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Lowe's Companies, Inc. (NYSE:LOW)

Q1 2014 Earnings Conference Call

May 21, 2014 09:00 AM ET

Executives

Robert Niblock - Chairman, President and CEO

Mike Jones - CCO

Bob Hull - CFO

Rick Damron - COO

Analyst

Matthew Fassler - Goldman Sachs

David Strasser - Janney Capital Markets

Chris Horvers - JPMorgan

Budd Bugatch - Raymond James

Dan Binder - Jefferies

Dennis McGill - Zelman & Associates

Kate McShane - Citi Research

Greg Melich - ISI Group

Mike Baker - Deutsche Bank

Operator

Good morning everyone and welcome to Lowe's Companies first quarter 2014 earnings conference call. This call is being recorded. (Operator Instructions). Also supplemental reference slides are available on Lowe's investor relations website within the investor packet. While management will not be speaking directly to these slides, these slides are meant to facilitate your review of the Company's results and to be used as a reference document following the call.

During this call, management will be using certain non-GAAP financial measures. The supplemental reference slides include information about these measures and a reconciliation to the most directly comparable GAAP financial measures. 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.

Hosting today’s conference will be Mr. Robert Niblock, Chairman, President and Chief Executive Officer; Mr. Mike Jones, Chief Customer Officer; and Mr. Bob Hull, Chief Financial Officer.

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

Robert Niblock

Good morning and thanks for your interest in Lowe’s. We delivered comparable sales growth of (9/10 of a 1%) [ph] for the quarter driven primarily by an increase in comp average ticket. While prolonged winter weather exerted pressure on our business, our enhanced sales and operations planning process along with our distribution infrastructure allowed us to align resources such as inventories, staffing and marketing more effectively bioclimatic zone.

In the south and west, where weather was more favorable, comps were in the mid single digits. The northeastern part of the country which was the most impacted by poor weather conditions during the quarter experienced negative comps and some of these regions faced additional headwinds from last year’s Superstorm Sandy recovery activity.

For the quarter, seven of our 12 products categories had positive comps; overall indoor products which accounted for roughly 65% of sales had solid performance with positive comps of approximately 2%. In fact in areas of the country where weather was more cooperative, indoor comps were mid-single digits. However, outdoor products declined approximately 1.5% overall.

We continue to see strength in our ProServices business which outperformed the Company average during the quarter and I am pleased to share that our team in Canada delivered double digit comps in local currency for the fourth consecutive quarter. We remain focused on improving our profitability even while investing in key capabilities to drive sales growth.

For the quarter, gross margin expanded 70 basis points driven by a number of factors that Bob will discuss. Additionally, we effectively controlled expenses in the quarter and delivered earnings per share of $0.61, which included unfavorable charges related to long life asset impairments and favorable impact of a lower tax rate for the quarter for a net benefit of $0.03 per share. Delivering our commitment to return excess cash to shareholders in the quarter we repurchased $850 million of stock and paid $186 million in dividends.

Moving onto the economic landscape for the remainder of 2014. The backdrop for home improvement industry growth remains positive despite the slow start to spring. Economic forecast still suggests a moderate improvement in growth for the year. Growth and key indicators such as employment, income, and consumer spending have recently begun to improve from weather effective levels earlier in the year. All the signals from the housing market are mixed with existing home sales declining in recent months. While home values continue to increase, we believe stronger job and income growth and gradually loosening credit conditions indicate that the environment for home improvement spending should remain favorable.

These macroeconomic data points align with our first quarter consumer sentiment survey. According to the survey, home owners increasingly believe that improvements made to their homes will increase their value and consumers’ views around personal finances continue to improve as homeowners report that they are less likely to decrease home improvement spending. With these factors in mind, we believe underlying home improvement industry demand remains intact despite pressures exerted by unfavorable weather in the first quarter, in fact performance has already improved in May and continued improvement in the macroeconomic landscape and consumer sentiment together with our strengthening execution, strategic priorities, and keen focus on productivity and flow through continue to give us confidence in our business outlook for 2014.

Before I turn the call over to Mike, I want to highlight a couple of recent organizational changes. At the end of April, Greg Bridgeford retired from Lowe’s after providing 32 years of world-class service to the organization. Succeeding Greg as Chief Customer Officer is Mike Jones who previously served as Chief Merchandizing Officer. Mike brings extensive leadership experience, expertise in key product categories, and a clear focus on the customer. In his new role, Mike will be responsible for creating experiences that better serve customers and differentiate us from our competitors. He will oversee U.S. home improvement strategy and customer experience design, merchandizing, and marketing and communications.

