Good morning. My name is Paula, and I will be your conference operator today. At this time, I would like to welcome everyone to the O’Reilly Automotive third quarter 2012 earnings release 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 then the number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Mr. McFall, you may begin your conference.
Thank you, Paula. 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. You can identify these statements by forward-looking words such as expect, believe, anticipate, should, plan, intend, estimate, project, will, or similar words.
In addition, statements contained within this press release 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 revenues, and future performance. These forward-looking statements are based on estimates, projections, beliefs, and assumptions and 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 regulations, the company's increased debt levels, credit ratings on the company's public debt, the company's ability to hire and retain qualified employees, risks associated with the performance of acquired businesses such as CSK, weather, terrorist activities, war, and the threat of war. Actual results may materially differ from anticipated results described or implied in these forward-looking statements. Please refer to the Risk Factors section of the annual report on Form 10-K for the year ended December 31st, 2011, for additional factors that could materially affect the company's financial performance. The company undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events, or otherwise.
At this time, I'd like to introduce Greg Henslee.
Thanks, Tom. Good morning, everyone, and welcome to the O’Reilly Auto Parts third quarter conference call. Participating on the call with me this morning is, of course, Tom McFall, our chief financial officer, and Ted Wise, our chief operating officer. David O’Reilly, our executive chairman, is also present. I would like to begin today by thanking all the members of Team O’Reilly for their commitment to our ongoing success by providing industry-leading customer service. In the midst of a quarter where we saw continued impact from a challenging economy and the lingering effects of a mild winter, we were still able to increase comparable store sales by 1.3%, which was on top of a 4.8% increase in comparable store sales in the prior year and on top of a challenging two-year stacked comparable store sales of 15.9%.
Our relentless focus on profitable growth, combined with a solid expense control, allowed us to increase operating margin to an all-time quarterly high of 16.4%. During the quarter, our focus on generating profitable sales, especially in the midst of the current challenging macro environment, combined with disciplined capital allocation, allowed us to increase our diluted earnings per share by 20%, marking our 15th consecutive quarter of adjusted diluted earnings per share growth of 15% or greater. We are all contributors to the success of our company, and our continued dedication to providing both our professional and DIY customers with the highest level of service each day will allow us to continue our profitable growth. Again, thanks to all of Team O’Reilly for your commitment to our continued success. I'd like to add some color around our sales results for the third quarter.
As we discussed on our second quarter earnings results conference call in July, the third quarter included an extra Sunday, which created an approximate 50-basis-point headwind to comparable store sales. We continue to see our sales performance impacted on a regional basis by the warm winter weather we experienced at the beginning of the year. The most pronounced impact from this historically warm winter has been on our Central and Upper Midwest and Great Lakes regions and has primarily pressured the maintenance and repair categories where we didn't see the normal winter weather wear and tear that typically leads to failure of a variety of parts. These areas significantly underperformed the areas of our company that are in more temperate regions.
Despite the softer-than-anticipated results for these regions, our company generated positive comp store sales results all three months of the quarter. We saw moderate improvements in comparable store sales throughout the quarter, adjusting for the extra Sunday we experienced in the month of September. The extra Sunday during the month impacted our professional business as our customer shops were closed an extra day. As a result, the sequential slowdown from the second to the third quarter in comparable store sales was impacted more by do it for me sales than do it yourself sales. Adjusted for the extra Sunday, the slowdown in comparable store sales was relatively similar between both DIY and do it for me. However, both sides of the business generated positive comparable store sales results during each month of the quarter.
The CSK-acquired markets continue to outcomp the core O'Reilly markets and continue to be accretive to the total company comp performance. Our core O'Reilly markets were relatively flat for the quarter. These markets contain the majority of the weather-impacted stores. As I discussed earlier, our core O'Reilly markets have a much larger mix of professional business and as such, were impacted to a greater degree by the extra Sunday in the period. Total traffic continues to be pressured by the difficult macro environment, with positive do-it-for-me traffic being offset by soft do-it-yourself traffic counts. Average ticket was positive on both sides of the business as we continue to see a larger percentage of our sales generated in the hard parts categories, and with the increasing complexity of vehicles on the road today, repairs continue to be more and more costly.
In the short term, we frequently experience various strengths and weaknesses across different regions and categories. These periods of short-term volatility, partially driven by weather, do not change our confidence in the long-term outlook for our business. Motor vehicles have historically been the primary source of transportation for consumers in the U.S. and will continue to be the primary source of transportation long into the future. Annual miles driven in the U.S. increased 90 basis points through August and continues to be approximately 3 trillion miles, and the total light vehicle population is increasing. Sustained vehicle scrappage rates and better engineered and manufactured vehicles have driven the average age of vehicles to historically high levels. In our history, we have not experienced a time where the vehicle fleet has been comprised of so many vehicles which are greater than seven years old.
We believe that consumers will continue to maintain these better engineered and older vehicles for longer and longer periods of time, driving continued demand for our products. Overall, for the quarter, our comparable store sales came in near the low end of our expectations, and needless to say, we were not satisfied with these results. The macro environment continues to be a headwind, with low consumer confidence and sustained high gas prices. Unemployment continues to maintain its historically high level, although it has slowly improved over the course of the year. To offset these challenges, we continue to focus on the fundamental concepts of providing top-notch customer service, supported by a robust distribution infrastructure, which has allowed us to continue to grow into new markets while also gaining share in existing markets.
