Advance Auto Parts Q3 2007 Earnings Call Transcript

Advance Auto Parts, Inc. (AAP)

Q3 2007 Earnings Call

November 1, 2007 8:00 am ET

Executives

Eric Margolin – General Counsel

Jack Brouillard - Chairman, President, CEO

Jim Wade – EVP, Business Development

Michael Moore – EVP, CFO

Elwyn Murray – EVP, Merchandising Supply Chain and Technology

Analysts

Matthew Fassler – Goldman Sachs

Armando Lopez -Morgan Stanley

Danielle Fox – Merrill Lynch

David Cumberland - Robert W. Baird

Dan Wewer – Raymond James

Scott Ciccarelli - RBC Capital Markets

Gary Balter – Credit Suisse

Tony Cristello - BB&T Capital Markets

Rick Weinhart - BMO Capital Markets

Presentation

Operator

Welcome to the Advance Auto Parts third quarter 2007 conference call (Operator Instructions) Before we begin, Eric Margolin, Senior Vice President and General Counsel, will make a brief statement concerning forward-looking statements that will be made on this call.

Eric Margolin

Good morning and thank you for joining us on today's call. Certain statements contained in this conference call are forward-looking statements as that term is used in the Private Securities Litigation Reform Act of 1995.

Forward-looking statements discuss, among other things, management succession and expected growth and future performance, including new store openings, remodels and relocations, comparable store sales, sales per store, gross margin, SG&A expenses, operating margin, return on invested capital, free cash flow, accounts payable ratio, capital expenditures, tax rate, and earnings per share for the fourth quarter and fiscal year 2007 and fiscal year 2008.

These forward-looking statements are subject to risks, uncertainties and assumptions including those disclosed in the companies 10-K for the fiscal year ended December 30, 2006, on file with the Securities and Exchange Commission. Actual results may differ materially from anticipated results described in these forward-looking statements.

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. Our results can be found in our press release and 8-K filing which are available on our website at www.AdvanceAutoParts.com.

For planning purposes, our fourth quarter earnings release is scheduled for Wednesday, February 13, 2008 after market close; and our quarterly conference call is scheduled for the morning of Thursday, February 14, 2008. To be notified of the dates of future earnings reports you can sign up through the investor relations section of 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 Jack Brouillard, our Chairman, President, and CEO, who will be followed by Jim Wade, EVP of Business Development, and Michael Moore, EVP and CFO. Also joining us today on the call will be Elwyn Murray, EVP, Merchandising Supply Chain and Technology.

Jack Brouillard

Good morning and welcome to our third quarter conference call. We are pleased to report that we remain on track with the initiatives that we reviewed with you on the last call. Although we anticipated it would take time, we believe the results of those initiatives are beginning to have a positive impact on our sales, earnings, and return on capital.

I will spend my time this morning reviewing with you the highlights of our third quarter results, the status of our initiatives, and how we see the business over the coming months.

In the third quarter, comp store sales grew by 1.1%, which was in line with our sales growth over the past several quarters, but better than we had expected for the quarter. As you may recall, we forecast our third quarter sales to be in the negative 2% to zero range based on how the quarter started off. After those early weeks, sales trends improved and stayed fairly consistent during the remainder of the quarter.

As Jim will discuss, Do-It-For-Me our sales showed solid improvement over our year-to-date run rate, but our Do-It-Yourself trend has not yet improved. We believe that the tough economic environment continues to hamper sales across much of retail, including our business.

Our gross margin percent was 28 basis points less in the third quarter than last year, due to several factors that Mike will discuss in more detail. Although gross margin was down in the quarter, we do see the opportunity to continue to grow the gross margin rate as we go forward, although at a lower rate.

Overall, SG&A was up 37 basis points in the quarter, but leveraged 18 basis points excluding the severance costs and asset write-offs related to our expense reduction initiatives. We feel this is a solid step in the right direction and reflects our team’s commitment to getting our costs in line. We anticipate additional SG&A leverage in the fourth quarter. We believe the expense reductions we have put in place will not compromise future sales growth. Our priority is to drive the top line while lowering our expense rate.

Earnings per share were $0.57 which was at the high end of our guidance range of $0.53 to $0.57 per share. Earnings per share was $0.61 excluding the severance cost and asset write-offs, or an increase of 9% over last year’s third quarter.

Now I will provide you an update on the status of our initiatives to drive sales, earnings, and return on capital. As I discussed on our last call, we are in the process of returning to what matters most in the auto parts business to reinvigorate our sales and earnings growth. Our recent business strategy review and the related customer research provided good insight and background for our action plans.

First, we are improving parts availability. We are well into implementing our plan to increase parts availability in our stores. We believe this will drive improvement in both our DIY and commercial sales. The plan is focused on greater late model and foreign vehicle coverage, as well as being more aggressive in getting parts into our stores and closer to our customers. I mentioned that our DIFM business has started to improve but that our DIY Business has not yet shown the same trends.

Our plan to improve parts availability is on schedule. Some of this increase in coverage has now been distributed to our stores and we anticipate much of it will be completed by year end.

We told you on the last call that we expected to fund part of this increase by making our existing inventory more productive. That process is also underway and ahead of schedule; Mike will review our progress. In the short term, we are making select investments in more parts inventory that we believe will help grow sales. Going forward, however, we are committed to grow sales at a rate faster than inventory growth.

