Genuine Parts Company (GPC) — Q2 2018 Earnings Call Transcript

Good morning, and thank you for joining us today for the Genuine Parts Company Second Quarter 2018 Conference Call to discuss our earnings results and current outlook for the full year. I'm here with Paul Donahue, our President and Chief Executive Officer; and Carol Yancey, our EVP and Chief Financial Officer. Before we begin this morning, please be advised that this call may include certain non-GAAP financial measures, which may be referred to during today's discussion of our results as reported under generally accepted accounting principles. A reconciliation of these measures is provided in the earnings press release issued this morning, which is also posted in the Investors section of our website. Today's call also may involve forward-looking statements regarding the company and its businesses. The company's actual results could differ materially from any forward-looking statements due to several important factors described in the company's latest SEC filings, including this morning's press release. The company assumes no obligation to update any forward-looking statements made during the call. Now let me turn the call over to Paul.

Thank you, Sid, and welcome to our second quarter 2018 conference call. We appreciate you taking the time to be with us this morning. Earlier today, we released our second quarter 2018 results. I'll make a few remarks on our overall performance and then cover the highlights across our three businesses, Automotive, Industrial, and Business Products. Carol Yancey, our Executive Vice President and Chief Financial Officer, will provide an update on our financial results and our current outlook for 2018. After that, we'll open up the call to your questions. So to recap our second quarter performance across our global platform, total sales were a record $4.8 billion, up 17.6%, driven by the favorable impact of strategic acquisitions and a 3.4% comp sales increase, which has improved from the plus 2% in the first quarter. Net income was $227 million and earnings per share of $1.54 was also a new record. Excluding the impact of transaction and other costs related to the acquisition of Alliance Automotive Group and the agreement to spin off the Business Products Group, adjusted net income was $234 million, up 23%, and adjusted earnings per share was $1.59, also up 23%. As we look to our global Automotive group, total sales were up 27.7% in the second quarter, including an approximate 2.1% comp sales increase, which compares to a 1.5% increase in the first quarter. We are pleased to see our comps headed in the right direction. We also have the benefit of acquisitions and favorable foreign currency translation. Breaking it down further, sales for our U.S. Automotive operations were up 4% in the second quarter, with comp sales up 1.5% and improved from the first quarter. We were encouraged by the positive shift in the underlying sales environment for this business, which we believe reflects the continuing favorable effect of this winter's more normalized weather as well as the summer heat across most of the U.S. in both May and June. After a slow start out of the gate, largely due to the cold and wet conditions at the start of spring, our sales were much improved in both May and June. By market segment, sales to our retail customers continue to outpace sales to the commercial segment, although our commercial comps were improved from the first quarter and reflect our strongest results over the past nine quarters. By customer segment, we were encouraged to see stronger results in both NAPA AutoCare and Major Accounts sales. NAPA AutoCare sales were up 3% for the quarter while Major Accounts sales were up slightly for their first positive comp in several quarters. Looking ahead, we believe the improving conditions for underlying sales demand, combined with our ongoing initiatives, continue to enhance our value-added services for both existing and new commercial customers. This should drive further sales growth in the upcoming quarters. Turning to our retail business, we remain pleased with the continued solid growth in this segment due primarily to initiatives like the NAPA Rewards Program, expanded store hours, and our retail impact store project. These initiatives continue to drive incremental sales growth. And while retail remains at 20% to 25% of our U.S. Automotive sales, it is an important segment of the overall market. In summary, we are encouraged by the improvement in our U.S. Automotive comp sales in the second quarter, and we expect to see demand across the aftermarket continue to strengthen. As we head into the second half of 2018, we are seeing the positive shift in demand for failure and maintenance parts due to the continuing impact of more normalized winter weather patterns and the record heat across much of the U.S. thus far this summer. We expect the number of vehicles in the aftermarket sweet spot to further stabilize and ultimately become a tailwind in 2019 and into 2020. The long-term fundamental drivers for the automotive aftermarket remain sound with a growing total and aging fleet and an increasing number of miles driven among consumers. We also expect our ongoing acquisitions and overall footprint expansion to positively contribute to our future sales. In addition to the five Smith Auto Parts stores added to our U.S. network in March, we recently added the Sanel Auto Parts to our network of independent NAPA auto parts stores. Sanel Auto Parts is a 44-store, fourth-generation business with a market-leading position in New Hampshire, Vermont, and Maine markets. Sanel represents the largest independent changeover in the history of NAPA, and we want to welcome both David and Bobby Segal and the entire Sanel team to the NAPA and GPC family. The addition of Smith Auto and Sanel Auto Parts to our overall store network, as well as other accretive tuck-in acquisitions, remain an important part of our growth strategy, and we see additional opportunities to expand our U.S. store footprint. So now let's turn to our international Automotive businesses in Canada, Mexico, Europe, and Australasia. Collectively, these operations delivered a second consecutive quarter of 6% total sales growth, including a 2% comp sales increase and accounted for approximately 40% of our total Automotive revenues. Starting with our other North American Automotive operations, total sales were up mid-single digits at both NAPA Canada and in Mexico. In Canada, sales were driven by low single-digit comp sales growth and acquisitions, including the addition of Universal Supply Group on December 31, as we discussed last quarter. The NAPA Canada team remains focused on their sales initiatives and with positive industry fundamentals and a stable economy at their back, we expect continued growth at our Canadian operations over the balance of 2018. Now turning to Alliance Automotive Group, this business continues to operate well across its European footprint in France, the