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Lowe's Companies Inc. (NYSE:LOW)

Q3 2007 Earnings Call

November 19, 2007 9:00 am ET

Executives

Robert Niblock - Chairman and CEO

Larry Stone - President and COO

Bob Hull - EVP and CFO

Greg Bridgeford - EVP of Business Development

Analysts

Deborah Weinswig - Citi

Budd Bugatch - Raymond James

Brian Nagel - UBS

Eric Bosshard - Cleveland Research

Colin McGranahan - Bernstein

Danielle Fox - Merrill Lynch

Matthew Fassler - Goldman Sachs

Operator

Good morning, everyone, and welcome to Lowe's Companies Third Quarter 2007 Earnings Call. This call is being recorded.

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 call 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 program over to Mr. Niblock for opening remarks. Please go ahead, sir.

Robert Niblock

Good morning, and thanks for your interest in Lowe's. Following my remarks, Larry Stone will review additional details of our performance and describe what we're doing to manage the business in today's environment. Then, Bob Hull will review our third quarter financial results.

Sales in the quarter fell short of our expectations. That shortfall can be attributed to several factors, which I will discuss. However, we were able to deliver earnings per share at the low-end of our guidance, thanks to great expense management and effective execution of our program combined with promotions that allowed us to gain share while maintaining an appropriate margin rate.

Certainly the largest impact on our sales, yet the hardest to quantify, was from housing-related pressures on the consumer. The deterioration in housing-related metrics combined with disruption in the credit markets and the tightening of lending standards and credit availability impacted our performance this quarter. As a result, our comp trend deteriorated through the quarter from negative 1% in August to negative 6% in October, even as we faced easier prior year comparisons.

In addition to continued macroeconomic pressures, our sales were impacted by the fact that several regions of the country experienced a drought combined with warmer than normal temperatures throughout much of the quarter. As anecdotal evidence of the drought impact, our nursery category experienced the largest decline versus year-to-date run rates of any category.

But to further estimate the impact of our drought, we looked at the trends in indoor products versus outdoor products. We saw a significant decline in the performance of outdoor products and drought-affected regions versus their second quarter run rate. In fact, outdoor products in drought-affected regions had an average decline of nearly 800 basis points from the second quarter.

On the contrary, indoor categories in those same markets only saw 150 basis point change in performance versus the second quarter, likely due in part to reduced slow traffic. Using our indoor versus outdoor product performance analysis, we estimate the drought conditions in many parts of the US negatively impacted total company comp by approximately 75 basis points during the quarter.

Also lumber and plywood prices continue to impact out comp results. While comps in these product categories improved versus our results in the first half of the year, we did experience worse comps in Q3 compared to Q2.

During the quarter, we expected lumber and plywood to provide a slight positive impact. However, lumber prices experienced further declines setting 15-year lows according to Random Lengths and more than offset year-over-year inflation in plywood. As a result, we estimate deflation in these categories negatively impacted total company comps by 5 basis points, which is an improvement compared to prior quarters but worse than our expectations at the start of the quarter.

Finally, our Region 23 composed of stores alone in the US Gulf Coast continued to experience double-digit negative comps in the quarter. We've been monitoring these markets and anticipate improved performance as we passed the two-year anniversary of Katrina and Rita.

While we're seeing gradual improvement in performance, our expectation was that our third quarter results would prove to be better. It's apparent that these markets are experiencing other housing and credit-related pressures, which are negatively impacting our sales. In the end, our Gulf Coast region negatively impacted total company comps by approximately 50 basis points.

We are experiencing regionally disparate performance with the two California regions, our Florida region and the region that covers the Gulf Coast experiencing double-digit negative comps, with third quarter performance trending worse in California, but improving slightly in the hurricane-impacted regions. But in the end, the change in sales trends we experienced in the quarter was broad-based with many factors driving the less than anticipated performance resulting in lower third quarter comps versus second quarter in 16 of our 22 regions.

At our Analyst Meeting this past September, we described three broad groupings of markets based on home price dynamics within those markets. We described our performance at overpriced markets, with the correction expected or occurring, overpriced markets with no pricing correction expected and not overpriced markets. While we continue to see the overpriced and correcting markets performing worse than the not overpriced markets, we saw a very similar magnitude of decline from Q2 to Q3 across all three buckets.

Combined with the other pressures to sales that I've mentioned, the widespread decline in comp trends may reflect the tightening of mortgage credit standards across all markets or, perhaps, a psychological headline effect of housing-related news negatively impacting consumer's behavior in structurally solid markets. Either way, during the quarter it was difficult to sustain sales momentum across much of the country.

Based on our results and a significant losses in write-downs announced this quarter in the banking and mortgage industry, it's clear that the pressures on our industry in the home improvement consumer are greater than we previously anticipated and are likely to last longer than we expected. As a result, we are focused on balancing our efforts to respond appropriately to the current environment, while at the same time positioning Lowe's for the eventual stabilization and ultimate improvement of the industry.

In today's sales environment, we're intensely focused on managing expenses as well as evaluating ways to better leverage technology, our infrastructure and our great people to efficiently drive sales and deliver great customer experiences. We're committed to disciplined inventory management for seasonal products to ensure we minimize markdowns for maximizing sales.

