $41.71.

While we may be opportunistic with some share repurchases, we remain committed to managing to our rent-adjusted leverage ratio of 2.5x.

To put our second quarter financial results in perspective, we are pleased with our six consecutive quarter of double-digit commercial comp sales growth, our second consecutive positive DIY comp in over three years, as well as the strong gross profit rate improvement which fueled our strong earnings growth. We are pleased with the year-to-date cash flow we generated and the fact that we continue to strengthen our balance sheet.

While 11% SG&A dollar growth, excluding store divestures, is not what we are striving for longer term, we believe we are investing in the right parts of our business that will drive long-term value.

Given the ramp-up of SG&A investments that began during the second half of 2008, we would expect that SG&A dollar growth will moderate as we progress through the remainder of 2009.

Now I would like to share with you the progress we are making on the key financial dimensions of our transformation around growth, profit, and value creation as measured by our four gauges. As we have shared, our strategic investments are being made to accelerate our growth, improve our profitability, and increase the value of our company.

Turning to growth, we have targeted a significant portion of our spending into the customer-facing parts of our business. This represents our largest driver of SG&A dollar growth from last year and includes more trucks, drivers, parts pros, sales force, inventory upgrades, and tools, which are translating directly into sales growth for our company as evidenced by our sixth consecutive quarters of double-digit commercial comps and our market share gains.

Another area of spending that is fueling our growth is the structural changes we made to our field incentive programs that pay on growth rather than budget. Although on a year-to-date basis we are deleveraging SG&A, as a result of higher incentive comp, our bonus expense as a percentage of incremental gross profit dollars, is approximately 700 basis points lower on a year-to-date basis versus 2008 for the same period. Said simply, we are getting a higher return on the incentive dollars we are spending.

This program is also translating into changed behaviors, as evidenced by the approximately 73% of our stores with comp store sales gains on a year-to-date basis, versus less than 60% last year for the same period.

Looking forward, we continue to see growth potential as we look to build on our modest 3% share in commercial market.

Turning to profit, we continue to make significant strategic investments in our Availability Excellence and Superior Experience strategies. This includes investments in merchandising capabilities and systems, global sourcing, supply chain capabilities and network, margin drainer improvements, e-commerce, and better store execution.

These investments translated into the 189 basis point margin improvement we delivered in our second quarter.

What is also compelling is we are as price competitive as we have ever been, yet we are still in the early stages of what we think the potential of these investments can deliver. While we are seeing significant deleverage on our SG&A line from these investments, given we are in the heaviest investment cycle, we are encouraged that our operating margin continues to grow, as evidenced by our 53 basis point increase during our second quarter.

An area of opportunity we have to improve our profitability is narrowing the high degree of variability was see today in many of our performance metrics across our store base. We see the Implementation Factory as a new capability that will help us improve this variability and consistency in performance.

When you combine the potential improvements, driven by more consistent execution, with the growth potential in commercial and the margin benefits still to be realized, our future profit model looks promising.

In addition to the progress we are making in growth and profit, we are also focused on value creation. This includes more rigors around capital deployment, working capital management, and cash flows.

On a comparable year-to-date basis, ROIC has increased to 14.9% from 14.3% during the same period last year. This increase reflects a sharper focus on the investments we are making relative to the returns generated.

To illustrate, inventory actually decreased from last year's second quarter by 3% compared to sales growth of 7%. This is the direct result of our decision last year to remove non-working inventory and replace it with more productive inventory that better meets customer needs.

These activities are all contributing to us building a strong financial platform to grow from and have us on a pathway to investment rate as evidenced by the recent outlook upgrades by both S&P and Moody's. We are particularly proud of these outlook upgrades as they reflected independent assessment validating our improved operational performance, strong liquidity, solid operating cash flows, and strong financial metrics.

While we are making progress in the areas of financial value, we also see many opportunities ahead, such as supply chain financing, occupancy cost reductions, store purchases, and continued inventory management improvements that will further improve our financial strength.

Looking ahead, we continue to be optimistic in our growth and profitability profile based on our second quarter results and we remain committed to our strategic objectives and investment profile.

