Earnings Call Transcript - AAP Q3 2022

Elisabeth Eisleben, Senior Vice President, Communications and Investor Relations

Good morning, and thank you for joining us to discuss our Q3 results. I'm joined by Tom Greco, President and Chief Executive Officer; and Jeff Shepherd, Executive Vice President and Chief Financial Officer. Following their prepared remarks, we will turn our attention to answering your questions. Before we begin, please be advised that remarks today will contain forward-looking statements. All statements, other than statements of historical fact are forward-looking statements, including, but not limited to, statements regarding our initiatives, plans, projections and future performance. Actual results could differ materially from those projected or implied by the forward-looking statements. Additional information about factors that could cause actual results to differ can be found under the caption forward-looking statements and risk factors in our most recent annual report on Form 10-K and subsequent filings made with the commission. Now let me turn the call over to Tom Greco.

Tom Greco, President and Chief Executive Officer

Thanks, Elisabeth, and good morning, everyone. Before we begin, I'd like to thank our entire Advance team and Carquest independent partners for their dedication throughout Q3, in particular, our teams throughout the Southeast who are still working diligently to get their communities back to normal after the damage caused by recent hurricanes. Our team always rises to the occasion in situations like this, and I could not be prouder of how we've helped others in a time of great need. We simply could not do what we do without our team's unwavering focus on the customer. I'll begin my remarks today with an overview of our Q3 performance and how we're thinking about the balance of 2022. This includes the factors that led us to reiterate our full year guidance on net sales growth, comparable store sales and adjusted operating income margin while revising adjusted diluted earnings per share and free cash flow. Based on the updated full year guidance we provided in our press release last night, 2022 will be our second consecutive year of sales growth and adjusted operating margin expansion on the back of our strong performance in 2021. We believe we'll be one of very few retailers delivering back-to-back years of sales growth and adjusted operating income margin expansion. Secondly, I'll briefly discuss some of the actions we're taking in the fourth quarter. These actions reflect our analysis of year-to-date performance and were informed by our early thinking surrounding 2023. Finally, I'll conclude with a review of the progress we're making on primary strategic initiatives before turning the call over to Jeff. Starting with the third quarter. Net sales were up 0.8% and comparable store sales declined by 0.7%, in line with previous expectations. As we're expanding our footprint, new stores are providing incremental net sales growth. Increasing owned brand penetration is an important part of our margin expansion plans. However, owned brands have a lower price point, reducing net sales growth by 78 basis points and comp sales by 88 basis points in the quarter. In terms of category growth, batteries, fluids and chemicals as well as brakes were the top performers in Q3. Regional sales performance was led by the West, Mid-Atlantic and Florida. Both Pro and DIY omnichannel comp sales were in line with overall comp performance. Moving to profitability. We're pleased that we were able to deliver a 98 basis point increase in our adjusted gross profit margin rate in Q3. This was primarily driven by our focus on category management, which is our largest initiative to drive profitable growth. Strategic pricing initiatives and higher margin rates associated with owned brands were key enablers to adjusted gross profit margin expansion. In Q3, owned brands as a percent of total net sales were up nearly 230 basis points. SG&A costs were up 5.4% year-over-year, and given limited net sales growth, more than offset adjusted gross margin expansion in the quarter. Higher SG&A was primarily driven by inflationary costs. Overall, in Q3, adjusted operating income margin was 9.8%, which was down 68 basis points versus Q3 2021. As we lapped strong net income growth in Q3 2021, adjusted diluted earnings per share of $2.84 was down 11.5% versus the prior year quarter. Both GAAP and adjusted diluted earnings per share included a headwind of approximately $0.20 per share from foreign currency impacts in Q3. Importantly, we continued to invest in the business while maintaining our strong commitment to capital stewardship by returning approximately $860 million in cash to shareholders through share buybacks and dividends during the first three quarters of 2022. Turning to guidance. There are a couple of factors which led to our updates in the press release yesterday. First, we reiterated full year guidance on net sales growth, comparable store sales and adjusted operating income margin rate. We revised full year adjusted diluted earnings per share to reflect both the foreign currency headwind in Q3, along with the estimated impact in Q4. Our full year guidance reflects an expansion of adjusted operating income margin and a range on adjusted diluted earnings per share growth of 5% to 6%. This is on top of a 48% increase in 2021 versus 2020 on a comparative 52-week basis. Secondly, we revised our free cash flow outlook for the year to a minimum of $300 million due to updates in our working capital assumptions primarily related to inventory. Jeff will further outline the drivers of these changes to our free cash flow guidance later. While our full year 2022 guidance affirms that we believe we will expand margins, we're lagging the market in top line growth in 2022. We're not at all satisfied with this outcome as it's inconsistent with our target of growing at or above the market over the long term. As we develop plans for 2023 and beyond, we've done a deep dive on the competitive environment and the actions necessary to accelerate growth. From our analysis, two opportunities came to the forefront, particularly in the professional sales channel. First, we have opportunities on availability in certain categories, which require inventory investment to enable us to get more SKUs closer to the customer. Secondarily, while our research has consistently indicated that price is not the most important driver of choice for professional customers, we've tested and will make surgical pricing actions in certain categories to enable us to better address changes in competitive pricing dynamics. We believe of these two, the targeted inventory investment is by far the most important step needing to set us up for improved top line performance and share gains in 2023. As you know, 2023 will be the final year of a three-year strategic plan we outlined in April '21 that