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Executives

Darin Pellegrino – Controller

Will Oberton – President and CEO

Dan Florness – EVP and CFO

Analysts

David Manthey – Robert W. Baird

Sam Darkatsh – Raymond James

Brent Rakers – Morgan Keegan

John Baliotti – FTN Equity Capital Markets

Tom Hayes – Piper Jaffray

Jeffrey Germanotta – William Blair

Fastenal Company (FAST) Q3 2009 Earnings Call Transcript October 12, 2009 10:00 AM ET

Operator

Good day everyone and welcome to the Fastenal Company's third quarter fiscal year 2009 earnings conference call. Today’s conference is being recorded. At this time, I would like to turn the conference call over to Mr. Darin Pellegrino. Please go ahead sir.

Darin Pellegrino

Good morning and welcome to Fastenal’s third quarter earnings conference call. This call will be hosted by Will Oberton, our Chief Executive Officer and Dan Florness, our Chief Financial Officer. The call will last up to 45 minutes.

The call will start with a general overview of our quarterly results and operations by Will and Dan with the remainder of the time being open for questions and answers. Today's conference call is a proprietary Fastenal presentation and is being recorded by Fastenal.

No recording, reproduction, transmission or distribution of today's call is permitted without Fastenal's consent. This call is also being audio simulcast on the internet via the Fastenal’s investors’ home page at www.investor.fastenal.com. A replay of the web cast will be available on this website until December 1, 2009, at midnight Central Time.

As a reminder today's conference call includes statements regarding the company's anticipated financial and operating results as well as other forward-looking statements based on current expectations as defined by the Private Securities Litigation Reform Act of 1995.

Forward-looking statements may often be identified with words such as we expect, we anticipate, upcoming or similar indications of future expectations. It is important to note that the company's actual results may differ materially from those anticipated.

Information on factors that could cause actual results to differ materially from these forward-looking statements are contained in the company’s periodic filings with the Securities and Exchange Commission, and we encourage you to review those carefully. Investors are cautioned not to place undue reliance on such forward-looking statements as there is no assurance that the matter contained in such statements will occur.

Forward-looking statements are made as of today's date only and we will undertake no duty to update the information provided on this call.

I would now like to turn the call over to Will Oberton. Go ahead Will.

Will Oberton

Thank you, Darin, and thank you everybody for joining us this morning. I will spend a few minutes talking about the third quarter, then I will turn it over to Dan.

I'm going to jump right in and talk about sales. We had a very nice trend or we started a very nice trend in the third quarter. It was tough going into the third quarter, but if you look at the June through September daily average trend through the end of June, through the end of September in normal times between ‘98 and 2008 our average improvement was 2.4%, our June daily average to our September daily average.

During this period, the third quarter of 2009, we improved by 5.2%. So much stronger than we have over the last 7 or 8 years, or 10 years I should say. And the thing that impresses me -- or one thing that impresses me a lot about that is that we are able to do this without the help of new stores. Normally new stores would have contributed between 25% and 30% of that growth, and we didn't have a lot of new stores opened. So the growth is unusually strong considering that.

Talking to people in the field, trying to understand what is going on with our people in the field, I believe, the trend is a combination of one, low inventories at our suppliers that they have really worked the inventories down, and now I don't think they are rebuilding from what I hear, but they are using, consuming what they buy and so we are working off a very low show [ph].

The second is, I believe our sales force is really doing a good job taking market share. They are out there working hard, and a lot of our customers and even companies that aren’t our customers are still trying to save money. So they are very open to changing suppliers if the new supplier has something new to offer. So a very, very positive sales trend. We hope we can keep that going forward.

The margin was probably the only tough spot for us. So there are a lot of tough things, but the margin was the most difficult point for us in the third quarter. We knew going into the third quarter that it would be tough on margins, but we believe we hit bottom in August. All indications are that we hit bottom in August, and we should see improvement going forward.

I'm going to break down the components of the margin just a little bit. The biggest difficulty we had in the third quarter was caused by deflation in our product, and year-over-year we believe that cost us probably close to 100 basis points, and it is really that last year was so good because things were moving up and this year it was moving down so rapidly. It was more of a whipsaw effect.

