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Lowes Companies, Inc. (NYSE:LOW)

Q3 2008 Earnings Call

November 17, 2008

Executives

Robert A. Niblock – Chairman of the Board & Chief Executive Officer

Larry D. Stone – President & Chief Operating Officer

Robert F. Hull, Jr. – Chief Financial Officer & Executive Vice President

Gregory M. Bridgeford – Executive Vice President Business Development

Analysts

Deborah Weinswig – Citigroup

Matthew Fassler – Goldman Sachs

Christopher Horvers – J.P. Morgan

Gregory Malik – Morgan Stanley

Eric Bouchard – Cleveland Research Company

Stephen Chick – Friedman, Billings, Ramsey & Co.

Michael Lasser – Barclays Capital

Colin McGranahan – Bernstein

Scott [Chickervelli] – RBC Capital Markets

Operator

Welcome to Lowes’ Companies third quarter 2008 earnings conference call. This call is being recorded. 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 assurances that they will prove to be correct.

Those risks are described in the company’s earnings release and in its filings with the Security and Exchange Commission. Also, during this call management will be using non-GAAP financial measures in discussing the company’s performance and financial condition. You can find the presentation of the most directly comparable GAAP financial measures and a reconciliation of the differences between the two posted on Lowes’ investor relations website under corporate information and investor documents.

You will also find a statement of the reasons management believes this presentation of these non-GAAP financial measures provides useful information to investors regarding Lowes’ financial condition and performance. Hosting today’s conference call will be Mr. Robert Niblock, Chairman and CEO, Mr. Larry Stone, President and COO and Mr. Bob Hull, Executive Vice President and CFO.

I would now like to turn the program over to Mr. Niblock for opening remarks.

Robert A. Niblock

Thanks for your interest in Lowes. Following my remarks, Larry Stone will review our operational performance including what we are doing to manage our business in today’s challenging environment then Bob Hull will review our financial results.

The third quarter continued what has been a very difficult period for our industry. As many external factors weigh on home improvement sales. Our -5.9% comp for the quarter was within our guidance but short of what we hoped to deliver. Contributing to our results, hurricane preparation and recovery spending aided comps by an estimated 100 basis points in the quarter and as we anticipated outdoor categories benefitted for more seasonable weather as cycled last year’s drought conditions in many parts of the US.

In addition, in a tough sales environment we continue to gain market share, a function of our commitment to great service and our ability to capitalize on the revolving competitive landscape. But, the pressures on the consumer have intensified over the past 90 days as unemployment as risen, equity markets have spiraled downward and concerns about the broader economy have grown. When combined with falling home prices driven by excess supply and weak demand and exacerbated by tight credit markets, it paints a challenging picture for consumers for the near term.

Highlighting those challenges and likely compounded by the distraction of the equity markets and interest in the election, we saw a slowdown in sales in the last week of October which has continued into the first two weeks of November. We continue to see the greatest sales weakness in bigger ticket discretionary products and the weakness is most pronounced in areas hardest hit by the housing slowdown.

The bottom 20% of housing markets, those with the biggest home price declines, delivered double digit negative comps while the top 20% delivered nearly flat comps in the third quarter. Although they are difficult to find, there are a few bright spots. It seems housing turnover is bottoming and September’s housing numbers include the first year-over-year increase in a seasonally adjusted annual rate of existing home sales in almost three years and was driven in part by the stress sales of foreclosed homes.

Estimates suggest that as many as one-third of September’s sales were related to foreclosures. Based on data from our customer database it appears purchasers of foreclosed properties spent similar to traditional existing home purchases. In addition, energy prices have dropped dramatically in the last few months with the price of gas dropping nearly 50% from the peak just four months ago.

Many other factors are impacting consumers today and we hope that falling energy prices will provide a steadying influence on consumer’s wallets and their confidence in the future and a Lowes specific bright spot. In October, Lowes was named by J.D. Power as the number 1 appliance retailer in the US for customer satisfaction. Measured on many attributes including sales staff, installation and delivery service, store environment, product selection and price, this is clear evidence and just one example of how our stores are providing unmatched service and selection to capture market share.

Nevertheless, since the balance of the macro factors that impact our business remain weighted to the down side and at least the near term signs indicating consumers are retrenching further, we feel it is prudent to continue to take a cautious approach playing it conservatively and insure we are well positioned to capitalize on opportunities as they develop.

Despite the challenges of a weak demand environment, our employers did a great job at controlling calls and improving efficiency allowing us to deliver third quarter earnings per share of $0.33 which exceeded our guidance. It is these efficiency gains with a continued commitment to great service which ensure we will be well positioned for an eventual improvement and demand.

Our focus today is on the fundamentals of retailing. While we must always keep an eye on the future, now is not the time to stray from the basics of providing great service, great products and great value for consumers. As many economists are forecasting a recession, we are confident in our ability to continue to capture market share as weaker players struggle in the current environment.

We are also hopeful that early signs of stabilizing housing turnover and eventual loosening of credit in the mortgage markets and decline in the fuel and commodity prices, will lead to stabilization and demand for home improvement products. Regardless of the external environment, we continue to strive to become more efficient and remain nimble enough to react appropriately in an uncertain environment.

