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Lowe's Companies (NYSE:LOW)

Q2 2007 Earnings Call

August 20, 2007 9:00 am ET

Executives

Robert Niblock - Chairman and CEO

Larry Stone - President and COO

Bob Hull – CFO

Greg Bridgeford - EVP, Business Development

Analysts

Deborah Weinswig - Citigroup

David Schick - Stifel Nicolaus

David Strasser - Banc of America Securities

Chris Horvers - Bear Stearns

Budd Bugatch - Raymond James

Mike Baker - Deutsche Bank

Matthew Fassler - Goldman Sachs

Presentation

Operator

Good morning, everyone, and welcome to Lowe's Companies second quarter 2007 earnings conference call. This call is being recorded.

Statements made by management during this call may include forward-looking statements, as such are provided for by the Private Securities Litigation Reform Act of 1995. Although the company believes the expectations, opinions, projections and comments reflected in such statements are reasonable, it can give no assurance that they will prove to be correct. A wide variety of potential risks, uncertainties and other factors could materially affect our ability to achieve the results expressed or implied by our forward-looking statements and those risks and uncertainties are detailed in the company's earnings release and other filings with the SEC.

Hosting today's conference will be Mr. Robert Niblock, Chairman and CEO; Mr. Larry Stone, President and COO; and Mr. Bob Hull, Executive Vice President and CFO. I will now turn the conference over to Mr. Niblock for opening remarks.

Robert Niblock

Good morning and thank you for your interest in Lowe's. Following my remarks, Larry Stone will review additional details of our performance and update you on a number of initiatives. Then Bob Hull will review our second quarter financial results.

First, a few highlights for the quarter. The sales environment remains challenging as home improvement consumers hesitate to take on longer discretionary projects, but the core of our business remains relatively strong as our employees continue to help consumers maintain their largest financial asset. Total sales increased 5.8% while comp store sales declined 2.6% during the quarter. Our comp store results were within our guidance range, but are certainly reflective of a weak sales environment. Despite the current environment, we continue to capture market share, gaining a full percentage point of unit share for the total store in the second calendar according to third-party estimates. Our market share gains are evidence of our focus on customers and execution of our initiatives to drive sales.

Earnings grew 9% and diluted earnings per share of $0.67, or 12% higher than the second quarter last year, exceeding our guidance. Year-to-date earnings per share of $1.15 increased 2% versus the first half of last year. Three months ago, at the end of our first fiscal quarter, I mentioned that in addition to our expectation to continue to capture market share in a difficult sales environment, our guidance for improving sales trends through 2007 was based on two primary factors: easing comparisons and a belief that the housing market and its impact on our business was at or near bottom.

When housing will bottom is certainly a topic of debate, but much of the external data received over the past three months has fallen short of analyst's mean estimate, suggesting parts of the housing market may still be in the process of bottoming. In addition, while we're not directly at risk with regard to sub-prime mortgage lending and exposure, the impact of the fallout from increasing foreclosure rates among higher-risk borrowers and tightening lender standards for all mortgage applicants is something we'll continue to watch closely.

But it's important to remember most of these housing-related factors have been regional and the impact on our business has also been regional. As we monitor our performance, we see a profoundly disproportionate impact in those markets where housing was most stretched during the past several years. For example, our two operating regions in California had double-digit negative comps for the quarter and performed worse than in this year's first quarter. As housing dynamics in California continue to get worse, our expectation is that we will continue to experience negative comps in that market through the end of the year.

But encouragingly, there are signs of improvement in certain areas of the country. Several markets in the northeast, while still comping negatively, are showing signs of improvement. Our northeast division comped above the company average in the second quarter and improved over 800 basis points versus the first quarter. Clearly, some of this improvement was attributable to better weather, so it's probably a little early to say housing pressures in the northeast are behind us, but our improving results are an encouraging sign.

The housing environment has been difficult to predict and there's a continuing debate as to when the bottom will occur. However, easing comparisons, which is the primary factor leading to our expectation of improving trends in the back half of 2007, remains. As we cycle the two-year anniversary of the 2005 hurricane season in the third quarter, the difficult comparisons we faced for the last four quarters lessened. I would like to share a few examples of the easing comparisons that are already showing up in our results.

In the first quarter of this year, we indicated that our region that includes the Gulf Coast had negative 23% comps. In the second quarter, that improved to negative 15%, and we had negative 12% comps in that region in the last week of the quarter. Still a large drag on total company comps in the quarter, but an improving trend. Many of our Florida stores are still experiencing negative comps because of the dual effect of negative housing market trends and hurricane recovery spending compares in many of those markets but we saw some signs of improvement in the quarter as the hurricane compares eased.

