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

F1Q08 Earnings Call

May 19, 2008 9:00 am ET

Executives

Robert A. Niblock - Chairman of the Board, Chief Executive Officer

Larry D. Stone - President, Chief Operating Officer

Robert F. Hull Jr. - Chief Financial Officer, Executive Vice President

Analysts

Deborah Weinswig - Citigroup

David Strasser - Banc of America Securities

Chris Horvers - Bear Stearns

Budd Bugatch - Raymond James

Colin McGranahan - Sanford C. Bernstein

Mitch Kaiser - Piper Jaffray

Matthew Fassler - Goldman Sachs

Mike Baker - Deutsche Bank

Operator

Good morning, everyone, and welcome to Lowe's Companies’ first quarter 2008 earnings conference 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 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 A. Niblock

Good morning and thanks for your interest in Lowe's. Following my remarks, Larry Stone will review our operational performance, including what we are doing to manage the business in today’s challenging environment. Then Bob Hull will review our first quarter financial results.

First, a few comments about the quarter -- as expected, the decline in housing activity that has weighed on the home improvement industry and pressured our performance over the past six quarters continued into the first quarter of 2008. Top line sales decreased 1.3% and comp sales declined 8.4%. Both were below our expectations.

While our guidance anticipated a very difficult sales environment, two primary factors accounted for our below plan sales. First, wet cool weather in February and March more than offset the more seasonable weather experienced in April. Comps were down 12% in the February to March period and negative 1% in April.

Second, and probably the larger of the two, the continued erosion of macroeconomic variables and the resulting impact on consumers was greater than we anticipated. Food and fuel inflation and an increasingly negative employment environment pressured consumers’ wallets and eroded confidence. In addition, today nearly 80% of our comp stores are located in markets experiencing housing price declines.

As a result, many consumers remain hesitant to begin big ticket projects. The continued housing contraction in certain U.S. markets, increasing pressure on discretionary income, and an uncertain jobs market are all top of mind with consumers.

While April’s performance is encouraging, it is certainly too early to characterize it as a change in trend and the uncertainty in the broader economy suggests a conservative outlook is warranted.

In all sales environments, our goal is to prudently manage expenses and identify opportunities to drive efficiencies while working to maintain the excellent service customers have come to expect from Lowe's. Our disciplined expense management continued in the first quarter and drove respectable earnings per share of $0.41, which was within our stated guidance.

In addition, despite the external pressures on sales, we continued to capture market share. During the quarter, we gained 70 basis points of total unit market share according to third-party sources. Our market share gains are driven by the dedication of our 215,000 plus employees who remain focused on providing exception customer service every day and our compelling offering of customer-valued solutions. Later in the call, Larry will provide more color about product-specific category performance.

On the past several conference calls, we’ve described our use of third-party home price information to define three broad market groups based on home price dynamics. We described our performance in over-priced markets with a correction expected or occurring, over-priced markets with no pricing correction expected, and not over-priced markets.

We continue to see our most significant negative comps in over-priced markets going through housing price correction. But in the first quarter, the relative difference in comp performance between over-priced with a correction expected and not over-priced markets narrowed, driven by a slightly worse comp in the not over-priced markets compared to fourth quarter. We believe comp sales declines in these more stable housing markets are a reflection of the broader overall downturn seen in the U.S. economy during the first quarter.

It bears repeating -- the external pressures facing our industry will likely persist throughout 2008 and the sales environment will remain challenging. We remain cautious about our outlook and have a prudent plan in place for 2008. we will continue to closely monitor consumer sentiment and the other structural drivers related to home improvement, including housing turnover, employment, and personal disposable income.

Historically, fed rate cuts, as well as physical stimulus packages have been beneficial to our business. However, consumers are facing rising costs elsewhere that may dampen their spending on home improvement. The net effect is difficult to predict so we are taking a conservative view with respect to the recent fed action and the economic stimulus plan. We are managing the business for the long-term and will continue to build upon our already strong foundation. Our goal is to provide outstanding value and gain market share through our superior shopping environment, compelling selection of products, and great service. We are confident that we are well-positioned to take advantage of the opportunity to gain market share in the current environment.

Now, Larry Stone will provide greater detail on our first quarter results. Larry.

Larry D. Stone

Thanks, Robert and good morning. As Robert mentioned, the sales environment remains extremely challenging as the external pressures facing our industry have intensified. Today, I will share a few details of the quarter and describe the things we are doing to drive profitable sales in the current environment.

When I spoke on the earnings call three months ago, I described the fact that we were anticipating a tough sales environment in 2008 and that we were planning conservatively but we would be ready to react if sales came in differently than we had planned. Unfortunately, sales and comps for the quarter were weaker than anticipated. We saw a 3.1 reduction in comp traffic and a 5.3% reduction in comp average ticket, leading to our negative comps of 8.4%.

On the positive side, we experienced a significant improvement in sales in April versus March, an encouraging sign, but much of that improvement was driven by the sale of seasonal products and we have still not experienced a significant improvement in some of our core categories. Until we see improvement in our core categories, we will remain cautious in our outlook and remain conservative in our planning.

None of our product categories generated a positive comp in the quarter, a clear sign of significant pressures on our sales. Categories above the average comp included flooring, lawn and landscape products, nursery, paint, and appliances. In flooring, we’ve seen a very favorable response from customers to our 199 entire house carpet installation program. This offer simplifies a somewhat complex and intimidating process of determining the costs for having carpet installed. As a result of this program, we have seen a solid lift in our installed carpet sales.

