Welcome to the Advance Auto Parts second quarter 2017 conference call. Before we begin, Prabhakar Vaidyanathan will make a brief statement concerning forward-looking statements that will be made on this call.
Good morning. Thank you for joining us on today's call to discuss our second quarter results. I am joined this morning by Tom Greco, our President and CEO, Thomas Okray, our Executive Vice President and Chief Financial Officer, Bob Cushing, our Executive Vice President for Professional, Mike Broderick, Senior Vice President Merchandising and Operation Support, and Leslie Keating, Executive Vice President Supply Chain Strategy and Transformation. Tom Greco and Thomas Okray will open the call with prepared remarks regarding the quarter, and Bob, Mike, and Leslie will join them to answer questions for the Q&A portion of the call. Before we begin, be advised that our comments today include statements that are not historical facts and may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.
Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, which are described in the company's filings with the Securities and Exchange Commission. Our comments today will also include certain non-GAAP measures. Please refer to our earnings press release and accompanying financial statements issued today for important information and additional detail regarding these forward-looking statements and the reconciliation of the non-GAAP measures referenced in today's call. The content of this earnings call will be governed by the information contained in our earnings press release and related financial statements. Let me turn over the call to Tom Greco.
Thanks, Prabhakar. Good morning. Let us dive right in. In Q2, we narrowed our historical competitive growth gap versus peers by registering a slight sales increase of 0.3%, with comp sales flat versus prior year. This represented sequential comp sales improvement once again when compared with the combined Q4 plus Q1 timeframe. As we indicated on our Q1 call, we have been looking at Q4 and Q1 combined due to a couple of factors that made it logical to do so. These results reinforce that we are strengthening our customer proposition for both DIY and professional customers. We are encouraged by our performance relative to the industry, as we have consistently narrowed the comp sales gap over the past year. Turning to operating income, our adjusted operating margin rate came in at 8.6%, with adjusted EPS of $1.58. On a year-over-year basis, this was 214 basis points less versus the same period last year.
It's important to note that this rate includes 26 basis points from non-cash P&L headwinds related to reduction in inventory. As we'll discuss in detail later, we think it's very important for you to understand this and for us to make sure we're transparent, as the non-cash P&L headwinds will continue as we keep reducing our inventory through good business decisions. Excluding the non-cash impact of the inventory reduction of the adjusted operating income would've been $207.3 million, or a 9.2% margin, a decline of 188 basis points on a year-over-year basis. Therefore, our Q2 operating margin performance versus prior year was primarily driven by investments in the customer and, as I mentioned, the non-cash P&L impact of our inventory optimization efforts. As stated previously, we have a tremendous opportunity to improve profitability.
That said, before we achieve that objective, we need to strengthen the team and make necessary investments to support our customers and frontline team members. While we understand this increases costs in the short term and puts pressure on operating margins, we remain confident these decisions are in the best long-term interest of our shareholders. The investment in the frontline is necessary to stabilize and grow the business. The plans to execute productivity and transformation needed the strengthened team first in order to refine the plans and to execute. We're still in the early phases of our turnaround and as noted before, the historic lack of investment in the customer needed to be rectified. We lacked a coherent strategy. Our frontline turnover was unacceptable. Our technology platforms were segregated and difficult to navigate, and our supply chain infrastructure was duplicative and siloed.
All of this created a suboptimal experience for both customers and team members and was the primary reason our top line underperformed versus our competitive set by a wide margin for years. Simply put, we were an easy share donor for our competitors. Our new team has been acutely focused on changing this. Our focused investments have consistently enabled us to narrow the gap over the past 52 weeks, demonstrating that our elevated focus on the customer is driving desired outcomes. While we're narrowing the competitive gap versus peers, which gives us tremendous confidence in our investment, we also recognize the short-term headwinds the industry is facing and have factored this into our full year guidance. You saw our fiscal 2017 guidance revision in our press release today.
Our revised full year guidance ranges from down three sales comp on the low end to down one comp on the high end. With regard to sales, there's little doubt the industry experienced a short-term drag on sales in the first half of 2017. This has been widely reported in both public company releases and syndicated data. While we don't think the softness is indicative of a longer-term trend, we do believe it's now prudent for us to plan for this softer industry backdrop to persist into the second half of 2017. As a result, we're moderating our growth expectations for 2017, as we do not believe we'll offset the first half sales softness in the back half, nor do we believe industry growth rates will snap back to historical levels in half two. We attribute the temporary industry softness to three primary factors. First, economic uncertainty for low-income consumers.
The most measurable dimension here is the year-over-year increase in gas prices, which has led to a lower increase in miles driven in 2017 versus prior year, relative to the increases we saw in both 2015 and 2016. Second, a temporary trough in vehicles in the age and maintenance sweet spot, resulting from a substantial decline in new car sales in the 2008-2009 recession. Eventually, this reverses, as new car sales accelerated double digits for three straight years starting in 2010 and experienced strong mid-single-digit growth for the succeeding years after that. As a result, we expect meaningful improvement for industry growth in the future.
Finally, it pains me to say this, weather played a role in the first half of the year, as two consecutive mild winters combined with a spring and summer that was cooler than last year impacted certain categories like shocks and struts, under car, as well as air conditioning. Growth rates for these categories were down low-single-digits in Q2, and given the summer is almost over, we don't expect categories like AC to recover lost sales balance of year. In addition, the industry had a record-breaking finish last year because of an unusually cold December, which leaves us with a known difficult compare at the end of the year. All of this has been factored into our sales guidance. Of course, these weather impacts even themselves over the long term, they may not even themselves out this fiscal year.
