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Advance Auto Parts Incorporated (NYSE:AAP)

Q4 2009 Earnings Call Transcript

February 18, 2010 10:00 am ET

Executives

Joshua Moore – Director, Planning & Performance Management

Darren Jackson – CEO

Jim Wade – President

Kevin Freeland – COO

Mike Norona – EVP and CFO

Analysts

Anthony Cristello – BB&T Capital Markets

Matthew Fassler – Goldman Sachs

Gregory Melich – Morgan Stanley

Scott Ciccarelli – RBC Capital Markets

Kate McShane – Citi Investment Research

Michael Lasser – Barclays Capital

Dan Wewer – Raymond James

Operator

Welcome to the Advance Auto Parts fourth quarter 2009 conference call. Before we begin, Joshua Moore, Director, Planning & Performance Management and Investor Relations will make a brief statement concerning forward-looking statements that will be made on this call.

Joshua Moore

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

The company intends these forward-looking statements to speak only as of the time of this conference call and does not undertake to update or revise them as more information becomes available. I’d like to remind you that our fiscal 2009 results include the impact of store divestitures and our fiscal 2008 fourth quarter and full year results include the impact of both a 53rd week and a non-cash inventory adjustment resulting from a change in inventory management approach.

Results on this call will be on a 12-week and 52-week comparable operating basis as that provides a more transparent and relevant year-over-year comparison. We have provided both GAAP and comparable financial results in our press release. For planning purposes, our first quarter earnings release is scheduled for Wednesday, May 19th, 2010, after market close, and our quarterly conference call is scheduled for the morning of Thursday, May 20th, 2010. To be notified of the dates of future earnings reports, 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. Darren?

Darren Jackson

Thanks, Joshua. Good morning everyone. Welcome to our fourth quarter conference call. First, I would like to begin by thanking our 49,000 team members for their hard work during the fourth quarter and fiscal 2009 year. Their contributions have produced many accomplishments this year both financially and strategically. Since we begin our journey to turnaround and transform our company, there has been several quarters which the financial results significantly outpaced our strategic results. However, during the fourth quarter our strategic results outpaced our financial results. Overall, we had many strategic successes in the quarter, but quite frankly our fourth quarter performance did not meet our financial expectations.

As an organization we don’t measure success by the results of one quarter. However, our organization will never be satisfied with underperformance. We believe that the fourth quarter performance more of a short-term setback than a long-term trend. That said, both our strategic and financial results for fiscal 2009 were very encouraging. Results can mean different things to different people, our results include improvement and customer satisfaction, team member engagement increased average to our sales growth, and double digit gains in both our operating income and economic profit. These results translated into return on invested capital of 15.1%, which is up 110 basis points over last year.

Collectively our balance between long-term and short-term improvements reinforced our positive outlook for 2010 and beyond. Fiscal 2009 and it’s the turnaround phase of our Advance Auto Parts' strategic plan. Over the past few years our focus has been on setting clear strategic direction for advance throughout the four key strategies, closing material capability gaps and accelerating our top line growth. Simply put, we focused on reigniting our core values of our team, inspire, serve and grow to deliver legendary customer service. To this then we began rebalancing our business to pave the way for an integrated 50/50 DIY commercial model. We overhauled our merchandise and supply chain capabilities to grow both our top line and our margin rate. We developed our first truly integrated e-commerce website to provide a multi-channel experience for customers, and we strengthened our hard parts business, which had been neglected over the years.

Finally, we accelerated our commercial growth, which resulted in eight consecutive quarters of double digit commercial comps sales growth for advance stores. The breadth of pace of this change and both the aggressive – can be both aggressive and challenging at times, yet it had been necessary, fiscal 2010 over the new year and the next phase of our strategic plan. We continue to see positive trends for our industry with the strengthening of our garage customers is the result of dealer closings, increases an average vehicle age and increases in miles driven. Combined with these positive signs in our industry and the breadth of our change over the past few years, our focus will now move from depth to change focusing on fewer priorities to bigger impacts.

That focus will be squarely on our customer facing capabilities, primarily retail, commercial and store operations. The specific areas we will focus on are leadership effectiveness, customer engagement and operations excellence. We will ensure our team leaders in our stores are prepared to manage an integrated service model providing legendary customer service, both our DIY and our commercial customers, and ensure our team members have the tools in the form of systems, standardized processes and training to deliver service consistently each time and every time. Jim, Kevin and Mike will outline some of these priorities later in the call.

In early January, we held our annual leadership conference with all our general managers, district managers and other team leadership, nearly 4880 front line leaders. Our ability to harness 49,000 team members to understand, embrace, execute our strategies and priorities will drive our success in the long-term. I am confident we are moving in the right direction. That confidence comes as a result of the feedback from our Leadership Conference where 95% plus respondent their poll [ph] clear about what is expected of them and are excited about the future of our company. We have a focused agenda to accelerate growth and I am encouraged with our start for 2010.

During the conference, we recognized store general managers and our field teams for their accomplishments over the past year. As part of that recognition, we also acknowledged one regional vice president in each of our three areas of RVP of the year. Our three award winners for 2009 were Joe Gandalis [ph], Frank Miller and Mike Hox [ph]. These leaders and their teams are great examples of leaders who teach our values by serving our customers better than anyone. Congratulations to all of our work winners including Joe, Frank and Mike for their contributions.

Now, I would like to turn the call over the Jim Wade, our President to provide progress update on our commercial acceleration and DIY transformation strategy.

Jim Wade

Thank you, Darren and good morning. I would also like to thank our team for a successful year in 2009. I'll start my comments by reviewing our total sales growth and then talking about our progress with our commercial acceleration and DIY transformation strategy.

Our total comp sales growth for the fourth quarter was 2.4% compared to 3% during the same quarter last year. We are not satisfied with our overall fourth quarter sales results. However, we did again achieve an increase in both customer transactions and average transaction size and our sales growth rate was close to two times the market growth during the quarter, which has positioned us well for a successful 2010.