We saw good sales in seasonal products, especially in April, and that led to above average comp performance in our lawn and landscape and nursery categories in the quarter. Consumers looking to repair lawn damage from last year’s widespread drought conditions and the introduction of innovative easy-to-use products led to strong sales in grass seed. On the nursery side, trees and shrubs had strong sales in the quarter as customers replaced many of the products that did not survive last fall’s drought.

Even in today’s tough economic times, consumers appear willing to take on smaller projects around the home, as evident in the relative performance of our paint category, the number one DIY home improvement project.

Finally, our appliance category continues to perform well. We launched the Electrolux brand during the first quarter and all of our stores have [been set] with this new offering. Early sales of this brand certainly contributed to success of the appliance category in the quarter.

On a regional basis, there remains a wide range of comp performance as four of our 22 regions delivered positive comps in the quarter, while six regions had double-digit negative comps. Positive comp in regions include areas of the Northeast that experienced a very rough early spring last year and generated relatively better sales this year, and our strong sales performance in areas of Texas and Oklahoma that we experienced in fiscal 2007 continued into the first quarter this year.

On the other side of the coin, all four regions of our western division delivered double-digit negative comps as housing markets in California, Nevada, Arizona, and the Pacific Northwest remain pressured. Our Florida and Gulf Coast regions also had double-digit negative comps in the quarter. On the plus side, these two regions experienced a slight improvement from the first quarter of 2007 to continue the improving trend we saw throughout last year.

In the first quarter we had our best relative performance in our big three initiatives in several quarters. Driven by our flooring category, our installed sales delivered a comp above the company average but continued weakness in our cabinets and millwork categories forces us to remain cautious.

Our special order business, again driven by flooring and strong special order appliance sales, also outperformed the company average comp in the quarter. Finally, our targeted efforts to attract commercial customers continue to pay dividends. We recently rolled out an enhanced customer account management tool that is ensuring our stores stay in touch with both active and inactive commercial accounts, driving sales, and producing above average comp in the quarter.

While we still have room for improvement in all three of these businesses and each experienced a slightly negative comp in the quarter, we are encouraged by the relative performance.

In the end, a negative 8.4% comp is certainly nothing to get excited about but in an environment where the market is shrinking, our goal remains to get a bigger piece of that market in every part of the business.

According to third-party market share estimates, we continue to capture solid share in the first quarter. We gained unit market share in 15 of our 19 product categories, and as Robert mentioned, we gained 70 basis points of total store unit market share.

I am also encouraged by our draw rate, or the number of times Lowe's [was in the consideration set] of customers buying the products we sell. Of our 19 categories, draw rates improved in 17, stayed flat in one, and declined slightly in one in the first quarter. These solid results suggest that we are moving ever closer to achieving our vision of become the customer’s first choice for home improvement.

We also know the competitive landscape is changing, as anecdotal evidence shows less well-capitalized competitors are struggling during this downturn in the industry. We are working to ensure we are positioned to capitalized on the opportunities created by a changing competitive environment. I am confident we are appropriately managing our business and I think our ability to respond quickly to our sales shortfall in the first quarter is evidence of that.

We staffed our stores cautiously into the spring season, ready to ramp quickly if needed but also ready to pull back if sales didn’t materialize. In the first quarter, we deleveraged payroll by 61 basis points. Considering the weak sales environment, I am pleased with our stores’ efforts to manage payroll in the always challenging spring season, and I am also pleased that our customer service scores improved in the quarter, which shows we are still delivering great service every day.

Also last quarter I mentioned our conservative inventory build heading into the spring. I think our solid inventory position at the end of the quarter shows our ability to manage this asset in a tough selling environment. Despite the slow start to spring, we are in a great inventory position on seasonal product. Our distribution infrastructure has allowed us to cost effectively position inventory in the right place to sell the product. We continue to utilize our coastal holding facilities to better position seasonal inventory to maximize sales and profits.

During the quarter, we opened 20 new stores and remain on track to open 120 stores in fiscal 2008. As the sales environment remains pressured across most of the country, we continue to closely scrutinize every new store project to ensure we are putting capital to good use and maximizing returns to shareholders. Our current [inaudible] store base includes a disproportionate number of stores in some of the hardest hit markets from a housing perspective, including California and Florida, and some of these stores are generating sales below our original expectations. Over time, we are confident these markets will recover and returns will improve but as we mentioned last quarter, we have taken a close look at our expansion pipeline, including the 100 additional stores we opened this year. In some cases, we have postponed plan new store openings in the most pressured markets until conditions improve. In other cases, we’ve walked away from prospective sites with plans to revisit the market in the future.

We think the steps we have taken will help ensure continued solid sales productivity and appropriate returns from our new stores.

On the marketing side, encouragingly we continue to see a relatively stable promotional environment. Consumers are clearly looking for value and with the price of gasoline today, they want the confidence to shop without worrying about whether they are getting a great price and without the trouble of driving around to compare prices. They want simple, easy-to-understand offers where the value is clear. Our commitment to EDLP and our 10% price guarantee gives customers the comfort to shop our stores with confidence.

We are also continuing the use of our new lower price or NLP program. These are price reductions on products that consumers want to purchase every day. Our merchants have done a great job working with our vendors to deliver enhanced value to customers.

