Lowe's Companies, Inc. (LOW) Q3 2011 Earnings Report, Transcript and Summary

Good morning, everyone, and welcome to Lowe's Companies' Third Quarter 2011 Earnings Conference Call. This call is being recorded. [Operator Instructions] Statements made during this call will include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Management's expectations and opinions reflected in those statements are subject to risks, and the company can give no assurance that they will prove to be correct. Those risks are described in the company's earnings release and in its filings with the Securities and Exchange Commission. Also during this call, management will be using certain non-GAAP financial measures. You can find a reconciliation to the most directly comparable GAAP financial measures and other information about them posted on Lowe's Investor Relations website under Corporate Information and Investor Documents. Hosting today's conference will be Mr. Robert Niblock, Chairman, President and CEO; Mr. Rick Damron, Executive Vice President of Store Operations; and Mr. Bob Hull, Executive Vice President and CFO. I will now turn the program over to Mr. Niblock for opening remarks. Please go ahead, sir.

Good morning, and thanks for your interest in Lowe's. Following my remarks, Rick Damron will review our operational performance, and Bob Hull will review our financial results in detail. But first, let me share a summary of our third quarter performance, as well as how we're thinking about our business going forward. Sales for the quarter increased 2.3% while comparable store sales were positive 0.7%. Comp traffic increased 0.7% in the third quarter, and comp average ticket was flat. Gross margin contracted 99 basis points in the quarter. Bob Hull will provide more details regarding gross margin in a few minutes. We had good operating expense control in the quarter third quarter, however, as detailed in today's release, we recognized charges related to store closings and discontinued projects, which in aggregate reduced pretax earnings for the quarter by $336 million and diluted earnings per share by $0.17. Including this charge, we delivered earnings per share of $0.18 in the third quarter. Excluding the charge, we delivered earnings per share that exceeded our guidance for the quarter. As I said before, our performance is not at the level we expect relative to the market or, frankly, that we demand of ourselves as we define success, so we're taking action. The executive team is looking at our business from a fresh perspective, and we're evaluating how we operate on a cross-functional basis to ensure consistent and connected execution. During the third quarter, we reorganized our store operations and merchandising organizations to improve efficiencies, increase speed to market for new products and services and enhance the shopping experience for customers. We streamlined our field organizational structure, resulting in fewer districts and regions. And we've announced the closing of 27 stores this year that were underperforming despite the tremendous effort and hard work of…

Thanks, Robert, and good morning. During my time today, I will review our third quarter performance, as well as discuss some of the recent changes we have made to streamline our core operations and then provide an update on some of the store investments we discussed earlier this year. We finished the third quarter with positive 0.7% of basis point comp, Hurricane Irene contributed roughly 60 basis points to our comp growth as we help customers on the Eastern shore, inland mid-Atlantic and New England prepare for work and cleanup from high winds and flooding. There was particularly strong demand for roofing products, dehumidifiers, pumps and tanks, generators, wet dry vacuums and cleaning supplies. Separately, our private brands continue to provide customers with compelling value. Our new line of cobalt power tools combined with our strong national brands drove strong tool comps. Seasonal clearance of patio furniture generated strong seasonal living comps, unfortunately, it also negatively impacted gross margin. [indiscernible] benefited from consumers buying more energy savings LED bulbs and stockpiling incandescent bulbs in anticipation of federal regulations phasing out 100 watt incandescent bulbs beginning in 2012. Large discretionary products remain pressured. Millwork recorded double-digit negative comps with the greatest weakness in entry doors, storm doors and windows, which last year benefited from ENERGY STAR tax credits. Cabinets and countertops, appliances and fashion plumbing also recorded negative mid- to high-single digit comps in the third quarter. According to third-party measures, cabinets and countertops continues to show strong share gains, but not enough to offset the contracting market for these products. Within appliances, we chose not to match some competitor's extremely aggressive third quarter percent off promotions. Inventories ended the quarter 5.2% or $447 million higher than the third quarter of last year. This increase was driven by an additional investment…

