Advance Auto Parts (NYSE:AAP) released second-quarter financial results and hosted an earnings call on Thursday. Read the complete transcript below.
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The full earnings call is available at https://events.q4inc.com/attendee/400875169
Summary
Advance Auto Parts reported a slight decline in comparable sales for Q2 2026, with the Pro channel showing low single-digit growth but DIY sales declining more than expected due to tighter household budgets.
The company achieved an adjusted operating margin of 5.6%, with significant margin expansion driven by strategic initiatives, despite facing headwinds from shifts in channel mix and increased commodity costs.
Advance Auto Parts reaffirmed its full-year guidance, expecting comparable sales growth in the 1% to 2% range and maintaining a focus on executing strategic priorities in merchandising, supply chain, and store operations.
The company completed a significant distribution center consolidation, reducing from nearly 40 to 15 DCs, and plans to accelerate Market Hub openings, aiming for 60 locations by mid-2027 to enhance same-day parts availability.
The company's adjusted gross profit margin expanded by 240 basis points, driven by tariff refunds and an improvement in product margin, despite challenges from higher freight and fuel costs.
Advance Auto Parts generated $120 million in free cash flow year-to-date, marking a return to positive cash flow after two years of outflows, and utilized $30 million to repurchase a portion of its outstanding debt.
Management remains confident in achieving a medium-term adjusted operating margin target of 7%, with plans for continued operational improvements and investments in strategic initiatives to drive long-term shareholder value.
Full Transcript
OPERATOR
Welcome to the Advance Auto Parts second quarter 2026 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, goals, 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 progress on our strategic priorities for 2026. Later, Ryan will discuss results for the second quarter and provide an update on the guidance for full year 2026.
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 O'Kelly, CEO
Thank you, Lavesh, and good morning, everyone. I would like to start by expressing my appreciation for our frontline team for their hard work and dedication to serving our customers. During the second quarter, the team navigated a volatile demand environment, which contributed to a slight decline in comparable sales. This included low single-digit sales growth in the Pro channel, which performed in line with our expectations. Within Pro, the Main Street business continued to outpace overall growth, supporting share gains in that segment.
In the DIY channel, sales declined more than we anticipated, particularly during the last four weeks, as tighter household budgets weighed on consumer spending during the quarter. Against this backdrop, the Advance team continued to prioritize actions across our strategic initiatives, which contributed to solid profitability in Q2. With an adjusted operating margin of 5.6%, excluding the benefit of IEEPA refunds received in the quarter, adjusted operating income margin expanded by nearly 130 basis points to 4.3%.
We maintain focus on executing actions within our control, which has translated to sequential improvement in core operational KPIs, including NPS, time to serve, and attachment rates. The second quarter marked an inflection point for Advance with the return to positive free cash flow, as we generated $120 million year-to-date compared to an outflow of cash during the last two years. During the quarter, we also repurchased approximately 30 million of outstanding debt, which, along with improved profitability, supported further deleveraging of the balance sheet while we continue to allocate more capital to investments to grow the business.
Based on our first-half performance and updated projections for the remainder of the year, we are reaffirming our full-year sales, operating margin, and free cash flow guidance. This includes comparable sales growth in the 1% to 2% range, which considers continued spending pressure in the DIY channel, offset by ongoing strength in the Pro channel, along with higher same-SKU inflation due to increased commodity costs. We are also implementing a focused action plan aimed at strengthening execution across our operational KPIs and driving higher customer engagement to deliver better transaction performance in the second half compared to trends during Q2. Our margin outlook balances the tailwind from recent tariff refunds with incremental headwinds stemming from shifts in channel mix and increased commodity costs. We will continue to prioritize efforts to make progress in our strategic objectives as we work to create long-term value for our shareholders. Let's turn to an update on our strategic priorities for 2026. Our strategy remains unchanged and is built on three pillars: merchandising, supply chain, and store operations, supported by targeted initiatives to drive sustainable, profitable growth over the long term.
We remain committed to executing actions under our 2026 strategic priorities as we make progress in our journey towards a medium-term 7% adjusted operating margin target. Let's begin with merchandising. We are focused on ensuring reliable product availability, which supports the efforts of our store team to enhance customer service and drive growth in unit sales per transaction. Our new assortment framework, launched last year, is helping us increase the breadth of parts we carry in each store and broaden availability across our network of DCs, hubs, and stores.
Halfway through this year, we have added approximately 80,000 new SKUs to our assortment catalog, building upon the 100,000 new SKUs we introduced last year. Through comprehensive category reviews, we are strengthening relationships with existing vendors and identifying opportunities to improve margins, while also partnering with new vendors to further expand our selection of parts. In the near term, our merchandising team is refining communication within the DIY channel to enhance brand awareness and deliver value-driven offerings aimed at increasing customer engagement.
We are collaborating with vendors on targeted media campaigns, leveraging Advance Rewards, providing store incentives, and optimizing online paid search to stimulate transaction growth and improve conversion in stores. Moving to an update regarding our pricing and promotions management initiatives, we are on schedule to complete the full deployment of a new pricing framework for both DIY and Pro segments by year-end. Our pricing philosophy remains unchanged.
We aim to offer everyday competitive prices and operate rationally in the market. The new framework is expected to enhance visibility of competitive pricing actions and enables the execution of precise, market-based pricing strategies. The early results from the Pro channel have shown an increase in team member and customer confidence, which we expect to support efforts to grow share among Main Street Pros. Alongside the implementation of more sophisticated pricing models, we are also improving discipline around the management of store-based promotional activities.
We expect to offer everyday competitive prices along with seasonally relevant promotions and plan to deploy marketing dollars on offers that yield an improvement in sales or profitability on a year-to-date basis. Our merchandising initiatives have contributed approximately 100 basis points to product margin expansion. We anticipate building upon this growth in the second half of the year to support our margin improvement goals for the year. Turning to supply chain, in the second quarter we completed our distribution center consolidation.