But on a positive note, the CRU steel index that we follow actually bottomed out in the April-May time frame for both US steel and Asian steel markets. This is low carbon. Stainless steel also bottomed out, but it is slightly earlier than that. And now it is up about 10%. We have seen that in the prices that we are getting from our suppliers, mainly fastener suppliers. Our prices are starting to move up. So the deflation as we worked the inventory through is pretty much over as we see it, and we may even see some slight increases going forward. So that is very positive in that note.

Another area that we got -- we were hit hard with would be the volume incentives or product rebates that we receive from our suppliers for buying products. Our purchasing people did a really good job of renegotiating the deals going in, and I was confident that this wouldn't be a problem earlier in the year. But that was before I realized that our sales would be down as far as they were. So we worked hard to minimize the reduction in rebates, but it is still going to affect us. And a lot of that has to do with our decision to lower our inventories.

Another part of that is about -- probably in the August-September or late August, early September, as a management team we made a decision to not chase the volume incentives and really push hard going into the end of the year. We looked at our inventory position, we looked at where we were with our purchases and we said you know what, “Let us just buy what makes sense to us. Let us not be aggressive, because this is a really good decision for 2010.” So because of that you will see -- continue to see reductions in our inventory going forward into the year.

I was involved in that decision and believe it is a very good decision for Fastenal, but it will probably cost us or did cost us 20 to 30 basis points more in margin than it would if we would been aggressive, but yet a good decision.

The third thing in the margin that has been very difficult for us are what I would call market pressures. Earlier in the year, we were seeing just crazy pricing, and it was mainly in the fastener areas, not so much in the non-fasteners, but prices that we just were not just willing to go down to. In some cases we did lowered -- in many cases we lowered our prices, but not as far as we were getting pushed to do.

We believe it was caused by several things. One is that our competitors had a lot of inventory and they needed to create cash, turn the cash into inventory. We know that was happening with some of our suppliers, because they actually talk to us about it and explained their motives. We also believe it is going on with some of our competitors. Another part of it was people just trying to survive the market was very difficult out there earlier in the year.

Since about the June-July timeframe, the talk of that has been going down slightly, and I was out in Indianapolis last week, and had the opportunity to talk to dozens of customers that were there for a show, and it really seems like the crazy pricing has slowed down. Things have stabilized, and we believe going forward it will actually be more of a normal environment, maybe not an improving environment, but a normal environment from what we had seen earlier in the year.

So as a company we are very confident that we will see improvement in our margin going forward for all three of those reasons. Switching gears to expense control, not a lot to talk about on the SG&A. We did a nice job in almost all areas and believe we can continue that trend going forward. Inventory, another good area, I think we have done a very nice job in inventory. The people were able to reduce inventory more than we had expected going into the quarter. Part of that is due to our decision to not chase the rebates, and the volume incentives. But a lot of it is due just to hard work, looking at areas that we can reduce things out of, areas that we need to add inventory.

Going forward, I see in the fourth quarter that we will see another reduction in our inventory but it will be far slower than it was in the third quarter. It is more of a flat to down versus down, but still a very positive trend. Accounts receivables, the accounts receivable area is the area that I was most concerned with going into the year. When you read about -- every time you read in the newspaper, it was about bankruptcies and companies going out of business.

So I was very worried that our accounts receivable would stretch. As it turns out, that didn't happen and at this point year-over-year we are actually slightly better than we were last year, which is a very positive surprise or a very positive trend and I guess it surprises in my mind, because you would think accounts receivable would stretch in a very, very difficult time.

I think a lot of that has to do with the hard work our collections people have done. They have just been really stepping it up and trying to chase down customers or bad debt before it becomes a real problem. Transportation area, you saw if you read the release. We lowered our costs in transportation again. Little bit due to fuel costs. Well, quarter-to-quarter fuel costs were about the same, or the cost of fuel really rationalizing what we were doing, making sure that we are looking at all of our routes, hard work by the transportation group to keep things in line.

So with the exception of gross margin, most parts of our business are really doing well, and I'm very confident we will see improvement in the margin going forward. Another positive, and this is kind of a side note is that we have done a really good job or the company has done a good job of retention, especially with our middle and senior management. I went through it this morning and I could not identify one person that has left us for another opportunity in the middle and senior management. So we have at least a 99% retention, and what I can tell is actually at 100%, but I don't want to quote that without making sure my reports are right.

