Lowe's Companies, Inc. (LOW) Q2 2012 Earnings Report, Transcript and Summary

Good morning, everyone, and welcome to the Lowe's Companies Second Quarter 2012 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 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 use 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 Investor Documents. Hosting today's conference will be Mr. Robert Niblock, Chairman, President and CEO; Mr. Greg Bridgeford, Chief Customer Officer; and Mr. Bob Hull, Chief Financial Officer. 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, Greg Bridgeford will review our operational performance, and Bob Hull will review our financial results in detail. But first, let me provide a summary of our second quarter performance. Comparable store sales for the second quarter were negative 0.4% with an 0.8% decline in comp transactions and a 0.4% increase in comp average ticket. The comp for our U.S. business was negative 0.2%. Ahead of the quarter, we expected comps to be within the 1% to 3% range. And while we fell short, our performance improved sequentially each month of the quarter, and 9 of 14 product categories ended the quarter with a positive comp. In fact, 7 of those product categories generated comps above 1%. The most significant comp pressure came from building materials, lawn and garden and Millwork, and Greg will discuss those categories in a few minutes. We also continue to see strength in our Commercial business, which outperformed the company average in the second quarter. As a reminder, our Commercial business is roughly 25% of our sales. While second quarter gross margin contracted 56 basis points, we continue to improve sequentially while working to strike the right balance relative to promotions. We effectively controlled operating expenses in the quarter, delivering earnings per share of $0.64, which included approximately $0.01 of severance and other cost associated with our voluntary separation program. Delivering on our commitment to return excess cash to shareholders, in the second quarter, we repurchased $1 billion or 36.8 million shares of stock and paid $166 million in dividends. Before I turn the call over to Greg, I'd like to address 2 additional topics: first, my level of satisfaction with the progress on our strategic initiatives; and second, our nonbinding proposal to acquire…

Thanks, Robert, and good morning, everyone. During my time today, I want to dive a little deeper into our quarterly results, describe our challenges and progress and provide clarity on our priorities. Our second quarter performance resulted from a number of factors: a challenging start, learnings applied and a better finish. For the first few minutes, I'd like to focus on product category performance. As Robert noted, building materials, lawn and garden and Millwork put significant pressure on our total comp growth. In fact, excluding these categories, the remaining 11 categories combined comped above 1%, with particular strength in lumber, cabinets and countertops, paint and tools and outdoor power equipment. We faced a headwind in building materials, which finished the quarter with double-digit negative comps. Substantial tornado and hurricane repairs drove double-digit positive comps in this category in the second, third and fourth quarter of 2011. In lawn and garden, the combined effect of a strong pull-forward in the early spring season followed by extreme heat and drought conditions led to slow sales and distressed live goods inventory, which negatively affected margin in this category. Millwork sales were negatively impacted as we struggled to strike the right balance on promotions. Focusing on our monthly comp progression, our May comps were negatively impacted by a reduced promotional schedule that resulted in light Memorial Day weekend traffic, particularly in appliances, flooring, cabinets and countertops. As a result of early adjustments, we improved sales as the quarter progressed, but in hindsight, we overcorrected and added too heavily to big-ticket promotions, negatively impacting margin. Based on our experience in the second quarter, we've completely taken apart our promotional strategy, not to go back and add in more events for the third and fourth quarters but to rebuild from the inside out, revising tab item…

Thanks, Greg, and good morning, everyone. As noted in our earnings release, there was a week shift in fiscal 2012 as a result of 2011's 53rd week. Sales for the second quarter were $14.2 billion, which represents a 2% decrease from last year's second quarter. The decrease was driven by the counter week shift and negative comp store sales, offset slightly by new stores. We estimate that the week shift negatively impacted sales for the quarter by $259 million or 1.8%. In Q2, total cost per transactions decreased 2.4%, primarily a result of the week shift impact, while total average ticket increased 0.4% to $62.66. Comp sales were negative 0.4% for the quarter. Looking at monthly trends, comps were negative 2.1% in May, positive 0.4% in June and positive 0.7% in July. Through the first 3 weeks of May, comps were running above 1%. But as Greg noted, with tough Memorial Day weekend, and as a result, comps were negative for the month. With regard to product categories, the categories that had above-average comps in the second quarter included lumber, cabinets and countertops, paint, tools and outdoor power equipment, flooring, seasonal living, home fashion storage and cleaning, hardware and fashion electrical. Plumbing and appliances performed at approximately the overall corporate average. For the quarter, comp transactions declined 0.8%, which is primarily attributable to lawn and garden, which was impacted by a seasonal pull-forward as well as extreme heat and drought conditions in much of the country. Comp average ticket increased 0.4%. The positive comp average ticket was driven by strength in our Commercial business, above-average performance in cabinets and countertops, tools and outdoor power equipment and flooring as well as lumber inflation, offset slightly by the impact of the 5% off credit value proposition. Year-to-date, total sales of $27.4 billion…