And we're focused on the opportunities we see in the current environment to gain profitable market share. As evidence of our success, according to third-party estimates, we gained 100 basis points in total store unit market share in the calendar quarter, continuing a trend of solid share gains.

As we conclude 2007 and move into 2008, we'll continue to watch the macro factors that have historically been leading indicators of demand for our industry. Specifically, we're watching housing turnover, home price depreciation, employment and income growth in order to anticipate trends and appropriately manage our business where sales are slow, but at the same time, capitalize on opportunities where they exist.

In addition, there are other well documented pressures on the consumer today. As I mentioned access to mortgage financing is a concern, we'll continue to watch in addition to the impact on our consumers' purchasing power of resetting adjustable rate mortgages. Furthermore, elevated energy costs and the anticipation of further increases continues to impact American's ability to spend on discretionary projects.

We improved our guidance for the fourth quarter, acknowledges a continuation of having correction as appropriately conservative given the uncertainties that exist. As always, our goal is to provide great products and unmatched customer service to ensure we capture a profitable market share regardless of the level of industry growth.

Before I turn the call over to Larry, I want to thank our employees who respond to the needs of communities and citizens in the fire-ravaged parts of California. Many worked long hours to ensure affected residents had the products and supplies they needed to begin their recovery.

In addition, our California stores serve as official donation sites for the American Red Cross. Donations from customers and contributions from Lowe's totaled more than $350,000 and helped the Red Cross meet their fund-raising goal for the recovery effort. It's dedicated employees with a strong commitment to their communities that are the foundation of Lowe's success.

Finally, I'd like to congratulate Jimmie Johnson, Chad Knaus, Rick Hendrick and the entire team at Hendrick Motorsports on winning their second consecutive NASCAR NEXTEL Cup Championship. Lowe's is proud to be partnered with such a great organization and have them represent the Lowe's brand each week on and off the track.

Now here is Larry to describe in greater detail the results of the quarter and provide some insights on how we're managing the business today. Larry?

Larry Stone

Thanks, Robert, and good morning. As Robert mentioned, sales environment remains challenging, and the external pressures facing our industry will continue into 2008. This morning I'll provide some details on the third quarter results and discuss our focus on some near-term opportunities to ensure we continue to meet customers' needs and drive efficiencies in a challenging sales environment.

Our goal is to balance those opportunities while maintaining our commitment to manage the business for the long-term. Following two product categories achieved positive comps in the quarter. We continued to capture market share, which reflects our ability to capitalize on opportunities created in the slower sales environment. According to third-party estimates, 17 of our 20 product categories gained unit market share in the third calendar quarter versus the same period last year.

Highlighted here are the outperforming categories. Home environment generated positive comp sales for the quarter. Extreme heat experienced in most of the country drove air conditioner sales in the first part of the third quarter. The shift in air conditioner sales from the second quarter to the third quarter had a slight drag on this quarter's gross margin rate. Rough plumbing posted positive comps for the quarter driven by consumer strong demand for repair products, which is reflective of their commitment to maintain their biggest asset, their home.

Water and air filtration products also had robust sales for the quarter driven by consumers desire to maintain a healthier home environment. Lighting also posted above company average for the quarter in terms of comps driven by the strong demand for high-efficiency lighted solutions, including compact fluorescent lights and motion sensor lighting products.

Major appliances also were above average in the quarter, but had a slightly negative comp. Our lineup of brand name products coupled with their in-stock program for more than 200 major appliances, outstanding service, next-day delivery continues to drive sales in this category.

Additionally, lawn and landscape sales were weak in the Southeast, but this weakness was partially offset by strength in other regions that experienced more typical seasonal weather leading to overall performance above the company average. This shows that where weather permits, customers remain committed to having their lawns ready for the spring season.

In August, I highlighted the fact that favorable weather in the second quarter helped our nursery and lawn and landscape sales, and we anticipated that the momentum would continue in the third quarter. However, the severe drought experienced in many parts of the country led to slower sales in many of our outdoor categories, including nursery which performed significantly below the company average.

As we enter the fourth quarter, we feel good about our inventory position. Despite the dry weather in several areas, we had good sell-through this year in seasonal categories and we have plans and disciplined programs in place to ensure we continue to drive improvement. Also, we are comfortable with our inventory levels and sell-through for our trim-a-tree and seasonal heating products at this point in the quarter.

5 of our 22 regions had positive comps in the quarter. The magnitude of housing issues affecting a number of markets across the country has differed by region with the most significant impact in California and Florida. As Robert mentioned, these markets continue to perform significantly below the company average, driving down our overall comp.

Additionally, consumers remain hesitant to take on larger discretionary projects, including mini projects offered through our installed sales and special order programs. As a result, our sales in those areas fell short of our average comp and we continue to see regional disparity in these areas. Specifically, California and Florida continued to show the most pronounced year-over-year sales declines in big ticket projects.

Detail fees in our installed sales business continue to show improving trends for the quarter, and while comp detail fees are still negative, the trend has improved over the past couple of quarters. As this is the starting quarter for many installed sales projects, we monitor the detail fees and the close rate for those that result in project sales. In this challenging environment, our close rate has remained stable.