Looking at our commercial performance, our total comp sales increase was 9.5% and for advance stores our comp increase was 10.2%, which represented our eighth consecutive quarter of double-digit growth. When adjusted for the calendar change from last year, our total commercial comp sales increased to 11.3%. This increase was on top of the 13.7% comp sales increase including AI and a 14.5% comp increase for Advance Stores during the fourth quarter last year. As a result of our comp sales growth our commercial sales mix as a percent of total sales increased to 32% towards our goal of 50% of total sales overtime.

We continue to gain significant market share in commercial during the fourth quarter and even with accelerated growth our market share in the $40 billion commercial market is less than 5%. Our team knows we have a lot of room for continued growth. Our commercial gross profit rate also continues to improve driven by the increased mix in part sales and better merchandizing and operational capabilities. Since we are at the end of our year, I want to take a moment to look back and what we accomplished with our commercial initiatives in 2009 as well as for our focuses will be in 2010.

As we’ve said in previous calls, we focused our commercial initiatives and what our customers tell us is most important for them. Have the part, I need, deliver to me quickly and accurately every time. We’ve now completed investments in additional parts pro’s, trucks and drivers in approximately one-third of our stores. These stores have produced comp sales increases significantly higher than our double-digit company average. We’ll use the return on these investments as they mature to make investments in additional store of 2010.

We have made investments in inventory upgrades across many of our stores over the past two years. Kevin has been keeping you up-to-date on both key brands added as well as increased parts availability. These improvements have contributed significantly to our commercial growth and will continue in 2010. We made good progress in 2009 on redefining and aligning the roles and responsibilities of our field and store teams to prepare us for a 50/50 commercial in DIY sales mix.

Being a leader in commercial requires changes in how our general managers and key store leaders do their jobs to enable and to serve both DIY and commercial customers effectively. We also made progress in 2009 raising the overall operation consistency of our service to our garages. This will be a key focus in 2010 as we expand our use of technology in our stores to receive, track and deliver orders consistently and quickly. We believe this will be a key to increasing our retention of existing customers while continuing to add new customers.

In 2009, we built and strengthen our commercial sales force. For the year, our sales force grew by over 120 team members representing a 45% increase from the beginning of the year. While we are not completely where we think we need to be in the size of our sales force, we made substantial progress towards that goal. In 2010, we will focus on making our sales force more productive by continuing to refine our focus on our most important customers and to build deeper relationships with those customers.

In addition to sales growth, we track our customer satisfaction scores to measure our progress in commercial. We are pleased that our satisfaction scores have increased significantly over last year. Also our net promoter score, the percentage of customers who are saying we almost always have the part they need, and the percent of customers who say we almost always deliver the part on a timely basis all showed strong gains.

We are also pleased that our customer gave us high scores for taking the time to understand our business, which we believe measures the deep relationships we are building. With these initiatives, we believe we have the potential to grow this business in low double-digits again in 2010.

Now turning to our DIY transformation, our fourth quarter DIY comp store sales were negative 0.8% after three consecutive quarters with positive comp. After adjusting for the counter shift our comp stores sales decreased by roughly 0.4%. Although our fourth quarter year-over-year comparison became significant and more challenging, we are not happy with our fourth quarter results. For the 2009 year, we delivered a comparable 1.7%, which was our first full year of positive DIY comps since 2005.

Our DIY market share decreased just slightly, about 10 basis points at the end of the fourth quarter compared to the same time in 2008. To put that in perspective, our growth in DIY in 2009 was impacted by the acceleration of store closings, the deceleration of new store openings, reduced marketing spend in the second and third quarters and the absence of e-commerce platform.

However, we made significant success to strengthen our core capabilities, including marketing, real estate and the establishment of our e-commerce platform, which provide us confidence in our ability to strengthen our relationship with our DIY customers and grow our business with them.

As I deal with commercial I want to take just a moment to look back at what we accomplished with our DIY initiatives in 2009 as well as where our focus would be in 2010. We have focused our DIY initiatives on what customers tell us is most important. Friendly and knowledgeable people who can solve my problem, are available when I need them and have the part I need when I need it.

The parts availability initiatives I described in regard to commercial apply equally with DIY. We will continue to increase our parts availability in 2010. In order to ensure our customers that our team members are available when needed, we are improving the staffing of our stores based on the demand driven model that focuses on customer transactions and traffic patterns.

The next phase of this process will be rolling out to our stores in the first half of 2010, we will provide them more tools to have their staffing available at the right time. We focus significant resources in 2009 and especially in the second half of the year on DIY sales training and development. This reinforces the basic reading and problem solving skills of our teams. Likewise the next phase of this training rolls out in the first half of this year. We are also working to fully more effective strategies to increase the number of customers who come to our stores. As we discussed last quarter, we made significant changes to our marketing program and approach. We've implemented a more targeted approach to attract our highest potential customers. Through this work we had established a title sponsorship with Monster Jam, which we announced in the fourth quarter.

We believe that Monster Jam is a perfect fit for us as their store footprints aligns very well with our store footprints. Our customer satisfaction stores for DIY have also continued to increase over last year on an already strong base. Again we are receiving high marks for our increased parts availability and our net from auto [ph] stores increased as well. With these stores and with the initiatives that we are focused on, we believe we can maintain and grow market share over time with their DIY customers while continuing to aggressively grow our commercial business.

As then in Hawaii [ph] we held our annual general managers conference during the first week of January. This meeting is always a great opportunity for all of us to deepen our focus on building and coaching great store teams and recommitting ourselves to doing those things that are essential to meeting our customers' needs. We always come away from this meeting excited about the passion and commitment of our team to serving our customers better than anyone else, which is what makes Advance Auto Parts the special company. Our team's energy and customer focus I believe what leaves us to another successful year in 2010. Thanks again to our team for what you are doing each day to serve our customers and drive our results. We look forward to a great 2010.

