Advance Auto Parts Q2 2023 Earnings Call Transcript

Presentation

[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, SVP, Communications and IR at Advance Auto Parts]

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 fact are forward-looking statements, including but not limited to statements regarding our leadership transition, initiatives, planned 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 caption 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, Interim Executive Chair at Advance Auto Parts]

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 will turn the call over to Tom and Tony shortly to review 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 perspective on the business, the work that we have ahead of us and 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 exchange caliber to join Advance, who haven't come on board, as we are undertaking the operational and strategic review of the business. Together with our financial adviser, 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 has joined Advance from HD Supply, where he 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 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 I'm 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'm taking a deeper dive into the business and our strategy. As a Board, we recognize that there are 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 on a number of operational improvements, including inventory optimization initiatives, improving asset productivity across the enterprise, investments in our frontline organization to reduce turnover and disciplined cost controls, which we expect to benefit the cost structure and working capital, while strengthening Advance for a long-term.

However, we know there is 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 enhanced 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, President and Chief Executive Officer at Advance Auto Parts]

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 is 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 own 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 continue 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 sustain competitive price targets.

In addition, we discussed in the past, the opportunity to increase own brand penetration to improve margins. As discussed on the May call, we launched the 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 higher level of accountability to grow weekly customer accounts 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 head 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 of 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 move 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 and 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, sustained 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 will 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, Interim Chief Financial Officer at Advance Auto Parts]

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 to 0.8% compared with Q2 2022 and comparable-store sales decreased 0.6%. Gross profit margin deleverage 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 headwind. 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 are in compliance with all debt 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 rate in the back half. This was primarily due to our commitment 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 own brand.

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 rate at the midpoint 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 and free-cash flow, and 40 to 60 new-store and branch openings.

With that, let's open it up for questions, operator?

Questions and Answers

[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, Analyst at Morgan Stanley]

Good morning, everyone. I'll have a question and a follow-up, and I guess this is to Tom and 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, President and Chief Executive Officer at Advance Auto Parts]

Hey, good morning, Simeon. Obviously, we still run Worldpac as, you know, the design that they that initially they did integrate Autopart 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. Overall, they still run the business relatively independently, and it continues to perform very well.

[Simeon Gutman, Analyst at Morgan Stanley]

Okay, and then the follow-up is, if you look at, and I'm gonna isolated to a couple of areas, merchandising, supply-chain and operations. If we are 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 a combination of P&L investments in capital or does it wait to one side or the other?

[Gene Lee, Interim Executive Chair at Advance Auto Parts]

Good morning, Simeon, it is Gene. I think that's what the strategic review is all about, looking at 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 pay-back as quick as possible, and I would say that will be in Shane's 90-day agenda along with me. 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, Analyst at Evercore ISI]

Hey, 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 assumption in top-line 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, President and Chief Executive Officer at Advance Auto Parts]

Good morning, Greg. Yeah, so we expect low-single digit on the pricing front, and wage inflation is more like mid single.

[Greg Melich, Analyst at Evercore ISI]

And that low single-digit pricing and inflation, how does that -- what's the cadence through the year, was that like high singles on the first-quarter and then get to zero or low singles in the fourth quarter?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, we were more like mid single early in the year, it's gradually coming down. We do have, you know, 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 retail overall.

[Operator]

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

[Michael Lasser, Analyst at UBS Group]

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, President and Chief Executive Officer at Advance Auto Parts]

Yeah, no, we haven't broken that out, Michael.

[Michael Lasser, Analyst at UBS Group]

My follow-up question, Tom, is, as you think about the pricing environment, is it that Advance has to -- had to play a significant amount of catch-up in its price gaps with the peers in this space had been widening, and so 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 account versus up and down the street accounts.

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

There's lot there, Mike, I'll do my best here. First of all, I think you 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 were unacceptable to us. So, we did start correcting that early this year, and it has sustained through the year.

