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Advance Auto Parts, Inc. (NYSE:AAP)

F2Q08 Earnings Call

August 7, 2008 10:00 am ET

Executives

Judd Nystrom – Vice President, Finance and Investor Relations

Darren Jackson – President and Chief Executive Officer

Elwyn Murray – Executive Vice President, Customer Development Officer – DIY

Jim Wade – Executive Vice President, Customer Development Officer – Commercial

Mike Norona – Executive Vice President and Chief Financial Officer

Kevin Freeland – Executive Vice President, Merchandising, Supply Chain and Information Technology

Keith Oreson – Senior Vice President, Human Resources

Ken Wirth – Senior Vice President, Customer Experience Officer

Analysts

Seth Basham – Credit Suisse

Dan Wewer – Raymond James

Anthony Cristello – BB&T Capital Markets

Christopher Horvers – JPMorgan

Matthew Fassler – Goldman Sachs

Scot Ciccarelli – RBC Capital Markets

Colin McGranahan – Sanford C. Bernstein

Alan Rifkin – Merrill Lynch

Operator

Before we begin, Judd Nystrom, Vice President, Finance and Investor Relations, will make a brief statement concerning forwardlooking statements that will be made on this call.

Judd Nystrom

Certain statements made during the conference call will contain forwardlooking statements that incorporate assumptions based on information currently available to the company. Any statements that are not related to historical facts are forwardlooking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. These forwardlooking statements are subject to risks, uncertainties, and assumptions including those listed from time to time in the company's annual report, on Form 10K, and its other filings with the SEC.

If any of these risks or uncertainties materialize or if the underlying assumptions prove incorrect, the company's actual results may differ materially from anticipated results discussed in these forwardlooking statements. The company intends these forwardlooking statements to speak only as of the time of the conference call, 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 third quarter earnings release is scheduled for Wednesday, October 29, after market close and our quarterly conference call is scheduled for the morning of Thursday, October 30. To be notified of the dates of future earnings reports, you can sign up through our 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 Darren Jackson, our President and CEO, who will be followed by Elwyn Murray, EVP, Customer Development Officer, DIY; Jim Wade, EVP, Customer Development Officer, Commercial; and Mike Norona, EVP and CFO.

Darren Jackson

Good morning and welcome to our 2008 second quarter conference call. I want to begin by personally thanking our Advance and AI team members for continuing to deliver outstanding customer service and financial results in the second quarter. The 23% increase in earnings per share reflects the team members' commitment and progress on our four strategies. We have a saying at Advance, which is “sell more parts, have more fun”. My view is, sell more parts, have more fun on the conference call. So let's begin.

We are 180 days into our AAP turnaround, and we're on track from my perspective. More importantly, we're beginning to build pockets of momentum. Our goal is simple. Grow to $10 billion in sales in the next five years by focusing on our four key strategies. Our commercial acceleration, DIY transformation, availability excellence, and experience strategies are all gaining traction. To make our turnaround happen, it takes commitment and dedication from every Advance team member to live our Advance values, try change, and embrace the future.

Q2 was a great step in our turnaround journey. Here are a couple of highlights for the quarter. Comp store sales increased 2.9%. What's interesting is this is the first quarter in nine quarters that comps were positive in all four areas of the country, including Florida. Our commercial business continues to be the driver. Commercial continues to accelerate with comp sales growth of 13.5% in Q2. DIY comp sales trends improved as well, to negative 0.8% in the quarter. That's up from the past two quarters when DIY comps were down 3%.

Finally, our operating income grew 9%, which allowed us to leverage our share repurchase into a 23% EPS increase. Mike will share with you more about how these results fit into the broader financial picture going forward.

Our strategies continue to progress as well. For example, we conducted a DIY summit that identified key themes and ideas to grow and transform the DIY business. Now this approach was similar to our parts summit conducted last year which led to our parts focus as a company. More importantly, we are seeking, actively seeking, feedback from the front line team and using it to make improvements to our DIY business. Elwyn will share with you the progress for making that focus on DIY customer needs.

We're pleased to welcome several new field operations leaders in the quarter. They are Derrick Thomas, Carl Hauch, Dan Peterson, and Dave Hamilton, who are firmly engaged in our superior experience strategy. I am excited about the passion and the experience around customer service and team member engagement these leaders bring to Advance. Each of these leaders is already making an impact on the business.

Still, this year is proving to be a challenging one for customers and team members alike. The current economic crisis is a constant reminder that our turnaround and transformation efforts must go beyond the traditional approach. More importantly, the changes we need to make are not optional. Our company must drive change versus being driven by change. The truth is that we're moving in the right direction. Even so, we still have a long way to go from our destination.

I remain guarded about the economic environment, which continues to be challenging to navigate with consumer confidence near a 16year low. Weakening business and job conditions, along with record high gas prices, are a heavy burden for many of our customers. Our second quarter results are very encouraging, yet we may have benefited from the economic stimulus which could have accelerated some sales from the second half of this year.

As a result, our outlook remains balanced for the remainder of the year. We will continue to assess, adjust, and focus our resources to accelerate the execution of our key strategies. Our new commercial team is a great example of this focus. Jim will talk about that in a minute.

Our longterm objective remains the same. We remain committed to a future that is leading, not lagging behind the industry. We remain committed to a future that's great, not good. We remain committed to a future that tries to change, not one that reacts to it. Most importantly, we remain committed to winning with superior team members, serving customers better than anyone else, and growing the business and profitability with integrity.

Now I'd like to turn the call over to Elwyn Murray to provide a progress update on DIY.

Elwyn Murray

I, too, am encouraged by our second quarter results and would like to express my thanks and appreciation to our team as well. I attribute the success to our team and the traction we are gaining on many of our strategic initiatives.

