Good day, ladies and gentlemen, and welcome to the O'Reilly Automotive, Inc. Third Quarter 2020 Earnings Conference Call. My name is Howard, and I will be your operator for today's call. [Operator Instructions]. I will now turn the call over to Mr. Tom Mcfall. Mr. Mcfall, you may begin.

Thank you, Howard. Good morning, everyone, and thank you for joining us. During today's conference call, we will discuss our third quarter 2020 results. After our prepared comments, we'll host a question-and-answer period. Before we begin this morning, I'd 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, 2019 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 our -- 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 on the call. We are pleased to announce record-breaking performance for our third quarter and are again amazed at the ability of team O'Reilly to produce such excellent results in the midst of one of the most challenging periods in the history of our company. Our team remained dedicated to our customers and drove an outstanding 16.9% increase in comparable store sales in the third quarter, a 39% increase in diluted earnings per share to $7.07, while also consistently executing on our protocols to protect the health and safety of our team members and customers in the midst of the COVID-19 crisis. While the challenges we face during 2020 are far from routine, our teams have done an exceptional job adjusting to the current environments and modifying the ways we conduct business during this pandemic. They've done so without sacrificing our focus on providing excellent customer service or any of the value our customers have come to expect. We continue to be diligent in our efforts to constantly evaluate and revise our safety protocols as recommended by public health and governmental agencies and are extremely focused on executing best practices across our company. Before we continue with our prepared comments, I'd like to express our deep gratitude to our team for their hard work and commitment to our customers. There is absolutely no question about how important our business is in meeting our customers' critical needs, and I couldn't be prouder of Team…

Thanks, Greg, and good morning, everyone. I want to start today by echoing Greg's comments and expressing my sincere thanks to Team O'Reilly for another incredible quarter. Our team's ability to diligently follow all of our pandemic protocols to protect the health and safety of our team members and customers, while generating the best top line results we've ever seen is simply remarkable. We operate a very stable business model that has been fine-tuned over many years to deliver an exceptional value to our customers while maximizing the productivity of our human capital and shareholder investment. However, we would have never expected our model to be tested in the way it has in 2020. And we've never imagined a scenario where store volumes skyrocketed overnight and sustain such a high rate of productivity for 6 months. Simply put, delivering the results we announced yesterday requires a tremendous amount of hard work and ingenuity by the teams in our stores and DCs. As Greg previously discussed, we generated an increase in operating margin of 250 basis points to 22.6% and operating profit dollar growth of 35%, both of which represent record third quarter operating profit results for our company. We drove this increased profitability by generating 16.9% comparable store sales, capitalizing both on the strong macroeconomic environment and taking market share, while limiting our SG&A per store growth to 3.6% for the quarter. As we discussed last quarter, the timing and unique circumstances of the changes we've seen in our business in 2020, starting with the significant headwinds at the onset of the COVID-19 crisis, followed by the dramatic, immediate surge in business have created a perfect opportunity for us to execute our model and drive record-breaking operating profits. As a result, we indicated on last quarter's call that we expected…

Thanks, Jeff. I'd also like to thank all of Team O'Reilly for their continued commitment to our customers, which drove our incredible performance in the third quarter. Now we'll take a closer look at our quarterly results. For the quarter, sales increased $541 million, comprised of a $441 million increase in comp store sales; a $71 million increase in noncomp store sales; a $32 million increase in noncomp, nonstore sales; and a $3 million decrease from closed stores. As a reminder, we previously withdrew our 2020 guidance. And given the ongoing uncertainty related to COVID-19, we are not resuming guidance at this time. As Greg previously mentioned, gross margin for the third quarter decreased 96 basis points to 52.4%, which was driven by a year-over-year comparison to the significant gross margin benefits we captured in the third quarter of 2019 related to the sell-through of pre-tariff, on-hand inventory as well as dilution from the acquisition of Mayasa. As a reminder, throughout 2019, we received a gross margin benefit from the sell-through of on-hand inventory that was purchased prior to tariff-driven acquisition price increases in 2018 and 2019 and anticipated we would see a continued benefit that would taper off each quarter in 2020. We did not receive a third quarter benefit in 2020 and since we received the full benefit of pre-tariff inventory in the first half of 2020 due to acquisition cost decreases in the second quarter, which create a short-term headwind but benefits future POS. Looking at the third quarter stand-alone, we did not have a materially positive impact from LIFO. We expect to see year-over-year headwind again in the fourth quarter as we compare against the prior year pre-tariff inventory benefit. We received a more muted benefit from same SKU inflation, in line with our expectations as…

