Item 7. 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.

In Management’s Discussion and Analysis, we provide a historical and prospective narrative of our general financial condition, results of operations, liquidity and certain other factors that may affect our future results, including

•	an overview of the key drivers of the automotive aftermarket industry;

•	key events and recent developments within our company;

•	our results of operations for the years ended December 31, 2018, 2017 and 2016;

•	our liquidity and capital resources;

•	any contractual obligations, to which we are committed;

•	any off-balance sheet arrangements we utilize;

•	our critical accounting estimates;

•	the inflation and seasonality of our business;

•	our quarterly results for the years ended December 31, 2018, and 2017; and

•	recent accounting pronouncements that may affect our Company.

The review of Management’s Discussion and Analysis should be made in conjunction with our consolidated financial statements, related notes and other financial information, forward-looking statements and other risk factors included elsewhere in this annual report.

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 “estimate,” “may,” “could,” “will,” “believe,” “expect,” “would,” “consider,” “should,” “anticipate,” “project,” “plan,” “intend” 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, integration 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, the economy in general, inflation, tariffs, product demand, the market for auto parts, competition, weather, risks associated with the performance of acquired businesses, our ability to hire and retain qualified employees, consumer debt levels, our increased debt levels, credit ratings on public debt, governmental regulations, information security and cyber attacks, 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, 2018, for additional factors that could materially affect our financial performance. Forward-looking statements speak only as of the date they were made, and we undertake no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise, except as required by applicable law.

OVERVIEW

We are a specialty retailer of automotive aftermarket parts, tools, supplies, equipment and accessories in the United States. We are one of the largest U.S. automotive aftermarket specialty retailers, selling our products to both do-it-yourself (“DIY”) customers and professional service providers – our “dual market strategy.” Our stores carry an extensive product line consisting of new and remanufactured automotive hard parts, maintenance items, accessories, a complete line of auto body paint and related materials, automotive tools and professional service provider service equipment. Our extensive product line includes an assortment of products that are differentiated by quality and price for most of the product lines we offer. For many of our product offerings, this quality differentiation reflects “good,” “better,” and “best” alternatives. Our sales and total gross profit dollars are highest for the “best” quality category of products. Consumers’ willingness to select products at a higher point on the value spectrum is a driver of sales and profitability in our industry. Our stores also offer enhanced services and programs to our customers, including used oil, oil filter and battery recycling; battery, wiper and bulb replacement; battery diagnostic testing; electrical and module testing; check engine light code extraction; loaner tool program; drum and rotor resurfacing; custom hydraulic hoses; professional paint shop mixing and related materials; and machine shops. As of December 31, 2018, we operated 5,219 stores in 47 states.

Operating within the retail industry, we are influenced by a number of general macroeconomic factors including, but not limited to, fuel costs, unemployment rates, consumer preferences and spending habits, and competition. We have ongoing initiatives aimed at tailorin

g our product offering to adjust to customers’ changing preferences, and we also have initiatives focused on marketing and training to educate customers on the advantages of ongoing vehicle maintenance, as well as “purchasing up” on the value spectrum.

We believe the key drivers of current and future demand for the products sold within the automotive aftermarket include the number of U.S. miles driven, number of U.S. registered vehicles, new light vehicle registrations, average vehicle age and unemployment.

•

Number of Miles Driven – The number of total miles driven in the U.S. influences the demand for repair and maintenance products sold within the automotive aftermarket. In total, vehicles in the U.S. are driven approximately three trillion miles per year, resulting in ongoing wear and tear and a corresponding continued demand for the repair and maintenance products necessary to keep these vehicles in operation. According to the Department of Transportation, the number of total miles driven in the U.S. increased 0.3%, 1.2% and 2.4% in 2018, 2017 and 2016, respectively, and we expect to continue to see modest improvements in total miles driven in the U.S., supported by an increasing number of registered vehicles on the road, resulting in continued demand for automotive aftermarket products.

•

Number of U.S. Registered Vehicles, New Light Vehicle Registrations and Average Vehicle Age – The total number of vehicles on the road and the average age of the vehicle population heavily influence the demand for products sold within the automotive aftermarket industry. As reported by The Auto Care Association, the total number of registered vehicles increased 8.5% from 2007 to 2017, bringing the number of light vehicles on the road to 270 million by the end of 2017. For the year ended December 31, 2018, the seasonally adjusted annual rate of light vehicle sales in the U.S. (“SAAR”) was approximately 17.5 million, contributing to the continued growth in the total number of registered vehicles on the road. In the past decade, vehicle scrappage rates have remained relatively stable, ranging from 4.2% to 5.7% annually. As a result, over the past decade, the average age of the U.S. vehicle population has increased, growing 21.9%, from 9.6 years in 2007 to 11.7 years in 2017. We believe this increase in average age can be attributed to better engineered and manufactured vehicles, which can be reliably driven at higher mileages due to better quality power trains and interiors and exteriors, and the consumer’s willingness to invest in maintaining these higher-mileage, better built vehicles. As the average age of vehicles on the road increases, a larger percentage of miles are being driven by vehicles that are outside of a manufacturer warranty. These out-of-warranty, older vehicles generate strong demand for automotive aftermarket products as they go through more routine maintenance cycles, have more frequent mechanical failures and generally require more maintenance than newer vehicles. We believe consumers will continue to invest in these reliable, higher-quality, higher-mileage vehicles and these investments, along with an increasing total light vehicle fleet, will support continued demand for automotive aftermarket products.

•

Unemployment – Unemployment, underemployment, the threat of future joblessness and the uncertainty surrounding the overall economic health of the U.S. have a negative impact on consumer confidence and the level of consumer discretionary spending. Long-term trends of high unemployment have historically impeded the growth of annual miles driven, as well as decrease consumer discretionary spending, both of which negatively impact demand for products sold in the automotive aftermarket industry. As of December 31, 2017, the U.S. unemployment rate was 4.1%, and as of December 31, 2018, the U.S. unemployment rate decreased to 3.9%. We believe total employment should remain at healthy levels supporting the trend of modest growth in total miles driven in the U.S. and the continued demand for automotive aftermarket products.

We remain confident in our ability to gain market share in our existing markets and grow our business in new markets by focusing on our dual market strategy and the core O’Reilly values of hard work and excellent customer service.

KEY EVENTS AND RECENT DEVELOPMENTS

Several key events have had or may have a significant impact on our operations and are identified below:

•

Under the Company’s share repurchase program, as approved by our Board of Directors in January of 2011, we may, from time to time, repurchase shares of our common stock, solely through open market purchases effected through a broker dealer at prevailing market prices, based on a variety of factors such as price, corporate trading policy requirements and overall market conditions. Our Board of Directors may increase or otherwise modify, renew, suspend or terminate the share repurchase program at any time, without prior notice. As announced on February 7, 2018, and November 13, 2018, our Board of Directors each time approved a resolution to increase the authorization amount under our share repurchase program by an additional $1.00 billion, resulting in a cumulative authorization amount of $11.75 billion. Each additional authorization is effective for a three-year period, beginning on its respective announcement date. As of February 27, 2019, we had repurchased approximately 73.1 million shares of our common stock at an aggregate cost of $11.02 billion under this program.