[Operator Instructions] Your first question comes from the line of Alan Rifkin from Barclays Capital.

With respect to the results that you're seeing from the line reviews so far, Greg, can you maybe just talk about with the 50% of the products that you've already completed, what's the incremental gain there? And can we assume that the line reviews that you're conducting earlier in the program should yield greater results than what you're anticipating for the -- as opposed to the reviews later in the program?

I'll address that last part first. Not necessarily, because in a number of cases where we think that it's taken some time for the vendor community to digest the strategy that we're going after in some of these line constructions and the way we're trying to create value for the customer. And be honest with you, in -- as we come around to a cycle of some line reviews, you're seeing the same vendors come to the table with, actually, much more alignment with where we're taking the strategy to create value within each of these categories. And with respect to where we are with our expectations and the performance of the line reviews, as we described earlier, from an inventory -- net inventory reduction standpoint, we're exceeding our initial expectations. And from a cost standpoint, we're increasing our progress towards our target, and that's -- and we're looking -- again, we're looking forward for a stronger performance in that area as we go through continuing cycles of this accelerated line review process.

Okay. And then just a follow-up for Robert, if I may. Robert, do your results in the first half of the year and the fact that you've now lowered your expectations for the second half and the housing recovery seems to be as elusive as ever, does that give you pause that maybe you should be pursuing RONA at a different time, a time when the U.S. business is exhibiting a little bit more stabilization than what we're presently seeing?

Yes. I mean, it's a -- obviously, a fair point, Alan. The -- with regard to the U.S. business, we still feel really good about where we're going. We know that we had a lot of -- probably the peak of disruption in the second quarter with everything that we threw at the organization. I think we've gotten the organization settled back down. We are understanding that the benefits are still there, but it is taking a little bit longer to accrue. So certainly, with regard to the transaction with RONA and to your question, first of all, the set of transactions not imminent, even if we could get to that point, you would be into 2013 before a transaction would close, and we'd be through a lot of the -- what Greg has talked with the cadence of the line review process and the other changes, the heavy changes that we're making in the store environment. But first and foremost, we're looking at several options as to how we get scale in our business in Canada. This is one of the options that we're looking at, and we really don't know, until we can get to the point of confirmatory due diligence, whether it makes sense. From the outside, it makes sense. We need to get inside and get confirmatory due diligence to be able to confirm those beliefs, but we have a preference for friendly transaction. We're not going to do something that doesn't make long-term sense for the company. It's something that we don't think we can absorb. That's why we've kind of bifurcated the operations of the company from international and U.S. to minimize any distraction there, and we're not going to overpay something that we don't think we can get an adequate return on. So unfortunately, we can't always pick the timing as to when something may be available, when it's time to -- the right time to pursue something given what else we have in the business, but we're going to try and manage through that and try and make the right long-term decisions for the organization. But understand your point and it's a point well taken, so.

And your next question comes from the line of Peter Benedict from Robert Baird.

First, just, Bob, thinking about the second half comp plan of flat. I know there's some comparison differences, third and fourth quarter. Is there anything we should think about in terms of the pace? I know that the -- some of the merchandising efforts you've got should be accruing benefit increasingly as you go forward, but the comparisons are tougher fourth quarter. Just maybe talking about the -- how you see the third quarter versus the fourth quarter. That's the first question, then I have a follow-up.

