Good day, everyone and welcome to today's Home Depot third quarter earnings conference call. Today's conference is being recorded. Beginning today's discussion is Ms. Diane Dayhoff, Vice President and Investor Relations. Please go ahead.
Thank you, Joseph and good morning to, everyone. Welcome to the Home Depot third quarter earnings conference call. Joining us on our call today are Frank Blake, Chairman and CEO of the Home Depot; Craig Menear, Executive Vice President of Merchandising; and Carol Tomé, Chief Financial Officer and Executive Vice President Corporate Services.
Following our prepared remarks, the call will be opened for analysts' questions. Questions will be limited to analysts and investors. And as a reminder, we would appreciate it if the participants would limit themselves to one question with one follow-up, please. This conference call is being broadcast realtime on the Internet at homedepot.com, with links on both our home page and the Investor Relations section. The replay will also be available on our site. If you are unable to get to your question during the call, please call our investor relations department at 770-384-2387.
Before I turn the call over to Frank, let me remind you this today's press release and the presentations made by our executives include forward-looking statements, as defined in the Private Securities Litigation Reform Act of 1995. These statements are subject to risks and uncertainties. These risks and uncertainties include but are not limited to those factors identified in the release and in our filings with the Securities and Exchange Commission.
Today's presentations also include certain non-GAAP measurements. Reconciliation of these measurements is provided in the financial statements included with our earnings release.
Now, let me turn the call over to Frank Blake.
Thank you, Diane and good morning, everyone. Sales for the third quarter were $16.4 billion, down 8% from last year. Our comp sales were negative 6.9%. Diluted earnings per share were $0.41. As Carol will detail, our comp sales in the U.S. were negative 7.1%.
From a regional perspective, our Gulf market had double-digit negative comps as we anniversaried the impact of last year's hurricanes. But as a sign of the steadying of our business at the end of the quarter, 36 of our top 40 markets showed a sequential comp improvement on a rolling six-week average basis.
Our strongest regions were the mid-Atlantic and mid-South, but we also continue to see signs of stabilization in the markets that were hardest hit by the housing crisis, such as California, Florida and Arizona. We gained overall market share in the quarter.
From a macro perspective, for the first time in the last few years, private fixed residential investment, PFRI, as a percent of GDP did not decline quarter-over-quarter. We've referenced the PFRI data point consistently and while it's not a perfect indicator of our business, it is at least directionally relevant. So, it's positive news that the PFRI data seemed to have bottomed.
Despite this positive momentum, caution is appropriate. We are still in less bad territory for comps, not positive. Average ticket performance remains a concern, even as our comp transaction rate stabilizes. Our average ticket reflects not only pressure on high end discretionary items, but also pressure on our pro business.
Data from the Home Improvement Research Institute confirm our own data that pro sales are under significantly more stress than DIY oriented sales. We have not yet seen sustained evidence of a recovery in the pro business.
In this environment, we're focused on improving customer service and taking significant steps to improve our overall business. On the supply chain front, we now have 10 rapid deployment centers, RDCs, serving approximately 1,000 stores or more than 50% of our U.S. store base. We have opened our second mechanized facility in Redlands, California.
We've talked a fair amount about our RDCs, but at the same time that our supply chain team is proceeding with the rollout of these new facilities, we're also restructuring another part of our supply chain, our stocking DCs. We have closed two stocking DCs so far in 2009 and in total, we'll reduce approximately 1.3 million square feet of stocking warehouse space by the end of the year, driving additional supply chain efficiency.
Our merchandising and IT transformation remain on track. For example, Matt Carey and his team are well underway with the development of new forecasting tools to feed into our centralized automated replenishment system. Over 70% of our SKU's are on automated replenishment.
We're pleased with our in-stock improvement to date, but our current forecasting system is too manual requiring frequent associate intervention, particularly, to deal with spike sales. When you think about the project and seasonal orientation of our business, that's a significant issue.
The new system will use multiple forecasting algorithms to improve our ability to predict and handle these spike sale variations, returning hours to our associates for customer-facing activity and further improving our in-stock rates. You may have heard Matt, at our Annual Investor Conference, talking about moving the Home Depot into the 21st Century on our merchandising systems. This is just one part of that effort.
Craig and his team are doing a great job bringing value and innovation to our customers and helping them find simple solutions to their project needs. Increasingly, simplification also leads to a better answer from an environmental perspective, whether it's paint and primer in one, recycling programs for holiday lights and power tools or water saving toilets.
On the store operations side, our net promoter score, which takes the percent of our customers who rate their experience with us as a nine or better, and subtracts from that the percent of customers who rate their experience as six or worse, with 64.1% in October, over 8.5 percentage points higher than last year at this time.
