Lowe's Companies Q3 2007 Earnings Call Transcript

| About: Lowe's Companies, (LOW)

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 - ClevelandResearch

Colin McGranahan - Bernstein

Danielle Fox - Merrill Lynch

Matthew Fassler - Goldman Sachs

Operator

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

Statements made during this call will includeforward-looking statements as defined in the Private Securities LitigationReform Act of 1995. Management's expectations and opinions reflected in thosestatements are subject to risks, and the company can give no assurance thatthey will prove to be correct. Those risks are described in the company'searnings release and in its filings with the Securities and ExchangeCommission.

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 openingremarks. Please go ahead, sir.

Robert Niblock

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

Sales in the quarter fell short of our expectations. Thatshortfall 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 programcombined with promotions that allowed us to gain share while maintaining anappropriate margin rate.

Certainly the largest impact on our sales, yet the hardestto quantify, was from housing-related pressures on the consumer. Thedeterioration in housing-related metrics combined with disruption in the creditmarkets and the tightening of lending standards and credit availabilityimpacted our performance this quarter. As a result, our comp trend deterioratedthrough the quarter from negative 1% in August to negative 6% in October, evenas we faced easier prior year comparisons.

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

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

On the contrary, indoor categories in those same marketsonly saw 150 basis point change in performance versus the second quarter,likely due in part to reduced slow traffic. Using our indoor versus outdoorproduct performance analysis, we estimate the drought conditions in many partsof the USnegatively impacted total company comp by approximately 75 basis points duringthe quarter.

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

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

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

While we're seeing gradual improvement in performance, ourexpectation was that our third quarter results would prove to be better. It'sapparent that these markets are experiencing other housing and credit-relatedpressures, which are negatively impacting our sales. In the end, our Gulf Coastregion negatively impacted total company comps by approximately 50 basispoints.

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

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

Combined with the other pressures to sales that I'vementioned, the widespread decline in comp trends may reflect the tightening ofmortgage credit standards across all markets or, perhaps, a psychologicalheadline effect of housing-related news negatively impacting consumer'sbehavior in structurally solid markets. Either way, during the quarter it wasdifficult to sustain sales momentum across much of the country.

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

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

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

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

In addition, there are other well documented pressures onthe 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' purchasingpower of resetting adjustable rate mortgages. Furthermore, elevated energycosts and the anticipation of further increases continues to impact American'sability to spend on discretionary projects.

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

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

In addition, our Californiastores serve as official donation sites for the American Red Cross. Donationsfrom customers and contributions from Lowe's totaled more than $350,000 andhelped the Red Cross meet their fund-raising goal for the recovery effort. It's dedicated employees with astrong 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 theirsecond consecutive NASCAR NEXTEL Cup Championship. Lowe's is proud to bepartnered with such a great organization and have them represent the Lowe'sbrand each week on and off the track.

Now here is Larry to describe in greater detail the resultsof the quarter and provide some insights on how we're managing the businesstoday. Larry?

Larry Stone

Thanks, Robert, and good morning. As Robert mentioned, salesenvironment remains challenging, and the external pressures facing our industrywill continue into 2008. This morning I'll provide some details on the thirdquarter results and discuss our focus on some near-term opportunities to ensurewe continue to meet customers' needs and drive efficiencies in a challengingsales environment.

Our goal is to balance those opportunities while maintainingour commitment to manage the business for the long-term. Following two productcategories achieved positive comps in the quarter. We continued to capturemarket share, which reflects our ability to capitalize on opportunities createdin the slower sales environment. According to third-party estimates, 17 of our20 product categories gained unit market share in the third calendar quarterversus the same period last year.

Highlighted here are the outperforming categories. Homeenvironment generated positive comp sales for the quarter. Extreme heatexperienced in most of the country drove air conditioner sales in the firstpart of the third quarter. The shift in air conditioner sales from the secondquarter to the third quarter had a slight drag on this quarter's gross marginrate. Rough plumbing posted positive comps for the quarter driven by consumerstrong demand for repair products, which is reflective of their commitment tomaintain their biggest asset, their home.

Water and air filtration products also had robust sales forthe quarter driven by consumers desire to maintain a healthier homeenvironment. Lighting also posted above company average for the quarter interms of comps driven by the strong demand for high-efficiency lightedsolutions, including compact fluorescent lights and motion sensor lightingproducts.

