Advance Auto Parts Q2 Earnings Call Transcript

123jump.com Staff
26 Aug, 2010
New York City

The specialty retailer of automotive aftermarket parts reported quarterly sales increased 7.2% to $1.42 billion on comparable store sales gain of 5.8%. Net quarterly income rose 25.6% to $100.91 million. Earnings per share grew to $1.16 versus 83 cents per share in the same quarter last year.

Advance Auto Parts, Inc. ((AAP))
Q2 2010 Earnings Call Transcript
August 12, 2010 10:00 a.m. ET

Executives

Joshua Moore – Director, Finance and IR
Darren Jackson – CEO
Jim Wade – President
Kevin Freeland – COO
Mike Norona – EVP, CFO

Analysts

Dan Wewer – Raymond James
Scot Ciccarelli – RBC Capital Markets
Allen Hatzimanolis – BB&T Capital Markets
Chris Horvers – JPMorgan
Michael Lasser – Barclays Capital
Alan Rifkin – Bank of America
Gregory Melich – ISI
Ryan Brinkman – Goldman Sachs
Mark Mandel – ThinkEquity


Operator

Welcome to the Advance Auto Parts second quarter 2010 conference call. Before we begin, Joshua Moore, Director of Finance and Investor Relations will make a brief statement concerning forward-looking statements that will be made on this call.

Joshua Moore

Good morning and thank you for joining us on today’s call. I would like to remind you that our comments today contain forward-looking statements we intend to be covered by and we claim the protection under the Safe Harbor provision for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995.

Forward-looking statements address future events, developments or results and typically use words such as belief, anticipate, expect, intend, will, plan, forecast, outlook or estimate, and are subject to risks, uncertainties and assumptions that may cause our results to differ materially, including competitive pressures, demand for the company’s products, the economy in general, consumer debt levels, dependence on foreign suppliers, the weather and other factors disclosed in the company’s 10-K for fiscal year ended January 2, 2010 on file with the Securities and Exchange Commission.

The company intends these forward-looking statements to speak only at the time of this conference call and does not undertake to update or revise them as more information becomes available. The reconciliation of any non-GAAP financial measures mentioned on the call with the corresponding GAAP measures are described in our earnings release and our SEC filings, which can be found on our website at advanceautoparts.com.

For planning purposes, our third quarter earnings release is scheduled for Wednesday, November 10, 2010, after market close, and our quarterly conference call is scheduled for the morning of Thursday, November 11, 2010. To be notified of 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 CEO. Darren?

Darren Jackson

Thanks, Joshua. Good morning, everyone. Welcome to our second quarter conference call. First, I would like to thank our 51,000 team members for delivering a record performance in our second quarter 2010. The team continues to position us for another great year with strong top line and bottom line results through their focus on execution and an unwavering commitment to serving our customers.

We remain confident in our team members and our strategies as they fueled the 6.9% increase in our year-to-date comp store sales. Our team continues to drive the resurgence of our DIY business, while extending the string of double digit comp store sales gain in our commercial business. The favorable market conditions and successful execution of our key initiatives drove a 7.2% increase in total sales and a record store sales productivity that reached $1.64 million per store on a trailing four quarter basis.

Our availability excellence teams continue to shine by expanding our gross profit rate by over 100 basis points resulting in double digit operating income growth during the quarter. The 12% operating margins are a glimpse in the potential of our overall business. I am encouraged by our continued improvements in our overall customer satisfaction scores achieved while delivering a record 16.5% return on invested capital.

Collectively the strategic and financial progress is evident in our customer experience and our bottom line results. Similar to the first quarter, we outperformed both our financial and strategic objectives during the second quarter 2010. We are pleased with the continued progress of the initiatives that we had previously shared with you. Jim, Kevin, and Mike will provide updates on some of these initiatives later in the call.

Our team is the most important factor to Advance’s success. Our highly engaged team members have a passion for serving our customers, and are committed to serving our customers better than anyone else. We continue to assess the engagement of our team through our team’s calibration survey, and I am encouraged that those scores continue to increase across the company.

Clearly, we are moving in the right direction. The economic landscape and our industry vital signs, such as more stable gas prices and miles driven along with the increase in average age of vehicles continue to be favorable and have fueled our market over the first half of the year. These dynamics combined with our continued focus on select initiatives are helping us deliver strong results. Yet we are also aware that we will compete with back-to-school and the holiday shopping season for top spot on our customers’ priority list in the back half of the year.

Overall, we are encouraged by a good start to the third quarter and are upbeat as we look to the second half of 2010. Our focus in the second half will remain on key initiatives including demand-driven labor, the roll out of our B2B website, our commercial customer growth and retention programs, our B2C website and global sourcing. These initiatives continue to make a difference with our customers and to our bottom line. Our confidence is tempered by the fact that our business has benefited from extremely favorable weather conditions, in the first half of 2010.

However, weather tends to even out over the course of the year. Additionally, consumer priorities will have an understandable impact, principally in Q4, due to the holiday shopping season. I would like to take a moment to recognize some members of our team who are driving great outcomes.

Through the second quarter our biggest improvement has come from our 42% increase in free cash flow which rose to $407.6 million, a record cash flow along with work, on our owned inventory management are examples how leaders are working hard to transform our business.

Leaders such as Kevin Quinn, our Vice President of Treasury, Jamie Akemann, our Vice President of Merchandise, Jim North, our Vice President of Inventory Management and key members like Navdeep Gupta, John Lammers, and Jim Fannin worked diligently to make these pools become a reality. The work of this cross functional team affected all areas of the business and we will see benefits of this work for a very long time to come. This type of work is a testament of the success of Advance’s transformation, and it wouldn’t be possible without the commitment of these talented and dedicated team members. We remain committed to maintaining our investment grading metrics and we would like to congratulate this dedicated group on the work that they are continuing to do to make this happen.

