Prabhakar Vaidyanathan - Advance Auto Parts, Inc. Thomas R. Greco - Advance Auto Parts, Inc. Thomas Okray - Advance Auto Parts, Inc. Bob Cushing - Advance Auto Parts, Inc..

Scot Ciccarelli - RBC Capital Markets LLC Matthew J. Fassler - Goldman Sachs & Co. LLC Michael Baker - Deutsche Bank Securities, Inc. Christopher Horvers - JPMorgan Securities LLC Alan Rifkin - BTIG LLC Bret Jordan - Jefferies LLC Michael Louis Lasser - UBS Securities LLC Matthew McClintock - Barclays Capital, Inc. Seth I.

Sigman - Credit Suisse Securities (USA) LLC Seth M. Basham - Wedbush Securities, Inc. Simeon Ari Gutman - Morgan Stanley & Co. LLC Brian Nagel - Oppenheimer & Co., Inc. Benjamin Bienvenu - Stephens, Inc. Chris Bottiglieri - Wolfe Research LLC Steven Forbes - Guggenheim Securities LLC Dan R. Wewer - Raymond James & Associates, Inc. A.

Carolina Jolly - Gabelli & Company.

Welcome to the Advance Auto Parts third quarter 2017 conference call. Before we begin, Prabhakar Vaidyanathan 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 third quarter results. I'm joined this morning by Tom Greco, our President and Chief Executive Officer; Tom Okray, our Executive Vice President and Chief Financial Officer; and Bob Cushing, our Executive Vice President of Professional.

Following their prepared remarks, we will turn our attention to answering your questions. Before we begin, be advised that our comments today may include statements that are not historical facts and may be deemed forward-looking statements as defined by the Securities and Exchange Commission's Private Securities Litigation Reform Act of 1995.

While actual results may differ materially from those projected in such statements, due to a number of risks and uncertainties, which are described in the company's filings with the Securities and Exchange Commission and on our website, we maintain no duty to update forward-looking statements made.

Additionally, our comments today include certain non-GAAP financial measures. Please refer to our quarterly press release and accompanying financial statements issued today for important information and additional detail, regarding both the forward-looking statements and the reconciliation of non-GAAP measures referenced in today's call.

The content of this earnings call will be governed by the information contained in our earnings press release and related financial statements. Now, let me turn the call over to Tom Greco..

22) directly or through the shop software system. In Q3, Advance Pro was deployed to 8,000 Professional customers, up from 1,000 at the end of the second quarter. And once again, cross-banner visibility is an added feature embedded in Advance Pro. We also implemented cross-banner visibility in all U.S.

Carquest stores for both company-owned as well as independent Carquest stores. This gives them the ability to view and order products from the Carquest network, in-market Advance stores, Advance DCs, and WORLDPAC; once again, all in one place. These stores are performing well and exceeding initial projections.

Our independent partners were instrumental in enabling us to move faster on this and continue to provide an important perspective as we construct our plans. Our employees and independent partners are providing us with very positive feedback on cross-banner visibility.

They're seeing higher conversion rates and increased average spend per transaction and lower returns. Cross-banner enables us to do a much better job leveraging our asset base to make more parts available to more customers faster and easier than we do today.

In summary, we're making excellent progress in enabling our people and customers to find parts more easily when the parts they need are not available in their particular store. To build on this and improve order-to-delivery speed and efficiency, we continue the installation of telematics in our vehicles.

We'll be leveraging telematics data with a fleet and transportation management system. This technology solution is critical for real-time fleet management and enables us to accurately measure and manage order-to-delivery times. Additionally, this new capability will provide critical insight into efficiency and safety metrics.

We'll begin leveraging these new capabilities in Q1 2018. Shifting to DIY omni-channel, we're building new capabilities to integrate physical and digital assets to ensure a seamless omni-channel experience across all customer touchpoints.

Following the successful launch of our enhanced website, we're now seeing significant improvements in traffic and conversion rates. We want our customers to get the best of online, while also enjoying the convenience and satisfaction of our knowledge and store base for pick-up, exchange or delivery.

In the stores, we're improving the customer experience, which is driving performance on key metrics like units per transaction and social media sentiment. In terms of productivity, we began to implement and execute our multi-year agenda.

Our material cost optimization, or MCO for short, our supplier partners are invaluable to AAP, and a critical contributor to our long-term success. We've engaged material cost discussions at a higher level than we have in the past, and the conversations are as much about long-term growth and partnership as they are about MCO.

We're finding ways to work collaboratively with our suppliers to result in positive outcomes for both sides. We've now conducted comprehensive category reviews on approximately 56% of our core-product categories in 2017, with plans to complete the balance in 2018.

In terms of supply chain, we made progress on several initiatives, including standardization across distribution centers, refinement of our material flow process, and improved utilization of our transportation vehicles.

Our supply chain productivity agenda is partially offsetting previous investments in supply chain which were made in a siloed fashion and have been a headwind on costs in 2017. Our early work on end-to-end supply chain is expected to optimize this asset base over time.

On zero based budgeting, or ZBB for short, we started to realize benefits in Q3 and are gaining much-needed momentum in managing costs. Examples of ZBB contributors to Q3 savings include G&A associated with our restructuring efforts, efficiencies realized in managing professional fees, and process improvements which are yielding savings in rent.

Further areas of focus include vendor consolidation in Goods Not For Resale categories, including facility maintenance and temporary staffing. Rounding out our transformation agenda, we are tracking and developing talent across every function at AAP.

In the past few months, we stood up a digital marketing team, a fully integrated professional marketing team, as well as a data and analytics center of excellence. We continue to have considerable success attracting high caliber talent to the new AAP where we need it.

In summary, we took deliberate actions in Q3, and continue to build a strong foundation to delight the customer. With three quarters of a five-year transformation plan behind us, we continue to move forward on key initiatives that are core to AAP's long-term success.

This includes, first, transforming Professional through our availability transformation, cross-banner visibility, and the implementation of order-to-delivery measurement and performance management.

