Lowe’s Companies (NYSE:LOW) Q2 2018 Earnings Conference Call August 22, 2018 9:00 AM ET
Marvin Ellison - President, Chief Executive Officer
Mike McDermott - Chief Customer Officer
Marshall Croom - Executive Vice President, Chief Financial Officer
Christopher Horvers - JP Morgan
Simeon Gutman - Morgan Stanley
Michael Lasser - UBS
Eric Bosshard - Cleveland Research
Zach Fadem - Wells Fargo
Steve Forbes - Guggenheim Securities
Seth Sigman - Credit Suisse
Good morning everyone and welcome to Lowe’s Companies Second Quarter 2018 Earnings conference call. This call is being recorded. Please note if you pressed star, one to enter the question queue prior to the start of today’s call, your signal did not register. You will need to press star, one again to enter the queue. Also, supplemental reference slides are available on Lowe’s Investor Relations website within the investor packet. While management will not be speaking directly to the slides, these slides are meant to facilitate your review of the company’s results and to be used as a reference document following the call.
During this call, management will be using certain non-GAAP financial measures. The supplement reference slides include information about these measures and a reconciliation to the most directly comparable GAAP financial measures. 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. Marvin Ellison, President and Chief Executive Officer; Mr. Mike McDermott, Chief Customer Officer; and Mr. Marshall Croom, Chief Financial Officer.
I will now turn the program over to Mr. Ellison for opening remarks. Please go ahead, sir.
Thank you, Regina, and good morning everyone. It’s an honor to be here today as the President and CEO of Lowe’s. Before I get started, I’d like to take a moment and acknowledge the many contributions of Robert Niblock during this 25 years of service, including 13 years as Chairman and CEO. Running a large public company is never easy, and Robert led Lowe’s through some impressive periods of growth, doubling the size of the company and navigating through an important era of transformation in retail. I’d like to personally thank Robert for his service and his commitment to the hundreds of thousands of men and women who work for this great company.
Now let’s turn to our second quarter results. We capitalized on a delayed spring demand to drive strong growth in seasonal businesses and achieve comp sales above the company average in lumber and building materials, appliances, rough plumbing and electrical, and delivering a comparable sales growth of 5.2% overall. Our U.S. home improvement comp was 5.3% with positive comps in all 14 geographic regions and 14 in 8 of our 11 product categories, and we drove an 18% comp growth in Lowes.com. Diluted earnings per share were $1.86 and adjusted diluted earnings per share were $2.07, an increase of 31.8% from the same period a year ago.
Taking a step back, our second quarter results represent three broad themes. Theme no. 1, resilience. Despite significant organizational changes during the quarter, the associates and the leaders of this company remained focused and resilient, and I’d like to personally thank the more than 310,000 associates for their hard work and commitment. Theme no. 2, great marketplace. After spending almost four years in the apparel sector, it is obvious to me that the home improvement marketplace is among the most robust in retail, and we anticipate continued growth in the home improvement sector where there is a strong demand for our products and services from a diverse group of customers motivated to invest in their homes. The final theme is we have work to do. Despite delivering a 5.2% comp and $2.07 adjusted EPS for the second quarter, we have a lot of opportunity as a company. Specifically, we are significantly behind in our supply chain strategy, our in-store technology is dated, overall execution is impaired by complexity, we have a large number of out-of-stocks in our stores that must be addressed, and we need to increase the rigor with which we evaluate capital investments.
Although it’s never good to be behind, our current position presents significant upside potential for Lowe’s and for Lowe’s shareholders, so the question is, how do you realize this potential? Over the past 12 weeks, we’ve hired some of the best leaders in retail to help us address these shortcomings, and I’m excited to see how great we can be as a company when we have these retail fundamentals corrected. Although I’ve only been in the position for seven weeks, my opinions on the current state of the business have been formed by the following.
First off, detailed business reviews with all of our functional leaders. I’ve spent time with suppliers, I’ve engaged our customers around the country and conducted numerous town halls with our associates, and visited stores in all 14 U.S. regions. My aggressive travel schedule has given me the opportunity to learn from those closest to the customer, and in fact my greatest learning thus far is just how outstanding our associates are. Our frontline teams find ways to serve our customers despite some of the competitive disadvantages we’ve created for ourselves, and without question our associates are our greatest asset, and we must give them better tools to compete. Simply stated, at Lowe’s we desire to be a great omni channel retailer.
While we have the foundational elements of an omni channel network, we need to better connect and align our systems and processes to create a truly integrated ecosystem. Fortunately I’ve been down this road before and I have a clear understanding of the steps and processes required to build a world-class omni channel environment.
