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Lowe’s Companies, Inc. (NYSE:LOW)

Q3 2010 Earnings Call

November 15, 2010 9:00 am ET

Executives

Robert Niblock – Chairman, Chief Executive Officer

Robert Hull – Executive Vice President, Chief Financial Officer

Nicholas Canter – Executive Vice President, Merchandising

Larry Stone – President, Chief Operating Officer

Gregory Bridgeford – Executive Vice President, Business Development

Analysts

Stephen Chick – FBR

Michael Baker – Deutsche Bank

Scot Ciccarelli – RBC Capital Markets

Budd Bugatch – Raymond James

Michael Lasser – Barclays Capital

Brian Nagel – Oppenheimer

Peter Benedict – Robert W. Baird

David Strasser – Janney Montgomery Scott

Operator

Good morning everyone and welcome to Lowe’s Companies Third Quarter 2010 Earnings conference call. This call is being recorded. Please note if you pressed star, one to enter the question queue prior to the start of today’s call, your signal did not register. You will need to press star, one again to enter the queue.

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

Also during this call, management will be using certain non-GAAP financial measures. You can find a reconciliation to the most directly comparable GAAP financial measures and other information about them posted on Lowe’s investor relations website under Corporate Information and Investor Documents.

Hosting today’s conference will be Mr. Robert Niblock, Chairman and CEO; Mr. Nick Canter, Executive Vice President of Merchandising; and Mr. Bob Hall, Executive Vice President and CFO.

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. Following my remarks, Nick Canter will review our operational performance and Bob Hall will review our financial results.

Sales for the quarter increased 1.9% and comparable store sales were slightly positive. Comp traffic and comp average ticket were also positive for the quarter. New store cannibalization reduced comps by approximately 30 basis points in the quarter.

Although the sales for the quarter trended below our guidance, our merchandising strategies helped us deliver 85 basis points of gross margin expansion in the quarter. Nick will provide more details on those efforts in a few minutes.

As detailed in today’s release, we recognized a charge which reduced pretax earnings for the quarter by $50 million and diluted earnings per share by $0.02. The charge was associated with the impairment of long-lived assets and write-offs related to store sites we no longer intend to pursue. Even with these charges, we leveraged expenses for the quarter and delivered earnings per share of $0.29 which was within our guidance for the quarter.

Our third quarter sales were impacted by the continued sluggishness of the economic recovery driven by ongoing uncertainty in employment and housing. As we’ve seen over the past several quarters, consumers are not yet willing to consistently take on larger discretionary home improvement projects. They remain cautious and continue to rationalize the scope of their projects or in many cases delay projects until they have better clarity about their personal financial situations, the value of their homes, and the overall macroeconomic outlook.

In our third quarter consumer survey, homeowners indicated that half of the home improvement projects they have planned in the next six months are discretionary in nature. However, the majority of that discretionary spend is expected to be on projects under $500.

We continue to evaluate our operating model and look for opportunities to work more efficiently and better position Lowe’s for the future. As a result, we closed two regional offices during the quarter. Our districts have been realigned such that we now operate 21 regions in the U.S. versus the previous 23. Although 11 of our 21 U.S. regions generated positive comps in the quarter, the economic recovery continues to bounce along the bottom; however, even in a difficult environment, we are seeing gradual improvement in the fundamentals of the housing market.

Sales were also affected by the prolonged extreme heat across much of the U.S. in August and September, which delayed consumers fall law and garden plans, causing sales of live goods to suffer. However when temperatures began to cool in October, we experienced better performance in our lawn and landscape and nursery categories as consumers restored their lawns.

Throughout the quarter, we saw strength in categories supporting smaller projects such as tools and paint, and we were also pleased with our performance in seasonal living and appliances.

During the quarter, commercial and installed sales exceeded our overall sales trends, continuing to reflect the investment we made in our district commercial account specialist and project specialist exteriors positions. In fact, installed sales produced double-digit comps for the quarter driven in part by categories such as windows, doors and fencing, which are a focus of our project specialist exteriors position.

I’m pleased with our inventory position at the end of the third quarter, which was up only 1.4% year-over-year. You will recall that our inventory position grew earlier in the year due to opportunistic purchases in categories such as appliances and paint. We made those purchases to pursue opportunities to drive sales and capture profitable market share.

We used third party data to gauge our retail market penetration, and on a rolling four quarters basis we gained 20 basis points in total store unit market share with gains in 10 of our 20 product categories, including appliances and paint. We also maintained our unit market share in an additional four product categories.

On the expansion front, we opened 10 stores in the quarter, four of which were in Canada including our first store outside Ontario in the Calgary market.

As we said on our second quarter earnings call, we don’t expect consistent improvement in core demand until the fundamentals of the labor and housing markets improve. However, we are prepared to operate effectively in a slow growth environment, focusing on operational efficiency and prudent expense management. We are ready to respond if demand is better or worse than expected.