Second, we are increasing our commercial focus. We said on our last call that we believed we had missed meaningful opportunities to drive our commercial sales and as a result, our comp growth in this area had slowed. We continued to achieve 5% to 6% comps, but believe that undershot our potential in this area.

With our increased focus on commercial sales, our commercial comps for the third quarter rose to 8%. We saw an improvement in commercial comps as we went through the quarter and comps continue to run above 8% for the fourth quarter to-date. We continue to look at store staffing and training, compensation policies, truck utilization, and many other areas to best structure us for further commercial growth. You will hear more about this over the next several quarters.

Third, we are changing our previous focus on the front room. As part of our ongoing business review, we are improving the productivity and efficiency of our sales floor or front room portion of our stores. We are in the process of rationalizing and removing SKUs within sales floor categories, as well as full categories that do not align with our focus on parts and related items. We now have less frequent end cap rotation, fewer sales floor planogram changes, fewer price changes and less frequent rotation of point of purchase signage. The hours previously spent on these tasks are now being applied to parts-related, sales-driving initiatives.

We are on schedule with all the SG&A reductions and return on invested capital improvements we outlined in the last call, as well as having worked through additional cost reductions that Mike will address on this call. The reduction of 250 positions in our field and store support center has been completed.

We have reduced our new store openings for 2008. On our last call, we announced guidance of 140-150 new stores for 2008. As we look at the significant changes in many parts of our business that our new strategy requires, we now believe that our new store openings for 2008 will be in the range of 110- 120 stores. We would anticipate store openings will increase in 2009. Jim will talk in more detail about the additional steps we are taking to better align our new store growth strategy with our updated strategic plan and to improve our return on new store investments. We anticipate store relocations to be in the range of ten to 20 stores in 2008 for the same reasons.

We halted our 2010 store remodel program. We discontinued our Advanced TV Network in our stores. We eliminated advertising expenditures that we determined were not productive. We continue to test and measure other portions, including our print advertising program and we are implementing a plan for 2008 that will shift expenditures away from print towards more electronic media.

In addition, we will be increasing the portion of our total spend targeted to the Hispanic customer. In partnership with our new ad agency, we believe we can achieve greater results in 2008 with less expenditure. We eliminated IT, logistics, and other investments that did not demonstrate an acceptable return.

Over the past three years, we have repurchased over 18 million shares, including 6.2 million shares repurchased in the third quarter at an average price of $33.26. We see this as an excellent use of our capital at our current stock price and as we generate additional free cash flow, we will review further purchases. We are also currently evaluating taking on additional debt to repurchase shares.

Externally, the economic headwinds continue to be a negative for sales growth. We believe these headwinds have reduced our customer’s ability to make purchases and has led to increased maintenance deferrals.

With our parts-focused initiatives, we are pleased to see our parts categories are growing; however, we continue to see softness in our more highly discretionary categories. We believe our focus on parts availability, a more productive and effective advertising program, increasing parts knowledge in our stores, and other initiatives will drive DIY positively but it has not yet offset the economic headwinds and regional challenges. We anticipate that over time, customers will adjust their budgets, and coupled with our initiatives, we will see a benefit.

We will not be providing specific guidance for 2008 until the February conference call. However, we will address how we are planning for next year. At this time, we continue to see a challenging sales environment where we believe it is prudent for us to plan comps in the 1% to 2% range until we see our trends show consistent improvement. We anticipate gross margin to improve incrementally by 10 to 15 basis points as we continue to pursue lower costs and leverage our logistics network, but we anticipate that these increases will be somewhat offset by a higher commercial sales mix.

Lastly, with our SG&A reductions, we believe we can leverage SG&A in 2008 at the higher end of our forecasted 1% to 2% comp levels.

In regard to the CEO search, we feel very good about our progress and expect to announce a new CEO by the end of the year.

Now, I'd like to turn the call over to Jim and Michael, who will review further our third quarter results and our guidance for the remainder of the year.

Jim Wade

Thank you, Jack and good morning. I'll provide a further break down of our sales for the third quarter as well as store growth, and Michael will discuss gross margin and SG&A, as well as our balance sheet and cash flow.

Our comp store sales increase for the quarter was 1.1% compared to 1.4% last year. As Jack mentioned, our sales started off slower at the beginning of the third quarter. As the weather in August became warmer, we began to see sales pick up and we saw that momentum continue for the remainder of the third quarter. We've also seen sales continue in the current range so far in the fourth quarter, and we believe we are seeing a positive impact from our sales initiatives even though the macroeconomic environment remains challenging.

On a geographic basis, comps continue to be stronger in the North and Midwest and weaker in Florida and the Gulf Coast. Our comps, excluding Florida and the Gulf Coast, were 2.1% in the third quarter. The comps in Florida and the Gulf Coast improved slightly over the second quarter.

During the third quarter, our DIY comps were a negative 1% compared to negative 0.6% last year. We believe we're doing the right things to improve DIY and will be well-positioned over the next several months.