focused on growing at or above market, expanding margins and returning excess cash to shareholders. We established three-year performance ranges for several financial metrics and an overarching goal of delivering top quartile total shareholder return. We achieved that TSR goal for 2021 and continue to believe that we will achieve the majority of the three-year goals outlined. In terms of adjusted operating income margin rate, we've delivered significant margin expansion since the start of 2021. We're also executing strategic initiatives to enable further margin expansion. However, we now expect that reaching the targeted three-year range for margin by the end of 2023 will be very challenging. We're not satisfied that we've lagged industry growth in 2022, and we're taking actions to accelerate growth. If the current competitive environment in the professional sales channel extends into 2023, it will make achieving the targeted margin and earnings per share thresholds shared at the start of 2021 even more difficult. All that said, we remain optimistic about the fundamentals of our industry. We also believe we'll deliver against the majority of the three-year goals outlined in 2021. And importantly, we're building plans to accelerate growth in 2023. It's also critical to reinforce that margin expansion remains an integral part of our TSR strategy, and we believe that we still have significant opportunity to drive profitable growth over the long term. Shifting back to 2022 and specific to our Professional business in Q3. Strategic accounts in TechNet led our growth. As discussed in August, we are carefully monitoring how and where we're investing within Pro, which includes deploying resources to our fastest-growing and most profitable categories and customers. Overall, we remain highly focused on what customers value most: extensive parts availability, excellent customer service both online and in their shops as well as consistent and reliable delivery. As we strive to improve customer service and delivery reliability, we recognize our Professional customers' weekend car counts are growing as a percent of their overall business. During the quarter, we deployed new delivery software to leverage the gig economy as well as our extensive vehicle fleet. This enables us to improve delivery speed and consistency on the weekend when our Pro customers are relying on us while reducing fixed costs over time. As we build additional capabilities in our Advance and Carquest Professional B2B platforms, our online penetration has reached record levels. Strategic partnerships are also enabling us to drive our connected shop initiative, which enables customers to access tools and data resources, generate faster repair order approvals, deliver higher conversion rates and improve shop efficiency. With our connected shop, Advance Pro and Carquest Pro are directly integrated into Tekmetric, our exclusive partner and industry-leading shop management system. This powerful workflow combination allows our Pro shops to purchase parts and drop them directly into repair shop work orders quickly and easily. With the integration of our diagnostic and service information, MotoLogic, we have a powerful operating platform for our customers that helps drive shop efficiencies and increases work order conversion rates. For DIY omnichannel in Q3, our highly regarded owned brands are a differentiator for Advance. Specific to DieHard, we continue to build this brand and delivered another quarter of double-digit sales growth. This ongoing strength is due in part to the combination of strong consumer regard and our commitment to building brand equity with innovation. Our latest product innovation launched earlier this year is the exclusive first-to-market DieHard xEV battery, optimized for the growing number of hybrid and electric vehicles on the road. The combination of trust, reliability and innovation for DieHard sets us apart. In addition, the enhancement of Speed Perks through the launch of Gas Rewards has been a highlight for DIY this year and is helping drive increased loyalty. Year-to-date, Active Speed Perks members have increased to over 13 million. In Q3, Speed Perks as a percent of both sales and transactions significantly increased compared with the prior year quarter. In addition to the double-digit growth in new members, we're also delivering double-digit growth in graduations to our VIP and Elite tiers. Finally, we're making meaningful progress on expanding our footprint. Altogether, we opened 37 new locations this quarter, bringing our total to 115 new locations year-to-date. We expect that we will be within our guidance range of 125 to 150 new stores and branches for 2022. This will be the largest number of new locations we've opened in 8 years. I'll now shift to the progress we're making to capitalize on our margin expansion opportunity. We continue to execute our category management strategy, which includes having the right brands, quality products and the optimal mix of good, better and best options. In addition, growing owned brands and implementing strategic pricing actions to cover cost increases are key enablers of margin expansion. Our new strategic pricing capabilities also enable us to respond with targeted and precise actions. This means we can both eliminate unprofitable discounts to improve gross margin rate and, at the same time, make calculated investments elsewhere to drive sales. Within supply chain, we're ramping up the new San Bernardino DC to increase capacity to support our West Coast expansion. This DC will be a critical consolidation point for supplier shipments and enhance our e-commerce capabilities. Our new Toronto DC went live shipping in late October and is now fully operational. In this DC, we have both Worldpac and Carquest parts, which consolidates two buildings in Toronto and the surrounding Southern Ontario area to one large DC. We've also completed a major expansion of the DC in Thomson, Georgia, increasing the size by 40% and optimizing the building layout to significantly improve productivity. While these investments drive growth and productivity, we're also exiting four DCs as planned. In summary, while this was a difficult quarter for Advance, Comp sales and adjusted operating income margins were generally in line with our expectations. And based on our updated guidance, we'll deliver the second consecutive year of net sales growth and adjusted operating margin expansion. However, we're not satisfied with relative top line performance versus the industry this year and are taking measured deliberate actions to accelerate growth in 2023. It's important to reinforce that we still see significant opportunity to drive total shareholder return over the long term through sales growth, margin expansion and returning excess cash to shareholders. I'll now turn the call over to Jeff to review Q3 financials and updated outlook for the balance of the year.

