Lowe’s - Earnings Call - Q3 2012

Transcript

Speaker 5

Good morning, everyone, and welcome to Lowe's Companies third quarter 2011 earnings conference call. This call is being recorded. Please note, if you pressed star one to enter the question queue prior to the start of today's call, your signal did not register. You will need to press star one again to enter the queue. 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.

Speaker 1

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. 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. However, as detailed in today's release, we recognized charges related to store closings and discontinued projects, which in the aggregate reduced pre-tax 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've 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 our employees. These were very difficult decisions that unfortunately affected hardworking employees in the communities we serve. Although the decisions were difficult, they were absolutely necessary to right-size the organization for the realities of the economic environment we operate in today. We also recognize that we need to bring excitement back to the Lowe's experience, and we're making incremental improvements to make our business better. Our near-term focus is on value improvement and product differentiation, both of which will drive greater asset productivity. Value improvement will ensure that we're getting the lowest inventory acquisition costs by working with our vendor partners to simplify deal structures.

We will also rationalize promotions, which will allow us to provide low retail prices every day. We will also localize our product assortments, ensuring that the right product is in the right market in the right quantity. Product differentiation will establish Lowe's as the place to find the newest and most relevant products for home improvement. These products can be national brands, or they can be private brands. We're working more closely than ever with our key vendor partners on new product development and new display techniques. In fact, we're in the process of refreshing in-caps and establishing drop zones in approximately one-third of our chain, highlighting innovation, value, private and national brands, and creative ideas solutions. This focus will also drive the expansion of items online, providing customers a broader assortment of products than we stock in our stores, essentially providing customers an endless aisle.

We expect to have over 260,000 items available online by the end of the year. You'll hear more about our merchandising strategies at our analysts and investor conference on December 5th and 6th. In mid-September, we launched our new brand positioning and advertising campaign, Never Stop Improving. This is more than a tagline, it's a mindset for our customers and a rallying cry for our employees. We're committed to constantly innovate and improve in order to satisfy the ever-changing needs of our customers and inspire them to innovate and improve their homes. The brand positioning and advertising campaign are the results of in-depth research showing that consumers are looking for inspiration and motivation. We will lead them through the journey of home improvement from inspiration and planning to execution and enjoyment.

We are keenly focused on improving our core business while also developing new capabilities and services for the future, and I'm pleased to announce that we launched My Lowe's in mid-October. My Lowe's is a revolutionary new online tool that makes managing, maintaining, and improving homes simpler than it's ever been. Customers can create home profiles, save room dimensions and paint colors, organize owner's manuals and product warranties, create shopping to-do or wish lists for projects on the horizon, set recurring reminders for common maintenance items, and store purchase history from all sales channels. The capabilities of My Lowe's will grow and evolve over time based on customer and employee feedback. Customers are excited about this very relevant and personalized offering, and we're pleased with early reads on operating metrics. The ultimate goal of My Lowe's is to consolidate spend that is currently spread across many competitors into Lowe's.

We will more deeply penetrate our existing customer base, garnering a greater share of wallet, as well as attract new customers with a lower cost of acquisition. You'll hear more about our commitment to deliver better customer experiences, experiences that are simple and optimized across all channels at our analyst and investor conference. We've experienced a lot of change in the past 90 days, and disruption is inevitable when changes of this magnitude are made. However, I am confident that the team is more connected than ever and focused on the most impactful enterprise priorities. The team is energized and moving forward on a clear path that is not dependent on an unlikely near-term economic recovery. I would like to thank our hardworking employees for their ongoing dedication and customer focus during a time of significant change. Thanks again for your interest, Rick.