U.K., Germany, and Poland. The team at AAG posted mid-single-digit sales comps for the second quarter and continues to benefit from ongoing acquisitions. AAG remains on plan for both sales and profit, and we are pleased with the continued progress on our integration plans, including our initiatives to drive synergies. As mentioned before, AAG's robust acquisition strategy resulted in additional bolt-on acquisitions again in the second quarter. We also announced on June 7 the addition of the Hennig Group in Germany, a leading supplier of light-duty and commercial vehicle parts. Hennig has 31 branches across Germany and is expected to generate annual revenues of approximately $190 million. We are excited to welcome the Hennig team to our German operations and expect to close on this transaction in the September-October time frame. The addition of the Hennig business, the full pipeline of other potential acquisitions and our continued focus on underlying core growth is supported by relatively solid economic and industry fundamentals. We are encouraged by the opportunities we see for our European operations and are confident that the AAG team will drive strong results through the balance of the year and beyond. In Australia and New Zealand, total sales in local currency were up mid-single digits while comp sales were up low single digits in the second quarter, consistent with the first quarter. The Asia Pac team is doing an excellent job of balancing their strategy to generate both comp sales growth and accretive acquisitions, including important e-commerce investments to enhance our digital capabilities. We expect our continued focus in each of these areas, coupled with sound economic and aftermarket fundamentals, to drive continued solid results. But before we launch into our review of our Industrial business, allow me to summarize our global Automotive results. After a slow start to the quarter, our U.S. business rebounded in the months of May and June and finished out the quarter with improved comps. Our European acquisition, AAG, continues to outperform, and we expect continued great things from this team. Our remaining international Automotive businesses in Australasia, Canada, and Mexico continue to perform to plan, and we are optimistic for a solid second half from this group. So now let's turn to our Industrial Parts Group. We are pleased to report the sales environment for this business remains positive. Total sales for Industrial were up 8.7% in the second quarter, including 6.5% comp sales growth, plus the benefit of acquisitions. These increases improved on the already solid growth we reported last quarter and reflect the positive impact of our ongoing growth initiatives and favorable economic and industry-specific factors. These would include the continued strength in major industrial indicators such as Purchasing Managers Index, industrial production, active rig counts, and U.S. exports. In addition, 13 of our 14 major product groups, including the electrical specialties group, posted sales gains, and all 12 of the top industries we serve were up as well. The aggregate and cement, equipment and machinery, chemicals and allied products industry sectors were especially strong, with each showing low double-digit increases. The broad strength across our products and customer base indicates a strong industrial economy, a promising sign for the balance of 2018 and well into 2019. Our Industrial management teams at Motion and EIS continue to work closely together and are making progress to generate additional revenue opportunities, economies of scale, and improved efficiencies in the combined organization. The combination of these two businesses into a larger and stronger industrial group was absolutely the right decision for our team and the opportunities we see ahead for this business are encouraging. As we look to the second half of the year, we expect continued strong results from the Industrial group. We also remain pleased with the ongoing growth at Inenco, the Australian-based industrial distribution company we partnered with in 2017. This business is performing well, having just closed its fiscal year with a record-setting performance. This group surpassed the AUD 500 million threshold for the first time in their fiscal year 2018. As Inenco further expands its footprint across Australia and New Zealand, with acquisitions such as HCD Flow Technology in New Zealand, which we announced last quarter, while they also expand their presence in Indonesia and Singapore, we are further encouraged for the future growth prospects for this business. As a reminder, we currently have a 35% investment in Inenco and we look forward to further investing in this business within the next 12 to 18 months. This quality organization will be a great addition to our global Industrial group. Now a few comments on S.P. Richards, our Business Products Group. This segment reported flat sales for the second quarter, which was a vast improvement from the 5% decrease recorded last quarter. While this business faces headwinds in the demand for traditional office products, our diversification into the facilities, break room, and safety supplies category is offsetting some of these headwinds. With that said, we continue to work towards the closing of our definitive agreement with Essendant and now is back on April 12, whereby GPC will spin off the S.P. Richards business and merge it with Essendant, another national business products wholesaler. As discussed last quarter, this transaction made sense for several reasons. Primarily, the newly combined company is in the best interest of all stakeholders as it will be better positioned to effectively compete in the business product space with greater ability to support their customer community. Additionally, this allows GPC to further strengthen our focus on our core and larger, higher growth, and more profitable Automotive and Industrial businesses. Since we last reported on April 19, you are likely aware of several developments involving this transaction with Essendant. Despite these developments, our agreement remains in place. And subject to regulatory and Essendant shareholders' approval, we continue to expect to successfully close on the agreement. We believe the combination of Essendant, along with S.P. Richards, creates a stronger, more diversified business as together, these talented management teams and complementary cultures, with a shared commitment to serving customers, will be better positioned for future success. Likewise, for employees, the new company will have the scale and depth to compete more effectively. We look forward to supporting the S.P. Richards and Essendant team in facilitating a seamless integration. So that is a summary of our consolidated and business segment sales results for the second quarter of 2018. We are pleased to report improved results with many positive developments to build on as we move through the back half of the year. So with that, I'll hand it over to Carol for her remarks.