Finally, I mentioned last quarter a new initiative we are calling innovation at a value. Our goal is to work with vendors to bring exciting product innovation that has historically been limited to the best and premium end of the pricing continuum, more to the middle of the line. We gained traction with this initiative in the first quarter with products like our exclusive Shop-Vac Upright Vacuum. It’s the lightest full power upright on the market today and at $129, compares to vacs priced at more than $300 -- a true example of innovation at a value. This is just one example and our merchants have many more in the pipeline to help continue to differentiate Lowe's and reinforce our value message.

Unfortunately, pressures will remain on the industry at least through 2008. Our goal remains to drive profitable market share gains, manage expenses, and make the right decisions to ensure we are well-positioned when the sales environment does improve. With this approach, I feel we will continue to maximize long-term returns to shareholders.

Thanks for your attention and I will now turn the call over to Bob Hull to review the financials. Bob.

Robert F. Hull Jr.

Thanks, Larry and good morning, everyone. Sales for the first quarter were $12 billion, representing a 1.3% decrease from last year’s first quarter. Total transactions increased 1.6% for the quarter, while total average ticket was down 2.9% to $66.23. Comp sales were negative 8.4% for the quarter, which is below our expectations of negative 5% to negative 7%. Looking at monthly trends, comps were negative 9% in February, negative 14% in March, and negative 1% in April.

As a result of a shift in timing of the Easter holiday, March comps were negatively impacted by slightly less than 200 basis points and April comps were positively impacted by just over 200 basis points. There was no impact on the quarter.

And as Larry mentioned, for the quarter comp transactions decreased 5.3% and comp average ticket decreased 3.1%. Lumber, plywood, and gypsum prices in the quarter were down for the same period last year. This deflation negatively impacted first quarter comps by approximately 30 basis points.

With regard to product categories, the categories that performed above average in the first quarter include rough plumbing, hardware, paint, flooring, nursery, lawn and landscape products, and appliances. In addition, building materials and rough electrical performed at approximately the overall corporate average.

Gross margin for the first quarter was 34.7% of sales and decreased 30 basis points from last year’s first quarter. The decrease in gross margin was driven by a number of factors. First, there are a few product categories where it has been difficult to pass on price increases. Specifically, some commodities such as lumber, gypsum, pipe, and copper cable have proved to be particularly challenging. This had an approximate negative 20 basis point impact on gross margin in the quarter.

In addition, higher fuel costs increased cost of goods sold and negatively impacted gross margin by approximately 10 basis points.

Lastly, the whole house carpet promotion that Larry mentioned negatively impacted gross margin by approximately 10 basis points in Q1. This led to an opportunity to simplify the shopping experience and offer the customer a great value. The customer did respond favorably to the offering and the promotion generated positive gross margin dollars. However, as with anything new, we will continue to identify ways to improve the net profitability associated with this offer.

Slightly offsetting these items were a positive impact of 13 basis points from lower inventory shrink as a percentage of sales and 12 basis points from the margin mix of products sold.

SG&A for Q1 was 22.7% of sales, which deleveraged 63 basis points, driven by store payroll and fixed costs. As sales per store declined, additional stores are hitting the minimum hour’s threshold, which increases the proportion of fixed to total payroll. For the quarter, store payroll expense deleveraged 61 basis points. In Q1, rent and property tax expenses deleveraged approximately 10 basis points each.

The utilities expense was flat to last year as a percent of sales. Cooler weather in the quarter led to lower consumption which offset higher energy costs. Bonus expense was essentially flat to last year as a percent of sales in the quarter as we adjusted accruals due to lower-than-planned sales. Our expectation for Q1 was to deleverage 20 basis points.

Over the past several quarters, we have discussed our initiatives related to in-sourcing certain tasks previously performed by third-party vendors in our stores. In 2006, we implemented phase one of our product service associate, or PSA program. In 2007, we implemented phase two and in Q1 2008, phase three. In-sourcing these tasks gives us more control over the work being done which improves productivity at a lower cost.

As I mentioned earlier, we deleveraged payroll by 61 basis points, approximately 25 basis points of which was caused by the additional PSA position. As a result of the PSA transition, we were able to leverage in-store service expense by 30 basis points in the first quarter. The net positive impact of the PSA transition to SG&A in the quarter was approximately five basis points.

Depreciation at 3.1% of sales totaled $375 million and deleveraged 47 basis points compared with last year’s first quarter, primarily due to negative comp sales and a 15% increase in fixed assets driven by the addition of 154 stores over the past 12 months.

Store opening costs of $18 million deleveraged five basis points to last year as a percent of sales. In the first quarter, we opened 20 new stores. This compares to 15 new stores open in Q1 last year.

Earnings before interest and taxes, or EBIT margin, was 8.7% of sales and decreased 145 basis points, which is better than our expectation of a 170 basis point decline.

Interest expense at $76 million deleveraged 24 basis points as a percent of sales. This deleverage was caused by the additional expense associated with the $1.3 billion of senior unsecured bonds issued in the third quarter of 2007 and short-term borrowings outstanding during the quarter.

For the quarter, total expenses were 26.6% of sales and deleveraged 139 basis points.

Pretax earnings for the quarter were 8.1% of sales. The effective tax rate for the quarter was 37.6% compared with 38% for Q1 last year. Diluted earnings per share of $0.41 were within our guidance of $0.38 to $0.42 for the quarter but decreased 14.6% versus last year’s $0.48.

Now to a few items on the balance sheet -- our cash and cash equivalents balance at the end of the quarter was $913 million. Inventory turnover, calculated by taking a trailing four quarters cost of sales divided by average inventory for the last five quarters, was 3.92, a decrease of 16 basis points from Q1 2007.