If we look historically, such short-term volatility is not unusual. In any given year from 2000 to 2016, the industry experienced variability in growth rates year to year. Yet overall, the market has grown with a CAGR of 3.5% over that 16-year period. Based on our analysis, car parc has the highest correlation with auto parts sales of any variable we've studied. Given current estimates for car parc over the next five years, we see the current 2017 headwinds for the industry as temporary. Taking all of this into account, while we're projecting temporary softness for the industry balance of year, we're forecasting roughly 3% sales growth for the industry over the next few years with healthy underlying demand. In addition, we believe we'll be share gainers instead of share contributors based on our actions over time. We continue to take aggressive steps to fundamentally change the business.
However, we believe it'll take time for us to fully realize the benefits of our actions. I'll elaborate on this shortly. In the near term, while we're moderating our expectations for growth this year, we're accelerating our planned inventory reduction efforts to improve free cash flow. We have more inventory than we need and plan to reduce it in a thoughtful and disciplined fashion. In Q2, we were encouraged that we reduced inventory without impacting sales, and we're pulling forward our inventory reduction efforts ahead of what was originally scheduled in our five-year plan to improve free cash flow. As a result, we expect our balance of year profitability to be impacted by, first, higher deleverage related to the change in the comp guidance. Second, ahead of schedule inventory reduction that will drive a non-cash P&L headwind from inventory reduction. Let me explain the non-cash P&L impact of inventory reduction.
The company has purchased inventory at higher costs in the past, which are reflected in the balance sheet on a LIFO basis. In addition, under accounting rules, certain supply chain costs associated with inventory have been capitalized. As the company reduces inventory, these costs move from the balance sheet and generate a non-cash negative impact to gross margin. As we continue to reduce inventory, it will improve cash flow, but there will continue to be a significant non-cash negative impact to gross margin. It's important to understand this, as it is clearly good business to reduce unnecessary inventory, and we want to make sure the non-cash accounting effect on margin doesn't drive bad business decisions. The third factor impacting balance of year profitability is necessary investments in the customer, our frontline team members, and organizational talent to ensure long-term sustainable growth.
As we move to Q4, these investments get more than offset by productivity initiatives we have in flight. The change in the comp outlook is the single biggest driver of the change in guidance. Additionally, while inventory reduction positions the company for improved free cash flow, it's expected to drive a non-cash P&L headwind in 2017. Tom Okray will provide more color on the financials shortly. Before that, I'm very excited to provide more details on phase two of our transformation plan. We shared our objectives for phase two on our transformation plan on our Q1 call. They were, first, elevate focus on the customer. Second, drive productivity. Third, attract and develop talent. Let's start with the customer and driving growth. For professional, it's foundational that we have the right part in the right place at the right time.
We've had substantial early success with lead market initiatives to improve our value proposition. Importantly, we've proven we can significantly improve our value proposition. When we do so, it directly drives performance. First, a brief update on our availability transformation, or AT for short. We've implemented AT in approximately 400 stores. At the core of availability transformation is a radically different approach to assortment and delivery. This is resonating with our customers. Sales are performing around five points better in AT test stores versus control stores. We're expanding AT to another 600 stores by Q4. AT has shown us that we can satisfy the customer with better service, better availability, and less inventory. Secondly, many of our professional customers order through our digital platform. We've recently introduced a new B2B platform called AdvancePro to over 1,000 customers.
We expect thousands of additional customers to move to this exciting platform balance of year. AdvancePro also includes our new enterprise catalog called APEX. The AdvancePro B2B platform integrates with a wide array of shop management tools used by our professional customers and provides enhanced search capability and repair job details, as well as labor and fluid specifications. Our early testing of AdvancePro is very positive, and our customers love it. We're also rolling out a new enterprise catalog, APEX, internally to team members. We've already rolled this out to 3,300 Advance stores. Today, APEX is providing increased speed and functionality. Ultimately, APEX will give team members visibility to parts across the enterprise in one place. This will save time and make it easier and faster to access all the parts that AAP has, regardless of whether it was sourced from Advance, Carquest, or Worldpac.
We expect these actions to be completed and in place by Q4. Another professional initiative currently in test is Worldquest. Worldquest is a standalone professional-only model, which leverages our current technology to source parts across Advance, Carquest and Worldpac. Worldquest provides an enterprise-wide portfolio of OEM and replacement products for professional customers under one roof with one-stop ordering and delivery. This takes some of the best elements of Worldpac and Advance and combines them with the full enterprise catalog to provide the best of the best solution for professional customers. We've been piloting this new model for a few months, and it's driving significant growth and capturing market share by acquiring new customers and selling more parts to the customers we have. We're very excited about AT, AdvancePro, APEX and Worldquest, and expect these initiatives will improve first-call status.
As you can tell, Bob Cushing is leveraging the same industry-leading tools he built at Worldpac, and he's raising the bar on execution across the entire AAP professional organization. Shifting to DIY omni-channel, we're building new capabilities to integrate physical and digital assets to ensure a seamless omni-channel experience across all customer touchpoints. We've refocused on our customer, and we want to satisfy customer needs and desires for parts and service in the manner that is most desirable for DIY customers. We've charged Mike Broderick, who has close to 25 years in the parts business, to do with DIY what Bob is doing with professional, completely leverage all of AAP's assets across the enterprise to accelerate DIY growth. We're offering DIYers a choice in how they shop while ensuring a consistent experience every time, both in store and online.
