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

F2Q08 Earnings Call

August 18, 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

Gregory M. Bridgeford - Executive Vice President, Business Development

Analysts

Deborah Weinswig - Citigroup

Colin McGranahan - Sanford C. Bernstein

Budd Bugatch - Raymond James

Matthew Fassler - Goldman Sachs

Gregory Melich - Morgan Stanley

David Schick - Stifel Nicolaus

Michael Lasser - Lehman Brothers

Laura Champine - Morgan Keegan

Dan Binder - Jefferies & Company

Operator

Good morning, everyone and welcome to Lowe's Companies’ second 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 second quarter financial results.

First a few thoughts on the quarter -- while many challenges remain, I am proud of the results we delivered this quarter. Our 215,000 plus dedicated employees focused on taking care of customers and capitalizing on opportunity in order to deliver better-than-anticipated results in a difficult economic environment, comps for the quarter were negative 5.3% but exceeded our guidance.

Contributing to our better-than-expected results was relative strength in many outdoor categories as generally more seasonable weather and replanting and recovery from last year’s droughts helped drive sales.

Reflecting that strength, comps of broadly defined outdoor products exceeded indoor product comps by over 300 basis points in the quarter. We saw a similar lift in last year’s second quarter, which seems to suggest that in addition to drought recovery, consumers remain willing to take on smaller outdoor projects.

Also aiding sales in the quarter was the positive impact of the fiscal stimulus payments. We cashed some checks for customers but many more customers deposited their checks and used other forms of payment. We saw evidence of this with an increased use of cash and debt cards in the quarter, but it’s obviously difficult to get an accurate read on the exact stimulus spend in our stores.

Based on external estimates of spend within the home improvement channel and our own consumer surveys, we feel the stimulus payments benefited second quarter comps by 100 to 150 basis points, slightly more than we expected heading into the quarter.

As a result of our customer focused efforts and compelling product and service offering, our solid market share gains continued this quarter. According to third party sources, we added 120 basis points of total store unit market share in the second calendar quarter, which represents our largest unit share gain in eight quarters.

As we navigate through this down cycle for our industry, our share gains continue to be driven by great in-store execution, our disciplined store expansion program, and market share gains from competitive closings.

On the other hand, we continue to experience weakness in spending for larger projects and more discretionary purchases, leading to our eighth consecutive quarter of negative comps.

As many of you know, we’ve watched home pricing dynamics at the market level over the past several quarters. Today, nearly 90% of our stores are in markets experiencing year-over-year home price declines and generally our weakest comps continue to be in those markets that have experienced the greatest declines.

Where home prices have been or have become more stable, our comps have been much better. By way of comparison, the bottom 20% of markets, those with the biggest home price declines had double-digit negative comps in the quarter, while comps for the top 20% were essentially flat.

While our sales results will likely continue to vary widely by market, we are focused on capturing the unique opportunities presented in each of our stores and driving profitable market share gains.

For the quarter, we experienced a slight decline in gross margin as a percent of sales. Our gross margin performance, combined with solid expense management, helped minimize the earnings impact of continued industry wide sales weakness. As a result, earnings per share of $0.64 declined only 4.5% and exceeded our guidance for the quarter.

Finally, great working capital management led to a 26% increase in cash flow from operations versus the first half of last year despite a decline in earnings.

As we look to the balance of the year, we continue to watch the macroeconomic variables we feel are driving our business. While there are signs that suggest stabilization in the absolute or month-to-month level of housing turnover, significant year-over-year declines remain the norm. In addition, broad-based declines in home prices, rising mortgage delinquencies and foreclosures, and increasing inventory of unsold homes, tight credit markets and rising mortgage rates, as well as rising unemployment, all suggest continued pressure on the home improvement consumer.

We expect some continued benefit from drought revitalization spending in the third quarter but we also anticipate the typical seasonal mix shift away from many of the categories that drove our second quarter results. I am confident we will continue to capture market share and we remain focused on providing the best products and service in home improvement. As I mentioned earlier, considering the level of uncertainty in the current macro environment, the waning effect of the federal stimulus payments, and the larger mix of indoor versus outdoor category sales in the back half of the year, we feel it’s prudent to maintain a cautious near-term outlook.

Thanks again for your interest and I’ll now turn it over to Larry Stone to provide a few more details on the quarter. Larry.

Larry D. Stone

Thanks, Robert and good morning. As Robert mentioned, we achieved solid results in a challenging sales environment. Today, I’ll share some details with order and describe the things we are doing to continue to drive profitable sales in the current environment.

Reflective of the tough sales environment that has been pressuring our industry for the past eight quarters, only two of our product categories, rough plumbing and nursery achieved positive comps for the quarter. Our positive comps in rough plumbing were driven by solid sales in air filtration products, pumps and tanks, water treatment, and HVAC controls. Also, we experienced commodity price inflation in copper and resin products, which drove part of this increase.

Favorable weather, wide product selection, and great customer service helped drive solid nursery sales as consumers took on small projects to enhance the appearance of their outdoor space. Additionally, as homeowners repaired damage caused by last year’s drought and continue to do routine lawn maintenance, we drove better-than-average comps in lawn and landscape and outdoor power equipment.

