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Lowe’s Companies, Inc. (NYSE:LOW)

Q2 2013 Earnings Call

August 21, 2013 9:00 a.m. ET

Executives

Robert Niblock - Chairman, President & Chief Executive Officer

Rick Damron - Chief Operating Officer

Robert Hull - Chief Financial Officer & Executive Vice President

Gregory Bridgeford - Chief Customer Officer

Analysts

David Strasser - Janney Capital Markets

Budd Bugatch - Raymond James

Laura Champine - Canaccord

Brian Nagel - Oppenheimer

Michael Lasser - UBS

Greg Melich - ISI Group

Matthew Fassler - Goldman Sachs

Chris Horvers - JPMorgan

Eric Bosshard - Cleveland Research

Operator

Good morning everyone and welcome to the Lowe's Companies' second quarter 2013 earnings conference call. This call is being recorded. [Operator instructions.].

Statements made during this call will include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Management's expectations and opinions reflected in those statements are subject to risks, and the company can give no assurance that they will prove to be correct. Those risks are described in the company's earnings release and in its filings with the Securities and Exchange Commission.

Also, during this call, management will be using certain non-GAAP financial measures. You can find a reconciliation to the most directly comparable GAAP financial measures and other information about them, as well as reference slides pertaining to second quarter results posted on Lowe's Investor Relations website under Investor Documents.

Hosting today's conference will be Mr. Robert Niblock, chairman, president and chief executive officer; Mr. Rick Damron, chief operating officer; and Mr. Bob Hull, chief financial officer.

I will now turn the program over to Mr. Niblock for opening remarks. Please go ahead, sir.

Robert Niblock

Good morning, and thanks for your interest in Lowe’s. Once again this quarter, we have provided slides on our investor relations website to supplement our call. While we do not plan on speaking directly to the slides, we encourage you to download them to facilitate your review of our results and to use as a reference document following the call.

After my remarks, Rick Damron will review our operational performance and Bob Hull will review our financial results in detail. But first, I’ll provide some highlights of the quarter as well as our view on the economic landscape for the second half of the year.

Comparable sales for the quarter were positive 9.6%, driven by a healthy balance of ticket and transaction growth. As expected, we recovered most of the outdoor sales we missed in the first quarter from unfavorable weather conditions, and we also capitalized, as planned, on consumers’ natural mindset shift during the second quarter, from lawn maintenance early on to outdoor enjoyment in the mid to latter part of the quarter.

Our Time to Shine campaign resonated with customers looking forward to spending time outdoors and celebrating summer with family and friends. While outdoor categories were strong, we also saw strength in indoor categories. In fact, all 12 product categories had comps at or above 5%.

Likewise, all regions had positive comps in the quarter, and our pro services business continued to perform well. We’re focused on improving our core business through cross-functional collaboration and consistent execution in store and across other selling channels. I’d like to thank our employees for their hard work and continued dedication to serving customers.

Home improvement demand was strong during the quarter, and the team’s improving execution allowed us to capitalize on it.

Gross margin expanded 42 basis points in the second quarter, as we made further progress with our value improvement initiative. We also continued to effectively control expenses and deliver earnings per share of $0.88 for the quarter, a 37.5% increase to last year’s second quarter.

Delivering on our commitment to return excess cash to shareholders, in the second quarter we repurchased $1 billion of stock and paid $174 million in dividends.

I’m also pleased that we made further progress with our previously announced bid for Orchard Supply Hardware. The government antitrust review has concluded, and yesterday the bankruptcy court approved our bid for the 72 stores that we chose to include in the transaction. We expect the deal to close at the end of August and to be funded with operating cash flow.

Strategically, the transaction will provide Lowe’s with an attractive opportunity to increase our footprint in California, where we’re currently understored, through a neighborhood format that is complementary to our strength in big box retail.

Orchard’s hardware and backyard stores have a loyal customer base and are situated in high density prime locations. We see significant potential for Orchard as a standalone business within Lowe’s portfolio, and we look forward to the opportunity to participate more fully in California’s economic recovery.

Now looking at the landscape in the second half of the year, the stronger than expected pace of home improvement industry growth so far this year was fed by modestly stronger gains in housing turnover and job growth than originally forecast, further offsetting the negative effects of higher taxes.

Industry outlook for the second half hinges on the impact of steep increases in mortgage rates experienced over the last few months. The rate increases will likely take some sting out of the recent housing market rebound, but shouldn’t derail it as long as job gains persist, homes continue to appreciate, and rates rise more gradually going forward.

The macroeconomic transition from recovery to sustainable expansion, together with our initiatives and improving operational collaboration, give us confidence in our business outlook for 2013. Bob will show those details in a few minutes.

Before I turn it over to Rick, I’d like to share why I’m enthusiastic about Lowe’s long term prospects. Our business is sound, and our brand is strong. We’re the second largest player in the home improvement market, which provides tremendous buying power and economies of scale.

Additionally, we’re generating solid cash flows, even as the economy emerges from the worst housing downturn in generations. We will use that cash flow first to make strategic investments in our core business and other opportunities that draw on our ability to serve developing home improvement markets, second to pay dividends, and third to repurchase shares.

