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O’Reilly Automotive, Inc. (NASDAQ:ORLY)

Q1 2010 Earnings Call Transcript

April 29, 2010 11:00 am ET

Executives

Tom McFall – EVP, Finance and CFO

Greg Henslee – CEO and Co-President

Ted Wise – COO and Co-President

Analysts

Tony Cristello – BB&T Capital Markets

Alan Rifkin – Banc of America

Stephen Chick – FBR Capital Markets

Dan Wewer – Raymond James & Associates

William Truelove – UBS

Scot Ciccarelli – RBC Capital Markets

Mark Becks – Longbow Research

Christopher Horvers – JPMorgan

Michael Lasser – Barclays Capital

Operator

Good morning. My name is Lisa, and I will be your conference operator today. At this time, I would like to welcome everyone to the O’Reilly Automotive first quarter conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. (Operator instructions)

Thank you. Mr. McFall, you may begin your conference.

Tom McFall

Thank you, Lisa. Good morning, everyone and welcome to our conference call. Before I introduce Greg Henslee, our CEO, I’d like to read a brief statement. The company claims the protections of the Safe Harbor for forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

These statements can be identified by forward-looking words such as expect, believe, anticipate, should, plan, intend, estimate, project, will or similar words. In addition, statements contained within this conference call that are not historical facts are forward-looking statements. Such statements, discussing among other things expected growth, store developments, integration and expansion strategies, business strategies, future revenues and future performance. These forward-looking statements are based on estimates, projections, beliefs and assumptions that are not guarantees of future events and results.

Such statements are subject to risks, uncertainties and assumptions including, but not limited to competition, product demand, the market for auto parts, the economy in general, inflation, consumer debt levels, governmental approvals, our ability to hire and retain qualified employees, risks associated with the integration of acquired businesses including the acquisition of CSK Auto Corporation, weather, terrorists activities, war and the threat of war.

Actual results may materially differ from anticipated results described or implied in these forward-looking statements. Please refer to the risk factors section of company’s Form 10-K for the year ended December 31, 2009 for more details.

At this time, I’d like to introduce Greg Henslee.

Greg Henslee

Thanks Tom. Good morning, everyone and welcome to our first quarter conference call. Participating on the call with me this morning is, of course Tom McFall, our Chief Financial Officer; and Ted Wise, our Chief Operating Officer; David O’Reilly, our Executive Chairman is also present.

I would like to start off again by saying thanks to all our dedicated team members who work so hard each and every day to make sure our loyal customers receive the very best service in our business. This past quarter was an outstanding quarter for team O’Reilly, and I want to recognize each and every one of you for the great job you are doing, taking care of our customers, and systematically working us through the integration of CSK.

Clearly, we have a very bright future ahead of us as we complete this integration and focus on expansion and executing our dual market strategy coast to coast. Congratulations to all of you on the great performance in the first quarter.

Looking back to our fourth quarter conference call, it is clear that we underestimated the amount of demand that was pent-up as a result of the relatively soft sales our industry experienced for much of the winter. As I mentioned on the call, we attributed the softness in the fourth quarter to the continued strain the economic conditions in the US has placed on consumer budgets.

We believe this was amplified during the holiday season has many spent their discretionary cash on guests and holiday activities and deferred spending on auto repairs that didn't need absolute immediate attention. Comparable store sales are always difficult to forecast, and we’ve once again proven that sales trends can change relatively quickly. As you know, we were forecasting consolidated comparable store sales in the 2% to 4% range for the first quarter.

As it turned out, early spring weather arrived in many markets, and sales in the last half of the quarter accelerated dramatically and we were able to generate a robust 6.9% growth in consolidated comparable store sales for the quarter, on top of comparable store sales increase of 5.7% in the first quarter of 2009.

As previously mentioned, the fourth quarter of last year was the last time we were willing to disclose the details of our comparable store sales by store type. From this point forward, we plan to provide only our consolidated total company comparable store sales performance. However, I do want to reflect and add some color to our comp store sales performance for the quarter.

The stronger trends we saw in the last half of the quarter were present in the majority of our markets across the country. We saw retail traffic in our stores and our installer business picked up significantly. Again, I relate some portion of this strong increase in business to maintenance and repairs that were deferred last winter and with the early spring weather we benefited from this pent-up demand.

It would be very difficult for us to forecast the expectation that sales will continue for the full second quarter at the strong pace we saw in the last half of the first quarter. However, we do anticipate continued solid business trends. We're off to a good start to the quarter in April, and as a result are providing guidance of comparable store sales in the range of 4% to 6% for both the second quarter and for the year.

We will continue to update our annual guidance quarterly as we progress through this year. July 11 will be the second anniversary of our purchase of CSK. As you know, following the purchase will put in place an aggressive plan to implement our distribution model in the western half of the country, which establishes the foundation for us to execute our dual market strategy.

We also put in place an aggressive plan to convert the inventories and store layouts to fit our model. Many team members have worked extremely hard to execute this plan. And I'm very happy to announce that we are completing the integration plan on time and we are seeing very positive performance results as our efforts and investments gain traction.

The CSK Stores as a whole have generated positive comparable store sales each full quarter we have owned them, and in the first quarter we continued to see good business trends. The fully converted checker stores in the central part of the country, which were the first to be converted, are performing extremely well.

We have also seen solid improvements in the performance of the Murray Stores, but given the economy in these markets, especially in Michigan, these stores continue to lag the other stores.

In the western half of the country, it is very clear that we have a lot of opportunity to grow our business as we establish our company as a capable partner to the commercial customers in each market. These stores have done very well and are incrementally taking advantage of the additional parts availability afforded to them by our distribution expansion in the West. Even the stores that are still on the CSK systems and distribution model are doing much better as a result of better access to inventory, more competitive pricing and our team’s focus on providing great customer service.

Ted will be reviewing our integration plan in detail in a moment, but in general I want to convey that we remain very enthusiastic about the opportunity we have to grow same-store sales in the acquired CSK stores.