At the beginning of the year, we reorganized our service business under Marvin Ellison and his field team to give operational focus to that business. With that focus, they have improved our install satisfaction level to over 8.8 on a scale of one to 10, significantly above last year and have rolled out a version of customer-first training for our installers. This quarter, our installed sales comp outperformed our overall company comp.
We've also taken significant steps to revamp our approach to associate learning. Tim Crow and the HR team, in conjunction with Marvin's team, have developed creative new techniques for improving our associate product knowledge.
Road shows, where vendors and merchants travel to the field to give associates product and project training, have long been a hallmark of the Home Depot. But as our store base expanded, it became more and more difficult to use this vehicle for training and road shows became infrequent. But we've now implemented virtual road shows that take advantage of modern technology, while at the same time providing some of the excitement and immediacy of the prior format.
On the international side of our business, Mexico continues to perform well with a positive comp for the quarter in a very tough economic environment. The Canadian business had flat comps, which represents a strong quarter-over-quarter improvement and we had mid single-digit negative comps in China.
Overall, the economic environment remains difficult, but the dedication of our associates is making a difference, both in customer service and in the underlying improvements in the business. I want to thank them for all their hard work.
With that, let me turn the call over to Craig.
Thanks, Frank and good morning, everyone. We're starting to see early signs of stabilization in our business. We performed well in the quarter despite lapping hurricanes and for the second consecutive quarter, we posted a positive comp in paint.
The departments that outperformed the company average comp in the quarter were paint, plumbing, flooring, garden, kitchen and bath, and building materials. Lumber, hardware, electrical and millwork underperformed the company average comp for the quarter. In general, we continue to see strength in DIY repair and simple remodel projects.
Energy efficiency also remains an area of relative strength, as customers look for ways to save money on ENERGY STAR products like appliances and water heaters. On the other hand, typical pro and construction categories including plywood, dimensional lumber, concrete and gypsum, performed below the company average comp.
The pressure on big ticket projects continues to impact our total average ticket. Our average ticket for the third quarter was $51.89, down 7.1% from last year, but the rate of decline was slightly better than previous quarter. On a comp basis, our average ticket declined by 6.4%.
Transactions for tickets of $900 and above, which represent approximately 20% of U.S. sales, were down about 10% in the quarter, a lesser rate of decline than previous quarters. This improvement was due, in part, to appliances, which performed better than the company average comp. Our really free delivery program is just one example of how we're offering our customers great value and a simplified shopping experience, while driving improved results.
Transactions for tickets of $50 and below, also roughly 20% of our business in the U.S., were positive 2%. We also saw continued stabilization in total customer transactions, which were $314 million in the third quarter, basically flat to last year. Our operational initiatives around customer service, coupled with our strong value message, are helping to bring customers into our store.
In the quarter, we experienced commodity deflation in lumber and copper. This deflation negligibly impacted U.S. comp sales by approximately 30 basis points and 20 basis points respectively. However, as we exited the third quarter, these commodities were approaching prior year cost levels.
As I mentioned earlier, basic repair and maintenance categories performed well. For example, roofing, caulk, plumbing repair and chemicals all posted positive comps in the quarter. Additionally, categories that would be considered simple décor updates such as paint, vinyl flooring and special order carpet, also posted positive comps.
Over the past year, we've further implemented our portfolio strategy, resulting in strategic category investments. We review about 30% of our products each year updating our assortments and presentations. Some of the recent assortment resets include light bulbs, paint applicators and ceramic tile, all of which performed above the company average comp in the quarter.
As a result of these investments, our total U.S. market share has grown 95 basis points on a rolling 12-month basis. In the quarter, we gained consumer unit share in five of our 13 departments as reported by an independent third-party.
We continue to learn and leverage from our merchandising tools allowing us to improve efficiency and drive more value from our customers. With the tools, we better understand the cost components of our purchases and with that knowledge, we are better able to manage the productivity of our cost of goods sold.
Looking ahead to the fourth quarter, we're excited to offer our customers value, innovation and exclusive products for their homes. Studies show that approximately 60% of U.S. homes are under-insulated in the attic. In response, Home Depot has lowered the retail price on insulation to help our customers save money and improve energy-efficiency of their home. Additionally, we're excited to become the exclusive big box retailer for the number one insulation brand, Owens Corning.
Also in fourth quarter, we're looking forward to our initial launch of outdoor living and storage product lines through our exclusive partnership with Martha Stewart. We believe this is an opportunity to gain larger share of wallet of our customers by partnering with Martha, an authority on design and home improvement.
A key priority for us, as merchants, is to be the customer's advocate for value. In the third quarter of last year, we launched our new lower price campaign to highlight our every day value message. Over the past 12 months, we have lowered prices on hundreds of products, saving our customers over $0.5 billion. Our team will continue to focus on simplifying the shopping experience and offering innovative products at great value that save our customers' time and money.
Now, I'd like to turn the call over to Carol.