To enable a dramatically improved customer experience, we're investing in technology, and it's working. Our growth in B2C online significantly accelerated in Q2 almost immediately after we put more focus behind it. Mike is working closely with our new SVP marketing, Yogi Jashnani, to drive full integration of our digital and physical assets to deliver an omni-channel experience that is compelling and consistent. We want our customers to get the best of online while enjoying the convenience and satisfaction of our knowledge and store base for pickup, exchange, or delivery. This includes leveraging our Speed Perks loyalty program. With millions of Speed Perks members, we already have an identifiable audience who we can engage and improve loyalty. We're also very excited about the launch of our enhanced website later this month. We've made significant improvements to our new website.
We expect a much faster and more frictionless experience to drive website traffic, conversion, and of course, sales. We'll be relentless in improving the DIY omni-channel customer experience in our stores, on desktop, and on mobile devices, including an exciting launch of our app in the second half of the year. I've talked a lot about the tools we're implementing to better serve our customers, but let me spend a few moments addressing our actions with frontline team members in our stores. Our stores operate as DIY storefronts for the DIY omni-channel experience, as well as delivery nodes for professional. Without question, our stores and frontline team members are incredibly important for our business. The investments we've made in our team members behind Fuel the Frontline have enabled us to both narrow the competitive growth gap over the past year and dramatically reduce customer-facing employee turnover.
As proof, our turnover was down between 15% and 30% on key customer-facing positions in Q2, depending on the role. At the same time, our workforce is responding with improved execution against KPIs, which is a critical element to drive performance. We're now focusing our team members on a narrower set of metrics and making progress on the consistency of the in-store experience for our customers. Finally, our entire leadership team is really excited about a significant body of work transforming our supply chain from end to end. We're planning to integrate our supply chain across the enterprise, which will enable a step change in parts availability, customer service, and order to delivery time. At end state, we expect to have a multilevel supply chain that optimizes the role of every node and every square foot of our network based on customer needs.
The future network will improve professional customer availability, better support our DIY strategy, and enable more e-commerce delivery options. We expect to optimize our physical footprint by market to create fulfillment and replenishment nodes to best serve the customer and meet the company's market presence goals by DMA. While the end-to-end supply chain work will drive availability and growth, we also expect end-to-end to significantly reduce costs and inventory as we better leverage AAP's assets. This will include a comprehensive optimization exercise that evaluates rooftops, fleet, last mile delivery, transportation, product returns, replenishment, inventory positioning, and many other cost and effectiveness variables in ways we have simply not looked at them before. End-to-end supply chain is expected to leverage all the assets of all AAP banners. Let's talk productivity more broadly. As a reminder, our productivity agenda is comprised of three big buckets: material cost, supply chain, and ZBB.
On material costs, we've conducted a comprehensive category reviews on approximately 40% of our core product categories in 2017. This involves full product teardowns and developing a category strategy. While material cost negotiations are not new to AAP, our approach is very different than in the past. These discussions are fact-based and include rigorous market research and an elevated focus on building strategic partnerships. In supply chain, we've previously discussed the benefits from leveraging scale as we consolidated our last mile delivery fleet under one provider. These benefits will begin to be realized in the back half. We're also leveraging scale with a transportation center of excellence to manage transportation across AAP banners. Here we're finding significant opportunities to better leverage existing routes, reduce miles, and optimize assets while providing improved service. We're also implementing new technology to dynamically route demand, dispatch drivers, and optimize service while improving asset utilization.
On ZBB, we're embracing frugality as a fundamental cultural shift that will remove unnecessary costs from our P&L. As an example, we announced a field and corporate restructuring in late June. This changes how work gets done throughout the company. As part of this initiative, we used customer insights and market analytics to restructure our field organization from 34 to 12 regions. We streamlined our professional sales team and aligned them with store operations. We optimized multiple and disparate call centers to become more efficient. We're deploying new technology to drive efficiency. In summary, we continue to look for ways to simplify our business by integrating functions across banners and streamlining core business processes while we build new capabilities. A second example of ZBB is price match override. This is an opportunity to improve pricing discipline in our stores on professional.
Here we've taken a much more analytical approach to price match override. We're focused on improving gross margin rates by providing new analytical tools to assist our team members in optimizing price-matching activity. Of course, none of this can happen without world-class leadership and talent, and we've assembled a leadership team that has a combination of deep experience and knowledge in the parts business with leaders who bring significant new capabilities from outside our industry. We believe these are critical for future growth. New capabilities like insights and analytics, a transformational approach to supply chain, consumer marketing, online retail, and importantly, technology. Both our growth and productivity initiatives require execution, and the world-class leadership team we've assembled, along with thousands of dedicated team members and independent operators in the AAP family, bring a high level of intensity to the execution of our transformation plan.
To drive our growth and productivity work, we first needed to invest in talent, which temporarily increased overhead before we could remove other costs. It is this talent that now needs to drive the savings we've developed from our productivity agenda. A few of these leaders have joined me on the call today. In addition to proven industry leaders like Bob Cushing, who's building upon the success in Worldpac and expanding his mandate across all professional, we've added new individuals like Mike Broderick and Leslie Keating. Mike brings significant industry experience as our Chief Merchant, and has recently assumed responsibility for store operations, which includes all the staff-related functions which enable our field teams to succeed. In this role, Mike will spearhead our efforts in driving down acquisition costs, improve gross margin, and accelerate productivity in store operations.