Commercial business customer sales continue to perform well above the company average. Our focus on maintenance and repair customers who shop the entire store, not just lumber and building materials, and who are less dependent on the housing cycle have helped ensure solid CBC sales and margin performance so far this year.

As I stated earlier, we anticipated external pressures on the housing market to continue into 2008. Here are few examples of what we're doing to ensure we continue to deliver great customer experience and drive efficiencies in this challenging sales environment.

First, we remain committed to provide an excellent customer service in all sales environments as well as identifying ways to increase store productivity. A basic tenant of increased store productivity is the accurate forecast of sales and correct planning of hours. Our labor scheduling tools that flexes up and down dependent on sales trends aids us in this process.

We know that maintaining the appropriate staffing complement in our stores is one of the keys to our continued success. However, during periods of robust growth we staffed ahead of our sales to ensure we would meet the growing demand of the customer. Specifically, we added hours of sales trends approach to threshold that would trigger changes to the staffing complement. We will not sacrifice service, and we'll continue to launch staffing levels with current sales trends.

However, in this sales environment we're taking a more disciplined approach by waiting to increase our base staffing hours until the sales threshold has been achieved. Our flex and staffing model enables us to react quickly to change in sales environments. Therefore, when the sales improve, we can efficiently add hours to support growth. With this more focused approach, we remain confident that we will continue to provide the level of service customers have come to expect from Lowe's while at the same time drive efficiencies.

Also, we continue to work with our vendor partners to drive efficiencies by streamlining and automated receiving processes. Approximately 75% of our goods are now running through our distribution network. Moving more product through our network leads to more good faith receiving at our stores, which means employees don't need to spend additional hours verifying the product they are unloading. In turn, this gives us more hours to assist the customers in our aisles.

In order to drive additional efficiencies, we're also looking at methods to allow good faith receiving of select product that come store direct from vendors. Obviously, part of the process includes ensuring we and our vendors have controls in place to properly account for product and controlled stream. We currently have programs in place with our molding and hardware vendors as a good faith to receive their products. Once again these programs will drive efficiencies in our stores.

Next, we're always looking for opportunities to leverage our best-in-class logistics and distribution network, and we are continuously expanding the network to support our growth. Based on planned store growth and increased sales volume, our long range plan anticipated that we would open our 14th RDC in the spring of 2008.

Because current sales levels are not what we expected and our existing network has the capacity to manage our current demand, we have postponed the opening of our 14th RDC by six to nine months. The expense statements from postponing the opening of a fully operational and staffed RDC far outweigh the costs associated to slightly longer hauls to our stores. This prudent decision is right for Lowe's and we're confident our current network has the capacity to ensure our stores remain in stock and customer demand is met.

Our fourth opportunity is related to store environment. While we continue to identify ways to simplify the shopping experience and make our stores more operationally efficient, we are also evaluating the frequency and scope of our reset and remerchandising program.

Our philosophy has not changed. We remain committed to ensuring our customers have a great shopping experience and that our stores feature the most up-to-date sets. However, in this sales environment, we're taking a more conservative approach and completing only those projects that we're confident will drive traffic. This year we'll complete 116 major remerchandising projects, and our plans for 2008 will mirror this year with 120 major remerchandising projects slated to be completed.

Fifth, adjusting for the environment. We're looking for opportunities to gain additional advertising efficiencies, including better alignment of our 18-month promotional calendar. The market analysis Robert mentioned provides insight in the housings impact on our performance by region. It's a good tool that helps us manage our business, enabling us to better target promotions that connect with customers in local markets.

For example, specific market dynamics have led some consumers to remain hesitant to begin big ticket projects which is leading soft project sales in those markets. In order to continue to offer impactful market message to these customers, our targeted local communications will highlight maintenance and repair products that continue to show relative strength across all regions.

In other markets where projects sales remain strong, we will continue to feature the products and services that drive large project sales. This refinement allows us to align our advertising with customer demand, which results in a more efficient use of our advertising dollars.

This morning I have shared with you a few things we're doing to respond to the realities of the current environment, as well as to assure you that our commitment to provide an excellent customer service in a great shopping environment has not changed. In all sales environments, we look for opportunity to make our company stronger and provide customer valued solutions.

Our goal of being customer's first choice for home improvement in every market has not changed. Our philosophy about managing the business for the long-term has not changed. Given the external pressures that we're currently weighing on the industry, we believe we're making adjustments necessary to make Lowe's a stronger company and position us for continued long-term success.

Thank you for your time this morning. And I'm now turning the call over to Bob Hull to provide the details of our financial results. Bob?

Bob Hull

Thanks, Larry, and good morning, everyone. As Robert indicated, sales for the third quarter were $11.6 billion, representing a 3.2% increase over last year's third quarter. For the first nine months of 2007, sales increased 3.8% to $37.9 billion.

Comp sales were a negative 4.3% for the quarter. Looking at the monthly trends, comps were down 1% in August, negative 5% in September and down 6% for October. For the first three quarters of 2007, comp sales were negative 4.3%. Comp sales for the same period last year were positive 1.7%.

In Q3, total customer count increased 4.7%, but average ticket decreased 1.5% to $66.95. For the quarter, comp transactions declined 2.3% and comp average ticket decreased 2.2%. Lumber and building materials deflation negatively impacted third quarter comps by approximately 20 basis points.

