Advance Auto Parts, Inc. (NYSE:AAP) Q3 2023 Earnings Call Transcript

Advance Auto Parts, Inc. (NYSE:AAP) Q3 2023 Earnings Call Transcript November 15, 2023

Advance Auto Parts, Inc. misses on earnings expectations. Reported EPS is $-0.82 EPS, expectations were $1.43.

Operator: Hello and welcome to the Advance Auto Parts’ Third 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 Q3 2023 results. I’m joined by Gene Lee, our Interim Executive Chair; Shane O’Kelly, President and Chief Executive Officer; and Tony Iskander, Interim Chief Financial Officer. Following Shane and Tony’s 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 the historical fact are forward-looking statements, including but not limited to statements regarding our ongoing strategic and operational review, 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 Shane.

Shane O’Kelly: Good morning, everyone, and thank you for joining us. I’m pleased to be here for my first earnings call as the CEO of Advance. We have several topics to discuss with you this morning. But before I begin, I’d like to thank all of Advance’s team members who I’ve come to know during my first 60 days with the company. During that time, I visited our stores across multiple markets, met with numerous customers, spent time in our distribution centers, got to know our Carquest Independence and attended our Annual Vendor Summit where I had the chance to meet with many of our major suppliers. Through all of this, I came away impressed with the passion and dedication of our frontline team members and I remain optimistic about the future of the company.

In addition to spending time in the field, I have partnered closely with the Board and Management team to make progress on our strategic and operational review. As the new CEO, I place a premium on capabilities learned during my time in the military. This includes aligning the company around fewer measurable goals while ensuring discipline and accountability in the process to achieve those goals. During my review of Advance, we identified the need to simplify our overall strategy while also improving execution, both of which will create value. Consistent with that, we are moving forward with a sense of urgency to help stabilize the company and return to profitable growth. Today, we are announcing decisive actions that we have initiated to achieve these objectives.

Those actions are, number one, the initiation of a sale process for Worldpac; number two, the initiation of a separate sales process for our Canadian business; number three, significant cost reductions; number four, reinvestment in the field and number five, the appointment of a new CFO as well as other organizational updates. These decisive actions are further reinforced with a renewed and vigorous commitment of selling auto parts, that is our core business. This includes eliminating numerous initiatives that were distracting us from a clear focus on the most fundamental aspects of our business. We believe our success will come from disciplined execution across the blended box model, where we service both professional installers and DIY customers from our Advance and Carquest locations.

Let’s take a moment and further describe our five decisive actions, beginning with the decision to initiate the sale process for Worldpac. Worldpac is a high-performing business and, as you know, is very different than our core blended box model. As we get back to the fundamentals of servicing our professional and DIY customers, we view now as the right time to simplify our model. The Worldpac business still operates relatively independently from Advance, and we believe that the sale process will not create a distraction. Next, let’s talk about our business in Canada, which goes to market under the Carquest banner. Today, we are announcing a separate sale process for that business. Like Worldpac, our Canadian business also runs largely independently and predominantly serves professional customers.

We do not believe this sales process will cause a distraction for our US business. Third, as part of our operational review, we have launched a new cost reduction program that we expect will generate a minimum of $150 million in savings on an annualized basis. These savings will be primarily driven by simplifying our organizational structure, minimizing duplicative efforts and eliminating investments that are not core to supporting our frontline team members and customers. Four, while we expect to see the benefits of these cost reductions beginning next year, we recognize that we must take action to improve the retention of our frontline teams and ensure we have experienced team members to serve our customers. In line with this, we expect to reinvest approximately $50 million of our savings back into the business inclusive of wages and training enhancements.

In fact, we began making changes to our frontline compensation structure in Q3 and are already seeing a reduction in turnover in targeted frontline roles. And fifth, following a robust search, I am pleased to announce that we have appointed a new CFO. We’re thrilled that Ryan Grimsland will be joining the Advance family from Lowe’s to lead our finance organization. Ryan has more than 20 years’ experience leading high-performing teams and omni-channel retail businesses serving both Pro and DIY customers. He has a strong track record of driving organizational improvements while implementing best practices to resolve complex issues. I look forward to Ryan joining us later this month and partnering with him and the entire leadership team to drive the needed change for Advance.

In addition to our CFO announcement, we’ve taken action to streamline our management structure. We have reorganized parts of my leadership team and transition responsibilities for our marketing, merchandising and e-commerce functions to the appropriate leaders in our organization, who will drive enhanced collaboration and accountability. We have made additional organizational adjustments in several other areas to help us operate more effectively. I would also note, as part of our strategic review, we are taking a disciplined approach to the evaluation of all assets including corporate stores, independently owned Carquest locations and our distribution network, all to enhance productivity. This may include the rationalization of unprofitable assets to better allocate resources focused on core fundamentals.

