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AutoZone Inc AZO
Q2 2010 Earnings Call Transcript

Transcript Call Date 03/02/2010

Operator: Good morning and welcome to the AutoZone Conference call. Your lines have been placed on listen-only until the question-and-answer session of the conference. Please be advised, today's call is being recorded. If you have any objections, please disconnect at this time. This conference call will AutoZone's second quarter financial results. Bill Rhodes, the Company's Chairman, President and CEO, will be making a short presentation on the highlights of the quarter. The conference call will end promptly at 10 a.m. Central Time, 11 a.m. Eastern Time.

Before Mr. Rhodes begins, the Company has requested that you listen to the following statements regarding forward-looking statements. Certain statements contained in this press release are forward-looking statements. Forward-looking statements typically use words such as 'believe,' 'anticipate,' 'should,' 'intend,' 'plan,' 'will,' 'expect,' 'estimate,' 'project,' 'positioned,' 'strategy' and similar expressions. These are based on assumptions and assessments made by our management in light of experience and perception of historical trends, current conditions, expected future developments and other factors that we believe to be appropriate. These forward-looking statements are subject to a number of risks and uncertainties, including without limitation; credit market conditions, the impact of recessionary conditions, competition, product demand, the ability to hire and retain qualified employees, consumer debt levels, inflation, weather, raw material costs of our suppliers, energy prices, war and the prospect of war, including terrorist activity, availability of consumer transportation, construction delays, access to available and feasible financing, and changes in laws or regulations.

Certain of these risks are discussed in more detail in the 'Risk Factors' section contained in Item 1A under Part 1 of our Annual Report on Form 10-K for the year ended August 29, 2009, and these Risk Factors should be read carefully.

Mr. Rhodes, You may now begin.

William C. Rhodes, III - Chairman, President and CEO: Good morning, and thank you for joining us today for AutoZone’s fiscal 2010 second quarter conference call. With me today are Bill Giles, Executive Vice President, Chief Financial Officer, Store Development and IT; and Brian Campbell, Vice President, Treasurer, Investor Relations and Tax.

Regarding the second quarter, I hope you’ve had an opportunity to read our press release and learn about the quarter’s results. If not the press release along with slides complementing our comments today is available on our website www.autozoneinc.com. Please click on ‘Quarterly Earnings Conference Calls’ to see them.

We are pleased to announce for the quarter an EPS increase of 21.2% and a domestic same-store sales increase of 1.0%. We believe the initiatives we put in place surrounding our hub store enhancements, hard parts additions, especially our late model coverage, disciplined category line reviews, our leadership training of store managers, our ongoing development of an effective commercial sales force, enhancements to our Z-net technology, and our store refresh efforts have continued to allow us to grow both our sales volumes and more importantly our market share in both the DIY and do-it-for-me segments.

Furthermore, we believe these initiatives are building momentum in our business. As we began this quarter, we were cognizant that our comparable sales - same-store sales results would become more challenging. As you recall, it was the second quarter last year when our sales began to increase. While we were cautious going into the quarter about our sales comparisons, not knowing how weather and consumer buying habits would play out, we were confident that the actions and strategies we were implementing would be highly valued by our customers during these challenging times.

As we said on our last call, we didn’t see anything on the horizon that would cause a material change in consumer buying behavior. Simply put, we did not anticipate new car sales, gas prices or employment statistics to change materially over the last few months and clearly they have not. Our customers continued to buy our products similarly to the previous 12 months. With the economy remaining challenged, we continued to expect our customers to look at AutoZone to provide them with all their vehicle solutions through our offering of high quality products at a good value supported by trustworthy advice.

With respect to the weather, it is fair to say that the weather conditions were more harsh throughout much of the United States in comparison to the prior year. Although cold weather is positive for our business, it remained wet and certainly towards the end of our quarter much of the country experienced heavier than normal snowfall, which in some cases may have impacted customers’ ability or desire to reach our stores. Having said that, over time weather averages itself out and we are always going to have some positive or negative effect from the weather. The important factors for us are that we take care of our customers and continue to capture profitable market share.

I want to take a moment to congratulate our AutoZoners on delivering our fifth straight quarter of 20% plus EPS growth, and our 14th straight quarter of double-digit EPS growth. This long stretch of success can be attributed to a simple and clear strategy of delivering exceptional customer service and trustworthy advice, all while continuing to refine our retail, commercial, Mexico and ALLDATA offerings. These important qualities are embedded in our culture and they are the principles we live by every single day. It is again worth noting that our stretch of 14 straight quarters of double-digit EPS growth have occurred in very different macroeconomic cycles. Through both boom and bust cycles, our organization has performed very well and our Company's financial performance has been quite strong.