And at the store manager level, we have done very well there also. And one thing that this will do for us is going forward these people that are running these districts, running the stores, running our distribution centers, almost all of them have ran a bigger business, and they ran it back in 2008 when our business was bigger, and the most difficult thing we have ever done as a company is to develop people that can run larger businesses.

We have thousands of people in place today that have already done that. So as the business comes back and things pick up, it will be easier for us because the people that are running the business as individuals have already done it before. So the learning curve should be far lower, and we should be able to accelerate the growth going forward.

Based on the recent sales improvements and our confidence going forward, we have made a decision to open up the store openings or increase the store openings slightly. We are going to open approximately 25 stores in the fourth quarter, most of them being in the November-December timeframe. With that being said, we will continue to hold very tight on all other expenses, including labor. We will probably have to add a few people to put into those stores. I'm not sure of those numbers yet. I haven't looked at the individual numbers. But we're going to hold tight on all of our expenses, but we believe getting the new store machine running again and getting a head start going into 2010 is a very good decision considering a lot of the cost of opening a new store in a very good spot right now. Rents are down, a lot of good reasons to open businesses.

With that I thank you, and I am going to turn it over to Dan to touch on a few more areas.

Dan Florness

Thank you Will. Four things just going to highlight from the release. Will has touched on most of them, but I will just run through quickly and touch on a few myself. The gross margin challenges that Will talked about, I think he covered it in pretty good detail. The sales trend strengthening, and I will touch on that a little more in a second. Our SG&A, I believe that we managed it well going through the quarter. And as we have seen in the previous two quarters, continued strong cash flow as we have done, I think a good job managing the working capital side of our organization.

On the sales trends, lot of you, when I talked on previous calls and as Will touched on, we look at different periods in time and try to understand the sequential dynamics of our business, what happened in August and how that will influence September and how that will influence October et cetera. Historically, you have heard us talk about January being very, very driven by October of the previous year from a daily average standpoint.

Couple of things appear to me when I take historical numbers and just apply those to the reality what we have right now, and as Will touched on, in the last two months we have exceeded the trend line of those normal sequential patterns. If we were to just meet those trend lines as we go through the balance of the year and into next year what you would see is a continuing drop in our contraction level. I believe if the trends held through and I just apply that to where we are today, we would have contraction in the December timeframe in the single digits, and that would flip to growth in January, in the low single digits, and continue to grow from there if the historical patterns play out.

And in the last two months we have exceeded them, the previous months we were behind them. Some information I touched on last quarter, I will touch on again as it relates to some specifics within different industries we sell into. As we have talked in the past, manufacturing customer base is our largest single customer base. It represents approximately 50% of our sales. Our next largest customer base would be non-residential construction. That represents somewhere between 20% and 25% of sales. In the current quarter it was about 23%.

Selling to other wholesalers represents about 10% of our business. Government represents about 3%, transportation warehouse customers represent about 2%. Then a whole group of other ones combined add to up about 8%, all those are less than 2% individually. When I start looking at those pieces of our business, and I will focus on the manufacturing and construction, because those two represent over 70% of our sales, if you go back to January and you look at where we were versus the previous October, the business dropped off dramatically as the economy melted down globally, but extremely in the US.

Since January, our manufacturing book of business contracted from January down to about April. Since April, we have seen stabilization in that business and improvement of that business to where we are today. On a year-over-year basis in the month of September our manufacturing business was down about 20%. So it was performing slightly better than our overall company numbers for the month of September.

The construction business really has been sliding since February, and as of September that businesses is down 27% versus September of the year ago. Fortunately for us, the strength in manufacturing is more than 2 times larger than the construction piece. So it has been driving our improvements. The other piece of the business that has been fairly strong is our government sales, partly because of execution, partly because of the expanded spend by our federal government.

Our government business on a year-over-year basis, September to September is up about 10%. And so you lump all those together our September number was down 20.8 [ph]. It is a combination of all those pieces. The second item I want to touch on is the SG&A, and Will touched on a bit about the things we have been doing and we have touched on previous calls about things that we are doing to manage that.