Many of the markets in which these acquired stores do business generate an incredible amount of auto part sales, and the level of CSK's underperformance due to the lack of inventory availability and non-competitive pricing is clearly apparent. As we stated before, we put a lot of effort into correcting this. We reset our pricing over a year ago and over time the perception consumers have of our competitive price position will continue to improve. The same thing applies to inventory availability.

CSK had developed the reputation of not having robust hard part inventories. We corrected this, and our marketing and advertising efforts are now geared towards giving customers a reason to give us a chance to prove that we're the best choice when it comes to helping them with their automotive needs. We feel we have come a long way on these fronts, but still have a long way to go.

In reviewing our first quarter sales performance, we would be remiss not to mention the continued solid performance of the core O’Reilly stores. We have a very strong team in our core markets, and we are very pleased with the performance of our core stores. One of the early concerns among analysts and investors with the acquisition of CSK was that we could potentially lose focus and market share in our core markets. And with almost 2 years of CSK ownership under our belt, I can assure you as reflected in our performance that our core stores continue to perform extremely well.

The strong comparable store sales we generated during the quarter leveraged our expenses nicely, and coupled with the significant improvement in gross margin, we are now able to sustain as a result of the buying synergies we have experienced as part of the CSK acquisition, we are very pleased with the 13.2% operating margin we were able to generate. This operating margins is the highest first-quarter margin we have generated since going public in 1993.

Tom will be reviewing our financials in more detail in a moment, but I just want to express that we are very encouraged with the solid start we have had to 2010. As planned this acquisition of CSK is proving to have been a very good investment for our company, and we are very excited about what the future will bring as we continue to establish our presence in the markets that are relatively new to us. As an industry, while a more robust economy would certainly be helpful we feel we continue to benefit from the growth of the average age of vehicles on the road in the US as new car and truck sales have decreased.

We feel that many consumers have established a new perception of how far a vehicle can be safely driven and we expect for years to come autos will be higher and higher mileages than in the past. The higher mileage vehicles obviously require more maintenance.

We also see a lot of opportunity for continued growth as our industry continues to consolidate. At the end of this year, we will have opened 150 net new stores, but will still have the distribution capacity in existing facilities to add approximately 500 stores using our existing distribution methods. So, we won’t need to add any additional distribution capacity to support our new store growth until approximately late 2013 or 2014.

We are also working as diligently as ever to continue to improve our levels of customer service and operating efficiencies. We have several initiatives currently under way to ensure we maintain our industry leading customer service levels. These include point-of-sale system improvements, parts cataloguing enhancements, inventory management system increments, and better productivity management in our distribution centers just to name a few.

As I have mentioned, we are very encouraged by the strong start we’ve had this year and are looking forward to the continued solid performance throughout the year as we worked through the final chapters of the CSK integration.

I will now turn the call over to Ted Wise.

Ted Wise

Thanks Greg, and good morning everyone. Like Greg, I would like to begin by saying a quick thank you to team O’Reilly for the fantastic sales and profit performance we're here to discuss this morning. Through our teams commitment to great customer service and execution of our dual market sales programs we continue to expand our market share. 10% top line growth and 6.9% comp sales performance is truly remarkable. But once again thanks to all of our team members throughout the organization for your contribution last quarter.

With regard to our new store growth in the first quarter, we finished with a net 48 new locations, bringing us to a total of 3469. Our expansion plans for new stores this year is 150 locations. So we are on excellent shape on our schedule.

We continue to share and balance the time of our installation teams between new store installations and performing front floor resets on CSK’s stores out west. Our real estate group is aggressively working new store expansion around our core O’Reilly market, as well as the new West Coast states. As a result of the slower economy, we are finding good sites for future expansion at reasonable rates.

In regard to the CSK stores, we have completed individual store and market assessments, and have a stay or relocation strategy for all stores. We have also identified potential expansion opportunities in the undeveloped markets, and growth in new markets. Opening stores with our dual market plan with the expanded product offering and daily distribution service to the store, opened up new markets that would not have fit the CSK retail sales plan.

Now for a brief overview of our store expansion for the first quarter. Once again, the great state of Texas led our growth for the first quarter with seven new stores which brings us to 528 Texas stores that are serviced from our distribution centers located in Houston, Dallas and Lubbock.

Following Texas, North Carolina and South Carolina contributed five stores each. And rounding out to growth in the south-east part of the country, we added three new stores in Virginia. There are also five new stores in Ohio, and three new stores in Michigan that are being serviced from our recently converted Murray distribution centre in Detroit. Indiana, Florida and Tennessee all contributed three stores each.

The remaining 12 new stores were spread out in eight more states and includes our first new store in California. To summarize, our store expansion involved 17 different states, which as I’ve mentioned in the past gives us the ability to be more selective and have better planning and execution in rolling out our new stores.

In the first quarter, we also moved five older stores to new locations and had 12 major store renovation projects going on. In addition to our normal new store growth, we made good progress on phase 2 of our CSK store conversion on the West Coast. Our installation teams performed CSK store resets to the O’Reilly retail format. As you may recall these are resets of the front display area, and do not typically involve the back rooms since the hard parts inventory changeovers were completed throughout the most of last year.

These front floor resets are also independent from their computer system conversions. This is totally different from how we handled the major projects in the first phase of the changeover of the Murray Stores and the Midwest Checker stores, which were total inventory lifts, new computer systems, and store reset all at the same time.

Needless to say, it is much less disruptive to the business, allowing the store to stay open during all of the work and maintaining a high level of customer service. As I mentioned, the hard part line changeovers are of the most part finished and the product department is working on the final phase of front floor line evaluations and changeover.

As these out-front lines are reviewed, new planogram changes and product line upgrades are being rolled out to the stores, and by the end of this year all stores will have a fresh upgraded planogram retail mix. We will continue to step up the pace on the store reset schedule throughout the remainder of the year, and plan on having all the CSK store resets in the O’Reilly interior décor and image package installed during the next 12 months.

Now to outline the DC openings and the conversion schedules, which also includes, our store computer conversions. The west coast schedule began with the opening of our new 388,000 square foot Seattle DC last December, and the following conversions of the 193 shut stores to daily replenishment and installation of a new O’Reilly computer system.