Second, reinventing DIY omni-channel with a heightened focus on improving the customer experience both online with our new website, and in our stores, as we leverage improved tools and training. Third, streamlining our supply chain from end-to-end as we advance our plans to optimize the asset base across all of AAP.

And fourth, implementing our productivity plans through MCO, supply chain, and ZBB. With the major field operations and Professional sales team restructure now behind us, the high-caliber team we've built at AAP is now laser-focused on driving execution without the distractions we experienced in Q3.

We're confident in our ability to drive significant shareholder value going forward. With that, I'll pass it to Tom Okray..

Thanks, Tom and good morning, everyone. In the third quarter, net revenue of $2.18 billion was down 3% as compared to the prior-year third quarter. On a comparable store basis, this represents a negative 3.4% comp.

Gross profit for the quarter was $948 million and, on a rate basis, our gross profit margin of 43.4% was 51 basis points lower than the prior-year quarter of 43.9%. The primary drivers of our margin contraction in the quarter were increased supply chain costs and shrink, which reduced our margin by 44 basis points.

In addition, the non-cash impact of our inventory optimization efforts in the quarter negatively impacted our gross margin by 23 basis points. Improved material costs in the quarter helped offset these increased costs by 17 basis points compared to the third quarter of 2016.

Adjusted SG&A was $776 million in the third quarter, an increase of $5 million as compared to prior year. This was $22 million lower versus Q2 2017 adjusted SG&A of $798 million. As a percentage of net sales, our third quarter adjusted SG&A increased 127 basis points from 34.3% to 35.5%.

Labor, medical costs and insurance claims resulted in a 131-basis-point increase in the quarter. In addition, increased marketing expenses accounted for 26 basis points. These were partially offset by 25 basis points in third-party fee reductions and other improvements in utility, maintenance and repair costs.

Turning to adjusted operating income, we delivered adjusted operating income of $172 million in the third quarter and adjusted operating margins of 7.9%, a 178-basis-point reduction as compared to the prior year. Our third quarter adjusted operating income margins were impacted by the gross profit and adjusted SG&A levers we described above.

Going forward, we expect that our adjusted operating income margin, when compared to the prior year, will have similar results in the fourth quarter as were posted this quarter. That said, there is no change in the overall full-year 2017 guidance that was provided in August.

Turning to cash flow, our free cash flow was $240 million, a 7.7% increase as compared to prior year. This increase was the result of reduced operating income offset by the change in inventory, in addition to lower capital expenditures. I am encouraged that our focus on cash flow is bearing fruit.

We have modified our finance organization, meeting forums, and compensation programs to focus on cash. These modifications have enabled us to make progress in inventory optimization, working capital, and capital expenditures. Transforming our organization to become an industry leader for the long term requires innovation.

In many cases, the innovation will be iterative. Importantly, we need to fail fast, learn from our mistakes, and move forward. It is important to note, at Advance, we're building a culture that embraces this philosophy.

We will continue to aggressively pursue innovative initiatives that increase our performance, while ensuring that we delight the customer. With that, let's open it to addressing your questions.

Brian?.

Thank you, sir. And our first question will come from the line of Scot Ciccarelli with RBC Capital Markets. Please proceed..

Hi, guys. Scot Ciccarelli. First, just a clarification.

Tom, did you say that you expect fourth quarter operating margin to be down in the fourth quarter at a similar rate to the 178-basis-point decline we just saw in 3Q?.

That's correct, Scot..

Okay. Got it.

And can you help us understand what the – if you can quantify at all, how much disruption you guys think you caused yourselves by the labor changes implemented to the organization?.

Well, first of all, good morning, Scot. We made some pretty bold moves in Q3, as you know, to really set us up for the future. And we're really excited about the changes that we made. I mean we had 34 regions, and it was just difficult to run the business with 34 regions and a very disparate approach on how we ran it.

We know that when you make these kinds of changes, and I've done them many times in my career, you're going to have temporary distraction from the business because there's a lot going on. People are moving into new roles, they're learning new direct reports, they're learning new geographies, they're learning new customers.

So, there's a lot of change that happens there. That said, we really feel good about the end result. I was on a call with the regions yesterday, and I think all of them would say that we're performing better than we were pre-the change, because we're able to really get focused on specific issues in specific geographies. For example, Florida.

We're running Florida as a separate region now. We used to have four people running Florida. So, we're operating much more effectively and efficiently than we were. And we're really more focused on the customer, which has been the goal of the whole change that we made. So, we knew this was an important change for our transformation effort.

We'd originally planned to do it in 2018 and we're really excited that it's behind us and we're able to perform better as a result..

And is there a way to quantify what you thought the disruption was, Tom?.

It's difficult to say, obviously, but if you look at the two-year stack, we were essentially above 30 basis points below where we were in Q2. So, I mean, there were a lot of other factors into the equation, but I would say that's probably in the range..

Got it. Okay. Thanks, guys..

Thanks, Scot..

Thank you. And our next question will come from the line of Matt Fassler with Goldman Sachs. Please proceed..

Thanks a lot. Good morning. I have a brief follow-up on Scot's question and then another very quick one.

You talked about having modulated the pace of some of the change during the quarter, so the question associated with that is the degree to which you saw the sales perhaps erode and then presumably improve as you pulled back from the pace of disruption..

Yeah, I think the big things we talked about, Matt, in terms of the change were obviously the restructure itself, not just in terms of the field, but the Professional sales organization that Bob Cushing leads. And then we also optimized our inventory and initiated a little bit more aggressive actions in our productivity agenda.

I think all of those things combined, we had some learnings out of them. The restructure is kind of a one and done, right? I mean, you make the change; people get adjusted to their new geographies. The sales people get adjusted to their new customers. And we feel pretty good about the fact that we made the change, it's now behind us.

And then on the productivity agenda, we're going to continue to work productivity agenda hard because we believe we've got a substantial margin expansion opportunity out in front of us and we're going to continue to push the envelope on productivity.

