領先汽車配件 (AAP) 2016 Q2 法說會逐字稿

Welcome to the Advance Auto Parts second-quarter 2016 conference call.

(Operator Instructions)

This conference is being recorded. If you have any objections you may disconnect at this time. Before we begin, Zaheed Mawani of Investor Relations will make a brief statement concerning forward-looking statements that will be made on this call.

Good morning, and thank you for joining us on today's call to discuss our second quarter results. I'm joined this morning by Tom Greco, our CEO, and Mike Norona, our Chief Financial Officer. Tom and Mike will open the call with prepared remarks regarding the quarter, and will be available to answer questions.

Before we begin, I'd like to remind you that our comments today contain forward-looking statements. We intend to be covered by, and we claim the protection under, the Safe Harbor Provisions for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Forward-looking statements address future events, developments, or results, and are subject to risks, uncertainties, and assumptions, that may cause our results to differ materially.

Our comments today will also include certain non-GAAP measures, including certain financial measures reported on a comparable or adjusted basis, to exclude the impact of costs in connection with the integration of General Parts International, and the recurring amortization of General Parts' intangible assets. Please refer to our earnings press release and accompanying financial statements issued today for important information, and additional detail regarding these forward-looking statements, and the reconciliation of the non-GAAP measures referenced in today's call.

The Company intends these forward-looking statements to speak only as of the time of this conference call, and does not undertake to update or revise then as more information becomes available. Now, let me turn the call over to Tom. Tom?

Thanks, Zaheed, and good morning, everyone, and welcome to our second-quarter conference call. I joined Advance Auto Parts four months ago, and I'm even more energized today than I was when I started.

We're conducting a deep dive into our business, to fully understand the challenges we have faced over the past few years. I'm finding many areas for significant improvements based on actions and strategies that are well within our control. I have no doubt we will address these challenges. In fact, we're developing a long-term strategy to put this behind us, to accelerate growth, and to drive profitability.

We need to always put the customer first. This is essential to drive growth. We must earn and retain the trust of our customers, which can only be achieved through outstanding service, every single day, every single time.

As you saw from our release, our comp performance in the quarter was a disappointing negative 4.1%. These results are certainly not acceptable, given our potential. They are in line with the near-term expectations we provided last quarter. This is in part because we've been spending our time working on the real changes required to put us in the leadership position we expect. We'll execute better, with more accountability, in the near term. In parallel, we're working on material and significant change for the long term. Specifically, identifying issues and opportunities, while creating a sound, winning strategy for Advance, which we can execute flawlessly.

We know we have work to do. I remain extremely confident in our ability to address the current challenges we face, which largely have been self-inflicted. In terms of profitability, our adjusted operating margin rate of 10.8% and adjusted EPS of $1.90 reflect the impact of lower-than-expected gross margin performance in the quarter, higher supply chain expenses, and operating deleverage.

There were a couple of drivers of sales and profit performance in the quarter. First of all, our Customer Service metrics were just not where we need them to be. In Q2, we conducted significant primary research with both our commercial customers and DIY consumers. We now know, in excruciating detail, what's important to them. We know where opportunities exist to better serve customers, for Advance, as well as for our competitors.

Of course, consistent product availability is at the very top of the list. It's table stakes in our business. Our performance against the availability metrics that matter to customers were just not where we need them to be, and that cost us in Q2. As in Q1, we experienced availability challenges in several key markets. There are clear areas for improvement here, and we're addressing them today, and we know that they're fixable.

At the same time, while inventory was down slightly on a sequential basis over Q1, inventory still grew 7.3% over last year. As indicated on our Q1 call, inventory growing faster than sales, without the requisite improvement in availability, was inconsistent with our objectives. We've dedicated a team against this challenge, and they're focused on ensuring the improved inventory productivity and consistency of product availability, while improving working capital and ROIC going forward.

Secondly, another factor in our P&L flow through in Q2 was a sizeable insurance adjustment. Mike will explain this in a few minutes.

Finally, our performance in the quarter was disproportionately impacted by results in the Northeast and Great Lakes regions. In retrospect, we just didn't adequately plan for a transition to daily replenishment in these markets. We moved too far, too fast, significantly burdening our DCs with unnecessary complexity over the past few months, and we didn't sufficiently prepare our DC and field leaders for the substantial changes we are asking them to execute. Not only did this materially increase our supply chain costs in the quarter, this initiative negatively impacted our fill accuracy in the Northeast. As a result, the stores that were being serviced by these DCs were actually experiencing much worse availability, as a result of the move to daily replenishment.

Obviously, increasing costs and complexity with inconsistent availability is just not acceptable. Since my arrival in April, we've been intensely analyzing our supply chain and distribution processes, and we're currently working on near and long term changes to improve order and fill accuracy, and ultimately, availability to best-in-class levels. What's most important to customers is the reliability and consistency of our service. They have to be able to trust us to have the right part at the right time. Therefore, our primary objective is to provide best-in-class service to our customers, by delivering high quality, great valued parts, accurately, reliably and consistently, exactly when our customers need them. That is the goal. DC to store delivered frequency is not our goal.

We've been carefully analyzing our asset base and processes, and we're confident we can leverage our assets in a manner that enables us to efficiently deliver best-in-class customer service while lowering costs and inventory. The great news is, we're already seeing a positive impact on our performance from the initial steps we've taken, and we absolutely expect to see improvement in customer service metrics and inventory reduction in the second half of the year in these markets. I have no doubt we can do a much better job leveraging our assets in order to provide the bet service for our customers, while producing the best returns for our shareholders.

To sum up Q2, we're not where we need to be. I know that and my team knows that. There's a heightened sense of urgency and accountability at Advance, and we will drive it throughout the organization. Given where we are, we do not expect to turn our performance around overnight. We simply can't. We will execute better, but we need to make sure we focus on the material and significant step change opportunity in front of us, and make certain we execute these changes flawlessly, versus trying to fix aspects of our existing strategy that are flawed in the current state.

