ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Unless
otherwise indicated, "we," "us," "our" and similar terms, as well as references to the
"Company" or "O'Reilly" refer to O'Reilly Automotive, Inc. and its subsidiaries.
Overview
O’Reilly Automotive, Inc. is one of the largest specialty retailers of
automotive aftermarket parts, tools, supplies, equipment and accessories in the United
States, selling our products to both do-it-yourself customers and professional installers.
At September 30, 2007, we operated 1,744 stores in Alabama, Arkansas, Florida, Georgia,
Illinois, Indiana, Iowa, Kansas, Kentucky, Louisiana, Minnesota, Mississippi, Missouri,
Montana, Nebraska, North Carolina, North Dakota, Ohio, Oklahoma, South Carolina, South
Dakota, Tennessee, Texas, Virginia, Wisconsin and Wyoming. Our stores carry an extensive
line of products consisting of new and remanufactured automotive hard parts and
accessories and a complete line of auto body paint and related materials, automotive tools
and professional service equipment. We do not sell tires or perform automotive repairs or
installations.
Forward-Looking Statements
We claim
the protection of the safe-harbor for forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995. You can identify these statements by
forward-looking words such as “expect,” “believe,”
“anticipate,” “should,” “plan,” “intend,”
“estimate,” “project,” “will” or similar words. In
addition, statements contained within this annual report that are not historical facts are
forward-looking statements, such as statements discussing among other things, expected
growth, store development and expansion strategy, business strategies, future revenues and
future performance. These forward-looking statements are based on estimates, projections,
beliefs and assumptions and are not guarantees of future events and results. Such
statements are subject to risks, uncertainties and assumptions, including, but not limited
to, competition, product demand, the market for auto parts, the economy in general,
inflation, consumer debt levels, governmental approvals, our ability to hire and retain
qualified employees, risks associated with the integration of acquired businesses, weather,
terrorist activities, war and the threat of war. Actual results may materially differ from
anticipated results described or implied in these forward-looking statements. Please refer
to the “Risk Factors” section of our annual report on Form 10-K for the year
ended December 31, 2006, for additional factors that could materially affect our financial
performance.
Critical Accounting Policies and Estimates
The
preparation of our financial statements in accordance with accounting policies generally
accepted in the United States (“GAAP”) requires the application of certain
estimates and judgments by management. Management bases its assumptions, estimates, and
adjustments on historical experience, current trends and other factors believed to be
relevant at the time the consolidated financial statements are prepared. Management
believes that the following policies are critical due the inherent uncertainty of these
matters and the complex and subjective judgments required to establish these estimates.
Management continues to review these critical accounting policies and estimates to ensure
that the consolidated financial statements are presented fairly in accordance with GAAP.
However, actual results could differ from our assumptions and estimates and such
differences could be material.
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Vendor concessions
– We
receive concessions from our vendors through a variety of programs and
arrangements, including co-operative advertising, allowances for warranties,
merchandise allowances and volume purchase rebates. Co-operative advertising
allowances that are incremental to our advertising program, specific to a
product or event and identifiable for accounting purposes, are reported as a
reduction of advertising expense in the period in which the advertising
occurred. All other vendor concessions are recognized as a reduction to the
cost of inventory. Amounts receivable from vendors also include amounts due to
us relating to vendor purchases and product returns. Management regularly
reviews amounts receivable from vendors and assesses the need for a reserve for
uncollectible amounts based on our evaluation of our vendors’ financial
position and corresponding ability to meet their financial obligations. Based
on our historical results and current assessment, we have not recorded a
reserve for uncollectible amounts in our consolidated financial statements, and
we do not believe there is a reasonable likelihood that our ability to collect
these amounts will differ from our expectations. The eventual ability of our
vendors to pay us the obliged amounts could differ from our assumptions and
estimates, and we may be exposed to losses or gains that could be
material.
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Self-Insurance Reserves
– We
use a combination of insurance and self-insurance mechanisms to provide for
potential liabilities related to workers’ compensation, general
liability, vehicle liability, property loss, and employee health care benefits.