Speaker 3

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 basis points high. Hurricane Irene contributed roughly 60 basis points to our comp growth, as we helped customers along the Eastern Shore, Inland Mid-Atlantic, and New England prepare for and clean up 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 Kobalt 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. Fast LEDs benefited from consumers buying more energy-saving LED bulbs and stockpiling incandescent bulbs in anticipation of federal regulations phasing out 100-watt incandescent bulbs beginning in 2012. Large discretionary projects 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 continue to show strong share gains, but not enough to offset the contracting market for these products. Within appliances, we chose not to match some competitors' extremely aggressive third quarter % 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 in holiday merchandise and the timing of the associated inventory build, as well as the expansion of some product lines. For instance, laminate and tile flooring and LED light bulbs. Further, last year's demand for winter storm-related items outstripped our supply, so we are more aggressively ramping up for this winter. As a result, we were well prepared to meet customer needs during the recent early winter storm. We expect year-end inventories to be 2% to 3% above last year as we sell through holiday products, reduce replenishment, and rationalize SKUs based on line reviews completed with input from our integrated planning and execution tool. As Robert mentioned, we have been looking at the organization with a fresh perspective and identifying ways to improve our performance both in the short and long term.

The third quarter saw significant changes to our organizational structure, store base, and store IT infrastructure. Each change represents a move towards a leaner, more efficient company, better able to serve the needs of our customers whenever and wherever they shop. Taken together, these changes reflect our focus on protecting retail excellence as we seek to grow share of wallet through our existing store base. The new organizational structure is designed to improve speed to market, efficiency, and store autonomy, what I refer to as flexibility within the framework on our first quarter call. By providing the right balance of oversight and assistance in order to empower our store managers to focus on taking care of our customers and driving sales opportunity.

With the goals in mind, this quarter we consolidated our store operations from five divisions to three, from 21 regions to 14, and from 188 districts to 132 markets. Likewise, we consolidated our merchandising management from four business areas to two and from 18 to 16 merchandise divisions. This reorganization impacted many Lowe's employees who played an integral role in the company's tremendous growth over the last decade, and we thank them for their years of dedicated service and significant contributions. For the customer, our new structure should translate to an even better shopping experience. For our employees, the response has already been positive. The online conversation with our employee community portal indicates an overwhelmingly favorable response to these changes.

Disruption is inevitable when making changes of this magnitude, but we minimize them by using a structured and quick decision-making process and a transparent internal communications process to explain what changes were being made, when they were effective, why they were necessary, and how they would benefit the company. Fall involves many product transitions, so the August and September timing of these changes was necessary to mitigate potential disruptions. The effects on SG&A are neutral this year as lower salary expense is offset by severance. We also announced this quarter the closing of 27 underperforming stores. In 2012, we expect the closings of these stores to add roughly 30 basis points to EBIT and return on invested capital.

Additionally, after completing a comprehensive review of our pipeline of proposed new stores, we decided to discontinue a number of planned new store projects, and now we expect to open 10 to 15 stores per year in North America from 2012 forward. This is more than a 50% reduction in our expansion plan. In addition to the organization and store changes we discussed, we have been investing in our store systems and infrastructure in order to enhance system speed and ease of use for associates, providing a better experience for customers and greater productivity in our service model.

We saw an opportunity to improve our in-store data speeds, make our in-store workstations operate more efficiently, provide customers the ability to check prices against competitors and the ability to communicate with sales associates via email, and provide employees with a mobile device that would allow them to better serve customers in the aisle. In fact, we realized that doing these things would free up time for our associates to sell projects and serve more customers. I'd like to update you on our progress. We are over 90% complete in upgrading our in-store data capacity. We have updated all of our workstations, including system speed, providing better product images, and providing higher productivity through the ability to run multiple applications at once. We have increased the data capacity of employee mailboxes in addition to rolling out email to all remaining regular and part-time store employees.

Now all regular and part-time employees are able to correspond directly with customers by email and share images. Finally, we have rolled out mobile devices based on Apple iPhone technology to more than 60% of our stores. We expect to complete the rollout by the end of this year. Customized store applications allow store employees to scan items, track inventory, print price labels, and search for items without ever leaving the customer. Further, because the applications and operating platform are so intuitive, this is the first piece of technology we have deployed to the stores without training manuals. On average, each store has 25 of these devices and is using them instead of walking to a fixed terminal about 400 times a day, improving the customer experience and making our employees more productive.