In addition to drive value for our customers and shareholders, we must simplify the business to produce better results and more consistent results. The company has unfortunately become distracted over the past few years and specifically, we’ve tasted initiatives that did not add value and were not core to our retail business. Spending time on these non-core initiatives shifted capital, people and attention away from being an operationally sound home improvement retailer, and these distractions also created a complex environment for our frontline associates.
We recently took steps to simplify our organizational structure, and my experience has taught me that a simplified organizational structure is the first step to create operational excellence and allow for faster decision making. We also made several important leadership appointments and I’m pleased to welcome Bill Boltz as our Executive Vice President of Merchandising, Joe McFarland as our Executive Vice President of Stores, and Don Frieson as our Executive Vice President of Supply Chain, and earlier today we announced the addition of David Denton to the team as our new Chief Financial Officer. David currently serves as the EVP and CFO of CVS Health, where he has held that position for over eight years. We’re very excited to welcome David to the Lowe’s team.
All of our new executive vice presidents have strong retail pedigree and proven track records of success. Combined, Bill and Joe bring over 50 years of home improvement experience, and Don and David will bring a deep technical knowledge from their related fields of supply chain and finance. All four leaders will be instrumental in helping us to establish the necessary building blocks to create a world class omni channel environment, and where you can find proven leadership with disciplined capital allocation, great things can happen.
We’re also working aggressively to fill our open Chief Information Officer position and expect to have a leader named in short order. In addition to implementing a new leadership structure, simplifying the business also means that we will shift our focus away from less effective projects.
As we have announced this morning, we have initiated a strategic reassessment of the business which has already led us to make a series of decisive moves to refocus our financial and intellectual capital on running a great retail business. First, we decided to exit our Orchard Supply hardware operations to allow us to focus on our core home improvement business. We expect to close all 99 stores which are located in California, Oregon, and Florida, as well as one distribution facility by the end of fiscal 2018. To ensure an orderly wind down process, we plan to conduct store closing sales and have partnered with Hilco Merchant Services to help manage the process to ensure a seamless experience for our customers. Closing stores is always difficult and we’ll take all possible steps to find positions for our displaced associates in nearby Lowe’s stores.
Second, we are eliminating approximately $500 million in planned capital projects for 2018. Specifically, we’re eliminating projects that were not focused on improving our core business, did not delivery productivity for our associates, and did not meet our hurdle rate. Instead, we will reallocate that $500 million to our share repurchase program, and we believe this will deliver more value to our shareholders.
Third, I have charged the new leadership team to develop an aggressive plan to rationalize our store inventory to remove clutter and reduce lower performing inventory. This will enable us to invest in improved job lot quantities for pro and increase our depth of inventory in our top 2,000 high velocity SKUs. None of these actions are easy to take; however, they are the right decisions for our company and our shareholders, and this will allow us to position our core home improvement business for continued growth.
The company’s strategic reassessment is ongoing as we will evaluate the productivity of our real estate portfolio and our non-retail business investments. Going forward, our goal is simple. We plan to deploy both human and capital resources to their highest and best use.
Finally as we work to create more value for our shareholders, we must create a true expense reduction culture here at Lowe’s. No longer will we throw payroll at each problem. Instead, we will rigorously scope out the issue and implement technology to improve our processes. This will ensure that we deliver better sustained expense discipline and more effective capital allocation that will drive improvements in our return on invested capital.
To summarize, our short-term priorities at Lowe’s are the following. We’ll simplify our organizational structure, recruit outstanding leaders, improve our reset execution, rationalize store inventory while improving our in-stock position, invest in high velocity SKUs for our pro and DIY customers, implement more rigor into our capital allocation process, intensify our customer engagement, and develop a true expense reduction curve. This is what I define as sharpening our focus on retail fundamentals.
I look forward to sharing more details on our long-term strategic plans at our analyst and investor conference on December 12. With that, I’ll turn the call over to Mike.
Thanks Marvin, and good morning everyone. It has been a pleasure to serve Lowe’s over the past five years, and though we have a lot of work to do, I believe the business has great potential for success going forward.
As Marvin shared with you, we capitalized on delayed spring demand in the second quarter, posting comparable sales growth of 5.2%. We drove increased traffic to our stores and Lowes.com and grew transactions 6/10ths of a percent while increasing average ticket 4.5%. We leveraged holiday events designed to take advantage of seasonal project demand with strong messaging, attractive offers, more personalized marketing, and our continued shift into digital and localized marketing channels. We were positioned with seasonal inventory in place and staff trained and ready to help customers complete their projects. In fact, we kicked off the quarter with significant outdoor recovery driving comparable sales growth of 8.2% in May.