The other factor that's important to note is we called out the accelerated sell-down of products that were 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's 30 to 35 basis points of rate in the back half. So that's also a factor, but 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, it's going to have a benefit for us down the road, but those of the two big wildcards 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 suspect 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, Analyst at Bank of America]

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, President and Chief Executive Officer at Advance Auto Parts]

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.

[Elizabeth Suzuki, Analyst at Bank of America]

Okay, so more of the margin headwinds going to be on the growth side and then theoretically going-forward as owned brands become a larger percentage of your total, that should result in some gross margin expansion in the years ahead. I mean, this is all pending whatever the strategic review comes out, but just thinking about that one piece of the gross margin story.

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, that's correct. In the back half, we expect more deleverage from gross margin. And as I just mentioned to Michael, 30, 35 basis-points of that is this accelerated transition of products into CQ.

[Elizabeth Suzuki, Analyst at Bank of America]

Great, thank you.

[Operator]

Our next question comes from Chris Horvers from J.P. Morgan. Chris, your line is now open. Please go ahead.

[Chris Horvers, Analyst at J.P. Morgan]

Thanks, good morning. So, following up on an earlier question, the improvement that you've seen in the business in the last eight weeks, was that, I guess, to what degree than the DIY business improve? And then on the Pro side, you mentioned both national accounts and up-and-down the street business improved, but was it weighted to one side versus the other side of the Pro.

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, good morning, Chris. We are pleased with DIYs, our third consecutive quarter of growing comp sales in DIY and it did improve in the quarter. So, the availability investments that we're making benefit DIY too. Our e-commerce business is performing well. Pro has improved more, as you know, in the last half of 2022, we slipped in Pro, so disproportionately in the last several weeks, Pro has improved better and the national accounts versus up and down the street, we're seeing improvement in both. So, there is good progress there. TechNet is performing better. So really all of our professional business is benefiting from the actions we're taking. And I will call out that the field is doing a very good job executing as well. They're getting out there, meeting with the garages, moving up the call list, all the things that we need to do to win the business with our installers up and down the street and national camps.

[Chris Horvers, Analyst at J.P. Morgan]

Got it. And then there's a lot of questions around Worldpac sizing the business, the margins of the business as a potential way to create shareholder value. I guess, can you talk out loud for us as you think about the strategic relevance of having Worldpac, and the argument from the start of the acquisition and through your tenure has always been the expansiveness of the catalog, the one stop shop that Worldpac brings on top of what Advance brings. So, what do you lose? And then secondly, is there any cash flow dynamics that we're concerned about here? Obviously, your free cash flow guidance has come down. Are you concerned that this could start to unwind some of the vendor financing programs that you have in place, and there's some compelling reason to create cash flow and better sort of financial leverage on the balance sheet.

[Gene Lee, Interim Executive Chair at Advance Auto Parts]

Hey, this is Gene. There was a real lot in that question. I'm not sure we're going to get to all of it, but let me just start off with, I think the first part of the question asking about Worldpac's role in the organization. I think Tom can give his opinion on that, but this is going to be Shane's decision on how -- after we do the strategic and operational review, he's going to need to be the one who decides what role Worldpac plays in the organization. Whether you integrate it or you don't integrate it, you run it as a separate business and how does it play with all the other assets in the organization. So, I think that's really important now. I think Tom can give his opinion how he thinks about the business, but this is going to be a Shane's decision as we move forward.

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Sure, so, I mean the big thing, Chris, is the enterprise assortment. It gives us a broader assortment than anybody in the industry. Obviously, we've got national brands, we've got our own brand lineup which we're very proud of, and then obviously the OE products that Worldpac brings to the table gives us up to $350,000 in market stock parts. So that gives us an advantage there, and we're able to leverage that through all of the banners that we sell to the customer. So that's the big thing, but again, as Gene said, we've got to go through the review and find new ways to flow through profitability to the bottom line, so that'll come out of the review.

[Chris Horvers, Analyst at J.P. Morgan]

And then anything on the balance sheet side?