Thank you, Paul. We will begin with a review of our key financial information and then we will provide an update of outlook for 2018. Our total sales in the second quarter were up 18% or up 3% before acquisitions and a slight benefit from foreign currency translation. Gross margin for the second quarter was 31.55% compared to 30.24% last year. Consistent with the first quarter, this strong increase primarily reflects the higher gross margin associated with AAG and other acquisitions as well as the benefit of increased supplier incentives in our Industrial business. These items were partially offset by lower supplier incentives for the Business Products Group. We remain focused on enhancing our gross margins through several key initiatives, including continued supplier negotiations both globally and across our businesses, the ongoing investment in more flexible and sophisticated pricing strategies, and improved analytic capabilities around product and customer profitability. The pricing environment has been somewhat inflationary in our Industrial and business products businesses thus far in 2018, and we would expect this to continue with the ongoing rhetoric around new tariffs. With the latest round of tariff talk, we could also see an inflationary impact in Automotive; however, there is still a fair amount of uncertainty around its timing and ultimate impact. With that said, we expect to be able to pass along any increases to the customers. Our cumulative supplier increases through the six months of 2018 were flat for Automotive, up 2% in Industrial, and up 1.1% for Office. Turning to our SG&A, total expenses for the second quarter were $1.22 billion, representing 25.33% of sales. This is up from last year due to the higher operating cost model at AAG as well as incremental depreciation, amortization, and interest associated with the acquisition. In the quarter, we also incurred $9 million in transaction and other costs related to AAG and the pending transaction to spin off S.P. Richards. In addition, we continue to experience the lack of leverage on our comparable sales in the Automotive and business product segments, as well as ongoing pressure from rising costs in areas such as payroll, freight, and delivery, IT and digital. Finally, as we discussed in prior calls, we increased the level of technology and productivity investments this year, which we believe will generate longer-term cost savings and efficiencies. As we move forward in the year, we're focused on our plans to address the rising cost environment and generate meaningful savings. This is essential as we work to improve our operating margin in the Automotive segment and specifically, the U.S. Automotive business. This is a top priority for us, and we're fully committed to taking the necessary steps to get this done. Now let's discuss the results by segment. Our Automotive revenue for the second quarter was $2.7 billion, up 28% from the prior year, and operating profit of $244 million was up 18%, with an operating margin of 8.9% compared to the 9.7% margin in the second quarter of 2017. Primarily, the decline in operating margin reflects the deleveraging of expenses in our U.S. Automotive business, as well as the cost pressures and investments just discussed. Our Industrial sales were $1.6 billion in the quarter, a 9% increase from quarter two, and our operating profit of $125 million is up 12% and our operating margin is 7.8% compared to 7.6% last year, with the 20 basis point improvement due to a solid gross margin and improved leverage on our expenses with a 6.5% comparable sales increase. We expect to see continued margin expansion at Industrial over the balance of the year. Business products revenues were $483 million, flat with the prior year, and their operating profit of $21 million is down 29%, with an operating margin of 4.4%. Although we saw sales stabilize for this group in the second quarter, the business products segment continues to operate in a challenging environment and faces unfavorable product and customer mix shifts. Both of these issues are pressuring their profitability. Our total operating profit in the second quarter was up 12% on the 18% sales increase, and our operating profit margin was 8.1% compared to the 8.5% last year. This change in margin is consistent with the first quarter, and as we said before, improving on these results in the quarters ahead is a top priority for us. We had net interest expense of $25.5 million in the quarter. And for 2018, we expect net interest expense to be in the range of $98 million to $100 million, which is an increase from our previous guidance of $93 million to $95 million. Our total amortization expense was $22 million for the second quarter, which is an increase from the prior year due to the amortization related to AAG. For 2018, we're updating our full year amortization to be $88 million to $90 million, which is up from the prior guidance of $83 million to $85 million. Our depreciation expense was $31 million for the quarter, up $4 million from last year. For the full year, we continue to expect total depreciation to be in the range of $140 million to $150 million. And on a combined basis, we would expect depreciation and amortization of approximately $230 million to $240 million. The other line, which typically reflects our corporate expense, was $43 million for the second quarter, and this includes $9 million in transaction-related costs incurred in the quarter. Excluding these costs, our corporate expense was $34 million, which is consistent with the second quarter of 2017. For 2018, we continue to expect our corporate expense to be in the $115 million to $125 million range, which excludes transaction-related costs. Our tax rate for the second quarter was 24.4%, which is an increase from the 23% in the first quarter, as expected, but down significantly from the 36% tax rate in the prior year, which is due mainly to the benefit of U.S. tax reform. In addition, our tax rate was positively impacted by the favorable mix of U.S. and foreign earnings. We are updating our full year estimate for the 2018 tax rate to approximately 25% from the previous estimate of 26%. Now let's turn to a discussion of the balance sheet, which remains strong and in excellent condition. Our accounts receivable of $2.7 billion is up 23% from the prior year and up 3%, excluding the impact of acquisition, primarily AAG, as well as foreign currency. The 3% increase is in line with our 3% comparable sales increase for the quarter, so we made progress in improving on our receivables during the quarter. In addition, we remain pleased with the quality of our receivables. Our inventory at June 30 was $3.5 billion, up 5% from June of last year and down 3%, excluding AAG, our acquisitions, and foreign currency. Inventory at June 30 highlights the positive impact of our current initiatives to improve the inventory levels in our core businesses, and we're very focused on maintaining this key investment at the appropriate levels as we move forward. Accounts payable of $3.8 billion at June 30 is up 16% in total and flat with the prior year excluding AAG, other acquisitions, and foreign currency. Our flagged for payables is primarily driven by the 3% increase in inventory, which is resulting from the lower levels of purchasing activity in our U.S. Automotive and Business Products Groups. These factors were partially offset by the benefit of improved payment terms with certain suppliers. And at June 30, our AP to inventory ratio was approximately 110%. Our total debt of $3.2 billion at June 30 is consistent with our debt at December 31 and March 31, and it reflects our increase in borrowings for the AAG acquisition in the fourth quarter of 2017. Our debt arrangements vary in maturity and currently, the average interest rate on our total debt stands at 2.98%. We're comfortable with our current debt structure, and we have the strong balance sheet and financial capacity to support our growth initiatives, including strategic acquisitions and investments such as AAG and the Inenco Group in Australia, which we believe creates significant value for our shareholders. So in summary, our balance sheet remains a key strength of the company. Turning to our cash flows, we've generated $455 million in cash from operations for the six months in 2018, which has improved from last year. Our cash flows continue to support the ongoing priorities for the use of our cash, which we believe serve to maximize shareholder value. And for 2018, we continue to project cash from operations in the $950 million to $1 billion range and free cash flow of approximately $400 million. Our priorities for cash remain the dividend, reinvestment in our businesses, share repurchase, and strategic acquisitions. Regarding the dividend, 2018 represents the 52nd consecutive year of increased dividends paid to our shareholders. Our 2018 annual dividend of $2.88 represents a 7% increase from 2017. We have invested $65 million in capital expenditures thus far in 2018, which is up from $54 million in 2017. For the year, we continue to plan for capital expenditures in the range of $200 million to $220 million, with the increase from 2017 mainly due to the impact of AAG and certain technology, facility, and productivity investments that we're planning for in association with our tax savings. We have not purchased any of our common stock in 2018. And today, we have 17.4 million shares authorized and available for repurchase. We have no set pattern for these repurchases, but we expect to be active in the program over the long term as we continue to believe that our stock is an attractive investment and combined with the dividend, provides the best return to our shareholders. So now let's turn to our guidance for 2018. Based on our current performance, our growth plans and initiatives, as well as the market conditions we see for the foreseeable future, we now expect total sales to be in the range of plus 13% to plus 14%, excluding the benefit of any future acquisitions and any impact from foreign currency. This represents an increase from the previous guidance of plus 12% to plus 13%. By business, we're currently expecting plus 21% to plus 22% total sales growth for the Automotive segment, which is an increase from the previous guidance of plus 19% to plus 21%. Plus 6% to plus 7% total sales growth for the Industrial segment, which is an increase from the previous plus 4% to plus 5%. And a sales decrease of minus 3% to minus 4% for the Business Products Group, which we continue to include in our guidance until the spinoff transaction is closer to completion. This estimate is unchanged from the prior guidance. On the earnings side, we continue to expect adjusted earnings per share, excluding any transaction-related costs incurred during the year, to be in the range of $5.60 to $5.75. This EPS guidance includes the benefit of a full year of operations with S.P. Richards, the Business Products Group. So that's our financial report for the second quarter. And we closed the first half of 2018 with positive momentum, and we look forward to building on that over the second half of the year as we address those areas in need of improvement, such as our SG&A and Automotive operating margin. Again, this is a top priority for us, and we look forward to reporting to you on our progress in the quarters ahead. Before turning it back over to Paul, I'd like to thank all of our GPC associates for their continued hard work and dedication at GPC. We appreciate all you do. And now I'll turn it back over to Paul.