I also want to point out the successes we're seeing in our commercial business. This quarter now marks the 11th consecutive quarter of sales growth. We are pleased with the gradual acceleration that we're seeing as our commercial business grew 8.5% this quarter, a sequential improvement from last quarter's 7.7% increase. Our growth was driven primarily by our up and down the street customers. These smaller usually independent garages continue to show double-digit sales improvement for the quarter.

We feel the progress we've made with this customer segment reflects the enhancements we've made to our overall business model and those changes are positively impacting our customers and their purchasing behaviors. Our improved product offerings and the difference our sales force is making is exciting for our organization. We feel we're very well positioned to further capture market share in this business in future quarters and years. Additionally, I would like to congratulate the organization for delivering another strong performance on return on invested capital as we were able to grow this metric to 25.2% on a trailing four-quarter basis. It is important to note that during 2009 and continuing for the first half of fiscal 2010 we've made substantial investments in our business, both operating expense investments and investments of capital, working capital and capital expenditures, to strengthen our position in the marketplace. During these times of investment, we’ve expanded our return on invested capital. This gives us great confidence in our planning models to confirm that where we have invested your dollars, we are getting an adequate return. We will always maintain our diligence regarding capital stewardship.

Now, I’ll discuss our quarterly performance in a little more detail and try to address questions you may have. Let me begin by discussing category sales. In recent quarters, we provided more detail on the performance of our categories and clusters we have called out as failure, maintenance and discretionary. In recent quarters, our acceleration has come from maintenance and failure categories offset by pressures in the discretionary categories. This quarter our performance was more balanced, although our failure related categories were our top performers.

From a regional perspective, we did not experience any material changes in sales trends that differed from the overall chain performance. Based on NPD market share, we continue to see market share gains in both retail and commercial in virtually every geographic segment. Our competitors, both large and small, continue to be very strong and formidable, and it is incumbent on us to execute at an extremely high level and flawlessly execute our enhancement initiatives to continue to earn these market share gains.

As I mentioned earlier, we have several initiatives underway at various stages, but I’d like to highlight the performance of our hub store enhancements. Last year we implemented an enhanced model in 60 of our 143 hubs. Through the second quarter, we have completed an additional 22 implementations. This effort includes adding additional inventory and increasing the frequency and reach of our daily deliveries to satellite stores.

While this initiative represents a material investment both in terms of operating expenses and some capital, we are quite pleased with the sales performance we are experiencing. The incremental parts additions that are now sold throughout the surrounding satellite stores are both exceeding plan and adding to the overall sales performance of the hub store and its market. With approximately 60 hubs left to convert, we’ll manage those roll outs accordingly. We are learning as we go, so the remaining roll out schedule will be appropriately paced.

Overall, our gross margin rate remained healthy and showed improvement this last quarter. I would like to congratulate our merchandising team on their efforts to improve merchandise margins through lower procurement cost, import initiatives, and price optimization efforts. We continue to feel that margin opportunities exist for us heading into the second half of this fiscal year.

I would also like to recognize our organization from our loss prevention team, to store operations, merchandising, information technology, finance and supply chain for their diligence on reducing our shrink expense. They have worked tirelessly to combat this never-ending waste and their efforts are beginning to payoff.

From an expense standpoint, while we continue to accelerate some of the initiatives that we’ve been testing, we also managed our overall expense structure appropriately as sales increases moderated. This organization takes great pride in our disciplined approach to managing our cost structure and leveraging our culture of thrift and this quarter’s performance further solidifies that this team is highly capable of effectively managing cost. I believe we continue to be well positioned to manage our cost structure for the foreseeable future.

As noted previously but worthy of highlighting again, our commercial business trends remain positive as we continue to build our internal sales force, refine our parts assortment, and focus our efforts on our most profitable customers. With 8.5% growth this past quarter, we expect this business to be a continuing source for sales and earnings growth for many years to come. While we are encouraged by our current performance, we are not satisfied with our current sales levels. We continue to feel confident in our strategy and we look forward to capitalizing on this tremendous opportunity for the remainder of 2010 and beyond. I'd also like to congratulate our Mexico team for opening their 200th store this past quarter. While we've been methodical with this business over the years, it’s exciting for our entire organization to reach this important milestone. Congratulations to our entire Mexico team for achieving this important milestone.

Now I'll take a few moments to talk more specifically about our retail, commercial and Mexico results for the quarter and then Bill Giles will review gross margin result, operating expense result, balance sheet and cash flows. For the quarter, total auto part sales increased 4.1% versus last quarter's 7.7% and last year’s second quarter of 8.1%. This segmentation includes both our domestic retail and commercial businesses and our Mexico stores. Mexico's pesos and dollar converted sales were positive for the quarter. The exchange rate was generally neutral this quarter after having been a significant headwind for most of fiscal 2009.

