Advance Auto Parts: Rebuilding for Profitability and Growth (NYSE:AAP) - AAP Stock Research Report

## Executive Summary / Key Takeaways * Advance Auto Parts is undergoing a comprehensive strategic turnaround, focusing on core retail fundamentals across merchandising, supply chain, and store operations to drive profitable growth. * The company reported its strongest quarter in over two years in Q3 2025, with comparable sales growth of 3% and adjusted operating margin expansion of 370 basis points year-over-year to 4.4%. * Strategic initiatives, including the completion of store footprint optimization, accelerated rollout of a new assortment framework leveraging AI, and expansion of market hubs, are showing early positive impacts on sales and operational efficiency. * A proactive reorganization of the debt capital structure in Q3 2025, including a $1.95 billion Senior Unsecured Notes issuance, has significantly enhanced liquidity and provides a pathway to an investment-grade credit rating by targeting a net adjusted debt leverage ratio of 2x to 2.5x by 2027. * While macroeconomic headwinds, particularly consumer elasticity to rising prices and ongoing tariff impacts, present risks, the company's long-term target of approximately 7% adjusted operating income margin by 2027 remains unchanged, underpinned by expected gross margin expansion and operational efficiencies. ## A Turnaround Story Rooted in Fundamentals Advance Auto Parts, Inc., founded in 1929, has long been a cornerstone of the North American automotive aftermarket, serving both professional installers (Pro) and do-it-yourself (DIY) customers. Operating under the Advance Auto Parts and Carquest brands, the company has established a significant footprint across the United States, Canada, Puerto Rico, and the U.S. Virgin Islands, complemented by independently owned Carquest stores in Mexico and the Caribbean. The company's business model is inherently resilient, with over 90% of its sales driven by nondiscretionary maintenance and "break/fix" repairs for an aging and growing U.S. vehicle fleet. The company is currently executing a multi-year strategic turnaround, characterized by decisive actions and a renewed focus on core retail fundamentals. This transformation began in late 2023 and accelerated through 2024 and 2025, aiming to streamline operations, enhance profitability, and deliver sustainable long-term growth. The industry itself is disciplined, with competitors generally responding rationally to rising product costs, including those stemming from new global trade tariffs. This rational competitive environment provides a stable backdrop for Advance Auto Parts' strategic adjustments. ### Technological Edge: Powering Precision and Efficiency A critical differentiator and foundational element of Advance Auto Parts' turnaround strategy is its increasing leverage of advanced technology, particularly artificial intelligence (AI). The company has designed a multiyear roadmap to deploy AI-based applications across key operational areas, establishing a foundation for stronger execution. In merchandising, AI is being utilized to power SKU placement decisions and inform a new AI-powered pricing matrix. This technology significantly improves the ability to make data-driven decisions and quickly adapt SKU requirements to meet specific market needs. For investors, this translates into more optimized inventory, better product availability, and potentially enhanced gross margins through more effective pricing strategies, with larger benefits expected in 2026 and beyond. Within the supply chain, AI-based applications are deployed for optimum demand forecasting across millions of SKU combinations in the network. This technological capability is crucial for improving DC productivity, measured by product lines per hour, which has already seen mid-single-digit percentage improvements year-over-year. The "so what" for investors is a more efficient and responsive supply chain, leading to lower operating costs, improved inventory turns, and ultimately, better profitability. These technological advancements are integrated early in the company's strategy, contributing directly to its competitive moat by enabling greater precision and efficiency than traditional manual processes. ### Competitive Positioning and Strategic Responses Advance Auto Parts operates in a highly competitive landscape alongside major players such as AutoZone (TICKER:AZO), O'Reilly Automotive (TICKER:ORLY), and Genuine Parts Company (TICKER:GPC). While precise, directly comparable market share figures for all niche competitors are not publicly detailed, Advance Auto Parts has strategically positioned itself to compete effectively. Approximately 75% of its store footprint is now concentrated in markets where it holds the #1 or #2 position based on store density, providing a strong right to win in these regions. Compared to AutoZone, which emphasizes operational efficiency and private-label products, Advance Auto Parts differentiates itself through a multi-brand portfolio (Advance Auto Parts and Carquest) and a broader array of services like battery testing and engine light scanning. While AutoZone may exhibit stronger cash flow generation and profitability margins due to its efficiency focus, Advance Auto Parts' service diversification and market density aim to capture a wider customer base. Against O'Reilly Automotive, known for its customer service excellence and omnichannel retailing, Advance Auto Parts competes with its focus on rapid delivery and enhanced parts availability through market hubs. O'Reilly's historical aggressive expansion and inventory depth provide a strong competitive edge, but Advance Auto Parts' initiatives, such as improving "time to serve" to 30-40 minutes for Pro customers, are designed to close this gap and strengthen its reputation as a reliable parts provider. Genuine Parts Company, with its NAPA brand, excels in automotive and industrial parts distribution, particularly with professional installers. Advance Auto Parts' integrated retail-service model and growing online presence offer a distinct value proposition, especially for DIY customers. While GPC's robust distribution network provides scale, Advance Auto Parts' strategic investments in its supply chain and market hubs aim to improve its own distribution efficiency and responsiveness. The company's strategy to strengthen relationships with "Main Street" and regional Pro accounts represents a significant opportunity for higher-margin market share. This focus, combined with its technological investments in assortment planning and pricing, allows Advance Auto Parts to tailor its offerings and compete more effectively against rivals across various customer segments. ### Financial Performance and Liquidity Reinforcement Advance Auto Parts' recent financial performance reflects the early stages of its turnaround, with Q3 2025 marking a significant step forward. For the twelve weeks ended October 4, 2025, net sales decreased 5.2% to $2.04 billion, primarily due to store closures under the 2024 Restructuring Plan. However, comparable store sales increased by a robust 3%, indicating underlying operational improvements. For the forty weeks ended October 4, 2025, net sales declined 6.6% to $6.63 billion, with comparable store sales increasing 0.7%. Profitability saw a notable improvement in Q3 2025, with the adjusted operating margin expanding by 370 basis points year-over-year to 4.4%. Gross profit margin for the quarter increased by 100 basis points to 43.3% of net sales. This expansion was driven by more favorable product margins resulting from strategic sourcing initiatives and pricing adjustments, coupled with lower supply chain costs. A non-cash charge of $28 million was recorded in cost of sales due to estimated future credit losses from a vendor's Chapter 11 bankruptcy filing, partially offsetting these gains. Selling, general and administrative (SG&A) expenses, exclusive of restructuring costs, decreased by 110 basis points to 40.6% of net sales, reflecting reduced overhead from store closures.