So Peter, thanks for the question. So if we take a look at last year, we do have tougher comparisons in the fourth quarter. Q4 last year, we said favorable weather helped us roughly 150 basis points, so we're certainly mindful of that comparison. Greg, in his comments, took you through the cadence of the line review process. So momentum is certainly building there. We are seeing good results from the few that have been set to date. Certainly, more gets set as we move into the back half of the year. In addition, we've got greater number of stores set with the product differentiation, the end caps and the drop zones. So as the year progresses, we expect more benefits from those items that hopefully offset the tough compares we've got in the fourth quarter. We also recognize that we've got tough building material comparisons, as Greg alluded to, not only in Q2 of last year but Q3 and Q4. Part of Q4 is -- was in the 150 basis points of weather favorability. So as a result, we landed a flat comp for the back half.

Okay. That's helpful. And I guess understanding that the early part of May wasn't a great indicator for the quarter, can you just maybe talk to the August trends to date. And then can you help clarify kind of the promotional strategy changes that you're making? I'm not sure I completely understood that. Just how you're viewing the second half promotional strategy versus maybe where you thought it would be 3 months ago.

I'll take the first part and let Greg address the promotional piece. So 16 days does not make a quarter. So thus far, in August, sales trends have continued to accelerate. August comps are higher than what we reported for the month of July, and again, through 2 or so weeks, gross margin is essentially flat with last year.

And Peter, on the promotional strategy, when I said we would take it apart from the -- and rebuild it from the inside out, what we're really doing is -- it actually has a number of components, and I'll try to address all of them. We're centrally coordinating our product selection to make sure that we are very strategic in what areas that we're promoting for the right time. We're specifically looking at the timing, the impact and the duration of every offer. And we're -- there's a heavy focus towards a balance in the item selection to balance traffic-driving items and attachment items, and that has a very big impact on your out margin. We're also taking a look at the bigger-ticket promotions and again, making sure that the cadence is appropriate, and the duration's appropriate. And from another factor in the quarter and a little bit of talking to where Bob is referring to sales momentum for the third and fourth quarter, we're taking a hard look at our lawn and garden plan and making sure that we've got a solid mix in the advertising plan of cross-merchandising opportunities so that we make sure that our attachment rates are strong in lawn and garden. And again, that has -- it has positive margin implications from executing on those plan revisions.

And your next question comes from the line of David Strasser from Janney Capital Markets.

A couple of questions. When you looked at the differences, May, June, July, I mean, obviously, May was hurt seasonally due to the traffic and the pull-forward. Any other big changes within any categories kind of as the business improved through the quarter sequentially?

David, this is Greg Bridgeford. I would say that if you look at the cadence of the businesses, as we described, lawn and garden had a strong pull-forward effect. And then we -- it really had an impact on our inventory sell-through, and that had a margin impact. In addition, you have the -- you have a really tough comp on the building materials side which as they begin cycling up against all the activity we had in the East and Central part of the country last year in this time. On the decor categories and on -- in particular, we saw a pretty solid performance that continued to do well sequentially, and I would say that we're continuing to see strength there. And we're starting to see -- again, we're working through a balance on the big-ticket categories so that we can get a more balanced output and more predictable output. And that's a heavy focus of all of our promotional tweaking.

And just as a follow-up, I -- when you look at -- well, how about appliances, particularly ACs, did that -- how much did that help as the weather, the really warm weather, particularly in the Northeast, Mid-Atlantic -- maybe I'm being too Northeast centric here, but how much -- did that help a lot? Because when you look at the match up numbers, it seems like those -- that was a pretty big category, particularly as the quarter progressed.

David, it was a factor early in the quarter and in the first 2 months as we cycled into some very hot weather, and we sold through. We had a good performance in that category, strong comp performance and a nice handling of the sell-through of the inventory.

And your next question comes from the line of Mike Baker from the Deutsche Bank.

So I guess a couple of questions. One, in your estimation, how much of your comp weakness and gross margin weakness was sort of self-inflicted from this promotional activity?

So Mike, this is Bob. I'll start. From the margin perspective, I said 45 basis points was from promotional activity, markdowns and such. We estimate that roughly 20 basis points of the 45 results from promotional activity associated with big-ticket categories. As it relates to sales impact, it's a mixed bag. We think it probably helped cabinet and countertop sales, appliance sales, flooring sales. We think promotional activity actually hurt Millwork sales in the quarter, so we think it's a mixed bag from a sales perspective.

Okay. And then a couple more quick follow-ups. So you said you're pushing out when you're supposed to see the benefit from this phase of transformation to mid-2013. That was, I presume, supposed to be the -- by the end of 2012. Is that the right way to think about it? Some of the -- and where does that show up mostly? In sales or gross margin or SG&A?