As we cycle the dates of the 2005 hurricanes in the third quarter, comparisons get easier and in affected areas, we anticipate a continuation of the improving comp trends we've seen so far this year. While we hope no areas of the country face the devastating affects of a hurricane this season, if a storm does hit, our stores stand ready to help residents prepare for and recover from those storms.

Also, as expected, we are cycling the headwind of significant lumber and plywood deflation. In the third quarter of 2006, we experienced deflation in wholesale prices of over 25% in lumber and over 45% in plywood. But last week's wholesale prices provided by Random Link indicated lumber was up 1% versus last year and plywood was up nearly 20%. As a result of these easing pricing pressures, comp sales in our lumber category have shown gradual improvement, increasing from negative 9% comps on a year-to-date basis to negative 3% in the second quarter and actually positive 1% in the last week of the quarter. Based on current wholesale pricing and the resulting retail market, we expect a minimum of 40-basis point drag to second quarter comps caused by deflation in these products to ease significantly in the third quarter.

We can't control the macro environment, but we are focused on executing and delivering great service in our stores to capture share. As I mentioned, we remain very aware of the macro pressures on our business, especially in certain areas of the country. Given the uncertainties in the macro environment and the continued unfavorable trends in the sub-prime market, which are pressuring consumer’s access to credit, we believe it is prudent to be slightly more cautious with our sales and earnings outlook over the balance of the year. Clearly, many external uncertainties remain, but I am confident Lowe's is well positioned to capitalize on longer-term opportunities created by the current environment.

Now Larry Stone will highlight several details of the quarter.

Larry Stone

Thanks, Robert, and good morning. As Robert mentioned, we do face some near-term challenges, but we also see some clear opportunity in today's tough sales environment. This morning I'll provide some details on the second quarter results and how we're balancing our goals for delivering results in the current environment by capitalizing on opportunities and maintaining our commitment to manage the business for the long-term.

While only six of 20 product categories achieved positive comps in the quarter, we continue to capture market share, which shows our ability to capitalize on the opportunities created in the slower sales environment. According to third party estimates, 15 of 20 product categories gained unit market share in the second calendar quarter versus the same time period last year. Highlighting a few of the outperforming categories, as weather improved in the last two weeks of the first quarter and continued into the second, our nursery sales were very strong. As a core part of the maintenance of the exterior of the home, consumers continued to purchase live plants to enhance the appearance and enjoyment of their yards. Based on the extreme weather conditions we faced in the first quarter, we expect this category to continue its strong performance into the fall season.

Favorable weather, great service, and a solid product offering drove sales of our lawn and landscape category during the quarter. The bagged goods needed to support the live nursery sales had strong comps for the quarter and watering products also had a strong performance in the quarter.

Our paint category generated positive comp sales in the quarter, driven by the solid performance of our exterior paint and stain offering. Valspar Duramax exterior paint, our high end super premium offering, had a great quarter and our Cabot and Olympic lineup of stains, two of the best stain brands available, also delivered solid results in the quarter. In addition, our performance in the seasonal categories were reasonably strong in the quarter. We effectively sold through much of our patio and gas grill inventory, maintaining above-planned gross margin in most subcategories, and we feel inventory's in good shape on seasonal products.

The only exception is air-conditioners where an unusually cool late spring and early summer in many parts of the country has impacted sales. We have plans in place to ensure a disciplined sell through process, which has been aided by the extreme heat experienced by much of the country over the past couple of weeks. The shift in AC sales from the second quarter to the third quarter helped gross margins in the second quarter, but could be a slight drag in the third quarter. We feel very good about our overall inventory position and our seasonal inventory, specifically, as we head into the third quarter.

Twelve of our 22 regions had positive comps in the quarter. We also had 684 stores that had positive comps for the quarter and 118 of those stores had double-digit comps, so clearly there are areas of the country that are delivering solid sales results. The center of the U.S., including Texas and Oklahoma up through the Ohio Valley and some of the Mid-Atlantic states never experienced the housing-driven highs and these areas continued to deliver solid comp performance. Unfortunately, many of the underperforming regions that Robert mentioned like Florida, the Gulf Coast and California had comps significantly below the average, which dragged down our overall comp.