We've seen solid improvements in our comparable store sales performance during the first several weeks of October, and we are cautiously optimistic this stronger sales trend will continue as winter sets in across the country. The fourth quarter has historically been a volatile quarter for us, as economically constrained consumers start the custom of holiday spending. The timing of the holiday this year will likely negatively impact our results in the fourth quarter. Based on our improving trends, somewhat offset by the timing of the holiday, we are raising our comparable store sales guidance as compared to the third quarter to a range of 2%-4%. Despite our lower-than-expected comp performance during the summer, our year-to-date comparable store sales have increased 3.7% on top of 4.9% last year.
For the first nine months of 2012, we have also been able to increase our adjusted diluted earnings per share by 25% to $3.60 as we continue to focus on profitable growth and disciplined capital allocation. During the third quarter, we continued to see improvement in our gross margin, which was up 117 basis points over the prior year and 39 basis points over the prior quarter. These improvements have been driven by our continued ability to improve our acquisition costs, along with a very targeted and focused advertised price strategy. Our distribution centers continue to perform at historically efficient levels, and we also continue to see improved shrink results. The pricing environment continues to be competitive but also remains rational.
As we have continued to increase our store-level inventories as part of our initiative to increase our store and hub in-stock levels, which I will discuss in a moment, we saw a non-recurring benefit from capitalized distribution costs that benefited our gross margin in the quarter by approximately 25 basis points. In a few minutes, Ted will discuss our distribution system efficiencies, and Tom will provide more color on the specific components of our gross margin performance. For the fourth quarter, we would expect our gross margin results to be down sequentially based on the anticipated lower level of capitalized distribution costs. We therefore expect our full-year gross margin to finish in the 49.8%-50% range. Now, I would like to take a few minutes to update everyone on some of our key initiatives.
First, I would like to update everyone on our initiative to improve customer service levels by increasing our store-level inventories. As I mentioned on previous calls, we have evaluated our store and hub stocking levels and based on multiple data points and made the decision to invest an additional $100 million in store-level inventories. We have done an extensive review using a variety of very sophisticated proprietary systems and have worked with over 250 vendors to determine the most appropriate inventory to add to each store. Through the end of the third quarter, we have approximately 80% of the inventory rolled out to the stores and would anticipate rolling out the remaining 20% during the fourth quarter of this year. Over time, this additional inventory will help drive sales and enhance relationships with our customers. We remain committed to remaining the industry leader in parts availability.
The next initiative I would like to comment on is our enhanced proprietary electronic parts catalog. Our new electronic catalog has been rolled out to all of our stores and continues to improve the level of service that we are able to provide our customers. As I have mentioned on prior calls, the proprietary catalog allows us to expand the content and applications covered as compared to our previous catalog, while also customizing a more user-friendly interface, making the catalog easier to learn and to navigate. We continue to make improvements to the catalog based on our team's feedback, and we will continue to enhance the system in order to build the most robust catalog in our industry. We remain confident that the new electronic catalog allows our professional parts people to provide even higher levels of service to our customers and will result in improved sales growth over time.
Finally, I would like to briefly comment on our B2C e-commerce initiatives. One of our major initiatives is to ensure we have a user-friendly online interface which allows our customers to search product and repair content, check our in-store availability of products, and place orders which can be delivered to their homes or picked up that day in our stores. One of the major factors in a consumer's buying decision is parts availability. DIY customers are relying more heavily on the internet to research purchases and check availability, and providing a friendly and convenient interface for these customers will continue to build the O’Reilly brand. This is an ongoing evolution. Thus, we will continue to enhance the functionality of our online store to meet this growing need.
Before I turn the call over to Ted, I just want to comment that while our comparable store sales for the third quarter were lower than we would have preferred, we are encouraged by our sales performance to this point in the fourth quarter and are optimistic about the long-term outlook for our industry. We believe our commitment to providing the highest levels of customer service in our industry will allow us to capitalize on this positive long-term outlook. I would like to again thank all of our team members for their continued focus on making sure that every customer that calls or comes in our stores experiences the incredible customer service we offer. I'll now turn the call over to Ted.
Thanks, Greg. Good morning, everyone. Before I get into my comments for the third quarter, I want to take a minute to thank our store and distribution teams for their continued dedication and commitment. With the challenging sales environment that we have experienced over the last several months, we are more aware than ever before that the long-term success is built day by day, one customer at a time. Our store and DC teams continue to provide top-notch customer service every day, and I want to thank them for their hard work. We saw a continued challenging macro environment in the third quarter. Greg spoke to some of the regional variations we saw in our results, I won't rehash those comments. What I would like to focus on today is our commitment to long-term profitable growth.
Expense control has always been a core culture value for O’Reilly. We always want to have productive store payroll while allowing for some extra payroll dollars and hours necessary to continue growing the business. As a result, in difficult macro sales environments, we can't make immediate significant changes to our SG&A structure without negatively impacting service levels. However, we do make well-thought-out adjustments to our SG&A to ensure we react to sustained sales trends, always keeping the focus on maintaining our long-term profitable growth. Our third quarter results shows our ability to over time adjust our SG&A while protecting sales as we deleveraged by only 43 basis points on a soft 1.3% comparable store sales growth. For the first six months of 2012, our SG&A per store had increased to 2.8% over the prior year.
