O’Reilly Automotive - Earnings Call - Q2 2011
July 28, 2011
Transcript
Speaker 5
Good morning. My name is Latasha, and I will be your conference operator today. At this time, I would like to welcome everyone to the O'Reilly Automotive 2011 second quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star one on your telephone keypad. If you would like to withdraw your question, press the pound key. I will now turn the call over to Mr. Tom McFall, Chief Financial Officer. The survey may begin.
Speaker 6
Thank you, Latasha. Good morning, everyone, and welcome to our conference call. Before I introduce Greg Henslee, our CEO, we have a brief statement. The company claims the protection of the safe harbor for forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements can be identified by forward-looking words such as expect, believe, anticipate, should, plan, intend, estimate, project, will, or similar words. In addition, statements contained within this conference call that are not historical facts are forward-looking statements, such as statements discussing, among other things, expected growth, store development, integration and expansion strategy, business strategies, future revenue, and future performance. These forward-looking statements are based on estimates, projections, beliefs, and assumptions that are not guarantees of future events and results.
Such statements are subject to risks, uncertainties, and assumptions, including but not limited to competition, product demand, the market for auto parts, the economy in general, inflation, consumer debt levels, governmental approvals, our increased debt levels, credit ratings on our public debt, our ability to hire and retain qualified employees, risks associated with the integration of acquired businesses, including CSK Auto Corporation, weather, terrorist activities, war, and the threat of war. Actual results may materially differ from anticipated results described and implied in these forward-looking statements. Please refer to the risk factors section of the company's Form 10-K for the year ended December 31, 2010, for more details. At this time, I'd like to introduce Greg Henslee.
Speaker 0
Thanks, Tom. Good morning, everyone, and welcome to the O'Reilly Automotive second quarter conference call. Participating on the call with me this morning is, of course, Tom McFall, our CFO, and Ted Wise, our Chief Operating Officer, and David O'Reilly, our Executive Chairman, is also present. To start off, I'd like to again congratulate Team O'Reilly on the excellent performance. Our second quarter operating margin of 15% is a significant milestone and sets a new high watermark for our company. This performance, as always, is a direct result of the effort each one of us puts into abiding by our culture values every day, ensuring our customers receive the best customer service in our business, that we're all as productive as we can possibly be, and that we manage our expenses with an eye toward making sure we create the best value in the automotive aftermarket for our loyal customers.
Great job, Team O'Reilly. Now on to some details of our second quarter performance. As we discussed on our first quarter conference call, we projected second quarter comparable store sales in the range of 3% to 5%, and we ended the quarter in that range at 4.4%. We've been on a reasonably steady sales trend for some time now, generating first and second quarter comparable store sales on a two-year stack basis of 12.5% and 12.3%, respectively. With consideration to the variation in comparisons we had by market, we saw solid sales performance across most of the country. As has been the case for some time now, the markets in which we've converted CSK stores continue to be our best comparable store sales contributors, as the seeds we've sown during the integration of CSK continue to bear fruit.
July 11 marked the third anniversary of the acquisition of CSK, and I'm very pleased to announce that the vast majority of the integration work is now behind us. Ted will review this in more detail in a moment, but generally speaking, we're now able to focus all our efforts in these markets towards growing market share by establishing ourselves as an incredibly capable business partner for the commercial customers in each market, as well as an outstanding resource and supplier for the DIY customers. We've still got a long way to go to reach our potential in the CSK markets, but we are well down the road and are in a good position to incrementally gain market share on both the commercial and retail sides of our business.
To this point in July, the steady sales trend we've been on has continued, and with the extremely high temperatures we've seen the past few weeks across much of the country, we've seen very good seasonal demand. However, with fuel prices approximately 35% higher than they were this time last year, miles driven down 1% for the year through May, and unemployment hovering around 9%, we're inclined to be somewhat conservative in our comparable store sales forecast for the third quarter, especially when considering that we're comparing to the 11.1% comp store sales gain we generated last year. With this in mind, we're forecasting comp store sales for the third quarter in the 2% to 4% range, which at the midpoint would put us around a 14% increase on a two-year stack basis.
Gross margin for the quarter came in at 48.6% of sales, a 12 basis point decrease compared to last year. This decrease is primarily related to the timing of some advertised commodity items on which we receive cost increases, along with the faster rate at which we're growing our commercial sales versus our DIY sales, which yields a slightly lower gross margin rate. This is primarily related to CSK integration and the execution of our dual market strategy in those markets. As I've mentioned before, we have several initiatives underway to enhance our gross margin over time. These include refinements to the way we price products, both commercial and DIY, more direct sourcing of products coming from overseas, growth of some of our private label product offerings, and continued distribution efficiencies.
To this point, we've been pleased with our ability to maintain our gross margin rate as we execute our dual market strategy plan in the CSK conversion stores. SG&A expenses for the quarter came in at 33.5% of sales, a 95 basis point improvement compared to last year. This is primarily the result of our ongoing focus on productivity and expense control. However, winding down the CSK integration was also a contributor. I'm extremely proud of the job our team is doing managing expenses. It's part of our culture, and I feel like we're doing as good a job as we've ever done, focusing on spending money where it's necessary to provide better service to our customers and eliminating unnecessary expenses. Also, it's clear that the rollout of our commission-based compensation plan in the CSK stores has been a contributor.