Despite this significant pressure on sales, we continue to gain market share, a good indication that our programs are working as we continue to offer value-added solutions for home improvement customers.

According to third-party estimates, we gained unit market share in 17 of 20 product categories in the second calendar quarter versus the same time period last year, and we gained 120 basis points of total store share in the quarter.

We had solid performance in seasonal products, reflecting additional needs for markdowns outside the normal course of business, helping us to maintain gross margin. Also our seasonal inventory is in good shape leading into the third quarter.

On a regional basis, we continue to see a wide range of comp performance as five regions achieved positive comps while six regions had double-digit negative comps. The solid sales performance we experienced in Texas and Oklahoma during the third quarter continued into the second quarter. Additionally, we are seeing solid results into the Ohio Valley and in parts of the upper Midwest. These were markets that did not experience the same overheating of home prices that was experienced in other parts of the country.

On the other hand, sales continue to be pressured in two of our California regions, some of the markets most pressured by the overheated housing market. The two California regions improved slightly compared to quarter one but we still experienced double-digit negative comp performance for the quarter.

In our Florida and Gulf Coast regions, the story remains the same, with both regions posting double-digit negative comps for the quarter. In Florida, easier year-over-year compares were offset by an increasingly difficult housing market. The Gulf Coast, while improving over our 2007 performance, still has double-digit negative comps. Also, we had double-digit negative comps in two of our Northeastern regions as housing pressures and unfavourable weather led to below planned performance in these regions.

For the quarter, we had good success in installed sales. We achieved positive comps, the first time in the past several quarters. But on the flip side of the coin, big ticket projects had the highest sales decline and on a regional basis, we saw the largest year-over-year sales declines in our western regions, Florida and the Gulf Coast.

Although there was some weakness in our special order sales, comps outperformed the company average for the quarter, driven by special order window treatments and carpet. However, consumers remain cautious about buying big ticket discretionary products, including many that are available through special order. During the quarter, we continue to see soft demand in cabinets and counter-tops and fashion plumbing.

Finally, sales to commercial customers outperformed the company average for the quarter, an indication that our targeted marketing programs and products are resonating with this customer. We are driving comps in many different categories across the store, which has been our stated strategy for our commercial business.

While sales remain soft in lumber and commodities, we continue to focus on property management for the day-in, day-out repair business is still strong.

Despite the weak sales environment, the promotional environment was rational during the quarter. We remain committed to our rolling 18-month promotional calendar that supports our marketing plans. We continue to focus on easy-to-understand promotions with a fewer, bigger, better approach, and this is resonating well with customers.

For the quarter, we leveraged advertising as a percent of sales and our draw rate for the number of times Lowe's was in consideration instead of customers buying products we sell improved in 17 of 20 product categories, a clear indication that our advertising is connecting with home improvement customers.

On the merchandising front, we continued to experience product cost pressures and in most categories, we’ve been able to pass these increases along to our retail prices. Some categories have been slower to move and we have not been able to change our retail price. Primarily as a result of the soft sales environment, we de-leveraged payroll by 32 basis points in the quarter but I am confident we are prudently managing the business, ensuring our stores remained appropriate staffed and positioned to ensure great service to customers. In fact, our customer service scores for the second quarter increased in all five categories compared to the same period last year.

I was very pleased with improved scores for selling skills, checkout, and phone service. This further demonstrates that our store teams are doing a great job of taking care of customers.

In addition to prudent expense management, we have a heightened focus on maximizing every customer interaction to drive sales while improving customer service. Project selling to the DIY customer has always been a priority for Lowe's. We continue to look for ways to maximize all opportunities to still complete the projects while continuing to provide great customer service.

Earlier this year, we rolled out a related item selling report to our stores. This tool helps us sharpen our focus on project selling and ensures we consistently offer customers all the supplies needed to successfully complete their projects. Specifically, this tool gives store managers visibility into missed opportunity to sell the entire project, as well as provides them the report to measure their performance. This increased visibility has helped motivate employees to drive sales in their respective departments, as well as create a friendly competition among stores. Also, this tool can be used to coach employees to help them better identify products needed to complete projects.

By selling the entire project, we have the opportunity to increase the ticket and provide customers a level of service they have come to expect from Lowe's. Customers are now properly equipped to complete their project and related item selling makes Lowe's a one-stop shop, which is extremely important to customers, considering today’s fuel prices.

Another opportunity to drive efficiencies was store signage. Over the past couple of quarters you head us discuss our approach to ensuring we maintain our best in-store environment while reducing redundant store signage. During the quarter, we continued to identify ways to reduce store expenses by replacing disposable product information kit cards with promotional towers, which are mobile, reusable A-frame towers that enable us to highlight special values and promotional items by simply changing the signage.