In addition, we continue to solidify plans to enhance our market share gains as the macroeconomic environment slowly improves. At our analyst and investor conference later this month, we will update you on initiatives that we are working on to drive sales in market share gains.

Thanks again for your interest, and I’ll now turn it over to Nick Canter to provide an update on successes in the quarter as well as how the merchandising team is focused on profitably gaining market share. Nick?

Nicholas Canter

Thanks, Robert, and good morning. This morning I will review our third quarter performance and then update you on our strategies to profitably grow market share.

I am pleased with how we’ve continued to manage for profitability in an uncertain environment. As Robert mentioned, comps for the quarter were slightly positive but we were able to expand our gross margin by 85 basis points and our inventory into the quarter only 1.4% above last year.

Ten of our 20 product categories generated positive comps. We continue to see strength in categories supporting smaller projects including tools, paint, and lawn and landscape. Within tools, we are capitalizing on our partnerships with great brands such as Porter Cable, Rockwell, Hitachi, Bosch, and DeWalt; and our store teams continue to drive additional power tool accessory sales yielding higher margins and repeat traffic. Both interior and exterior paints performed well and we have received a strong response to our launch of Valspar Signature Colors paint with hi-def advanced color system technology.

Some larger ticket items such as appliances, patio and grills also performed well. Appliances continued to benefit from our knowledgeable associates, our wide selection of brands, and free next-day delivery and haul-away; and we have the most items in stock for take home today of any major retailer.

Lawn and landscape benefited from particularly strong sales of watering products, grass seed and lawn repair products as homeowners worked to restore lawns damaged from the summer drought. On the other hand nursery, which we had expected to perform well as our customers planted trees and shrubs after an unseasonably hot second quarter, continued to struggle as excessive heat lingered into August and September. We saw strong positive comps in October when the heat finally broke, but nursery still ended the quarter below our expectations.

Weather patterns also affected home environment, which was our lowest performing category for the quarter. Early heat throughout the northeast and the Midwest pulled air conditioning sales forward into Q2 from Q3.

Gross margin grew by 85 basis points as a result of coordinated efforts across a number of areas, including refinement of our pricing strategy, carefully managed and seasonal sell-through, and our response to customers’ increasing demand for the value offered by private branded products.

Two important changes to our pricing strategy were fully implemented prior to the beginning of the third quarter. First, we increased the number of patch areas or competitive pricing zones from just under 90 to more than 210. This allowed us to price more competitively in each market. In addition, we implemented base price optimization which adds to the capabilities we have benefited from with markdown optimization. Just as markdown optimization has helped us to better tailor our markdown approach to each store based on specific demand for an item, base price optimization determines the best price by item and patch area to optimize our positive price perception and total basket profitability.

Improved seasonal sell through allowed us to take lower clearance markdowns for grills, patio, and air conditioners. In grills and patio, we leveraged more market-specific assorting and our advanced supply chain capabilities to ensure we had the right product in the right markets. Consequently, we were able to uniformly meet demand and end the season with very little excess inventory which reduced the margin impact of seasonal markdowns. So for both patio and grills, this approach translated into both higher sales and improved margins.

For air conditioners, we decided early in the year to enter the summer with a moderate number of units in order to minimize the markdowns we would need to take at the end of the season. With warmer weather, we were able to sell through most of all of our units with minimal markdowns, and we ended the quarter with our inventory in great shape.

Finally, our increasing penetration of private brand products also contributed to our margin improvement. We will always be predominantly a house of national brands, but over the next few years we expect to further increase our penetration of private branded products from approximately 15% to 18%. This strategy will provide great value to our customers while giving us opportunity to improve margins.

In the third quarter we continued to gain share according to an independent third party assessment, and on a rolling four quarter basis we grew share in 10 of our 20 product categories and maintained share in four categories. We made noticeable progress in appliances, hardware, seasonal living, tools, and paint. These gains were driven by our continued focus on four simple principles for growing profitable market share: go local, focus on everyday value, first to market, and what we call the Why Lowe’s shopping experience.

Go Local means that we tailor our assortments to each market we serve while always adhering to the fundamentals of customer service and store environment that makes Lowe’s unique. For instance, as front load washing machines became increasingly popular, we began to carry more inventory in the front load machines than in the more traditional top load machines. However, ongoing store level analysis has shown us that in many markets, our customer preference had shifted back to top load machines as the efficiency and the capacity of these units had improved; so we have rebalanced our by-market inventory accordingly.

Another example is our local market customer appreciation days event. We select markets where we have opportunity to gain share, then we invite commercial customers to an event to showcase what we can offer them with product demonstrations from our key vendor partners. These events have received great feedback from customers and our stores and helped generate strong commercial customer sales.

We have always gone local but we get better at this every year, and as we mentioned at our last quarter’s call, we expect to implement integrated planning and execution, or IP&E, in 2011. IP&E will compliment the judgment and the creativity of our merchants by helping them better target the stores within the markets we serve. In simple terms, these tools and processes will help us to get the right product to the right place at the right time even more efficiently and effectively than we do today. We will use IP&E to more specifically determine what products and quantities to offer in each store based on market requirements, demographics, and customer shopping preferences.