We're very focused on team member productivity, and our incentive programs align our store team's interests in making our sales and productivity goals. That said, we're very pleased with the operational expense improvements we've seen in the converted stores as well as our execution in the O'Reilly stores. The result was an all-time high quarterly operating margin of 15% of sales and an 83 basis point improvement compared to last year's adjusted operating margin. Our average inventory value for the quarter was at 5.2% over last year, but generated a sales increase of 7.1%. As we've discussed before, we're working to dial in the converted store inventories and are gaining ground. Currently, our converted store inventories are higher on average than the core O'Reilly stores, and over the remainder of next year, we'll work to bring them much closer to the core O'Reilly store per average inventory.
Our goal continues to be to incrementally, over time, return to our pre-CSK inventory turnover rate of approximately 1.7 times as we dial in inventory levels and work to increase our per unit average volume in the converted stores. With the majority of the conversion work behind us, we continue to focus on some strategic priorities that we feel will drive long-term value. These initiatives, for the most part, are simply improvements that we want to make to our business now that we're able to focus. I've mentioned some of these before, but I'll touch on them again. There are things like more detailed work with our vendors on a wide array of projects to assure appropriate inventory coverage in our DCs and stores, best use of capital in deploying inventory, logistics cost management, improved demand forecasting, along with several other merchandise-related priorities.
We're very pleased to see that our efforts to improve use of capital yielded a 10.6% improvement in our AP to inventory ratio, taking it from 44.2% last June to 54.8% this year. Another initiative is enhancing the content we have available in our point-of-sale systems. Having the best information easily available to our parts specialists is one of the keys to success in our business. We've been an industry leader in this area for a long time. However, we see more opportunity to not only improve the way we look up application parts, but to provide more information for our parts specialists in order to help them quickly help our customers solve their problems. This includes more information about problem diagnosis, product specification, and installation, along with other pieces of content detail we're working to add. We're also continuing our efforts to improve our e-commerce and now in-commerce capabilities.
As I've mentioned before, we've done a good job on this for a long time with our professional customers that feel we have continuing opportunity to improve not only those systems, but also the electronic interaction we have with our DIY customers, especially on mobile devices. We've deployed some improvements and are working on several additional improvements as time goes along. There's a long list of additional internal priorities, but I wanted to just mention a few of the things we continue to work on to improve our customer service, our profitability, and our market penetration. We continue to see a lot of opportunity to grow our business through market share gains and through the continued growth of our store count.
The opportunity that we saw three years ago when we bought CSK Auto Corporation is now coming to fruition, and we expect solid sales results from these stores over the next several years as we gain credibility with both commercial and the DIY customers. Our industry continues to benefit from the average age of vehicles on the road reaching record highs. I continue to believe that many of our customers have learned that with proper maintenance, cars and light trucks can be driven at higher mileages than ever before due to the quality of the drivetrains and other key componentry. I don't believe the positive effect this aging of the vehicle population could have on our industry has yet been fully realized. With unemployment as high as it's been the last couple of years, there's no question that there's been a lot of maintenance deferred.
We hear this not only from our commercial customers, but see it in our stores as DIY customers look for low-cost alternatives and weigh the risks of deferring repairs that can be deferred. In closing, I'd just like to again say thanks to all of Team O'Reilly for their hard work and for the great service we provide our loyal customers. Our team has done an excellent job over the past three years incorporating what used to be CSK Auto Corporation into Team O'Reilly. We have a bright future ahead of us as we continue to improve our customer service capabilities and we expand the O'Reilly culture in new markets. I'll now turn the call over to Ted Wise.
Speaker 3
Morning, everyone. Like Greg, I would like to start by saying thank you to over 49,000 O'Reilly team members. Our team working together, whether it be in the corporate office, distribution centers, or in store operations and sales teams, was responsible for producing our first-ever 15% operating margin. Following the excellent comps from a year ago, we knew we had to focus on great customer service levels to grow our business. Under these challenging market conditions, we produced a very respectable same-store sales last quarter. We realize the company's sales and profits performance are the result of the commitment and hard work of our talented group of professional auto parts people, and we sincerely appreciate everyone's contribution. Before I give a brief update on the last stage of the CSK store conversions, I want to overview our new store growth during the second quarter.
We installed 44 new stores, which on top of the 55 new stores in the first quarter brings us to 99 new installations for the year. During the first part of the year, we closed 12 CSK non-performing and overlapping stores that we had previously announced in our plans last year. For the year, we have grown a net 87 new stores, bringing us up to 3,657 stores operating in 39 states. Our third quarter installation schedule is shaping up nicely and looks to be in the range of an additional 60 new stores, well on track to finish the year on plan with us 170 net new stores. The new store growth was spread out in 17 different states, with North Carolina at nine stores and Texas at six stores leading the path.
Our real estate teams, working closely with field operations, continue to identify and find good expansion opportunities that can be adequately serviced within the current capacity of our network of 23 distribution centers. On the West Coast, we are very focused on expanding into new markets, but store relocations will be very critical to our overall growth as we work to relocate stores out of shopping centers into more freestanding prototype buildings. West Coast real estate is challenging, but we are confident that over time we can find good options in many markets that will improve our location and our occupancy costs. Now for an update on the final stage of our store conversions out West. As outlined on our last call, we have implemented our O'Reilly dual market infrastructure and installed distribution centers so that all stores are serviced on a nightly basis.