Through store-by-store adjustments to payroll and adjustments to our advertising spend, we were able to decrease the year-over-year increase to 2% at the end of the third quarter. Our single largest controllable expense is store payroll, and we continue to focus on staffing each store with the right people at the right times in order to deliver top-notch customer service and grow the business, while at the same time reacting to the slower sales environment. Our store staffing and leadership remains the key priority for the O’Reilly store management team. Our regional and district managers continually work on training and building our store teams and making sure that we have the right leadership in the stores, not only during the day, but also on nights and weekends. Our focus is on superior execution at every store, every day. In early September, we hosted our annual regional managers meeting.
During the meetings with our regional managers, the main topic of the conversation centered around the idea that every region and every district around the country has opportunities for improvement, that we needed to concentrate our efforts on improving the performance on the bottom 20% of our stores in every district and every region. Our focus in these stores needs to be consistent execution of our proven business model. Understanding that every region has stores which outperform the others, it is apparent that the success of those stores is a result of having great store leadership and consistent superior customer service. We have tasked and challenged our regional managers with improving the leadership and the customer service of these underperforming stores in their regions. By improving the performance of these stores one by one, we will see solid impact on our company-wide performance.
Another important focus of the regional managers meeting was the execution of an effective professional customer sales call program. Currently, the O’Reilly sales team consists of over 500 full-time dedicated territory sales managers. In addition, every store has a trained sales specialist that is assigned a weekly call schedule on a part-time basis. Our goal for our 4,500-plus O’Reilly sales team is to make quality sales calls to build strong relationships with every professional customer in their individual markets and become the first call for their business. Another area where we have the ability to control our expenses in the short term is advertising. We continue to focus our advertising and marketing spend on print and radio with targeted promotions to drive traffic into our stores and build O’Reilly brand awareness.
During the quarter and for the remainder of the year, we closely scrutinized our advertising spend and opted to pull back on some of our non-core advertising programs. As we did in the second quarter, we ran call to action themed promotional events with intentions to drive traffic into our store. When a customer comes into the store, our team members' responsibility is to provide them with exceptional customer service, offer them related sale items, and pursue upsell opportunities. The goal of these call to action events is to generate foot traffic into the store and create a positive customer interaction, so when the customer is in need of a hard part down the road, O’Reilly is top of mind.
We also continue to build our brand awareness to new and existing customers through our NASCAR and our NHRA race sponsorships, as well as grassroots marketing through local and regional races and the various community events. During the fourth quarter and into the new year, we will again be a big sponsor of college basketball with on and off-court signage. Now I’d like to discuss our distribution operations. The DCs continue to see improved efficiencies and have managed expenses very well in this difficult macro sales environment. Our established DCs have managed the slower than expected sales volumes very well by adjusting staffing needs as needed. Our newer DCs continue to see efficiency improvements. The store-level inventory enhancement project Greg spoke about earlier put a heavy burden on our DCs as significant stock-up volumes moved into and through our distribution network this year.
However, even with this additional volume, our DC operations management team has effectively managed this project while continuing to provide industry-leading service to our stores. Now I’d like to take this opportunity to talk about our future distribution network expansion. We are very pleased to announce plans to open a new DC in Lakeland, Florida. The 390,000 sq ft DC is scheduled to open in the first quarter of 2014 and will service our existing stores in northern Florida and support our expansion into central and southern Florida. Florida is a largely untapped market for us but offers tremendous potential for both the DIY and the professional sides of our business. Currently, the real estate market in Florida is very attractive, and the state offers great opportunities in both large and small markets. We currently have over 50 stores in the state, primarily in northern Florida.
Our 2012 and 2013 expansion plan is to continue to expand farther south, servicing the new stores out of our existing Atlanta and Mobile distribution centers. Central Florida will also be supported by our super hub stores, which were opened during the first part of this year. Through these expansion efforts, we will open the new Lakeland distribution center with the proper store count to leverage the new DC from day one. Finally, I would like to briefly speak to our expansion efforts during the first nine months of this year. During the quarter, we opened 37 net new stores covering 20 states. Eight of these new stores came from our acquired Western market stores. We continue to see good expansion opportunities in the Western markets as we more thoroughly understand the individual markets and build the O'Reilly brand awareness.
For the year, we have opened 156 net new stores, and we are highly confident we will hit our goal of 180 net new stores for 2012. We are also happy to announce that we will increase our store count for 2013 to a net 190 new stores. We plan to open new stores next year across our entire existing distribution network, as well as expand the new markets in central Florida. During this quarter, we also relocated nine stores and completed 22 existing store renovations as we remain committed to keeping our installed store base looking fresh, ensuring they are attractive locations for our DIY customers. We continue to evaluate the existing West Coast lease store locations, especially the stores which are located in strip centers.
As the leases near expiration dates, we are actively negotiating with existing landlords to get the best possible lease rates where we have the opportunity, relocate the store to a standalone location. This will be an ongoing process over the next few years as the acquired CSK West Coast store leases come up for renewal. Before I turn the call over to Tom, I just want to reemphasize that we remain focused on providing customers with consistent store-level execution of our proven dual-marketing strategy. We will continue to manage the business to be successful in times of strong and weaker demand, are always focused on growing our market share and providing industry-leading customer service while controlling cost and managing expenses, leading to profitable long-term growth. I'd like to turn the call over to Tom.