Regarding our domestic business, during the second quarter we continued to focus on driving sales and profits through improving the customer experience. This quarter we updated 14 of our 40-plus major merchandise categories, and we remain committed to completing at least one line review per major category on an annual basis. Our vendors have worked diligently with us to refine our merchandise assortment as a core element of improving our ability to say yes more frequently to our customers with specific emphasis on adding late model coverage. Parts proliferation continues to present a challenge to our industry, but to combat it appropriately we remain committed to the timely executed merchandise assortment updates and we will continue to leverage our hub stores to ensure we have the required level of coverage to serve our customers well.

I’ll break my comments regarding retail sales up into four major categories. Specifically I’ll address first our new hub store operating market model, then we’ll touch on our best of the best leaders, third, I’ll spend a moment on our marketing themes slated for 2010, and finally, I’ll address the macro trends we’ve seen.

Although I previously mentioned our hub strategy, let me take a moment to highlight this quarter’s activity. We converted an additional 11 hub stores to our new operating model during the second quarter, increasing the frequency of delivery to our satellite stores and refining or rather increasing the hard parts assortment. Today, we have converted 82 of our 143 hubs to this new model. Along with our ability to say yes more frequently to our customers, the enhanced hub offers us the ability to improve the productivity of inventory, particularly slow turning inventory. We no longer have to retain certain slower moving products in each of our satellite stores, because we can now access the slower turning SKUs from hub stores thereby reducing working capital.

Currently, we are redeploying these inventory investments to add more late model products. We have plans in place to continue to implement this new model in our remaining hub stores and we continue to refine this relatively new operating model to make it more effective and efficient.

Second, trading continues to be a key priority to improve customer service and increase sales. This past quarter we recognized the best of our commercial and retail AutoZoners with induction into our Sales Leadership Council, and we held a celebration to recognize these best of the best performers. We are intensely focused on learning from these peak performers in order to cross-pollinate their great ideas and best practices throughout the rest of the organization. Over the long run it is our culture that differentiates us and positive reinforcement is a vital element of our culture.

The third item focuses on our customers. An in-depth understanding of our customers is critical, and we are relentless at continuing to learn more about our customers and leverage those learnings to enhance their experience with us. We are experimenting with segmenting our marketing messages to different customer sets. We need to make sure we are communicating our complete value proposition to a wide range of customers while also communicating specific value propositions to specific customers.

Secondly, we have increased our focus on search and display initiatives in an effort to exploit the power of the Internet; and third, we will remain heavily focused on radio advertising as we are one of the largest radio advertisers in the U.S. today.

Regarding macro trends, during the second quarter unleaded gas prices started out at $2.64 a gallon and remained static finishing at $2.61 a gallon. We believe gas prices have not been a material story to our sales results over the last quarter, although we are cognizant of the price increases during last year’s third quarter. Last year’s second quarter ended at $1.96, flat with the year’s Q1 prices. However, prices grew starting in Q3 last year, up to $2.31 a gallon. Unfortunately, current prices remain above last year’s level, but they appear to be stable.

Regarding miles driven, we noted improvements for November and December. However, we expected these increases as gas prices stabilized and the comparisons became easier. Whilst recently we have seen minimal correlation in sales performance with miles driven, historically it has been one of the key statistics which correlate to our sales result over the long-term. The other is a number of seven-year old motor vehicles on the road, which continues to trend in our industry’s favor.

Regarding weather, we believe it had a negative impact on our results, especially last week or so of the fiscal quarter due to heavy snowfall across the country. For the trailing four quarters, total auto part sales per square foot were $241. This statistic continues to set the pace for the rest of the industry.

Now we'll turn to commercial, for the quarter total commercial sales increased 8.5%. We remain encouraged by the consistent progress we have made demonstrated by the gradual acceleration in our sales performance over the past several quarters. While we have made meaningful progress in building and training a world-class sales organization, we recognize that there is still significant work yet to be done to achieve our goals.

As we analyze our commercial sales growth across the country, we were pleased to see growth has come from both existing and new customers. As we continue to increase market share, we continue to enhance our selling capabilities and improve our parts offering. With improved tools in place combined with constant enhancements, we're building a platform for long-term growth.