Thank you, Carol. To recap the second quarter, we have several accomplishments to highlight. Although we also have a few areas requiring improvement, and we plan to address these head on. We fully recognize the need to show progress in our core operating results. And the key here is to improve our Automotive margin, specifically in our U.S. operations. To this end, our team is focused on driving core sales growth to better leverage our fixed expenses. We have more work to do to execute on our sales initiatives and maximize the growth opportunities available to us. And we are also focused on ensuring a steady gross margin along with an efficient cost structure. Rising costs in several areas have continued to offset our savings initiatives, so we must work to eliminate even more cost while continuing to provide exceptional customer service. We are committed to taking action to deliver cost savings in every aspect of our U.S. Automotive business. From an execution standpoint, we can and we will do better. Our team has delivered a much needed lift in revenues this quarter. And now we must increase our intensity around our execution and deliver improved results. As we look at the highlights from the second quarter, there are many to report on. We established a new sales record at $4.8 billion and up 18%. We established the new earnings record with EPS of $1.54, up 19%. We improved on our Automotive sales comps on our U.S. operation, and we continue to perform well in our international Automotive businesses. Our Industrial segment produced strong sales growth and improved on their profitability with an expanded operating margin. We stabilized our business products sales and continue to work towards the spinoff of this business. We improved the strength of our balance sheet and generated strong cash flows to support our capital allocation plans. We announced a significant strategic acquisition in Germany that will strengthen our position in this key market. And we increased our full year sales guidance to plus 13% to plus 14% and reiterated our full-year adjusted EPS guidance at plus 19% to plus 22% over last year. With these accomplishments, as well as our other action plans to address areas requiring improvement, we entered the second half of 2018 focused on improving our operating results. We will continue to emphasize an organic and acquisitive sales strategy to drive long-term, sustained revenue growth and will continue to execute on our plans and initiatives to enhance our gross margins, reduce costs, and build a highly productive and cost-effective infrastructure. We expect our focus in these key areas to improve the operating performance in our core businesses and for the company overall. As always, we look forward to updating you on our progress again in October when we report our third quarter 2018 results. So with that, we'll turn it back to the operator, and Carol and I will take your questions.

