Welcome to the O’Reilly Automotive, Inc. Third Quarter 2019 Earnings Conference Call. My name is John and I will be your operator for today’s call. [Operator Instructions] And I will now turn the call over to Tom McFall.

Thank you, John. Good morning, everyone and thank you for joining us. During today’s conference call, we will discuss our third quarter 2019 results and our outlook for the fourth quarter and full year of 2019. After our prepared comments, we will host a question-and-answer period. Before we begin this morning, I would like to remind everyone that our comments today contain forward-looking statements and we intend to be covered by and we claim the protection under the Safe Harbor provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You can identify these statements by forward-looking words such as estimate, may, could, will, believe, expect, would, consider, should, anticipate, project, plan, intend or similar words. The company’s actual results could differ materially from any forward-looking statements due to several important factors described in the company’s latest annual report on Form 10-K for the year ended December 31, 2018, and other recent SEC filings. The company assumes no obligation to update any forward-looking statements made during this call. At this time, I’d like to introduce Greg Johnson.

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 are Jeff Shaw, our Chief Operating Officer and Co-President and Tom McFall, our Chief Financial Officer. David O’Reilly, our Executive Chairman; and Greg Henslee, our Executive Vice Chairman, are also present. It’s my pleasure to congratulate Team O’Reilly on our excellent performance in the third quarter and to thank every member of the team for their unwavering commitment to our company’s culture of providing excellent customer service to each and every one of our valued customers. After seeing some weather-driven volatility in the first half of 2019, demand in our industry evened out in the third quarter, and our team did an excellent job of taking advantage of the solid industry backdrop to deliver a strong 5% comparable store sales growth in the quarter, which is at the top end of our guidance range. I’m pleased that our team was able to translate this top line performance into an 11% increase in operating profit dollars and a 13% increase in earnings per share to $5.08 per share, which exceeded the top end of our guidance range by $0.25. Our third quarter performance is the result of our team’s relentless focus on excellent customer service and expense control. Year-to-date, our comparable store sales growth stands at 3.9%, which is consistent with prior year and in line with our full year guidance we have maintained throughout the year at 3% to 5%. Now I’d like to provide some additional color on the composition of our third quarter comparable store sales results. Both the DIY and professional sides of our business contributed positively to our comp growth in the third quarter, with professional again being the stronger contributor. Part…

Thanks, Greg and good morning everyone. I would like to begin today by echoing Greg’s comments on the dedication of Team O’Reilly. As a result of the hard work and commitment of each of our store and DC team members, we were able to produce strong results in the third quarter, at the top end of our expectations. In my comments today, I will provide some color on our performance in the third quarter and discuss our organic store and DC expansion plans and I will also touch on the exciting plans we have to expand our company’s footprint into Mexico with our upcoming acquisition of Mayasa Auto Parts. Our success has been built on the foundation of the O’Reilly culture of excellent customer service, and we remain very confident in our team’s ability to seize on growth opportunities as we expand into new markets. I will begin my comments today by discussing our SG&A results for the third quarter. We were pleased to be able to leverage SG&A expenses 22 basis points during the quarter as a result of the strong comp performance and effective expense management by our teams. On an average per-store basis, SG&A grew 2.5%, which was in line with our expectations for the quarter. As we discussed on last quarter’s conference call, we have experienced continued pressure in SG&A this year from rising wages and other variable costs in the current tight labor market and those pressures continued in the third quarter. However, the year-over-year comparisons ease as we calendar against the increased payroll spend in 2018 from our reallocation of the savings from the tax reform, which had ramped fully by the third quarter of 2018. We are maintaining our guidance range for full year growth in SG&A per store of 2.5% to 3%,…