Our first quarter inventory balance decreased $63 million, or 0.7% versus Q1 last year. Comp store and distribution inventory were both down from last year as we build more conservative sales plans for seasonal products and successfully implemented inventory productivity initiatives in several categories.

At the end of the first quarter, we owned 87% of our stores versus 86% at the end of the first quarter last year. Our debt-to-equity ratio was 34.6% compared with 27.7% for Q1 last year. This increase was due to last year’s bond deal and short-term borrowings to fund our Canadian expansion.

Return on invested capital, measured using a trailing four quarters earnings plus tax adjusted interest divided by average debt and equity for the last five quarters, decreased 309 basis points for the quarter to 13.1%.

Return on assets, which is determined using a trailing four quarters earnings divided by average assets for the last five quarters, decreased 215 basis points to 8.7%.

Our leverage guard rail remains 1.2 times lease adjusted debt to EBITDAR for the first three quarters and due to the seasonality of our cash flows, 1.4 times at year-end. These targets were established based on our goal of maintaining a strong single A credit rating and an A1 P1 commercial paper rating, which is not only prudent in this environment but provides us the financial flexibility to manage our business.

At the end of the first quarter, leased adjusted debt to EBITDAR was 1.35 times, which exceeded our 1.2 times target for Q1. There were no shares repurchased in the first quarter and our current plans do not contemplate any share repurchases for fiscal 2008. We continue to evaluate market conditions and diligently evaluate our options to balance financial flexibility against the opportunities presented in the market. Should conditions change, we’ll react appropriately.

For the quarter, cash flow from operations exceeded $2.5 billion, which represents a $399 million, or 18.7% increase over Q1 2007. Looking ahead, I would like to address several of the items detailed in Lowe's business outlook. In Q2, we expect a comp sales decrease of 6% to 8% and to open 23 new stores, one in May, 12 in June, and 10 stores in July. Total sales are forecasted to increase approximately 1% in the second quarter. EBIT margin for the second quarter is expected to decrease approximately 190 basis points over last year. The decline in EBIT margin will be largely attributable to store payroll as well as depreciation, fixed costs, and gross margin.

We expect the gross margin pressures related to commodity pricing and fuel impacted transportation costs to continue for the remainder of the year. We are forecasting an effective tax rate of 37.8% for Q2. For the second quarter, we are expecting diluted earnings per share of $0.54 to $0.59, which represents a decrease of 12% to 19%.

For 2008, we expect to open approximately 120 stores, resulting in an increase in square footage of 7% to 8%. We are estimating a comp sales decrease of 6% to 7% and a total sales increase of approximately 1%.

We expect EBIT margin to decline by approximately 190 basis points in the second half of 2008. EBIT decline will be more pronounced in the third quarter as a result of comparison to the favorable self-insurance adjustment in Q3 of 2007.

For the fiscal year, we are anticipating an EBIT margin decrease of approximately 180 basis points, driven by store payroll as well as depreciation, fixed costs, and gross margin.

We are forecasting an effective tax rate of 37.75% for 2008. As a result, we expect diluted earnings per share of $1.45 to $1.55 for the year.

We are now ready for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Deborah Weinswig with Citigroup.

Deborah Weinswig - Citigroup

Good morning and congratulations on managing well in a tough environment. In terms of the expense side of the picture, you know, we were very impressed with your expense management in the quarter. Can you talk about anything specifically that you did in terms of new initiatives, et cetera, to really hone in on what maybe you could postpone, et cetera, from a kind of cost perspective?

Robert A. Niblock

I think what I would like to do is get Larry to talk a little bit about from the store side what we did to manage payroll hours in the store and how we built the plan differently this year than what we’ve done in the past, which helped us obtain some of that less deleverage than we had anticipated.

Larry D. Stone

Certainly this year, as we said in the fourth quarter call, we want to really plan conservatively going into the spring and typically in the spring, we ramp up the hours and ramp up the stores, but this year we went in with a very conservative plan and gave instructions on how to ramp. The sales came quicker than we expected.

As I said in my prepared comments, the comps did not come like we expected so certainly we didn’t build the staffing plan like we had anticipated we might. A lot of initiatives Mike Brown, who heads up store operations, has bee working on in terms of the sales tiers that we spoke of many times, how we staff the stores to make sure we are maximizing the labor that we have in the store and at the same time doing a great job on service.

So when things [have fell] as rapidly as they did in the past several quarters, we’ve had to adjust stores down to the various sales tiers and what we wanted to do is let attrition take care of a lot of it, so that’s why sometimes we didn’t get the payroll down as much as we’d like. This year, going in more conservatively and coming through the winter months, we were able to hold that payroll number down a lot better in my opinion. And Mike has a lot of initiatives they are working on for the back half of the year so hopefully we’ll be able to continue to do a good job and manage that payroll expense.

Deborah Weinswig - Citigroup

Okay, so Robert, most of this was just very I would say tight expense control at the store level?

Robert A. Niblock

A lot of it’s tight expense control. We also talked about in Bob Hull’s comments, the switch where we went from having third parties doing some of the tasks inside the store to using our own people, our PSAs as we call them. And obviously that put deleverage on payroll but it ticked up leverage on our store services line. The net of that was favorable about five to seven basis points, in that range. And we continue with some of the initiatives we have with some of our costs for providing insurance. We are self-insured over a lot of categories for insurance. We continue to see favorable trends and a lot of that is just initiatives that we have put in place to try and manage that, be it either on the employee side for health insurance and initiatives we’ve taken there to try and manage down the escalation in costs, on the general liability side, you know, safety programs and other things that we’ve put in place to continue to try and manage those trends at favorable trendlines. So some of those are coming in a little better than we had originally anticipated the trendlines would be and we’ll continue to try and pursue those efforts as well.