This initiative commenced more than two years ago when we operated nearly 40 DCs across the United States, utilizing multiple warehouse management systems. As of today, we operate 15 DCs supported by a unified warehouse system, marking a key milestone in our efforts to enhance asset productivity throughout our supply chain. Along with consolidating our DC network, we also launched Market Hubs that improve same-day parts availability for our customers.
Areas equipped with Market Hub locations consistently outperformed those without Market Hubs, which reaffirms the strategic value of these locations. Year-to-date, we have opened five Market Hubs, bringing the total to 38 locations. Our real estate team has done a great job in expanding our capabilities, and I am pleased to share that we are accelerating the pace of Market Hub openings for this year. We now plan to open 15 to 20 Market Hub locations this year and remain on track to achieve our goal of operating 60 locations by mid-2027.
Regarding DC productivity, our team is concentrating on key process improvements aimed at streamlining and standardizing operations within our distribution centers. We anticipate that these actions will yield greater operational efficiency and facilitate improved product flow into and out of the DCs. During the second quarter, we completed 25% of the identified process improvements and remain on track to systematically implement the remaining process changes by mid-2027.
These actions are aimed at increasing labor productivity within our DCs and provide visibility into cost reductions per unit shipped, which is expected to contribute to margin expansion starting next year. Our strategy is focused on minimizing redundant product handling, improving shipment accuracy, reducing inventory lead times, and transitioning to a more variable cost structure. For example, we have now standardized the DC receiving process across our facilities, eliminating a significant number of variations, which is expected to deliver better productivity through higher processing volumes per labor hour.
Another critical component of supply chain productivity is transportation optimization. We are currently rebidding all of our carrier contracts, and we expect to consolidate our volume with 70% fewer carriers. This initiative is expected to generate tens of millions of dollars in cost savings, which will support margin expansion in 2027. Collectively, the DC process changes and transportation initiatives are expected to enhance our ability to operate a more efficient and scalable supply chain.
Next, I will conclude with an update on our third strategic pillar, store operations. In our stores, we are holding teams accountable for service execution and measuring the effectiveness of our initiatives to clearly identified KPIs as we strive to increase labor utilization. The second quarter provided further evidence of progress on our store-based initiatives. NPS, or Net Promoter Scores, have improved to nearly 80 points from the high-60-point range in the same period last year, which suggests that our service enhancements are resonating with customers in store.
Attachment rates have improved to nearly 30% from the mid-high-20% range in the same period last year, which contributes to unit share gains, and average time to deliver Pro orders consistently tracked below 40 minutes during each week in Q2, which is improving reliability for our Pro customers. In addition to measuring progress through these KPIs, we are also identifying opportunities to better prioritize store tasks, investing in technology to drive operational efficiencies, and enhancing training content to further elevate customer service.
These actions will help us strengthen execution across our primary KPIs in the near term, while our store and merchandising teams partner to drive higher customer engagement and improve conversion in the second half of the year. During the second quarter, we also completed an independent evaluation of store task execution with the objective of updating our store labor standards that were previously unchanged for over a decade. This activity follows the rollout of our store operating model last year, which determined the allocation of resources such as trucks and drivers based on market demand factors.
The study examined time allocated to routine store responsibilities, including picking or stocking products, receiving shipments from distribution centers, and assisting customers with product installations such as batteries and wipers. We expect to use the findings to identify tasks that deliver the highest value to our customers and simultaneously highlight non–value-added activities that can be reduced to enhance productivity. The next phase of this initiative involves updating our labor allocation systems to align with the newly developed labor standards.
We anticipate beginning this implementation later this year, which will enable us to further improve NPS and drive productivity in the years to come. To conclude, I want to reiterate that our strategic plan is unchanged, our KPIs are improving, and we have returned to positive free cash flow. We are cognizant of the external macro pressures impacting consumer spending in the near term. We are implementing a focused action plan to support the business in the second half while we actively manage the execution of our strategic initiatives throughout the year.
I will now hand the call over to Ryan to discuss our Q2 financial performance.
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. For the second quarter we reported net sales of $2 billion with a slight decline in comparable sales. The Pro channel delivered low single digit growth which was in line with our expectations. The strength in Pro was more than offset by a decline in DIY sales in the low single digit range as constrained household budgets impacted spending during the quarter.
We also experienced milder summer weather in several of our markets which drove an underperformance in weather sensitive categories such as cooling and climate control and fluids and chemicals. In our view, the combination of a larger than anticipated deceleration in DIY spending with deferral in large ticket projects, a reduction in discretionary spending compared to last year and weather related drivers during Q2 accounted for approximately 100 to 150 basis points of comps headwind in the quarter.
Turning to the cadence of sales, during the first eight weeks of Q2 comparable sales grew by approximately 1% including a low single digit growth in Pro and flattish DIY sales in the final four weeks. Comp growth moderated in both channels as we cycled through difficult comparisons from last year. Also, this time frame coincided with price changes to reflect movements in commodity costs which further stretched consumer budgets. In this period the Pro channel delivered positive comparable sales growth but DIY volumes slowed further driving most of the shortfall in sales for the quarter.
For the quarter, average ticket was positive and included same SKU inflation of approximately 4%. The sequential step up in inflation from approximately 3% last quarter was driven by market related price adjustments and increases in commodity costs which impacted motor oil and other petroleum products. Our team remains committed to enhancing customer service and these efforts continue to support growth in units per transaction which grew on both a one and two year basis helping partially offset lower transaction volumes.
Diving deeper into category performance, within DIY, sales were stronger in maintenance and failure categories such as filters, motor oil and batteries, while hard parts categories lagged, likely indicating selective spending behavior and deferral of larger projects. On the other hand, in the Pro channel, our hard parts business, including brakes and undercar, continue to outperform, supported by an improvement in parts availability and consistency in delivery times.