Now, I would like to turn the call over to Jim Wade, our President to provide a progress update on our commercial acceleration in DIY Transformation strategies.

Jim Wade

Thank you, Darren and good morning. I want to add my congratulations and thanks to our store teams, our sales force and our source support teams for another strong quarter. Our team continues to serve our customers through our company values and we thank our customers are entrusting us with their vehicles needs. This quarter was a continuation of the plans we have laid out before in the past few quarters. Our team continues to execute our plan very successfully.

In addition, as Darren mentioned our industry fundamentals remain strong. These fundamentals are positive through our business and we believe they will remain positive in the future. This includes the increase in average age of vehicles, more vehicles entering our industry sweet spot, dealer closings and more consumers who need to repair their own vehicles. Our total comp store sales grew by 5.8% in the second quarter compared to 4.8% during the same quarter last year.

Again, this quarter we achieved an increase in both the number of customer transactions as well the average size of each of those transactions. Each of our geographic area has produced positive comps in DIY and double-digits comps in Commercial. This marks our tenth consecutive quarter of double-digit commercial comps in our Advance Auto Parts stores. Commercial now represents 34% of our total sales.

Also we saw a solid growth in our DIY business and achieved our fifth quarter of positive DIY comps in the last six quarters. We continue to gain market share during the quarter. We are continuing to focus on the initiatives that we previously described for both Commercial and DIY. Our pace of new initiatives is slowing and we are focused on fully implementing and executing the initiatives that we have rolled out.

This focus is enabling more consistent sales growth while slowing our level of investment. Our team is focused on leading through our values and they are measuring their success with clear goals and we are proud of their progress. In terms of initiatives, we remain on schedule with those things that allow us to serve our customers best. This focus has produced our strong sales results and the high sales per store in our industry.

We have completed commercial investments in half of our stores with commercial programs. Those investments are continuing to fuel our commercial growth in 2010, as we look towards extending these investments to the entire chain over the next couple of years. At the same time, we are using what we have learned from those stores and are already applying much of it across our entire chain. Our investments in parts availability continue to benefit both our DIY and Commercial business, as we are getting better every quarter and having the parts to our customers need when they need them.

We continue to use our commercial customer data as a base from which to develop stronger and deeper relationships with our best customers with a high potential for growth. This will be an ongoing focus and will be a key to our growth in customer retention, as well as continuing to increase the productivity of our investments in the Commercial business.

To ensure our Commercial DIY customers have team members available when needed, we have implemented the first two phases of our customer driven staffing model. We will continue to increase our staffing effectiveness as we build on this model.

To ensure our store teams have the knowledge and skills needed to help solve our customer’s problems, we have increased the quality and effectiveness of our training and development programs for our team members. This includes our on-boarding programs for new hires, product knowledge and related problem solving skills and customer grading and sales training for all the team members.

In the past year, Kevin’s team has launched new capabilities in e-commerce that are also benefiting our sales growth. In DIY, e-commerce is increasing our sales and providing our customers the tools to do research, before coming to the store. Our commercial customers are rapidly signing up to use B2B as a tool to facilitate their ordering process. Kevin will update you further on these initiatives.

We continue to refine our marketing approach to better target both our highest potential customers and our underserved customer segments. This new more targeted approach has allowed us to more than double our marketing effectiveness while keeping our overall marketing spend roughly in line with last year. We are very pleased with the returns and the progress of our marketing initiatives.

In addition to sales growth we are pleased that our customer satisfaction scores have continued to improve in 2010. We are focusing on those stores where our customers have given us our lowest customer satisfaction ratings. As we build a stronger Advance Auto Parts brand, every store must provide exceptional service consistently. With these initiatives, the positive industry fundamentals and the positive feedback from our customers we are excited about our ability to achieve double-digit growth in our Commercial business and grow our DIY business as we look forward.

Lastly, we are also reaching new customers in growing our sales through successful new store openings. During the second quarter, we opened 36 stores, including 14 Autopart International stores, while closing one store. As of the end of the second quarter our total store count was 3,497 including 181 Autopart International stores.

Additionally, in the first week of the third quarter we opened our 3,500 stores in Westerly, Rhode Island marking another significant milestone in our growth stores. In closing, thanks again to our team for another successful quarter, and for achieving those results through commitments to leading inspired teams and providing great customer service.

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

Kevin Freeland

Thanks, Jim and good morning. I would also like to congratulate the team for a strong second quarter. I will take a moment to highlight a few of our accomplishments during this quarter as well as update you on our initiatives to strengthen our gross profit rate and improve product availability.

During the second quarter, our gross profit rate increased 111 basis points versus the same quarter last year. The second quarter improvement was driven by increases both in front room and back room categories resulting from the roll out of our custom mix and price optimization strategies, the strengthening of our merchandising capabilities and the impact of our rapidly growing global sourcing capabilities. We will continue to be pleased with the strides that we have made in improving our gross profit rate which has increased over 300 basis points on a two-year basis.

Through our custom mix roll out we completed approximately 180 inventory upgrades during the quarter. This strategy allows us to improve our end market availability of parts and accessories and drives improvement both in sales lift and margin performance. As a result of our improved availability, the sales of hard parts continued to outpace that of our company average and is increasing as a percent of total revenue versus the second quarter of last year. This increase in sales mix for hard parts and improvement in category margin rates were strong contributors to 111 basis point expansion and total gross profit rate.

Additionally, we continue to grow sales and expand our margins and accessories which have benefited greatly from our new global sourcing capability. In total, global sourcing had a positive impact on gross margin in the second quarter, and we expect the global sourcing benefits will grow over time to become a material driver of our gross margin performance in 2011 and beyond.