Today, I would like to cover two things. First, update you on the actions that we are taking now to turn around our current DIY business trend and second, provide further visibility to our emerging thinking to drive to full potential in DIY as we know it today and also transform our retail business. We are making tangible progress in several areas that are impacting our current results. Specifically, we are gaining meaningful traction through our parts inventory investments, the launch of our attachment selling initiative, and our efforts to improve weekend scheduling.

We are in the infancy of addressing our full potential to improving bilingual staffing, identifying new categories to tap, and measuring our team member engagement and customer satisfaction. Our attachment selling strategy is more than pushing items to customers. It is a sales approach enabling team members to be eager, trusted problem solvers for our customers. With our help and advice, customers get everything they need on their first visit, saving them gas, time, and trouble.

In addition, attachment selling helps us grow our sales and margin. Attachment selling is truly a winwin for our customers and our company. We are currently tracking our attachment rate to allow our leadership team to better assess their team members' sales skills and identify where training opportunities exist to better serve our customers while growing our sales.

Division Manager Kyle [Wideman] in Buffalo, New York, understands the significance of attachment selling. His store teams are fully embracing the strategy under his leadership, guidance, and support, and are producing some of the highest sales results in recent weeks. Kyle says the key to attachment selling is simple, serve the customer better than anyone else. He says his team is passionate about serving the customer by having the parts knowledge and selling the complete job. He is very proud of his team for all of their hard work and dedication to help our customers keep the wheels turning, and we are very proud of Kyle and his leadership.

We are also in the process of measuring how well we inspire and engage our team members and how well we serve our customers. Engaged team members bring their best game to work every day and are deeply committed to the success of our customers, our stores, and our company. Loyal customers repurchase, buy additional items, and refer other customers, all of which help grow our sales and margin. It is no coincidence that a highly engaged workforce is strongly correlated with great customer service.

That's why it's so important to understand how well we are doing in these two areas. We are committed to defining what great customer service looks like, to measure it and to consistently improve. We look forward to sharing more information with you about these results and the impact they are making later this year.

Currently, we are approximately 75 days into our 100day assessment of our DIY business, which is focused on driving the full potential in DIY, as we know it today and also transforming our retail business. In this pursuit, as Darren mentioned, we conducted a DIY summit and DIY growth workshop during this second quarter. These sessions produced several key themes and hundreds of ideas straight from the field.

We are prioritizing these opportunities based on customer interest, market attractiveness, and proximity to our core. We anticipate these ideas resulting in pilots and/or rollout, depending on the nature of the idea, beginning as early as the fourth quarter.

We are also taking action to enhance the speed and capability of our team in order to accelerate the transformation of our DIY retail space. We have decided to locate our sales floor merchandising team, which accounts for over 50% of DIY business today, in our regional office in Minneapolis. This location will allow us to more readily add talent from nearby retail and consumer [inaudible] companies, as well as network and benchmark with other retailers with similar systems and practices. Approximately 70 positions will be located in Minneapolis as part of the sales floor integrated operating team.

In conclusion, I am encouraged by the traction we are gaining and the results we are seeing from the near-term initiatives mentioned. I am confident that opportunities like bilingual staffing, new product categories and services, and our customer satisfaction and team member engagement initiatives will make meaningful contributions in future quarters as well.

While encouraged by our progress, we recognize that more will be required of us in order to achieve our longer-term vision of a $10 billion company that produces $2.5 million per store comprised of a 50/50 mix of retail and commercial sales. To that end, we remain committed to optimizing our near-term initiatives, as well as developing additional sales ideas in order to transform our DIY business, as we know it today.

Now, I would like to turn the call over to Jim.

Jim Wade

I want to congratulate our store chains, our commercial sales force, and our commercial organization on their 13.5% commercial comp sales increase in the second quarter. Our team has driven solid sequential comp sales improvements over the last five quarters, but we still only have approximately a 3% market share. There is still great room for accelerated commercial growth. We're taking actions and building plans to achieve our full potential and significantly grow our commercial market share.

Our commercial sales increases are coming first and foremost from unleashing the enthusiasm and passion of our team and empowering them to do what they do best, which is serve our customers better than anyone else. I want to share one example of how a commercial team member is living our values and moving our commercial acceleration strategy forward.

During his time as the area commercial sales manager, Bill [inaudible] was the leader in commercial sales growth with significantly higher results in his region. Bill is known for developing his commercial sales team and for partnering with the store team to provide great service to his customers. Bill was recently promoted to an area commercial sales director. In his new role, Bill now leads a quarter of our commercial sales force and is using his winning strategies to further accelerate our growth. Thank you and congratulations, Bill.

Beyond our team, we continue to work very hard on the basics of the business.  We're focusing on our strengths and getting the parts quickly delivered to the garage so our customers can better grow their businesses. We're partnering with availability excellence team to aggressively add parts to our stores and move them closer to our customers throughout our supply chain. We're capitalizing on the well-respected brands we've added to our stores over the past year. And we're working to further develop and strengthen our team of parts knowledgeable people.

The last thing we're focusing on being a reliable partner that the garage can consistently count on. In addition to the basics, we're making good progress in formalizing our commercial sales force and providing the information they need to focus on our highest potential customers. We're developing systems to identify those customers where we have the best opportunity to deepen our existing relationship and grow our share of their purchases by acquiring new customers so we can further accelerate our total growth.

We're also formalizing our processes for targeting customers, tracking our progress, and insuring we keep them once they are buying from us. As part of our commercial model development, we continue to pilot several different initiatives that are common within our industry and to look at other distribution businesses outside our industry. The results of these pilots are being built into our commercial model and rolled out on a larger scale as they're developed.

These pilots include everything from how we allocate resources, to how we staff our stores, to how our sales force targets customers. This will continue to be a key part of our process for developing and improving our commercial model. Over time, we believe we can develop additional value added services that will further increase our customer attraction and retention.