Filling the Chief Merchandizing Officer role is Mike McDermott. Mike has more than 20 years of experience in leading global product management and merchandizing teams and driving innovation. Mike McDermott will ensure continued refinement of our improved line review of reset process now that value improvement has been rolled into our base operations. And he will continue the effort he started as general merchandizing manager of Building and Maintenance to ensure that we have the products and brands per customers’ demand.

Lastly, Mike Mabry has been named US Home Improvement Strategy and Experience Design Executive. He will oversee our efforts to satisfy customers’ needs with a seamless omni-channel offering and to differentiate with better customer experiences than any other home improvement provider. Both Mike Mabry and Mike McDermott report to Mike Jones.

I look forward to the continuing contribution from our more than 260,000 employees and I’d like to thank them for their dedication to serving customers and for their efforts to continue building on the momentum established in 2013 as we further transform our business model. Thanks again for your interest and with that, let me turn the call over to Mike.

Mike Jones

Thanks Robert and good morning everyone. We executed well during the quarter despite an unexpected prolonged winter in many areas of the country. While we saw reduced demand for many outdoor products, we bolstered performance in our seasonal categories by helping customers dig out from snow and ice, as we positioned truckloads of weather relevant products at our regional distribution centers which enabled quick deliveries to our stores in areas hardest hit by winter weather.

We also offered customers a new outdoor living experience that inspired them to buy patio furniture and accessories even when the weather didn’t cooperate in parts of the country. I’ll share more on this experience in a few minutes.

In rough plumbing and electrical, we generated strong sales by providing ample supplies of products customers needed to repair pipes damaged by the severe cold as well as repair the HVAC systems for spring.

Moving to interior projects, we drove strong sales in fashioned fixtures, we saw particular strength in light bulbs driven by LED and other energy efficient products and in fashioned plumbing products such as bath faucets, vanities and toilets. We are providing compelling new styles in coordinated sets for customers refreshing or remodeling the bathrooms and our in home project specialists are simplifying the process by guiding customers to inspiration, design and installation. We continue to drive solid performance in kitchen appliances where extensive offering of major brands along with service advantages of next day delivery and haul away and in-house facilitation of repairs and maintenance provides a best-in-class customer experience.

We also drove solid performance within tools and hardware particularly in power tools where our line-up of Bosch handheld power tools and accessories performed very well. We are focused this year on three priorities to drive further top-line growth, using our enhanced sales and operations planning process to optimize performance in micro-seasons by-market, improving our product and service offering for the pro customer and building customer experience design capabilities. Through our enhanced sales and operations planning process, we have addressed an opportunity to improve seasonal planning including the cadence of inventory allocation, staffing, associate training and marketing. This quarter this process helped us drive ticket growth and support traffic against the unfavorable weather backdrop.

The theme for this year’s spring plan was spring is calling. It didn’t call as early as we initially expected but when it did, we were well prepared and where it did, we performed well. We built plans by climatic zones in order to get the most from our investments in inventory, staffing and marketing. For instance, we staggered our spring Black Friday campaigns. The earliest roll-out occurred in the Deep South in March and the last roll-out took place in the north just after beginning of May. All occurred at appropriate times for each geography when customers planned to clean and prep their outdoor spaces for enjoyment throughout the spring, summer and fall.

Our second area of focus is to better capitalize on the pro market which is growing faster than the consumer market, so we are enhancing our product and service offering for this important customer.

While pros shop across the entire store, the penetration of sales to pro customers is highest within traditional building and maintenance categories including lumber and building materials, mill work, rough plumbing and electrical and tools and hardware. So, we have grouped these building and maintenance categories together to focus on assuring we have the types of products and brands pros demand. For example the mix in customer shopping electrical wire is roughly 70% pro and 30% DIY. We are losing share in this core category, particularly with electricians, so within last year’s line review, we focused on why and what we needed to change.

We identified pro purchase drivers by attaining insights from our vendors and surveying our dedicated pro sales team. We then validated our initial findings with pro customers. We found that while we had opportunity to enhance our offering for pros working our residential jobs, we had even greater opportunity to enhance our offering for pros working on commercial jobs. In the end, we added to our selection of wire types, gauges and colors as well as full rows of wire and cable to supplement the offering of wire sold by the foot along with contractor packed pricing so pros could benefit from buying bulk rolls.

We also launched our new hand tools from South Wire, a brand of electricians known in trust. Of course, winning the pros business also requires great service, in our omni-channel environment to make doing business with us quick and convenient. This quarter, we will relaunch lowesforpros.com, testing it with our pro customers before rolling it out more broadly. This relaunch will provide a dedicated platform for pro customers to purchase online from Lowe’s, in addition to align pros to access contract pricing, develop requisition list and view purchase history. And Lowesforpros will be enabled for convenient mobile access.