Thank you, Craig and hello, everyone. In the third quarter, sales were $16.4 billion, an 8% decrease from last year, reflecting negative comp or same-store sales of 6.9% and the net impact of fewer stores, due primarily to the closing of our EXPO businesses. Net earnings were $689 million, compared to $756 million last year. Earnings per diluted share from continuing operations were $0.41 versus $0.45 last year.
We reported negative comps of 9.6% in August, negative 7.2% in September and negative 4.3% in October. Comps for our U.S. stores were negative 7.1% for the quarter. Given that we had no hurricane-related sales in 2009 compared to approximately $125 million of hurricane-related sales in the third quarter of last year, we were pleased with our comp result. Our U.S. comps were negative 9.3% in August, negative 7% in September, and negative 5.2% in October.
The sales impact of currency fluctuations moderated in the third quarter. Fluctuating exchange rates negatively impacted sales by $94 million in the third quarter, as compared to $750 million for the first nine months of the year.
Our gross margin was 34% in the third quarter, an increase of 29 basis points from last year. Our gross margin expansion reflects the impact of our portfolio strategy and was driven by the following factors.
First, higher sales in certain categories drove us to higher purchasing tiers and allowed us to earn more co-op and rebate dollars in last year; second, we experienced a lower penetration of certain lower margin categories; and third, we experienced positive shrink performance in the quarter.
Operating expenses, as a percent of sales, were 26.3%, flat to last year. As expected, we deleveraged payroll in the third quarter but that was offset somewhat by a lower cost of private label credit. Further, the changes we've implemented, to improve spending efficiency across our business, continued to gain traction. Our total expenses were $74 million under our plan in the third quarter.
Costs out is one of our strategic imperative and we've made great progress in this area during 2009. On a year-to-date basis, we've delevered expenses by about three basis points for every point of negative comp. That's considerably better than our general rule of thumb of 10 basis points of deleverage for every point of negative comp. As we look to the fourth quarter, we will show considerably more expense deleverage than we have in the previous three quarters due to harder year-over-year comparisons.
Operating margin was 7.7% in the third quarter, up 28 basis points from last year. In the third quarter, our income tax provision rate was 37.3%. For the year, we expect our effective tax rate to be approximately 35%.
Now, moving to our operational metrics, during the third quarter, we opened two new stores for an ending store count of 2,242. At the end of the third quarter, selling square footage was 235 million, down 1.3% from last year. Reflecting the sales environment, total sales per square foot for the third quarter were $276, down roughly 6.6%.
Now, turning to the balance sheet, inventory remains a good news story. At the end of the quarter, inventory was $10.8 billion, down approximately $1.1 billion or 8.9% from last year. On a per store basis, inventory was down 7.8%. Inventory turns were 4.2 times, flat to last year.
We ended the quarter with $43.1 billion in assets, including $2.7 billion in cash and short-term investments. This is an increase of approximately $2.2 billion in cash and short-term investments, from the end of fiscal 2008, reflecting cash generated by the business of approximately $5 billion, offset by $568 million of capital expenditures, $1.1 billion of dividends paid, $98 million of share repurchases and $1 billion used to repay senior notes that came due in September.
In the quarter, we used excess cash to repurchase shares. We have $12.6 billion remaining in our share repurchase authorization. We will continue to use excess cash to repurchase shares, but the debt finance portion of our share repurchase program remains on hold.
To determine how much debt will remain in our capital structure, we look to our ratio of adjusted debt-to-EBITDAR. Our target adjusted debt-to-EBITDAR ratio is 2.5 times and we expect to be near that target by the end of fiscal 2009. At the end of the third quarter, the ratio stood at 2.3 times.
As a reminder, we have a $3.25 billion A2/P2 commercial paper program that is 100% back stopped by a committed bank line of credit. As of the end of the third quarter, we had no outstanding commercial paper.
We have approximately $10.4 billion of outstanding debt, of which $750 million comes due in the fourth quarter of 2009. It is our intent to repay this debt maturity, as it comes due, using the cash we have.
Computed on the average of beginning and ending long-term debt and equity for the trailing four quarters, return on invested capital was approximately 9.5%. On an adjusted basis, excluding charges related to our 2008 store rationalization actions and the closing of our EXPO businesses, return on invested capital was 10.4%.
We are executing well in a tough environment. We continue to focus on our strategic imperative and our financial results reflect the progress we're making. Based on our results for the first nine months of the year and our forecast for the fourth quarter, we continue to believe sales will be down roughly 9% for the year.
On the earnings front, we are projecting diluted earnings per share from continuing operations of approximately $0.13 for the fourth quarter and for the year, on a GAAP basis, diluted earnings per share from continuing operations of approximately $1.50, up 9.5% from last year.
On an adjusted basis, we are projecting diluted earnings per share from continuing operations of $1.55 for the year, a decline from fiscal 2008 of approximately 13%. In each case, our earnings per share guidance includes $0.03 of earnings per share benefit, resulting from a favorite foreign tax settlement we reported in the second quarter.