Now, I would like to turn the call over to Kevin Freeland, Chief Operating Officer to review our availability, excellent strategy.

Kevin Freeland

Thanks, Jim, and good morning. I would also like to thank the team for their hard work during the fourth quarter in 2009. I will take a minute to highlight a few of the accomplishments during the quarter and year as well as update you on our initiatives to strengthen our gross profit rates and improve our inventory availability.

During the fourth quarter, our gross profit rate increased 78 basis points versus the fourth quarter last year. This increase was on top of 140 basis point increase during the same comparable period last year. For the year our gross profit rate increased 149 basis points to 48.9%.

During the quarter our improvement was driven by increases in both front room and back room categories resulting from the rollout of our price room, price optimization strategies, strengthening our merchandising capabilities and the impact of our rapidly growing law enforcing capabilities.

For the year we made significant progress increasing our availability through the net addition of six PDQs or part delivered quickly warehouses and 80 hub stores. We also upgraded inventories in nearly 1500 stores and we are able to re-assort the vast majority of our planograms using our new custom mix tool.

Through the course of the year, we have substantially disposed of the slow moving inventory identified in fourth quarter of last year. Aggressive management of slow moving inventory in 2009 resulted in no material inventory write-offs this year. Major enhancements in inventory management processes led to improve DIY and DIFM availability and a decrease of over $16 million in owned inventory. The 9% decrease in owned inventory year-over-year combined with the 149 basis point improvement in gross margins contribute heavily to the 110 basis point improvement in return on invested capital.

Our adjusted accounts payable to inventory ratio of 61.2% is up 400 basis points compared to 57.2% at the end of fourth quarter last year, and is at an all time high. This significant achievement was evenly split between fewer days of supply and greater days of payables. We are on pace to achieve our long-term goals and expect to see a continued improvement in 2010.

As I announced during the third quarter conference call, we have implemented engineered standards at all of our main distribution centers. Engineered standards drove double-digit productivity improvements in the quarter. To date, we have exceeded our expectations through this initiative. We are also exceeding our expectations with respect to our fleet outsourcing we announced earlier in the year. We expect that we will generate significant savings from transportation perspective going forward. The combination of engineered standards and fleet outsourcing allowed us to fund our same-day availability investments and positions us to reduce our supply chain costs as a percentage of sales in 2010.

While the absence of an e-commerce platform in 2009 reduced our DIY sales in the first three quarters of the year, I am delighted to announce that our e-commerce launch that occurred in October is going well. Our sales in the quarter surpassed our Q4 2008 sales despite spending the previous seven months as an information-only site. Based on our current trend, we believe e-commerce business will contribute positively to our DIY business in 2010. We launched the test of our new business-to-business e-commerce site in Q4 and expect to begin a national rollout in 2010. Ultimately, our combined e-commerce platforms should prove to be a significant growth engine for us in the future.

In third quarter, I assumed responsibility for Auto Part International team in addition to my existing responsibility. Although the past quarter I have been working with Roger and his team on developing strategies to accelerate their growth while further identifying opportunities to integrate our supply chain, IT and other back office capabilities.

In 2009 AI’s revenue grew 19.6%, which was driven by our comp stores sales increase of 9.9% and 31 net new stores opened in 2009. We are very pleased with the AI team’s results and I am excited to announce in 2010 AI will add approximately 40 new stores. Overall, 2009 was a very successful year for our team and I am thrilled by the strategic and financial progress we’ve made through our availability excellent strategy.

Let me turn the call over to our CFO, Mike Norona to review our financial results.

Mike Norona

Thanks, Kevin and good morning, everyone. I would like to start by thanking all of our talented and dedicated team members for the financial progress we made in 2009. I plan to cover the following topics with you this morning. One, provide some financial highlights of our 2009 fourth quarter performance. Two, put our fourth quarter results into context with our 2009 full year performance and the turnaround. And three, provide you with our annual financial outlook for 2010.

Before I comment on our results, I would like to remind you that 2009 includes the impact of store divestitures and our 2008 fourth quarter and full year results include the impact of both the 53rd week and a non-cash inventory adjustment resulting from a change in inventory management approach. The 53rd week increased diluted EPS by $0.10 while the non-cash inventory adjustments decreased EPS by $0.25. I will speak of our 2009 results on a 12-week and 52-week comparable operating basis as that provides a more transparent and relevant comparison to 2008 results.

We have provided GAAP financials as well as comparable operating results in our press release. Turning to our fourth quarter, earnings per diluted share of $0.36 include $0.03 related to store divestitures. Excluding the impact of store divestitures, earnings per share were $0.39 versus $0.41 last year and analyst consensus estimates of $0.46. For all 2009, our earnings per share increased 14% on top of the 16% increase in EPS last year excluding the $0.17 impact of store divestitures.

We shared our third quarter call that our fourth quarter would be a more challenging because we are up against stronger comparisons to last year. While this was the case, we are disappointed that we did not meet our internal expectations for our fourth quarter top-line and bottom-line performance. That said, we are pleased with the sequential improvements we made in our financial measures for the full year 2009, which I will speak to you later in my remarks.

Some of our highlights for the fourth quarter include a 2.4% comp store sales increase comprised of an 9.5% increase in commercial and a 0.8% decrease in DIY. As previously communicated, our comp store sales were impacted as a result of the calendar shift. On a calendar-adjusted basis, fourth quarter comp store sales increased 3.1%. For fiscal 2009, our comp store sales increased 5.3% over 1.5% increase in 2008, and our total revenue increased 7.1% on a 52-week adjusted basis.