For the quarter, we achieve double digit comps in lawn and garden driven by broad-based strength in lawn care, live goods, and landscape products. We delivered high single digit comps in seasonal and outdoor living with double digit comps in cooling, where we were pleased with the results of our transition to GE air conditioning products, and we delivered double digit comps in outdoor power equipment driven largely by strength in battery powered cordless products as well as double digit comps in pressure washers following the introduction of Craftsman to the category. We drove market share gains across all major categories where we introduced Craftsman to our line-up.
In the second quarter, we also saw continued strength in categories such as lumber and building materials, appliances, and rough plumbing and electrical. We achieved high single digit comps in appliances as our omni channel offering together with leading brands, breadth of assortment, competitive pricing and service advantages continued to propel our performance. Pro demand as well as inflation drove strong comps in rough plumbing and electrical and lumber and building materials.
In order to continue growing our sales to pro customers, we will further strengthen our portfolio of pro-focused brands. Today we’re proud to announce the introduction of Mapei to all stores, the leading brand in tile setting materials, and we’re also excited to announce the addition of Zoeller, the number one brand in pumps and a retail exclusive. Lowe’s will be offering the full line of Zoeller products, including well, sump, submersible, and utility pumps.
As we look forward, we’re focused on capitalizing on the opportunity presented by a strong home improvement sector. We’ll work to sharpen our execution, as Marvin noted, by simplifying the business and focusing on core retail fundamentals, improving our in-stocks, and reducing the time our associates spend on tasking so that they may focus more on serving our customers. We’ll also streamline and simplify our reset process to improve our execution and reduce disruption for our stores. Reset challenges adversely impacted our performance in fashion fixtures, specifically light bulbs, and in paint throughout the quarter. We’re working diligently to address those issues. We’ll also continue to make advancements in our supply chain, opening our first direct fulfillment center this fall to allow for expansion of our online product offering and more efficient deliver for our customers, and we’re testing predictive delivery scheduling for our stores to allow them to better plan for shipment arrivals from our regional distribution centers.
We’re excited about our continued rollout of Craftsman in the second half, including individual mechanics and hand tools, power tools, and fall outdoor power equipment. Given the strong response we’ve seen in category introductions thus far, we’re thrilled to be the exclusive destination in the home center channel for this iconic brand, offering some of the best tools, storage and outdoor power equipment in the industry. We’ll also leverage our expanded strategy partnership with Sherwin-Williams, one of the most recognized brands in paint, highly respected for quality products by both homeowners and pros. With this partnership, Lowe’s is the only national home center to offer top selling stain brands Minwax, Cabot, and Thompson’s WaterSeal.
Moving beyond the reset pressure we saw in Q2, in the second half of the year we’ll deliver a simplified line design that makes it easier for customers to select the right product for their painting needs with exclusive HGTV Home by Sherwin-Williams, and Valspar interior and exterior paints, as well as the top paintbrush brand, Purdy. We’re excited to bring customers more of the top brands they trust for their next paint or stain project. We’re also rolling out a new paint desk experience, including an updated product selector display as well as a simplified and streamlined service model to make it even easier for customers to work with an associate to find a color, pick a paint or stain, quickly have it mixed, and begin their project.
We’re excited about the second half of the year with great brand introductions, exciting marketing plans and events to drive traffic, and a focus on core retail fundamentals. We will capitalize on strong demand in a health sector.
Thank you for your interest in Lowe’s, and I’ll now turn the call over to Marshall.
Thanks Mike, and good morning everyone. It has been a great experience for me to serve Lowe’s for the past 21 years in many different capacities. I’m excited to see what the future holds for this great company.
As a reminder, in the first quarter we adopted the new revenue recognition accounting standard and as a result, we reclassified certain items within operating income, the most significant of which was the reclassification of the profit sharing income associated with our proprietary credit program from SG&A to sales. The adoption of this standard had no impact on operating income and no impact on comparable sales. It was adopted on a modified retrospective basis, so the prior year has not been adjusted.