We maintained our strategic focus on growing share across Main Street Pros, which represents the largest portion of our addressable market. The Pro team carried the momentum from Q1, with transaction performance for this segment outpacing the overall enterprise. The Main Street Pro comp exceeded our total Pro comp by more than 200 basis points, helping offset the headwind created by the optimization of national accounts. Moving to margins, adjusted gross profit was $924 million or 46.2% of net sales, resulting in approximately 240 basis points of gross margin expansion in Q2 compared to the same period last year.
Tariff refunds contributed $26 million in gross margin, accounting for 130 basis points of year over year change. The balance 110 basis points of margin expansion was primarily driven by an improvement in product margin and included two incremental cost drivers in the quarter. First, a channel mix shift due to the slowdown in DIY sales resulted in a headwind of approximately 20 basis points. Second, supply chain expenses, including higher freight and fuel costs, drove approximately 20 basis points of deleverage due to the lower than expected sales volume.
These headwinds were offset by approximately 40 basis points of tailwind from immaterial LIFO and warehousing expenses in the quarter compared to a headwind in the same period last year. Excluding the benefit of IEIPA refunds, we generated a gross margin of approximately 45% for the first half of 2026, highlighting the progress across our merchandising strategies. Shifting to expenses, adjusted SG&A was $812 million, or 40.6% of net sales, driving 15 basis points of leverage.
Compared to last year, expenses were down approximately 1% year over year, reflecting our focus on labor productivity through simplification of store tasks and management of resource allocation along with reinvestment of savings from indirect spend optimization. Adjusted operating income came in at $112 million, or 5.6% of net sales, resulting in approximately 260 basis points of year over year margin expansion. Adjusted diluted earnings per share was $1.03 compared to $0.69 during the second quarter last year.
We generated $120 million of free cash flow year to date, marking a significant improvement from an outflow of $201 million last year. The improvement in free cash flow was driven by improved profitability and working capital management, a reduction in cash expenses related to our store optimization activity last year and the receipt of tariff refunds. Our balance sheet continues to be in a solid position as we ended the quarter with a cash balance of approximately $3.1 billion.
During the quarter, we utilized approximately $30 million of cash to repurchase a portion of our 2028 senior notes and we ended the quarter with a net debt leverage of 2.1 times compared to 2.4 times last quarter, which is in line with our targeted range of 2.0 to 2.5 times. We remain committed to repaying debt at or before maturity. Turning to full year guidance, let's start with net sales. For the full year, net sales are projected at approximately $8.5 billion including comparable sales growth in the 1 to 2% range.
Based on product cost inflation experienced during Q2, we now expect full year same SKU inflation of approximately 3%, implying second half inflation of approximately 3% consistent with the first half of 2026. The step down in inflation compared to the second quarter reflects the comparison against last year's tariff driven price adjustments. Based on revised inflation expectations along with our focused action plan to increase customer engagement, our range of comparable sales growth guidance assumes a recovery in transaction volumes compared to the second quarter.
Regarding Q3, trends during the first four weeks of the quarter are tracking slightly ahead of trends in the final weeks of Q2 and have accelerated on a two year basis. As a reminder, these first four weeks of Q3 represent our most difficult comparisons to last year and our comparisons begin to ease significantly over the next eight weeks. Moving to margins, we have reaffirmed full year adjusted operating income margin guidance between 3.8 to 4.5%, resulting in 130 to 200 basis points of year over year margin expansion.
We expect full year gross margin to expand in the range of 110 to 150 basis points to approximately 45%. Most of this margin expansion is expected to be driven by the merchandising initiatives related to strategic vendor sourcing and optimization of pricing and promotions. We expect the benefits from these merchandising initiatives to be partially offset by investments in supply chain productivity. As I discussed earlier, we had some moving items within gross margin in Q2.
These items have also been factored into our full year guidance. During the second quarter we received substantially all the IEIPA refund claimed by us. These refunds equate to approximately 30 basis points of gross margin contribution for the full year. However, this benefit is being fully offset by the headwind from changes in sales mix compared to our prior forecast and the incremental impact of higher shipping, freight and fuel costs in the supply chain.
We will continue to work closely with our vendor partners to navigate the evolving geopolitical landscape and mitigate potential supply or cost pressure. Regarding SG&A, we expect reported full year expenses to be down year over year, contributing between 20 to 50 basis points of leverage. This is largely due to cycling of approximately $90 million in non-recurring expenses from 2025. Adjusting for these expenses, we expect SG&A to grow at a low single digit rate compared to last year.
We expect to deploy savings generated from better in-store task management, effective resource allocation and a reduction in indirect spending to fund general wage inflation, new store and market hub opening expenses and strategic labor investments in priority markets. As we move forward, we will continue to look for opportunities to streamline tasking operations in stores to dedicate more time to serving customers. Moving to other items and guidance, we have raised adjusted diluted EPS guidance to a range of $2.60 to $3.30.
The revised EPS outlook includes approximately $100 million of interest income which is an increase of $20 million compared to our previous expectations. Based on trends through Q2, we continue to plan for pre-tax interest expense of approximately $210 million for the full year. The recent debt repurchase does not have a material impact on guidance. The benefit of higher interest income is being partially offset by a slight increase in tax expectations for the year.
Shifting to cash flow, we continue to expect 2026 capital expenditures of approximately $300 million with spending allocated to new stores and greenfield market hub growth, store infrastructure upgrades and strategic investments. We have revised our store opening schedule for this year. Our revised guidance includes 30 to 35 new store openings this year with six stores opened in the first half of 2026. For market hubs, our guidance now assumes 15 to 20 new market hubs this year which exceeds our prior expectations.
We opened five market hubs in the first half of 2026 and currently plan to open nine market hubs during Q3. We are reaffirming our full year free cash flow guidance of approximately $100 million. Our guidance includes the flow through of tariff refunds received during the second quarter and timing for certain general operating expenses planned for the balance of the year. The change in free cash flow trend compared to our year to date trend of $120 million does not reflect any change in underlying operational progress of the business.
To conclude, I want to thank our frontline associates for the continued improvement in the quality of service provided to our customers. Their efforts are supporting improved conversion, NPS and attachment rates while our Pro team continues to drive share gains across the Main Street Pro. I will now hand the call back to Shane.