Our goal at the present time is to build a rock solid foundation for future growth, and we won't compromise on this goal to prop up short-term results. Therefore, our annual comp store sales estimate remains unchanged in the range of down 3% to 5% for the year.

Accelerating growth and transforming our business is an exciting opportunity. The changes necessary to win are well within our control, and there are no structural impediments to our success. While we now know many of the areas where we can improve, we cannot rush. We need to be thoughtful and disciplined as we transform and create a growing platform for the future.

That said, today, we are taking decisive actions to deliver near-term improvement in two key areas: Commercial growth and execution. Allow me to talk first about how we're going to accelerate commercial growth.

Our commercial business accounts for approximately 60% of our business, and will be an area of growth for years to come. Getting our structure and people right in commercial is foundational to improve performance, and position us for longer-term growth and market leadership.

As you saw in today's release, we named Bob Cushing, formerly President of WORLDPAC, to serve in a newly-created position of Executive Vice President - Commercial. Bob's going to oversee all of the Company's commercial operations, including Advance, Carquest, Autopart International, and of course, WORLDPAC.

As I look at the organizational structure of Advance today, it's clear we need a unified leader for the entirety of our commercial business. As we consider the leadership skills necessary to accelerate growth, we have to start with the customer. Therefore, we need a leader who puts the customer first, always. We need a leader whose deeply understands customer service and customer intimacy. And finally, we need a leader with a track record for driving growth, improving profitability and building industry leading capabilities.

Fortunately, Bob Cushing is the perfect person for the role, as he's uniquely qualified to spearhead this effort. Bob is an exceptionally talented industry veteran, with over 30 years of experience, and has been the driving force behind WORLDPAC's tremendous growth and market-leading position. He has a proven track record of delivering results, and he's an industry pioneer, who long ago recognized the role of technology and e-commerce in better serving customers.

Last but not least, Bob is competitive. He's going to be relentless on driving outcomes, and he will expect nothing less than the best as he instills a high-performing culture and ensures we execute and we win in the marketplace. This is a significant first step in a transformative process to leverage all of our assets, to create the leading commercial organization in North America, which provides the absolute best service to customers.

Secondly, I'll comment on the importance of improving execution. Two weeks ago, we flattened our organizational structure when we announced our three division field leaders, as well as others, who will now report directly to me. These changes will facilitate faster, more efficient decision-making, and I'm confident this change will elevate operating intensity, drive greater accountability, and improve execution across the organization.

To summarize these actions, we're moving thoughtfully and swiftly to improve the trajectory of our business. In addition to driving near term performance, these changes are important steps in strengthening our foundation for the future. To that end, we're hard at work in constructing a comprehensive five-year strategic business plan with the goal of delivering industry-leading performance.

As we outlined for you last quarter the focus of the plan is around three value drivers: Growth, productivity, and people. We're excited with our progress and our potential. With respect to growth, as I indicated earlier, we've conducted a deep dive into the drivers of demand for our business, and we've collected volumes of customer insights that the organization has never had before. We're laser-focused on customer needs, as well as future trends, to help guide us in how we position the business for tomorrow. The drivers of demand are key inputs for our growth agenda, and will inform us on our holistic supply chain and availability strategy.

In terms of supply chain, we're doing considerable work on improving the consistency of part availability, dedicating disproportionate resources toward addressing this massive opportunity for Advance. The goal is clear: get the right part to the right customer at the right time, accurately, reliably and consistently. We'll be making changes in how we distribute, assort and deliver parts to our customers, and we'll do it faster, more accurately, and more consistently than we do today. We're testing multiple solutions to address these opportunities, and we have several pilot programs across the country, to assess alternative strategies to improve product assortment, reduce delivery time, and to reduce inventory. While it's early, our results from the pilots are extremely encouraging, and will drive growth going forward.

That leads us to our second area of focus, productivity. We're building a clearly defined productivity pipeline, aimed at improving margins and profitability, while building new capabilities to fuel our future growth agenda. This includes establishing productivity targets for our DCs, network, fleet, procurement, and stores. We're looking across our entire supply chain, and we're challenging each discrete cost. We've identified multiple projects which will yield savings in 2017 and beyond.

In the second quarter, we also launched zero-based budgeting. I know many of you are familiar with zero based budgeting, and the proven track record this approach has had in other companies and other industries. We plan to move as fast as possible on ZBB, while remaining mindful that we cannot affect service to our customers. In fact, the plan is to drive out unnecessary costs, such that we can invest in better service for our customers. I believe the productivity opportunity at Advance is significant, and it will fuel our growth for years to come.

Finally, people and culture are a major component of our strategic business plan. We're in the process of developing a comprehensive people strategy, to support our business strategy. In Q2, we established HR as a separate function. It was previously combined with our legal team. We subsequently hired a talented and experienced Senior Vice President of HR, Natalie Rothman. Natalie joins us from Pepsico, following a highly successful career there. Natalie and the team are also hard at work developing our people strategy.

Specifically, we're making sure that we have the right talent to succeed, the right culture to attract and retain a diverse and high-performing team, and the right capabilities to compete at the highest level to differentiate us and to win with our customers. You'll hear more about growth, productivity and people when we provide an overview of our strategic business plan later this Fall. With that, allow me to turn it over to Mike.

Thanks, Tom, and good morning, everyone. Total sales for the second quarter decreased 4.8% to $2.26 billion, principally driven by our comp store sales decline of 4.1%, the store closures we executed in 2015, and the effect of our Carquest consolidations. The declines were partially offset by positive growth at WORLDPAC, our store conversions, and new stores opened. Tom also talked about some of our internal challenges on availability, and in certain geographies earlier.

In our commercial business, the comp store sales declines were more pronounced in our Northeast and Great Lakes markets. Within DIY, the declines were primarily seen in our under car, brakes, and ride control categories, offset by higher wiper blade sales due to the wetter conditions in the Southeast during the early part of the quarter. Our gross profit rate decline of 110 basis points was primarily driven by supply chain expense deleverage due to the comp store sales decline, and higher supply chain expenses, driven by our move to daily replenishment.

