Advance Auto Parts, Inc. (NYSE:AAP) Q2 2023 Earnings Call Transcript

Advance Auto Parts, Inc. (NYSE:AAP) Q2 2023 Earnings Call Transcript August 23, 2023

Operator: Good morning, and welcome to the Advance Auto Parts’ Second Quarter 2023 Conference Call. Before we begin, Elisabeth Eisleben, Senior Vice President, Communications and Investor Relations, will make a brief statement concerning forward-looking statements that will be discussed on this call.

Elisabeth Eisleben: Good morning, and thank you for joining us to discuss our Q2 2023 results. I’m joined by Gene Lee, Interim Executive Chair; Tom Greco, President and Chief Executive Officer; and Tony Iskander, Interim Chief Financial Officer. Following their prepared remarks, we will turn our attention to answering your questions. Before we begin, please be advised that remarks today will contain forward-looking statements. All statements other than statements of historical facts are forward-looking statements, including but not limited to, statements regarding our leadership transition, initiatives, plans, projections and future performance. Actual results could differ materially from those projected or implied by the forward-looking statements.

Additional information about factors that could cause actual results to differ can be found under the captions Forward-Looking Statements and Risk Factors in our most recent Form 10-K and subsequent filings made with the commission. Now let me turn the call over to Gene Lee.

Gene Lee: Good morning, everyone, and thank you for joining us. I’m pleased to be able to join the call today and speak with all of you. I’ll turn the call over to Tom and Tony shortly to review the second quarter results and outlook for the remainder of the year. But before I do that, I’d like to take a moment to address the announcements we made this morning regarding new leadership and a comprehensive strategic and operational review, as well as provide some of my own perspectives on the business, the work that we have ahead of us and the actions we are taking. Following a thorough search, the Board has named Shane O’Kelly as President, Chief Executive Officer and Director of Advance Auto Parts, effective September 11. We are pleased to have identified an individual of Shane’s caliber to join Advance and have him come on Board as we are undertaking the operational and strategic review of the business.

Together with our financial advisor, Centerview Partners, we are committed to evaluating the full spectrum of alternatives and opportunities to increase shareholder value and ensure the long-term success of Advance, and I’m confident Shane will add valuable insight to this review. Shane is a highly accomplished customer centric executive with more than 30 years of operational, strategic development, integration and complex supply chain experience. He has a proven record of success developing high performing teams and cultures to drive results. He joined Advance from HD Supply, where he has served as CEO since 2020, following the company’s acquisition by the Home Depot. Prior to HD Supply, Shane was CEO of Interline Brands, which also operated as the Home Depot Pro.

We are confident that Shane brings the right skill set, discipline, and expertise to lead Advance into the future. I plan to remain in the Interim Executive Chair role through the end of the year to work alongside Shane and the management team. I look forward to welcoming him to [Raleigh] (ph) in September. Until Shane’s official start date, Tom will continue to serve as President and CEO. Thereafter, he will serve as an advisor to help ensure seamless transition of leadership responsibilities. On behalf of the entire Board, I thank Tom for his many contributions to Advance, which notably includes the culture he has built with highly skilled and committed team members and a talented bench of leaders. We also announced today Tony Iskander as Interim Chief Financial Officer.

Tony brings more than 25 years of finance and accounting expertise to the role, and has served as the company’s Senior Vice President, Finance and Treasurer since 2020. We are beginning a search to identify the company’s next permanent CFO and are pleased to have someone with Tony’s experience to step into the role on an interim basis. We are also pleased to have Tony on the call today to review Q2 results along with Tom. Since expanding my role to serve as Interim Executive Chair and partnering more closely with the leadership team, I am taking a deeper dive into the business and our strategy. As a Board, we recognize that there is significant work to be done. We are conducting the operational and strategic review to develop a long-term strategy to deliver best-in-class shareholder value.

We are executing a number of operational improvements, including inventory optimization initiatives, improving asset productivity across the enterprise, investment in our frontline organization to reduce turnover and discipline cost controls, which we expect to benefit the cost structure and working capital while strengthening Advance for a long-term. However, we know there’s more work to be done and the team is focused on building on these actions and looking for ways to drive even stronger performance and enhance value. The company is providing updated full-year 2023 guidance today, which considers recent performance and balance of the year expectations. I would note that after Shane joins next month, I expect to work closely with him on the business plan to ensure we capitalize on both Advance’s near-term and long-term potential.