Finally I would like to congratulate Jimmy Johnson, Chad [Canals] and the entire team of motor sports for winning their third consecutive Nascar Championship. Only the second time in Nascar history that the title has been won by the same driver three consecutive years. Lowes is proud to be partnered with such a great organization and have them represent the Lowes brand off and on the track. Thanks again for your interest and I will now turn it over to Larry Stone to provide a few more details on the quarter.

Larry D. Stone

As Robert mentioned the broad based macro pressure weight on industry will continue in 2009. This morning I will provide some details of our third quarter results and discuss how we manage in this challenging environment while balancing our focus on maximizing your term results and driving long-term shareholder value.

As expected, our third quarter results reflect a tough sales environment, only four of our product categories had positive comps for the quarter, building materials, outdoor power equipment, seasonal living and nursery. Our performance in building materials and outdoor power equipment was driven by demand of hurricane related products including asphalt, roofing and generators.

Thanks to our storm recovery team we were able to quickly reopen stores in hurricane-affected areas and our best in class distribution network assured our stores were stocked and ready to assist customers with their cleanup and rebuilding efforts. Dry results in seasonal living and strong sales of pellet fuel and pellet stoves as consumers shifted toward alternative heating products in preparation for winter.

Also, solid sales in outdoor living products in our warmer year round markets helped drive this positive comp. Nurseries performed well as homeowners continue to take on smaller projects that enhance their outdoor space. Easier comparisons from last year’s drought in addition to strong demands for fountains and outdoor accessories helped deliver a positive comp for the quarter in this category.

Other categories have performed by the company average include lawn and landscape products that also benefitted from last year’s drought as homeowners completed some of the fall lawn maintenance they put off last year. Above average [inaudible] hardware was driven by increased demand for flashlights and batteries in hurricane-impacted markets and reflected consumers desire to make their home more energy efficient and minimize winter heating bills.

We had solid demand for air filters and programmable thermostats which helped rough plumbing perform above the company average. Despite the pressures weighing on consumers, they still appear willing to complete smaller projects that maintain and beautify their homes. This is evidenced by the relative strength in our paint category, the number 1 DIY home improvement project.

Additionally, our lumber category performed better than company average driven by solid demand of fencing in hurricane-impacted areas. Despite the weak sales environment our continual focus on inventory management resulted in a decreased comp store inventory for the quarter and we enter the fourth quarter we are comfortable with our inventory levels.

In August, on our second quarter call we highlighted the fact that outdoor products outperformed indoor products and aided our second quarter results. For this comparison we defined outdoor products to include not only nursery and lawn and landscaping products, but any product predominantly used outdoors. We anticipated this performance would continue as consumers seemed willing to take on smaller outdoor projects, but as the year unfolded we would see the typical seasonal shift away from these categories.

Outdoor products out comp indoor products by approximately 800 basis points in the third quarter, but were approximately 30% of sales versus 40% of sales in the second quarter. This declining mix of outdoor products contributed to our lower comps quarter-over-quarter. Importantly, many of our product categories are comp negligently maintained our long trend of market share gains.

Looking at results from a regional basis we continue to see a wide range of comp performance as two regions achieve positive comps while eight regions have double-digit negative comps. Positive comp areas include one region in the Ohio Valley and a region that includes Southern Texas and Houston. The solid sales performance we experienced last quarter in [inaudible] Valley continued in the third quarter. This is an area that did not experience an over-heated housing market that occurred in other regions of the country.

Our Southern Texas stores have performed well for several quarters, but during the third quarter experienced increased demand for hurricane related products in these markets which resulted in strong comp performance for the quarter. The negative far outweigh the positives. While there are recent signs of home price declines are bringing buyers back to the housing market, the pressures of some of the countries weakest housing markets are significantly impacting our sales in our Western Division as all four regions had double digit negative comps in the quarter.

Our Florida regions improved slightly during the quarter, but still posted double digit negative comps and two of our Northeastern regions also had double-digit negative comps in the quarter. Consumers in these regions remained pressured by weak housing markets and the recent volatility in financial markets and the uncertainty leading up to election appeared to have further impact to consumer’s willingness to tackle home improvement projects.

Driven by consumer’s uncertainly to tackle bigger ticket discretionary projects specialty sales performance for the quarter fell below the company average. Our whole house carpet installation promotion continues to resonate with consumers, however, during the quarter we saw a demand soften in this category. This contributed to installed sales performing below the company average.

On the special order sales front we saw pronounced weakness in cabinets and countertops, fashion plumbing and lighting leading to below average comps performance for the quarter. Reflective of the macro pressures weighing on consumers on a regional basis we saw our largest year-over-year decline since both installed sales and special order sales in the West and in Florida.

Encouragingly commercial business sales continued to post comps above company average. They are focused on professional trades person, property maintenance professional and repair remodeler continues to drive solid sales results. Despite the external pressures weighing on [inaudible] the promotion environment remains rational. We continue to use our rolling 18-month promotional calendar to support our marketing message of how much basic home improvement projects that consumers are doing to maintain their home.

