Earnings Call
Advance Auto Parts Inc (AAP)
Earnings Call Transcript - AAP Q3 2025
Operator, Operator
Hello, and welcome, everyone, to the Advance Auto Parts Third Quarter 2025 Earnings Conference Call. I would now like to turn it over to Lavesh Hemnani, Vice President, Investor Relations.
Lavesh Hemnani, Vice President, Investor Relations
Good morning, and thank you for participating in today's call. I'm joined by Shane O’Kelly, President and Chief Executive Officer; and Ryan Grimsland, Executive Vice President and Chief Financial Officer. During today's call, we will be referencing slides, which have been posted to our Investor Relations website. Before we begin, please be advised that management's 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 initiatives, plans, projections, guidance and expectations for the future. Actual results could differ materially from those projected or implied by the forward-looking statements. Additional information can be found under forward-looking statements in our earnings release and risk factors in our most recent Form 10-K and subsequent filings made with the SEC. Shane will begin today's call with an update on the business and our strategic priorities. Later, Ryan will discuss results for the third quarter and provide an update on full year guidance. Following management's prepared remarks, we will open the line for questions. Now let me turn the call over to our CEO, Shane O'Kelly. Shane?
Shane O'Kelly, CEO
Thank you, Lavesh, and good morning, everyone. I want to take a moment to acknowledge and thank the team for their hard work and dedication. Their unwavering focus on delivering exceptional customer service and advancing our strategic priorities helped us achieve our strongest quarter in over 2 years. For the third quarter, we reported comparable sales growth of 3% with both Pro and DIY channels delivering growth. Adjusted operating margin expanded by 370 basis points year-over-year to 4.4%, demonstrating progress on the execution of our strategic plan. During the quarter, we also strengthened our balance sheet by proactively reorganizing our debt capital structure. We raised nearly $2 billion in cash, which provides enhanced liquidity for the business as well as a path to return to an investment-grade credit rating in the future. As anticipated, tariff-related price increases have accelerated in the auto aftermarket. And in our view, the industry has been responding rationally by adjusting prices in response to rising product costs. We saw some variability in performance as prices moved higher during the quarter, although on a 2-year basis, both transaction and unit trends were relatively stable. As we look to the balance of the year, we believe there is potential for temporary volatility in sales trends as consumers manage household budgets in an inflationary backdrop. Our teams are prepared to navigate in this dynamic environment and provide consistent high-quality service to our customers. The long-term fundamental drivers of the industry remain healthy. More than 90% of our sales are driven by maintenance and break/fix repair, which gives us confidence for the long term. Based on our performance to date and expectations for the remainder of Q4, we have updated our full year guidance. We have reaffirmed the midpoint of our prior comparable sales growth and adjusted operating margin guidance, which implies approximately 200 basis points of margin expansion for the year. I want to recognize the team for their tremendous effort in delivering operational stability and maintaining focus on our turnaround priorities. We still have considerable work ahead of us as the initiatives underlying our strategic pillars continue to build through 2026. We remain committed to the steady execution of our plan to expand margins and create long-term value for shareholders. The Advance team is prioritizing actions to successfully execute the basics of selling auto parts while strategically utilizing innovative technological assets to position the company for the future. Our technology team has designed a multi-year road map to support the effective execution of our plan. These include using generative AI content and deploying AI-based applications in routine processes and providing sharp analytical data for our teams to improve service levels. Some of the areas where we are leveraging these applications include processes within merchandising to power our SKU placement decisions and within our supply chain to determine optimal demand forecasting for millions of SKU combinations in our network. These are just a couple of examples, among other projects, where we believe we will collectively establish a foundation for stronger execution across fundamental retail operations. Next, let's turn to an update of our strategic plan. To recap, our turnaround goals are built on three pillars, each supported by targeted initiatives that we believe will position us to deliver profitable growth. I will share updates on the progress we have made within each pillar, and then Ryan will discuss our financial performance. Let's begin with merchandising. Throughout the year, we have taken deliberate and strategic actions to position Advance as a trusted long-term growth partner for our vendors. With a sense of urgency, we have streamlined legacy processes, reduced complexities in order management, restructured our distribution center footprint and prioritized operational excellence to enhance the overall vendor experience. Our vendor community is reacting positively to the bold decisive actions we've made such as exiting underperforming markets and investing in new stores and market hubs. They are actively engaged in strategic business planning, exploring supply consolidation opportunities and collaborating on joint marketing efforts to support our transformation. This alignment has already begun to deliver improved product margins, and we expect additional cost benefits in the future. I am proud of the team's progress, especially given the added complexities of navigating a new tariff environment. Another key priority for the company has been enhancing the availability of hard parts. We are pleased to report the successful completion of the rollout of our new assortment framework across our top 50 DMAs, which cover approximately 70% of our sales. We achieved this ahead of schedule by leveraging proprietary assortment planning tools that have significantly improved our ability to make data-driven decisions and quickly adapt SKU requirements to meet specific market needs. We expect this initiative to deliver incremental growth over and above the initial 50 basis point uplift as these markets mature over the next 12 to 18 months. Along with refreshing our store assortment, we have also improved DC stocking programs to drive greater effectiveness in store replenishment processes for each market. These activities have enabled us to achieve our store availability target and ensure improved depth of hard parts in stores and distribution centers. With this major milestone accomplished, we are now focused on improving the speed at which we bring new parts to market to expand our breadth of coverage. We have already introduced tens of thousands of new SKUs into our network this year, and our work has uncovered additional opportunities to enhance our responsiveness to market demand signals. Increasing the breadth of hard parts coverage will enable us to further improve service levels for our