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

Q2 2014 Results Conference Call

August 20, 2014 9:00 AM ET

Executives

Robert Niblock – Chairman, President & CEO

Rick Damron – COO

Bob Hull – CFO

Mike Jones – Chief Customer Officer

Analysts

Eric Bosshard – Cleveland Research Company

Alan Rifkin – Barclays Capital

Aram Rubinson – Wolfe Research

Brian Nagel – Oppenheimer & Co.

Chris Horvers – JPMorgan Chase & Co.

Matt Fassler – Goldman Sachs

Peter Benedict – Robert W. Baird & Company, Inc.

Jaime Katz – Morningstar, Inc.

Operator

Good morning, everyone, and welcome to Lowe's Companies second-quarter 2014 earnings conference call. This call is being recorded.

[Operator Instructions].

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. Rick Damron, Chief Operating Officer; and Mr. Bob Hull, Chief Financial Officer. I will now turn the call 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 solid results for the second quarter. Comparable sales were 4.4% with an increase in comp transactions of 3.1% and an increase in comp average ticket of 1.3%.

As expected, we recovered most of the outdoor product sales missed in the first quarter due to unfavorable weather conditions. But discretionary interior projects did not perform as well as expected. Outdoor product sales were strong with a roughly 6.5% comp for the quarter while indoor comps were roughly 3%.

All 14 regions had positive comps for the quarter; likewise, all 12 product categories had positive comps. We saw a particular strength in lawn and garden during the quarter and the outdoor living experience we discussed on our first-quarter earnings call drove success in patio furniture and accessories.

While seasonal categories were strong we also saw strength in millwork, paint and tools and hardware which were all above the Company average. And we saw solid performance in line with the Company average in fashion fixtures, flooring and lumber and building materials.

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 fifth 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 20 basis points and we effectively controlled expenses delivering 67 basis points of operating margin expansion and earnings per share of $1.04, an 18.2% increase over last year's second quarter.

Delivering on our commitment to return excess cash to shareholders in the quarter we repurchased $1.1 billion of stock and paid $183 million in dividends. As we look at the backdrop for the second half of 2014, economic forecasts suggest continued strength in the home improvement market as employment, income and consumer spending levels continue to improve. At the same time signals from the housing market appear mixed as home values have increased moderately while existing home sales in total have declined this year.

However, when distressed sales are omitted from the data, which we believe is a more appropriate indicator of the long-term health of our industry, existing home sales have seen a slight increase through the first half of the year revealing a more positive and sustainable trend. In light of the positive trajectory of these factors we believe home-improvement spending will continue to progress in tandem with strengthening job and income growth.

This also aligns with recent consumer confidence ratings in our second quarter consumer sentiment survey which revealed that homeowners' views around personal finances and home values continue to improve. Consumers are indicating stronger intentions to complete a home-improvement project with most of them planning a specific project in the next 3 months. And while most of these planned projects are still small ticket we are seeing a rise in homeowners planning big-ticket projects.

Plans we have in place to support our continued top-line growth, our enhanced sales and operations planning process will help us capture seasonal opportunities in the second half of the year. We also remain focused on improving our product and service offerings for the pro in order to drive sales for this important customer. And we will continue to build the customer experience design capabilities that differentiate Lowe's from other home-improvement retailers.

Continued improvement in the macroeconomic landscape together with our strengthening execution, strategic priorities and keen focus on productivity and flow through give us confidence in our business outlook for 2014. Before I close I would like to thank our employees for their hard work in achieving this quarter's solid results and for their continued dedication to serving customers while we further transform our business. Thanks again for your interest and with that let me turn the call over to Rick.

Rick Damron

Thanks, Robert, and good morning everyone. As Robert shared with you we generated positive comps across all regions and product categories as we continue to capitalize on an improving macro backdrop through our enhanced sales and operations planning process, improved relevance with the pro and develop customer experience design capabilities.

Our lawn and garden category experience the strongest growth among our seasonal categories even over strong growth in the second quarter of last year. Customers shopped our compelling offering of live goods as they took advantage of improved weather to spruce up their yards.

Likewise, we grow growth in outdoor power equipment to over double-digit growth in the second quarter of last year with great national brands like Husqvarna, John Deere and Troy-Bilt supplemented with the launch of our Kobalt line of battery-powered handheld outdoor power equipment. Within our seasonal living category patio and outdoor fashion products topped their solid first-quarter results generating double-digit positive comps and better-than-anticipated sell-through. This strong performance offset softness in the window air conditioners in the north which has experienced cooler-than-normal summer.

The strength in patio and outdoor fashion is a testament to the outdoor living experience we rolled out over two-thirds of our stores in advance of the spring selling season. We removed 15 bays of steel racking to create a showroom feel with about 35% more open space, which is made possible by our larger store format.