Our third area of focus is developing a process to coordinate the elements of great customer experiences. To do this, our dedicated customer experiences line team is working with customers to better understand how they think about specific home improvement projects from planning, shopping and buying to using and enjoying. And based on these insights, this team is designing an entire experience from inspiration and product assortment to purchase and fulfillment. That experience must meet three critical criteria. It must be desirable to our target customer. It must be feasible. In other words, it must fit within our organization’s competencies and must be viable, something we can deliver in a profitable and sustainable way.

An example of what can be accomplished with this approach is the outdoor living experience we rolled out to the majority of our stores in advance of our key spring selling season. We started with the research and determined that customers shopping for outdoor living products rely mostly on in-store display for inspiration. Further, while selection, price and coordination of patterns and colors, our customers top shopping attribute, brand does not index as high for this product category. Customers are looking for inspiration as they seek to create an extension of their home and to use their outdoor space during more of the year. They want to directly interact with the patio furniture to access its comfort and to envision using it, and they want their ability to build a collection over time.

With these attributes in mind, we examined our previous outdoor living area and determined that customers cannot navigate easily through aisles filled with product and that coordinating products, colors and trends was more difficult when they were not close to one another. In short, we were selling isolated products, not helping customers build their outdoor room. We then used these insights to evolve our outdoor living experience. And with two-thirds of our stores, we removed 15 bays of steel racking to create a showroom fill with about 35% more open space which is made possible by our larger store format. It helped customers envision their outdoor space were displaying patio sets with coordinating rugs, umbrellas, and accessories like pillows, lanterns and planters, along with grills, and other outdoor products, just as you would expect in your own backyard.

Customers can also customize their sets. Special orders can be delivered from distribution centers to stores in seven days or less and coordination extends to lowes.com. Customers can find style at every price point. In fact, this area showcases several sets under $500. This new experience better positions Lowe's as a destination for outdoor living and should drive sales to more improved close rate and attachment. In this case, because we have determined brand to be a less important shopping attribute for outdoor living products, we can leverage our direct sourcing capability to buy these high quality products at a competitive cost which should benefit both sales and gross margin.

We’re pleased with the performance of the outdoor living experience so far. As the year progresses, this space will provide a flexible stage display other seasonal products such as holiday decor. Even while we are building customer experience design capabilities, our merchandising team continues to bring exciting new products to Lowe’s customers. For instance, we just recently introduced stain master pet protect, and exclusive in the home center channel. This carpet is made with a new fiber specifically designed to withstand the toughest pet stains, reduce pet odor, and lessen the time required to vacuum pet hair.

In February, we became the authorized dealer of [indiscernible] whose interior lighting collection has the highest market share with pro customers. We are also excited about our recent roll-out of Valspar Reserve which will be our most technologically advanced paint formulated with a new coloring system to increase durability, scrubbability and adhesion to challenging surfaces and to provide unparalleled hide and coverage. These are just a few examples of how we continue to work day-in and day-out with our vendors to bring more innovation and value to customers even while we work to better capitalize on the pro market and differentiate through customer experience design.

Thank you for your interest in Lowe’s. I will now turn the call over to Bob.

Bob Hull

Thanks, Mike and good morning everyone. Sales for the first quarter were $13.4 billion, an increase of 2.4% over last year’s first quarter. Total transaction count increased 2.9% while average ticket decreased one-half of 1% to $64.68. As previously discussed, the Orchard supply stores have more transactions per square foot but fewer per store and a lower average ticket than a traditional Lowe’s store. So, our Orchard aided total sales by approximately 110 basis points and it added roughly 240 basis points to our total transaction growth, it negatively impacted total average ticket growth by approximately 130 basis points. The Orchard stores are considered non-comp but will be included in our comp sales calculation after the anniversary of the acquisition in the third quarter of 2014.

Comp sales were up nine-tenths of 1%, comp average ticket was up eight-tenths of 1% and comp transactions were up one-tenth of 1%. Looking at monthly trends, comps were essentially flat in February, 2.5% in March and flat in April. While the late Easter holiday did not affect comp sales for the quarter, it did impact the monthly spread. We estimate that normalizing for the timing of Easter holiday, March and April comps would have been eight-tenths of 1% and 1.9% respectively. We are encouraged that both ticket and transactions adjusted for the Easter shift improved sequentially each month of the quarter. This trend has continued into May. Gross margin for the first quarter was 35.5% of sales, a 70 basis point increase over last year’s first quarter. The increase was driven primarily by value improvement and the mix of products sold.

SG&A for Q1 was 24.76% of sales which deleveraged 14 basis points, employee insurance deleveraged 18 points primarily due to the Affordable Care Act which drove a 10% increase in enrollment. We incurred long-lived asset impairment expense of $23 million which resulted in 17 basis points of deleverage. These items were somewhat offset by proprietary credit which leverage 23 basis point due to continued growth in the program and lower operating costs. Given the sales shortfall relative to our expectations, we are pleased with our efforts to manage the expenses in the quarter. Depreciation for the quarter was $373 million which was 2.78% of sales and deleveraged 9 basis points compared with last year’s first quarter as a result of the timing of information technology assets placed in service.