[Tony Iskander, Interim Chief Financial Officer at Advance Auto Parts]

Hey Chris, this is Tony. So, we're not seeing any changes in our supplier finance programs or any attractiveness in that. So, as you know, as you know, we disclosed that and you'll read more about that in the queue later today.

[Chris Horvers, Analyst at J.P. Morgan]

Got it. Thanks very much.

[Operator]

Thanks Chris. Our next question comes from Bret Jordan from Jefferies. Your line is now open. Please go ahead.

[Bret Jordan, Analyst at Jefferies Financial Group]

Hey, good morning, guys. On the Carquest private label strategy, I guess you've been losing some commercial market share in the last quarters, and obviously are talking about price investment now around the brand. I guess, is that something that is either -- is the commercial perception of that an issue in the share loss or is it an availability issue in the share loss?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

I think if you look back last year and into the first part of this year, it was primarily availability, Bret, as you highlighted a minute ago, but I do think our availability improvements that we've made there have been the biggest driver of the change. Our on-hand rates are up very nicely in the key categories we transition, which you know, engine management, underpower, etc., and that's been the bigger driver, and we expect that to continue to be a benefit for us in the back half.

Our professional installers love the Carquest brand. Our brakes are the best, we have the best brake program in the business. And transitioning these products has been very difficult. It's taken us more time than we would like, but once we get them in and the customer gets a chance to install them, this is a product that we get repeated business off of.

[Bret Jordan, Analyst at Jefferies Financial Group]

Okay. And then a follow-up question on that supplier base. I guess, obviously the fact the payables programs, given the leverage ratio, might be under some pressure, but in the transition to more private label, is that going to support the payables? Are those vendors willing to take a longer term than maybe a national brand would?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

I mean, we obviously factor in all those changes, Bret. When we make a change from a national brand to Carquest, we know what the change in the terms are. So, we factor all that in, and it's part of the calculus, right, when we make the decision. We look at the margin rate, we look at the quality, we look at the vendor itself, most of which are OE providers, so they make a very high-quality product and then we evaluate the terms. So, it's a holistic decision that we're making in terms of selecting our suppliers.

[Bret Jordan, Analyst at Jefferies Financial Group]

Okay. I guess from the forecast on cash flow for the year, where do you see the payables ratio getting down to? I guess as we add another couple of EBIT quarters that might have your leverage ratio above three.

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah. As you saw from Q1 to Q2, it's starting to go up and we expect it to continue to increase over time as we get some of those investments behind us, and then we continue to build and replenish. So, we actually believe that the AP ratio will continue to expand.

[Bret Jordan, Analyst at Jefferies Financial Group]

Okay, great. Thank you.

[Operator]

Thanks, Bret. Our next question comes from Seth Sigman from Barclays. Seth, your line is now open. Please go ahead.

[Seth Sigman, Analyst at Barclays]

Hey, good morning, everyone. I wanted to follow up on the gross margin. It sounds like part of the issue is pricing to cover the cost. But I'm curious, why is that so different for AAP? And I'm curious, are you still seeing incremental cost pressures in cogs or is this really a function of, you had elevated product and supply chain costs last year. Some of that was capitalized into inventory or on the balance sheet. It's just flowing through now as the inventory turns. And if that's right, do you have visibility into when that starts to normalize through this year?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

I think that the earlier question sort of answered that one, Seth, which is we did see our pricing elevate above the market in the back half of last year, and we are addressing that as we go into this year and you'll see that through the back half. So, we're committed to a holistic solution here. We want to make sure our availability gets better, the visibility of our products is better and service and delivery continues to improve. And we are going to sustain the price index. We'll continue to stay focused on that, but as we get into obviously further out, you'll see that normalize.