Deborah Weinswig - Citigroup

Okay, and then I just wanted to clarify one of your comments about Florida and the Gulf Coast region -- would you go as far as to say that you’ve seen stabilization in those two regions based on your comments in this call?

Robert A. Niblock

Yeah, I think so. If you look at the comments we made, I think we saw improvement in the negative comps in those regions over 2007 and that improvement continued into the first quarter of 2008.

Deborah Weinswig - Citigroup

Great. Thanks again and congratulations.

Operator

Your next question will be from David Strasser with Banc of America Securities.

David Strasser - Banc of America Securities

Thank you. Looking at gross margin, you went through a couple of things that help and hurt. As you think about it through the rest of the year, how stable do you think those numbers are -- the gross margins are and how should we be thinking about it into the back half of the year?

Robert F. Hull Jr.

As we’ve talked about in the past, we came into the year thinking we might have some slight gross margin expansion. As a result of the pressures we are seeing related to fuel and commodities, we think it’s probably a slight decline for the year. In addition, as we’ve said in the past, not all quarters are made alike so the impact quarter by quarter will be a little bit lumpy. I think your guess is as good as mine what’s going to happen with fuel prices so we are planning conservatively at this point in time. Typically there is some time lag between price increases and retail increases for commodities. We think that will be true here as well but it might just take a bit longer to get in and impact the retail prices.

David Strasser - Banc of America Securities

So you think actually some of these areas where you weren’t able to pass on that pricing, you might, you know, as the year progresses you might be able to do some of that?

Robert F. Hull Jr.

I think that’s a possibility, yeah.

David Strasser - Banc of America Securities

And just one last question on interest -- you guys paid off some interest this quarter. You had relatively strong cash flow. Can we start to see that get -- you know, those increases start to subside?

Robert F. Hull Jr.

I think so. As you know, we’ve got in the market the past couple of years with financings. There’s none contemplated in 2008. We have a pretty wide swing in our seasonal cash flows, so right now we are entering our Christmas selling season, which is our peak cash balances. We were able to pay off all of our outstanding commercial paper at the end of the first quarter with the exception of the Canadian borrowings that I mentioned. We do expect to exceed our lease adjusted debt to EBITDAR metric at year-end, so at year-end as our business slows we expect our cash balance to only be slightly above where it finished year-end 2007.

David Strasser - Banc of America Securities

Thank you. Appreciate it.

Operator

Your next question will be from Chris Horvers of Bear Stearns.

Chris Horvers - Bear Stearns

Thanks and good morning. The question is can you take us through the rationale on the change in guidance? The first quarter EPS comes in a little bit above, the comps below, probably shaving about 60 basis points off the comp guidance for the year. The question is -- is the year playing out as you expected? Meaning if you look at the second quarter, what we had expected for 2Q, you are pretty much in line there. So could you take us down the rationale for bringing down the back half?

Robert A. Niblock

I’ll start with just some overview comments and then I’ll have Bob get into the details of the drivers of the guidance on the first versus the second half. I mean, obviously when you think about coming into the year with the guidance we gave and where we took the earnings to for the year versus last year, when we talk about our first quarter comp guidance as being a negative 5% to a negative 7%, and then you come in outside of that, that’s a -- you know, that has stand up and take pause. Certainly I talked about in my comments the wet, cool weather and we think without the wet, cool weather, yes, we would have probably been within or close to possibly the negative 7 part of that guidance but maybe not quite in it. So net net, what that tells us is that in the first quarter of the year, the environment was weaker than we anticipated. I mean certainly when you look at some of the unprecedented things that took place in the credit markets, we continue to hear negative information coming out on overall macro variables. If you look at what’s happening and all the press you are seeing about food and fuel prices, as I mentioned in my comments, net net when we look at everything, the environment was still slightly weaker than we anticipated.

You know, it’s really tough. We’ve got, as we said, we don’t know what the full impact of the economic stimulus package will be. We think there will be a benefit. How much of that there will be is hard to determine, so when we reduced our guidance like that and you still fall outside of it, it caused us to take just a slightly more conservative standpoint as we go over the balance of the year. Hopefully things are better than we anticipate, hopefully we’ve gotten conservative enough over the balance of the year but that’s really what drove that decision, is that even when you ex out the weather, the first quarter was still slightly weaker than what we anticipated.

So with that, I’ll let Bob talk about some of the detail drivers.

Robert F. Hull Jr.

As Robert mentioned, our sales came in below expectations for Q1 so if you think about coming into the year, we guided for comps down 5% to 6% for the year. We are now down 6% to 7%. The second piece of that is on my comments regarding gross margin, we expected some slight gross margin increase for the year. That’s flipped to slight gross margin decline for the year.

And then as Robert said, we continue to think about the business in this uncertain environment with the many pressures facing the consumer and just try to be as prudent as possible in our planning.

Chris Horvers - Bear Stearns

So was -- have you thought about what you might have thought for 2Q one quarter ago? Is this pretty close to where you thought it might be?

Robert F. Hull Jr.

Ninety days ago, we were a little bit more optimistic about 2Q.

Chris Horvers - Bear Stearns

Okay, and then just one follow-up question on April -- you had really easy comps in the first half of the month. Was there a big dichotomy between the first half and the second half of April?