A couple of questions on AAG. So the mid-single-digit comp in Europe, is that, do you think, better than the market? Are you gaining share there? Or was the market very strong in Europe?

Bret, I think that overall, as we model that business and did our due diligence, we believe we're outperforming right now. Our thoughts going into the year would be really on the low side of positive comps, and we outperformed. And I would really call out our team in the U.K. where we had strong single-digit comps in the U.K. And Germany, we did just fine as well. So a really good performance by the AAG team.

How do we think about their EBITDA margin? I guess it sounds like their gross margin's high, but maybe some incremental SG&A in that business mix?

No, actually, when we look at their operating margin, their operating margin is performing better than our U.S. Automotive margin and more in line with our other international Automotive businesses. So they actually carry a slightly higher operating margin, and there isn't really any concerns with SG&A with that group. I can tell you when you have mid-single-digit comps and you're growing a little bit better than the industry, they're doing a really nice job on the margin side. So they are at plan with where we told you guys back last year with the $0.45 to $0.50 EPS on a full-year basis and probably more at the high end of that number.

Okay, great. And then the question I have to ask, any regional performance spreads in the quarter in the U.S.?

Yes, the strength for us this past quarter was in our warmer markets. Our Southeastern division performed well, and our Southwestern division also had a strong quarter. In the West, we did well and surpassed the performance of our colder weather division, which includes the Midwest, Central, Northeast, and Mountain regions. The soft start in April, with snow in the Midwest, affected our Northern divisions, but they recovered nicely in May and June.

Okay. And then one last question. We said you would probably passing through anything you see in tariffs. Have you had any conversations or have your suppliers been opening the conversation about higher pricing? Obviously, even before tariffs, they were seeing labor and maybe some material input inflation. But what do you expect for inflation in the second half? It sounded like it was flat in the second quarter.

Yes, regarding the tariffs for Automotive, we have seen flat price increases in the first half. We have experienced some fluctuations, and we anticipate changes in the second half of the year. Specifically for tariffs, their impact has been minimal so far, particularly within our U.S. Automotive business this year. We have been in continuous discussions with our suppliers, and our team is actively engaged in this process. We are monitoring any increases in raw materials, freight, interest rates, and tariffs comprehensively. Our global sourcing offices are collaborating with our teams, and we are conducting extensive data-driven negotiations with our suppliers. Ultimately, any cost changes will likely be passed on to the customer, and we will need to see how this develops.

Nice improvement in the U.S. comps. But I was wondering if you could address some of the margin weakness in the U.S. Can you give us a breakdown how the margin performed between gross and SG&A, and what's been the drivers are specifically?

Yes. So Seth, when we look at our Automotive margins and the decline that we had in the quarter, that is completely related to the U.S. Automotive business. So combination, flat to slightly up on gross margins. We had a little bit of customer and product mix issues in the quarter that were a headwind on gross margin. But the primary issue is SG&A. And what I would call out is what we're seeing is probably about half of the margin deterioration is great and diesel fuel and delivery related and also IT investments, which we've called out, and the other half is payroll. And so the two things I would say is that these increases in payroll and specifically freight and delivery are greater than what our, say, 5% sales increases, including AAG. And so we had particular issues in the quarter with freight. You guys have seen it. April, it particularly spiked. It stayed up very strong in the Q2. We had some additional driver regulations. There's labor shortages. So our teams are working very hard to deal with those freight increases that are greater than our sales. And so we're working on that and considering and looking at a number of things from passing along to the customers. And the other thing with payroll, as you know, again, with payroll increases, some of the minimum wage increases and some of the unemployment. And quite honestly, incentive compensation swing this year compared to last year, which is a function of the improved sales, all that with a up slightly comp that we don't leverage on is really what's weighing on those U.S. Automotive margins. But having said that, and you heard Paul say it, we've got a lot of plans in place for the second half to hopefully narrow that gap and make up some of the progress there.