As we've seen for the past few quarters, consumers remain cautious about taking on larger discretionary projects, including many projects offered through our installed sales and special order programs. As a result, our sales in those areas fell short of our average comp. Big ticket projects had the biggest declines, but the installed sales and special order sales components for our business also saw significant regional differences, with areas of California and Florida described before showing the largest year-over-year reduction in demand.

One encouraging sign in our installed business over the past few months has been an improving trend in detail fees for new installed projects. This is a starting point for installed projects, and while comp detail fees in total are still down, the trend is significantly better than a few months ago. We're hopeful this trend will continue and those details will turn into more project sales in the coming months.

Weakness in our installed and special order business was somewhat offset by relative strength in our commercial business customer sales. In the second quarter, our commercial business significantly outperformed the company average driven by positive comps in many of the merchandising divisions. Our comp traffic for commercial customers was positive for the quarter, which shows we continue to attract more commercial customers to our stores. Our average ticket for the commercial customer was down, but this decline was driven, for the most part, by deflation in lumber and plywood. We are confident that our programs will continue to drive favorable sales for the commercial business customer for the second half of this year.

As we've said in the past, our goal is to grow comps by driving increases in both transaction and ticket size. In the second quarter and similar to recent quarters, our transaction count held up relatively well, while our decline in comp sales was driven by a reduction in ticket size. This reduction in ticket is a reflection of fewer project sales, reduced hurricane rebuilding efforts, and lower lumber and plywood prices. As some of the pressure for average tickets fade in the coming months, specifically as we cycle hurricane spending and experience reduced pressure from lumber and plywood deflation, our feeling is we'll move closer to a balance in transactions and ticket growth. In addition, the encouraging trend I've mentioned in detail fees should aid ticket growth when and if those details are converted into project sales.

Regardless of the sales environment, our goal is to always improve our stores, our merchandising, our distribution systems, and most importantly our service to customers. Here's a few examples of how we're doing that. First, we work hard to match staffing levels to the current sales environment, ensuring we manage payroll as efficiently as possible. With our deep-seated culture of customer service, if we're going to make an error, it would be on the side of having too much payroll in the stores, versus to too little payroll for the sales we're generating. Our goal is to be well positioned to capture share in an environment that's tough for all competitors. We deleveraged payroll in the quarter by 57 basis points, but we feel confident that as sales improve, leverage on the payroll line will return, and most importantly providing a great customer experience and capturing market share.

Additionally, we continue to make significant investments in our existing store base. It's through those investments, delivering better merchandising, better store layouts, and more efficiency and adjacencies that we ensure our stores remain bright, clean, and easy to shop. But, we're constantly looking for a better process question our approach, looking to ensure minimal customer interruption, and making certain that our assumptions are driving adequate returns. As a part of this ongoing effort, in the last 12 months, we completed 128 major remerchandising projects and reset some 400,000 plus bays in our stores.

Also, we have what many consider a state of the art distribution infrastructure and supply chain, but we're constantly working to improve. Recent examples include our successful R3 and E2 initiatives, but there's others in the pipeline that will make us better at serving customer needs and more efficient at the same time. In a difficult sales environment, our supply chain infrastructure allows us to better manage inventory and react to opportunity as demand patterns change across the country.

One thing I can assure you: in my long career with Lowe's, our commitment to customer service has never been stronger. We're committed to providing the best service in the industry, which will ensure Lowe's is positioned for long-term success. We will continue to measure our customer's perception of great service with our customer-first focus program. This program measures five key service components, which customers have identified as key drivers for delivering great service and our second quarter results shows continued improvement over the second quarter of last year.

Since our goal is to be customer's first choice for home improvement, we also work hard to understand how we measure up versus the competition. Our consumer research organization conducts a quarterly survey to measure customer's perceptions on 28 different attributes versus our competition. We've seen a very positive trend in this survey over the past several years, and our most recent survey completed in July suggests customers continue to view Lowe's in a more positive light. Continuous improvement in these surveys gives me confidence that we're making the right moves to respond to the current environment and at the same time managing our stores with longer-term success in mind.

In short, the message I want to ensure is conveyed today is that we're always working to improve every facet of our business. In good times and in slower times, we're focused on making our company stronger to become the store of choice for home improvement purchases. It's those efforts to constantly improve our service to customers that helps drive market share gains and position the company for continued long-term success.

Thanks for your time this morning. I will now turn the call over to Bob Hull to provide the details of our financial results.