Mike, I'll start. It’s Robert. And then I'll have Greg follow on. Yes, as you know, nothing has changed on the line review schedule and the cadence that we talked about from the line review schedule. We still expect to have approximately 90% of those done by the end of the year. So there was already some benefit that would be lapping over into 2013. It's probably pushing out probably a quarter, so when you get to mid-2013. And really, what we're trying to say there is that we're excited about what we're seeing. We’re seeing, as Greg said, the inventory reductions, we're moving in on the cost reductions. We just got to turn it through the layers. But these changes, until we get enough of the store out there, we're not really out promoting anything different to the consumer. So it's taken the consumer in the store, shopping, to be able to see the changes that we've made. It basically comes back to not want to overpromise, under deliver. We also, as I said, with a lot of the disruption that we had in the organization, organizational changes in getting the new go to market structure lined up earlier in the year that caused a little bit probably more disruption than we’d anticipate. I think we've got the organization settled down and focused on getting back to business and running the business. So it probably pushes out about a quarter, and quite frankly, we just decided to give ourself a little bit more breathing room. We've got a lot of lines to go through. As we clear those lines, we won't be able to get through the sell-down process. We don't -- we want to make sure that we're doing that in the appropriate manner. Managing the margin appropriately will give us enough breathing room to move through that as we need to so we can go ahead and get this phase of the transformation behind us and then start thinking about other phases. So Greg?

Yes. Mike, the best way I can describe it would be that as I look through the handful of categories that have been set for more than a few weeks, I know what some of the values and some of the line review improvements are, and it's interesting to see where you're seeing the comp and margin dollar progress. So you go to a category that's very active and is a high foot traffic category, like paint, and you start seeing the benefits flow through. And that's when we describe that it will take the customer some time to encounter and discover the improvements we've made in some of the lower traffic categories. That's what Robert was referring to when he said we're going to see maybe a lengthened out impact on some of the lower foot traffic volume categories. Paint's the opposite end of the spectrum, and we're seeing customers encounter the new accessories. They're encountering the new paint lineup. They're encountering the new displays, and they like what they see, obviously.

Okay. That makes sense. One more quick thing. On the buybacks, you said $4.25 billion for the year. I think at your Analyst Day, you had been saying $4.5 billion a year to get to $18 billion by 2015. Is this a change, albeit a small change, but a change in that outlook? Or is -- are you still on pace for $18 billion through 2015, RONA notwithstanding?

So when we laid out the -- kind of a 4-year plan, the $4.5 billion was simple math. We just take the $18 billion divided by 4. It wasn't exactly $4.5 billion per year, so this would be more temporary in nature. It does not...

So you haven't changed it from what you were thinking in December? For December, you were thinking $4.25 billion this year as well.

The only change to $4.25 billion is the recognition that with top line coming down, with gross margin coming down, cash flow from operations is coming down. And as we think about balancing that with the leverage target, we needed to moderate share repurchases at this point in time.

And your next question comes from the line of Brian Nagel from Oppenheimer.

So quick -- I just want to follow up on the gross margin commentary further just so I'm clear. The -- you called out the 45 basis points and then the 20 basis points of promotional activity. So just to understand, that -- should we think about that as more onetime in nature? What's really the nature of that promotional activity? And how does it play in the strategy going forward?

Brian, I'll -- this is Greg. I'll take that. The majority, as Bob described, in the 45 basis points of adverse impact from promotions were the big-ticket categories that when we looked at sales coming out of May and the impact of a much less in promotional event calendar than we had in the comparable time period, I would say that we leaned into big-ticket promotions heavily. And recognizing that our predictions about how customers would take up the various offerings that we had. And late in the quarter, we believe we overcorrected. That's a very heavy portion of that. There's other portions of it. Nursery, as I described, that had an impact in the sell-down of the distressed inventory towards the end of the quarter. We didn't get as strong an attachment item performance in nursery, which has an impact in margin. And then when you took -- talk about price actions that we took in EDLP that are stretching out year-over-year, that has a minor, a very minor portion of that 45, and we're cycling against those changes that we made as we guide into this process in Q3. So if you're looking at more of a longer-term impact versus a shorter-term impact, I was trying to parse that up. Does that makes sense?