[Operator Instructions]. Our first question or comment comes from the line of Greg Melich from Evercore.

I wanted to follow-up a bit more on the traffic and the share gains in the ticket. So if you think about it, is that gap now between DIY and do-it-for-me, both are healthy, but it sounds like into this quarter, they're still narrowing a bit. Was that fair to interpret that? And then second, when you say that you've been gaining share, do you think that's been bigger on the DIY side or the do-it-for-me side?

Greg, a lot of questions there. First, on the traffic and ticket question, I would tell you that if you divide that into the 4 quadrants, cash and charge for each, all 4 of those quadrants were positive. And we were pleased with both our ticket count and our average ticket. Looking at the gap between our DIY and DIFM side of the business, it did narrow slightly this time. Our overall comp was less. So our side of the business performed well to our expectation. And our DIY traffic was off slightly from where we were last quarter.

What I would add to that is if we reflect back to the beginning of the second quarter, where we saw significant drop in business and then a spike in continued strong sales from the middle of April, that was primarily on the DIY side of the business. The professional side of the business was impacted longer due to the customer service nature at dropping off your car, to have it worked on. So it took longer for the professional business to come back. So the narrowing of the gap in the third quarter, I think, is more of a reflection of the more significant challenges that the professional side of the business had in the second quarter.

And do you think you gained more share in DIY or do-it-for-me?

That's a hard one to determine. We will see over time as others report, and we look at industry data. What we would tell you is that we think we gained significant share on both sides of the business.

Our next question or comment comes from the line of Brian Nagel from Oppenheimer.

Congratulations on a really nice performance here. So the first question I want to ask is with regard to sales trends, recognizing that the strength we've seen now for the last several quarters and has persisted here into the fourth quarter, but as we particularly see what now -- maybe to Q3, Q4 transition, are you seeing any significant difference [Technical Difficulty]. I'll try again. If that's any better. I apologize, [indiscernible] I'm just on the cellphone. So the question I have is whether -- it's particularly with regard to sales from Q3 to Q4, has there been any significant change in the categories you're performing? Are you seeing a different way that customers are shopping the stores as these COVID headwinds persist?

Brian, I would tell you that the trend we saw in the second quarter has carried over end of the third quarter. A lot of our traditional categories that performed well have continued to perform well in the fourth quarter. We called out batteries, especially performing well -- I'm sorry, not fourth quarter, third quarter. I'm getting ahead of myself there. But we did see strong performance in a lot of DIY categories as we did in the second quarter. A lot of categories that historically have not performed as well, meaning whether it's hot rod parts, performance parts, car detailing components, things like that, that we just think that a lot of that DIFM consumer have more time on their hands to perform some of those repairs. And frankly, feel like some of the shift from DIFM to DIY for some of those easier repairs has been a result of that DIFM customer, completing some of those repairs themselves as opposed to taking into the shop for repair.

Brian, what I would add to that is, as our professional business strengthens as we work away from COVID in the restrictions on their business that, that drove. That business is much more focused on hard part repairs. So to the extent that those have done better, it's narrowed the gap, but more about raising more of the traditional categories than weakness in others.

Our next question or comment comes from the line of Kate McShane from Goldman Sachs.

My first question was just with regards to the SG&A dollar growth. Tom, I know you went through that a little bit in your prepared comments. But can you remind us the areas where you're still being able to limit that spend?