A lot of discussions I have been having with our regional and national leadership has centered on not just what we have done, but our ability to hold those improvements as we go into the New Year. If you look at the payroll piece of the equation, between 60% and 65% of our operating expenses, we have done a nice job on that throughout the year. Some of that has occurred naturally because of our compensation models. Our commission dollars have dropped year-over-year. Our bonus dollars have dropped year-over-year just because of the level of sales and the level of profitability.

If I look at that going into the first quarter that will be our biggest challenge to manage through, but I look at that as a good problem. I look at that as I am talking to our leadership of those dollars we want to be there, we need to manage everything else around it to make sure that happens for our stores personnel and for our district personnel, and I believe it's in the cards that you heard what Will talked about with our headcount plans as we go into the balance of this year and into the new year.

The second biggest component of operating expenses is occupancy. A couple of numbers I will share with you. From Q2 to Q3, our occupancy expense increased three-tenths of 1%. On a year-over-year basis, our occupancy is up seven-tenths of 1%. Early in the year we talked about things that we were doing as it related to renegotiating existing leases, as it related to when we do move or when we do open a store, what level of rent we are willing to pay.

We have been very strict on that internally. We haven't accomplished everything that we set out to do, but I'm very pleased with what we are seeing in the numbers right now, because it really sets us up in a good position for 2010 to be able to manage our occupancy expenses very well, because of the changes we have made, the changes that are being made, and the discipline we have when it comes to new store openings late this year and into the new year.

Finally, the third biggest piece within operating expenses is the product movement. Will touched on it a little bit ago. Fuel was as a piece of it on a year-over-year basis, not so much on a sequential basis. But one thing that when I look out to Q1 and Q2, last year we were very, very aggressively selling off vehicles in our store fleet. Late in 2008, we built a little bit of a backlog of vehicles, in that we buy our vehicles and we turn our vehicles with a certain level of frequency to maintain a very new fleet at our store locations.

And in doing that in the first and second quarters of this year, we incurred about $1 million a quarter in losses because we were turning our fleet so dramatically. Those dollars discontinued as we got into Q3, and they will be behind us as we get into the new year. And so that was a good decision early in the year to cycle our fleet, but we incurred some expenses because of it.

Finally on the cash flow side, I'm also very pleased with what we have been able to do on the working capital. If you look at our third quarter, our sales are down 21.7, our accounts receivables were down 22.6. If I look at the year, personally the year has been frustrating from this standpoint. We have incurred bad debt at a much higher rate than we have historically seen. We are at close to 50 basis points in the third quarter here.

Our expense for the year will be up -- year-to-date is up roughly 25% versus what it was in 2008, even our sales are off quite dramatically. However, when I really split that apart if you look at our 2009 expense, about 15% of that is because we have increased the reserves as we have gone through the year because of some of the ageing and some of the bankruptcies we have been dealt. So I feel very good about that going into the new year, as the trends improve and I believe they will that we will be in a good position to not only maintain the improvement in collections that we have enjoyed, but also see a reduction in our bad debt rates.

And one item I would touch on when I look at our accounts receivable, the improvement has really been driven by improvements in the ageing of 30 to 60 day year old receivables. We modified some things that we do with billing. We have more electronic billing today than we have ever had in the past. It speeds up the process both for us and for our customers, and so when I look at the improvements in accounts receivable, it is actually not shining through as strongly as it could because of some of the bankrupt accounts that are still sitting in our aging [ph], but very pleased with not only the improvements but the sustainability of the improvements.

On inventory, if you look at the year-to-date reductions, about a third of that is at the store level, about two thirds of that is at the DC. I feel good about that because historically we have struggled when we it comes to managing inventory at the store level. If you manage inventory at the DC level by turning off the inbound spigot by pulling back on your buying, but because of the decentralized nature of our organization, managing at the store level is a lot more challenging, and I really believe we built the mechanism to do that. And we will have the benefit of that as we go into the new year.

Finally, on cash flow, the second piece of cash flow after working capital really looks at your CapEx. Coming into the year, we said we expected about $65 million worth of CapEx. That number I believe now will be closer to 55 or maybe just slightly below that number. If you look at the delta, about half of that is coming from the pull-back in some of the store openings that we’ve had this year and pull-back in some of the vehicles we are buying this year. The other half is coming from IT spend just being less than we anticipated coming into the year, which is a great thing. And so I believe for the year it will be 55 or just slightly below.