Thanks again for your interest in Lowe’s. Rick?

Rick Damron

Thanks, Robert, and good morning everyone. As Robert shared with you, our performance for the quarter was balanced across categories, where comps range from mid-single digits to double digits, and across regions, where our comps also range from mid-single digits to double digits.

Additionally, ticket and transaction growth contributed evenly to our overall performance. We also saw balance throughout the quarter, with comps above 8% every month. Finally, we were pleased that this top line sales performance was accompanied by continued improvement in gross margin rates.

We achieved this balanced growth by executing well within the second quarter’s strengthening home improvement market and ensuring we were ready to sell outdoor products as customers responded to the warmer spring and summer weather. In fact, our outdoor product comps increased approximately 13% in the second quarter, compared to a decrease of 7% for the first quarter, resulting in an outdoor comp of 3.5% positive.

We achieved very strong second quarter growth in products needed to improve and maintain the yard, tools and outdoor power equipment, and lawn and garden were among our best-performing product categories in the quarter.

However, strong growth wasn’t limited to outdoor categories. Kitchens and appliances also outperformed in the quarter, driven by robust growth in appliance sales as the LG line gained further traction after its first quarter rollout.

We are excited about the innovation that LG adds to an already strong lineup of national brands and the most extensive in stock offering of appliances in the home center channel. In fact, this month JD Power and Associates ranked Lowe’s highest in appliance retail customer satisfaction for a fourth consecutive year.

We were also pleased by strength in the core of the store, where categories such as hardware, paint, and fashion electrical not only achieved mid single digit comps, but did so with solid growth and gross margin rates. This balance of sales and gross margin rate improvement within these categories reflects the progress we’re making in our value improvement initiatives.

At the end of the second quarter, we had completed resets representing approximately 70% of our business and we expect to substantially complete the initial round of resets in 2013. Examples of resets completed in the second quarter include core products like plumbing tools and wall plates and core products such as blinds and shades, ceiling fan accessories, and hardwood flooring.

A recent example of how value improvement was used to more effectively assort a product grouping was in power tools sandpaper, where the team created a clear and practical progression and enhanced inventory productivity. They eliminated price point and design duplications and established exclusives within the mass retail channel with the Gator Grip and Shopsmith brands.

Gator Grip offers opening price points and the Shopsmith line offers premium [film backed] ceramic grain sandpapers which are more aggressive and durable, and sell primary to the pro customer.

As a result, the financial benefit of value improvement is greatest once we have reached stabilization. That is, when we are past the clearance and selling only new product assortments. We estimate that roughly 50% of our business was at this stage in the second quarter. We continue to expect average mid single digit comps and roughly 100 basis points of improvement in gross margin rate for product lines that have reached stabilization.

As I mentioned earlier, our performance in the second quarter was not only balanced across categories, but across regions as well, with all regions achieving mid single digit comps or above. Those regions that have struggled from cooler and wetter weather in the first quarter, including most of the East Coast and Midwest, recouped most of those sales in the second quarter.

In our north division, we achieved our strongest performance in the upper Midwest, which suffered from droughts last year and experienced a delayed spring this year. Additionally, we estimate that the stores most affected by Superstorm Sandy contributed approximately 30 basis points to our total comps.

Housing recovery markets on the West Coast and Florida and healthy markets along the Texas Gulf Coast continue to show high single to double digit comp improvement. We expect to see continued strength in these markets and further improvement along the south to east coast and in the Midwest, where the recovery is now taking root.

Looking at payroll, as expected, strong second quarter sales growth generated solid payroll leverage across all regions of the country as we leveraged the fixed component of store labor hours. As a reminder, we added approximately 150 hours per week to the staffing model for nearly two-thirds of our stores. These additional hours are dedicated to the interior sales floor. We continue to monitor performance and make adjustments as necessary.

As Bob will share with you, our expectation for year-end inventory is approximately $200 million higher than we had forecasted last quarter. Part of this increase is due to air conditioners and ceiling fans. The cooler and wetter summer to date has greatly reduced our sales of these items. We expect to sell them until the end of the summer, but we will carry over the remainder to sell next year.

The greater part of this inventory increase reflects our commitment to further lean into increasing demand as we bolster job lot quantities to benefit pros, increase overall in store service levels, and present compelling end cap displays. We expect that these incremental inventory investments will be completed this year, and that we will be positioned to achieve greater inventory productivity in 2014.

Before I hand it over to Bob, I am pleased to share that for the first half of this year, approximately 80% of our U.S. stores have qualified for a service and sales employee incentive, or SSEI payment. As a reminder, SSEI is a profit sharing program for hourly associates. This quarter’s payment will be the highest we have made since the start of this program.

Thank you for your interest in Lowe’s, and I will now turn it over to Bob.