With regard to products, the categories that performed above average in the third quarter include rough plumbing, hardware, paint, lighting, lawn and landscape products, appliances and home environment. In addition, flooring, fashion plumbing and cabinets countertops performed at approximately the overall corporate average.

From a regional perspective, 5 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. The negative double-digit comp regions are in California, Florida and along the Gulf Coast.

Gross margin for the third quarter was 34.3%, which was a 20 basis point decrease compared with Q3 2006. The decline in margin for the quarter was attributable to markdowns of seasonal inventory. For example, in the second quarter as our sell-through was behind plan, we began to markdown air conditioners.

During the extreme heat of August, we sold a lot of air conditioners. Last year, most of the markdown air conditioners were sold in the second quarter. Offsetting the impact of timing of seasonal markdown, the mix of products sold positively impacted margin rate by approximately 10 basis points.

In addition, lower inventory shrink positively impacted gross margin by approximately 15 basis points. In last year's third quarter, we experienced higher shrink related to stores in the Gulf Coast. This year inventory shrink has returned to normal levels.

Year-to-date, gross margin of 34.6% represents an increase of 32 basis points over the first nine months of 2006.

SG&A for Q3 was 21.6% of sales and deleveraged 93 basis points driven by a number of items. For the quarter, store payroll deleveraged 64 basis points due to maintaining base staffing levels in our stores, while sales per store are declining. Cycling against accrual reversals in last year's third quarter, bonus and retirement expense deleveraged 47 basis points in the quarter.

Rent, property taxes, utilities and other fixed expenses deleveraged due to the comp sales decline. In addition, we saw casualty insurance expense leveraged in the quarter associated with our ongoing safety initiatives and benefit of some regulatory changes.

Our efforts over the past several years to maintain a safe shopping and working environment have resulted in a reduction of both claims incidents and severity. These efforts contribute to the actuarial projections of lower cost to settle current and future claims, which led to a reduction of our actuarially determined insurance reserves. As you will recall, we had a favorable adjustment in last year's third quarter. As a result, we had 19 basis points of casualty insurance expense leverage for the quarter.

Year-to-date, SG&A is 21.2% of sales and deleveraged 90 basis points to the same period last year. Year-to-date store payroll has deleveraged 75 basis points. Depreciation at 2.9% of sales totaled $340 million and deleveraged 29 basis points for the quarter.

Operating margin, defined as gross margin less SG&A and depreciation, decreased 142 basis points to 9.7% of sales. Year-to-date, operating margin of 10.8% represents a decrease of 87 basis points over the first nine months of 2006.

Store opening costs of $41 million leveraged 3 basis points to last year as a percentage of sales. In the third quarter we opened 40 new stores. This compares to 49 new stores in Q3 last year.

Interest expense at $50 million deleveraged 3 basis points as a percent of sales. For the quarter, total expenses were 25.4% of sales and deleveraged 122 basis points. Pre-tax earnings for the quarter were 8.9% of sales. The effective tax rate for the quarter was 37.6% versus an effective tax rate of 38.2% for Q3 last year.

Diluted earnings per share of $0.43 decreased 6.5% versus last year's $0.46. For the first three quarters of fiscal 2007, diluted earnings per share were $1.58, which is down fractionally from the same period last year.

In the third quarter, we repurchased 16.6 million shares at an average price of $30.12 for a total repurchase amount of $500 million. For the year, we have repurchased 62.3 million shares at an average price of $31.32 for a total repurchase amount of $1.95 billion. We have $2.5 billion remaining for share repurchase authorization.

Weighted average diluted shares outstanding were 1.5 billion for the quarter. The computation of diluted shares takes into account the effect of convertible debentures which increased third quarter weighted average shares by 21 million.

Now, to a few items on the balance sheet. Our cash and cash equivalents balance at the end of the quarter was $336 million. Inventory turnover was 4.1, a decrease of 30 basis points from Q3 2006. Our third quarter inventory balance increased $556 million or 7.7% versus Q3 last year. The increase in inventory is driven by a 10% increase in square footage. At the end of the third quarter, we owned 86% of our stores versus 84% at the end of third quarter last year.

In the third quarter, we issued $1.3 billion of senior unsecured bonds in three tranches, $550 million of 5-year notes with a 5.6% interest rate; $250 million of 10-year notes with a 6.1% interest rate; and a $500 million 30-year issue with a 6.65% interest rate. The proceeds of the notes will be used for general corporate purposes and to finance repurchases of our common stock.

Our debt-to-equity ratio was 35.1% compared with 29.3% for Q3 last year. Return on invested capital, measured using beginning debt and equity in the trailing four quarters earnings, decreased 220 basis points for the quarter to 16.1%. Return on assets, determined using beginning total assets and the trailing four quarters earnings, decreased 167 basis points to 11.1%. Year-to-date, cash flow from operations was $3.8 billion, an increase of $142 million or 4% over the first three quarters of 2006.

Looking ahead, I'd like to address several of the items detailed in Lowe's business outlook. We expect a fourth quarter sales increase of approximately 3% which assumes we open 72 new stores, 13 in November, 32 in December and 27 stores in January. Comp store sales are estimated to decline 3% to 5% for last year.