As I look out to 2010 and 2011, I don't want to get out too far ahead of myself, and we haven't done our detailed capital budgeting for next year, I really believe we can get to a number that in the 40s. That is the realist side of me talking. The accountant side of me would say that will probably be in the low 50s, but that is only because I will be hedging my bet. But I think we can get that number down into the 40s. And it really reflects our ability to leverage the dramatic capital infusion we have had over the last several years in our distribution side, most notably our Indianapolis facility and our Denton, Texas facility, and our ability to leverage that into the future and reduce the need for some capital spending and improve on the operational side at the same time.

With that I will turn it back over for the Q&A section, and again I would appreciate so everybody could have the opportunity to ask questions, limit yourself to one question and then get back in queue if you want to do a second. Thank you.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) We will take our first question from David Manthey of Robert W. Baird.

David Manthey - Robert W. Baird

Hi guys, good morning.

Will Oberton

Good morning Dave.

David Manthey - Robert W. Baird

Just a quick question on outside sales reps, do you have a target for OSRs in 2010?

Will Oberton

We really aren’t putting out a number Dave. Right now it's going to depend on sales growth. As sales pick up, we'll move that number up and right now we're still historically high if you compare it to our daily sales rate.

David Manthey - Robert W. Baird

Just as a follow-up there Will -- can you then compare it maybe to the 7 to 10 range and just give us an idea if there is a multiplier or a different range that you might fall in to relative to the store openings?

Will Oberton

I am going to let Dan -- I didn't quite understand it. Go ahead Dan.

Dan Florness

If you look at the, you know, if we open 7% to 10% stores, each of those stores will have an OSP, and so an outside salesperson, excuse me, and assuming that the sales numbers trend out the way we were talking. I am shooting a little bit from the hip here, maybe 130% of our store openings will be our number for OSPs as far as -- if we are at you know, 7% maybe that number is more like 9% outside sales growth, but I don't want to get too far ahead of myself because we are really going to wait and see how that plays out because it is going to be driven. What's really going to drive that number is when you look our 5 plus and 10 plus year old stores, seeing the contraction drop and the growth pickup in that group because that's really what's going to drive it.

We believe that a lot of our growth in 2010 will just be our existing customers increasing their spend, which really doesn't require any more selling time. The really positive is we retain those customers through this difficult time.

David Manthey - Robert W. Baird

All right, thanks a lot guys.

Operator

We'll go to Sam Darkatsh of Raymond James.

Sam Darkatsh – Raymond James

Good morning Will and Dan, how are you?

Will Oberton

Thanks, doing well.

Sam Darkatsh – Raymond James

The 51% gross margin, I believe was your original expectation, your time to give the differentials, the variances on a year-on-year basis, but what was outside of the 20 to 30 bips of lower vendor volume allowances because of your decision to take inventories down, what was the -- what were the primary variances versus your expectations for gross margin heading into the quarter?

Will Oberton

Well, you know, coming at you know, in the second quarter we were at just north of 51. We were at 51.1, and in our July call we really talked about we expected the gross margin to contract in the third quarter. I actually expected it would contract, I thought we'd come in at about 50.5 coming into the quarter. I don't necessarily you know, call it out that way on the cogs. We are always careful not giving guidance because that's is not just our MO [ph] but just my gut was telling me that we would see some additional challenges on what we call our point of sale margin, our transactional invoice margin, and I knew just based on what trends we were seeing with spend, excuse me with sales consumption versus spend with our suppliers that we would see some contraction, say 20 basis points in our rebate vendor allowances side of the equation. Both of those end up being a little higher than anticipated, and that's really what pulled this down to 50.

Sam Darkatsh – Raymond James

So your expectations then for Q4 based on what you're seeing now would be again similar 50, 51 kind of thing or would there be sequential improvement you believe?

Will Oberton

I would expect to see a sequential improvement, although I believe that's going to be nominal until we really start getting into 2010. Some things that link to the calendar if you think about different components of our gross margin. The biggest one that we talked about is the vendor allowance rebate program. Those are typically calendar year programs, and they'll reset themselves as you get into the new year, and so you'll see a nominal improvement in Q1, and then you really see the improvement start to take hold in Q2 because the inventory that you have at the end of the -- the rebate or vendor allowances you earn in the first quarter, they are really sitting on your balance sheet at the end of the first quarter just because those are part of your cost of inventory, but then they start turning through your costs in that second quarter.