Our adjusted accounts payable to inventory ratio at 72.1% is at an all time high and compares to 58.4% at the end of second quarter last year. This significant achievement was primarily driven by more favorable payment terms and the timing of inventory purchases.

We are on pace to achieve our long-term goal, and expect to see continued year-over-year improvement in 2010. The combination of substantially higher margins and significantly lower owned inventory gave us the opportunity to increase sales through improved inventory availability. While owned inventory declined, total inventory rose in the quarter. This resulted in an all time high and our customer perception of product availability.

In the second quarter, we continued to make significant progress in increasing our availability through the addition of seven hub stores. Our delivery hub network is at 172, providing multiple deliveries a day to 1,000 stores, in addition to over 29 PDQs. We have driven double-digit productivity improvements year-to-date from our engineered standards in the distribution center on top of a double digit improvement last year. We are integrating our Southeastern AI supply chain into our Lakeland distribution center, and fully intend to use this as a springboard to supply chain integration nationwide.

We continue to be pleased with our progress for our DIY e-commerce business and continual increases in all key metrics; traffic, conversion rates, sales. As stated last quarter, the DIY e-commerce business is materially contributing to the fiscal year 2010 performance.

We were very pleased with the launch of our expanded MyGarage during the DIY site during the quarter. This new feature site aims to help customers maintain vehicle information in one place. Consumers can register one or more vehicles and keep track of service work, receive recall notices and email works when the car needs tune-ups, brakes, tire rotation, tire replacement. These spring enhancements are giving our customers even more reasons to shop online with Advance Auto Parts and to visit us more often.

On the last call, we discussed the launch of our B2B e-commerce capability in December. Based on a successful pilot program, we have moved to full scale roll out of the B2B e-commerce and currently have over 850 stores and thousands of customers using this system successfully. The system has been well received by our customers and we see a lift in sales with customers who are on the system. The store and customer count is growing weekly as we roll out nationally.

In the second quarter, AI’s revenue grew 14.8% driven by the net addition of 39 new stores over the past 12 months and a positive comp sales performance. AI opened 14 new stores in the quarter bringing their total store count to 181. Overall, the second quarter was very successful for our team and I am thrilled by the strategic and financial progress we have made to our availability, excellent strategy.

Now, let me turn the call over to our Chief Financial Officer, Mike Norona to review our financial results.

Mike Norona

Thanks, Kevin, and good morning everyone. I would like to start by thanking all of our talented and dedicated team members for the strategic progress and fantastic financial results we delivered during the second quarter. I plan to cover the following topics with you this morning.

One, provide some financial highlights of our 2010 second quarter performance. Two, provide an update on the key financial dimensions of our transformation, and three, link our second quarter performance to the balance of 2010.

As you may recall our fiscal 2009 results included the impact of the store divestitures which decreased diluted EPS by $0.06 during the second quarter last year. But We will speak about year-over-year results versus 2009 on a comparable operating basis, excluding the impact of the 2009 store divestitures as that provides a more transparent and relevant comparison. We have provided GAAP financial results, as well as comparable operating results in our earnings release.

Overall, we are pleased with our strong second quarter performance, which builds on the momentum from our first quarter. Our second quarter earnings per diluted share of $1.16 were $0.27 favorable to last year, representing a 30% increase in EPS, excluding the $0.06 impact of store divestitures. This was on top of last year’s 14% EPS increase. On a GAAP basis EPS increased 40% or $0.33 over 2009 second quarter results.

Some highlights for the second quarter include a 5.8% comp store sales increase fueled by again DIY performance and our 10th consecutive quarter of double-digit gains in Commercial. This was on top of a 4.8% comp during the same period last year representing a 10.6% two year comp store sales increase. During the second quarter, our gross profit rate increased 111 basis points versus last year primarily driven by improved merchandising and pricing capabilities, increased inventory levels, and results in supply chain efficiencies and improved parts availability. The 111 basis point increase was on top of 180 basis point gross profit rate improvement during the second quarter of 2009.

Our SG&A rate during the quarter decreased 10 basis points excluding the impact of store divestitures last year which exceeded our expectations. The 10 basis point decrease was driven by strong comparable store sales which resulted in leverage of occupancy costs and a decelerated pace of incremental spending on the company’s strategic capabilities.

We are pleased with the progress we have made to balance growth, while positioning the company to leverage expenses at lower comp sales levels. After adjustment for higher variable expenses as a result of the better than expected comp store sales growth and the favorable timing of SG&A spend during the quarter, our SG&A dollar growth continues to be in line with our expectations and our previously shared annual outlook.

Free cash flow through the second quarter was $407.6 million representing a 42% increase over the same period last year, primarily driven by our strong operating performance and reduction in our owned inventory. Our accounts payable inventory ratio increased to a record 72.1% from 58.4% last year as a result of our continued focus, efforts to reduce our owned inventory.

Our rent adjusted leverage ratio at the end of the second quarter was 2.2 times which is in line with our internal target and consistent with our financial policy. Our return on invested capital was 16.5% representing 160 basis points increase versus last year. Our performance through our second quarter as well as our performance over the past two and a half years reinforced our commitment to accelerate growth and prove profitability and drive shareholder value. We will continue to measure our performance based on these three dimensions and our progress thus far shows, we are on the right path.

Turning to growth, we continue to make strides in increasing our productivity. This is reflected on our 4% growth in our industry-leading sales per store now at $1.64 million and a 4% increase in sales per square foot on a trailing four-quarter basis through our second quarter. Our ability to grow our profitability is marked by continued gross profit expansion and an increase in operating income rate which grew 111 basis points and 121 basis points respectively during the quarter.

Our gross profit rate expanded 300 basis points on a two-year basis and significantly contributed to our second quarter operating margin rate of 12.1%. Our strategic choices along with our execution and favorable industry dynamics fueled our growth and profitability in our second quarter and we continue to expect operating income expansion through improvements in our gross profit rate and more moderate SG&A dollar growth.