I would like to also remind you that the impact of the calendar shift that we benefited from in Q1 will begin to reverse and create a modest headwind for our comp store sales in Q3 and Q4.

In addition, as previously shared, we will increase our investment spending in key strategic areas in the back half of 2009, including commercial trucks, parts pros and drivers, as well as in new capability areas such as global sourcing, e-commerce, and our Implementation Factory. We will also be opportunistic with some store location purchases which will modestly increase our capital expenditure spending from our previous outlook.

Our proven results, coupled with our low commercial market share, demand that we move faster. We still expect each 1% in comp store sales will add approximately $0.05 in EPS on an annual basis and a 10 basis point change in the operating margin is still expected to add approximately $0.03 of EPS. These sensitivities do not include our store divestiture costs.

In closing, we are pleased with the financial results we delivered this quarter and in the first half of 2009. They contain clues that we are on the right pathway to reach our full potential and are also a reminder that we are still in the investment cycle of our transformation.

Most importantly, we are proud of our dedicated team members who delivered fantastic second quarter results and who are passionately leading our transformation.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Analyst for Gregory Melich – Morgan Stanley.

Analyst for Gregory Melich – Morgan Stanley

As it relates to comp progression during the quarter, can you talk about how comps may have trended or improved as you began cycling stimulus.

And then relating to some of the gross margin, improvement we've seen and the initiatives you have there, if you could provide an update again on the percentage you feel we're through and what's left to be realized there.

Michael A. Norona

First of all, we typically don't provide inter-quarter results just because as you know, last year we talked about the 2% stimulus, we say that. Obviously that did have an impact on our DIY comps.

As you look between the quarters there's so many things that could happen. You look at unemployment that was up about 400 basis points from last year, so you've got weather, you've unemployment, the economic factors.

What we can tell you is that we're focused on rebalancing our portfolio and we are pleased with the progress to date.

Jimmie L. Wade

That's pretty much what I could add. I think as we looked at the second quarter, especially relative to the first quarter, we knew we had some stimulus impact from last year. We certainly look at how we're doing relative to market share, overall, and feel pretty comfortable with where we are there. So nothing significant one way or the other in regard to the trend during the qtr.

Darren R. Jackson

And if you were to look at it, June was a little bit softer. I think we had some of the record coolest weather than we had a long time. And July was up a little over June, so it was a little bit choppy.

Kevin P. Freeland

On the margins, relatively straight forward, about two-thirds of it was actually at the register and it was various initiatives, both the price optimization that we've spoken of previously, lower cost of acquisition of goods and greater preservation of margin at the register, and about a third of it was comprised of the continuing improvement in our shrink results.

Analyst for Gregory Melich – Morgan Stanley

And then to follow-up with the two-thirds at the register, as far as price optimization goes I know in the past you've spoken about that likely continuing into next year. Can you provide an update, if we're about a third of the way through with custom mix, about how far would price optimization be at this point?

Kevin P. Freeland

We're largely complete on price optimization in the front room and it's migrating to behind the parts counter at this point. And in terms of the cost of acquisition of goods, we are continuing with the roll out of our category management capabilities, which is allowing us to partner more closely with our vendors on pricing of their programs and the global sourcing.

First orders ship next month and that will ramp up substantially and put tail winds to our margins literally for years to come.

Darren R. Jackson

We're really in things that are other structural, as well. So we just began the Implantation Factory. There's an effort that we call reduce the margin drainers. What we're seeing in that space, just take an example like battery return rates, in our test districts we've been able to cut those in half. If we're able to sustain that and take that across the country, that will add to the margin going forward.

The other thing we talk about is that we have price overrides and what we could see, if we quartile our stores, some of our lowest margin performing stores, just by adding tools and decision frameworks for those store managers, we're seeing margin increases in our low quartile stores about 200 basis points, which doesn't mean they're necessarily raising prices, it's just we're making better decisions and we have better tools in terms of seeing the portfolio differently.

So I would say as we look out, we just see different things that we're putting time and energy into that are structural that I still think we're relatively early in the game in terms of those benefits and RP&O.