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Restructuring and related expenses were substantial, totaling $33 million for the twelve weeks and $180 million for the forty weeks ended October 4, 2025, as the company executed its optimization plans. Interest expense increased due to higher long-term debt, while other income, net, benefited from increased cash balances following the Worldpac sale and new debt issuance. The company reported a diluted loss per share of $0.02 for Q3 2025, compared to a loss of $0.10 in the prior year. For the forty weeks, diluted earnings per share were $0.63, a significant improvement from a loss of $1.32 in the prior year, partly aided by a $126 million net discrete tax benefit in Q1 2025.

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Liquidity has been significantly strengthened through proactive capital management. Cash and cash equivalents surged by $1.31 billion to $3.17 billion as of October 4, 2025. This was primarily driven by the issuance of $1.95 billion in Senior Unsecured Notes in August 2025, yielding net proceeds of $1.90 billion, a portion of which was used to redeem $300 million of existing debt. The company also established a new $1 billion asset-based revolving credit facility (ABL Facility), replacing its prior facility. As of October 4, 2025, the ABL Facility was undrawn, with $741 million of borrowing availability. Approximately $2.30 billion of cash is designated as "Qualified Cash" under the ABL Facility, underscoring the company's commitment to financial stability. The company was in compliance with all ABL Facility covenants.