We had some good learnings as it pertains to optimizing inventory and managing excessive discounting and PMOR that we're continuing to thread through the P&L. And you saw some of the benefits of that in the third quarter, which we're going to continue to see going forward.

I guess the key point we want to make is, as we roll out the productivity agenda, we're going to put the customer front and center, and we're not going to do anything where we feel we're impacting the customer. And where we saw that happen, we quickly reacted, literally within weeks. And all of that has, obviously, been adjusted and is behind us..

And then just quickly following up, you reduced the annual impact of the non-cash inventory hit to gross margin by about 40 basis points. You left the annual operating margin guide unchanged.

So, does that get offset somewhere else? And also, does that inventory reduction hit show up sometime in 2018, or are we likely not to sustain it?.

Yeah, no, as Tom said, Matt, we still believe that we need to optimize our inventory. But the actions that we put in place in Q3, just to come back to his comments, we learned a lot. We learned about stratification of the SKUs. We learned about how our supply chain could process returns.

So, we have pulled back a little bit on that, but we will continue to aggressively optimize the inventory going forward. We stand by an AP ratio of being in the high 90%..

Great. Thank you so much, guys..

Thanks, Matt..

Thank you. And our next question will come from the line of Mike Baker with Deutsche Bank. Please proceed..

Thanks. Just simply wanted to ask about the pace of same-store sales through the quarter, sort of what Matt was getting at. But I will just specifically ask if you can talk about comps through the quarter, and then what is the fourth quarter expectation? We know you have the full-year guidance, but that gives you a huge range for the fourth quarter.

So, you must be able to narrow that a little bit, as you did for the full year operating margin outlook and what that implies to the fourth quarter. Thanks..

Well, Mike, there's a lot going on, as you guys already know, in the third quarter. Clearly, we had our own internal actions, which we just talked about. Independent of that, you had an historic hurricane season. We talked about that in our prepared remarks.

We also had our northern geographies where we've had the back to back mild winters, a mild summer, over half of our store base is up in those northern geographies. We can see much more movement in those geographies when we have extreme weather.

I think we disproportionately benefit in these northern geographies when we have extreme weather and we disproportionately get impacted when it goes the other way. And I think in the third quarter, we had a little bit of that on the downside.

We also expect that in period 13, where it was unseasonably cold last December, we've had a very difficult lap. That said, the set-up for 2018 looks terrific. We've done all the work on the key variables that drive long-term demand in the industry.

The car park, the vehicle miles driven, vehicles inside the sweet spot, GDP, all of those things look very positive for us in 2018. The pace of the comps in the third quarter, we're not going to comment on them specifically, but we feel good that the key changes that we made are behind us.

And obviously, the important thing for us is we're executing better than we were prior to the change..

Okay. And so, does that better execution presumably show up in better same-store sales? Is that a fair assumption? You had answered a previous question by talking about looking at the two-year comp rate.

Is that a fair way to look at the fourth quarter outlook?.

I think it is. I think it is. I think it's important to look at the two-year, and it's also important to look at Q4 and Q1 combined. Because that's what, what we really saw last year. And the set-up for that timeframe looks favorable for us on a two-year basis..

If I could ask one more, sorry to hog the mic, but if you're saying the two-year stack should stay the same in the fourth quarter, that would imply it down 7% in the fourth quarter. I just want to be clear if that's what you're trying to say or not. My guess is it's not. But I'd like to hear that from you..

The two-year stack will improve in the fourth quarter..

Understood. Thank you very much..

Thank you. And our next question will come from the line of Chris Horvers with JPMorgan. Please proceed..

Thanks. Good morning. So, on the operating income performance in the third quarter, as well as in the fourth quarter, was there something that you're pushing out, it seems like, some of the beat in the third quarter, you're sort of tucking into the fourth quarter in that regard.

So, was there something in terms of a timing that hit in the third quarter that maybe came early relative to your expectations or an expense that's coming into the fourth quarter that you had not anticipated previously? And is any of this just trying to be conservative given the volatility in the numbers?.

No. I mean, there's nothing about being conservative in the numbers. The Q3 went largely as we thought it was going to go. And, as we said in the prepared remarks, we're reiterating our full year guidance..

Understood. And then, following up on the – two follow ups. So, first, on the inventory reduction, I think you had previously spoken about taking maybe perhaps a $1 billion of inventory out of the system over time, over $800,000 of inventory per store, much higher than peers.

Based on what you've learned, is that still a long-term target? Are you thinking that, given that you have the four different platforms, essentially, that you will end up something south of that..

We still stand by the AP ratio up into the high 90%. And if you do the math, that's going to get you to roughly a $1 billion. You're right. We have a headwind now that we've got the four different supply chains. But if you recall, we've got an end-to-end supply chain initiative that's going to rectify that.

So, again, AP ratio in the high 90s, we need to optimize inventory. Part of that is getting to one supply chain..

Understood. And one quick follow-up as well. You're approaching three times leverage, it looks like, from our perspective at the end of this year. That's actually an adjusted number, it's not on GAAP number. So, what's the conversations like with the rating agencies, this has been a question that's been going around the market.

So, curious what the conversation is there on a potential risk and a downgrade?.

Yeah, I mean, I can't speak for the rating agencies, but our focus on cash inventory optimization, free cash flow, working capital, I believe that's going to be attractive to both equity and debt investors..

Got it. Thank you..

Thank you. And our next question will come from the line of Alan Rifkin with Boyd Thomas (sic) [BTIG] Please proceed..

Thank you. It's Alan with BTIG. Tom, you had said that you will continue to optimize your inventory at a more measured pace. And I believe in the past, that was a significant contributing factor in your EBIT margin degradation of 200 basis points to 300 basis points for the year.

So, why then have you not – if you're taking at a more measured pace going forward, why are you actually not raising the EBIT margin degradation number or lowering it, I should say? Why is it not a narrower EBIT margin loss?.

Well, Alan, as we learned in Q3, there's a lot of volatility, a lot of moving parts that happen in this inventory optimization space. To reiterate again, we learned a number of different things throughout the process. So long story short, we didn't want to put an adjusted operating income margin related to the inventory out there.

