ADVANCE AUTO PARTS INC Q3 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 third quarter and provide an update on full year guidance. Following management's prepared remarks, we will open the line for questions. Now let me turn the call over to our CEO, Shane O'Kelly. Shane?

Thank you Lavesh and good morning everyone. I want to take a moment to acknowledge and thank the team for their hard work and dedication. Their unwavering focus on delivering exceptional customer service and advancing our strategic priorities helped us achieve our strongest quarter in over two years. For the third quarter, we reported comparable sales growth of 3% with both Pro and DIY channels delivering growth. Adjusted operating margin expanded by 370 basis points year-over-year to 4.4%, demonstrating progress on the execution of our strategic plan. During the quarter, we also strengthened our balance sheet by proactively reorganizing our debt capital structure. We raised nearly $2 billion in cash, which provides enhanced liquidity for the business as well as a path to return to an investment-grade credit rating in the future.

As anticipated, tariff-related price increases have accelerated in the auto aftermarket, and in our view, the industry has been responding rationally by adjusting prices in response to rising product costs. We saw some variability in performance as prices moved higher during the quarter, although on a two-year basis both transaction and unit trends were relatively stable. As we look to the balance of the year, we believe there is potential for temporary volatility in sales trends as consumers manage household budgets in an inflationary backdrop. Our teams are prepared to navigate in this dynamic environment and provide consistent, high-quality service to our customers. The long-term fundamental drivers of the industry remain healthy. More than 90% of our sales are driven by maintenance and break-fix repair, which gives us confidence for the long term.

Based on our performance to date and expectations for the remainder of Q4, we have updated our full-year guidance. We have reaffirmed the midpoint of our prior comparable sales growth and adjusted operating margin guidance, which implies approximately 200 basis points of margin expansion for the year. I want to recognize the team for their tremendous effort in delivering operational stability and maintaining focus on our turnaround priorities. We still have considerable work ahead of us as the initiatives underlying our strategic pillars continue to build through 2026. We remain committed to the steady execution of our plan to expand margins and create long-term value for shareholders. The Advance team is prioritizing actions to successfully execute the basics of selling auto parts while strategically utilizing innovative technological assets to position the company for the future.

Our technology team has designed a multi-year roadmap to support the effective execution of our plan. These include using generative AI content and deploying AI-based applications in routine processes and providing sharp analytical data for our teams to improve service levels. Some of the areas where we are leveraging these applications include processes within merchandising to power our SKU placement decisions and within our supply chain to determine optimum demand forecasting for millions of SKU combinations in our network. These are just a couple of examples among other projects where we believe we will collectively establish a foundation for stronger execution across fundamental retail operations. Next, let's turn to an update of our strategic plan. To recap, our turnaround goals are built on three 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, and then Ryan will discuss our financial performance. Let's begin with merchandising. Throughout the year, we have taken deliberate and strategic actions to position Advance Auto Parts as a trusted long-term growth partner for our vendors. With a sense of urgency, we have streamlined legacy processes, reduced complexities in order management, restructured our distribution center footprint, and prioritized operational excellence to enhance the overall vendor experience. Our vendor community is reacting positively to the bold, decisive actions we've made, such as exiting underperforming markets and investing in new stores and market hubs. They are actively engaging in strategic business planning, exploring supply consolidation opportunities, and collaborating on joint marketing efforts to support our transformation. This alignment has already begun to deliver improved product margins, and we expect additional cost benefits in the future.

I am proud of the team's progress, especially given the added complexities of navigating a new tariff environment. Another key priority for the company has been enhancing the availability of hard parts. We are pleased to report the successful completion of the rollout of our new assortment framework across our top 50 Designated Market Areas (DMAs), which cover approximately 70% of our sales. We achieved this ahead of schedule by leveraging proprietary assortment planning tools that have significantly improved our ability to make data-driven decisions and quickly adapt SKU requirements to meet specific market needs. We expect this initiative to deliver incremental growth over and above the initial 50 basis point uplift as these markets mature over the next 12-18 months. Along with refreshing our store assortment, we have also improved distribution center stocking programs to drive greater effectiveness in store replenishment processes for each market.