Operating margin for the fourth quarter is expected to decline by approximately 280 basis points to last year as a percentage of sales. The lower sales forecast will cause deleverage and deprecation in other fixed costs. In addition, we expect store payroll deleverage of approximately 90 basis points.

Given the challenging sales environment, our store employees are working extremely hard to take care of customers, and third-party market share numbers indicate that they are successful. Our bonus programs are based on performance versus plan. So, unfortunately, many bonus eligible employees are not scheduled to earn a bonus.

As a result, we recently implemented an incremental bonus plan to reward these employees for driving sales and earnings in the fourth quarter. This could negatively impact operating margins in the fourth quarter by as much as 50 basis points or $0.02 per share.

The income tax rate is forecasted to be 37.6% for the fourth quarter. The anticipated sales growth and operating margin decline are expected to generate fourth quarter diluted earnings per share of $0.25 to $0.29, which represents a decrease of 28% to 38% compared to last year's $0.40.

For 2007 we expect to open approximately 153 stores, including 4 relocations, resulting in an increase in the square footage of approximately 11%. For the year, we're estimating a total sales increase of 3% to 4%, while comp sales are expected to decline by approximately 4%.

As Robert mentioned, we've seen housing metrics continue to deteriorate and a corresponding slowdown in our business. While we did see a deceleration in comp trends for the third quarter against easier prior year comparison, for first two weeks of the fourth quarter, our trends have improved slightly and we believe we can achieve the sales guidance we've provided.

For the entire fiscal year, we are anticipating an operating margin decrease of approximately 130 basis points. The effective tax rate for the year is projected to be 37.7%. As a result, we're expecting diluted earnings per share of $1.83 to $1.87 or down 6% to 8% to last year's $1.99.

Tina, we're now ready for questions.

Question-and-Answer-Session

Operator

Ladies and gentlemen, we are now ready for question-and-answer session. (Operator Instructions). Our first question will come from the line of Deborah Weinswig with Citi.

Deborah Weinswig - Citi

Good morning. Bob, we saw you continue to repurchase shares during the quarter. Can you help us think about the remainder of '07 and '08 in terms of capital allocation?

Bob Hull

Sure, Deb. We did repurchase 500 million shares in the third quarter. As you know, we do not comment on prospective share repurchases. However, given that we've repurchased almost $2 billion year-to-date at an average price north of $30, we view the current prices relatively attractive.

Our CapEx plan for the year is $4.1 billion. We continue to invest in not only the new stores that are opening for the remainder of this year, but land acquisition and building construction for the stores to open in 2008 and beyond. We still have ongoing investments in our infrastructure, distribution, IT, etc. And as Larry noted, we are still investing in the existing stores, just taking a much more rational approach to doing so.

Deborah Weinswig - Citi

And if you can, help us understand what you saw in the third quarter. Maybe what you're thinking in terms of fourth quarter with regards to a promotional environment?

Larry Stone

Deborah, it’s Larry Stone. Based on everything that we've encountered in the previous three quarters, we did come up with what we felt are very conservative sales estimates for the fourth quarter. And as indicated in my prepared comments, some of the big ticket categories are not really kicking-in in some of these real depressed markets in the Florida and California regions and particularly in the Gulf Coast.

So, therefore, those areas really had a lot of the huge growth in the past in terms of big ticket projects. And as I stated, we're trying to more tailor our advertising based on the current environment based on what we think we'll perform in each market.

Deborah Weinswig - Citi

So Larry, would you say that your approach is more localized than it's been in the past?

Larry Stone

I think so. I think we've really anticipated all year that some of these markets were going to return and come back. And we were very optimistic going against the softer comps in the third quarter. But so far, the housing market just does not allow the stores to come back as quickly as we thought they would.

Deborah Weinswig - Citi

And last question for Robert, based on what you saw in the third quarter, and obviously, it sounds like the fourth is turning a bit better, how has your outlook changed?

Robert Niblock

Yeah. As we think about the third quarter, certainly our comparisons were weaker that we were going up against. Now, as I've talked about in my comments, we had the additional impact of the drought. But we were a little bit surprised that our sales, considering everything, were significantly weaker than we had anticipated with a negative 4.3 comp.

So given that, we're just trying to take a little more conservative approach going into the fourth quarter. Certainly, we've got our negative comps we're going up against in the fourth quarter. But when you hear the daily revelations that are coming out in the credit and mortgage and subprime industry and as those impacts are starting to make their way to the market, that certainly has an impact on our home improvement spending as it impacts housing turnover so on and so forth.

You add on top of that, the fact that any time we have a little bit slower environment like this and you have a trim-a-tree category coming into the holiday season not knowing exactly when others will choose to start marketing down those categories as we're heading into the Christmas season, you certainly want to be a little bit more cautious and conservative as you build our guidance.

So, as Bob said in his comments, first two weeks have trended better than we came out of the third quarter, and so, we're pleased about that. So, to sum it up, we're being cautiously optimistic as we go into the fourth quarter that we will see better performance than we saw in the third quarter.

Deborah Weinswig - Citi

Great. Well, thanks so much and best of luck.

Robert Niblock

Thank you.

Operator

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

Budd Bugatch - Raymond James

Good morning, Bob and Robert and Larry. I'd like to get inside the 280 basis points operating margin decline. Maybe you could help flush that out with some parsing between gross margin and SG&A?