We will share our 2010 guidance with you during our fourth quarter earnings conference call, which is scheduled for February 23rd.
So, thank you for your participation in today's call. Joseph, we are now ready for questions.
(Operator Instructions). We'll take our first question from Peter Benedict of Robert Baird.
Peter Benedict - Robert Baird
Just wanted to get a sense, maybe Carol, of the traffic patterns in the U.S. stores during the third quarter. How was that number? I think it was up for the first time in awhile in the second quarter. Was it up again, and if not, was that impacted by the absence of the hurricane activity?
Well, we were very pleased with the comp transactions in our U.S. stores in the third quarter. They were basically flat year-over-year and that's particularly notable, given that we have 26 fewer stores than we had one year ago.
Peter Benedict - Robert Baird
Could you just take us through the decision to resume to buybacks in the third quarter? It sounds like you did a little over $100 million. What kind of got you guys to decide to go forward with it this quarter?
Well, we are a company that is a cash cow and the last thing we want to do is leave cash in a bank earning less than 1%. We've said all along that we will use our excess cash to repurchase shares. We were feeling pretty good about our liquidity. We have a trading window that opened up at the end of our second quarter earnings and we bought back some shares. Then, the trading windows closed and we stopped buying back shares.
As we look forward, if we have excess cash, we will use it to repurchase shares. As I mentioned in my prepared remarks, the debt finance portion of our buyback is on hold because we use our adjusted debt-to-EBITDA ratio as the governor for how much debt we will have in our capital structure.
We'll take our next question from Chris Horvers of JPMorgan.
Chris Horvers - JPMorgan
Can you talk about, I guess, some specifics around California and Florida? How they did versus the total company and what kind of sequential change was there?
Also, on gross margin, can you share with us how you're thinking about the fourth quarter, given that you've seen such a nice lift here in the gross margin because of the merchandising tools year-to-date? Is that a contribution or a trend that should begin to moderate or do we have a lot of legs there?
So, Chris, first on California and Florida, one of the things to note there is there are actually a lot of different markets within those states and you see different patterns within the different cities. So, for example, in California, I see relatively more stability in, say, the San Diego area than in the Los Angeles area.
The way we kind of look at it is we see markets that we think have fundamentally bottomed, markets that we think have a few more quarters to go until they bottom and then, markets that we're still a little uncertain about.
Overall, I would say that the markets in California and Florida performed better in Q3 than they had previously. But whether they're above or below the company average, depends a little bit, again, on the city by city analysis.
On the gross margin rate we see a slight improvement there. Maybe, Craig, you want to address that for the fourth quarter.
Yeah, I mean we're looking for some modest expansion in the fourth quarter. We're up against pretty strong performance from a year ago. But we do believe, that at this point, that we'll see some modest expansion.
Chris Horvers - JPMorgan
If I could just squeak one more in here, your fourth quarter comp outlook, given that you've guided to total sales, you can get a wide range in terms of comp expectation. Is there a number that we should be focused on there?
The fourth quarter comp, we project, will be better than the third quarter comp and you can use a mid single-digit number. When we guide total sales down approximately 9% for the year, it's an approximate. That could be 8.7% or something like that.
David Schick from Stifel Nicolaus has our next question.
David Schick - Stifel Nicolaus
You talked about big ticket pressure and should we expect to see either merchandising changes or associate labors, staffing, how you are addressing that as 2010 plays out? How are you thinking about positioning around that or do you think it'll change quickly and no changes are needed?
Well, first, I don't expect quick changes. I think we'd like to see sequential improvement. As I said in my comments, it's important as you think about big tickets to think not only high-end discretionary items but also our pro business.
For sure, one of the things that we've seen is the pro business tail off a little bit more, which makes some sense when you think about the overall credit issues in the country. One of the key questions in 2010 is going to be, how and what's the pace of that business starting to pick back up? But you wouldn't see us do anything dramatically different in terms of the labor in our stores.
Moving on to of Gary Balter of Credit Suisse.
Gary Balter - Credit Suisse
Just one question and one follow-up. Could you kind of define out your share buyback strategies? Because you're going generate over $4 billion of free cash flow next year. What should we be looking at for parameters in terms of debt-to-equity, et cetera? Obviously, you have to pay off some of the debt that you have.
Right. Well, let's start with the debt or the leverage question, Gary. We use adjusted debt-to-EBITDAR as the governor for how much debt we will have in our capital structure. After we pay back the $750 million of maturities that come due in December, we estimate that at year end we'll be close to that 2.5 metric.
Clearly, as the earnings start to return to positive, we'll have increasing room to add leverage into our capital structure. So, if you think about next year, for example, we have $1 billion that comes due in August. It's our intent, at this time, to refinance that maturity. So then, we are faced with, as you point out, a lot of cash, cash that's being generated from our business.