Bob Hull

Thanks, Larry and good morning, everyone. Sales for the second quarter were $14.2 billion, which represents a 5.8% increase over last year's second quarter. For the first half of 2007, total sales increased 4.1% to $26.3 billion. Comp sales were negative 2.6% for the quarter compared with 3.3% positive comps in Q2 2006. Looking at monthly trends, the comps were negative 1.8% in May, negative 3.6% in June, and negative 2.3% in July. In Q2, total customer count increased 8.5%, but average ticket decreased 2.5% to $68.47. For the quarter, comp transactions increased 0.5 of 1%, however comp average ticket decreased 3%. Our second quarter 2006 comp sales were aided by approximately 75 basis points as a result of 2005 hurricane activity. Cycling against last year's elevated sales caused a negative impact of approximately 75 basis points on this year's second quarter comp sales. As Robert and Larry mentioned, we experienced lumber and plywood deflation in the quarter. This deflation negatively impacted second quarter comps by approximately 40 basis points.

With regard to product categories, the categories that performed above average in the second quarter include rough plumbing, hardware, paint, lighting, flooring, nursery, lawn and landscape products, fashion plumbing, and appliances. From a regional perspective, 12 of our 22 regions had positive comp sales in the quarter. However, 4 of the 22 regions had double-digit negative comps for the quarter. Two of the negative double-digit comp regions are in California and the other two regions are in Florida and along the Gulf Coast.

Gross margin for the second quarter was 34.5%, which was 103-basis point improvement over Q2 2006. The increase in gross margin was driven by distribution efficiencies and changes of our strategy for flowing seasonal goods, a 16-basis point positive impact associated with the mix of products sold, 5 basis points lower inventory shrink as a percentage of sales, and a more rational promotional environment relative to last year.

Our new transload and coastal holding facilities contributed to our gross margin increase in the second quarter by helping us better manage imported product. We successfully delayed allocation of many of our imported seasonal products, flowing product to areas with the greatest known demand versus using forecasted demand developed weeks before products arrive in a U.S. port. As a result, we're able to sell more product for full retail and avoid some of the markdown pressures that are always part of seasonal business.

Also, our gross margin in Q2 2006 declined 32 basis points so our comparisons were relatively easy. Year-to-date gross margin of 34.7% represents an increase of 55 basis points over fiscal 2006. SG&A for Q2 was 20% of sales, which deleveraged 50 basis points driven by store payroll. For the quarter, store payroll deleveraged 57 basis points due to maintaining base staffing levels in our stores. While this creates short-term pressure on earnings, this is the right decision to maintain the high service levels that customers have come to expect from Lowe's.

In addition, rent, property taxes, utilities and other fixed expenses deleveraged due to the comp sales decline. This deleverage was offset by leverage in bonus, store service and advertising expense in the quarter. Year-to-date, SG&A is 21% of sales and deleveraged 88 basis points to the first half of 2006. Depreciation at 2.4% of sales totaled $332 million and deleveraged 24 basis points compared with last year's second quarter, primarily due to negative comp sales and the opening of 148 new stores over the past 12 months.

Operating margin, defined as gross margin less SG&A and depreciation, increased 29 basis points to 12.1% of sales. Year-to-date operating margin of 11.3% represents a decrease of 62 basis points over the first half of 2006. Store opening costs of $26 million leveraged 3 basis points to last year as a percent of sales. In the second quarter, we opened 26 new stores, including two relocations. This compares to 24 new stores, including one relocation in Q2 last year.

Interest expense at $50 million deleveraged 12 basis points as a percent of sales. This deleverage was caused by the additional expense associated with last year's bond deal and commercial paper outstanding in the quarter.

For the quarter, total expenses were 22.9% of sales and deleveraged 83 basis points. Pretax earnings for the quarter were 11.6% of sales. The effective tax rate for the quarter was 37.7% versus 38.5% for Q2 last year. Diluted earnings per share of $0.67 increased 11.7% versus last year's $0.60. For the first six months of fiscal 2007, diluted earnings per share of $1.15 were up1.8% to 2006.

In the second quarter, we repurchased 23.7 million shares at an average price of $31.68 for a total repurchase amount of $750 million. For the year, we have repurchased 45.7 million shares at an average price of $31.76 for a total repurchase amount of $1.45 billion. We have approximately $3 billion remaining authorization on our share repurchase program. Weighted average shares outstanding for the quarter were 1.52 billion, which includes 21 million shares for convertible notes.