With the exception of employee health care benefit liabilities, which are
limited by the design of these plans, we obtain third-party insurance coverage
to limit our exposure for any individual claim. When estimating our
self-insurance liabilities, we consider a number of factors, including
historical claims experience and trend-lines, projected medical and legal
inflation and growth patterns and exposure forecasts. The assumptions made by
management as they relate to each of these factors represents our judgment as
to the most probable cumulative impact of each factor on our future
obligations. Our calculation of our self-
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ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
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Self-Insurance Reserves (continued)
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insurance liabilities requires management to apply judgment to estimate the
ultimate cost to settle reported claims and claims incurred but not yet reported as of the
balance sheet date and the application of alternative assumptions would result in a
different estimate of these liabilities. Actual claim activity or development may vary from
our assumptions and estimates, which may result in material losses or gains. As we obtain
additional information that affects the assumptions and estimates we used to recognize
liabilities for claims incurred in prior accounting periods, we adjust our self-insurance
liabilities to reflect the revised estimates based on this additional information. If
self-insurance reserves were changed 10% from our estimated reserves at December 31, 2006,
the financial impact would have been approximately $4.5 million or 1.6% of pretax
income.
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Accounts receivable
–
Management estimates the allowance for doubtful accounts based on historical
loss ratios and other relevant factors. Actual results have consistently been
within management’s expectations, and we do not believe that there is a
reasonable likelihood that there will be a material change in the future that
will require a significant change in the assumptions or estimates we use to
calculate our allowance for doubtful accounts. However, if actual results
differ from our estimates, we may be exposed to losses or gains. If the
allowance for doubtful accounts were changed 10% from our estimated allowance
at December 31, 2006, the financial impact would have been approximately $0.3
million or 0.1% of pretax income.
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Taxes
– We operate within
multiple taxing jurisdictions and are subject to audit in these jurisdictions.
These audits can involve complex issues, which may require an extended period
of time to resolve. We regularly review our potential tax liabilities for tax
years subject to audit. The amount of such liabilities is based on various
factors, such as differing interpretations of tax regulations by the
responsible tax authority, experience with previous tax audits and applicable
tax law rulings. Changes in our tax liability may occur in the future as our
assessments change based on the progress of tax examinations in various
jurisdictions and/or changes in tax regulations. In management’s opinion,
adequate provisions for income taxes have been made for all years presented.
The estimates of our potential tax liabilities contain uncertainties because
management must use judgment to estimate the exposures associated with our
various tax positions and actual results could differ from our estimates.
Alternatively, we could
have applied assumptions regarding the
eventual outcome of the resolution of open tax positions that would differ from
our current estimates but that would still be reasonable given the nature of a
particular position. Our judgment regarding the most likely outcome of
uncertain tax positions has historically resulted in an estimate of our tax
liability that is greater than actual results. While our estimates are subject
to the uncertainty noted in the preceding discussion, our initial estimates of
our potential tax liabilities have historically not been materially different
from actual results except in instances where we have reversed liabilities that
were recorded for periods that were subsequently closed with the applicable
taxing authority.
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Share-based compensation –
Prior to January 1, 2006, we accounted for share-based
compensation plans under the provisions of Accounting Principles Board Opinion
No. 25,
Accounting for Stock Issued to
Employees
(“APB No. 25”), as permitted
under Statement of Financial Accounting Standards No. 148,
Accounting for Stock-Based Compensation - Transition and
Disclosure - an amendment of FASB Statement
No.
123
. Effective January 1, 2006, we
adopted SFAS No. 123R, “Share Based Payment,” under the
modified prospective method. Accordingly, prior period amounts have not been
restated. Under this application, we record share-based compensation expense
for all awards granted on or after the date of adoption and for the portion of
previously granted awards that remain unvested at the date of adoption.
Currently, our share-based compensation relates to stock option awards,
employee share purchase plan discounts, restricted stock awards and shares
contributed directly to other employee benefit plans.