We have begun piloting IP&E in seven merchandise subcategories and we expect to begin realizing the benefits of IP&E’s clustering and assorting capabilities as we reset products during 2011. Further benefits should be realized when we tie together the assortment planning, the store layout and plan-o-grams, as well as our financial models and logistics systems to ensure that we have the right products and inventory to meet customer demand.

Go Local no longer means just within our stores. Local is wherever our customers need to tap into our resources and our expertise. It includes the project specialist exteriors, who make in-home visits to sell exterior categories; or the district commercial accounts specialist who meets with commercial customers at their place of business, or Lowes.com where customers can now find over 350 how-to videos to start them on their next project or help them recover from one they’ve already started. We are looking forward to sharing more about this concept with you at our analyst and investor conference.

The second principle is everyday value, and the value is more than just a low price. We have to offer something more than a competitive price like low price plus innovation, or low price plus compelling style, or low price plus unmatched service. One way we are bringing value plus style to the marketplace is with our Allen + Roth brand of home décor products. This line offers customers the ability to coordinate across many product categories including window treatments, paint, lighting, bath vanities and accessories, closet organization, and more. Allen + Roth delivers a classic style with a modern flair and provides our customers with a specialty store look that fits both their style and their budget.

The third principle is First to Market. We want to be the first home improvement company to offer something new and different to our customers, like the new heat pump water heater from GE, which won the Popular Science Best of What’s New Award in 2009. In fact, our desire to work with vendors to offer environmentally responsible and cost savings products has resulted in the U.S. EPA and the Department of Energy honoring Lowe’s with the 2010 Energy Star Sustained Excellence Award. Lowe’s is the first retailer to win the Sustained Excellence Award and it is our eighth consecutive Energy Star honor. Additionally, we are the first retailer to win the WaterSense Partner of the Year in consecutive years. Our research indicates that these designations play an important role in our customers’ purchase decisions.

Another example of First to Market is our exclusive launch of Valspar Signature Colors paint with high-def advanced color system technology, which delivers ultimate hide, exceptional color accuracy, and superior fade resistance. This great new product simplifies our customers’ painting projects and gives them another compelling reason to shop Lowe’s for their painting supplies.

The fourth and final principle – the Why Lowe’s shopping experience – captures the many things that we do to differentiate us from our competitors. It’s what convinces customers they should come to Lowe’s the next time they need to complete a home improvement project, no matter how large or how small. That could mean visually inspiring customers with a wide array of paint colors, or ensuring we carry enough plumbing parts to finish a job, or providing an uncluttered and inviting shopping environment both in our stores and increasingly on our website, or merchandising fashion plumbing items together so a customer can better visualize the final appearance of their bath project – what I like to call putting it all together for the customer.

Or it could mean offering our customer something they can’t find at other large home improvement retailers. In fact, one great example of the Why Lowe’s experience is our channel exclusive on Stainmaster carpet. Combine this well-known and trusted brand with our $39 whole house installation, and our customers have a compelling reason to buy their carpet from Lowe’s before looking anywhere else.

We are excited about our current and expanding capabilities for providing differentiated value to our customers. We continue to improve our market share, and when the market rebounds we look forward to taking further share and growing profitably.

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

Robert Hull

Thanks, Nick, and good morning everyone. Sales for the third quarter were $11.6 billion which represents a 1.9% increase from last year’s third quarter. In Q3 total customer count increased 1.6% while average ticket increased 0.3% to $61.59. Comp sales were positive 0.2% for the quarter which was below our guidance of 1 to 3%.

Looking at monthly trends, comps were flat in August, negative 0.5% in September, and positive 1.2% in October. For the quarter, both comp transactions and comp average ticket increased 0.1%.

With regard to product categories, the categories that performed above average in the third quarter include millwork, tools, lumber, paint, rough electrical, seasonal living, lawn and landscape products, rough plumbing, and appliances. In additional, home organization performance was essentially in line with the Company average.

Year to date, sales of $38.3 billion represent a 3.5% increase over 2009 driven by new stores and a comp store sales increase of 1.4%. Gross margin for the third quarter was 35% of sales, an increase of 85 basis points from last year’s third quarter.

As Nick described, the increase in gross margin was driven by a number of factors. We estimate that the favorable impact from base price optimization and patch area expansion on the quarter was approximately 25 basis points. In addition, the impact of seasonal sell through both to benefit of lower markdowns this year in patio furniture and grills, and the comparison to last year’s air conditioner markdowns helped gross margin by approximately 25 basis points. Lastly, inflation in commodity categories and a higher proportion of private label products aided gross margin the quarter. Year-to-date gross margin of 35% represents an increase of 18 basis points over the first three quarters of 2009.

