ADVANCE AUTO PARTS INC (AAP) FY 2022 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion and analysis of financial condition and results of operations should be read in conjunction with our consolidated historical financial statements and the notes to those statements that appear elsewhere in this report. Our discussion contains forward-looking statements based upon current expectations that involve risks and uncertainties, such as our plans, objectives, expectations and intentions. Actual results and the timing of events could differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under the section titled “Part 1. Item 1A. Risk Factors” elsewhere in this report. The discussion of our financial condition and changes in our results of operations, liquidity and capital resources for the fiscal year ended January 1, 2022 (“2021”) compared with the fiscal year ended January 2, 2021 (“2020”) has been omitted from this Form 10-K, but are included in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Form 10-K for 2021, filed with the Securities and Exchange Commission (“SEC”) on February 15, 2022. Amounts are presented in thousands, except per share data, unless otherwise stated.

Management Overview

Net sales increased 1.4% during the fifty-two weeks ended December 31, 2022 (“2022”) compared with 2021, driven by improvements in strategic pricing and growth in both new store openings and sales to professional customers, partially offset by declines in DIY customer sales and units sold. Category growth was led by batteries, fluids and chemicals and motor oil.

We generated Diluted earnings per share (“Diluted EPS”) of $8.27 during 2022 compared with $9.55 in 2021. When adjusted for the following non-operational items, our Adjusted diluted earnings per share (“Adjusted EPS”) in 2022 was $13.04 compared with $12.02 in 2021:

Refer to “Reconciliation of Non-GAAP Financial Measures” for a definition and reconciliation of Adjusted EPS and other non-GAAP measures to the most directly comparable financial measures calculated and presented in accordance with U.S. GAAP.

A high-level summary of our financial results and other highlights from 2022 includes:

•Net sales during 2022 were $11.2 billion, an increase of 1.4% compared with 2021, driven by improvements in strategic pricing and growth in both new stores openings and sales to our professional customers, partially offset by declines in DIY customer sales and units sold.

•Gross profit margin for 2022 was 44.5% of Net sales, a decrease of 33 basis points compared with 2021. This decrease was primarily due to inflationary product costs, including the impact of LIFO related expenses, and unfavorable channel mix, primarily offset by improvements in strategic pricing and product mix.

•Operating income for 2022 was $714.2 million, a decrease of $124.6 million from 2021. As a percentage of Net sales, operating income was 6.4%, a decrease of 122 basis points compared with 2021. The increase in Selling, general and administrative (“SG&A”) costs was primarily driven by increases in labor-related inflation and transportation and fuel costs, partially offset by decreases in incentive compensation and COVID-19 related expenses.

•Cash flow from operations was $722.2 million during 2022, a decrease of 35.1% compared with 2021, primarily due to a decrease in Net income, as well as a decrease related to working capital primarily driven by an increase in cash used by Accrued Expenses and Inventories, partially offset by an increase in cash provided by Receivables, net.

Refer to “Results of Operations” and “Liquidity and Capital Resources” for further details on our results.

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Business and Risk Update

We continue to make progress on the various elements of our strategic business plan, which is focused on improving the customer experience and driving consistent execution for both professional and DIY customers. To achieve these improvements, we have undertaken planned strategic initiatives to help build a foundation for long-term success across the organization, which include:

•Continued refinement of a demand-based assortment, leveraging purchase and search history from our common catalog, versus our existing push-down supply approach.

•Advancement towards optimizing our footprint by market to drive share, repurpose our in-market store and asset base and streamline our distribution network.

•Continued evolution of our marketing campaigns, which focus on our customers and how we serve them every day with care and speed and innovate to meet their needs, inclusive of the iconic DieHard® brand.

•Progress in the implementation of a more efficient end-to-end supply chain to deliver our broad assortment of inventory.

•Actively pursuing new store openings in 2023, including through lease acquisition opportunities as available and appropriate, in existing markets and new markets.

•Continued negotiations with vendors on strategic sourcing and pricing to help mitigate inflationary pressures.

Industry Update

Operating within the automotive aftermarket industry, we are influenced by a number of general macroeconomic factors, many of which are similar to those affecting the overall retail industry. In addition to the “Business and Risk Update” section included within Management’s Discussion and Analysis of Financial Condition and Results of Operations, these factors include, but are not limited to:

•Inflationary pressures, including product costs, logistics and labor

•Global supply chain disruptions

•Fuel costs

•Unemployment rates

•Consumer confidence and purchasing power

•Competition

•Changes in new car sales

•Miles driven

•Vehicle manufacturer warranties

•Average age of vehicles in operation

•Economic and political uncertainty

•Deferral of elective automotive maintenance and improvements in new car quality

While these factors tend to fluctuate, we remain confident in the long-term growth prospects for the automotive parts industry.