We have not wavered from a everyday low price strategy which we’ll continue to emphasis going forward. And, to further convey the value message many consumers are looking for today, we’ll continue to use our new lower price initiative as a tool to build traffic, transactions and ticket. Despite the soft demand for discretionary projects, according to third party estimates, we increased unit market share in 13 of our 20 product categories in the third calendar quarter.

This is a clear indication that customers continue to choose Lowes’ for their home improvement needs. As I stated earlier, we anticipated external pressures weighing on the industry and consumers will continue in to 2009. We’ll navigate through these challenging times, cutting cost where we can while maintaining our commitment to deliver excellent customer service and drive profitable growth.

In all sales environments, we’re always working to identify ways to improve store productivity and operation efficiencies. Our flexible staffing model provides us with the tool to match sales hours so we have the right people, at the right time, doing the right job. During this challenging sales environment we’re making continual efforts to match hours to sales. However, driven by the soft sales environment, we deleveraged payroll by 81 basis points in the quarter.

In conjunction with our cost-controlled efforts we remain committed to provide great customer service. In fact, our third quarter customer focus scores showed customer service and satisfaction continues to improve demonstrating that while we’re reducing payroll to match lower sales, we’re also making the right decisions to ensure our stores are ready to serve customers.

In tough times like we face today, we have a solid foundation on which to build and we remain focused on executing the basics better than anyone else. I’m confident we’re making the right decision focusing on the customer and driving efficiencies that position us to increase market share and maximize the opportunities in the market place. Being consumers’ first choice for home improvement in every market is our driving goal as we manage the business for long-term success.

Thanks for your attention. Now, I’ll turn the call over to Bob [Boll] to review our financial results.

Robert F. Hull, Jr.

Sales for the third quarter were $11.7 billion which represents a 1.4% increase over last year’s third quarter. In Q3, total customer count increased 3.4% but average ticket decreased 2% to $65.64. Year-to-date total sales increased .9% to $38.2 billion. Comp sales were -5.9% for the quarter which was within our guided range of -5% to -7%. Looking at monthly trends, comp were -7.2% in August, -5% in September and -5.7% in October.

For the quarter, comp transactions decreased 3.5% and comp average ticket decreased 2.3%. We estimate that hurricane related sales positively impacted our third quarter comp sales by approximately 100 basis points. In addition we believe that comps were positively impacted by approximately 50 basis points due to favorable comparisons of last year’s route impacted third quarter.

We experienced building material inflation in the quarter driven by roofing which had approximately 50 basis points positive impact on third quarter comps. With regard to product categories, the categories that performed above average in the third quarter include lumber, building materials, rough plumbing, hardware, paint, nursery, seasonal living, outdoor power equipment and lawn and landscape products.

From a regional perspective 8 of our 23 regions had double-digit negative comps for the quarter. The double-digit negative comp regions were in the west coast, northeast and Florida markets. Gross margins for the third quarter was 34% of sales and decreased 29 basis points from last year’s third quarter. The decrease in gross margins was driven by a number of factors: the mix of items sold in the quarter had a -10 basis point impact on gross margin.

Higher fuel prices increased cost of goods sold and negatively impacted gross margins by approximately 10 basis points. Deleverage on distribution fixed cost caused approximately 9 basis points negative impact on gross margin in the quarter. Lastly, we review and reforecast our accrual vendor programs on an ongoing basis. Based on current and projected sales trends, we expect to achieve fewer volume rebate dollars than we original predicted.

The reversal of these accrued vendor volume rebates negatively impact Q3 margins by 8 basis points. Slightly offsetting these items was positive impact of 10 basis points from lower inventory shrink. Year-to-date gross margins of 34.3% represents a decrease of 24 basis points over fiscal 2007. SG&A for Q3 was 23.2% of sales which deleveraged 160 basis points driven by store payroll, insurance, bonus, fixed expenses and credit.

For the quarter, store payroll deleveraged 81 basis points driven by negative comps. In the quarter we experienced 46 basis points of deleverage and insurance expense associated with comparison’s to last year self-insurance reserve adjustment for workers’ comp patients and general liability. However, this deleverage was less than the approximately 100 basis points of deleverage we expected as we continue to see favorable trends in this area.

Bonus expense deleveraged by 36 basis points in the quarter as we achieved more performance targets this year versus missing many of our performance targets in 2007. In addition, rent, property taxes, utilities and other fixed expenses deleveraged approximately 20 basis points due to the comp sales decline. Also, as expected, we did experience 11 basis points of deleverage related to proprietary credit due to higher losses than last year.

This deleverage was offset slightly by leverage in in-store service and advertising expense in the quarter. Year-to-date SG&A is 22.1% of sales and deleverage 96 basis points to the first nine months of 2007. Store opening cost of $31 million leveraged 9 basis points to last year as a percentage of sales. In the third quarter we opened 39 new stores with no relocations. This compares to 40 new stores with no relocations in Q3 last year.

Depreciation at 3.3% of sales totaled $385 million and deleveraged 35 basis points compared with last year’s third quarter primarily due to negative comp sales and the additional of 154 stores over the past 12 months. Earnings before interest and taxes or operating margin decreased 215 basis points to 7.2% of sales. Year-to-date operating margin of 9% represents a decrease of 153 basis points over the first nine months of 2007.