[Seth Sigman, Analyst at Barclays]

Okay, so if we look at the EBIT margin outlook for the second half of the year, you did lower it, but it looks like the year over year change will be down less than I guess in the first half of the year. Can you just help us contextualize what may be driving that improvement in trend in the second half of the year?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, sure. For sure, on the gross margin side, we mentioned freight earlier. Freight becomes a tailwind for us in the back half. Some of our category management initiatives begin to benefit us in the back half, and just year-over-year, price versus cost is not as punitive as it was in the front half of the year. We've got more sales, so there's less supply chain deleverage on the gross margin side. As we said, SG&A is smaller, we're going to have slightly above last year's rate on SG&A, which involves the investments we're making in our team to make sure that we reduce turnover in the stores, and really keep all the great people we have here in the corporate office. So those are the two drivers, and both of them are going to get better than they were in the front half.

[Seth Sigman, Analyst at Barclays]

Got it. All right, thank you.

[Operator]

Thanks Seth. Our next question comes from Steven Zaccone from Citigroup. Stephen, your line is now open, please go ahead.

[Steven Zaccone, Analyst at Smith Barney Citigroup]

Great. Good morning. Thanks very much for taking my question, and congrats on the new CEO announcement. I guess, Gene, my question is for you. As you take a more active role in the business, I'm curious for your assessment of how long it will take for this business to return to profitable growth. I know Shane will come in and seems like he has a lot to figure out. But from your seat, do you think of this as a one-year invest to grow margin strategy or is this something that's more multiyear in nature?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

I think it's less than one year. I think that we should start seeing incremental improvement pretty quickly here. There are some really good actions that are being taken right now, especially around the operational front.

I think we're doing a much better job today up and down the street with our professional customers. I think we're operating at the store level much better. I think we're making significant improvements in supply chain. And more importantly, I think when you think about our strategy with our top 4,000 products that we're calling never out, we've made great progress there too. So, I think that the price to inflation gap will continue to grow, and as we move forward, we should actually be able to price to cover inflation after we wrap. Therefore, you're not going to see the same kind of deleverage in the gross margin line.

And so, I think that we're going to start seeing improvement pretty quickly. We've been working hard in the last 90 days to 120 days on, I think, some focused initiatives that are starting to come through for us. We're seeing that in the sales line. We're excited every morning that we're seeing some sales growth. So, I think as we get past the back half of the year, we will actually see price at inflation or slightly above inflation, and then we can get to start to leveraging both gross margin and gross profit and our SG&A.

[Steven Zaccone, Analyst at Smith Barney Citigroup]

That's great, thank you for that detail. And then just to follow up, because there's been several questions clearly on Worldpac, but I was curious, with the operational and strategic review, is it fair to conclude that includes the potential for asset divestitures?

[Gene Lee, Interim Executive Chair at Advance Auto Parts]

I think there's a range of options that we have to consider. We sit here today, we think Worldpac is a great asset, and as I think about all our assets, I think the number one issue in our organization today is asset productivity. So, we need to evaluate the productivity of all of our assets, including Worldpac. We need to understand what's the potential of all those assets, how do they fit organizationally and how to best operationalize those assets? To me, that's what the comprehensive strategic review is all about. And I think, there's going to be more focus on the operational review because we have a lot of opportunity there to improve our processes and procedures from end to end. And I think that's really over time where the cost savings will come is through improving those processes and procedures. And I think Tom mentioned earlier, and we were working hard on our category management. We have an outside consultant and working with us and we're making some really great progress that I think will show some positive results into '24, and I'm excited about that. But there's other opportunities, and what I've been referring to as the value chain to evaluate all our processes and procedures. So, I would say we have a wide range of options, everything is on the table. But I think we need to truly understand, Shane needs to truly understand what's the potential of all these assets and how do they fit in and how do we best operationalize them.

[Steven Zaccone, Analyst at Smith Barney Citigroup]

Great. Thank you for all the detail. Best of luck.

[Operator]

Thanks Steven. Our next question comes from Stephen Forbes from Guggenheim Partners. Stephen, your line is now open. Please go ahead.