The feedback from our stores on all of these upgrades has been highly positive for one simple reason: associates feel they are better equipped to serve customers. These improvements will also free up time in the stores to serve more customers, and we're taking the opportunity to critically review our existing store processes in order to eliminate unnecessary activities. To date, we have identified opportunities to repurpose several hundred thousand labor hours from support tasks to directly serving customers. We have also just completed the rollout of a labor scheduling system across the United States and Canada. Store employees have responded very well to the enhanced visibility to their work schedules and to self-service features such as electronic time-off requests. User-friendly screens and simple steps allow managers to accomplish their work more efficiently so they can dedicate more time to customer-facing activities.

Store management can now learn and use one simple system instead of three antiquated ones. Further, this tool automates several processes that were previously manual. Early findings indicate that the average store has reduced the time spent on scheduling and timekeeping tasks by four hours per week. In addition, we are now able to provide weekly detailed payroll performance reports directly to the store and field management teams, which aligns their view of payroll performance and helps them identify efficiency opportunities. I have shared with you some of the important changes we have been making. Change is never easy, but these changes provide the operating framework and IT infrastructure for future enhancements to grow share of wallet and to bring more of every dollar to the bottom line.

Thanks for your interest in Lowe's, and I will now turn the call over to Bob Hull to review our third quarter financial results. Bob?

Speaker 4

Thanks, Greg, 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 about 0.7%, while comp average ticket was flat to last year. With regard 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 for 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 a 0.6% increase over 2010. Gross margin for the third quarter was 34.06% 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 in 2010. The decrease in gross margin was driven by a number of factors. A proprietary credit value process should negatively impact gross margin by approximately 35 basis points.

The Q3 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 well as an increase in the mix of proprietary credit to total sales. This was more than offset by leverage and tender and other costs associated with our proprietary credit program. I will provide the SG&A and EBIT impacts in a moment. Also, inflation hurt gross margin in the quarter by 23 basis points, driven primarily by paint. During the quarter, higher fuel costs increased cost of sales and negatively impacted gross margin by 13 basis points. In addition, seasonal sell-through, both the impact of markdowns this year as well as in comparison to last year's strong sell-through, hurt gross margin by 10 basis points.

As we've discussed, we are working to lessen our promotional activity and move to an everyday low price philosophy. Actions taken to date negatively impacted gross margin in Q3 by approximately 10 basis points. Lastly, of the $336 million in charges related to store closings and discontinued projects, $12 million relates to inventory markdowns associated with closed doors, which negatively impacted gross margin by 10 basis points in the quarter. Year-to-date gross margin of 34.66% of sales represents a decrease of 36 basis points from the first three quarters of 2010. In 2010, gross margin increased 18 basis points versus the first nine months of 2009. SG&A for Q3 was 27.27% of sales, which deleveraged 197 basis points. The biggest driver was asset impairment and other costs associated with store closing and discontinued projects, which totaled $324 million for the quarter.

SG&A was also negatively impacted by $32 million related primarily to asset impairment of operating locations. Together, these items compared to $52 million in expense in last year's third quarter, resulting in 256 basis points of expense deleveraged in Q3 this year. Also, we experienced approximately 19 basis points of deleverage related to investments made to improve customer experiences. The expenses related to the continued build-out of our customer relationship platform, internal and external resources to complete and launch My Lowe's during the quarter, and the store infrastructure upgrades. During the quarter, legal expense deleveraged 17 basis points as a result of current and threatened litigation matters. In addition, in Q3, we experienced 12 basis points of deleverage associated with rolling out new product differentiation sets.

These include in-caps and drop zones, which we expect to be in over 500 stores by year-end, updated lawn and garden sets in approximately 200 deep south locations, and bathtub displays in fashion plumbing. While it is still early, we are pleased with the results. Leverage and proprietary credit and bonus slightly offset these items. We experienced 89 basis points of leverage associated with our proprietary credit program. This leverage was driven by a combination of fewer losses as well as lower promotional financing. In addition, tenant costs were lower as the penetration of proprietary credit decreased roughly 270 basis points over last year's third quarter to 23.1% of sales. For the quarter, bonus expense leveraged 14 basis points due to lower attainment levels versus planned. Year-to-date SG&A of 24.84% of sales and deleveraged 81 basis points through the first nine months of 2010.