Okay. Jeff covered those comments, but I'll go through because it sounds like an accounting question. When we look at our SG&A, the biggest driver of our SG&A expense is store payroll and when COVID hit and we had 4 weeks of horrible sales, we were planning for the worst and reduced our staff, and Jeff can speak to the specifics of how we went through staff evaluations and what that means to our long-term business. But we continue to be very conservative in our sales outlook and make sure that we're staffing to run the business and provide great customer service, but still be cognizant that sales trends could change. When we look up and down our P&L, a lot of items -- some items have been deferred when you look at maintenance. When we look at anything fuel related, whether it's utilities or gas to run the delivery vehicles, those have been significantly less than we would have thought some of our CapEx projects where we deferred the CapEx. They have a great return over time but have some drag in the initial implementation. So some of those deferrals have caused a positive short-term P&L impact but the main item and the main driver for our SG&A is store payroll. I'll turn it over to Jeff to comment on that.

Yes. I'd just add that as we talked about in the second quarter, the tail end of the second quarter, is we made headway, ramped up our staffing levels to try to meet the demand, and that trend can continue into the third quarter, but we still remain very cautious in our staffing just not knowing how long the sales demand will last. Now the other thing I'd mention is we've had an ongoing focus on our company about increasing our full-time team member mix, and we've made a headway with that this year. There are several benefits that, obviously, the higher levels of service, especially on nights and weekends from a more tenured full-time team member but really just as important, it continues to build our bench for our future promotions from within. And obviously, there's a cost associated with that besides the wages, the additional health benefits and paid time off, but we believe it's the right thing to do to drive even higher levels of service. And over the long term, that will make for a more productive workforce.

And then my follow-up question was just on the very strong used car sales that we've been seeing. I wondered in the history of the company if you've seen probably not a similar level, but just when there are higher used car sales, how it worked through your business? And what kind of sales lift and timing could we expect from that over the long term?

Historically, when we've seen used car sales go up and the prices go up, that's a benefit to our business from two standpoints. One, the price increase is being driven by people who are seeking use cars as opposed to as many new cars. So more miles driven are on cars outside of warranties. That's a positive for us. The other big positive for us is it's a used car sale, but it's new to somebody else. So both on the seller side, people are making repairs to sell their vehicles. And as people acquire new vehicles, they're making repairs to those vehicles. Both of which benefit us.

Our next question or comment comes from the line of Zach Fadem from Wells Fargo.

Could you talk about the impact of the discretionary or product -- project categories and how's that lift compared versus Q2? And then when thinking about this hobby customer, any indication that you're seeing a step-up in new customers relative to your typical run rate?

Well, Zach, it's hard to really determine. Some categories, it's obvious that it's "the hobby customer" other categories, it's really hard to tell. When you sell spark plugs, is that a hobby customer? Or is that a maintenance need? Are they working on a project car that's had dust on it with a cover on it for 4 or 5 years that they just have time to work on all of a sudden because they've got more time from working from home. They don't have the daily commute, things like that. So I would say those categories that we called out, performance, car care, things like that, they performed similarly to second quarter. But again, I don't want to send any impression to anybody that, that was the meat of our sales improvement because it's not. We did see -- that is an unusual trend for our industry to see sales in those categories. But really the meat and potatoes of our P&L were the traditional categories that we sell that continue to sell throughout the quarter.

Got it. That makes sense. And for Tom, on the gross margin line, can you talk about how the LIFO dynamics have compared to your expectations at the beginning of the year? And when you think about the initial 52.5% to 53% gross margin guide, I know that's no longer on the table, but is the low end of that range, the right way to think about the gross margin run rate going forward? Or are there any other one-off items around mix or the supply chain that we should keep in mind?