[Steven Forbes, Analyst at Guggenheim Partners]

Good morning. I have a two-part question on capital spending. So first, given the reduction in spending plans year to date from the start of the year, can you help us better understand what the team has pulled back on? And then the second part is as we think about sort of more normalized capital spending ratios looking out, any initial thoughts on what the go forward spend rate should be.

[Tony Iskander, Interim Chief Financial Officer at Advance Auto Parts]

Yeah, thanks, and good morning, Stephen, this is Tony. As you'll recall, in the first quarter we had a higher number of new store openings, and we brought that down in our guide after the first quarter, and that's primarily driving the reduction in capital spend. On a go forward basis, that's what the strategic review is going to help us identify.

[Operator]

Thanks, Stephen. Our next question comes from Kate McShane from Goldman Sachs. Kate, your line is now open. Please go ahead.

[Kate McShane, Analyst at The Goldman Sachs Group]

Hi. Thanks, good morning. Thank you for taking our question. We just had a simple question about your view on current inventory levels and in stocks, and if there are any categories where you still think your inventory is not where you want it to be, and when you can expect to maybe be more in line there.

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, so we feel pretty good, Kate, about the inventory levels. As Gene mentioned, the real intense focus on our highest velocity SKUs and making sure that we're in stock on those items. We've added some depth to the highest velocity SKUs in the stores and the distribution centers, that's paying dividends, and we've also added coverage or breadth, which is also helping. We measure that by virtue of our on-hand rates and our close rates, which are both growing significantly. So, we feel very good, and the categories themselves that are benefiting the most are the ones that we were weak on last year. So, the transition that was made, we had a lot of different suppliers that were involved with. Those suppliers have really stepped up and we're grateful for that. Our suppliers are really important to us. We're starting to really make some gains in those categories, and there's still a lot of room for us to grow from there. So, there's nothing uniformly good or uniformly negative at this point. We've grown in aggregate and each of those categories are moving up nicely.

[Kate McShane, Analyst at The Goldman Sachs Group]

Thank you.

[Operator]

Thanks, Kate. Our next question comes from Brian Nagel from Oppenheimer. Brian, your line is now open. Please go ahead.

[Brian Nagel, Analyst at Oppenheimer]

Hi, good morning. So, my first question, a bit of a follow up to your prior question, but if you look at the improving business you've seen lately, improving sales you've seen lately, stepping back, how much of that is internal efforts on the part of Advance, versus maybe a solidifying backdrop within the sector?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, I mean, that's difficult to say, Brian. Obviously, we don't really get to see that until our peers will report a more comparable timeframe, and we see DIY, which we feel really good about comparatively. But the Pro channel is the one I'm referencing, so we really need to see how everybody else performs. It's been extremely hot this summer, so we are seeing strength in those categories. You'd expect heating and cooling, obviously, but overall, as we talk to our suppliers, particularly the ones in our parts categories, we are doing much better. So, we feel good about the actions we're taking, and we're going to continue to execute against them.

[Gene Lee, Interim Executive Chair at Advance Auto Parts]

Hey, Brian, it is Gene. I wanted to say that what I've seen is that the team is taking a specific action, and we're seeing a specific result because of that action. So, I think Tom is correct. We need to see the backdrop, but what I can see from where I sit is they tell me we're going to do something, we do it, and then we get a reaction from that. That's positive in my mind.

[Brian Nagel, Analyst at Oppenheimer]

That's helpful. I appreciate it. And then my follow up question. In your prepared comments, you talked about, I guess, a shift you made in a debt covenant, if I said that correctly. So, I guess the question is maybe you can articulate what you did there, to what extent that affords you more flexibility, and could there be other similar type adjustments being made here to the debt structure of the company?

[Tony Iskander, Interim Chief Financial Officer at Advance Auto Parts]

Hey, Brian. This is Tony. I'll take that. As I mentioned in the prepared remarks, we adjusted our interest coverage ratio, that provides a little bit of relief primarily due to the higher interest expense that we carried earlier in the year. We did not adjust the leverage ratio. Those are two primary covenants. We're confident in that, it gives us further financial flexibility should we need it.