SG&A for Q3 was 25.3% of sales which leveraged four basis points, driven by a number of expense lines. For the quarter, bonus expense leveraged 31 basis points due to lower attainment levels versus plan. In Q3 we incurred a $39 million charge related to an evaluation of the carrying value of long-lived assets including two stores that closed on November 7. In addition, we incurred $11 million in write-offs related to the pipeline of potential future store sites we are no longer intending to pursue. As a result of these two items, SG&A was negatively impacted by $50 billion which reduced earnings per share in the quarter by approximately $0.02. This compares to $57 million in expense for similar items in last year’s third quarter, resulting in 6 basis points of expense leverage in Q3 this year. Also, we experienced modest leverage in both store payroll and payroll tax expenses.

Slightly offsetting these items, we experienced deleverage in the following expense lines: insurance, proprietary credit, bank card, and fleet. Year-to-date, SG&A is 24% of sales and leveraged 16 basis points to the first nine months of 2009.

Depreciation at 3.4% of sales totaled $399 million and leveraged 10 basis points compared to last year’s third quarter.

Earnings before interest and taxes for operating margin increased 99 basis points to 6.3% of sales. Year-to-date operating margin of 7.9% represents an increase of 49 basis points over 2009.

Interest expense at $80 million deleveraged one basis point as a percentage of sales. For the quarter, total expenses were 29.4% of sales and leveraged 13 basis points.

Pretax earnings for the quarter were 5.6% of sales. The effective tax rate for the quarter was 37.9%.

Earnings per share of $0.29 for the third quarter were within our guidance of $0.28 to $0.32 and increased 26% versus last year’s $0.23.

Now I’d like to comment on the balance sheet, starting with assets. Cash and cash equivalents balance at the end of the quarter was $1.1 billion. Our third quarter inventory balance increased $119 million or 1.4% versus Q3 last year. The increase was due to 36 new stores opened over the past four quarters.

Inventory turnover, calculated by taking a trailing four quarters cost of sales divided by average inventor for the last five quarters was 3.6, a decrease of 5 basis points from the third quarter of 2009.

Return on assets, determined using a trailing four quarters earnings divided by average assets for the last five quarters, increased 39 basis points to 5.6%.

Next I’d like to highlight a few items from the liabilities and shareholders equity section of the balance sheet. At the end of the third quarter, our accounts payable balance was $5 million or about 2% lower than last year. The reduction in accounts payable relates to the timing of purchases. As we noted earlier in the year, our inventory was higher than planned due to some opportunistic purchases. As we work to get inventory inline with plan, our inventory purchase activity moderated, resulting in a lower AP balance at the end of Q3 relative to last year.

Our debt to equity ratio was 29.5% compared with 26.1% in Q3 last year. At the end of the third quarter, lease adjusted debt to EBITDAR was 1.58 times. We are increasing our previously stated lease adjusted debt to EBITDAR target from 1.5 times to 1.8 times, while reiterating our commitment to protecting our A1P1 commercial paper rating. This change provides improved flexibility to return value to our shareholders while maintaining strong liquidity and lowering our weighted average cost of capital.

Return on invested capital, measured using a trailing four quarter earnings plus tax adjusted interest divided by average debt and equity for the last five quarters increased 54 basis points for the quarter at 8.6%.

Now looking at the statement of cash flows, year-to-date cash flow from operations was $3.8 billion which was down about 12% versus the first nine months of 2009, due in large part to the lower accounts payable balance. Cash used and property acquired was $1 billion for the first nine months of 2010 compared to 1.4 billion for the same time frame last year. As a result, year-to-date free cash flow was just over $2.8 billion.

During the quarter, we repurchased 29 million shares at an average price of $20.72 for a total share repurchase amount of $600 million. We have $3.4 billion remaining on our share repurchase authorization. We estimate that the third quarter repurchase activity helped the current quarter’s earnings per share by approximately 4/10ths of a penny.

Looking ahead, I’d like to address several of the items detailed in Lowe’s business outlook. We expect fourth quarter sales to grow by 2 to 4% over last year, which incorporates the opening of 17 new stores - four in November, five in December, and 8 stores in January. Comp stores sales are thus estimated to be flat to positive 2% versus last year. Even our operating margin for the fourth quarter is expected to increase by approximately 80 basis points to last year as a percentage of sales. The increase is driven by gross margin improvement as well as SG&A and depreciation leverage.

The anticipated sales and operating margin results are expected to generate diluted earnings per share of $0.16 to $0.19 which ranges from an increase of 14 to 36% compared to last year’s $0.14.

For 2010 we expect to open approximately 42 stores resulting in an increase in square footage of roughly 2%. We’re estimating a comp sales increase of 1 to 2% and a total sales increase of 3 to 4%.

For the fiscal year, we’re anticipating an operating margin increase of 50 to 60 basis points. We are forecasting an effective tax rate of 37.8% for both Q4 and the year. As a result, we expect diluted earnings per share of $1.37 to $1.40 for the year.