It is our view, as we look to returning capital to our shareholders, that we must look at both share repurchases and dividends. We are working on an articulated strategy, as it relates to both, which we will be happy to share with you when we give you our 2010 guidance in February.
Gary Balter - Credit Suisse
Then just to follow-up. Last year, it was fourth quarter, where you really started doing a superb great job on expense reductions and that's probably what's behind the earnings for this year. But how should we think about expense savings going forward? Have we seen the bulk of it or is there still opportunity?
Well, Gary, there is still opportunity and obviously, a lot of the things that we're doing, in terms of investments in our supply chain and our merchandising and IT tools, have benefits also on the expense structure within the business.
I mean I referenced just very briefly the consolidation of our stocking DC's. That has an interesting IT component to it because previously, we actually had separate systems and were not able to have that kind of consolidation.
So, as we have developed improved IT tools, that allows us to get more efficiency on the operational side. I think we continue to have opportunities on that going forward.
Now, we'll move on to a question from Michael Lasser of Barclays Capital.
Michael Lasser - Barclays Capital
I'm curious if you have a sense of the spending break down by socioeconomic income demographic, such there might be a discernible pattern in the stores, depending on the medium home value in the surrounding areas?
Frank, you mentioned that certain areas of California are doing better than others. So it seems that middle and lower income consumers are still feeling a considerable amount of stress, but the upper tier is feeling better. So, have you been able to recognize any pattern from that perspective?
Yeah, Michael, it's a great question. We actually look for those patterns. We look for what's the spend in the metropolitan area? What are the demographics? What are the unemployment rates? It's hard to tease out really strong correlations there.
Intuitively, you'd think some of the markets, for example, in the Midwest that have been very hard hit, from an unemployment perspective, would be doing quite poorly. Yet, we see a pretty good performance from our stores there. So, there isn't any kind of broad statement that we can make that works.
Michael Lasser - Barclays Capital
What about just in the weakest housing market states, is there even a subtle pattern?
Well, again, to the extent there is a pattern and we talked about this a little before, was in areas where we saw accelerating rates of foreclosure. That put some pressure on performance. That measure still kind of holds but it's more 50/50 now. We see some areas that have accelerating rates that are actually, on a quarter-over-quarter basis, doing a little better.
Michael Lasser - Barclays Capital
One quick follow up. Carol, you've noted that overall buyer markdowns, in the past, have been about 2%, but in the lowest volume stores, the markdowns are closer to 7%. I was curious, you didn't necessarily call that out or improvement in that metric as a driver of the gross margin gains for the quarter.
So are you seeing any convergence there? If you are, are you reinvesting any of that in the lower prices, like Craig talked about passing along savings of about $0.5 billion?
Yes, our overall gross margin performance is a direct reflection of the portfolio strategy that our merchants are running. With the portfolio strategy, we are optimizing markdowns across our retail store base. We are then able to reinvest.
Craig talked about our new lower price campaign, where we've saved over $0.5 billion in retail prices for our customers. So the portfolio strategy is working. We can optimize the value that we offer for our customers and create value.
Colin McGranahan of Sanford Bernstein has our next question.
Colin McGranahan - Sanford Bernstein
I wanted to focus back on expenses. A fairly impressive performance now, three years in the negative comps, to be able reduce expense dollars year-over-year by about 8.5%. Can you give us a little bit more color on how much of that was impacted by the private label credit? What were some of the other specific drivers of with it's a pretty big dollar reduction in expense dollars?
We worked really hard on driving efficiencies across our business. In the third quarter, we deleveraged payroll by 46 basis points. The benefit of the private-label credit card negotiation offset that by 28 basis points. So we had about a $50 million year-over-year benefit.
Across the rest of the expense structure, we just saw cost out everywhere we looked. So you can't point to one item, it's everywhere, from occupancy to our administrative overhead costs to depreciation. We're just driving benefits across the board. As Frank pointed out, as we bring our new tools online, we think we have more opportunities ahead.
Colin McGranahan - Sanford Bernstein
The fourth quarter of last year is a little squishy because it was 52-week against a 53-week. Can you help us understand and remind us what the dollar expense reduction was, adjusted for that extra week in the fourth quarter last year?
Well, probably the best way to do that is to look at expenses on a per-store basis. If that's helpful. If I look at Q4 of 2007, expenses per store, and this is all adjusted, basically $2 million in 2008, $1.9 million. So, that gives you an idea. We're about $1.9 million right now.
If I just could take a moment to talk about our fourth quarter guidance, this might be helpful. As we told you, we expect to delever expenses by about 10 basis points for every point of negative comp. Year-to-date, we're much better than that. We're at three basis points for every point of negative comp.
For the year, we're going to do better than our 10 basis point rule, we are. But in the fourth quarter, we're forecasting that our expense deleverage will be about 20 basis points per point of negative comp and you may say, "Well, why is that?"
