ADVANCE AUTO PARTS INC Q2 2025 earnings call

Good morning and thank you for participating in today's call. I'm joined by Shane O'Kelly, President and Chief Executive Officer, and Ryan Grimsland, Executive Vice President and Chief Financial Officer. During today's call, we will be referencing slides which have been posted to our Investor Relations website. Before we begin, please be advised that management's remarks today will contain forward-looking statements. All statements other than statements of historical fact are forward-looking statements, including but not limited to statements regarding initiatives, plans, projections, guidance, and expectations for the future. Actual results could differ materially from those projected or implied by the forward-looking statements. Additional information can be found under forward-looking statements in our earnings release and risk factors in our most recent Form 10-K and subsequent filings made with the SEC. Shane will begin today's call with an update on the business and our strategic priorities.

Later, Ryan will discuss results for the second quarter and provide an update on full year 2025 guidance. Following management's prepared remarks, we will open the line for questions. Now, let me turn over the call to our CEO, Shane O'Kelly. Shane?

Thank you, Lavesh, and good morning, everyone. I would like to take a moment to express my gratitude for the hard work and dedication of the Advance team. Their focus on providing excellent customer service and driving progress in our initiatives enabled the company to deliver solid second-quarter results that were in line with the upper end of our expectations. In Q2, we also achieved an important milestone in our turnaround journey with the return to profitability. This was supported by actions to optimize our store footprint and progress with our strategic initiatives. Comparable sales growth was about flat for the quarter, and our performance was driven by strength in the pro business, which continued to deliver positive comp growth. In our DIY business, we are encouraged by emerging signs of stabilization as comparable sales were consistent with Q1 and improved on a two-year basis.

Notably, we concluded the quarter on a strong note, with both pro and DIY delivering positive results, and this momentum has continued into the first four weeks of Q3. We are working with our vendor partners to effectively manage tariff-related cost increases while thoughtfully adjusting retail prices in response to market dynamics. We anticipate that tariffs will have a more pronounced impact in the second half of this year. Importantly, more than 90% of our business is non-discretionary, with demand driven by maintenance work and break-fix repair for an aging and growing vehicle fleet in the United States. We believe that this puts us in a strong position to navigate a higher product cost environment. Our industry has consistently demonstrated a disciplined approach to adjusting prices in response to rising costs. This rational behavior is evident in the current tariff environment, and we expect that to continue.

From our perspective, the market is in a transition phase, and while recent trade deals are expected to provide further clarity in vendor negotiations, consumers are still adapting to an evolving landscape of higher prices. We are closely monitoring consumer behavior and the potential for recalibration in purchasing habits, especially within our DIY business. While we have not observed any significant shifts to date and remain encouraged with our recent DIY trajectory, we believe it is prudent to take a cautious approach in planning for the remainder of the year. This is reflected in our assumptions for the second half of 2025, and we are reaffirming our full year sales, operating margin, and free cash flow guidance. As a management team, we have maintained transparency in our efforts to take decisive actions that drive progress on our turnaround.

These include the decision to divest Worldpac, optimize our store footprint, and consolidate our supply chain. In line with this commitment to take decisive actions, we proactively reorganized our debt capital structure earlier this month to ensure financial flexibility in the turnaround. We believe this action will enable us to support our current supply chain financing program while also allowing us to strategically optimize its utilization for the long term. I would also like to note that we view this as a bridge structure as we work to return to an investment-grade credit rating in the future. We are confident that the long-term advantages of a stable supply chain financing program and enhanced financial flexibility will serve as catalysts for driving EPS growth and value creation over time. Let us now turn to an update on our strategic initiatives.

To recap, our turnaround plan is built around three strategic pillars, each supported by targeted initiatives that we believe will position us to deliver profitable growth. I will share updates on the progress we have made within each pillar before Ryan discusses our financial performance. Let's begin with merchandising. Approximately a year ago, the merchandising team embarked on a transformation journey following the appointment of our Chief Merchant, Bruce Starnes, and other key leaders in pivotal roles. They have been focused on reestablishing Advance as a premier destination for high-quality auto parts and rebuilding trust as a long-term growth partner for vendors. The team is engaged in line reviews and several rounds of negotiations with vendors to secure products at a more competitive cost. They have undertaken joint business planning with vendors to discuss category strategies, SKU development, and growth plans that establish mutual trust for a long-term partnership.