Through three quarters, the impact of asset impairment and other costs associated with store closings and discontinued projects negatively impacted SG&A by 103 basis points. Depreciation totaled $361 million for 3.05% of sales and leveraged 39 basis points compared to last year's third quarter. Earnings before interest and taxes or operating margin decreased 257 basis points to 3.7% of sales. Year-to-date operating margin of 6.98% represents a decrease of 89 basis points from 2010. Store closing and asset impairment charges negatively impacted EBIT for the quarter and year to date by 266 and 106 basis points, respectively. We estimate that our proprietary credit value proposition positively impacted EBIT by 16 basis points for the quarter. Interest expense of $91 million deleveraged 8 basis points as a percentage of sales. For the quarter, total expenses were 31.09% of sales and deleveraged 166 basis points.

Pre-tax earnings for the quarter were $352 million or 2.97% of sales. The effective tax rate for the quarter was 36.1%. The rate was lower than expected due to the settlement of certain state tax matters. For the quarter, we reported earnings per share of $0.18. Earnings per share impact of charges for store closing and discontinued projects was $0.17 for the quarter. Now I'd like to comment on the balance sheet starting with assets. Cash and cash equivalents balance at the end of the quarter was $675 million. As Rick mentioned, our third quarter inventory balance increased $447 million or 5.2% versus last year. Inventory turnover calculated by taking a trailing four quarters cost of sales divided by average inventory for the last five quarters was 3.6, flat to Q3 2010.

Return on assets determined using a trailing four quarters earnings divided by average assets for the last five quarters decreased 31 basis points to 5.24%. We estimate that the impact of charges for store closing and discontinued projects negatively impacted return on assets by 72 basis points. Next, I'd like to highlight a few items from the liabilities and shareholders' equity section of the balance sheet. At the end of the quarter, our accounts payable balance was $5.2 billion or 6% higher than last year. The increase in accounts payable relates to the timing of purchases. Our debt to equity ratio was 39.4% compared to 29.5% in Q3 last year. At the end of the quarter, lease-adjusted debt to EBITDA was 1.85 times. We estimate that without the impact of charges for store closing and discontinued projects, lease-adjusted debt to EBITDA would have been 1.72 times.

Return on invested capital measured using a trailing four quarters earnings plus tax-adjusted interest divided by average debt and equity for the last five quarters decreased 18 basis points to 8.43%. We estimate that the impact of charges for store closing and discontinued projects negatively impacted ROIC by 102 basis points. I'd like to take a moment to update you on our thinking regarding capital structure. We are increasing our previously stated lease-adjusted debt to EBITDA target from 1.8 times to 2.25 times, resulting in approximately $3 billion of additional debt capacity, which we expect to fully implement by the end of 2012. We feel this modest increase in leverage appropriately balances liquidity with the opportunity to return value to shareholders while providing sufficient operating and strategic flexibility. Our short-term credit ratings likely will be lowered one notch to A2 P2.

In addition, we expect our long-term ratings to be lowered to A minus A3. However, once implemented, the revised capital structure should reduce our weighted average cost of capital by approximately 50 basis points. We do not anticipate further adjustments to our lease-adjusted debt to EBITDA target for the foreseeable future. In addition, last month we successfully renewed our five-year $1.75 billion revolving credit facility in banks. This credit facility serves as a backstop to our commercial payment program. Now looking at the statement of cash flows, year to date, cash flow from operations was $3.9 billion, which was up 1.5% versus the first nine months of 2010. Cash used in property acquired was $1.3 billion for the first nine months of 2011, compared with $1 billion for the same period last year. As a result, year to date free cash flow is just over $2.6 billion.