As we look at our ability to create value, we are pleased with our year-to-date free cash flow and the improvements in our balance sheet primarily due to a reduction in our owned inventory of $126.2 million. Additionally, our disciplined approach to capital management is generating strong incremental returns on our investments as reflected in our 160 basis point improvement in our ROIC versus last year. Over the past two years, we have been focused on building an integrated service model and investing in our capabilities and team members in order to fuel our growth and generate both strong operating performance and strong financial returns. Our progress on these dimensions was recognized in April when S&P upgraded our credit rating to investment grade status.

We recently moved another step closer to achieving full investment grade status as Moody’s formally announced they are reviewing us for upgrade. This announcement by Moody’s is a direct result of the positive impact our team members are making on growing our business, and I want to personally thank all of our team members for moving us much closer to a historic milestone for our company. In fact, it is the confidence in our team members and their ability to drive continued growth, along with our strong free cash flow that led us to repurchase approximately 3.4 million shares of stock in our second quarter or 4% of our shares outstanding for $167.8 million at an average share price of $49.83.

Through second quarter, we have repurchased approximately 10.3 million shares at an average share price of $44.31. We were very aggressive in buying back our stock as a result of our relatively low valuation and our internal confidence in our company’s ability to grow profitably and to create long-term shareholder value. As we have stated in our press release, the company’s Board of Directors authorized a new $300 million share repurchase program. The new authorization replaces the previous $500 million share repurchase program that was authorized in February 2010, which had approximately $45 million remaining. We remain committed to managing our rent adjusted debt to EBITDA leverage ratio to a maximum 2.5 times using six times capitalized rent.

Next, I would like to link our second quarter performance to what we see for the balance of the year. We continue to be on track to open approximately 115 new Advance and Autopart International stores and remain committed to our previously communicated investment profile. We are very pleased with our first half performance and have momentum going into the back half of fiscal 2010; given our industry dynamics, previous investments and confidence in our team’s execution.

That said, we do not expect the same level of over performance that we delivered in the first half given the seasonality of our businesses clearly more heavily weighted towards the first half and the reality is our back half volume is historically more challenging and volatile as consumer makes trade-offs with respect to back-to-school and holiday shopping season. We also estimate our SG&A will run slightly higher then we planned in the back half due to spending which was anticipated to occur in our second quarter and due to expenses driven by our higher than anticipated first half performance.

As we have shared previously our practice is not to update our annual outlook unless there is a material factor or factors impacting that annual outlook. As a result of our first half performance which exceeded our internal expectations combined with our significant share repurchase activity which was not included in our original annual EPS outlook, we believe it is prudent to reflect these material changes and update out previously communicated annual EPS outlook. We now estimate our fiscal 2010 annual EPS outlook to be in the range of $3.70 to $3.80 per share.

In closing, we are pleased with our strong second quarter financial performance that was driven by our previous strategic investments, fantastic team member execution and positive industry dynamics. These factors contributed to our delivering strong top line and bottom line growth, along with record cash flow and returns as measured by return on invested capital.

Our share repurchases through the second quarter reflect our confidence in our company’s ability to drive further value and we remain committed to driving growth, profitability and continued shareholder returns through investing in our team members and inspiring them to serve our customers better than anyone else. Again, I would like to thank all of our talented team members for their meaningful contributions which drove our second quarter performance and who continue to help our company reach new heights.

Operator, we are now ready for questions

Question-and-Answer Session

Operator

Thank you. We will now begin the question-and-answer session. If you would like to ask a question please press star, one. Please unmute your phone and record your name clearly. To withdraw your request, press star, two. Again press star, one, to ask a question. And one moment for our first question. And our first question comes from Dan Wewer with Raymond James. You may ask your question. One moment please. Go ahead with your question, sir.

Dan Wewer – Raymond James

Thank you. Good morning. Mike, in listing the reasons behind the significant gross margin improvement, I believe the second item was increased inventories and supply chain efficiencies. I wondered if you could discuss that a bit more, I wasn’t sure that this was alluding to maybe better financing terms from your vendors on the additional inventory up here just the capitalization of the distribution cost over your inventory levels. But if you could just could walk through that a bit more?

Mike Norona

Yeah, Dan, I will let Kevin to take that question.

Kevin Freeland

Essentially, if you go back to first quarter we had a wonderful quarter, end of the quarter leaner in inventories than we would have wanted. The team and the impact at that point is our product availability and in-stocks were not exactly where we had wanted them to be. So, the team’s essentially moved throughout the quarter and not only corrected that, but as you take a look at the way that we manage inventory we are proud to have the best inventory turn of our main competitors and the things that you would look at would be what kind of margin rates do you earn, how much of the inventory do you own, what kind of a list do you get from increases of inventory, what is the risk of obsolescence and essentially over the last several years all of those metrics have gotten materially better. So in addition to getting back into stock, we have added a layer of incremental inventory to go for a higher than previously achieved availability which our customers are reporting back to us that they have noticed and believe that that is a part of the success that we had in sales for the quarter. In terms of the supply chain, as we have previously announced that we have a program in the main distribution centers to enhance the productivity that created a double-digit improvement in productivity in the quarter on top of a comparable lift last year because of the lion’s share of our supply chain costs being classed into gross margins, those efficiency show up in the gross margin line.

Dan Wewer – Raymond James

Okay, and as a follow-up on the discussion on SG&A. You noted that the deceleration in SG&A growth will not be quite a significant as first anticipated due to some shifting in dollars from 2Q. Could you discuss the magnitude of those dollars and what SG&A items are related to?