To help customers envision and create their outdoor space the experience in product purchasing we displayed 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. The outdoor living experience is one example of how a dedicated customer experience design team is working with customers to better understand their purchase drivers and based on these insights is designing an entire experience just from inspiration to purchase and enjoyment.

Other categories showing particular strength in the quarter included millwork, paint and tools and hardware. In addition, fashion fixtures, flooring and lumber build materials had solid performance in line with the Company average.

Fashion fixtures, flooring, lumber and build materials and millwork benefited from customers' increasing interest in refreshing both the interior and exterior of their homes and our in-home project specialists are simplifying the process by guiding customers through inspiration, design and installation. While we already have project specialists that focus on the exterior of the home available across all US stores, we continue to expand our interior project specialist program. Customers have responded very positively to these programs and we are pleased with their performance.

The paint category, particularly deck stains and exterior paints including newly launched Valspar Reserve, performed well as customers took advantage of better weather to refresh the outside of their homes. We introduced Valspar Reserve exterior and interior paints at the end of the first quarter to appeal to both DIY and pro customers and our sales to both customers have exceeded our expectations.

Within tools and hardware our enhanced sales and operations planning process help us drive strong power tools performance with great holiday values. And we are improving our attachment of fastening and repair products to sales of lumber and build materials.

As Robert mentioned, our pro business continued to perform well. In fact, pro services comps outpaced the Company average for the 12th consecutive quarter, increasing customer willingness to complete refresh projects coupled with our strong product offering led to notable pro sales strength.

We will continue to invest in our core product and service offering for pros, a segment that is growing faster than the rest of the home-improvement market. We are working to ensure we have the right products and brands pros demand and the inventory depth required to help pros complete their jobs.

We also strive to provide pros with great service that makes doing business with us as quick and as convenient as possible. So we continue to reach out to them through multiple channels whether they're in-store where we have dedicated specialist to answer questions and dedicated loaders to help them get back to the job quickly, or at the pro's place of business where our account executives help regional maintenance, repair and operations customers order and replenish products across multiple stores, or through our national account representatives who assist customers doing business with Lowe's across the country, or online where we are also committed to providing great service to pros.

During the quarter we began the relaunch of www.lowesforpros.com, a dedicated platform for pros to purchase online from Lowe's. This site will provide pros useful functionality such as tools to develop requisition list and views of their purchase history as well as customized product catalogs. And the site can be integrated with purchasing systems pros use to manage their business to further streamline their day-to-day operations.

The site is currently being tested with a select group of pro customers and we received positive feedback on the site's flexibility and ease-of-use. We will expand our test group and continue refining the site with a goal of a broad-based release by yearend.

In addition to our efforts to drive top-line growth we are focused on driving productivity and profitability. And we have made good progress in the second quarter as we leveraged payroll and inventory.

Just over a year ago we added an average of 150 stores per week to the staffing model for nearly two-thirds of our stores in order to improve close rate by increasing the proportion of selling hours during high traffic weekday times. This year we are optimizing this investment by better aligning hours with customer traffic. This allowed us to meet second-quarter customer demand with only a slight increase in payroll hours relative to the second quarter of last year resulting in roughly 10 basis points of payroll expense leverage.

Similarly, last year as part of our value improvement initiative we reinvested our inventory to provide greater depth of high velocity items and drive up quantities. This year we have held inventory per store roughly constant in the second quarter even while increasing comps sales.

We are pleased with the progress we are making this year on productivity and operating profitability and we will continue to look for ways to make further progress. As we have shared with you previously, our enhanced sales and operations planning process has enabled us to improve seasonal planning including the cadence of inventory allocation, staffing, associate training and marketing. This year the process helped us stay connected on the inventory and staffing needed to recover sales while ensuring we address key summer holidays including Memorial Day and July 4 and home-improvement occasions such as maintaining lawns and gardens and refreshing patios.

Entering the second half of the year we will use the same process to ensure we are prepared to address a new set of customer needs for the fall such as planting, home winterization and exterior maintenance. Then as winter arrives we will help customers refresh their homes for holiday guests, decorate and organize their home after the holidays.

Over the next few months as appropriate by climate zone you will see us repurpose this space used for outdoor living experience to focus on products used for fall cleanup outdoor power equipment such as leaf blowers, to clear yards, seeding, fertilizer and ultimately holiday decor. Our focus will be on using this space to provide the inspiration, guidance, products and service that customers need to tackle the projects that are relevant for each micro season.

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

Bob Hull

Thanks, Rick, and good morning everyone. Sales for the second quarter were $16.6 billion, an increase of 5.7% driven by comp sales and Orchard Supply Hardware. Total customer transactions increased 5.6% and total average ticket increased one-tenth of 1% to $65.65.