As Head of Supply Chain Strategy and Transformation, Leslie is leading the end-to-end supply chain transformation work described earlier. She has an outstanding track record in delighting the customer and delivering continuous improvement in productivity. In a moment, I'll turn the call over to Tom Okray, who brings terrific industry experience in automotive and online retail. Tom has been instrumental in dramatically upgrading his team and is relentlessly focused on driving growth and margin expansion. These are just a few of the world-class leaders committed to executing a bold and exciting transformation plan for AAP. In summary, we're in quarter three of a five-year transformation plan. Our unwavering focus on the customer and the investments we're making to improve the customer experience is driving real improvement and narrowing the historical performance gap versus the industry.
In addition, during the back half of 2017, we begin to execute the productivity agenda we've constructed to drive long-term growth, margin expansion, and free cash flow improvement. The opportunity ahead for AAP is truly unique within our space and could not be more exciting. With that, I'll pass it over to Tom Okray.
Thanks, Tom, good morning, everyone. In Q2, we delivered $2.26 billion in net sales, a 0.3% increase versus prior year. This growth was led primarily by professional, which has been our initial focus during the transformation. Gross profit margin came in at 43.9%, 91 basis points lower versus the prior year, of which 26 basis points was related to the non-cash impact of the inventory reduction. Excluding the non-cash impact of the year-over-year inventory reduction, the company's gross profit margin decreased 65 basis points. We are calling out this non-cash inventory headwind as we believe it is important for the shareholder to understand that our decision to lower inventory is a good cash flow decision, and we're not going to let the non-cash hit to earnings inhibit what is clearly a good business decision.
With respect to inventory, in Q1 and Q2, we delivered two consecutive quarters of reduction on a year-over-year basis. This is the first time that the company achieved this since 2009. Further, the inventory reduction in Q2 of roughly $120 million was the largest quarterly inventory reduction that we have had since at least 2005. It is important to note that we achieved the Q2 inventory reduction while growing sales. Our intent is to continue to reduce inventory going forward to set the company up for strong free cash flow in the future. While absolutely the right thing to do, these actions will continue to be a non-cash P&L headwind. Keep in mind, these inventory-related headwinds are non-cash. Let me explain further. To reiterate Tom's previous comments, the company has purchased inventory at higher costs in the past, which are reflected in the balance sheet on a LIFO basis.
In addition, under accounting rules, certain supply chain costs associated with inventory have been capitalized. As the company reduced the inventory, these costs moved from the balance sheet and generated a non-cash negative impact to gross margin. As we continue to reduce inventory, it will improve cash flow, but there will continue to be a non-cash negative impact to gross margin. The remaining 65 basis points was driven by approximately 35 basis points related to an increase in supply chain costs, 50 basis points from unfavorable mix and commodity headwinds, offset by approximately 20 basis points of favorable material cost performance. Adjusted SG&A came in at 35.2% of revenue, a 123 basis point increase versus prior year. The increase was primarily driven by roughly 93 basis points related to investing in the customer and growing AAP talent.
More specifically, customer service hours, along with investments in talent through Fuel the Frontline and a new leadership talent we've attracted to AAP. In addition, we had increased employee-related costs from medical and insurance that contributed 30 basis points. As we have previously mentioned, in Q2, we are lapping significant cuts from prior management. This was a major driver of our adjusted SG&A increase year-over-year. This lap will continue into Q3. Going forward, as a part of our productivity initiatives, we will optimize these investments while being thoughtful to not impact the customer. While we acknowledge that our adjusted SG&A costs are up, we needed to reinvest in the customer, stabilize our frontline, and grow our talent base. This investment in leadership talent will not only drive and execute the productivity initiative, but also change the culture of AAP.
Consequently, costs went up before they are going to go down. We will continue to aggressively drive productivity in the second half of this fiscal year. It should be noted that in fiscal year 2017, the majority of the productivity will be reflected in improvement in gross margin versus adjusted SG&A. Having said that, adjusted SG&A will decline in absolute dollars as we go through the remainder of the year. More specifically, we expect to end Q4 at least $25 million lower than Q2. Of course, the adjusted SG&A margin impact will be dependent on our growth rate. As noted previously, gross margin will face a non-cash P&L headwind from our inventory reduction initiative. In summary, our Q2 adjusted operating income came in at $195.5 million, with adjusted operating margins down 214 basis points over the same period last year to 8.6%.
Excluding the non-cash impact of the inventory reduction, the adjusted operating income would have been $207.3 million, or a 9.2% margin, a decline of 188 basis points on a year-over-year basis. Turning to cash flow, our free cash flow more than doubled through Q2 versus prior year, and operating cash flow was up 28% through Q2 versus prior year. The details of our revised 2017 guidance are reflected in our press release from this morning, but let me provide some additional color on key elements. Given that half of the year is behind us and considering both current industry sales environment as well as the ramp time of actions we are taking to flow through to the P&L, we believe it is now prudent to revise our 2017 guidance.
Considering our first half comp performance as well as the outlook we have for overall industry growth in the back half, we have revised our full year comp expectations to now be between down 3% and down 1%. Turning to operating profit, we have revised our adjusted OI margin expectations to be between 200-300 bps decrease versus prior year. The primary driver of the change is the leverage of fixed costs associated with the lower comp expectations. Also contributing to the change is a 75 bps headwind related to non-cash expenses from reducing our inventory significantly more than we had planned at the beginning of the year. Excluding the impact of the non-cash expenses from inventory reduction, the adjusted operating income margin expectation would be a 125-225 bps decrease versus prior year.