We have completed about two-thirds of our line reviews and continue to march towards our goal of delivering about 50 basis points of annualized cost reductions in the second half of 2025. We expect to build on this next year as the remaining activities are completed over the next few months. The groundwork laid by this team over the last year is also supporting productive negotiations with vendors on sharing the tariff burden. As we have indicated previously, approximately 40% of our reported cost of goods is exposed to tariffs at a blended rate of approximately 30%. The dynamic tariff environment has certainly presented challenges across the industry. However, we have been able to navigate through this complex landscape thanks to our much-improved price management capabilities. Our pricing team has been successful in identifying dutiable components across product lines, which is enabling more effective discussions with vendors around cost increases.

Simultaneously, the team has been proactive in exploring alternative sources of supply and diversifying countries of origin to mitigate costs. In addition to handling external tariff discussions, the team is internally optimizing product promotion strategies to minimize reliance on ineffective promotions. This work involves close collaboration with store teams to refine the use of unproductive discounting mechanisms. We view promotion management as an important lever to balance the impact of higher costs and to maximize profit dollars. We expect to make progress on this initiative later this year with a bigger impact in 2026. Moving to assortment management, the team has made great strides in accelerating new SKU growth and the speed at which we bring parts to market. Over the past year, we have made considerable progress on analyzing customer needs, identifying gaps within our assortment, and improving internal processes to introduce new products in the market.

This has enabled us to add more than 60,000 new SKUs in our network year to date, which is up nearly 300% compared to last year. Providing faster access to parts enables us to respond to demand signals more quickly, driving more effective placement of SKUs across our network. The progress we have achieved in SKU expansion has also contributed to the improvement in our store availability KPI, which increased by approximately 100 basis points compared to Q1 and is currently in the mid-90% range. Next, I'd like to provide an update on the rollout of our new assortment framework, which is designed to enhance parts coverage across each store, hub, and market hub within a Designated Market Area. We have been able to accelerate this rollout by harnessing advanced technological tools, including the use of AI.

These innovative tools are enabling us to introduce greater intelligence in the assortment planning process, which has traditionally been done manually. Today, we are better equipped to make data-driven decisions and swiftly adapt to SKU requirements by market. We are successfully increasing coverage in key hard parts categories by rebalancing hundreds of SKUs per store to better align inventory with market-specific needs. We recently completed this rollout in an additional 19 DMAs and currently operate the new framework in the top 30 DMAs. We expect to substantially complete the rollout across the top 50 DMAs, representing approximately 70% of our sales by the end of the third quarter, well ahead of our original schedule. While it is still early to assess the results of the recent rollout, the improvements in the newer DMAs are tracking directionally in line with the DMAs completed earlier in the year.

The initial DMAs continue to deliver an average comp uplift of approximately 50 basis points. Notably, in some of these markets, we are beginning to observe a comp uplift exceeding the average, which in our view is a promising indicator of this initiative's growth potential. Based on our expectations, the complete benefit of this initiative will become more apparent over a 12 months-18-month horizon due to the slow turning nature of inventory in the industry. We are energized by the progress achieved thus far and optimistic about the potential to meaningfully advance our goal of enhancing parts availability. Turning to supply chain, year to date, we have successfully closed or converted nine DCs in the U.S. and remain on track to achieve a total of 12 closures by year end, bringing us to a total of 16 DCs in the U.S.

In parallel, we are enhancing productivity within these facilities by refining processes, which we anticipate will drive sustained improvements in product throughput, measured as lines per hour. Year to date, we have achieved a low single-digit increase in this metric. The operational efficiencies of our DCs have a direct and significant impact on parts availability for our stores. Our supply chain team is actively identifying and sharing best practices across all facilities while fostering a culture of operational excellence. These efforts are aimed at ensuring high product availability and reliable service for our stores. Recent operational changes in our DCs are already yielding measurable results. Over the past six months, we have reduced shipment errors from the DCs to stores by approximately 33% and also improved DC-to-store order fill rates.