Robert Hull

Thanks, Rick, and good morning everyone. Sales for the second quarter were $15.7 billion, which was an increase of 10.3%, driven by positive comp sales and new stores. In Q2, total customer transactions increased 5.3% and total average ticket increased 4.7% to $65.60. Comp sales were 9.6% for the quarter. Looking at monthly trends, comps were 9.5% in May, 8.5% in June, and 11.3% in July. For the quarter, comp transactions increased 5% and comp average ticket increased 4.4%.

With regard to external factors, we estimate that the recovery of lost Q1 sales from a delayed spring aided second quarter comps by approximately 120 basis points. Also, lumber deflation and sales related to Superstorm Sandy recovery efforts added roughly 60 and 30 basis points to comps, respectively.

Our internal efforts, including value improvement, product differentiation, lowes.com, proprietary credit value proposition, outside selling positions, and the weekday labor hours investment drove approximately 250 basis points of the Q2 comp.

The balance of the comp growth, 5% or so, we believe was driven by improving execution and strengthening industry demands. Year to date sales of $28.8 billion were up 5.1% versus the first half of 2012, driven by a 4.6% increase in comp sales and new stores.

Gross margin for the second quarter was 34.35% of sales, which increased 42 basis points over Q2 last year. The biggest driver of the increase was value improvement, which helped gross margin by approximately 55 basis points, our estimate of the improvement nets the clearance impact of the reset against the benefit of the stabilized line.

For the quarter, the percentage of resets completed increased from 50% to 70% while the percentage of resets stabilized increased from 30% to 50%, which was consistent with our plan. Also, more effective promotional activity relative to Q2 of last year aided gross margin by an estimated 20 basis points.

This improvement was offset somewhat by the following items. First, our proprietary credit value proposition negatively impacted gross margin by approximately 15 basis points. This is driven by higher penetration of our proprietary credit program, which reached 24.7% of sales, a 90 basis point increase over Q2 2012.

Also, the mix of products sold negatively impacted gross margin by 14 basis points. Lastly, lumber inflation negatively impacted gross margin by rough 10 basis points.

Year to date, gross margin of 34.56% of sales is an increase of 26 basis points over the first half of 2012. SG&A for Q2 was 21.73% of sales, which leveraged 53 basis points.

During the quarter, store payroll leveraged 30 basis points. Payroll dollars were up approximately 7% versus Q2 of last year, which includes the additional weekday hours investment that Rick noted. While payroll grew in the quarter, it was at a lower rate than sales, resulting in expense leverage. Similarly, insurance, both casualty and employee, advertising, utilities, rent, profit taxes and other cost leveraged as a result of the 10.3% sales increase.

Also, expenses incurred last year for the voluntary separation program resulted in roughly 10 basis points of leverage this year. These items were offset somewhat by incentive compensation expense, which deleveraged 31 basis points as a result of higher expected attainment levels relative to last year.

Year to date, SG&A was 23.04% of sales, which leveraged 36 basis points to the first half of 2012.

Depreciation for the quarter was $367 million, which was 2.33% of sales, and leverage 26 basis points compared with last year’s second quarter as a result of the sales growth.

In Q2, earnings before interest and taxes, or EBIT, increased 121 basis points to 10.29% of sales. For the first half of 2013, EBIT was 9.02% of sales, which was 82 basis points higher than the same period last year.

For the quarter, interest expense was $110 million, and deleveraged 2 basis points to last year as a percentage of sales. In Q2 2012, we settled various tax matters that resulted in lowering interest accruals by $22 billion, causing an interest expense deleverage in this year’s second quarter.

Total expenses for Q2 were 24.76% of sales and leveraged 77 basis points. Year to date, total expenses were 26.31% of sales, and leveraged 52 basis points to last year.

Pre-tax earnings for the quarter were 9.6% of sales. The effective tax rate for the quarter was 37.5%, which is down slightly from Q2 last year.

Net earnings were $941 million for the quarter, an increase of 26% over Q2 2012.

Earnings per share of $0.88 for the second quarter were up 37.5% to last year. The $0.88 per share compares with our plan of $0.83, with a nickel beat driven primary from higher planned sales.

For the first six months of 2013, earnings per share of $1.36 represented a 27% increase over the first half of 2012.

Now to a few items on the balance sheet, starting with assets. Cash and cash equivalents balance at the end of the quarter was $1.1 billion. Our second quarter inventory balance of $9.1 billion increased $407 million, or 4.7% versus Q2 last year. The increase was driven by higher inventory levels to support demand, inflation in lumber and building materials, as well as the air conditioner and ceiling fan carryover that Rick noted.

Inventory turnover, calculated by taking the trailing four quarters cost of sales divided by average inventory for the last five quarters, was 3.73x, or essentially flat with last year.

Return on assets, [measured] by using the trailing four quarters earnings divided by average assets of the last five quarters, increased by 114 basis points to 6.38%.

Moving on to the liability section of the balance sheet, accounts payable of $5.7 billion represented an 11% increase over Q2 of last year, caused by the timing of purchases this year relative to last year.

At the end of the second quarter, lease adjusted debt to EBITDAR was 2.05x. 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, increased 201 basis points for the quarter, to 10.62%.