Thanks, Jeff. I would also like to thank all of Team O’Reilly for their continued commitment to our customers, which drove our strong results in the third quarter. Now we will take a closer look at our quarterly results. For the quarter, sales increased $184 million, comprised of $122 million increase in comp store sales; a $57 million increase in non-comp store sales, which includes the contribution from the acquired Bennett stores; a $7 million increase in non-comp, non-store sales and a $2 million decrease from closed stores. For 2019, we continue to expect our total revenue to be $10 billion to $10.3 billion. As Greg previously mentioned, our gross margin is up 35 basis points for the third quarter. On a year-over-year basis, third quarter gross margin benefited from the sell-through of on-hand inventory that was purchased prior to tariff-driven acquisition price increases, which have gone into effect in stages starting in the second half of 2018 and continuing throughout 2019 and the corresponding retail and wholesale price increases. When we established guidance for 2019 at the beginning of the year, we expected this gross margin benefit from the sell-through of lower cost inventory to be bigger in the first half of the year based on the then current tariffs and pricing environment. However, with the most recent round of acquisition cost increases driven significantly by the last round of tariffs, but also by other inflation being passed on by our suppliers, we are seeing an additional benefit to our gross margin. This benefit will continue in the fourth quarter of 2019 which is the driver of our expectation that gross margins will be at the top end of our full year guidance range as Greg mentioned earlier. While we are not yet prepared to provide gross margin guidance…

Thank you. And I will begin the question-and-answer session. [Operator Instructions] And our first question is from Chris Horvers from JPMorgan.

Thanks. Good morning guys. I wanted to ask a little bit about the DIY business and sort of what you are seeing on the sequential trends in the do-it-yourself business. As you pass along more price increases, what have you seen from an elasticity deferral perspective? In one hand, prices are higher. But on the other hand, miles driven have generally picked up since bottoming in the back half of last year and we think that’s a nice driver of that business and the overall business. So how is this balanced out in terms of deferred expanding?

Sure, Chris. Third quarter, we were up slightly on the cash, the DIY side of our business. If the tariffs and inflation persist, we feel like the more cash-strapped consumer will have to make some decisions, not much different than what we would face with rising fuel prices and ordinary inflation. And while we haven’t seen a lot of evidence of deferred maintenance, it would be somewhat likely that, that would be a decision that, that consumer might make if they were having financial difficulties to defer – not, not complete those maintenance cycles but defer those and extend those maintenance cycles out a little bit longer. So we haven’t seen a lot of evidence. Those more elastic categories are more the maintenance categories like oil and things like that. And we haven’t seen any evidence that there has been a big shift there, but that could happen to these tariffs and inflationary – should this inflationary environment continue.

What I would add to that, Chris, is ticket comps were up slightly on the DIY side. Total comps were relatively strong although as Greg mentioned in his prepared comments the professional business continues to lead the way in total comps. When we look at our category performance, items that can be deferred especially on the DIY side are a little bit lagging whereas our hard parts business things that you need to run your car continue to be good on both sides of the business.

And then as you think about – have you tried to disaggregate the strength in the hard parts business between price and unit to try to tease out how the car park improving this year and even more so next year, if that’s – how much of that is driving this commercial comp acceleration, which is accelerating on a stock basis?

So not to breakdown the individual numbers, but when we look over the last few years with the lighter SAAR years coming into the professional side of the business really entering our market, which tend to be – the newer the car, the sooner it’s off warranty, the higher propensity is to be serviced by a professional. That put pressure on us over the last couple of years when we were seeing that abate. When we look at our category type performance, especially items like brakes which are routinely repaired or changed out after they come out of warranty, we continue to do well on that side. So we think the – that bubble moving into our years and then higher SAAR years coming into our market off-warranty bodes well, has been a positive this year or not a negative and we would expect that to continue into the next year.

Thanks. Best of luck guys.

Our next question is from Matt McClintock from Raymond James.

Hi, yes. Good morning, everyone. I was wondering just given the magnitude of this being your first time going into a different country if you could just remind us how you think about the Mexican market overall, the opportunities there, how it’s different than the United States market just give us a little bit more context just so we can frame it in general? Thanks.

Sure. Great question, Matt. One of the things kind of going back we have been talking about entering markets outside of U.S. for a few years now. And we have been looking obviously in Mexico as well as in other North American countries for that right opportunity. What I would tell you is that the Mexico opportunity seemed to come about more quickly than other areas of North America. And as we moved into Mexico, we really were looking for acquisition candidates that check several boxes that we needed to have checked. And some of those include they need to have a solid store base. They need to have a leadership team that was grounded and understood the marketplace very well. They needed to be a good culture fit for our company. And they needed to have scalable systems. And while we looked at some companies along the way that were larger than the Mayasa organization, the Mayasa organization seemed to check all of those boxes, so very solid leadership team. As Jeff said in his prepared comments, they’ve been in business for well over 60 years. The leadership team in Mexico will remain in place and will work very closely with our company’s leadership to direct our future opportunities down there. Now what I would tell you is we haven’t closed on the deal yet and there is much work to be done, which, as Jeff said, was one of the reasons that we reduced our store count outlook for 2020, is because of the level of effort that goes into preparing for growth in Mexico. And again, the Mayasa organization gives us the ability to do that. They’ve got distribution. They’ve got the knowledge of the marketplace. But our real estate team and operations teams have a great deal of work to do to really understand, to fully understand that marketplace and learn from the Orendain family and the leadership to drive our future growth in Mexico. Jeff, did you want to add anything to that?