We completed the changeover and update of all the hard parts inventory lines and all out-front planograms in the stores. We've installed all store computers and have our teams fully trained on the point of sale and store operational procedures. As Greg mentioned, the O'Reilly store and city plans have been rolled out, and we've restructured and added the management required for our store operations and sales team to properly cover the current store count and future growth. We're in the final stage of completing the store interior resets and remodels, as well as wrapping up the exterior store sign conversions to the O'Reilly brand. During the past quarter, we completed another 108 store resets, leaving us approximately 50 stores to complete this quarter.
We are also at the end of the sign conversions with around 100 stores pending release of permits, delivery of signs, and scheduled to install as soon as possible. While we still have some fine-tuning and miscellaneous projects to finish, the store interiors with O'Reilly planograms, layout, and decor is a huge improvement in our retail image. Many of the CSK exterior signs were in very poor shape, and now our stores present a new, bright, sharp exterior image with O'Reilly signage and, in many situations, new exterior paint jobs. We are ready for business as O'Reilly as we discontinue the co-branding advertising and now convert over to using only O'Reilly advertising in market throughout all of our markets. The development and growth of our West Coast stores and sales teams is progressing well as we continue to focus on several key areas.
The store sales teams have become very efficient as they understand and implement the O'Reilly point of sale and other operational procedures. Now, with the distraction of the store resets and the inventory work behind us, our teams are focused entirely on sales, product training, and providing a higher level of customer service on the retail counter and to our first call customers. Second, we continue to expand our outside sales efforts to build solid relationships with our more professional customers. It takes repetition and time to build these relationships and earn the professional customer's business, and we are starting to see good progress made in this area. Our team member training is resulting in higher productivity at the store level. We've also improved our store productivity by better scheduling for the business using our scheduling tool, which provides higher service levels.
The obvious result has been increased sales and better leverage of our store payrolls. We have to be very careful in our staffing plans and ensure the stores continue to have the level of staffing that will provide the great customer service needed to compete for each individual market's sales entitlement. Staffing for great service levels is a store-by-store, market-by-market evaluation and is considered the top priority for our entire field management team. We feel we have trained and developed a great leadership team in the West Coast stores and also feel confident that we will continue to see the growth and success that mirrors our core O'Reilly store group. I'll now turn the call over to Tom.
Speaker 6
Thanks, Ted. Now we'll cover our second quarter financial results and our guidance for the remainder of the year. For the quarter, comparable store sales increased 4.4%, which was within our 3 to 5% guidance for the quarter. Sales increased 7.1% to $1.48 billion. The sales increase of $98 million was comprised of a $60 million increase in comp store sales, a $39 million increase in non-comp store sales, a $3 million increase in non-comp non-store sales, and a $4 million decrease from closed stores. For the quarter, ticket average drove our comparable store sales gain. The ticket average trends for the quarter were consistent with previous quarters, driven by the continued shift in our product mix towards hard part categories, which typically carry a higher average ticket. During the quarter, comparable DIY ticket count came under pressure as consumers faced increased fuel costs.
However, this pressure was offset by continued strong growth in the DIFM comp ticket count. Year to date, our comparable store sales increased 5% on top of last year's 7.4% first half gain. Our third quarter comp guidance is 2 to 4% on top of the 11.1% comp for the third quarter of 2010, which was our highest comp quarter for that year. Our full-year sales guidance remains at $5.7 to $5.8 billion, and our 2011 comparable store sales guidance is also unchanged at 3 to 6%. While we do expect continued headwinds from fuel prices and the high level of unemployment, we expect sales remain relatively solid based on the continuing economic pressure that requires consumers to maintain their existing vehicles and on the solid growth potential we have in the acquired CSK Auto Corporation markets.
Gross profit for the quarter was 48.6% of sales and was down slightly from the prior year, but within our expectations. Looking at the quarter, we definitely saw inflationary pressures with our LIFO reserve increasing $23 million. While we still feel confident in our long-term ability to pass along raw material price increases to our customers, the second quarter margin was compressed in part by price increases on highly promotional merchandise. The tight timing of the price increases and our seasonal promotional activities did not allow us to adjust advertised pricing. This compression, in addition to the ongoing pressure on gross margin percentage caused by a higher mix of commercial business, resulted in a 12 basis point decrease in gross margin percentage for the quarter. We're maintaining our annual guidance of gross margin of 48.4% to 48.8% of sales versus 48.6% in 2010.
While we do anticipate further inflationary pressures, we expect the pricing environment and industry will remain rational and inflationary pressures will be effectively passed on to the consumer. SG&A results for the quarter were very strong at 33.5% of sales versus 34.5% in the prior year. The improvement was driven by improved leverage on store occupancy costs, improving store payroll efficiency, and improved leverage on headquarters expenses. These efficiencies were partially offset by increasing fuel costs related to store delivery vehicles, and we'd expect that headwind to continue throughout the year. Looking at average SG&A per store for the second quarter, we were able to keep the expense flat through tight expense control.
Year to date, SG&A per store has increased less than 1%, and for the full year, we now expect to see an average per store SG&A increase below 1% as we leverage store activity costs in the acquired CSK Auto Corporation stores, leverage headquarter expenses, and benefit from the reduced store project costs related to conversions and training in 2010. Operating margin for the quarter was 15% of sales, representing an 83 basis point improvement over the prior year on an adjusted basis as we were able to tightly control expenses. Based on an operating margin of 14.6% of sales for the first half of this year versus 13.7% in the prior year on an adjusted basis, we are updating our full-year operating margin guidance to 14.2% to 14.6% of sales as compared to an adjusted operating margin of 13.6% in 2010.