And those turn faster than when we talk a lot about our import dollars that we've been running through this year because a lot of that is very much driven by domestic vendors. That's where the rebate programs are more prevalent and that inventory turns faster, because we are sourcing it and we tend to stock more of that at our store locations than at our DCs, whereas our DCs tend to stock more of the import side because they are acting as the master importer.

Sam Darkatsh – Raymond James

Thank you very much.

Operator

We will go to Brent Rakers of Morgan Keegan.

Brent Rakers - Morgan Keegan

Yes, good morning. I think following up with the last question. Dan and Will, I was hoping you could maybe walk us through each of the three major categories of gross margin and maybe talk us through, you know, if August was I guess the worst you experienced of the quarter, September got better but I just want to understand within the different three metrics deflation, rebates and market pressures, if all of those three categories got better or maybe which ones got worse and give me a directional feel on that line?

Will Oberton

I will start, then hand it to Dan but you have to understand on both market pressure and the deflation, they are ready very, very hard to measure on a short term month-to-month basis. The market pressure mainly it is anecdotal, you talk to your customers; we talk to our people. The only measure we have on that is looking at our POS reported margin and that did improve -- internal margin that did improve. August was the low point for that, and on the deflation that's really about inventory coming through and you know, printed or posted numbers, steel hit the bottom in May, April-May time frame. It has been moving up ever since. So that will it be improving with August being the low point. I'll hand it to Dan.

Dan Florness

On the final piece, the rebate side, we do a pretty detailed analysis by vendor, where we think the number is going to come in at, and so that doesn't really lend itself to month-to-month changes. That's really the number we book for the -- recorded for the quarter is based on that analysis. So it really won’t lend itself to those type of changes, but it's really looking at the POS or transactional data that we focus the energy on.

Brent Rakers - Morgan Keegan

And just as a quick follow-up, I think in your guys opening comments you talked about on the rebate side making some decisions in September that caused you 20 to 30 basis points for the quarter. Does that at all mean that given that that will carry over to Q4, does that mean we should take that impact three months fold in Q4, so a greater impact negative in Q4?

Dan Florness

No.

Will Oberton

No. It affected the quarter. I'm just saying the decision was made in the August-September timeframe. It affected the entire quarter, and the fourth quarter will have the same effect.

Brent Rakers - Morgan Keegan

Great. Thank you.

Operator

We will go to John Baliotti of FTN Equity Capital Markets.

John Baliotti - FTN Equity Capital Markets

I just want you to break down SG&A a little bit, you guys mentioned in the release that your payroll and related expenses are about down to about 60% to 65% of sales, and -- but SG&A in total is up about 180, 190 basis points, could you maybe walk through the other 35% or 40%, how the dynamics there are moving around?

Will Oberton

The -- well the payroll piece was right around 62%. Historically, we always talk about that being 65% to 70%. The reason that's lower is our commissions and bonus pay out as well as our headcount and part-time hours are down so dramatically from the year ago that we really made that a very variable cost component of our operating expenses.

If I look at other items within the operating expenses, our occupancy was basically flat, or was up three-tenths of a percent or 30 basis points from last quarter, and is up about 70 basis points year-over-year.

John Baliotti - FTN Equity Capital Markets

But if you compare that to sales, that would add almost a point of SG&A relative to sales as our sales were down 20%.

Will Oberton

Yes, our occupancy is running about 7% of sales and it was about 6% a year ago.

John Baliotti - FTN Equity Capital Markets

So that's almost the entire increase you’re talking about?

Will Oberton

Right. The other piece that -- the other two components of the increase would be and we touched on this last quarter. Our health insurance costs have increased meaningfully year-over-year, and what's really driving that is when we look at the percentage of our employees that are opting for healthcare and the percentage of those employees that opt for healthcare that are taking family coverage, both of those are up dramatically from where they were in the first three quarters of 2008, and it really comes from our employee has a spouse.