Our adjusted SG&A expenses were down nearly $35 million versus our second quarter last year. Despite this, our second-quarter adjusted SG&A rate increased 17 basis points year-over-year, driven primarily by fixed cost deleverage, due to our comp store sales decline. We also experienced approximately $12 million of higher self-insurance costs, or 56 basis points, as we cycled roughly a $7 million insurance benefit from last year, versus higher insurance costs this year. These costs were partially offset by lower incentive costs, and our continued focus to reduce expenses.

All in, second quarter adjusted EPS decreased 16.3% compared to last year, and adjusted operating income decreased 14.8% to $243.2 million. Adjusted operating margin decreased 127 basis points over the same period last year, to 10.8%. Additionally, we had a $7.7 million adjustment to our income tax expense related to a GPI income tax audit for time periods prior to our acquisition that inflated our Q2 tax rate. The majority of this adjustment was offset in other income below the operating income, as this amount is recoverable under our GPI indemnification agreement.

Operating cash flow through the second quarter was $192.9 million versus $330.8 million last year, primarily driven by an increase in inventory versus last year, and lower than expected sales. The increase in inventory was principally driven by our Carquest consolidations, store closures, new Dallas WORLDPAC DC, and lower than expected sales. We expect to reduce the inventory growth through the balance of the year, and expect total inventory at the end of the year to be up low single digits versus last year.

Our adjusted debt to EBITDAR was 2.5 times at the end of the quarter, and we remain within our maximum stated leverage ratio target of 2.5 times. We continue to be focused on improving our business performance, while preserving our investment grade ratings. While we have not provided an annual EPS outlook, we did, however, want to give you some context to how we are thinking about the back half. Based on our current sales outlook, we expect continued fixed cost deleverage of our SG&A and supply chain costs, and are making some investments to improve our service and availability.

Additionally, as we reduce our inventory in the back half of the year as part of our ongoing efforts to improve our inventory productivity, we expect to experience gross margin headwinds driven by the expensing of previously capitalized supply chain costs.

With that, let's open up the call for questions. Operator?

(Operator Instructions)

The first question is from Simeon Gutman with Morgan Stanley.

The guidance last quarter, negative 3% to 5% for this period, it seems like you started out pretty negative, I guess maybe at the low end of that range. Granted, negative 4% is not that much of an improvement. Just curious, if things did get a little bit better or were they variable throughout the quarter? And realize in the context of negative 3% to 5% for the rest of the year, doesn't sound like much improvement, but curious if you can talk about if Northeast at least has gotten a little better post the end of the quarter?

First of all, if you step back and look at our performance over the last 40 weeks, it's in the down 3% range, so when you look at going forward, I would say we are conservative with the down 3% to down 5%. We finished better than we started, but we're still working through a lot of things inside the Company.

We swept the P&L every Monday, we look at the execution metrics that matter, we're making some progress on those metrics, so clearly I'm feeling like some of those things are moving in the right direction, but at the moment, we feel that it's important to be conservative with that guidance at the moment, and that's where we are.

So my follow-up is, it sounds like the business is still paying the price or just suffering from some of the integration things that have happened over the past year. I know a year ago, we talked about the business might be at its maximum pain point, and granted you weren't there at the time, and there's a lot of change, but I'm curious why if there were fixes that were made to address some of these issues, why things are getting worse? Could it be a sign that our customers giving up on the business, or it's just going to take a lot longer for you to dig out of some of these setbacks?

Well, there's obviously a lot to your question. We're building a strategy that we feel can win over the long term.

That strategy is going to incorporate the work that we had done on the integration, so it's a very comprehensive business strategy, that spans a growth agenda, and it has a very robust productivity agenda. It's going to align the people and culture behind the business strategy, so we're building that strategy out.

I think the performance that we've had so far is reflective of a strategy that really hasn't been as comprehensive and holistic as the one we are going to have going forward, and the execution against that strategy was not where it needs to be, candidly. So we're confident that we have a strategy going forward, but where we are now is, we still are trying to address some of the fixes from the previous approach.

Okay, thanks.

Thank you. The next question is from Seth Sigman with Credit Suisse.

My main question relates to the store and consolidation strategy. The consolidation of Carquest, it went from a benefit to a negative in the quarter. Can you elaborate on what changed with the strategy, and why that reversed, and if there's a way to quantify how much of a negative that was to the quarter, that would be helpful.

Well, the consolidation programs themselves, the CCR itself, we've taken a step back, Seth, from those. And we're looking at what elements of the CCR initiative actually worked in our favor, and which ones were not necessarily lined up behind the original estimates that were done, and we have pluses and minuses there.

Consolidations, we didn't really hit the goals that we set for ourselves on consolidation, so we have to step back on that one, and we have reduced the number of consolidations that we have going forward. Other aspects of the CCR strategy have worked better than we anticipated, and we're accelerating those. So we're looking very carefully at that, and that will be folded into the broader strategy going forward.

Okay thanks, and then Mike you'd mentioned investments in service and availability planned for later this year. Can you elaborate on that, and maybe help quantify it? Thanks.

Yes, we're looking at the fourth quarter, Seth in terms of how do we make sure we ramp up the top line? We really need more growth. As you saw in the quarter, the deleverage was the single biggest driver of our profit shortfall, and obviously, we're focused on retaining momentum in the top line. And with our customers we're making very selective investments in how we drive the top line, and that spans across multiple different lines. I'm not going to get into specifics, but we feel really good about our ability to stimulate more growth in the fourth quarter.

Okay, thank you.

Thank you. Our next question comes from Matt Fassler with Goldman Sachs.