Pro customers. Moving to pricing and promotion management. As a company, our goal is to offer competitive pricing supplemented with seasonally relevant promotions to engage customers and drive repeat purchases. We are in the initial stages of testing a new AI-powered pricing matrix to inform pricing decisions for SKUs within the DIY and Pro channels. Separately, we have also built guidelines for field discounting programs to take advantage of select market growth opportunities. In this regard, we are adopting a fundamental retail approach by installing a centralized price management system for segmenting categories, markets, SKUs and customer channels. Consistent with prior expectations, we expect this initiative to deliver a larger benefit in 2026 and beyond. Turning to supply chain. Our U.S. distribution center consolidation plan is progressing on schedule, and we expect to end the year with 16 DCs in the U.S., which is a significant reduction from 38 DCs just 2 years ago. We will enter the next phase of consolidation in 2026. And as part of our planning process, we are evaluating our operational capabilities across the network. DC productivity measured through product lines per hour has improved in the mid-single-digit percentage range compared to last year, and our team is putting incremental focus on execution of key functions in our DCs. These include product picking, packing and routing to drive additional productivity. We believe our current DC network is well positioned to support strong service levels and the continued growth of our multi-echelon network. A key element of this growth is opening new market hubs. Approximately 75% of our stores are in markets where we have the #1 or #2 position based on store density. Our team has made great strides in accelerating market hub openings, which is enabling us to capitalize in markets of strength. During Q3, we opened 6 locations and concluded the quarter with 28 market hubs. We now expect to open a total of 14 market hubs this year, including 10 conversions and 4 greenfield locations. With these openings, we expect to end the year with 33 locations. A market hub typically carries between 75,000 to 85,000 SKUs, expanding same-day parts availability for a service area of about 60 to 90 stores. Thus far in Q4, we have opened 1 greenfield location in the Atlanta area. Built from the ground up, this facility is poised to serve as a model for future hub development. We are particularly enthusiastic about the opportunities presented by greenfield openings as these facilities enable us to establish new points of distribution within designated market areas. This strategic expansion not only enhances our ability to provide additional hard parts coverage in previously underserved regions, but it also creates incremental opportunities to gain market share. We will continue to open new market hubs in 2026 and stay on the path to opening 60 market hubs by mid-2027. Moving to store operations. As we've previously communicated throughout the year, we have been testing a refreshed store operating model designed to enhance productivity and ensure the delivery of consistent high-quality service to our customers. I would like to thank our frontline team for their collaboration and adaptability during the testing phase as we work to identify a more effective path forward. We are now prepared to launch this model in Q4 as part of the first phase of the rollout with full implementation anticipated during the first half of 2026. This updated operating model enables us to improve driver and store team labor hours along with vehicle allocations, aligning them more effectively with demand patterns to better serve our customers. We expect this model to provide three key benefits. First, it will enable us to instill greater confidence in our Pro customers while strengthening our reputation as a trusted and reliable parts provider in the aftermarket. Second, it strengthens the collaboration between our customer-facing outside sales team and our internal store teams who play a critical role in efficiently procuring and delivering parts. And third, from an economic standpoint, this model should support greater transaction velocity, improve labor utilization and enable us to compete more effectively. The introduction of this new operating model, combined with the expansion of new store locations and our delivery commitment of 30 to 40 minutes naturally positions us to accelerate growth in each Pro account. Our team is putting added emphasis on strengthening relationships with Main Street and regional accounts. The Main Street customer group represents our single largest opportunity for higher-margin market share in the Pro channel. To further boost our sales within this cohort, we are providing our account managers with enhanced visibility on customer data and additional training resources to increase our transaction volumes. For our national accounts, we are actively collaborating with them to optimize parts availability in specific categories by market, which will enable us to improve service levels. Shifting to DIY. As we refocus on the core fundamentals of selling auto parts and work to execute each initiative, we have asked our store team members to embrace significant changes. The fact that our team members are committed to supporting our customers and the sequential improvement in DIY transactions on both a 1-year and 2-year basis is a testament to their customer-focused mindset. As a management team, we have launched a renewed effort to simplify store tasks and streamline communication to the stores to improve the experience for our team. This initiative is being managed through a centralized execution team, which oversees weekly communications and provides organizational visibility into the tasks being assigned to the stores. By prioritizing only the most critical activities, we expect to drive further operational efficiency. We believe this new level of operational discipline will create additional capacity within our stores, allowing teams to dedicate more time to training and customer service. Separately, to monitor the performance in our stores, we have also launched a new Net Promoter Score, or NPS metric that is collected through customer transactions. In addition to providing visibility into the impact of strategic actions being executed by the stores, the data is used by store and district managers to drive targeted service improvements. We expect to focus on operational discipline, along with our ongoing effort to upgrade store infrastructure to enhance the overall experience for team members and for our customers. We continue to upgrade HVAC systems, roofing, parking lots and signage in our stores as part of a multi-year asset management plan. Year-to-date, we have invested about $50 million in store upgrades, which is more than double the total CapEx allocated to these projects last year. To date, we have updated more than 1,400 stores compared to 440 stores upgraded in all of 2024. In addition to these critical store upgrades, we are also building a pipeline of new store openings for the future and continue to target at least 100 new store openings over the next 2 years. To wrap up my section, I want to once again recognize the team for their hard work and for the progress achieved thus far. We remain focused on prioritizing actions to deliver sustained improvement in our turnaround. I'll now hand the call over to Ryan to discuss our financials. Ryan?