Now looking at the statement of cash flows, cash flow from operations was $3.4 billion, an increase of $560 million over last year, largely due to the timing of purchases that contributed to the higher accounts payable balance, as well as growth in net earnings.

Capital expenditures were $376 million, a 40% decrease from last year. As a result, year to date free cash flow of $3 billion was 37% higher than the first half of 2012.

For the quarter, we repurchased 24.4 million shares, or a little bit more than $1 billion. Also in the quarter, we received approximately 2.7 billion shares as part of the final settlement associated with the accelerated share repurchase program executed in Q1. We have approximately $3 billion remaining on our share repurchase authorization.

Before getting into the details of the Lowe’s business outlook, I’d like to note that the income statement impact from the Orchard’s Supply acquisition is not expected to be material and, except for [unintelligible] related expenses, is not included in these figures.

Also, I wanted to note that our outlook for the second half of the year is unchanged from our prior outlook. Our 2013 outlook combines the above planned sales and earnings performance in Q2 with our previous assumptions for the second half of 2013.

Now to our outlook for 2013. We expect total sales to increase by approximately 5%, driven by comp sales of approximately 4.5%. We expect continued momentum for our internal efforts, tampered by moderating home improvement industry demand. We expect to open approximately 10 stores for the year.

For the fiscal year, we are anticipating an EBIT increase of approximately 65 basis points. The effective tax rate is expected to be approximately 37.9%. As a result of these inputs, we’re expecting earnings per share of approximately $2.10, which represents an increase of 24% over 2012.

For the year, we are forecasting cash flow from operations to be approximately $3.9 billion, which is lower than our prior forecast, due to the higher inventory levels that Rick described, offset somewhat by higher earnings.

Our 2013 forecast for fixed assets required is approximately $1 billion. The decline from our prior expectations relates to spend rationalization, lower expected costs, and project timing, primarily related to information technology. This results in an estimated free cash flow of $2.9 billion for 2013.

We expect to close the Orchard transaction in the quarter. Our guidance assumes approximately $3.6 billion in share repurchases for 2013, which is lower than our prior expectation, as a result of the $205 million Orchard purchase price.

For the year, we expect lease-adjusted debt to EBITDAR will be at or below the 2.25x. We continue to execute against the long term strategy that we outlined during our analyst investor conference last December. Our initiatives are gaining traction, and we are pleased with our results for the first half of 2013. In addition, housing is turning. So, for the first time in a while, both internal and external forces are moving in the right direction.

We will not be holding an investor conference in 2013, but look forward to updating you on our strategy in mid-2014. Operator, we are now ready for questions.

Question-and-Answer Session

Operator

[Operator instructions.] Our first question will come from the line of David Strasser with Janney Capital Markets.

David Strasser - Janney Capital Markets

Bob, I just wanted to follow up on a comment you made as you were talking about the guidance, about the moderating home improvement demand. July seemed like the strongest category. It seems accelerating throughout the quarter.

Robert Hull

As we think about Q2, I talked about some of the improving execution. So we have implemented some procedures, specifically sales and operations planning, that allows us to work on behalf of the customer in a more collaborative and coordinated fashion. So that’s aiding this year’s performance.

But if you think back to Q2 last year, we had a lot of moving pieces as it relates to the value, a voluntary separation program, the change in commission for some of the sales folks in the store floor. We had some reset challenges, the execution of resets related to value improvement. We had inconsistent promotion activity in Q2 of last year. So some of the benefit in Q2 was specific to recovery of some disruption in Q2 last year.

Also, as you think about the external factors I just described, there was the recovery of the lost sales from Q1, lumber inflation, and Hurricane Sandy, 200 or so basis points largely doesn’t continue into the second half of the year.

And then lastly, I’ll talk about interest rates. We’re seeing positive momentum in housing, but the wildcard is interest rates and the impact that has on housing affordability. So we’re kind of watchful of that potential impact.

David Strasser - Janney Capital Markets

I guess along those lines, one follow up question. Yesterday, Best Buy and Home Depot talked about really strong appliances. You’re talking about really strong appliances out there. Is there something in the industry that’s happening that’s driving such dramatic demand in that space? Each person has incremental brands and so on, but it just does seem like the category has expanded fairly dramatically recently. And just trying to understand a little bit more about what may have driven that.

Robert Niblock

I think part of it is underlying economic fundamentals we talked about, which we attributed part of the increase in the quarter to. As home prices started to move up, I think it does have homeowners feeling gradually better about willingness to spend, particularly as you get to big ticket durables. And I think some of appliances - some of those things are probably some of the purchases that consumers have otherwise delayed during the downturn, because they could get better clarity with regard to where the value of their home was moving. So I think we’re seeing part of that come into play. It’s no different than what you’re seeing in the auto industry and other places, where you’re seeing consumers have a willingness to move towards some of those big ticket durables as they’re feeling gradually better about things.