We're developing a business model for how we conduct and grow our commercial business while building accountability and a culture with customer service for commercial that is rooted in our Advance values. At the heart of commercial acceleration is partnership. By arming our commercial sales force and our store teams with the information and tools they need to keep customers base turning, we will build loyalty. To date, we built strong local partnerships, but the real key to our commercial business success is to put the full power of our company behind its development.

During the second quarter, in addition to strong commercial sales increases, we continue to see all of our key profitability metrics grow at the same time. That included higher parts productivity, increased truck and driver utilization, and the higher balance of parts sales.

I'd also like to thank the Autopart International team for a strong second quarter, as they significantly increased sales and profitability. Overall, they produced a 7.2% comp to the quarter. They also opened 10 stores, which included the acquisition of a fivestore local parts distributor. This acquisition provided AI the opportunity to strengthen its presence in the Philadelphia market.

Switching to new store development, in the second quarter, we opened 36 stores, to bring our total for the year to 70. We also closed two stores and relocated four stores. At the end of the second quarter, out total store count was 3,325. During our first quarter call, we indicated we'd be reviewing our store performance and real estate portfolio. As a result of our recent review, we anticipate closing approximately 20 to 30 underperforming stores for all of 2008, with the majority occurring during the third and fourth quarters.

Over the last six months, we've been testing smaller prototype buildings and different store layouts to improve our new store productivity and reduce occupancy costs while increasing our parts availability. We started rolling out our 6,000 square foot prototype as we opened new stores, in place of our current 7,000 square foot store. We'll continue to measure results and build a prototype that best serves the needs of both our DIY and commercial customers, as well as improving results for our shareholders.

Now, I'll turn the call over to Mike to review our financial results.

Mike Norona

It's enjoyable to share our strong second quarter results with you. Clearly, these results are directly attributable to our talented and dedicated team members who are leading change, embracing our turnaround, and focusing on serving our customers. I have planned to cover the following topics with you this morning. One, provide an overview of our second quarter results. Two, link the actions we are taking to transform our business to our shortterm financial performance. Three, share our philosophy on our four performance gauges as we look to improve our mid to longterm financial performance.

Turning to our second quarter, total revenue increased 5.6% to $1.24 billion compared with revenue of $1.17 billion in the second quarter last year. This revenue increase reflected the net addition of 138 new stores in the past 12 months and a comp sales increase of 2.9% on top of a 1.2% increase last year. Yeartodate revenue is $2.76 billion.

The comp sales gain is comprised of a 13.5% increase in commercial sales, partially offset by a 0.8% decrease in DIY sales. This compares to a 5.4% increase in commercial and 0.2% decrease in DIY in the second quarter of last year. Yeartodate, our comp sales have increased 1.6%.

Our second quarter commercial sales represented 29% of our total sales compared to 26% last year. For the quarter, our total commercial sales were $358 million, resulting in a 17.2% increase over last year. Currently, 83% of Advance stores have commercial programs as compared to 82% last year. Clearly, our commercial teams are leading our company with a fantastic growth, despite a challenging economic environment.

Our gross profit rate was 48.6% in the second quarter, as compared to 48.1% last year, which reflects a 51 basis point improvement. This improvement was primarily due to lower supply chain and logistics cost combined with more effective pricing. SG&A expenses were 38.3% of sales compared to 38% last year. This 23 basis point increase was driven by increased incentive compensation, increased spending on strategic initiatives, and higher gasoline expenses related to commercial delivery.

Partially offsetting the SG&A increases were cost savings realized from actions taken last year combined with expense leverage as a result of a solid Q2 comp. Net interest expense was $7.3 million in the quarter compared to $6.9 million last year. Our current borrowing costs remain at approximately 5%.

Earnings per share increased 23%, $0.79 for the quarter, as compared to $0.64 for the second quarter last year. This 23% increase in EPS was primarily driven by a 9% increase in operating income and the benefit of 13 million shares repurchased over the past year. For the first half of the year, our EPS has increased 22%. We're pleased with this increase.

Now I will comment on a few items on our balance sheet and cash flow. For the quarter, inventory increased 8.1% to $507,000 per store. As previously communicated, the increase in inventory was driven by our parts availability initiative, as well as initial inventory buildup of our new MOOG and Wagner brands partially offset by our focus plan to improve inventory productivity.

Inventory per store was slightly higher as compared to prior year, given we are funding the majority of our parts availability initiative through some inventory reduction initiative. I would personally like to thank Jim [North] and his team for all the work they're leading on our inventory upgrades and inventory reduction initiative.

In Q2, our accounts payable to inventory ratio was 61.6% compared to 57.1% last year. While this increase is primarily driven by our inventory buildup, I am encouraged by the initial progress that our merchant team is making to improve this ratio. This initiative will have positive impacts to our cash flow in the future.

Operating cash flow for the year increased $7 million to $350 million. Free cash flow for the year increased 25% to $244.6 million, which reflects a $48.7 million improvement as compared to last year. This increase is primarily driven by higher net income and lower owned inventory.

Capital expenditures were $106 million for the year, as compared to $115.7 million last year. This decrease is primarily due to reduction in store development. To put our Q2 results in context, our sales, margin rate, and bottom line exceeded our expectations and our SG&A came in higher given the investments we are making in our strategic initiatives. I will share more on our SG&A profile later. Collectively, Q2 was an encouraging step forward in our turnaround journey. All strategies are starting to gain traction, with our commercial business leading the way.

Now I would like to link the actions we are taking to transform our business to our shortterm financial performance, specifically our cost profile. Our turnaround involves transforming from primarily a retail business model to an integrated operating model that is focused on both retail and commercial customers. While this turnaround is absolutely the right thing needed to differentiate our company, it will put strain on our expenses in the short term. That is because our current capabilities, operating level, support mechanisms, systems, were primarily built to support a retail model.