No. I mean, you covered it pretty well. I mean it’s obviously a new market and we’ve got a lot to learn. But when you go down there and visit the markets, I mean, it’s like the U.S. 40 years ago. I mean it’s a highly fragmented market. There is really not that many chains of any size, AutoZone being the biggest. But there’s just a ton of small independent jobber business. So it’s obviously a much smaller market than U.S., but we’re very excited about entering the market and growing our business down there.

It sounds pretty exciting. I wish you all the best of luck. Thanks for the color.

Thank you.

Our next question is from Greg Melich from Evercore ISI.

Hi, thanks. I would love to follow-up a little bit more on the pass-through of inflation and the response from both DIY and do-it-for-me. Specifically, you mentioned already some of the potential deferral, what have you guys been able to do to help offset or mitigate that by maybe growing private label or offering a different sort of assortment both in hard parts and maybe more traditional maintenance stuff?

Okay. Thanks, Greg. This is Tom. Just to clarify one item on Chris’ question earlier when he asked about DIY ticket trends. What I meant to say was the trend was slightly positive, but continues to be under pressure. To answer your question, Michael, we continue to look for ways to entice our DIY customers to repair their vehicles. We do a lot of work online with how to repair vehicles. We are promotional in our industry, but really, we think our best opportunity is to continue to grow that base is to provide great customer service, know-how, tool loaners, testing, so that as these consumers feel the pinch of higher prices, they feel more confident in their ability to repair their vehicles and save money that way.

Do you see indirectly any of that happening on the hard part side where you’re getting the unit demand but people are maybe changing the mix on older cars?

Not any more than what we’ve normally seen. When you look at the life cycle of our good, better, best product levels, as the vehicle gets older in that life cycle, the consumer tends to buy more towards the good or better end of the spectrum. There’s exceptions to that, but overall leading into the higher-end vehicles would tend – and the professional side of our business would lean more towards the higher end of that good, better, best spectrum. And then the older the vehicle gets, the more likely they are to trade down to the lower end of that spectrum.

Got it. And then my follow-up was on Mexico and the grander scheme of the growth algorithm. I think you mentioned stores now being about 180. Is that the number you guys said in the beginning? b

No, company-owned stores is 20 in Mexico.

Got it. But for the company, now we’re going to do 180 net new stores next year?

Yes.

And so should we be – is that just like in the – is that because next year you’re doing Mexico? And should we think about the 180 as a step-down that could step up again? Or is it more of like look at – look for the U.S. business to do 3.5% footage growth and now the additional point of footage growth might come out of Mexico?

What I would tell you is we still feel like we can operate somewhere in the neighborhood of 6,500 stores in the U.S., and our U.S. growth over time will continue as we approach that number. But what we’re going to do is we’re going to kind of blend that growth between the U.S. and countries outside the U.S., the first being Mexico.

To add to Greg’s comment, we felt like it was prudent having gone through a number of acquisitions, knowing how important it is to get the foundation of that acquisition right before we move forward. That we, as a company, are going to allocate a lot of time to understanding the Mexican market, developing our plan and to make sure that we can put the appropriate amount of focus on developing and starting that plan. We’re going to back off new stores just for this year. I don’t think it indicates anything about future years of what we’re going to do. We’re going to run our business with the mind of continuing to grow our store base profitably and set that going forward, but we wouldn’t say that this is an indication we think the total number of stores we can open in U.S. or our ability to open stores has changed.

Right that’s clear thanks a lot guys and good luck.

Thank you.

Our next question is from Scot Ciccarelli from RBC Capital.