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### Strategic Initiatives Driving Future Performance The turnaround plan is built on three strategic pillars: merchandising, supply chain, and store operations, each with targeted initiatives. Merchandising Excellence: The company has successfully completed the rollout of its new assortment framework across its top 50 Designated Market Areas (DMAs), covering approximately 70% of sales, ahead of schedule. This initiative, leveraging proprietary assortment planning tools and AI, is expected to deliver incremental comparable sales growth beyond an initial 50 basis point uplift as these markets mature over the next 12 to 18 months. Store availability, a key performance indicator (KPI), improved to the mid-90s percentage range, up approximately 100 basis points from Q1 2025. The company has also introduced tens of thousands of new SKUs this year to broaden coverage and enhance responsiveness to market demand. Strategic vendor partnerships are yielding more favorable product margins and cost benefits, despite the complexities of a new tariff environment. Supply Chain Optimization: The company is on track to consolidate its U.S. distribution center (DC) network, aiming to end 2025 with 16 DCs, down from 38 two years prior. The ultimate goal is to operate 12 large DCs by the end of 2026. DC productivity, measured by product lines per hour, has improved in the mid-single-digit range year-over-year. The market hub expansion is also progressing, with 28 locations open as of Q3 2025 and a target of 33 by year-end, en route to 60 by mid-2027. These market hubs, carrying 75,000 to 85,000 SKUs, expand same-day parts availability for 60 to 90 stores and have shown an average estimated comparable sales uplift of 100 basis points for supported stores. The recent opening of a greenfield market hub in Atlanta serves as a model for future expansion, enhancing coverage in previously underserved regions. Store Operations and Customer Service: A refreshed store operating model is set to launch in Q4 2025, with full implementation anticipated in the first half of 2026. This model aims to enhance productivity, improve labor utilization, and align vehicle and driver allocations with demand patterns. The company has already improved its "time to serve" for Pro customers, moving into the target range of 30 to 40 minutes, a critical factor for professional installers. Efforts are also underway to strengthen relationships with "Main Street" and regional Pro accounts, leveraging enhanced customer data visibility and training. For DIY customers, initiatives include simplifying store tasks, streamlining communication, and implementing a new Net Promoter Score (NPS) metric to drive targeted service improvements. Significant investments are being made in store upgrades, with approximately $50 million spent year-to-date on HVAC, roofing, parking lots, and signage across over 1,400 stores. The company is also building a pipeline to open at least 100 new stores over the next two years. ### Outlook and Risks Advance Auto Parts has reaffirmed its full-year 2025 guidance, reflecting confidence in its strategic execution despite a dynamic macroeconomic backdrop. The company expects net sales between $8.55 billion and $8.6 billion, with comparable sales growth of 0.7% to 1.3%. This includes an anticipated $100 million to $120 million in sales from the 53rd week in Q4. Adjusted operating income margin is projected to be between 2.4% and 2.6%, implying approximately 200 basis points of margin expansion for the year. Adjusted diluted earnings per share are expected in the range of $1.75 to $1.85. For Q4 2025, management anticipates gross margin to be slightly below 44%, benefiting from higher capitalized inventory costs but offset by higher-than-planned LIFO expenses, estimated at $70 million, adding 80 to 100 basis points of pressure. SG&A expenses are expected to decline in the high single-digit range year-over-year. Capital expenditures have been revised to approximately $250 million, with a portion shifted to next year. Free cash flow is projected to be negative $90 million to $80 million for the year, primarily due to higher-than-planned inventory investments to improve assortment. Excluding $150 million in store optimization cash expenses, core free cash flow would be positive.

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The company's long-term objective remains an adjusted operating income margin of approximately 7% by fiscal 2027, with a net adjusted debt leverage ratio target of 2x to 2.5x. This will be achieved through debt repayment, lease obligation reductions, and improved profitability. Key risks include potential temporary volatility in sales trends as consumers adjust to an inflationary environment, particularly impacting the DIY channel. While the industry has responded rationally to tariff-related price increases (same SKU inflation expected around 4% in Q4 2025, increasing slightly into Q1 2026), consumer elasticity remains a factor. The recent Chapter 11 bankruptcy filing of a vendor, while leading to a $28 million non-cash charge, has been mitigated by Advance Auto Parts' diversified vendor base and alternative supply sources, with less than 2% of cost of goods sourced from this supplier. Legal proceedings, including class action lawsuits, also present ongoing, albeit currently dismissed, risks. ## Conclusion Advance Auto Parts is in the midst of a profound transformation, strategically shedding non-core assets and aggressively optimizing its operational footprint to refocus on its core automotive aftermarket business. The Q3 2025 results demonstrate tangible progress in this turnaround, with strong comparable sales growth and significant operating margin expansion, signaling that the foundational work is beginning to yield positive outcomes. The company's proactive strengthening of its balance sheet and liquidity, coupled with a clear technological roadmap leveraging AI for efficiency and customer service, positions it for sustained improvement. While the path to its 2027 adjusted operating margin target of 7% is acknowledged to be nonlinear, the consistent execution of strategic initiatives across merchandising, supply chain, and store operations, supported by a rational industry backdrop, provides a compelling investment thesis. Investors should monitor the company's ability to manage inflationary pressures, consumer spending shifts, and the continued realization of benefits from its technological and operational enhancements, all of which are critical to achieving its ambitious long-term financial objectives and solidifying its competitive standing.