Therefore, our work entails performing indepth assessments of all the fundamental parts of our business and transforming them to support this new integrated retail and commercial model. Realistically, we think the changes are not simple on/off switches, which means you cannot immediately transition from one to the other. Usually, there is an overlap period where higher costs result from duplicity.

To illustrate with an example, we have committed $60 million of multiyear capital and expense investments to build new merchandising systems and capabilities. These investments will enable us to better support both our retail and commercial businesses. Unfortunately, it takes time to build and implement these new systems and capabilities and, as such, we will have some added expenses in the short term as we build the new infrastructure while continuing to run our existing merchandising infrastructure. This simple example can be applied to many aspects of our business that need to change.

Therefore, our challenge is twofold. We must continue to make the investments required to transform our business, for example, improving parts availability, investing in training and development of team members, and investing in delivery trucks and parts pros while at the same time looking for ways to fund these investments. It is critical that we do both. This can be accomplished by appropriately sequencing investments, getting more out of existing resources, and eliminating activities, capabilities, and resources that are no longer relevant to our new operating model.

Lastly, I would like to share our focus on our four gauges as we look to improve our medium to longterm financial performance. We continue to believe these gauges provide a transparent and holistic financial view of our four strategies and will serve as a barometer of our progress. We are committed to improving our gauges, but we are not trailing the class of our competitors but are realistic that certain gauges will show progress before others.

We anticipate seeing improvement in two of the gauges, sales per square foot and operating income per team member, first. We believe the positive momentum we have in commercial and the focus of our talented team members to embrace and lead our turnaround will help these gauges. We also anticipate seeing measured improvement in our incremental ROIC, given our new rigor around investments pending. That said, the large capital base, it will take time for new investments to move the total ROIC.

Finally, given our shortterm expense needs required to build new capabilities and transform our business, we anticipate our focus on our SG&A per store gauge to be one fluctuating around its current level rather than reducing in the short term. We think this is prudent, as we believe investing in our business today will lead to higher sustained returns in the future. That said running a leaner costeffective operation will always be in our sights.

As a reminder, the company provided an annual outlook at the beginning of the year and does not provide quarterly guidance. However, for fiscal year 2008, the company now anticipates leveraging SG&A at an increase of approximately 2% comparable sales versus the 1% increase previously disclosed.

This increase is primarily driven by investments in merchandising capabilities and systems, e-commerce investments, and accelerating some test in commercial combined with the impact of rising fuel costs. We expect these increases will constrain profit growth for the balance of the year.

In closing, we are pleased with our second quarter results and are excited about our longterm prospects given our renewed focus on the customer. We believe we are focused on the right four strategies and are committed to taking action and making the necessary investments required to create long-term shareholder value. While we remain cautiously optimistic over the shortterm economic headwinds, we remain vigilant to have our four gauges measure our progress. Most importantly, we are investing in and betting on our talented team members to lead us to our turnaround.

We are now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Seth Basham – Credit Suisse.

Seth Basham – Credit Suisse

Could you just tell us what the LIFO credit or charge was this quarter?

Mike Norona

We didn't experience really any material adjustments through LIFO for the quarter.

Seth Basham – Credit Suisse

Going forward would you expect any of the strong credit from last quarter to reverse?

Mike Norona

No.

Seth Basham – Credit Suisse

Secondly, I'd like to focus on gross margins. Can you give us a breakdown of where that margin strength is coming from? You mentioned supply chain, you mentioned pricing, but how much of it was really pricing, and how much of it was supply chain, and how did the addition of the new brand come into play there?

Mike Norona

When you look at our margin rate, 66% of it was related to supply chain and logistics efficiency. And the other, the rest of it, was attributable to pricing.

Kevin Freeland

The portion that is attributable to the gross margin or the product margin side, again, the minority was relatively evenly split on a mix rate basis. We benefited from both the parts categories were up in the quarter, predominantly they hold a higher overall rate. In terms of the new brands, it's too early to tell. We're transitioning at this point and we'll have a better sense of that next quarter.

Seth Basham – Credit Suisse

You talked about constrained profit growth for the back half of the year. Are you referring to net income growing marginally from here? How did that factor into the extra week?

Mike Norona

Let me give you a little bit of context. We talked about that. We're looking at the total picture, so if you think about the top line in Q2, we believe there was some impact of stimulus, even though we haven't been able to quantify it that may have pulled some sales forward from the back half of the year. That would be one.

Second is, as we look forward, there are some investments we have to make in our business. We refer to them a little bit in e-commerce, our new Minnesota regional office. We see some pressure coming from fuel costs, obviously, and increasing our store closings. And then the third bucket is we continue to make investments in our business in our capabilities and in our four strategies. So that's where you're seeing some of the pressure come from.

Seth Basham – Credit Suisse

That's understandable, but does that mean that you're expecting very minimal net income growth? How does the extra week figure into that?

Kevin Freeland

No, Seth, you could look at the first half of the year, and I think Mike put it this way when he explained it in the release. The truth is, we're ahead of where we thought we would be both in terms of the top line and margin line, expense is about what we thought, maybe a little higher, are things we're proud of. We're paying out bonuses, which is terrific and we're making some investments to grow the business. I think collectively we're up 22% principally driven by op income growth and leveraging EPS.

When you look to the back half, I got to tell you that I'm trying to sort out just how bumpy this is going to be for the consumer. And we know we have to keep investing and, in the example Mike used, in terms of the merchandising systems so we can grow the business and into 2009, 2010. We know we have to make the e-commerce investment. Part of our word is so people don't run away and say, gee the front half is 20% and naturally the back half should be at least that good. I think we're just trying to reflect it's bumpy from a consumer point of view.

We're going to continue to make the investments to make this business better. You know what? We're thrilled when we're paying out bonuses. I think in Q2 what we're most proud about is that every store manager in one of the periods in Q2 got a bonus. I don't remember the last time that happened.