Well, there are a couple of things you need to keep in mind. At the beginning of the year, we told you we thought our adjusted earnings per share from continuing operations would be down about 26%. We're now telling you that they will be down 13%. We're outperforming and because we're outperforming relative to our plan, we're going to pay higher bonuses than we did last year. If you look success sharing alone, right now, 80% of our stores are in success sharing. A year ago, only 60% were in success sharing. So we've got more bonuses.
We also see that we have expense pressure coming from medical that we didn't have in fourth quarter of last year. I don't think we're alone in this. I think a lot of companies are facing a higher medical costs, but we certainly are.
A couple of other things that are driving the year-over-year comparisons: Last year, as you'll recall, we reduced our support staff by over 2,000 people. As a result of that, we had some forfeitures in our stock option expense. We won't repeat that this year. So, that's another year-over-year comparison Then, the benefit from credit should diminish. So when we add it up all, fourth quarter is going to look a little odd, but for the year, we're going to do better than our rule of thumb.
Our next question comes from Stephen Chick, FBR.
Stephen Chick - FBR
I guess, Carol, that the items you've just quantified, it's a lot of separate little items that are going to impact the quarter versus, I guess, the sequential trend. Is there a number or a figure you can assign to all that combined or the success sharing piece, the bonus accrual piece, I mean is there some type of dollar figure we could have that might help us from a modeling perspective?
Well, what I'd like you to use is 20 basis points of deleverage for every point of negative comp. So based on your comp assumption for the fourth quarter, you can figure out what the deleverage will be.
Stephen Chick - FBR
That helps. So related to your comp guidance then, I think you're saying a mid single-digit decline, I think, is what you're implying for the fourth quarter. Call it negative six and it seems like, I don't know, if that's total company but I'm kind of thinking that the foreign currency piece might actually, maybe work in your favor for the fourth quarter, just on the math.
What do you guys think in your U.S. comp, it is within that guidance? Then, it would be helpful, maybe, if you could tell us where you've started the quarter trend so far?
Well, it's very hard to predict what will happen with currency (inaudible). If you look at the behavior of our dollar, it's all over the place. So for the company, we're projecting a mid single-digit negative for the fourth quarter. As it relates to our performance, quarter to date in November, we're trending right along our expectations.
Stephen Chick - FBR
So you've slipped from in November versus where October was. Is that fair to say?
I don't want you to leave with that impression. As we built our comp plan, we built a comp plan that suggested November would be stronger than October. It's trending along our expectations. Remember, this is a very seasonal business. For the quarter, we expect it to be a mid single-digit negative.
Stephen Chick - FBR
So it sounds a little conservative, Carol, just because of the comparison is pretty easy here in the fourth quarter versus what happened last year.
Steve, we obviously have that comparison in mind when we do the plan as well.
Stephen Chick - FBR
No, it's fair. It's just a pretty good deceleration in your two and three-year stack trends, as I look at it. Secondly, if I could, Carol, the U.S. comp store sale number for the quarter, you've been giving it more definitively in the last couple of quarters, whereas a year ago, you didn't. So, I'm wondering, actually, if you have what the U.S. store comp was for Q2 '08 and Q3 '08?
Well, [to be honest], I don't have that with me, but Diane will call you.
I can get you that, Steve.
I don't have it. I'm sorry.
We'll now move to Deborah Weinswig of Citi.
Deborah Weinswig - Citi
Craig, you had mentioned some details around the further implementation of your portfolio strategy. Can you please update us on some of the merchandising tools and more specifically, when will you expect them to be fully rolled out? As the assortment management tool, at this point in the game, the one that is the most developed?
Yeah, Deb, I think it's fair to say that the assortment management tool and some of the forecasting tools that we have are probably the most developed. Our seasonal businesses have now been on them for, this is the third planning cycle that we've done. In total, we're about 25 percent-ish of the way there.
We continue to learn with the tools. We continue to be able to extract additional benefit as we go through each planning cycle and get better at using the tools. But I think it's fair to say that the two that you called out, the assortment management tool along with the forecasting, at this point, are most advanced use and benefit.
Deborah Weinswig - Citi
Obviously, there was very impressive inventory performance in the quarter. How much of an impact was it from the tools and how much of it was other processes and as a result of the impressive inventory performance? Obviously, we've seen impressive shrink, but what other impacts has it had in the organization?
Well, the combination of the tools and if you'll recall, we've talked about in past about as we kind of go through our merchandising transformation, we're actually redoing all those processes in terms of how we actually run the business and then build the tools to support the new method to run the business.
So it's a combination of the process and the support of the tools that's giving us greater visibility into the business and giving us a more granular focus when it comes to forecasting which has allowed us to have a better overall inventory performance.