Interest expense at $65 million deleveraged 13 basis points as a percentage of sales. This deleverage was caused by the additional expense associated with last year’s bond deal and lower capitalized interest costs associated with fewer stores under construction. For the quarter total expenses were 27.4% of sales and deleveraged 199 basis points. Pre-tax earnings for the quarter were 6.6% of sales.

The effective tax rate for the quarter was 37.3% versus 37.6% for Q3 last year. Earnings per share of $0.33 for the quarter exceeded our guidance but decreased 23% versus last year’s $0.43. For the first nine months of fiscal 2008, earnings per share of $1.38 were down 13% to 2007.

Now, to a few items on the balance sheet starting with assets. Cash and Cash equivalents balance at the end of the quarter was $322 million. Our third quarter inventory balance of $8.3 billion increased $552 million or 7.1% versus Q3 last year. The increase was due to square footage growth of 10.2% from this time last year, offset somewhat by 3.7% lower inventory in comp stores.

Inventory turnover is calculated by taking a trailing four quarters cost of sales divided by average inventory for the last five quarters with 3.9, a decrease of 12 basis points from Q3 2007. At the end of the third quarter we owned 87% of our stores versus 86% at the end of third quarter last year. Return on assets determined using a trailing four-quarter’s earnings divided by average assets for the last five quarters decreased 275 basis to 7.7%.

Moving on the liability section of the balance sheet, we ended the quarter with accounts payable of $4.8 billion which represents a 24% increase over Q3 last year. The increase is attributable to ongoing efforts to improve vendor payment terms and the timing of purchases in the quarter. We ended the quarter with $249 million of short-term borrowings. This was comprised of $189 million of Canadian debt to fund our expansion there and $60 million of commercial paper outstanding.

During the depths of the credit crisis with our A1P1 commercial paper rating we received daily indications from our banking partners that the commercial paper markets were available to us at reasonable rates. While we felt good about our financial position in Q3 we knew that we’d need to access the commercial paper markets in the fourth quarter. Given the strain and uncertainty in the financial markets we decided to test the waters in Q3 and were able to confirm that the CP markets were available to us at attractive rates.

Our debt to equity ratio was 29.7% compared to 35.15 for Q3 last year. Our leverage target remains 1.2 times lease-adjusted debt to EBITDA for the first three quarters and due to the seasonality of our cash flows, 1.4 times at year-end. These targets were established based on our goal of maintaining a strong A credit rating and an A1P1 commercial paper rating which has proved to be prudent in this environment.

At the end of the third quarter lease adjusted debt to EBITDA was 1.35 times which exceeded our 1.2 times target for Q3. There were no share repurchases in the quarter and our outlook does not contemplate any share repurchases for 2008. We will continue to evaluate market conditions and diligently evaluate our options to balance financial flexibility against the opportunities presented in the market.

Return on invested capital measured using a trailing four quarters earnings plus tax adjusted interested divided by tax-adjusted interest divided by average debt in equity for the last five quarters decreased 378 basis points for the quarter to 11.5%. Now, looking at the statement cash flows, year-to-date cash flow from operations was $4.4 billion an increase of $573 million or 15% over the first nine months of 2007.

The strong cash flow from operations growth versus last year is driven by the growth in accounts payable I noted earlier. Looking ahead, I’d to address several of the items detailed in Lowes’ business outlook. There continues to be a great deal of uncertainty related to the financial market, housing and the state of the consumer. In addition, we did see a slowing of sales trends beginning in the last week of October. These factors are contemplated in our outlook.

We expect fourth quarter total sales to range from a decrease of 3% to an increase of 2% which incorporates the opening of 33 to 38 new stores. Comp sales are estimated to decline 5% to 10% to last year. EBIT, our operating margins for the fourth quarter is expected to decline by approximately 330 basis points to last year as a percentage of sales driven by expected store payroll deleverage of approximate 180 basis points as well as depreciation, fixed costs and gross margins.

We are forecasting diluted earnings per share of $0.08 to $0.16 which represents a decrease of 41% to 71% compared to last year’s $0.27. For 2008, we expect to open 115 to 120 stores resulting in an increase in square footage of 7% to 8%. We’re estimating a comp sales decrease of 6% to 7% and total sales to range from flat to last year to an increase of approximately 1%. For the fiscal year we’re anticipating an operating margin decrease of approximately 190 basis points driven by store payroll as well as depreciation, fixed costs and gross margin.

We’re forecasting an effective tax rate of 37.4% for 2008. As a result, we expect diluted earnings per share of $1.46 to $1.54 for the year. For the year we expect cash flow from operations to be approximately $4.4 billion, up about 2% over fiscal 2007. In addition, we forecast total capital expenditures of approximately $3.9 billion with roughly $300 million [inaudible] operating leases leaving cash cap ex of approximately $3.6 billion for 2008.

Operator, we are now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Deborah Weinswig – Citigroup.

Deborah Weinswig – Citigroup

Bob, you had originally guided for the quarter EBIT margin to decline I think it was about 290 basis points, you obviously came in better than that. What were the major drivers there?

Robert F. Hull, Jr.

The main driver of the better than expected EBIT performance was insurance expense. We had guided to roughly 100 basis points of deleverage in the third quarter second against the large self-insurance adjustment in Q3 2007. We continued to see favorable trends in that area this year as a result we only had 46 basis points deleverage versus the expected 100 basis points.