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Results of Operations

The following table sets forth certain of our operating data expressed as a percentage of net sales for the periods indicated.

Note 1: Table amounts may not foot due to rounding.

Note 2: Fiscal years 2022 and 2021 included 52 weeks. Fiscal year 2020 included 53 weeks.

Net Sales

Net sales for 2022 were $11.2 billion, an increase of $156.7 million, or 1.4%, compared with 2021, and was primarily driven by an improvement in strategic pricing and growth in both new store openings and professional sales, partially offset by declines in DIY customer sales and units sold. Comparable store sales increased 0.3% led primarily by the professional business. Category growth was led by batteries, fluids and chemicals and motor oil.

We calculate comparable store sales based on the change in store or branch sales starting once a location has been open for 13 complete accounting periods (approximately one year) and by including e-commerce sales. Sales to independently owned Carquest stores are excluded from our comparable store sales. Acquired stores are included in our comparable store sales once the stores have completed 13 complete accounting periods following the acquisition date. We include sales from relocated stores in comparable store sales from the original date of opening. Comparable sales is intended only as supplemental information and is not a substitute for Net sales presented in accordance with accounting principles generally accepted in the United States of America (“GAAP”).

Gross Profit

Gross profit in 2022 was $5.0 billion, or 44.5% of Net sales, compared with $4.9 billion, or 44.8% of Net sales, in 2021, a decrease of 33 basis points. Gross profit as a percentage of Net sales was negatively impacted by inflationary product costs, including an increase in LIFO related expenses, of $189.5 million and unfavorable channel mix, primarily offset by improvements in strategic pricing and product mix.

Selling, General and Administrative Expenses

SG&A for 2022 was $4.2 billion, or 38.1% of Net sales, compared with $4.1 billion, or 37.2% of Net sales, for 2021, an increase of 89 basis points. This increase as a percentage of Net sales was primarily driven by increases in labor-related inflation and transportation and fuel costs partially offset by decreases in incentive compensation and COVID-19 related expenses.

Interest Expense

Interest expense for 2022 was $51.1 million, an increase of $13.3 million compared with 2021. This increase was primarily due to incremental borrowings on our unsecured revolving credit facility, partially offset by a 100-basis-point rate differential between our issued versus retired senior unsecured notes in 2022. Refer to Note 6. Long-term Debt and Fair Value of Financial Instruments of the Notes to the Consolidated Financial Statements included herein for further details.

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Loss on Early Redemptions of Senior Unsecured Notes

During the fifty-two weeks ended December 31, 2022, we incurred charges related to a make-whole provision and debt issuance costs of $7.0 million and $0.4 million related to the early redemption of our 4.50% senior unsecured notes due December 1, 2023 ("2023 Notes"). Refer to Note 6. Long-term Debt and Fair Value of Financial Instruments of the Notes to the Consolidated Financial Statements included herein for further details.

Provision for Income Taxes

Our Provision for income taxes for 2022 was $146.8 million compared with $189.8 million for 2021, a decrease of $43.0 million primarily due to a decrease in taxable income. Our effective tax rate was 22.6% for 2022 and 23.6% for 2021. In 2022, the rate decreased compared with prior year primarily due to a tax benefit resulting from the expiration of statute of limitations for certain tax years in multiple states as well as enhanced utilization of tax credits in the current year.

Reconciliation of Non-GAAP Financial Measures

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” includes certain financial measures not derived in accordance with GAAP. Non-GAAP financial measures, including Adjusted net income and Adjusted EPS, should not be used as a substitute for GAAP financial measures, or considered in isolation, for the purpose of analyzing our operating performance, financial position or cash flows. We have presented these non-GAAP financial measures as we believe that the presentation of our financial results that exclude: (1) LIFO impacts; (2) transformation expenses under our strategic business plan; (3) non-cash amortization related to the acquired GPI intangible assets; and (4) other nonrecurring adjustments, are useful and indicative of our base operations because the expenses vary from period to period in terms of size, nature and significance and/or relate to store closure and consolidation activity in excess of historical levels. These measures assist in comparing our current operating results with past periods and with the operational performance of other companies in our industry. The disclosure of these measures allows investors to evaluate our performance using the same measures management uses in developing internal budgets and forecasts and in evaluating management’s compensation. Included below is a description of the expenses we have determined are not normal, recurring cash operating expenses necessary to operate our business and the rationale for why providing these measures is useful to investors as a supplement to the GAAP measures.