It does. I mean, so I guess the question -- I mean, not -- I don't want to over think this, but -- so we had the weaker gross margins this quarter. And with all that you're doing, the line reviews and the move to more of an EDLP strategy, how should we -- is there -- should we put those 2 factors together? Or is it more -- was the gross margin decline as a result of the promotional activity more of a one-time -- more of a kind of a seasonal effect this time?

Heavily impacted by decisions we made to increase big-ticket promotions that played out in -- basically in July.

Okay. And then if I could follow up with a bigger picture question, just on the overall environment, you made some comments in your prepared remarks about the housing recovery. As you look at the data you've seen recently, maybe since the last time we spoke a quarter ago, I mean, how was your view -- as a company, how is the view of the overall housing environment, as that relates to home improvement demand, evolving?

Brian, this is Robert. Overall, I think macro -- the overall macro environment certainly has its challenges out there. While there have been some positive signs out there in housing, certainly, there's a lot of that in sales and housing prices and stuff have been really driven by a change in the mix of houses available. We started to sell through some of the distressed inventory that's out there, so that's led to increase in home prices. Housing turnover is up, but certainly, it is down from the peak it was prior to the downturn. So we are encouraged by the positive signs out there in housing. Obviously, unemployment is still a challenge in the large macro -- overall macro environment, are still a challenge and a headwind going forward. We don't know what will -- what -- how demand will be impacted by that, but certainly, we think housing is nearing the bottom of the cycle. And as we get through the election, get into 2013, we hope that there'll be some tailwinds coming out of housing, but we're not looking at anything -- any type of a dramatic tailwind coming from housing. So...

So your final question then comes from the line of Matthew Fassler from Goldman Sachs.

I've got 2 questions, one of a general nature and then a follow-up on promotions. If you think about the progress that you're making on your internal initiatives and the notion that you're going a bit slower than perhaps you anticipated, where would you say the slowness is? Is it in the internal execution against the plan? Or is it customer reception to the changes that you're making? If you could differentiate between the 2.

Matt, in -- I'll start in VIP, it's -- or value improvement program, it is customer recognition of the changes that we're making in the marketplace and as that recognition turns into comparable sales and margin generation. As we -- as I described earlier, we're on target with our execution of the line reviews and our execution of the resets, as we described last quarter, and that progress is going well. But I think we're just being a little more realistic about customers' perception of certain categories that we reset.

So Matt, it's Robert. Still optimistic about what are de-leveraged, just we were probably overoptimistic -- overly optimistic as to how quickly those benefits would begin to accrue. But we still, longer term, think the benefits are there and are optimistic about where we de-lever and what it will mean for the future, so.

Got it. And then my second question relates to promotional activity. It seems like there is some zigging and some zagging over the course of the quarter. So with that in mind, you give us comp -- just a comp trajectory during the quarter. What do the gross profit dollar trajectory look like? And is there a change in the value approach that you're seeking to pursue? I'm trying to see where the moves that you made intra quarter sort of fit in within that -- within the philosophy that you had put forth initially.

Matt, this is Bob. So roughly, through the middle of the quarter, gross margin was close to flat with last year. As Greg indicated, there was a bit of an overcorrection regarding promotions and then just responding to a prior question, noted that the largest big-ticket impact was felt in July. So it actually got a little bit worse in the big-ticket categories towards the end of the quarter, which is why when Peter asked me about the start to this quarter, I did note that gross margins are essentially flat to last year through 2 weeks. Again, 2 weeks doesn't make a quarter.

Matt, regarding the composition of the promotions, when we look to the second half, what we're -- what we are planning for and executing is a more balanced approach to it. And the way I would describe that would be whether it's our execution of the focal points of each weekend coming up or whether it's the promotional vehicles itself with -- it's a tad mixed. We're looking for a more balanced approach to ticket-driving items and especially, what you would call anchor items, which are items which you build attachment rates around and more project-starter type items. As we will get a better mix out from that on a gross margin basis, which is key, because we're trying to make sure that just driving sales without it, we recognize the impact of that.

As always, thanks for your continued interest in Lowe's. We look forward to speaking with you again when we report our third quarter 2012 results on November 19. Have a great day.

And this concludes today's conference call. You may now disconnect.