And so, I think you have to put it all into context given the environment that we're navigating in and the fact that we remain committed to making these investments in the second half in order to insure that we can talk about a good FY09, a good FY10 and after that. So, that's what's underneath those words.

Mike Norona

And, Seth, we previously released that we anticipate the 53 week to be about $0.10.

Operator

Your next question comes from Dan Wewer - Raymond James

Dan Wewer - Raymond James

Darren, it sounds like the growth in the number of executives in Minneapolis is accelerating at a fairly rapid rate. Could you just discuss what challenges, if any, in having your team so far away from Roanoke and maybe just long-term will there be a gradual relocation of the headquarters to Minneapolis?

Darren Jackson

The answer to are we migrating Roanoke to Minneapolis in terms of all the headquarters people, absolutely not. And so, I think, Dan, we started with a view that might be 25 executives, maybe up to 40. I think as we've done the work, and we've been out loud with you and internally. As a matter of fact, we held a number of town hall meetings with everybody at our corporate support center and said, look, one of the challenges that we have is our DIY, our front room business.

And that's not a secret. It's been challenging for a number of years. And when we step back and look at our parts business, that business, candidly, has been driving terrific outcomes, particularly in the first half of this year. And we're very proud of that, that's not going anywhere. And as we look at how do we achieve longerterm what we're looking to achieve and how do we source some of that talent and how do we get the best of both communities? It was clear to us, I think, and Kevin knows this better than I do.

I think there's $200 billion worth of business done here in the twin cities that’s consumer package and retail product. That's essentially a lot of our front room. And in Roanoke, it's two. So it's a multiple of a hundred to one and when you look at putting in systems like retech, which are, I don't want to call it an industry standard, or it's Oracle now. I think our choices in Minneapolis for that very specific part of our business are just much greater.

And so, we did make a change and, we spent time with our team members explaining that change and, what we're trying to do is one where we can take advantage of the talent or we can take advantage of, hopefully turning this business around that's what we're going to do.

Dan Weaver – Raymond James

And then what about the other part of the question on the challenges of managing the corporate office in Roanoke from Minneapolis?

Darren Jackson

The way we're set up with the Executive Committee Jim and Elwyn and Keith are headquartered in Roanoke, and they will stay headquartered in Roanoke. Kevin, Mike, Mike Marolt, and I are in Minneapolis. Ken Wirth, who runs the stores, is in Chicago. The field teams tend to be out in the field. We've been down there five days of the week in the first five months every day of the week. And I think the last four weeks at least three days a week.

I think what we'll get to is somewhat of an alternating schedule, Dan, where we're down three days a week one week and Elwyn and Jim and Keith are up here a few days week. And I think you can do that in today's world. I certainly feel very comfortable doing that given the quality of this leadership team. And that, I think, has a lot to do with it in terms of the nature of the leaders and the team members there. So, I think this gives us the opportunity again to use the talent and the strengths of both communities.

Dan Wewer - Raymond James

On the acceleration in your commercial growth, is that reflecting adding more commercial customers or is it taking your existing customers and getting them to give you a greater number of first calls on parts?

Jim Wade

It's a combination of both. In the second quarter we saw a similar type of situation as we did in the first, where we saw both our existing customers buying more as well as we're adding parts and additional availability and taking advantage of the basics of the business, so we're attracting new customers as well. And our sales force is doing a nice job of telling the story about what we're doing in commercial, and I think we'll see our new customer base continue to grow as well.

Operator

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

Anthony Cristello - BB&T Capital Markets

When you look at the improvements sequentially on the DIY, was there any one initiative that you would point to, whether it's inventory or advertising or pricing, that stood out or perhaps had a better traction than the rest?

Elwyn Murray

It's easy to develop a complex trying keep pace with Jim and his commercial sales, so I appreciate the interest. I would say, specifically, our traction is strongest around our parts availability. I don't want the point to be lost that literally 50% of our DIY business is still in parts, so we're a major beneficiary of these investments that we're making. I would say the other one that is having the most traction at this point would be our attachment selling initiative where we're looking to sell the complete solution to our customer. And we're providing our team with both the business case for doing that, the tools to assist in that, and also the visibility to the metrics to let them know how we're doing in that area. So, again I like parts availability and attachment selling as probably the top two, with expectations of more to come from both of those.

Darren Jackson

Wouldn't you also state, Keith, our turnover at store level this year is tracking, what, 20% plus down?

Keith Oreson

It's actually tracking year-over-year down about 35%.

Darren Jackson

Tony, those things are hard to put in a spreadsheet, but at store level it's one of the things I'm most proud about is our store turnover. Keith pointed down 35%. When you have more skilled parts pros than team members in a store, there's a level of consistency that will clearly show up in the numbers.

Anthony Cristello - BB&T Capital Markets

What do you think is behind the decline? Obviously, is it a function of incentives? Is it a function of, hey, I can come to work now and I have better parts availability to sell and I fell more confident in dealing with my customers? Is there something you can point to or is it just, hey, the job market is tightening and I got a good thing here at Advance.

Ken Wirth

There are a lot of things that I think you answered that question with and parts availability and feeling confident for the team member to be able to wait on their customer is certainly contributing to it I think to an extent. Also, we've initiated some on boarding processes that we're taking our new team members through, improving the turnover for the new employee, and, certainly when team members begin to make more bonuses, they certainly feel good about working for the company as well.

Anthony Cristello - BB&T Capital Markets

When you look at it from a category standpoint, was there a demand or strength on items that could be perceived as mileage enhancers or was strength generating categories of parts that traditionally would have more deferability in nature to them or can you tell?