Our commercial comps are 8% in the third quarter over 8.7 % last year. As Jack mentioned, the steps we're taking to refocus on commercial growth has started to show up in our comps as the 8% comp in the third quarter grew from the 5.4% comp in the first half of 2007. Our focus remains on getting our commercial comps back to the double-digit run rate we've previously achieved. Our commercial comps continue to run in the 8% plus range in the fourth quarter to date.

Commercial sales, including Autopart International, represented 27% of our total sales for the quarter. Our total commercial sales were approximately $314.1 million, a 13% increase over last year. During the quarter, we added 46 new commercial programs to our Advance Auto Parts stores, most of which were in our new stores, bringing the total number of Advance stores with commercial programs to 2,571. Today, about 82% of our Advance stores have commercial programs, compared to 81% for the third quarter last year.

In the third quarter we opened 43 new stores; 39 of these new stores opened as Advance Auto Parts and four opened as Autopart International. Year-to-date we've opened 156 new stores, 139 as Advance and 17 as AI. We closed two stores in the quarter and ten year-to-date. Our new store productivity remained comparable to last year.

We continue to expect to open 190 to 200 stores in 2007 through a combination of Advance and AI stores. As Jack mentioned, we now expect to open 110 to 120 new stores in 2008. This represents an approximate 6% rate of growth in 2007 and 3.5% to 4% in 2008. In 2007 and 2008, we anticipate all of our new stores will open within our existing 40 state footprint. Year-to-date we've relocated 24 stores and foresee approximately 30 relocations in 2007. We anticipate ten to 20 relocations in 2008.

We mentioned last quarter that we're doing a complete review of our new store strategy and related occupancy costs as part of our overall strategy SG&A and CapEx review. That project is now well underway and we've identified a number of opportunities to more closely align our go-forward focus on what matters most in being a parts store, while reducing our new store site and building costs.

We're looking at where we can locate our stores to maximize both our DIY and our commercial sales. Previously our focus was on maximizing DIY sales and then capturing available commercial sales. We're testing smaller prototype buildings and different store layouts to optimize parts availability and sales floor needs.

Some of these opportunities can be implemented quickly, and some will take time as we work through our new store pipeline. In the meantime, we'll open new stores at a reduced pace in 2008. With our real estate activity in 2007, we ended the quarter with 3,124 Advance Auto Parts stores and 104 Autopart International stores for a total store count of 3,228 stores.

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

Michael Moore

Thanks, Jim, and good morning. Let me begin with our income statement. For the quarter, gross margin was 47.9%, a 28 basis points decrease over last year’s rate of 48.2%. Gross margin was down from last year, primarily due to a less favorable merchandise sales mix this year. In addition, fewer discounts were earned as merchandise purchases were less than year-ago levels, and we had a greater proportion of commercial sales this year.

Third quarter was our most difficult quarterly comparison of the year. Third quarter 2006 was a 100 basis point improvement over the prior year, while the entire year of 2006 was 50 basis points higher than 2005.

Looking forward, we expect lower procurement cost and logistics efficiencies will more than offset the unfavorable rate impact of a greater mix of commercial sales and that our gross margin rate will grow over time by ten to 15 basis points per year. For fourth quarter, we expect gross margin percent to be in line with fourth quarter last year.

LIFO was a $0.4 million charge in this year’s quarter compared to a $0.4 million credit in last years third quarter. Going forward, we would expect modest LIFO credits in most quarters as we benefit from lower costs in most product categories.

Turning now to SG&A. In the quarter, we recorded a pretax charge of $6.3 million or $0.04 per share in severance costs related to our position eliminations and asset write-offs associated with shutting down the Advance TV Network. On a reported basis, our SG&A rate for the quarter was up 37 basis points. However, excluding the severance and asset write-offs, we leveraged SG&A by 18 basis points as compared to last year. This was an improvement of 62 basis points over the 44 basis points of de-leverage we saw in the first half of 2007.

Over the past quarter, we have taken a number of steps to further reduce our expense structure. We have identified additional expense initiatives that will reduce SG&A by more than $20 million in 2008. These are in addition to the $50 million in expense reduction initiatives that we announced in conjunction with our last quarterly earnings report.

These expense reductions include savings in advertising and marketing, store occupancy, utilities, transportation expense, non-merchandise purchasing costs, and an additional 30 positions in our field and store support center that have been eliminated. These new initiatives will impact 2007 to a minimal degree but will favorably impact 2008 by $20 million.

As Jack stated, we believe the expense reductions we have put in place will not compromise future sales growth. Our priority is to drive the top line while lowering our expense rate. In fourth quarter 2007, as a result of the expense reduction initiatives that we have implemented, we expect to leverage SG&A within our comp sales guidance of zero to 2%.

Interest expense, net of interest income, was $7.6 million in the quarter compared to $9.1 million last year. Interest expense decreased from last year as a result of less debt outstanding and lower borrowing costs. Our borrowing costs in the quarter was approximately 6%.

In third quarter last year, in conjunction with the refinancing of our credit facility, we recorded a net pre tax gain of $1.0 million which was recorded in the gain on extinguishment of debt line on the income statement.

Our third quarter income tax rate was 36.4% as compared to 37.6% last year. Both this year and last year’s income tax included a benefit from a successful completion of state income tax audits. In addition, this year included the benefit of additional federal and state tax credits. In the fourth quarter, we expect our tax rate to be in the 37.8% to 38.0% range.