Deborah Weinswig – Citigroup

Robert, you had in your opening remarks talked about obviously the tight credit markets. What are you doing to help your customers with regard to liquidity? And also, what kind of trends are you seeing with regard to credit card penetration, etc. in the store?

Robert A. Niblock

I’ll start and I’ll let Bob follow up on it. Our credit card penetration I think is down about 100 basis points from what we have seen previously. We think part of that is obviously we talked in the second quarter conference call about the impact of stimulus checks coming in and consumers using that versus credit availability. Then also, I think you have consumers more and more may be moving towards the upper end of their credit line so they don’t have open to buy.

Certainly, in the more robust economic times we did not loosen our credit standards but certainly GE Capital has gone through a review and evaluation of our credit limits under certain FICO scores, they’re taking a look at that. Then on the lower end, they’ve actually pulled down some of the credit limits of some which we think is prudent in the current environment and I’ll let Bob give a few more specifics on what we’ve done along those lines.

Robert F. Hull, Jr.

As Robert indicated, proprietary credit as a percentage of total we’ve got around 100 basis points Q3 this year versus Q3 last year. We also saw a similar reduction in credit cards so as a result we have seen a pickup in cash, check and debit card transactions year-over-year again, consistent with what we saw in the second quarter.

As Robert indicated, GE came to us with some suggested changes in taking a look at the scoring, they have increased the FICO cut off score to extend credit to new applications as well as did reduce the credit limits to the balances for a number of the consumers.

Operator

Our next question comes from Matthew Fassler – Goldman Sachs.

Matthew Fassler – Goldman Sachs

I’d like to focus on the guidance for the fourth quarter. Based on the work that we did kind of trying to back in to your implied fourth quarter EBITDA guidance issued on the second quarter call, it would assume like you would have expected about a 200 basis point decline, now you’re looking for something somewhat greater than that. I’d like to know how much of that relates to the fact that the sales bend is wider, down five to 10 instead of down five to seven?

Then specifically, is the vendor rebate issue a big issue for the fourth quarter and is the insurance line item that you sited in answering the prior question factoring in to that movement at all?

Robert F. Hull, Jr.

Certainly, the drop in the sales guidance is a fact as that contributes the lion share of the greater expected deleverage than you might have implied on the Q2 call. Store payroll deleverage goes up about 100 basis points entirely driven by the decrease in sales. As you know from a cyclical standpoint, our Q4 is our lowest volume quarter and we’re going to have our third straight year of negative comps in the fourth quarter.

The volume rebates, we anticipate margin impact of five to 10 basis points in the fourth quarter so not dissimilar to what we saw in the third quarter. Other items, we had about 10 basis points of advertising leverage in Q3, that flips to about 10 basis points of deleverage in Q4, really just based on the timing of how the calendar was laid out for the year. So, those are the big drivers of really going from your number of 200 basis points of EBIT climb to roughly 330 as outlined in our guidance.

Matthew Fassler – Goldman Sachs

So it’s basically SG&A rather than gross margin and it is primarily volume driven?

Robert F. Hull, Jr.

Correct. Gross margin might be slightly worse in Q4 than in Q3 but the lion’s share of the change is in SG&A.

Matthew Fassler – Goldman Sachs

And just to follow up, I mean doing the arithmetic on that, it would then look like your expenses per store would essentially flatten out. If you were to look at the low end of your sales guidance, to get to the low end of your earnings guidance, your SG&A per store would probably need to be essentially flat with last year having declined something like eight out of the past 10 quarters. Do you feel like you still have more room in absolute terms to take SG&A dollars out if sales remain difficult?

Robert F. Hull, Jr.

We think there’s still plenty of opportunity to reduce cost but we’re going to do it in a prudent manner. We’re not going to sacrifice the Lowes’ brand, we’re not going to sacrifice the relationship we have with consumers. We do feel like there’s a lot of things out there that we’re looking at testing and studying regarding cost reduction but we’re going to do it in a prudent manner.

Operator

Our next question will come from the line of Christopher Horvers – J.P. Morgan.

Christopher Horvers – J.P. Morgan

I’d love to really just aggregate your comp outlook in 4Q and compare that to 3Q. How much of it is the trend, the -5 to -10, how much of that is the trend at the end of the quarter versus how could you quantify how the seasonal shift, the mix of seasonal business changes in 4Q, how much that might pull your comp down for 4Q and also the factors that you mentioned previously on the draught, the hurricane and so forth?

Robert A. Niblock

I’ll start and let others add as appropriate. First, from a outdoor category perspective, Larry gave you the color around how that’s defined which is products primarily used for outdoor application, that’s roughly 30% of the mix of business in Q3, drops to 20% in Q4. In addition, as I mentioned in my comments, we had about a 50 basis point benefit from draught impact in the third quarter expecting no impact in the fourth quarter and then finally the biggest result of the change in outlook is the slowing trends that started that last week of October.