•

On May 17, 2018, we issued $500 million aggregate principal amount of unsecured 4.350% Senior Notes due 2028 (“4.350% Senior Notes due 2028”) at a price to the public of 99.732% of their face value with UMB Bank, N.A. as trustee. Interest on the 4.350% Senior Notes due 2028 is payable on June 1 and December 1 of each year, which began on December 1, 2018, and is computed on the basis of a 360-day year.

•	After the close of business on December 31, 2018, we completed an asset purchase of Bennett Auto Supply, Inc. (“Bennett”), a privately held automotive parts supplier. The asset purchase included 33 stores that were not included in the Company’s 2018 store count and were not operated by the Company in 2018, and a warehouse located in southern Florida.

RESULTS OF OPERATIONS

The following table includes income statement data as a percentage of sales for the years ended December 31, 2018, 2017 and 2016:

	For the Year Ended December 31,
	2018			2017			2016
Sales	100.0	%		100.0	%		100.0	%
Cost of goods sold, including warehouse and distribution expenses	47.2			47.4			47.5
Gross profit	52.8			52.6			52.5
Selling, general and administrative expenses	33.8			33.4			32.7
Operating income	19.0			19.2			19.8
Interest expense	(1.3	)		(1.0	)		(0.8	)
Interest income	—			—			0.1
Income before income taxes (1)	17.8			18.2			19.1
Provision for income taxes	3.9			5.6			7.0
Net income	13.9	%		12.6	%		12.1	%

(1)	Each percentage of sales amount is computed independently and may not compute to presented totals.

2018 Compared to 2017

Sales:

Sales for the year ended December 31, 2018, increased $559 million, or 6%, to $9.54 billion from $8.98 billion for the same period in 2017. Comparable store sales for stores open at least one year increased 3.8% and 1.4% for the years ended December 31, 2018 and 2017, respectively. Comparable store sales are calculated based on the change in sales for stores open at least one year and exclude sales of specialty machinery, sales to independent parts stores and sales to Team Members. Online sales, resulting from ship-to-home orders and pickup in-store orders, for stores open at least one year, are included in the comparable store sales calculation.

The following table presents the components of the increase in sales for the year ended December 31, 2018 (in millions):

	Increase in Sales for the Year Ended December 31, 2018, Compared to the Same Period in 2017
Store sales:
Comparable store sales	$	336
Non-comparable store sales:
Sales for stores opened throughout 2017, excluding stores open at least one year that are included in comparable store sales	101
Sales for stores opened throughout 2018	120
Decline in sales for stores that have closed	(7		)
Non-store sales:
Includes sales of machinery and sales to independent parts stores and Team Members	9
Total increase in sales	$	559

We believe the increased sales achieved by our stores were the result of store growth, the high levels of customer service provided by our well-trained and technically proficient Team Members, superior inventory availability, including same day and over-night access to inventory in our regional distribution centers, enhanced services and programs offered in our stores, a broad selection of product offerings with a dynamic catalog system to identify and source parts, a targeted promotional and advertising effort through a variety of media and localized promotional events, continued improvement in the merchandising and store layouts of our stores, compensation programs for all store Team Members that provide incentives for performance and our continued focus on serving both DIY and professional service provider customers.

Our comparable store sales increase for the year ended December 31, 2018, was driven by an increase in average ticket values for both DIY and professional service provider customers and positive transaction counts for professional service provider customers, offset by negative transaction counts for DIY customers. The improvement in average ticket values was the result of the increasing complexity and cost of replacement parts necessary to maintain the current population of better-engineered and more technically advanced vehicles and same SKU inflation. These better-engineered, more technically advanced vehicles require less frequent repairs, as the component parts are more durable and last for longer periods of time. This decrease in repair frequency creates pressure on customer transaction counts; however, when repairs are needed, the cost of replacement parts is, on average, greater, which is a benefit to average ticket values. During the year ended December 31, 2018, DIY transaction counts also continued to be pressured by increased gas prices and other inflationary impacts, resulting in an increased deferral of vehicle maintenance and repairs over the short term.

We opened 200 net, new stores during the year ended December 31, 2018, compared to opening 190 net, new stores during the year ended December 31, 2017. As of December 31, 2018, we operated 5,219 stores in 47 states compared to 5,019 stores in 47 states at December 31, 2017. After the close of business on December 31, 2018, we acquired the 33 Bennett stores that were not included in our 2018 store count and were not operated by the Company in 2018. We anticipate new store growth will be 200 to 210 net, new store openings in 2019 and will net an additional 20 stores, as we will merge 13 of the acquired 33 Bennett stores into existing O’Reilly stores during 2019.

Gross profit:

Gross profit for the year ended December 31, 2018, increased 7% to $5.04 billion (or 52.8% of sales) from $4.72 billion (or 52.6% of sales) for the same period in 2017. The increase in gross profit dollars for the year ended December 31, 2018, was primarily the result of sales from new stores and the increase in comparable store sales at existing stores. The increase in gross profit as a percentage of sales for the year ended December 31, 2018, was primarily due to a non-cash last-in, first-out (“LIFO”) charge in 2017, partially offset by an increase in distribution expenses. The increase in distribution expenses was primarily due to wage pressure and increased transportation costs, as compared to 2017. During the year ended December 31, 2018, we did not realize net acquisition cost decreases, and as a result, we did not record a LIFO charge. During the year ended December 31, 2017, our LIFO costs were written down by approximately $22 million to reflect replacement cost.

Selling, general and administrative expenses:

Selling, general and administrative expenses (“SG&A”) for the year ended December 31, 2018, increased 8% to $3.22 billion (or 33.8% of sales) from $3.00 billion (or 33.4% of sales) for the same period in 2017. The increase in total SG&A dollars for the year ended December 31, 2018, was primarily the result of additional Team Members, facilities and vehicles to support our increased sales and store count, the planned allocation of a portion of the tax savings realized as a result of the U.S. Tax Cuts and Jobs Act, enacted in December 2017 (the “Tax Act”) and unfavorable comparison to a 2017 benefit of $9.1 million from the reduction in our legal accrual following the expiration of the statute of limitations related to a legacy claim. The increase in SG&A as a percentage of sales for the year ended December 31, 2018, was primarily due to our tax savings allocation initiatives and the 2017 legal accrual benefit.

Operating income:

As a result of the impacts discussed above, operating income for the year ended December 31, 2018, increased 5% to $1.82 billion (or 19.0% of sales) from $1.73 billion (or 19.2% of sales) for the same period in 2017.

Other income and expense:

Total other expense for the year ended December 31, 2018, increased 38% to $121 million (or 1.3% of sales), from $88 million (or 1.0% of sales) for the same period in 2017. The increase in total other expense for the year ended December 31, 2018, was primarily the result of increased interest expense on higher average outstanding borrowings.

Income taxes:

Our provision for income taxes for the year ended December 31, 2018, decreased 27% to $370 million (21.8% effective tax rate) from $504 million (30.8% effective tax rate) for the same period in 2017. The decreases in our provision for income taxes and our effective tax rate for the year ended December 31, 2018, were primarily the result of the lower federal corporate tax rate set forth by the Tax Act, partially offset by a $53 million benefit in 2017 from the required revaluation of our deferred income tax liabilities based on the lower federal corporate tax rate set forth by the Tax Act and lower excess tax benefits from share-based compensation in 2018, as compared 2017. During the year ended December 31, 2018 and 2017, excess tax benefits from share-based compensation were approximately $35 million and $49 million, respectively.