Now, I will review key components of our balance sheet and our cash flow statement. For the quarter, inventory increased 5.4% on a sales increase of 5.3%. This was a significant improvement over the second quarter and reflects our focused plan to improve inventory productivity while increasing parts availability. Even with our significant investment additional parts inventory, we expect that inventory will grow only slightly higher than sales in the fourth quarter.

We expect to fund the majority of our investment in additional parts availability through several inventory reduction initiatives. We expect that our parts availability initiative will require an investment of approximately 5% of our total inventory; however, we expect to offset most of this incremental investment through the rebalancing of inventory in selected categories and stores and other inventory reduction actions. We expect that our net incremental investment, net of accounts payable, will be less than 1% of total inventory.

As Jack said, we are making investments in additional parts inventory that we believe will help grow sales. Going forward, however, we are committed to grow sales at a rate faster than inventory growth.

Our accounts payable to inventory ratio was 55.9% compared to 55.4% last year. We continue to see opportunity to grow our AP ratio. As a result of working with our suppliers, we expect that this ratio will exceed the prior year’s corresponding ratio for the fourth quarter.

On the cash flow statement, our capital expenditures were $31 million for the quarter and $147 million year-to-date. This compares to $201 million year-to-date last year or a reduction of $54 million. We now estimate capital expenditures for 2007 to be $215 million to $225 million, a reduction from our previous guidance of $230 million to $240 million.

Our 2007 capital expenditures break down as follows: $110 million for store development which includes new, relocated and remodeled stores; $70 million in maintenance capital for our stores, distribution centers and corporate infrastructure, primarily IT-related; $15 million for new IT and logistics initiatives; and $25 million for our ninth distribution center in Indiana. As a result of fewer new store openings in 2007 and 2008 than originally planned, we have pushed the opening of our next distribution center to the beginning of 2010.

Our efforts to improve return on invested capital are beginning to show up in our free cash flow. As a result of lower capital spending and less working capital required, we are now increasing our free cash flow estimate for full year 2007. We now expect free cash flow for the year to be in the range of $200 million to $220 million. This is an increase from our previous guidance of $150 million to $170 million and compares to $83 million in free cash flow generated in 2006, or more than a 140% increase.

In the quarter, we repurchased 6.2 million shares or approximately 6% of our total outstanding at an average price of $33.26, for a total expenditure of $207 million. In the last three years, we have repurchased over 18 million shares at a cost of nearly $600 million. We now have $335 million left on the share repurchase authorization approved by the board of directors on August 2007.

As a result of our share repurchases, our fully diluted third quarter share count was 103.2 million shares, a reduction of more than 4 million shares from second quarter. In the fourth quarter, we expect our fully diluted share count to decrease to slightly less than 102 million shares, assuming no share repurchases in the fourth quarter.

As Jack said, we are currently evaluating adding debt to fund additional share repurchases. We believe that we have some flexibility to increase leverage and still maintain our current debt rating.

In terms of updated guidance for comp store sales, we are reaffirming our guidance of zero to 2% for fourth quarter. We continue to base our guidance on an assumption that a challenging macroeconomic environment will continue through the fourth quarter and because of the implementation timeframe, our sales-building initiatives will positively impact sales to a limited degree in 2007.

We expect fourth quarter gross margin percent to be more in line with last year, as compared to the third quarter. Also, we expect to leverage SG&A in the fourth quarter as a result of the expense initiatives we have implemented.

We expect earnings per diluted share in the fourth quarter to be $0.36 to $0.40, an increase of 9% to 21%; and for the year, to be $ 2.28 to $2.32. Excluding the $0.04 per share in severance, cost and asset write-offs recorded in the third quarter, earnings per diluted share for the year are expected to be in the range of $2.32 to $2.36, an increase of 7% to 9%.

Although we will not be providing 2008 earnings guidance until our fourth quarter call, we are providing guidance for some of our operating metrics for 2008. As Jack stated, in 2008 we are basing our planning on a 1% to 2% comp sales increase. We expect an improvement in gross margin of ten to 15 basis points and we expect to leverage SG&A at a 2% comp level.

In addition, as Jim stated, in 2008 we are expecting to open 110 to 120 new stores and to relocate ten to 20 existing stores. As a result, we expect 2008 capital expenditures to be in the range of $170 million to $190 million. Also, you should know that 2008 will be a 53 week fiscal year.

In summary, we believe that all the steps we are taking will position us to grow sales, reduce SG&A expenses and improve return on invested capital going forward.

Now, I would like to turn the call back over to Jack.

Jack Brouillard

Thanks, Mike. In closing, I'd like to again thank our team for their commitment over this past quarter. I am confident that our sales-driving initiatives will show solid results over the next few months.

We are now ready for questions, operator.

Question-and-Answer Session

Operator

Your first question comes from Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

Good morning to you. I'd like to start by focusing on gross margin. If you could shed a little more light on the decline this quarter, and the moderation in growth you expect going forward?

I understand that commercial should have some impact on the margin, but for a number of years your commercial comp growth has sharply exceeded retail comp growth so my sense is that mix shift is not a new phenomenon for you. Any light you could shed on what, if anything, has changed on the gross margin front would be great.