Thanks, Ted. We'll take a closer look at our results and add some color to our guidance. Comparable store sales for the quarter increased 1.3% on top of a 4.8% comp last year and an 11.1% comp two years ago, yielding a three-year stacked comp of 17.2%. Year-to-date, our comparable store sales increased 3.7% on top of prior year comps of 4.9%. DIY and DIFM were again both positive for the quarter, with DIFM contributing a larger percentage to the growth. Average ticket growth for both DIY and DIFM sides of the business was again the driver to the comp improvement. We continue to see pressure on our DIY traffic counts, which were down for the quarter, were partially offset by positive DIFM traffic counts for the period.
For the quarter, sales increased $66 million, comprised of a $20 million increase in comp store sales, a $47 million increase in non-comp store sales, flat non-comp non-store sales, and a $1 million decrease from closed stores. As Greg mentioned earlier, while we are encouraged by the improving comparable store sales trends thus far through October, we remain cautious about consumer confidence levels and the potential impact on spending during the remainder of the fourth quarter, especially during the volatile holiday season. In addition, as a reminder, our stores are closed on Christmas Day, because of the timing of Christmas this year as compared to last year, it moves from a Sunday in 2011 to a Tuesday in 2012. We anticipate this change will have an approximately 50 basis point headwind on comparable store sales for the fourth quarter.
With these factors in mind, our guidance for comparable store sales for the fourth quarter is 2%-4%. Based on these projected fourth quarter comp sales and the softer-than-expected third quarter sales results, we're revising our full-year comparable store sales guidance down from 3%-5% to 3%-4% for the year. We're also revising the top end of our full-year sales guidance for 2012 down slightly, bringing our full-year sales guidance to $6.15 billion-$6.2 billion. Gross margin for the third quarter increased 117 basis points over the prior year to 50.3% of sales, bringing our year-to-date gross margin to 50%, which is a 128 basis point improvement over the prior period. Improved acquisition costs, shorter duration and targeted advertising strategies, distribution efficiencies, and improved shrink all continue to drive our gross margin improvement.
During the quarter, we also saw the benefit from the amount of capitalized distribution costs. As a result of our ongoing inventory rollout associated with our initiative to put more inventory closer to our customers, we added significantly to our store-level inventories during the quarter. The cost to move this inventory into a saleable position in the stores is capitalized on our balance sheet at an overall distribution rate. However, moving this stock up inventory into place is more efficient than normal orders. We saw a one-time benefit in gross margin of approximately 25 basis points for the quarter. We'd expect the fourth quarter gross margin as a % of sales to be lower than the third quarter due to this one-time benefit, product mix, and seasonally lower sales volumes.
The fourth quarter of 2011 represented the first quarter we reached our current gross margin run rate just below 50%. We expect the fourth quarter of 2012 to be relatively similar to the prior year. Based on the results of the third quarter and our expectations for the fourth, we are raising our full-year guidance to 49.8%-50% of sales. SG&A for the third quarter delevered 43 basis points to 33.9% of sales. The deleverage was a result of softer-than-expected comparable store sales as we planned our SG&A spend around the middle of our comp guidance for the third quarter. As Ted discussed, we have made adjustments to better match the slower sales environment. We will continue to make adjustments to reduce the year-over-year growth of SG&A through the end of the year.
As a result, for the full year, we anticipate that average SG&A per store will increase less than 2%. For the third quarter, operating margin was 16.4% of sales, representing a record-high quarterly operating margin and a 74 basis point improvement over the prior year. The deleverage in SG&A was more than offset by the improvement in gross margin. For the first nine months of 2012, operating margin improved 106 basis points to 16.1% of sales. For the full year, we now anticipate operating margin to be in the range of 15.5%-15.8% of sales. Diluted earnings per share for the third quarter increased 20% to $1.32 a share from $1.10 for the same period last year. For the first nine months of 2012, diluted earnings per share increased 25% to $3.60 a share from an adjusted diluted earnings per share of $2.88 during the same period last year.
As a reminder, adjusted diluted earnings per share for the first nine months of 2011 excludes the one-time charges for our financing transactions from January of 2011. Now we'll move on to the balance sheet. Our focus on improving the productivity of our net inventory investment continues to gain traction. For the trailing 12 months ended September 30th, 2012, our inventory turnover net of payables increased to six times versus three times for the comparable period last year. At the end of the third quarter, our average inventory per store is up 5% to $567,000 versus $542,000 per store at the end of the third quarter last year. For the full year, we expect average inventory per store to increase approximately 7% as a result of our store and hub on-hand inventory initiative.
Our vendor financing program continues to see increased vendor participation and has been the catalyst to reducing overall supply chain costs and improving the productivity of our net inventory investment. At the end of the third quarter, our accounts payable to inventory ratio was 84.4%, which is another great improvement over the prior year ratio of 59.3%. We now expect to finish the year at approximately 84%, slightly lower than our current ratio due to the seasonality of the business and payment for a portion of the inventory ordered earlier in the year as part of the store and hub inventory initiative. For the first nine months of 2012, we increased our free cash flow 37% to $816 million from $597 million for the same period one year ago.
The improvement is driven by the increase in net income, our significant improvement in our net inventory investment, and reduction in capital expenditures. For the full year, we're increasing our free cash flow guidance to $800 million to $830 million. For the year, we expect capital expenditures to be between $300 million and $320 million. From the beginning of the year, we've reduced our expected annual capital expenditures approximately $20 million as we saw attractive opportunities to lease more existing sites than we'd planned. In 2013, we expect a higher CapEx spend as we plan to open a higher mix of owned stores and we work on the new Lakeland DC. We're working on our more detailed 2013 plan for CapEx spend and will provide more details on our fourth quarter conference call. During the third quarter, we issued $300 million in 10-year senior notes at 3.8%.