Darren Jackson

Sure. So let me give you a little context. At the beginning of the year, we came in and said that SG&A dollar growth this year would decelerate and that actually has happened. You saw that happen in Q2 where our dollars grew about 6.9% I think in comparison about 10.6% last year. We are pleased that we leveraged SG&A in the second quarter. For the year, what we have said is our SG&A dollar growth will decelerate and we still anticipate that, the numbers that I have given out there is our SG&A dollar growth. This year per store would be in the high-end of mid single-digit, so we still think that’s the case. What happens is sometimes you ask me things that happens, some timing issues. We have a little bit of timing that happens that moves out of Q2 into Q3, it’s not significant. The other aspect that we have in the back half of the year is things like our long-term incentive program. We have to do accruals for that. Those are over three-year periods, but that is a result of our higher performance. Our LTI programs are tied to growth in EVA. Our EVA as a company is growing because of our operating performance and our strong balance sheet performance. So its costs like that, I want to be really clear though, we have not changed our investment profile. Our investment profile is exactly what we said at the beginning of the year. I think, last year we spent about 50% of our dollar growth was in investments, this year it’s about 20% to 25%, and we are right on path to that.

Jim Wade

Yes, so accounting timing.

Dan Wewer – Raymond James

Okay, great. Thank you.

Operator

Thank you. Our next question comes from Scot Ciccarelli with RBC Capital Markets. You may ask your question.

Scot Ciccarelli – RBC Capital Markets

Thanks. Hi, guys.

Darren Jackson

Hi, Scot.

Scot Ciccarelli – RBC Capital Markets

Thank you. You made several references to I guess what I would call seasonality, back-to-school, holiday season. Times, I think you guys are suggesting that the seasonal volatility that you are seeing or at least expecting is even greater than what we have seen in the past. In other words, seasonality is typically captured in a comp figure over time, but sounds like you are expecting a bit of that change on that front. Is that the right interpretation?

Darren Jackson

Yes, Scot, I would say that is the right interpretation, because there has been a – and it’s principally Q4. I would say last year and we said this publicly in Q4, we did a two comp and we were surprised that underachieved our expectations, I think underachieved the market. But I think when everybody reported, the comps across the industry were lower and then when we appear back into it we really didn’t see a Christmas shopping season, where it appears the behavior is all about prioritization in small periods of time and we are making an assessment that that behavior is sinking in. If you actually go back almost three years ago now we saw a trend just after thanksgiving where we running 2% DIY comps that literally after Thanksgiving went almost to minus six and they stayed that way all the way through the shopping period. When you kind of step back and look at the overall macro trends, you have to say, you know, the consumer is really picking their spots and they are shopping based on this level of prioritization of their pocket book and you know what? Maybe we are being a little conservative or maybe what we are doing is actually coming to grips with this shift in the prioritization of spending, and I think we talked about that in the first quarter where we were the beneficiary of it certainly in the first quarter and, what, as it’s gone into the first half now.

Scot Ciccarelli – RBC Capital Markets

All right. That’s very helpful. Thanks, guys.

Operator

Thanks. Your next question comes from Tony Cristello with BB&T Capital Markets. You may ask your question.

Allen Hatzimanolis – BB&T Capital Markets

Good morning, gentlemen. This is actually Allen Hatzimanolis in for Tony. My first question relate to improving parts availability. This has been a key driver to your comp growth in Commercial. At $520,000 in inventory for store in Q2, it looks like you are investing is continuing. I guess my question is, one, do you see the levels moving higher from here and two, can we expect this approach to further lift Commercial gross margins as you are able to compete more on availability and less so on price?

Kevin Freeland

Hi Allen, this is Kevin. What we are doing is as I mentioned in the previous questions are the returns that we are getting on inventory are improving. The amount that we own is declining. The lift that we are seeing through the custom mix tool and its ability to discern what to put into the store is improving. We have identified inventory in the stores essentially belongs someplace else, and have an aggressive program of pulling those products out of the stores and getting them into the right markets. So, for a whole host of reasons we are improving our availability. On the commercial side, the customer perception of our availability has gone up dramatically in the last year and a half, and I believe that that will continue as we go forward. An awful lot of that story for the last couple of years has been trading inventory for information. So, without raising inventory levels we are raising availability by making it more accurate. What you saw on the quarter is we are also increasing the total quantity as well, and as we move forward, we will continue to evaluate all those factors figuring out what is the best investment of inventory for the company.

Allen Hatzimanolis – BB&T Capital Markets

Okay, and then as a follow-up. What is the seasonally stronger sales quarter, it looks as if total headcount per store ticked down slightly. Is there just an element of timing to this or just more function of the roll out of the demand driven staffing model? And if so, exactly where are you in that process and the part to improve customer service levels, are there further net cost savings to be realized?

Darren Jackson

Allen, this is Darren. So, yeah, a little bit of it is…we have been going out a journey that we call it demand-driven labor, our internal language is customer-driven labor. Over the course of the first half for the year which you have seen is that the first step of that clearly is kicking in and think about we are able to better put team members part-time, full time, in the hours of the day that the customer is showing up. And there is no doubt that we are seeing that show up in terms of our service levels in stores and we are able to see the benefit in our sales per labor hour. I would say we are into the next phase of that now. We think about tailoring down to a store level based on the type of transactions distance to commercial customers in an activity based way. We are able to make that next at it in terms of labor at a store level. I would say our goal is to get the right amount of labor to the right store in the right time. We are not sitting there in this moment thinking about, boy, that is the best way to take cost out of the system. But it is the best way, candidly, to increase service levels, and move labor around and added it out to places where the return isn’t where it needs to be.

Allen Hatzimanolis – BB&T Capital Markets

Okay. That was very helpful. Thank you.

Darren Jackson

Yes.

Operator

Thank you. Your next question comes from Chris Horvers with JPMorgan. You may ask your question.