Operator

Your next question comes from Matthew J. Fassler – Goldman Sachs.

Matthew J. Fassler – Goldman Sachs

The inventory decline was quite impressive in terms of the kind of sales that you were able to produce with inventories down year-on-year. I guess a chunk of the decline related to the upslate of inventory that you cleared out and I guess didn't impact the P&L. I know this is ancient history now in terms of the charge that you took, but to what degree do you think that might have retrospectively added to gross margin performance, as you were able to achieve that inventory reduction without taking that hit?

Darren R. Jackson

To be honest, I think those are unrelated events. The improvement in turnover clearly that the getting rid of obsolete inventory is the lion's share of what's going on. As we reported, we have upgraded many, many stores' inventories. We are adding distribution facilities closer in to our stores in numerous markets. Those obviously require additional inventories, so the decline is coming in areas that we categorize as non-working, more than offsetting that.

But the lion's share of the margin gains that we're getting are on the main existing programs that would be considered healthy inventory.

Matthew J. Fassler – Goldman Sachs

Relating to the margin outlook over the remainder of the year, you listed a series of drivers that should be enduring in their impact for you and gross margin's been an obviously a driver of your improvement. As you look to Q4 you're up against an extremely impressive performance last year. As we look forward a quarter out, if you could just recap for us were there any tail winds a year ago that you would not expect to repeat and is there enough that you have in your tool box this year that you didn't have a year ago that will allow you to potentially cycle that successfully.

Michael A. Norona

Typically, as you know, we don't provide guidance. We have provided an annual outlook and so we're not going to comment on quarters three and four. But Kevin will share with you what the initiatives are and where we expect to see some of the benefits.

Kevin P. Freeland

The areas that we're working, as I mentioned on a previous question, what you're seeing embedded in the numbers right now has been price optimization in the front room and we're in the fall migrating into the back room.

There's also been an overall lower cost of acquisition of goods, through category management, and it's a very fine line and detailed process, category by category, vendor by vendor. And that will continue through the fall as well.

We have commented on the custom mix, which we're growing our share in the parts business and that will continue to grow as custom mix rolls out through the fall as well.

And then all the points that Darren made, there are numerous activities that are rolling out through the Implementation Factory that will preserve even a greater portion of the margins at the register than what we saw in second quarter.

Operator

Your next question comes from Anthony Cristello – BB&T Capital Markets.

Anthony Cristello – BB&T Capital Markets

When you look at the success you've had on the commercial side of the business and it seems like a lot of investment dollars and initiatives to drive what are very good sales there. If you contrast that with what's going on on the Do-It-Yourself side of the business, your traditional retail side, and I understand you've got initiatives underway, but it doesn't seem like the same level of emphasis is on that side of the business to try and either recapture share or aggressively close what is perceived to be a little bit, I think Jim noted, a market gap between the second quarter and what maybe the rest of the industry is doing.

Can you give a little bit of an update on how you see the DIY business evolving and how you are approaching that, in light of the aggressive push you have on commercial?

Jimmie L. Wade

I think a couple of different ways we look at it is that first of all, we are looking at the four walls of the store and how much total volume are we doing in the stores, so we are growing that, we're growing our share in total pretty significantly.

When we look at the individual businesses, you are certainly right, our biggest push and of our investment is in commercial and we certainly see the biggest opportunity there. But we are doing a lot of things internally to, not invest as much in DIY but to invest more specifically and get a better return on our investment. And we're spending less in areas like advertising and others on DIY but we are focusing our effort better on what we are spending.

And with the opportunities that we see, I think we mentioned in our comments about increasing the conversion rate of customers that are walking in our store and at the same time doing some things that increase the consideration rate, a lot of those things don't specifically take lots of investments. They do take a lot of hard work, to get into the detail and look at where we can drive the business better.

And when we look at our market share numbers, we have held our—in terms of our market growth, we have held that to the market through the first half of the year. Second quarter we were a little bit lower but when we're talking about little bit lower, it's literally tenths of a percent as opposed to significant.