Well, Zach, I appreciate that you acknowledge that we've suspended guidance and therefore, I can't make any comments in relation to past guidance because it's been suspended. But we'll talk about the gross margin for the quarter. So as we talked about on our third quarter 2019 conference call, and we're very pointed in calling out as we were seeing a benefit and gross margin from items where tariffs have been imposed, prices on the Street, selling prices had increased, but we were able to sell-through the merchandise that we had on hand, and we were seeing a benefit from that. We expected that to benefit to continue, although declining through the first and second quarter of this year. In the second quarter of this year, we actually saw more price decreases, primarily as suppliers work to adjust their supply chains to limit the impacts of tariffs. So when we get to the third quarter, we've really annualized those items. And it's reflected in our LIFO charge or our LIFO benefit as the case may be. In this case, it's a benefit. So you'll see it in our Q last year, we had a LIFO benefit in the third quarter of $22 million. This year, it was $1 million.

Our next question or comment comes from the line of David Bellinger from Wolfe Research.

Can you talk a bit more about some of these better performing categories, particularly the battery category, where sales have been incredibly strong over the past few quarters. So how is supply shaping up at this point? And are you working through any constraints now? And what does that mean subsequently to gross margins?

Yes. I'll take the category question and see if Tom wants to comment on the margin component. As we said, all of our categories, we're very pleased with how all of our categories have performed. The only surprises, again, will be the call out. But I talked about the last question about performance, although not nearly as material as the traditional lines that sell very well for us. If you talk specifically about batteries, yes, we've seen significant battery sales for the quarter, actually, the past 2 quarters. Why? There's probably several reasons why I think some of it is related to maybe cars sitting at home because people are working from home. We had a mild winter last year, so there may be some pull forward. We'll have to see how that plays out in the fourth quarter. But as far as supply, we've had some supply issues throughout the third quarter from some of our suppliers. It's probably a handful of suppliers that had significant supply issues. There's only a couple of major battery suppliers in the industry. And both of those suppliers have performed well. One of them better than the other, but both have performed well. Like other categories, our suppliers have faced challenges with COVID related to the number of shifts they can work related to social distancing requirements, in one case related to wildfires out west. So it's been tough for our suppliers, just like it's been tough for us and our competitors to maintain staffing levels to keep up with demand. But overall, battery sales are great as we called out, and our suppliers are doing a good job. I think that if you look at the chart of fill rate from our suppliers over the past 6 months since the pandemic began, you see the hockey stick effect and those few that are still not feeling as well as we would like, we're starting to see an upturn in their fill rate. Tom, do you want to talk about the margin impact?

Sure. So to reiterate what Greg said, we're happy with the performance of all our categories. We can't post a 16.9% comparable store increase unless all the categories are doing well. The items where we point out some of the discretionary items that DIY consumers are buying, which is really for 2 reasons. One, when we get into economic constrained conditions, those typically go in the other direction. So that's abnormal. The other item is just that consumers are looking at their vehicles, wanting to invest in their vehicles, wanting -- in the reduction of repair, underperformed or unperformed maintenance is going down, and that is helping our sales value. So all the categories are doing well. So the difference in gross margin between those categories and other categories is not significant enough and the performance difference is not significant enough to create a mix difference in our gross margin.

Understood. And maybe just another follow-up on the previous margin question. So you walked us through the mechanics, post-tariffs and the flow-through there. But in the Q3 period, was there anything else out of the ordinary that you saw in terms of the year-over-year margin decline? Anything from a promotional perspective to keep some of these DIY customers in your ecosystem or higher transportation costs? And just anything out of the ordinary that further explains that the year-over-year 96 basis point decline?

So yes, I'd put it in three buckets. One is LIFO, we covered that. And then two is we have some dilution, as we talked about on our first quarter call from the Mayasa business in Mexico, where they run more independent chopper -- much more independent chopper business, and it's got a lower gross margin. You're not operating the stores. You share the gross margin with the independent chopper's operating stores. And we have normally, you would think in the distribution centers with high volume, we'd have leverage. But in this case, the volume is so high that we're having to do extraordinary things to get products shipped out. So we actually have some headwind there.

What Tom is referring to is just the incredible volume stream that just created really inefficiencies and are really receiving and shipping areas in our DCs. And with that volume and trying to stack that volume, we've had to use over time until we can catch up with headcount as well as temps to help us keep our shipping percentages where they need to be.