Elwyn Murray

I would make a couple of comments on category themes we saw in the quarter. First was parts, and generally across the board we saw an improvement from the investments that we've been making in our enhanced availability. Specifically to your question I would say we saw some nice improvement in performance chemicals, which is an area of things like fuel additives where people are looking to improve fuel mileage, but also to extend performance and delay ultimate repairs. So we did see improvement in categories related to that.

Anthony Cristello - BB&T Capital Markets

I know you’ve added a lot of parts, particularly behind the counter, and maybe you've changed some things in the front of the store, when you look at the allocation of what's selling square footage might be at the front of the store versus what's behind the counter now, how has that changed over the course of the last year as you restructured stores a bit?

Kevin Freeland

The allocation between the front and back rooms has remained relatively consistent. Our sales increases are inordinately coming from behind the counter, but that has to do with being led by, as you said, the improved availability behind the counter and the increase in the commercial business. As Elwyn and his team defined the changes as we go forward on the DIY side, I think it's reasonable to expect a comparable turnaround in the front room.

Operator

Your next question comes from Christopher Horvers – JPMorgan.

Christopher Horvers - JPMorgan

You mentioned that maybe you saw a benefit from the stimulus. Is that something that you saw on a monthly trend? Obviously don't give out what the monthlies are, but is it something with how the checks were sent out from the government that you saw an ebb and flow in the comp?

Mike Norona

One of the reasons that we make that comment is when your comp jumps from a 0.65 to a 2.9% in a tough economic environment we think the stimulus had something to do with that. When you quantify that, when people walk into stores, they don't necessarily tell why or how they're funding their purchase.

Darren Jackson

And we should look at the weather charts and see how hot it was. And what we were trying to signal there and this is one of the questions I asked Elwyn and his team to go back and look at is how did the overall market grow in Q1? We knew how we grew and how the overall market grew in Q2, and what you saw really across the board is a little bit of the tide rising in Q2 for everybody. And so it led you to believe, to Mike's point, we could go on this call and tell you we're geniuses and we've turned it from 0.6% to nearly a 3% comp and there are real good things happening in our commercial business, and there are good things happening in DIY and attachment selling, and there's good things happening in turnover, those all contributed.

But you just saw such a jump up and take 15 years of watching retail and watching the tax stimulus packages, they always help. A year from now we'll be on the conference call and if the number is not what we thought, we’d say, “Well, we had tax stimulus.” I think it's fair to have the door swing both ways. We're trying say the door needs to swing both ways. It helped us in this quarter. I can't map it for you, but I think we can go back and look at mapped years past.

A year from now we'll be having a call and we'll know it probably did. We'll say, boy, we had stimulus last year and it hurts, we won't be able to quantify it next year, either. Clearly it's out there, and probably the key thing that we said in the call is that sometimes what it does is it fast-forwards some of the purchases that would have happened in the balance of the year.

And the other phenomenon is that the consumer is so tight these days, I think whenever they get a little extra money, they see what's at the top of the list. As we go into the back half of the year, we know we get into the Christmas season and Christmas moves to the top of the list. We get in backtoschool there'll be moments in there where backtoschool will move to the top of the list. They're making trade offs. I think we benefited in the second quarter with stimulus, there was some benefits to being at the top of the list.

Christopher Horvers - JPMorgan

Well now that you have GPS in the stores maybe you are a backtoschool or Christmas destination. As you think about guidance and what you're saying for the back half of the year, clearly some SG&A pressure is coming in. Is there an element that the gross margin opportunity may be in the pricing and the logistic cost savings is coming down and maybe, Mike, if you could talk to how much that, now we need to lever for a 2% comp versus 1%, how much of that delta is driven by fuel costs versus spend?

Mike Norona

At the beginning of the year, we gave an annual outlook. We're not going to give quarterly guidance. But what we have said is now we're going to leverage on the 2%, our SG&A versus a 1%. And I want to put that in context to the sensitivity grid I gave you at the beginning of the year.

As a result of the change of going from 1% to 2% on the SG&A leverage, our best estimate is that a 1% comp improvement now is about $0.06 EPS and a 10 basis point improvement in operating margin is going to be $0.03 EPS. And then just some more context on the supply chain, we will be annualizing in the fall some of the supply chain efficiencies that you've been seeing that have been showing up in our numbers, but I will let Kevin talk a little bit about that.

Kevin Freeland

As Mike said earlier on the call, 2/3 of the pick-up was on the supply chain side, and we will anniversary much of that in the fall. It was also partially driven by the $40 million increase in inventory that sales were up 5.6% and inventory was up 8.1%. That increase in inventory essentially improves the efficiency of running the distribution centers. I think it's reasonable that we will continue to make inventory investments through the fall, but again, that was certainly a subset of the overall impact that we saw in the second quarter.

In terms of the product margins on the goods, the smaller portion of this, I think it's reasonable to expect that the inflationary impact [inaudible] that those numbers are sustainable?

Longer term on both fronts, though, as was mentioned we have a pretty material investment at this point going into new systems and new capabilities. I think as years go by it would be reasonable to expect that we can lever on our supply chain costs and improve the sharpness and accuracy of our pricing.

Operator

Your next question comes from Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

First of all on the SG&A side, I think you gave these numbers at the EPS level a moment ago. The change that you're talking about in terms of the comp you'll need to lever, it sounds like that would suggest, call it 2 or 2.5 percentage points of incremental growth in SG&A dollars over prior plan, is that basically the way to look at it?

Mike Norona

Yes, we don't really look at it that way, Matt, what we've said is that originally we were expecting to leverage SG&A to 1% comp, now we're saying 2%. The primary three drivers around that, and we've given the reasons. Professional services to invest in capabilities, fuel, and then some of the other spending that we're doing. So, that's how we're thinking about it. We typically don't break out the details of the basis points.

Darren Jackson

We're still running the business trying to figure out if we can spend about $600,000 $601 and trailing 12-monts. We continue to remain vigilant with the balance in commercial investments and merchandising systems and taking costs out of these.