Thanks, Rick. And good morning, everyone. Sales for the third quarter were $11.9 billion, which represents a 2.3% increase over last year's third quarter. In Q3, total customer count increased 1.9%, and average ticket increased 0.4% to $61.84. Comp sales were positive 0.7% for the quarter. Looking at monthly trends, comps were 1.4% in August, 0.3% in September, 0.4% in October. For the quarter, comp transactions were up 0.7% while comp average ticket was flat to last year. With regards to product categories, the categories that performed above average in the third quarter included building materials, rough plumbing, seasonal living, lawn and landscape products, fashion electrical, tools and hardware. In addition, home fashion storage and cleaning and nursery performed, essentially, in line with the company average. We estimate that our proprietary credit value proposition, which offers customers a choice of 5% off every day or promotional financing positively impacted Q3 comps by 90 basis points. Likewise, we estimate that sales related to Hurricane Irene positively impacted Q3 comps by 60 basis points. Our business continues to be negatively impacted by customers postponing big-ticket purchases. During Q3, comps per transactions greater than $500 were negative 0.8% driven by Millwork, appliances and cabinets and countertops. Year-to-date, sales of $38.6 billion represents 0.6% increase over 2010. Gross margin for the third quarter was 34.6% of sales, a decrease of 99 basis points from last year's third quarter. As a reminder, gross margin increased 85 basis points in Q3 2010. A decrease in gross margin was driven by a number of factors. Our proprietary credit value proposition negatively impacted gross margin by approximately 35 basis points. In Q3, the impact was larger than the 11 basis point impact in Q2 due to the launch of the commercial program at the end of Q2, as…

[Operator Instructions] Our first question comes from the line of Eric Bosshard with Cleveland Research.

Could you talk a little bit -- you talked about becoming a little less promotional, a little more of this Everyday Low Price focus. I know this is a quarter where you cycled price rationalization you started a year ago. Can you talk a little bit about how we should think about the gross margin performance going forward, and how you think -- how you're planning on managing competitively this transition of being a little bit less promotional in an environment that seems like wants promotional efforts?

Sure, Eric. This is Bob Gfeller. And as we look at being competitive every day, there is price transparency in the marketplace for the customer. And we've got to make sure, therefore, that whatever channel the customer desires to search products at Lowe's, we're priced competitively. In order to be priced competitively, we've got to make sure that working with our vendors we have the lowest possible acquisition costs. And in order to do that, we really need to simplify the deal structures that we have with our vendors, and part of simplifying the deal is structure is to become less promotional. So as we are looking at our business, and each business is going to be a little different, certainly the big-ticket businesses that Bob talked to versus, let's say, the hardware business. We are working through a product line review cadence of all of our businesses over the next 12 months, utilizing our integrated planning and execution tools that I think we've talked about in the past with a more accelerated process to make sure that we're locally assorted correctly, as Robert mentioned, in every market, and we're priced right appropriately to the competition in the market. At the same time that we're working to tighten up our lines as it relates to stock product, we are looking to expand our online assortments dramatically. I think Robert referenced the 260,000 items on lowes.com by year end, and we need to continue to grow that so that as the customer shops Lowe's, again, depending on the channels they shop, they can take advantage of our growing flexible fulfillment capabilities. And so as we look forward all of this is to improve our ROIC, specifically as it relates to margin and timing. The implications are there is going to be margin friction as we go forward into 2012, but we expect by the time we get to the end of next year, we will have addressed 3/4 of our sales through this accelerated process, and the margin benefit of the rationalized cost should more than offset the retail price pressure by the second half of next year.

So if I can drill into that a bit more, how should we expect this to play out in terms of them -- the gross margin performance over the next 12 months and the relative market share performance that I know you referred to in your release this morning?

So Eric, this is Bob Hull. I'll take the first part of the question, which is the gross margin cadence, and let others chime in as it relates to market share. Specifically for fourth quarter, I think you can think about gross margin performance in Q4 similar to Q3, largely driven by the same factors, albeit some of the impacts of a different. We expect inflation to be a little bit lower. We expect EDLP price reduction impact to be a little bit greater. In addition, we'll take some markdowns as we work to start addressing underperforming inventory and SKU reduction. As Bob mentioned, there's probably some negative margin pressure in the first half of 2012 flipping to margin improvement beginning second half of '12 and beyond.

Eric, this is Bob, again, Bob Gfeller. I was just addressing market share. Based on, I think, all the work that we have in the pipeline now, we like what we're seeing in market shares, it relates to some of our core businesses, paint and tools, nursery and building materials. We've got a couple businesses that are in transition, flooring and fashion bath. I think some of the scripts referenced some significant resets as it relates to the departments in our store as well as the product in the store as well as online. So we're looking to see advancement in sales and share on those 2 businesses. The ones that are harboring now are cabinets and appliances, and Millwork, as I think Ricky mentioned. They are big ticket. And we have significantly depromotioned ourself on Millwork, and we've got to work through that. As it relates to appliances, we are anticipating a solid fourth quarter on appliances.