Larry D. Stone

Just a couple of other things, as we look to what we’re comping up against from the fourth quarter of last year, our comps got more negative through the quarter so our easiest comparisons are ahead of us so certainly right now we’re going up against our toughest comparisons from the year ago period. If you also layer on top of that the fact that the Thanksgiving holiday has shifted about a week so that delays the kick off to the holiday selling season of holiday related products so there’s a little bit of a calendar shift there from that point.

Then, just as we mentioned in the comments, the disruption you saw around the interest in the election, everything that was going on in the financial markets caused an impact in our comps in the last week of October and in to the first two weeks of November. Taking that all in to account, we think it’s appropriate to be cautious, we think it’s appropriate to give a wider range because certainly we expect things to improve as the consumer moves back to normal as we get closer to that Thanksgiving key kick off date for the Christmas and holiday selling season and as we get to easier comparisons.

But, given all of those are future items and there seems to be much more negative than positive macroeconomic news coming out on a daily basis, we think it’s prudent to be cautious, widen the range and adjust the other line items of guidance accordingly.

Christopher Horvers – J.P. Morgan

Just to check that math, the drought benefit of 50 basis points, that goes away and then this outdoor seasonal mix, that’s 80 basis points that comes in to a drag in 4Q, is that right?

Robert F. Hull, Jr.

Roughly.

Christopher Horvers – J.P. Morgan

Then from the expense perspective, the follow up on previous questions, how should we think about SG&A dollar growth going forward? You’ve been able to pull back down over time, are you getting to that point next year where it will get a lot more difficult and how should we think about the change in inflation and commodity costs and other wage costs going forward?

Robert F. Hull, Jr.

I guess I’ll provide the same answer I provided Matt with. We still think there are still a number of opportunities to reduce costs. We’re very active in a number of initiatives, it’s just very tough for those to be reflected when you’re in a negative comp environment.

Robert A. Niblock

Certainly things like if fuel prices continue to decline, the cost of moving goods reduces fuel and commodity prices, that helps to reduce our operating costs. Certainly, there’s a big component of that in a lot of what our vendors manufacture so to the extent that you continue to see that you hope that some of the price increases that we have experienced over the past year to 18 months would lessen and in certain situations potentially start to reverse depending on the extent of those drops in fuel and commodity prices.

Operator

Our next question comes from the line of Gregory Malik – Morgan Stanley.

Gregory Malik – Morgan Stanley

Two questions, first Bob, on the payables, you said it was basically extending terms and also timing. Can you get a little bit more specific on that given the importance of that payables growth to the cash flow?

Robert F. Hull, Jr.

The timing of purchases within the quarter did have an impact. Later purchase in the quarter means you don’t have the opportunity to pay for it. When we think about forecasting year-end we think payables will be up roughly 10% Q4 over Q4. Inventory will be up 5% to 6% again, that’s driven by a 7% to 8% increase in square footage for the fourth quarter. As a result, we’re forecasting AP to inventory to be roughly 51% at year-end which compares to roughly 49% for the fourth quarter of 2007.

Gregory Malik – Morgan Stanley

Then the second question is you talked in the release and I think Robert you talked about it as well or Larry, how the project sales are pretty much just gone away. Can you give us something to put a number on that? How many tickets you do, what percentage of your sales are on tickets above $1,000, just to give a sense of how close that actually is to being zero?

Robert A. Niblock

Greg, we don’t give out information of the sales by the ticket size. But certainly, the pressures in the third quarter really came in several areas namely kitchen cabinets, we had a really tough quarter in kitchen cabinet sales in the third quarter and certainly we had a couple of things that we kicked off in the later part of the third quarter on kitchen cabinets that did show some positive response in terms of sales but overall for the quarter those categories were down quite a bit.

As you head in to the fourth quarter the large ticket installed items normally decline due to seasonality. We’ll do carpet jobs up until next week and then carpet kind of levels out as a lot of people are trying to get ready for the holidays. The same thing for kitchen cabinets, that business always declines in the fourth quarter compared to the other quarters. But, if we’re looking at all the different categories that we install, certainly as I mentioned in my comments, the full house carpet installation programs worked well, our full house blind installation programs worked well.

But, you look at some of those ticket prices, especially on blinds, they’re not as large as a carpet job and certainly not as large as a whole house or kitchen cabinet jobs. So, we’ve got a lot of plans and programs in place and there again we just think that consumers right now are just kind of sitting back and kind of waiting to see how things play out before they tackle those larger projects.

Robert A. Niblock

I don’t think that those large tickets, tickets over $500, $1,000 have completely dried up. There are certain things that Larry talked about such as cabinets and countertops and those areas where the consumers pulled back kind of on the discretionary side of the home remodeling repair business. But, as we talked about in our overall comments, when you look at outdoor power equipment, a lot of that being storm related in response to better seasonal conditions this year versus last year’s drought and you saw substantial increase in big tickets in that category.

If you look at something like our building materials driven by roofing installation and some of those other things that we talked about, you saw a substantial increase in large ticket purchases in those areas. So, overall yes, those large tickets are up. It’s being more impacted in kind of the discretionary type purchases and major purchases. There are still customers out there that are putting in new kitchens but there are many of them that are also sitting on the sidelines and impacting those areas of the business.

Gregory Malik – Morgan Stanley

Just a follow up from before, just to confirm, these last few weeks, the first couple of weeks in November, you’re running below that 5 to 10 comp for the quarter?