Our best-in-class logistics and distribution infrastructure ensures our stores have the right products at the right time. To further drive efficiencies, we continue to implement changes that improve transportation and DC performance. Rising fuel costs have been and continue to be a concern. However, for the quarter we offset the majority approximately 15 basis points of incremental fuel costs through network optimization, where we shortened our average length of hauls to our stores. Also, we increased the outbound payload per truck and increased our dedicated DC back-haul to mitigate the impact of rising diesel prices. As a result of these actions, the net fuel impact for the quarter is approximately five basis points.

As we examined our sales, it was clear that much of our sales were driven by seasonal and outdoor products, and as we discussed in our previous quarters, we continue to see stability in repair and maintenance products.

A few more examples of our opportunity include shingles, where our sales have been strong all year as few consumers will put off roof repair, regardless of the macro environment. Also, we are seeing strength in [inaudible] heaters, as consumers anticipate higher fuel costs this winter. Additionally, we are seeing relative strength in freezers, probably a function of consumers buying groceries in bulk for better prices and also the trend of more consumers having gardens this year.

But until we see improvement in our core categories and larger ticket items, we will continue to take a cautious and measured approach to our outlook.

Stating the obvious, we are not happy with the negative 5.3 comp for the quarter. But considering the sales environment, I feel we posted solid results. We anticipate that the challenging sales environment will continue into 2009. We have plans in place to continue to capture market share and grow profitably as we capitalize on the opportunities created by the changing competitive landscape in our industry. I am confident that our [inaudible] focus on the customer and prudently managing the business will position Lowe's for continued long-term success.

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 second quarter were $14.5 billion, which represents a 2.4% increase over last year’s second quarter. In Q2, total customer count increased 4.6% but average ticket decreased 2.2% to $6.95. For the first half, total sales increased 0.7% to $26.5 billion.

Comp sales were negative 5.3% for the quarter. Looking at monthly trends, comps were negative 5.5% in May, negative 4% in June, and negative 6.5% in July. For the quarter, comp transactions decreased 2.7% and comp average ticket decreased 2.6%. As Robert noted, we estimate that the stimulus checks positively impacted our second quarter comp sales by 100 to 150 basis points.

We experience nominal lumber and building material inflation in the quarter, which had minimal impact on second quarter comps.

With regard to product categories, the categories that performed above average in the second quarter include building materials, rough plumbing, hardware, paint, flooring, nursery, outdoor power equipment, lawn and landscape products, appliances, and home environment. In addition, walls and windows and seasonal living performed at approximately the overall corporate average.

From a regional perspective, five of our 22 regions had positive comp sales in the quarter. The positive comping markets were in the middle of the country, from the upper Midwest down through Texas. However, six of our 22 regions had double-digit negative comps for the quarter. The double-digit negative comp regions were California, the Northeast, Florida, and Gulf Coast markets.

Gross margin for the second quarter was 34.3% of sales and decreased 13 basis points from last year’s second quarter. The decrease I gross margin was driven by a number of factors. First, the whole house carpet promotion negatively impacted gross margin by approximately 20 basis points. The customer has responded favourably to the offer and the proposition -- and the promotion generated positive gross margin dollars. However, as I mentioned last quarter, we continue to modify offers like this to find the right balance between sales and profitability. As a result, we did increase labor retail 2.49 related to this offer.

In addition, we have received vendor price increases in a number of product categories. In most cases, we have been able to pass on price increases. However, there is sometimes a lag in the timing between our increase in cost and the movement in retail prices. This had an approximate negative 10 basis point impact on gross margin in the quarter.

Higher fuel costs increased cost of goods sold and negatively impacted gross margin by approximately 5 basis points. Lastly, deleverage on distribution fixed costs caused approximately 5 basis points of negative impact on gross margin in the quarter.

Lightly offsetting these items were positive impacts of 13 basis points from lower inventory shrink as a percentage of sales and 8 basis points from the margin mix of products sold. [Due to a] gross margin of 34.7% represents a decrease of 21 basis points over fiscal 2007.

SG&A for Q2 was 20.8% of sales, which deleveraged 74 basis points, driven by store payroll, fixed expenses, bonus, and credit. For the quarter, store payroll deleveraged 32 basis points. As sales per store decline, additional stores are hitting the minimum hours threshold, which increases the proportion of fixed to total payroll. In addition, rent, property taxes, utilities, and other fixed expenses deleveraged approximately 20 basis points due to the comp sales decline.

Bonus expense deleveraged 18 basis points in the quarter as we attained a higher performance level this year versus missing many of our performance targets in the first half of 2007.

Also, as expected, we did experience deleverage related to proprietary credit due to higher losses than last year, but credit losses came in on plan for the quarter. This deleverage was offset by leverage in in-store service and advertising expense in the quarter. Year-to-date, SG&A of 21.6% of sales and deleveraged 68 basis points for the first half of 2007.

Store opening costs of $21 million leveraged four basis points to last year as a percentage of sales. In the second quarter, we opened 23 new stores with no relocations. This compares to 26 new stores, including two relocations in Q2 last year.

Depreciation at 2.6% of sales totalled $381 million and deleveraged 28 basis points compared with last year’s second quarter, primarily due to negative comp sales and the addition of 153 stores over the past 12 months.