For the year, we expect cash flow from operations to be approximately $4.2 billion. We forecast total capital expenditures of approximately $2 billion with roughly 400 million funded via operating leases, leaving cash CAPEX of approximately $1.6 billion for 2010. As a result, we are forecasting free cash flow of approximately $2.6 billion for the year.

Our outlook does not contemplate any share repurchases for the fourth quarter.

Regina, we’re now ready for questions.

Question and Answer Session

Operator

We are now ready for questions. To ask a question, press star, one on your telephone keypad. To withdraw your question, press the pound key. In order to allow questions from as many individuals as possible, please limit yourself to one question and one follow-up.

Our first question comes from the line of Stephen Chick with FBR.

Stephen Chick – FBR

Hi, thanks. I guess for Bob, it looks like the comps for the quarter as they progressed really were helped out by the last month of the quarter, and I was wondering if you could speak to how much of that might have been driven by outdoor and some of the pent-up lawn restoration activity that occurred and may have helped out the last month there.

Robert Hull

I think as Nick described in his comments, we did have some pressure early in the quarter based on the heat. Nursery business came back; in fact, was double-digit comp in October, so that certainly helped. But as Nick stated in his comments, nursery was still below the Company for the quarter. So certainly that did help, having improved or more normal weather in October relative to the first two months of the quarter.

Stephen Chick – FBR

Okay, so as you look at your outlook for the fourth quarter and kind of the November, December, January time frame, you could look at the guidance and maybe indicate—because I think some of the outdoor product categories become a lower piece of the mix in the fourth quarter. So are you assuming that some of the other categories pick up as the end of the year comes in here?

Robert Hull

You’re right. The outdoor categories are a lower percentage of our mix of total business in the fourth quarter. That’s certainly contemplated in our outlook. We feel good about our plans for the upcoming holiday seasons. We think the more typical products for this season will be the drivers of comp improvement as you think about the trimming tree category, as you think about tools and appliances, things of that nature, are more typical focuses versus your nursery category.

Stephen Chick – FBR

Okay, and did you give the ticket breakout of the comps for your bigger ticket comp for the quarter, and the items—the $50 or less than you typically speak to?

Robert Hull

Steve, we did not. I can give those to you. The tickets below $50 were essentially flat. Tickets above $500 were up just shy of 1%.

Stephen Chick – FBR

Okay. All right. Thanks, Bob.

Robert Hull

Thank you.

Operator

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

Michael Baker- Deutsche Bank

Hi. Thanks. My questions are more on the expense line where even adjusting for those charges, you were able to lever your expenses at essentially a flat comp. So I think that’s better than in the past. Is there something that you’re doing on the expense line differently than in the past, areas where you’ve found some cost savings that might continue? And I guess along the same lines, store closings – you’ve closed a couple here. Are there more over the next year or so that you think can be closed to further save some costs? Thanks.

Robert Hull

Good morning, Mike. This is Bob. I’ll start out with some comments on the expenses and let others chime in; then we can move on to the second part of your question. So really two thoughts – first, a large proportion of the leverage in this quarter came from bonus leverage, 31 basis points. As you know, our sales came in below our guidance and earnings came in at the lower end of our guidance. Our bonus plans are largely predicated on plan, so we performed a little bit lower than we expected versus plan. Second, a lot of work’s been done by the store operations team regarding store payroll – real focused on decomposing processes, leveraging thoughts from the field as to how we could do things better. As a result, we have a greater proportion of hours in customer facing activities and the stores have been able to reduce the number of hours to run-up a Lowe’s store by almost 400, so a lot of work by the store operations team to continue to refine the payroll model, which is going to help us in the back half of 2010 and beyond.

On the store closing question, we did close two stores in November 7, just after quarter-end. As we noted in the past, we continue to evaluate our stores and the markets they’re in, both current and expected performance. After a thoughtful evaluation of these two stores, their markets and projected growth for the next five-plus years, we felt like the best decision was to in fact close those stores.

Michael Baker – Deutsche Bank

Okay, thanks. And the true follow-up to that number you just gave, that reduction in hours by 400, that’s 400 fewer hours over what time frame? And then what is that as a percent of total hours to run a store; in other words, is it 400 fewer hours a month or a year, or—so yeah, if you could help us with that.

Robert Hull

(Inaudible) roughly 400 hours per week, and I’m not going to provide you the percentage which would give you the base hours, which we choose not to provide.

Michael Baker – Deutsche Bank

Okay, thank you.

Operator

Our next question comes from the line of Scot Ciccarelli with RBC Capital Markets.

Scot Ciccarelli – RBC Capital Markets

Hi guys. Scot Ciccarelli. I guess my question is if we look at kind of a three-year stack here, it seems to have been a pretty good indicator for what the run rate of the business is. So your comps were essentially flat from the second quarter basically, but to the basis point. What is it that you see in your business at this stage that gives you confidence we should see an acceleration in that metric as we head into the fourth quarter?