We're just standing by the full year that we have guidance..

Okay.

And as a follow up to that, since it will be a more measured pace, can we conclude that you won't get to where you want to be on the inventory level, the $1 billion reduction until even later in 2018?.

Yeah, wouldn't conclude that. We're not talking about that right now. More to discuss that in February..

Okay. Thank you very much..

Thanks, Alan..

Thank you. And our next question will come from the line of Bret Jordan with Jefferies. Please proceed..

Hi. Good morning, guys..

Good morning.

Good morning..

On that line of questioning, I guess, inventory reduction, but then you're talking about you are expanding your payables program to the 90s.

Are we talking about gross inventory reduction or are you talking about funded inventory reduction?.

Both..

Okay.

So, when we're talking about a $1 billion, are we talking about taking $4.2 billion to $3.2 billion or are we talking about some mix of the two?.

$4.2 billion to $3.2 billion..

Okay. And then I guess as we're looking at the supply chain, obviously you've got the cross-banner initiative going.

At what point can you ship across distribution centers, so you can basically start consolidating the number of DCs in the field?.

Yeah, we're actually really excited about the intense supply chain work that we've been doing, Bret. It's revealing a lot of opportunities in our overall supply chain in terms of how we move products around. We really think that an integrated and holistic look at supply chain is the way to go. And we just haven't been doing that.

We looked at supply chain essentially in four different places, as you know, and even inside the functions, we were quite siloed in how we viewed supply chain. The store operations team managed the fleet that shipped to the stores, the supply chain managed the DCs to the stores, all of those types of things.

So, now it's fully integrated under one single point-of-contact. We do have plans to pilot some of the moves that you're describing in 2018. We'll talk more about that in February next year. But the cost take-outs associated with that are substantial.

And we just have to make sure that we've got the technology platforms right, that everything's working properly, that we have a broad-based, company-wide assortment strategy in place.

So, we're working through all those details, but needless to say, when you've got 50 million square feet of assets, around 50 distribution centers, we've got optimization opportunities up and down the supply chain..

Okay, thank you..

Thank you. And our next question will come from the line of Michael Lasser with UBS. Please proceed..

Good morning. Thanks a lot for taking my question.

Do you still expect that SG&A dollars are going to be down $25 million or so from the second quarter to the fourth quarter? And if you do, why would your gross margins be so much worse in the fourth quarter, down, call it 120 basis points to 140 basis points compared to the improvement that we've seen progressively over each quarter of this year?.

Yeah, Michael, I mean, first of all, we're happy with the traction that we got in SG&A in the prepared remarks. We said $22 million less than Q2 for SG&A in this quarter. We believe that we're on track to get into the $25 million range for Q4.

Some of that might have been pulled ahead into Q3, but we think we're going to be in the neighborhood of $25 million in Q4..

And if that's the case, then why was the gross margin down so much to get you to an operating income decline of 175 basis points to 180 basis points in the fourth quarter?.

I'm not following the point here.

I was talking SG&A and you're switching to gross margin?.

Yeah. Yeah, so, if your SG&A dollars are down by about $25 million year-over-year, it would imply about 45 basis points of SG&A deleverage on a minus 4% to minus 5% comp in the fourth quarter.

And that would mean your gross will be down in the neighborhood of 120 to 140 basis points to get to overall operating margin decline that's equal to where it was in the third quarter. And it seems like it's a big step-function change from the trajectory of your gross margin and where it sits..

Yeah, remember, we're talking about for the Q4, we're talking versus Q2 $25 million, not year-over-year..

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Good morning, Michael. I think I caught your question. You're breaking up a little bit. But, first of all, the big impact in Q3 was really the restructuring. And we got the question earlier. I mean, we really feel good about the moves that we made. And, as we get behind these moves, we did exit with momentum in the quarter. We like the start out of Q4.

So I don't believe that the changes that we made are disrupting the long-term performance of the company; in fact, quite the opposite. Again, I had the 12 regions on our weekly call yesterday.

We literally went around the horn on where we are in putting those changes behind us and dialing our execution and every one of those key field measures that we look at every week in terms of our execution performance, and it's getting better. So our ability to drive the agenda is actually better now than it was four or five months ago.

So I'm actually more confident in our long-term prognosis and ability to get above the industry average growth rates. That's the goal. We're putting the customer first, and our goal is to be above the industry growth rate, and we're not going to be satisfied until we get there.

And I think the changes we made in the third quarter actually underline and strengthen our ability to accomplish that goal..

Thank you..

Thank you. And our next question will come from the line of Matt McClintock with Barclays. Please proceed..

Hi, yes. Good morning, everyone. Tom, you talked a lot about the new and improved Apex and providing that access or view to inventory across all the banners.

Just how do you think about the benefit of that building? Is that something that can create a step-function change in your business as you roll that out? Or is that something that really – is something that builds over 2018 into 2019 and beyond? What have you seen in the stores where this access has been provided? Thanks..

Well, I'll flip this question over to Bob. I mean, Bob has been intimately involved, Matt. He's built a very strong platform at WORLDPAC that has enabled us to have an advantaged business model with our professional customers. I'll let him respond..

Yeah. So, thanks. So throughout 2017, we've been building the foundation for growth. What matters most to the customers, first to market, to enable first-call status. So importantly we needed to start with the catalog.

So we have the enterprise catalog Apex so that we could end up eventually getting to where we are today where we've just tested out the cross-banner visibility and rolling it out across to all the stores.

So importantly, for all of us, we needed to make sure that we could end up showing and displaying to our customers the portfolio of brands across the enterprise, which we've done. So Apex is kind of the engine behind it.

So when you look at Advance Pro, which is the new B2B platform that we introduced with 8,000 customers and growing and accelerating that out, the Apex catalog is basically behind that, meaning it's powering it. So importantly that was another opportunity that's out there.