Finally, on free cash flow, we now expect to deliver a minimum of $300 million in free cash flow in fiscal year 2017. The change versus our prior $400 million free cash flow forecast is primarily driven by the change in our net income expectations, partially offset by the benefits from our increased inventory reduction effort. While below our initial guidance, the $300 million in free cash flow is a significant improvement from prior year performance. With that, let's open it up to questions. Operator?
Thank you. We will now be conducting a question and answer session. If you'd like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Our first question is from Simeon Gutman of Morgan Stanley. Please go ahead.
Well, Tom, you mentioned in the last couple of quarters that you don't expect the turnaround to be linear, and I don't think the market expected that either. There's arguably a lot of room here for improvement for top-line and margin. Based on the original guide, it seems like the organization may have been unfamiliar with some of the investments that needed to turn the business around. How do we get confidence now that management understands the magnitude and depth of investments required?
Well, good morning, Simeon. First of all, I think the big thing that the guide reflects is adapting to the environment that we're competing in right now. When we entered the year, as you recall, we finished the year strong. We had basically a free comp in the fourth quarter. The industry was performing at a different level than we've seen in the front half of the year. As we outlined in our prepared remarks, the front half of the year has been softer for the whole industry, and I think you've seen that reflected in the earnings reports from people in our industry, from The NPD Group data. For all the reasons that we indicated in our prepared remarks, we feel that we have to adapt to this current environment in the back half of the year.
That said, going forward, this is a healthy industry, and we're very confident in the outlook for the industry overall based on the car parc and all the variables that are associated with that. I think the guide is more a reflection of the current environment, and we saw a real opportunity to pull forward some of the key initiatives that we actually had in our strategic plan earlier in the year. Most notably was the pull forward of the inventory reduction effort, which we're very pleased that we were able to take that on and take the inventory down while still registering a narrowing of the comp sales gap versus our competition. We're very happy with the fact that we were able to take the inventory down and drive sales performance in that same environment.
I guess as a follow-up to that, is that implying that internally that the progression of the business is similar to how you thought about it? Are there things that require greater investment than you initially laid out? Just thinking as a second part to that, thinking about timing of improvement, it sounds like now for this year it's maybe fourth quarter. Should there be improvement in 2018, should the business begin to bounce back or does it get pushed out further, even to 2019?
Well, back to the first part of your question, we entered the year thinking that the industry would perform at the historical 3%-4% growth rate. As per NPD data or anything else we see, we're not at that rate. That was really the big driver there, that's why we've had to rethink the environment. Going forward, we certainly expect a significant improvement in 2018 over 2017.
Okay, thanks.
Thank you. Before our next question, we would like to remind everyone to please limit themselves to one question and then re-queue for any additional questions. This way, everyone does have a chance to participate. With that, our next question is from Seth Sigman of Credit Suisse. Please go ahead.
Thanks. Good morning. A couple follow-up questions. I guess first, against the weaker industry backdrop, as you highlighted, Tom, as you make improvements to availability and service, what are you doing to drive awareness in that type of environment? Specifically on price, if we do assume that industry growth remains constrained here in the near term, do you feel like you need to change your pricing strategy, sharpen it potentially to drive more awareness of some of those improvements that you're making?
Well, first of all, on availability, Seth, we're really focused on executing against the fundamental customer promise that we have, and that starts with the right part in the right place. That's what the availability transformation is all about. Taking our advantage brand portfolio, our assortment management tools, and really leveraging those to make sure we have the right part in the right place. Of course, we've got to have it at the right time as well. We're working really hard on improving our order to delivery time to our customers. We're in the process of installing telematics in all of our vehicles, and that enables us to link the order time through, whether it's over the phone or through one of our catalog platforms, to the order to delivery time and make sure that we're measuring that and continuously improving there.
The third leg of the stool is the value proposition itself, and that's about having well-trained, knowledgeable professionals, making sure that we're looking at pricing. Pricing is really the third most important variable to our professional customers based on all of the work that we've done. We've got to make sure we've got the availability right. We've got to make sure we get it to them as quickly as possible. Yes, we've got to be competitive on price. We're very focused on making sure we've got the right part in the right place and getting it to the customer at the right time.
In terms of the higher investments here, the integration and transformation expenses of $100 million-$150 million, which I think is up from $30 million-$35 million. Can you walk us through the buckets that are incremental to the original plan, and what is gross margin versus SG&A?
Well, first of all, there's three big things that are in those expense lines. The first is obviously the restructuring that we did, which was a big undertaking that we had in the second quarter. I'm really pleased that we were able to make that change in our entire field organization, we've actually kept on the momentum of the business as we exited the quarter. We made a really big change. There was a restructuring charge that's embedded in there. That's the first thing. The second thing is we did engage an outside firm to help us in the transformation effort itself. We really didn't have all of the capabilities we needed in-house, so we had to engage an outside firm to get us kick-started on the transformation effort.
The third is we actually sold our corporate aircraft, or are in the process of selling our corporate aircraft. Those are the three things that are in that bucket.
Okay. Thank you.
Thank you. Our next question is from Scot Ciccarelli of RBC Capital Markets. Please go ahead.
Hey, guys. Scot Ciccarelli. Tom, I was hoping you could help us understand, specifically how much of the OI change is due to the comp change versus incremental investments. I guess it's a bit of a follow-up on Simeon's question, but just trying to understand what's the deleverage impact versus what things are costing more than anticipated.