Now to a few items on the balance sheet. Our cash and cash equivalents balance at the end of the quarter was $337 million. Inventory turnover was 4.13, a decrease of 36 basis points from Q2 2006. Our second quarter inventory balance increased 8.7%, driven by new stores opened over the past year. At the end of Q2, square footage was up 11.1% over the same period last year. At the end of the second quarter, we owned 86% of our stores compared with 84% at the end of second quarter last year. At the end of the second quarter, we had $555 million of commercial paper outstanding and our debt to equity ratio was 30.9% compared with 23.1% for Q2 last year.

Return on invested capital, measured using beginning debt and equity in the trailing four quarters was 17.4%, a decrease of 197 basis points to Q2 last year. Return on assets determined using beginning total assets and the trailing four quarters earnings was 11.9%, a decrease of 170 basis points. Year-to-date cash flow from operations was $3.1 billion, an increase of $474 million or 18% over the first half of 2006.

Looking ahead, I would like to address several of the items detailed in Lowe's' business outlook. As Robert indicated, the housing impacts are regional and we have limited visibility to the bottom for each specific market. We do expect some markets to improve, however others will get worse. In addition, we do have easing comparisons in the second half of 2007. Given this, we expect a third quarter sales increase of 7% to 8%, which incorporates the opening of 40 new stores: six in August, 11 in September, and 23 stores in October. Comp sales are estimated to be approximately flat to last year.

Operating margin for the third quarter is expected to decline by approximately 140 basis points to last year as a percentage of sales. The expected operating margin decline is primarily attributable to the comparisons to bonus, retirement, and insurance expense leverage experienced in Q3 2006. As a reminder, bonus and retirement expenses leveraged 99 basis points and insurance expense leveraged 34 basis points in last year's third quarter. The anticipated sales growth and operating margin decline are expected to generate diluted earnings per share of $0.43 to $0.45 which represents a decrease of 2% to 7% compared to last year's $0.46.

For 2007, we expect to open 150 to 160 stores, including three relocations, resulting in an increase in square footage of approximately 11%. For the year we're estimating a total sales increase of approximately 6% while comp sales are expected to decline by approximately 2%. For the entire fiscal year, we are anticipating an operating margin decrease of 70 to 80 basis points. The effective tax rate for the year is projected to be 37.8%. As a result, we are expecting diluted earnings per share of $1.97 to $2.01 or essentially flat to last year's $1.99.

Also, I want to update you on our CapEx forecast for the year. We now expect cash capital expenditures of $4 billion to $4.1 billion versus our plan of $4.3 billion. All figures are net of approximately $300 million of operating leases.

We are now ready for questions.

Question-and-Answer Session

Operator

Your first question will come from Deborah Weinswig - Citigroup.

Deborah Weinswig - Citigroup

If we look at not only the commercial business customer, because in the category where you saw growth there, but also six of the 20 categories with positive comps, can you talk about any surprises in the quarter?

Larry Stone

Debbie, to be honest, probably the only surprise that we really experienced was in some of the seasonal businesses, as we mentioned air conditioner sales kind of had a flip-flop and the first couple of weeks of this quarter we had strong air conditioner sales. As an example, we are now back within our plan in terms of inventory budget on air conditioner sales. If you looked at the second quarter, the biggest negative growth category we had was home environment, which has air conditioners in that subcategory. We didn't see as many generator sales develop in the second quarter as we thought we would. However, we did see generator sales coming back in the last couple of weeks. In fact, this weekend was a pretty good week in generator sales as the storm approaches.

Our seasonal categories held up well. Overall, we're pretty pleased with that. Kitchen cabinets were not as strong as we had hoped, but there again you can see pockets where kitchen cabinet sales and counter top sales were extremely strong. All in all, those were a few of the categories. Finally, rough electrical. With all the inflation and deflation we've had in those categories, that's really been a real up and down category for us the last quarter. So certainly we think rough electrical compared to where we were last year at this time was not as strong as we had hoped for. All in all, we're very pleased with the quarter. We're pleased with the balance, as I mentioned in the comments, we're extremely pleased with our inventory positions overall.

Deborah Weinswig - Citigroup

Bob, you talked about the positive of mix on gross margin from a category perspective. Can you also kind of flesh that out as well?

Bob Hull

Sure. We've talked about lumber and plywood deflation obviously has a negative impact on lumber comps. That's one of our lower margin categories. Some of the categories that performed well in the quarter are the higher margin categories. So it continues the theme we've seen for the past couple quarters of strong mix. Obviously, the ACs being down helped the margin mix as well in the second quarter. We expect that to turn around a little bit in the back half of the year, which is why we're less than bullish on our gross margin forecast for the back half of the year.