Advance Pro has a lot of features and benefits out there for the customer, most importantly on the cross-banner side. In market, it's showing availability of all the portfolios between Advance, Carquest, and WORLDPAC. So now as one location, one portal they see all of that. So Apex is driving that. So that's a critically important part of all of this.

Because, again, as with anything else, what we're seeing in all of this is, number one, on Advance Pro with the customer we're seeing a larger order size. We've seen improvement in that. Secondly, we've seen a higher conversion rate.

Thirdly, we basically have seen return rate go down, which means that accurate catalog, they're getting the right part at the right time accurately. So, we're driving that. Tom mentioned earlier, as far as on the order cycle time, working on all of that.

So Advance Pro, basically, again, powered by the Apex catalog, cross-banner visibility, all of these are the technology footprint we're building out having first-call status with our customer. And again, it started with Apex and now it's working through. This has been our plan all along.

We're basically setting it all up in 2017 to come out strong in 2018..

Thank you very much..

Thank you. And our next question will come from the line of Seth Sigman with Credit Suisse. Please proceed..

Thanks. Good morning. I wanted to follow up on the SG&A question from earlier. So if you go back to your productivity targets for 2017, I think you had originally talked about more coming from gross margin this year. It seems like based on trends year-to-date, more is actually coming from SG&A. So I'm just wondering, is that right.

If so, are you seeing just more near-term opportunity on the SG&A side versus gross margin?.

Yeah, that's a great question, Seth. Let me comment on the gross margin. While we saw some traction this quarter, we're not satisfied where we are from a gross margin perspective. Let me give you one example or couple of examples. On our material cost optimization, we've got two components of that.

We've got material cost reduction and we've got trade or vendor income. The trade and vendor income is masking the great work that we're doing with our vendor partners to lower our acquisition costs for material. The only way to capture that trade vendor income is when we start to grow and get our sales going in a positive comp basis.

So right now that good work is being masked or delayed until we start to grow. Another headwind that we've got is from a supply chain perspective. We have opened a couple of DCs, and there is the legacy cost associated with opening those DCs, which is hitting the gross margin.

So while we started to get some traction, we expect that to accelerate significantly in the future..

Is there a way to quantify how big that trade and vendor income issue was this quarter and what it's been year-to-date?.

We're not going to break that out, Seth..

So when you look at gross margin in this quarter, it was down 50 basis points. Last quarter, it was down 90 basis points year-over-year. So the trend is improving sequentially.

So what are the drags that are actually improving from quarter to quarter? Were the issues just less impactful or did you just have more offsets within the gross margin now?.

The MCO or the material cost optimization definitely improving. So we stand by what we said that we would see the productivity in the back half. But the gross margin was masked by three big things. One is the new DC costs associated with that. The other one is the trade or vendor income. And then there's the 23 bps for the inventory related..

Okay. Thank you..

Thanks..

Thank you. And our next question will come from the line of Seth Basham with Wedbush Securities. Please proceed..

Thanks a lot and good morning. My first question is going back to the outlook for the fourth quarter in terms of operating margins. Last quarter in the call you said that fourth quarter operating margin should be higher year-over-year excluding the inventory reductions. I just wanted to make sure that guidance is no longer accurate..

Yeah, that's correct..

Got it.

And the biggest changes from your perspective are related to what's happened in the gross margin line?.

Yeah, that's correct. As well – yeah, factoring in the softness in the industry for sure. Thank you..

Fair enough. And my follow-up question is related to Availability Transformation initiatives that you're testing in 500-plus stores.

Can you give us any perspective on what kind of lift you're seeing in sales or profitability from those stores since those tests were implemented?.

Yeah, good morning, Seth. We're really pleased with the learnings we're getting out of Availability Transformation. We're seeing mid-single digit growth versus control in those stores, and we're gradually rolling them out. I think we announced that we achieved 500 stores in Q3 and we're continuing to roll those out in the fourth quarter.

We're getting good visibility. Again, I'm going to go back to Bob and WORLDPAC because historically they've been able to assort parts quite differently than we do here at Advance.

And one of the benefits of Availability Transformation is we're now getting visibility into the physical lookups that are coming into our store, whether they're coming in by phone or a customer ordering off of Advance Pro or one of our B2B platforms. That gives us much better visibility into the demand that exists in that store.

And that's a much superior way for us to be assorting parts and making sure that we're able to say yes more often. And that's the goal for Availability Transformation. We're pleased with the performance in the test versus control. We're continuing to monitor it closely.

And when we see a region that's not ready to get it done or has some key indicators that we don't like, we essentially don't roll it out there.

But when we do have all the positive indicators in place, the leadership team is ready to go, they're executing at a level that we believe is necessary to achieve the goals for the Availability Transformation overall, we continue to roll it out. So it's been a very positive initiative for us, and we're continuing to focus on it..

Thank you..

Thank you. And our next question will come from the line of Simeon Gutman with Morgan Stanley. Please proceed..

Good morning. It's Simeon. Thanks for taking my question. I don't know if this was asked, but sort of big picture, I think the big question we're trying to figure out is how the restructuring or how sustainably beneficial this restructuring is going to be. You lowered your cost structure a lot. It seems like it came at the expense of sales.

So how on that lower cost structure are you able to then reaccelerate the top line, which looks presumably like lower – fewer resources?.

Yeah. I think, Simeon, we think – we don't think, we're absolutely convinced that this was a temporary impact, okay. Again, a large restructuring of this size where we did take out a lot of cost. We went from 34 to 12 regions.

We reduced the number of customer account managers that are out there in the marketplace, but we enabled everyone with new tools and technology. Bob has rolled out iPad devices to all the customer account managers. We're giving them the tools they need.

So if you go to one of our customer account managers and speak to them today, they're far more enabled to get their job done.

Find a 25-year-old or 30-year-old young leader in our organization and ask them if they would rather be walking to a customer with a stack of papers and having the responsibilities they had before, or walking in with an iPad device and having all the tools and technology that we have to enable them today, and they would absolutely say they're far better off today than they were before.