Net income:

As a result of the impacts discussed above, net income for the year ended December 31, 2018, increased 17% to $1.32 billion (or 13.9% of sales), from $1.13 billion (or 12.6% of sales) for the same period in 2017.

Earnings per share:

Our diluted earnings per common share for the year ended December 31, 2018, increased 27% to $16.10 on 82 million shares from $12.67 on 90 million shares for the same period in 2017. Due to the revaluation of our deferred income tax liabilities in 2017, our diluted earnings per common share for the year ended December 31, 2017, included a one-time benefit of $0.59.

2017 Compared to 2016

Sales:

Sales for the year ended December 31, 2017, increased $385 million, or 4%, to $8.98 billion from $8.59 billion for the same period in 2016. Comparable store sales for stores open at least one year increased 1.4% and 4.8% for the years ended December 31, 2017 and 2016, 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, sales to Team Members and sales from Leap Day during the year ended December 31, 2016. Online sales, resulting from ship-to-home orders and pickup in-store orders, for stores open at least one year, are included in the comparable store sales calculation.

The following table presents the components of the increase in sales for the year ended December 31, 2017 (in millions):

	Increase in Sales for the Year Ended December 31, 2017, Compared to the Same Period in 2016
Store sales:
Comparable store sales, including sales from the 48 acquired Bond stores	$	182
Non-comparable store sales:
Sales for stores opened throughout 2016, excluding stores open at least one year that are included in comparable store sales	126
Sales for stores opened throughout 2017	108
Sales from Leap Day in 2016	(25		)
Decline in sales for stores that have closed	(5		)
Non-store sales:
Includes sales of machinery and sales to independent parts stores and Team Members	(1		)
Total increase in sales	$	385

We believe the increased sales achieved by our stores were the result of store growth, sales from the 48 acquired Bond Auto Parts (“Bond”) stores, the high levels of customer service provided by our well-trained and technically proficient Team Members, superior inventory availability, including same day and over-night access to inventory in our regional distribution centers, enhanced services and programs offered in our stores, a broader selection of product offerings in most stores with a dynamic catalog system to identify and source parts, a targeted promotional and advertising effort through a variety of media and localized promotional events, continued improvement in the merchandising and store layouts of our stores, compensation programs for all store Team Members that provide incentives for performance and our continued focus on serving both DIY and professional service provider customers.

Our comparable store sales increase for the year ended December 31, 2017, was driven by increases in average ticket values for both DIY and professional service provider customers, partially offset by negative customer transaction counts from both our DIY and professional service provider customers. The improvement in average ticket values was the result of the increasing complexity and cost of replacement parts necessary to maintain the current population of better engineered and more technically advanced vehicles. These better engineered, more technically advanced vehicles require less frequent repairs, as the component parts are more durable and last for longer periods of time. When repairs are needed, the cost of replacement parts is, on average, greater, which is a benefit to average ticket values; however, the decrease in repair frequency creates pressure on customer transaction counts. In addition, customer transaction counts for the year ended December 31, 2017, were negatively impacted by softer industry demand, resulting, in part, from the unseasonably mild winter weather at the onset of 2017 and a cool, wet summer in many of our markets. The mild winter weather did not stress vehicle components to the degree more typical harsh winter weather would, which resulted in a lower level of automobile parts breakage and associated demand for our products. The cool, wet summer in many of our markets resulted in a lower level of demand, as the absence of typical seasonally high temperatures resulted in fewer heat related product repairs.

We opened 190 net, new stores during the year ended December 31, 2017, compared to opening 210 net, new stores and acquiring 48 Bond stores during the year ended December 31, 2016. As of December 31, 2017, we operated 5,019 stores in 47 states compared to 4,829 stores in 47 states at December 31, 2016.

Gross profit:

Gross profit for the year ended December 31, 2017, increased 5% to $4.72 billion (or 52.6% of sales) from $4.51 billion (or 52.5% of sales) for the same period in 2016. The increase in gross profit dollars for the year ended December 31, 2017, was primarily a result of sales from new stores, the increase in comparable store sales at existing stores and sales from the 48 acquired Bond stores, partially offset by gross profit dollars generated from one additional day due to Leap Day for the same period one year prior. The increase in gross profit as a percentage of sales for the year ended December 31, 2017, was primarily due to a smaller non-cash LIFO impact, partially offset by a lower merchandise margin and higher inventory shrinkage. The smaller LIFO impact is the result of fewer product acquisition cost improvements during the year ended December 31, 2017, compared 2016. Our policy is to not write up inventory in excess of replacement cost, and accordingly, we are effectively valuing our inventory at replacement cost. For the year ended December 31, 2017 and 2016, our LIFO inventory costs were written down by approximately $22 million and $49 million, respectively, to reflect replacement cost. The lower merchandise margin was primarily the result of merchandise mix, driven by the unfavorable weather conditions during 2017. The higher inventory shrinkage was primarily cyclical in nature, following a period of lower than average shrinkage trends.

Selling, general and administrative expenses:

SG&A for the year ended December 31, 2017, increased 7% to $3.00 billion (or 33.4% of sales) from $2.81 billion (or 32.7% of sales) for the same period in 2016. The increase in total SG&A dollars for the year ended December 31, 2017, was primarily the result of additional Team Members, facilities and vehicles to support our increased sales and store count, partially offset by a $9.1 million benefit from the reduction in our legal accrual following the expiration of the statute of limitations related to a legacy claim and incremental SG&A expenses incurred from one additional day due to Leap Day for the same period one year prior. The increase in SG&A as a percentage of sales for the year ended December 31, 2017, was primarily due to deleverage of store operating costs on soft comparable store sales during the year ended December 31, 2017.

Operating income:

As a result of the impacts discussed above, operating income for the year ended December 31, 2017, increased 2% to $1.73 billion (or 19.2% of sales) from $1.70 billion (or 19.8% of sales) for the same period in 2016.

Other income and expense:

Total other expense for the year ended December 31, 2017, increased 41% to $88 million (or 1.0% of sales), from $62 million (or 0.7% of sales) for the same period in 2016. The increase in total other expense for the year ended December 31, 2017, was primarily the result of increased interest expense on higher average outstanding borrowings and increased amortization of debt issuance costs.

Income taxes:

Our provision for income taxes for the year ended December 31, 2017, decreased 16% to $504 million (30.8% effective tax rate) from $600 million (36.6% effective tax rate) for the same period in 2016. The decrease in our provision for income taxes for the year ended December 31, 2017, was the result of a one-time $53 million benefit to the provision for income taxes related to the required revaluation of our deferred income tax liabilities based on the lower federal corporate income tax rate set forth by the Tax Act and excess tax benefits from share-based compensation, which provided a benefit of $49 million to the provision for income taxes. The decrease in our effective tax rate for the year ended December 31, 2017, was primarily due to the required revaluation of our deferred income tax liabilities, which provided a one-time benefit of 325 basis points to the effective tax rate for the year ended December 31, 2017, and excess tax benefits from share-based compensation, which provided a benefit of 297 basis points to the effective tax rate for the year ended December 31, 2017.