Elwyn Murray

A few things I would add. First of all, I would highlight what Michael did in that Q3 was obviously a tough comparison versus last year, with 3Q06 being 100 basis points higher versus the entire year around 50 basis points.

We did see some softness in what I would categorize as discretionary categories, in particular things like appearance accessories, appearance chemicals, interior accessories, exterior accessories, things of that nature that carry with them around a 60% or so gross margin.

Some of that, I think, is reflective of a softer consumer wallet and I think some of it as well is specifically linked to some of the drier conditions as far as less car washing and things of that nature.

We did see, as Michael mentioned, some lower volume discounts as we work to bring our inventory in line with sales so we're consciously working hard to be more disciplined in what we're bringing in while we're at the same time investing in more parts.

I would certainly want to reiterate our guidance going forward of ten to 15 basis points. We certainly see continued cost of goods reduction opportunities and are working hard to identify those. In addition, continuing to work with AI on synergy opportunities there. We continue to see logistic improvement opportunities while simultaneously strengthening the capability of our supply chain. I certainly want to reiterate our commitment to pricing and remaining competitive there, particularly in the categories that matter most.

So, overall, I think Q3 is interesting to observe from a year-ago perspective, but we're confident going forward that there's ten to 15 basis points of growth. But again, as we stated in our last call, we don't see 50 to 100 basis points growth year over year like it had been.

Matthew Fassler – Goldman Sachs

That's very helpful. On the expense reductions, where are you from a run rate perspective in terms of harvesting the $50 million that you discussed? Did the third quarter’s results reflect the full annualized impact of that number? Is there still some of that to come as you come into Q4?

Elwyn Murray

Matt, as we said on our second quarter call, we had $20 million that would benefit 2007 out of the $50 million that we put in place and certainly, a sizeable portion of that $20 million favorably impacted the third quarter.

Matthew Fassler – Goldman Sachs

The $20 million for next year, is that to be felt through the year or is that a run rate to be harvested incrementally as the year progresses?

Elwyn Murray

It would be felt throughout the year.

Operator

Your next question comes from Armando Lopez -Morgan Stanley.

Armando Lopez -Morgan Stanley

A quick question on the capital spending, or the CapEx. The CapEx expectations continue to come down. Could you maybe talk a little bit about what's the difference or what drove the difference from your current expectations relative to what you were forecasting?

Michael Moore

Yes. I can speak to that. I think certainly this year we have reduced the amount of new stores that we originally had planned to open. We have reduced the amount of relocated stores from originally 35 to 30 stores; certainly we've eliminated all remodels so there's no more CapEx earmarked for remodels. We have some of our new projects we're spending a bit less on, so it's primarily store development related reduced spending.

Armando Lopez -Morgan Stanley

In terms of the pricing environment, could you comment a little bit about what you're seeing from a competitive perspective on the commercial side? And then just from an overall inflation perspective?

Elwyn Murray

I would say we continue to monitor pricing with all competitors, certainly on the DIY and the commercial side, and we are not seeing any significant shifts there but continue to position ourselves competitively.

Operator

Your next question comes from Danielle Fox – Merrill Lynch.

Danielle Fox – Merrill Lynch

First, just going back to the quarter, you beat the comp by it looks like about 100 basis points at the high end of the range, and you came in at the high end of your EPS range. Was gross margin the reason why your EPS didn't exceed your plan in the way that sales did?

Michael Moore

I would say primarily it was gross margin related. If gross margin was less of a decline, we would have exceeded the high end of our guidance.

Danielle Fox – Merrill Lynch

Could you talk a little bit more about the decision to slow unit growth in 2008? Is this decision being driven by the performance of your new stores or is it being driven by the desire to focus on execution at your existing stores?

Jim Wade

It's a combination of factors. I think as we've gone through the strategy review this past year and we've done a lot of customer research, both on the DIY and commercial customer, we are using that to identify better where we should be opening our new stores. Through that process, as we focus on maximizing both DIY and commercial potential, we're looking at the opportunity to have somewhat less main-on-main type of locations and still get us in the right position for our customers so we can manage our occupancy costs at a better rate.

What we've seen happen over the last few years is our sales in our new stores have continued to increase and we've seen that continue, but the cost of occupancy has gone up at a faster rate than our sales increase; so we're working through that. I think with the slower pace in 2008, by the time we get to 2009 we'll be in a position to better locate our stores relative to the potential of both DIY and commercial, and at the same time, do that at a lower occupancy cost than we have in the past. It makes sense from our standpoint to open fewer stores in 2008 while we're working through that.

Certainly, your other point is valid as well, that as we're opening fewer stores during this timeframe, it certainly gives our team the opportunity to focus on executing and implementing the strategy changes in our stores that we've talked about as well.

Danielle Fox – Merrill Lynch

So does this mean that you're experimenting with a format that's much more dedicated to targeting the commercial customer or is it simply trying to find better real estate opportunities?

Jim Wade

I wouldn't say it's much more focused on the commercial customer but what I would say is as we've looked at why our DIY customers shop with us and what the optimal location is for commercial, that we can accomplish both of those and grow our sales per store, while at the same time not being in a location that is quite as expensive from an occupancy standpoint as we've seen over the last three or four years.