Gregory Bridgeford

I agree with Robert that from a household economic trend standpoint, I think we are seeing the impact of what’s been some delayed spending now coming into our favor. And what’s worked for us, and what drove our share increases in Q2, was innovation. The launch of LG continues to provide a lot of momentum for the category. Also, new innovative products from Samsung, innovative products from Bosch, some new rollouts of GE and Whirlpool. That’s been driving our sales in appliances. And I think we’ve gotten into the cadence. You know, Bob mentioned it earlier. I think we’ve gotten into the cadence of the proper balance of traffic driving promotions and ticket building promotions too, so that’s been a big hit in terms of driving sales and driving margins simultaneously.

Operator

Your next question will come from the line of Budd Bugatch with Raymond James.

Budd Bugatch - Raymond James

My first question comes on the penetration of the pro business. Typically I think it’s been around 20% for you. Can you give us some flavor and comment of what you’re seeing in the pro, and maybe how that penetration is moving?

Rick Damron

We continue to see good growth in the pro for the quarter. Our pro business outperformed our sales totals, or comp totals. You look at it overall, it’s roughly, we say, approximately 25% of our total volume at this point in time. If you think back to several initiatives that we launched mid year last year, we’re gaining traction with those.

When you look at the focus that we’ve got on the MROs, the maintenance repair customers, when they come into the stores, as well as the reorganization that we went through and talked about. Our account executive, pro services, in the field, getting them focused on building strong relationships with our core customers. And really pulling that together as a cross-functional program across the organization, to make sure that we’re really doing the things that benefit the pro.

I talked a little bit about it in our opening comments, the job lot inventory, just making sure we have the right depth of inventory, being able to present those effectively to the pro customer, has really benefited. You look at [inaudible], and our product differentiation aspects, and the freeing up of end cap space, has allowed us to present our contractor pack value offerings to the pro customer, which is a way to give them discounts on multiunit purchases.

And then the everyday value proposition on our proprietary credit has also really benefited that category. So we’ve been extremely pleased with the programs the teams have built, the progress we’re making, and the traction we’re making, as the pro continues to rebound in the marketplace.

Budd Bugatch - Raymond James

And my follow up really has to do with the air conditioner issue. Did I hear you correctly that you’re going to pack away about $200 million worth of air conditioners? Just my question is, what risk of obsolescence do you have, and have you done this before? And what risk is there in this particular strategy?

Robert Hull

The $200 million relates to many factors, not just ACs. So it does relate to, as Rick described, as we think about going through the lines, we’re adding greater depth of inventory to the products that are the eight items, the highest velocity items. So greater in stock levels there. So that’s the bulk of it.

We do have some carryover from both air conditioners and ceiling fans. As we think about seasonal product, we evaluate the quality of that product, whether it makes sense to mark it down at that point in time, or carry over.

ACs is a category where there’s not much change year over year. So as we think about carrying over air conditioners, there’s really no impact to the 2014 line, there’s no risk to the line, there’s no risk of damaging the product as we carry it over through the season. So yes, we have done that before and feel comfortable with that decision.

Operator

Your next question will come from the line of Laura Champine with Canaccord.

Laura Champine - Canaccord

I understand the air conditioner and ceiling fan issue, but given those strong sales trends in Q2, how are your in-stock positions as we move into Q3?

Robert Niblock

I think we feel really good about our in-stock positions. A lot of the cross-functional work that we’ve talked about, certainly our strength with our extensive logistics and distribution network that we have out there has allowed us to stay very comfortable with in-stock positions that we have. And we said the seasonal categories, the air conditioning, there’s still time to sell through part of that, and it’s an easy product to carry over to next year. So we feel really good about in-stock.

Rick Damron

As you think about inventory in general, I think it’s important to go back and realize some of the changes that we’ve made to our strategy this year, that are helping us impact our in-stock levels in the stores today and what we’re continuing to do.

We talked about previously, as we looked at opportunities for inventory moving into 2013, that we saw some opportunities to improve our in-stock positions. Actions that we took were greater depth of the job lot inventory, meaning that we have greater depth of inventory available for our pros and our DIY customers when they come into the stores to complete those projects.

We also increased our in-store targeted service level across many items, particularly those that have gone through the value improvement line initiatives to drive greater in stock levels of that inventory when those categories come out of that line review. So that has helped us meet those demands as well.

And then as it relates to Q2, related to seasonal categories, remember we talked about in Q1 the way that we built our inventories more aggressively to hit those high seasonal peaks and demands for the consumer allowed us to capture that upside from that initial spike when the consumer was ready. And that allowed us to proactively flow that inventory for the remainder of the season.

So I think collectively all of those initiatives have played out very well, and have us in a good position going into the second half of the year.

Gregory Bridgeford

The only thing I’d add to Rick’s comments would be that when you look at the top four categories that had above average performance for the quarter, three of the four are what we’d call flow through and sell out categories. And one of the keys to the quarter was really a tremendous performance on the part of our vendors, our logistics teams, and our store operations teams, from being able to flow through that much inventory and putting it in the hands of the customers, whether it’s in outdoor power equipment, live goods, lawn and garden hardlines, or appliances. That was one of the keys to the quarter.

Operator

Your next question will come from the line of Brian Nagel with Oppenheimer.