My first question relates to daily replenishment, and it seems like the execution of that strategy was a big challenge for you during the quarter, both sales-wise and cost-wise. Can you try to dimensionalize for us any impact, how many stores or a percentage of the chain made that shift? What kind of dollar excess on the distribution cost side, that is, did you see as a result of this process, not going quite the way you wanted?

Yes, well obviously, Matt, our customers trust us to have the right part at the right time, and that means making sure we're delivering high quality, great value parts, accurately, reliably and consistently, when they need them, so that's the goal. Our customers really don't care how we get them the part, as long as we get them the part when they need it, and that's an important learning we've had.

Replenishment delivery frequency to the stores is just one element of the supply chain. It's not the goal itself. So we're really looking carefully at our entire supply chain and how to provide the absolute best solution for each store and its customers. We're making sure that every aspect, whether it's the fill rate from our DC, the quality of our assortment in the market, the order accuracy, the consistency and speed of our delivery throughout the supply chain are grooved.

And we had some markets, as you referenced, where we moved a little bit too quickly to a solution that didn't make sense for those markets at the time, and it did impact our profit flow through in the quarter. We've addressed that immediately. In fact, we're beginning to see some progress already from the actions that we've taken in those markets. I'm not going to get into specifics in the number of stores or DCs, but they were in the Northeast and Midwest, and we've taken the appropriate actions there.

That's great and my follow-up question relates to customer relationships, and I think there was a question alluding to this earlier, and we're getting a lot of questions on it, that are concerned about the permanent potential share loss, given the stickiness of commercial relationships. Is there any way to quantify customer defection, customer losses? Obviously from a same-store sales are under pressure, is that reduction in sales per customer, or is that a reduction in customer count on the commercial side? If we just get a sense as to decomposing out of that sales decline on the commercial side, and thinking about how easy it is to win some of that business back, or not?

Well, I've been around customers for 35 years, and I can tell you that it's a very dynamic situation with customers. You're either getting better with those relationships or you're getting worse, and I can tell you, we're going to get better.

We have put Bob Cushing into that big role today, overseeing all of commercial. He is maniacally focused on customer service, and getting the right part to the right place at the right time. I have tremendous confidence that we will build those relationships back.

We are focused on all aspects of the customer agenda, how many customers we're picking up, how many we're losing, whether we're gaining share inside each customer, so all of those aspects are being considered at the moment, Matt, and we do have to build the execution muscle inside of Advance as we make progress against that. I'm pretty confident that with Bob's appointment, we're going to really start to make material changes on that.

Thank you so much.

Thank you. Our next question is from Chris Bottiglieri with Wolfe Research.

A question on distribution strategy. A while back, you had alluded to some mega hubs that you were introducing. Just trying to figure out where that fits into your strategy going forward, preliminary results you may have seen, and how those may differ from the PDQ facilities you've used in the past?

Well, we're really stepping back, Chris, on the supply chain in total. We want to look at every aspect of it. We're working through this transition, as Bob comes into commercial.

We want to make sure that we're focused on the right metrics, so I mean, everything is on the table in terms of how we approach the supply chain. We need to transform it, and make it much more customer friendly, so that we're delivering the part when the customer needs it. You'll hear more about that in the Fall, but it's really more of a holistic approach to the supply chain than we've had in the past.

And then one brief follow-up, kind of related. You seem very metric driven, accountability focused. Can you talk about how that fits into compensation plans? The previous team had alluded to test in some markets to change the compensation structure. Can you maybe talk about how the two relate and how you look at that going forward? Thank you.

Obviously critical. We want to make sure once we've got alignment to the strategy, and we picked the right metrics to drive against that strategy, that the incentive systems are directly lined up against those. So that applies up and down the organization, right, Chris? We look at the Senior Executive Team and whether those metrics are lined up to deliver, the incentives are lined up to deliver the metrics, right down to the front line organization.

And we want to make sure people are incented to go after the metrics that matter the most. And I think in the past, we did shift around a little bit in terms of what we challenged our large field organization to do, and we want to get really grounded on a very small limited set of metrics for them to focus against, and we'll incent them and reward them for achieving those goals.

Okay, great. Thanks a lot, and good luck with the turnaround.

Thank you. The next question is from Michael Lasser with UBS.

So you outlined several factors that will pressure your profitability in the back half but also sounds like sales remained pretty sluggish. So how should we think about your margins in the third quarter and the fourth quarter, particularly in that last quarter of the year, where you're going to be facing a very easy comparison? So are your margins going to be down year over year in both of those quarters?

No, I think Tom laid it out well. Our focus in the back half is improving our service and our availability, and getting that top line going. So I'd say there are three drivers of how we're thinking about the back half. We aren't giving an EPS annual outlook, but I did give you a little bit of context that would be helpful to how we're thinking about the back half of the year, financially.

Based on that down 3% to down 5% for the full year, we are going to continue to see SG&A and supply chain deleverage. Our model needs sales and with an 80% roughly fixed-cost model, you just deleveraged, that will be the largest driver of our operating margins in the back half.

Second of all, we're going to make investments in service and availability that Tom talked about earlier. And then third is, as we, and you could see our inventory in the second quarter was up 7.3%, we are planning on our inventory being up low single digits by the end of the year. There's some capitalized supply chain costs that will be a headwind as we go into the back half of the year, so those will be the three drivers. So yes, we would anticipate some strain on our margins, but that's all I'm going to say, because we aren't giving an EPS annual outlook.

Understood. Tom, now that you've had time to digest and diagnose the Company's problems, how long do you think it's going to take to generate a positive comp?

We're obviously not giving specifics beyond the balance of the year on the comp, but I'm pretty optimistic we can accelerate our sales going forward. I think the idea of really getting this entire organization focused on the customer, Michael, is going to benefit us. I can feel it when I go out into the field. People want to win.

We've got great leaders that run our field organization. The general managers want to drive the top line. They're very competitive. They just need the tools to go up there and get it.