Good morning guys. Scot Ciccarelli. I guess I have a bigger picture question for you guys. So historically, this industry kind of viewed a sweet spot for cars entering their initial repair stage at maybe 6 to 8 years old for the pro side of the business. But a recurring theme for a long time is we keep hearing about, let’s call it, sluggish ticket counts being offset by higher average ticket. So my question is this, with parts continuing to be made better and lasting longer, should we start to think about that initial repair stage maybe starting later in the vehicle’s life? In other words, could we have seen – or are we seeing, I should say, the sweet spot maybe shift to 7 to 9 years or 8 to 10 years where they really come into that kind of initial repair stage for your pro customers?

Yes. Scot, what I would tell you is I don’t know the starting point of that sweet spot has moved that much. But I think the sweet spot itself has expanded because vehicles are just lasting longer. If you look at whether it’s 5 to 7, 6 to 8, 6 to 10, I think that, that initial inflection point of the sweet spot is driven by the vehicles coming off warranty. As soon as those vehicles come off warranty, a lot of those maintenance and repair items go to the professional installer. And then over time, as those vehicles get older, we benefit on the DIY side as well. But vehicles are just lasting longer, vehicles lasting between 11 and 12 years now. And a lot of times vehicles that are on their second and third ownership pattern are being maintained as well as they were when they came off the assembly line.

Okay. Just conceptually like you owned the – yes, I understand that it comes off the warranty and then you start taking it somewhere other than the dealer and you start using aftermarket parts but, I don’t know, let’s call it is the breaks and the starter. Maybe it doesn’t need to be changed, right, at 6 years. You really can last till 7 or 8 or 9 years. I guess that was the thought process.

So what I would add to that, Scot, is a lot of the routine maintenance items, when you look at oil change intervals, fluid change intervals, when you look at tune-up type items, those have definitely expanded with different technologies that cost more to do but don’t happen as often. When you look, a lot of our core items: brakes, belts, hoses, rotating electrical, batteries, that hasn’t changed dramatically. But some of those categories that have changed and have been spread out, example oil changes where it used to be 3,000 miles and now your car tells you when you should change your oil with synthetic or semi-synthetic, those had a lot – have a lot of ticket count but don’t have the per-transaction value that hard part repairs have.

Got it, okay. Thanks, guys.

Our next question is from Simeon Gutman from Morgan Stanley.

Thanks everyone. So you are on track to hit, looks like, your midpoint of your comp guidance of about 4%. You mentioned there’s a little bit of help from price hitting 2% to 3% now for the full year, if I heard that right. So if you look at it that way, the underlying growth is more like 2% – maybe 1% to 2% arguably. And if you look in the past, your business seemed to have averaged something a little bit higher than that with no inflation, 2% to 3% or even better than that with no inflation. Do you diagnose it in that same way? Or how do you diagnose it? Is underlying demand softer? And then when we start to lap some of this pricing, will the units go back up? I don’t know if that’s how it should work but curious to hear your thoughts on that.

So when we look at our business, I think we’ve been pretty clear that the professional side of the business where the average consumer or end consumer is less price sensitive, continues to see good unit growth and average ticket growth, and that’s why that side of the business continues to lead. On the DIY side of the business, we have pressure on our ticket count from rising prices so that is limiting what the comp is on that side. So we still feel very good about a 5% comp in the third quarter. When we look at annualizing these price increases, I think our direction is similar to where we’ve see shocks in gas prices. We would expect that the DIY side will – the average consumer will become adjusted to what the current prices are and that we will see, as we annualize these increases, less pressure on count.

Okay. So I think it just, if I could paraphrase, it seems like there is really no impact to the do-it-for-me demand side or unit count. It’s really the do-it-yourself sort of would explain maybe some of that – some of the underlying the softness, I guess?

Well, I don’t know that we would characterize it as soft when we deliver 5% comps. We’re very, very happy with that result.

Fair enough. Can I ask this one follow-up? Have you thought about a scenario in which tariffs get revoked? I don’t know if you plan for that or thinking through that, but what percentage of the price increases could the industry – do you think the industry could keep?

Well, we’ll have to see what happens with tariffs. As we’ve talked about on our quarterly calls, starting with the first quarter, our guidance anticipates that the current inflationary/tariff environment will remain. And we will adjust our business accordingly when those changes occur. But to speak about something that hasn’t occurred or may not occur is probably not the appropriate thing to do.