As a reminder, the store computer conversions does not involve any inventory or physical changes to the store. It is basically changing the store computer and going to O’Reilly POS and store operation system. The point of sale orientation and systems training is handled at the store by sending seasoned, experienced O’Reilly team members from the core O'Reilly stores to work side by side with the manager and team members during the conversion and they stay at the store for at least one week following the conversion.

Following Seattle, our new Moreno Valley 408,000 square foot distribution center in southern Californian opened in January, and the store computer system conversions for 238 surrounding Kragen stores were completed. In the middle of March, we opened a 225,000 square foot distribution centre in Denver, Colorado servicing the surrounding 84 stores. And these stores are now finished with their computer conversion systems.

Next on the schedule in May is the opening of our 205,000 square foot Salt Lake City distribution centre, which will service the 86 stores and will follow the same computer conversion schedule. Then we will have a short breather until September, when the mover existing Dixon DC to a new 520,000 square foot DC in nearby Stockon, California. This DC will service the surrounding 274 Kragen stores, and again will start their computer system conversions at that time.

To finish the DC and store conversions, we will return to Phoenix in the first week of November, and convert the CSK distribution centre to the O’Reilly system, and begin transition to a data replenishment at the store level. This will include converting the 151 Checker stores to O’Reilly computer systems at the same time the DC converts.

So, by the end of November we will have completed all the store computer system conversions, installed five new distribution centers, converted the existing CSK distribution centers to O’Reilly system and the stores will all be receiving daily stock order replenishment. This is an amazing accomplishment and has required a lot of hard work and great planning to have executed these tasks in such short of a time.

As I mentioned, the store resets will be progressing throughout the year, and while most of them will be finished by the end of this year, there will be a small group of stores to finish resetting in the first half of next year. We are also well under way with our sign conversions to O’Reilly Auto Parts. And we will project rebranding all of the stores to be completed by early next year.

Now in regard to the business development on the West Coast, our stores continue to gain sales traction on both the retail and installer side of the business. A key factor in growing our sales has been the increased hard parts selection at the store level. The store inventories has also been supported by hub and spoke systems that have set routes throughout the store groups. Also as new distribution centers open and area stores begin receiving not only replenishment, they also special order availability of the broad SKUs at the distribution center overnight, or in the case when the store is in the immediate area, they have same day access to the distribution center’s inventory.

In addition to having the right inventory, our market competitive pricing is in place, and beginning to change the perceptions that customers have developed of the CSK store inventory and pricing model. It took CSK years to establish these customers’ perception, and although we feel good about the sales trend and traffic of customers, changing these perceptions will take a while. We definitely feel there is a lot of additional opportunity ahead of us as we continue to convert the stores and establish the O’Reilly name in these markets.

Now on the installer side of the business, we are seeing great results from our consistent sales call and developing customer relationships over this last year. Our territory sales managers and in-store sales specialist are in front of the customers selling the O'Reilly program of quality parts, competitive pricing and most important great service. We have improved service levels with additional trucks and stacking our first call installer counters with experienced parts professionals.

No different than changing the perception of the retail customer, we still have a lot of work to do and lots of opportunity ahead of us as we establish the O'Reilly brand and win the wholesale customers business.

Improving our sales skills, product knowledge and overall service levels of our store sales teams will be the key to growing our business. As the stores go on the O’Reilly computer systems, our O’Reilly LMS or learning management system and all the O’Reilly training programs are available to our store teams. CSK did not have a computer-based training system, and this addition is being well accepted and be a great tool in increasing our parts knowledge and providing better customer service levels.

Our store operations and sales teams continue to grow stronger and become more effective O’Reilly leaders, as they fully comprehend our programs and they see the results of implementing them. We are very fortunate to have had so many quality team members in the CSK stores that are willing to adopt the O'Reilly culture and become part of the new West Coast O'Reilly management team.

We continue to evaluate our staffing requirements that are required to manage these stores, and will continue to add district managers, territory sales managers and other field positions critical to the control and management of our store operations and sales. It is very exciting to think that much of the task oriented work of the changes we were making that occupied so much of our teams time in these stores is behind us. And now we have more time to totally concentrate on servicing our customers and grow the sales and profit in stores.

With that I will turn it over to Tom.

Tom McFall

Thanks Ted. Now we’ll move on to the numbers. For the quarter, sales increased $116 million, 10% over the prior year to $1.28 billion. The increase was attributable to a $78 million increase in comp store sales, a $35 million increase in non-comp new store sales, and $3 million increase in non-comp non-store sales. For the quarter, both ticket average and ticket count contributed to our comparable store sales increase, but the majority of the comp increase was driven by the comp ticket count.

For 2010, we are increasing our total revenue guidance to 5.2 billion to 5.3 billion, which is $100 million increase from our previous guidance.

Gross profit was 48.3% of sales for the quarter versus 46.6% the prior year. The 167 basis point improvement was driven by the acquisition buying synergies, which were not in the comparable 2009 period. As you will recall, the majority of the new vendor deals were signed at the end of the first quarter, beginning of the second quarter of 2009. As a result, this will be the last significant non-comparable quarter for buying synergies.

For 2010, we continue to estimate gross profit as a percent of sales, will be 48.1% to 48.4% of sales. Where we end up in this range will be driven largely by how successful we are at adding commercial sales in the acquired stores, as commercial sales carry a lower gross profit percentage. Based on our performance in the first quarter, we would anticipate being in the lower end of this range.

SG&A for the quarter was 35.1% of sales, versus 36.9% in the prior year. Leverage on SG&A was the result of strong comparable store sales. On a per store basis, SG&A per store was up approximately 1%, which allowed for strong leverage and 6.9% comparable store sales. For 2010, we are now expecting SG&A dollars per store to be slightly up from 2009 as we see opportunity to more aggressively invest in store SG&A to drive sales. We anticipate the total SG&A for 2010 will increase approximately 4.5% over the entire year.