The spouse either loses benefits where they work or loses their job, so they either go from not having coverage at all to family coverage or they go from single coverage because they each had coverage with their own employer to family coverage, and that's quite a bit more expensive for us to offer for our employees. So that is one piece of it. The other piece of it is what we talked about on the bad debt side.

Dan Florness

One other piece of it is our -- some of our fixed expense like phone expense, trash, computer license, all of that is up slightly because they're really fixed expenses if you, you know, your phone lines. They amount to about 2% of sales, sales being down, those being flat, still increase the SG&A as a percentage of sales. There is very little we can do in some of those expenses when sales contract.

John Baliotti - FTN Equity Capital Markets

Yes, I will just follow up there, you mentioned in this release that given the shifts you have done through pathway to profitability that more of your cost is variable versus fixed, but I don't know if that -- it didn't seem evident on the quarter. It just -- if you look at sales and profits for store they seem to be down more than the sales decline, and I just, is that just something that we should see later in the year on does it seem like that would indicate there is more fixed cost than variable cost right now?

Will Oberton

Well, you have to look at it in the context of magnitude. When your sales are off, you know, 20% to 22% there is you know, components that are variable but they are not that variable. If you look at even you know, on the payroll side we've done a good job managing that relative to our sales. Even when you look at the other components of operating expenses, the fixed versus variable, if we were down you know, 10% our business was flat.

That's what we talk about when we talk about fixed versus variable. It's just that the magnitude of the drop in sales is so dramatic, you know, we're still even though we are not opening as many stores as historically normal for us, we're still opening stores, and so we are adding expenses to the pool, and then there is some that quite frankly should be variable when I think like a healthcare, that should be a variable expense. If your head count is down your expense should be down, and we have seen just the opposite of that.

Dan Florness

And we've made some decisions that may not help the bottom line as much. One is that, you know, we looked at our health insurance and we have very generous programs. We’re not going to change that because we believe it's the right thing to do, and the other thing that we've done is we really tried to keep all of our good people. A lot of companies would have been laying off like crazy.

So we've made some decisions on expenses where we could have reinforced the bottom line or improved the bottom line, but they're really good decisions because as things pick up as I said early we have retained our people, we're taking care of them from an insurance standpoint. We really believe going forward the benefits are going to be huge.

John Baliotti - FTN Equity Capital Markets

Okay. So in the future, I mean it is more -- more of your cost is variable versus fixed, would that impact -- wouldn’t that impact your leverage going forward as volume picks up or is it just because on a weighted basis it's not really that much more.

Dan Florness

Well, you look at it and say it's variable, but again we get back to magnitude, and let's go back to the Q1 as an example because it's something that's fresh in my mind in that I am talking to a lot of our regionals about it, as they have been in for their meetings. In Q1 if you look at our labor costs, our labor costs were down about $10 million year-over-year. 90% of that came from bonus and commission, and so it was a variable component and that's one where we have to be very conscious of that number growing as we're going to the new year, but it grows because our profits and sales are growing, but it's not going to -- but when you look at the other components of labor and you look at the other components of SG&A, even though they are variable, they are not a one-to-one match variable to sales, and so you will, you know, you would see leverage in that environment.

They aren't variable enough to get it down to negative 20, but they're are variable enough to hold the expense from growing as we leverage into the new year.

John Baliotti - FTN Equity Capital Markets

Got you.

Will Oberton

And had we not done the pathway to profit and had 300 or 400 more stores on the books, our profit picture would be far worse than it is, because of the fixed expense of those stores. That's what Dan is referring to in the pathway to profit, variable versus fixed cost scenario.

John Baliotti - FTN Equity Capital Markets

Got you, thank you.

Operator

(Operator instructions) We will go to Tom Hayes of Piper Jaffray.

Tom Hayes - Piper Jaffray

Great, good morning. Just want to follow up a little bit on the SG&A type questions. You had -- you mentioned that the company has been transitioning to more of a variable base cost. I was just thinking, looking towards 2010, you know, assuming as you stated in the release that there is some increased store openings with the 25 stores in the fourth quarter, and generally improving outlook for the economy as you stated, it's getting a little bit better. What are your some of your underlying assumptions for SG&A going forward as far as, how much of the reductions you're seen this year are likely to come back?