These activities have enabled us to achieve our store availability target and ensure improved depth of hard parts in stores and distribution centers. With this major milestone accomplished, we are now focused on improving the speed at which we bring new parts to market to expand our breadth of coverage. We have already introduced tens of thousands of new SKUs into our network this year, and our work has uncovered additional opportunities to enhance our responsiveness to market demand signals. Increasing the breadth of hard parts coverage will enable us to further improve service levels for our Pro customers. Moving to Pricing and Promotion Management, as a company, our goal is to offer competitive pricing, supplemented with seasonally relevant promotions to engage customers and drive repeat purchases.

We are in the initial stages of testing a new AI-powered pricing matrix to inform pricing decisions for SKUs within the DIY and Pro channels. Separately, we have also built guidelines for field discounting programs to take advantage of select market growth opportunities. In this regard, we are adopting a fundamental retail approach by installing a centralized price management system for segmenting categories, markets, SKUs, and customer channels. Consistent with prior expectations, we expect this initiative to deliver a larger benefit in 2026 and beyond. Turning to supply chain, our U.S. Distribution Center consolidation plan is progressing on schedule, and we expect to end the year with 16 DCs in the U.S., which is a significant reduction from 38 DCs just two years ago.

We will enter the next phase of consolidation in 2026, and as part of our planning process, we are evaluating our operational capabilities across the network. DC productivity, measured through product lines per hour, has improved in the mid-single digit percentage range compared to last year, and our team is putting incremental focus on execution of key functions in our DCs. These include product picking, packing, and routing to drive additional productivity. We believe our current DC network is well positioned to support strong service levels and the continued growth of our multi-echelon network. A key element of this growth is opening new market hubs. Approximately 75% of our stores are in markets where we have the number one or number two position based on store density. Our team has made great strides in accelerating market hub openings, which is enabling us to capitalize in markets of strength.

During Q3, we opened 6 locations and concluded the quarter with 28 market hubs. We now expect to open a total of 14 market hubs this year, including 10 conversions and 4 greenfield locations. With these openings, we expect to end the year with 33 locations. A market hub typically carries between 75,000-85,000 SKUs, expanding same day parts availability for a service area of about 60-90 stores. Thus far in Q4, we have opened one greenfield location in the Atlanta area. Built from the ground up, this facility is poised to serve as a model for future hub development. We are particularly enthusiastic about the opportunities presented by greenfield openings as these facilities enable us to establish new points of distribution within designated market areas.

This strategic expansion not only enhances our ability to provide additional hard parts coverage in previously underserved regions, but it also creates incremental opportunities to gain market share. We will continue to open new market hubs in 2026 and stay on the path to opening 60 market hubs by mid-2027. Moving to store operations, as we've previously communicated throughout the year, we have been testing a refresh store operating model designed to enhance productivity and ensure the delivery of consistent, high quality service to our customers. I would like to thank our frontline team for their collaboration and adaptability during the testing phase as we work to identify a more effective path forward. We are now prepared to launch this model in Q4 as part of the first phase of the rollout, with full implementation anticipated during the first half of 2026.

This updated operating model enables us to improve driver and store team labor hours along with vehicle allocations, aligning them more effectively with demand patterns to better serve our customers. We expect this model to provide three key benefits. First, it will enable us to instill greater confidence in our Pro customers while strengthening our reputation as a trusted and reliable parts provider in the aftermarket. Second, it strengthens the collaboration between our customer-facing outside sales team and our internal store teams who play a role in efficiently procuring and delivering parts. Third, from an economic standpoint, this model should support greater transaction velocity, improve labor utilization, and enable us to compete more effectively. The introduction of this new operating model combined with the expansion of new store locations and our delivery commitment of 30-40 minutes naturally positions us to accelerate growth in each Pro account.