As previously discussed, the Orchard stores have more transactions per foot but fewer per store and a lower average ticket than a traditional Lowe's store. So while Orchard aided total sales by approximately 100 basis points and added roughly 220 basis points to our total transaction growth, it negatively impacted total average ticket growth by approximately 115 basis points. The Orchard stores are considered non-comp but will be included in our comps sales calculation after the anniversary of the acquisition in Q3 2014.

Comps sales were 4.4% for the quarter. Looking at monthly trends, comps were 4.7% in May, 4.6% in June and 3.7% in July. As a reminder, in last year's second quarter July had the highest comp at 11.3%.

For the quarter, comp transactions increased 3.1% and the comp average ticket increased 1.3%. As you have heard discussed we recovered most of the outdoor product sales missed in the first quarter due to unfavorable weather conditions as evidenced by our roughly 6.5% comp in exterior products categories. However, interior categories at approximately 3% comp performed lower than the Company average.

Year-to-date sales of $30 billion were up 4.2% versus the first half of 2013 driven by a 2.8% increase in comp sales, the addition of Orchard and new stores. Gross margin for the second quarter was 34.55% of sales which increased 20 basis points over Q2 last year and is up 62 basis points on a 2-year basis. The increase was driven primarily by value improvement; year-to-date gross margin of 34.98% of sales, an increase of 42 basis points over the first half of 2013. SG&A for Q2 was 21.33% of sales which leveraged 40 basis points. Bonus expense leveraged 28 basis points due to lower expected attainment levels relative to last year.

Also in the quarter we experienced leverage in store payroll and advertising largely as a result of the sales increase. These items were somewhat offset by employee insurance which deleveraged 17 basis points, primarily a result of the Affordable Care Act which drove a 10% increase in enrollment.

Year-to-date SG&A was 22.87% of sales which leveraged 17 basis points from the first half of 2013. Depreciation for the quarter was $375 million, which was 2.26% of sales leveraged 7 basis points compared to last year second quarter as a result of the sales growth.

In Q2 earnings before interest and taxes, or EBIT, increased 67 basis points to 10.96% of sales. For the first half of 2014 EBIT was 9.62% of sales, which was 60 basis points higher than the same period last year.

For the quarter interest expense was $126 million and deleveraged 6 basis points to last year as a percentage of sales. The effective tax rate for the quarter was 38.6% which was higher than last year's 37.5%. The higher rate, which was consistent with our expectations, was a result of tax programs that expired at the end of last year.

Net earnings were just over $1 billion for the quarter, an increase of 10.4% over Q2 2013. Earnings per share of $1.04 for the second quarter were up 18.2% to last year.

For the first 6 months of 2014 earnings per share of $1.64 represented a 20.6% increase over the first half of 2013.

Now to a few items on the balance sheet starting with assets. Our cash and cash equivalents balance at the end of the quarter was just over $1 billion.

Our inventory balance of $9.3 billion increased $209 million, or 2% versus Q2 last year. The majority of the increase was driven by the addition of the Orchard stores.

Inventory turnover was 3.74, up slightly over last year. Asset turnover increased 10 basis points to 1.63.

Moving on to the liability section of the balance sheet, accounts payable of $6.2 billion represented a 9% increase over Q2 of last year caused by the timing of purchases year-over-year. At the end of the second quarter lease adjusted debt to EBITDAR was 2.07 times. Return on invested capital increased 199 basis points for the quarter to 12.61%.

Now looking at the statement of cash flows, cash flow from operations was $3.9 billion, an increase of $567 million over last year largely due to working capital as well as growth in net earnings. Capital expenditures were $384 million, a 2% increase over last year.

Year-to-date free cash flow of $3.5 billion was 19% higher than the first half of 2013.

In May we entered a $750 million accelerated share repurchase agreement. At this point we expect to receive approximately 15.9 million shares but the ultimate number of shares will be determined upon the completion of the program in the third quarter.

We also repurchased approximately 8.1 million shares for $380 million through the open market. In total we repurchased a little more than $1.1 billion in the quarter. We have approximately $4.3 billion remaining on our share repurchase authorization.

Looking ahead let me share our business outlook. We expect a total sales increase of approximately 4.5% driven by a comp sales increase of 3.5% and the opening of 10 Home Improvement stores and 5 Orchard locations.

Our sales outlook is modestly lower as a result of our year-to-date performance. However, our improved flowthrough assumptions allowed us to maintain our prior EBIT expectations.

We are anticipating an EBIT increase of approximately 65 basis points and expect that the improvement will come from both gross margin and expense leverage. The effective tax rate is expected to be 37.2% for the year. We expect earnings per share of approximately $2.63 for the year which represents an increase of 22.9% over 2013.