Robert F. Hull Jr.

A couple of things about April -- one, we did have dramatically easier comparisons in the first half of the month. I think last year we were negative 19% in the first two weeks and negative 10% for the month. The other thing to take into account is the shift in Easter holiday. So absent the shift in the Easter holiday, April comps would have been minus 3% versus minus 1%.

Chris Horvers - Bear Stearns

Okay, but the back half, there was -- any difference in -- how do you shake out the first half versus the back half of April?

Robert A. Niblock

Comps in the first half of April were better than the second half of April but probably not as much as you would have anticipated, given we also had the weather was a little more favorable the second half of April than the first half.

Chris Horvers - Bear Stearns

Thank you very much.

Operator

Your next question will be from Budd Bugatch of Raymond James.

Budd Bugatch - Raymond James

Good morning. As you are demonstrating how to navigate through this difficult climate, I guess my thoughts go to as we come out of this climate some time either hopefully this year or maybe next, how do you look now towards unit growth going forward? You’ve got this year growing square footage at 7% to 8%. What do you look like going forward, Robert, as you think about 2009, 2010 and beyond?

Robert A. Niblock

Today I don’t think we are prepared to give you a full updated number with regard to the out years. We would plan on doing that at our annual analyst meeting this fall. I’d give us a little bit more time to look at the environment out there. You know, it’s something we are continuing to look at on a day-by-day basis. You know, a week-by-week basis, I guess you’d say. As Larry talked about in his comments, [as we meet in a] real estate committee, we are continuing to evaluate markets and projects and make decisions. Certainly we did pull back the number for this year. Over the long-term, we are still very confident about the long-term opportunity that is out there, that opportunity to still add a significant number of stores here in the U.S., but really we are just going to get to the back half of the year and say okay, what does it look like as far as when the recovery is going to be taking place and then that will be the driver of how we look at the 2009 and 2010 period as to whether we have a number similar to what we are talking about for 2008 or is it a number that is slightly less or slightly more. We haven’t made that final decision yet. I think we’ve got plenty of stores in the pipeline that we can go either way but you know, it will be just looking at those, looking at the individual markets they are in and trying to make a decision on the timing as to when it’s most appropriate to get those stores open.

Budd Bugatch - Raymond James

And just as a follow-up, looking at the performance of the new stores, did I hear you say that they performed below expectations? Is that primarily macro driven or do you have any other thoughts about maybe those locations themselves?

Robert A. Niblock

They performed below our original expectations when we approved them and obviously if you think about it, Budd, several of these or a lot of these stores we were approving a couple of years ago and we are finally getting them open now. And as Larry said in his comments, a lot of those are in some of the more challenging markets that we’ve had from a housing standpoint. So we really think what we are seeing in most of these markets where we’ve seen them performing a little bit less than our original expectations is really macro driven based on the current environment, the credit environment, the housing environment, those type of things. Most of those markets we think are going to be fine longer term and so we don’t have any long-term concerns about those stores we’ve opened in the past year.

Larry, did you --

Budd Bugatch - Raymond James

Thank you very much.

Operator

Your next question will be from Colin McGranahan of Bernstein.

Colin McGranahan - Sanford C. Bernstein

Good morning. Just wanted to follow-up a little bit on Budd’s question there. Obviously the new store productivity is pretty weak. It sounds like that’s a cyclical pressure from Florida and California openings but we would expect that new store productivity to be weakening. So I guess philosophically, I want to understand capital allocation a little bit and how you are allocating capital to these stores versus not to buying back the stock and understanding you have this 1.2 times adjusted debt to EBITDAR guard rail, but why is that the right guard rail today when the return on capital of the new stores doesn’t look like it’s as good as maybe the return on capital would be of buying back the existing stores, i.e. buying back stock. So maybe philosophically you can just talk about that capital allocation decision a little bit here.

Robert A. Niblock

I’ll start and then I’ll let Bob talk about the guard rail but you know, in a pure laboratory setting, I can understand your argument and the question that you are proposing. However, when you think about the pipeline or real estate projects and the amount of time it takes to get these stores in the pipeline, to get the approvals, to get them developed and out of the pipeline, you can’t really just turn the spigot on and turn the spigot off, okay? Unless you are talking about turn the spigot off and then having a substantial lag between when you really have a meaningful pipeline full of stores to go into the future.

Also, if you look at the market share gain numbers that we are talking about, we really believe that this is an opportunity for us to gain substantial market share over the next several years because when you look all across the landscape, there are less well capitalized competitors that just due to the circumstances that they are facing in the macro environment may not make it through the downturn, so there’s going to be opportunity to gain share.

So we are trying to balance the competing options there. You know, one, we know that there’s going to be opportunity to gain share. We are looking hard to storage those that had, were more on the borderline from a return standpoint. We’ve either delayed or walked away from, as Larry said, but those that we think that have got great long-term opportunity, we are continuing to pursue those opportunities because we think they are going to give our shareholders great return over the long-term. Yeah, you may have a slightly lower return over the next few quarters but longer term I think it will pay big dividends for us, so --

Colin McGranahan - Sanford C. Bernstein

Okay, so philosophically I agree with that but then would it make sense in this market to maybe adjust up that guard rail a little bit, that that is something that can be moved up and down much more flexibly than a store development schedule?