Robert A. Niblock

We did not say that.

Robert F. Hull, Jr.

We talked about the slowdown in October Greg so if the month of October was -5/7, then last week was -8.5. But, I will tell you to start the quarter we’re closer to the -10 than we are the -5.

Operator

Our next question comes from Eric Bouchard – Cleveland Research Company.

Eric Bouchard – Cleveland Research Company

You commented that the gross margin expectation in 4Q, it sounds similar to perhaps a little worse than 3Q. Can you just give a little more color within gross margin what you see going on in terms of cost from suppliers, especially in an environment now where commodity and input costs are changing pretty meaningfully for them.

Larry D. Stone

I’ll start and let Robert and Bob weigh in on it. Certainly, with the decrease in fuel prices we see cost have potentially started to come down. But, as we kept less fuel costs in our inventory, we’ve got to sell through those layers of higher costs so we really think it’s probably going to be the first quarter of ’09 before we start to get a lot of impact from that.

But, we’ve worked with our suppliers and pushed back on the increases we were getting 12 to 18 months ago and certainly the decreases have started. Anything fuel related you can certainly see it so we think there’s a lot of opportunities as we head in to next year and fuel prices continuing where they’re at or stabilized, we don’t have that dramatic swing like we had back at the early part of this quarter.

Operator

Our next question comes from Stephen Chick – Friedman, Billings, Ramsey & Co.

Stephen Chick – Friedman, Billings, Ramsey & Co.

Maybe for Bob, the operating cash flow guidance for the year ticked down if I heard you correctly to $4.4 billion and that’s kind of where you are year-to-date actually so it looks like you’re predicting a pretty low level of operating cash flow for the fourth quarter if I heard you right. I was wondering if you could speak to that?

Secondly, if you’re targeted leverage ratio which I think was 1.4 times, if that is what we should still be looking for, for the year as well?

Robert F. Hull, Jr.

On the cash flow you’re right, the expected cash flow from operations in fourth quarter is roughly flat with two items impacting that. First, a decline in earnings of roughly $200 million, second is as I mentioned earlier, the timing of purchases. So, as the inventory percentage flattens out from 58% to 51% Q3 to Q4 that’s impacting the cash flow from operations in the fourth quarter.

The second question regarding the debt target, where you asking about where we’re forecasting for year end?

Stephen Chick – Friedman, Billings, Ramsey & Co.

Yes, I think your targeted leverage ratio is 1.4 times for the year.

Robert F. Hull, Jr.

We’re actually forecasting it to be close to 1.6 times at the end of the fourth quarter.

Stephen Chick – Friedman, Billings, Ramsey & Co.

Is that a little higher?

Robert F. Hull, Jr.

It’s actually right where we thought we would be when we first planned the year. It will be about 1.6 times. The only changes, because we’ve done a relatively good job with working capital throughout the course of the year, we’re able to call the convertible debentures in the second quarter or otherwise a little bit worse earnings offset by lower debt because of the convert call.

Operator

Our next question will come from the line of Michael Lasser – Barclays Capital.

Michael Lasser – Barclays Capital

On the weakness that you started to see in the last week of October and extending in to November, what did the distribution look like from a market perspective? Was it mostly queued in the weak housing market or did you start to see some of the other markets that had been holding up well decline guessing that the macroeconomic concerns are starting to overweigh housing issues in other areas?

Larry D. Stone

Basically the weakness that we felt in the last couple of week of October pretty much across the whole US and I really think it had a lot to do with the upcoming election and fuel prices were finally starting to trickle down a little bit which was helping consumers. I just think the uncertainty of the election and then the real impact of the financial markets I think had a lot of people kind of in a sit on the sidelines let’s see what’s going to happen. I think those two issues had more to do with it then anything the last couple of weeks of October.

Michael Lasser – Barclays Capital

Then a real quick follow up on the foreclosures, you made a comment that you’re seeing investment from buyers of foreclosed properties that were similar to what you’d seen with non-foreclosed properties but are you also seeing – what are you seeing in regards to the amount of investment that banks are willing to put in such that it might change the relationship between housing turnover and your comps moving forward?

Gregory M. Bridgeford

We are seeing spend rates from the research that we’ve done in to our customer transactions from the standpoint of a housing turnover related to a change of ownership from a foreclosure similar to a normal change of ownership spend post possession of the house. We haven’t been able to dive in and detect bank spend to fix up a house for example, for sale but we can tell you that we’ve been tracking this for about nine months and we’re trying to get a feel but right now our research tells us that the spend post possession of the house in a foreclosed situation in our market seem to a be a very similar spend to what we’re finding from a normal turnover of housing.

Operator

Our next question comes from Colin McGranahan – Bernstein.

Colin McGranahan – Bernstein

Two questions, first for Larry, I hoped you could speak a little bit more about the appliance category given it is one of the big ticket categories but has an interesting mix of both discretionary and non-discretionary pieces in it. What have you seen in that category, especially as you went in to late October and November and how you were thinking about the promotional environment there, looking especially at some of your competitors, especially Sears? So, first question there for Larry.