During the fourth quarter, our gross profit rate increased 78 basis points versus last year primarily due to continued investments in pricing and merchandising capabilities, increased parts availability, and improved store execution, partially offset by the impact at the anniversary of shrink benefits we reported during fourth quarter last year. The 78 basis point increase was on top of a 140 basis point gross profit rate improvement in the fourth quarter of 2008. On a full year basis, we are pleased with our 149 basis point increase in gross profit rate as a result of the investments we have made over the last two years.

During the fourth quarter our SG&A rate increased 165 basis points excluding the impact of store divestitures. The 165 basis points increase was driven by commercial investments including store labor, higher benefits expense, additional advertising expense and new capabilities, such as global sourcing and e-commerce, partially offset by reduced incentive compensation.

The SG&A rate increase is somewhat magnified given our softer sales performance and Q4 being a lower volume quarter. Q4 SG&A dollar growth increased 7.8%, which represented the lowest SG&A growth in any quarter in 2009. For all of fiscal 2009, the SG&A rate excluding store divestitures was 125 basis points unfavorable to last year due to investments in store labor, higher incentive compensation, strategic initiative expenses and higher medical expenses, partially offset by lower advertising expense and store occupancy leverage driven by the 5.3% increase in comp store sales.

Free cash flow for all of fiscal 2009 was a record $410 million, which represents a 46% increase over last year. This record cash flow increase was $130 million more than 2008, primarily driven by improvements in inventory management, working capital management and increased net income. Adjusting for the 53rd week in 2008, our free cash flow increased to $160 million, which represented a 64% increase over last year.

Our rent adjusted leverage ratio at the end of the fourth quarter was 2.2 times, which is down from 2.7 times last year driven by last debt outstanding and increased operating income. During the fourth quarter we repurchased approximately 1.24 million shares of stock for $50 million at an average share price of $40.24. As mentioned in our fourth quarter earnings release, we have cancelled the remaining share repurchase authorization and our Board of directors has authorized a new share repurchase program. We will continue to be opportunistic with the share repurchases in 2010 and are committed to managing our rent adjusted leverage ratio to our maximum 2.5 times.

Overall, we are disappointed that our fourth quarter results trailed our financial expectations from both the top line and bottom line standpoint. We have previously shared that our financial performance would not be linear quarter-to-quarter given the breadth of changes we have made as part of our turnaround, and we saw this with our results in our fourth quarter.

As we now end our turnaround phase it is also important that we put our fourth quarter financial results in context with our full year 2009 financial performance. In 2009, our comp store sales grew 5.3%; our total revenue growth outpaced the rest of the market by 390 basis points. Our operating income grew 10%, our return on invested capital increased 110 basis points, and we delivered record free cash flow of $410 million. Sometimes these improvements can be large and we focused on just one quarter. As previously shared our turnaround has been of positioning the company to accelerate growth, improve profitability and drive shareholder value. These three dimensions will continue to be how we measure the path ahead and our performance thus far that shows we are trending in the right direction.

Turning to growth, we are pleased with the 5% improvement we made in sales per square foot in 2009 and the fact that our total business growth as measured by NPD was 390 basis points better than the rest of the market driven by our strong commercial growth. Looking ahead we are focused on building integrated store that service both our DIY and commercial customers, and we will measure our performance based on the total four wall sales growth.

Turning to profit, we are pleased with the 149 basis points gross profit rate expansion and the sequential growth we have seen in our operating income in 2009 versus 2008. Looking ahead we expect the significant investments we have made in our capabilities, and infrastructure will drive continued operating income expansion.

Turning to value creation, we are pleased with our $410 million record free cash flow in 2009, improvements in our balance sheet driven by our inventory management and reduced debt, and the 110 basis point increase in our return on investment capital. Looking ahead we expect to turn and leverage the strong financial platform we have build and to continued growth in economic profit.

Turning to fiscal 2010, we provided a more robust annual outlook in our press release, which is included in our 2010, estimated EPS range of $3.20 to $3.40 per share. I would like to remind you that our first quarter has the most challenging comparison to last year, which will limit our ability to grow our first quarter operating income, which is factored into our annual outlook.

Now, I’d like to provide you with the key financial assumptions applied in our annual financial outlook. In 2010, we will continue to expand our store base and anticipate new store openings will increase to 2009 levels for both advanced and auto part international brands to approximately 150 stores. We will continue to make investments to grow our commercial business and to improve our DIY sales performance, which we expect will result in total four wall comp store sales increase in the low to approaching mid-single digits. We also see the third straight year of continued gross profit rate expansion as a result of our previous investments in merchandising and inventory management capabilities, interim benefits as a result of recent investments and capabilities such as global sourcing.

Turning to our cost structure, we expect that our SG&A growth will decelerate in 2010. The past two years required large SG&A investments to build the foundational and strategic capabilities needed to turnaround our business. A large portion of these investments have now become part of our 2010 cost base, which will result in reduce growth in our SG&A. We must also ensure we get the appropriate yield from our both our fixed and variable expenses. For example, we expect some of the capability initiatives for 2010 in areas such as labor management, commercial operations and field implementation will help us improve our productivity and yield in areas such as labor, our commercial programs and our variability and store performance.

Additionally, we expect to see reduced costs in some of the areas we invested in 2009 such as outsourcing goods not for resale and our DC fleet. While we expect to see a deceleration in SG&A spending compared to previous higher levels, we are still in a transformation that requires continued strategic investments in areas such as commercial, e-commerce and global sourcing along with the fact we will be annualizing partial year investments in 2009.

Before investments, we expect SG&A to leverage at low-single digit comps, all in with investments we expect SG&A for store to grow approximately mid-single digits in 2010. We higher SG&A dollar growth during the first two quarters of 2010, which will result in higher comp sales leverage, point as a result of investments we made during the second half of 2009.