We are very pleased with the coupon rate, and we are committed to maintaining and improving our investment-grade credit rating going forward. With the additional debt issuance at the end of the quarter, our adjusted debt to adjusted EBITDAR was 1.85 times, an increase over our adjusted debt to adjusted EBITDAR ratio of 1.66 times at the end of the second quarter of this year and 1.81 times at the end of the third quarter last year. We will continue to incrementally move toward our long-term targeted leverage ratio of two to two and a quarter times. From the beginning of the year and through the date of our earnings release, we repurchased 14.2 million shares of our stock at an average price of $88.95 for a total investment of $1.3 billion.
This brings our life-to-date repurchases to 30.1 million shares at an average price of $74.45, for a total investment of $2.2 billion. We continue to believe that the best use of our free cash flow is to reinvest in our business by maintaining and growing our store base and consolidating the industry through accretive acquisitions. To the extent these opportunities do not use our available cash for the remainder of the year, we'll continue to prudently execute our share repurchase program. Our guidance for both the fourth quarter and full year takes into account shares repurchased through the date of our earnings release but does not reflect the impact of any potential future share repurchases. For the fourth quarter, our diluted earnings per share guidance is $1.03 to $1.07 per share. For the full year, our diluted earnings per share guidance is $4.64 to $4.68 per share.
At this time, I'd like to ask Paula, the operator, to return to the line, and we'll be happy to answer your questions. Paula?
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. We do ask that you limit your questions to one question and one follow-up question. We will now pause for just a moment to compile the Q&A roster. Your first question comes from the line of Alan Rifkin of Barclays.
Thank you very much. A couple questions, if I may. Greg, in the past, you had talked about the former CSK stores over the longer course of time getting to $1.8 million per store. I think it's been a little while since you updated that number. Could you maybe give us an update as to where that is today, and do you still think the 1.8 is an achievable number?
Yeah, Alan, thanks. Yeah, we do. The CSK stores are divided into different sections of the country, and The upper Midwest stores have not performed as well as the Western stores, and we relate that primarily to just the weather effect that we've seen throughout the industry as a result of the milder winter last year. Speaking of the Western stores for just a moment, they continue to perform very well, and we're well down the road to getting to our $1.8 million goal. We would expect that we will do that, in what time would you guess? Somewhere in 2014, probably.
Alan, as you know, we're getting away from giving regional performance as it causes competitive issues for us. We continue to make very good progress. We continue to be very comfortable we'll hit the $1.8 million number. Then we'll set a new goal from there.
Alan, just to add something to that for you. When we set that, part of the rationale was that many of the markets that we do business in today, big metro markets like, I don't know, Houston or Dallas-Fort Worth or just other large markets where we have a large population base, a lot of miles driven, a lot of vehicles, our stores today exceed that $1.8 million average in many markets. It's not a stretch for us to expect that in these larger markets out West. It's just taking time as we expected and as we talked about when we bought CSK to ramp the stores up to that rate. We fully expect that we'll get that, and in some markets even past that.
Okay. Just to follow up, if I may. Greg, with more and more of the competition certainly targeted the commercial side of the business, which has long been your mainstay side of the business. What incrementally are you guys doing to defend your share on that side of the business?
As I talked about earlier, we're strategically placing more inventory out in the stores and kind of beefing up our hub network. We continue to educate our team members on the best ways to manage relationships, the best ways to use our professional customer promotions to maintain relationships with customers. The main opportunity with any relationship with a professional customer is just the level of service that you provide. We're making sure that our team members have the facilities and assets they need to give the best customer service in the industry. We think we've been very successful in defending against the more retail competitors as they've come into that business. We feel like we've done a good job defending our market share there.
Okay, one last one, if I may. The 390,000 DC in Lakeland, Florida is even larger than what we thought. First of all, how many stores do you think you can ultimately have in the southern portion of the state? How many of the 190 earmarked for 2013 will be in Florida?
I'll have Ted give some color on that.
Alan, we're thinking probably in the 300-350 range for Florida total. The DC will handle that. In other words, that'll take care of the entire state. As far as expansion in 2013, like I said, we've got about 51 stores open now. We would expect to probably have another 25 open next year. We're going to some degree, kind of push those back towards the end of the year to make sure from a service level standpoint, that the DC is open relatively quick after the stores open in the central part. Like I said, we have two hub stores, super hub stores open now in Central Florida, which will help a lot as far as the same-day service on parts availability, in addition to overnight out of our Atlanta and Mobile DC.
I think there'll probably be about 25 of our stores be in Central Florida next year.
Just something to add to that, Alan, is that part of the rationale with the square footage there is to take some pressure off our Atlanta and our Mobile DCs, which are servicing some of that area now, which is a little bit of a stretch for the ideal range for those distribution centers.
Okay. Thank you all very much.
Thanks.
Your next question comes from the line of Gary Balter of Credit Suisse.
Morning, Gary.
Good morning. First of all, Alan asked about the professional side. Could you talk about what you're doing on the DIY side? That seems to have been the weaker area and remains the weaker area. What efforts are you doing to try that?