Net income:

As a result of the impacts discussed above, net income for the year ended December 31, 2017, increased 9% to $1.13 billion (or 12.6% of sales), from $1.04 billion (or 12.1% of sales) for the same period in 2016.

Earnings per share:

Our diluted earnings per common share for the year ended December 31, 2017, increased 18% to $12.67 on 90 million shares from $10.73 on 97 million shares for the same period in 2016. Due to the required revaluation of our deferred income tax liabilities, our diluted earnings per common share for the year ended December 31, 2017, included a one-time benefit of $0.59. Due to the adoption of ASU 2016-09, our diluted earnings per common share for the year ended December 31, 2017, included a benefit of $0.50.

LIQUIDITY AND CAPITAL RESOURCES

Our long-term business strategy requires capital to open new stores, fund strategic acquisitions, expand distribution infrastructure, operate and maintain our existing stores and may include the opportunistic repurchase of shares of our common stock through our Board-approved share repurchase program. The primary sources of our liquidity are funds generated from operations and borrowed under our unsecured revolving credit facility. Decreased demand for our products or changes in customer buying patterns could negatively impact our ability to generate funds from operations. Additionally, decreased demand or changes in buying patterns could impact our ability to meet the

debt covenants of our credit agreement and, therefore, negatively impact the funds available under our unsecured revolving credit facility. We believe that cash expected to be provided by operating activities and availability under our unsecured revolving credit facility will be sufficient to fund both our short-term and long-term capital and liquidity needs for the foreseeable future. However, there can be no assurance that we will continue to generate cash flows at or above recent levels.

Liquidity and related ratios:

The following table highlights our liquidity and related ratios as of December 31, 2018 and 2017 (dollars in millions):

		December 31,								Percentage Change
Liquidity and Related Ratios		2018				2017
Current assets		$	3,543			$	3,398			4.3	%
Current liabilities		3,894				3,647				6.8	%
Working capital (1)		(351		)		(250		)		(40.4	)%
Total debt		3,417				2,978				14.7	%
Total equity		$	354			$	653			(45.8	)%
Debt to equity (2)		9.66:1				4.56:1				111.8	%

(1)	Working capital is calculated as current assets less current liabilities.

(2)	Debt to equity is calculated as total debt divided by total equity.

Current assets increased 4%, current liabilities increased 7%, total debt increased 15% and total equity decreased 46% from 2017 to 2018. The increase in current assets was primarily due to the increase in inventory, resulting from the opening of 200 net, new stores in 2018. The increase in current liabilities was primarily due to the increase in accounts payable, resulting from inventory growth related to new store openings. Our accounts payable to inventory ratio was 105.7% as of December 31, 2018, as compared to 106.0% in the prior year. The increase in total debt was attributable to the issuance of $500 million of 4.350% Senior Notes due 2028 and borrowings of $287 million on our revolving credit facility at December 31, 2018. The decrease in total equity resulted from the impact of share repurchase activity, under our share repurchase program, on retained deficit and additional paid-in-capital, partially offset by a decrease in retained deficit from net income for the year ended December 31, 2018.

The following table identifies cash provided by/(used in) our operating, investing and financing activities for the years ended December 31, 2018, 2017 and 2016 (in thousands):

		For the Year Ended December 31,
Liquidity:		2018				2017				2016
Total cash provided by/(used in):
Operating activities (1)		$	1,727,555			$	1,403,687			$	1,510,713
Investing activities		(534,302		)		(464,223		)		(529,096		)
Financing activities (1)		(1,208,286		)		(1,039,714		)		(951,320		)
Net (decrease) increase in cash and cash equivalents		$	(15,033	)		$	(100,250	)		$	30,297
Capital expenditures		$	504,268			$	465,940			$	476,344
Free cash flow (2)		1,188,584				889,059				978,375

(1)	Prior period amount has been reclassified to conform to current period presentation, due to the Company’s adoption of a new accounting standard during the first quarter ended March 31, 2017. See Note 1 “Summary of Significant Accounting Policies” to the Consolidated Financial Statements of the annual report on Form 10-K for the year ended December 31, 2017.

(2)	Calculated as net cash provided by operating activities, less capital expenditures and excess tax benefit from share-based compensation payments for the period.

Operating activities:

The increase in net cash provided by operating activities in 2018 compared to 2017 was primarily due to increased operating income, reduced cash taxes paid, due to the Tax Act, and a reduction of accounts receivable, due to the business day timing of year-end 2018, as compared to 2017.

The decrease in net cash provided by operating activities in 2017 compared to 2016 was primarily due to a smaller decrease in our net inventory investment, partially offset by an increase in net income. Our accounts payable to inventory ratio was 106.0%, 105.7% and 99.1% as of December 31, 2017, 2016 and 2015, respectively. The smaller increase in our accounts payable to inventory ratio in 2017

was primarily attributable to fewer new suppliers entering our supplier financing programs in 2017 and a smaller decrease in net inventory, due to a softer sales environment, as compared to 2016.

Investing activities:

The increase in net cash used in investing activities in 2018 compared to 2017 was primarily the result of an increase in capital expenditures in 2018 and an increase in other investing activities. Total capital expenditures were $504 million and $466 million in 2018 and 2017, respectively, and the increase was primarily related to the timing of property acquisitions, closings, construction costs for new stores and the mix of owned versus leased stores opened during 2018, as compared to 2017. The increase in other investing activities was primarily due to more acquisition related expenditures in 2018, as compared to 2017.

The decrease in net cash used in investing activities in 2017 compared to 2016 was primarily the result of a decrease in other investing activities and a decrease in capital expenditures in 2017. The decrease in other investing activities was primarily due to less acquisition related expenditures in 2017, as compared to 2016. Total capital expenditures were $466 million and $476 million in 2017 and 2016, respectively, and the decrease was primarily related to the timing of property acquisitions, closings, construction costs for new stores and the mix of owned versus leased stores opened during 2017, as compared to 2016.

We opened 200, 190, and 210 net, new stores in 2018, 2017 and 2016, respectively, and acquired 48 Bond stores in 2016. After the close of business on December 31, 2018, we acquired the 33 Bennett stores that were not included in our 2018 store count and were not operated by the Company in 2018. We plan to open 200 to 210 net, new stores in 2019. The current costs associated with the opening of a new store, including the cost of land acquisition, building improvements, fixtures, vehicles, net inventory investment and computer equipment, are estimated to average approximately $1.6 million to $1.8 million; however, such costs may be significantly reduced where we lease, rather than purchase, the store site.

Financing activities:

The increase in net cash used in financing activities in 2018 compared to 2017 was primarily attributable to a lower level of net borrowings during 2018, as compared to 2017, partially offset by a lower level of repurchases of our common stock in 2018, as compared to 2017.

The increase in net cash used in financing activities in 2017 compared to 2016 was primarily attributable to a greater impact from the repurchases of our common stock under our share repurchase program during 2017, as compared to 2016, partially offset by a higher level of net borrowings during 2017, as compared to 2016.