Larry Stone

Scot, this is Larry Stone. We feel real confident about our fourth quarter plans in terms of the promotions we have planned for Black Friday and other events into the fourth quarter, and certainly the previous calls talked about nursery not being a big driver in the fourth quarter, which is correct, but our trim and tree products, our seasonal heating products, our trim and tree products and a lot of the interior categories really have a much stronger fourth quarter than they do in previous quarters. So we feel confident that our fourth quarter numbers are very obtainable, and we feel confident about our plan that we have put together as we head into this quarter.

Scot Ciccarelli – RBC Capital Markets

Okay, that’s helpful. And then just philosophically, if comps were to go negative, is there a point where you would actually slow your buyback program?

Robert Hull

We would evaluate the cash that’s available. As I mentioned, free cash flow is forecast to be $2.6 billion for the year. We continue to evaluate, as I mentioned earlier, our expenditures, specifically payroll. We continue to evaluate our CAPEX. So Scot, I think all that would come into play – what’s the cash generated by the business less cash required for CAPEX and dividends, and that’s the cash left over for share repurchases. So we would go through that process to determine the cash that’s available given the new leverage target of 1.8 times lease adjusted debt to EBITDAR.

Scot Ciccarelli – RBC Capital Markets

All right. Thanks a lot, Bob.

Robert Hull

Thank you.

Operator

Our next question comes from the line of Budd Bugatch with Raymond James.

Budd Bugatch – Raymond James

Good morning and thank you for taking my question. Bob you normally, I think, call out Canadian comps versus U.S. Can you give us those numbers?

Robert Hull

Yes. So the Canadian comps were negative 8%--

Budd Bugatch – Raymond James

Negative 8?

Robert Hull

--on the quarter, really due to a change in tax legislation. There was an additional sales tax added to installed sales so we saw a huge ramp-up in installed business ahead of that change, which took effect in July. That was really contemplated in our Q3 outlook, so our consolidated comps were 0.2% and the U.S. comps were also 0.2% given the fact that we only had 14 comp Canadian locations. It really didn’t have an impact on the consolidated total.

Budd Bugatch – Raymond James

I got you. Thank you. And just as you look at the discretionary products, I was pleased to see that, I think the comps you said were up 1% for tickets above 500. What’s the promotional environment looking like for cabinets and appliances, and maybe you could give us kind of some color of what you’re seeing out there for the consumer?

Robert Niblock

Hey Budd, this is Robert Niblock. Yeah, to date I don’t think we’ve seen anything dramatically ramp up in promotional environments. You have seen a few things as pertain to Black Friday, a few competitors starting to signal either advance Black Friday promotions, those type of things. So we do think that between now and certainly Black Friday, heading into the rest of the holidays, that you may see a little bit of an elevated promotional impact. We’ve taken that into account in our guidance as we’ve looked at what we think will happen from an EBITDA margin standpoint in Q4 compared to Q3; and so that is contemplated in our guidance. So in an environment like this where unemployment’s at 9.6%, the consumer is still, as it pertains to large projects, still having to be kind of enticed to spend on those large projects. We think that you will see probably a slightly elevated impact over the balance of the holiday season; but as I’ve said, we think we’ve adequately taken that into account via the guidance that we’ve provided today as it pertains to the fourth quarter.

Budd Bugatch – Raymond James

But Robert, haven’t we seen some of the appliance manufacturers also have fairly heavy inventories which would indicate to be a more promotional environment on that side of the business?

Robert Niblock

Yeah, you saw obviously coming out of the first half of the year where we had all the cash for appliances programs, you saw obviously they were ramping up to try and build back the inventory that was depleted from that. We’ve continued to see good performance in our appliance category – once again, one of the categories that was above our overall Company comp, and we’re expecting a good appliance sell through in the fourth quarter as well. So yeah, I think that is to the fact that they have ramped up inventory and probably have inventory to move. It also leads to some of that—my comments with regard to probably slightly enhanced promotional activity over the balance of the quarter.

Budd Bugatch – Raymond James

Understood. Thank you very much and good luck on the fourth quarter and the balance of the year.

Robert Niblock

Okay, thanks, Budd.

Operator

Our next question comes from the line of Michael Lasser with Barclays Capital.

Michael Lasser – Barclays Capital

Good morning. Thanks a lot for taking my question. So as you think about the relationship between housing turnover and your comps, what do you think the correlation is going to be moving forward? Is that going to become decoupled? Are we reaching—and why might that be? Is it because we’re reaching a base level of demand? How are you contemplating that.