Chris Horvers – JPMorgan

Thanks and good morning.

Darren Jackson

Hi, Chris.

Chris Horvers – JPMorgan

How is it going?

Darren Jackson

Good.

Chris Horvers – JPMorgan

On the gross margin side, earlier this year you talked about the pace of expansion actually slowing down and it accelerated impressively in the second quarter. So, maybe Kevin, could you speak to what exactly drove that? Why do you think it accelerated, and then with Mike speak to, and how sustainable should we think about that over the back half of this year and into 2011?

Kevin Freeland

Yeah Chris, as we have reported in the past, the way that we are raising the company’s gross margin is on a host of fronts. So, the fact that the part business is growing, disproportionately is positive. We have gone into global sourcing and the cost of acquisition of goods is declining. We have developed a relatively sophisticated approach to the category management and how we drive category growth and relate to the structure of negotiations with our vendors. We through the custom mix program have substantially reduced the amount of our inventory that is unproductive which historically had, for obvious reasons, lower gross margins. That all said, this is an imprecise set of activities, it’s a very broad based, the teams are working aggressively to strike deals to push this forward, and we were pleased in the quarter, much like we are pleased with our earnings in the quarter. I would say that beyond a shadow of doubt those efforts and energies will continue. But I would not expect that it would be reasonable the level we saw on the quarter is a sustainable number for the long term.

Mike Norona

Yeah, and Chris, it is Mike. We don’t breakout the individual components, I think Kevin has been very clear on where he sees the opportunities to continue to grow gross margin not in the quarters but as we look out, and that is what I would tell you. We have incorporated what we anticipate for gross margin improvements into our annual outlook. So, that is factored in.

Kevin Freeland

Right, and there is a little bit of mix benefit, right. We are thrilled we are still growing double-digit comps in commercial. The resurgence of DIY, when DIY is resurging that is going to help the mix in terms of our overall margin rates as well, Chris. So, it’s a list of host of things.

Chris Horvers – JPMorgan

So, it sounds like if I were try to summarize that. It sounds like DIY helped on the mix side and then that’s part of the upside surprise, and then the clearing of unproductive inventory those two factors helped faster deep commercial growth.

Kevin Freeland

Yeah, in the hard part mix too, that continues to be just the lead business for us in terms of it is taken years to get back into that business. It is showing up in our inventory investment and showing up both in reporting our DIY resurgence, as well as our Commercial business.

Chris Horvers – JPMorgan

So that part, little confusing because I thought historically people would say that Commercial side of the house is 300 basis points smaller margin rates. So how is the hard parts helping there?

Darren Jackson

The hard parts business is actually a sizeable DIY business and over half of that business is on the DIY side and yes, the margins are higher on the retail side than they are on the Commercial side. But again, as we do not break out the individual components it’s difficult to get into solid details. But as an example, as we went through last year the larger single category which we have reported was price optimization and it was price optimization exclusively on the DIY side. As we go into the fall of this year for the first time we are rolling out price optimization on the Commercial side, which is not in our historical numbers. So, I think what we can guide you to is that margin rates and the activities that would enhance margins are well underway and are continued to be likely to contribute to the gross margin gains in the future. Just 301 basis point improvement in the last two years is not likely to be a reasonable number for the next two years.

Chris Horvers – JPMorgan

I got, and then one quick follow-up. Mike, can you talk about, you are talking 20% to 25% of the SG&A growth this year, is that investment dollars? Can you talk about what that was in the first half of this year?

Mike Norona

Yeah, primarily in continuing to expand our commercial waves, continuing to invest in capabilities like DotCom and Global Sourcing.

Chris Horvers – JPMorgan

No, I mean in terms of the percentage, how much?

Mike Norona

Yeah, in the first half it was about 20% to 25%. I think that is what I have said.

Chris Horvers – JPMorgan

I thought you said that was for the year.

Mike Norona

Yes, and that is the first half as well.

Chris Horvers – JPMorgan

Okay. Thanks very much.

Operator

Thank you. Your next question comes from Michael Lasser with Barclays Capital. You may ask your question.

Michael Lasser – Barclays Capital

Good morning. Thanks a lot for taking my question. Can you talk about the trend in customer churn over the last few months and how it compared to the last three quarters and did it have an impact on sales during the second quarter?

Darren Jackson

That is an interesting question. So, Michael here is what I would say is that when we look at our DIY business, we wish we could get to that level of detail in terms of we don’t have a loyalty card today and different things that some of the tools that would allow us to see that on DIY. What we are paying attention to is that clearly the growth continues to come out of transactions or traffic is up and customer average is up as well. On the Commercial side, what we can see is that we have literally as we entered this year one of the things I talked about is how we think about commercial customer retention and growth. We literally this quarter began that process with our organization and language we use is our focus customers. I would say the information isn’t stable enough to say whether it is good or whether it is bad in terms of overall trend at this point. What I am excited about is that we are able to now narrow down from a here are our best customers and how are they behaving from a product point of view, how are they behaving in terms of the sales pattern point of view. I think it would be more appropriate as we are having this call a year from now and the information is stable, better stabilized across 2,800 programs that we would be able to talk more thoughtfully about that.

Michael Lasser – Barclays Capital

Okay, and on the Commercial side, I know in the past you said that there is a concentration where the top 10% of your customers do a disproportionate amount of business. So, can you talk about the relative performance of those customers versus the relative performance of the remaining customer group during the second quarter?

Jim Wade

This is Jim. A similar answer I think to what Darren just described. We do have a significant percentage of our volume coming from a relatively small number of our customers, which I don’t think is unusual and we are focusing on tracking those. We are pleased with what we achieved in the second quarter returns are overall confident and it occurred from both that group of customers, as well as the broader group, but the real health of the business as Darren described is continuing to learn more of that those customers and ensure that we in fact are retaining and growing them. I think we are on a good road to be able to do that and to talk more about more specifically as we go forward.