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 strong Q3 results for the third quarter. Net sales from continuing operations were $2 billion, which declined 5% compared to last year. This decline was mainly attributable to the store optimization activity that was completed during Q1. Comparable sales grew 3% during the quarter with positive weekly performance throughout the quarter. Sales trends were strongest during the first four weeks, followed by a moderation during the last eight weeks. From a category perspective, brakes, undercar components, and engine management led performance. We have made significant progress in improving our coverage and availability of hard parts, which is helping us deliver better service to customers. For the quarter, ticket was positive and largely driven by tariff-related price adjustments that expanded throughout the quarter.

Our industry has been reacting rationally to rising product costs, and we have been adjusting prices in response to market dynamics. In aggregate, same SKU inflation was about 3% in Q3 compared to about 2% last quarter. Transactions were down but improved sequentially as we cycled through discrete events from last year on a two-year basis. Transactions and unit productivity were relatively stable to last quarter, reflecting the team's continued focus on delivering consistent, high-quality service. Now let's look at channel performance. Pro comps grew by just over 4% as we cycled through the softness from last year on a two-year basis. The Pro channel recorded its fifth consecutive quarter of positive performance and relatively consistent two-year trends in each month. Our DIY channel delivered positive low single-digit comps in the quarter and improved sequentially on a two-year basis.

Moving to margins, adjusted gross profit from continuing operations was $913 million, or 44.8% of net sales, resulting in gross margin expansion of about 260 basis points compared to last year. The year-over-year margin expansion was driven by savings associated with our footprint optimization activity completed in March and reduction in product costs driven by our strategic sourcing initiatives. I want to recognize the merchandising team for their solid execution this year. They have been able to secure competitive product costs while managing prices in a higher tariff environment to offset incremental cost pressures, which is yielding stronger merchandise margins. During the quarter, we cycled through approximately 70 basis points of atypical margin headwinds from last year. We also experienced a benefit of approximately 50 basis points related to capitalized inventory costs driven by our strategic decision to carry more inventory through the year.

Regarding product costs, as previously anticipated, we expected LIFO expenses to move higher due to cost inflation. This resulted in total LIFO expenses of $33 million for Q3. Shifting to operating expenses, adjusted SG&A from continuing operations was $823 million or 40.4% of net sales and was consistent with our expectations. The year-over-year reduction in SG&A expense is primarily related to operating fewer stores compared to last year. As a result, adjusted operating income from continuing operations was $90 million or 4.4% of net sales, resulting in about 370 basis points of year-over-year operating margin expansion. Our strongest operating margin in over two years, adjusted diluted earnings per share from continuing operations was $0.92 compared with a loss of $0.05 last year.

Year-to-date free cash flow is -$277 million, largely driven by payments for inventory purchased in Q3 last year, which is in line with our typical cadence for managing payables. Also, during the quarter we spent an additional $20 million on cash costs related to our store optimization activity for a total of approximately $130 million incurred through the year. Looking at year-to-date free cash flow more closely, we have only seen a modest change in operating cash flow between Q2 and Q3, which shows the stability of our operational execution while we continue to allocate higher CapEx to strategic investments. Turning to an update on full year guidance, starting with net sales, we expect net sales of $8.55-$8.6 billion, including comparable sales growth between 0.7%-1.3%.

Q4 is typically our most volatile quarter of the year and our guidance includes trends through the first three weeks, which have started off soft. While the Pro channel continues to track positive, the DIY channel is seeing pressure with more week-to-week variability in transactions. We believe this is being driven primarily by adjustments in consumer purchasing habits in response to rising prices. Same SKU inflation is expected to move higher compared to Q3, and we remain cautious in our planning assumptions based on recent trends. In addition, I want to highlight two sales-related items that are unique to Q4. First, last year in Q4 we generated $74 million in non-recurring liquidation sales related to our store optimization activity, and second, we expect between $100 million-$120 million in sales from the 53rd week. As a reminder, neither of these items impact comparable sales growth.