Robert A. Niblock

I’ll let Bob speak to the details of the guard rail. Unfortunately, Colin, as you are probably aware, any time you have a slower environment like this, you start pushing out the guard rails up too high, generally the rating agencies are more concerned in a slowing environment than they are in other environments, so it can have kind of a compounding effect on you and if you are not careful, can potentially lead to a downgrade that we don’t think would be prudent given that today in what we’ve seen in the credit markets and all the disruption that’s taken place, we want to maintain our A1 P1 rating on our short-term facility.

Bob, anything to add to that?

Robert F. Hull Jr.

Two comments, Colin -- as it relates to the stores that we are opening, it’s been discussed a moment ago about the process in real estate, taking a look at all of the openings. We are also taking a look at the appropriate prototypes for the particular market. In some cases, we are actually either moving down to a 94 or building a 103K per market, so that’s an opportunity relative to the 117 to potentially take as much as $1 million of invested capital out to serve that market. So we are trying to right-size the investment for the opportunity market by market.

As it relates to the leverage metric, we can spend a long time talking about the balance between leverage and liquidity. In today’s market, high grade issuers are having no trouble accessing the credit markets and we were in the commercial paper market to a large degree at year-end 2007 and the beginning of the first quarter. We are now out of the market and have had no trouble accessing commercial paper markets.

Others who aren’t as well-capitalized either had trouble accessing the market or were paying significantly higher interest rates for the opportunity to get funds. There’s been a couple of examples in the retail landscape where credit has dried up for retailers, so we are being cautious in this environment. We believe things will turn in 2009 but that’s not certain today. So we are being very prudent in managing our capital structure at this point in time.

Colin McGranahan - Sanford C. Bernstein

Thank you.

Operator

Your next question will be from Mitch Kaiser of Piper Jaffray.

Mitch Kaiser - Piper Jaffray

Thanks, guys. You’ve done a very good job on the expense control on the SG&A side in a tough environment. As we think about an improving sales environment, what type of leverage do you think you can get on positive comps? What’s a good rule of thumb that we should be using?

Robert F. Hull Jr.

I’ll start and see if anybody else wants to chime in. The interesting dynamic here, Mitch, is when you’ve been deleveraging for a period of time because of negative comps, as you deleverage less there’s an opportunity to improve your expense performance. Certainly as we think about -- as the turn comes, I think the first year we get to flat comps, there’s an opportunity to have flat expense performance, so as a percent of sales or even slight leverage, just taking pressure of the deleverage of fixed cost. And then certainly from there, we would expect decent leverage at a low-single-digit comp.

Mitch Kaiser - Piper Jaffray

Okay, and then one follow-up, if I may; if you look at the second quarter comp and look at it on a two-year basis, you are going up against your easiest comp in the second quarter, a negative 2.5. So is there an acceleration in the business in the second quarter or is there something that I am missing there because it looks like if you take first quarter stacked, it’s about a 14, second quarter it’s about a negative 9, negative 10 or thereabout. Is there something in May that suggests a slight acceleration or not really?

Robert F. Hull Jr.

If you look at our comparisons, it’s actually a little bit tougher comparison. We had our best comp performance in Q2 last year. There are some factors that we think contribute to the less negative comps in Q2 relative to Q1. We have seen a decent performance in [inaudible] categories as a market to the spring selling season. The northern part of the country is just hitting that spring selling season, so that is an opportunity for us in the second quarter.

There are some markets that were, principally in the Southeast that were impacted by last fall’s drought that we think there’s some recovery efforts and some additional business to be garnered there.

And then we think there’s slightly less pressure from commodities in the second quarter than the 30 basis points we saw in the first quarter. So those are a couple of items that we are thinking about as it relates to improving trends.

And again, the big unknown is what happens with the stimulus package. There are expectations that some $3 billion will get spent in the home improvement market. However, there are significant pressures facing the consumer today so it’s unknown how much of that actually gets spent.

Mitch Kaiser - Piper Jaffray

Okay. Thanks, guys. Good luck.

Operator

Your next question will be from Matthew Fassler of Goldman Sachs.

Matthew Fassler - Goldman Sachs

Thanks a lot and good morning to you. I want to follow-up on expenses a bit. On a per store basis or per square foot basis, you had much, much sharper cuts than you had at any time in the past number of quarters. I just want to understand how sustainable that is. You spoke about reaching -- more stores essentially reaching their minimum hours threshold. I’m curious, was it a lot more stores than you had say in the fourth quarter or was this kind of when you finally went to defcon 5 or call it what you will, where you took expenses down to that level? And once again, is it a sustainable level of expense cuts for you as we look through the year?

Larry D. Stone

I’ll start and let Bob fill in. We did have a few more in the first quarter than we did have last year and any time you go through these economic downturns and we’ve talked about it for the past several quarters, I think you go in and really do a much better job of looking at everything under the hood of these stores and figuring out how can you get more efficient. And we like to say around the company now do more with less. So I think it’s really forced us to take a look at a lot of our sales tiers, take a look at a lot of positions in terms of can we do things differently and more efficiently, and I really applaud Mike Brown and his team and the folks out in the field. They have really taken the lead on this thing and done a great job in holding down expenses on our payroll.

Is it sustainable? I think so. I think we are making improvements in our infrastructure. We are making improvements in terms of systems. We are making improvements in terms of the way we go to market with different parts of the business, so yeah, I think once things do turn, I think there’s a lot of things we’ve learned here in these past several quarters that will certainly help the company be a stronger performer in the future.

Matthew Fassler - Goldman Sachs

And as we look at the year-on-year run-rate here, I mean, we look at it on a per-store basis. There’s lots of ways to do so. You think that having achieved these kind of declines, the compares aren’t terribly different certainly next quarter, that they are maintainable I guess through this year?