With that, I’ll now turn the call over to Tom.

Tom Greco: Thanks Gene, and good morning, everyone. Before I start, I want to express my sincere appreciation to the Board for all their support over the last seven years. I look forward to working with Gene, Shane and Tony to enable a seamless transition. As I turn to our Q2 results, I also want to thank all of our team members for their relentless focus on serving our customers. Coming into the quarter, we knew Q2 was going to be challenging, and that the investments we’re making in both inventory to help improve availability and strategic pricing to maintain competitive price targets would build through the year. On our Q1 earnings call, we talked about moving with urgency with a back-to-basics approach and a heightened focus on execution, and this is how we approach the quarter.

We delivered net sales growth in the quarter. However, the balance of our Q2 financial metrics remain challenged. As Gene noted, while we’re executing some operational improvements, there are further actions that need to be taken to accelerate profitable growth. I’ll speak to our sales and transactions in the quarter, and Tony will speak to the key drivers behind our results in more detail. Before that, I’d like to touch briefly on steps we’ve taken recently to better support our people. During the quarter, we made investments to more strongly position Advance in attracting and retaining high-caliber talent in our frontline roles. More specifically, we implemented compensation increases for key roles in our stores and supply chain. In our Customer Support center, we’re also making investments this year, to help retain high-caliber talent.

We know that having the right compensation in place for our organization is critical to maintaining our strong culture and delivering operational excellence, and we’ve already seen reduced turnover. Turning to net sales. We saw growth in both DIY omnichannel and DIFM during Q2, with DIY omnichannel outperforming DIFM through continued e-commerce momentum which delivered another quarter of double-digit growth. From a category perspective, motor oil, batteries, brakes and engine management led the growth in Q2. DieHard continues to perform very well, and gained unit share within batteries once again in the quarter. Meanwhile, improved availability on our Carquest brand resulted in further owned brand penetration in the quarter. Regionally, our sales growth was once again led by the West.

In terms of comparable store sales, the decline of 0.6% was primarily driven by negative comparable store sales in Pro. However, we saw sequential improvement in each period in both Pro and DIY with the last four weeks of Q2 registering slightly positive comparable store sales growth overall. Our topline sales continued to improve into the third quarter, as we delivered low-single-digit comparable sales growth during the first four weeks. Our performance benefited from the initiatives we’ve talked about earlier this year to drive improved transactions in both DIY omnichannel and Pro. First, our improved availability was driven by the inventory investments we made along with year-to-date improvements in supply chain fill rates and store on-hand rates.

As in-stocks improved in the quarter, we saw sequential sales growth in key hard parts categories. Second, our category management actions continued in Q2 to ensure we sustained competitive price targets. In addition, we’ve discussed in the past the opportunity to increase owned brand penetration to improve margins. As discussed on the May call, we launched a sales campaign in Q2. This was primarily targeted at accelerating the transition to Carquest branded products, as well as reducing slower moving inventory in our network. Finally, our field team is now in full stride executing a Pro customer activation plan highlighted by increasing customer sales calls and ensuring a high level of accountability to grow weekly customer counts and drive share of wallet gains with existing customers.

Our actions resulted in sequential improvement in transactions in Q2 compared to Q1 in both Pro and DIY. While DIY omnichannel transactions were down slightly in Q2 versus the prior year, average ticket was up mid-single-digits. We continue to make progress increasing loyalty with DIY consumers as evidenced by ongoing traction with our Speed Perks program which grew by approximately 15% and ended the quarter with nearly 15 million active members. Our Speed Perks percentage of transactions continues to climb and hit over 48% in the quarter, a 420 basis point increase from this time last year. I’d like to commend our field team for their strong execution at Speed Perks and their dedication to strengthening our value proposition for DIY consumers.