So we think we can continue to see our DIY business perform well without substantial investments by focusing on some of those consideration and conversion opportunities that we have in our stores, and at the same time grow commercial and grow the total business in the stores and gain share.

Darren R. Jackson

Maybe to build on that a little bit, I think you're right. We came into this year with a view if we could pull DIY share, grow it a little bit, but we made deliberate decisions to channel resources, marketing being one of it, some of the labor dollars to out of the DIY business into the commercial business, and some of the focus of the team.

But there are other things that are running in the background. For example, I think we are up to 500 traffic counters and the way we think about the business as we think about concept, proof of concept scale, in terms of where we're going. And right now we're working on proof of concept in terms of what can we learn about conversion rates. We're working on tools, like staff to demand, to better put labor in the stores and help our store managers when the customers are in the store.

We are working on twenty-plus-three test divisions in terms of R&D to test new product categories. There are a handful of those that will work, a handful that won't work in terms of the business. We're testing new direct mail approaches.

But the truth is there still is a waiting, and it may even be a disproportionate waiting, when you start to think about the parts pros, the commercial sales people, the hours that are going into the commercial business, because we do believe, and we haven't veered from this, is that we have to rebalance the four walls of our store to be able to grow the profitability and the top line consistently over time.

And I think you will experience volatility in the short term. What Jim didn't say is we experienced a slight decline in dollar share, but in unit share, we actually saw our unit shares grow in the second quarter. Part of that is we're cleaning up pricing. And so as we've gone through all the pricing, as Kevin talked about, we will find places—an example is batteries—where we had to r-price.

And there are places, yes, that we're taking price up, other places where we're taking it down to be more competitive. Not necessarily having to leave the market, but we're recognizing in those key categories, we have to be able to project to our DIY customers better value, too.

So when you put all of that together, I would expect, and I know there's probably some concern about what happened to DIY, it's going to be a little more volatile in terms of our business, in part because we're a little further behind, and in part because we're cleaning up.

But you should know, we are not walking away from that business, but at this moment in time we just see the rebalancing effort is just critical to the longer-term business model of Advance.

Anthony Cristello – BB&T Capital Markets

On a follow-up, would you say that the initiatives underway to drive the commercial, then you're two-thirds of the way done, maybe more, and as you get into next year that you're going to be much better positioned. Will 2010 be the year where you try to say maybe and adjustment to APAL is necessary or—and I don't know that you gave specific numbers on traffic or what your conversions are, does that customer get the part 60% of the time, is it there 80%--but then are those when those initiatives sort of take hold for the DIY side?

Darren R. Jackson

I wish we were two-thirds done. We have a little further to go than that in terms of the commercial work.

Here's what I would say, is that we're going to launch the new commercial merchandising system in the second part of this year. We are beginning to turn our efforts towards, and we can't fix all of the past, but the truth is in many of our systems we started in the back of the house. We've got a terrific people soft HR system, but our POS system is not where it needs to be. Neither is APAL.

Kevin and his team with Rick Core are beginning that journey of what is POS, APAL, our e-commerce, as we talked a little bit about, we'll have our initial launch later this fall of our Beta C and I'm thrilled with the progress we're making. That's a principal DIY investment that will improve in-store pick up. You know, we're getting 1.5 million people coming to a site that you can just look at things today.

And so there are things that are DIY-oriented as we go into the back half of this year and into the next year, that I'm certain under Greg's leadership and the other leadership, we'll start to see better conversion. And that's what we've been focusing most of our efforts on right now.

But we're beginning to do testing in terms of the consideration efforts that as we look to next year I think will make that business a little more predictable. But it doesn't change the structural dynamics of that business, that it just tends to be, when looked at over the long term, a slower growth business, smaller than commercial, that we have to recognize in our longer-term strategy.

Operator

Your next question comes from Dan Wewer – Raymond James.

Dan Wewer – Raymond James

I was wanting to play devil's advocate on pricing optimization. One could view the completion of rolling that out to the front end of the stores coinciding with some deceleration in your Do-It-Yourself sales growth. Do you ever ask yourself, perhaps, demand is a bit more elastic, the pricing changes, than you had first anticipated?