Earnings before interest and taxes or operating margin decreased 111 basis points to 10.8% of sales. Year-to-date operating margin of 9.9% represents a decrease of 125 basis points over the first half of 2007.

Interest expense at $69 million deleveraged 12 basis points as a percentage of sales. This deleverage was caused by the additional expense associated with last year’s bond deal.

For the quarter, total expenses were 24% of sales and deleveraged 110 basis points. Pretax earnings for the quarter were 10.3% of sales. The effective tax rate for the quarter was 37.4% versus 37.7% for Q2 last year.

Earnings per share of $0.64 for the quarter exceeded our guidance but decreased 4.5% versus last year’s $0.67. For the first six months of fiscal 2008, earnings per share of $1.05 were down 8.7% to 2007.

Now to a few items on the balance sheet -- cash and cash equivalents balance at the end of the quarter was $477 million. Inventory turnover, calculated by taking a trailing our quarters cost of sales divided by average inventory for the last five quarters, was 4.01, a decrease of 12 basis points from Q2 2007.

Our second quarter inventory balance increased $140 million, or 1.8% versus Q2 last year. The increase was due to the addition of 153 stores from this time last year, offset somewhat by lower inventory and comp stores.

At the end of the second quarter, we owed 87% of our stores versus 86% at the end of the second quarter last year. Our debt to equity ratio was 30.1% compared with 30.9% for Q2 last year.

Return on invested capital, measured using the trailing four quarters earnings plus tax adjusted interest divided by the average debt and equity over the last five quarters, decreased 374 basis points for the quarter to 12.4%.

Return on assets [inaudible] a trailing four quarters earnings divided by average assets for the last five quarters, decreased 265 basis points to 8.3%.

Our leverage guard rail remains 1.2 times lease-adjusted debt to EBITDAR for the first three quarters due to the seasonality 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-T1 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 second quarter, lease-adjusted debt to EBITDAR was 1.3 times, which exceeded our 1.2 times target for Q2.

There were no shares repurchased in the quarter and our outlook does not contemplate any shares repurchased for fiscal 2008. We will continue to evaluate market conditions and diligently evaluate our options to balance financial flexibility against opportunities presented in the market.

An outcome of our ongoing evaluation was the decision to call all of our outstanding convertible debt in the quarter. As a result, we have retired $521 million of debt from our balance sheet and removed approximately 21 million shares from our diluted share count.

Year-to-date cash flow from operations was $3.9 billion, an increase of $790 million or 26% over the first half of 2007. The strong cash flow from operations growth versus last year was driven by good inventory management and continued efforts to improve payment terms.

Looking ahead, I would like to address several of the items detailed in Lowe's business outlook. We continue to expect our sales results to vary widely by market and as the housing impacts are regional and we have limited visibility to the bottom for each specific market. We do expect some markets to improve; however, markets like California and Florida will continue to be challenged.

Given this, we expect a third quarter sales increase of 1% to 2%, which incorporates the opening of approximately 38 stores, two in August, seven in September, and 29 stores in October. Comp store sales are estimated to decline 5% to 7% from last year.

EBIT or operating margin for the third quarter is expected to decline by approximately 290 basis points to last year as a percentage of sales. Approximately 100 basis points of this decline is related to the reduction of self-insurance reserves for workers’ compensation and general liability experienced in last year’s third quarter.

The anticipated sales growth and operating margin decline are expected to generate diluted earnings per share of $0.27 to $0.31, which represents a decrease of 28% to 37% compared to last year’s $0.43.

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

For the fiscal year, we are anticipating an operating 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 37.6% for 2008. As a result, we expect diluted earnings per share of $1.48 to $1.56 for the year.

For the year, we expect cash flow from operations to be approximately $4.5 billion, up approximately 3% over fiscal 2007.

In addition, we forecast total capital expenditures of approximately $3.9 billion with roughly $300 million funded via operating leases, leaving cash CapEx of approximately $3.6 billion for 2008.

Regina, we’re now ready for questions.

Question-and-Answer Session

Operator

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

Deborah Weinswig - Citigroup

Good morning and congratulations on managing well in a difficult environment. In terms of store openings, we saw that you kept your store opening plan and obviously many retailers have backed off. Two questions, one -- well, of the same question, so in terms of store openings can you talk about maintaining your plan? And then secondly, can you not only talk about international expansion but also international performance, please?

Robert A. Niblock

For the current fiscal year, we are maintaining our plan of approximately 120 new store openings that we announced at the beginning of the year. That was down from our original plan. We originally had a number closer to the 140, 145 range. So approximately 120, they’re on plan for this year. We are, in light of the current environment, in light of how long it looks like the recovery is going to take place, and also before the recovery takes place, evaluating the number of stores that we’ll open next year and determining what the appropriate adjustment needs to be and we will announce the final number for that at our analyst conference next month.

With regard to our international outperformance, as far as markets beyond Canada and Mexico that we’ve announced, we continue to evaluate markets. Nothing beyond that. We are continuing to -- we’ve got a team assembled down in Monterey working on our plans for our store openings in Monterey late 2009. We continue to be very pleased with the performance we are seeing out of our initial stores that we’ve opened in Canada and we will have three or four more of those opening between now and the end of the fiscal year.