Ryan Grimsland, CFO
Thank you, Shane, and good morning, everyone. I want to begin by thanking our frontline associates for their commitment to serving our customers and delivering strong Q3 results. For the third quarter, net sales from continuing operations were $2 billion, which declined 5% compared to last year. This decline was mainly attributable to the store optimization activity that was completed during Q1. Comparable sales grew 3% during the quarter with positive weekly performance throughout the quarter. Sales trends were strongest during the first 4 weeks, followed by a moderation during the last 8 weeks. From a category perspective, brakes, undercar components and engine management led performance. We have made significant progress in improving our coverage and availability of hard parts, which is helping us deliver better service to customers. For the quarter, ticket was positive and largely driven by tariff-related price adjustments that expanded throughout the quarter. Our industry has been reacting rationally to rising product costs, and we have been adjusting prices in response to market dynamics. In aggregate, same SKU inflation was about 3% in Q3 compared to about 2% last quarter. Transactions were down but improved sequentially as we cycled through discrete events from last year. On a 2-year basis, transactions and unit productivity were relatively stable to last quarter, reflecting the team's continued focus on delivering consistent high-quality service. Now let's look at channel performance. Pro comps grew by just over 4% as we cycled through the softness from last year. On a 2-year basis, the Pro channel recorded its fifth consecutive quarter of positive performance and relatively consistent 2-year trends in each month. Our DIY channel delivered positive low single-digit comps in the quarter and improved sequentially on a 2-year basis. Moving to margins. Adjusted gross profit from continuing operations was $913 million or 44.8% of net sales, resulting in gross margin expansion of about 260 basis points compared to last year. The year-over-year margin expansion was driven by savings associated with our footprint optimization activity completed in March and reduction in product costs driven by our strategic sourcing initiatives. I want to recognize the merchandising team for their solid execution this year. They have been able to secure competitive product costs while managing prices in a higher tariff environment to offset incremental cost pressures, which is yielding stronger merchandise margins. During the quarter, we cycled through approximately 70 basis points of atypical margin headwinds from last year. We also experienced a benefit of approximately 50 basis points related to capitalized inventory costs driven by our strategic decision to carry more inventory through the year. Regarding product costs, as previously anticipated, we expected LIFO expenses to move higher due to cost inflation. This resulted in total LIFO expenses of $33 million for Q3. Shifting to operating expenses. Adjusted SG&A from continuing operations was $823 million or 40.4% of net sales and was consistent with our expectations. The year-over-year reduction in SG&A expense is primarily related to operating fewer stores compared to last year. As a result, adjusted operating income from continuing operations was $90 million or 4.4% of net sales, resulting in about 370 basis points of year-over-year operating margin expansion, our strongest operating margin in over 2 years. Adjusted diluted earnings per share from continuing operations were $0.92 compared with a loss of $0.05 last year. Year-to-date, free cash flow is negative $277 million, largely driven by payments for inventory purchased in Q3 last year, which is in line with our typical cadence for managing payables. Also, during the quarter, we spent an additional $20 million on cash costs related to our store optimization activity for a total of approximately $130 million incurred through the year. Looking at year-to-date free cash flow more closely, we have only seen a modest change in operating cash flow between Q2 and Q3, which shows the stability of our operational execution, while we continue to allocate higher CapEx to strategic investments. Turning to an update on full year guidance. Starting with net sales. We expect net sales of $8.55 billion to $8.6 billion, including comparable sales growth between 0.7% to 1.3%. Q4 is typically our most volatile quarter of the year, and our guidance includes trends through the first 3 weeks, which have started off soft. While the Pro channel continues to track positive, the DIY channel is seeing pressure with more week-to-week variability in transactions. We believe this is being driven primarily by adjustments in consumer purchasing habits in response to rising prices. Same SKU inflation is expected to move higher compared to Q3, and we remain cautious in our planning assumptions based on recent trends. In addition, I want to highlight 2 sales-related items that are unique to Q4. First, last year in Q4, we generated $74 million in nonrecurring liquidation sales related to our store optimization activity. And second, we expect between $100 million to $120 million in sales from the 53rd week. As a reminder, neither of these items impact comparable sales growth. Moving to margins. We expect adjusted operating income margin between 2.4% to 2.6%, reaffirming the midpoint of our prior guidance range. Given the typical seasonality of the business through the end of the year, we expect Q4 gross margin to moderate compared to Q3. We are planning for Q4 gross margin slightly below 44%, which includes the benefit of higher capitalized