In closing, we are disappointed we did not deliver the financial results we expected in our fourth quarter, yet our full year 2009 financial results show we are on the right path. As we enter 2010, we remain committed and focused on our four strategies that are allowing us to build a differentiated model to serve both our DIY and commercial customers. We continue to see a pathway to improve our operating and financial results and continue to be optimistic of our long-term growth prospects. Most importantly, we are appreciative of our talented team members who are passionately leading us through our transformation.

Operator, we are now ready for questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question today is from Anthony Cristello. You may ask your question and please state your company name.

Anthony Cristello – BB&T Capital Markets

Thanks. Good morning. BB&T Capital Markets. Good morning, guys.

Darren Jackson

Good morning, Tony.

Kevin Freeland

Good morning, Tony.

Anthony Cristello – BB&T Capital Markets

Darren there were a few references made this morning about being disappointed in the fourth quarter financial performance, and I am just curious from your standpoint what disappoints you most of the fourth quarter and relative to what your expectations were?

Darren Jackson

Tony, I would say it’s a couple of things. I would say we are thrilled with our commercial progress. That being said, we probably finished a couple of points lower than what we would like to in terms of comp store sales. On the DIY side, naturally, we want to see positive comps in the fourth quarter and we didn’t see them. Now that being said, I would tell you that when I look at what was going on in the market you saw something interesting in the overall market trend, the DIY based on our NPD data says the fourth quarter was about the weakest year-over-year growth that we have seen all year.

So, maybe I shouldn’t be as disappointed, but we did see some contraction in that business, albeit still positive, it was probably the weakest, it was the weakest of the four quarters on an overall market basis, and I am sure that’s a piece of it but, you know what, a piece of it, as we think about it, was we can always execute a little bit better. Commercial on the other hand strengthened in the fourth quarter sequentially on an overall market basis, and I think we probably should have participated in that a little bit more. That being said we had a lot and I can't emphasize, and as part of my worrying in this job, we had a lot going on in terms of training in the field, working with our commercial sales team, and I bet, we distracted them a little bit. And I think, as I said, I think more about a short-term setback in terms of things that we were doing versus a long-term trend because as I said in my comments too, we felt good particularly about period one January as we came into the quarter and saw a life come back in both of those businesses.

Anthony Cristello – BB&T Capital Markets

So, when you look then at the guidance that you have given in – in what happened in the fourth quarter, is there any issue of the initiatives you talked about being maybe having some a lot going on? Is there the risk that you still have a lot going on that would prevent you from maybe meeting your expectations or perhaps creating some further disappointment relative to where this guidance is that you have given for the full year?

Darren Jackson

Well, here is what I would say to this is that, we wouldn’t give guidance that we weren’t confident in. Is it a guarantee? Nothing is guaranteed. But I would say when I am confident about it is we have taken some time out. Jim talked about it in his comments particularly in the fourth quarter here again in the first part of the year right there energy is going into things that are field facing. So we are in the process of bringing our teams new tools and whenever we are touching the broader 49,000 in terms of better ways to schedule our labor as opposed to just controlling, and that doesn’t mean we are going to overspend our labor, but we are giving our teams new tools as we did last year to better see gaps in their coverage on the floor. We are viewing, well I think we touched – we touched every district last year and what we call our gas for the training process and this is just – you know you can take many different clues, I think for the first time, and at least a quarter is what we saw are simple things like our units for transaction even in DIY go up in the fourth quarter, our attachment rates increased 300 basis points in the fourth quarter.

We had some inflation, deflation pressure but what I look for are the things that we are putting energy into that need to translate into the field, are those going to make a difference? And I think we are seeing some encouraging results whether it’d be in our proof of concepts and our commercial operations, Jim talked about it in terms of, how do we make sure the teams have the tools to get the orders to our commercial customers on time, every time with the right order. I mean one of the exciting things we have going on is we just, we are literally 10 minutes into an e-commerce platform, and that e-commerce platform not just in terms of what will sell but that ability to pick-up in our store and navigate is going to help our teams in terms of sales. We had one customer in the fourth quarter that went up on our new B2B e-commerce platform, so that’s one.

And so, and we think that is a huge opportunity for many of our business partners that we've been constrained from doing business because you couldn’t do business on line with us on a B2B space. So our energy is really focusing on how do we narrow our efforts on the highest priorities that our teams in the field are looking for us to support as a way of driving those outcomes. And that’s, he said what’s it underneath the numbers, it’s more those efforts than hoping the market goes one way or another.

Anthony Cristello – BB&T Capital Markets

And just one last follow-up. When you look at then the level of spend, and I think Mike sort of framed it as mid-single digit SG&A spend sort of through the first half of the year, are you going to see a traction with initiatives, because of this traction, because of the spending be more accelerated in the second half of the year once your investment starts to wind down, is that how we should think about it?

Darren Jackson

I want to make sure I understood that.

Anthony Cristello – BB&T Capital Markets

Basically, it still seems like you are spending even though it's decelerating to some degree, you are still spending mid-single digit growth in SG&A, is what I think Mike kind of guided to as a result of initiatives underway. And what I am wondering is the level of initiatives in such has not yet peaked. And so the ability to get the full benefit that may seems more weighted to the second half of the year.

Darren Jackson

Yes, I would say a way to frame that and think about it, Tony, and tell me if this doesn’t answer your question is that, you are going to have two things going on in the first part of the year. One, we’ll finish the annualization because we didn’t add every commercial sales person on the first day of last year, and we’ll feel the ways of the annualization of our sales force who feel the annualization of, we put our retail merchandizing system into operation in the third quarter sales force dotcom. So you are going to have some annualization that will be felt more in the first half, we will do some more commercial waves in the first half of the year.

In the second half of the year, what we're spending time working on it is that, how do you give the organization time to absorb it. We’ve recognized last year and a lot of our customer data says, we created extraordinary demand in terms of new customers and even growing our business with existing commercial customers, but unfortunately we gave away a lot of business because we didn’t hold on to them, net it was still a 14 comp, it could have been double that if our operation side of the business. And it's not a criticism of our team members but it's a recognition that we have to get out into the field and make sure those teams are supported not just in growing demand but being able to sustain those customer relationships going forward.