For the year, we expect depreciation expense to be essentially flat to last year. Earnings before interest and taxes increased 47 basis points to 7.96% of sales. Interest expense at $124 billion for the quarter, deleveraged 7 basis points to last year as total debt increased approximately $1.1 billion versus last year. Pretax earnings for the quarter were 7.03% of sales. The effective tax rate for the quarter was 33.8% versus 37.8% for Q1 last year. The lower tax rate which aided earnings per share by $0.04 for the quarter relates primarily to a settlement of prior year tax matters.

Earnings per share of $0.61 for the quarter, represents a 24.5% increase over last year’s $0.49. The $0.61 per share includes both the $0.04 favorable tax rate impact and the negative $0.01 impairment impact.

Now to a few items on the balance sheet starting with assets. Cash and cash equivalents at the end of the quarter were $658 million. Our first quarter inventory balance of $10.5 billion, increased $241 million or 2.3% over Q1 last year, the majority of the increase was driven by the addition of the Orchard supply stores.

Inventory turnover was 3.61, an increase of 4 basis points over Q1, 2013. Asset turnover increased 14 basis points to 1.59 times.

Moving onto liability section of the balance sheet, accounts payable of $7.1 billion, represents a slight increase over Q1 last year. The increase in accounts payable is lower than the 2.3% increase in inventory due to the timing of purchases in the quarter versus last year.

At the end of the quarter, lease adjusted debt to EBITDAR was 2.14 times. Return on invested capital increased 249 basis points for the quarter to 12.02%.

Now looking at the statement of cash flows. Cash flow from operations was $2 billion. Capital expenditures were 194 million, resulting in free cash flow of $1.8 billion. In the quarter, we repurchased 17.9 million shares or 850 million in the open market, we have approximately 5.4 billion remaining under share repurchase authorization.

The remaining 60 million of the $910 million shown on the statement of cash flows as repurchase of common stock relates to shares repurchased from employees that satisfy statutory tax withholding liabilities as well as the timing of share repurchase settlement across quarters.

Looking ahead, here’s our business outlook. We believe that we’ll recover the majority of the Q1 sales shortfall. As a result, we have not adjusted our outlook for the year. Our sales outlook for the year, we expect the total sales increase of approximately 5% driven by a comp sales increase of 4% and the opening of approximately 10 big-box stores and five Orchard Supply locations. We’re anticipating an EBIT increase of approximately 65 basis points and expect the improvement will come from both gross margin expansion and SG&A leverage.

After reflecting the favorable tax settlement from this quarter, the effective tax rate is expected to be 37.2% for the year. Given the lower tax rate and Q1 impairment expense we expect earnings per share of approximately $2.63 for the year versus our prior outlook of $2.60 which represents an increase of 22.9% over 2013. We’re forecasting cash flows from operations of approximately $4.1 billion; our capital plan for 2014 is approximately $1.2 billion. This results an estimated free cash flow of 2.9 billion for the year.

We expect to issue incremental debt during the year as we managed to the 2.25 lease adjusted debt to EBITDAR target. Our guidance assumes approximately $3.4 billion in share repurchases for 2014 spread roughly evenly across the four quarters.

Carmen, we’re now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question will come from the line of Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

My first question relates to sales and my second question, a follow up if you will relates to SG&A. Would it be possible for you either to quantify the sales that you think you lost to the weather in Q1? Or talk about the first half versus second half sales relationship that you’d expect for 2014?

Robert Niblock

So Matt we think the weather impacted our Q1 sales by approximately 150 basis points, about 35% of our sales are outdoor or mix related so I had a pretty good impact on Q1. As we said in our prepared comments, we do expect to recover the majority of that in the second quarter.

Matthew Fassler - Goldman Sachs

And as we think about the base that you had added that to -- should we think about the run rate that you have in a non-weather impacted markets and then add 1.5 to that or is that too simplistic of a calculation?

Robert Niblock

Probably too simplistic, since we’ve got tougher Q2 compares, as we indicated our (maze) [ph] off to a good start, we’re running at about mid-single digit comp driven by good balance of (taking traffics) [ph], we feel good about the start to Q2 and our ability to recover loss sales from Q1.

Matthew Fassler - Goldman Sachs

Great. And then on expenses, I just want to refer back to some of the color that I think you gave us after Q4 about a couple of expense items that you didn’t reference. I think you had originally expected bonus from retirement to deleverage for you a bit, you had also called out a property tax, I am sorry store payroll item in terms of significant leverage. Can you talk about what impact bonus accruals had on SG&A and if it’s possible to quantify the labor leverage, it would be very helpful.