Specific to Pro, we remain committed to delivering a best-in-class customer experience. Transactions moved back into positive territory in Q2, an improvement versus Q1. As expected, average ticket was down slightly as we sustained our focus on maintaining competitive price targets and the execution of the targeted sales campaign I just mentioned. Within both strategic accounts in TechNet, we saw improved performance in the quarter and TechNet grew to almost 17,000 members. In summary, the actions we’ve taken to improve availability, sustain competitive pricing, and enhance our service helped us drive share of wallet gains and improve our call status with Pro installers, including the very important up and down the street business. With that, I’ll turn the call over to Tony to review some of the drivers behind our second quarter results and provide an update on our outlook for the full-year.

Tony?

Tony Iskander: Thanks, Tom, and good morning. I would first like to thank the Board and Tom for their confidence in me. I would also like to thank all our team members for their continued dedication and focus on the customer. In Q2, our net sales increased 0.8% compared with Q2 2022, and comparable store sales decreased 0.6%. Gross profit margin deleveraged 174 basis points compared to the prior year, primarily driven by higher product costs, and supply chain deleverage. Sustaining competitive price targets contributed to transaction growth in the quarter, however, this resulted in the majority of gross margin headwinds. Additionally, we experienced higher supply chain costs that were driven by investments in our distribution center team members, as well as positioning more parts closer to the customer.

We expect these investments will help further improve retention and drive productivity. SG&A as a percent of net sales deleveraged year-over-year due to labor related inflation, which includes investments in store payroll. As a result of gross margin and SG&A headwinds, our Q2 operating income margin deleveraged 256 basis points compared with the previous year. Our lower operating income combined with higher interest expense resulted in diluted earnings per share of $1.43 compared to $2.38 in Q2 2022. Free cash flow through the end of Q2 was an outflow of $309 million. In Q2, we had an inflow of $150 million. We finished the quarter with a cash balance of $277 million and $95 million outstanding on the revolver. While we’re in compliant with all of that covenants we amended the interest coverage ratio in our credit agreement.

In terms of full-year guidance, we are slightly increasing our outlook for both net and comparable store sales based on recent trends and continued progress in the professional sales channel. We are reducing our outlook for operating income margin rates, diluted earnings per share and free cash flow. We now expect deleverage in gross margin rates in the back half, this is primarily due to our commitments to maintain competitive price targets and our expectation that channel mix will remain a headwind as professional continues to strengthen. In addition, as we highlighted earlier, we are accelerating the sell down of products and categories to expedite the transition to higher margin owned brands. In terms of SG&A, we expect the compensation investments we are making in our team as well as certain non-recurring costs, primarily related to the leadership changes announced this morning, will result in slight SG&A deleverage in the back half.

These headwinds will be partially offset by cost savings we expect to realize from our corporate restructuring earlier in the year. We now expect our SG&A rates [as a mid] (ph) point will be slightly below the back half of last year. All of these factors have been considered in our full-year updated guidance, which includes net sales of $11.250 billion to $11.350 billion, comparable store sales of minus 0.5% to positive 0.5%, GAAP operating income margin of 4.0% to 4.3%, income tax rate of 25%, diluted earnings per share of $4.50 to $5.10, capital expenditures of $200 million to $250 million, a range of $150 million to $250 million in free cash flow and 40 to 60 new store and branch openings. With that, let’s open it up for questions. Operator?

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question comes from Simeon Gutman from Morgan Stanley. Your line is now open. Please go ahead.

Simeon Gutman: Good morning, everyone. I’ll have a question and a follow-up. And I guess this is to Tom Gene and Tony. First, on Worldpac. I wanted to ask how deeply it’s integrated into Advance, and then if you can talk about the synergy with the business today?

Tom Greco: Hey. Good morning, Simeon. Obviously, we still run Worldpac as the design that they’ve had initially, they did integrate Auto Part International into Worldpac. We are able to source parts from Worldpac, our enterprise catalog is visible to all of our customers. So in that respect, it’s integrated. But overall, they still run the business relatively independently. And it’s continues to perform very well.

Simeon Gutman: Okay. And then the follow-up is, if you look at and I’m going to isolate it to a couple of areas, merchandising, supply chain, and operations. If we’re to diagnose the biggest priorities of enhancement, especially as new leadership looks at this business, where do you think the biggest opportunity exists between those? And then as a solution, do you think it’s combination of P&L investments in capital, or does it wait to one side or the other?