As a reminder, our fourth quarter operating margin is typically the lowest operating quarter based on sales volume and mix. Diluted earnings per share for the second quarter was $0.96 per share, which represents an increase of 19% over an $0.81 per share adjusted diluted earnings per share in the prior year, which excludes the impact of the CSK Auto Corporation DOJ settlement charge. Year to date adjusted EPS, which excludes the charges related to the company's new financing plan in 2011 and the aforementioned CSK Auto Corporation DOJ settlement in 2010, was $1.78 per share versus $1.51 in the prior year, which is an 18% increase. At the end of the second quarter, our adjusted debt to adjusted EBITDA was 1.6 times, which is consistent with the beginning of the year but remains well below our long-term targeted leverage range of 2 to 2.25 times.
While we will incrementally increase our leverage over time, we remain very committed to maintaining our investment grade ratings. Looking at our balance sheet at the end of June, two things stand out. First, we're sitting on an unusual amount of cash, which we'll discuss in a moment, and second, we're making significant progress towards improving our net inventory investment. Reducing our first store inventory, as well as improving our vendor terms, both represent great opportunities for us to improve our net inventory investment position. Year to date, we've opened 87 new stores with an increase of inventory of only $12 million. On a per store basis, inventory at the end of the quarter was $557,000 versus $567,000 per store at the end of 2010.
We expect to see continued reduction in our per store inventory over the next few years as we continue to work hard to refine the mix and depth of inventory at the converted CSK Auto Corporation stores and new DCs. For the year, we continue to believe we can add 170 new stores with only a small increase in gross inventory. At the end of the quarter, our AP to inventory ratio was 54.8%, which was a tremendous improvement over the second quarter of the prior year in December of 2010, which were 44.2% and 44.3% respectively. A portion of the improvement is the result of some timing issues related to product changeovers. However, the biggest improvement is the result of permanent improvements in payable terms, which we've been able to negotiate with vendors as a result of our improved vendor financing program.
We've been able to enhance our program to reduce supply chain costs based on our new unsecured debt structure. We expect to continue to increase our AP to inventory ratio over time. Cash flow from operations improved $206 million over last year, which represents a 58% increase. This strong improvement was driven by increased adjusted net income and the improvement in net inventory investment. Looking at capital expenditures for the first six months, our spend of $151 million was $32 million less than last year. This decrease relates to the 2010 CapEx on new DCs to support the CSK Auto Corporation conversions. For the full year, we're reducing our forecast from between $310 and $340 million down to $290 to $320 million based in part on timing and in part on below-plan expenditures.
The strong improvement in our cash flow from operations, coupled with CapEx spend below last year, drove a significant improvement in our free cash flow. The first six months' free cash flow of $411 million was a $237 million improvement over the prior year. For the full year, expected free cash flow guidance will increase in our estimate from $360 to $400 million up to $425 to $475 million. We've increased our guidance based on expected lower net inventory investment at the end of the year, lower CapEx, and lower than planned cash taxes based on changes to the tax law. During the quarter, we continue to aggressively repurchase shares. Prior to June 4, when we entered our restricted trading window, we executed a 10b5-1 plan, which allowed us to continue to repurchase shares during the closed window.
At the time, our stock had been trading in a relatively tight range between $58 and $60, and we developed our 10b5-1 plan with that range in mind. During the closed window, our share price saw significant appreciation, and as a result, we have not repurchased as many shares to date as we had anticipated. The result of this lower than expected level of repurchase was the quarter-end cash balance of $269 million. Our 10b5-1 plan remains in effect until our trading window reopens on August 2, and when it does, we anticipate continuing to execute our repurchase program. Our guidance from both the third quarter and full year takes into account the shares repurchased through yesterday but does not reflect the impact of any potential future share repurchases. For the third quarter, our diluted earnings per share guidance is $0.98 to $1.02 per share.
For the full year, our adjusted diluted earnings per share guidance, which excludes the non-recurring charge related to the refinancing plan mentioned previously, is $3.53 to $3.63 per share. The second quarter represents another solid operating performance on many fronts, and we remain confident in our ability to execute our plan through the remainder of the year. At this time, I'd like to ask Latasha, the operator, to come back, and we'll be happy to answer your questions. Latasha?
Speaker 5
At this time, I would like to remind everyone, in order to ask a question, press star then the number one on your telephone keypad. Please limit your question to one question and one follow-up question. Again, that is star one if you have any questions at this time. Your first question comes from the line of Alan Rifkin from Barclays.
Speaker 4
Congratulations, gentlemen.
Speaker 0
Thanks, Alan.
Speaker 4
Greg, if we go back and look at the stores supported by, let's say, either Stockton or Phoenix, which were converted later in the process, and compare them to, let's say, the upper Midwest or Western Texas or even Seattle, which were converted earlier in the process, can you maybe just shed a little bit of color on the difference in the operating performance of those two groups of stores?