Shane O'Kelly, CEO
Thank you, Ryan. I'd like to close by thanking the Advance team for staying focused on elevating our customer experience and driving operational productivity, which we believe will position us well to create long-term value for our shareholders. Thank you, operator.
OPERATOR
We can now open the line for questions. Thank you. If you would like to ask a question, please press star one on your telephone keypad. If you'd like to withdraw your question, simply press star one again. We ask that you please limit yourself to one question and one follow-up. Your first question comes from the line of Steve Forbes from Guggenheim Securities. Your line is open.
Steve Forbes, Analyst at Guggenheim Securities
Good morning, Shane, Ryan. Shane, I wanted to maybe dig into customer segmentation and whether you're seeing transaction growth among your largest up and down the street customers and maybe any comments you can provide that help build conviction around sort of sustainable transaction comp growth into the out year here as you reap the benefits of the strategic priorities.
Shane O'Kelly, CEO
Yeah. Hey, good morning, Steve. Thank you for the question. And let me just begin by thanking our team. Important to recognize what they're doing each and every day. So, great question. Let's unpack Pro. Think about it in terms of Main Street and think about it in terms of national accounts. We are excited by what we're seeing with Main Street. The growth there is 200 basis points above what we're seeing in total Pro, and that's inclusive of transactions.
What we're doing with Main Street, we're getting real traction in businesses in the trenches. Think a local shop with somebody with two or three bays, and that's where both our connectivity, our reputation and really the quality of what our outside and inside sales team members can do is making a difference. Know that inside our Pro numbers we have national account headwinds and Ryan can unpack the numbers a little bit. But the way I think about it is we're starting to lap that.
And remember, this is us saying, hey, where do we want to be in the Pro segment? Where do we have a right to win? Where is our profitability more attractive? All of that points to Main Street. So national accounts waning, and we're starting to see that diminish over time. So given the success we've had with Main Street, given how we're situated to compete with Main Street, we feel good about that both in what you've seen here and what we think we can do for the future.
Ryan Grimsland, CFO
Yes, Steve, I'll add a couple of things. I'll hit on the Main Street and the national accounts. The national account pressure will be about half of what it was in the first half in the second half. So we are starting to lap. It will still be some pressure there, but it'll be about half of what we've seen in the first half of the year. So that'll help a little bit on the trends there. On the Main Street Pro, we're not just seeing accounts that we've had for a while continue to shop with us, buy more transactions.
We're seeing accounts on Main Street that hadn't shopped much with us before start to give us some of their business and that's a good sign that our assortment's getting there. The service level is improving. A couple things to note why we believe that we're making the right moves here. By the end of the year, 70% of our stores will have a market hub. We're bringing more parts closer to the customer and that allows us to reach other Main Street Pros and provide a better level of service to them.
So we're excited about the market hub acceleration we're able to do here. We still think by the middle of next year all stores will be in a market hub, but being able to accelerate a few more this year. By the way, we're going to open up 9 in Q3, so that acceleration is going to be impactful, bringing more parts closer to the customer. The other thing is our assortment work that we're doing, and we still have opportunity to improve that assortment for the Pro customer, make sure we’ve got the right coverage.
But the work we have done is starting to resonate. We're going to continue to do that. We see opportunity to continue to improve that coverage and be more relevant for our Pro customers.
Shane O'Kelly, CEO
Couple just last additions and then look forward to your follow up. If you look at how we’ve played in the Pro space over the years, we have a TechNet program which has been very successful, and included in that is a warranty program. So you say, Steve, you own a small shop somewhere and you fix their car and the customer drives three states away and needs to get that original work repaired. They could do that through an unrelated shop, through our warranty program and get that paid for.
We have programs like Moto Visuals, Moto Logic that help break down what's going on in vehicles, our credit programs, our tools and equipment programs, our ability to work with your account as you grow. And so there's a number of things that we do with Main Street that—I'm going to use the word—are specialized or even bespoke relative to what else is out there that helps our level of attractiveness and builds that partnership. Most recently, and this is just sort of coming out now, with Anthony Sarlanas and our Pro team is owning the mile, where he's using both our CRM software, the partnership between the outside sales team member, which is called a CAM, and our inside sales team member, which is CPP, to really focus on customers who are geographically proximate to our stores. Now on the plus side, our aggregate total time to serve is under 40 minutes and we think that's a key threshold. But now when you think about focusing on customers that are very close to the store—and I'm thinking one, two, three miles—we’ll be well under 40 minutes there. And that's a further point of differentiation.
So look for us to continue to do that. But net net, we feel good about what we can do with Main Street Pro.
Steve Forbes, Analyst at Guggenheim Securities
Appreciate that. And maybe just a quick follow up, given the commentary around hub growth. I know the transition here was the greenfield growth, I believe this year, over repurposed footage, right, of the distribution footprint. So can you talk about how those greenfield hubs are performing relative to the original cohort of hubs that were more repurposed footage and if that sort of performance is what supports the acceleration that you're referencing here into the back half?
Ryan Grimsland, CFO
Yeah, I'll jump in here, and Shane can add color. But the greenfield market hubs—the actual store, because there's a store within the market hub—they actually are performing a little bit better than the other ones. And I'll give you just the background on the other ones. The non‑greenfield were actually conversions of old Carquest DCs, smaller DCs that we converted. They weren't necessarily in prime retail locations, but they did service the market.
They do service the market for parts. So the hub runs help the market. The greenfield ones tend to be in a better retail location area where we can get more retail sales out of that hub as well. So from a volume standpoint, they tend to do a little bit better on the greenfield side than the conversions just because the nature of the retail business we generate from them, and also the conversions, those still supplied some parts of the market through what we call PDQ.
So there was still some service level. It wasn't as strong or as efficient as the market hubs are. So when we put a greenfield in place, that is a lot of parts going to that market that weren't there before. So they tend to perform a little bit better than the conversions.