Kevin P. Freeland

We actually have a system that we're very proud of how we manage our pricing and essentially every product that we carry is identified in how sensitive it is to prices vis-à-vis our competitors. The items that have been identified as the most sensitive, essentially we are competing aggressively in the market and attempting to be very aligned with what the market price for the products are.

And according to our records, have improved that position substantially over the course of the first and second quarter. So we would believe that a customer who is price aware and is calling around or shopping around would be quite pleased with what they see.

The benefits that we're receiving in optimization are in items that are not essentially high in a customer's thought process, they're more convenient type purchases. So we think the system is quite sustainable.

On top of that, that's only a portion of the gain. There's also gains in lower cost of acquisition of the product and is unrelated to the prices that we need to charge the customers and then it's also preservation of margins at point of sale, as Darren mentioned, adherents to battery-return policies and maintenance of–what level of ancillary discounts are we making to our commercial shop.

So according to the work that we're looking at, we don't see a link between what we're doing in pricing and the DIY sales.

Michael A. Norona

I'm just going to build on one thing that Kevin said earlier because as I'm reading all the research reports this morning, one of the themes and one of the questions that gets asked is what amount is this LIFO impact in the margin. I think Kevin said two-thirds were pricing the merchandising capabilities and one third were areas of shrink.

LIFO had no impact on the incremental margin of 189 basis points. What you will see in our 10-Q will be $3.3 million LIFO impact this year, annualized against a $3.5 million adjustment last year. So there is no impact from LIFO for the quarter.

Dan Wewer – Raymond James

And Mike, just to follow up on that, the industry has always told investors that margins are higher on do-it-yourself than commercial. And yet as Advance grows at commercial at a faster rate than Do-It-Yourself, you're actually delivering an accelerating increase in gross margin rate. Which doesn't make any sense. So just curious, are you seeing a significant increase in your margins in commercial that's more than offsetting this change in mix?

Darren R. Jackson

The short answer is if you think about at three levels you're right. Structurally DIY is a better gross margin business than commercial. I would say part two is, yes, we're seeing increases in our commercial business, pretty material ones in terms of the business. And I think you would say, well, what's driving it.

And part the truth is commercial, for us, I don't know that we put the time and energy into until recently, as I said earlier, bringing tools and techniques down to our parts pros. Things that help us in tiered pricing so we could look across all the different groups of commercial programs and begin to ask questions in terms of, well, wait a minute, we've got to have a level of integrity and pricing or consistency in pricing.

And we're just beginning that journey. So many of the things that I would say that the pricing benefits are coming from, a lot of it's hygiene. You know, that hygiene of consistency in terms of our offer.

I would say the other thing that we're seeing in pricing is we step up our service levels, our consistency, and our reliability. We're getting paid for it, and we would expect to get paid for it. We felt that one of our benefits, structurally, given our store locations, is that we're within 30 minutes of many of our key customers and we can turn those products around sometimes in 20 minutes and build those relationships that way.

And so the way I think about it is that consistency is getting us some benefit. I see it in some of my lowest margin stores getting better. The other thing I see in terms of margins getting better across, not necessarily from pricing, but from delivering on the value proposition of the service in 30 minutes.

Now, are we where we need be? We've still got a long way to go. But I think that's principally what's driving it.

Jimmie L. Wade

I think another way to look at that as well is that one of the ways that we're getting paid for it is as we provide that service level and we've become a bigger portion of that garage's purchases, we're seeing more parts sales. And that is driving higher margins because parts sales have higher margins to them. And that's clearly part of our entire value proposition that's built around the service to the customer.

Operator

Your final question comes from Chris Horvers – JP Morgan.

Chris Horvers – JP Morgan

I don't know if you have this data, but in terms of the market growth, you talked about June and July, was there a similar trend in the overall market growth?

And then could you refresh us on the gas shortages last year and how that played out as you went across Q3?

Jimmie L. Wade

On the first part of the question, in terms of how we look at the market growth relative to individual months, I think it's a much better view of a quarter than it is individual months, because it's just hard to look at specific trends on a monthly basis.