So we didn't just make the changes without enabling them. We did both. So we're very confident that the changes we made were the right changes for the future. They obviously impacted us when we made the changes but, as I mentioned earlier, every week that's gone by, we're executing better and we're seeing that in our performance..

And you mentioned, Tom, that in the future you expect the business to outgrow the industry.

I guess with some of the traction that you're getting in some of the recent changes, I guess what is the reasonable timeframe for which to expect that to occur?.

Yeah, I mean, obviously we're going to – we're finalizing our 2018 plans right now, Simeon. We have narrowed the competitive gap two years in a row now versus our peer set if you look at where we were in 2015, where we were in 2016, and where we are year-to-date in 2017.

So we're continuing to narrow the performance gap versus our primary competitors in the industry, and we expect that will continue into 2018. And I don't have a specific time for you, but that's the goal..

Okay. Thanks. Good luck..

Thank you..

Thank you. And our next question will come from the line of Brian Nagel with Oppenheimer. Please proceed..

Hi. Good morning. Thanks for taking my question. So it might be a bit of a follow-up to Simeon's question just from a bigger picture perspective.

With all that we've done now in the last three quarters and what you've detailed in your comments today, how much of the heavy lifting is now done as far as just the correcting the infrastructure? And the second part of that is what's the next thing as we're looking to the fourth quarter, more likely early 2018, what's the next big initiative that needs to take place?.

Well, first of all, we've done a lot of the very difficult stuff, I would say. The people changes are always hard, and we had to make those changes. That was an important part of the transformation journey.

You can't go from where we were to top quartile performance without a leadership team that is a global leadership team and one that can compete at the highest level. We've done that. I feel like we have a leadership team that is capable of competing at the highest level. We did not have that a year ago.

There's no way we could have done what we're about to do with the leadership team that we had. So that is probably the most difficult part; it's finding the capable talent that you need, not just outside of Advance but also inside of Advance. Finding the great leaders inside of Advance that we've lifted up and developed and put into big jobs.

So that part of it's done. The heavy lifting on the planning, the strategic planning is done. The field restructure is done, which is an important initiative for us because that gets the 12 best field leaders we have out into the marketplace driving execution as compared to 34 individuals that were not as capable as the current 12. That's done.

So really we're moving into a stage here where we're executing against the key initiatives that we've outlined in our strategic plan, which is about being clear on expectations, measuring the performance rigorously, sharing best practices, and driving the agenda. So do we still have some heavy lifting to do? Yes, we do.

We referenced earlier the fact that we've still got work to do on the supply chain front. And we've got a pretty robust plan to go after that one. So it's difficult to say where we are, but from here we like the setup for 2018, and we think the moves that we've made today have really positioned us well for the future..

03)?.

37), which, as you know, is approaching 280 million vehicles. That's continuing to grow. The vehicles miles driven is expected to grow again next year.

The vehicles in the sweet spot that's been a challenge and that's a difficult one to talk about because it is also contingent on how long it takes parts to fail, which has been changing over the years as qualities improve. But that factor is actually improving as we head into 2018 as well.

So the macroeconomic factors that drive our performance and the industry's performance overall look better for 2018 than they did in 2017. And then you've got the famous weather variable, which has been difficult over the last couple of years. But we know that one's going to come back, and we've seen that happen repeatedly in the last 15 years.

So I believe the industry is going to have a stronger year next year and the setup looks good..

Thanks a lot. Appreciate it..

Thank you. And our next question will come from the line of Ben Bienvenu with Stephens, Inc. Please proceed..

Hi. Thanks. Good morning. I wanted to ask just about how the organization is responding to the changes you're making.

In particular, I'd love to hear about the response from the fields that you're seeing and if you're continuing to see the improvement in turnover that you've highlighted in the past despite the disruption associated with the regional reorganization..

Well, I'll take that in two parts. I'm going to ask Bob to speak about the professional sales organization in a minute and I'll talk about the field leadership team and the districts and what we've seen there. Again, big change to a big thing, no question about it. This was distracting. You've got the before, the during, and the after.

And you've got the planning before where people are speculating and wondering what's going to happen. You've got the during where you're literally impacting people who've been with the company for a long time, and then you've got the after where people are meeting new people and meeting new customers and all of those things.

So, for that group, it was very challenging. I think the field reaction to it today, and I get out in the field a lot. I'm leaving for a trip to Florida here tomorrow. I try to listen to the field leadership team. We have a call every week with the region vice presidents where we get feedback.

We have ways of hearing from our districts and reporting back up. The field – obviously during the change, we went through a trough. There's no question about it. It's a difficult time when you're impacting people. That said, I think, today they would say we're much better positioned than we were. Much better.

So, overall, the feedback we're getting is very positive on the changes that we made. And again, the important thing is we're enabling them. We're not just making the change, you know, reducing people. We're actually changing the work.

And when you change the work and you enable people with new tools and technology, and you make the job better, that's a positive.

So, Bob, do you want to talk to Professional a little bit?.

Yes, sure. So, you said it, I mean, certainly the technology that we built there, with the iPads, and certainly what we've done on the CRM side of it, we're giving them those tools. We've released a digital sales aid. So we digitized basically all the information that they need when they're making calls.

I think, importantly, the customer engagement strategy is working quite well. We also have a defined accountability relating to the customer engagement side with both the CAM, of course the commercial sales manager, and of course on the district manager and GM side. So, that's all there. We have measurements. We have key performance indicators.

It's all there today. The team is extremely excited, especially about now that they have all of these other tools with Advance Pro, the Apex catalog. Especially now the cross-banner visibility. This is huge. Everybody's excited about it, both in store and in the field.

So, overall, when I look at this and they're working shoulder to shoulder with the operations team on execution, this particular to me, this is the best possible configuration structure we can have out there to be most effective for taking care of our customers and being able to say yes to them more often. So, we're excited about it, the team is.

And we're looking forward to a terrific 2018..

Understood. Thank you.

And then, can you discuss the investment in labor that you're making? And what evidence are you seeing that this investment, in particular, is yielding improved results or would you say that the benefits are still somewhat theoretical at this point?.