That's helpful color. How do you think about the pricing power of your business in the U.S. given these rising costs that everyone else is facing? Do you have an ability to pass along those higher cost in the form of higher prices?

Yes, we do, Seth. If you look across our businesses in the U.S., whether it's Industrial, auto, or business products, our intent is to pass those costs along. This is consistent in 2018 as it has been in past years. Given our size and scale in the Automotive sector, we believe we have the capability to pass those costs along, not just in the U.S., but globally as well.

Fair enough. Regarding the sales pattern in the U.S. for the quarter, you mentioned April was softer while May and June were stronger. Was May your peak month followed by a slowdown in June? And how has July started for you?

No, well, Seth, April was a mess. The weather in April really put us at a disadvantage. I'm only referring to the U.S. Automotive right now, but the trend was similar across all of GPC. We saw a good rebound in May, and it continued in June. There was no decline in June and July, and the heat we're experiencing across the U.S. is holding steady. As we anticipated last quarter, that combination of the harsh winter we had and the heat that started in May and continued through June and July is looking promising for the aftermarket.

Regarding your guidance, you have increased the sales growth outlook and reduced the tax rate for the full year, but the EPS range remains unchanged. Do you believe there is some conservatism factored into that earnings outlook, especially considering the uncertainty surrounding tariffs? Or do you think costs are rising higher than you initially anticipated, leading you to maintain the EPS outlook as it was?

Yes. So what we looked at, certainly, we look at where we are thus far through the six months. So there is certainly a consideration that we're a bit behind through the six months. We had implied kind of flattish operating margins on a full year, and we're a little bit behind now. So that's part of it. We are implying a little bit stronger comp growth when we've got a range for a second half. If we come in a little bit stronger there, that would give us more comfort. But the other thing I'd point out is we called out a couple of cost increases for the second half. So interest, amortization. We even have a little bit of FX in the second half. So I think our second half margins would be somewhat comparable to what you saw in the first half, and we hope to kind of narrow that range. And look, as you mentioned, which is all the uncertainties right now, we just felt it was appropriate to leave the range that we have at this point.

Yes, that makes sense. And as you mentioned, the inability to leverage cost in the auto business this quarter, comps were above 2%, globally. So what do you think is the bogey for where your comp needs to be in order to get operating leverage in this current environment?

Well, we've said in the past that that comp is around more of a 3% number to get us there. Having said that, when you've got these kinds of increases in freight and delivery, we're working awful hard to get that to where it needs to be. So having 1.5% or 2% is certainly helping us, but we need to get 3% or above. And the reason we're comfortable with that is we can look at our industrial business and see what we've done there, their margins and their improvement, and we know also historically what we've done in the past. So a number of these projects we have will be helping us try to narrow that gap.

And Liz, I would just add to the comments Carol just made, the 3% number. The good news is that we were there and a little above that number in both May and June.

My first question is about the gross margins. Can you remind us what the acquisition benefit was in the gross margin? I'm trying to determine if the core gross margin rate performance, excluding acquisitions, in the second quarter compared to the first quarter showed a similar year-over-year increase or if there was some decline in performance in the second quarter versus the first quarter, and what may have caused that?

Yes. In Q2, our core gross margin, excluding AAG, increased slightly, by about 10 to 20 basis points. This improvement is mainly attributed to the strong performance of the Industrial sector in their core gross margin and better supplier incentives, although it is somewhat offset by lower supplier incentives and challenges related to product and customer mix. Additionally, the core Automotive margin also saw a slight increase. Comparing Q1 to Q2, there was a minor shift in Q2 primarily due to mix issues. Certain categories within Automotive, such as batteries, tools and equipment, commodities, and chemicals, tend to reflect lower gross margins, leading to this mix shift. Overall, for the full year, we expect a slight increase in gross margin, and this trend should continue.

Understood. As you consider the core growth rate or comparison in Industrial at 6.5%, which is impressive with its acceleration over one and two years, the margins haven't really reflected that growth. At such a pace, one would expect to see more expansion in the operating income rate. Is there something unique about the current cycle? Could it be related to the freight costs you're mentioning? Are the vendor allowance dynamics varying with the cycles? Is there a specific mix of business that is experiencing growth? I'm interested in your thoughts on the long-term potential of the Industrial operating income rate, given how robust it is at this moment.

Yes. So the one thing I would call out, our Industrial business has performed quite well. As you recall, we combined the electrical division within motion. So when you look at their performance in the quarter, motion standalone was actually up 30 basis points in the quarter. So nice improvement there. The supplier incentives are moving in line with sales. This team is doing a terrific job on their balance sheet, working capital, and inventories. So we're always going to be mindful of that. On a long-term basis, we're looking for their margins to be at 8 to 8.5. You're going to see more incremental margin improvement with the 10, 20, 30 basis points because it's a very competitive environment out there. So as they are having these increases, they're working very hard with their customers, especially those under contract to pass them along. So it remains a competitive environment. But we're pleased with this 30 basis point improvement that we have thus far. And on a long-term basis, I think you can expect to see about this rate going forward.