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Thanks, Tom, and good morning. I would also like to start by thanking our team members for their hard work while navigating this challenging environment. In Q3, net sales of $2.6 billion increased 0.8% compared with Q3 2021, driven by strategic pricing and new store openings. Comparable store sales declined 0.7%. Adjusted gross profit margin expanded 98 basis points to 47.2%. In the quarter, same-SKU inflation was approximately 7.9%, and we expect this to continue through the balance of the year. Q3 adjusted SG&A of $989 million grew 5.4% and was 37.5% of net sales. This compares to $938 million or 35.8% of net sales in Q3 2021. The largest SG&A headwinds in the quarter were higher inflation in store payroll, medical and fuel; and this, coupled with softer top line performance resulted in deleverage. It's important to note that we did not see significant headwinds from our California expansion in Q3 and expect this will contribute to SG&A leverage in Q4. Our Q3 adjusted operating income was $258 million, a decrease of 5.8% compared with Q3 2021. Our Q3 adjusted OI margin rate was 9.8%, a decrease of 68 basis points compared with Q3 2021. Our adjusted diluted earnings per share of $2.84 decreased 11.5% compared with our Q3 2021. Our diluted EPS on both a GAAP and adjusted basis was negatively impacted by approximately $0.20 from foreign currency. Free cash flow year-to-date was $149 million compared with $734 million in the same period of 2021. As Tom mentioned, we are making strategic inventory investments to improve availability in the back half of 2022, which are important to accelerate growth in 2023. In addition, through process and technology improvements, we are now processing aged and disputed payables more efficiently. These changes to our working capital expectations have led to a reduction of our 2022 free cash flow guidance with inventory being the primary factor. In addition, we continue to invest in the business, and Q3 capital expenditures were $122 million, bringing year-to-date capital expenditures to $334 million. As stated in our press release, we're increasing expectations for CapEx this year which is primarily due to higher inflation impacting construction costs related to new store openings. While expectations for free cash flow have changed, our capital allocation priorities remain the same, and we are delivering on them. We continue to return cash to shareholders through a combination of share repurchases and our quarterly cash dividend. In Q3, we returned $75 million to shareholders through the repurchase of approximately 444,000 shares at an average price of $168.93 and approximately $91 million through our quarterly cash dividend. Our Board also recently approved our quarterly cash dividend of $1.50. Year-to-date, we've returned approximately $860 million to shareholders, in line with our capital allocation priorities. Moving to guidance. We anticipate slight gross margin deleverage in Q4, driven by higher product costs coming off the balance sheet as expected, which will be offset by significant SG&A leverage. This will enable full year adjusted operating income margin expansion between 20 basis points to 40 basis points as guided in August. We believe that we will be one of the few companies in all of retail to deliver adjusted operating income margin expansion in 2022. In summary, we're reiterating the following elements of our August guidance: net sales of $11 billion to $11.2 billion; comparable store sales of negative 1% to flat; adjusted operating income margin rate of 9.8% to 10%, income tax rate of 24% to 26%; and 125 to 150 new stores and branch openings. However, we're making the following updates to adjusted diluted earnings per share of $12.60 to $12.80, which is entirely attributable to the estimated full year impact of foreign currency: minimum CapEx of $350 million; minimum free cash flow of $300 million; and share repurchases of up to $600 million. With that, let's open the phone lines to questions.