Robert Niblock

I’ll start, Michael, then I’ll ask Greg Bridgeford to join in. I think—in the past, housing turnover has been as important in the past. I would think it’s still important today and it’ll be important in the future because, as you know, it provides a natural incident for the homeowners who need to come and buy products related to the home in our industry. Obviously what’s been challenging is even though that there’s been still continued positive correlation associated with that, the bigger issue is the more than offsetting fact that the pullback you’ve seen in overall demand with unemployment where it’s at and with home prices continuing to drop. You know, home prices were down about 29% when they bottomed in January or so earlier this year. When you had the stimulus programs for the home buying tax credit, you saw a little bit of a pick back up; but now home prices are falling again and probably anticipated to fall through at least the middle of next year, so you’ve probably got another four to eight percent or so, potentially, on home price decline. And even though we’re gaining jobs, that’s still not growing fast enough to drop the unemployment rate on the jobs front So even though you’re seeing fundamental improvement, the majority of the decline of home prices is behind us, we are gaining jobs – all those type of things are positive signs. Those two halo effects – employment and the continued decline in home prices – probably offset or kind of water down what you would normally see as that correlation you’ve been able to draw on in the past between housing turnover and our sales. So housing turnover is still important, but it’s offset by some of these other factors.

Greg, did you--

Gregory Bridgeford

I think Robert covered it well, Michael. I think that we’re watching very carefully employment incomes and then spending—consumer spending. I do think Robert’s right that that’s going to be the first factor—I mean, if you combine those factors, that entire scenario has to strengthen for us to see some spend in our category. And where we’ve seen housing turnover spike regionally and market by market, we’ve seen some moderation and some bottoming on an market basis of home values, and unfortunately that situation has been a little more variable lately. So you saw some markets seem to stabilize six months ago, and all of a sudden they seem to have fallen off again. So I think Robert’s right – the factors to watch most carefully now are employment incomes and spending.

Michael Lasser – Barclays Capital

I guess I was thinking about more prospectively than—you haven’t seen necessarily the pop in your comps from the spike in housing turnover from a couple quarters ago. Does that suggest you may not see the fall-off now that housing turnover has moved down quite significantly over the last couple of periods when we get into the spring selling season?

Robert Niblock

I think, Michael, what we’re saying is that over the long term, housing turnover is a strong correlator; but what’s taking place now and the impact on the consumer mindset has been how that’s impacting their spending patterns. That’s even more important today given that house prices are likely to decline modestly into 2011 and unemployment rises from here, that’s still going to be a driver of our business into 2011. Longer term as we think beyond 2011, I think the housing turnover would be a stronger correlator as it has been in the past.

Michael Lasser – Barclays Capital

Okay, and just a quick follow-up on the gross margin – it seems like some of the improvement from the current quarter is sustainable. A, how should we think about that, at least the half that came from the pricing patches and the private label penetration; and B, should we actually see that portion accelerate as there is more time to incorporate that into the business?

Nicholas Canter

Mike, this is Nick Canter. I’ll comment on that and let others jump in. On the base price optimization rollout, yes, we think that is sustainable. We think we see some opportunity as we wrap that next year. We got that rolled out in August throughout all categories. We certainly see more opportunity for the private branded product margin, as I said on my comments. We’re increasing the penetration of private branded comments which offer great value to our customers and enhanced margins for us, going from about 15% penetration to about 18. The only thing that’s not sustainable in Q4 versus Q3 was we did have some great seasonal sell-through upside, as Bob said earlier, on the 25 basis points that we had on a great sell-through program with limited markdowns. That would be the only thing that we wouldn’t see repeat itself, probably, in Q4.

Michael Lasser – Barclays Capital

Okay. Thanks a lot and good luck.

Nicholas Canter

Thank you.

Operator

Our next question comes from the line of Brian Nagel with Oppenheimer.

Brian Nagel – Oppenheimer

Hi, good morning. Thank you. The first question I have is on the appliance category. In your prepared remarks, the commentary around appliances seemed relatively upbeat, and that seems at odds with what we’ve heard from a number of the appliance manufacturers as well as some retailers lately. So I guess the question I have there is maybe you can help quantify what you saw in the appliance category through the quarter; and then help to kind of sort of, say, bridge the gap with some of this other weaker data we’ve seen recently.

Robert Hull

Brian, this is Bob. I’ll take kind of the first piece of it. As we talked about in the first half of the year, we bought a lot of appliances, so for us to get our appliance inventory back inline we had to slow our appliance purchases. So that’s what you see in conflict with some of the manufacturers, is our purchases from them would have been skewed towards the first half of the year. As we worked to get our inventory back in line, we would have moderated our purchases which would have been a negative for them. Our appliance inventory is in great shape. We feel good about where we are today, but our appliance inventory has moderated from the first half of the year.

Brian Nagel – Oppenheimer

Okay, so a follow-up to that, did we see any lumpiness with the government stimulus early in this year and then obviously the expiration of that later? What type of effect did that transition have on your sales trends?