And Chris, I would just add, our Industrial business really shows no signs of slowing down. And as you commented, they're building upon quarter after quarter. I mean, this rebound really began in Q4 of '16, carried all the way through last year. And now, the first half of this year. And when you look at key indicators, whether it be the manufacturing capacity numbers or the PMI numbers, rig count, all those continue to be very positive. So we're bullish on our Industrial business and expect to see continued good results from this group.

That's a good transition. Considering the energy sector and your involvement in it, I'm curious about what you're observing. I'm surprised that it didn't show a significant increase. You didn't highlight it as a low, double-digit grower. Is there something different this time regarding the hiring activity as oil prices rise? Is it that there's been more automation and increased investment, leading to less need for certain components of existing products compared to the past cycle?

No, I don't think so, Chris. One thing I would point out is that when we look across our divisions in the motion business, our best-performing operations are in the Southwest part of the U.S. We are continuing to stack these increases quarter after quarter and compared to last year. Specifically regarding our oil and gas extraction business, it is up in the mid- to high-single digits, which is still a very good performance.

Yes. And then my last question is just for the peeling of the onion on the Automotive business. You talked about the West and the South being stronger because it didn't have April. I don't know if you have this in front of you, but if you could just focus on the May and the June side. Was the performance in sort of the North Central and Northeast more similar to the other areas of the country?

Yes, they made a strong recovery. I've talked about this several times, including last quarter. I recently visited the Midwest and spent time with our owners in Illinois and Minnesota. The farmers there had trouble getting into the fields due to snow at the end of April. However, once the snow melted, and we got into May and June, those businesses recovered well, although they were emerging from a tough situation in April.

I guess, a quick follow-up on the auto trends and then I want to fully understand the guidance. Paul, when you talked about that bounce back in those markets, like the Midwest and Northeast, are those areas now actually running ahead of the rest of the country? Is there some sort of catch-up from that? Or are they just sort of back to a more normalized trend? And then I have a follow-up.

Back to more normalized, Greg. And if I look at the Northeast, for instance, they're going to get skewed with the, I mentioned, the big changeover there. We're going to have really starting to take hold here in the second half, Sanel Auto Parts up in New England. So our Northeastern business is going to benefit greatly from adding that business. But no, we've returned back to more normal growth patterns across the Northern, Northern sector of the U.S.

Great. And then a follow-up on a bigger picture question on tariffs and passing through. What percentage of your product in the auto business is imported either indirectly or direct? And how, historically, it's been so long since we had any inflation in auto parts. What's the history? Or what do you think it takes in terms of timing for that to actually flow through to the end market?

Yes, I'll take the first part of that question, Greg, and I'll let Carol weigh in on the second half of your question. As we look across our businesses and what percentage of their business is coming out of China, whether it be on a direct sourcing standpoint, which is still relatively small for us. But our manufacturers and suppliers who manufacture and bring parts in from China, our Automotive business is about 40% and S.P. Richards is greater than that on the office side. Motion is significantly less than that number. So that's kind of how it breaks down by business.

I would like to add that, as we have mentioned before regarding this tariff, despite the uncertainties, it does not affect our European Automotive business or our Australasian business. The 40% mentioned by Paul pertains specifically to the U.S. Automotive figure. In terms of the timeline and how we will manage this, we have seen with the initial round of tariffs that when they take effect, it leads to numerous discussions with suppliers. A lot of modeling is conducted, and we can explore opportunities for early buy-ins and assess the market's capacity to absorb the changes. We might even find chances to increase margins in certain areas. Therefore, we will have the necessary time to collaborate with our suppliers to manage these changes effectively, especially with the tentative effective date of September 1st for this third list of tariffs.

Great. So it sounds like something more for fourth quarter in terms of...

Well, we're keeping a close eye on it. However, we don't have any specific information at this moment. We can say with certainty that it will be later in the year.

Greg, the list three that Carol referenced is the one that we're all keeping a very close eye on. We really, as we mentioned, it's negligible to this point, but everybody is keeping a close watch on list three.

Quick clarifying one. The 5% comp growth or mid-single-digit that you said, slight in Europe, is that all same-store sales? Or is some of that like square footage growth?

It's a combination of both, Chris. Our AAG business in Europe, we've done a number of small bolt-on acquisitions that's kind of been their historical pattern. And we've continued that as we've stepped into that business. Again, where we were pleasantly surprised is the strength of our comp number in the quarter. And again, hats off to our team in the U.K. and in Germany. They've done a terrific job.

Got you. Okay, that's helpful. And then earlier in the conversation, you start talking about productivity investments. Can you just maybe remind us what you're doing there and the types of projects are working and there's a way to quantify to the extent that those are currently impacting margins? And is there a point where you lap those? Are you kind of seeing this as like a multiyear process?

The first thing I want to emphasize is that this is a multiyear process driven by GPC on a global scale. I recently attended a meeting with our senior operations team, and we discussed projects based in Australia, Canada, and Europe. We're implementing further automation in our facilities, particularly in our distribution centers, and enhancing those facilities. In some cases, this involves moving to newer, improved facilities and consolidating operations while incorporating automation. On the technology front, we're focused on automation in areas like back office and shared services, with several ongoing projects. This includes enhancements in warehouse management software. Pricing is another key area of focus. We're investing in technology and productivity related to pricing, employing data analytics and software to develop a more optimized pricing strategy for our retail and wholesale operations. Overall, our investments are directed towards these areas. It's important to note that this is a multiyear process, and while it's challenging to discuss specifics, these initiatives align with our long-term margin goals moving forward.