Operating margin for the quarter was extremely strong at 13.2% of sales, an improvement of 342 basis points over the prior year. This large improvement is the result of full year run rate of buying synergies, strong comp sales and expense controls. The 13.2% first-quarter operating margin represents the highest first-quarter operating margin we’ve had in the public company, and one of the highest quarters of all time. For the full year, we expect our operating margin to be in the mid-12% range.

Net interest expense for the quarter was $11 million, which was $1 million less than the prior year on lower average interest rates. For 2010, we expect net interest expense to be $39 million to $42 million based on lower average debt levels. This estimate is also subject to unforeseen changes in LIBOR levels to the extent our debt is not swapped to fixed rate.

The tax provision for the quarter was 38.5% of pretax income, which was flat with the prior year. For 2010, we expect our tax rate as a percent of pretax income to be 38.0% to 38.4%. Where we fall within this range will be dependent on resolution of open tax year audits that occur during the year.

Diluted earnings per share for the first quarter was $0.70 per share, which represents a 52% increase over the first quarter of 2009.

Now we’ll move on to the balance sheet. The average inventory per store at the end of the year was $549,000, which was a 13% increase over the prior year average of $487,000. This increase is the result of significantly increasing the hard part SKU stocks in the acquired stores and the addition of the Western DCs to support our dual market strategy. In 2010, we are focused on refining the inventory mix in stores, and as the new DCs come online, we will be able to reduce the stocking deficits at CSK stores.

Based on these 2010 initiatives, we expect to only increase our inventory investments slightly in 2010, despite opening 150 new stores and 3 new DCs. Through the first quarter, we added 48 net new stores or reduced our total inventory by $10 million, which equates to a 2% reduction in the average inventory per store.

Our reserve for LIFO at the end of the quarter was $13.1 million, which was an increase of $4.4 million from the previous quarter. This change in our last buy to LIFO reserve did not have material impact on gross margin for the quarter. Accounts payable of $795 million was 41.8% of inventory, as compared to 46.8% in the prior year. Our AP to inventory ratio at the end the first quarter of 2009, benefited from special extended dating on changeover orders.

That said, in 2010, we expect our AP to inventory ratio will continue to be under pressure as we work excess inventory through and out of this system. Capital expenditures were $91 million for the quarter. For 2010, we continue to estimate capital expenditures will be in the range of $400 million to $440 million, as we complete our DC projects and continue to invest heavily in store conversions. Depreciation and amortization for the quarter was $40 million. For 2010, we continue to expect depreciation and amortization to be $154 million to $159 million.

Total borrowings at the end of the quarter were $703 million compared to $791 million at the end of Q1 2009. Also at the end of the quarter we had $531 million of availability under our ABL facility. For 2010, we expect to reduce our total outstanding borrowings by $170 million to $220 million. Included in this reduction, is our planned redemption of a $100 million legacy CSK convertible notes in December. Our plan is to fund this with our existing ABL, which will still allow us significant financial flexibility.

Now for some other financial information. Cash flow from operating activities for the quarter was $171 million, an increase of $84 million over the first quarter of 2009. The improvement was driven by higher net income and deferred taxes, and the lower increase in net inventory investments in comparison to the first quarter of 2009.

For the quarter, free cash flow was $80 million versus a use of $65 million in the first quarter of 2009. The improvement of $145 million was driven by the previously mentioned increase in cash flow from operations, and a $60 million decrease in capital expenditures.

We now expect free cash flow to be $140 million to $160 million in 2010, as we again invest heavily in CapEx, but do not have a significant increase in investments in that inventory.

Stock option expense for the quarter was $3.6 million compared to $3.3 million in the prior year. The increase was driven by our year-over-year increase in stock price. For 2010, we continue to expect stock option expense to be approximately $16 million.

To recap our overall guidance, for the second quarter, our comparable store sales guidance is 4% to 6%, and for the year, we are increasing our comparable store sales guidance from an increase of 3% to 5% to an increase of 4% to 6%. Our GAAP diluted earnings per share guidance for the second quarter is from $0.70 to $0.74 on a 140.6 million shares, and we are raising our GAAP diluted earnings per share guidance for the full year to a range of $2.55 to $2.75 on 140.7 million shares.

At this time, I’d like to ask Lisa, the operator to come back, and we’ll be happy to answer your questions. Lisa?

Question-and-Answer Session

Operator

(Operator instructions) Your first question comes from Tony Cristello with BB&T Capital Markets.

Tony Cristello – BB&T Capital Markets

Thanks. Good morning, gentlemen.

Greg Henslee

Good morning Tony.

Tom McFall

Good morning.

Tony Cristello – BB&T Capital Markets

Greg, you had mentioned in your prepared remarks some initiatives that you were talking about, whether it's a POS or parts cataloging, or inventory or productivity enhancements or measurements at the DC level. I'm just wondering if you could give us a little bit more color, sort of what's the timeline on those? Are those things that are already underway? And sort of what's sort of behind the launch of some of these initiatives right now?

Greg Henslee

Well, these things really aren't anything new Tony for – this is my 26th year here and David is here, and he will give us, you know, the business [ph]. We’ve constantly evolved really everything we do, point of sale, catalog, the way we manage productivity and things like that. Today, with you know, technology being what it is there is so much opportunity to incrementally improve the function of our POS, the content that we make available to our parts specialists, just the whole interaction experience with our customers in general, and then also just continuing to improve the way back that we manage inventories, measure productivity in our distribution centers, you know, incent our distribution team members to be as productive as they can be and so forth.

So we have teams in our IT department and operational departments that manage these projects that we work on ongoing. Some of these are things that we implement in pieces, and some of the improvements that we are making will be implemented this year. You know, some of the presence the way that we handle what would be considered a minor thing to many but it's a major thing when it comes to running a store. It is the way you deal with you know, sales tax, for instance, when it comes to installer customers. You know, lot of installer customers want to not pay tax.

If they bill their customer for tax and state laws in most states allows us not to bill them for tax, but they require tax on certain items. You are making that as automated as it can possibly be, enhances our POS system. Another example would be just making sure that we have you know, pictures of all of our products, and those pictures are available from different use of the product. So we don't have any stock, we can match it up at the counter, and make sure we order the right part.