Our next question or comment comes from the line of Bret Jordan from Jefferies.

On the supply chain question, it sounds like a couple of suppliers, maybe one of the big battery guys has had some recent challenges. Could you give us color, sort of the cadence of supply chain stresses we heard back a quarter ago about some of the specialty performance parts being in short supply. Do you see your suppliers sort of having adjusted to the disruption in improving their in-stocks? Or I guess those weeks have the sustained period of above-average demand, is the supply chain having a harder time keeping up?

Yes. Good question, Brett. What I would tell you is we've seen improvement. Like I said, there's really only a handful of suppliers that are -- well, let me break that out. There's a handful of suppliers that are having fill rate issues that they control. There's also a handful of smaller chemical suppliers that are having some issues just simply to get product for their product. In other words, there are so many containers that are going towards hand sanitizers. Some of these specialty vendors are still having trouble getting containers to ship their products in. But that too has started to shift back into a favorable position. So what I would tell you from a supplier component of the supply chain, we're seeing continued improvement. And there's only really a handful of suppliers that are really continuing to not fill at a rate that we desire. Looking at the entire supply chain, as Jeff called out, as strong as our supply chain is and as strong as our DCs perform, they're just not equipped for the comparable store sales volume we've seen. So to Jeff's earlier point, we've seen some pressures there in our DCs keeping up with the demand. We've done a good job of getting product out to our stores on a daily basis, but we've had some backlog on incoming freight, and we're working really hard to get that caught up. So overall, we feel good. Suppliers are doing a good job. We're doing a good job of getting caught up. And I would say, within the next 30 to 45 days, we feel like our supply chain will be back to normal.

Okay. And then could you give us a quick update on regional performance, maybe the highs and the lows and what kind of spread you're seeing between those comps?

Yes. Jeff, do you want to take that?

Sure. As we mentioned on our second quarter call, we were extremely pleased with the performance on both sides of the business across all of our markets, really exceeding our expectations. And really, that trend continued into the third quarter. As you'd expect, our newer markets continue to outcomp our more mature markets. But overall, the outperformance in the third quarter was really across all of our divisions. All of our divisions performed very well exceeding our expectations.

Our next question or comment comes from the line of Mike Baker from Davidson.

A couple, let's say, I guess, I'll ask on the gross margin. So the -- if the remaining -- you talked about -- so gross margin down 90 points. I think if we do the math on the LIFO, you talked about, maybe that looks like it's a 65 basis point headwind. So can we assume the remainder is Mexico? And more importantly, how do we think about it in the fourth quarter? You said the dynamic will play out similarly, or will play out the same factors will play out, but what about the magnitude? In other words, should we expect the same impact from that LIFO dynamic of roughly 65 basis points as we saw this quarter?

Well, what we would expect -- first item is there were some other factors in there. So I wouldn't necessarily assume that mass is all of those, and we're not -- we talked about we're not commenting that specifically on their P&L. What I would tell you is that when we look at the fourth quarter, we would expect not to have a significant LIFO impact on our gross margin.

Not significant? Or not as significant. Sorry, I just didn't hear.

Not significant.

Not significant. Understood. Okay. And then, I guess...

Maybe to be more clear, you never know until the quarter is done and a lot of price changes happen during the quarter. But we were $1 million positive this year -- or this quarter, so pretty darn flat.

Right. But on a year-over-year basis, that's where the issue comes, right? So when you say not a significant LIFO in the fourth quarter, so let's say it's around that same level of $1 million, but on a year-over-year impact -- year-over-year basis, that impacts the gross margin change or the gross margin rate year-over-year. Is that the right way to think about it?

Our fourth quarter 2019 impact is within our SEC filings.

Yes. Okay. No, I get that. Okay. Okay. By way, perhaps a follow-up, if it's still in the P&L if that count as the same general area. On the SG&A, my sense is after the second quarter, you were pretty insistent that you're going to ramp back up the SG&A because it was too low. And now it sounds like a little bit more cautious from the third quarter going into the fourth quarter. Is that because you've gotten the SG&A back to the level that you think is appropriate? Or is it more a commentary of where you think sales are going in the next 3 months?