So on a monthly basis we look more internally, on a quarterly basis we look more across how have we done across the market.

Darren R. Jackson

And it's probably fair to say that the second quarter in general, from a market view in terms of the market data we get, came back to more of a rebalancing on historical levels. The first quarter, there's no doubt about it and particularly from a DIY point of view, it was terrific market growth quarter for Advance Auto Parts and we exceeded the market, by a touch.

And then in the second quarter I would say it returned to more historical levels, and we underperformed it, again by a touch. And that's in dollar share.

In unit share was the opposite. Our units were just a little shy of the market in Q1. But our units were a little better in Q2. And so I'm not losing a lot of sleep that DIY has had a big change. I think the market, when we looked at the first six months, looks reasonable to us.

Michael A. Norona

Just to build on Darren's point, the first three months of the year, the market grew about 7.5 and in the last three months it fell by about a half, to about 3.5.

Chris Horvers – JP Morgan

Any thoughts you have on what is slowing that down? I mean you hear a lot of talk out there about what Clunkers is doing. Are you hearing anything from your commercial guys, or within the traffic counters you have out there, any insight on is there an impact that you expect from that or any other change that would have caused that market growth to slow?

Kevin P. Freeland

The Clunkers program, I think it's going to be a short-term phenomenon and starting with about $1.0 billion, I think it's 250,000 cars. They've added on to it. You read mixed reports on what it's done. We think it's a short-term phenomenon. You know, it's a choppy market down there and I think Darren said it earlier, I think we got a little ahead of ourselves in terms of the retail business in the first quarter of the year, and I think it's normalizing back to the recent history and trends.

Jimmie L. Wade

As we went into the second quarter, even after we saw the first quarter strength in DIY, we didn't really plan on that for the second quarter. We anticipated somewhat of a lower rate and I think the lower rate is probably more reflective of what we're seeing as opposed to the strength in the DIY market overall in the first quarter and I think as Darren mentioned, there is going to be volatility from quarter to quarter as we work through some of the external factors that are affecting the business.

Darren R. Jackson

Of course, I come back to how are we doing on the units, how are we doing on the traffic, and some of it will sit in the pricing. A little bit in the inflation was probably a little less in the second quarter than it was in the first quarter. And so what I pay attention to is that when I look at our traffic counts, we didn't see a demonstrable fall off in year-over-year traffic patterns in the second quarter, so that's good. Customers are showing up.

And the other thing is, as I said before, we didn't see our units from a share point of view, fall off in the second quarter, we actually saw an uptick, so that's encouraging as well.

I think as we look to the back half of the year, without giving any projections, we're going to stay on strategy, we're going to stay focused on growing that commercial business. We did take some resources out of the DIY business, as we said. Principally in marketing. Maybe that's a little overdone and we have to re-look at that, but as I said, this market is going to go up, it's going to come down, but we feel good that what we set out to do, we're achieving.

Chris Horvers – JP Morgan

Any comment on the third quarter, how the shortages last year hurt you?

Darren R. Jackson

I don't know. I think the shortages probably hurt us but I think we had a few hot days in the third quarter that helped us, too. I used to tell my team, I don't want to talk about weather. I want to talk about things in our control. So you're right, we did in the third quarter have those gas shortages, we also had a gas price in the third quarter last year is my recollection, of about $3.82 a share. We're doing about $2.54 right now. So that should help us. Who knows where miles driven is going to go.

Michael A. Norona

Miles driven is positive, unemployment is up.

Darren R. Jackson

Mike always reminds me we're better operators than predictors of the future.

Operator

That's all the time we have for questions. I would like to turn the call back over to Judd Nystrom for final comments.

Judd Nystrom

Thanks to our audience for participating on our second quarter earnings conference call. If you have additional questions, please contact Joshua Moore at 952.715.5076. Reporters, please contact Shelley Whitaker at 540.561.8452.

Operator

This concludes today’s conference call.

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Source: Advance Auto Parts, Inc. Q2 2009 Earnings Call Transcript
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