We're doing a lot of work on the product offerings that we have in place to draw the DIY customer more to, in many cases, expanding our private label products, making sure that we're price competitive on the entry-level products. From a store staffing perspective, we're working to make sure that our stores are staffed for nights and weekends, which is typically when the DIY business happens for the most part.
From a systems standpoint, I talked earlier about our electronic catalog. A big part or a big push with this electronic catalog is the content that exists to express to a customer that's maybe working on their own car, the things they might do to fix a car, help them diagnose a problem, just give our parts specialists better information when discussing with a DIY customer the process that they might go through to repair a car.
All those things over time, we think culminates into a higher level of customer service to the DIY customer, and we think it's working for us. As we've talked about in the past. Our average DIY volume per store versus some of our competitors leaves us with an obvious opportunity to grow market share there, and we're working today to do that.
Just a follow-up, and you kind of addressed the gross margin a number of times during the call, but one of your competitors earlier this week talked about promotional activity in the sector. It was very hard to see in your strong gross margin results, and it doesn't sound like that has anything to do with the guidance you're giving for Q4. What are you seeing in the environment right now?
Well, the promotions that we all run are pretty similar. They're promotions on the DIY side that would be for commonly used items, maintenance items like oil changes and motor oil and filters and stuff like that. We run them pretty similarly priced. I guess the variance between us would be the frequency at which we run them, the length we run them, the number of products we run at one time. We've not seen any major change among any of our competitors with what they do there. What we have seen on the Do It For Me side is just the work that a company coming into the Do It For Me side will do to draw a customer to them.
Since in many cases, those companies don't have a service advantage or availability advantage or any advantage other than the fact that they might be able to offer a customer a lower price for a period of time to maybe change buying habits or something, my guess would be that when that was spoken of, it was more on the promotions on the Do It For Me side.
Okay. Thanks very much.
You bet. Thanks.
Your next question comes from the line of Scot Ciccarelli of RBC Capital Markets.
Hi, Scot.
I think you'd mentioned there's a significant difference in performance in some of the Midwest markets, and I think you mentioned another area as well. I guess the questions related to that are, first, can you give us an idea how much of a difference or spread you're seeing in those markets? Second, what % of your stores are exposed to those areas?
It's hard to draw a line and say, "Here's the stores that were affected, and here's the stores that weren't." The way we would look at it is that our central Midwest, upper Midwest, the Great Lakes regions, that those were the markets that were most affected, and that's where we see the effect on our comp store sales the most. If we compare that area of the country with some of the regions that just are more temperate, that were not affected so much. Let me back up. We would consider those stores to represent about 25% of our store base, thereabouts.
Again, it's hard to draw a specific line, but we would see as much as about a 700 basis point difference in their performance from a comp store sales perspective during the third quarter to the markets that are in a more temperate area.
Very helpful. Then just quickly on, I guess, the balance sheet question. You guys are expanding kind of gross margins rapidly, AP to inventory ratio is going up. Does it create a situation where you start to get some pushback from your vendors?
Well, none of this is easy. The vendors haven't been knocking our door down trying to make these deals, but for a long time, we've had fantastic relationships with our suppliers. Our suppliers, part of their growth and success is contingent on partnering with companies like ours to grow their market share and the availability of their product offering to customers. There's some end certainly to what we can do from an AP to inventory standpoint. To this point, we feel like our vendors have been very in favor of the things that we've done, and that they benefited from it. Tom, you might have some comments on the financing part of it.
On the financing part, our goal is to make this a win-win situation, and this was a big factor in us going out and becoming a publicly rated company from a debt perspective to lowering the overall borrowing costs for our whole supply chain. Our ability to offer that lower cost and reduce the working capital requirements for our vendors is a savings for them, and we have shared in that saving. From our standpoint, we're looking for a win-win situation. When we look internally, we have also committed a significant amount of capital over the last five years in new store growth, distribution centers, acquisitions, and our vendors see our investment in the business as an opportunity for them to increase the breadth and penetration of their products across the U.S. We're looking for win-win situations with our vendors.
We can't be successful unless we have vendors that are also successful.
Very helpful. Thanks, guys.
Thanks.
Your next question comes from Matthew Fassler of Goldman Sachs.
Hi, Matt.
Good. First of all, we hear you loud and clear on gross margin for the fourth quarter of 2012 and what might be driving the flattening end of that performance year-on-year. If you think about your opportunities, particularly on distribution, how do you feel about the longer-term gross margin trajectory for O'Reilly?
I think we have some continued opportunity. It's going to come from several different places. One, we have the opportunity to grow our DIY business, which is higher gross margin. We think we have continued opportunity on the acquisition cost side as we continue to look to countries that we currently don't buy products directly from. In some cases, there's opportunities for us to enhance private label products with some of those offerings. Just through managing our pricing better. I know you hear every retailer talk about price optimization. I don't think there is just one way of doing that. On our professional side, that's more complicated and difficult than it is retail, but I think we have some opportunity there.
Just to take a wag at what our opportunity is, I would say that we have an annual opportunity of a 10-20 basis points improvement over the next few years.
You think the pace, because this was a very good year, obviously?
Yeah
You think the pace of that movement probably moderates from here in the fourth quarter as the beginning of that?
I do. I think that the fourth quarter, we annualize a higher gross margin step-up that our company made, that we would see slower growth from that point forward.