Bob Hull

Sure, Budd. This is Bob. I'll take a whack at it. First, we do expect some slight decline in gross margins in the fourth quarter. As Robert talked about, seasonal categories and not knowing when others might initiate markdowns, our expectation is there might be some deterioration in gross margin rate for the fourth quarter.

As relates to SG&A, I gave you the 90 basis points of store payroll deleveraged in my prepared comments, as well as the bonus impact as much as 50 basis points of deleverage. The fixed costs, rent, utilities, property taxes, etc, should be about 40 basis points. And then insurance, both casualty insurance and employee insurance, is probably another 40 or so basis points deleveraged in the quarter.

Budd Bugatch - Raymond James

That gets us to 220. Should we then expect about 60 basis points of gross margin impact? Is that the way to read that?

Bob Hull

The other piece I was going to mention, Budd, is depreciation.

Budd Bugatch - Raymond James

And how what do you think that impact is?

Bob Hull

That would be somewhere around 40 basis points.

Budd Bugatch - Raymond James

Okay. So that gets you to the 280. And so, essentially, you're looking almost flat then on the gross margin line because you were up 10 basis points year-over-year without considering the air conditioning markdowns, I believe, if I heard you right?

Bob Hull

The way to think about the AC markdowns, Budd is to just look at the year-to-date. It was in Q2 last year and Q3 this year. Year-to-date, we're up 32 basis points, so that kind of washes out year-to-date.

Budd Bugatch - Raymond James

Okay, alright. Thank you, Bob.

Operator

Your next question will come from the line of Brian Nagel with UBS.

Brian Nagel - UBS

Hi, good morning, just a couple of quick questions. First-off, with respect to the benefit you received in Q3 from the improving claims just to help us understand, was that something that you had baked into your guidance previously?

Bob Hull

Brian, we did expect some favorable benefits when we provided our Q3 outlook. I thought it might be a penny or two, I didn't envision it would be $112 million. Certainly, it was a positive surprise. Again, last year, self insurance reserves were about $77 million. So, as I said in my prepared comments, the net leverage for the quarter in casualty insurance was 19 basis points.

Brian Nagel - UBS

And the second question, with respect to the impact that droughts across the country have had on your business, then, we talked a lot about that at your Analyst Meeting in late September, did that improve as we went through October? And then, second question on that would be, if it hadn't, how much of those sales now are lost as opposed to delayed for the year?

Robert Niblock

Brian, this is Robert. The drought condition really didn't improve as we went through the quarter. So a significant portion of the fall lawn restoration that you'd see in those drought-impacted market as late as you're getting, you're going to lose a good portion of that and those consumers may very likely decide to do their restoration in spring, assuming that the rain conditions have improved in the spring.

But certainly, as you move into the fourth quarter, those categories outdoor, nursery, lawn and garden, they kind of, over index in the second and third quarter of the year. So there is certainly not as much of an impact in the fourth quarter coming from those categories because there's just not as much volume done out of those businesses in the fourth quarter of the year.

But clearly some of that business, we believe, will be lost and you would ideally hope that provides for a little stronger spring selling season in those affected areas to the extent that the drought conditions have corrected themselves.

Brian Nagel - UBS

That's helpful. Thank you.

Operator

Our next question will come from the line of Eric Bosshard with Cleveland Research.

Eric Bosshard - Cleveland Research

Good morning. Bob, if you could, the 280 basis point margin degradation in 4Q, I understand the components of that, but I guess taking a step back, it's roughly 2X the margin decline of 3Q on similar sales performance. Can you just explain a little bit further why it looks so worse in 4Q than what was experienced in 3Q?

Bob Hull

Sure, Eric. Two items to note. One is the casualty insurance pickup in Q3 will not repeat itself in Q4. That's roughly 100 basis points. Second, as you think about fourth quarter is our lowest volume per store for week, it's actually about 11% lower sales per store per week than Q3 and actually 28% lower than Q2. So, we're at a point now where the lion's share of our expenses is fixed costs. The other thing we're seeing as relates to those fixed cost is, unfortunately, fixed does not mean that they don't fluctuate. So, when you've got property taxes and utilities with the rising energy cost, that's having an impact as well.

Larry Stone

And also, Bob, on top of that, the incremental incentive compensation that we've put out there for the fourth quarter was not there in the third quarter, Eric.

Eric Bosshard - Cleveland Research

Can you just explain a little further what that is, what drives the variability of that, and just a little bit of the thinking behind what you're specifically doing with that variable, with that incentive comp?

Robert Niblock

Yes. It's quite simple. If you think about how the year has wound up versus how we started the year, in many of these markets with the impact from housing, credit, subprime, we gave our operators just unrealistic budgets. Given the environment, it wasn't realistic for them to be able to obtain that. Had we known the way that the cards were going the play out, we certainly would have provided a different budget.

Every year we try and give our store teams a budget based on the market conditions that we think is an appropriate budget that provides them the ability to earn a target bonus if they make their plan and then stretch opportunity above that. Certainly, in many of these markets, there was not the opportunity to earn a target bonus, much less the stretch bonus, whereas, in other markets we do have stores that are performing very well.