[Brian Nagel, Analyst at Oppenheimer]

Got it. Thanks, Tony. I appreciate it.

[Operator]

Thanks Brian. Our next question comes from Scott Cicarelli from Truist. Scott, your line is now open. Please go ahead.

[Scot Ciccarelli, Analyst at Truist Financial]

Good morning, guys. I know you talked about improving sales trends in the last, call it, six to eight weeks, but you've posted negative comps in the first half. Can you help us understand why you would slightly raise the full year comp estimate? Is it just a matter of kind of the latest momentum or is there something else you're expecting to play out in the back half?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

It really is the momentum we've seen in recent weeks, Scott. Obviously, the fourth quarter is always volatile, so we have to keep that in mind. And we did finish the year strong on DIY in the fourth quarter last year. But based on everything we've seen, we track as you guys do, the multiyear comps, the multiyear sales, everything that we're doing, we feel very good about our guidance on sales.

[Scot Ciccarelli, Analyst at Truist Financial]

Okay. And then secondly, I know Tony talked about expectations for payables to inventory to improve during the course of the year, but I think someone asked about it. Is there any kind of target ratio for the end of year? I don't think I caught that.

[Tony Iskander, Interim Chief Financial Officer at Advance Auto Parts]

Yeah, we haven't identified a targeted ratio, but we expect to see improvement in that accounts payable to inventory ratio throughout the year and into next year.

[Scot Ciccarelli, Analyst at Truist Financial]

And no magnitude you can provide us?

[Tony Iskander, Interim Chief Financial Officer at Advance Auto Parts]

Not today.

[Scot Ciccarelli, Analyst at Truist Financial]

Okay, thank you.

[Operator]

Thanks, Scott. Our next question comes from Seth Basham from Wedbush. Seth, your line is now open. Please go ahead.

[Seth Basham, Analyst at Wedbush]

Thanks a lot, and good morning. Within your professional business, are you currently seeing more gross margin rate pressure in national accounts or up and down the street customers?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, it's really -- when we look at the competitive price index, Seth, we look at it in multiple ways obviously, and so we are matching targeted in each of those channels, so there's no major difference between the two.

[Seth Basham, Analyst at Wedbush]

Got it. And then in terms of your balance sheet, with the declining free cash flow, do you see risk that your credit rating could be downgraded from investment grade?

[Tony Iskander, Interim Chief Financial Officer at Advance Auto Parts]

Yeah, so we can't speak on behalf of the agencies, but we are in active dialogue with them all the time. We do believe that the free cash flow that you see in the year is reflective of the inventory investments we've made. And if you look at in prior years, we do believe that that's a good indication of what this company can return to.

[Operator]

Thanks, Seth. Our next question comes from Zach Fadem from Wells Fargo. Zach, your line is now open. Please go ahead.

[Zach Fadem, Analyst at Wells Fargo & Company]

Hey, good morning. Is there any extra color you can provide on how the up and down the street business has been performing relative to your national accounts? And just from an infrastructure perspective, can you talk about what you think your competitive advantages and disadvantages are today for serving these particular customers relative to your peers?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

First of all, the up and down the street business, as we mentioned earlier, I mean, there's a lot of customers, Zach. We look at how many customers we're selling to every week. We look at the dollars per customer every week, and we are seeing progress there. I think longer term, our belief is that the larger strategic accounts are going to grow faster than the up and down the street business. But at the moment, we are seeing strength on both sides of that business. Can you repeat the second part of your question again? I just want to make sure I understood it right.