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Under SFAS No. 123R, we use a Black-Scholes option-pricing model to
determine the fair value of stock options. The Black-Scholes model includes various
assumptions, including the expected life of stock options, the expected volatility and the
expected risk-free interest rate. These assumptions reflect our best estimates, but
they involve inherent uncertainties based on market conditions generally outside our
control. Since our adoption of SFAS No. 123R, share-based compensation cost would not have
been materially impacted by the variability in the range of reasonable assumptions we could
have made to value option award grants, but we anticipate that share-based compensation
cost could be materially impacted by the application of alternate assumptions in future
periods. Also, under SFAS No. 123R, we are required to record share-based compensation
expense net of estimated forfeitures. Our forfeiture rate assumption used in determining
share-based compensation expense is estimated based on historical data. The actual
forfeiture rate and corresponding share-based compensation expense could differ from those
estimates.
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Inventory Obsolescence and Shrink –
Inventory, which consists of automotive hard parts, maintenance
items, accessories and tools is stated at the lower of cost or market. The
extended nature of the life cycle of our products is such that the risk of
obsolescence of our inventory is minimal. The products that we sell generally
have application in our markets for a relatively long period of time in
conjunction with the corresponding vehicle population. We have developed
sophisticated systems for
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ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
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Inventory Obsolescence and Shrink (continued)
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monitoring the life cycle of a given product and, accordingly, have
historically been very successful in adjusting the volume of our inventory in conjunction
with a decrease in demand. We do record a reserve to reduce the carrying value of our
inventory through a charge to cost of sales in the isolated instances where we believe that
the market value of a product line is lower than our recorded cost. This reserve is based
on our assumptions about the marketability of our existing inventory and is subject to
uncertainty to the extent that we must estimate, at a given point in time, the market value
of inventory that will be sold in future periods. Ultimately, our projections could differ
from actual results and could result in a material impact to our stated inventory balances.
We have historically not had to materially adjust our obsolescence reserves due to the
factors discussed above and do not anticipate that we will experience material changes in
our estimates in the future.
We also record a reserve to reduce the carrying value of our perpetual
inventory to account for quantities in our perpetual records above the actual existing
quantities caused by unrecorded shrink. We estimate this reserve based on the results of
our extensive and frequent cycle counting programs and periodic full physical inventories
at our stores and distribution centers. To the extent that our estimates do not accurately
reflect the actual inventory shrinkage, we could potentially experience a material impact
to our reported inventory balances. We have historically been able to provide a timely and
accurate measurement of shrink and have not experienced material adjustments to our
estimates. If unrecorded shrink at December 31, 2006 were double the estimate that we
recorded based on our historical experience, the financial impact would have been less than
$2 million or less than 0.7% of pretax income.
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ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
Results of Operations
Sales
increased $65 million, or 10.8% from $597 million in the third quarter of 2006, to $662
million in the third quarter of 2007. Sales for the first nine months of 2007 were $1.92
billion, an increase of $193 million or 11.2% over sales for the first nine months of 2006.
A 4.3% increase in comparable store sales for both the first three and nine months of 2007
provided $24.6 million and $71.5 million of the three and nine month sales increase,
respectively. Comparable store sales are calculated based on the change in sales of stores
open at least one year and exclude sales of specialty machinery, sales to independent parts
stores and sales to team members. We believe that the comparable store sales increase is
primarily attributable to our offering of a broader selection of products in most stores,
an increased promotional and advertising effort through a variety of media and localized
promotional events, continued improvement in the merchandising and store layouts of most
stores, and compensation programs for all store team members that provide incentives for
performance.
The addition of 134 net new stores opened in the first
nine months of 2007 added $23.6 million and $41.9 million to the three and nine month sales
increase, respectively. Finally, a full three and nine months of sales for stores opened
throughout 2006, excluding sales which are included in our comparable store sales totals,
contributed an additional $16.8 million and $79.2 million to the three and nine month sales
increase, respectively. At September 30, 2007, we operated 1,744 stores compared to 1,596
stores at September 30, 2006. We anticipate that continued store unit and sales growth
consistent with our historical rates will continue in the future.