LIFO Impacts — Beginning the first quarter of 2021, to assist in comparing our current operating results with the operational performance of other companies in our industry, the impact of LIFO on our results of operations is a reconciling item to arrive at non-GAAP financial measures.

Transformation Expenses — Costs incurred in connection with our business plan that focuses on specific transformative activities that relate to the integration and streamlining of our operating structure across the enterprise, that we do not view to be normal cash operating expenses. These expenses will include, but not be limited to the following:

•Restructuring costs - Costs primarily relating to the early termination of lease obligations, asset impairment charges, other facility closure costs and team member severance in connection with our voluntary retirement program and continued optimization of our organization.

•Third-party professional services - Costs primarily relating to services rendered by vendors for assisting us with the development of various information technology and supply chain projects in connection with our enterprise integration initiatives.

•Other significant costs - Costs primarily relating to accelerated depreciation of various legacy information technology and supply chain systems in connection with our enterprise integration initiatives and temporary off-site workspace for project teams who are primarily working on the development of specific transformative activities that relate to the integration and streamlining of our operating structure across the enterprise.

GPI Amortization of Acquired Intangible Assets — As part of our acquisition of GPI, we obtained various intangible assets, including customer relationships, non-compete contracts and favorable lease agreements, which are subject to amortization through 2025.

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We have included a reconciliation of this information to the most comparable GAAP measures in the following table:

(1)During 2022, we incurred charges relating to a make-whole provision and debt issuance cost of $7.0 million and $0.4 million resulting from the early redemption of our 2023 Notes.

(2)The income tax impact of non-GAAP adjustments is calculated using the estimated tax rate in effect for the respective non-GAAP adjustments.

Liquidity and Capital Resources

Overview

Our primary cash requirements necessary to maintain our current operations include payroll and benefits, inventory purchases, contractual obligations, capital expenditures, payment of income taxes, funding of initiatives under our strategic business plan and other operational priorities, including payment of interest on our long-term debt. Historically, we have also used available funds to repay borrowings under our credit facility, to periodically repurchase shares of our common stock under our share repurchase program, to pay our quarterly cash dividend and for acquisitions; however, depending on the priorities of our business and in consideration of ongoing uncertainties related to general global macroeconomic conditions, our future uses of cash may differ, including with respect to the weight we place on the preservation of cash and liquidity, degree of investment in our business and other capital allocation factors. Given macroeconomic uncertainties and our planned focus on improved working capital, we expect to temporarily pause share repurchases in 2023.

Typically, we have funded our cash requirements primarily through cash generated from operations, supplemented by borrowings under our credit facilities and notes offerings as needed. We believe funds generated from our expected results of operations, available cash and cash equivalents, and available borrowings under our credit facility will be sufficient to fund our obligations for the next year. We also believe such funds, cash and available borrowings, together with our ability to generate cash through credit facilities and notes offerings as needed, will be sufficient to fund our obligations long-term. Cash requirements for obligations next year and beyond are discussed in the “Contractual and Off Balance Sheet Obligations” section below.

On March 4, 2022, we issued our 3.50% senior unsecured notes due 2032 (the “2032 Notes”). Refer to Note 6. Long-term Debt and Fair Value of Financial Instruments of the Notes to the Condensed Consolidated Financial Statements included herein for further details. Proceeds from our 2032 Notes were utilized to fund the early redemption of our 2023 Notes and supplement operational and capital expenditures.

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Share Repurchases

In August of 2019, our Board of Directors approved a share repurchase program. Under the program, we may periodically repurchase shares of our common stock at market prices through open market purchases effected through a broker dealer and in privately negotiated transactions. The Board of Directors may increase or otherwise modify, renew, suspend or terminate the share repurchase program without prior notice. On February 8, 2022, our Board of Directors authorized an additional $1.0 billion toward our share repurchase program. Previously, in April 2021 and November 2019, our Board of Directors authorized $1.0 billion and $700.0 million for our share repurchase program.

During 2022, we repurchased 3.0 million shares of our common stock at an aggregate cost of $598.2 million, or an average price of $201.88 per share, in connection with our share repurchase program. During 2021, we repurchased 4.6 million shares of our common stock at an aggregate cost of $886.7 million, or an average price of $192.92 per share, under our share repurchase program.

We had $947.3 million remaining under our share repurchase program as of December 31, 2022. Refer to “Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities” for further details on our share repurchase program.

Capital Expenditures

Our primary capital requirements have been the funding of our investments in information technology and supply chain, e-commerce and maintenance of existing stores and branches. We lease approximately 84% of our stores and branches.