Brian Nagel - Oppenheimer

You called out, as part of your outlook, some concern with respect to the potential for rates to climb higher. The question I have is, interest rates already ticked higher by a bit here. Have you seen any indication yet in your business that this is having an effect? And given the history you have with Lowe’s, if interest rates continue to climb higher, how could that impact Lowe’s business in the coming quarters or years?

Robert Niblock

Certainly if you look at any of the numbers out there with regard to refinancing or new home sales, housing turnover, those types of things, certainly you’re seeing the impact of interest rates starting to show up in some of those numbers.

As I said earlier, I think, however, the biggest positive impact that we had seen so far on the business to date has been the fact that overall, from a macro environment, home prices starting to move up, and the strong housing turnover job gains that we’ve seen to date, we think that’s contributed to what we’ve seen in the business. Yeah, interest rates, since May or something, are up about 110 basis points or so. So it is starting to have an impact on refinancings, those type of things.

As long as it kind of stays in this area, moves up a little more gradually, we think it has some impact, but we’re not overly concerned about it. If you were to start seeing interest rates that were to move north of the 6% interest rate for a 30-year mortgage, we think that that would probably start to have some impacts that we would start feeling in the business.

Brian Nagel - Oppenheimer

And then maybe just a quick follow up. Any update on the remerchandising and resets, and what lift you’re seeing in your comps, in the areas of the store you touched?

Gregory Bridgeford

As we discussed, we’re making a lot of progress with value improvement. We did perform a normal amount of resets for the second quarter, and provided the bulk of, when you look at the lift that Bob detailed, the 55 basis points we attributed to value improvement, we’ve continued to see progress being made in what I call the interior categories, which is the center of the store. When we execute resets and refresh the lines, that’s provided a strong basis for the business. Because you saw very balanced performance across the categories for Lowe’s.

And then going into the season, obviously we perform line reviews pre-season for categories such as lawn and garden. And we actually do line reviews about twice a year on the appliance categories as new models and innovations roll out. So continue to be a major foundational factor in our performance, and it’s at the point now, as Rick mentioned, with 50% of lines reaching a form of stabilization, where it is becoming part of our business. And it’s a solid foundation for our business.

Operator

Your next question will come from the line of Michael Lasser with UBS.

Michael Lasser - UBS

On the 150 labor hours that you added at the store, how much do you think that you have opportunity to much a little further on that, increase service levels even more? And what sort of benefit might you be able to see from that?

Rick Damron

Right now we’re comfortable with the program that we have in place, and executing against that 150 hours. I think when you go back and you look at the analysis that we did when we put those numbers, those hours back in, we felt confident that that would get us back to where we were from a service level and an hours level to meet the sales needed for the quarter. So we feel confident in that program. We’re still making adjustments to that program as we move into Q3, and looking at how we allocate the hours, what departments we allocate the hours into, and how we mix them across the floor. But we’re still comfortable that the 150 hours is the appropriate number, and we don’t see, at this point in time, a need to increase those hours.

Michael Lasser - UBS

And my follow up question is on your outlook. I’m curious about the level of conservatism that you’ve baked into your outlook. Can you kind of frame how you see the upside, downside, and potentially what type of momentum have you carried into the current quarter from that very strong July?

Robert Niblock

If you remember back, at the end of the first quarter, when we fell short of what our internal plan was, we didn’t really change our guidance, because we anticipated that with the impact we saw from a delayed spring, we would make up the majority of that in the second quarter. And the second quarter we actually covered most of those sales and then had actually performance above what our internal plan we’re seeing.

So our thought process has been we take the amount we exceeded our internal plan for the second quarter, roll that into the annual guidance, combined with what our plan was basically for the second half of the year. So we’ve got good momentum going into the third quarter, so that gives us additional confidence. There are some additional headwinds out there, as Bob outlined in his comments, including some unknowns out there with things like interest rates that we just went through, and the impact that that could have potentially on the industry.

So we feel good about the outlook for the second half of the year, but that’s kind of how we got to building the revision to our guidance for the year.

Robert Hull

Two comments. One related to your guidance question. You asked about where we were so far. If you think about our 4.5 comp outlook for the year relative to the 4.6, that implies a comp of 4-4.5% in the second half of the year. I would tell you that August to date we are running somewhere between that 4-4.5% and the 11.3% we ran in July. So nice big range for you.

The other point I’ll make really ties together your question on payroll and prior questions on inventory. So as we think about the second quarter, we saw a ramp in industry demand that we haven’t seen for quite some time. In fact, we recorded our highest quarterly comp in almost 10 years. So we were focused on capitalizing on the opportunity.

As you heard from Rick, we’ll focus on the inventory productivity that we outlined in 2015. We’ll get there, but we didn’t want to lose sight of the opportunity that was in front of us in this quarter.

Michael Lasser - UBS

That’s a pretty wide range that you could drive a sledgehammer through that. No chance you could narrow that for us?

Robert Hull

You can do it with your model as you see fit.

Operator

Your next question will come from the line of Greg Melich with ISI Group.