Christian Carlino, Analyst

It's Christian Carlino on for Chris. Just trying to better understand the decision to build inventory. Are there particular regions or categories where you were previously starved? And how should we think about the margin implications putting those extra units to work?

Tom Greco, President and Chief Executive Officer

Well, first of all, our goal is to grow at or above the market and we didn't achieve that in Q3. So we did a pretty deep dive on the underperformance, and it was really concentrated in a couple of Professional categories. And the analysis that we did identified two primary drivers: first of all, getting more inventory closer to the customer was a key opportunity, and we also talked about relative price. But the much larger opportunity is inventory availability and getting parts closer to the customers. So the focus is really on a couple of areas. First of all, the categories that we transitioned over the last couple of years to owned brand. These are big categories. That's where a lot of the underperformance was in Professional. We're making sure that we've improved our on-hand position on those categories. We're still not exactly where we want them to be. We spend a lot of time with our suppliers and our team on this, and we're focused on making sure that we're in a really strong position on these categories we've transitioned. We benefited from the owned brand margin expansion. Now we need to get the top line going in some of those categories. We're also adding some depth to high-velocity SKUs and also some breadth to certain applications and getting them closer to the market. So we feel the inventory investment is really important for us to accelerate our growth, which is the #1 priority we have right now.

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Yes. So as it relates to our LIFO costs, you'll see it later on, but we had about $67 million of LIFO costs in the third quarter. We expect that to continue into the fourth quarter. Fourth quarter will largely look like it did last year. So that's going to put us on track to have capitalized costs in sort of the $275 million to $300 million range. Under the assumption that costs are going to come down over the back half of the year, we would largely recognize these over the first half of 2023. So that's the way we're looking at it right now. Obviously, it's a very dynamic situation, having a good understanding in terms of what these products or input costs are going to do and how they're going to shape up over the balance of '23.

Simeon Gutman, Analyst

I wanted to ask about pricing. You made the business healthier over the last few years because you've taken out these price match overrides. And I think it sounds like you've been more disciplined in general. So can you talk about pricing? Your peers have obviously engaged in some discounting. You haven't used that lever. And I know you're, I guess, attacking the problem with inventory. But curious how you think about price versus assortment or depth of inventory.

Tom Greco, President and Chief Executive Officer

Simeon, so our analysis suggests that the majority of the underperformance in Pro is driven by availability and inventory positioning. So you're right on interpreting that. Availability is the #1 driver of choice for the professional installers. And as we said many times, price is much lower down the list. So in general, we are continuing to execute our category management strategy and much of that remains the same. So we are going to remain very disciplined in how we price in the marketplace. We have so much more in terms of sophisticated tools to manage pricing than we did when all of us arrived here a few years ago. So I feel really good about where we're positioned there. The new capabilities allow us to price by region, by market, by channel, by store. So we're still focused on removing unprofitable discounts in really in all channels. So that doesn't change. I think what is new is we successfully tested some surgical pricing actions in some of the more challenged categories, and we're going to essentially continue to do that and expand that more broadly. Our goal overall is to price to cover cost increases. However, we're going to make some investments in key categories where we expect to drive incremental top-line growth.

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Yes. I mean, certainly, those costs are going to come off the balance sheet over the balance of next year. We think this is going to be a challenging headwind for us as we go into '23 and try to continue to grow our margins, both the product cost as well as the capitalized costs, whether it's freight costs being capitalized, whether it's supply chain costs being capitalized. That will land on the balance sheet with the inventory as we acquire it and will come off over the balance of next year. Again, we think most of this will roll off in the first half of the year. We will give an update on 2023 in terms of how we're thinking about our margins, but we know that this is going to be a significant headwind as we go into next year.

Mark Jordan, Analyst

Just wondering if you can talk about your category management initiative and specifically the removal of these unprofitable discounts. How far along you are moving those discounts? And how much of a headwind it might have been to comps in the quarter?

Tom Greco, President and Chief Executive Officer

Well, we're really pleased with the progress we've made on category management over the last couple of years. It's the single biggest driver of gross margin. It's been a huge contributor to the fact that right up until Q3, we had expanded margins overall for nine straight quarters. So the execution of that plan continues. There's a couple of elements. There's strategic sourcing. There's the owned brand penetration, which improved in the quarter. We were up a couple of hundred basis points in terms of our owned brand penetration. And then on the pricing front, as I mentioned on the previous question, we're being very surgical in how we act. So we're able to remove unprofitable discounts where it doesn't make sense, and we're able to invest where we need to in order to drive profitable top-line growth. So it's really leveraging all the tools that we put in place over the past couple of years. This was the single biggest driver of the margin expansion plan that we laid out over the last couple of years, and we're continuing to execute against it.