Dan Florness

Well, you know, on the -- if you look at the components that we breakout in our monthly releases as well as in our quarterly releases, some of the reductions at the store level will come back as the volumes dictate, but when I look at the ability to leverage, that should be you know, no worse than it would have been a year ago as far as our ability to leverage. The piece that relates to distribution and the piece that relates to support, those are dollars we've pulled back that we believe have much greater staying power, because we've improved the efficiency of the organization.

You know, the one thing you do in an environment like this is you challenge yourself to get better. You know, the headcount reductions on the store side were partly predicated on a need to reduce expense relative to the contracting sales. It was also predicated on the fact if you're moving 20% fewer boxes or 20% less products it takes a portion of our store laborers about moving the package, not about making the sale. And so those reductions would be there.

Hopefully we've gained some efficiency. We won’t need to replace it dollar for dollar as we grow, but if we were sitting on an environment next year and we're going at 10%, 15%, 20%, 25% whatever the market gives us, you would see that store labor going up for two reasons, one removing more boxes and two we're willing to invest more aggressively in our outside sales program. On the distribution side and on the support side, if we are moving more packages yes, we would need more people in our distribution centers, but our distribution centers are night and day more efficient, especially our Indianapolis and Denton facilities than they were a year ago because of the automation we have added into those facilities.

The administrative support side, there wouldn't be much additions there because we really are -- have leaned up the organization, and we have leaned that up in an environment where transactionally, our transaction count isn't down that very much from a year ago. In fact, some of the transactions are up. It's just the dollars per transaction are down. So we've really already incorporated those savings into our equation. Flipping that over to the SG&A side, you know, I believe we'd in a great position to leverage some of our insurance costs, to leverage our occupancy cost going to the new year. On the transportation side, it's really been predicated on what few budgets do more than anything else, but we are better at turning our fleet than we were a year ago.

Tom Hayes - Piper Jaffray

Okay.

Will Oberton

We'll also leverage like I talked about computer licensing, software agreements, telephone costs, all that will leverage right up because that's pretty much fixed.

Tom Hayes - Piper Jaffray

Okay, I mean you mentioned the increased leverage that you're seeing through the Indianapolis and Denton facilities, just to get some idea of scale, how much of the total locations with those two locations support?

Will Oberton

Well, Denton only supports about 8% or 9% of our revenue, but Indianapolis is a central distribution and from an expense standpoint, it represents close to 30% of our total distribution expense, and it's going to show significant improvement.

Tom Hayes - Piper Jaffray

Okay, great. Thank you.

Operator

We'll go to Jeffrey Germanotta of William Blair.

Jeffrey Germanotta - William Blair

Hi, good morning.

Will Oberton

Hi Jeff.

Dan Florness

Good morning Jeff.

Jeffrey Germanotta - William Blair

This question is kind of a derivative of some things that have been asked already, but in the past you've said you have lowered expenses to the point where flat sales growth could result in flat profit growth going forward. As you contemplate ramping up investments in stores and sales people you know, in the months ahead, does that dynamic still hold or will that increased investment spending perhaps slow that down a little bit?

Dan Florness

That dynamics still holds.

Will Oberton

I will make one point at little [ph] at your question Jeff, but everyone has to understand that our people are paid out bonuses and those bonuses don't kick in until the profits kick in. So they work in parallel or they work, you know, run together. So if the profits don't come back with the sales that means the bonuses don't come back with this sales, and we have a highly motivated team that all they stuck with is sort of a slow down. They'd like to get their bonuses back. So on a really positive note, we have a team that's going to work really hard, increase their bonuses and the side product or the end product of that is improved profit, and that's the way our system has always worked. I mean that's why we have the variable variability in it, because when it's coming back it should come back very rapidly.

Jeffrey Germanotta - William Blair

Thank you.

Operator

And I'll turn the conference back to management for any additional remarks.

Dan Florness

Thank you Shelby. Again as Will mentioned at the start of the call, I want to thank everybody. I know we have employees on the call, we have shareholders on the call, and I want to thank everybody for participating in our call today. Hopefully, you find these calls useful and can appreciate the optimism we have as we look forward to the balance of the year and in 2010. Thank you and have a good day.

Operator

That concludes today's conference call. We thank you for your participation.

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