Major appliances also were above average in the quarter, buthad a slightly negative comp. Our lineup of brand name products coupled withtheir 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 theSoutheast, but this weakness was partially offset by strength in other regionsthat experienced more typical seasonal weather leading to overall performanceabove the company average. This shows that where weather permits, customersremain committed to having their lawns ready for the spring season.

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

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

5 of our 22 regions had positive comps in the quarter. Themagnitude of housing issues affecting a number of markets across the countryhas differed by region with the most significant impact in Californiaand Florida.As Robert mentioned, these markets continue to perform significantly below thecompany average, driving down our overall comp.

Additionally, consumers remain hesitant to take on largerdiscretionary projects, including mini projects offered through our installedsales and special order programs. As a result, our sales in those areas fellshort of our average comp and we continue to see regional disparity in theseareas. Specifically, California and Florida continued toshow the most pronounced year-over-year sales declines in big ticket projects.

Detail fees in our installed sales business continue to showimproving trends for the quarter, and while comp detail fees are stillnegative, the trend has improved over the past couple of quarters. As this is thestarting quarter for many installed sales projects, we monitor the detail feesand the close rate for those that result in project sales. In this challengingenvironment, our close rate has remained stable.

Commercial business customer sales continue to perform wellabove the company average. Our focus on maintenance and repair customers whoshop the entire store, not just lumber and building materials, and who are lessdependent on the housing cycle have helped ensure solid CBC sales and marginperformance so far this year.

As I stated earlier, we anticipated external pressures onthe housing market to continue into 2008. Here are few examples of what we'redoing to ensure we continue to deliver great customer experience and driveefficiencies in this challenging sales environment.

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

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

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

Also, we continue to work with our vendor partners to driveefficiencies by streamlining and automated receiving processes. Approximately75% of our goods are now running through our distribution network. Moving moreproduct through our network leads to more good faith receiving at our stores,which means employees don't need to spend additional hours verifying theproduct they are unloading. In turn, this gives us more hours to assist thecustomers in our aisles.

In order to drive additional efficiencies, we're alsolooking at methods to allow good faith receiving of select product that comestore direct from vendors. Obviously, part of the process includes ensuring weand our vendors have controls in place to properly account for product andcontrolled stream. We currently have programs in place with our molding andhardware vendors as a good faith to receive their products. Once again theseprograms will drive efficiencies in our stores.

Next, we're always looking for opportunities to leverage ourbest-in-class logistics and distribution network, and we are continuouslyexpanding the network to support our growth. Based on planned store growth andincreased sales volume, our long range plan anticipated that we would open our14th RDC in the spring of 2008.

Because current sales levels are not what we expected andour existing network has the capacity to manage our current demand, we havepostponed the opening of our 14th RDC by six to nine months. The expensestatements from postponing the opening of a fully operational and staffed RDCfar outweigh the costs associated to slightly longer hauls to our stores. Thisprudent decision is right for Lowe's and we're confident our current networkhas the capacity to ensure our stores remain in stock and customer demand ismet.

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

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

Fifth, adjusting for the environment. We're looking foropportunities to gain additional advertising efficiencies, including betteralignment of our 18-month promotional calendar. The market analysis Robertmentioned 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 bettertarget promotions that connect with customers in local markets.

For example, specific market dynamics have led someconsumers to remain hesitant to begin big ticket projects which is leading softproject sales in those markets. In order to continue to offer impactful marketmessage to these customers, our targeted local communications will highlightmaintenance and repair products that continue to show relative strength acrossall regions.

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

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

Our goal of being customer's first choice for homeimprovement in every market has not changed. Our philosophy about managing thebusiness for the long-term has not changed. Given the external pressures thatwe're currently weighing on the industry, we believe we're making adjustmentsnecessary to make Lowe's a stronger company and position us for continuedlong-term success.

Thank you for your time this morning. And I'm now turningthe 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% increaseover last year's third quarter. For the first nine months of 2007, salesincreased 3.8% to $37.9 billion.

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

In Q3, total customer count increased 4.7%, but averageticket decreased 1.5% to $66.95. For the quarter, comp transactions declined2.3% and comp average ticket decreased 2.2%. Lumber and building materialsdeflation negatively impacted third quarter comps by approximately 20 basis points.