Matthew Fassler – Goldman Sachs

Related to the SG&A line, how much of what you're talking about on a year on year basis is a function of the fact that a year ago the company started making some pretty significant cost cuts. Is it more a question of cycling those cost cuts or more of a question of the incremental dollars?

Darren Jackson

Last year, we actually made moves to take $70 million out of the business in terms of costs. $20 million showed up last year. $35 million of that was annualized this year, and then $20 million of that were new initiatives that we did this year. Those have been planned this year and we are achieving those.

Matthew Fassler – Goldman Sachs

On gross margin and that relates to product price increases and the impact of cost inflation. It sounds like pricing is leading to actual gross margin rate improvement. So, presumably to the extent there's any increase in product costs due to raw materials or what have you, you're getting back at least that much on the pricing front. How do you see that balance playing out over the course of the year? Do you feel like product inflation, cost inflation is at run rate that you can more than manage on the pricing front, or do you feel like that's an issue that might still be on the comp?

Elwyn Murray

I would agree with your assessment. We obviously monitor what we call price indices for both our sales floor as well as our parts department and feel good about our positioning there. Many of the cost increases that we have incurred we have been able to pass along, as has the market. I wouldn't anticipate any downward pressure from this cost increase given the ability to pass those through. But we do want to make sure that we remain competitive as we consider each increase.

Operator

Your next question comes from Scot Ciccarelli – RBC Capital Markets.

Scot Ciccarelli – RBC Capital Markets

Can you help me understand, you talk about increasing the threshold on SG&A to a 2% comp where you show leverage. Yet we just saw almost a 3% comp and we de-levered by several basis points. Can you help us understand, was there already an acceleration of investment spending or was there something else in there?

Judd Nystrom

When Mike made that comment, we were looking at it on an annual basis and not on a quarterly basis. Part of our driver in Q2 is actually an increase in incentive compensation. That was a component as well as rising fuel prices, specifically on unleaded gasoline for our commercial delivery. So Mike's actual frame is for the full year, not on a quarterly basis, so we're going to see ebbs and flows in our spending as we progress through the fiscal year.

Scot Ciccarelli – RBC Capital Markets

Just in terms of use of cash, you looked to have paid down about $100 million of debt in the quarter. A couple quarters prior to that, buyback was the primary use of your cash flow. Now it sounds like you're increasing spending or investment in the business. Can you help us understand how you are going to allocate the future cash flow?

Mike Norona

A big part of our cash flow is obviously going into inventory. We talked about that. And I would say that's the big driver. We don't comment about some of the other things like share buybacks. I think most of our share buybacks was done at the beginning of this year. I think we've said we are going to look at our share buyback on an opportunistic basis and, as consistent with past practices, we don't comment before we buy the shares. Those are a couple of the drivers.

Darren Jackson

Let me build on that a little bit. Scot, I think as we look out, Mike is right. I think we're real early in the commercial work, and we're excited about what we're learning in some of the results. The comps, quite frankly, are ahead of where we thought we'd be at this time. As we get in and count different types of ways to continue to sustain that type of growth in commercial, I think we'll see different ways that we can put stores together and prototypes together and grow the business.

That doesn't mean run away and put 200 stores in your spreadsheet tomorrow, but I'm asking where can we deploy some of that capital. Because I think if you look at our debt to adjusted EBITDA, we’re 2:6. That's a reasonable leverage ratio, so we paid down a little debt this quarter. The thing that's going to actually get this company where we need to go is we continue to see ways to take that capital and invest it and grow.

It’s principally going to be in the commercial area, as we've been talking about for a while. We're just not at a point where we can line up and say this is the new store prototype or here's the other specifics as it relates to commercial parts investment. But what we're seeing at least early on is we're going to have other opportunities to invest that capital beyond making opportunistic purchases in stock buybacks.

Operator

Your next question comes from Colin McGranahan – Sanford C. Bernstein.

Colin McGranahan – Sanford C. Bernstein

I know you're about 80% hedged on diesel fuel, so outbound freight. It sounds like the pressure here really is on unleaded gasoline so delivery to customers. When did the hedges roll off on the fuel that you've already hedged, and can you quantify what you think the impact is on total gas and diesel inflation this year and how you're thinking about that going forward?

Kevin Freeland

The inordinate portion of fuel that we purchased operates the trucks in our stores that are the commercial delivery vehicles and, as you mentioned, those are not hedged. The minority factor is the diesel fuel for our tractor-trailers. Essentially, what we do is we hedge a major portion of that diesel fuel on annual basis, so we can give annual guidance. We would intend to hedge again for next year prior to giving that guidance. So, essentially, we're insulated from that portion which is embedded in margin within any one fiscal year.

Colin McGranahan – Sanford C. Bernstein

Just quantify the gasoline impact basis points and SG&A.

Darren Jackson

Colin, we never do that, come on.

Mike Norona

I know you're prodding at the SG&A. The other item we haven't talked about so far is the impact on store closings. Last year we closed roughly 15 stores. This year, as Jim mentioned, we've reassessed that. At the beginning of the year we were thinking 10 to 20, we've taken it up to 20 to 30. Now as I look at the impact compared to last year, I think last year's impact was $0.05 to $0.06 and this year it's going to be $0.09 to $0.10.

Darren Jackson

Last year, Mike, my recollection is more in the first half, this year, more in the back half. So, the bulk of that expense is coming in the second half still ahead of us.

Colin McGranahan – Sanford C. Bernstein

And your preference is not to break that out as a charge?

Mike Norona

No. That's just part of our regular business.