During the quarter, there were no share repurchases. Looking ahead, I'd like to address several of the items detailed in Lowe's business outlook. We expect fourth quarter total sales increased by approximately 8%, with comp sales estimated to be flat to positive 1%. We estimate that the 53rd week will aid Q4 sales by approximately 7%. Earnings before interest and taxes for the fourth quarter are expected to decrease by approximately 50 basis points to last year as a percentage of sales. This EBIT outlook includes approximately $10 million or 10 basis points of additional expenses associated with previously announced store closings. The income tax rate is forecasted to be 37.6% for the quarter. We expect earnings per share of $0.20 to $0.23, including additional expenses associated with previously announced store closings. We estimate that the 53rd week will aid Q4 earnings per share by $0.02 to $0.03.

For 2011, we're estimating total sales increase of 2% to 3%, with comp sales declining by approximately 1%. For the year, we expect to open approximately 26 stores, two of which are relocations, and close 27 stores, resulting in a net reduction of three stores. We estimate that the 53rd week will increase 2011 sales by roughly 1.5%. For the year, we are anticipating EBIT to decrease 80 to 90 basis points. This includes approximately 80 basis points associated with store closings and discontinued projects. For the year, we expect the effective tax rate to be 37.4%. The sum of these inputs should yield earnings per share of $1.37 to $1.40, which includes approximately $0.20 per share in store closing and discontinued project charges. For the year, we are forecasting cash flow from operations to be approximately $4 billion.

We've updated our capital expenditures forecast for 2011 and now believe that they will be between $1.9 billion and $2 billion, with roughly $100 million funded by operating leases, resulting in cash capital expenditures between $1.8 billion and $1.9 billion. This forecast is a bit higher than our plan for the year, as we elected to accelerate our store information technology infrastructure investment originally planned to be completed in 2012, which will now be complete by the end of this year. We will see a corresponding reduction in our 2012 capital plan. I will share more details on future CapEx plans at our analyst conference next month. As a result, we are forecasting free cash flow of $2.1 billion to $2.2 billion for the year. Our outlook does contemplate share purchases in the fourth quarter. Regina, we are now ready for questions.

Speaker 5

To ask a question, press star one on your telephone keypad. To withdraw your question, press the pound key. In order to allow questions from as many individuals as possible, please limit yourself to one question and one follow-up. Our first question comes from the line of Eric Bashford with Cleveland Research.

Speaker 3

Good morning.

Speaker 1

Morning, guys.

Speaker 3

Could you talk a little bit? You talked about becoming a little less promotional and a little more of this EDLP focus. I know this is the 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 of 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?

Speaker 2

Sure, Eric. This is Bob Gfeller. As we look at being competitive every day, there is price transparency in the marketplace for the customer. We have to make sure, therefore, that whatever channel the customer desires to search products at Lowe's, we are priced competitively. In order to be priced competitively, we have to make sure that, working with our vendors, we have the lowest possible acquisition cost. In order to do that, we really need to simplify the deal structures that we have with our vendors. Part of simplifying the deal structure is to become less promotional.

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 have talked about in the past, with a more accelerated process to make sure that we are locally assorted correctly, as Robert mentioned, in every market, and we are priced right appropriately to the competition in the market. At the same time that we are 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 a customer shops Lowe's, again, depending on the channel that they shop, they can take advantage of our growing flexible fulfillment capabilities. 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. We expect by the time we get to the end of next year, we will have addressed three quarters of our sales through this accelerated process. The margin benefit of the rationalized cost should more than offset the retail price pressure by the second half of next year.

Speaker 3

If I can drill into that a bit more, how should we expect this to play out in terms of 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?

Speaker 4

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 a little bit different. If we expect inflation to be a little bit lower, we expect the 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 secure 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 2012 and beyond.

Speaker 2

Eric, this is Bob again. Bob Gfeller, 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 share as it relates to some of our core businesses: paint and tools, nursery, and building materials. We've got a couple of 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. We're looking to see advancement in sales and share on those two businesses. The ones that are hard right now are cabinets and appliances and millwork, as I think Rick Damron mentioned. They are big ticket, and we have significantly de-promotioned ourselves on millwork, and we've got to work through that.

As it relates to appliances, we are anticipating a solid fourth quarter on appliances.