Unsecured revolving credit facility:

On April 5, 2017, the Company entered into a credit agreement (the “Credit Agreement”). The Credit Agreement provides for a five-year $1.20 billion unsecured revolving credit facility (the “Revolving Credit Facility”) arranged by JPMorgan Chase Bank, N.A., which is scheduled to mature in April 2022. The Credit Agreement includes a $200 million sub-limit for the issuance of letters of credit and a $75 million sub-limit for swing line borrowings. As described in the Credit Agreement governing the Revolving Credit Facility, the Company may, from time to time, subject to certain conditions, increase the aggregate commitments under the Revolving Credit Facility by up to $600 million, provided that the aggregate amount of the commitments does not exceed $1.80 billion at any time.

As of December 31, 2018 and 2017, we had outstanding letters of credit, primarily to support obligations related to workers’ compensation, general liability and other insurance policies, in the amounts of $35 million and $37 million, respectively, reducing the aggregate availability under the Credit Agreement by those amounts. As of December 31, 2018 and 2017, we had outstanding borrowings under the Revolving Credit Facility in the amounts of $287 million and $346 million, respectively.

Senior Notes:

On May 17, 2018, we issued $500 million aggregate principal amount of unsecured 4.350% Senior Notes due 2028 (“4.350% Senior Notes due 2028”) at a price to the public of 99.732% of their face value with UMB Bank, N.A. (“UMB”) as trustee. Interest on the 4.350% Senior Notes due 2028 is payable on June 1 and December 1 of each year, which began on December 1, 2018, and is computed on the basis of a 360-day year.

The Company have issued a cumulative $3.15 billion aggregate principal amount of unsecured senior notes, which are due between 2021 and 2028, with UMB as trustee. Interest on the senior notes, ranging from 3.550% to 4.875%, is payable semi-annually and is computed on the basis of a 360-day year. None of our subsidiaries is a guarantor under our senior notes.

Debt covenants:

The indentures governing our senior notes contain covenants that limit our ability and the ability of certain of our subsidiaries to, among other things, create certain liens on assets to secure certain debt and enter into certain sale and leaseback transactions, and limit our ability to merge or consolidate with another company or transfer all or substantially all of our property, in each case as set forth in the indentures. These covenants are, however, subject to a number of important limitations and exceptions. As of December 31, 2018, we were in compliance with the covenants applicable to our senior notes.

The Credit Agreement contains certain covenants, including limitations on indebtedness, a minimum consolidated fixed charge coverage ratio of 2.50:1.00 and a maximum consolidated leverage ratio of 3.50:1.00. The consolidated fixed charge coverage ratio includes a calculation of earnings before interest, taxes, depreciation, amortization, rent and non-cash share-based compensation expense to fixed charges. Fixed charges include interest expense, capitalized interest and rent expense. The consolidated leverage ratio includes a calculation of adjusted debt to earnings before interest, taxes, depreciation, amortization, rent and non-cash share-based compensation expense. Adjusted debt includes outstanding debt, outstanding stand-by letters of credit and similar instruments, five-times rent expense and excludes any premium or discount recorded in conjunction with the issuance of long-term debt. In the event that we should default on any covenant contained within the Credit Agreement, certain actions may be taken, including, but not limited to, possible termination of commitments, immediate payment of outstanding principal amounts plus accrued interest and other amounts payable under the Credit Agreement and litigation from our lenders.

We had a consolidated fixed charge coverage ratio of 5.38 times and 5.72 times as of December 31, 2018 and 2017, respectively, and a consolidated leverage ratio of 2.10 times and 1.98 times as of December 31, 2018 and 2017, respectively, remaining in compliance with all covenants related to the borrowing arrangements.

The table below outlines the calculations of the consolidated fixed charge coverage ratio and consolidated leverage ratio covenants, as defined in the Credit Agreement governing the Revolving Credit Facility, for the years ended December 31, 2018 and 2017 (dollars in thousands):

	For the Year Ended December 31,
	2018				2017
GAAP net income	$	1,324,487			$	1,133,804
Add: Interest expense	122,129				91,349
Rent expense	317,283				298,614
Provision for income taxes	369,600				504,000
Depreciation expense	255,866				232,674
Amortization expense	3,071				1,171
Non-cash share-based compensation	20,176				19,401
Non-GAAP EBITDAR	$	2,412,612			$	2,281,013
Interest expense	$	122,129			$	91,349
Capitalized interest	9,092				8,548
Rent expense	317,283				298,614
Total fixed charges	$	448,504			$	398,511
Consolidated fixed charge coverage ratio	5.38				5.72
GAAP debt	$	3,417,122			$	2,978,390
Add: Stand-by letters of credit	35,148				36,843
Discount on senior notes	4,294				3,721
Debt issuance costs	15,584				13,889
Five-times rent expense	1,586,415				1,493,070
Non-GAAP adjusted debt	$	5,058,563			$	4,525,913
Consolidated leverage ratio	2.10				1.98

The table below outlines the calculation of Free cash flow and reconciles Free cash flow to Net cash provided by operating activities, the most directly comparable GAAP financial measure, for the years ended December 31, 2018, 2017 and 2016 (in thousands):

	For the Year Ended December 31,
	2018				2017				2016
Cash provided by operating activities (1)	$	1,727,555			$	1,403,687			$	1,510,713
Less: Capital expenditures	504,268				465,940				476,344
Excess tax benefit from share-based compensation	34,703				48,688				55,994
Free cash flow	$	1,188,584			$	889,059			$	978,375

(1)	Prior period amount has been reclassified to conform to current period presentation, due to the Company’s adoption of a new accounting standard during the first quarter ended March 31, 2017. See Note 1 “Summary of Significant Accounting Policies” to the Consolidated Financial Statements of the annual report on Form 10-K for the year ended December 31, 2017.

Free cash flow, the consolidated fixed charge coverage ratio and the consolidated leverage ratio discussed and presented in the tables above are not derived in accordance with United States generally accepted accounting principles (“GAAP”). We do not, nor do we suggest investors should, consider such non-GAAP financial measures in isolation from, or as a substitute for, GAAP financial information. We believe that the presentation of our free cash flow, consolidated fixed charge coverage ratio and consolidated leverage ratio provides meaningful supplemental information to both management and investors and reflects the required covenants under the Credit Agreement. We include these items in judging our performance and believe this non-GAAP information is useful to investors as well. Material limitations of these non-GAAP measures are that such measures do not reflect actual GAAP amounts. We compensate for such limitations by presenting, in the tables above, a reconciliation to the most directly comparable GAAP measures.

Share repurchase program:

In January of 2011, our Board of Directors approved a share repurchase program. Under the program, we may, from time to time, repurchase shares of our common stock, solely through open market purchases effected through a broker dealer at prevailing market prices, based on a variety of factors such as price, corporate trading policy requirements and overall market conditions. Our Board of Directors may increase or otherwise modify, renew, suspend or terminate the share repurchase program at any time, without prior notice. As announced on February 7, 2018, and November 13, 2018, our Board of Directors each time approved a resolution to increase the authorization amount under our share repurchase program by an additional $1.00 billion, resulting in a cumulative authorization amount of $11.75 billion. Each additional authorization is effective for a three-year period, beginning on its respective announcement date.