Speaker 0
Yeah, I can to some degree, Alan. The stores that, of the converted stores, the ones that took off the quickest and performed the best out of the gate have been the stores that we converted in the upper Midwest and Texas. That's partly due to the fact that the O'Reilly brand was recognized there. We had team members that existed in markets close that we were able to use for training and, in some cases, move them into some of those stores to help teach our strategy. We had the distribution capability to those stores that allowed us to very quickly execute the dual market strategy that we execute.
Of course, with the Seattle stores and the other markets that we've converted, we've had similar results, but they didn't come on quite as quick, mainly because of just the fact that there's a training curve and that the team members had to get over that training curve before they were really capable of executing our business model. If you compared those to Stockton and Phoenix, those two markets probably haven't done as good as the two that you mentioned, the upper Midwest, Texas, and Seattle. Putting the upper Midwest and Texas into one group and Seattle in another, those two would fall a little bit behind those. Some of the other markets, like Southern California, for instance, which is a very big market supplied out of Moreno Valley, they've done incredibly well, and they would be more comparable to what we saw in the upper Midwest and Seattle.
On balance, they all tend to kind of migrate towards the same spot and the same rate of comp, or at least a similar rate of comp, but the time it takes to get there has varied some, depending on probably people more than anything.
Speaker 3
Yeah, I might add there. The first stores we converted over all in one big project, and we had the line conversions, the out-front converted, everything was short and a lot of pain for a little amount of time. These other markets, we've had these store remodel resets going on all through this transition too. That combined with the computer conversions and the learning curve, it's kind of made a little difference in their speed on picking up our whole strategy and implementing it.
Speaker 0
Alan, this is Tom. In general, what we've seen is the longer the stores have been converted, the better they've performed as we've gotten over those training issues, as we've had time to start developing commercial relationships and bolstering our DIFM business. The stores that have been converted the longest continue to perform the best, and we see a similar trajectory given the time after conversion between the different conversion classes.
Speaker 4
Okay, so stores converted the longest are performing the best. Okay. If I could just follow up with a question, if you don't mind. Greg, with the significant increase in free cash flow, together with you guys pretty aggressively buying back stocks since you first announced the program at the beginning of the year, can we expect going forward a greater emphasis on share buybacks and possibly even a dividend implementation in the future?
Speaker 0
I think what I would say is that our first priority with the use of free cash flow is to grow our company and be opportunistic when it comes to expansion. That's been the case for a long time, and that's clearly the best return to our investors. To the extent that we have excess cash that we can't use to grow, our first priority will be share buybacks. I would expect that in the future, as we use up the authorized capability that we have, we'll be looking to expand our share buyback authorization. Today, we have no plans to implement a dividend program, but that could change in the future. Our board has not yet seriously considered approving that in light of the fact that we have the expansion opportunities that we have and the fact that we've implemented the share buyback program we have.
That could happen in the future, but we have no current plans to pay a dividend right now.
Speaker 4
Okay, thank you all very much.
Speaker 0
Thank you, Alan.
Speaker 5
Your next question comes from the line of Kate McShane from Citigroup. Thank you for joining us.
Speaker 2
Morning.
Speaker 5
Morning.
Speaker 2
I wondered if you could get a little bit more specific on which categories you're seeing the most inflationary pressure, and what gives you the confidence that prices will be able to be passed through in the back half of the year when there seems to have been a little bit more promotional activity during the quarter.
Speaker 0
The primary product that we see the most inflationary pressure on is lubricants. With oil prices going up, motor oil, transmission fluids, all the lubricants that are used in automobiles are increasing. Those are highly promotional products, especially during the peak of our selling season in the summertime when we're working to try and drive traffic into our stores. That's where we're seeing the majority of it, although that does carry over into some other products that oils and various products like that are used in the manufacturing process, they're used in transportation. We've seen some inflationary pressure in other products, including friction materials where heavy resins are used and things like that.
We feel confident in our ability to pass these increases along to the consumer, although what Tom and I mentioned in our prepared comments is that some of the promotional activity that we plan sometimes eight weeks out or really even further than that, but within six to eight weeks out, we're pretty well locked into the promotional activity that we would have planned for a specific period. Because costs have escalated as fast as they have, we've had a little bit of a problem keeping our costs in parity with those promotional plans. For that reason, we had some drag on gross margin during the quarter related to some of the promotional, mainly motor oil type products.
Speaker 2
Okay, that's very helpful. Thank you.
Speaker 0
You bet. Thank you, Kate.
Speaker 5
Your next question comes from the line of Michael Lasser from UBS.
Speaker 1
Good morning. Thank you all for taking my questions. Tom, can you expand on your comments about most of the comp increase being driven by a rise in average tickets? Does that suggest that any transaction gains that you're seeing from the commercial business are more than being offset by softness in transactions on the DIY side?
Speaker 0
When we look at our average ticket going up, it's also a mix shift as we have a higher percentage of DIFM business as a mix of the total, and that relates to the CSK conversion stores. When we look at the DIY side of the business, we continue to sell more and more hard parts. To answer your question directly, we were pretty neutral on tickets in total with pressure on the DIY side to a below zero number and above zero number on the DIFM side of the business.
Speaker 1
Is that as things have been as trends have improved a little bit in July because you're facing a more difficult comparison, it sounds like the cadence of the business has gotten a little bit better as the comparisons become more difficult. Is that because the commercial business has gotten better or the DIY business has gotten better with the weather?
Speaker 0
We've seen improvements in the trends on both sides of the business here in July.