Shane O'Kelly, CEO
But just to add that, the market hub paradigm for us is a key part of how we're going to grow, not just with Pro but with DIY. And so we're accelerating what we're doing there. And as Ryan touched on, we'll open nine in Q3. We're sitting at 38 currently. We want to be at 50 by the end of the year. As a reminder, think about these as having 70, 80,000 SKUs, sometimes a little bit more. Being able to get parts same day to a radius of stores, you know, 50 plus stores.
So that really changes our ability to compete for parts that people want that day. And so we're going to continue it, we're going to refine it and we'll talk more about what we'll do as we get to the 50 going forward.
Steve Forbes, Analyst at Guggenheim Securities
Thank you.
Shane O'Kelly, CEO
Thanks, Steve.
OPERATOR
Your next question comes from a line of Simeon Gutman from Morgan Stanley. Your line is open.
Simeon Gutman, Analyst at Morgan Stanley
Hey there. Good morning, guys. This may be a slight repeat from the prior question. I missed some of the prepared remarks, but thinking about the core driver of do‑it‑for‑me, you know, if there's temporal pressure in the back in the economy like gas prices, I would expect DIY to be more sensitive, not DIFM. So can you talk about the trajectory you're on with core DIFM improvements and how much of this quarter was more macro or could be strategy just taking some time to take hold?
Ryan Grimsland, CFO
Yeah, I'll talk about Q2 and then the Q3 trend. So in Q2, the deceleration we saw in our P7, the last period of the month, we were running about flattish on day and low single‑digit positive in Pro for the first eight weeks. We saw really DIY decelerate towards the end of the quarter. That was really the bulk of the lower performance of what we expected. DIFM, while slight deceleration, was still positive during that time period. I think it was more just a reflection of a little bit of macro pressure there.
But the Pro was still positive in the quarter and in the final four weeks, still positive. The momentum in Pro has continued into Q3. We like what we're seeing there. On the DIY side we've seen a little bit of acceleration from the trend we saw in Q2 and on a two‑year basis we've seen some good acceleration. More importantly, on the trends in Q3 we're seeing transaction growth improve. So the transactions have improved versus our Q2 trend where we exited Q2.
So some positive things there that give us confidence in our guide for the rest of the year.
Simeon Gutman, Analyst at Morgan Stanley
Okay, and then a quick follow up, and again I apologize if you said this already, but merchandising success or excellence—I forget the terminology—for some of the gross margin initiatives, I guess ex‑tariff. If I got this right, the margin may have come in a little bit, I guess worse than we expected. I don't know if that's right or wrong. Some of that I assume was deleverage of distribution expense, or was there any slowdown in just the merchandising success strategy during the quarter?
Ryan Grimsland, CFO
Actually good questions. The rate was impacted a little bit by mix here. So you get about 20 basis points of mix impact from DIY, the lower volumes than we anticipated, and then about 20 basis points of fuel surcharge, just things that were flowing through. So those are really the two that impacted us that drove it down. It still was like a 44.9, so close to the 45. Still able to manage close to the 45. The merchandising initiatives—still cost‑out really strong and provided great value for us.
I mean 110 basis points year over year if you back out the tariff impact on margins. So the real slight decrease versus our expectation in the quarter was driven by fuel supply chain expenses and the channel mix.
Simeon Gutman, Analyst at Morgan Stanley
Got it. Okay, thanks guys. Good luck.
Shane O'Kelly, CEO
Thanks, Simeon.
OPERATOR
Your next question comes from a line of Steven Zaccone from Citi. Your line is open.
Steven Zaccone, Analyst at Citi
Great. Good morning. Thanks very much for taking my question. I want to follow up on the second half here. So clearly the decision to reiterate the same‑store sales guidance, it does look like the second quarter still missed expectations. So maybe just help us understand some of the phenomenons that can help in the back half. The lost sales due to weather—do you expect them to come back? And then any help on the third quarter versus the fourth quarter, because it seems like you've got some work to do and the compares get a bit tougher in the second half of the year.
Shane O'Kelly, CEO
Hey Steven, it's Shane. I'll start and then Ryan can unpack it further. Just big picture, we cater to the lower and mid-tier consumers and you see this not just in our numbers, but I think you see it broadly in our market and others — that's been a very stressed consumer. And so from a macro perspective, they've struggled. They've struggled as fuel prices have risen and those budgets have continued to get tighter as they've gone through. And you saw that, by the way, in our Q2.
And if you look at the last four weeks of our Q2, we were probably a little slower pivoting to value, given that the consumer said, hey, this is what's really important to me. So as we look at Q3 and Q4, we're taking a series of actions to be more attractive and to maintain and improve conversion for those consumers as they come and visit us. So here's what's going on with that. So we've got our Advance Rewards program that's been recently launched.
We'll continue to reach out to that cohort of customers. We're doing work with paid search optimization to make sure both in terms of what keywords we're using, what geography of customers we're talking to and how we get them in there, we're going to continue to promote our Good Parts campaign. We're simplifying tasks inside of stores and communications so that when a customer does come in, that experience is as positive as it can be. And by the way, I've seen an uptick in feedback that I personally get from customers about what they're seeing in our stores.
We know that value plays are important. We've got Argos, which is our private brand of oil, and we're now expanding across a broader line of products that we think will be attractive. We also know that — and this is a good part of what we do from an assortment perspective — is good, better and best. And so in the past, when the consumer's healthier, they'll say, hey, tell me more about the better and the best. Now they want to learn a little bit more about tell me about the better or tell me about the good.
We've got those products in. So that speaks to what we're doing on conversion, that speaks on what we're doing with units per transaction. So we have a series of activities geared towards rekindling what's going on with the DIY customer to do as well as we can on the pro side. You heard some of that with how we respond to Steve's earlier comments. But we really like what we're doing with Main Street Pro. We're going to continue to push in there.