With regard to products, the categories that performed aboveaverage 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 approximatelythe overall corporate average.

From a regional perspective, 5 of our 22 regions hadpositive comp sales in the quarter. However, 4 of the 22 regions haddouble-digit negative comps for the quarter. The negative double-digit compregions are in California, Floridaand along the Gulf Coast.

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

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

In addition, lower inventory shrink positively impactedgross margin by approximately 15 basis points. In last year's third quarter, weexperienced 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 increaseof 32 basis points over the first nine months of 2006.

SG&A for Q3 was 21.6% of sales and deleveraged 93 basispoints driven by a number of items. For the quarter, store payroll deleveraged64 basis points due to maintaining base staffing levels in our stores, whilesales per store are declining. Cycling against accrual reversals in last year'sthird quarter, bonus and retirement expense deleveraged 47 basis points in thequarter.

Rent, property taxes, utilities and other fixed expensesdeleveraged due to the comp sales decline. In addition, we saw casualtyinsurance expense leveraged in the quarter associated with our ongoing safetyinitiatives and benefit of some regulatory changes.

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

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

Operating margin, defined as gross margin less SG&A anddepreciation, 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 thefirst nine months of 2006.

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

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

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

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

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

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

In the third quarter, we issued $1.3 billion of seniorunsecured 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 thenotes will be used for general corporate purposes and to finance repurchases ofour common stock.

Our debt-to-equity ratio was 35.1% compared with 29.3% forQ3 last year. Return on invested capital, measured using beginning debt andequity in the trailing four quarters earnings, decreased 220 basis points forthe quarter to 16.1%. Return on assets, determined using beginning total assetsand 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 $142million or 4% over the first three quarters of 2006.

Looking ahead, I'd like to address several of the itemsdetailed in Lowe's business outlook. We expect a fourth quarter sales increaseof approximately 3% which assumes we open 72 new stores, 13 in November, 32 inDecember 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 todecline by approximately 280 basis points to last year as a percentage ofsales. The lower sales forecast will cause deleverage and deprecation in otherfixed costs. In addition, we expect store payroll deleverage of approximately90 basis points.

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

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

The income tax rate is forecasted to be 37.6% for the fourthquarter. The anticipated sales growth and operating margin decline are expectedto generate fourth quarter diluted earnings per share of $0.25 to $0.29, whichrepresents 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 ofapproximately 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 todeteriorate and a corresponding slowdown in our business. While we did see adeceleration in comp trends for the third quarter against easier prior yearcomparison, for first two weeks of the fourth quarter, our trends have improvedslightly and we believe we can achieve the sales guidance we've provided.

For the entire fiscal year, we are anticipating an operatingmargin decrease of approximately 130 basis points. The effective tax rate forthe year is projected to be 37.7%. As a result, we're expecting dilutedearnings 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-answersession. (Operator Instructions). Our first question will come from the line ofDeborah Weinswig with Citi.

Deborah Weinswig -Citi

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

Bob Hull

Sure, Deb. We didrepurchase 500 million shares in the third quarter. As you know, we do notcomment on prospective share repurchases. However, given that we've repurchasedalmost $2 billion year-to-date at an average price north of $30, we view thecurrent prices relatively attractive.

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

Deborah Weinswig -Citi

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

Larry Stone

Deborah, it’s Larry Stone. Based on everything that we'veencountered in the previous three quarters, we did come up with what we feltare very conservative sales estimates for the fourth quarter. And as indicatedin my prepared comments, some of the big ticket categories are not reallykicking-in in some of these real depressed markets in the Floridaand California regions and particularly in theGulf Coast.

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

Deborah Weinswig -Citi

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

Larry Stone

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

Deborah Weinswig -Citi

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

Robert Niblock

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

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

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

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

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 Bugatchwith Raymond James.

Budd Bugatch - RaymondJames

Good morning, Bob and Robert and Larry. I'd like to getinside the 280 basis points operating margin decline. Maybe you could helpflush 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, wedo expect some slight decline in gross margins in the fourth quarter. As Roberttalked about, seasonal categories and not knowing when others might initiatemarkdowns, our expectation is there might be some deterioration in gross marginrate for the fourth quarter.

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

Budd Bugatch - RaymondJames

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

Bob Hull

The other piece I was going to mention, Budd, isdepreciation.