Our capital expenditures were $424.1 million in 2022, an increase of $134.4 million from 2021, and were primarily related to investments in new store openings, inclusive of leasehold improvements, as well as investments in information technology and supply chain.

Our future capital requirements will depend in large part on the timing or number of the investments we make in information technology and supply chain network initiatives and existing stores and new store development (leased and owned locations) within a given year. In 2023, we anticipate that our capital expenditures related to such investments will range from $300 million to $350 million but may vary with business conditions.

Analysis of Cash Flows

The following table summarizes our cash flows from operating, investing and financing activities:

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Operating Activities

In 2022, Net cash provided by operating activities decreased $390.0 million to $722.2 million. The net decrease in cash flows provided by operating activities compared with the prior year was primarily driven by lower Net income, higher incentive compensation expense payout and a decrease in overall working capital. The decrease in working capital was primarily driven by an increase in cash used by Accrued expenses and Inventories, partially offset by an increase in cash provided by Receivables, net. Refer to “Results of Operations” for further details on our results.

Investing Activities

In 2022, Net cash used in investing activities increased $137.1 million to $424.4 million compared with 2021. Cash used in investing activities for 2022 consisted primarily of purchases of property and equipment attributable to investments in new store openings, including leasehold improvements, as well as information technology and supply chain.

Financing Activities

In 2022, Net cash used in financing activities decreased by $443.4 million to $620.7 million compared with 2021. The net decrease in cash used in financing activities was attributable to net proceeds of $348.6 million received from the issuance of the 2032 Notes, a decrease in share repurchases of our common stock of $287.7 million and proceeds from net borrowings under our unsecured revolving credit facility of $185.0 million during the fifty-two weeks ended December 31, 2022. The decrease was partially offset by a net payment of $201.1 million for the early redemption of our 2023 Notes and an increase in dividends paid of $175.3 million during 2022 compared with 2021.

Our Board of Directors has declared a quarterly cash dividend since 2006. Any payments of dividends in the future will be at the discretion of our Board of Directors and will depend upon our results of operations, cash flows, capital requirements and other factors deemed relevant by our Board of Directors.

Long-Term Debt

On March 4, 2022, we issued $350.0 million aggregate principal amount of our 2032 Notes. The 2032 Notes were issued at 99.61% of the principal amount of $350.0 million, are due March 15, 2032 and bear interest at 3.50% per year payable semi-annually in arrears on March 15 and September 15 of each year.

On April 3, 2022, we redeemed the remaining $193.2 million principal amount of our outstanding 2023 Notes. In connection with this early redemption, we incurred charges related to the make-whole provision and debt issuance costs of $7.0 million and $0.4 million.

For additional information on transactions entered into relating to long-term debt during the fifty-two weeks ended December 31, 2022, refer to Note 6. Long-term Debt and Fair Value of Financial Instruments of the Notes to the Consolidated Financial Statements included herein.

As of February 28, 2023, we had a credit rating from S&P of BBB- and from Moody’s Investor Service of Baa2. The current outlooks by S&P and Moody’s are both stable. The current pricing grid used to determine our borrowing rate under our revolving credit facility is based on our credit ratings. If these credit ratings decline, our interest rate on outstanding balances may increase and our access to additional financing on favorable terms may be limited. In addition, it could reduce the attractiveness of certain vendor payment programs whereby third-party institutions finance arrangements to our vendors based on our credit rating, which could result in increased working capital requirements. Conversely, if these credit ratings improve, our interest rate may decrease.

With respect to all senior unsecured notes for which Advance Auto Parts, Inc. (“Issuer”) is an issuer or provides a full and unconditional guarantee, Advance Stores, a wholly-owned subsidiary of the Issuer, serves as the guarantor (“Guarantor Subsidiary”). The subsidiary guarantees related to our senior unsecured notes are full and unconditional and joint and several, and there are no restrictions on the ability of the Issuer to obtain funds from its Guarantor Subsidiary. Our captive insurance subsidiary, an insignificant wholly-owned subsidiary of the Issuer, does not serve as guarantor of our senior unsecured notes.

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Contractual and Off Balance Sheet Obligations

We enter into operating leases for certain store locations, distribution centers, office spaces, equipment and vehicles. Our property leases generally contain renewal and escalation clauses and other concessions. These provisions are considered in our calculation of our minimum lease payments that are recognized as expense on a straight-line basis over the applicable lease term. Any lease payments that are based upon an existing index or rate are included in our minimum lease payment calculations. As of December 31, 2022, our operating lease obligations were $2.69 billion. As of December 31, 2022, our long-term debt, consisting of senior unsecured notes with varying maturities through 2032, was $1.20 billion and our credit revolver outstanding balance was $185.0 million. Future interest payable related to long-term debt was $293.3 million as of December 31, 2022. As part of our normal operations, we enter into purchase commitments primarily for the purchase of goods or services that are enforceable, legally binding and specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. As of December 31, 2022, our purchase commitments were $121.0 million.