Well, first of all, our – I guess I would say the science around how we invest in labor has evolved materially since we got here. And Mike Broderick, who is leading that effort, joined us with 25 years of experience in the industry, has really led a very different approach to how we're managing labor in the stores.

We're making sure we have people in the stores when our customers are there. I know that sounds like an obvious thing, but we weren't necessarily doing that. So that we're supporting them on the weekends. We're enabling our people with the tools they need and the incentives they need to really go after it. And I'll give you an example.

We introduced, obviously, the Ship to Home, we've been doing Ship to Home off of our website for a while.

But we weren't compensating our general managers and our store personnel for Ship to Home orders and that was something that we changed in the third quarter to make sure that when somebody walks in for buy online pick up in store, we're actually selling the customer on going to our website and ordering parts off of our website.

And if they want it shipped to their home, that's great. And then the people in the store will go after it. So, our investments in labor are much more focused on the high performing stores, and the ones that are actually earning the rights to have more labor in the stores. And we obviously measure the lift against it.

And if they don't perform against that lift, we pull back on that labor. So, we're getting much more granular store by store, full-time/part time mix, weekend service, all of those things are variables that Mike and our two division presidents look at every single week with every single region.

And I'm very confident that we're going to continue to get better at how we measure and perform with respect to our investments in labor..

Great. Thanks for that color..

Thank you. And our next question will come from the line of Chris Bottiglieri with Wolfe Research. Please proceed..

Hi. Thanks for taking my question. Follow -- actually follow-up on the omni-channel initiative, so from our vantage point, I think, you're probably a little more forward looking company in the industry right now. We're witnessing here I think greater buy online, pick up in store discounts.

You just talked about you are incentivizing your local managers to encourage customers to Ship to Home, when it makes sense to do.

From your perspective, are you doing this from competitive response what you're seeing in the marketplace? Or is this your philosophical view of the world? Customers demanding a more integrated omni-channel approach and more transparent pricing between channels?.

That's a good question, Chris. I mean, first of all, we look at every decision we make through the customers' lens. So you're referring here to the DIY customer, and again, I mentioned, Mike Broderick earlier, he's come in with a lot of experience in DIY. We're really excited about DIY. Someone asked me the industry trends earlier.

We did see an uptick in DIY performance, in the most recent couple of periods, and – through NPD. So, DIY is still a pretty exciting place. DIYers – our business is going to grow in DIY, but we have to be able to give the customer what they want, where they want it and how they want it.

And some of our customers are going to want to come into our store and speak to one of the – our knowledgeable staff and get advice. Others are going to want to order off of a mobile device and have it shipped to their home.

The thing is, in our business, when you have a very high return rate, and knowledge and advice is so critical, which is quite different than other industries.

Imagine yourself trying to repair a vehicle on a weekend and finding out that the parts you ordered online was the wrong part, now what are you going to do? Well, in our case, we have, obviously, a footprint of stores where somebody can go to the store and get advice. They can return the part. They can learn from it.

So, making sure from our vantage point, it's really understanding the demand journey that exists for the customer itself.

And what are the decisions they make along the way on that journey, and how can we delight them at every touch point? Where do they get angry along that demand journey, with an online experience, and how do we make sure that we capitalize on that? So, there – we've looked forward.

We've got a pretty clear idea of where we think the demand is going to unfold, how much of it's going to be in-store, how much of it's going to be buy online, pick up in store, how much of it is going to be Ship to Home and we've obviously engineered our resources and investment platforms around that..

16) cost inflation, which you were able to pass through, and how that's helping comps? And then maybe how it's affecting the supply chain, and if at all you're seeing any kind of customer response to the marginally lower discretionary spending? Thank you..

Yeah, the only real commodity headwinds that we saw, Chris, were R-134a refrigerants and ethylene glycol in the quarter. Other than that, didn't really see much..

Got you. And....

Yeah. And fuel prices, obviously, are important for our industry. We see a real high correlation, obviously, with fuel prices and miles driven. And there hasn't been a ton of movement there. I think, it's been – it hasn't come down as much as it did a year ago in the previous year, which obviously benefits miles driven.

It's a pretty clear inverse correlation between fuel prices and miles driven, right?.

Got you.

And then, in terms of like – you haven't seen any kind of changes to pricing from suppliers on base oil, like kind of, motor oil, chemicals or even some of your costs or some rising fuel prices, like, do you anticipate that could be something to think about for next year? Or how do you think about that?.

Yeah, I mean, it's something we're looking at, obviously, with the vendors, and each negotiation, we have it split out with the commodities which impact a given category. And, just to repeat, the only real headwinds we saw in the quarter were ethylene glycol and the R-134a refrigerant..

Okay. Great. Thanks for clarifying. Appreciate the help..

Thank you. Our next question will come from the line of Steve Forbes with Guggenheim Securities. Please proceed..

Good morning. Maybe a multi-part question here on the end-to-end supply chain optimization effort.

Right, so, can you remind us where Leslie and the team are as it relates to the strategic review of those assets? And I guess, maybe just touch on, if you can, right, is it fair to say that we should expect kind of a detailed plan as it relates to both the timeline and maybe the magnitude of opportunity of those initiatives in February? Or is that still too early as it relates to kind of going back to where you guys are in that whole review?.

First of all, just to give you the color on what we're doing here, Steve, I mean, the approach we've taken, Leslie's taken is really customer back. Okay? So, we're starting with the customer and trying to understand from that lens how do we go back from what the customer wants and go into the supply chain.

We're looking across all of the current supply chains that we have, which we mentioned. There are at least four – I would argue five if I include Canada into that mix, because what you really want is an integrated North American supply chain.

When you make changes to a supply chain that – such as ours that has the size and scale that ours does, you've got to make sure that you get it right. You've got to have all of the technology platforms in place. You've got to make sure the assortment plan is dialed; the execution is planned.

So, we are planning on piloting changes with our supply chain in 2018, and we'll come back to you more in February. But, in terms of a detailed plan, in terms of how that's going to unfold, this is going to be an iterative effort over a period of time..