We now have our commercial program in 2,321 stores supported by 143 hub stores. During the quarter we opened 9 additional programs. Our main focus remains on building and developing a sales force. Over the last 36 months we built our sales force from basically zero. We are targeting sales growth through first increased penetration of existing customers and second on acquisitions of new customers in our existing service radius. The majority of our business is derived from up and down the street customers who experienced double-digit sales growth during the quarter.

Additionally, we continue to work closely with our national account customers and have developed a strong business relationship with many of them. We remain committed to growing this business profitably and constantly ensuring that our investments are resulting in improved sales and profitability. This past quarter, we were successful in growing both operating margins and dollars for our commercial business. We continue to believe more intense personal focus on existing account management will drive continued improved results.

Lastly, we continue to test our one (team) concept in a few locations. Our goal is for our store AutoZoners to support both sides of the business. We are looking to create common systems that are intuitive to operate across both businesses. We believe this has the potential of utilizing our store labor hours more effectively, thereby garnering better coverage and support for both types of customers. As this remains in test phase, we won’t say much more this morning, but we are excited about the future potential of the strategy. In summary, we remain excited about the growth prospects of our commercial business heading into the third fiscal quarter of 2010 and beyond.

Our Mexico stores performed generally on plan this past quarter. We opened 9 new stores during the second quarter and currently have 202 stores in Mexico. Exchange rates did not play a material part in the business’s financial results this past quarter as it did in the second fiscal quarter of last year when the exchange rate jumped to 13 pesos to the dollar. We continue to see our business model perform well in Mexico and remain committed to growing this business and we’ll continue to grow our store count on a percentage basis generally consistent with the last couple of years. We believe that we have an appropriate strategy to manage our Mexico business for the long run while minimizing foreign currency risks. Our ongoing commitment remains to prudently and profitably grow the Mexico business.

Now I’ll turn it over to Bill Giles to discuss the remainder of the income statement, cash flows and balance sheet. Bill?

William T. Giles - CFO and EVP, Finance, Information Technology and Store Development: Thank you, Bill. Regarding the second quarter for the 12 weeks ended February 13th, we reported sales of $1.5 billion, an increase of 4% from last year’s second quarter. Same-store sales or sales for stores opened more than one year were up 1% for the quarter. We experienced sales growth from both our retail and commercial customers. Net income for the quarter was $123 million, an increase of 6.4% versus last year’s second quarter and diluted earnings per share increased 21.2% to $2.46 from $2.03 in the year ago quarter.

Our continued disciplined capital management approach resulted in return on invested capital for the trailing four quarters, up 25.2%. We’re proud to report that this metric continues to improve over last year’s already industry-leading rate. Return on invested capital is a key measure of our success. We have and we’ll continue to make investments that we believe will generate returns that significantly exceed our cost of capital.

Gross margin for the quarter was 50% of sales, up 36 basis points compared to last year’s second quarter. The improvement in gross margin of 36 basis points was positively impacted by a favorable shrink expense comparison of 17 basis points, a shift in mix of sales to higher margin product, and lower product acquisition cost. We continue to not see a material shift to our good level categories from our better and best categories.

Our Duralast, Duralast Gold and Valucraft product lines continued to show sales increases in both our retail and commercial businesses. Our customers continue to recognize the value proposition these high quality brands offer. We continue to spend marketing dollars to promote our brands as we feel they can create real competitive advantages for us on an ongoing basis. Looking forward, we believe there continues to be opportunity for gross margin expansion. We do not manage to a targeted gross profit margin percentage, however, as our key focus is on increasing absolute gross profit dollars.

SG&A for the quarter was 34.7% of sales, down 11 basis points from last year's second quarter. The reduction in operating expenses as a percentage of sales was a result of tighter expense management, partially offset by 25 basis points of expense from the continued investment in our hub store initiative. As discussed in last quarter's results, this quarter also included an increase in pension expense of approximately $2.8 million or approximately 20 basis points, which reflected the decline in value of the underlying assets of the plan. It is our expectation that we will incur a similar expense increase in the upcoming third and fourth quarters of fiscal 2010. Offsetting these expenditures we experienced a gain similar to many other retailers related to the final Visa/MasterCard settlement, which for us amounted to $2.5 million or 17 basis points for the quarter. We will continue to appropriately manage our expenditures to enhance the customer experience while being fiscally prudent.

EBIT for the quarter was $230 million, up 7.3% over the last year’s second quarter. Our EBIT margin improved 47 basis points versus the previous year's second quarter. Interest expense for the quarter was $36.3 compared with $31.9 million in Q2 a year ago, a 13.8% increase. Much of this increase was due to a combination of terming out a majority of our commercial paper borrowings in late June and the additional costs associated with our new three-year revolving credit facility and to a lesser degree increasing our debt outstanding by 3% versus last year. We would expect that higher interest expense run rate to continue for the balance of the fiscal year.