Deborah Weinswig - Citigroup

Some of your retailers this earnings season have pointed out that shrink has been an issue and I think you're really one of the few that has pointed out this as being a benefit. Can you talk about if there's any specific initiatives you have in place, or what's really allowing you to continue to see improvement there?

Bob Hull

We've got ongoing initiatives with our partnership with loss prevention and store operations and merchandising. We have a game plan that we execute every year, but really what you're seeing in terms of shrink leverage this year relative to last year, Q2 last year is when some of the stores had their first inventory subsequent to the '05 hurricanes. So we saw kind of a spike in increase in those store's shrink results last year as we take second and third and fourth inventories subsequent to that first inventory, we're getting more normalized shrink results.

Deborah Weinswig - Citigroup

Great. Thank you and best of luck.

Operator

Your next question comes from David Schick - Stifel Nicolaus.

David Schick - Stifel Nicolaus

If we isolate the northeast and you talked about business getting better there and take some of the hurricane noise out of the numbers, could you go in particular to big ticket project spending just in the northeast, in the trend, what we're seeing?

Robert Niblock

As we mentioned, I think part of it was the fact that we had better weather in the northeast. Certainly that drove some of the outdoor categories, which is what suffered most in the first quarter when we went through and gave you the analysis there in the first quarter. I think it's that, I think it's overall improvement. We have seen a spike or an increase in our detail fees that have taken place. In many parts of the country, generally not in the west coast where we've talked about having the most challenges, but we have seen an increase in detail fees probably in the northeast, there's probably been a bigger increase in detail fees than there has been in other parts of the country.

Generally it's probably not the biggest projects, which is a total new kitchen, even though you are continuing to do that, but it's more in your carpet and windows and some of the millwork and some of those categories we're seeing an increase in detail fees, fashion plumbing so on and so forth and then the larger projects will follow after that. We are starting to see some improvement in those install and special order categories in the northeast. We think that gives us a favorable sign that things are headed in the right direction, but we don't think we're out of the woods yet on it.

David Schick - Stifel Nicolaus

So after you account for the push and pull that you see from weather over time, you can isolate it and say that consumer propensity is maybe getting a little better to spend on the big stuff in the northeast?

Robert Niblock

Yes, I would agree with that.

Operator

Your next question comes from David Strasser - Banc of America Securities.

David Strasser - Banc of America Securities

Thank you. I guess last week when Home Depot talked on their call, they talked about their flooring getting better. I'm curious if you've seen any impact from that or you've talked about some market share data that you had. I don't know if any of it relates to flooring. Can you talk about that a little?

Larry Stone

Our flooring business was certainly well above the comps that we reported for the company for the second quarter and there are certain categories that still remain strong in flooring. Laminates, hardwood floorings, ceramic, rugs, all extremely good. The softness in flooring is in carpet and in some of the laminate products. Overall, we're very pleased with our flooring performance and certainly the numbers we posted in the second quarter in Florida, one of the highlights that Bob mentioned in his formal comments.

David Strasser - Banc of America Securities

Do you think in the flooring side, even just the weakness in carpet is a transition away from that in general towards the hardwood?

Larry Stone

If you look at the sales, for example, in ceramic over the past several of years, ceramic has absolutely exploded and the same with all your laminates and your hardwood floorings and so forth. We think it's just a natural shift. If you tour a lot of new homes being constructed today, you're seeing less and less carpet in new homes. We still think carpet has tremendous opportunity and certainly we're doing a lot of things that our flooring merchants are working on to drive carpet sales, but I think longer term, carpet will probably not be as dominant as it once was in the U.S. in my opinion.

David Strasser - Banc of America Securities

As you look at some of the resets you do, are there any new categories in particular that you're sort of bringing into the store? Are you thinking about it as if there's a longer-term housing downturn of any sort, that you have products that are maybe less correlated to that?

Larry Stone

Well, certainly we evaluate a lot of different products that the merchants have. Nick Canter and his team are constantly looking at new ideas, new product. Nothing that's really is significant that we're bringing in. We're always trying to bring in new lines and just experiment with what customers think about it and so forth. But nothing on a large scale that would totally change the industry currently. Like I say, we never say never about anything. We're always looking at what products do fit, but they must fit in the division of home improvement retailer. We've really tried to stay the course on our vision and make sure we don't wander out beyond that vision in terms of products that we want to sell in our stores.

Operator

Your next question comes from Chris Horvers - Bear Stearns.