Our next question comes from the line of Mike Baker with Deutsche Bank.

One question and then a follow-up. First question is just on buybacks. You increased your leverage and you're a little bit below your target leverage right now, and you say you're going to buy back stock in the fourth quarter. Just curious as to why there were no repurchases this quarter? Did it have to do with some of the announcements you made during the quarter so that closed your window? So that's my first question. The second question has to do with some of the drop zones and the end caps that you talked about in your resetting. Do you have an early read on what kind of improvement and excitement in your comps, or however you want to measure it, that that's having so far?

Sure, Mike. As with the share repurchases, there were no share repurchases in the third quarter because our lease adjusted debt to EBITDAR target until that time was 1.8. We were concerned about bumping up against that target at that time. Given that we revised our outlook to 2.25x, we now will be active in the share repurchase department. So really, that was the largest driver of not being in the market for Q3.

Mike, Bob Gfeller, again. As it relates to the resets, the end cap and drop zone resets that Robert referenced, 500 stores completed by first week of December. Additionally, we've updated our lawn and garden set in 200 of our stores, particularly in the deep south. And we were able to do it to catch the Fall Is For Planting season. And then, lastly, I think Bob referenced to the fashion bath resets that are actually just rolling out as we speak. I would tell you, overall, we are seeing positive results in the stores. It's a little early because the sets are really just taking hold. So our plan is that at our Analyst and Investor Conference in December, we'll be able to share more detail with you, as well as take you on a store tour during the conference so that you can actually see exactly what we've put in place.

Your next question comes from the line of Greg Melich with ISI.

I had a couple of questions really revolving around the top line, and you mentioned that credit helps 90 bps. I'm just curious, how much of that was traffic versus ticket? And also on the top line, what you think inflation helped in the quarter?

Sorry, Greg. So your first question was regarding the credit value, 90 basis points, how much was traffic and how much was ticket?

Correct.

It is more towards traffic than ticket. If you think about the value proposition to promotional financing, which is $2.99 and above, it was already geared towards big tickets. The 5% off everyday was for those everyday purchases. So of the 90 basis point impact, 2/3 of that would have been from transactions.

Got it. And then the follow-up on the inflation and how that's impacting the comp. So you said that it hurt gross margin. I imagine it would have helped the top line as well, maybe not in traditional lumber and copper, but just in terms of pass-through on a lot of products where prices were going up this year. Do you have any estimate of that?

Yes. It's basically a wash on comps, Greg, as we had inflation in build materials, primarily roofing. We did have cost inflation in paint, but the margin pressure came because there was no retail inflation, offset by lumber and plywood deflation in the quarter. So the net impact of inflation on comps in Q3 was potentially 0, which is basically our forecast for Q4 as well.

Okay. And this is a follow-up, I promise, on credit. It helped EBIT by 16 bps in the quarter and you gave us the mix on gross margin SG&A. Is that where you think we are now with run rate, or does the credit program start to have some cost as we look at it into next year?

I think it's probably close to 10-or-so basis points, 10 to 20 at the top side. Really, I think, funded by lower promotional financing. One of the pass-through costs we have with our credit agreement with GE is we fund customer acquisition costs, whether that's promotional financing, which hits SG&A, or 5% of everyday, which hits margins. So basically what we're seeing is that the 5% off everyday is more productive than the promotional financing has been previously.

The next question comes from the line of Michael Lasser with UBS.

I wanted to get a sense for the way you're deriving the expected returns from some -- all the pricing actions that you have and will take, and maybe one way we can get that is from the performance of the expanded list of benchmark items recently. Have you seen any noticeable difference in that?

Michael, this is Bob Gfeller. As it relates to the benchmark item list and the expansion, that's actually -- we've been rolling that out over the past 30 days. So we've got -- we need some more time to be able to read that. Again, trying to be price competitive across multiple channels. Probably be able to share more of that with you in December.

Yes. Michael, this is Robert Niblock. As Bob indicated, I know I think it was on the second quarter conference call we talked about expanding our list of benchmark items. Once Bob put his value improvement team in place in his merchandising organization, they went back and they've taken another look at the list of benchmark items. So we've been a little bit delayed in rolling that out versus where we anticipated. So that's why kind of the delay that Bob talked about with being able to get a read on that. Certainly, as Bob described to you, not only are we -- have got this move back to EDLP, or if you want to call it EDLP plus, because we know there are certain big-ticket categories that you're going to need to promote at certain times of the year. And it's a cadence that we're going through now, as Bob is going through his line review process to get the pricing right and really trying to balance the price and promotion cadence that we have, and trying to make sure that we're doing it in a way where the customer is going to give us credit for that. So Bob and his team are being very disciplined in that process. As we go through it, we're reading what we're seeing and we'll make necessary adjustments along the way. But I think at this point, it's probably just a little bit too early to be able to give you any feedback on where we stand.