inventory costs continuing through the end of the year as inventory levels are expected to be higher than previously planned. Strong coverage of parts across our network is critical for our long-term success, and we are working to ensure we provide our customers access to the right depth and breadth of parts. However, this inventory benefit is expected to be offset by higher than previously planned LIFO expenses, that is driving 80 to 100 basis points of added pressure. We currently estimate total fourth quarter LIFO expense of approximately $70 million based on cost trends through Q3. For SG&A, we expect Q4 expense dollars to decline in the high single-digit range compared to last year, which is in line with prior expectations. As a reminder, we are also lapping approximately 280 basis points of atypical margin headwinds, which will drive favorability in the year-over-year operating margin expansion. Moving to the other items in our guidance. We have updated our adjusted EPS guidance to a range of $1.75 and $1.85, which includes slightly higher interest income compared to prior expectations. For Q4, our interest expense is expected to move higher due to a full quarter impact of the debt refinancing transaction that was completed in Q3. For capital expenditures, we have revised our target to approximately $250 million for the year compared to the prior expectations of approximately $300 million. About half of the change is associated with the allocation of spend between PP&E and other assets on our balance sheet, which is a net neutral from a free cash flow perspective. The balance of the CapEx reduction is related to a shift in timing of projected spend from Q4 into next year as we continue to execute initiatives across our 3 strategic pillars. Regarding free cash flow, we have revised our expectations to a range of negative $90 million to $80 million for the year. As I indicated earlier, we expect to carry higher than previously planned inventory through the end of the year. This is being driven by our strategic decision to improve the depth and breadth of assortment across our network and to support new store growth. Despite the higher inventory, we expect positive working capital contribution in the fourth quarter, which is in line with our planning assumption at the start of the year. We continue to expect full year cash expenses of approximately $150 million related to our store optimization activity. Adjusting for this spend, our core free cash flow would have been positive for the year, which gives us confidence in our ability to deliver positive free cash flow in 2026 and beyond. In summary, we are pleased with our year-to-date financial performance and remain on track to end the year with solid margin expansion after 2 consecutive years of decline. We have enhanced our liquidity position to fuel our turnaround, and the team is doing a commendable job by staying nimble in a dynamic macro backdrop. Before moving to your questions, I want to address a recent industry concern stemming from the bankruptcy proceedings of a supplier. In our view, this is an isolated situation and not a broader concern regarding the health of the aftermarket industry. Over the last 12 to 18 months, our merchant team has worked to diversify our vendor base, including consolidation of product lines, and we currently source less than 2% of our cost of goods from this supplier. Given the risk associated with the bankruptcy proceedings, we have recorded a noncash charge of $28 million to cost of sales in the third quarter. This charge reflects an estimate for future credit losses on certain other receivables due from the supplier and is recorded in our GAAP income statement. It does not impact adjusted results and full year guidance. Following this charge, we have reserved against the risk associated with potential credit losses. We are maintaining a positive dialogue with the vendor and continue to work with them. We also source products from hundreds of other suppliers and maintain alternate sources of supply to minimize any disruption to our operations. Separately, we have also heard market concerns related to our supply chain finance program and the aftermath of financial issues related to the supplier. We do not believe these concerns are applicable to us. I want to emphasize, Advance's suppliers continue to receive early payments on their confirmed invoices through our network of large reputable banks. As a reminder, earlier this summer, we raised nearly $2 billion in cash to support the operations of our supply chain finance program and asset-backed lending facility. Following the execution of the facility, our vendor programs continue to operate smoothly. We have a strong balance sheet and more than ample liquidity with over $3 billion in cash and have access to $1 billion revolving credit facility that is currently undrawn. In closing, I want to recognize the team once again for delivering our strongest financial results in over 2 years. This quarter was also our third straight quarter of delivering results in line with expectations. As we look ahead to next year, we expect to build on our recent performance to drive further progress across the business. I will now hand the call back to Shane.
Shane O'Kelly, CEO
Thank you, Ryan. We believe we have the right strategy centered on core retail fundamentals, along with a talented team driving execution of our strategic initiatives. We appreciate your interest in Advance Auto Parts and look forward to reconnecting in the new year. Thank you. Operator, we can now open the line for questions.
Operator, Operator
Our first question today comes from Simeon Gutman from Morgan Stanley.