Got you, okay. And then just one final unrelated question. You mentioned that the NAPA AutoCare Centers are seeing really strong growth right now. And then the national accounts, still a bit lighter. Can you talk about maybe what you think is driving that variance between the two customers? I would think they have kind similar demand patterns, but anything you can maybe talk to that could explain that gap?

Yes. First, I'd point out that the growth that we saw both out of our NAPA AutoCare Centers and the Major accounts is the best growth that we've seen in a number of quarters. We can do better and we will do better, but we're very pleased to see it headed in the right direction. NAPA AutoCare Centers, Chris, if you think about it, we've got a bit more of a captive audience there. They fly our flag. They fly the NAPA brand. They use our training, a lot of our systems, our guys are well entrenched there with our autocare centers. So our expectation would always be that auto care centers are going to outperform. Major Accounts, that's a competitive business for sure. And our competitors are all chasing that business as well. Again, we were pleased to see a positive increase in the quarter because it's been a while since we've seen our Major Accounts post positive comps. So we're encouraged by that.

My first question relates to your guidance, your revenue guidance. Can you talk about how much of the change in the revenue guide, that hike in the revenue guide, relates to your second quarter performance? And then on the forward, how much of it would relate to your organic outlook versus acquisitions versus what, I think, is probably a slightly less helpful FX outlook for you guys?

Yes, I mean, I'm going to start with the FX. And I think you're spot on. I mean, we had about a 0.5 point improvement in the first half, and it is not going to be as helpful in the second half. So we've modeled a slight headwind in the second half that would have us at maybe flattish, maybe up slightly for the full year. The second thing I'd remind you is AAG came on November 1 of last year. So you have that few months of revenue for AAG. I can tell you our guidance for second half versus first half is really largely based on where we are today. I mean, the run rate that we have to date and then mentioning the AAG 2 months and FX, we have not modeled in any acquisitions that haven't closed yet, and that would include the Hennig acquisition in Germany because that has not closed yet.

That's very insightful. You mentioned your confidence in the aging auto fleet and the stabilization in your business. It seems you have a clear view of the vehicles you are servicing in the coming years. Beyond the historical trends that suggest positive outcomes, are you noticing any signs that the challenges you're facing are lessening and that the older car models are beginning to benefit your operations?

Matt, for some time now we've been hopeful and expecting to see some improvement in the second half of this year, but particularly in 2019. It's been challenging to pinpoint exactly why there has been a noticeable uptick in May, June, and especially July. Whether it's due to weather changes or a recovery from the low point we experienced in '08 and '09 SAAR is still unclear. However, the reality is that business is on the rise. I believe this is due to a mix of factors, including the excellent work done by our team on the ground.

That's super helpful. And then one final question because we do get a lot of questions on the tariff scene. Presumably, the 40% of the products you said that is coming from overseas for the U.S. auto business are final goods or finished goods that are sourced from overseas. Correct me if I'm wrong, but beyond that, are there components that would contribute to or that are found in and some of your purchases that would make the underlying number a little bit better. Just trying to understand not just direct pressure, first order pressure, but whether there's additional potential inflationary pressure for the industry from those inputs?

No, it would largely be the finished goods that we're bringing in. We saw back when the steel and aluminum tariffs were introduced in June. It is still very early to assess the situation. Some companies have implemented a few minor price increases due to current conditions, but it is minimal, and it really started to become significant in June. Therefore, it’s too soon to draw conclusions. However, most of the 40% we are discussing is related to finished goods.

I'm sure it feels like that the horse is good at this point but I did have one more on the auto side. I'm trying to quantify train wreck, if we can. Paul, was the business in the U.S. down like kind of 2% to 3% in April? Or was it even worse than that?

No, you're within the range. It may have been a poor choice of words, but you're right in that range, Scot.

Got it. Okay, that's helpful. And is there any kind of difference in terms of DIY or commercial performance when you have those kind of wet and cold conditions in the spring? Or is that kind of uniform across the business?

Well, as we reported now for a number of quarters, our retail business continues to outperform. And our retail business, once again, was up mid-single-digit in the quarter. And that's a number of quarters in a row. What we are encouraged about is the slight lift that we saw on the wholesale side, which it's been a challenge. We've been battling that flat to even slight declines on the wholesale business. So it's really encouraging to see a lift in our wholesale business as well.

We expect to remain at this level, between 100% and 110%. In the quarter, we had a reclassification in inventory, amounting to about $200 million related to sales returns, which moved from inventory to current assets. This likely caused a spike this quarter, but it will remain at this level for the rest of the year. Overall, I believe we made good progress on working capital, and we will continue to maintain this level.

We want to thank you for your participation in today's conference call. We look forward to reporting to you in our third quarter call in October, and thank you for your support and your interest in Genuine Parts Company.