Robert Niblock

So Matt I think a couple of items we talked about were risk insurance would be unfavorable because of an unfavorable -- excuse me to a favorable adjustment we had in Q1 ’13. We actually experienced a favorable adjustment, this quarter as well but that was somewhat offset by the impairment higher utility and some removable costs associated with the weather. We did think that bonus was going to leverage -- excuse me, de-leverage in the quarter, it actually provided some leverage. If you think about our experience in first quarter we missed our sales and earnings plan, our bonus plans are predicated on operating profitability so the tax pick up had no impact on the bonus accruals we did leverage bonuses of 9 basis points in the quarter.

Operator

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

David Strasser - Janney Capital Markets

Two questions, first of all on the balance sheet you had an impairment charge that you intent to take unusually in Q4. You took it in Q1 of this year. Can you just give a little background on what -- where the impairment came from? And sort of why the timing of it?

Robert Niblock

Sure, so we’ve got a process to evaluate the profitability and liability of store locations. That process occurs throughout the course of the year, there is a footnote in our 10-K that explains a process in some detail as we take a look at cash flows for the rolling 12 months to evaluate. There is no magic about what quarter that trigger occurs and when impairment occurs, it does relate to two operating locations that did give rise to the $23 million charge in Q1.

David Strasser - Janney Capital Markets

Back in February you had -- Bob you had made a comment that Q1 would be the best comp of the year. obviously the weather kind of impacted that. As you kind of -- and I am asking Matt’s question a little bit differently, but as you kind of look at for the first half of the year, how substantial of a recovery do you need to sustain in Q2 to kind of hit your first half estimate -- to hit your first half sales estimates? I mean can you see a deceleration as that tough comp continues and the tough comparison from last year continues through Q2 and still get to your first half plan or is that kind of mid-single that you talked about a kind of number that you sort of need to hit?

Bob Hull

Yes, so on the Q4 call we talked about Q1 being our -- coming to the year we thought that Q1 would be our best performing comp, Q2 would be our lowest performing comp really based on compares relatively to 2013. Obviously weather is going to push some sales from Q1 to Q2. Q2 looks like it’s going to be our highest comp in quarter at this point in time even with [indiscernible] but having said that, the band between comp for Q2, 3 and 4 is fairly narrow.

Operator

Your next question is from the line of Chris Horvers with JPMorgan.

Chris Horvers - JPMorgan

Thanks. Good morning. I was curious your quarter ends on Sunday and Home Depot’s quarter ends on Friday, so we’re out on the stores that weekend and it was a pretty nice weekend in the East Coast, so do you think that was some of the delta in the comp performance because you probably had a really not a great first week in the February weather wise and then you had -- you missed what looked like on the East Coast, the Northeast a pretty nice weekend weather wise in the beginning of May?

Robert Niblock

Yes, Chris, this is Robert. Actually what you said was that we end of Friday and they end on Sunday, [indiscernible] what you meant, that you -- like you say you stated it backwards, but yes, certainly as you think about the extent of the conversation that we’ve had so far today, weather was very difficult in the quarter, certainly pretty wide spread, we’ve actually looked at to numbers and said, if we had adjusted and we looked at just the days that would have picked up that last weekend and dropped up the first weekend of the quarter, it would have made a difference on our first quarter comps of about 50 basis points favorable.

Chris Horvers - JPMorgan

Okay, that for the base lines. And then two (exchange) [ph] questions, one, I might have asked it, but did you say anything about any negative impact in gross margin from proprietary credit and then also on D&A when you say flat year-over-year, is that -- I assume that’s a dollar number?

Robert Niblock

So there was no negative impact, no significant impact to gross margin from the proprietary credit program and the 5% off [indiscernible]. As relates to depreciation, we do expect dollars to be essentially flat to last year therefore driving some leverage that contributes to the EBIT increase of 65 basis points for the year.

Operator

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

Budd Bugatch - Raymond James

Good morning. Thank you for taking my question. Just a couple of quick ones, pro sales penetration in the quarter, where was it as a percentage of sales and where do you think it will wind up for the year with your new programs?

Rick Damron

Bud, this is Rick. We’ve looked at pros now approximately 30% of our total mix of business and we continue to work on that daily, the thing that we’ve really looked at pro, we looked at Q1, it was roughly three times our comp number for the company and I think we’re giving some credit for the continued progress of the initiative, when you look at the pros they’re reacting very strongly to our structure that we implemented last year of the in-store specialist to really manage and handle the customers when they come inside the stores, our market account specialist which manages the larger accounts within the marketplace and then our national accounts program which manages those accounts that do business across many stores across the country, that process and that program is working extremely well.