Simeon Gutman, Analyst
I want to ask first about elasticity of demand, the health of the consumer and then maybe even throwing something about weather. Can you put all together because it sounds like your quarter started off strong and then decelerated and now it sounds a little soft. And it makes sense given price has come up, not just in this category, but across the board. But how much also is weather a factor? And then can you talk about the things you're doing, the internal initiatives, how you can see and measure progress in those outside of these variables?
Shane O'Kelly, CEO
Thank you for the question, Simeon. I'll begin by addressing the consumer aspect, as it's crucial. Overall, we're monitoring the health of our low to mid-end consumers, which make up our customer base. There are indicators suggesting that these consumers may be reducing their overall spending on general merchandise. This is evident in areas like the subprime auto market, general consumer sentiment, discretionary spending patterns, and credit card usage, all of which influence their purchasing behavior. The positive aspect of our industry is that cars are essential for commuting and social activities, and much of what we offer is necessary maintenance and repairs. However, I believe consumers are adjusting their budgets due to inflationary pressures, and the rising costs of routine maintenance may lead them to reconsider how often they come to us. It’s a somewhat uncertain situation for them. Looking ahead, I'm optimistic about our industry's future and our strategic initiatives. Regarding the second part of your question, I'll pass it to Ryan to discuss specifics about our store initiatives aimed at enhancing the DIY environment. We realized we had overburdened our stores with too many tasks, which distracted staff from engaging with customers. I actually received a great note last night from a customer who mentioned how quickly they were greeted in our store. One of our team members took the time to assess their needs, spent another 20 minutes explaining their options, and ultimately helped them purchase a part. It’s essential for us to be there for our customers. By freeing up staff time, we aim to make each customer visit more likely to result in a sale. Ryan, would you like to elaborate on the specifics?
Ryan Grimsland, CFO
Yes. On the elasticity piece, it's still early for us to gauge exactly what the impact is on the consumer. But more broadly, we see the consumer impacted across retail. And more recently, we've heard from other retailers, how much of that is the government shutdown and that impact? How much of that is price inflation that you see in the industry. We're still trying to understand that. I think the industry is still trying to understand that, but we're watching it closely. The one thing you did ask was how do we measure our initiatives in the midst of this stuff going on around us. And the way we do that is we take a very measured approach to that by looking at test versus control. So when we go out and roll out whether that's the assortment work or looking at our market hubs, we look at how these perform versus like stores that performed similarly in the past. And we're able to gauge the success of those and the traction of that and get learnings from that before we roll out. So we do test and control here around our initiatives before we start rolling things out more broadly, and that helps us better understand whether it's working, what is working, what's not working as we roll those things out. So that helps a little bit because the pricing piece is more macro across our store fleet, and we're able to isolate the discrete initiatives that we're putting in place.
Simeon Gutman, Analyst
And my quick follow-up is on inventory. Shane, can you talk about where you are versus where you want to be? It sounds like you pivoted a little bit in '25. You bought more than I think you were expecting. You can clarify if that's the case. And why wouldn't that make sense to do in '26? I know you talked about driving free cash flow, but why wouldn't it make sense to invest more in inventory to drive the business?
Shane O'Kelly, CEO
Well, just as a reminder, we're doing our assortment rollout. So there's a lot of activities going on here. And we're pleased that we've got all 50 DMAs that we originally planned to do done. And if you think about that, there are hundreds of SKUs coming in and out of stores. And so we want to make sure that we've got the right amount of product going into those stores. Keep in mind also that in the tariff environment, we bought ahead. We wanted to make sure that we had the inventory we needed perfectly at the price pre-moves so that we could be in good position. So we're focusing on having the part for our customer, which means investing to get it in our system, both at the DC and the store level.
Ryan Grimsland, CFO
Yes. And I'll just add, we're really focused on the breadth. I think the depth is one that we've been really hitting on and getting the right depth. But now it's the number of SKUs and making sure that we've got the right assortment at the different levels within the supply chain echelon. So I think that inventory can come down and then some inventory investment will be needed, but that's more of a mix as we get the right depth and breadth for the consumer. So not a big investment needed going into next year. We've already made some pretty big investments. Now it's managing through that. We'll have some sell-through with that earlier buys that we made and the assortment work we've done, and that will afford us the ability to invest in the other areas of breadth that we need.
Christopher Horvers, Analyst
My first question is about inflation. Can you discuss what the inflation situation looked like in the quarter? Do you still expect to reach the higher end of the mid-single digits in the fourth quarter? There's a significant debate among investors regarding when the year-over-year inflation benefit will peak. One of your peers suggests it will happen in the fourth quarter, while another believes it won't occur until spring since inventory isn't turned every ten months. Can you clarify this for us?