We are forecasting cash flow from operations to be approximately $4.1 billion. Our capital plan for 2014 is approximately $1.2 billion. This results in an estimated free cash flow of $2.9 billion for the year.

We expect to issue incremental debt during the year as we manage to the 2.25 times lease adjusted debt to EBITDAR target. Our guidance assumes approximately $3.4 billion in share repurchases for 2014.

Kim, we are now ready for questions.

Question-and-Answer Session

Operator

We are now ready for questions. [Operator Instructions]. Okay. Thank you. Our first question comes from Eric Bosshard with Cleveland Research Company.

Eric Bosshard – Cleveland Research Company

Good morning.

Robert Niblock

Good morning, Eric.

Eric Bosshard – Cleveland Research Company

Curious on your thoughts on market share performance. Obviously a lot of thing going on in merchandising and leadership changes within that. I'm curious in how you are seeing the progress there and how you expect that to play out as we move forward?

Robert Niblock

I'll start and talk about it, Eric. Then we've got Mike Jones in the room and he can jump in as well. Certainly there has been a lot of changes in the organization. But I feel really good about the transition. Greg retired earlier in the year. Long-tenured employee, done a phenomenal job for the organization.

Mike has jumped right in without missing a beat. I think that Mike and Mike McDermott who is now our Chief Merchant, both working hard to try and dissect on a category-by-category basis where we have opportunity, where we see particularly with where our stores are located with the way we go to market, our ability to try and develop better customer experiences. And also as we've mentioned several times, the strength that we are trying to go after with an opportunity with the pro customer, opportunity to get the brands we need, obviously depth of inventory, the things we've talked about that we've improved in the past.

So we see a significant amount of opportunity as we have said. Pro continues to lead the overall comp. We see that continuing in the back half of the year as we continue to work with our sales and ops planning process to dive into some of the categories we are dissecting on a category-by-category basis where some of that opportunity is and we've got plans in place to go after it.

Won't fix it all within the next quarter or 2. But over the balance of the next few quarters we think we've got a lot of things that will help drive sales.

Mike?

Mike Jones

Good morning, Eric. Yes. I’d add to that. At a high level, we feel real good about continuing to drive the top line and drive growth for the Company. We feel real good about the engagement of our merchandising team.

We love the merchandising tools that have been deployed. We feel very good about our vendor partnerships. When we look at market share it is category by category, as Robert mentioned.

We do see some choppiness in the way the industry continues to get forecast. So we watch it very closely and again we look category by category to ensure that we feel comfortable that our plans are delivering growth.

Eric Bosshard – Cleveland Research Company

All right. I guess a follow-up. When you think about the changes that you are making, and I appreciate Robert that it's not the next quarter or 2, but when do you think you do have your best and brightest merchandising strategies in place implemented? When can we start to look for that to really be in place and gaining traction with the customer?

Robert Niblock

I’d say we’ve done a lot of foundational work over the past couple of years with the depth of inventory and the job lot quantities, those type of things for the pros. We kind of threw that whole massive value improvement process which was the original line of [inaudible] where we cleaned up the inventory.

We've got some key things we're working on from a website standpoint to improve the functionality of our website that will be delivered in the next 12 months. And then things like our outdoor living experience that we rolled out this year. That's where you are start to really see the organization come together to deliver something different and better in-store than the way we went back to market previously.

And they're continuing to go through and figure out based on working with Mike and his team, where the opportunities where we can put our resources to plays that will resonate in the greatest way with the customer. Obviously for competitive reasons we are not going to talk about what is coming along those lines.

But I think when we look at what we are doing with the pro customer, what we are doing on the brand side, the fact that we are through the line review process, I think over the next – and what we are doing from the website – I think what you're going to see over the next 12 months, you will see some pretty significant improvements in our execution above and beyond what we've already been working on.

Eric Bosshard – Cleveland Research Company

Great. Thank you.

Robert Niblock

Thanks, Eric.

Operator

Thank you. And our next question comes from Alan Rifkin with Barclays Capital.

Alan Rifkin – Barclays Capital

Thank you very much. So you’ve kept your earnings guidance the same despite taking down revenue slightly both on a comp basis and total for the year. Bob, can you just provide a little bit more clarity as to where on both the gross margin and SG&A line you are anticipating seeing the incremental leverage that you can maintain the earnings guidance?

Bob Hull

Sure, Alan. So as we think about the outlook for the year we have maintained it at 65 basis points. We do expect roughly the same level of gross margin improvement that we previously expected.

We will get a little bit better performance on expense leverage. As you have heard us talk about in prior years we are really focused on productivity and profitability on a number of fronts. And that is showing up in 40 basis points of SG&A leverage in Q2 even with 17 basis points of headwind due to the Affordable Care Act.