Robert Niblock

Brian, this is Robert. Yeah, we talked earlier in the year we had strong double digit positive comps in appliances through the first half of the year heavily driven by the stimulus program, the cash for appliances program. As we saw the early indications on a state-by-state basis, those appliance sales, we did some opportunistic buys because we were concerned how much production capacity would be out there. We secured that inventory from a major manufacturer which then provided us the inventory to be able to sell through. But even without the cash for appliances program, we still would have seen very strong comps over the first half of the year. Now, we did expect that to soften some in the third quarter, and that was part of the reason when we gave our guidance from second quarter going to third quarter of the increase that we thought we would see on gross margin, it was because of the impact – mix from very strong double digit appliance comps in the quarter negatively impacted our margin. We expected them to soften but still run above the Company average in the third quarter, which then improved them. From a mix standpoint, we didn’t have that drag on gross margin that we had in the second quarter. I suppose it kind of rebalanced. And then we’re still expecting from our plans to have strong appliance sales in the fourth quarter. We still expect appliances to lead our overall comp guidance for the fourth quarter.

Brian Nagel – Oppenheimer

Okay, helpful. Then as one follow-up kind of maintenance question, Bob, the $0.02 charge you had here in Q3, is that reflected in the updated annual guidance you gave for the year?

Robert Hull

Yes, it is. We report on GAAP and we guide to GAAP.

Brian Nagel – Oppenheimer

Okay. Thanks a lot.

Robert Hull

Thank you.

Operator

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

Peter Benedict – Robert W. Baird

Hey guys. Two quick ones – first, Bob how quickly do you plan to get to the 1.8 leverage ratio benchmark that you’ve laid out here this morning?

Robert Hull

We’re going to be very thoughtful about our approach to navigate going from the 158 today to the 18, so it’s not specific timetable. But it’s not contemplated in our guidance, if that’s what you’re asking.

Peter Benedict – Robert W. Baird

Okay. And then when we think about the IP&E initiatives, there’s seven categories pilot today. How long have they been in pilot, and when we think about 2011, does it go to all categories, or how is the rollout of this going to look?

Nicholas Canter

Peter, this is Nick Canter. Good morning. We started piloting seven of these subcategories beginning early October—late September, early October We’ve been working on the project for quite some time. There’s many legs to this initiative. The clustering tools and assortment planning tools that are in pilot today will start a full rollout in early 2011, and we will hope to roll all those clustering and assorting tools to all merchandise divisions during the year. The other pieces to that, such as the financial planning, the store layout planning, and thus, will be subsequent projects after that.

Peter Benedict – Robert W. Baird

Great. Thanks, Nick.

Nicholas Canter

Thank you, Peter.

Robert Niblock

I think we’ve got time for one more question.

Operator

Our final question comes from the line of David Strasser with Janney Montgomery Scott.

David Strasser – Janney Montgomery Scott

Thank you very much. I have two questions – one regarding inflation and one regarding big ticket trends. The first one on inflation, you guys with Lowe’s global sourcing obviously have a pretty good read into what’s going on over particularly in China, if not all of Asia. What are you seeing there from that trend across your various product segments—taking our lumber, obviously, from an inflation standpoint as you head into 2011?

Robert Niblock

Dave, this is Robert. If you’re taking out lumber, yeah, you probably are going to see some slight inflation trends. You’re seeing a lot of increase in commodity prices that are out there. We are starting to hear, particularly on the wage front in China and Asia and those other areas, that there’s probably going to be fairly strong wage inflation. You know, in the short term, I think basically all of our contracts are denominated in U.S. dollars, but certainly as you’re doing your re-buys and redoing those contracts, then certainly there will be some inflation that will creep in. So yeah, as you look at it over the next several quarters, you probably will have some slight positive impact on comps as it pertains to inflation.

David Strasser – Janney Montgomery Scott

So what you’re basically saying, though, is even as this inflation comes, you’re pretty confident that you could pass through sort of that inflation, that type of Asian wage inflation, to your customer.

Robert Niblock

At this point, yeah, we think that we should be able to pass all or the majority of that through.

David Strasser – Janney Montgomery Scott

Okay, great. Thanks. And the second question – you talked about big ticket being up for the quarter. I’m just getting a sense as the home buying credit expired, which seemed to have a fairly positive impact across a lot of parts of retail, did you see that have an impact on that trend throughout the quarter, or how did that trend as we went through the quarter, the bigger ticket?

Robert Hull

Not much changed during the quarter. That big ticket, higher average comp was driven by the appliances, as Nick talked about, the patio furniture and grills – less markdowns there. So that contributed to big ticket performance relative to last year, and the last piece of that was inflation in lumber build materials. So all of that was fairly consistent throughout the third quarter.

Robert Niblock

David, also we talked about the strength in our commercial business and our installed sales business driven by some of the investments that we made last year heading into this year with our district commercial accounts specialist and our project specialist exteriors which focuses on installation of those key exterior projects around the home. And as you know, both of those businesses generally run a higher average ticket. So a little bit of remixing there between that and our retail business would have also helped that as well.

David Strasser – Janney Montgomery Scott

All right, thanks. That was great. Thank you very much.

Robert Niblock

Thanks, and as always thanks for your continued interest in Lowe’s. We look forward to speaking with you again when we report our fourth quarter results on February 23. Thanks and have a great day.

Operator

Ladies and gentlemen, this does conclude today’s conference. Thank you all for participating, and you may now disconnect.

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