My second question, if I could, relates to the weather-impacted versus non-impacted markets. The breakout you gave us on the 25% impacted 700 basis point gap is very helpful. I guess there's two ways to ask this. One is, has that 700 basis point gap been consistent since the business started to slow down? I guess the other way is, what was the trend in the non-weather impacted markets? Did it stay the same, accelerate, decelerate, et cetera?
In the non-weather impacted markets, the third quarter was a little slower than what it had been in the second quarter, so the trend was slightly down. The trend from the second quarter to the third quarter was pretty similar, a little bit more of a drag. When we look at the more temperate markets, they have been pretty consistent all year long.
Got it. Okay. Thank you so much.
Thanks.
Your next question comes from Gregory Melich of ISI Group.
Morning, Greg.
Good morning. I want to follow up on the top line and how inflation or disinflation may have impacted that when we talk about the deceleration we've seen this year. Then also, why you expect an acceleration in the fourth quarter comp, especially given the Christmas shift.
Well, this is Tom. I'll answer the first part on inflation and let Greg talk to the broader sales environment. When we look at the third quarter specifically, we actually saw a little drag from pricing. We'll see our LIFO reserve decrease, then it was a slight positive to gross margin. When we look year to date, we're relatively flat, maybe a little bit of price pressure, which creates a little bit of headwind versus last year through this time of the year when we had seen a tailwind from inflation.
Yeah. Then just, Greg, from a broader perspective, just the drivers of comps, the effect of weather and stuff like that. We feel like that the cold winter, as exemplified by our performance in these northern markets and our competitors' performance in these northern markets, that there's no question that it had an effect. The extent to which it's a factor is a little hard to measure other than the way that we articulate the performance. We gave a little more information this time than we would normally give, and so would our competitors. We're just trying to give everyone the ability to assess that situation as best they can. We've been very encouraged by our performance so far this quarter.
Our comp store sales started improving at the end of September, and that improvement has very consistently sustained to this point, three and a half weeks through the fourth quarter. Like we talked about, the holiday season can be a little volatile because of holiday spending and things like that. Our expectation or estimate, just based on years in this business, would be that if we have a cold winter this winter, that very likely the aftermarket will have a good season.
That's great. Tom, if I could just follow up on your answer. Last year, there was some inflation. Could you help us quantify that? Was it like 100 basis points or 200 basis points or?
It would be between those two.
Okay. Thanks a lot.
Thanks.
Your next question comes from the line of David Cooper of Morgan Stanley.
Going back on the top line and not to get into too much of the nitty-gritty there, are you seeing that drag from the weather-impacted markets fading at all? Is that what you're seeing in late September, early October? As we think about the fourth quarter, you mentioned the 50 basis point headwind from the shift in Christmas. Are you also picking back up the Sunday that you lost in the third quarter?
Well, this is Tom. I'll address the Sundays. We have an extra Sunday during the year. We have the same number of Sundays in the fourth quarter as last year, except that we were closed one of those Sundays last year and not closed this year. In essence, same number of Sundays, but we pick up an extra Sunday business day.
To answer your question as far as the weather drag or the potential effect on the markets that were most affected by weather, yeah, we've seen a nice improvement during this past four or five-week period in the markets that have been most affected by weather. Those markets, winter comes earlier and people start thinking about maintaining their car for winter earlier. Batteries that were fried, for lack of a better word, during the summer, fail as weather starts getting colder and the engines start getting harder to crank. We've seen good performance in that category as a result of weather. Yeah, we've seen a sequential pickup in those markets that has been a little better than what we would have had in the markets that are in more moderate regions of the country.
Okay, good to hear. I guess a follow-up, just thinking about the longer-term secular environment, which I think you touched on in your prepared remarks, particularly with the aging of the car park. Could you talk about the sweet spot of the car park? How do you think that has evolved? Historically, you would've thought cars age seven to 12 or somewhere thereabouts would be the sweet spot. Do you think that's extended? What do you think the spend per vehicle looks like outside of that? Because I think, one of the concerns over the next few years is that we are going to have a lot of very old cars. Is the drop-off after year 13 or 14 or 15, is it a 10% drop-off? Is it a 20% drop-off once you get out of that sweet spot?
How do you think that evolves over the next couple of years?
Yeah. Well, what I would say to that is, just a couple or three years ago, you would hear us say that the sweet spot was maybe 6 to 10 years. As people have hung onto their cars longer, and I feel like the quality of the engineering and the manufacturer of new cars has been recognized by consumers as they've driven these cars at higher mileages. I think that's moved forward a little bit or extended a little bit. It's maybe more 6 to 12 or something like that. I guess I don't really have any scientific data to answer your question, I don't really know when we would see a drop-off relative to an age of a vehicle.
What I would say is that if you're driving a car that's your daily driver, and it's your commuting vehicle, which in many of our markets in Dallas, Fort Worth, or Houston, you might have a 50 or 80-mile daily commute back and forth, not one way, but both ways, to get to work and back. You've got to have reliable transportation. If the car is 12 years old or 13 years old or 14 years old, you still have to do the primary things to maintain that car to drive it every day.
Now, that doesn't mean that you're going to be fixing a rough spot that comes up or fixing the seat that might have worn through or fixing the cracked dash or something like that, because there's going to be some things that cause the car to maybe not look as good as it did when it was new or five years old or six years old. Still, the mechanical part of the car has to work well for it to be reliable transportation. In many cases, these cars are not only the commuter cars, they're the cars that families use for vacations and weekend outings and things like that, so they have to be safe and well-maintained.