As we think about the second half we will drive further expense leverage going into the year. So we feel good about that. So the change is more on the expense leverage side than the margin side for the second half of the year.

Alan Rifkin – Barclays Capital

Okay, thank you. And one follow-up, if I may. Is there any discernible difference between the performance of your stores by class of the year with respect to the comp? Are more recently opened stores comping above the corporate average, or where do we stand there? Thank you.

Bob Hull

So Alan, generally speaking we don't see a material difference in comp performance based on year of opening. What we do see is stores within markets performing roughly similar. So it's local market economics, the local economy and the state of local housing are more impactful to a store's performance versus the year they opened.

Alan Rifkin – Barclays Capital

Okay. Thank you.

Bob Hull

Thank you, Alan.

Operator

Thanks. Our next question comes from Aram Rubinson with Wolfe Research.

Aram Rubinson – Wolfe Research

Thanks. A couple of things. One, I'm hoping you can give us a little bit of clarity on the Australia business, where you are strategically with that and how that impacts the P&L? Because I am pretty sure there are some losses that are incurred there.

And then the second question is on the distribution side, most companies that we talked to have kind of changes going on on the distribution side whether it's for e-commerce or for something else. You guys have always had a very established and very advanced distribution network but I don't think we have heard a lot about it. So would you mind giving us an update to see how that is going to stay a competitive advantage for you as your peers make progress there too? Thanks.

Robert Niblock

It’s Robert. I'll start on the Australia question and we’ll let Rick and Bob follow-up on the distribution. On the Australia question, we've got 49 Masters stores open as of the end of their fiscal year which was the end of June, as you know. That's 49 stores. I think they've been open a little less than 3 years.

So getting a great foothold there. We also bought another business there called Danks that now [trends are] [ph] in the home, timber and hardware group that was bought about time we started the joint venture. And it really does distributors to a lot of the independents in the area, there's about 400 or so independent stores they distribute to but they also have 28 company-owned stores.

So we've gotten a good foothold. I think the initial receptivity of the business has been good. Obviously as is the case any time you open up a new concept in the market there is the competitive response that normally takes place.

And when you are taking a business from greenfield growing up, growing the business making sure that you are being able to staff and grow that business. So what the joint venture decided to do is they are slowing down slightly the new store growth to allow a little bit more maturity in being more targeted and strategic in where those new stores will go so that we will have a little less cannibalization on existing stores and more in the markets that are underserved.

So they are pulling back to about a 10 to 15 stores per year over the next few years. Previously it was closer to about 20 stores a year.

So we are still excited about the opportunity there. There's a lot that we bring to with our global sourcing and private label brand capabilities. And from a financial standpoint, the losses from that obviously it's an equity investment so it runs through the P&L as a separate line item, it's not – operations aren't consolidated because we only have one-third of the operations.

Aram Rubinson – Wolfe Research

And the dollar amounts that are run through it each quarter for that?

Robert Niblock

I don't think we speak for…

Bob Hull

We haven't spoken directly to that, Aram. You can take what Masters reports so since we are a minority participant we will let our majority partner speak for the business.

But you can take what they report on the Home Improvement business and infer what the impact to us is. It is a couple cents per share this year.

Aram Rubinson – Wolfe Research

Okay. Thank you.

Rick Damron

And this is Rick. I'll give you an update on the distribution teams. First, let me say extremely proud of what both our supply chain and stores were able to accomplish in the movement of goods and making sure that we had products available for the customer during Q2 during our most volatile time of the year from a seasonal standpoint. The teams did a phenomenal job in making sure that we had products for the customer.

Second, I would say Aram, as you mentioned we have a world-class distribution center that is it was stood up to supply our brick-and-mortar stores and we have been over the last several years continuing to look for ways to optimize that channel to really be able to deliver our omnichannel experiences. So a couple of the changes that we have made over the past year, one being our ability to offer flexible fulfillment to our customers and through our stores. Flexible fulfillment allows us the capability to ship from 35 of our – excuse me, 54 of our stores as well as all of our distribution hubs and nodes direct to consumer on parcel product that allows us to better leverage that inventory and drive greater flexibility there.

The teams continue to work on driving productivity both in the distribution center itself as well as in trends particularly in cube throughput. So as we look at Q2 the teams were able to really offset a lot of the incremental costs in fuel with greater productivity and greater cube movement through the distribution center.

We continue to look for ways to optimize what we stock and maintain in our network versus what we used to crossdock and what we flowthrough as a crossdocking channel. And we feel comfortable that we have optimized that spend in a way that those products flow through the alternate channels.

And then we continue to look for new ways to meet the customers' demand in the future through supply chain strategy improvements. So we have a lot going on but we feel comfortable with where we are and pleased with the performance we are getting out of the network.