To unlock further productivity, we are optimizing our warehouse management system that was fully rolled out at the end of last year. Our efforts are focused on the execution of key functions such as product picking, packing, and routing deliveries to stores. We expect these efforts to improve the efficiency of our DC-to-store operations as we strive to leverage fixed costs and narrow our margin gap relative to the industry. Moving to an update on market hubs. As a reminder, we introduced the market hub last year as a new node in our multi-echelon supply network. The market hub carries 75,000 SKUs-85,000 SKUs, expanding same-day parts availability for a service area of about 60 stores-90 stores. It plays an important role in improving customer service. With stores receiving multiple shipments from a market hub each day, they are able to more quickly access and deliver parts to customers.

Thank you, Shane, and good morning, everyone. I want to begin by thanking our frontline associates for their commitment to serving our customers and delivering solid Q2 results. For the second quarter, net sales from continuing operations were $2 billion, an 8% decline compared to last year. This decline is mainly attributable to the store optimization activity that was completed during Q1. Comparable sales growth was positive 0.1% for the quarter, which included an approximately 25 basis points headwind due to the shift in timing of Easter from late Q1 into early Q2. During the second quarter, sales growth in the first four weeks was in line with trends exiting Q1. In the middle four weeks of the quarter, trends softened. We believe this was driven by higher-than-normal precipitation levels, which contributed to softer transaction growth.

Sales growth was strongest in the final four weeks of the quarter, with both DIY and pro channels comping positive. This improvement was driven by a recovery in transactions and strength in our core hard parts business. Undercar components, engine management, and the brake category led performance during the quarter. For the quarter, transactions declined in the low single-digit range, while ticket was positive and improved compared to Q1. We estimate that inflation was about 2% during the quarter and included tariff-related price adjustments that began midway through Q2. This rate of inflation was also influenced by the comparison to last year's price investments, which had pressured ticket growth last year. Looking at channel performance more broadly for the full quarter, pro grew in the low single-digit range and accelerated compared to Q1. DIY underperformed with a low single-digit sales decline. However, Q2 DIY performance was stable compared to Q1.

On a two-year basis, both channels improved relative to Q1. Adjusted gross profit from continuing operations was $880 million, or 43.8% of net sales, resulting in gross margin expansion of about 16 basis points compared to last year. Our Q2 gross margin was relatively in line with expectations. The year-over-year margin expansion was driven by savings associated with our footprint optimization activity completed in March. These savings were partially offset by the reversal of previously capitalized inventory costs. Adjusted SG&A from continuing operations was $819 million, or 40.7% of net sales, or about flat compared to last year. The year-over-year reduction in SG&A expense was primarily related to operating of fewer stores compared to last year. As a result, adjusted operating income from continuing operations was $61 million, or 3.0% of net sales, resulting in about 20 basis points of margin expansion.

Adjusted diluted earnings per share from continuing operations was $0.69 compared with $0.62 reported in Q2 last year. Year to date, free cash flow was a use of $201 million and included a $15 million improvement in operating cash flow compared to last quarter. Q2 free cash flow also included $20 million in cash costs related to our store optimization work. Next, I would like to discuss our recent debt offering and the rationale for pursuing a reorganization of our debt capital structure. In early August, we completed a debt offering of $1.95 billion of senior notes divided into two equal tranches, one maturing in 2030 and the other in 2033. We received net proceeds of $1.92 billion after payment of transaction fees. Separately, we have also entered a new $1 billion asset-backed revolving credit facility to replace our prior $1 billion revolving facility.

Proceeds from the senior notes offering were used to redeem $300 million of outstanding senior notes due 2026. Following this redemption, we expect to carry more than $3 billion of cash on the balance sheet. Up to $2.5 billion of this cash, plus other assets, including inventory and accounts receivable, will be used to support the new $1 billion asset-backed revolving credit facility and the $3 billion supply chain financing program. Essentially, we are providing a one-for-one asset support for the new debt capital structure. I would like to note that we expect to operate the supply chain financing program as we did prior to the debt offering. The revolving credit capacity under the new AVL facility provides an additional liquidity source beyond our cash on hand. We have no current plans to draw on the new revolver.