Deborah Weinswig - Citigroup

Great. Well, thank you and congratulations again.

Operator

Your next question comes from Colin McGranahan with Bernstein.

Colin McGranahan - Sanford C. Bernstein

Good morning. Just two actually little quick ones; first, the average ticket looked like it was down about 2.2%, not on a comp basis but a total basis. Best performance since it looks like the end of 2006 and yeah, you commented that you continue to see the biggest declines in the big ticket items. Can you just reconcile that and maybe provide a little bit more detail on what you are seeing in average ticket and whether that’s just an outcome of having now anniversaried some of those big ticket declines?

And then secondly, you also mentioned you saw the greatest share gains on a unit basis in eight quarters, and I was wondering if you might be able to provide a little bit more insight into as to whom you think those share gains are coming from and how you think that’s trending?

Robert F. Hull Jr.

I’ll take the first question regarding average ticket. I think some if it is cycling prior comparisons where we’ve seen big tickets being impacted. Also in this quarter, a lot of smaller projects related to outdoor lawn and garden, so they are smaller than let’s say a cabinet transaction but they are still a decent sized project, which I think helps what will be the rate of decline in average ticket for the quarter.

Robert A. Niblock

As far as the unit share gain, that’s the track line results that we speak to. Certainly the 120 basis points of unit share gains we said was the largest we’ve seen in eight quarters. We’ve continued to see gains quarter over quarter and really you really have to get all the track line stuff and look at -- it depends on what product category you are talking about as to where the share gains are coming from. As you know, it’s a highly fragmented market. Sometimes it’s coming from independents, sometimes it’s coming from other direct competitors that are out there but it’s really on a category by category basis. And as you know, the track line information is really sample base, where they contact consumers. They ask them where they shopped, where they [inaudible], what brand they bought, those type of things. So it is consumer recall so there can be from time to time a little bit of noise in the numbers. We really use it as directional guidance to say okay, we continue to see that we are moving in the right direction, we are gaining unit share, we are gaining dollar share, we’re drawing more customers, we’re closing more customers. So we really use it as directional guidance, not hard and fast by any one particular category because there has been from time to time a little bit of noise in the numbers. But I really think it’s kind of across the board. We’ve seen a lot of independent closings that are out there. They are harder to accumulate but as we poll our stores out in the market and ask them, give us feedback on the competitive dynamics, the competitive changes that are taking place in your market. As you can imagine, some of the areas that have been most hardest hit from the housing environment have also been the areas where we are hearing more about small competitive closings that are taking place, be it a cabinet shop, a lawn and garden store, a small lumber yard, whatever the case may be. And those I think are providing some of those gains that we are seeing, so --

Colin McGranahan - Sanford C. Bernstein

Yeah, that’s really what I was trying to drive to, whether you’d seen any kind of a step change in some of the closings from the independents, and I know that’s hard to see in the track line data versus were you were seeing any kind of change in, step change function in like Sears’ share, or something like that.

Robert A. Niblock

I think the biggest step change we probably have seen is from independents based on what we have anecdotally seen coming in from our stores, but it’s hard to quantify. You really don’t have that historical data. It doesn’t all roll up the way that we’ve seen where you really get independent data other that what our stores are telling us, and then anecdotally what we think that environment was like in the past and we saw a significant number of those independent competitors opening up in very robust economic and housing market times, so --

Colin McGranahan - Sanford C. Bernstein

Okay, great. Thank you.

Operator

Your next question comes from Budd Bugatch with Raymond James.

Budd Bugatch - Raymond James

I’m curious about the promotional environment -- you said it has been fairly rational and you are maintaining your 18-month rolling calendar. Do you see it getting more promotional to try and generate sales? We’re hearing from some of the suppliers that might be what’s in the cards, at least going forward. And I also wanted to ask about inventory, so I’ll come back.

Robert A. Niblock

I’ll start and then I’ll toss it over to Larry. I think we look at the promotional environment, so far it has been fairly rational out there. We continually look at the promotions that we’ve done and try and adjust those accordingly for what works in the current environment, what will be best received by the consumer. So we are very pleased with the way things turned out in the second quarter, in light of the environment. We had some promotions that worked well.

As we look at our forward guidance, the exact things you mentioned is what causes us caution in our forward guidance -- the longer, the deeper the slowdown is, you don’t know what’s going to take place out there in the competitive environment from a promotional standpoint. So we try and have an element of caution built into that guidance.

We know what our promotional calendar is. We plan on executing according to the promotional calendar but that doesn’t mean that we may not see something out there in the competitive environment that would cause us to have to shift and/or react, depending on what it is.

Larry, I’ll see if you have anything to add.

Larry D. Stone

Just a couple of things to add to that, as we’ve talked before, this 18-month promotional calendar really helps us give guidance to our merchants and our operators about what’s coming up for the next quarters and so forth, and we also go back -- every promotion we run, we go back and really tear that promotion apart, see what did work, what didn’t work, so we don’t repeat the same mistakes or we take things that really worked for us and really figure out a way to make them better in the future.