Ryan Grimsland, CFO
Yes. Absolutely, Chris. Thanks, it's Ryan. On the inflationary front, we finished Q3 just under 3%, so close to 3%. Q4, we expect it to be around 4% but going into, say, Q1 of next year, we expect that to increase slightly, but not at the same rate of increase. And then by that point in time, I think we'll be getting more to a normalized state. Obviously, there's a lot that can play out. I mean we just had a China deal overnight that we still have to think through. So this thing is ever evolving. But for the most part, we are substantially done with the negotiations with our vendors around that, a few left. So substantially done. And as those have gone into the system, the prices are going into the system. So I would expect there's some balance between what our peers are saying and somewhere in between there is probably where we reached the peak. But obviously, it's an evolving landscape. But we're thinking 4% in Q4 and then a slight increase in Q1 of next year.
Christopher Horvers, Analyst
Got it. That is super helpful. And then as we think about the path to the 7% operating margin, can you help us maybe on the linearity of that? And as a part of the question, it's always hard to put a LIFO question into the call, but what is sort of the net LIFO headwind in '25 between LIFO and the capitalized inventory costs? And how do you think about the recapture of that next year and then more broadly that the linearity of the path to 7% by '27?
Shane O'Kelly, CEO
Yes. Just quickly, Chris, on the strategy, we think we've got the right strategy for the company. We've got the right focus areas. And our goal is unchanged for 2027. Having said that, there's a lot of space between now and then. And you use the word linear. I would say turnarounds are nonlinear in terms of how things go. There's puts and takes. Some initiatives go faster, some go slower, market receptivity. So we view '25 and '26 as building block years. And if you look at what's happened this year, I mean just think about it, 2 quarters ago, we were closing stores, exiting California. We were going through the Worldpac TSA transitions, doing our assortment. This year, we'll go from 28 to 16 DCs. I mean these are huge muscle mover activities and '26 will feature a lot of building block tough things that we're doing to continue forward. So we're really pleased with the progress, really pleased with the team, and we're focused on closing 2025 strong. But as we go forward, 2026 is a building block year, and I would emphasize the nonlinear nature of turnarounds. As for LIFO, I'm going to go over to Ryan for that.
Ryan Grimsland, CFO
Chris, yes, so just to give you net of the warehouse capitalization costs, obviously, that netted out some of it. LIFO was still a headwind. It's roughly 60 to 80 basis points. We expect it to be by the end of the year, 60 to 80 basis points of headwind in 2025. I hope that's helpful for you.
Bret Jordan, Analyst
One quick question on the working capital programs, it doesn't sound from channel checks like there's any contraction in availability. But have you seen any increase in risk spreads in the short term related to that particular supplier issue?
Ryan Grimsland, CFO
No. Actually, we haven't seen any change in the risk spreads there. Our supply chain finance program, if you're talking about the supply chain finance program rates they're getting, obviously, that's a decision between the banks and the vendor, but the work we did this summer created a lot of stability within that program, and it's been a very positive movement. We've had positive discussions with the banks around rates, not ready to provide any further information around that, but we haven't seen the spreads increase. We've had positive discussions around probably the other side of that. Given the stability of this program now with the structure that we put in place, we're supporting that program with the cash and assets on our balance sheet, which provides a risk or downward risk pressure for the banks for that program, kind of unique relative to the other programs in the industry right now as we're bridging ourselves back to investment grade.
Shane O'Kelly, CEO
Just to add that we're really pleased with the supply chain financing we've set up through the capital raise and the cash support we provide for it. Regarding that vendor specifically, I see this as a unique situation. First, merchandising excellence is a key focus for us. Bruce Starnes and his team have implemented the PLR process with a strong emphasis on how we develop plans and partnerships with vendors. They engaged with this vendor well before the current circumstances and began moving certain product categories to other vendors as a result. The cost of goods sold exposure is relatively small, around 2% or a bit less. We’re still in active dialogue with them and will maintain the relationship, wishing them well. If they come through, we see the potential for continued relationships. Overall, across merchandising, our focus on alternative sources of supply is also a fundamental principle. For everything we purchase, we always consider where else we could buy it and apply that same thinking to this vendor.
Bret Jordan, Analyst
Great. And then a quick question on the Atlanta hub greenfield. Could you give us color sort of as to the performance of stores in that market? I mean, as you build the perfect hub, what's the outcome? And sort of what's the timing on developing further greenfield hubs like that one?
Shane O'Kelly, CEO
Yes, that's a great question. Our market hubs are operational, featuring a store integrated within. We have a range of 75,000 to 85,000 SKUs available. We anticipate that this will provide a 100 basis point increase for supported stores. The Market Hub itself also acts as a store due to the large inventory available on-site. We are pleased with our progress on the market hubs; originally, we set a goal of 29 for this year, but we have decided to increase that to 33 to continue our acceleration. We are transitioning from smaller DC conversions to establishing new greenfield market hubs, with 4 already in the works. This new approach allows us to strategically choose locations that best serve our stores, supported by our real estate team, ensuring a more efficient rollout. We project a network increase of 100 basis points and will keep you updated on any changes. Our aim is to reach 60 hubs by mid-2027, and we will continue to provide updates on that progress.