Budd Bugatch - RaymondJames

And how what do you think that impact is?

Bob Hull

That would be somewhere around 40 basis points.

Budd Bugatch - RaymondJames

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 10basis 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 justlook 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 outyear-to-date.

Budd Bugatch -Raymond James

Okay, alright. Thank you, Bob.

Operator

Your next question will come from the line of Brian Nagelwith 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 improvingclaims just to help us understand, was that something that you had baked intoyour guidance previously?

Bob Hull

Brian, we did expect some favorable benefits when weprovided our Q3 outlook. I thought it might be a penny or two, I didn'tenvision it would be $112 million. Certainly, it was a positive surprise.Again, last year, self insurance reserves were about $77 million. So, as I saidin my prepared comments, the net leverage for the quarter in casualty insurancewas 19 basis points.

Brian Nagel - UBS

And the second question, with respect to the impact thatdroughts across the country have had on your business, then, we talked a lotabout that at your Analyst Meeting in late September, did that improve as wewent 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'timprove as we went through the quarter. So a significant portion of the falllawn restoration that you'd see in those drought-impacted market as late asyou're getting, you're going to lose a good portion of that and those consumersmay very likely decide to do their restoration in spring, assuming that therain conditions have improved in the spring.

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

But clearly some of that business, we believe, will be lostand you would ideally hope that provides for a little stronger spring sellingseason in those affected areas to the extent that the drought conditions havecorrected themselves.

Brian Nagel - UBS

That's helpful. Thank you.

Operator

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

Eric Bosshard - Cleveland Research

Good morning. Bob, if you could, the 280 basis point margindegradation in 4Q, I understand the components of that, but I guess taking astep back, it's roughly 2X the margin decline of 3Q on similar salesperformance. Can you just explain a little bit further why it looks so worse in4Q than what was experienced in 3Q?

Bob Hull

Sure, Eric. Two items to note. One is the casualty insurancepickup 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 forweek, it's actually about 11% lower sales per store per week than Q3 andactually 28% lower than Q2. So, we're at a point now where the lion's share ofour expenses is fixed costs. The other thing we're seeing as relates to thosefixed 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 incentivecompensation that we've put out there for the fourth quarter was not there inthe third quarter, Eric.

Eric Bosshard - Cleveland Research

Can you just explain a little further what that is, whatdrives the variability of that, and just a little bit of the thinking behindwhat 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 haswound up versus how we started the year, in many of these markets with theimpact from housing, credit, subprime, we gave our operators just unrealisticbudgets. Given the environment, it wasn't realistic for them to be able toobtain that. Had we known the way that the cards were going the play out, wecertainly would have provided a different budget.

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

So it really boils down to the right thing to do for theorganization. It's really designed to offset somewhat, the fact that thebudgets were too tough out there in light of the circumstances, and it's reallydesigned, 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 largercompensation based on those earnings per share targets.

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

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

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

So, yes, while there is some slight cost here in thenear-term, we think it pays huge dividends for us, with the morale and loyaltyof 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 ColinMcGranahan with Bernstein.

Colin McGranahan - Bernstein

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

In your comment now that you're kind of seeing a lot morefixed cost, the variable portion that you're able to reduce, there is lessleeway there. So, as I start to think about and model '08 numbers a little bitmore carefully, and I know you haven't given guidance, but if we just ignorecomps they are where they are, is that a rate of expense dollar growth that weshould be thinking about or is there some delta to your square footage growththat 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 bethinking about 2008. Obviously, Q3 didn't turn out as we expected. We kind ofreset our Q4 targets based on what we've seen not only in Q3, but early Q4. AsLarry talked about, we are looking for a number of ways to be more efficient inour operations. So I think it's a little bit premature to think about specificsabout 2008 at this point in time.

Robert Niblock

Colin, this is Robert. And as you are try to make thenecessary adjustments for the IB&R change in the third quarter, so on andso forth, and all of those certainly are issues that you have to adjust asyou're looking out. But, as you know, not all quarters are made equally. So, Iwould 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 perweek per store lessens.

So certainly, it has a bigger impact if you have softnessthere 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 thingslike the adjustment we have in the third quarter for the insurance adjustment,certainly that's the quarter that gets adjusted coming out of our actuarialanalysis.