And we have to enable that by looking carefully at our supply chain, and figuring out how to do a better job getting them the part they need when the customer wants it. So we're optimistic about this, very optimistic we can drive the top line. I can't give you a specific timeline, but we are making a lot of progress on the things that need to be done, in order to accelerate growth.

Tom, maybe another way to ask it is if you look back in the second quarter in your mind, do you have a sense for how much of the comp decline or the underperformance was due to self-inflicted factors, and how much was due to weakness in the market, particularly in the geographies that Advance Auto is levered to?

I think if you look at our comparative performance you would say the majority of it is self-inflicted, right? Just look at the relative performance. Our goal is to perform above the top performers in the industry, so for us to achieve that, that's a significant gap. There was some geographic softness which has been called out by others, but relatively speaking, it's a small percentage of our opportunity. As we start to improve on some of the basic metrics that are important to execute against in the marketplace, we can grow significantly.

Very helpful. Thank you so much.

Thank you. The next question is from Ben Bienvenu with Stephens Inc.

You've talked a lot about improving availability and service levels. I'd be curious, as you look across the industry, and in places where you're winning back share, is it purely on account of availability and service levels, or maybe said another way, given the level of service of some of your peers, do you think that's solely enough to win back share that you've lost? Or do you see it more a story of winning share from the consolidation of the industry and independent operators in that space?

Well, Ben, we did a pretty deep dive, as I mentioned in the prepared remarks, on what matters most to our customers, whether that's on the commercial side or on the retail side. And we've got a pretty clear idea of the table stakes that matter the most. We've got an idea on specific jobs in terms of where we can make a difference.

So it is obviously not as simple as I'm describing it, but getting in the right place is really, really foundational to success. And we have not done as good of job on that as some of our competitors candidly, and we've got to elevate our game there. So we're very focused on solutions that will enable us to do that, and we've got some very, very promising pilots that we're testing out there in the marketplace, that are giving us confidence that going forward, we can provide solutions that are as good as, or better than our competition out there in the marketplace.

Understood and then looking at the balance sheet a bit, AP-to-inventory ratio ticking down a little bit. I'd be curious to get your sense of, in the back drop of some of the changes that you're making, what you expect the opportunity to look like there, and can we think about that as another lever to pull to improve shareholder returns over time?

Yes, absolutely, and Tom talked about it. Improving our working capital is another large opportunity, and it's going to be a by-product of our improved performance. So, and I would say there's two big drivers. One, as Tom's talked at length about the need to improve our performance and that will drive free cash flow, and that will drive obviously an ability to return back to shareholders.

The second biggest opportunity we have and the opportunity that drove our AP ratio a little bit lower than last year, was our inventory management. And there is a very large focus around that, Tom talked about it in his remarks. We're going to see in the back half some of that movement happen as we move through the transitional inventory, particularly in our Carquest branded stores, for the consolidations we've done and the closed stores.

Obviously, at our AAP branded stores, there are going to be some improvements there. We're making investments in availability, and we've got some new stores, but also, we're getting more productive with our inventory, and we're looking at areas that we can get better in AAP.

And then the third one is Worldpac. One of the drivers of our 7.3% increase was Worldpac, and Worldpac's inventory growth was up about 15%, and the reason is, is we've got a new Dallas DC for Worldpac, so what we anticipate is inventory management is going to be a big driver of the opportunity to improve the free cash flow as you return it, and obviously the return back to shareholders.

Great. Thanks so much, and best of luck.

Thank you. The next question is from Seth Basham with Wedbush Securities.

My first question is just, if you could give us any more detail on the relative performance in terms of basis points and gap between the Northeast and Great Lakes, versus the rest of the chain?

Seth, we had a big gap. There's no question about that, and I mentioned the challenges that we had in some of those distribution centers up there that really hurt our business in the short term that we corrected. So the gap is pretty sizeable. I'm not going to give you specific numbers, but it was a pretty sizeable gap in the quarter, and I'm confident the changes we've just initiated. In fact we just reviewed the performance in the first week yesterday, I'm confident we're going to make pretty big progress up there.

That's helpful. And then secondly, you're making a bunch of changes to investments here you're talking about. As you look forward to 2017, obviously without providing any guidance, would you expect your operating margins to rise versus 2016, or do you think there will be investments that will offset those improvements?

Well we're obviously over time, the margin expansion opportunity is massive here. There's no question about that, I haven't talked on the Q&A much about the productivity agenda, but I'm really excited about the work we're doing on productivity. We're going throughout our entire organization, bucketing the costs the way that I feel we need to, in order to get at the discrete real productivity opportunity, sustainable multi-year productivity opportunities that are out there, we're leading that throughout each function.

We've got a cost base that we've laid out. We've got targets for distribution centers, distribution centers to stores, inside the stores, stores to customers. We're very focused on zero-based budgeting. All of those things will give us sustainable margin expansion opportunities, and also enable us to invest back in growth.

So there's little doubt in my mind that we will expand margins over time. I think it's early for me to say whether that will happen in 2017. We should be in a position to talk to you about that, some time in November, once we have finished our strategic planning process, and we have sequenced our investment profiles, and got ready for all of those tradeoffs, right? That need to be made between top-line growth and productivity.

Look forward to it, thanks a lot.

Thank you. The next question is from Scot Ciccarelli with RBC Capital Markets.

I know you've had a bunch of questions around this, but when you do think about that margin expansion opportunity, I think you just used the word massive through productivity improvements, et cetera. But Tom, you've also mentioned investments need to be made, so when you think about 2017 versus 2016, can you provide some color on how you are thinking about the margin profile, just call it one or two years out, like what the general cadence is going to be, even if it's not specific numbers?

Sure. First of all, Scot, when we think about constructing the productivity pipeline that I just described, we obviously want more than just necessary to expand margins. So we're targeting to have enough cost takeout that we can invest back and expand margins at the same time.