Moving to margins, we expect adjusted operating income margin between 2.4%-2.6%, reaffirming the midpoint of our prior guidance range. Given the typical seasonality of the business through the end of the year, we expect Q4 gross margin to moderate compared to Q3. We are planning for Q4 gross margin slightly below 44%, which includes the benefit of higher capitalized inventory costs continuing through the end of the year as inventory levels are expected to be higher than previously planned. Strong coverage of parts across our network is critical for our long-term success, and we are working to ensure we provide our customers access to the right depth and breadth of parts. However, this inventory benefit is expected to be offset by higher than previously planned LIFO expenses that is driving 80-100 basis points of added pressure.

We currently estimate total fourth quarter LIFO expense of approximately $70 million. Based on cost trends through Q3 for SG&A, we expect Q4 expense dollars to decline in the high single-digit range compared to last year, which is in line with prior expectations. As a reminder, we are also lapping approximately 280 basis points of atypical margin headwinds, which will drive favorability in the year-over-year operating margin expansion. Moving to the other items in our guidance, we have updated our adjusted EPS guidance to a range of $1.75-$1.85, which includes slightly higher interest income compared to prior expectations for Q4. Our interest expense is expected to move higher due to a full quarter impact of the debt refinancing transaction that was completed in Q3.

For capital expenditures, we have revised our target to approximately $250 million for the year compared to the prior expectations of approximately $300 million, but about half of the change is associated with the allocation of spend between PP&E and other assets on our balance sheet, which is a net neutral. From a free cash flow perspective, the balance of the CapEx reduction is related to shift in timing of projected spend from Q4 into next year as we continue to execute initiatives across our three strategic pillars. Regarding free cash flow, we have revised our expectations to a range of -$90 million to $80 million for the year. As I indicated earlier, we expect to carry higher than previously planned inventory through the end of the year.

This is being driven by our strategic decision to improve the depth and breadth of assortment across our network and to support new store growth. Despite the higher inventory, we expect positive working capital contribution in the fourth quarter, which is in line with our planning assumption. At the start of the year, we continue to expect full year cash expenses of approximately $150 million related to our store optimization activity. Adjusting for this spend, our core free cash flow would have been positive for the year, which gives us confidence in our ability to deliver positive free cash flow in 2026 and beyond. In summary, we are pleased with our year-to-date financial performance and remain on track to end the year with solid margin expansion after two consecutive years of decline.

We have enhanced our liquidity position to fuel our turnaround, and the team is doing a commendable job by staying nimble in a dynamic macro backdrop. Before moving to your questions, I want to address a recent industry concern stemming from the bankruptcy proceedings of a supplier. In our view, this is an isolated situation and not a broader concern regarding the health of the aftermarket industry. Over the last 12-18 months, our merchant team has worked to diversify our vendor base, including consolidation of product lines, and we currently source less than 2% of our cost of goods from this supplier. Given the risk associated with the bankruptcy proceedings, we have recorded a non-cash charge of $28 million to cost of sales in the third quarter.

This charge reflects an estimate for future credit losses on certain other receivables due from the supplier and is recorded in our GAAP income statement. It does not impact adjusted results and full year guidance. Following this charge, we have reserved against the risk associated with potential credit losses. We are maintaining a positive dialogue with the vendor and continue to work with them. We also source products from hundreds of other suppliers and maintain alternate sources of supply to minimize any disruption to our operations. Separately, we have also heard market concerns related to our supply chain finance program and the aftermath of financial issues related to the supplier. We do not believe these concerns are applicable to us. I want to emphasize Advance's suppliers continue to receive early payments on their confirmed invoices through our network of large reputable banks.

Thank you, Ryan. We believe we have the right strategy centered on core retail fundamentals along with a talented team driving execution of our strategic initiatives. We appreciate your interest in Advance Auto Parts and look forward to reconnecting in the new year. Thank you, operator. We can now open the line for questions.