Yeah. Let me take that one. First of all, I'd like to talk about how excited we are about our productivity agenda. As we talked about in Q1, most of this would hit in the back half of the year. Specifically, 80% of our productivity plan is coming in the back half of the year, and the majority of that is coming in Q4. That is really on track. Let me give you a specific example. If you're talking about material cost performance, we said in our prepared remarks we've been through 40% of our categories, so not even half. Of those 40%, with the negotiations that are ongoing, those are going to hit primarily in the back half of the year. Obviously, we're going to continue to ramp up as well.
That's consistent with the other areas of the P&L as well, whether it's the restructuring activities or the supply chain work that we're doing. The majority of the OI drag, coming to your question, is related to the top line, the deleverage.
Thank you. Our next question is from Michael Baker of Deutsche Bank. Please go ahead.
Hi. Thanks. A couple follow-ups. One, I'd like to talk about the $750 million in cost savings you talked about last quarter, and I think at the time it said it's non-sales dependent. We understand you're investing, but any insight into the confidence of that number and when we start to see that show up in the operating margin? I guess the second follow-up, you just said that you expect the productivity to really hit in the fourth quarter. Can you give us some help on the margin differential in the third quarter versus the fourth quarter in terms of the year-over-year decline that we should expect?
Yeah. Well, first of all, couldn't be more excited and more confident about the $750 million over four years. I'll just reiterate what we said on the previous quarter's call. With bringing in the new leadership team, we're finding more and more each day. Having said that, we are going to continue to invest in the things that are important. The customer, for sure. Building out the leadership team below Tom's direct team. As it relates to the back half of the year, we expect that we will have Q4 margins be above prior years' margins, excluding the non-cash inventory reduction that we see. With respect to breaking out Q3 and Q4, not going to go into that at this time.
Thank you. The next question is from Matthew Fessler of Goldman Sachs. Please go ahead.
Thanks a lot. Good morning. I'm trying to understand the trajectory of investment versus harvesting. This is a business that I think you've all believed for a long time has a margin target well above historical levels, and that would come either through higher sales or lower expenses. It seems like the costs are rising at a rate that would outpace even a solid sales gain in terms of the trajectory of the margin. At what point do you think you net out to the, at least the inputs to the cost structure and consequently to margins starting to favor margin expansion? Obviously the sales will be what they'll be.
Good morning, Matt. Good question. Let me come back to the $750. That's a big number. Obviously, we're on track to achieve it, as Tom said. We know exactly when we're going to get to $750. We know the gross, we know the net, we know how we're investing back. We're not communicating details on how that's going to unfold at this time. Obviously, we're going to continue to hone that, at the appropriate time, we'll let you know exactly how that's going to unfold.
Thank you. Our next question is from Michael Lasser of UBS. Please go ahead.
Good morning. Thanks a lot for taking my question. It seems like the rest of this year is going to be one of transition
For your P&L. Can you help frame what's probable for next year, especially in light of the multi-year cost savings that you've previously laid out? As we think about next year, you're no longer going to see the drag, or potentially no longer going to see the drag from inventory reduction activities. Can we layer on $150 million or so of the pro rata $750 million savings program, meaning that you could realistically see 150 to 200 basis points of margin expansion next year, even if your sales remain flattish or slightly positive? What could stand in the way of that expectation? What would drive downside to that? Hi, Michael. First of all, I'd like to talk a little bit about the inventory. We're extremely pleased with what we were able to do this quarter.
We took inventory down, as we said in the prepared remarks, by about $120 million. That's the largest quarterly inventory reduction that the company's seen since 2005 and the first time since 2009 that we've put together back-to-back quarters on a year-over-year basis where we've had a reduction. Simply put, we are going to continue this aggressive inventory reduction. As we said in the prepared remarks, it's just simply the right thing to do to set the company up to be able to generate cash. We are prepared to take the non-cash hit to earnings. Free cash flow for the 28 weeks ending in Q2 is up 104%. Net cash from operating activity is up 28%. Our cash and cash equivalent balances at $257 million is 145% higher than Q2 of the prior year. We're going to continue on the inventory reduction.
It's the right thing to do for the business. We will have guardrails up to make sure we don't impact sales, just like we did this quarter. To get to answer your question is, will that continue into 2018? Absolutely. We're not going to give guidance or comment on 2018 right now, but that will continue to be an initiative we pursue in 2018.
Thank you. The next question is from Christopher Horvers of JPMorgan. Please go ahead.
Thanks. Good morning. A couple of detail questions. Can you share your thoughts on the comp cadence in the back half? Should we look at the stacks, with 3Q maybe down low singles and 4Q down mid singles, we net down to that -3%, which appears to be what you're implying at the midpoint. Can you remind us of what the non-cash impact was in the first quarter so we can back into what you're embedding in the back half for that gross margin pressure? Finally, you mentioned the guide partly reflects the current sales environment. Presumably that's slower. What gives you the confidence that this presumed slowdown is not related to some of the field changes that you've made? Can you point to recent market share trends, what you think the industry growing and so forth? Thank you.
There was a lot there, Chris. I'll take the sales question, and I'll flip the non-cash question over to Tom. We're not going to comment on the cadence between Q3 and Q4. We've kind of stepped back on the overall outlook for the industry and assessed our best estimate as we sit here today on what we think the industry is going to grow. We feel great about our sales momentum. We're competing now. We're earning new business. We used to be a share donor consistently every time we reported these earnings releases. We're now starting to win business. Bob Cushing is doing a terrific job rallying our professional sales team together. On the industry front, we know there's ups and downs. We've looked at this over many years, and it's really difficult to predict any given year what it's going to look like.