So to Robert’s point, we’re not quite certain what’s going to happen in the next six months of this fiscal year but certainly it’s been pretty rational much of the year and we continue on that same track. We think -- let’s hope it’s going to stay rational. If it does, we’ll continue our promotional calendar as we have it laid out for the next 18 months. But please keep in mind we are constantly reviewing it, we’re constantly looking at it, we’re constantly being challenged by the merchants and operators and my staff takes a look at it every week to determine if we need to make any fundamental changes to what we are doing, but we still think things are going to be pretty rational for the balance of the year.

Budd Bugatch - Raymond James

Okay, and on inventories, you control them. It looks like you did that exquisitely and it looks like it was down about 8% on a per store basis. I’m curious about if you looked at it on a unit basis, what do you think inventories are down? Because obviously this year’s inventories have got a fair amount of -- or some price increases built into what you’ve had to expect, or what you’ve had to endure. Bob, any thoughts on that?

Robert F. Hull Jr.

I don’t have the change in units specifically. On a comp store basis, inventory was down 7.7% second quarter this year versus second quarter last year, but a couple of categories really drove the majority of that decrease -- good inventory management practices in fashion, plumbing, and lighting, doing a better job with reset activity, less duplicity in inventory as we transition through recent activity. And then the other one I’ll mention, Budd, is tools. Tools have done a very good job being smarter with promotions. Larry mentioned earlier kind of fewer, bigger, better. We’re doing a better job with tool promotions and less in-and-out inventory. So those are really the three specific product categories that drove the majority of the decrease in comp store inventory for the quarter.

Larry D. Stone

I’ll just add to that -- we’ve spent a lot of time in the past several years educating our stores on better inventory management and making sure that we don’t have excessive inventory. And yeah, we talked a few years ago about R3 and how we get inventory faster to our stores, so a lot of efforts that we’ve been working on for the past several years are starting to pay off this year in better inventory management.

Budd Bugatch - Raymond James

I see, okay -- but in tools, I would expect that that was one of the three categories you might not have gained share in? That was a fairly well-understood and well-publicized transition that’s going on in your tools, tools that should hit the third or fourth quarter. Isn't that correct, in terms of a transition from Firestorm?

Larry D. Stone

We have a new line rolling out with [Porter Cable]. That will be rolling out this quarter and next quarter and certainly some fundamental changes in our products in terms of DeWalt and other products that we sell in our stores.

But I’m not going to comment on the three we didn’t gain share in but certainly we feel like we have a real solid tool program as we head into the balance of this year.

Budd Bugatch - Raymond James

All right, thank you, Larry. Thank you, guys.

Robert A. Niblock

Budd, we actually gained more share in tools than we did in total store.

Budd Bugatch - Raymond James

Oh, really? Okay. That’s very interesting. Thank you.

Operator

Your next question comes from Matthew Fassler with Goldman Sachs.

Matthew Fassler - Goldman Sachs

The first question I would like to dig into relates to your comments on outdoor/indoor, and I guess there’s two elements to it. First of all, did the trend of indoor versus outdoor improve a lot from where it had been? In other words, had this been consistent through say the past several quarters? And then what’s the magnitude of mix shift, indoor versus outdoor, that you see from Q2 into Q3, please?

Robert F. Hull Jr.

I’ll talk about the mix impact indoor/outdoor. The outdoor categories represent roughly 40% of our total sales in the second quarter, drops to about 30% in the third quarter, and further drops to about 20% in the fourth quarter. So certainly it is a much bigger mix of our business in the second quarter, has a bigger opportunity to have a positive or a negative impact.

Matthew Fassler - Goldman Sachs

And you said that second quarter last year outdoor outperformed, second quarter this year outdoor outperformed. What happened in between? Had it been a consistent outperformer as the macro trends faded or was it more volatile than that?

Robert A. Niblock

A lot of it is weather driven, Matt. If you think about, you know, last year I think the spring, the early spring we had pushed some sales over into the second quarter, so pushed it to a higher peak than normal this year. Somewhat of a similar trend for the drought recovery from last year and the economic stimulus checks on top of that, and that was particularly if the customer is focused on the outdoor re-planning and recovering from the drought and they’ve got stimulus checks, some of that may be helping push those sales as well.

Matthew Fassler - Goldman Sachs

And a very quick financial follow-up -- your payables ratio increased nicely and that really helped drive the cash flow from working capital. You know, you typically see that I guess from more aggressive ordering and yet your inventories are in very good shape. So can you talk a bit about the payables pop that you got?

Robert F. Hull Jr.

Sure, Matt. It’s really two factors driving that. One is timing of purchases, Q2 this year versus Q2 last year. Last year our business was trailing off and orders slowed throughout the course of the quarter. This year, more of a constant purchase throughout the course of the quarter so a bit of timing quarter over quarter.

Second is it’s an ongoing focus from our merchant team to work with our vendors to increase days payable outstanding.

Matthew Fassler - Goldman Sachs

Because it’s up on the -- it seems like the best payables ratio you’ve ever had in the second quarter, so would you agree that it’s more structural at this point?