So we have to self-fund our growth, and given the first pass we have had on this, we will be in a good position to do that in 2017. The question is how much investment is going to be required to stimulate the top line in 2017, but over time, we've done the five year. There's no question that we can build this business with sustainable top-line growth, and expand margins at the same time.

Okay, that's helpful. And then one of the things I think you mentioned on the last call was you were out meeting with a lot of the vendors, some of the lean vendors in the community. Can you share the general feedback that you've had from the vendors, that as Advance tries to rework how they've historically worked with that vendor community?

Sure. We've had really good discussions with our vendor partners. They're central to our success, over the long term. We've had several meetings with them. We've got several meetings coming up with them.

They are all-in. They really want to be part of a growth story within the industry. I think from their standpoint, they look at us as perhaps the biggest growth opportunity they have. So we're spending a lot of time with our vendors, and they're working collaboratively with us on solutions that can help differentiate us in the marketplace.

Got you. Thanks guys.

Thank you. The next question is from Matt McClintock with Barclays.

Tom, earlier you talked about consolidations. You mentioned historically they didn't hit the goals, and you've reduced that plan going forward. Have you ever given us the size of that reduction? And just as a second question on that, previously, you would decide to consolidate some stores. What does that mean about the profitability profile of the stores, now that you aren't going to consolidate them? Thank you.

Well, versus what we originally planned, I think we ended up roughly two-thirds, is where we ended up, in terms of the go-forward strategy, in terms of what we originally planned X number of stores, and we're probably at about two-thirds of that. So essentially, we've stepped back and looked at the performance.

And candidly, as we went through the process, the first stores we did were stronger than the more recent ones. That's the reality of it, and you go to the ones that are let's say the lowest hanging fruit from the beginning. And then as you move along, the business case the economic case isn't as attractive. And when we are giving back significant amount of market share, the trade-off on profitability just isn't worth it over the long term. So I think that's where we ended up.

Thank you very much.

Thank you. The next question is from Kate McShane with Citi Research.

This is Chris Weng on for Kate. Regarding the slip in execution with the replenishment, can you quantify how much you think this cost you in comp? And also on the integration side, can you also quantify the sales transfer rates that you're seeing from consolidations than the sales retention in the converted stores?

Yes, well first of all, on what it cost us in the stores impacted, I'm not going to give you a specific number, Chris, but it was a significant number. We moved rapidly. We challenged our team to get something done, that was very difficult for them to do. And in the end, I spent a lot of time in those DCs, in the marketplace with those general managers, and they dealt with a pretty tough set of circumstances for a period of time.

So our ability to correct that for them, which as I mentioned earlier, we've just done, is a welcome change, and we had just a great discussion about it yesterday. I'm very excited about how the team feels about it, because we did respond to something that was important to them.

Can you repeat your second question again? I want to make sure I understand it.

Just on the consolidation side, what are you seeing on the sales transfer rates from consolidated stores into stores in the existing markets? And for those stores that were converted, what kind of sales retention are you seeing in those stores?

Yes, the converted stores, we're pretty excited about. I mean, we've seen some nice growth on the conversions, and in fact, those we've actually increased. The consolidation stores, we had a percentage of sales that we wanted to retain going into it. We started to slip below that percentage, and that's why we've pulled back on it.

And just a quick one. In the past you've mentioned some impact to retaining talent as a result of the merge and other factors. Has that improved in recent months, and how are you approaching the retention of talent?

Yes, we are all over retaining our top talent. There's nothing more important in this Company than the front-line organization that faces our customers every single day out there in the marketplace, and I'm really proud of the way our team has rallied against this issue. I mean, a couple of months ago, we declared a crisis in this area, and we've got very focused on how are we going to retain our general managers, our commercial parts pros, our commercial account managers out there in the field, and we've actually started to see positive performance year on year on retention.

So you can count on us to be very focused on our front-line organization. It's incredibly important for our business. That's who faces our customers day in and day out, and we're going to do everything we can to enable them to succeed in the marketplace. And that includes giving them the tools, the training, the technology, and the incentives to go out and win in the market.

Okay, thank you.

Thank you the next question is from Mike Baker with Deutsche Bank.

So in some of your customer survey work, I'm wondering, so obviously the availability most important, how important is price to customers? And then, can you square into there with some of the investments you said you're making in the fourth quarter? How much of that, and even into 2017, how much of that investment is going to be in price to drive demand? And again how is that related to what the customers tell you they place the importance on price?

Yes, it came up. I mean I'm not going to skirt that one, Mike. Value is important. You can't ignore value.

At the same time, I think you've heard from others, it isn't the number one thing that comes up. It's on the list, but it's not in the top couple of things that are important for them. So we can't ignore it, and so we have to look, and we just did this yesterday. We go category by category, part by part.

We benchmark versus competition, we look for opportunities surgically, but we are not looking at some kind of broad based pricing action at the Company. The investments that we need to make are going to be made against the quality of our assortment, our fill rate, our order accuracy, the consistency of our delivery, our overall service proposition to the customer. That's where we are looking at making investments.

Okay, thanks. That's helpful. Just as a follow-up to some of the other comments that you've made, so in the Great Lakes and the Northeast, you've changed some things around, and things seem to be getting better. My sense is you are not going to quantify that for us, but is there any way to dimensionalize it? Have things gone from negative comps to positive comps or anything along those lines, where you've made those improvements? Something to sort of point to what the possible could be over the coming quarters?

Well that would be quantifying it, I think, but I'll try to answer that. I mean, we're definitely seeing improvement, okay? Based on where we were, I think we should see pretty substantial improvement in those stores that were impacted. Keep in mind, it's not a huge number of stores across our network, but in the stores that experienced some of those difficulties, they should see a substantial improvement in their performance.

Okay, thanks for the color. Appreciate it.

Thank you. Our next question is from Greg Melich with Evercore ISI.

It's Mike Montani on for Greg. Just wanted to ask if I could, Tom, can you talk about last quarter, you guys had said $260 million to $280 million of CapEx. Can you just provide an update there? And then as we move forward the next few years, how are you all thinking about what that number could become, if you were to do all of the different initiatives that you have potentially on tap?