Gene Lee: Good morning, Simeon. This is Gene. I think, that’s what the strategic review is all about. Looking at a different parts of our organization and trying to determine where is the biggest leverage point. So I think it’s not right for me to answer that question. I think that’s a question for Shane to figure out as soon as he gets on board, I think the way you’ve framed it is a good way to frame it. And then I think what we need to do is determine how do we prioritize what initiatives will give us the biggest payback as quick as possible. And I would say that will be in Shane’s 90-day agenda along with me. But I don’t really want to commit to which one of the three is where the investment needs to be made.

Operator: Thanks, Simeon. Our next question comes from Greg Melich from Evercore ISI. Your line is now open. Please go ahead.

Greg Melich: Hi. Thanks, good morning. Given the investments in both people, and not passing through pricing, I guess I have two parts to one question, which is, what are your inflation assumptions in topline for the back half? And then second, could you fill us in on how much payroll is growing year-on-year both in the first half and then in the plan for the back half?

Tom Greco: Good morning, Greg. Yes. So we expect low-single-digits on the pricing front and, wage inflation is more like mid-single.

Greg Melich: And that low single digit on pricing inflation, how does that — what’s the cadence through the year? Was that, like, high-singles in the first quarter? And then gets to zero or low-singles in the fourth quarter?

Tom Greco: Yes. We were more like mid-single early in the year. It’s gradually coming down. We do have a lot of work, we’re doing on sourcing and through the category management work, which will, help us a little bit with that in the back half, but it’s a very gradual reduction through the year. We also have a freight benefit in the back half, as you know, I’m sure that you’re seeing that in other parts of the, rev retail overall.

Operator: Thanks, Greg. Our next question comes from Michael Lasser from UBS. Your line is now open. Please go ahead.

Michael Lasser: Good morning. Thanks a lot for taking my questions. Number one, can you give us a rough approximation of the sales and profitability of the Worldpac as it stands today?

Tom Greco: Yes. No. We haven’t broken that out, Michael.

Michael Lasser: My follow-up question, Tom, is, as you think about the pricing environment, is it that, Advance has just had to play a significant amount of ketchup, and it’s price gaps with the peers in the space has been widened. And so it’s constantly having to make these price investments because of these wide gaps, or are you seeing further, are you seeing further decreases in prices across the space that you’re having to invest in. And to what degree is this happening more so among national accounts versus up and down the street account?

Tom Greco: There’s a lot there, Michael. I’ll do my best here. First of all, I think you’re characterized it fairly well. In the back half of last year, we did see our price indices move above the market, to places that we didn’t like and run acceptable to us. So we are — we did start correcting that early this year, and it’s sustain through the year. The other factor that’s important to note is we called out the accelerated sell down of products that we’re transitioning to the Carquest brand in the back half. And, that is something that is going to weigh on gross margin in the back half. It’s neutral on dollars, but it 30 to 35 basis points of rate in the back half. So, that’s also a factor. The good part of that is, we’re transitioning out of inventory that we’ve already paid for, and we’re moving into higher margin products with terms.

So know, it’s going to have a benefit for us down the road, but those are the two big wild cards on the, or big factors rather on the pricing front. National accounts versus up and down the street, there’s really not a lot of difference there in terms of what we’ve seen. This has been a rational industry for a long time, and I expect it will be going forward.

Operator: Thanks, Michael. Our next question comes from Elizabeth Suzuki from Bank of America. Your line is now open. Please go ahead.

Elizabeth Suzuki: Great. Thank you. I just wanted to clarify on the margin guidance. So, you mentioned you expect to deleverage gross margin in the back half and then some slight SG&A deleverage in the back half, but then there was a comment about, some of those headwinds being partially offset by cost savings and the SG&A rate being slightly below the back half of last year. So, I just wanted to understand whether SG&A was going to be a headwind or a tailwind to margin in the second half of this year?

Tom Greco: Good morning, Liz. It’s a slight headwind. So, it’s a little bit above last year, and it’s based on the investments we’re making in our people. We’ve really prioritized the customer and our people. And as Gene mentioned, that opens the door for the operational review to really look for ways to more efficiently and effectively flow through to the bottom line.