Ryan Grimsland, CFO
Yeah. And Steven, I'll just be a little specific around what's driving the back-half comp performance expectations. So all that that Shane talked about we think will help with the DIY, and we're actually seeing on a two-year basis that accelerated a little bit. And you mentioned difficult compares in the back half — the real difficult compare tends to ease as we go throughout the rest of the back half of the year. One thing also to note is we had about 50 basis points of impact last year in Q4 due to product transitions.
We won't be cycling that in Q4 this year. It was related to First Brands Group and other product transitions in our front room that had an impact last year. We won't have that this year. So that's kind of a tailwind to cycle over. But we're focused on Pro. Pro will continue to outperform. We're seeing those trends continue and that will be a driver. We still think there'll be DIY channel pressure — more than we originally thought. Even though trends have improved after the last four weeks of the quarter into Q3, we still are expecting that DIY will be pressured in the back half.
But to Shane's point, we think we have a really compelling value offering within our product set and our categories. We have good, better, best, and that Argos expansion into other categories couldn't come at a better time. I think for the consumer it's a good value offering across many different categories now. I think our efforts to increase customer engagement will be good. One other thing to note: in the back half we've got a 3% inflation expectation that's really due to kind of the commodity price — oil prices — that are going in.
That's about 100 basis points higher than we originally planned.
Steven Zaccone, Analyst at Citi
Okay, understood. I appreciate all that detail. My follow-up is the prior commentary: 7% operating target on a medium-term basis. I think next year, ’27, was expected to see at least 100 basis points of expansion. Do you still think that's a reasonable target in light of some of these weaker DIY trends and maybe cost inflation across the business?
Ryan Grimsland, CFO
Yeah, I mean we're still focused on 7% as a medium-term target. The 100 basis points next year — that's where we're at today. It's a little too premature to give specific guidance for next year. But I'll tell you what Ron's doing in supply chain, because the bulk of this year is supply chain planning, driving improvements, understanding the timing of benefits we'll get from supply chain, and also our store optimization work and what we're doing there.
And both Ron and Tony have been digging in. What Ron is doing — he's about 25% of the way through really looking at the productivity in different areas. Think of our receiving capabilities, our inbound, our outbound. And that team has been hard at work. It's giving us more confidence in the value unlock in supply chain. We're not ready to necessarily give what that guidance will be for next year — still working through the planning — but the work he's uncovered year to date is just continuing to confirm for us that there's opportunity there.
So we're still — 100 basis points for next year still makes sense for us — but we're not ready to give more specific guidance.
Shane O'Kelly, CEO
Yeah, and let me build. I think 7% is the right target. We're in a very complicated geopolitical situation that's impacting the consumer. And so the consumer is stressed. But think a little bit longer term. I don't think we're going to be permanently in this state of affairs. If you think longer term, the backdrop of the industry that we're in remains very attractive. So think about that in terms of number of vehicles on the road. Think about that in terms of how old they are.
Think about that in terms of what the penetration of electric vehicles has been or now a prevalence of a hybrid vehicle that has an engine. Think about that in terms of miles driven. Think about that in terms of cost of a new car — people, new cars are pushing $50,000. People are keeping their cars longer and want to fix them. Think about the total TAM. It's a $160 billion market, it's fragmented. So the idea that all of those backdrop fundamentals for the longer term — just think beyond the immediate pressing concerns of the consumer — those are all good things for us as we compete in the market.
And so that's why keeping that target the same is appropriate.
Steven Zaccone, Analyst at Citi
Understood.
OPERATOR
That's the block. Thank you. Your next question comes from the line of Brett Jordan from Jefferies. Your line is open.
Brett Jordan, Analyst at Jefferies
Hey, good morning, guys. How should we think about working capital — I guess, you know, accounts payable to inventory — and what your factoring costs are looking like now that your leverage ratios have come down a little bit?
Ryan Grimsland, CFO
Yeah, well, we got our coverage actually improved a little bit. I think we would expect that to continue to improve over the medium to long term. Here we are making some investments obviously in working capital related to our assortment work, but we're also finding productivity. So overall we'll see improvement in our working capital, we'll see improvement in our coverage. We have great conversations with vendors to work through that. But that's going to be over the medium term.
But we have seen improvement in our coverage ratio. Obviously the banks versus with our vendors — you know, they obviously provide rates to them; we don't get involved in that — but we know they've kind of stabilized for sure. Obviously the external rate so far has been under pressure as well, but it has stabilized since we put in the transaction last year. And so what I've heard anecdotally is just that the difference is starting to converge. But it's, I think, about where it's been for a while. It's stabilized in a really volatile rate environment, which is good for our vendors. They want stability. I think one of the key points that happened in Q2 was rating agencies — both Moody's and S&P — stabilized our outlook, which is just a demonstration of the improved balance sheet that we have. It's in a solid position. The free cash flow returning to positive free cash flow — that's the first time in two years this company has gone to positive free cash flow.
So I think from a balance sheet standpoint, improving; supply chain finance, very stable. The banks are supportive of the program. I think the transaction really helps bridge us to investment grade.
Brett Jordan, Analyst at Jefferies
Okay. And then on the commercial business ex the national account cutbacks, are you gaining share, do you think, or retaining share with the up-and-down-the-street business? I mean, sort of adjusting for same-SKU inflation and looking at that 200 basis point comp ahead of Pro — do you think that's a share gain indicator or just holding share?
Ryan Grimsland, CFO
I think it's a hold.
Shane O'Kelly, CEO
And then potentially in some markets a gain is how I think about it. A lot of noise going on as we transition the mix with the national accounts to the Main Street. But as I — personally, when I visit accounts — the consensus on improving time to serve, improving the assortment, thinking about what we're doing with TECHNET and other promotions I think gives us confidence about what we're doing going forward.
Ryan Grimsland, CFO
Yeah, the Main Street, Brett — larger addressable TAM. I mean, you know this, but we're really excited about larger transactions there for us. So the transactions are stronger for us in the Main Street. So, you know, I think maybe it's hold and gain in certain areas. We're excited about what we're doing on the Main Street Pro.