Well, first of all Mike, we're right in the middle of our strategic planning process and we've had a couple of discussions with our Board on this topic. We're continuing to narrow the list of priorities that need to be done, sequencing them appropriately over the strategic horizon.

CapEx is essentially an output of all of that work. So at the moment, we're really not in a position to say where we're going. We're looking at multiple places to drive value for the Corporation.

That includes across our supply chain, information technology, new store openings, geographic expansion, all of those things that are on the table, but eventually, we've got to narrow that list and come up with the most appropriate mix of growth-related capital, productivity-related capital, information technology, and we have not completed that yet. So the working hypothesis is continuing with the number that you had. That's what we are working with at the moment, but it's more to come.

Okay, great. And then if I could just follow up on, for the quarter, can you provide any incremental color about traffic versus ticket split on the negative 4%, and then also just on store growth and square footage growth for the back half of the year? How should we think about consolidations and closures versus new openings?

First of all, you have to split out the outlier commercial, but broadly more of a traffic issue than a ticket issue at the moment. And on store growth in the back half, we'll have to get back to you on that one. I don't have that right off the top of my head.

Okay, thank you.

Thank you. The next question is from Dan Wewer with Raymond James.

Mike, you reminded us that you'll have higher capitalized supply chain costs in the fourth quarter, as you begin to drawdown your inventories. Will that headwind continue through the first three quarters of 2017, until you anniversary the inventory reduction?

No, not necessarily, Dan. I mean, it really depends. Because we haven't given the outlook for 2017, I mean, the big driver obviously in the back half of the year is, we're going to see a significant fall-off. Typically our inventory growth and bleed down is a little bit smoother, but with the moves we're making in the back half of the year, and again, they're very planful.

But I can't say that because really, our plan is to get -- a big driver of that is the sales. So as we start to position ourselves, and when we give that outlook and how we're thinking about 2017, we will be in a better position to give you a holistic picture, because there's other things that impact that.

I was just thinking with the unit cap accounting rules for inventory, that would be a headwind, because you'd have fewer units, but you're saying that may not be the case?

That may not be the case. You're correct. Obviously as you continue to bleed down inventory with lower sales, yes, that will be a headwind, especially if your supply chain costs are increasing. But our plan is to get the top line going, get rid of some of this inventory that's transitional. And obviously we're going to be buying inventory. And as Tom said, we're improving the efficiency of our supply chain so there's a lot of moving pieces there.

Tom, I'll follow-up with you on the consolidations. So what happens going forward if there's a Company-owned Carquest store, and an Advance store in the same market, but you decide not to go down the consolidation path? Are you thinking about a dual branding strategy in that same market? And the reason I'm asking is because I thought the original plan was to only use the Carquest brand in the independently operated locations?

Yes, we are still not complete in our assessment of that, Dan. Obviously, the independents, which are a critical part of our business, and one that potentially we see further opportunity to grow going forward, we've got a great group of independent operators out there who operate under the Carquest banner, that we want to continue to drive growth with. That's going to be central to our strategy. But we haven't aligned on the role, the two different brands, as we go forward.

We've got some markets where it's exclusively Carquest, as you know. We've got others where it's exclusively Advance. And where we have the two of them, we do believe that we can have them co-exist in the same market. We've just got to figure out how those two banners can operate in a way that are incremental. And play a different role and that's where a lot of the work that we've done on demand and the specific jobs that are relevant to our customers.

We can focus Carquest on a certain part of the business, we can focus Advance on another part of the business, and make sure that it's incremental to the Company. That's the trick, in terms of making sure that they work together.

You also noted that you're right in the middle of the strategic planning process, that you also had multiple pilots for supply chain changes that you're testing, as well. How long do those pilots need to continue, before you can finalize your strategic plan? I think you mentioned November, but I was thinking it would take longer than that to analyze the results.

We're going to move fast. We've got the pilots in flight as we speak. We do have phases to the pilots, and we're working against those phases. But we're obviously going to take the learning from the pilots, and the ones that can be applied immediately, and leverage those. Other aspects are going to take longer.

But the pilots are really exciting for us. They're designed to at the same time provide greater availability for our customers, improve the quality of the assortment, and make sure that we're delivering parts faster and most more consistently to our customers, while we're taking costs out of our supply chain and reducing inventory.

So it has really the triple benefit of doing all three. We're measuring against a very, very detailed dashboard that looks at all of those metrics in tandem, and we're iterating as we go. But the early results are very good, so I feel like we can move faster than perhaps you may have indicated.

Okay.

We won't be able to roll everything out at once. I mean again, given it's phased, once we get past the first checkpoint, there's other things we want to explore. But I guess what I'm saying is, you go through the first phase of a pilot, we can roll those aspects that make sense into the marketplace, and then test phase two as we go.

Would you ever be comfortable haves one distribution facility supporting Worldpac, Advance, and Carquest, and perhaps AI, as well?

Well, clearly the move with Bob today is designed to really look horizontally across our organization, our commercial organization. Now, I don't think that we're going to get to that particular dimension right out of the gate, but we're going to look at it. Clearly on the customer side, we've never had a holistic strategy between Advance, and AI, and Worldpac.

We've had multiple organizations going out there, selling to commercial customers. And admittedly with different products, but as import vehicles are growing, private label is becoming increasingly important, which is Autopart International Specialty, we do see an opportunity to look across, and clearly leverage some of the capabilities more broadly.

On the supply chain itself, I think there are elements of the supply chain where it could make sense. As an example, we have an Advance store close by here, the office, that gets eight deliveries, a day from the Worldpac branch, and yet we're also delivering from the Advance store, going to the Worldpac branch.