Robert F. Hull Jr.

Some of it is structural. However, by year-end, the timing of purchases is going to have an impact, so we think the AP leverage at year-end is going to be close to about 51% relative to just under 49% Q4 last year. So we’ll still have an improvement, not to the same degree we had second quarter.

Matthew Fassler - Goldman Sachs

Understood. Thanks so much.

Operator

Your next question comes from Gregory Melich of Morgan Stanley.

Gregory Melich - Morgan Stanley

You mentioned the stimulus having a bigger impact than you thought, and then cited cash and debit card. Could you just update us on how much of your sales were on your own private label credit card and how much that shifted?

Robert F. Hull Jr.

Roughly about 22% of our sales are on our proprietary credit card for the second quarter. That was down about 100 basis points from Q2 last year, driven largely by the increase in mix of cash and debit card.

Gregory Melich - Morgan Stanley

And just -- you were cashing people’s checks. Did they have to spend all of it on a product or were you giving them the cash difference?

Robert F. Hull Jr.

They didn’t have to spend any of it on the product.

Gregory Melich - Morgan Stanley

Okay. And then a question on the CapEx -- this year it’s roughly flat year-to-date, despite the stores coming down. But you said for the year it would be a 3.6. What would you say is normalized CapEx if you keep opening 120 stores a year?

Robert F. Hull Jr.

Normalized CapEx at 120 stores would be probably somewhere in the 3.4 to 3.6 billion range, depending upon location of store, size of store, things of that nature.

Gregory Melich - Morgan Stanley

Okay, and would that be cash CapEx or --

Robert F. Hull Jr.

Cash CapEx, that’s right.

Gregory Melich - Morgan Stanley

Great. Thanks.

Operator

Your next question comes from David Schick of Stifel Nicolaus.

David Schick - Stifel Nicolaus

You talked about the overall comps and you sort of split them out by markets that are doing better or worse from the housing sense. How about on the big ticket installation, which you’ve said are quite weak? Is there any discernible difference in the markets that are discernibly different from a housing standpoint?

Larry D. Stone

In the California, Florida, and Gulf Coast that we spoke of, you can tell a big difference on the big ticket purchases in terms of comp sales and things like cabinets, fashion plumbing, countertops and so forth are not as strong in those particular markets.

If we look at other parts of the country where the economy is not as overheated, Texas, Oklahoma, the [inaudible] Valley and places like that, and we’ve got reasonably good growth in our cabinets and countertop business, so it is a bit affected by those overheated housing markets.

David Schick - Stifel Nicolaus

So that’s my question -- so you are, in the markets where housing is better for whatever reason, it’s positive?

Larry D. Stone

It’s better.

David Schick - Stifel Nicolaus

Okay, is it -- you’re not saying it’s positive?

Larry D. Stone

I’m not saying it’s positive. I’m saying it’s much improved over what we are experiencing in some of those --

David Schick - Stifel Nicolaus

Right, okay. Better than the other places. Okay, that’s helpful. Thank you.

Operator

Your next question comes from Michael Lasser with Lehman Brothers.

Michael Lasser - Lehman Brothers

On the installed sales, I believe you said it was -- that part of it was positive for the period, and then historically you’ve talked about detailing fees being a leading indicator and that had been improving for the last couple of quarters. How is that trending now? And does that relationship forbade anything else, such that it leads to overall improvement at the store level or the market level?

Larry D. Stone

I’ll start -- detail fees are still trending in the right direction. Installed sales, as I stated in my comments, we have positive comps for the first time in the past several quarters, so certainly we are seeing a lot of our jobs, the carpet promotion that we did, the walls and windows promotions that we did really got us a lot of good foot traffic and some positive details. However, as I’ve stated, kitchen cabinets still seemed to lag and some of our fashion [blending] products are still lagging, but overall we’re pleased with the increase in installed sales. And you know, we think there’s a lot of small projects that people are still doing that our installed program works well for.

Michael Lasser - Lehman Brothers

Okay, and then on the mix shift to cash and debit cards, was that solely due to a shift away from the private label card or was that -- or do you also experience that in the third party cards as well, such that -- and then how are you able to discern that was related to the stimulus? Could it have been due to just generally contracting environment for consumer credit?

And the last question is have you changed any of your assumptions about proprietary credit losses, since you did comment they were trending up a bit?

Robert F. Hull Jr.

As relates to the mix of tender type, cash and debit were up just about a little more than 200 basis points quarter over quarter, so they increased about 200 basis points. Proprietary credit was down about 100 basis points. Bank card was down just a little bit more than 100 basis points, so we haven’t done anything different as it relates to getting new apps and getting new accounts. I’m sure folks are stressed for credit but I think it has more to do with the stimulus checks than anything else as people had -- 8% of the folks had money directly deposited into their accounts.

As it relates to the credit program, our credit outlook for the year hasn’t changed. Credit losses are higher than last year but where we expected them to be. That is being somewhat offset by increased cardholder income and lower money costs related to the portfolio. So our expectations for where the credit program will be for the year isn't any different than it was 90 days ago.