Darren Jackson

In the last conference call, Colin, we said it won't be linear this or that. Part of it is we're looking at everything. We're looking at everything from our supply chain to how we do DIY to how we change commercial store portfolio. I think we looked upwards of 30 stores. If 30 stores are all the stores we ever make a mistake on we'll go to the Hall of Fame. Let's just get them behind us. That getting behind us will happen in the second half of the year by and large. I don't think people are processing that through. We're not going to give quarterly guidance, but that is somewhat of a change.

Kevin Freeland

I think it's also important to state that's always going to be an important part of our business. But it may be a more important aspect of our business as our business transforms now from a retail model to a retail and commercial model. And our [inaudible] are changing. I think we need to continually go back and reassess those stores. Because a store that may have not been that profitable on retail may be really good when we balance it and the converse could be true as well.

Colin McGranahan – Sanford C. Bernstein

Apparently, aspirational goal to be 50/50 commercial retail and I know you're still fairly into the process of looking at the entire supply chain. If you think about O'Reilly that runs about 2,700 distribution square foot per store, I think you are running closer to the 1,500. How are you thinking about the supply chain investment needs, infrastructure, and capabilities going forward? And when might you have a little bit more visibility to what those investments would be?

Kevin Freeland

You are correct. It would reasonably take a shift in supply chain strategy to support the work Jim and his team are undertaking at this point and, in the test market, we are also testing supply chain changes. Part of the $60 million investment that Mike referred to earlier on the call is involved in studying effectiveness of different parts of the merchandising supply chain area, including a network study. So we are currently under way looking at the way the supply chain network is laid out. We have not completed that work, don't have conclusions at this point and would get back with you at a future point.

Colin McGranahan – Sanford C. Bernstein

And who is your external partner on this?

Darren Jackson

Well, we'll leave that to your imagination, Colin, but you could probably guess.

Operator

Your final question comes from Alan Rifkin – Merrill Lynch.

Alan Rifkin - Merrill Lynch

What would the commercial comps have been without the inclusion of AI and without the additional [inaudible] that you rolled out year-over-year?

Mike Norona

Our commercial comp would have been 14.1 at Advance and [inaudible] for those at AI.

Alan Rifkin - Merrill Lynch

I'm pretty intrigued about, Darren, the statement of $10 billion of revenue in five years. If we do some quick math, that implies a 15% [inaudible] in top line. And if you assume 50% commercial, you would have commercial growing from $1.5 billion at the end of this year to $5 billion five years from now, which is almost a 30% annual rate. Could you maybe just provide a little bit more color as to how you get to those top line numbers?

Darren Jackson

In the framework I give you, think about an artist's rendering versus the detailed blueprint. And, when we back up, there's a couple things that go into that artist's rendering. One, it starts with when we look at the commercial business in terms of the structural industry. Jim will correct me if I'm wrong. But in industry out there that's, in terms of addressable for us, not less than $40 billion and arguably could be $45 billion.

It's growing I think, in terms of its own organic growth, not less than 4%, Jim? And could be as high as 6%, depending on whose numbers you watch. And today, when we do our own math, we are 2.5% market share. And there doesn't seem to be anyone dominant. There's clearly good players out there and we've taken nothing away from NAPA and nothing away from O'Reilly.

But you can see as we position our business model with such small market share, the ability to leverage our structural benefit that we have are those store locations being real close to many of our commercial partners. And trying to think about how do we simply take advantage of that benefit and how do we participate in a very vibrant market? One assumption is that just playing that market you have some wind at your back, develop the capabilities, it’s going to take some time. What does the road map look like in order to get to that 50% mark?

Others might argue it has to be higher in light of the structural economics of that commercial market. On the DIY side, conversely, the good news is that our heritage is where it's harder to make any headway, and we enjoy double-digit market share there. Structurally, it's got a little better economics. Elwyn would probably tell us that we're doing a lot of business today, $3 billion plus in that business and that probably doesn't even equal half of what comes in our door every year.

And so how do we start by using simple types of techniques? We talked about attachment selling. We didn't talk about weekend scheduling and getting those basics right, and how do we start to think about new product categories that are happening in the DIY space? I think someone was kidding me about GPS. Depending on whose numbers, you think about it, GPS this year will approach $4 billion, that’s about as big as our company.

I think when we look at the greater things that fit around a car we can see addressable markets today of $22 billion if you stretch your imagination. Correct me if I'm wrong, Elwyn, if you throw out fuel and throw out a bunch of stuff, we can see a number that's ten times the number that we're participating in today. But the truth is we don't have it figured out as to which one, given our capability, will be most adept at trying to participate in.

We can tell you in the quarter that currently was taken into the quarter was the funeral expenses for the big papa pickle, so we’re leaving pickles behind and we're trying to find things that are more adjacent to the business and part of that will require a culture change for us. But, the size of those markets, our team members desire to get growing again, has us focused as the leadership team. We could argue that’s a big goal for us, but I don't know how else to help drive an organization without setting a real big goal out there because we need to break through where we are today.

Alan Rifkin - Merrill Lynch

Darren, holistically, can you triple your commercial revenues over the next five years without a major, major shift in the distribution structure as you look at it today focusing on commercial?

Darren Jackson

I would say this, if we don't make investments to supply chain, merchandising systems, and, candidly, how we do commercial, be more of a sales driven culture and more of a distribution culture. I think the answer, the answer is no. Part of what you're hearing from us is, yes, we're making investments in merchandising systems; yes, we're making investments in supply chain; yes, we're going to make investments in CRN systems for our team. And could this business go from $1 billion to $3 billion over the next five years; it better. Because that's part of our growth plan as a company.

Judd Nystrom

Thanks to our audience for participating in our second quarter conference call. If you have additional questions, please contact Joshua Moore at (540)5618301. Reporters, please contact Shelly Whitaker at (540)5618452. That concludes our call. Thank you.

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Source: Advance Auto Parts, Inc. F2Q08 (Qtr End 07/12/08) Earnings Call Transcript
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