The following table identifies shares of our common stock that have been repurchased as part of our publicly announced share repurchase program (in thousands, except per share data):

	For the Year Ended December 31,
	2018				2017
Shares repurchased	6,061				9,301
Average price per share	$	282.80			$	233.57
Total investment	$	1,713,953			$	2,172,437

As of December 31, 2018, we had $1.00 billion remaining under our share repurchase program. Subsequent to the end of the year and through February 27, 2019, we repurchased an additional 0.8 million shares of our common stock under our share repurchase program, at an average price of $342.95, for a total investment of $269 million. We have repurchased a total of 73 million shares of our common stock under our share repurchase program since the inception of the program in January of 2011 and through February 27, 2019, at an average price of $150.73 for a total aggregate investment of $11.02 billion. As of February 27, 2019, we had approximately $0.7 billion remaining under our share repurchase program.

CONTRACTUAL OBLIGATIONS

Our contractual obligations as of December 31, 2018, included commitments for short and long-term debt arrangements, interest payments related to long-term debt, future payments under non-cancelable lease arrangements, self-insurance reserves, purchase obligations for construction contract commitments and other long-term liabilities, which are identified in the table below and are fully disclosed in Note 6 “Leasing,” Note 10 “Share-Based Compensation and Benefit Plans” and Note 11 “Commitments” to the Consolidated Financial Statements. We expect to fund these commitments primarily with operating cash flows expected to be generated in the normal course of business or through borrowings under our Revolving Credit Facility.

Deferred income taxes, as well as commitments with various suppliers for the purchase of inventory, are not reflected in the table below due to the absence of scheduled maturities, the nature of the account or the commitment’s cancellation terms. Due to the absence of scheduled maturities, the timing of certain of these payments cannot be determined, except for amounts estimated to be payable in 2019, which are included in “Current liabilities” on our Consolidated Balance Sheets.

We record a reserve for potential liabilities related to uncertain tax positions, including estimated interest and penalties, which are fully disclosed in Note 13 “Income Taxes” to the Consolidated Financial Statements. These estimates are not included in the table below because the timing related to the ultimate resolution or settlement of these positions cannot be determined. As of December 31, 2018, we recorded a net liability of $39 million related to these uncertain tax positions on our Consolidated Balance Sheets, all of which was included in “Other liabilities.”

We record a reserve for the projected obligation related to future payments under the Company’s nonqualified deferred compensation plan, which is fully disclosed in Note 10 “Share-Based Compensation and Benefit Plans” to the Consolidated Financial Statements. This estimate is not included in the table below because the timing related to the ultimate payment cannot be determined. As of December 31, 2018, we recorded a liability of $25 million related to this uncertain liability on our Consolidated Balance Sheets, all of which was included in “Other liabilities.”

The following table identifies the estimated payments of the Company’s contractual obligations as of December 31, 2018 (in thousands):

		Payments Due By Period
Contractual Obligations		Total				Before 1 Year				Years 1 and 2				Years 3 and 4				Years 5 and Over
Long-term debt principal and interest payments (1)		$	4,273,542			$	141,414			$	1,077,183			$	1,056,936			$	1,998,009
Future minimum lease payments under operating leases (2)		2,429,044				309,743				557,091				447,607				1,114,603
Self-insurance reserves (3)		157,538				77,012				48,864				19,255				12,407
Construction commitments		177,664				177,664				—				—				—
Total contractual cash obligations		$	7,037,788			$	705,833			$	1,683,138			$	1,523,798			$	3,125,019

(1)

Our Revolving Credit Facility, which has a maximum aggregate commitment of $1.20 billion and matures in April 2022, bears interest (other than swing line loans), at our option, at either the Alternate Base Rate or Adjusted LIBO Rate (both as defined in the Credit Agreement) plus a margin, that will vary from 0.000% to 0.250% in the case of loans bearing interest at the Alternate Base Rate and 0.680% to 1.250% in the case of loans bearing interest at the Adjusted LIBO Rate, in each case based upon the better of the ratings assigned to our debt by Moody’s Investor Service, Inc. and Standard & Poor’s Rating Services, subject to limited exceptions. Swing line loans made under the Revolving Credit Facility bear interest at the Alternate Base Rate plus the applicable margin described above. In addition, we pay a facility fee on the aggregate amount of the commitments in an amount equal to a percentage of such commitments, varying from 0.070% to 0.250% per annum based upon the better of the ratings assigned to our debt by Moody’s Investor Service, Inc. and Standard & Poor’s Rating Services, subject to limited exceptions. Based on our current credit ratings, our margin for Alternate Base Rate loans was 0.000%, our margin for Eurodollar Revolving Loans was 0.900% and our facility fee was 0.100%. As of December 31, 2018, we had outstanding borrowings in the amount of $287 million under our Revolving Credit Facility.

(2)

The minimum lease payments above do not include certain tax, insurance and maintenance costs, which are also required contractual obligations under our operating leases but are generally not fixed and can fluctuate from year to year. These expenses historically average approximately 20% of the corresponding lease payments. See Note 6 “Leasing” to the Consolidated Financial Statements for further information on our operating leases.

(3)

We use various self-insurance mechanisms to provide for potential liabilities from workers’ compensation, vehicle and general liability, and employee health care benefits. The self-insurance reserves above are at the undiscounted obligation amount. The self-insurance reserves liabilities are recorded on our Consolidated Balance Sheets at our estimate of their net present value and do not have scheduled maturities; however, we can estimate the timing of future payments based upon historical patterns. See Note 11 “Commitments” to the Consolidated Financial Statements for further information on our self-insurance reserves.

OFF-BALANCE SHEET ARRANGEMENTS

Off-balance sheet arrangements are transactions, agreements, or other contractual arrangements with an unconsolidated entity, for which we have an obligation to the entity that is not recorded in our consolidated financial statements. We historically utilized various off-balance sheet financial instruments, including sale-leaseback and synthetic lease transactions, but we have not entered into any such transactions for over 10 years and do not plan to utilize off-balance sheet arrangements in the future to fund our working capital requirements, operations or growth plans.

We issue stand-by letters of credit provided by a $200 million sub-limit under the Revolving Credit Facility that reduce our available borrowings under the Revolving Credit Facility. Those letters of credit are issued primarily to satisfy the requirements of workers’ compensation, general liability and other insurance policies. Substantially all of the outstanding letters of credit have a one-year term

from the date of issuance. Letters of credit totaling $35 million and $37 million were outstanding at December 31, 2018 and 2017, respectively.

Other than in connection with executing operating leases, we do not have any off-balance sheet financing that has, or is reasonably likely to have, a material, current or future effect on our financial condition, cash flows, results of operations, liquidity, capital expenditures or capital resources. See “Contractual Obligations” section of Item 7 of this annual report on Form 10-K and Note 6 “Leasing” to the Consolidated Financial Statements for further information on our operating leases.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of our financial statements in accordance with 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 to the inherent uncertainty of these matters and the complex and subjective judgments required in establishing 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.

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 applications in our markets for a long period of time in conjunction with the corresponding vehicle population. We have developed sophisticated systems for 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 products 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 on hand 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. To the extent that our estimates do not accurately reflect the actual unrecorded inventory shrinkage, we could potentially experience a material impact to our 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 the shrink reserve changed 10% from the estimate that we recorded based on our historical experience at December 31, 2018, the financial impact would have been approximately $1 million or less than 0.1% of pretax income for the year ended December 31, 2018.