Michael Lasser - Lehman Brothers

Thank you.

Operator

Your next question comes from Laura Champine of Morgan Keegan.

Laura Champine - Morgan Keegan

Good morning. I guess we’re all looking for when the comp can turn positive on a sustainable basis and you mentioned continued sales pressure into 2009. When you mentioned macro factors, I think the first one you cited is housing turnover. Is that in your view the key factor or should we be looking to home prices or is there some other driver that will help us see when that top line turn is coming?

Robert A. Niblock

I think when we think about the macro factors, certainly there’s -- you can draw a relationship between comps and housing turnover. Now we’re just trying to find the bottom in the housing turnover, certainly so we can start forecasting an upward trend. [inaudible] is probably somewhere in the third quarter or so is the best estimate of when the housing turnover will bottom out on an absolute number basis, so we’ve still got some pressure from a year-over-year standpoint.

Certainly you have a significant amount of inventory that has to be worked off and you have continued pressure from foreclosures and other delinquencies and the existing inventory of homes that’s going to continue to put pressure on housing prices. So the latest forecasts show housing prices probably not bottoming until the second quarter of next year, so I really think on a sustained basis, you’ve got to probably get past that second quarter of next year. We can really start to see then the markets turn.

What does that mean for comps? Well certainly we’ve got easier comparisons we’ll be going up against between now and then, and then depending on what takes place, the competitive dynamic that takes place in the environment, closings, opportunities to gain share, those types of things puts the -- what happens with unemployment as those type of things all have an impact on our business. So we’re talking about really looking at positive sustained comps, you probably -- for recovery, you are probably looking at the second half of next year for the recovery. It doesn’t mean that comps can’t move positive before then, depending on what else takes place in the environment, how many more positives versus negatives that we have, what happens with fuel prices, what happens with food prices, those type of things that are currently putting pressure on the consumer.

Greg, I don’t know if you have anything else you want to add.

Gregory M. Bridgeford

If you look at some of the factors we are trying to monitor very closely is on the positive side with a decline on median home prices across most markets in the U.S. that we track, especially the larger markets, we are seeing housing affordability, long-term housing affordability factors come back into play. We are moving more towards the long-term medium affordability ratios, which is very positive.

But as Robert said, it’s housing but it’s also consumer spending and we have to watch that, the factors that affect consumer spending very carefully. So you’ve got two major dynamics that we are trying to track and understand, and as he said most economists today say you really won’t see housing prices bottom out. You’ll see some stabilization in housing prices until the second half of 2009 and housing prices start to recover and move back towards more what you would consider longer term growth rates until 2010 plus.

Laura Champine - Morgan Keegan

Great. Thank you.

Robert A. Niblock

We have time for one more question.

Operator

Your last question will come from the line of Dan Binder with Jefferies.

Dan Binder - Jefferies & Company

A couple of questions; the credit, proprietary credit down 100 basis points. I know you said some of that will have to do with the tax stimulus. Is there -- what level of tightening is going on with that card for your customer and are the approval ratings coming down? That’s the first question.

The second question was if you can give us an update -- I’m not sure if you did already but, I may have missed it, an update on how quarter to date trends are looking relative to your plan.

Robert F. Hull Jr.

As relates to credit, we’ve had no changes in lending standards related to the proprietary credit, no changes in how we think about the FICO scores, how we think about the account lines and what not. We’ve had a prudent growth strategy over the past several years. Yes, losses are ticking up slightly in this environment but we felt good all along about our growth strategy and have not changed anything there.

One other thing that is impacting our credit performance slightly is, as Larry talked about, is big tickets suffer when you think about a 12 months no pay offer with a ticket requiring more than $299, some of that is having an impact on the credit program as well.

As relates to the start of Q3, the third quarter has started right where we expected it to be.

Dan Binder - Jefferies & Company

Okay, and then just a follow-up on the credit side -- can you quantify what the SG&A pressure is from that deleveraging that you mentioned earlier?

Robert F. Hull Jr.

The credit program deleveraged about 15 basis points or so in the second quarter, driven primarily by losses. We expect increased losses to have roughly a $0.04 per share impact. However, as I mentioned earlier, the higher [float] income, lower money costs will offset the majority of that, so for the years the income related to our proprietary credit program will only be down slightly from 2007.

Dan Binder - Jefferies & Company

Okay, and then last question on inflation -- I know you said that the building material and lumber had a nominal impact. What would you say the level of inflation is that you are seeing to your sales across the entire store?

Robert F. Hull Jr.

The lumber and building material impact had about -- I’d say nominal, only about 8 or so basis point impact in the quarter. It’s kind of a mixed bag, Dan, when you think about inflation as relates to our product. You’ve got some price increases, you’ve got a greater mix of foreign sourced goods that has a net deflationary impact. So on balance, I think it’s a less than 1% impact across the board.

Dan Binder - Jefferies & Company

Okay, great. Thanks.

Robert A. Niblock

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

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Source: Lowe's F2Q08 (Qtr End 8/1/08) Earnings Call Transcript
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