Brett Jordan, Analyst at Jefferies
Great, thank you.
OPERATOR
Your next question comes from the line of Max Reclinko from TD Cowen. Your line is open.
Max Reclinko, Analyst at TD Cowen
Great. Thanks a lot, guys. So first, can you just help bridge gross margin for both 3Q and 4Q — the key puts and takes that we should be considering — and then just any help triangulating to final outcomes compared to 2Q?
Ryan Grimsland, CFO
Yeah, absolutely. A couple things. Think about the back half of the year — we are expecting it does include headwinds from higher freight, fuel costs, some channel mix headwinds. So DIY coming down, you'll have a little bit of a mix pressure on DIY. We still expect elevated freight and fuel costs — that'll be in our margins. Looking at kind of Q2 as our guidepost — sorry, operating income: these cost items drove approximately 30 to 40 basis points of headwind.
One thing to keep in mind: we are cycling a 53rd week. So in Q4 operating margins, that's approximately 20 basis points of headwind in the Q4 operating margins. So even margin guide for the second half is 3% to 4%, with the high end consistent with last year excluding the 53rd week. The gross margin specifically — we're assuming a margin range of 44% to 45%, with Q3 higher than Q4 just due to seasonality in the mix that we sell. We don't expect any material tariff refunds inflows coming in the back half of the year.
So just a thought on that. On SG&A, if you're thinking about operating income and the flow-through there, we expect those dollars to be relatively flat to last year in Q3, including more store openings. The decline in Q4 year over year is really due to that extra week — so that extra week of SG&A. So in general, excluding that, a low single-digit increase.
UNKNOWN Analyst
Got it. That's helpful. And then so you guys repurchased a little bit of debt this quarter for the first time in a while. If you remain on track to hit your guide for this year, should we see further repurchases ahead and then will it be a similar magnitude or potentially, you know, step up? And then just bigger picture, can you update us on conversations with the rating agencies and any sort of goalposts that we should consider as you get back to investment grade?
Ryan Grimsland, CFO
Yeah, so a couple things on that. We're always going to be opportunistic with excess cash that we can't deploy or don't feel like we can deploy into the business. So the way our capital priorities go, we're going to deploy cash into the business to continue to drive this comeback, improve the business operations. When we have excess cash beyond that, if we find economic benefits to retiring debt before maturity, we'll deploy it towards that. We have no plans at this time, but we're always looking at the market.
So we'll look to do that at or before maturity is our plan. And if we have excess cash we're confident in, we'll do that. But again, I'm excited about the fact that this is the first time in a long time we've been able to use excess cash, and our cash balance continuing to be a positive for us. On the balance sheet, we've got 3.1 billion of cash. We are in an excess cash position relative to our obligations. So if we can deploy that to the business, we will.
If not, we'll continue to delever the balance sheet. As far as the rating agencies are concerned, we've had very constructive dialogue. We're excited about the stable outlook. Just a reminder, to get to investment grade with Moody's it's about three jumps, and S&P it's two jumps. So this is a journey that we're on. It's been positive conversations. I think the free cash flow returning to positive, free cash flow beginning to delever the balance sheet are all good indicators that I hope they will see as positives.
But we have dialogue with them regularly. We're working towards getting back to investment grade, but it is a little bit of a journey.
UNKNOWN Analyst
Got it. Thanks a lot, guys, and good luck in the second half.
OPERATOR
Your next question comes from the line of Kate McShane from Goldman Sachs. Your line is open.
Mark Tordon, Analyst at Goldman Sachs
Hey, good morning. This is Mark Tordon, I'm from Kate McShane. Thank you for taking our questions. As we think about your focus on Main Street customers, is there a way to quantify how much of that DIFM comp is coming right now from existing customers? How much is coming from new customers? And I guess if we think about the time it takes to win a new account, is there a lag, or what is the lag between opening a new market hub and maybe signing up a new pro account?
Shane O'Kelly, CEO
Yeah, good question. On the plus side, most customers know who we are, and we will commonly get some sort of business from them. Within the pro world, there's a hierarchy where you want to be first call. You want to be the guy that the customer says, hey, I'm ordering a lot of parts today and Advance is going to be the first call. And by the way, the questions that go around how you earn that is: do you have the part, yes or no? When can I get it?
Time to serve? And then sometimes, hey, what's my cost going to be? And so as we improve in each of those areas, our ability to get first-call customers or earn our way into first call improves. And we haven't sort of unpacked that number specifically, other than to say that we're very focused on it. And opening Market Hubs certainly helps. In my experience, when you go into somebody where you're not first call, it's not a question of, hey, I make one visit and then the customer says, great, you're here.
And so now I'm going to switch. So it usually takes a series of visits over a period of weeks where you have to both demonstrate the value proposition and earn that right. And usually it comes in the form of, okay, I'm going to give you guys this category, I'm going to give you this set of orders, and then how do you perform? And you earn your way in. It's a trust-based business. It's a relationship-based business. And if I go back to some of the things that we talked about before, whether it's our TechNet program or the quality of our CAMs, our outside sales team member, we've got the right constituent parts to go make that happen.
And now the Market Hubs become a further enabler of that. But it's not an immediate process. But we feel good in terms of where Main Street Pro sits today. We feel good in terms of how we're migrating through some of our national account business. And we feel good about where we're going forward with our Own the Mile program, our use of CRM, our value plays for our pro customers, the quality of our inside sales team and our stores, our CPPs, our reputation.
Advance has long been known for being in the pro universe.
Ryan Grimsland, CFO
And just to add the mix between new and existing, it's a mix of both. So we're seeing growth in both.
Mark Tordon, Analyst at Goldman Sachs
Perfect. And one follow-up if I could. You mentioned the same-SKU inflation you're seeing on motor oil and other lubricants. Can you just talk about how your Argos line is positioned relative to the competitors there?