Larry D. Stone

I think so. Everything we’ve got built in place, we think we are and certainly we are just continuing to dig in and evaluate in everything that we do and quite frankly question everything that we do and like I said earlier, how can we do it better and how can we do it with less and at the same time maintain customer service in our stores.

Matthew Fassler - Goldman Sachs

Understood. I just want to follow-up on Bob Hull, your answer to the last question when talking about the expectations for Q2 versus Q1, you intimated that you expected less commodity pressure in the second quarter than you saw in the first quarter, less than that 30 basis points. It sounded like the commodity inflation issue is probably a bigger deal now than you would have thought it would in February. Are you saying that you see that very much a capped issue over the course of the year or did I kind of misread that?

Robert F. Hull Jr.

That is accurate. There have been a number of mill curtailments, a number of mill closures that are firming up the lumber prices of plywood to basically flat to last year at this point. Gypsum was about 18% down Q1 year over year. We expect that to be negative most of the year but less negative as the year progress.

Matthew Fassler - Goldman Sachs

So you are talking then [inaudible]?

Robert F. Hull Jr.

I’m sorry?

Matthew Fassler - Goldman Sachs

So that 30 basis points related to the comp store, the numbers? And on the commodity inflation issue, in terms of other cost of goods, that is something that you’d expect would probably persist through the year it sounds like.

Robert F. Hull Jr.

Yes, but to the extent prices increase, there is less pressure on our suppliers. They are getting more dollars for the board that they are producing therefore there is less pressure on us.

Matthew Fassler - Goldman Sachs

Thank you so much.

Robert A. Niblock

Matt, congratulations to the new addition to your family. We hope everyone is doing well and you are getting some sleep.

Matthew Fassler - Goldman Sachs

That’s very kind of you. Thank so much, guys.

Robert A. Niblock

Operator, we have time for one more question.

Operator

Your last question will be from Mike Baker with Deutsche Bank.

Mike Baker - Deutsche Bank

Thanks, guys. So my question is on some of the regionality discussion you had with the different markets, the markets that aren’t going through a correction, et cetera. It sounded like those markets were the worst -- I guess is this the right interpretation, that the weakness that you are seeing is now more broad-based and you are seeing it -- you know, it’s not just Florida and the West Coast. It’s actually getting worse in some of the other areas that maybe were holding up better in the past. Is that a fair interpretation?

Robert A. Niblock

I’ll address that. Certainly if you talk about the West Coast, as we said, we still have double-digit negative comps out there. Florida, as we said, we saw some improvement through 2007. It improved into 2008. We did see, as you narrowed the gap between those better performing, more stable markets than those worse performing markets that have had the biggest impact from housing decline, you did see a narrowing of the gap. There was a slight improvement on the worst-performing markets coming up but the better performing markets declined a little bit. We’re talking about a narrowing of less than 100 basis points or so in total, but there was a drop in the better-performing markets.

If you think about that, you know, some of the areas of the country that were less impacted by the run-up in housing -- the Midwest, the middle parts of the country, didn’t have the sustainable run-up in housing over the past several years. And if you look at average household incomes, they are generally slightly lower in there than they are in some of these more coastal markets, where you’ve seen the large run-up in housing. So as you see fuel prices going up, as you see food prices going up, they have a larger proportionate impact on some of those areas of the country that have lower median household incomes. So you have seen a slight closing of the gap between the two but we are talking about less than 100 basis points, but that is part of what drove a little bit of our revision of our guidance for the year, is when you see that kind of a ramp-up in the other pressures on the consumer, tightening credit, a ramp-up in food and fuel and those other issues, it does -- one wants to be slightly more cautious over the balance of the year.

Mike Baker - Deutsche Bank

That was going to be my follow-up, so you -- it makes you less optimistic about a recovery seeing the markets that had hung that are getting worse rather than the really bad markets getting a little bit better, if you follow me. Is that right?

Robert A. Niblock

I think what we are looking at is we have the ongoing pressures from housing, we have tight credit markets but now all of a sudden, you’ve got a couple of other variables that are coming in on top of those. We know if you look at housing, even if housing stays where it’s at, I mean, you’re a year out before you get flat year-over-year housing turnover, so -- and now you are adding a couple of other variables in there, whether it’s employment, food, fuel, the other pressures on the consumer. Yes, there will be some offset there from the stimulus package, you know, and while consumers have said that there’s a certain amount of that that is going to be spent on home related items, we’ll have to wait and see how that proves to be true.

So the unknowns are what happens from the stimulus package, what happens from the competitive standpoint and able to gain market share if there are competitive closings out there. So those are some of the unknowns. We think both of those will happen. If they come to fruition, yeah, our numbers may prove to be conservative and we may have better performance than we’d anticipated, but as I said, we thought we took a pretty nice reduction in our outlook for the first quarter. Yeah, we made our numbers from an earnings standpoint but we still fell short on the top line and so that caused us to say even ex weather, it was still a little bit weaker than we anticipated and so we think it’s appropriate to be slightly more cautious than we previously were so we can see how the economic stimulus package plays out and how things play out on the competitive front.

Mike Baker - Deutsche Bank

Good. Thank you. Fair enough, appreciate those comments.

Robert A. Niblock

Thanks and as always, thanks for your continued interest in Lowe's. We look forward to speaking with you again as we report our second quarter results in August. Thanks and have a great day.

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Source: Lowe's F1Q08 (Qtr End 5/2/08) Earnings Call Transcript
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