So integrating the transportation management systems of those supply chains can help us reduce cost and be more efficient, and there's many other things that Bob's going to look at. So we're very excited about this change. Bob is a terrific leader. They've built this online capability out there in Worldpac that is really as good as anybody's in the industry, and with the growth in online coming up in the future years, our intention is to leverage their online and e-commerce capabilities more broadly across Advance.

Okay, thank you.

Thank you. The next question is from Brett Jordan with Jefferies.

Quick question. I guess as you're talking about the IT and the pilot programs, have you stopped rewriting the Apex system, and are evaluating how you're going to consolidate the systems behind distribution, or are you still looking for one common backbone to that? And I guess a piece of the same question, where are you on point-of-sale consolidation? And then the read through, you talk about Northeastern and Midwestern supply chain problems in the quarter. Are those around the DCs that run Red Prairie or is that something different?

Well first of all in Apex we just had a review on Friday. We're making some really good progress there. Our field team members, we've got several stores, Brett, that are up and running in the pilot.

With any change, when you are talking about a change to your catalog and how people work, every single day, it does take some time to make sure that it's absolutely performing at a level that our people love it. And we've still got some work to do there. So the short answer on Apex is it's proceeding along the timeline that we had, but we want to make sure when we roll it out that it's really driving our top line, and the efficiency of our team members, and we're continuing to refine how we approach the Apex rollout, because we want to make sure it's about is absolutely [good] when we roll it out.

We're continuing to work through the POS consolidation, essentially that continues on the timelines that we've talked about there. I don't know that it was entirely Red Prairie related in the Northeast. It's a factor, but it's not just Red Prairie. There was other distribution centers impacted that do not use Red Prairie.

Okay, thanks. And one follow-up question. You talked about some of the high profile branded parts that have been taken out of the merchandise mix, possibly coming back. Could you give us any color where we are on how you think about the branded products that were important to commercial customers?

Charles and his team are doing a pretty thorough review of where we are on hard parts, and how we benchmark versus our competition. For the most part, we feel pretty good about our assortment, but we are looking at some things that we actually have the meetings coming up next week on this topic. So there's nothing specific to report right now, Brett, but we are going to look very closely at our hard part assortment, because we have to have something that's competitive across every single category.

Great, thank you.

Thank you the next question is from Carolina Jolly with Gabelli.

So, I guess in regards to Worldpac, I know a couple of quarters ago you mentioned some cannibalization in comps when there were branches or DCs, is there any more of that, or do you have any details on relative Worldpac comps year over year, or any deceleration or acceleration?

Just to clarify when you say cannibalization, what are you referring to?

So when they opened some of the new branches initially, I think, there was some mention there was some cannibalization from branch to branch?

Oh, branch inside Worldpac?

Right. Yes.

So let me hit that. So first of all, at the highest level, Worldpac continued to grow their business. And I think we mentioned it in our remarks, they were one of the bright spots in the quarter for us, so they continue to grow. And in terms of cannibalization, I think that it's a little bit different for a commercial-only business, when they open up a -- because almost 90% of their business is controlled by systems, meaning their customers order online, when they actually open another branch, they actually move those customers that were serviced out of one branch, and they move them to another branch.

So they actually -- cannibalization is actually -- they are actually changing their systems, so we don't view that as a bad thing. What typically happens is when they open up a new branch, that was close to where another branch was, they see cannibalization of the original branch, because they deliberately move the customers, because they can give them better service by servicing them out of the new branch. And then what happens is both branches grow. So the cannibalization is, if you look at their total growth, and I think that's a better way to view the Worldpac business, their total business is growing as they're opening up new branches, and that cannibalization that they see in the original branch, that just grows back, their businesses grows back, and it actually grows back strong in both branches.

Great, thanks for the detail. And just to make sure I understood what you said initially, did you mention, or were you able to say if there was some acceleration in the Worldpac growth?

They had, I didn't say acceleration, but they had another, they were one of the bright spots for us in the second quarter, and their top line grew over last year.

Great, thank you.

Thank you. Our final question today comes from Craig Kennison with Robert W. Baird.

Tom, you opened three super hubs in Atlanta, in June. Is that at all representative of the type of DC investment you want to make, on a national basis?

Well Craig, again, we're stepping back on the supply chain, right? We have a number of things that were in flight before I got here, but we are really looking carefully at how to transform our supply chain and future fit that structure for the market place that we see is going to happen in the future. And I think the things that we have done, there will be many things that we incorporate into that overall growth strategy.

Some of them we won't, so just a question of, is Atlanta what we're going to do? The answer is, I don't know yet, because we're having to step back on the whole strategy that we've had, because it hasn't produced the results that we desire to have. There will be elements of things that we've done that we'll incorporate in, but we're testing some new and very different approaches, to how we service our customers, and efficiently get product to the marketplace.

So aspects of it, yes, specifically Atlanta, I don't know yet. I'm not sure. We are going to have that laid out in more detail as we get into November.

Thanks, and then with respect to the deep dive survey you mentioned, do you have any sense of how often your customer that's not choosing Advance today, how often that customer is choosing a national competitor that may be hard to displace, versus a smaller competitor, over what you would seemingly have a scale advantage, if your service levels are improved?

Yes, the answer to that question is yes. We do.

Got it. Thank you.

Thank you. At this time, there are no further questions. I will turn the call back to Tom Greco for any final comments.

Okay, well, thank you everyone, for joining us. Q2 was a difficult quarter for sure, but we do know the issues. I want to reinforce that the issues are absolutely fixable. There's no structural impediments to us addressing those issues. I feel great about the progress that we're making, and I couldn't be more excited about our future.

You can count on us to dramatically elevate our focus on the customer and the top line, to transform our supply chain for the future. We're going to dial up the intensity against our execution, and we'll have a robust productivity pipeline. The Board and the Leadership Team are aligned, and prepared to take decisive actions, and really create the value we need for shareholders over time, and we're eager to get back to work and look forward to sharing our progress with you later in the year. So thanks for joining the call, and this concludes the call for today.

And that concludes our call today. You may now disconnect. Thank you for joining us.