Michael Lasser – Barclays Capital

Sounds great. Best of luck.

Darren Jackson

Thank you.

Operator

Thank you. Your next question comes from Alan Rifkin with Bank of America. You may ask your question.

Alan Rifkin – Bank of America

Yeah, thank you very much. A question on the Commercial side, maybe for Jim. Jim, the double-digit comps that you have now seen the (inaudible) running it certainly quite admirable. But would you be able to provide some color on where that growth is from? Is it new account growth or is it more a function of increasing penetration of the accounts that are already signed up?

Jim Wade

Alan, this is primarily continuing the growth of the business on accounts that we have and again just to elaborate a little bit on that, we do business with a lot of customers. So, when we are in any given market, we are touching a lot of garages and that varies from having a substantial part of their business to doing a very small part of their business. So, the growth is coming from, primarily from growing the business with existing customers, where our focus is continuing to narrow that to a point where we are able to clearly retain and grow with our best customers that have the highest potential.

Alan Rifkin – Bank of America

And as follow-up, Jim. I seem to recall that last year you undertook a program that significantly increased the number of sales people on the commercial side. Would you be able to just give an update on the productivity levels of those people and it’s just a program that you are happy with? Where do we see the program going, going forward?

Jim Wade

Sure. What we have shared with you over the last couple of quarters is that, through last year we would increased our sales force I think by about 45% in total, and so, as we finished the end of last year what we had talked about was, we felt like at that point we were at a place in terms of our coverage that enabled us to continue to grow the commercial business the way that we are growing it. We were able to narrow the spend significantly and really start to focus our team on the customers that were most important who gave our team, our sales force a tremendous number of additional tools to use to do that with. So this year we are maintaining basically where we were last year. As a result of that, obviously, as the sales are growing the productivity of that team is increasing significantly.

Alan Rifkin – Bank of America

One last question maybe for Mike. Where the hard parts have been right now as a percent of your revenues versus?

Mike Norona

We don’t typically break that out. It’s an important part of our business, I think Kevin has been really clear and it’s a majority part of our mix but we don’t break it out.

Alan Rifkin – Bank of America

Okay. Thank you very much.

Darren Jackson

Yes. Thanks, Alan.

Operator

Thank you. Your next question comes from Gregory Melich with ISI. You may ask your question.

Gregory Melich – ISI

Hi. Hi, how are you guys? I bound to make that mistake in one of these calls. I am glad you got, first of all congrats on a great first half.

Darren Jackson

Thank you.

Gregory Melich – ISI

What a difference six months make. So two questions, one is, Kevin, could you help us understand little bit more of this inventory and payable dynamic, and how much of it was driven by the growth of global sourcing I mean sometimes you start buying products in Asia and you start taking ownership early or you might be able to extend the payables. And of that 40% payables growth, how much might just be it in timing within the quarter as opposed to a more structural shift, then I have a follow-up on commercial?

Kevin Freeland

First of all, the global sourcing program has had a pronounced impact on our gross margin it is not a large program today, and it will grow substantially over the next several years. The programs that we have would actually have that share of our product not materially different in terms of the payable structure of the rest of the business. So, combination of its small size and similarity to the whole, that is not what is driving it. And if you take the two main drivers which is timing of inventory and just the kind of underlying fundamentals the lion’s share of it is the fundamentals themselves, and it’s just the structural change in a way that we are setting up the relationship with our vendors, and it’s a series of efforts that have go on for years. To be honest, we were somewhat constrained in the past just with rest of the world in the banking industry and the things that have happened globally a year or two ago, I would say that the program is in place, partnership with the finance teams has been magnificent and Charles and his team are hearing all over the program that I think will play out over the next several years.

Gregory Melich – ISI

Mike, has the upgrade from the rating agencies been a capital share?

Mike Norona

Yes, it has. It actually helps us in two respects. It helps with our increase in our capacity, and second it helps with our pricing. So it has.

Gregory Melich – ISI

And then on the commercial side, I think I caught in the commentary that the commercial B2B is at 850 stores and 2,100 accounts is that right?

Kevin Freeland

Essentially, I think you are directionally correct. Where we are at right now is this is the program that is being rolled out nationally. So, literally that number is changing each and every day. And what would be a true statement is, it will have been rolled to all of our stores by the end of fourth quarter.

Gregory Melich – ISI

Can you give us any more insight as to what behavior you are seeing out of the people the accounts that do sign up for? Is it you just get a much bigger basket, you become their first or second call as opposed to third or fourth is there any other insights on those early adopters?

Kevin Freeland

What we have right now is first of the total number of customers that we deal with is substantial, and not all of them are internet savvy. So we have identified a prospect list and we are today staying within our existing customer base as we are rolling this program out, and it is generally a behavior that we see is these are customers that are substantial customer of ours, but quite frankly have been requesting the ability to order with us online for a while, and as they move to this program as a whole as a group, they are up noticeably above the comps that we are reporting externally and it’s in essence we are allowing them to order from us the way that they would prefer and they are choosing to essentially get closer with us and move higher up on their first call list.

Gregory Melich – ISI

That is great, you wanted to find noticeably at all?

Jim Wade

Don’t believe that we have broken that out now.

Gregory Melich – ISI

Congrats, guys. Thanks.

Darren Jackson

Thanks, Greg.

Jim Wade

Thanks, Greg.

Operator

Thank you. Your next question comes from Matt Fassler with Goldman Sachs. You may ask your question.

Ryan Brinkman – Goldman Sachs

Hi, this is Ryan Brinkman for Matt Fassler. How much of the accounts payable ratio improvement in the quarter related to the increase in the inventory and how should we think about that ratio going forward in the event that inventory growth were too slow for example?