Greg Melich - ISI Group

I wanted to talk a little bit about guidance, but rather the top line on the flow through. It’s specifically in the margin guidance, you basically only increased the guide by 5 basis points, even though second quarter was up 100 basis points. So I’m just wondering why that was. Is there something going on with the flow through from the resets, maybe a little different than you thought? Or on the SG&A side? As comps decelerate, help us understand the difference based on whether that deceleration is traffic or ticket in terms of the leverage.

Robert Hull

So, following up on Robert’s response to Michael’s question, our outlook for 2013 is a function of taking our year to date performance plus our prior expectations for the second half of the year. So yeah, it looks like, on a 1% sales increase, the EBITDA only goes up 5 basis points. We didn’t change our second half outlook.

We do expect a 4-4.5 comp in the second half to be balanced across ticket and traffic. We do have some expense pressures that we talked about previously, the 10 basis points from additional labor hours. Reset expense is actually 20 basis points. We talked about 10 basis points previously, it’s now 20 basis points for the year instead of comp. We’ve modeled the year at performance at target.

Given where we are today, sales and earnings are forecasted above our plan, which means that we’re accruing a bonus above target, which is another 10 or so basis points. So we’ve got some expense pressures that are probably resulting in the flow through rate looking less than what we’ve guided in the past, which is the 20 basis points for each point of comp. That’s what’s taking place in the second half of the year.

Greg Melich - ISI Group

And then if I could, on the D&A, that’s been pretty choppy and bouncing around. Should we use this quarter as the right run rate? Or how should we think about that?

Robert Hull

I think you can use a number of about $1.5 billion for the year.

Greg Melich - ISI Group

As an average, and then just accept that it’s bouncing around a little bit more?

Robert Hull

It should be more steady going forward. As we think about the nature of timing of asset adds, the last [big store ramp] was Q4 of 2005. A lot of 7-year assets became fully depreciated or ramping up a couple of years ago, so [my key was just 3-year lives]. That caused some of the lumpiness that we saw in 2012. I think we’ll see more consistent depreciation going forward.

Operator

Your next question comes from the line of Matthew Fassler with Goldman Sachs .

Matthew Fassler - Goldman Sachs

I have one follow up question on guidance, and then one question on demand. My question on guidance, just sort of phrasing it another way, it looks like the implied operating margin guidance for the second half of the year would be up about 10 basis points. And that’s actually a little less than you did in the first quarter with a 1% comp decline.

Obviously you levered much more in the second quarter on a much bigger comp decline, despite throwing a lot of money into expenses, probably a little more than you had initially intended. Are the expense pressures, those discrete pressures you discussed, sufficient to limit operating leverage to 10 basis points? Or should you comp [four] or so? Or could that be a conservative number in the event that the top line gets to that level?

Robert Hull

I’m not sure where the 10 basis points comes from. We’re at 82 for the first half of this year, expect 65 for the second half.

Matthew Fassler - Goldman Sachs

I guess I was looking on a non-GAAP basis. That might be the difference.

Robert Hull

We report on GAAP and guide to GAAP.

Matthew Fassler - Goldman Sachs

Understood. We can move on from there. I guess the second question relates to the kind of visibility of big ticket sales. If you could talk about some of the projects that have sort of longer life cycles, from the consumer’s initial visit to completing the project, what is traffic in some of those categories looking like today? And what can you glean about the sustainability of demand from your interactions with consumers in your stores?

Rick Damron

What we’ve seen is probably one of the most balanced performances that I’ve ever seen from category performance. We saw strong demand for the bigger ticket project categories in a way that we haven’t seen in recent time periods. Whether it’s kitchen cabinets, whether it was appliance sales, or whether it was fashion plumbing sales, we’re seeing strength in those categories and interest and traffic in those categories that we haven’t seen in previous quarters.

So as we look at the focus of a lot of our [unintelligible] work over the last nine months, we’re coming into somewhat of a sweet spot as we get into the second half of the year, because 60% of fall project sales comes from flooring, paint, bath, and appliances. And we put a lot of effort in those categories to make sure that we’re able to capture that customer demand.

As I mentioned before, we’re really working hard to execute and maintain a good cadence of promotional activity that is margin accretive, that’s foot traffic driving, builds basket, and is margin accretive in the process. And that’s part of this plan as we head into the second half of the year.

Operator

Your next question comes from the line of Christopher Horvers with JPMorgan.

Chris Horvers - JPMorgan

Looking at the benefits from the value improvement program, the gross margin was a big higher than the math would suggest based on the percentage of resets completed and through clearance and so forth. So that was a little better there. Was that a catch up from the first quarter? And then thinking about the math, both on the comp and the gross margin into the back half, should that normalize back into what the basic math of the percentage completed and through reset and times a percentage, the mid single digit and 100-basis point comp lift?

Rick Damron

Your first question was on the 55-basis point improvement relative to the 50% of lines stabilized?

Chris Horvers - JPMorgan

Yes.