You know, things like that are implemented incrementally and then something specifically that we're implementing over the next couple of months is what we call a labor management system in our distribution centers that basically kind of set standards for productivity in our distribution center based on the layout of the DC, where the products are located, the amount of time it takes to stock or pick a product and then we are putting in place an incentive program for our distribution team members to be as productive as they can be, and we’ll start back here in the next couple of months in Detroit.

Tony Cristello – BB&T Capital Markets

And I guess just on a follow-up, when you think about the POS, is there anything that you've been lacking in terms of your ability to sell through to – and I'm assuming this is more of a DIY approach, I know that the Hispanic community has been sort of a big target for DIY, especially right now. Is this something that might draw incremental sales? And this is a benefit that could be added to what's going on with the West Coast and the conversions at CSK?

Greg Henslee

I don't think that we would be doing anything to would add measurable incremental sales. I think that every improvement we make we make because we feel like it's the best thing to do for the business that it improves our competitive position and improves just the customary action, but I don't think anything that we're doing right now would create a measurable benefit beyond the benefit that we get from having you know, robust POS systems that we have in place today.

Tony Cristello – BB&T Capital Markets

Okay, perfect. Thank you.

Greg Henslee

Thanks.

Operator

Your next question comes from Alan Rifkin with Banc of America.

Alan Rifkin – Banc of America

Thank you very much. Congratulations, gentlemen.

Greg Henslee

Thanks Alan.

Alan Rifkin – Banc of America

Your SG&A leverage is obviously quite admirable despite costs in the quarter that are not being capitalized, but expensed as a result of the conversion process. How much in your opinion did this impact the SG&A rate in Q1? And would it be reasonable to expect that these costs go away at the end of 2010 altogether?

Greg Henslee

I'd make a comment, and then Tom might have more details. You know, in the scope of our overall SG&A, you know, as you said there are many of the conversion expenses you know, payroll dollars that are expense as opposed to amortized and I don't think it creates a material difference in our SG&A. Tom, you may have a comment on that.

Tom McFall

Alan, we're not going to break out our SG&A separately, but when we look at 2009 we spend a lot of dollars that went to store payroll to reset back rooms and this year to the extent that the store personnel are helping on the front end, they are doing front end resets, and then all the training time or the conversions, we're incurring a similar amount of expense and it's a number that you know, we're looking for to not spending next year, and spending on items that really drives sales.

When we look at, as we've talked about before, when we look at the O’Reilly efficiency at the store level and the CSK efficiency, part of it is how many sales we are doing and a lot of it is this conversion process. But we continue to have an opportunity to better leverage our payroll at the CSK market, and on the O’Reilly side, the store payroll was tremendously leveraged this quarter, and they did a fantastic job.

Alan Rifkin – Banc of America

Okay. Thank you. And a follow-up if I may, Greg, you made a point of saying, and rightfully so, in the quarter you achieved a record high EBIT margin of 13.2. If we go back and we look at 2005, when you reached the peak on an annual basis of 12.5%, your EBIT margins in that year's first quarter were only 11.5%. So you've exceeded that number by 170 basis points. As we think about the opportunities for this company long-term, beyond 2010, can we kind of draw parallels between the EBIT margin be this quarter versus back then and what the long-term opportunities maybe for O’Reilly to achieve EBIT margins?

Greg Henslee

Well, I would hate to say that you know, that we could incrementally build annual models based on the beginning point being the difference between what we generated this first quarter and the first quarter of 2005. You know, that was the first full year that I was CEO of the company, and I remember the year well, but I don't really remember how the quarter is broke out. But what I would say Alan is that as we have these you know, strong comp quarters, we are in a great position to leverage our costs and our stocking focuses very intently on managing payroll, which is our single largest expense.

As we complete these conversions and as we become more productive in the western stores, and our team members get more professional on our POS, their sales per month increase, we will become more productive and yes, I think that over time we got a great opportunity to continue to set records from an operating margin standpoint for the company. You know, the extent, and I guess the time in which it takes to accomplish that is dependent on our incremental comp store sales growth and our ability to leverage that which I feel very good about.

Alan Rifkin – Banc of America

Thank you very much.

Greg Henslee

Okay, thank you Alan.

Operator

Your next question comes from Stephen Chick with FBR Capital Markets.

Stephen Chick – FBR Capital Markets

Hi, thanks. Good quarter.

Greg Henslee

Thank you Steve.

Stephen Chick – FBR Capital Markets

I guess maybe, you know, for Ted, the – if you look at the growth you're seeing in the converted stores, I guess, can you clarify if the installer commercial businesses is growing faster than retail? And then, you know, secondly, as you are ramping the commercial business and you look at – I don't know if it's NPD data or if you look at market specific data, can you tell, you know, where the market share may be coming from? Is it coming from three steppers [ph] or some of the regional folks, or maybe even some of the, you know, the larger incumbents that might be in that market?

Ted Wise

Steve, you know, we don't break out the retail and our wholesale growth, but I would say they're very, very close to each other. You know, lot of the wholesale volume is just now starting to you know, be material because of the distribution centers, the nightly service and you know, we got all of the traditional product lines in place and you know, the hub and spoke system is working good, and again you know, there is a lot of strong competitors on the West Coast and it has taken you know, a while to develop the relationships, and again now we totally have the tools in place.

So again they're growing about the same. You know, we anticipate the wholesale business will be much better this coming year, because of the tools we have and the fact that, you know, it takes more than just a few sales calls to build a relationship. You know, with regard to the competitors out there you know, on the West Coast it's basically you know, a two-step market. There is a lot of undercar small warehouses. They are regional you know, they have strengths and they have weaknesses.

You know, they've got good inventories, but not necessarily broad inventories. They don't have as good a replenishment frequency as we do. So again, now that we have the distribution centers in place and we have our inventories levels where they should be. You know, we'll continue to make progress on taking market share in that regard. Lot of it is tied to you know, the personnel we have at the store, and again as we you know, mature you know, our programs out there, we won't be able to track and recruit you know, higher level professional parts person you know, away from these more traditional two-step type competitors.