So I would think about this year that the first half and Mike said this will experience some annualization, it will experience another wave of commercial growth. As we’re going through the second half for the year, if we’re going through the entire year but it will be more – emphasis is that how we allow the organization to work that change and be effective with it. So the back half of the year is, as Mike alluded to, is we’re – it's not just the third and fourth quarter, I’d say second, third and fourth quarter, we would expect to see a larger portion of those benefits falling through.

Operator

Thank you. Our next question is from Gregory Melich; you may ask your question and please state your company name. Mr. Melich, please check your mute button. We’ll move on to the next question, Matthew Fassler, you may ask your question and please state your company name.

Matthew Fassler – Goldman Sachs

Goldman Sachs and good morning. Thanks so much for taking my call. My first question, based on your sales color and on the guidance that Mike just gave about the SG&A spending up mid single digit per store on the year. The implication to get to your numbers would be gross margin up substantially again in 2010 over 2009, something in the neighborhood of 100 basis points or more. I want to assure that my arithmetic is right on that, and then if so, if you could just recap the drivers if they are any different or if they are changing of composition of gross margin improvement of that magnitude?

Kevin Freeland

Matt, this is Kevin Freeland. Essentially the numbers that we looked at in the quarter of the year and what we’re looking to in terms of 2010, is if you look at the 2008 and 2009 combine, we picked up 220 basis points for the year over that three-year period of time, and 218 basis points in fourth quarter for the two years back to back. We don’t believe that the margin rate for 2010 will be in that league, but will be a substantial improvement at least if my map is directionally correct that we are expecting that. What’s underneath that is a very rapid expansion of our global sourcing capabilities and impact on margin. Last year, we drove a lot of incremental margin by optimizing the prices in the front room, and that work will move to the back room next year, and continuing improvements in the category management and the merchandising capabilities.

We also spent a lot of time last year and put a lot of investments in making sure that our prices were competitive and that was actually a drag on the 149 basis points that we picked up. That work is done, and essentially we are at the level with the market that we desire and that should not be a headwind for us in 2010.

Matthew Fassler – Goldman Sachs

Got it. My second question relates to SG&A, and you discussed leverage without investments and then or deleveraged without investments or leverage points without investments and the leverage with investments. Should we interpret that, I mean, in any way that investments are viewed as damned, more discretionary this year than last year or are you simply doing that, so that we understand what happens when the investments are checked on?

Kevin Freeland

I think it’s the second math. I want to be really clear; the investments we make continue to be strategic based, primarily in areas of commercial. I think Jim mentioned in his comment that we are one-third through our commercial changes, so that’s big part of our incremental investments next year that we are going to see. And then the other is going back to margins, and things like global sourcing our dotcom capability. So, just a frame to think about it we’ve just come out of turnaround phase that we have had the highest piece of our investments spend in growth as we invested through capability and strategy and is now a lot of those costs become part of our fixed cost base, you would expect our SG&A growth to decelerate.

Jim Wade

Right. Cost base comes with a lot of additional capacity. So we are not a capacity with all of our parts grows, we are not a capacity with our trucks, so part of that matter as you look out is that, and I notice this sometimes kind of a painful but, you end up profiting new parts, growing new truck spend and you’ve got a one way of capacity there that typically we think it should be almost 18 months until they reach that full capacity level. So, we thought of ways to go, but as we said earlier we got trying to think about how do we bring that to our organization more rhythmically and as Mike said in a more decelerated fashion.

Matthew Fassler – Goldman Sachs

Got it. Thank you so much.

Operator

Thank you. Our next question is from Gregory Melich. You may ask your question, and please state your company name.

Gregory Melich – Morgan Stanley

Hopefully you can hear me now?

Darren Jackson

Yes, Greg, we can hear you.

Gregory Melich – Morgan Stanley

Excellent. This is Greg Melich with Morgan Stanley. I want to follow-up on the gross margin. I think – and also getting to the commercial roll out, on the gross margin side you said the front room is done, but the more of the back room this year, where is custom mix in that, and if you were to put a percentage of store that’s really been reset where you want it to be, Kevin could you give us an update on that?

Kevin Freeland

Sure. Essential world customs makes up in two fashions that we referred to nearly 1500 custom mix upgrades and that’s literally changing the entire store at that point and secondarily that as we reset each planogram in the stock room, we actually affect all stores for that one planogram. The intersection of those two efforts is similarly all of the stores have been impacted by custom mix by the tail end of the year.

Now that said, what we did in terms of upgrades in 2008, we – up the (inaudible) with the custom mix upgrades in 2009, and there is a series of changes as we move into 2010 that – should further fine tune the assortments that we carry in our stores, but I think it would be fair to say that the majority of that benefit was in place by the end of the year.

Gregory Melich – Morgan Stanley

Right, so there are still some carry-through this year but that’s not the reasons that gross margin would have – the expansion going forward will be less than it was in the past, is that fair?

Kevin Freeland

I would say it is larger impact would be – we’ve made this statement in the past that the largest opportunity for us in terms of price optimization was in the front room, which is why we started there. Moving to the background, but that’s smaller overall impact for us and that’s been partially offset by the growth in global sourcing. But we’re in a year where we are ramping that up very quickly within that net up of the two is what we are able to accomplish in 2009 is not likely to be repeated at that scale.

Mike Norona

Yes, and Kevin it is also fair to say in custom mix, Greg, we are never done. I mean, right now, I think by example, Charles we’ll do brakes four times this year.

Gregory Melich – Morgan Stanley

Okay.

Mike Norona

And last year we did it once. And so I think it’s going to – it’s a building capability for us and it’s kind of a – we sometimes measure it just in terms of 1500, but you can imagine as we are getting smarter and the teams are learning, the way we will use that tool become more effective with each and every quarter and year.