We are early in this process and expect to share more as we progress in the thorough evaluation of our entire business. As I emphasized earlier, we are sharpening our focus on the fundamentals. As an example, last month, we held our annual Partner Growth Summit and our team spent a few days with hundreds of representatives from key suppliers, who are critical to how we better serve our customers. This annual event is a valuable opportunity for us to collaborate and share updates on our strategy. This year’s summit was a great venue for us to articulate to our vendors how we are turning the page as an organization and we are excited to return to growth with their partnership. We recognize that having the right inventory availability is crucial for our team members’ ability to serve customers, which would not be possible without the strong support of our vendor partners.

Finally, before I hand the call off to Tony, I’d like to thank him for his dedication and incredible work over the past few months, serving as our Interim CFO, in addition to his role as Treasurer. His servant leadership has been instrumental across our finance organization. I look forward to continue to partner with Tony as we build Advance and capture the immense opportunity ahead of us. With that, I’d like to now turn the call over to Tony to discuss our Q3 results and provide an update on our outlook for the full year. Tony?

Tony Iskander: Thanks, Shane and good morning. I would also like to thank all our team members for their continued dedication and focus on the customer. In Q3, our net sales of $2.7 billion increased 2.9% compared with Q3 2022, due to continued strength across our professional business. Comparable store sales increased 1.2%. All our regions were positive during the quarter with the West, Florida and Northeast regions posted mid-single-digit growth. From a category perspective, we saw strength in filters, engine management, motor oil and batteries. Importantly, we’ve delivered meaningful growth in heating and cooling as we significantly improved our in-stock levels year-over-year. In terms of the cadence of the quarter, both Pro and DIY omni-channel saw strength in the first two periods and softened the last four weeks of the quarter.

Our Pro business was positive throughout Q3 and outperformed DIY omni-channel as transactions continued to improve and were up mid-single digits from the previous year on top of the improvement in Q2. As expected, average ticket in Pro was down slightly as part of our ongoing efforts to maintain competitive price targets. However, units have increased slightly year-over-year. DIY omni-channel average ticket was up mid-single-digit with transactions down low single-digit in Q3. Before turning to the balance of our P&L, we’ve made strong progress towards remediating the material weakness and as part of our diligence in this process, we uncovered non-material issues with our previously reported financial results. The balance of our financial results will compare our Q3 actual results to the corrective results for the prior year.

The remediation of our material weakness remains a top priority. Despite improving top-line trends, our gross profit margin was negatively impacted by several factors and deleveraged 830 basis points compared with Q3 2022. First, in line with the decisive actions Shane highlighted earlier and as part of our operational review of the business, we implemented a change in estimate regarding our excess inventory reserve and incurred a one-time impact of approximately $119 million. Further, like previous quarters, we experienced approximately $80 million in higher product costs that were not fully covered by pricing actions as we sustained our CPI targets. In addition, wage inflation and increased volume resulted in elevated supply chain expenses.

These headwinds were partially offset by a reduction in LIFO-related expenses as we recognize the $56 million benefit this quarter compared with $67 million of expense in the same period last year. While SG&A dollars in the quarter increased year-over-year as a percent of net sales, SG&A leveraged nearly 30 basis points. Our Q3 operating income margin deleveraged approximately 810 basis points compared with the prior year quarter. As you saw in our release this morning and as Shane discussed, we are taking action to significantly reduce costs in the business that have increased faster than sales over the past few years. We expect to see the full annualized saving of a minimum of $150 million in 2024, with approximately $50 million reinvested in our frontline team members.

Diluted loss per share was $0.82 in Q3 compared with diluted earnings per share of $1.92 in the prior year quarter. Free cash flow in the quarter was an inflow of $148 million and year-to-date was an outflow of nearly $157 million. As we continue to focus on our working capital metrics, our AP ratio expanded 470 basis points from Q2 2023 to 79.8%. Before turning to guidance, let me touch on supply chain finance. We have maintained a similar level of capacity in our supply chain finance program, thanks to the strong bank partners that continue to support us and our vendors. As you saw in our release this morning, we are updating our full year guidance. We are adjusting the top end of our net and comparable store sales ranges. However, as mentioned, there are several one-time factors impacting margins in the back half of the year.

This includes the change in our excess inventory estimate in Q3 and costs we expect to incur related to our organizational restructuring in Q4. Accordingly, we are reducing our operating income margin, diluted EPS and free cash flow guidance ranges. We are taking decisive actions to improve our cost structure now and we’ll continue to evaluate further opportunities as we make additional progress on our strategic and operational review. As a result, we are updating our 2023 guidance ranges to include net sales of $11.25 billion to $11.3 billion, comparable store sales of minus 0.5% to flat, GAAP operating income margin of 1.8% to 2%, income tax rate of 25%, diluted earnings per share of $1.40 to $1.80, capital expenditures of $200 million to $250 million, positive free cash flow of $50 million to $100 million, and 55 to 65 new store and branch openings.