But a lot of those benefits that we get coming out of thatare ongoing benefits that we don't expect to have another big pickup, but weexpect to be able to maintain a lot of the positive drivers that have led tothat adjustment. And those get, obviously, spread out into the future as we'remaking 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 quartershere with some very unusual items, and then going into the fourth quarter, acouple of unusual items. But I think it makes more sense if you really look outacross the full 12 months. It smoothes out some of those impact and probablygives 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 yearwere up about 10% and I think square footage growth at 10%. Looks like squarefootage growth next year will be about 9%. So then, it's just fair to thinkthat what you're focused on in terms of expense opportunities probably isn'tenough to offset the natural increase in things like rent and insurance andutilities 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 tounderstand if your comp sales are increasing or decreasing to offset someinflationary pressures, wage increases, etc. Also, as we set our plan, we wouldexpect to pay a target bonus which will put some pressure on our bonus linenext year, so we haven't set all of those targets yet. So ideally, yes. I thinkyou think about growing expenses in line with square footage from a theoreticalstandpoint, but we haven't set our plan for 2008 yet.

Colin McGranahan - Bernstein

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

Bob Hull

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

So, yes, we have seen additional losses from credit, but notanything we didn't expect. Our credit portfolio's contribution to the bottomlineis 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 theend of promotional periods, say six months to 12 months financing, are youseeing any change in the number of people who are not paying that off andstarting 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 Foxwith Merrill Lynch.

Danielle Fox -Merrill Lynch

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

Greg Bridgeford

Danielle, this is Greg Bridgeford. Next year, we anticipatea slight modulation amongst the quarters of the opening schedule with some moreopenings in Q3 versus Q4 as we try to balance that out. It's a slow process. Itwill take a few years. We got behind a couple of years ago. It's going to takea few years to work out of that imbalance situation. But we should see someprogress. 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 forproviding 2008 guidance? As I recall, you typically would have provided somesort of '08 guidance and understanding that this is a period of tremendousuncertainty. Is there any thought to not providing an outlook for the upcomingyear and just sticking with your longer range growth target, what's yourcurrent thinking on the '08 guidance, timing and detail?

Bob Hull

First of all, at our Analyst Conference in September, wechanged our tactic a little bit, providing a little bit broader measures overlonger period of time, try to stay at a higher level for that forum. We willprovide 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 Fasslerwith Goldman Sachs.

Matthew Fassler -Goldman Sachs

Thanks a lot, just under the wire and good morning. Just acouple of follow-ups to some questions that others have answered or have askedrather, your fourth quarter guidance, where does that incremental $0.02 ofpotential incentive comp fit in? Is that in the number or would that beincremental 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 salesand 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 theaccruals that you took that you're now reversing? In other words, is this anadjustment that would cover the past two years, three years, one year, just toget a sense as to what the typical impact would be if you were to look at justthe quarter alone?

Bob Hull

The claims involved span a long period of time. The claimsthat we've received that have yet to be settled, which could have happened in2007 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 afull blown actuarial update once per year. We get quarterly refreshes. So,every quarter we get an update from our actuaries on the current state, butonly 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. Whatthe impact there is additional employees and additional customer footsteps,which is the items that generate claims. Those were lower today than we'veforecasted. Therefore, we over accrued in a sense, throughout the course ofthis 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 quarterin a row you've spoken about detail fees turning to move up. And clearly, thereis no direct linkage between what you saw there in Q2 and your sales trends inQ3, at least you didn't say that there was. How should we think about, howshould we interpret that customer activity in the context of people's abilityto buy and the drivers of that behavior, and is this something that we shouldbe 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 thestarting point for project sales and the trend line for the past couple ofquarters has been more positive even though it is still negative. And the waywe look at that and the way I think you should look at that is based on theproject sales, cabinets, flooring mill work, windows and so forth. Those arethe things that would continue to drive sales in the large project areas. Butour detail fees are still negative, but we do see some positive trends. Butareas like Florida and California, we do not see that trendhappening. So it's in other parts of the country.

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

Matthew Fassler -Goldman Sachs

And Larry just to clarify, where the detail fees arerecovering or the declines are diminishing, are you seeing the sales trend, theactual 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 stillhave pretty stable prices on houses and so forth. The big tickets are stillworking well for us.

Matthew Fassler -Goldman Sachs

Got you. Thank you so much.

Robert Niblock

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

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