Again, I don't think as you look at where we locate our stores it would not be a dramatic difference, but what we would see is slightly less retail locations that carry the highest level of occupancy cost. As part of that, as we're looking at the size of our stores and experimenting with sales floor space and more parts in our stores, it will allow us to likely get into some locations we might not have gotten into before, which again can help our ability to open more stores at a lower cost.

Jack Brouillard

On top of everything Jim said, we would expect and hope to increase the growth rate the year following. While we're rethinking some of our real estate, we're also, as you know, working on the business in a number of dimensions and that's why we pulled back a little bit in the second quarter. This is just a little more incremental thinking along those lines.

Operator

Your next question comes from David Cumberland - Robert W. Baird.

David Cumberland - Robert W. Baird

First a couple of questions on AI. What was revenue for AI in Q3? In ‘08 how many AI locations do you expect to add?

Jim Wade

Let me answer the second part of that first. In 2008, the guidance that we provided in total is 110 to 120 stores. We don't know specifically how that will break down yet but likely AI would be in probably the 15 range, somewhere in that range. Sales for AI for the quarter were approximately $34 million.

David Cumberland - Robert W. Baird

Related to the parts availability initiative, what types of changes do you foresee in terms of leveraging existing supply chain assets, meaning distribution centers, warehouses; and also perhaps in your relationships with suppliers?

Elwyn Murray

A great question. Obviously parts availability is a huge area of focus for us. Michael mentioned nearly 5% of our total inventory from a growth standpoint being what we're looking to invest here; which you can do the math and it's close to $75 million of incremental parts.

We're working very hard with our suppliers and our supply chain to accomplish this in a way that is relatively neutral to overall inventory and also that we can digest and do this effectively with our supply chain.

In addition to introducing incremental parts and having greater parts coverage in our network, we're also working very hard to ensure that our supply chain is flexible and nimble and capable enough to have those parts available in the markets and close to the customer. So simultaneous to the investments in dollars of just pure inventory, we're working our supply chain to ensure that it is laid out and operates in a way that accomplishes what we want.

We've just completed about an eight-week study looking at our supply chain really independent of what it is we have today and have determined some exciting opportunities that we see will allow us to provide greater coverage in our various markets, through our supply chain with some enhancements that actually should allow us to operate at a lower cost with improved coverage and availability. We're very excited about the future of this initiative.

David Cumberland - Robert W. Baird

Elwyn, can you elaborate on or give an example or two of an enhancement or change to the supply chain that you're considering?

Elwyn Murray

Sure. A lot of folks when they look at our supply chain, they look at us as more of a retailer set up with large distribution centers. while we certainly have eight large, 600,000 square foot facilities across the country, we also have a master PDQ facility, we have 20 PDQ facilities and 80 of what we call local area warehouses; not to mention 3,200 stores and about 6,000 vehicles.

What we find is if you look in different markets, we leverage those various assets in our supply chain differently. I would say the insight that we're gaining is what makes the most sense in specific markets? I think what you'll see is going forward, similar tools, if you will, in our supply chain but perhaps redeployed differently depending on what the market needs are. It may not be revolutionary, which on one hand is exciting to us because we think we understand how to distribute the product. We just need to apply it specifically to markets as it would best suit them.

Operator

Your next question comes from Dan Wewer – Raymond James.

Dan Wewer – Raymond James

Jack, am I correct in understanding the $20 million savings in ‘08 is in addition to the $50 million outlined in recent quarters, but at the same time, the point where you would expect SG&A leverage is going to be 2% in ‘08 rather than the 1% to 2% range?

Jack Brouillard

The $20 million, as Mike mentioned, is on top of the $50 million. As Mike also mentioned, for the various topics that involve it, it will unfold during the year and so we feel on an annualized basis, we've put $70 million worth of savings in place. For next year, that $70 million along with our continuing initiatives will allow us to leverage SG&A in that 2% comp range.

Michael Moore

One thing I want to add to that because we've made these significant reductions, we will be able to leverage at a 2% comp next year. On a long term basis though, we really need a 2% to 3% comp on a long term basis.

Dan Wewer – Raymond James

Was the prior thought on SG&A leverage in ‘08 was a range of 1% to 2% and now you're tightening it to 2%?

Jack Brouillard

No, I never said 1% to 2%. It will leverage in that range. The point is we've made a number of decisions that have immediate impact. Mike's point is other costs increase and over time, we think we need to get comps 2% to 3% based on our current model to leverage on a continuous basis. We will leverage next year because of the large amount of SG&A we've taken out.

Dan Wewer – Raymond James

A separate question on the real estate strategy. Other parts retailers that attempt to straddle the DIY and commercial segment with a real estate strategy, it sounds like you're going to follow. They end up giving up some DIY revenues in the pursuit of the growth of that DIFM. Do you see that balance, that trade off, as a risk for your DIY component?

Jack Brouillard

We do not see that as a risk and again, that's part of why we're taking the time and effort to work through this and make sure we make very clear decisions. I think we have all of the information we need through the research we've done and as I said before, I don't think you'll see us dramatically change where we locate stores but we're going to do it in such a way that we can manage our occupancy costs at a better level and we can take a strong DIY business that we have already, be able to capture a greater portion of the commercial business, and at the same time, do that in a location that will not put as much pressure on our expense structure going forward.