Steven Forbes, Analyst
Just a follow-up question on gross margin. I think it was Chris' question. I think if you back out the LIFO charge in the quarter, you guys are sort of exceeding that mid-40% range that underpins the long-term guide here. So curious just if there is a takeaway for us today on some of the structural gains that you're capturing on the back of your initiatives or if that sort of mid-40-ish level is still where you guys see the business trending to over the next couple of years here?
Ryan Grimsland, CFO
Yes, it's a good question. Yes, in Q3 tends to be a little bit better rate as well, just seasonality-wise. We'll see that come down a little bit in Q4. Our goals are still the same long term. We still like that spot long term, and we're making good progress. The merchant team has done an excellent job this year making progress towards that. We still are on a journey. '25 and '26 are build years as we're building against that. So I wouldn't say it's perfectly linear. You can see that in our Q4. We're going to have some LIFO expense that's going to have an impact on it. But net-net, we are happy with the progress we're making, still committed to that goal. We think that's a good strategic long-term play for us and where we want to be from a gross margin perspective.
Steven Forbes, Analyst
And then just another follow-up on really sort of the comp message this morning. So we think about like-for-like inflation, same SKU inflation going to 4%, maybe 4.5% in the first quarter of next year. The guidance for the fourth quarter, the implied comp guide is 1% to 3%. And so what is the sort of takeaway today around transactions? Are you guys seeing weakness in Pro transaction? Or is sort of the spread and moderation expected between same SKU inflation and the consolidated comp really just DIY related? Any sort of color on sort of comp complexion and message around that for the fourth quarter specifically?
Ryan Grimsland, CFO
Yes. In Q4, we anticipate a slowdown in both Pro and DIY segments, although the DIY side is showing a bit more impact. We mentioned earlier that there seems to be pressure on consumers, and we are trying to determine if this is a temporary situation. We're considering various factors, such as price sensitivity, which we've heard is a concern in the industry as well, especially regarding DIY. However, we are experiencing moderation in both segments as we enter Q4. It's also important to note that Q4 tends to be the most unpredictable quarter due to weather conditions that affect performance. This seasonal impact causes fluctuations, such as fewer oil changes during colder months. Therefore, we expect some volatility and have observed slight softness. While both segments are moderating, there's been more pressure on the DIY side this quarter. Nevertheless, all these scenarios remain within the guidance we've provided.
Michael Lasser, Analyst
To what extent did the decision to trade some margin for sales or vice versa impact the quarter, meaning you've foregone some lower-margin business that could have negatively impacted your sales but boosted your gross margin. If you could quantify any of those actions in the third quarter and to the degree to which it might impact your fourth quarter, that would be super helpful.
Ryan Grimsland, CFO
Yes, Mike, I appreciate the question. So what we're doing from just a pricing standpoint, I just want to talk about our strategy around pricing. We are going to remain a competitively priced business here. We're not trying to be low in the market. We're not trying to be higher in the market. So we're not trying to find ways to get margin out of that. So we're staying competitively priced. We like our pricing position. We think we are a fast follower in the market. So not trying to harvest margin not in an appropriate way. We're sticking to that strategy going forward. So we're not doing that. There are some areas of our business that we will look to make more profitable and look at certain accounts, et cetera, that we're working through. And I'll let Shane talk a little bit more about that. But we're going to stick to our strategy, which is we're going to be competitively priced in the market. We're a fast follower, and that's what we're continuing to do.
Shane O'Kelly, CEO
Michael, just touching on the Pro side, we think our biggest opportunity is with Main Street. So those are smaller accounts. Typically, the margin is a little bit higher. We certainly appreciate our national account and larger customers, and we're working closely with them, and we've got a series of initiatives. But we don't want that to come at the expense of seeing the small 2 or 3 bay garage at the end of Main Street. And so we're making sure that our outside sales team members aren't skipping by those accounts, and we're making sure that as we interact with them, they understand the breadth of capabilities that we offer to include things like our TechNet services. And so as we do that, we're gaining traction. So that's something we will look to do going forward and as a current emphasis as well.
Michael Lasser, Analyst
My follow-up question is, Shane, you consistently and repeatedly used the term nonlinear to describe the path forward for Advance Auto Parts. How should we interpret that from a numbers perspective? Does that mean there'll be some quarters maybe when it's hot on the East Coast and there's outperformance in those markets that Advance can rip off a 3 comp and report several hundred basis points of gross margin expansion and then vice versa. The next quarter, it might be flat to 1 and far less gross margin expansion. How would you characterize that nonlinearity that you would use to describe how the path forward might look over the next couple of years?
Shane O'Kelly, CEO
Yes, if you’re okay, I’ll discuss some tangible activities. For instance, when closing a distribution center, we calculate the expected value from combining it with another center. However, during this process, we anticipate the closure costs and may have to transfer several hundred replenishment stores from the old center to the new one, which incurs additional costs and complications in setting up the routing. There may also be specific products from the closing center that need to be sourced, creating variability in costs. We cannot simply divide a total cost by a number of months, as costs may arise all at once or at the end. The benefits may not materialize as quickly as expected, leading to unpredictable outcomes. This complexity is further amplified when we consider larger projects, such as significant software implementations that can take time to execute. While we believe we are making progress with our current strategy, the pace of benefits and costs can fluctuate, resulting in a nonlinear experience. Despite this unpredictability, our long-term view shows clear progress across our strategic areas. We are confident in our strategies and activities and are committed to moving forward, especially given a favorable industry landscape.