Kevin Freeland

This is Kevin. Brian, the lion’s share or the majority of the lift was unrelated to timing, but the honest answer is we started the quarter by having coming out of first quarter under where we would have preferred to have been end of the quarter, having made an intentional investment in inventories. So, there is an element of it that is timing. As I said that with Mike, if you just stay where you were for the balance of the year, that number would slightly come down by the end of the year. But the programs that we are rolling out with our vendors are continuing over the next six months and depending on the status of those negotiations that ratio could change.

Mike Norona

Yes, it’s Mike. I am comfortable saying I think what we have said is improving our AP ratio is important to us long-term. I think Kevin’s given the reasons behind that. I think I have been asked the question what kind of improvement do we expect to see this year and I think I have kind of leaky bloomed out that we would expect the same kind of improvement over the last year which we saw like 400 basis points. So, that would take you from 61 to 65. I am actually comfortable now saying I think that number at the end of the year is maybe closer to 70. Then really it’s tied to the work that Charles and the finance teams are doing to actually work with our vendors, work with our banks and the goal of supply chain financing is actually to sell more products, I mean, that is what the goal is. I think Charles and the team are doing a great job in terms of working with the vendors and it’s an important part of our partnership with our vendors. So, it has very little to do with inventory growth.

Ryan Brinkman – Goldman Sachs

Then can I just ask quick too is there a minimum leverage ratio that you expect to maintain going forward?

Mike Norona

We said publicly maximum of 2.5 times and that is what we said publicly. We are at 2.2 times, that is where we are comfortable and that is all we will disclose.

Ryan Brinkman – Goldman Sachs

Okay. Thanks a lot.

Operator

Thank you. And our final question today comes from Mark Mandel with ThinkEquity. You may ask your question.

Mark Mandel – ThinkEquity

Hi, congratulations.

Darren Jackson

Thanks, Mark.

Mark Mandel – ThinkEquity

I just had a follow-up on the inventory question. What sort of growth are you anticipating year-over-year by the end of this fiscal year?

Jim Wade

Yeah, Mark, I think that what we have seen or what we have produced in the past has been a growth in sales that outstrips the growth in inventory, whereas this quarter was kind of the exception to the rule. It’s unlikely that We will have this level of growth of inventory over sales for the back half. But all of the dynamics that would make inventory a good investment will be there at that point and likely to have improved between now and then. So, we are going to be looking at opportunities to invest in inventory and in ways that would be showing up in the top line sales number.

Darren Jackson

Yes, Mark this is Darren. It’s probably fair to say we have learned a little bit coming out of Q1. I would have said coming out of Q1 that we experienced this early in the quarter is that quite frankly we over achieved our sales plan we have been very clear about that. We worked spot to those levels. So, when we came into the quarter I would say both our inventory levels and we actually started off the quarter in terms of sales and I think our language was they were good. But they accelerated throughout the quarter in part as we got back in stock and so, when you look at our sales trend over Q2, part of it is that you have to look into where we were investing inventory and how we had to get back in stock and a number of key categories because quite frankly the teams did such a nice job in the sales in Q1. Now the inventory teams have done a great job getting us back in stock and that we have seen the benefit of that throughout the second quarter.

Jim Wade

Mark, just a final comment. We are in situation where in stocks are at record, the customers perception availability is at a record and while inventory dollars are up our owned inventory is down substantially in the quarter, which generated cash that we can use for corporate purposes.

Mark Mandel – ThinkEquity

So you would expect to see the inventory growth decelerate but still exceed the rate of sales growth by year end, is that fair?

Darren Jackson

I would anticipate it to be flat. So if you get to end of the year look at our sales growth, we would expect our inventory growth to be roughly flat on a year-over-year basis.

Mark Mandel – ThinkEquity

Okay, great. Then just to shift for a moment to the interest expense and other expense lines and they were up significantly year-over-year. To what extent were there non-recurring items in there from the debt refinancing?

Darren Jackson

Yeah, there are a couple of things in there. I think we have shared before with our bond, so that drove a little bit more with that bond and that will carry with us too because we still have the swaps outstanding until October of 2011 and then it was item in there. I don’t know if it’s recurring, but in the financial markets and the LIBOR markets continue to jump around. We had roughly $1.2 million adjustment to the fair of our market value of our swaps due to LIBOR fluctuations, and I can’t predict that going forward. Typically before those fluctuations used to flow through equity, when we did our bond yield now flow through P&L. I wouldn’t anticipate those to continue, but I can’t predict what LIBOR is going to do.

Mark Mandel – ThinkEquity

That adjustment was an expense then?

Darren Jackson

Yes, it was expense.

Jim Wade

In Q2.

Mark Mandel – ThinkEquity

As far as interest expense for the second half of the year can you give any guidance or should we just take the debt outstanding in the 5.75% interest rate?

Darren Jackson

Yeah, and just you know what I would do is just we will get that all incorporated in our annual outlook.

Mark Mandel – ThinkEquity

Okay. Okay, fair enough. And then finally any LIFO numbers to discuss? You are on LIFO right?

Darren Jackson

Yeah, you will see that in our…I was trying to remind folks we are required to breakout LIFO. You will see that when we do our Q. LIFO is only one component of our margin, so you will see that when we release our Q.

Mark Mandel – ThinkEquity

Okay, great. Good luck. Thanks a lot.

Darren Jackson

Great, thanks, Mark.

Operator

Thank you. And at this time, I will turn the call back management for any final comments.

Joshua Moore

Thank you Shirley and thanks to audience for participating in our second quarter earnings conference call. If you have additional questions please call me Joshua Moore at 952-715-5076. Reporters please contact Shelly Whitaker at 540-561-8452. That concludes our call. Thank you.

Operator

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