Shane O'Kelly, CEO
Yeah. So we like the name, we like the people that we source the product from, we like the performance within the category. Argos is actually our highest unit selling motor oil. And by the way, we represent very high-quality, prominent brands, and by the way, proud to sell those as well. But as the consumer says value is really important to me, they know the quality we put into the product. But the idea that it comes with affordability, reliability, sustainability, it really resonates with them and resonates with our team.
And so it's an easy product for our store team members to sell.
OPERATOR
Your final question comes from the line of Michael Lasser from UBS. Your line is open.
Michael Lasser, Analyst at UBS
Good morning. Thank you so much for taking my question. It seems like your guidance is basically saying, hey, at the low end we could do a flat comp. And part of that is you're going to see more like-for-like inflation in the back half of the year. The comparisons get a little easier. But on the other hand, it does seem like the business is becoming more volatile. You had spoken about some volatility coming into the second quarter and some volatility coming out of the second quarter.
So how does that influence your perspective on the back half? Said another way, was there any thought to lowering the comp outlook for the back half just to be a little bit more conservative?
Ryan Grimsland, CFO
Yeah, appreciate it, Michael. Just talk a little bit about the trends. You know, when we entered into Q2, we did talk a little bit about the DIY slowdown, a little bit of pressure there, softness in DIY. But even then, the first eight weeks was kind of in line with our expectations. We were tracking around a 1 comp for the first eight weeks, and DIY was roughly flat, Pro positive low single digits. It was really the last four weeks, and I think in that last four weeks we had one, unique weather impact in our areas.
If you look at our store footprint, the average temperature was actually down year over year. That's one. I think that DIY really pivoted to value. And I just say, I don't want to belabor this, but I think we were slower to pivot our messaging to that. I think we've got a great value offering, and we've pivoted going forward to make sure that the customer sees that. But the last four weeks really wasn't an indicator of the health of the business.
I think that was when we see the trends coming in Q3, that those Q3 trends have accelerated, and more particularly in transactions. And from a two-year basis, we are in line with what the guide would imply, which is roughly a 3% two-year stack. And that's what we're expecting going forward. So we're not expecting a deviation from that kind of two-year trend and where we're tracking today to be within our guidance range.
Michael Lasser, Analyst at UBS
Thank you very much for that, Gene. Sorry, Ryan. Ryan, my follow-up question is on the path moving forward. You have articulated a lot of confidence that over time there are idiosyncratic drivers to improve Advance Auto Parts profitability, especially from all the actions that have already been made. So are you still of the view that next year there could be more margin expansion as the fruits of those initiatives take place? And if the overall environment for the aftermarket remains more challenging next year, to what degree does that potentially offset the idiosyncratic gains in profitability that you are expecting in 2027?
Thank you so much.
Ryan Grimsland, CFO
Yeah, I appreciate it, Michael. I'll just talk about, you know, we talked about at least 100 basis points next year, and we still have confidence in that. And a lot of the work that Ron's been doing, because this year's been about supply chain, stores, planning, getting under the hood, and he's making his way through supply chain, it's giving us more confidence in the unlock that supply chain will have going forward. We're not ready yet to give specifics on that; we'll update later in the year on that. But honestly, we're getting more confidence as Ron is working through that. And then Tony on the store side, we're seeing a shift in making sure that our labor hours are as productive as possible—serving our customers, less tasking, focus on the customer, driving productivity there. We're seeing that, and we're getting more confidence in the actions that we're going to be able to take there. So we're more confident.
I think at least 100 basis points is still a target that we have for next year. You talked about the current pressures, and it's really around DIY, maybe some freight pressures. On the DIY, if that persists, there might be a little bit of pressure. And we saw that in Q2. We had 20 basis points of mix pressure, but yet we still delivered our underlying margin growth of over 110 basis points if you exclude tariffs. The business is still driving operating income growth, gross margin growth, even despite some of those headwinds and those trends.
And we would expect that to continue. If that were to continue, we'd expect to be able to mitigate that next year.
Shane O'Kelly, CEO
Hey, Michael, it's Shane. Thanks for the questions. If I come back to the big picture—and you're on the big picture—good industry, by the way. If you look at how we're running the business, we're willing to make the tough calls. We're using KPIs to track how we're doing. We're being transparent about it. We're being disciplined in the execution. We're not happy with how Q2 came out. We're putting in a series of initiatives to help us as we think about what we can do with DIY and what we can sustain with Pro.
But even in the tough moments, you can point to and find evidence of improvements in areas that are critical for our continued advancement, improvement for our turnaround, for our comeback. And you can think about that in terms of NPS. We rolled that out and our initial numbers were rough, and we've talked about the journey from the 60s to the 80s. That's meaningful. That's a customer saying, hey, I had a better experience than what I had last time.
You think about things about attachment rate, and you look at our Market Hub openings, look at what we're doing with the assortment, look at the DC consolidation. We literally just finished the DC consolidation. So I don't want to say we're nascent in the journey because we've been at it for a minute, but we are making improvements and getting better every day in the things that we can control. And we're staying at it in terms of being rational actors and putting in plans to make that improvement continue in the future.
Michael Lasser, Analyst at UBS
Thank you very much and good luck.
Shane O'Kelly, CEO
Thanks, Michael. Appreciate it.
OPERATOR
And that concludes our question and answer session. I will now turn the call back over to Shane O'Kelly for some closing remarks.
Shane O'Kelly, CEO
Thanks, everybody, for joining the call. I want to thank the team members at Advance Auto Parts. It's their hard work that's making the progress in some of the KPIs that I mentioned. And it's their hard work that's helping us as we go through Q3. We look forward to talking to everybody at the end of the quarter and we appreciate you following the company. Take care. Thank you.
OPERATOR
This concludes today's conference call. Thank you for your participation. You may now disconnect.
Disclaimer: This transcript is provided for informational purposes only. While we strive for accuracy, there may be errors or omissions in this automated transcription. For official company statements and financial information, please refer to the company's SEC filings and official press releases. Corporate participants' and analysts' statements reflect their views as of the date of this call and are subject to change without notice.
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