Elizabeth Suzuki, Analyst

Okay. We will move on to the next question that comes from the line of Steven Zaccone with Citigroup.

Steven Zaccone, Analyst

A question on the owned brand impact to same-store sales. How do you expect that to trend in the fourth quarter? And should that continue to be a drag into next year? At what point is that kind of in the baseline?

Tom Greco, President and Chief Executive Officer

Sure. Well, we've been expanding for several quarters now, as you know. We called out roughly 80 basis points of net sales and 90 of comp sales. And the big categories that are contributing are the ones that we've been transitioning, which is engine management and undercar. So we still have a ways to go yet in terms of reaching our goals there. So we would expect that to continue on. But it's a comp sales headwind, but it's a good thing in that we are driving significant improvement in gross margin. And that's the opportunity for us. I mean, margin expansion remains very, very important to us, and this is a key part of that. The good thing here is our customers love this product. I mean, we're building strong brands. DieHard is a terrific brand. It had another great quarter. We're the #1 most highly regarded battery in the country. We've extended that into other categories such as tools. And then the Carquest brand is very popular with professional installers. The quality that we put in place for our Carquest product is very much respected by our customers. We have much lower return rates. So it's a very positive story. And we'll take the comp sales on with obviously the margin expansion that we're getting from it. Certainly. Let me address the goals we discussed about 18 months ago, in April 2021. At that time, we set three main objectives to enhance total shareholder return: growth in comparable sales, margin expansion, and returning excess cash to shareholders. We also defined six financial metrics to support these objectives. In 2021, we performed exceptionally well with all six metrics and ranked in the top quartile for total shareholder return compared to the S&P. Up until now, we've enjoyed nine consecutive quarters of sales growth and margin improvement. However, as we entered 2022, changes in the macroeconomic and competitive landscape impacted our performance, particularly in the third quarter. While we anticipate margin expansion for the entire year and have already returned about $900 million in cash to shareholders, our sales for 2022 fell short of expectations. We are currently taking steps to rectify this underperformance. Looking ahead to 2023, we believe we can achieve the targets set for most metrics. However, the margin rate and earnings per share are heavily influenced by the competitive landscape we anticipate in 2023, which remains uncertain. Should the competitive environment in Professional resemble that of 2022, reaching even the lower end of our margin rate and earnings per share targets is unlikely. Beyond 2023, we are formulating a plan that encompasses all essential components of our current total shareholder return strategy, and we will continue to aim for top quartile growth in this area. There is still considerable potential for total shareholder return growth ahead, but we are being cautious regarding 2023 due to the current competitive conditions.

Atul Maheswari, Analyst

This is Atul Maheswari on for Michael Lasser. Advance has taken a lot of steps over the years to improve its business, yet it seems like the pace of market share losses are now accelerating. Why do you think that is the case? And are some of the factors that are causing the underperformance simply structural in nature and cannot be fixed?

Tom Greco, President and Chief Executive Officer

Well, as we said earlier, we've done a pretty deep dive on what drove the underperformance. We performed well right up until the third quarter in terms of our agenda. Our strategy is unique. Our goal is to drive total shareholder return through comp sales and margin expansion and returning excess cash to shareholders, which has worked well for us up until the third quarter. We're not happy that we didn't expand margins in the third quarter, but I am very pleased that the team has worked very hard at accelerating growth going forward. And that's where we're focused in 2023. The underperformance, we've identified a couple of key areas, and that is to get more targeted inventory investment closer to the customer and take some surgical pricing actions. And that will help us get our top line where it needs to be.

Atul Maheswari, Analyst

Got it. That's very helpful. And as a follow-up question, I had one on your inventory investments. So you're looking for inventory investments going forward. At the same time, the inventory growth has outpaced sales growth for a while now. So does that mean that there are certain categories where you have the inventory but simply not the right inventory? And if you could provide color on what categories those are?

Tom Greco, President and Chief Executive Officer

Sure. The focus is in a couple of areas, as I mentioned earlier. We want to make sure that we get these large categories that we've transitioned to owned brand over the past couple of years to an on-hand rate that we're comfortable with. And while we've improved over the last year, we're still not where we need to be in these big categories. So that's job one. We're also improving the depth of high-velocity SKUs and getting those closer to the customer; and then, in some cases, adding breadth that's closer to the customer. So it's really through our analysis of the Professional channel, how we're positioned in the market, what's our assortment rate, what's our close rate? We've done a very deep dive on where we are, and we're confident that the plans we're building are going to help us accelerate growth in 2023.