Gross
profit increased $30 million, or 11.5% from $263 million (or 44.1% of sales) in the third
quarter of 2006 to $294 million (or 44.4% of sales) in the third quarter of 2007. Gross
profit for the first nine months increased 12.2% to $850 million (or 44.3% of sales) in
2007, from $758 million (or 43.9% of sales) in 2006. The increase in gross profit dollars
was primarily a result of the increase in sales resulting from the increase in the number
of stores open during the third quarter and first nine months of 2007 compared to the same
period in 2006 and increased sales levels at existing stores. The increase in gross profit
as a percentage of sales is the result of improved product mix, lower product acquisition
cost and distribution system improvements. We improved our product mix by continuing to
implement strategies to differentiate our merchandise selections at each store based on
customer demand and vehicle demographics in the store’s market and through ongoing
Team Member training initiatives focused on selling products with greater gross margin
contribution. Product acquisition cost improved due to increased imports from lower cost
providers in foreign countries as well as improved negotiating leverage with our vendors as
a result of our growth. Improvements in our distribution system were the result of capital
projects designed to create operating expense efficiencies. We anticipate these trends to
continue at a moderate rate throughout the remainder of 2007.
Operating, selling, general and administrative expenses (“OSG&A
expenses”) increased $23 million, or 12.1% from $188 million (or 31.5% of sales) in
the third quarter of 2006 to $211 million (or 31.9% of sales) in the third quarter of 2007.
OSG&A expenses increased $69 million, or 12.8% from $539 million (or 31.3% of sales) in
the first nine months of 2006 to $609 million (or 31.7% of sales) in the first nine months
of 2007. The dollar increase in OSG&A expenses resulted primarily from additional team
members and resources to support our increased store count. The increase in OSG&A
expenses as a percentage of sales in the third quarter and for the first nine months of
2007 was primarily due to increased store pre-opening salaries, higher advertising costs
and increased stock compensation expense.
Our
estimated provision for income taxes increased $2.9 million to $30.4 million for the third
quarter 2007 compared to $27.5 million for the same period in 2006. Our provision for
income taxes increased $9.1 million to $89.6 million for the first nine months of 2007
compared to $80.5 million for the first nine months of 2006. These increases are the result
of our increased taxable income. Our effective tax rate was 36.4% of income before income
taxes for the third quarter of 2007 versus 36.5% for the same period in 2006. Our effective
tax rate for the first nine months of both 2007 and 2006 was 36.9%.
Liquidity and Capital Resources
Net cash
provided by operating activities increased from $159.8 million for the first nine months in
2006 to $281.9 million for the first nine months of 2007. This increase was principally due
to increased net income and a reduction in net inventory investment. Net inventory
investment reflects our investment in inventory net of the amount of accounts payable to
vendors. The reduction in net inventory investment is the result of reductions in our per
store inventory levels and our ongoing effort to extend payment terms with our
vendors.
Net cash
used in investing activities increased from $172.6 million during the first nine months in
2006 to $216.5 million for the comparable period in 2007, due to increases in capital
expenditures resulting from our ongoing store expansion program, store relocations and
enhancements to existing store technology. Our store expansion program resulted in the
addition of 134 new stores in the first nine months of 2007 compared to the addition of 126
new stores for the same period in 2006. During the first nine months of 2007, we relocated
30 stores compared to the relocation of 13 stores during the same period in 2006.
Enhancements to existing store technology include the roll out of our new point of sale
system as well as hardware upgrades.
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ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
Liquidity and Capital Resources (continued)
Net cash
provided by financing activities decreased from $22.2 million during the first nine months
of 2006 to $14.4 million for the same period in 2007. The decrease in cash flows from
financing activities is the result of a greater amount of repayment of long-term debt
during the first nine months of 2007 versus the comparable period in 2006.
We have
available an unsecured, five-year syndicated revolving credit facility in the amount of
$100 million. The credit facility may be increased at our request to a total of $200
million, subject to availability of such additional credit from either existing banks
within the credit facility or other banks. At September 30, 2007, there were no outstanding
borrowings under the revolving credit facility. Letters of credit totaling $31.6 million
were outstanding under the credit facility at September 30, 2007. Accordingly, we have
aggregate availability for additional borrowings of $68.4 million under the revolving
credit facility. The revolving credit facility, which bears interest at LIBOR plus a spread
ranging from 0.375% to 0.75% (5.688% at September 30, 2007), expires in July
2010.