Dan Wewer – Raymond James

the last question I had, Jack, I understand the decision not to complete any additional 2010 remodels given the returns were nil. On the other hand, it is critical for retailers to maintain a fresh store base. Are you considering testing some new remodels for the existing stores or is it just simply on hold for the next two years?

Jack Brouillard

Well one thing that should be a distinction is we've set aside plenty of capital and expense going forward to maintain the physical condition of the stores and that includes exterior painting and things like that. The expense was really fixtures and a lot of this inside work which was not proving out to be very cost effective, so I don't want to give anyone the impression that we're going to let our physical plant rundown because that's not our intent.

When and if we come up with some ideas which I think we will over time, about improving adjacencies and remodels, we'll get back into it. The prior program was expensive and not producing results. It doesn't mean we've shut off the idea going forward.

Jim Wade

I think the other thing I would add to that as well is that we talked about before because of the remodels we've done over the past several years in the new stores, well over 2,000 of our stores are either new or have been remodeled just in the last three or four years and as we got further into the remodel of stores, we're getting closer and closer to stores that have been either open new or have been remodeled in the not too far past.

Our overall group of stores is in good shape and we're focused as Jack said on using capital we've set aside to still address the stores that need to have work done but not to do it across all of our stores.

Operator

Your next question comes from Scott Ciccarelli - RBC Capital Markets.

Scott Ciccarelli - RBC Capital Markets

What do you guys see as the key to improving commercial comps? Obviously it's an area you guys are focusing on. Is it just the greater inventory investment? Is it more aggressive sales tactics? What is the pushback you get from potential commercial customers that you weren't servicing?

Jim Wade

I think if you look at our past several years we have had a track record of some strong comp increases in commercial, and last year or so, we had less focus on commercial and our comps were lower although they were still reasonably good.

What we're doing now first of all is we've talked about focus, ensuring that our entire team realizes the importance of growing it. All of the initiatives that we've talked about align very well with commercial along with DIY, and that's a big part of the parts availability expansion. It's a big part of the parts knowledge focus.

In addition to that, we're doing a number of things within the company to better allow us to drive the commercial business.

The other thing I would add is as we did the commercial research over the last several months, I think we're overall positioned probably better than we've been able to explain with the commercial customer. I think the opportunity is there and with the focus and with the additional availability, we can continue to see and to ramp up what you saw in the third quarter.

Scott Ciccarelli - RBC Capital Markets

So the infrastructure is there. You just have to market it better to the commercial customers?

Jim Wade

We have to market it better, we have to increase the availability which we're in the process of doing; Elwyn touched on some of the logistics related things that we're going to be able to take what works pretty well already and strengthen over the next year or so. So there's a number of factors that clearly start with focus.

Elwyn Murray

I would just add a few points to Jim's comment. Under the parts availability side, clearly the late model has more application there as we introduce that, so we're seeing some of the early gains from some of the parts initiatives there.

I would reiterate Jim's point: supply chain capability is a huge piece of being able to do commercial and do it well. IT capability, building the tools from a B2B online, a commercial customer database, those are things that we have not done historically, having viewed this more opportunistic than strategic so those will be things going forward that are important for us.

There are a number of capabilities that we are adding and building, as well as continuing our effort to gain access to the quality brands that we think have instant credibility with the commercial customers.

Scott Ciccarelli - RBC Capital Markets

Could we see more store closings if there's some stores out there with occupancy costs that just aren't yielding the desired returns?

Jim Wade

I don't think you'll see anything significantly different. We have over the years and certainly continued to at even a greater level look at the performance of each of our stores and where we have stores that are not performing to our expectations or with an occupancy cost, we go through a process of seeing what the maximum potential is and then addressing occupancy cost within that store with the landlord or whatever as we need to.

We've closed ten stores this year, you'll continue to see us close stores like that as we go forward, but overall, our base is in good shape. It's a matter of ensuring as we go forward that we better align the sales potential with the cost of the land and building that we've been experiencing the last two or three years.

Operator

Your next question comes from Seth Basham and Gary Balter – Credit Suisse.

Seth Basham and Gary Balter – Credit Suisse

Looking at the expense initiatives for 2008, could you potentially quantify or at least rank order the buckets of improvement? What's going to be the biggest savings initiative?

Michael Moore

From the $20 million, I think the two biggest items would be marketing and advertising and non-merchandise purchasing. Those two combined would be well over$10 million out of the savings. Behind that would be the utilities, I spoke about transportation, staffing and occupancy. Occupancy, we think there's a lot of opportunity to drive down occupancy cost but it takes time and we will achieve those savings over time as we open new stores going forward and the occupancy savings should be greater going forward beyond 2008.

Seth Basham and Gary Balter – Credit Suisse

Related to that, as you study the labor model in your stores on the DIY side and the commercial side, have you come to any conclusions about whether or not it's appropriate or whether you need to make any shifts?

Jim Wade

We are in the process over the last few months of taking a very long in-depth look at our staffing in our stores and how we best do it and I think we'll be able to be in a position over the next few months to be able to talk a little more in detail about that.