You know, and when that starts happening you know, you hire you know, one or two in a market and then you know, two or three more and pretty soon, you know, the profile of your installer service specialists you know, change to where you basically have experienced parts people, you know, on the ISS counters [ph], and not to say that you know, we don't have a lot today it is just that, you know, as we roll out more installer stores you know, from retail installer we’ll have to add you know, the experience levels you know, to grow the business and that's you know, work in progress and we are making good headway in that regard today.

Greg Henslee

And Steve, this is Greg. One thing I might add to that is that one, this particular quarter, I know Ted you're talking more kind of on maybe a 12-month back basis, and also by region we had you know, similar retail and wholesale growth for the consolidated company, and like Ted said, we don't disclose the business mix difference, but our commercial business continues to be a little bit stronger than our regional business on a whole basis.

And then as far as defining where the business comes from, that is – as Ted said, it is difficult for us to do, that I can't tell you that the categories in which we continue to grow business are the hard parts categories, the application parts, the nondiscretionary stuff, you know, chassis parts, ignition parts, you know, belts and hoses, things like that are performing extremely well. The discretionary display area merchandise is not growing nearly as fast in some of those categories are actually comping negative.

Stephen Chick – FBR Capital Markets

Okay, that's helpful. And the second question, if I could, Greg, we have seen other retailers who have made comments about kind of, April so far, with the pent-up sales demand that we saw in March, that kind of maybe indicated that April has been just a little – started off a little at a slower rate of growth than where the March quarter ended. So I was wondering if you could give us a little more kind of granularity and clarity on you know, how solid it is all in terms of the start to the second quarter here for sales?

Greg Henslee

Well, Steve what I would say is that March was an outstanding month for us as proven. I know that you guys back into what you think our March was based on what we said on February 20th and, you know, the math is going to lead to the conclusion that we have really strong sales in March. April has been a good month so far. I would say that you know, maybe it has slowed down slightly but it is still a very, very good start to the quarter and we're comfortable with the guidance we gave 4% to 6% for the quarter, again not knowing what the rest of the quarter will bring to having confidence in the trend of business since the middle of February.

Stephen Chick – FBR Capital Markets

Okay. Thanks, guys.

Greg Henslee

Okay, thanks Steve.

Operator

Your next question comes from Dan Wewer with Raymond James.

Dan Wewer – Raymond James & Associates

Thanks. Greg, I wanted to follow up on your comments about the change in the pricing strategy at CSK. As I recall, you took your everyday prices down about 4% to 5%. But in turn, the company was less reliant on the different types of promotions they were running. So, were you initially seeing the sales not respond to the reduction in pricing given that your do-it-yourself customers in those stores are only in those stores once or twice a year and they weren’t cognizant of the changes that were taking place?

Greg Henslee

Well, we’ve incrementally seen transactions increase, but at the same time we have seen our ticket average come down a little bit as a result of the price changes that we've made. Our perception is, and again this is just a perception based on having been in this business most of our lives, is that it takes a long time for consumers in the hard parts business to realize that you're more price competitive than what you were in the month before, maybe even the year before in some cases.

It takes a long time to establish those perceptions. We feel like we've incrementally gained traction with that and our marketing and advertising efforts to drive traffic into the stores as these customers come in buy an oil change or whatever it is that they may be buying, if they price something else and then check one of our competitors, they find out that we're not competitive whereas we’ve had the perception along that many of the customers that came into a CSK store came in because they were given a coupon.

They came in because they had an ad in their hand and they bought typically just those items, and if they buy something else, CSK proved to them that they weren’t price competitive with our primary retail competitors. I think the changes that we’ve made incrementally ramp from a traction standpoint as customers become more accustomed to the fact that we are competitive now, and then as they have reason to check us based on past experiences. They find out that our prices truly are competitive, and I think that that momentum builds and it's a reputation that takes time to correct.

Dan Wewer – Raymond James & Associates

Are you trying to say that the sales benefits were probably less in the quarter just ended than it will be later?

Greg Henslee

That's exactly what I'm saying.

Dan Wewer – Raymond James & Associates

Okay.

Ted Wise

You know, Dan this is Ted. I also might add that you know, when we adjusted our prices, it was a certain amount of time that we were able to roll out a lot of our private label lines too. So, you know, while we had a little bit lower prices on what they carry you know, most of last year's is the line at a time that we rolled out an inventory of more competitive private label products, which has been a big help in growing the retail business.

Dan Wewer – Raymond James & Associates

And Tom, I just wanted to make sure I understood your comment about inventories at year end. Were you indicating that you expect year end inventories to be equal to or less than the $1.9 billion that you had at the end of FY '09?

Tom McFall

We expect them to be up slightly but not, but through the process of fine-tuning our mix at CSK, we won't see the growth we would normally see from 150 stores.

Dan Wewer – Raymond James & Associates

So the total inventory dollars would be up slightly, the inventory per store be less, I guess?

Tom McFall

Correct.

Dan Wewer – Raymond James & Associates

Okay. Thank you.

Greg Henslee

Thanks Dan.

Operator

Your next question comes from William Truelove with UBS.

William Truelove – UBS

Hi, great quarter, guys.

Greg Henslee

Thank you.

William Truelove – UBS

In terms of the – I know you're not breaking out the sales growth pace between the old CSK and O'Reilly, obviously, but can you talk a little bit about the commercial sales at CSK? You said they're growing maybe slightly better, but wasn't the percentage of sales at the old CSKs around 10% commercial? And is it still roughly around there or has that changed materially since the conversions?

Greg Henslee

That has incrementally changed. It's increased some. You know, if we look back over the past 12 months, CSK by itself, the commercial business has grown better than the retail business and that's an ebb and flow from week to week, quarter to quarter for the consolidated company. Generally, our trend has been over the past couple of years that our commercial business has grown a little better than our DIY business.

Now, we've been able to maintain you know, positive comp store sales growth in both categories, but generally speaking the commercial business for us is growing faster than the DIY. For CSK, we have a lot of opportunity on the commercial side and CSK is an entity by itself. The commercial business is doing better of course than the retail business.

William Truelove – UBS

Multiples better than the retail business, or just moderately better?