Aram Rubinson – Wolfe Research

Is that all? No, I'm just kidding, that sounds great. Thanks for the help.

Robert Niblock

Thanks, Aram.

Aram Rubinson – Wolfe Research

Yes.

Operator

Thank you. Our next question comes from Brian Nagel with Oppenheimer and Company.

Brian Nagel – Oppenheimer & Co.

Hi, good morning.

Robert Niblock

Good morning, Brian.

Brian Nagel – Oppenheimer & Co.

So, I wanted to maybe dive a little deeper into the comment you made regarding the discretionary interior projects which were somewhat weighed upon your sales here in Q2.

First of all maybe describe more specifically what that is. Is it a specific category that caters to interior? Did you see any differences geographically? And do you think it was more a function of the overall environment competitively or something Lowe's did?

Robert Niblock

Yes. As we said, over all we had a lot of interior categories that performed well during the quarter but we did see some weakness in a couple areas. One of them, as you know, we give comps for kitchens and appliances area, when you dive down within appliances we were going up against an incredibly strong comp last year.

We were high teens comps last year in the second quarter. So when you look at our performance over 2 years we were still average double-digit comp over that 2-year period. So that was obviously something that was a little bit of a challenge in the second quarter.

It was a competitive environment out there for major appliances and tough numbers we were going up against. We also saw air conditioners with the summer, as Rick mentioned in his comments not being as warm as what we had expected, air conditioners sales were a little weak in July.

And then a couple of parts of flooring were a little weak in the quarter. So those were some areas that we saw some weakness in from the consumer, all of which we are looking at and trying to determine how we get better performance in those in our share of the opportunity as we head into the back half of the year.

Brian Nagel – Oppenheimer & Co.

So, on the flooring specifically, the 3 you mentioned, is – do you think that's more of a competitive issue, or is it more a function of the environment?

Mike Jones

Hi. If I can jump in. Just a couple of things. Just to put a finer point on the appliance discussion, we saw certainly high teens comps in major appliances specifically second quarter of last year. And if you take a look at our 2-year performance on major appliance we see double digits.

So it's actually performing very well. That said we have profiled a little more strength in appliances as well as AC, certainly, and I would add flooring to that as well.

To answer your question on flooring, we see very good performance in tile. We see very good performance in carpet. We see a little pressure in wood.

And laminate and we think part of it is industry. We think part of it is is that the competition has caught up with some of the first-to-market innovations that we launched last year. And our merchandising team continues to look at new first-to-market innovations that we can launch going forward.

Brian Nagel – Oppenheimer & Co.

Got it. Got it. Thank you. And then maybe just one follow-up. On the guidance, you've modestly lowered the guidance for the year. Just to be clear, the way the press release reads, and I think your comments and your prepared remarks set too, that's really a function of sales in Q1 and Q2. Your internal sales plan for Q3 and Q4 remains the same?

Bob Hull

That is correct, Brian.

Brian Nagel – Oppenheimer & Co.

Thank you.

Bob Hull

Thank you.

Operator

Thank you. Our next question comes from Chris Horvers with JPMorgan.

Chris Horvers – JPMorgan Chase & Co.

Thanks, good morning. Also wanted to follow up on the guidance.

So in the first half of the comp just under 3% and then in 2Q you comped 4.4% with the seasonal business up 6.5% and bringing that number out. So 2 related questions.

What do you think the seasonal recapture was in 2Q and as we try to think about what the underlying comp trend is to give us some light to that? And then what gives you the confidence that you can hit that 4% to 4.5% implied comp in the back half? Thanks.

Robert Niblock

I’ll start and then – this is Robert. And then I’ll have Bob jump in with any additional color. The pickup from Q1 impact was probably about 150 basis points going in to Q2. But as we did say with Q2 was our strongest comp performance last year, particularly strong as we just talked about in major appliances and the performance we had with our team comps for the quarter in major appliances last year.

We also talked about the weakness that hit the second quarter with regard to ACs, and that was a little bit of a drag on second quarter particularly in July's performance. As we look to the back half of the year and we normalize all of that, as we look at easier comparisons over the back half of the year, as we look at, as I said in my comments, continued acceleration that we see, growth over the back half of the year and employment income growing, home price appreciation hanging in. The FHFA forecast for home price appreciation is pretty much the same this year as it was last year.

And as I mentioned, once you normalize for distressed sales, a continued slight improvement in the housing turnover rate, we see – and everything we are doing that we've been talking about so far on the call, we are trying to continue to strengthen our execution. We look at the macro landscape, pull that together. We think that our back-half forecast is still reasonable from a top line standpoint.