Our
continuing store expansion program requires significant capital expenditures and working
capital principally for inventory requirements. The costs associated with opening a new
store (including the cost of land acquisition, improvements, fixtures, net inventory
investment and computer equipment) are estimated to average approximately $1.1 to $1.3
million; however, such costs may be significantly reduced where we lease, rather than
purchase, the store site. We plan to finance our expansion program through cash expected to
be provided from operating activities and available borrowings under our existing credit
facilities.
During
the third quarter of 2007, we opened 43 new stores. We plan to open approximately 56
additional stores during the remainder of 2007. The funds required for such planned
expansions are expected to be provided by existing cash balances, cash generated from
operating activities and the existing and available bank credit facilities.
We
believe that our existing cash, short-term investments, cash expected to be provided by
operating activities, available bank credit facilities and trade credit will be sufficient
to fund both our short-term and long-term capital and liquidity needs for the foreseeable
future.
Contractual Obligations
At
September 30, 2007, we had long-term debt with maturities of less than one year of
$25,317,000 and long-term debt with maturities over one year of $75,230,000, representing a
total decrease in all outstanding debt of $9,932,000 from December 31, 2006.
New
Accounting Standards
In July
2006, the Financial Accounting Standards Board ("FASB") issued FASB Interpretation No. 48,
"Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109"
("FIN 48"). FIN 48 prescribes a recognition threshold and a measurement process for
recording in the financial statements uncertain tax positions taken or expected to be taken
in a tax return. For a benefit to be recognized, a tax position must be
more-likely-than-not to be sustainable upon examination by the applicable taxing authority.
Additionally, FIN No. 48 provides guidance on derecognition, classification, accounting in
interim periods and disclosure requirements for uncertain tax positions. We adopted the
provisions of FIN 48 on January 1, 2007. No adjustment was required in the liability for
unrecognized income tax benefits as a result of the implementation of FIN 48. At the
adoption date of January 1, 2007, we had a gross exposure for unrecognized tax benefits of
$14.9 million and a related $4.9 million deferred tax asset for the corresponding potential
future tax deduction related to the gross exposure (for a net $10.0 million of unrecognized
tax benefits) which would affect our effective tax rate if recognized. At September 30,
2007, we had a gross exposure for unrecognized tax benefits accrued of $18.7 million and a
related $6.4 million deferred tax asset for the corresponding potential future tax
deduction related to the gross exposure (for a net $12.3 million of unrecognized tax
benefits) which would affect our effective tax rate if recognized. We recognize interest
and penalties related to uncertain tax positions in income tax expense. As of September 30,
2007, we had approximately $2.4 million of accrued interest and penalties related to
uncertain tax positions, before the benefit of the deduction for interest on state and
federal returns. Although unrecognized tax benefits for individual tax positions may
increase or decrease during 2007, we do not anticipate significant increases or decreases
to the total amount of unrecognized tax benefits during 2007 or for the one year period
subsequent to September 30, 2007.
Our U.S.
federal income tax returns for tax years 2005 and beyond remain subject to examination by
the Internal Revenue Service (“IRS”). The IRS concluded an examination of our
consolidated 2002, 2003 and 2004 federal income tax returns in the first quarter of 2007.
The statute of limitations for our federal income tax returns for tax years 2003 and prior
have expired. The statute of limitations for our U.S. federal income tax return for 2004
will expire on September 15, 2008, unless otherwise extended. Our income tax returns remain
subject to examination by various state authorities for tax years ranging from 2001 through
2006.
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ITEM
2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(continued)
Inflation and Seasonality
We
attempt to mitigate the effects of merchandise cost increases principally by adjustments to
our retail prices. We will also take advantage of vendor incentive programs, economies of
scale resulting from increased volume of purchases and selective forward buying. As a
result, we do not believe that our operations have been materially affected by inflation.
Our business is somewhat seasonal, primarily as a result of the impact of weather
conditions on customer buying patterns. Store sales and profits have historically been
higher in the second and third quarters (April through September) of each year than in the
first and fourth quarters.
Internet Address and Access to SEC Filings
Our
Internet address is www.oreillyauto.com. Interested readers can access our annual reports
on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and any
amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the
Securities Exchange Act of 1934, as amended, through the Security and Exchange
Commission’s website at www.sec.gov. Such reports are generally available on the day
they are filed. Additionally, we will furnish interested readers upon request and free of
charge, a paper copy of such reports.
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