I think the answer to your question is yet to be seen, but we view it as being unlikely and very difficult for a consumer to just say that because the car is 13 or 14 years old, they're going to stop maintaining it. It just doesn't work.
Okay, great. Thank you very much.
Okay, thank you.
Your next question comes from the line of Bret Jordan.
Hi, Bret.
Quick question here. Just to follow up, I know you mentioned private label and the opportunity there going forward and the opportunity to grow the gross margins through that. I know a couple of quarters ago, you were saying private label was running 33% of sales. Just wondering if you could update us on that number.
It's still about that. It's not grown. We've not seen a significant growth past that. A big part of our private label, the amount of product we sell private label is the amount of product we offer. As we add to that offering, our percentage of sales increases. Because in many cases today, especially a DIY consumer, they're going to buy the lowest priced product you have in some cases. As we expand our private label offering and various product lines, that grows. We haven't made any material changes here in the last couple of months to our private label offering. Although our plan is to continue to look for opportunities to establish private label brands that are recognized as high-quality national brands offered exclusively by our company to expand our private label offering.
That allows us to be more competitive on the DIY side, competitive on the do it for me side, and at the same time, expand our gross margin through better acquisition and just better gross margin on the product sale.
Okay, great. Thank you. Just a quick follow-up. With private label, is there a long-term run rate that you're eventually looking to get to, say, 40% of sales or so? Or is this just a quarter by quarter, year by year measure that you're going to look to expand on?
Yeah, there's no plan to get to a certain %. Really, it's not even quarter-to-quarter or year-to-year, it's by product line. We assess this by category, by product line, and decide how our company can best go to market with that product. If that means that we're best served to expand into a private label product or expand existing brand private label offering, we do that. In many cases, some of the brands we offer are very much preferred, and some of the brands we offer aren't necessarily always available in a private label. For that reason, we opt to carry a branded product because both DIY consumers and do it for me consumers prefer the branded product because of the recognition of the high quality of that particular part.
Okay, great. Thank you.
Okay, thank you.
Your next question comes from the line of Michael Lasser of UBS.
This is around the outlook for your cost structure. If we assume that the environment remains in a relatively slower period for a longer length of time, how do you feel about growing your cost structure at a slower pace? What comp rate do you think you need to leverage at this point? If you continue to pare back on some of these expenses, do you jeopardize some of your sales at that point?
When we look at our cost structure, as Ted talked about during his prepared remarks, we've always been very stringent on making sure we get a good return on all of our expenditures. We don't have a lot of programs that we could do without. If we did, we wouldn't have them to start with. We're pretty tight on expenses. As Ted talked about, we manage it over time. We don't want to knee-jerk customers in that service, but we want to make sure we're matching up to what the sales environment is. Given if we look at the fourth quarter, for example, and we say, sales, we're pretty confident are going to be in the 2%-4% range. We build our cost structure around that, but that starts in the beginning of the third quarter.
To the extent that we stay on a slower but stable environment, which we're optimistic it'll improve, we can get to a pretty even SG&A percentage at 2.5%-3% based on 190 new stores.
That's the level of comp that you would need to lever?
That's to be flat.
To be flat.
That's what we would need.
Okay. For the incremental inventory that you're currently putting in the stores, do you think that there's already been a sales lift associated with that incremental inventory, and can you quantify it?
It's a minor lift. These obviously are not the fastest moving items that we deploy. The fastest moving items were already in the stores. These would be the next layer of movement, and they've not been there long enough to generate a material sales lift. We don't have it quantified at this point, so we wouldn't be able to speak to anything. I can tell you that it was not a material change.
One last quick one. There was commentary about the supply chain and comparing the DCs in the legacy versus the newer markets. Where across the board do you think you are in the efficiency of your supply chain? Are you 90% of peak efficiency, 80%? Where do you think that is?
Well, in our existing core O’Reilly markets, we're pretty darn efficient, and there's not much left there to gain. In some of the expansion markets, we do still have some efficiencies to gain. Some of those DCs run a little higher expense to sales ratio than what we would like. As we continue to grow sales in those markets, we'll further lever those expenses. I don't have a number for you. I know that our overall distribution expenses, we're pretty pleased with that rate that we're currently at as a % of our sales. Our Senior VP of Distribution, Greg Johnson, who's not here, he'll tell you that we still have opportunity to increase that or to improve, decrease the expense next year and hopefully the year following.
We're working to do that, and we do have some distribution centers that aren't operating as efficiently as we would like, and those DCs we see as opportunities.
Thanks a lot for all the insight.
Thank you.
At this time, we would like to turn the conference back over to Mr. Greg Henslee for closing remarks.
Thanks, Paula. Before we end the call today, I would just like to reiterate our belief in the solid long-term growth potential for our industry. Total annual miles driven in the U.S. remains nearly 3 trillion. The light vehicle population is growing, and the overall age of the vehicle population continues to increase, all of which provide a solid foundation for future demand. We remain dedicated to our long-term strategy of having the friendliest and most knowledgeable parts professionals in all of our stores, supported by the most robust store-level inventories and availability of hard-to-find parts. We are committed to providing top-notch customer service to all of our professional and DIY customers every day. I'd now just like to thank everyone for their time today. We look forward to reporting our fourth quarter results and our full year results early in 2013. Thanks.
This concludes today's conference.