We don't know all of the answers yet in terms of what we want to do, but we have opportunities I think to do a better job with that in terms of staffing relative to the mix of DIY and commercial. The key is to do that, to get the right people in our stores that have the right knowledge and we've done all of that work internally here with some external resources that have helped us to look at how best we can staff the stores going forward.

Seth Basham and Gary Balter – Credit Suisse

But at this stage you're not cutting any labor hours?

Jim Wade

No. We have a pretty solid system, I think that you've heard us talk about it, it is called MPT, and we're looking at all of the aspects of how that builds a staffing model, what our cost per hour is, and managing those components. Our intent is to ensure we have staffing in the stores. If we were to reduce hours in a store, it's based on taking a task out of the store that was not there before as opposed to increasing the work load for the staff.

Seth Basham and Gary Balter – Credit Suisse

I think Gary has a bigger picture question.

We're watching oil hit $96 and could you talk about your thoughts if oil stays up here, how this impacts your projections for next year or your guidance for next year and your thinking about cost controls? Given that the top line may be more challenging?

Jack Brouillard

Well, a couple of things come to mind, Gary. Internally, you think about your transportation cost of fuel and we've addressed that through some forward contracting and we feel pretty good where we are vis-a-vis that.

I do think if the price of gasoline follows as people say it will, then it further increases the headwinds, particularly on our side, per customer. It's embedded in, we think we should not be planning for a robust consumer next year and that's why in our initial thinking we're thinking 1% to 2% comps.

As we mentioned, if that's the world we see coming forward at least for the nearer term, then we continue to think about our model in those terms and how much can we spend on various things and how do we run the business if that's going to be the case?

it's very much on our minds.

Operator

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

Tony Cristello - BB&T Capital Markets

You talked about the 5% increase for inventory. I'm wondering how you came about that being the right number? Was that a product of soliciting an opinion from your commercial segment? Was it looking at where parts were not in stock when needed? Is that a number that could go higher as this process evolves?

Elwyn Murray

That's a great question. The input or the sources of why the product we've put came from a number of sources. Clearly looking at the data that's available through the industry to understand what type of vehicle registration there are in different markets has clearly been a key informant, particularly when it comes to import coverage. We also solicited a significant amount of feedback from our field on what are we missing and that as well translated into the significant chunk of this dollar figure.

We will continue, I think, this is what I would consider what we've seen in our initial look at what's needed from a late model and import coverage for both commercial as well as DIY with some strong input from our field. We will continue to look at the sources of data and continue to increase inventory over time in the right categories.

I think simultaneously, it requires an active management of the tail, if you will, of things that you no longer need in your network. So this is not a “one and done” type of initiative. It's a major thrust for us right now but we will continue to make parts investments going forward and simultaneously work the less productive out of the equation.

Tony Cristello - BB&T Capital Markets

The DIY customer in particular, once they come to your store and you don't have their part, it's switching for them is not something uncommon. I'm wondering now and even maybe for the commercial side, once you replenish or sort of augment here what you're carrying in terms of in-stock, how do you go about now reeducating that consumer, whether it's the commercial customer or the DIY, that now we have this part, you need to come back and try us, when they've already switched to one of your competitors?

Elwyn Murray

That's a great question, and I would say that it's an opportunity for us as we are getting the inventory into the markets, we clearly need to market that, and while we have had significant placement of inventory in the third quarter, the fourth quarter literally 50% of this initiative is happening right now, so we have to get it physically in place but then it is imperative that our commercial salesforce be armed with the insight and information so they can as they're calling on customers -- existing and new -- to let them know what we now carry. We also are looking to produce some in-store signage if you will that allows the store to DIY'ers to also communicate the incremental coverage now available in their respective stores and markets.

Operator

Your final question comes from Rick Weinhart - BMO Capital Markets.

Rick Weinhart - BMO Capital Markets

On the labor model you're using in your stores. Is it safe to say at this point that you've now reviewed the compensation structure and that you're happy with what you currently have in place?

I'm thinking more or less along the lines for the commercial business; no thoughts on changing to a commission model?

Jim Wade

That's one of the things that we're looking at. As I mentioned before, through an internal review as well using some external resources we've been looking at really every aspect of our model and certainly, commercial incentives and incentives overall is a component of that analysis. We're not at a point yet where we have made any final decisions internally and certainly not to a point where we are implementing, but I think that will be in some way a portion of our plan as we go forward.

Rick Weinhart - BMO Capital Markets

A follow-up on the hedging strategy for fuel costs. Can you just clarify for us whether you had a hedge in place and when that expires? If you have any data you can share in terms of what the impact was?

Elwyn Murray

I'm going to look to Michael as far as what we want to disclose as far as the numbers, but perhaps a little distinct from a hedge, this is actually a forward contract. We have storage tanks in our distribution centers for diesel in particular, so we're not specifically a hedge as much as a forward contractor purchase.

Michael Moore

I would think that answers the question.

Operator

This concludes our question-and-answer session. I will now turn the call back to management for any final comments.

Jack Brouillard

Well, I'd like to thank everybody for being on the call today and we appreciate all of your interest in Advance. We view Q3 as having taken a number of steps in the right direction and our goal is to build on that momentum and take it into Q4 to set us up for a strong year in 2008.

So again, thanks for being with us today and we appreciate your interest in the company.

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