Well, clearly, in the second quarter, the spike in volume caught us by surprise is we had to reduce our workforce based on the fourth -- first onset of COVID in the results. So there are many different grades of leverage. The second quarter leverage was extreme, and that's something that is sustainable or good for our business in the long term. And the third quarter, as Jeff talked about, we increased our staffing to match the expected sales or closer to the expected sales. We continue to see significant SG&A leverage in the third quarter. I think our comments around that are we're going to manage our SG&A and our spend per store prudently so that we can react to changes in sales volume to be the same and continue at this high-low double-digit rate or to the extent that we see fluctuations that we can actively manage our expenses.

Our next question or comment comes from the line of Seth Sigman from Crédit Suisse.

Nice quarter. I wanted to follow-up on market share. Your results obviously outperforming the industry, it seems like by a wider margin than we've seen in the past. And it does seem like a good portion of that is actual share gains perhaps from independents. How much of this is transitory benefits from perhaps being able to manage inventory more effectively than others versus something that maybe is more structural? How do you think about the drivers of what's driving that outperformance right now?

Yes. So I think it's several things. And if you look at market share gains, one thing I would tell you is I think the pie itself is bigger this year. I think there's more money being spent in the aftermarket as a whole because of the stimulus and some of the incentives that consumers have. But if you look at where those market share gains are coming from, you mentioned the smaller independents, I think that is a result of supply chain string our leverage and our ability to have inventory within our supply chain and have that inventory positioned in such a way in our supply chain that gives us a competitive benefit. The other piece that I think, to a much lesser degree would be from the mass retail side. I think we're taking some market share from the mass retail side, although to a much lesser degree because it's a lot fewer categories. I think the consumer in that case is frequently concerned about walking into to a big box store to buy a battery or set of wiper blades or some product, and there's been a shift to the smaller retail box like ours. And I think there's been a surprise and delight function that goes along with that, when that customer comes into one of our stores, not only are they able to get that product with not having the degree of interaction that they would have in a big box store, but we also install that product them as well. And I think that's evident. I get a lot of letters from customers over the years. And lately, a lot of those letters talking about the service level we provide have called out with a degree of surprise that we perform those functions. And we install those batteries and wipers. And our traditional customer knows we do that. So I think we've brought some new customers under our stores. And I think one of the keys that market share that we've taken from both sides of the business is just the service level we provide and the stickiness and our focus on keeping those customers for the long term, from both channels that I described.

[Indiscernible] our team, just to expand on that. I mean, it's been an incredible -- incredibly disruptive the last 6 months to our business. And our corporate office has done a great job supporting our teams in the DCs and stores. And our DC teams have done a fantastic job with all the adversity they faced is shipping product to our stores and keeping them in an in-stock position. And then our stores have just in all the adversity and issues they face, in all their markets with lockdowns and the regulations have just done an incredible job in execution taking care of our customers day in and day out.

Okay. All right. And then just on one of the prior points around SG&A, it sounds like you'll continue to manage conservatively does that mean that if comps remain at this low double-digit rate, that SG&A growth may remain constrained in Q4 like we saw this quarter? Is that the way to think about it?

There's a lot of quarter left, and we'll see what happens with the sales volumes. What we would tell you is that the we are going to be conservative, that means not staffing up to the current level of business because the current level of business has been heightened from historic norms, to the extent that we can continue to drive those results, we will continue to see strong leverage.

Thank you. We have reached our allotted time for questions. I will now turn the call over to Mr. Greg Johnson for closing remarks.

Thank you, Howard. We'd like to conclude our call today by thanking the entire O'Reilly team for their continued selfless dedication to our customers. I'd also like to thank everyone for joining our call today, and we look forward to reporting our fourth quarter and full year 2020 results in February.

Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may now disconnect.