Larry D. Stone

In the appliance category we still have a pretty decent quarter overall in the appliances. We still gained according to third party measures according to dollar share and unit share and draw rate versus the competition. We think the fourth quarter, I mean so far, we’ve not seen anything irrational in terms of advertising and so forth. We think that our plans that we have in place for the quarter are real solid. As we always state all the time that we will react if things come out and certainly we’ve got our 10% price guarantee on major appliances that we’ll not only match the price but beat it by 10% if called to our attention.

But, we think the fourth quarter should be pretty solid. The weeks leading up to Thanksgiving are normally pretty good appliance weeks and then traditionally those purchases will kind of tail off a little bit as you get nearer Christmas but we think business is still pretty good out there. The products like high efficiency laundry, as we’ve talked about many times has continued to gain shares as consumers still will pay a couple of thousand for a high efficiency washer and dryer so we think that ties in to this whole thing about energy efficiency and at the same time the higher ticket purchases are driven by that. Overall, it’s mixed but it’s still pretty solid compared to the other parts of our business.

Colin McGranahan – Bernstein

The same question for Greg, what have you been able to gather in terms, or what have you done to your pricing in regards to Home Depot’s portfolio pricing moves and what kind of data were you able to gather there?

Gregory M. Bridgeford

Colin, we’ve looked very hard at what kind of impact we’re seeing in the marketplace from a price perception standpoint from all of our competitors and we’re able to track it pre-campaign, campaign and post-campaign. What we have not seen is a material change in price perception on the part of customers from the standpoint of any of our competitors campaigns that have gone on recently and that’s as recent as a month ago.

Colin McGranahan – Bernstein

Then did you actually make any price changes in your own portfolio in response?

Larry D. Stone

Certainly we’ve had NLPs for the last five years and when the competition did come out with their programs, our price shoppers looked at the markets and there were a few items that we did have to make adjustments on. But there again, it’s a program that we’ve had in place for several years, consumers have reacted well to it but nothing that was out there that we had to overreact to. I mean there’s always items that are price offers going up and going down and so forth but nothing that really gave us a lot of heartburn on the new program that was announced by the competition.

Operator

Our final question comes from Scott [Chickervelli] – RBC Capital Markets.

Scott [Chickervelli] – RBC Capital Markets.

I guess I wanted to follow up a little bit similar to Colin’s question and can you guys just talk about the competitive environment specifically in assessment regarding consolidation activity with the huge number of smaller players out there? I know a lot of questions tend to focus specifically on your biggest competitor but I’m just curious what you guys are seeing in terms of the financial strain that much be occurring with all the other smaller players that are out there.

Larry D. Stone

I’ll kick the question of, there’s a lot of [inaudible] companies that we can track and certainly there’s some competition, Stock Lumber and 84 Lumber have announced quite a few closings and that’s really two companies that sell a lot to new home builders so we kind of understand what’s happening there.

We get a lot of field intelligence from our store managers and the various markets of smaller independents are going out of business. It can be a carpet store, an appliance store, a hardware store, lawn and garden shop or so forth but most of those companies are not publically traded companies so it’s all anecdotal information that we get from the field. Greg Richard’s group compiles all this and we keep a running list of what’s happening in each market so it really helps us to better understand the markets, what’s taking place and helps us really understand the more opportunity that we have and how we might want to mix differently in those markets still after the business is being left in the market by a competitor closing.

Gregory M. Bridgeford

I agree with what Larry said and if you look at the trends we’re seeing out there, the businesses and Larry is right, it is anecdotal and it’s a lot of information we’re getting market by market especially by local independents. Businesses and entities associated with new residential market and businesses associated with large project sales especially dealers, we believe are under considerable strain right now and so as Larry said we take all that information in, we understand what opportunities that affords us and the ability to be there for the customers during these times.

Scott [Chickervelli] – RBC Capital Markets.

Is it fair to assume you’ve actually seen an acceleration in that process just given the anecdotal evidence you’re hearing at the store level?

Larry D. Stone

I don’t think an acceleration, I just think a continual closing of smaller businesses as things continue to tighten up and quite frankly, with the way things have been the last few weeks and so forth, we think it will probably accelerate as we go in to ’09 but as far as thinking we could list all those different suppliers and so forth and come up with a hard fast number right now would be pretty tough to do. But, we do look at it on a weekly basis and really try to take in to consideration the opportunity that presents for Lowes in those markets.

Robert A. Niblock

I think the information we get back from our field organizations, store managers about what they’re seeing change in their competitive landscape and their markets, you generally hear about more changes, closures, those types of things taking places in those areas that have been most heavily hit by the decline in housing prices. So, in the California, the Florida, the areas in the upper Midwest of it that are heavily impacted by the automotive industry, you generally hear more entries coming back in as far as local competitors that are struggling having going out of business, liquidation sales, whatever the case may be.

Operator

Robert A. Niblock

Thanks and as always thanks for your continued interest in Lowes. We look forward to speaking with you again when we report our fourth quarter results on Friday, February 20th, a few days earlier than our typical release date and in conjunction with our annual sales meeting that begins that weekend. Thanks and have a great day.

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Source: Lowes Companies, Inc. Q3 2008 (Qtr End 9/30/08) Earnings Call Transcript
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