Speaker 1
Okay, great. Keep up the good work.
Speaker 0
Thanks, Michael.
Speaker 5
Your next question comes from the line of Steven Paul Forbes from J.P. Morgan.
Speaker 0
Thanks. Good morning, guys.
Speaker 1
Morning.
Speaker 0
Recognizing that you don't disclose the comp delta or the different comp by CSK Auto Corporation versus core O'Reilly Automotive, can you perhaps talk about how the comps have ebbed and flowed over the past year and a half? Did you see a relative acceleration similar in CSK Auto Corporation and O'Reilly Automotive as you went into the back half of last year? As you reached these tougher comparisons, are they both similarly decelerating on the comp side at a similar pace?
Speaker 6
This is Tom. When we look at the, it's kind of a tale of two things. Core O'Reilly ran pretty consistent on do-it-for-me, do-it-yourself last year. On the CSK side, we put a lot of effort into growing the do-it-for-me business, and there was a lot more opportunity, so that comp has run faster. After the stores have been converted longer, they comp better and better. We're kind of at the point where all of them have quite a bit of time that they've been up there from a training perspective, from penetrating the do-it-for-me side of the business, and they're actually, they're definitely leading the comps for the company.
Speaker 0
Okay, is it fair to say then, Core O'Reilly has seen this VxSell, DxSell, but CSK has actually had, has decelerated, it didn't decelerate at the same pace because as it aged, it improved. Is that what you're saying?
Speaker 6
Yeah, our expectation, you know, when we looked at the beginning of the year of 2011 was that, you know, Core O'Reilly was going to have tough comparisons, especially, you know, in the third and fourth quarter. CSK did as well, but our expectation was that we were going to see an acceleration on a two-year stack basis as the stores have been converted longer, as they had better penetration into the DIFM business, as we became more familiar with our business model.
Speaker 0
Okay.
Speaker 6
We continue to expect that.
Speaker 0
I gotcha. You know, granted, I know a comparison went up 300 bps 2Q to 3Q 2010, but was there, I mean, was that more back half weighted to the quarter? Maybe some insight on how the monthlies stacked up in the third quarter of last year?
Speaker 6
Yeah, the third quarter that we're in right now, our performance, what we're comparing to our performance last year was better in the back half of the quarter than it was in the front half of the quarter. You know, all three periods, when we look at it monthly, of course, all three periods were strong periods, but July is our easiest compare.
Speaker 0
One final question, just sneak in here. On the expense side, very impressive in the second quarter in winding down some of those expenses. As you look at the comparisons to the back half, it looks like SG&A per store, you did like a, I have about 1.8% in 2Q 2010, and you go up to a 2.6%-ish. Is it fair to think that since those expenses are winding down, you should see an equivalent, why wouldn't you see an equivalent drop in SG&A per store into the back half?
Speaker 6
Two things. We have a lot of new stores to continue to open. We have a higher store count this year, and new stores obviously are not as efficient. The second item will be, Ted talked about it, you know, staffing is a very delicate item. We need to make sure that, especially, really in all our stores, that we're appropriately staffed for the business and have hours to go out and build the business.
Speaker 3
Yeah, especially at CSK, the low-hanging fruit this year came off pretty quick as our sales did well, and we got all the projects behind us, and we were able to better focus on staffing and using our scheduling program. Today we want to make sure that, to feed the sales, we make sure the CSK stores have the right amount of help. We think we have opportunity there, but not as much as maybe we had this year. We'll want to leverage our payroll with better comps and not try to overcut the payroll before it's time, reduce the payroll.
Speaker 0
Thanks very much.
Speaker 6
Thanks, Chris.
Speaker 5
Your next question comes from the line of Gregory Melich from ISI.
Speaker 1
Morning, Greg. I have a question on the SG&A, the leverage performance, which is impressive. I'm just curious how much of it had to do with the, you mentioned a change in the commission-based compensation plan at CSK, and sort of where are we in that process of getting them more on an O'Reilly Automotive type pay system?
Speaker 0
Yeah, there would have been no, you know, the positive effect I referred to as a result of the commission-based compensation plan is more just getting everyone focused on accomplishing sales goals and measuring productivity, making sure that a parts specialist who's well compensated is generating the amount of sales that would justify that compensation, just having measurements in the store and having some competitiveness in the store to create the environment that we want to create in each store. If there's a positive SG&A effect because of that, it would be a result of just better sales productivity because there would not have been a pure salary or pay decrease as a result of the commission-based compensation plan. It would simply be an incentive that's put in place to reward those that are highly productive and reward those that are not as highly productive less.
Speaker 1
Right. On the gross margin side, you mentioned the LIFO reserve. Is it fair to say given the timing of the promotions and that the LIFO reserve is behind you and easier to compare, that's why we expect gross margin to get better in the back half, or is there something else we should be watching given you're trying to take down inventory, etc., that could hurt the margin?
Speaker 6
When we look at our gross margin from last year, the second quarter was our best gross margin %. If we look at where we are year to date, you know, we're comfortably within our guidance range and very similar to where we were last year at this time.
Speaker 1
That's what you're reflecting in the guidance. What, you know, how do you think this feels like the biggest pain that you'd have from where you sit today?