Understood. That's helpful. And Robert, it seems like the organization is going through a lot of change organizationally, tactically, maybe even strategically. Do you think that there's been any distractions from some of the dynamics that have gone on, maybe even weighed on the results over the last couple of quarters, and as the changes settle in that could be a positive?

Absolutely. I think when you look at the significant amount of change that we put the organization through, any time you have that level of change there's got to be some amount of disruption associated with that. That was part of the reason that we tried to consolidate all of these changes and form together and execute them as quickly as we could, be it the change in the span of control in the field organization, the changes that were done here, for example, in Bob Gfeller's area in merchandising, going ahead and getting the necessary store closings behind us, the new approach to moving back to EDLP. All those things we wanted to try, and so that way we could then lay out the clear path forward for the organization, get everyone refocused on where we're moving in the future. And a lot of those changes, as we've said in our comments, are being driven by, one, where the customer's going, where the market is going. As Bob Gfeller talked about, price transparency is becoming greater and greater every day. And we think about other channels, Internet and those out there that we compete against as well, we've got to make sure that we're priced competitively every day across those channels so that long term, we're going to be able to provide the value proposition that consumers are looking for no matter what channel they choose to shop on. And that's also, while we're trying to continue to expand the Internet, for example, and bring other ways in to bear to be able to meet the consumers' needs, whether that's transaction projects in-home, if they want to do a major project and having a representatives in their home, whether it's buying online, whether it's buying in store, whether it's dealing with someone at our contact center to be able to ask a question, to be able to transact for that day. So we're trying to certainly approach it on a multi-channel, cross-functional basis and have a great cadence to it. But in the amount of changes, certainly, we understand that there were some disruption in the process, and we think that we've now gotten most of that behind us.

Your next question comes from the line of Alan Rifkin with Barclays.

First question for Robert. As a follow-up on the capital structure, so with your decision to take your debt to EBITDA ratio up, coupled with you guys taking the store count down for next year, certainly implies more capital focused on both dividend increases as well as share buybacks. Robert, I guess my first question was, is there an update to the payout ratio? And then philosophically with your weighted average cost of capital increasing by 50 basis points, can you kind of just tell us how you would think about the stores that are cash flow positive today but are not yielding an adequate rate of return?

I'll start, and then Bob will jump in. Alan, I think on a weighted average cost, the capital is actually decreasing 50 basis points, not increasing, with the new leverage targets. As far as looking at -- we aren't making any other changes to dividend payout ratio at this time. As far as looking at longer term, how we think that this plays out with regard to cash flow that will be available for dividends for share repurchase, those type of things, I think we would plan on updating you on those items at our Analyst Conference, when we get a little bit longer term view. The purpose today, which is to be able to signal that we have made that change and that we'll pool together and prepare for you what that looks like on a longer-term basis as we get to the analyst conference. Bob, did you want to add anything?

Yes. So Alan, to remind you, our payout ratio right now is targeted to be 30% to 35%. As Robert indicated, no plans to update that at this point in time. The last part of your question dealt with cash flow negative stores. As we told you, again, in Q2 we made 53 of those. Basically, since that time half of them have closed. We continue to monitor the remaining 26 or so stores. We do believe that they have future viability, given actions we're taking and given the markets they are in and the expected turnaround in those markets.

Okay. And one follow-up, if I may. I believe you said in the early commentary that you increased your holiday investment in inventory. Can you maybe shed a little bit of color on that incremental investment inventory, is much of it focused on the proprietary credit card program?

Really it has, Alan, nothing to do with proprietary credit program. That's just an opportunity for the customers to choose 5% off every day or promotional financing. As Rick indicated in his comments, the increase in inventory was due to some increases in holiday items, specifically storm products, as we think about gift-giving season. That was the kind of the focus of our efforts to increase inventory for Q4.

Your next question comes from the line of Peter Benedict with Robert Baird. Peter S. Benedict - Robert W. Baird & Co. Incorporated, Research Division: Two questions. First just on the paint business, it was interesting you'd mentioned, I think, Rick or Bob, you may have said that you had the cost increases but you weren't able to play it out at retail. Just understanding maybe what's going on in that category from a competitive standpoint or why you weren't able to pass it through? And then secondly, Bob, given all the changes you guys are making to the business, to your closing stores, investing in the merchandising, what are your latest thoughts on the longer-term sensitivity of operating margins to comps? I think in the past you've said if you could comp one, you maybe keep even margins flat, and then increase from 20 for every 100 basis points beyond that. Is that still where we're at? Does it get better than that because of the changes you've made? Is it worst than that? What can you tell us?