Thank you.

Our next question is from Michael Lasser from UBS.

Good morning thanks a lot for taking my question. There was a little bit of confusion in terms of some of the commentary about the consumer response to the price increases. And on the one hand, it seems as though there was a comment that you’re anticipating some unit demand destruction from the price increases. On the other hand, there was indication that some categories that were deferrable, like motor oil and some other areas were – actually mean some unit demand destruction from price increases. So could you clarify what category – if they’re actually seeing some elastic response and what categories right now?

Yes. Michael, we’re not seeing any. Again, our professional side of our business was very strong. So what we’ve been talking about here is the DIY side of our business. And we haven’t seen any of the elastic categories take a big hit because of this. What we would say in summary is if inflation persists, again, no different than ordinary inflation or gas prices or what have you, that, that consumer may have to make some decisions. And what those decisions may be would be deferring or extending maintenance cycles on those categories, some of which are more elastic, or perhaps trading down from a good, better, best spectrum on required repairs.

Okay. And so is the way to characterize what happened this quarter is everything remained largely stable. You didn’t see as much of a negative impact from the weather plus you had a slightly higher benefit from pricing this quarter and then – and that’s all adjusting out for the extra Sunday. Is that a fair way to think about it?

I think it is, yes.

Okay. And then my last question is for Tom. Is there a scenario in 2020 where SG&A per store doesn’t grow 2.5% or above? And what’s the likelihood of that?

Well, we’re not going to – we’re not giving guidance for 2020. But I’ll reiterate what we’ve said on previous conference calls is to the extent that the labor market remains tight, we would expect to continue to have pressure on our SG&A growth. That’s the biggest expense that we have in that line. And really, that pressure of higher wages impacts everything that we do and a business does. But we would expect to see, if that were the case, continued inflation in selling price to help offset that.

Our next question is from Seth Sigman from Credit Suisse.

Hey, guys. Good morning. Thank you for taking the question. I wanted to follow up on CapEx. So obviously, this year, there was a big increase related to some of the DC work and store conversions. I’d assume some natural step-down next year, particularly with less U.S. store growth. But can you just discuss some of the capital requirements related to Mayasa and whether there’s going to be a need for any sort of meaningful investment within that chain at some point?

So this is Tom. We would expect to have a lower CapEx level next year just based on not having three ongoing DC projects, although it will continue to be elevated because two of the projects will still be ongoing. To speculate on Mayasa right now and what we’ll do next year is premature. We haven’t even closed on the business. But our expectation over time is that we have a great opportunity to grow a large store base in Mexico and we’ll deploy capital successfully in Mexico. But to Jeff’s earlier comments, we really want to make sure we understand the market, have the team in place, have the infrastructure in place before we commit additional capital to start growing that store base robustly.

Got it. Understood, okay. And then I just want to follow-up on pricing, how would you guys categorize the competitive landscape today from a pricing perspective? Do you feel like it’s rational? Have competitors followed some of your moves on pricing? And then sort of related, when you analyze your price gaps versus some of the emerging competitors in the space, whether that’s pure-play online companies or whoever that is, have you seen any major change in those price gaps as you guys have taken pricing up?

Sure. So what I would say is we’ve seen very little change in the competitive landscape. Our industry still is very rational from a pricing perspective. And there are categories that we lead and move up in and typically, our competitors will follow, and I guess, vice versa. That holds true as well. But we – our industry has always been very rational and continues to be very rational from a pricing perspective. As far as online, really haven’t seen a lot of change there, except for the method by which some of the brick-and-mortar retailers price online. I think it’s become more typical that our price points are the same or very similar to what we have in the stores. And we offer discounts across the ticket to be more competitive with pure online retailers. And again, a lot of times there’s a perception out there that when you’re looking at brand to brand, we might not be competitive from a pricing standpoint. But when you look at it from an application-to-application standpoint, we are consistently very competitive from a price point standpoint. That consumer is buying products online. For price, we’ll be able to go out and look for a part for his vehicle that maybe we have on a proprietary brand at equal to or sometimes less than what the pure online retailers are selling at.

Okay. Thanks, guys.

The next question is from Chris Bottiglieri from Wolfe Research.