Speaker 3

Great. Thank you.

Speaker 4

Thank you.

Speaker 5

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

Speaker 0

Hi. Thanks, guys. One question and then the 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, and so that closed your window? 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 and your resettings. Do you have any early read on what kind of improvement in excitement or comps or however you want to measure it that that's happening so far? Thanks.

Speaker 4

Sure, Mike. As it relates to share purchases, there were no share purchases in the third quarter because our lease-adjusted debt to EBITDA 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 2.25 times, we now will be active in the share purchase market. That was the largest driver of not being in the market for Q3.

Speaker 2

I'm Bob Gfeller again. As it relates to the resets, the end cap and drop zone resets that Robert referenced, 500 stores completed by the 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 for planting season. Lastly, I think Bob referenced 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. 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.

Speaker 4

Thank you.

Speaker 0

Thank you.

Speaker 5

Your next question comes from the line of Peter Benedict with ISI.

Speaker 3

Hi, thanks. 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? Also, on the top line, what you think inflation helped in the quarter?

Speaker 4

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

Speaker 3

Correct.

Speaker 4

Because it was 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 every day was for those everyday purchases. Of the 90 basis point impact, two-thirds of that would have been from transactions.

Speaker 3

Got it. The follow-up on the inflation and how that's impacting the comp. 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?

Speaker 4

Yeah, it was basically a wash on comps, Greg, as we had inflation in bill 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. The net impact of inflation on comps in Q3 was essentially zero, which is basically our forecast for Q4 as well.

Speaker 3

Okay. This is a follow-up, I promise, on credit. It helped EBIT by 16 basis points 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 costs as we look at it into next year?

Speaker 4

I think it's probably close to 10 or so basis points, 10 to 20 at the top side. Really, it's being 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% off every day, which hits margins. Basically, what we're seeing is that the 5% off every day is more productive than the promotional financing has been previously.

Speaker 3

Great, thanks a lot.

Speaker 4

Thank you, Greg.

Speaker 5

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

Speaker 0

Good morning. Thank you for taking my question. I wanted to get a sense for the way you're deriving the expected return from all the pricing actions that you have and will take. 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?

Speaker 2

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

Speaker 4

Yeah. 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. We've been a little bit delayed in rolling that out versus where we'd anticipated. 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 have we got this move back to EDLP, or if you want to call it EDLP plus, because we know there's certain big ticket categories that you're going to need to promote at certain times of the year.

It's a cadence that we're going through now as Bob's 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. 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. 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, so.

Speaker 0

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

Speaker 4

Absolutely. I think when you look at the significant amount of change that we've put the organization through, anytime 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 these changes and pull them together and execute them as quickly as we could, be it changing 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. That way we could then lay out the clear path forward for the organization to get everyone refocused on where we're moving in the future.

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, where Bob, as in Bob Gfeller, talked about, price transparency is becoming greater and greater every day. When you think about other channels, the internet, and those out there that we compete against as well, we 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.

That's also why we're trying to continue to expand the internet, for example, and bring other ways to bear to be able to meet the consumer's needs, whether that's transacting projects in-home, if they want to do a major project and having a representative 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 and be able to transact for that day. We're trying to certainly approach it on a multi-channel, cross-functional basis and have a great cadence to it. In the amount of changes, certainly, we understand that there was some disruption in the process, and we think that we've now gotten most of that behind us.

Speaker 0

Okay, that's helpful. Thank you very much.

Speaker 5

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

Speaker 0

Thank you very much. First question for Robert. As a follow-up on the capital structure, with your decision to take your debt to EBITDA ratio up, coupled with you guys taking the store count down for next year, it 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? Philosophically, with your weighted average cost of capital increasing by 50 basis points, can you kind of just tell us how you think about the stores that are cash flow positive today but are not yielding an adequate rate of return?

Speaker 4

I'll start, and then Bob will jump in.

Speaker 0

Thanks.