Keep in mind the investments that we’ve made in the inventory as well as the proprietary credit discounts that we offer them to give them additional incentives as well as our normal contractor pack processing which Mike spoke about earlier as well as our other programs there to help continue to provide great value for them. We see the re-launch of Lowe’s for pros to be a significant opportunity to continue to drive share and increase penetration with that customer. As Mike said, we'll begin to test that with some customers in Q2 with the expected pro launch to be in Q3 from that program as well.

So we feel very good about where we are from a pro standpoint currently. We believe they reacted very well to our initiatives and our programs that were put in place over the last 18 months and we continue to see that to progress into this quarter.

And Mike, I’ll turn it over to you, let you talk about some of the initiatives from a merchandizing standpoint we’re working on from a brand and assortment standpoint.

Mike Jones

Absolutely, we continue to make good progress on being more relative with pros. Inventory depth is certainly critical. Localization continued to make progress on as well as on brand. Continue to work through our brand portfolio to ensure that we have the right brand step that pros need, so we feel very good that our holistic approach of separating out those divisions that lean very heavy towards categories that have a heavy penetration (approach) [ph]. I spoke about earlier, lumber and building material, tools, hardware rough electric, rough plumbing, mill work, that putting them together under a single leader has helped us put more focus there and the team continues to make progress on those savings that are critical for pros.

Operator

Your next question comes from the line of Dan Binder with Jefferies.

Dan Binder - Jefferies

So I had a couple of questions. First was on labor training and kind of where you are with labor and back and training. I think last fall you had thought you needed to maybe add some more training hours so maybe an update on that?

And then on gross margin as you know, your main competitor has essentially put a cap on where they want to see gross margin go for competitive reasons and I’m curious what your point of view is on that as it pertains to Lowe’s and where you think your gross margin should be?

Rick Damron

Dan, this is Rick. I'll take the first part of that question, then turn it over to Mike to answer the question around margin. From a labor perspective, we feel very good about where we were and what the operations teams with Dennis Knowles was able to accomplish in the quarter as we continue to look at payroll to provide positive leverage during the quarter during a very difficult environment from weather perspective was an outstanding job on their part. And we feel comfortable that the labor that we added back in gross stores last year as part of our weekday teams helped us fill that void that we had during the peak selling times of the weekdays, and we think there is no need to continue to add any incremental labor back into that environment.

So currently what we’re looking at of course is as sales improve we continue to add labor to match sales rate. That’s where staffing programs and plans work. And our part-time mix gives us the flexibility to flex up and flex down to meet sales trends throughout the quarter and that’s what really helped us continue to provide solid leverage during Q1.

As it relates to training, we spoke about training in Q3 from a perspective of making sure that our investment of those weekday team members was as solid as we can get it and we realized there were some training gaps there and then we made some adjustments to the program to help solve that issue by placing them into specific departments versus allowing them to work in multiple departments therefore able to provide them much better training to assist the customers in those departments. We feel good about that.

The other aspect that we talk about as we continue to migrate to become an omni-channel retailer is to continue to develop the skill sets of our employees in the stores, and we vested a substantial amount of training time last year making sure that they were able to address our customers when they came into the stores looking at the type of trips they were into shop whether that be the customers in on a specific mission trip, whether it was a project trip or whether they were into stores seeking inspiration. We did a substantial training with every associate on being able to recognize those and being able to adapt to the customer what they wanted to focus on. So we continue to work on training. It continues to be a significant focus as we move into the 2014, but we feel very good about our programs from last year, the investments we made and the results they provided.

So Mike I’ll turn it over to you to answer the question on margin.

Mike Jones

Sure, absolutely. Our 2014 outlook talks to approaching 35%, but we don’t think there is a hard cap on gross margin. Let me talk about value improvement because that’s the process that we usually manage, how we do our live reviews, which is a huge contributor to both the gross margin. We have a very balanced approach with our vendor partners. We always look at growth to both us and our partners. Innovation is central in those discussions. We get value for customers. We see these engagement opportunities as an opportunity to build partnership and of course cost is always a part of that discussion.

But when you think about gross margins, you always got to think about line design as it impacts mix and you got to think about the ability to find efficiencies with both us and our vendor partners so that we can drive our cost. So we think all this comes together to allows us to go after improve margining and its working and it’s working very well along all those fronts. So I don’t know that is a hard cap. We are continuing to drive mix, look for efficiencies and while improving our partnerships and going after innovation, and we’re doing it in an environment and in a way that’s allowing us to expand margin.

Rick Damron

Dan, this is Rick. Just to expand on one other key points and that's related to our sales and operation planning process. One of the things that we identified as we continue to look over the last couple of years was our ability to attach and how do we really continue to drive that through our employees and how we merchandize our stores and get our stores prepared for events. And our sales and operational planning process helps us really understand the attachment to go along with the core item which ultimately helps us improve the basket, therefore helping us to improve the overall margin mix within the basket as well.