Greg Henslee

Yes, well, it's doing better. I wouldn't give a definition on how much better, but yes it's doing I’ll say moderately better.

William Truelove – UBS

Sure. And then one follow-up to that is, you talked about hiring commercial reps, adding them to the marketplace. Would you say that your pace of hiring sales reps is going to be very aggressive near-term or is it going to be more moderate? Because as you may know, one of your competitors went out and hired a whole bunch of sales reps, and it had some disruptive effects on the SG&A expense ratio. So, how do you try to balance that too? And what do you think that the pace of hiring will be?

Greg Henslee

Well, we were very, very diligent stewards of our expense, and if we're going to do anything that got our SG&A out of pace with our ability to grow sales, we would build that into our forecast, and tell everyone we're going to do that. That's not the plan. Our plan as we add these outside salespeople, which CSK had many in place provided that we are kind of built into their expense model, just as we have as core O’Reilly. We continue to add them as we grow the sales, but we will not get our expense ahead of the sales growth.

William Truelove – UBS

Wonderful. Thank you so very much for answering my questions.

Greg Henslee

You bet, thank you.

Operator

Your next question comes from Scot Ciccarelli with RBC Capital.

Scot Ciccarelli – RBC Capital Markets

Hi, guys. It is Ciccarelli.

Greg Henslee

Hi Scot.

Scot Ciccarelli – RBC Capital Markets

Just kind of a follow-up on the previous question. You do have better inventory levels and replenishment systems in place at a lot of the CSK stores. I guess the question I think a lot of people are kind of trying to figure out right now is, have you learned anything about the business that will keep a typical CSK store from generating a comfortable amount of commercial sales as what you traditionally been able to generate through an average O'Reilly store?

Greg Henslee

Well, what I would say Scot is that the average CSK store should grow into doing something you know, very similar to what we've been able to do with the O'Reilly stores. You know, there is a you know, a big variance in the O'Reilly stores with if you compare rural markets to metro markets, but we generally have been able at core O’Reilly to keep the balance at approximately 50-50, again not by intent necessarily, but just by trying to do as much business on both sides as we can.

In the Western CSK stores there are some stores. I would say approximately 10% of the stores that are in locations that aren't necessarily conducive or as conducive as we would like them to be to doing a large amount of wholesale commercial business. Those stores most likely will never get to a 50-50 mix, but the remainder of the stores over time we believe can do as much wholesale business as the O'Reilly stores do on average and our efforts are to work to build that.

Ted Wise

Scot, this is Ted. You know, LA and some of those real dense population areas, the store count is pretty heavy and they're so close together that sometimes it just doesn't make sense to run wholesale business out of stores that are a mile and a half apart, when you can actually service installers better from one largest store bigger inventory more truck. So you know, they'll continue to be a small number of stores that you know, will be more retail, primarily retail, but again that's a very small percentage of them.

Scot Ciccarelli – RBC Capital Markets

But, it should be applicable to say, 90% of the store base?

Ted Wise

Yes, yes.

Scot Ciccarelli – RBC Capital Markets

Okay, great. Thanks, guys.

Greg Henslee

Okay, thanks Scot.

Operator

Your next question comes from Mark Becks of Longbow Research.

Mark Becks – Longbow Research

Hey, congrats on the great quarter.

Greg Henslee

Oh, thank you.

Mark Becks – Longbow Research

You mentioned the pent-up demand. I was wondering if you guys thought this was more of a 1Q tailwind, or you think that can kind of play out for the remainder of the year?

Greg Henslee

Well, you know, I say, I made that comment in complete speculation, because we have no way to measure pent-up demand. We’ve all been in the business a long time and we've seen periods when economic pressures placed on consumers result in comp store sales growth that is not as robust as we would like it to be. Generally directly following those periods, you'll have pretty robust sales as people take care of the things that may be they deferred.

So I think that with the winter weather that we had in many markets, I think prevented people from working in their driveways on vehicles on the DIY side. I think that caused some release of pent up demand in the springtime. I think the economy in general over the past couple of years has caused people to try and defer as many things as they could that didn't you know, absolutely have to be repaired. So I think that's more, maybe a slow release of pent-up demand as peoples’ individual financial situations improve with a growing economy.

So I think you see some benefit of it over a longer period of time, but I feel like we had an immediate benefit when spring weather got here from some of the things that had been deferred over the winter, and some catch up for some things that maybe weren’t done during the pre-holiday season as discretionary income was spent on more holiday activity type of thing.

Again that's all speculation on my part based on my experience in the business, but I, my observation would be that demand for parts right now has been strong based on the older vehicles being driven on the roads, and some release of the pent-up demand that we feel like is kind of accrued over the past year or two.

Mark Becks – Longbow Research

Okay, great. And then just as a follow-up, I was hoping you might be able to dig into gross margins a bit, and quantify if there was any sort of pressure you may have seen from the distribution costs with the new DCs ramping up. Thanks.

Greg Henslee

We have spoken about that our DC cost as a percent of sales will be up this year as we bring DCs online and get staffs trained. Those costs were higher than what they had been previous – in the previous quarter, but within what our expectations were. Obviously, when we do a big sales number like this, we always get a lot of leverage on fixed cost of our DC's. So that wasn't a big impact when we look at total dollars spent, it is within our expectations and you know, the cost of the DC's rolling on has – our DC ops group does a great job of planning and managing, and the results have been as we expected.

Mark Becks – Longbow Research

Just to kind of follow-up on the gross margin side, there wasn't a material impact with the increased transportation of stores with the two new DCs?

Greg Henslee

It was within our expectations.

Mark Becks – Longbow Research

Got you. Thanks so much.

Greg Henslee

Okay, thank you.

Operator

Your next question comes from Christopher Horvers with JPMorgan.

Christopher Horvers – JP Morgan

Thanks and good morning.

Greg Henslee

Good morning.

Christopher Horvers – JP Morgan

A question for you. You said all markets did relatively well. Did you see – I'm not sure if you commented if you saw more strength in the southeast where you have big exposure and where, perhaps the weather was pretty unseasonably cold and snowy?