So to the point, yes, we adjusted for where we are at for the first half of the year, but we still feel confident on what we are seeing – or what we think we can deliver on the back half of the year.

So, Bob?

Bob Hull

The only thing I would add is, so as Rick mentioned in his comments, we have seen great progress with pros for 12 consecutive quarters. But as you've heard us describe, there's still a lot a focus in that area and we expect continued traction and momentum in the second half of the year, which gives us confidence in our second-half outlook.

Chris Horvers – JPMorgan Chase & Co.

Is there something particularly on the pro, a certain initiative perhaps that you can point to, or is it just the continued improvement across the store in terms of close rates and more focus gaining traction?

Mike Jones

Sure. This is Mike Jones. A couple of things. First if you look at our 3 business areas, our building and maintenance business area was above the average, so that is very encouraging. We are continuing to see better traction.

We are seeing improvements in brands and we have returned some brands back to Lowe's, heavy coatings would be an example. We expanded our lineup of Lenox and Irwin. Certainly our Bosch brand continues to do well, DeWalt does very well. So that feels very encouraging. The team continues to work that very hard.

Our depth of inventory continues to improve. And we have made the necessary inventory trade-off decisions so that as we become more relevant with pros you don't see the pressure in the balance sheet.

So we are making those trade-offs so that we can better serve the pros and still protect our operating performance. And then the last piece I would say is that our pro selling team is doing an excellent job, excellent job, out engaging our pros and helping us build those relationships we need to continue to grow that business.

Rick spoke about Lowe's for Pros, which is our portal designed specifically for pros to help us transact with them, help us make doing business with us easy for them and frankly help them drive productivity in their own businesses. So we are very encouraged by the work that we see with pros and we continue to build on it.

Rick Damron

Yes. Chris, this is Rick. I’d just like to reiterate a point that Mike made. I think what we are continuing to see and feel comfortable with is the initiatives that we put in place over the past 18 months regarding both the organizational design to enable our stores, our field teams as well as our national teams to really meet the needs of the customer and the way that they need service.

And then you look at the value statements that we have made whether it be through inventory or whether it be through our contractor pack programs the merchants are driving or our proprietary value prop initiatives, continue to respond very well with the pro. As a matter of fact, when you look at Q2, our pro applications grew 23% over last year so we continue to see the pros respond very well to the initiatives that we've got in place.

As Mike said we continue to work on brands and inventory depth where needed to continue to maximize that opportunity. But we feel good with where we are and we feel very good with the way the pro is responding to the actions we have taken.

Chris Horvers – JPMorgan Chase & Co.

And then just related to that, so can you talk about close rates in the store? I know you added the value improvement, the resets are done and fully reset and labor hours are now in there. So can you talk about close rates as well? Thanks very much.

Bob Hull

So Chris, we have done all of the above to focus on improving close rates. What we've seen through the first half of the year is roughly 100 basis point improvement in close rates. So we feel good about progress we are making but we know there's still work ahead of us.

Rick Damron

And Chris, I’ll just add. This is again. And I think as a testament to what we've done there you look at the fact that we were able to leverage our payroll costs during the quarter increasing our sales per hour by 4%. And even when you look at the first half in totality even with the soft Q1, we were still able to increase the sales per hour work by 3.5%, so we feel the initiatives that we have put in place is working.

As Bob said, we are seeing roughly 100 basis point of close rate improvement. And we will continue to refine how we schedule, how we staff our stores to make sure that we are meeting our traffic patterns and the needs of the customers as they enter.

Chris Horvers – JPMorgan Chase & Co.

Thank you.

Rick Damron

Thanks, Chris.

Operator

Thank you. Our next question comes from Matt Fassler with Goldman Sachs.

Matt Fassler – Goldman Sachs

Thanks a lot and good morning to you. I'd like to try to connect the dots a bit between Robert some comments you made about doing some work on the online piece and talking about your interior projects. Where do you think you sit in terms of customers researching projects and leading in through online? Are you where you want to be, or do you see that as an opportunity for the business?

Robert Niblock

So, certainly. I said from interior products we talked about part of that being the tough comp compare we had for major appliances specifically and highlight a number of interior areas that are doing well. I think from an overall online standpoint we did make progress with the website.

There's things like delivery scheduling and those type of things that we need to get work on so it makes it a better, easier experience for the customer. But we are seeing a great transaction growth online on the website. We’re still seeing an overwhelming majority obviously of what is transacted online translating to either pick up in-store or the store delivering.

So the kind of the omnichannel aspect of it is working together really well and certainly with the customers online in many cases they made the buy it online, pick it up in-store, or they may be – and maybe they want to ensure that that product is available when they get to the store.

And then in many cases they are also shopping in the store and they're getting add-on sales on top of that. So I think there is still – we know that there's still a significant amount of influence sales coming from what's happening online but the world is changing at a fast pace.