Speaker 6
I don't know that it's, we talked about in the past that we will continue to have gross margin pressure as we increase the mix of DIFM business, which carries a 4% lower gross margin percentage. We also feel like we have a lot of initiatives out there and opportunities to grow it to offset that pressure. For this quarter, we just happened to get caught in a position where we had a lot of items coming up on ad price pops, prices hit us right before those promotions occurred, and you're, as Greg said, locked in. We don't look at it as a permanent challenge to gross margin, above the normal retail issue of always trying to maintain a good solid gross margin.
Speaker 0
Yeah. Greg, something else I might add is that there are some other things, just mitigating factors with regard to things we can do to grow gross margin as we bring in a higher mix of DIFM business. Some of those things we're in the process of implementing, others we're in the process of exploring. Our company is one that has typically used brokers and distributors here in the U.S. to bring in products from overseas. Over the past year, two years, and more aggressively in the past several months, we've made the decision to pursue some of those products more direct from some of the overseas manufacturers. Those things will create positive effects on our gross margin over time.
There have just been some other things that we can do relative to revenue management on a by-customer basis where we can just apply more science to the way that we manage gross margin by commercial customer and just being more in tune with what our competitors are doing on the retail side and making sure that we do everything we can to optimize our margin on the retail side. We have some factors that should play positive for our gross margin in the quarters to come that have not yet been fully implemented.
Speaker 1
Thanks.
Speaker 0
You bet. Thank you.
Speaker 5
Your next question comes from the line of Matthew Fassler from Goldman Sachs.
Speaker 4
Two questions on the numbers. First, on LIFO, you gave us the LIFO charge. I know it's not always perfectly straightforward how LIFO flows through gross margin. Can you talk about the impact that the LIFO number had on your gross margin rate year on year?
Speaker 6
Based on our LIFO index, the change is between 5% and 10% of the gross change rolls through gross margin as a pressure in this particular case.
Speaker 4
It's a couple of million bucks.
Speaker 6
That's fair to say.
Speaker 4
Okay. Pretty insignificant. Is there kind of a tail to that, or is this all we're going to see in terms of the impact it has on your reported gross?
Speaker 6
That would be the only, because we had price increases in the second quarter, won't impact, and had a LIFO charge in the second quarter, won't impact our third quarter to the extent we don't have additional price increases.
Speaker 4
Got it. Okay, thanks. The second question, just a bit more on payables to inventory. I think on the first quarter call, you indicated that the improvement would be somewhat back-end loaded. It sounds like even with some one-offs and some timing issues, the underlying rate of improvement is pretty good. How should we think about the payables ratio progressing now versus typical seasonality? Do we really give a little more back, or is this a pretty good base to build off of here?
Speaker 6
We've experienced a quicker ramp than we thought because we were able to get vendors to sign up not just for their payables going forward, but for all their payables outstanding, and that's what's jump-started the program and got us results faster. We continue to have tailwind to add more vendors and have those vendors that didn't convert their whole balance to fill up their bucket, so to speak. We also face, at this point in the year, we're at our highest inventory churn, so we have our best AP to inventory ratio from a seasonality standpoint, as you spoke. We have a lot of work to do between now and the end of the year. We'd expect to be somewhere in the range we are now with those two being offsetting forces.
Speaker 4
I ask in part because when you look at the free cash flow guidance relative to the earnings guidance, it seems like you might be implying some give-back of the progress that you made, and that if you were to actually hold current levels towards year-end, the free cash flow could be substantially higher. Is that a fair statement?
Speaker 6
It will depend on a number of factors. Typically, for us, the third quarter is a positive free cash flow quarter, and the fourth quarter is a negative free cash flow quarter based on sales volumes, reductions of AP to inventory ratios that are seasonally driven, and then cash taxes.
Speaker 4
Okay, thank you so much.
Speaker 6
Thanks, man.
Speaker 5
Your next question comes from the line of Colin McGranahan from Bernstein.
Speaker 1
Good morning, guys.
Speaker 6
Good morning.
Speaker 1
First question on expenses. You know, not thinking about leverage, but thinking about actual dollars and looking at it on a per-foot basis, by our math, it fell, SG&A fell like about 0.7% per foot. There was an actual reduction of SG&A dollars on a per-foot basis. How much of that was CSK kind of reduced integration labor and costs? How much of it was productivity, labor productivity specifically in kind of across the store base? Was there anything unusual or that wouldn't be persistent in terms of cost falling, not just leveraging?
Speaker 6
We had a number of conversions in the second quarter of last year with Denver and Salt Lake City converting and had a lot of activity. From a B negative standpoint, I would say that that is what's generating that negative. We also continue to look for ways to reduce our expenses. Looking at the model at CSK Auto Corporation, when we look at the negative, it's mostly coming out of the CSK Auto Corporation because we really feel like in what we've seen historically is we run tight expenses at the Core O'Reilly stores. We've also had a lot of traction with reducing rent in the current environment. Those are kind of the two drivers that allowed us to become negative from a square footage standpoint.
Speaker 1
Tom, no plans to bunk three in a room instead of two?
Speaker 6
Don't give anybody around here any ideas.
Speaker 1
Second quick follow-up, just again by our math, it looks like there was maybe around 2% of benefit or just under that from growth of CSK if we kind of assume some lift over time. Is that reasonable? If so, the core then was kind of running on a 2.5% comp base?
Speaker 6
Those are in general the numbers. The core stores and new stores are a high, two-thirds of the business, so that might be a little bit light.
Speaker 1
Okay, great. Thank you very much.