Hey guys. Thanks for taking the question. I guess first question is kind of wanted to think through the impact of opening DCs. It’s great to see you opening DCs again. It’s been a while, kind of what are the impacts on comps that you’ve observed when you open a DC? Is there any kind of quantifiable uplift in that market? And then two, how do we think about the margin cadence? I would think maybe initial headwind of some kind and then it becomes a tailwind but just kind of curious how you are thinking about the net of those? Thank you.

I might take the first part, this is Jeff, and then let Tom or Greg chime in. But any time you open a DC in a given market, I mean, that market could be serviced by a hub store carrying somewhere from 45,000 to 65,000, 70,000 SKUs. And opening that DC, we have availability same day, several times a day availability to 160,000 to 170,000 SKUs. So when you have that inventory available, you’re just able to say yes to the DIY customer or the professional customer or fill the – fulfill the B2B ticket more times than not where before it would have been available overnight. So I don’t know if it’s exactly quantifiable, but it’s sure another tool in the tool box for those stores in that given market serviced by that new DC.

And from a cost perspective, our history has been to continue to grow our store base and expand DCs really beyond the range that’s ideal from efficiency standpoint for them to run and to overload their store count, which makes them internally inefficient before we open a new DC. So as we open these new DCs and unload the stores from overloaded DCs, it makes their labor more efficient. It makes the miles driven more efficient. So we don’t see a real big impact in our gross margin on a comparative basis.

Okay. A quick follow-up on the gross margin commentary from tariffs you said earlier. I just want to kind of confirm, maybe it through a little bit more. So you expect the gross margins to be up year-over-year and accelerate the Q4 and then decelerate but still positive year-over-year into 2020. Is that the right way to look at it like or how should – like maybe just clarify a little bit. I wasn’t quite sure what the answer was?

So we are seeing a benefit in our POS margin as prices have moved up with the tariffs. I mean, basically we have a slow-turn industry. So we have an amount of inventory that we purchased before the tariff increase so we make a higher gross margin. So that was a benefit here in the third quarter. It will be a benefit in the fourth quarter. As we sell through that merchandise and reduce that amount that was basically sitting in LIFO, we will see that tailwind diminish quarter by quarter next year.

Got it, okay. But still up, though, is the answer or no?

The answer for the fourth quarter is we expect to see strong gross margins, which will drive us to the top end of our gross margin – full year gross margin guidance.

Got it. Good luck. Thank you.

Our next question is from Seth Basham from Wedbush Securities.

Thanks a lot and good morning. I have a question. As it relates to the number of employees, on a per store basis, we saw a bit of a decline year-over-year this quarter. Is that because of the mix shift towards full time? Or are you managing your employee base a little bit differently?

I think we fielded this question on a few different conference calls. We have, obviously, a large employee base and that number is a point-in-time number. So depending on the time of the week it ends, depending on how many jobs we have that are open and the fluctuation, especially on the part time, that number can fluctuate, but it’s not an indication of any actual a change in our business staffing philosophy. And for that, I’ll turn it over to Jeff.

Really, I mean, we run our business one store at a time and have the appropriate staffing to take care of the business in that market. And then that seasonally ramps up and ramps down depending on the time of the year. Obviously, we’re kind of in the ramp-down mode a little bit coming out of summer, going into fall and winter. So nothing’s changed structurally on how we run our business. We’ve always ran our business for the long haul, provide excellent customer service each and every day.

Got it. And just a follow-up, a clarifying question. Tom, did you say that DIY ticket count, so traffic on a comparable store basis was up or down this quarter? And how did that trend relative to the last 2 quarters?

Yes. I’d make sure I get it right this time. The number continues to be under pressure, so it was negative. It was slightly improved from the second quarter is what I was attempting to say.

Understood now. Thank you.

Thank you.

And we have reached our allotted time for questions. I will now turn the call back over to Mr. Greg Johnson for closing remarks.

Thank you, John. We’d like to conclude our call today by thanking the entire O’Reilly team for your continued hard work in delivering a strong third quarter. I’d like to thank everyone for joining our call today, and we look forward to reporting our fourth quarter and full year results in February. Thank you.

Thank you. Ladies and gentlemen that concludes today’s conference. Thank you for participating and you may now disconnect.