Technology is changing. We know that we've got to continue to improve our online experience and that's what Mike and his team are working on.

Matt Fassler – Goldman Sachs

Got it. And then secondly, I'm not sure if you touched on this in your comments, you spoke a lot in thinking about your sales outlook about the macro factors and where they are evolving through the second half of the year.

I guess you exited the quarter looking at July as kind of a subdued one-year comp but on a 2-year basis pretty consistent with where you were through the quarter, which was pretty good relative to trend. How is your quarter-to-date experience impacting your sales thinking and is it consistent with the numbers that you have out there?

Robert Niblock

Yes, we feel good about our start to August and particularly in light of the fact that when we look at, once again it's from a 2-year compare standpoint, August last year is our toughest comp comparison we are going up against. So we feel good about the way we started the quarter in line with what our guidance is for the back half of the year, Matt.

Matt Fassler – Goldman Sachs

Thank you so much, guys.

Bob Hull

Matt, one other point I would make as we think about impact of air conditioners. It had about a 30 basis point negative impact for the quarter and had about a 60 basis point negative impact for July. So that is a headwind in July that will not carry towards the back half of the year.

Matt Fassler – Goldman Sachs

Understood. Thank you so much.

Bob Hull

Thank you.

Operator

Thank you. Our next question comes from Peter Benedict with Robert Baird.

Peter Benedict – Robert W. Baird & Company, Inc.

Hey, guys. Thanks. Just a quick question. Bob, you spoke about all the progress you are making on the expense front. How about gross margin, just an update here on the long-term view? Do

still think that tops out around 35%, or do think you can maybe find ways to push it past that?

Bob Hull

Yes. We haven't set any arbitrary limit on what gross margin could be. I think we know we've got some work to do as a result of the value improvement and we are seeing that play out in both in terms of gross margin improvement experienced in 2013 and 2014.

As we have talked about we created the process to bring more formality and rigor to the process. We have always done line reviews. We are always going to do line reviews.

So that is not to suggest that wave 2 or wave 3 there is no benefit there. However, we also recognize that there's competitive pressures in the marketplace movement and sales by channel so we do expect to continue to make progress with value improvement.

Our long-term outlook beyond value improvement didn't suggest material increases beyond maybe 5 to 10 basis points per year. So we haven't set any arbitrary cap and we know there's still work to be done with value improvement and with other areas.

Peter Benedict – Robert W. Baird & Company, Inc.

Okay. Thanks that's helpful. Fair enough. And then just a clarification, the interior project specialist, I guess they are not available nationwide now? I guess when do you think you guys could have that capability rolled out nationally?

Rick Damron

Hey, Peter. This is Rick. As of this year we originally started this process and this program a couple of years ago. We had it test in really 3, 2.5 reasons, this past year, completed in Q1 of this year. We rolled it another 582 stores. We are looking at our rollout campaign into 2016 we see another 3 to 4 regions possibly being rolled out then. And then the remainder in 2016.

Peter Benedict – Robert W. Baird & Company, Inc.

Okay, great. Thanks very much.

Rick Damron

Thanks, Pete.

Operator

Thank you. Our next question comes from Jaime Katz with Morningstar.

Jaime Katz – Morningstar, Inc.

Good morning, thanks for taking my questions. My first question is on some of the medium-term goals that you have, which is EPS next year and EBIT and ROIC goals. Do you still feel confident that you can achieve them this far into 2014? And then if you are willing to comment on any of the rumors about Brazil that came out last week I would be glad to hear what you say.

Bob Hull

Sure, Jaime, I’ll take the long-term outlook. So we still stand by the 2015 outlook that we provided at our analyst conference a couple of years ago.

As we have talked about we are making good progress this year, specifically improvements in flowthrough on the incremental point of comp to the bottom line. Other efforts in place to further those efforts.

As you heard the team talk regarding product categories, continue to understand opportunities to take share, pro-DIY across the merch category. So we feel good about the outlook we provided for 2015.

Robert Niblock

Jamie, this is Robert. With regard to the rumors on Brazil, obviously we don't comment on specific rumors of a nature like that. I will now just reiterate what we said in the past. Our continued focus is on improving our existing operations in the US and other international markets where we are at today.

And in that light we continue in both veins to look at opportunities. But with regard to commenting on specific rumors, no we won't comment on that.

Operator

[Operator Instructions].

Robert Niblock

It sounds like we don't have anyone left in the queue so thanks for your interest in Lowe's. And we look forward to speaking with you again when we report our third-quarter 2014 results on Wednesday, November 19. Have a great day. Thank you.

Operator

Thank you. This concludes today's conference. You may disconnect at this time.

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