If you look over time, this is a 3.5% growth industry, and that's what we expect going forward. We're pleased that we're narrowing the competitive gap, and we did narrow the competitive gap in the second quarter, and we did narrow it after we made those field changes. We don't feel like the changes that we've made are impacting our performance, and we're going to continue to give our field team the tools they need to win. That's essentially the idea. We made the changes while we were introducing new tools, new technology to our field team. To that end, we feel both the efficiency and the effectiveness of our sales organization has been improved versus where it was. I'll flip the non-cash over to Tom. Yeah, with respect to the Q1 question on the non-cash inventory related, it was 49 basis points unfavorable.
Thank you. The next question is from Seth Basham of Wedbush Securities. Please go ahead.
Thanks a lot, and good morning.
Morning.
My question is around leverage. You guys are at 2.9 times adjusted debt to EBITDA. In the second quarter, your guidance implies that you'll probably be a little bit weaker than that going forward. Do you expect to be able to maintain your investor-grade credit rating?
We do. We have had discussions with both Moody's and S&P and have taken them through our plan. We're comfortable with that. We're committed to get back to the 2.5 leverage ratio that we have talked about previously. In the current environment, it'll be under pressure for the short term, we're comfortable and committed to get back to that, and we anticipate that the rating agencies will see that favorably.
Thanks.
Thank you. Our next question is from Bret Jordan of Jefferies. Please go ahead.
Good morning, guys.
Morning.
Morning.
On the second quarter, could you talk about regional performance dispersion and maybe what you think the market grew in those regions? Do you think you closed the performance gap but still lost some share in the second quarter?
Well, first of all, we feel very positive about the changes up your way, Bret. The north part of the country performed much better. If you remember last year, we really struggled up there if we look across our new regions. Let me just say, we went from 34 to 12 regions. These 12 regions that we have now are huge jobs. We've got great leadership in these jobs. We've made the changes, not just from a productivity standpoint. We think the effectiveness of these new regions is going to be much stronger. In the old world, if I'll just take Florida as an example, we would've had four people essentially leading our business in Florida. It was very difficult to compete with local competitors when you have four people that want to do different things. You got entrenched competitors down there that major in categories like AC.
Now we can go into Florida with a very aggressive plan and have a very nuanced approach to competing down there. In the quarter, if I look across the new 12 regions that we have, the Northeast obviously improved nicely versus where it had been in Q1. The Great Lakes, the Central, which for us is kind of in that Ohio area, and then Mid-Atlantic. Those were the big winners in the quarter, and I really feel that that group rallied around the change. They also rallied around the distribution centers that we have up in that area, which made some significant improvement in fill rates, and all of the key metrics that we look at. That's a bit of a snapshot.
Thank you. The next question is from Steven Forbes of Guggenheim Securities. Please go ahead.
Good morning.
Morning.
I wanted to focus on the regional org structure changes you highlighted. I know you just commented on it, but can you expand on how these changes have impacted the store ops org structure? I guess, how confident are you that you have the correct level of regional oversight now under a leaner structure given the importance of the touches? As we try to digest what it means for operations throughout the business, what are the average number of stores that an RVP is going to oversee now? And what is the expectation for the line of sight as you think about the evolution here in digesting these changes internally?
Well, first of all, we spent a lot of time making sure that this structure was going to make sense long term for the company and enable us to really get at some of the opportunities that we have in some of these local geographies. Again, we just didn't have the perspective to bring back here to Raleigh to get at some of these local opportunities and compete at the highest level in these geographies. Starting with the top, these new 12 regions that we have, they're bigger jobs. Yes, they have more stores, but we have put an infrastructure underneath them that enables them to run the business effectively. We're not concerned about that. The overall change in trajectory that we've seen since we made the structural change, we haven't seen a big change in the performance in the company.
We managed the change very well.
Thank you. Our next question is from Brian Nagel of Oppenheimer. Please go ahead.
Hi, this is David Bellinger on for Brian. You mentioned that the comps for the quarter essentially flat on an easier comparison here. Can you give us some more detail by category? Within that, are there any specific trends that you see that are indicative or really stand out from the weakness in the car parc? Or is that more of just a broad-based slowdown?
Well, first of all, we did see a nice uptick in some big categories in the second quarter. Batteries, oil, brakes were the most notable ones. Softness in cooling, okay? Which we saw in the second quarter, and honestly, we're continuing to see in the third quarter as we called out in our prepared remarks. Those are the big, most notable category performers.
Thank you. Our next question is from Dan Wewer of Raymond James. Please go ahead.
Thanks. Tom, I want to follow up on the leverage issue. When you were speaking with Moody's and S&P, you discussed with them an outlook that the adjusted debt EBITDA rate could approximate three turns for the next two or four quarters, and are you saying that they said that's okay, the investment grade rating is not in jeopardy? Did I understand that answer correctly?
We're in discussions with S&P and Moody's on an ongoing basis. They're very happy with the cash that we're generating. We're generating a significant amount of cash versus the previous year. We're very upfront about where we see our leverage ratio going, and I don't want to comment for them, but to date, we have had very positive reception from both S&P and Moody's.
Thank you. Our next question is from Carolina Jolly of Gabelli & Company. Please go ahead.
Morning, guys. Thanks for taking my question. Mine's pretty simple. When I look long term, and I understand that there are a lot of factors into getting there, I'm just trying to understand the difference between your AP to inventory ratio and your competitors, and how do you get to that ratio of 80% that goes or 90%, 100% as your competitors are currently producing?