Couple that with better linkage into Marvin and his team in the field and I should say, obviously, back into the supply chain as well, we're seeing the kind of benefit in inventory performance there that you've noted.
Our customers are happy. Marvin, you should talk about them.
Yeah, Deb, this is, Marvin. I think one real point that you can note. Just go to any store and look in the overheads, I think you'll see lesser inventory in the overheads than you've ever, historically, seen in the Home Depot. The visibility Craig mentioned is important to the store's associate because our customers want to be able to come in and get the product from the shelf.
In that past, we've had the product in the building but not on the shelf. Visibility is important. Associates can get the products out of the overhead, on the shelf. We can reduce $1 billion of inventory and still have our best in-stock percent we've had in years.
Again, that's alignment between the merchants, the tools, the supply chain and the operators in the stores. We're pleased with it. We can get better and these tools will allow us to get better but again, we're building from a real solid platform today.
Marvin said something really important and that is, as part of our process, we never look at inventory without looking at in-stock at the same time. So, those have to go hand-in-hand.
Deborah Weinswig - Citi
Then, just one follow up, thinking back to the tools, how should we think about holiday 2009 versus 2008? As the tools have been more developed, what should we see differently this year?
Well, I think we've utilized the tools to better mix the assortment in the right locations, depending on where you're at in the country and we've clustered stores. Right now, I would tell you that we're very pleased with how this season has started.
Alan Rifkin of Bank of America has our next question.
Alan Rifkin - Bank of America
Carol, you mentioned that total expenses were $74 million under your plan. Can you maybe provide some color as to where those expense savings came from and also comment on the sustainability of those savings going forward?
Most of the expenses are sustained cost out. There were some timing, I must say. For example, advertising was $3 million under plan. We'll spend that in the fourth quarter. So, there was some timing but most of it is sustained out and includes just running the business better.
For example, if you think about, we have a broad based expense category called operations. Under that category are numerous lines. These would be lines that would include the costs of shopping bags in our store, the cost of delivery and on and on and on.
Well, because we've implemented a new P&L checkbook for our stores, we saw that the operations expense line was $28 million under our plan, can't call out one big driver of that. It's just the stores working together with the finance teams and just doing a really good job of optimizing our costs. I could go on and on, Alan, but I feel pretty good about the controls that we're driving.
Alan, this is Marvin. Let me give you a perspective. Last year, a store would get a P&L at the end of the month, basically the middle of the month and they would then find out what they had spent. This online checkbook gives them realtime visibility, just like a normal account, so they know as they spend where they are versus their budget. It's a huge difference with 2,000 stores.
That's why this whole operational budget Carol talked about, a lot of small things, when you add those small things up in 2,000 stores with better visibility, it just creates better discipline. We're pleased, but again, we can get better. With more tools and better visibility, our associates are proving that we can just run a very efficient business.
Alan Rifkin - Bank of America
I do have a follow-up for Frank. Frank, it was mentioned a couple of times in the call that the excess cash, going forward, will be used to buy back stock. As we move into 2010 and as your CapEx is down 60% year-to-date and probably down in 2010 versus '09 and as your cash flows continued to significantly ramp up, irrespective of what the base business does.
If there is a scenario in which the core business is still a little bit challenged in the first half of 2010, yet your excess cash in the first half of year continues to increase, your projected cash flows continue to increase as well, I mean could we see at that point in time a payout ratio increase over and above what we've seen so far?
The first is just on the assumptions. I mean we'll give you more guidance on 2010 in the fourth quarter, but I wouldn't be building an assumption that would have CapEx down going into 2010. Beyond that I mean, as Carol said, the way we're looking at this, this is a business that generates great cash flow and we're being very disciplined about our capital allocation.
As we look into 2010 and beyond, as the business comes back, we'll look at how we balance both the payout ratio on the dividends, as well as what we can do on share repurchases, keeping in mind the guideline that Carol has referenced several times on the 2.5 times adjusted debt-to-EBITDAR.
We'll now move on to Scot Ciccarelli of RBC Capital Markets.
Scot Ciccarelli - RBC Capital Markets
Frank, you've called out residential investment spending before and did mention briefly in this morning's comments. Now that this metric has turned up for the first time since '05, has your thought process changed at all on the relevance of this metric to your own business?
I'd say a couple of things. First and the percent that fixed private residential investment makes to GDP turned up in the third quarter. So, it's now like 2.5% versus 2.4%. It is still down, year-over-year, over 20%. So, the measure is still down on year-over-year basis.
Then you say going forward and I think even Chairman Bernanke referenced this yesterday, at least there is some sense that PFRI will actually sort of tick up as a percent as we go into 2010. When you look at our business, it's important to see two things; first, the housing dependency, which clearly part of that PFRI captures and also, what's happening with the consumer and consumer spending, consumer debt levels and obviously, the broader issues around unemployment.