Zachary Fadem, Analyst

Can you walk through the mechanics around the FX hit in a little more detail? And considering this is primarily a domestic business in terms of your sales, maybe talk through transaction versus translation impact. And how should we think about the Q4 impact and anything lingering into 2023?

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Yes, sure. The impact is entirely related to transactions rather than translation, coming from two main sources. The first and more significant source is our Taiwanese purchasing entity located in Taiwan. This entity purchases inventory and facilitates its transportation to us for sale in the U.S. This situation creates one side of our exposure since there are no receivables to offset it. The Taiwanese dollar entity buys inventory in various currencies, including the U.S. dollar. The Taiwanese dollar has significantly weakened this quarter against the U.S. dollar, leading to this exposure, which we haven't encountered at this level before. While we have been aware of this exposure for some time, we haven't experienced such a dramatic change in the value of the Taiwanese dollar or the Canadian dollar. On the Canadian side, we also have a similar situation where our Canadian dollar functional entity buys certain inventory in U.S. dollars. The Canadian dollar has also weakened against the U.S. dollar. However, even though we have receivables in Canada, they are all in Canadian dollars, which means we lack a natural hedge. We do not engage in hedging at this organization because we have not found it necessary. Therefore, we did not expect this degree of fluctuation between the U.S. dollar and those two foreign currencies. This situation contributed to the $0.20 decrease in our EPS for the third quarter. For the fourth quarter, we estimate another $0.10 of EPS based on the midpoint of our August guidance and our current guidance.

Zachary Fadem, Analyst

Got it. That's helpful. And then with your Q4 operating margin outlook implying about 130 basis points of expansion, can you walk through the SG&A levers here in a little bit more detail that give you confidence in the sharp year-over-year improvement from here? And then how should we think about SG&A leverage as we move our way through 2023?

Jeff Shepherd, Executive Vice President and Chief Financial Officer

In the fourth quarter, several factors will significantly impact our performance. First, we are beginning to see the start-up costs related to our growth in California begin to stabilize. We opened 37 new stores in the third quarter and have a strong plan to continue opening stores in the fourth quarter, aiming for a total of 125 to 150 stores. This will help us improve the SG&A related to these new stores. Additionally, we are starting to see the effects of wage inflation from the previous year level out, which will also positively impact our year-over-year comparisons. These two factors will be the main contributors to our performance. However, it's important to note that the fourth quarter can be quite unpredictable, so we will be closely monitoring our expenses, particularly store labor and any discretionary spending that we don’t deem necessary as we approach the last 12 weeks of the year. This careful management will give us the confidence to leverage our SG&A in the fourth quarter. Looking ahead to 2023, we will provide more guidance as we develop our Annual Operating Plan in February, keeping in mind that we will be addressing several of these costs as we plan for the next year.

David Bellinger, Analyst

Just following up on that last one. So on the annual guidance, you lowered the EPS range about $0.30 at the midpoint. Based on your comments just now, so that the FX headwind was $0.20 in Q3, expected another $0.10 in Q4. So just absent the FX factor, is there anything else really changing in your fundamental view? Or should we just think about this guide down being all FX-driven and the underlying fundamentals Q3 to Q4 not really seeing any change?

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Look, the short answer is yes. I mean, it's entirely driven by the FX and that's the $0.30 that you've called out, $0.20 in Q3 and $0.10 in Q4. Everything else is in line with the expectations and the guide that we put out in August, which is why we haven't changed the rest of the P&L guide, if you will, for Q4.

Tom Greco, President and Chief Executive Officer

David, well, first of all, just to round out Q3, our strongest period of the quarter was the last period. So we saw improvement in the summer. We talked about making sure that we are removing these unprofitable discounts, that, that was going to have a bigger impact and would dissipate over time. So we expect that will happen. As we get into the fourth quarter, this is a highly volatile quarter. That's really the origin of the guide. This is a very resilient industry. You've heard that from us before. We expect that the category will continue to grow at the rates that it has been growing. It's been a robust year for the industry. We just need to be growing faster in Advance. That's why we're taking the actions that we're taking. So relative to what you're hearing about in total retail, we're not seeing that. I think that you'll continue to see strength in the automotive aftermarket. The DIY segment performed well at the end of the quarter for us. So we feel like the industry performance will continue to be strong, with the caveat that the fourth quarter is our smallest of the year and it has the most volatility.

Michael Montani, Analyst

It's Mike on for Greg Melich. Just wanted to ask if I could, first off, just for some additional color, if you could share it in terms of the comp trend for DIY versus Pro as well as ticket versus transaction count? And then I had a follow-up question.