Speaker 5
Your next question comes from the line of Tony Criscello from DB&C Capital Markets.
Speaker 1
Thank you. Good morning, gentlemen.
Speaker 6
Morning, Tony.
Speaker 1
A question on CSK. I wonder if you could update us sort of on what the mix is today on their DIY versus the commercial, just so we can kind of get an idea of the initiatives, the replenishment, and sort of gauge the success that you've had there growing that commercial side of the business.
Speaker 6
Yeah, they've grown to where they're about a 70-30 mix, right? That would be real close.
Speaker 1
With the demographics and with the locations of the stores, is there still the belief that you can get that number closer to the 50-50? Are there some things you've seen operationally and competitively that may have changed that thought, or are there perhaps the ramp time to get there?
Speaker 6
No, we still think we can get close to that. We continue to believe that there's a portion of the stores. I would say, just to use a round number, somewhere around 100 stores that would be in areas of markets that would not be as conducive to serving the commercial customers what we would ideally like. That will cause the, if we looked at historical CSK Auto Corporation as a whole, that will cause us to probably not get completely to the mix rate that we were at with Core O'Reilly Automotive, but we'll get close. Our target is not necessarily to get to that 50-50 rate, our goal is to have as much penetration both on the DIY side and the DIFM side as we possibly can. In Core O'Reilly Automotive, that has historically led us to about a 50-50 mix.
I would suspect that the CSK Auto Corporation stores over time will get to approximately that mix.
Speaker 1
Okay, it's sort of the replenishment capability now that is really what was needed to start to get you to that next level, or at least.
Speaker 6
Yeah, it's the replenishment capability. It's having the systems, the pricing abilities, the teams in place that can develop the relationships with the shops. It's having all the equipment that the shops need to run their shops and being able to partner with a supplier that can not only supply their parts, but supply the products to keep the shop running. It's having the electronic connections with the shops. It's a long list of things that we now have in place that have those stores in a good position to become more of a dominant supplier on the commercial side of the business.
Speaker 1
Okay, thank you.
Speaker 6
Okay, thanks, Tony.
Speaker 5
Your next question comes from the line of Jack Valo from Focused Research.
Speaker 1
Good morning. You've had very good expense control, you know, with 3.8% more average stores and only being up 4.2% in SG&A. I was wondering if you could tell us what particular productivity enhancements you're implementing and to what degree that can continue longer term, let's say, through 2012. In 2012, what kind of a total sales gain do you need to have continued SG&A leverage?
Speaker 0
Tom and Ted may have something to add to this, but I think the, and this is a very general statement, but I think you'll understand it well, Jack, is that if we look just at the CSK stores because I feel like we've had good productivity controls in Core O'Reilly forever, but at CSK, I don't think they did a very good job without us in managing their productivity by team member. They didn't align the productivity of team members in the stores, for instance, with what that team member was making from a compensation standpoint. Part of our management structure is to make sure that our District Managers and our Regional Managers do that ongoing.
What this does is not necessarily from a pay standpoint, but from a sales productivity standpoint, it creates kind of a competitive environment in the stores so that everyone's seeing how much each team member is selling and those team members want to do better and want to sell more. In addition, we make it, we create an economic incentive for them to want to sell more. We pay them a commission for selling more.
To offset the factor that you can have where we've got to change a planogram or we're changing over a product line and you have team members that might say, I don't want to do that kind of work because I'd rather be selling products to compete better, we have kind of a team commission plan so that the team members that are doing that kind of work also participate in the commission program by being part of a team that's overall more productive. I think that's been the biggest change that we've implemented with CSK that's improved the productivity.
Speaker 3
Yeah, I might add that there were just a lot of CSK stores that were medium volume or maybe even small volume. They had some great volume stores, but when you're more retail, you have to have X number of people to keep the store open seven days a week, you know, the hours, whatever they may be. As we've added the wholesale business, we've been able to add that to the business mix without adding as much salary as maybe we would have if we didn't have that retail base with the X number of people in the store. It's more or less been kind of incremental to the store staffing to a certain degree sometimes, and that's helped us leverage the payroll there.
Speaker 1
Jack, to answer the other part of your question, this is Tom. Obviously, we're growing sales without growing SG&A thus far this year, and it relates to the item that Ted and Greg just talked on of getting team members that are productive and buy into our culture and focused on what we want them to be focused on. The other part is we spent a lot of money on training and conversion projects last year, both at the CSK stores and then when you look at Core O'Reilly, all the store managers that went out and spent a week or two training, and many of them did multiple tours of that. That has helped this year, and that's driving that.
When we look at next year, we would expect to continue to be slightly below our historical leverage point as we continue to have good productivity gains in the acquired stores based on building staff, so understand the compensation structure, are motivated by the compensation structure, actually get paid more, but grow sales faster. You're saying that you expect continued SG&A positive leverage next year compared to this year?
Speaker 6
Somewhat, not to the extent of this year.
Speaker 1
Okay, thank you.
Speaker 6
Thanks, Jack.
Speaker 5
We have reached the time allotted for questioning. Back to you, Greg, for any closing remarks.
Speaker 0
I’d just like to thank everyone for their time this morning. We’ll be working hard in the third quarter to generate solid results, and we’ll look forward to reporting those results to you in October. Thanks.
Speaker 5
This concludes today's conference call. You may now disconnect.