Yeah. Good question. The first thing we do is optimize and draw down our inventory. We've said that we've got far too much inventory. It's something that we've been talking about since we first put out the strategic business plan. We put rigorous activities in place. We meet two times a month in a cash council talking about not only inventory, but also AP and AR. You have to understand, though, as we're starting this inventory drawdown, that it's driven by curtailing buying. Therefore, it's going to take some time for the accounts payable to catch up with that. The AP ratio will be a lagging measurement, but it will kick in, I would say around the end of fiscal year 2018, and then we'll be on a trajectory, both from a cash perspective and an AP ratio perspective to be very competitive with our peers.
Thanks.
Thank you. Our next question is from Matthew McClintock of Barclays. Please go ahead.
Hi. Yes. Good morning, everyone. First, just a clarification question. APEX, did I hear right that you said that you would have visibility across the enterprise for parts by Q4, or is that expected to be much later than Q4?
Yeah. Right now, we rolled out that catalog, APEX, in over 3,300 stores. Also AdvancePro, which is powered by APEX, just rolled out nationwide with over 1,000 customers on it. Importantly, we will be piloting out a full cross-banner sourcing capability within those platforms, and those platforms were necessary with that architecture to be able to do that. It's a Q4 event, and the team is extremely excited about it, and we certainly have seen already with what we did with Worldpac on what the results are and how customers view that. I think overall, Q4 is the plan, and we expect that to happen for sure.
Matt, I'll just add to what Bob just said. We're so excited about this rollout. You think about currently our team members are looking up parts in multiple places throughout the catalogs that we have. This enables them to have essentially a one-stop shop for parts across the enterprise. We've got a terrific portfolio of parts across AAP, and that's the idea with APEX, is to simplify the job for our people, make it easier for them to find parts, and that way we can serve our customers better than ever.
Thank you. Our next question is from Ben Bienvenu of Stephens. Please go ahead.
Thanks. This is Daniel Imbro in for Ben. Thanks for taking my question. When you think about the critical factors for driving sustainably positive comps long term, I would think that includes better speed of service, higher parts availability. What percentage of your stores possess those characteristics today? Then of those that don't, what's your assessment of how far these stores are from having performance metrics that meet your targets? Thanks.
I'm sorry, you broke up a little bit there. Can you repeat the question?
Yeah, of course. Thinking about driving positive comps longer term, what percentage of your stores possess those necessary characteristics today? Of those that don't, what is your assessment of how far those stores are from having those performance metrics meet your targets?
Well, first of all, we've narrowed the performance metrics pretty significantly for the stores themselves. You're always going to have a distribution when you've got thousands of stores. You've got some stores that are at the top that are performing at an extremely high level, and you've got stores at the bottom. In our case, we have a very unique position in the industry. Relative to others that are competing that have got very strong executional capabilities that they've had for many years, we're building out those capabilities overall. We're trying to pick up the whole bell curve and move it to the right. That means better availability inside our entire network. That means faster order to delivery time, and that means improved training and capabilities of the professionals in those stores. I think our agenda here is to improve the entire enterprise.
We obviously manage the lower performing stores on a weekly basis. I get a look at every single one of our key metrics by store, by district, by region. Every Monday we go through it in our operating committee meeting. We'll manage the performance, but the agenda we have to do what you said, which is to sustainably drive comp improvement, is one of essentially taking the entire customer value proposition we have and improving it overall.
Thank you. The next question is from Chris Bottiglieri of Wolfe Research. Please go ahead.
Hey, guys. Thanks for taking the question. Very quick one. Can you segment the inventory non-cash charges? Maybe between write-downs on new agreements LIFO headwinds, then lastly, capitalized supply chain costs. I know you had some issues last year, the previous management team taking inventory out. Then maybe the cost mix changes in the back half of 2018.
Yeah, Chris, it's no write-downs. It's the other two that you mentioned. It's quite simply the capitalizing the supply chain costs, taking those capitalized costs and moving them from the balance sheet to the income statement, as well as the treatment related to the LIFO debit that we've got on our balance sheet and the declining cost in the environment. It's those two that make up the difference.
Is there a point where you get through that or is it just as you continue to take down inventory, it's just going to be a perpetual headwind until inventory grows again?
Yeah. No, that's correct. We've got a rather large LIFO debit on our balance sheet and in a declining material cost environment as we draw down inventory, that will be a headwind to P&L. It's important to note that as inventory is growing, it was a tailwind to P&L. For seven years, the company was growing inventory much greater than sales. If I go back to the question they had in Q1, there was a 22 bps benefit in Q1 of the prior year related to the increase in inventory. Yes, it's going to be a headwind as we continue to draw down inventory, but again, it's non-cash. It's the right thing to do.
Once we get it to an optimized level and turns start kicking in, we get our payables in order, you will see a dramatic improvement in both cash flow and supply chain performance that it will enable.
Thank you. We have no further questions at this time. I would like to turn the conference back over to management for closing remarks.
As you heard today, we've got a lot of detailed work going on, and we look forward to continuing to update you on our progress moving forward. We knew this wasn't going to turn around overnight. We knew that from the very beginning. At the same time, we're moving rapidly to set the business up to compete at the highest level for the long term. We now have an outstanding leadership team in place that can do the job. We'd like to conclude our call by thanking all the team members and independent operators across the AAP family for their efforts to better serve customers this quarter, and thanks for joining us today.
Thank you. Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time, and thank you for your participation.