On February 27, 2023, we entered into Amendment No. 1 (the “Amendment”) to the Credit Agreement, dated November 9, 2021, with Advance Auto Parts, Inc., as Borrower, Advance Stores Company, Incorporated, as a Guarantor, the lenders party thereto, and Bank of America, N.A., as administrative agent (the “2021 Credit Agreement”). The Amendment extends the maturity date of the 2021 Credit Agreement by one year from November 9, 2026, to November 9, 2027. The Amendment also replaces an adjusted LIBOR benchmark rate with a Term Secured Overnight Financing Rate (“Term SOFR”) benchmark rate, as adjusted by an increase of ten basis points, plus the applicable margin under 2021 Credit Agreement. The Amendment made no other material changes to the terms of the 2021 Credit Agreement. The foregoing description of the Amendment does not purport to be complete and is qualified in its entirety by the full text of the Amendment, which is attached hereto as Exhibit 10.29 and is incorporated by reference herein. Subsequent to December 31, 2022 and through the date of this filing, we had additional net borrowings on our revolving credit facility of $469 million.

Critical Accounting Policies

Our financial statements have been prepared in accordance with GAAP. Our discussion and analysis of the financial condition and results of operations are based on these financial statements. The preparation of these financial statements requires the application of accounting policies in addition to certain estimates and judgments by our management. Our estimates and judgments are based on currently available information, historical results and other assumptions we believe are reasonable. Actual results could differ materially from these estimates.

The preparation of our financial statements included the following significant estimates and exercise of judgment.

Vendor Incentives

We receive incentives in the form of reductions to amounts owed and/or payments from vendors related to volume rebates and other promotional considerations. Many of these incentives are under agreements with terms in excess of one year, while others are negotiated on an annual basis or less. Advertising allowances provided as a reimbursement of specific, incremental and identifiable costs incurred to promote a vendor’s products are included as an offset to SG&A when the cost is incurred. Volume rebates and vendor promotional allowances that do not meet the requirements for offsetting in SG&A and that are earned based on inventory purchases are initially recorded as a reduction to inventory. These deferred amounts are recorded as a reduction to Cost of sales as the inventory is sold.

Vendor promotional allowances provided as a reimbursement of specific, incremental and identifiable costs incurred to promote a vendor’s products are included as an offset to SG&A when the cost is incurred if the fair value of that benefit can be reasonably estimated. Certain of our vendor agreements contain purchase volume incentives that provide for increased funding when graduated purchase volumes are met. Amounts accrued throughout the year could be impacted if actual purchase volumes differ from projected annual purchase volumes. Periodic assessments of the accruals are performed to determine the appropriateness of the estimate and are adjusted accordingly.

Amounts received or receivable from vendors that are not yet earned are reflected initially as a reduction to inventory, which subsequently is recorded to Cost of sales. Our estimate of the portion of deferred revenue that will be realized within one year of the balance sheet date is included in Other current liabilities. Earned amounts that are receivable from vendors are included in Receivables, net, except for that portion expected to be received after one year, which is included in Other assets, net. We regularly review the receivables from vendors to ensure they are able to meet their obligations. Historically, the change in our reserve for receivables related to vendor funding has not been significant.

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Self-Insurance Reserves

Our self-insurance reserves consist of the estimated exposure for claims filed, claims incurred but not yet reported and projected future claims, and are established using actuarial methods followed in the insurance industry and our historical claims experience. Specific factors include, but are not limited to, assumptions about health care costs, the severity of accidents and the incidence of illness and the average size of claims. Generally, claims for automobile and general liability and workers’ compensation take several years to settle. We classify the portion of our self-insurance reserves that is not expected to be settled within one year in Other long-term liabilities.

While we do not expect the amounts ultimately paid to differ significantly from our estimates, our self-insurance reserves and corresponding Cost of sales and SG&A could be affected if future claim experience differs significantly from historical trends and actuarial assumptions. A 10% change in our self-insurance liabilities at December 31, 2022 would result in a change in expense of approximately $14.5 million for 2022.

New Accounting Pronouncements

For a description of recently adopted and issued accounting standards, including the expected dates of adoption and estimated effects, if any, on our consolidated financial statements, see “Recently Issued Accounting Pronouncements” in Note 2. Significant Accounting Policies, of the Notes to the Consolidated Financial Statements included herein.