[Zach Fadem, Analyst at Wells Fargo & Company]

Yeah. What do you think your advantages or disadvantages are for serving these particular customers versus your peers?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

I think it's similar to what we've said. I think it's similar on both sides of the business. I mean, it's about having an enterprise assortment. We've got a great footprint. We've got terrific brands and high-quality parts, and we're going to continue to leverage our availability, the visibility of our products, our service and delivery. We grew up in the professional business. Carquest is a professional brand, and we'll continue to leverage all of the things that we have to win the professional business. As Gene said, the idea from here is to improve the asset productivity of our business and ensure that as we drive growth, we're able to flow it through better to the bottom line.

[Zach Fadem, Analyst at Wells Fargo & Company]

Got it. And I know that the strategic review is ongoing, so the answer to this question may change. But as you comb through all the short-term noise this year around your P&L pricing, investments, etc., can you talk through what you think the right structural EBIT margin is for this business over the long term?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

I think that, I mean, as we sit here today, that's impossible to pinpoint. What I believe today as I get more involved in this is that there's a lot of room for incremental improvement year over year. We do have some structural differences to our other big competitors. I think they're well documented. But we know that we can improve from where we are today significantly, and I think putting a number out there is unfair to Shane and the rest of the management team. We need to go through more so the operational review to understand what the true opportunities are to service our customers and take care of our team members and to provide the best service we can to every one of our customers. That's got to be the goal long term.

[Operator]

Thanks, Zach. Our next question comes from Michael Baker from D.A. Davidson. Michael, your line is now open. Please go ahead.

[Michael Baker, Analyst at D.A. Davidson]

Okay, thanks. You know, Gene, if I could just follow up on that last point. Can you remind what do you see as the structural differences between your margin structure and the other guys? We know there's different rent versus own situation which maybe drags down your margins a little bit versus competitors. But even if you look at it on like an EBITDAR basis, there's a huge gap and that gap is widened over time. So, what are the structural differences besides you guys rent more stores than they do?

[Gene Lee, Interim Executive Chair at Advance Auto Parts]

Well, I think it's the mix of the business. Remember, we've got a very large business inside our business, which is the Independence, which the margin structure is very, very different, but it's a very lucrative business. I would say the biggest thing that impacts our margins overall is the asset productivity, right? We're doing approximately 1.7 a box and the other guys are doing approximately 2.3, 2.4. So, if you just look at that productivity and just increase it just to 2 million, what it does to our margins. The flowthrough on that additional sales is fantastic. And also, when you look at the way our distribution centers are set up, that's a huge structural disadvantage that will need to be addressed at some point. How that gets prioritized, I don't know today, but that needs to be dealt with. And so, I keep reverting back to and I describe as asset productivity. Our assets are not productive enough to create the right margin structure. Then you get into own versus rent channel mix, our independent business, but the first priority is to improve the productivity of all the assets. That'll impact the biggest impact on margins.

[Michael Baker, Analyst at D.A. Davidson]

Yeah, I completely agree. And I would say that some of that isn't necessarily structural. So that's the opportunity. If I could ask one other question. I guess that was my follow up, the first question, this is my main question. Talk to us about the qualities that you thought make Shane O'Kelly the right pick. Is it his distribution capabilities or operational capabilities? It's been a while since I assume you looked at people who are in the auto parts business. How much does that factor in or how much did you consider that, and what made Shane better than anyone within the business?

[Gene Lee, Interim Executive Chair at Advance Auto Parts]

Yeah, I think. Great question. We did a comprehensive search, right. We talked to a lot of people, and by far Shane was the best person for this role. When you think about his experience, he's a very disciplined, thoughtful leader who has been in the professional channel most of his career, but has had exposure to big box retail, a lot of good process and procedures he's been a part of. I think that he's a car enthusiast. He has sold into the channel before. He loves the business, and I think his leadership style is perfect for where we are in our journey and what we need. I would say that as we talked to people that had industry experience, people that were most interesting had non-competes, and they're very difficult to get out of their current position because of the non-competes. But even so, when it was all said and done, Shane O'Kelly was by far our best candidate for this role in the current situation.