Chris Horvers - Bear Stearns

In thinking about your second quarter results, you really did a fantastic result on the gross margin side. You laid it out in terms of what the drivers were, but thinking back to what you said on your first quarter call, you clearly didn't expect this much upside. Was wondering where the biggest differential was? Was it ACs, was it the seasonal flow through the import facilities and how we should think about going forward?

Robert Niblock

Certainly Bob laid out a lot of the details with the seasonal flow, the mix of goods and the way that that came together in the quarter. Easier comparisons from last year where we certainly had to clear out a lot of that seasonal category earlier that we were heavy in last year and just in better all around shape this year. But I'll add on top of that. Certainly, in the environment we're in we're always going to be a little bit more cautious or try to be more cautious as we give our guidance looking out. If you remember, we came out of the first quarter where the environment was very promotional. Even though we believe that that promotional activity would lessen in the second quarter, you never really know until you get there. I think we take all those things into consideration when we're trying to build our guidance and our outlook. I think certainly part of that is what drove the difference between the results we delivered and the guidance that we gave you as we were going into the second quarter.

Bob Hull

The other thing I would add, Robert, is that when we think about the Q2, we had a 32 basis point decline in Q2 '06. When we think about the back half of '06, gross margin increased 68 basis points in Q3 and 41 basis points in Q4. We have much tougher comparisons in the back half of the year. The mix is going to turn around on us going from a positive to flat to slightly negative in the back half of the year.

Larry Stone

One final thing. I think a lot of the lessons learned last year helped the second quarter because on our seasonal products, I think we did a much better job this year in terms of selling through seasonal goods and less impact on the margin than it was a year ago. So there again, a lesson to be learned and certainly something, we'll take our learnings from this year and apply them as we go into '08.

Chris Horvers - Bear Stearns

As we think about the guidance for the balance of the year, is it just the overall tone of the market and the macro that's concerning you in having numbers come down in the back half, or is it something you're seeing in your business right now?

Robert Niblock

It's really more what we're seeing take place in the sub-prime and the credit markets and the unknown that's out there. I think if we go back a year ago, no one was aware of how deep the sub-prime market would go, how much the lending standards had been relaxed and the impact that that would have through the marketplace. We've seen over the past couple of weeks quite a bit of turbulence in the credit markets, continued new revelations coming out about the mortgage industry and sub-prime industry and lending. As I've said in my comments we're not directly impacted by that, but yet certainly to the extent it tightens lending standards, if there is other fallouts that may occur, whether it's job layoffs or whatever that would have more of a direct impact on our business we certainly think it's prudent to be a little bit more cautious with the fact that we beat our second quarter numbers, that allows us to take our numbers down for the balance of the year and still talk towards flat earnings for the year, which is basically what we've been talking about since the first quarter conference call.

Taking all that into consideration, we think it's not really so much what we're seeing in the business, it's just the unknown that's out there. Generally, as I've been talking and meeting with analysts as we're going through the second quarter, I think people were looking and say, why don't you give yourself more room in the back half of the year, and that's what we've tried to do. Hopefully if we don't have those negative macro environments that come out, then hopefully we can hopefully deliver better than what we promised given what we saw here in the second quarter.

Operator

Your next question comes from Budd Bugatch - Raymond James.

Budd Bugatch - Raymond James

Good morning and congratulations on the performance in the quarter. When you're looking at that guidance for the third quarter of 140 basis points decrease in the op margin, would be right to take, Bob, based upon what you were talking about two-thirds of that from SG&A and the other portion from gross margin based upon the mix issue? Would that be a right way to think about?

Bob Hull

Yes. I think I outlined some of the pressure points in my prepared comments related to the compares we have with bonus and insurance. We do expect some modest gross margin improving in the third quarter. The 140-basis point decline all comes from SG&A and depreciation after that.

Budd Bugatch - Raymond James

Just the other question I have relates to the comp trends in the housing market areas. I don't remember hearing whether you talked about whether they were decelerating or stabilizing during the quarter and how should we think about that in Florida and California?

Robert Niblock

As I mentioned in my comments, for the West Coast, particularly the California area we saw comp trends decline in the second quarter over the first and it really hasn't improved from that standpoint. As you're down in the hurricane markets, you're starting to see a little bit of improvement as you're moving away from those storms. The Gulf Coast area you still got, particularly Florida has still got the impact of housing, but the two regions that were impacted by the storms, you're starting to see better comparisons there, so it's trending in the right direction for the Gulf Coast area.

Budd Bugatch - Raymond James

I understand that, Robert, second quarter versus first. I was wondering during the second quarter, how did those trends go and what was it looking like coming out of the second quarter?