Material costs, zero based budgeting, and supply chain.

I mean, how big is supply chain optimization, right? And how does everything you just laid out, right, maybe just the timing, headwinds, or some of the other headwinds in the industry, how does that affect, right, the timeline for the net productivity gains that we should be modeling?.

We've got roughly $1 billion in the baseline in our P&L related to supply chain. And we're looking at our end-to-end supply chain can be a couple hundred million opportunity off of that $1 billion baseline. As Tom said, we'll give more color as we get further along with our pilot.

A lot of what we're doing – we – you have to remember, we're in the third quarter of a five-year transformation. We've got a number of moving parts, as you saw in Q3. We're doing a lot of innovation, testing a number of different things. The profile is going to be a little bit lumpy.

Rest assured that we're going to continue to mine the gold out of each one of these P&L items, as I've taken most of you through on many different occasions. But we're going to have the guardrails for the customer, and we're going to iterate accordingly.

So, it's a little difficult at this point to give the exact profile as it relates to end-to-end supply chain. But the overall opportunity is very meaningful, couple hundred million dollars..

Thank you..

Thank you. And our next question will come from the line of Dan Wewer with Raymond James. Please proceed..

Thanks. Tom, when you increased your estimate on cost take-outs, I think, now we're looking at what, $750 million? I believe, one of the buckets was reducing the amount of product returns and reducing the amount of sales discounts.

Are you now thinking that the blowback from customers to making those changes could be so significant that you'll perhaps dial back those two efforts?.

Yeah. I don't know if I would say dial back. I would just say be more cautious in terms of how we do it. I mean, a lot of this transformation, we're learning. We got a number of irons in the fire. We've got a tremendous amount of opportunity. But we're not going to hurt the customer.

So, we're not ashamed to say that a lot of this is trial and error, and we're going to continue to fine-tune. So, I think, the opportunity still exists. It's a matter of how we go after the opportunity and do we have the proper foundation in the business right to be able to capitalize on that opportunity..

Second question. On the goal of eventually $1 billion of inventory take-outs. The concern that investors are having is that the initial $140 million reduction has been very painful on both gross margin rate, as well as negative impact on same-store sales. And I would assume the next $860 million of inventory take-out could be even more painful.

Your thoughts on those two headwinds about reducing inventories?.

Yeah. Well....

Yeah..

Yeah, I mean, it's certainly challenging taking inventory out at that level, optimizing it. But we're finding a tremendous amount of opportunity to not only draw down the inventory, but get a better assortment. Again, end-to-end supply chain is a big part of this where we have four different supply chains, which means we have duplicative inventory.

A big part of this is getting our turns up and going. We were at 1.24 turns, we need to get those turns higher, which speaks to a better assortment, better execution in the stores, higher UPT. Another tranche of that is payables. We need to do – continue to do a good job in making sure that our payables structure is right.

So, while it's challenging, it's an industry benchmark to be up over 100%. With our mix, we think we can be in the high 90%s..

And the final question that I have is with the change in the field organization. I believe that the number of stores that report to each district manager is up to about 15 stores. And your competitors tend to limit that ratio to about 10 stores per DM.

If you could discuss why you're confident you can maintain the appropriate level of execution at the store level, given the district manager responsibility is going to be so much greater than they were before?.

Yeah, Dan, that's a good question. Coming from my previous life, I heard that there's no way we could change the district spans higher than 10 or 11 to 1 for about 20 years. And when we made the change, we actually changed the work, as I said earlier, by giving them the tools, technology that they need to do their job better.

So that's really the goal here. You have to change the work. You can't just change the spans without changing the work. And I'm absolutely confident that we'll be able to execute against that change. I'm not concerned about it..

Okay. Thank you..

Thank you. Our next question will come from the line of Carolina Jolly with Gabelli. Please proceed..

Oh, great. Thanks for fitting me in.

Just two very brief questions, one being, did you see any differences in how the do-it-for-me and do-it-yourself segments performed? And then second, just with some of the new competitors talking about entering the market or entering the Northeast, have you seen any increase in competition in any regions?.

First of all, on DIY/DIFM, it was a volatile quarter, let me just say. I mean, we had – with the hurricanes, you have the panic buying in DIY. You have professional garages that are closed for weeks, literally, on end in some cases. In DIFM, we've got a great business down in Puerto Rico and St.

Thomas, and our people down there just moved mountains to get the business back on track and really doing extraordinary things to get our business back up and running. So, pretty volatile. I think, overall, our professional business outperformed DIY, which has been the case for a period of time for us. In terms of the Northeast, we welcome competition.

We thrive on competition. We want to perform for our customers. We put our customer front and center. We're going to make sure that we're delighting our customers. And our Northeast business, we like where we're set up there.

We've been able to – similar to what I said earlier, we've got one leader overseeing the Northeast now that reports into Mike Creedon, our Division President, who knows the area extremely well. We've seen entrants come in there, and that makes us better. So, our intention is to continue to win. That's a very important geography for us.

And, we're going to continue to focus on delighting our customers in the Northeast and everywhere else..

All right. Thanks a lot..

Thank you. Ladies and gentlemen, this concludes our question-and-answer session for today. So now it's my pleasure to hand the conference back over to Mr. Tom Greco, President and Chief Executive Officer, for some closing comments and remarks.

Sir?.

Well, thanks, Brian, and thanks to all of you for joining us today. We really appreciate your interest in the company and your support as we execute our transformation plan. We're committed to the successful implementation of the plan. And we believe we're going to deliver significant growth to you, all of our shareholders that are out there.

So, I'd like to thank all of our team members across AAP who demonstrate every day our company's mission, passion for customers, and passion for yes. And together we're going to continue to work diligently to build the foundation for the company and ensure our long-term success.

I look forward to speaking with you in February and providing further updates on our progress..

Ladies and gentlemen, thank you for your participation on today's conference. This does conclude our program, and you may all disconnect. Everybody have a wonderful day..