Tom McFall

You know, we had relative strength throughout the country and yes, we were pleased with our performance in our Eastern division. We really were, you know, the best performing part of our company were the center country converted CSK stores, and the rest of the stores were primarily comparable on a division basis, and I would say that we were pleased with the Eastern division as well as the remaining division.

Greg Henslee

Chris, we would point to those stores gaining traction from being converted the longest, having more time to develop the commercial business, getting customers back or having competitive prices and inventory stock than we would put that on you know, geographic or weather, that’s right.

Christopher Horvers – JP Morgan

Fair enough. So if we kind of looked at maybe 4Q and 1Q together on a comp basis to try to smooth some of the weather impacts, it sounds like, based on what you're seeing in traction on the CSK side, even on that, that you're thinking there's you know, a potential acceleration even if we took the two quarters from a combined view?

Greg Henslee

Well, I think if you look at the CSK stores that have been converted the longest, they of course are accelerating the best. The remaining stores are doing well as a result of the things that I just mentioned on pent-up demand and just you know, springtime being here and things like that.

Christopher Horvers – JP Morgan

And then one final one, as you – can you maybe quantify how much of the, how much sales you took out the CSK stores a year ago? Was that 8%, 10% from a front-room product that is really non-core auto that, that you weren't – that basically suppressed your comps last year during the year?

Tom McFall

I don't think we have that number here. We did take you know, several product lines and some categories out of those stores that we have sold through as close up products. We replaced those sales with hard parts sales. So, you know, our hard parts categories are doing very well, and enough that they generate solid comp when compared to the sales of these other more discretionary products that CSK had kind of gotten into over the last several years prior to us buying them. I don’t know if you have any quantification of that or not.

Greg Henslee

Chris, we never gave any quantification of that. We obviously look at it internally from how much we're selling by product line. I can tell you that it was a pretty good headwind as were the changes in average ticket from you know, getting prices right. And as Ted mentioned adding entry-level product into the mix to the extent that you sell down to those, but it also drives our traffic for having that in being competitive and getting people in the store. So, you know, incrementally as we roll through the year, those headwinds will cease to be as big as they were last year.

Christopher Horvers – JP Morgan

Thank you.

Greg Henslee

Thanks.

Operator

Your final question comes from Michael Lasser with Barclays.

Michael Lasser – Barclays Capital

Good morning. Thanks a lot for taking my question. With the CSK stores shifting to a new compensation structure over the last several quarters that focuses more on the incentive part and a gradual rollout of the distribution centers, is there a risk? And how are you managing the risk of some of these folks over-promising ahead of what the capabilities might be?

Greg Henslee

Now...

Michael Lasser – Barclays Capital

To the commercial customers?

Greg Henslee

Okay. Well, you know, you're under the business one delivery at a time, you know, one day at a time, one week at a time, and I think we're pretty careful about what we promised. As a matter of fact, as we originally started really making a push to come into the commercial business, we're pretty careful because we’ve learned over the years how hard it is to earn our commercial customers business back once you got it and you didn't do the job you promised you would do.

So we've been pretty careful in describing what we're capable of and what we're not and promising more on the long-term of what we are putting in place and kind of eventually do. I think we've done a good job of managing that. I think the relationships that we're establishing a relationship that we can maintain based on being honest with the customers upfront about what our capabilities were, what they are becoming and what they're today in these markets. You know, Ted, I don’t know if you have anything to add to that.

Ted Wise

Yes, Michael we're definitely street smart in that regard and very conservative. We learned a long time ago that you can go out and buy business or promise the world or the sky from a service level and if you mess it up you'll lose the customer. So particularly out there we are, you know, we had so much going on last year from moving products and just getting the store raise new business. You know, we were conservative.

You know, a lot of times we would wait to rollout delivery service until we had the right staffing in the store, and kind of take it one step at a time with a long-term you know, commitment to service. On the other hand where we’re in a good position with the right people in the store and you know, the right competition, we were very aggressive. So that evaluation process goes on, you know, district manager and regional sales manager, you know, making a game plan to reach an individual store.

Michael Lasser – Barclays Capital

And as you look at the vintage of CSK stores that have been converted the longest, are you seeing more growth coming from new customers, or more growth coming from customers where you're moving up the call list?

Greg Henslee

I don't have a measurement of where the commercial sales come from. Many of these accounts are accounts that we're hoping that you don’t – that were opened immediately. When we put a store in the commercial business, we'll try to open accounts with virtually anyone that we would hope to do business with, so that when they do give us a call or they need a part they couldn't find anywhere else, we are capable of handling the transaction.

So the way we measure, we would measure the growth as increases in existing customers, but also realizing that many of those customers were customers that have been – had a competitor as a first call for some period of time. So that's really a hard internal measurement, but my observation would be that generally we have developed relationships with many customers that we're not buying from Checker stores in the thinner part of the country and the western US and that we are working our way to becoming the first call for those customers, and we're probably not on the top of the list on as many as we would like to be today, but we're working our way up the list.

Ted Wise

Michael, first of all CSK’s model was to have fewer customers, maybe larger volume customers based on price. We want those customers but you know, our philosophy is to do business with every customer in the market area. So we're calling on and have accounts with customers now that, you know, the former CSK folks didn’t even know exists. So you know, our customer base is much larger, and the greatest point, you know, when there are new customers it takes time to earn the business and work your way up on the first call list.

Michael Lasser – Barclays Capital

That's really helpful. Thank you so much.

Greg Henslee

Thank you, Michael.

Operator

And sir, do you have any closing remarks?

Greg Henslee

Well, I would just say as I mentioned earlier, you know, we are very pleased with our first quarter performance and you know, we were very encouraged by the integration plan execution. You know, we put an aggressive plan in place back at the time we acquired CSK, and we've been very fortunate to have had this outstanding team here at O'Reilly that has been able to execute the integration plan to this point and we are looking forward to continued success as we continue the integration and continue to execute in the core O’Reilly stores, and we will report further news to you after our second quarter performance. Thanks.

Operator

Thank you for participating in today’s conference. You may now disconnect.

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