Gregory Melich – Morgan Stanley

And are the systems now in place to have that inventory at the store level in Q1 where you look at the cars and you need to trade them. Are we finally there?

Darren Jackson

Essentially the mechanism is even more sophisticated in that, it's looking at numerous factors including the actual sales in the area, things that we can see and the interaction with customers that don’t show up in sales, the vehicles in operation. It’s a relative complex tool and what we are able to then see is how much is the demand actually get satisfied and that is coming up very nicely.

Gregory Melich – Morgan Stanley

Great. And then there is follow-up. I think Jim mentioned that a third of the stores now have the additional drivers and it will leverage those benefits as you really improve in 2010. is there a goal now on the number of stores that you think will have the additional drivers and commercial program or, it seems like this year you may add some more but its not going to be near the rate it was, and its more about making sure the ones you rolled work, please put some numbers around that or something?

Jim Wade

Yes, Greg, this is Jim. I think how you are describing is basically right. We in 2009, we finished our eighth consecutive quarter of double digit comps in commercial, and we did investments across roughly a third of our stores with the basic, the parts pros and trucks and drivers. We ramped up significantly our sales force. We had – for the first time we have a data base of our commercial customers in place that are now allowing us to start to leverage that. And over the next few years we'll do all of our commercial stores in terms of those investments. I think right now about 88% of our total stores had commercial, so we will be doing across that group, but at the same time while we are doing that, we are going to be doing the things that Darren talked about earlier that not only helps us create demand but helps us retain that demand at a greater level.

So there is going to be lot of work going on inside the store in terms of how we see that order, how we make sure we track it and deliver the right part in the timeframe we promised every time to our customers. We are continuing to do a lot of work, just teaching and training our team how to do at greater level with commercial and the store from the standpoint of General Manager’s responsibilities with those commercial customers and the partnership with the sales force.

So it's an ongoing process that this year we’ll continue the investments in stores for parts pros, drivers, trucks, etc. but emphasize to a greater level that operational consistency and the productivity of our sales force to retain customers.

Darren Jackson

You'd expect by the end of the year, we would be at least at 50% of our stores having gone through the way for the upgrade process.

Jim Wade

That’s correct.

Darren Jackson

So that's a way to think about where we are in the journey, and similar to upgrades and custom mix, Greg, I would say with each way we are learning and getting smarter as to where to deploy those trucks, where to deploy those parts pros, how the interaction, and how we’re organized between our sales force and our teams so.

Operator

Thank you. Our next question is from Scott Ciccarelli. You may ask your question and please state your company name.

Scott Ciccarelli – RBC Capital Markets

Hey, guys.

Darren Jackson

Hey, Scott.

Scott Ciccarelli – RBC Capital Markets

How are you?

Darren Jackson

Good.

Scott Ciccarelli – RBC Capital Markets

Two questions. The first is, just a little bit more color on the gross margin performance in the fourth quarter. And what I am trying to figure out is, did we actually see shrink increase in the quarter or were there any change to maybe volume rebate accruals, because it just seems like you guys are experienced about four to five quarters of very strong progress on gross margin line and yet this quarter wasn’t quite what we had – that needs to seen, so I am just trying to figure out if there is anything else going on there?

Mike Norona

Sure, Scott. And again, as I said a moment ago, if you look at the two year gross margin improvement of the whole year, I would pick it up, 71 basis points in '08, 149 in '09, so it's 220 basis points for the combined years. We picked up 218 for the combined years in fourth quarter. It's a 140 in '08 and 78 in '09. So essentially we were exactly where we had expected to be. The composition of the gross margin has literally changed each quarter and we have mentioned this in previous calls, there is a number of initiatives, that we have positives as negatives as we compare year-over-year but if you add it all together in total we essentially we’re on a track in fourth quarter there with little change from where we had been all year.

Scott Ciccarelli – RBC Capital Markets

Your gross margins actually came in line with what your expectations had been?

Mike Norona

Yeah, essentially yes.

Scott Ciccarelli – RBC Capital Markets

Okay, and then my other question is, is a follow-up on previous question about the inventory customization effort. It seemed to me like we’re on the big opportunities for you guys, let’s say, drive conversion rates, and something that you kind of emphasized a number of times particularly at your Analyst meeting. In that that we’re kind of going through the inventory customization progression, is there anyway to quantify the impact that you have seen if indeed we have seen an impact so far?

Mike Norona

We have seen impact, and it’s been a material amount of what we have been focused on as a team and executing nearly 1500 upgrades in the year as, many, many times what it had been two years prior, but we have not in the past disclosed what that impact is other than the fact that the payback on the program is high. If you can imagine this, we upgraded nearly 1,500 stores inventory materially improved availability as is measured by our DIY and commercial customers and dropped total on inventory $60 million. So the payback on that program is considerable.

Scott Ciccarelli – RBC Capital Markets

But is there – I don’t know if it’s a group of stores, or best stores or something where conversion rates have moved from X to Y after the inventory customization have been implemented?

Darren Jackson

We have all of those internal numbers but no, we have not disclosed those in the past.

Scott Ciccarelli – RBC Capital Markets

Okay. Thanks a lot, guys.

Operator

Thank you. Our next question is from Kate McShane. You may ask your question and please state your company name.

Kate McShane – Citi Investment Research

Hi, good morning. Citi Investment Research.

Michael Norona

Hi, Kate.

Kate McShane – Citi Investment Research

You had mentioned that this quarter SG&A benefited from lower incentive compensation, and excuse me if I missed this, but did you say when we can expect for this to resume?

Mike Norona

Kate, the incentive compensation to resume?

Kate McShane – Citi Investment Research

Yes, for you to go higher.