Peter, this as Bob Gfeller. I'll just hit the paint question very quickly. So in the paint business in the last quarter we had a good quarter, a lot of new product innovation from both Olympic and Valspar, our 2 primary brands. As it relates to the cost inflation, the TiO2, the main raw material continues to inflate, and it probably will continue to inflate. It's not that we weren't able to move prices up, but we just couldn't move them up enough to cover the inflation. It's not that we won't continue to test that as we move into the fourth quarter and into next year, so we'll see how much of that we can get back as we go forward.

And Peter, on the second part of your question. At this point in time, yes, I think it's fair to assume that guidance we provided in the past [indiscernible] change in comp, it's 20 basis points of EBIT impact. And then we will update you on our thinking long term at the Analyst Conference next month.

Your next question comes from the line of Chris Horvers with JPMorgan. Christopher Horvers - JP Morgan Chase & Co, Research Division: On the top line, I was just curious with the 27 store closures, were they in the comp base? Did you see any -- was there any benefit from having those closures? And then similarly on the pre-Halloween snowstorm, I think your quarter ends on Saturday, was there any lift out of that as well?

Chris, as it relates to store closings, they were not in a comp base. However, we did see sales from the closed-store locations transfer to comp store locations. So the positive impact of that was offset by cannibalization from new stores that opened over the prior 4 quarters. So really no net impact of transfer for closed stores relative to cannibalization from new stores. Lastly, our quarter actually ends on Friday. So none of that would have showed up in our Q3. Christopher Horvers - JP Morgan Chase & Co, Research Division: Okay. And then as a good follow-on to that, so on a 2-year basis, you were guiding to an acceleration here in the fourth quarter, and I was just curious if you could lay out the factors that drove that guidance?

Sure. We've got some specific actions we're taking. We did have value prop Q4 last year, for example. We gave you the impact of Q3. We talked about a number of the changes that were taking place in market as it relates to product differentiation. We've indicated we're seeing positive results to date, so we expect more of the same in the fourth quarter. So, really, the change in trajectory is up as a matter of some of the specific actions we're taking and starting to see benefits of those actions.

And Chris, this is Robert. Also keep in mind of the comments I made about the amount of disruption that we put the organization through in the third quarter this year. We've now got that behind us and got everyone refocused on the business, so I think that helps as well.

Your final question will come from the line of Colin McGranahan with Bernstein. Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division: I may have missed it, but did you go through any of the market share data by category? You typically say how many categories you gain share in and then the overall trends for the quarter. And then I have a follow-up for Bob Hull.

Colin, this is Bob Gfeller. I can -- just top line for you. So in the quarter on a rolling 4-quarter basis, dollar share we were up an 8, we were down an 8 and flat in one. On a unit share, we were up in 11, down in 6 and flat in one. And overall we held ground, if you look at total Lowe's. Colin McGranahan - Sanford C. Bernstein & Co., LLC., Research Division: Okay. Great. That's helpful. And then, Bob, just on the 2.25 lease adjusted debt to EBITDAR, was I correct in hearing that you said there'll be no more adjustments after that? So you're looking at that as kind of a perpetuity optimal capital structure? And then I know you're going to talk more about it at the analyst meeting, but how quickly do you think you can get there? Should we assume you get there pretty much relatively early next year, so add an incremental $3 billion to maybe an underlying go-forward rate of $2 billion in share repurchases for a total of around $5 billion next year?

So you are correct that I said that we don't foresee any adjustment to the 2.25 in the foreseeable future, and what I would call more of a practical cost of capital versus an optimal. You can engineer a higher -- a lower debt rating and a lower cost of capital, but we don't think that's practical in this environment to balance liquidity and flexibility. From a cadence perspective, we believe it's going to be by the year-end 2012. So we're not going to raise $3 billion immediately. I think that's, on a cadence approach, between now and the end of 2012. And yes, obviously, more to come on long-term share repurchases next month at the Analyst Conference.

Thanks for your continued interest in Lowe's. We look forward to speaking with you again when we report our fourth quarter results on February 27. Have a great day.

Ladies and gentlemen, this does conclude today's conference call. Thank you, all, for participating, and you may now disconnect.