Robert Niblock

Dan this is Robert, just to sum it up, as we go to market, we will continue to be priced competitively as Rick spoke of, it’s helping mix the margin with attachment and the right items there as Mike said, we’ve done a lot of work the past couple of years going through our value improvement, line review process if you recall. During that period of time there was some disruption where we had excess product that we had to clear and mark down and we started to cycle through the majority of that now. So a little bit cleaner numbers coming forward. But just so -- underpinning for all that is, we will continue to be competitive on price of the marketplace across all channels that we compete in.

Operator

Your next question is from the line of Dennis McGill with Zelman & Associates.

Dennis McGill - Zelman & Associates

You touched on a couple of regions I think you mentioned the Southwest and Northeast. I was just wondering, how many regions do you have and can you maybe just talk across all of them sort of what you saw relative to the company wide comp in the quarter?

Rick Damron

Yes Dennis this is Rick, we have three operating divisions and that’s what you heard us speak about when we talked about the southern markets, the west and the northeast. Within those we have 14 regions, encompassing a mix of each of those. What we saw was as Bob Hull added in his comments, where we had solid weather a good weather more normalized, we saw a solid mid-single digit comps around each of those geo zones as we refer to them, east south and south being particularly strong. The central parts of the country performed well particularly as we got into the latter half of the quarter. The north and the upper north was where we saw a greater amount of weather impact and where we saw the negative comps from an overall sales environment as a result.

So we feel very good in those markets for the quarter from the south, southern and central areas, the north and the upper north is what put pressure on the overall performance.

Dennis McGill - Zelman & Associates

So at the highest level, the south and west was at mid-single and the northeast was down at the three divisions.

Rick Damron

Correct.

Robert Niblock

And Dennis basically as we look, we look in the south and the west every region and those had positive comps when you get up to the north the division, every region within that had negative comps. So it really does kind of accentuate the condition that we saw during the quarter.

Dennis McGill - Zelman & Associates

Okay great. And then second question just on margins, I think you highlighted the value improvement as well as mix on gross margin in the quarter. Can you separate those two and just maybe talk to on the outlook how those two things would trend particularly here in second quarter?

Robert Niblock

So of the 70 basis points improvement, value improvement was 45 basis points and mix was 20. As we cycle last year’s value improvement activity, we expect that benefit to diminish as the year progresses. The mix impact was primarily a result of selling less seasonal goods. In the first quarter we expect that to flip, in the second quarter as we recover lost sales, it should be a slight drag in Q2 and then revert back to being flattish or neutral in the second half of the year.

Operator

Your next question is from the line of Kate McShane with Citi Research.

Kate McShane - Citi Research

Just wanted to know if we could have a little bit more detail on any changes we can expect from the changes in the merchandising team. Could we see further refinement to your merchandising strategy and how disruptive could this be?

And then just with regards to some of the refinement strategy you continue to make at the store, was there anything during the quarter that you could highlight that was particularly beneficial?

Mike Jones

Sure absolutely, this is Mike Jones. We don’t anticipate any rapid changes in our merchandising strategy, our initiatives are very well vetted, we believe they will continue to create value for us. We love the enhanced partnerships that we have with our vendor partners; we’re extremely close to our vendor partners. Our team has a very strong bench and all of our leadership was united and our development of our functional plans. So there is no anticipated change at all and we’re confident that the changes that we’ve made with some of these promotions of some of our talent that’s on our bench will be -- what we see by our vendor partnerships. So very comfortable there.

I spoke of the outdoor living set as one of the combined efforts between our merchandising team and our customer experience design team, which in particular in areas that had pretty good weather did extremely well, so excited about that. As you look at the divisions that performed above the company average, you’ll notice that our fashion fixtures is one of them and if you walk our stores, you’ll see a much more enhanced display of the way we do our assets, which is another example of how our merchandising team is working with their vendor partners to have the right products as well as the influence of our customer experience design team as well.

So we're very excited about our merchandizing initiatives, we’re very excited about our partnerships and would anticipate any amount of changes.

Robert Niblock

And then Kate, you also had a question about was it any store refinements, I’m sorry I didn’t really catch what the intent of your question was?

Kate McShane - Citi Research

Just as you continue to refine some of your merchandizing strategies, were there any wins during the quarter that maybe were surprising to the upside or that was better than expected.

Mike Jones

Yes, The two I would note would be the success that we had with our fashion fixtures as well as our seasonal set that I spoke of.