Mike Norona

So, the reason you saw that is, and I think we’ve shared with you at the beginning of 2009, all of our incentive programs are based on growth, sales growth and profitable growth. And so, our anticipation and our belief and the confidence in our field is that we will able to grow the top line and bottom line and our incentive compensation will grow accordingly. What I also expect is that if we don’t roll as much as we did last year we would expect to see a little bit of leverage on incentive compensation, and if we grow more than we did last year we would expect that number to grow.

Kate McShane – Citi Investment Research

Okay, great, that’s helpful, thank you. And then my other question is just on the competitive environment, I was wondering if you could give us a little bit of color on the DIY side, if you have seen any more competition in the pricing environment and in what forms in those competitions coming from the DIY business?

Darren Jackson

I think as we look at commercial pricing through the quarter, I think it was fairly rational pricing across all of the competitors. I think the couple of competitors have increased the amount of exposure that they have done in certain DIY categories, but in order to keep discounts in pricing that just expanded the amount of exposure (inaudible) but I don’t think we have seen any deeper discounting than we’ve seen in previous quarters.

Mike Norona

And Charles, would you say that maybe the one thing we saw in this quarter is, we did see Wal-Mart add – that’s little bit on oil, I want to say act up, be a little louder on oil than we probably have seen in the other three quarters.

Darren Jackson

At least a 130-day period whether they are early exposing through (inaudible) and then the news of that bringing into December when we saw some changing in pricing back to prior levels that they were at.

Kate McShane – Citi Investment Research

Thank you.

Operator

Thank you. Our next question is from Michael Lasser. You may ask your question and please state your company name.

Michael Lasser – Barclays Capital

Good morning. Michael Lasser from Barclays Capital. Thanks a lot for taking my question. Within your comp guidance for the year what have you assumed for growth in the market and how might that change if we continue to see a rebound in new car sales?

Darren Jackson

Mike, I would say this is that’s one of the hardest number as we try to track down to say that our best view right now is that we would be surprised in if the overall market trends in 2010 were worse than 2009, and so, I got to say I have been in three different industries and I have never seen anything jump around quarter-to-quarter with such volatility, but this market on a total – total market commercial and DIY together, it seems to up three – in good years it feels like a 4% grower, in bad years it feels like a 2% grower. So, I think you’re probably safe, but when we see the combined market, to be honest that’s what we focus on, 3% is probably a safe bet on year-over-year growth. But here again, we are better operators of the business in short than predictors of the future, but that’s what the historical data would say. We did a little better in '09; we certainly see the characteristics of the industries still being favorable as we go into 2010.

Michael Lasser – Barclays Capital

A real quick follow-up. How has the recent performance on the DIY side compared in markets where you have a more densely saturated or concentrated store base versus other markets that are perhaps less saturated, in those areas that it might be more concentrated are you seeing any more of a lift from the recent increase in advertising investments?

Jim Wade

This is Jim. I don’t think from the standpoint of different regions we really don’t talk that specifically, but we don’t see things in general that would be significantly different. I think promotionally, if I understood your question right, we did in the fourth quarter – we thought about the improvements that our team led by Greg Johnson has been making in that area and the fourth quarter, it says it is not a big quarter in terms of advertising impact by any of us, because it’s our volume and typically our most volatile quarter. But what we are seeing is that our customers are responding very favorably to the changes that we made, and we feel good about what we see going into next year in that regard.

Michael Lasser – Barclays Capital

Great. Thanks. Best of luck.

Jim Wade

Yes. Thank you.

Operator

Thank you. And our final question today comes from Dan Wewer. You may ask your question and please state your company name.

Dan Wewer – Raymond James

Thanks. Raymond James. A question on some of the price initiatives, I recognize the strategy is to identify items where demand is relatively pricing elastic and pursue that opportunity but it does appear that once you begin to push pricing into do-it-yourself category, that did coincide with the beginning of some weakness, and you do-it-yourself fails, is there any concern that perhaps – there is two part on the pricing initiative, on the do-it-yourself segment?

Darren Jackson

We certainly don’t believe that but – and again you have to look at the two hands of the whole. Exactly to your point, we have identified items that prices is unimportant or relatively less important to the customer and those are the categories that we have optimized. There are other categories that the customer benchmarks and makes their decisions based on price, and we've been sharper in price last year than we had been in the two preceding years. The net effect of those two is overall prices is up slightly year-over-year.

But as we are fine-tuning in this, I think if you look at the multiple year DIY performance, and if you look at the total DIY performance for the company last year, it was a better performance than we have seen in a couple of years and to a certain extent where we had struggled a couple of years back, it was an even a year of largely breaking even.

Dan Wewer – Raymond James

I know that, I believe this year in 2010 is when you begin to focus on the back room in pricing initiatives, I’m trying to think what are opportunities given that, now it appears to be getting a little bit more aggressive in pricing, and therefore do you see fewer benefits from pricing optimization on commercial?

Darren Jackson

Well, the work that we referred to of optimizing the prices behind the counter refers to specifically DIY pricing, we have a separate approach that we have for commercial customers, and as you well know that the margin difference is between those two businesses, the commercials accounts have always historically gotten historical prices than what our walk-in customer would achieve. We have not at this point made a material change in the pricing strategies for commercial accounts, and most of what we are seeing at this point has more to do with what the Jim has updated you in terms of the weight process that improvements in the – the growth in that business is better able to serve customers and are not actually price changes or change in price strategy.

Dan Wewer – Raymond James

Okay. Great. That’s helpful. Thank you.

Operator

Thank you. This conclude today’s question and answer session. I would now like to turn the call back to management for any final comments.

Joshua Moore

Thank you, Wendy, and thanks to our audience for participating in our fourth quarter earnings conference call. If you have additional questions, please call me at 952-715-5076. That concludes our call.

Operator

Thank you. That concludes our call today. You may now disconnect. Thank you for joining us.

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Source: Advance Auto Parts Incorporated Q4 2009 Earnings Call Transcript
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