Debt outstanding at the end of the quarter was $2.775 billion or approximately $84 million more than last year’s balance of $2.691 billion. Our adjusted debt levels at 2.5 times EBITDAR is in line with past quarter’s results. As we have previously stated, our objective is to manage our debt levels to maintain our investment grade debt rating and at 2.5 times adjusted debt-to-EBITDAR. We feel comfortable in our abilities to adhere to that goal over time. However, it is our expectation that in any given quarter, this may increase or decrease based on management’s opinion regarding debt and equity market conditions. We purposely manage our capital structure relative to our cash flow in order to maintain our credit rating to the investment grade while optimizing our cost of capital.

For the quarter, our tax rate was approximately 36.4%, in line with last year’s second quarter. For the third quarter, we expect to run a higher rate closer to 37%. Net income for the quarter of $123 million is up 6.4% versus the prior year’s second quarter. Our diluted share count of 50.2 million was down approximately 12% from last year. The combination of these factors drove earnings per share for the quarter to $2.46, up 21.2% over the prior year’s second quarter.

Relating to the cash flow statement, in the second quarter we generated $119 million of operating cash flow. We continue to see opportunities to increase operating cash flow going forward. We repurchased $88 million of AutoZone stock and at the end of the second quarter we had $517 million remaining under our share buyback authorization. We continue to view our share repurchase program as an attractive capital deployment strategy.

Next, I’d like to update you on our inventory levels in total and on a per store basis. We reported an inventory balance of $2.3 billion, up 3.3% versus the Q2 ending balance last year. On a per store basis, we were down 1.2% at $504,000. We feel our enhanced hub model will allow us to continue to manage our inventory levels more efficiently. We do, however, expect to offset some of these inventory reductions with new hard parts coverage.

Accounts payable as a percent of gross inventory finished the quarter at 94.8% versus 90.2% in last year’s second quarter. For the quarter, total working capital was a negative $101 million versus last year’s balance of a positive $112 million. Net fixed assets were up 5.1% versus last year. Capital expenditures for the quarter totaled $58 million and reflect the additional expenditures required to open 33 new stores this quarter, maintenance on existing stores, and work on development of new stores for upcoming quarters.

Specifically related to new store openings, our new stores remain on track and we continue to see opportunities to open domestic stores at a low-to-mid single-digit growth rate for the foreseeable future. We believe opening stores during these more difficult economic times can be beneficial. We opened 24 net new domestic stores in the quarter for a total of 4,289 stores in 48 states of the District of Columbia and Puerto Rico. Depreciation totaled $44.5 million for the quarter, in line with last year’s second quarter expense of $41.8 million.

AutoZone continues to be one of the few players in our industry to have investment grade debt ratings. Our senior unsecured debt rating from Standard & Poor’s is BBB, and we have a commercial paper rating of A2. Moody’s Investor Services has assigned us a senior unsecured debt credit rating of Baa2 and a commercial paper rating of P2 and Fitch has assigned us a senior unsecured rating of BBB as well and a commercial paper rating of F2.

Now I'll turn it back to Bill Rhodes.

William C. Rhodes, III - Chairman, President and CEO: Thank you, Bill. We managed our business very well during the second quarter. We executed our plan and we had very few surprises. We're encouraged with our execution and excited as we head into the back half of our fiscal year. Our stores’ appearance looks great, the morale of our field organization is very high, and we're committed to providing the outstanding service and trustworthy advice our customers deserve. We remain focused on our key priority stated at the beginning of the fiscal year; number one, relentlessly hiring, retaining and training our AutoZoners to make sure we're delivering on our stated corporate goal of providing the best trustworthy advice; secondly, continually refining our product assortment in order to meet all our customers’ needs; third, deploying inventory appropriately across our network with specific emphasis on utilizing our hub and satellite network of stores; fourth, commercial sales growth; with a pay-as-you-go mentality, improving our business with up and down the street, national account and public sector customers, we will continue to develop our sales team in order to make this happen. Finally, we'll continue to test our blended store concept, our (one team) initiative. We believe there can be real power in managing our stores as one cohesive unit. This will only strengthen our service levels to all customers. As we remain on track with all of these initiatives, we promise to continue our focus on innovation and improving every aspect of our business. We remain focused on steady, profitable sales and earnings improvement. We had a very good quarter, which again is worthy of congratulating our entire organization for their commitment to living the pledge. However, we will not rest on our laurels. Our approach remains consistent. We are focused on going the extra mile in 2010, and we will remain and we remain very well positioned to do just that.

Now I would like to open up the call for questions.

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