Tom Greco, President and Chief Executive Officer

Sure. I'll start with the channels. We noted that DIY and Pro were performing similarly, indicating an acceleration in DIY for us this quarter. We're pleased with the progress in DIY, especially with our expansion in the West contributing positively. We're capturing significant market share in that region and will maintain our focus on DIY as it's a crucial aspect of our business. DieHard continues to perform well, so overall, we observed growth in DIY. However, we experienced a decline in Professional relative to the second quarter, which is why we're implementing specific inventory investments and precise pricing actions. To summarize, DIY has strengthened for us while Pro has weakened. Regarding ticket versus transaction, it remained consistent with the second quarter, where our tickets decreased for both Pro and DIY, although transactions are still rising in terms of average ticket. That’s the key takeaway.

Michael Montani, Analyst

Got you. And then just on the market share front, just wanted to hit on, number one, if you can give some updates to the progress that you've been seeing for the Pep Boys converted stores. And then number two was you had mentioned increasing inventory availability, so I was wondering if there was anything you could share in terms of industry benchmark fill rates versus yourselves to help us kind of gauge what kind of improvement we could anticipate from the additional coverage?

Tom Greco, President and Chief Executive Officer

Sure. A couple of things in your question there. So on the Pep Boys conversion, Jeff called out, this is going to be the largest number of new store opens Advance has had in many, many years. So we've got that grooved much more so. We've got a new Head of our Field Operations, Junior Word, he is a terrific leader. He started out in stores 20 years ago. He's done all the key jobs inside of Advance. He's distinguished himself. He's done this before. So we're very excited to have Junior take on the role of leading the field organization, including those stores that we're converting in the West. So each period, our market share grows. In those West stores, we still got lots of room for growth out there. So more to come there. Second question was, Mike, again, remind me? Yes. So what we've seen there, we really expected the on-hand rate, which is the ultimate measure, right, in the stores themselves. Do you have it when the customer calls to get better in those categories that we converted. And it just hasn't. So I mean, we obviously have targets for each category. We also have targets by velocity bands. So A SKUs, B SKUs, C SKUs, et cetera. So what I can tell you is we've worked very collaboratively with our suppliers on this topic. And they've been extremely helpful. We stood up a number of new suppliers, literally all over the globe to enable this expansion. And as we said earlier, we're very pleased with the margin expansion and the quality of the products. We're still not happy with where we are in terms of our on-hand rates. So all I can tell you is we're below where we need to be, and that is the focus is to get to better on-hand rates in these key categories. And as I said earlier, there are some other things we're doing with inventory as well. But the biggest one are to get our on-hand rate up in these converted categories owned brand.

Seth Basham, Analyst

Tom, maybe you could just provide a little bit more perspective on what changed in terms of the competitive environment to drive these inventory and price investment decisions here. Was there a significant change in the third quarter? And then relatedly, do you expect the competitive reaction to these moves?

Tom Greco, President and Chief Executive Officer

We are following our unique strategy, which differs from that of our competitors. The inventory investments across the industry and the well-publicized pricing changes have begun to affect us, prompting our response. Our primary focus is on targeted inventory investments, as we believe ensuring the right product is available in the right place at the right time is crucial. We expect these actions to significantly enhance our growth in 2023. Regarding pricing, thanks to our tools, we can respond in a precise manner. However, for our customers, availability is more critical than pricing. Therefore, we will approach pricing changes thoughtfully and with discipline. As for the competitive response, we await developments, but we are optimistic that our inventory investments will improve our performance in key categories that have hindered us this year.

Seth Basham, Analyst

Got it. And as a follow-up, can you talk about the investments in these key categories being ones that you had been focused on migrating more to private label. Does that mean that you need to be more aggressive in bringing national brand inventory back in these categories?

Tom Greco, President and Chief Executive Officer

Generally speaking, we are very pleased with where our assortment is in the categories. Where we're focused is getting the on-hand rates where they need to be. So it's not that we have a brand issue necessarily. It's really more about getting the right part in the right place at the right time.

Bret Jordan, Analyst

Do you have any data to support the commercial customers' enthusiasm for the private label products? I mean, maybe sort of a turnover in A SKUs, assuming that's a category you probably have in stock, the velocity of that product versus your prior strategy. Would you add a bit more national branded product in that mix?

Tom Greco, President and Chief Executive Officer

We have seen that when we have the products available, the close rates are very strong and the return rates are significantly lower. Our customers have responded positively to this, so it really comes down to having the right items in stock.

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Yes. Looking at the current situation, our analysis suggests that we need to make investments. We have already made some in the third quarter and will need to make additional ones in the fourth quarter. This is a dynamic process, and we will continue to evaluate it. Right now, our focus is on making investments in the latter half of the year to ensure that availability is as close to the customer as possible.