The supply chain financing program is important to our vendor community, and we have taken proactive steps to ensure continuity in the program and mitigate potential risks. We believe this transaction puts us firmly in control of deciding the best course of action for the program for the long term. The new debt capital structure helps preserve financial flexibility, allows us to focus on execution of our turnaround plan, and serves as a bridge toward reattainment of an investment-grade credit rating in the future. Turning to an update on guidance. For fiscal 2025, we have revised our EPS guidance to account for the recent debt issuance. For the other items, we are reaffirming our expectations for the year. We are pleased with the progress on our strategic initiatives. However, we recognize that we are still in the early phases of our three-year turnaround plan.

We remain committed to diligently monitoring the implementation of our initiatives to drive further operational improvements. Also, as Shane indicated, the market is still in a period of transition as consumers adapt to an environment of higher prices. In this backdrop, we believe our guidance reflects the potential risks related to tariffs. Our approach to navigating tariffs is unchanged. We expect to be measured while adjusting prices, with a goal to hold rate where possible, but prioritizing profit dollar expansion. We also expect to continually measure competitive response and price demand elasticity as we execute our response to tariffs through the year. Let's discuss our full-year expectations. Starting with net sales, we expect net sales in the range of $8.4 to $8.6 billion. Comparable sales are expected to grow in the range of 50 to 150 basis points on a 52-week basis.

We expect positive low single-digit comp growth in Q3 and Q4, supported by our focus on improving parts availability and elevating service levels. Our tariff-related price actions are expected to contribute to low to mid-single-digit same SKU inflation in the second half. Full-year net sales also include contributions from new stores planned to be open this year, and we expect the 53rd week to contribute approximately $100 million-$120 million in net sales. Moving to margins, adjusted operating income margin is expected in the range of 2%-3%. For Q3, we are planning for adjusted operating income margin above 4%. This range embeds gross margin about in line to slightly better than Q2, supported by the merchandising team's progress on product cost negotiations and a range of potential scenarios for our tariff management activities. For SG&A, we expect expense dollars to be relatively in line with Q2.

Finally, with respect to Q3, and as disclosed in our results last year, we are lapping about 130 basis points of atypical sales and margin headwinds, which is expected to drive favorability in year-over-year operating margin leverage. Based on our expectations for Q3, combined with first-half results, our Q4 operating margin range implies a wide range of potential outcomes. While we continue to expect sequential improvement in margin leverage compared to Q3, it is important to note that Q4 is our lowest volume quarter and generally subject to seasonal volatility, which could impact results. Moving to other items in our guidance, we now expect adjusted diluted EPS to range between $1.20 and $2.20 compared to our prior guidance of $1.50 and $2.50.

This revision is mainly driven by the higher interest expense associated with the recent offering of $1.95 billion of senior notes and savings from the redemption of the 2026 notes. We expect some of the interest expense to be offset by higher interest income from short-term cash investments. Regarding free cash flow, we continue to target a range of -$85 million to -$25 million for the year, which includes positive operating cash flow through the end of the year. We continue to expect $150 million of cash expenses related to our store optimization project. In summary, we are pleased to enter the second half with positive sales and margin momentum. As we look to the balance of this year, we are planning cautiously in a dynamic macro backdrop and closely monitoring consumer behavior. To wrap up, I want to provide a quick overview of our 2027 objectives.

We continue to target low single-digit comparable sales growth and an adjusted operating income margin of approximately 7% for fiscal 2027. Following the recent debt issuance, we are updating our leverage ratio to a net adjusted debt leverage ratio of approximately 2x-2.5x. We believe this target provides financial stability for the business while maintaining the flexibility to invest for growth. We expect our strategic initiatives to strengthen cash flow generation and enable us to effectively manage supply chain financing and gradually reduce leverage over time. By achieving our leverage target, we aim to position the company to regain an investment-grade credit rating in the future, further strengthening the resilience of our strong balance sheet. I again want to thank our frontline associates for their commitment to serving our customers and delivering solid results in the quarter. I will now hand the call back to Shane.

Thank you, Ryan. Before closing today's call, I want to thank all our team members and frontline associates once again. We believe we have the right strategy centered on core retail fundamentals, along with a talented team driving execution on our strategic initiatives. I look forward to continuing to share updates on our progress in the future. With that, let's open the call for questions. Operator.