So it really boils down to the right thing to do for the organization. It's really designed to offset somewhat, the fact that the budgets were too tough out there in light of the circumstances, and it's really designed, if we make certain earnings per share targets in the fourth quarter, then it allows them to earn kind of a threshold, and then a little bit larger compensation based on those earnings per share targets.

But it is company-wide, and the reason for doing that is we want everybody, even though it's been a tough year in some of those markets, to be focused on sales, taking care of the customer, and in those markets where stores have not been as impacted and sales are going well, we want them to continue to drive sales as well.

And we do things like this from time-to-time when we've had broad-based impacts like this it's the right thing to do across the organization. I think it will keep everybody motivated in driving, providing great customer service. And as you think about it, we've talked about it before, anytime you have economic conditions, housing conditions like we see right now, it's a great opportunity to gain market share. Okay?

And that's what we're focused on, as Larry said in his comments, is gaining market share. And so, in some of these markets where we're seeing some of the toughest conditions from a macro standpoint, we still want everybody focused and motivated and morale high and taking care of customers so that we can gain share. And we think this is the type of programs that allows us to do that.

So, yes, while there is some slight cost here in the near-term, we think it pays huge dividends for us, with the morale and loyalty of our people and customer service for the long-term.

Eric Bosshard - Cleveland Research

Great. Thank you.

Operator

Your next question will come from the line of Colin McGranahan with Bernstein.

Colin McGranahan - Bernstein

Good morning. Just focusing on the expense line and knowing that the benefit from the self insurance is probably not repeating, if we were to back that out just for analytical purposes, it looks like SG&A dollars grew about 12.5% in the third quarter. Your guidance for the fourth quarter looks like SG&A dollars again, growing a little bit above 12% in the fourth quarter.

In your comment now that you're kind of seeing a lot more fixed cost, the variable portion that you're able to reduce, there is less leeway there. So, as I start to think about and model '08 numbers a little bit more carefully, and I know you haven't given guidance, but if we just ignore comps they are where they are, is that a rate of expense dollar growth that we should be thinking about or is there some delta to your square footage growth that you will be comfortable with in terms of the variable versus fix.

Bob Hull

Colin, I think it's, at this point, a little premature to be thinking about 2008. Obviously, Q3 didn't turn out as we expected. We kind of reset our Q4 targets based on what we've seen not only in Q3, but early Q4. As Larry talked about, we are looking for a number of ways to be more efficient in our operations. So I think it's a little bit premature to think about specifics about 2008 at this point in time.

Robert Niblock

Colin, this is Robert. And as you are try to make the necessary adjustments for the IB&R change in the third quarter, so on and so forth, and all of those certainly are issues that you have to adjust as you're looking out. But, as you know, not all quarters are made equally. So, I would encourage you more to do your analysis more based on an overall year, because, as Bob said, as you get into the fourth quarter your average sales per week per store lessens.

So certainly, it has a bigger impact if you have softness there against you base payroll numbers that are out there in the store. Obviously, it’s not as big of an issue in the spring of the year and things like the adjustment we have in the third quarter for the insurance adjustment, certainly that's the quarter that gets adjusted coming out of our actuarial analysis.

But a lot of those benefits that we get coming out of that are ongoing benefits that we don't expect to have another big pickup, but we expect to be able to maintain a lot of the positive drivers that have led to that adjustment. And those get, obviously, spread out into the future as we're making our necessary adjustment for our accrual rates and so on and so forth.

So, yes, when you look at it you've had a couple quarters here with some very unusual items, and then going into the fourth quarter, a couple of unusual items. But I think it makes more sense if you really look out across the full 12 months. It smoothes out some of those impact and probably gives you a little better read on what you're trying to get at.

Colin McGranahan - Bernstein

Okay. That's fair enough. And so expense dollars this year were up about 10% and I think square footage growth at 10%. Looks like square footage growth next year will be about 9%. So then, it's just fair to think that what you're focused on in terms of expense opportunities probably isn't enough to offset the natural increase in things like rent and insurance and utilities and what not? Is that just a fair way to think about the whole year?

Bob Hull

I think, first of all, you got to set a comp target to understand if your comp sales are increasing or decreasing to offset some inflationary pressures, wage increases, etc. Also, as we set our plan, we would expect to pay a target bonus which will put some pressure on our bonus line next year, so we haven't set all of those targets yet. So ideally, yes. I think you think about growing expenses in line with square footage from a theoretical standpoint, but we haven't set our plan for 2008 yet.

Colin McGranahan - Bernstein

Okay and then just one final quick follow-up. Home Depot mentioned some pressure on credit card income as they saw defaults go up in their portfolio. Can you just comment on what you're seeing in your portfolio and any impact?

Bob Hull

We are seeing some increases in losses for the year, credit card losses. They are higher than last year, but in fact, they are less than what we planned so far. We've had a disciplined growth strategy with our credit portfolio. We've not substantially changed our approval levels or our credit lines. We have a disciplined growth strategy where our mix of credit has increased about 100 basis points per year as a percentage of total tender type.

So, yes, we have seen additional losses from credit, but not anything we didn't expect. Our credit portfolio's contribution to the bottomline is on plan, year-to-date. We expect to be on plan for the fourth quarter.