Ryan Grimsland, CFO
And Mike, I want to highlight some tangible initiatives that have taken place this year. We have accelerated our assortment work based on what we observed. This represents a significant acceleration. However, we chose to pause on the store operating model to conduct further testing and gain more insights, ensuring that when we roll it out, we have the correct model in place. This approach didn’t align perfectly with our initial plans, and our stores and teams faced productivity challenges that would have arisen had we implemented the model earlier. The process isn’t perfectly linear because we are testing as we go along, and while some initiatives will be delayed for valid reasons, others will progress more quickly when possible. This reflects some of the complexities we are discussing, which focus more on our initiatives and their rollout rather than external factors. To Shane's point, we are also considering when to advance the call list with the Pro.
Michael Baker, Analyst
Following up on Mike Lasser's question, you mentioned a couple of times that 2025 and 2026 are build years. What does "build years" mean? Does it imply that even though margins are already expanding, you are still making investments? Is the idea that the margin expansion will significantly increase in 2027? Is that the correct interpretation of the term "build year"?
Shane O'Kelly, CEO
Yes. So by build year, it means we're still doing large-scale activities to set the company up for success. So let's do an example. So Market Hubs we didn't have any. And so we'll end the year with 33, but that's half of what we envision having by mid-2027. So there's going to be a ton of activity in the real estate team around making that happen. So that's a good example. On our DC consolidation, we're continuing now as we move to the smaller network, how do we optimize that? How do we optimize our routing? How do we optimize our lines per hour? On our new store opening, we put out 30 NSOs, but we want to continue to amplify the number that we do for that. And so by the way, if you want to open a single store, you got to go prospect 10 sites. So there's huge activity going on in each of the pillars to get to more of what that run rate will be longer term, and that's really what creates that nonlinear dimension.
Ryan Grimsland, CFO
Yes, I believe the initiatives we've outlined, which consist of three pillars, are not just a one-time effort aimed at 2025 but are part of a three-year plan that remains unchanged. We will continue to execute this strategy. As we mentioned, we are rolling out a new operating model in our stores starting in Q4, which will extend into the next year. This involves placing our assets correctly, ensuring trucks are in the right locations, and adjusting hours to meet store demand. We are also developing various technology capabilities, including new pricing tools that will be introduced later this year and into next year. Additionally, we are collaborating with Palantir on certain AI initiatives. Since developing this technology takes time, we expect to see the results of our efforts emerge over the next two years, as we work to fully implement our strategy across these three pillars.
Michael Baker, Analyst
Okay. That makes sense. And if I could ask one more follow-up and maybe not a fair question for you guys. So if not, feel free to pass. But for whatever it's worth, the consensus estimates aren't even close to a 7% margin in 2027. In all your conversations with investors or analysts, what do you think people are missing relative to your plan?
Ryan Grimsland, CFO
I'll begin and then Shane can add. First, our strategy remains the same, and we are focused on it, though it's still early in the process. We are just two quarters past the closure of our stores, so we are in the early stages of this transition. There’s a need to demonstrate progress, which is why we are providing additional metrics and data as we move forward. Being two quarters post-store closures and considering the decisions we’ve made to speed up our assortment work and expand market hubs—where we're opening more this year—we're trying to offer evidence of our progress. We need to reflect this in our numbers, and while it feels early, you may want to ask others why they lack confidence in our goals. We believe this is a developing process.
Shane O'Kelly, CEO
Yes. I can't speak to any specific analyst's assessment. However, as leaders and as a company, we need to establish a track record and demonstrate our commitments. Initially, our focus is on auto parts since we are an auto parts retailer. We are working on a clear and understandable strategy both internally and for our customers. We are also taking decisive action as we move forward, making tough decisions based on what an auto parts retailer needs to be successful in various situations. Finally, we will be transparent about our progress. You all will need to assess how much you believe in our plans and view them in a long-term context. We will continue to operate with the mindset of putting customers first, ensuring everything supports our front-line staff. We will keep concentrating on auto parts with decisive actions and hope to provide clarity on our intentions as we move forward.
Operator, Operator
Thank you. That does conclude our Q&A session for today. So I'll hand back over to the CEO, Shane O'Kelly, for closing remarks.
Shane O'Kelly, CEO
We want to thank everybody. In particular, thank the men and women of Advance Auto Parts for what they're doing as we complete this turnaround journey, and we'll look forward to sharing additional updates on both the closeout of the year and what we see for 2026 in our end of year call in February. So we appreciate you joining us today. Thanks very much. Take care. Bye-bye.
Operator, Operator
Thank you. This does conclude today's call. Thank you for joining. You may now disconnect your lines.