Valuation of Long-Lived Assets and Goodwill:

We evaluate the carrying value of long-lived assets for impairment whenever events or changes in circumstances indicate the carrying value of these assets might exceed their current fair values. As part of the evaluation, we review performance at the store level to identify any stores with current period operating losses that should be considered for impairment. A potential impairment has occurred if the projected future undiscounted cash flows realized from the best possible use of the asset are less than the carrying value of the asset. The estimate of cash flows includes management’s assumptions of cash inflows and outflows directly resulting from the use of that asset in operations. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized for the amount by which the carrying amount of the asset exceeds the fair value of the assets. Our impairment analyses contain estimates due to the inherently judgmental nature of forecasting long-term estimated cash flows and determining the ultimate useful lives and fair values of the assets. Actual results could differ from these estimates, which could materially impact our impairment assessment.

We review goodwill for impairment annually during the fourth quarter, or when events or changes in circumstances indicate the carrying value of these assets might exceed their current fair values. We have never recorded an impairment to goodwill. The process of evaluating goodwill for impairment involves the determination of the fair value of our Company using the market approach. Inherent in such fair value determinations are certain judgments and estimates, including estimates that incorporate assumptions marketplace participants would use in making their estimates of fair value. In the future, if events or market conditions affect the estimated fair value to the extent that an asset is impaired, we will adjust the carrying value of these assets in the period in which the impairment occurs; however, we do not believe there has been any change of events or circumstances that would indicate that a reevaluation of goodwill is required as of December 31, 2018, nor do we believe goodwill is at risk of failing impairment testing. If the price of O’Reilly’s stock, which was a

primary input used to determine our market capitalization during step one of goodwill impairment testing, changed by 10% from the value used during testing, the results and our conclusions would not have changed and no further steps would have been required.

Supplier Concessions:

We receive concessions from our suppliers 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 material supplier concessions are recognized as a reduction to the cost of sales. Amounts receivable from suppliers also include amounts due to us relating to supplier purchases and product returns. Management regularly reviews amounts receivable from suppliers and assesses the need for a reserve for uncollectible amounts based on our evaluation of our suppliers’ 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 suppliers 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.

Warranty Reserves:

We offer warranties on certain merchandise we sell with warranty periods ranging from 30 days to limited lifetime warranties. The risk of loss arising from warranty claims is typically the obligation of our suppliers. Certain suppliers provide upfront allowances to us in lieu of accepting the obligation for warranty claims. For this merchandise, when sold, we bear the risk of loss associated with the cost of warranty claims. Differences between supplier allowances received in lieu of warranty obligations and estimated warranty expense are recorded as an adjustment to the cost of sales. Estimated warranty costs, which are recorded as obligations at the time of sale, are based on the historical failure rate of each individual product line. Our historical experience has been that failure rates are relatively consistent over time and that the ultimate cost of warranty claims has been driven by volume of units sold as opposed to fluctuations in failure rates or the variation of the cost of individual claims. If warranty reserves were changed 10% from our estimated reserves at December 31, 2018, the financial impact would have been approximately $5 million or 0.3% of pretax income for the year ended December 31, 2018.

Self-Insurance Reserves:

We use a combination of insurance and self-insurance mechanisms to provide for potential liabilities from workers’ compensation, general liability, vehicle liability, property loss, and Team Member health care benefits. With the exception of certain Team Member health care benefit liabilities, employment related claims and litigation, certain commercial litigation and certain regulatory matters, we obtain third-party insurance coverage to limit our exposure for any individual workers’ compensation, general liability, vehicle liability or property loss 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, growth patterns and exposure forecasts. The assumptions made by management as they relate to each of these factors represent our judgment as to the most probable cumulative impact of each factor to our future obligations. Our calculation of self-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 could 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. These liabilities are recorded at our estimate of their net present value, using a credit-adjusted discount rate. These liabilities do not have scheduled maturities, but we can estimate the timing of future payments based upon historical patterns. We could apply alternative assumptions regarding the timing of payments or the applicable discount rate that could result in materially different estimates of the net present value of the liabilities. If self-insurance reserves were changed 10% from our estimated reserves at December 31, 2018, the financial impact would have been approximately $15 million or 0.9% of pretax income for the year ended December 31, 2018.

Legal Reserves:

We maintain reserves for expenses associated with litigation, for which O’Reilly is currently involved. We are currently involved in litigation incidental to the ordinary conduct of our business. Management, with the assistance of outside legal counsel, must make estimates of potential legal obligations and possible liabilities arising from such litigation and records reserves for these expenditures. If legal reserves were changed 10% from our estimated reserves at December 31, 2018, the financial impact would have been approximately $1 million or 0.1% of pretax income for the year ended December 31, 2018.

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 could differ from our current estimates but would still be reasonable given the nature of a particular position. 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.

INFLATION AND SEASONALITY

For the last three fiscal years, we have generally been successful in reducing the effects of merchandise cost increases principally by taking advantage of supplier incentive programs, economies of scale resulting from increased volume of purchases and selective forward buying. To the extent our acquisition cost increased due to price increases industry-wide, we have typically been able to pass along these increased costs through higher retail prices for the affected products. As a result, we do not believe inflation has had a material adverse effect on our operations.

To some extent, our business is seasonal primarily as a result of the impact of weather conditions on customer buying patterns. While we have historically realized operating profits in each quarter of the year, our store sales and profits have historically been higher in the second and third quarters (April through September) than in the first and fourth quarters (October through March) of the year.

QUARTERLY RESULTS

The following tables set forth certain quarterly unaudited operating data for fiscal years ended December 31, 2018 and 2017. The unaudited quarterly information includes all adjustments, which management considers necessary for a fair presentation of the information shown (in thousands, except per share and comparable store sales data):

	Fiscal 2018
	First Quarter				Second Quarter				Third Quarter				Fourth Quarter
Comparable store sales	3.4		%		4.6		%		3.9		%		3.3		%
Sales	$	2,282,681			$	2,456,073			$	2,482,717			$	2,314,957
Gross profit	1,201,258				1,288,638				1,315,755				1,234,315
Operating income	422,846				479,150				485,148				428,040
Net income	304,906				353,073				366,151				300,357
Earnings per share – basic (1)	$	3.65			$	4.32			$	4.54			$	3.76
Earnings per share – assuming dilution (1)	$	3.61			$	4.28			$	4.50			$	3.72

	Fiscal 2017
	First Quarter				Second Quarter				Third Quarter				Fourth Quarter
Comparable store sales	0.8		%		1.7		%		1.8		%		1.3		%
Sales	$	2,156,259			$	2,290,829			$	2,339,830			$	2,190,808
Gross profit	1,131,147				1,200,062				1,230,294				1,159,180
Operating income	403,157				457,445				461,963				402,835
Net income	264,934				282,821				283,734				302,315
Earnings per share – basic (1)	$	2.88			$	3.14			$	3.26			$	3.56
Earnings per share – assuming dilution (1)	$	2.83			$	3.10			$	3.22			$	3.52

(1)	Earnings per share amounts are computed independently for each quarter and annual period. The quarterly earnings per share amounts may not sum to equal the full-year earnings per share amount.