Robert Niblock

In the markets in California, I think it's continued to worsen. In the Gulf Coast areas, it's continued to improve and it's continued to improve now that we're headed into the third quarter.

Budd Bugatch - Raymond James

Florida also improving or worsening?

Robert Niblock

That's what I was talking about. Florida's improving. Continuing to be the case as we head into the third quarter.

Operator

Your next question comes from Mike Baker - Deutsche Bank.

Mike Baker - Deutsche Bank

Just wondering if you're seeing anything different competitively in terms of service levels. You talked about some areas where you lost share. I'm wondering what those areas were and why you think you may have lost share. CapEx, what was that coming down?

Larry Stone

The areas we did lose share in, certainly we can go back and dissect those areas and determine, was it due to promotions, ran by competition or products or whatever and we've went in and retaken a hard look at all those. In a lot of cases, we think that certain competitors were more promotional in products. Sometimes, as we've said in the past, we do elect to match and sometimes we elect not to match. We're still very much committed to our everyday low pricing strategy and certainly we don't want to become a high/low retailer.

I think in a lot of those categories that we might have gave up a little bit of share if you look down through all them, as an example, in draw rate, which is the number of times that customers give you consideration, we had 18 out of 20 that were positive, so only two categories were we not the best in draw rate versus the competition in terms of a third party survey that we used.

Overall, we feel real confident about what we're doing. We're certainly going to always monitor promotions that we have. We have an 18-month rolling calendar that we have laid out, update it every month about what we plan to do in each of the coming months to drive sales. We're very cognizant about the share gains and certainly we evaluate each one when we get the reports each month.

Mike Baker - Deutsche Bank

The CapEx?

Bob Hull

For new stores, there's a couple items in there. When we were thinking about the plan for '07, we saw some inflation in construction materials. We're still seeing some inflation, but not to the degree that we had planned. In addition, there's been a slight mix in stores. As you know, some of the northeast markets are the longest for stores to come out of the ground from the time that they're approved from real estate committee until the store opens. We had actually, three stores in top 25 markets planned to open in the back half of the year. They have slid out and [inaudible] have slid in.

As it relates to existing stores, when we build our CapEx plan for remerch and resets, it's largely a place holder until the merchants firm up their plans for the year. In fact, we have a process working with Nick Canter's team where the GMMs and Nick approve projects on a quarterly basis. So the actual amount of work being done is much less than we anticipated in the fall of 2006. Also part of what we've been talking about for the past couple of quarters, operations and efficient merchandising. Then the last item I mentioned, is as it relates to distribution, we've seen some delays in timing of RDCs and flat beds. So really all those factors combined led to the $250 million or so reduction in CapEx outlook for the year.

Operator

The final question will come from Matthew Fassler - Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning. I would like to focus for a moment on the guidance for the second half. It looks like it came more from EBIT margin than from comp. Is there anything about the expense trends that's different from what you would have seen a quarter ago or at the outset of the year that would have led you to address the expense issues today rather than having done it previously?

Bob Hull

Matt, when we think about the back half of the year relative to 90 or so days ago, comp came down about 1%. So obviously that's going to flow through impact on the expense structure. Nothing really dramatic outside of that, nothing specifically giving us heartburn in the expense category. Just, I think as Robert said, given the current environment and what we're seeing today, just some prudent planning in how we think about the back half of the year.

Matthew Fassler - Goldman Sachs

So the comp guidance coming down by around a percentage point would be the biggest driver of the guidance for the second half?

Bob Hull

Correct.

Matthew Fassler - Goldman Sachs

I know you have an extensive research function and the sub-prime issue has been brewing now for six months or so. What have you looked into and seen in terms of your actual customer base and their dependence on sub-prime mortgages? Have you gotten a sense as to what the overlap is or lack thereof between those people who have these loans that are going to reset and the people who shop in your stores and are in fact your better customers?

Greg Bridgeford

We don't see a big divergence in the percentage of our customers participating in the sub-prime market than the national penetration rate. What we do watch and track carefully is the impact of the sub-prime issues on credit availability. Because as Robert mentioned, housing affordability and credit availability are big issues that we're going to keep very tight track on as we look at the potential negative and positive factors influencing us over the next number of quarters.

Robert Niblock

Thanks, Greg, and as always, thanks for your continued interest in Lowe's. We look forward to speaking to you again when we report our third quarter results in November. Have a great day.

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Source: Lowe's Companies Q2 2007 Earnings Call Transcript
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