Rick Damron

It’s really somewhat a function of the lines that are reviewed and the timing of the reviews within the quarter. As Rick outlined in his comments, we still believe and still are seeing the average mid single digit comp increase, 100 basis points of gross margin, stabilize. So nothing to indicate that we would see anything different in the second half.

Chris Horvers - JPMorgan

And then thinking about the acceleration during the quarter and looking at two-year [stacks] accelerating during the quarter, clearly the seasonal business peaks in the Memorial Day to July 4 timeframe, so can you just talk about the texture of demand within July? How much was the moisture levels maybe carryover impact in July versus what you would consider more core and sustained demand as you look to the back half?

Gregory Bridgeford

We did see probably more moisture on a nationwide basis in July, more moisture in the ground, than we’ve seen in years, maybe a decade. And it did drive the opportunity for sustained live goods sales, bagged goods sales, and in particular outdoor power equipment sales as the normal dryness that hits in July and August didn’t retard the growth of grass. So we had a very strong performance in the outdoor power equipment categories, in particular. And we were able to execute against that because we were ready.

Robert Hull

You mentioned two-year comps in Q2. Given that we had some shift in demand between Q1 and Q2, I’d encourage you to take a look at the two-year stack for the first half, which is 5.6%, and then you take a look at the outlook for the second half, basically assumes that our two-year comp would be in the 5.5-6% range. So we do have tougher comparisons in the second half of the year, but on a two-year comparable basis, we’re expecting relatively the same performance second half versus first half.

Chris Horvers - JPMorgan

And one final one. As you think about the disruption last year around the promotional variation throughout the quarter and things that were successful and not successful, was that more of a June issue last year impacting comps? Or was that more of a July issue?

Robert Hull

A little bit of both. I think specifically, as we talk about last year, we had probably too light of promotions for Memorial Day, didn’t get the attachment rate. We responded by larger big ticket promotions. We didn’t get the unit movement. So I think it’s a little bit of impact all across the quarter.

Gregory Bridgeford

I’d agree with Bob. It was a May to mid-June issue, and then a separate issue in the latter half of the second quarter. The cadence and the integration and the collaboration that we’re executing through our sales and ops planning process today is helping to drive the balanced performance that you saw in Q2. We intend to improve on this process, and it’s really enabling us to meet expectations in terms of our performance.

Operator

Our final question will come from the line of Eric Bosshard from Cleveland Research.

Eric Bosshard - Cleveland Research

Wondering if you could give a little bit more color. I understand you talked about adding some inventory to the business, but curious of how the progress, the focus that you’ve had on margin, it seems like you’re having obviously very good success with sales, but how you’re thinking about sales and market share performance relative to margin and how that’s playing out in the strategy, and how you’re executing the strategy. What’s changed or what’s evolving within that, if you could speak to that.

Robert Niblock

Certainly as we’ve talked about with our sales and ops planning, I think we’re doing a much better job approaching the business on a cross-functional basis, which is helping get the promotional cadence right, helping with the lines, making sure that we responded to demand that we saw in the second quarter.

And certainly with the resets, the value improvement, those types of things, we think we’re starting to hit our stride so that we’re moving through those, got a good cadence to them, continuing with the markdown and clearing of the older inventory as the offsets get more normalized, after we’ve done that sell through. We’re starting to continue to see the margin performance that we anticipated.

So we’re optimistic about the path we’re on, and as we’ve indicated, expect a majority of those resets to be done by the end of the year. So we feel good about that and our ability to be able to deliver our margin goals for the second half.

Rick Damron

I would just add a couple of things to that. First, and this reference is back to the sales and ops planning that Greg’s talked about, [Vince Knowles] and the store teams have done an outstanding job this year in driving attachment of items to the project item. Much better than we’ve done in the past. Increasing the basket size so that we’re able to add the entire margin components onto the total transaction from a store standpoint.

That goes back to a lot of the training that he and the leaders of store operations rolled out in the past year of selling at Lowe’s, getting the stores to really understand attachment and assisting the customer throughout the entire project, has really been benefit to helping us drive that margin. And again, that goes back to a lot of the sales planning that Greg’s talked about earlier.

The other thing that I think we’ve done a great job on is understanding the reset activity itself. We’ve talked about a lot of missteps, when we first started rolling this out last year, going back into understanding the flow of the reset, making go, no go, decisions based upon preset guard rails and criteria before we allow it to hit the store, driving a better overall reset for the store to execute against with the consumer when they come in, helping us manage the amount of nonproductive inventory to a greater degree, so we’re not seeing that have as big a drag on us as we did last year at the same time.

Gregory Bridgeford

And probably the last element would be our big ticket categories, we performed very well, with the balance of driving sales and driving margin. So as you can tell from the categories that performed above average, you wouldn’t see that kind of margin performance unless we manage those very well, and it was great execution, I think, on the part of the teams on the sales floor. They were able to be able to deliver these big ticket projects and items to customers with a good margin outcome.

Robert Niblock

As always, thanks for your continued interest in Lowe’s. We look forward to speaking with you again when we report our third quarter 2013 results, Wednesday, November 20. Have a great day.

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