With that, I’d like to turn the call back to Shane.

Shane O’Kelly: As I mentioned earlier, we recognize there is substantial work to be done and are focused on executing a strategy centered on our customers and our frontline team members, while continuing to look at additional opportunities to simplify our operations. We are taking and will continue to take decisive action to stabilize the business and position Advance for long-term sustainable success. All of us at Advance, the Board and the entire Management team are committed to returning to profitable growth and creating value for shareholders. I look forward to providing you with further updates on our next earnings call. I would now like to open it up to address your questions. Operator?

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question today goes to Michael Lasser of UBS. Michael, please go ahead, your line is open.

Michael Lasser: Good morning. Thank you so much for taking my question. Shane, I know it’s been very early in your tenure at Advance Auto Parts, but there’s so many moving pieces in the business right now. As you think about the long term, what’s the realistic operating margin for the core business, you know, excluding some of the businesses that you’re looking to sell, and it seems like the implied gross margin is going to settle around the 41% range, is that the correct run rate that we should think about for the long-term?

Shane O’Kelly: Hey, Michael, thanks for the question. It’s too early for me to set what the long-term OI looks like for this company, other than to say that I’m optimistic about where it can go and that if we do these five decisive actions as we implement them, they’ll all help in boosting where we sit there and then same for margin, early days, but know that we are absolutely focused on where we can increase the margins and we’ll be looking to do that in ’24. Just one other small comment there, a way to help think about making that happen is with our org structure where one dimension of that is having merchandising via direct report to me and I view that as a critical component for managing margin in a retail company.

Michael Lasser: Okay. And my follow-up question is are you seeing any impact from the negative credit rating downgrade and how are you thinking about capital needs of the business and, if anything, you could comment around the size of Worldpac or the Canadian business that will help that as you go through the process?

Shane O’Kelly: So a lot there, I’m going to ask Tony to comment, but we don’t have liquidity issues or issues on supply chain financing and then, I’m not going to comment on the size of Worldpac or Canada, we’ve engaged Centerview to manage that process and interested parties can reach out to them, but Tony, can you tell us about the liquidity and financing?

Tony Iskander: Yeah. Hey, Michael. Good to talk to you again. As you heard in my prepared remarks, we have continued to maintain the same level or very similar levels for our supply chain finance program, which really supports our vendors and our finance programs. So we’re not seeing any impact, and as you saw in our earnings release, we continue to grow cash flow, our cash balance on the balance sheet grew and we did not have any outstanding on the revolver as we have paid that down during the quarter as well.

Michael Lasser: Thank you very much.

Shane O’Kelly: And the last thing, there is no — and Michael, there is no urgency or requirements around the sale of Worldpac or Canada, they are both good businesses. This is really around our strategy and what we want to focus on as a company going forward, which is that domestic blended box model.

Michael Lasser: Understood. Thank you very much and good luck.

Operator: Thank you. And our next question goes to Chris Horvers of JPMorgan. Chris, please go ahead, your line is open.

Christian Carlino: Hi, good morning. It’s Christian Carlino on for Chris. I guess, stepping back, how would you characterize, you know, what went wrong with the supply chain and any color on the path forward in terms of the timeline or the cost to fix it? You laid out the timeline for the cost saves, but it seems like you’ll also be paring back maybe some of the smaller Carquest DCs. So, will you then need to add, you know, more modern or better located facilities or is it more, you know, on the operational front fixing the inventory management process?

Shane O’Kelly: So a lot there, thanks for the question. The first thing I’ll say is, you know that our supply chain stems from the two entities from Carquest and from Advance. That’ll be one of the next areas where I’ll be putting focus is really around validating the design of our future supply chain and, as we do that, there’ll be some rationalizations, there may be some facility additions, but we’re comfortable, we’ll develop that plan as we go forward. In terms of availability, those efforts can be discrete of just what occurs on the actual supply chain design and there’s been a lot of work going on there, which we’ve improved across a number of areas, think about that as undercar, engine management, heating and cooling, brakes and that comes from the pick and shovel work going on with the merchandise and inventory teams.

Christian Carlino: Got it. That’s helpful and then just one quick one on the guide. What are you including for the one-time reorganization costs in 4Q. And then I guess also, you know, how — in terms of how you’re managing the supply chain finance program, are — is it — is the implication that you’re maybe giving suppliers back some margin in exchange for, you know, holding the payable days somewhat constant. How should we think about, you know, the puts and takes there?