The unaudited operating data presented above should be read in conjunction with our consolidated financial statements and related notes included elsewhere in this annual report, and the other financial information included therein.

RECENT ACCOUNTING PRONOUNCEMENTS

In May of 2014, the Financial Accounting Standards Board (the “FASB”) issued Accounting Standard Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers (Topic 606),” now codified in the Accounting Standards Codification (“Topic 606”). Under Topic 606, an entity is required to follow a five-step process to determine the amount of revenue to recognize when promised goods or services are transferred to customers. Topic 606 offers specific accounting guidance for costs to obtain or fulfill a contract with a customer. In addition, an entity is required to disclose sufficient information to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. We adopted this guidance using the modified retrospective transition method with our first quarter ended March 31, 2018. Results of the year ended December 31, 2018, were presented under Topic 606, while amounts in prior periods were not adjusted and continue to be reported under the accounting standard in effect for the prior periods. The adoption of Topic 606 did not have a material impact on our business process, internal controls, systems, consolidated financial condition, results of operations or cash flows; as such, a cumulative effective adjustment was not recorded to opening retained earnings.

In February of 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” (“ASU 2016-02”). Under ASU 2016-02, an entity will be required to recognize right-of-use assets and lease liabilities on its balance sheet and disclose key information about leasing arrangements. ASU 2016-02 offers specific accounting guidance for a lessee, a lessor and sale and leaseback transactions. Lessees and lessors are required to disclose qualitative and quantitative information about leasing arrangements to enable a user of the financial statements to assess the amount, timing and uncertainty of cash flows arising from leases. In July of 2018, the FASB issued ASU No. 2018-11, “Leases (Topic 842): Targeted Improvement” (“ASU 2018-11”), to provide an additional, optional transition method for adopting ASU 2016-02, which allows for an entity to choose to apply the new lease standard at adoption date and recognize a cumulative-effective adjustment to the opening balance of retained earnings in the period of adoption, while comparative periods presented will continue to be in accordance with current U.S. GAAP Topic 840. For public companies, Topic 842 is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period. We established a task force, composed of multiple functional groups inside of the Company, which has substantially completed its objective of reviewing the critical components of the standard and implementing changes to systems and controls necessary to support the adoption of the new standard beginning with our first quarter ending March 31, 2019. We will adopt this guidance using the additional, optional transition method, the package of transitional practical expedients relating to the identification, classification and initial direct costs of leases commencing before the effective date of Topic 842, and the transitional practical expedient for the treatment of existing land easements; however, we will not elect the hindsight transitional practical expedient. We will make an accounting policy election to not apply recognition requirements of the guidance to short-term leases. The adoption of the new guidance will have a material impact on the total assets and liabilities reported on our consolidated balance sheet, and we estimate net right-of-use assets and lease liability to be approximately $1.9 billion and $2.0 billion, respectively, as of January 1, 2019. The difference between these amounts is primarily due to the accrual for straight-line expense. These estimates are based on our current lease portfolio and changes to the lease portfolio, including the total number of leases, lease commencement and end dates and lease termination expectations, as well as changes in anticipated lease discount rates, could impact these estimates. We expect to make an adjustment to opening “Retained Deficit” on the Consolidated Balance Sheet of approximately $1.4 million related to the adoption of this new guidance. The adoption of this new guidance will not have a material impact on our results of operations, cash flows, liquidity or our covenant compliance under our existing credit agreement.

In March of 2016, the FASB issued ASU No. 2016-09, “Compensation - Stock Compensation (Topic 718): Improvements to Employee Share-Based Payment Accounting” (“ASU 2016-09”). Under ASU 2016-09, several aspects of the accounting for share-based payment transactions, including tax consequence, classification of awards as equity or liabilities, and classification on the statement of cash flows, were changed. We adopted this guidance with our first quarter ending March 31, 2017. Upon adoption of ASU 2016-09, the we elected to change our accounting policy to account for forfeitures as they occur; this change was applied using the modified retrospective transition method with a cumulative effect adjustment of $0.3 million to opening “Retained earnings” on the accompanying Consolidated Balance Sheet as of December 31, 2017. We applied the amendments related to the presentation of tax withholdings on the statement of cash flows using the retrospective transition method, which resulted in $0.6 million of tax withholdings being reclassified from “Net cash provided by operating activities” to “Net cash used in financing activities” on the accompanying Consolidated Statement of Cash Flows for the year ended December 31, 2016. We elected to apply the amendments related to the presentation of excess tax benefits on the statement of cash flows using the retrospective transition method, which resulted in $56.0 million of excess tax benefits related to share-based compensation being reclassified from “Net cash used in financing activities” to “Net cash provided by operating activities” in the accompanying Consolidated Statement of Cash Flows for the year ended December 31, 2016. ASU 2016-09 amendments related to accounting for excess tax benefits in the income statement were adopted prospectively, resulting in the reduction of $34.7 million and $48.7 million in “Provision for income taxes” in the accompanying Consolidated Statements of Income for the years ended December 31, 2018, and 2017, respectively.

In June of 2016, the FASB issued ASU No. 2016-13, “Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments” (“ASU 2016-13”). Under ASU 2016-13, businesses and other organizations are required to present

financial assets, measured at amortized costs basis, at the net amount expected to be collected. The allowance for credit losses is a valuation account that is deducted from the amortized cost basis, such as trade receivables. The measurement of expected credit loss will be based on historical experience, current conditions, and reasonable and supportable forecasts that affect the collectibility of the reported amount. For public companies, ASU 2016-13 is effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period, and requires a modified retrospective adoption, with early adoption permitted. We will adopt this guidance beginning with our first quarter ending March 31, 2020. The application of this new guidance is not expected to have a material impact on our consolidated financial condition, results of operations or cash flows.

In January of 2017, the FASB issued ASU No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment” (“ASU 2017-04”). ASU 2017-04 eliminates the second step in the previous process for goodwill impairment testing; instead, the test is now a one-step process that calls for goodwill impairment loss to be measured as the excess of the reporting unit’s carrying amount over its fair value. For public companies, ASU 2017-04 is effective for annual reporting periods beginning after December 15, 2019, including interim periods within that reporting period, and requires prospective adoption, with early adoption after January 1, 2017. We will adopt this guidance beginning with our first quarter ending March 31, 2019. The application of this new guidance is not expected to have a material impact on our consolidated financial condition, results of operations or cash flows.

In August of 2018, the FASB issued ASU No. 2018-15, “Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract” (“ASU 2018-15”). ASU 2018-15 aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. ASU 2018-15 is effective for annual reporting periods beginning after December 15, 2019, and interim periods within that reporting period, and allows for either retrospective or prospective adoption, with early adoption permitted. We early adopted this guidance with our third quarter ended September 30, 2018, using the prospective adoption method. We did not capitalize any implementation costs incurred in cloud computing arrangements that are service contracts subsequent to adoption, and therefore, the adoption of this new guidance did not impact our consolidated financial condition, results of operations or cash flows during the period. We do not expect that the application of this new guidance will have a material impact on our consolidated financial condition, results of operations or cash flows.