He's well educated, strong, disciplined, background, and he's a thoughtful human being with a real focus on customers. And so, we're excited to have the opportunity to bring in a leader like Shane. We're very pleased that we're able to do it as quickly as we're able to do it to identify someone with his skill and talents. And the Succession Committee did a fantastic job getting us to this point, and we can't wait for him to be involved.

[Operator]

Thanks, Michael. Our next question comes from Daniel Imbro from Stephens. Daniel, your line is now open. Please go ahead.

[Joe Enderlin, Analyst at Stephens]

Hey guys, this is Joe Enderlin on for Daniel. Thanks for taking our question. You mentioned earlier that you think your internal actions are driving improvements in sales. Are you seeing the sales accelerate in the categories you're specifically investing in price? Or is it more of a broader acceleration that may suggest a better weather backdrop?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Good morning. First of all, the drivers really start with availability. I mean, the availability improvements are much more closely correlated to the improvement in sales, and in particular in those categories where we have big opportunities to improve versus last year, and that's engine management and heating, cooling and undercar. So, we are seeing a very close connection, Gene said it well. There's an action that we're taking and then we see the corresponding lift, and it's building through the year. The price indices that we are targeting, we have a terrific team in the pricing area. They look at our pricing every week in every category, and we do look very closely at those elasticities. I mean, this category is honestly less elastic than many categories in retail because pricing is either third or fourth in the decision criteria for the installer, but you can't ignore it. So that's really what we're doing there.

[Joe Enderlin, Analyst at Stephens]

Got it. That's very helpful. Thank you. As a follow up, looking at retention, could you provide some color maybe on how turnover has trended recently? Are you finding it more difficult to retain talent on the Pro side or distribution side?

[Tom Greco, President and Chief Executive Officer at Advance Auto Parts]

Yeah, good question. We obviously measure it in our supply chain and in our stores. So, I'll start with the stores. There are some roles in our stores that are just vitally important. Every role is critical, but you think about the General Managers, our terrific General Managers in the stores, the DMs, the commercial parts Pros, that turnover was extremely high when I started here many years ago. It came down significantly, and in the last year and a half, it started to go back up. So, we started to address it directly towards the tail end of last year, and we are seeing that come down.

In supply chain, it is the same story. Steve, who's our new head of supply chain, has done a very good job addressing turnover and supply chain, and that one has come down significantly in the last six months. So, again, as Gene said, when your turnover is coming down, you're able to execute better, and we are executing better in our supply chain, and we're executing better in our stores, and we're going to stay committed to retaining that vitally important frontline talent that serves our customer every day.

[Operator]

Thanks, Daniel. We have no further questions at this time. So, with that, I will hand back to Elisabeth Eisleben for final remarks.

[Elisabeth Eisleben, SVP, Communications and IR at Advance Auto Parts]

Yeah. Thank you all for joining us today. We look forward to welcoming Shane here in a couple of weeks and speaking with you all again in November. Have a great day.

[Operator]

[Operator Closing Remarks]

Participants

Corporate Executives

• Elisabeth Eisleben, SVP, Communications and IR
• Gene Lee, Interim Executive Chair
• Tom Greco, President and Chief Executive Officer
• Tony Iskander, Interim Chief Financial Officer

Analysts

• Simeon Gutman, Morgan Stanley
• Greg Melich, Evercore ISI
• Michael Lasser, UBS Group AG
• Elizabeth Suzuki, Bank of America Co.
• Chris Horvers, J.P. Morgan
• Bret Jordan, Jefferies Financial Group Inc.
• Seth Sigman, Barclays PLC
• Steven Zaccone, Smith Barney Citigroup
• Steven Forbes, Guggenheim Partners
• Kate McShane, The Goldman Sachs Group, Inc.
• Brian Nagel, Oppenheimer Holdings Inc.
• Scot Ciccarelli, Truist Financial Co.
• Seth Basham, Wedbush
• Zach Fadem, Wells Fargo & Company
• Michael Baker, D.A. Davidson
• Joe Enderlin, Stephens