Speaker 4

Alan, I think on our weighted average cost of capital, it's actually decreasing 50 basis points, not increasing with the new leverage targets. As far as looking at any, we're not 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'll be available for dividends, for share repurchase, those types of things, I think we would plan on updating you on those items at our analyst conference when we give a little bit longer-term view. The purpose today was just to be able to signal that we have made that change and then pull 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? Yeah.

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 the cash flow negative stores. As we told you, at the end of Q2, we had 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're in and expect a turnaround in those markets.

Speaker 0

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

Speaker 4

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

Speaker 0

Okay, thank you.

Speaker 4

Thank you.

Speaker 5

Our next question comes from the line of Peter Benedict with Robert Baird.

Speaker 0

Hi, guys. Thanks. 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, you know, maybe what's going on in that category from a competitive standpoint or why you weren't able to pass it through. Secondly, Bob, given all the changes you guys are making to the business, you're 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'd maybe keep EBIT margins flat and then increase some 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 worse than that? What can you tell us? Thanks.

Speaker 2

Peter, this is Bob Gfeller. I'll just hit the paint question very quickly. 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 two 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. We'll see how much of that we can get back as we go forward.

Speaker 4

Peter, on your second part of your question, at this point in time, yes, I think it's pertinent to assume that guidance we provided in the past for each 1% change in comp at 20 basis points of EBIT impact. We will update you on our thinking long-term at the analyst conference next month.

Speaker 0

Okay. Great. Thanks, guys.

Speaker 4

Thank you.

Speaker 5

Our next question comes from the line of Christopher Horvers with JP Morgan.

Speaker 0

Thanks. Good morning. On the top line, I was just curious, were the 27-store closures in the comp phase? Did you see any benefit from having those closures? Similarly, on the pre-Halloween snowstorm, I think your quarter ends on Saturday. Was there any lift out of that as well?

Speaker 4

As it relates to store closings, they were not in a comp phase. However, we did see sales from the closed store locations transfer to comp store locations. The positive impact of that was offset by cannibalization from new stores that opened over the prior four quarters. There was 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 shown up in our Q3.

Speaker 0

Okay. As a good follow-on to that, on a two-year basis, you are guiding to an acceleration here in the fourth quarter. I was just curious if you could lay out the factors that drove that guidance. Thank you.

Speaker 4

Sure. We've got some specific actions we're taking. We didn't have a value prop Q4 last year, for example. We gave you the impact of Q3. We've talked about a number of the changes that are taking place in market as it relates to product differentiation. We've indicated we're seeing positive results to date, and we expect more of the same in the fourth quarter. The change in trajectory is a matter of some of the specific actions we're taking and starting to see the benefits of those actions.

Speaker 0

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

Speaker 4

Regina, we've got time for one more question.

Speaker 5

Your final question will come from the line of Peter Benedict with Bernstein.

Speaker 0

Good morning. Thank you. 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 the overall trend through the quarter. I have a follow-up for Bob Hull.

Speaker 2

Colin, it's Robert Gfeller. I can just top line for you. In the quarter, on a rolling four-quarter basis, dollar share, we were up in eight, we were down in eight, and flat in one. On a unit share, we were up in 11, down in six, and flat in one. Overall, we held ground if you look at total Lowe's.

Speaker 0

Okay. Great. Thank you. That's helpful. Bob, just on the 2.25 lease-adjusted debt to EBITDA, was I correct in hearing that you said there'd be no more adjustments after that? You're looking at that as kind of a perpetuity optimal capital structure. 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 all relatively early next year? At an incremental $3 billion to maybe an underlying go-forward rate at $2 billion in share repurchases for a total of around $5 billion next year?

Speaker 4

You were correct that I said that we don't foresee any adjustment to the 2.25 in the foreseeable future. What I would call more of a practical cost of capital versus an optimal. You can engineer a higher low 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. We're not going to raise $3 billion immediately. I think you could think that's on a cadence approach between now and the end of 2012. Yes, obviously, more to come on long-term share repurchases next month at the analyst conference.

Speaker 0

Great, thank you very much. Look forward to hearing from you then.

Speaker 4

Thank you. 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.

Speaker 5

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