Tom Greco, President and Chief Executive Officer

I'll add one thing to that, Bret. Earlier in the year, we recognized that we were consolidating suppliers and reducing some redundancy in our SKU base. This led us to believe that inventory could decrease in the second half. However, based on our analysis, we need to refine and adjust that assumption.

Bret Jordan, Analyst

But Q4 will likely be the inventory growth period in which one we're not going to be growing too much, not going to be a use of cash in '23 as much.

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Well, yes. We're investing in the inventory here in the back half. Obviously, depending on the terms, you'll get some carryover into Q4, and we will take that into consideration as we're generating our free cash flow assumptions for next year.

Mitch Ingles, Analyst

This is Mitchell Ingles on for Bobby Griffin. I hope you're all well. So to start, could you give us an update on your Canadian operations? How do you see the Carquest and Worldpac Canadian operations fit into your long-term plans? With the recent ForEx impact, is this business overall dilutive today to your performance? And how should we think about ForEx exposure going into 2023?

Tom Greco, President and Chief Executive Officer

We see a lot of opportunity with our Canadian business. We made a big investment up there in the distribution center that is now carrying the Worldpac and Carquest parts. It is not dilutive to our overall business. It is a strong performing business. And we believe that we're going to be able to grow that business significantly as we've made a pretty big change up there in Ontario, which is the largest market. You mentioned the ForEx, I mean, obviously, it dropped down to a level that we haven't seen in a while. But over time, there's a lot of room for growth for us up in Canada, and we're going to continue to drive that growth. And we expect 2023 to be a very strong year up there. We've got the largest assortment of parts in Southern Ontario in that building. So a combination of OE parts from Worldpac, our owned brand portfolio of DieHard and Carquest, it's a great national brand. So optimistic about Canada for 2023.

Mitch Ingles, Analyst

Got it. And then as a follow-up, as you now expand your store footprint again this year, the fastest growth in eight years, how should we think about the comp sales benefit as these new stores grow into your comp base? And should we expect similar opening cadence next year?

Jeff Shepherd, Executive Vice President and Chief Financial Officer

Yes. I mean, we're working through our store count for next year, but our plan is to expand our footprint. We think we have a number of opportunities both in terms of infill where we have a lot of density in areas where we have a lot of opportunity, namely out West. So we're going to work through that. In terms of comp, we absolutely expect that to give us a lift next year. It does take time. These stores generally reach their maturity over a 3- to 4-year time frame. So we expect that to be an ongoing benefit as we continue to open stores, it will continue to build onto our comp store base.

Chris Bottiglieri, Analyst

So first one is like just given the competitive dynamics in Pro and you’re unhappy as to market share dynamics, I wonder if you could consider the idea that focusing on margin expansion could be a distraction that is offsetting a lot of your hard work and significant accomplishments. Have you considered adjusting the TSR algorithm to focus on EBIT dollar growth rather than rate?

Tom Greco, President and Chief Executive Officer

Well, we've always had a balanced approach, Chris, to this topic. I mean there are three levers to our TSR equation: finishing in the top quartile in 2021 was driven by sales growth, margin expansion and returning excess cash. This year, we clearly have not performed at the sales level that we would have liked, particularly over the last two quarters. So as we look ahead, we're factoring that into the equation. But over time, we still have a very significant opportunity to expand margins. Margins remain very, very important. And we're not adjusting how we're looking at building long-term shareholder value, which remains significant for Advance. And that's a combination of driving sales growth, making sure that our margins continue to expand over time and returning excess cash. So the equation will remain the same, and we will continue to target top quartile TSR growth. Well, thanks for joining us today. As we've discussed, Q3 did not meet our expectations in terms of top line growth, and we're not satisfied with where we're positioned at the moment. However, we continue to believe we have significant opportunity to drive long-term TSR growth. As we build our plans for 2023, we're taking measured steps to accelerate growth while pursuing our margin expansion initiatives. We look forward to sharing our expectations for 2023 in February. In addition, we have a lot to be grateful for during this season of giving thanks, including celebrating Veterans Day last week. And I'd like to take a moment to recognize and thank all of the nation's military heroes for their service, including the thousands of Advance team members who currently or have previously served. We're grateful for your ongoing support, and I want to wish you and your families a happy Thanksgiving holiday. We look forward to sharing our 2022 results and 2023 guidance in February. Thank you.

Operator, Operator

Your first question is from Christopher Horvers with JPMorgan. This does conclude the Advanced Auto Parts third quarter conference call. We thank you for your participation. You may now disconnect.