So, while we still think and I'll kind of keep using the data point as a relevant general data point for our market, it's also worth a cautionary note as we go into 2010 that we've got some additional issues just with the consumer base that we're going to have to be dealing as well.
Matthew Fassler of Goldman Sachs has your next question.
Matthew Fassler - Goldman Sachs
A couple of questions here. First of all, taking a high level look at the business, this quarter, you generated operating leverage for the first time since, I believe, the first quarter of 2006 and you did it on a negative seven comp. Obviously, there is some expense elements that are unlikely to be repeated quite to the same degree.
I'm not thinking about the fourth quarter, where obviously there is such off-season and some other issues, but just in terms of the cost improvements that you generated. But still, as you look going toward, what do you think it would take you to lever the operating margin next year? Clearly, negative seven comp would be tough, but given that you have this precedent today, where do you think you could make this happen?
Well, we're working on our 2010 plan as we speak, as you can appreciate. To answer that question to your point, some of the cost out that we are enjoying this year, we won't repeat next year. For example, the renegotiation of the private-label credit card, we've taken $212 million out year-to-date. Our forecast is $250 million or something like that for the full year. Next year, we won't get that benefit.
We took out support staff. Next year, we won't get that benefit. So, while we've actually lowered our cost structure, which is a good thing, as we think about how do we drive operating leverage going forward? We need positive comps. So as we think about how we build our plan next year, when those positive comps might occur, is it the second half of the year, when in the second half of the year? That will impact our ability to leverage expenses.
We want to drive operating margin. As you know, Matt, our targets are to reach a 10% operating margin and a 15% return on capital margin. It's going to take a few years to get there, based on the sales environment, but we feel pretty good that we'll get there.
Matthew Fassler - Goldman Sachs
Then, one follow-up question, on the trajectory through the quarter just taking what you said to some of my counterparts as you've answered questions so far, you intimated that November rather was a bit better than October. Just looking at the compares in the U.S., they are relatively unchanged through the quarter. So are there any seasonal factors, other factors related to comparisons that would suggest that the trajectory would move around a lot over the course of the quarter?
Well, there is always the weather factor, of course, and we are seeing some pretty sales in some of the categories that Craig talked about, the core categories like roofing that we didn't have a year ago.
Moving on, our next question comes from Budd Bugatch of Raymond James and Associates.
T.J. McConville - Raymond James
This is actually T.J. McConville filling in for Budd, who is traveling today. I appreciate you taking my call. Frank, if we can return to the consumer versus the pro business. I know last quarter you gave us some really great detail as to what each represented as a percent of the whole using the new measurements you have. Can you give us that for the third quarter?
Yeah, TJ, first, I don't have that data set for the third quarter. It actually takes some time to generate this and we don't have it. What I would say, as I said in my prepared comments, it looks like it fundamentally didn't change too much in the third quarter, which would actually be consistent with your expectation when you think about what was happening in 2008. So the real question for us is going to be what happens particularly as we turn into 2010? Do we start to see some of that pick up a bit?
T.J. McConville - Raymond James
Is there any discernible difference that you can draw based on geography or maybe based on the level at which housing markets were hit over the last few years, as to where the pro is maybe returning sooner or is it just sort of down everywhere across the board?
Again, it's not far off from what you'd expect. So, if you look out in the western part of the country, you don't see a lot of that business returning. Some of it is impacted by weather events. So there was a pick up in the Gulf and now, you're anniversarying that and you see probably an abnormal decline.
But it would follow pretty much across, I mean we have looked at it regionally and there aren't huge regional variations, other than ones that you would otherwise be able to explain through weather and the like.
Joseph, we have time for one more question.
Our last question will come from William Truelove of UBS.
William Truelove - UBS
In terms of merchandising, can you give us an idea of what's happening between the good, better and best categories? Are you seeing people transition back towards the higher end categories, only if it improves their efficiency and energy savings or is that sort of broad based situation for customers? Thanks.
Well, it really depends on the category and what's going on inside the category. So for example, when you look at our Allure vinyl flooring, which has a tendency to be in the more towards the upper opening price point to mid price point, doing extremely well.
If you take our new Behr product primer and paint all-in-one, which is actually at the upper end of our liquid offering in paint, doing incredibly well. So, it really varies by category in terms of what's happening in the marketplace. There is not a pure pattern I guess that we could sit here and tell you that there's a shift in one direction or the other.
William Truelove - UBS
If I could ask one my one follow-up, then. Do you see any differential between the pro buyer in that kind of break down of categories versus the do-it-yourself category?
Not necessarily. There is not a big distinction. As a matter of fact, even in our Behr product, for example, we have a pretty good take up right now with the pro customer on that product because it does save them time.
Well, thank you to everyone for joining us today and we really look forward to talking to you at the end of our fourth quarter on our fourth quarter earnings call.
Once again, thank you for your participation. This does conclude the event.
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