Operator

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

Greg Melich - ISI Group

Thanks guys, I have a couple of questions. First on the traffic and ticket mix, I think at beginning of the year you guys said about two-thirds of a comp will be ticket and one-third traffic. Given how the first quarter played out, do you expect that to change for the full year and as May has recovered, how does the traffic and ticket breakdown look like?

Robert Niblock

So, as we think about our seasonal business, our lawn and garden in particular is a huge driver of transactions and traffic for us, that was weak in the first quarter, that is beginning to recover in the second quarter. So that gave rise to the out of balance performance with almost all the comp being driven by ticket in Q1 as we get that traffic in lawn and garden, this is back in Q2, that is more balanced almost 50-50 thus far in the second quarter, we think for the year, the two-thirds, one-third ticket in traffic still holds up.

Greg Melich - ISI Group

That’s great, helpful and then on dot com you mentioned in several of the answers how it’s an initiative with the pro, with the consumer and with some of the labor initiatives you have in the specialist departments. Could you give us an update on where you are on that in terms of percentage of sales or ship to store or other things you got going on?

Robert Niblock

Yes, overall I’ll start and let others jump in, Greg overall our dot com business was up a little more than 25% in the quarter, so we’re pleased with what we see there, obviously we’re excited about adding Lowe’s for pros and the second quarter really give the pro a dedicated website to be able to, to transact on what the additional functionality that Mike spoke of in his comment. We still continue to see about 50% of what is bought online is actually picked up in store. So the customers using it -- really it’s really the whole strategy of being there to meet their needs whenever and wherever they choose to engage and then on top of that, there’s about another 20% that is delivered from the store up to the consumers’ homes. If you think about it, about 70% of what we sell online is fulfilled through that store channels, so it’s -- as I said, being there whenever and wherever the customer chooses to engage and we’re happy to ship it to them, have it available in store whatever. And we’re continuing to add functionality, continuing to add the necessary products and refine the offering that we have out there, so Mike I don’t know if there’s anything else.

Mike Jones

No, I think this summarizes it well, but the -- the one thing I would add is that we do have very strong dot com businesses in some of the seasonal areas and some of the OPE where we tend to index very highly and as we look at the first quarter, you can see that some of the divisions that were below the company average have a pretty big footprint on our dot com sales and so that was a little bit of a headwind that we expect to see pick back up as we go into the second quarter but [indiscernible] comfortable with our continued build out of our omni-channel environment.

Operator

And your final question will come from the line of Mike Baker with Deutsche Bank.

Mike Baker - Deutsche Bank

Thank you, hi guys. Just a quick one to start, you said the weather impacted you by 150 basis points. If we add that back, then you would have comped at 2.4 in the first quarter which still would be below your plan, your plan was for the first quarter to be the highest comp of the year which means certainly above 4, so what else missed on the comp line in the first quarter.

Bob Hull

So we've had -- we are expecting some level of deflation in the quarter, it was a little bit higher than we anticipated. As we think about the aspects of comp impact, they’re not precise as Rick and Robert took you through the geography, strong performance in West and South really challenged performance in the Northeast, so we do feel like we can recover the lost sales, we do feel like there’s other activity, some of the initiatives that Mike spoke of regarding the experience design, Rick and Mike both talked to you about some of the pro initiatives, it’s going to gain traction throughout the course of the year, so we feel like we’ll recover the lost sales and do have other initiatives that will drive the 4% comp for the year and the good news is we’re seeing evidence of that thus far in May.

Mike Baker - Deutsche Bank

Okay. So to follow up on that, how much did deflation hurt and does that get better? And I guess maybe, maybe my words instead of yours, but you said 150 basis points, I guess what we should interpret that as, that’s not that precise, the weather could have been more or less than that.

Bob Hull

Right, so we estimate it’s a 150 basis points, however the West and South comped roughly positive 4 to Northeast comped roughly negative 5, so that goes, it’s a 900 basis points spread.

Mike Baker - Deutsche Bank

And what percentage of your stores were in the northern region?

Bob Hull

I’m sorry?

Mike Baker - Deutsche Bank

What percent of the stores were in the northern region? Is it roughly third?

Bob Hull

Roughly 30% of our sales.

Mike Baker - Deutsche Bank

Okay.

Bob Hull

So we have got a consistent methodology [indiscernible] with weather impact, that hasn’t changed but if you take a look at just the division performance you can see that weather could potentially be bigger than that. The deflation impact was 35 basis points. We see improvement in comparisons relative to lumber so we see that headwind going away as the year progresses.

Robert Niblock

Thank. And as always thanks for your continued interest in Lowe’s, we look forward to speaking with you again when we report our second quarter 2014 results on Wednesday August 20, have a great day.

Operator

Thank you for participating in today’s Lowe's conference, you may now disconnect.

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Source: Lowe's Companies' (LOW) CEO Robert Niblock on Q1 2014 Results - Earnings Call Transcript
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