Colin McGranahan - Bernstein

Okay. And any change in behavior as people are hitting the end of promotional periods, say six months to 12 months financing, are you seeing any change in the number of people who are not paying that off and starting to revolve?

Bob Hull

We are seeing some of that, but nothing substantial.

Colin McGranahan - Bernstein

Okay. Thank you. Good luck.

Robert Niblock

Thanks.

Operator

Your next question will come from the line of Danielle Fox with Merrill Lynch.

Danielle Fox - Merrill Lynch

Thanks. Good morning. This year you had a very year-end weighted or back-half weighted store opening schedule. I'm wondering if we should look for a similar cadence next year or if there is going to be more of an effort to balance it throughout the year to manage or at least to spread the expenses over not just your lower volume quarters, but all of the year.

Greg Bridgeford

Danielle, this is Greg Bridgeford. Next year, we anticipate a slight modulation amongst the quarters of the opening schedule with some more openings in Q3 versus Q4 as we try to balance that out. It's a slow process. It will take a few years. We got behind a couple of years ago. It's going to take a few years to work out of that imbalance situation. But we should see some progress. Right now, we're on track to see some progress in '08.

Danielle Fox - Merrill Lynch

Okay and just a quick follow-up. What are your plans for providing 2008 guidance? As I recall, you typically would have provided some sort of '08 guidance and understanding that this is a period of tremendous uncertainty. Is there any thought to not providing an outlook for the upcoming year and just sticking with your longer range growth target, what's your current thinking on the '08 guidance, timing and detail?

Bob Hull

First of all, at our Analyst Conference in September, we changed our tactic a little bit, providing a little bit broader measures over longer period of time, try to stay at a higher level for that forum. We will provide 2008 guidance during our Q4 earnings call in February.

Danielle Fox - Merrill Lynch

Okay, thanks.

Bob Hull

Yes, I think we have time for one more question.

Operator

And that question will come from the line Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot, just under the wire and good morning. Just a couple of follow-ups to some questions that others have answered or have asked rather, your fourth quarter guidance, where does that incremental $0.02 of potential incentive comp fit in? Is that in the number or would that be incremental to the number depending on your performance?

Bob Hull

That is in the 25% to 29% outlook that we provided.

Matthew Fassler - Goldman Sachs

And that just basically says if in fact you make those sales and EBIT numbers pre-bonus you take that [$0.02 hit then?]

Bob Hull

Right.

Matthew Fassler - Goldman Sachs

Fair enough. My second question, on the workers' comp item, the casualty insurance item. What period of time would be encompassed in the accruals that you took that you're now reversing? In other words, is this an adjustment that would cover the past two years, three years, one year, just to get a sense as to what the typical impact would be if you were to look at just the quarter alone?

Bob Hull

The claims involved span a long period of time. The claims that we've received that have yet to be settled, which could have happened in 2007 or any time prior, it also involves claims incurred but not reported. So, the claims involved span a number of years before and after today. We get a full blown actuarial update once per year. We get quarterly refreshes. So, every quarter we get an update from our actuaries on the current state, but only once a year is a full blown assessment of all of the factors.

So, as you think about what we've outlined for 2007, obviously, we expected our sales to have grown faster than it has been. What the impact there is additional employees and additional customer footsteps, which is the items that generate claims. Those were lower today than we've forecasted. Therefore, we over accrued in a sense, throughout the course of this year and our Q3 adjustment is somewhat undoing the accruals we've made year-to-date.

Matthew Fassler - Goldman Sachs

That's helpful. And then finally, this is the second quarter in a row you've spoken about detail fees turning to move up. And clearly, there is no direct linkage between what you saw there in Q2 and your sales trends in Q3, at least you didn't say that there was. How should we think about, how should we interpret that customer activity in the context of people's ability to buy and the drivers of that behavior, and is this something that we should be paying attention to or is there really a decoupling of these metrics now?

Larry Stone

Matt, this is Larry Stone. Detail fees, as I stated, is the starting point for project sales and the trend line for the past couple of quarters has been more positive even though it is still negative. And the way we look at that and the way I think you should look at that is based on the project sales, cabinets, flooring mill work, windows and so forth. Those are the things that would continue to drive sales in the large project areas. But our detail fees are still negative, but we do see some positive trends. But areas like Florida and California, we do not see that trend happening. So it's in other parts of the country.

I think if we saw the trend in Florida and California we'll be much more optimistic about our outlook for the fourth quarter. But those detail fees in those areas are still not responding. So that's why we want to rebalance our advertising, take a look at the parts of the country we can drive additional project sales in other parts of the country. We're not giving up on those categories, but certainly we're not going to push as hard as we might have in the past.

Matthew Fassler - Goldman Sachs

And Larry just to clarify, where the detail fees are recovering or the declines are diminishing, are you seeing the sales trend, the actual sales dollar trend recover commensurately?

Larry Stone

Yeah. We're seeing some good growth in parts of the country, especially in cabinets and flooring, and certainly, in those areas that still have pretty stable prices on houses and so forth. The big tickets are still working well for us.

Matthew Fassler - Goldman Sachs

Got you. Thank you so much.

Robert Niblock

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

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Source: Lowe's Companies Q3 2007 Earnings Call Transcript
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