Sales for the second quarter increased 7.1% to $20.9 billion, supported by a 1.3% increase in total transactions and total average ticket growth of 5.8% to $75.53. Adoption of the new revenue recognition standard provided a 74 basis point benefit to sales growth. Comp sales were 5.2% driven by an average ticket increase of 4.5% and transaction growth of 6/10ths of a percent. Looking at monthly trends, comps were 8.2% in May, 4.2% in June, and 3% in July. As Mike indicated, we capitalized on delayed spring demand, leveraged our strength in appliances, and drove strong comps in lumber and building materials and rough plumbing and electrical.
Gross margin for the second quarter was 34.46% to sales, an increase of 25 basis points from Q2 of last year. Adoption of the new revenue recognition standard provided a 55 basis point benefit to gross margin. Product mix shift negatively impacted gross margin by 20 basis points and higher transportation costs negatively impacted gross margin by 20 basis points.
SG&A for the quarter was 22.45% of sales, which deleveraged 229 basis points. As Marvin noted, we performed a strategic reassessment of Orchard Supply Hardware during the quarter, which led to non-cash charges of $230 million and a decision to exit the business. These non-cash charges drove 110 basis points of SG&A deleverage. Adoption of the new revenue recognition standard resulted in 64 basis points of SG&A deleverage, and in last year’s second quarter we recorded a $96 million gain from the sale of our interest in the Australian joint venture. This resulted in 49 basis points of deleverage this year. While increased demand from continued growth in appliances drove 16 basis points of deleverage in customer delivery costs, it was offset by 21 basis points of payroll leverage in the quarter.
Depreciation and amortization for the quarter was $345 million, which was 1.65% of sales and leveraged 18 basis points. Operating income decreased 186 basis points to 10.36% of sales. Interest expense for the quarter was $153 million, which leveraged seven basis points. The effective tax rate was 24.4% compared to 36.2% last year as a result of tax reform.
Diluted earnings per share was $1.86 for the second quarter compared to $1.68 in the second quarter last year. Excluding the non-cash charges as a result of the strategic reassessment of Orchard, adjusted diluted earnings per share was $2.07, a 31.8% increase over last year’s adjusted earnings of $1.57.
Now to a few items on the balance sheet, starting with assets. Cash and cash equivalents at the end of the quarter was $2.3 billion. Inventory at $11.9 billion increased $478 million or 4.2% versus the second quarter last year. Inventory turnover was 3.85 times, a decrease of 15 basis points versus Q2 of last year.
Moving on to the liability section of the balance sheet, accounts payable of nearly $9 billion represented a $335 million or 3.9% increase over Q2 last year. At the end of the second quarter, lease adjusted debt to EBITDAR was 2.23 times and return on invested capital was 20%.
Now looking at the statement of cash flows, operating cash flow was nearly $5.8 billion and capital expenditures were $543 million, resulting in free cash flow of $5.2 billion. In the second quarter, we paid $338 million in dividends and in May, we entered into a $550 million accelerated share repurchase agreement which settled in the quarter for approximately 5.6 million shares. We also repurchased approximately 5.8 million shares for $550 million through the open market. In total, we repurchased $1.1 billion of stock in the quarter. We have approximately $5.1 billion remaining on our share repurchase authorization.
Looking ahead, I’d like to address several updates we made to Lowe’s business outlook. From a macroeconomic perspective, we maintain our positive outlook for the home improvement industry. We expect to see solid sector growth driven by gains in employment, which should boost disposable income and consumer spending, and we expect that housing will remain a positive driver as solid housing demand and continued home price appreciation supports home improvement spending. However, while we recovered approximately half of the seasonal miss in the second quarter, assortment issues in flooring, inventory out-of-stocks, and reset disruption continue to exert pressure on sales growth. As a result, we now expect a total sales increase of approximately 4.5% for the year, driven primarily by a comp sales increase of approximately 3%, and we anticipate opening approximately nine stores.
As Marvin shared, we are developing plans to aggressively rationalize our store inventory to remove clutter and to allow for investments in job lot quantities for the pro and overall depth of high velocity SKUs. These actions may put up to 55 basis points of pressure on operating income in the second half of the year.
Also, our business outlook reflects the $230 million non-cash charges we incurred in the second quarter related to long-lived asset impairments and discontinued projects for Orchard, as well as the expected $390 million to $475 million of additional charges expected in the second half of 2018 as a result of our decision to exit this business. On a GAAP basis, we now expect an operating margin decline of approximately 180 basis points.
Effective tax rate is now expected to be approximately 25%. For the year on a GAAP basis, we now expect diluted earnings per share of approximately $4.50 to $4.60.
As Marvin mentioned, we lowered our capital forecast for the year by $500 million, eliminating projects that were not focused on improving our core business, did not delivery productivity for our associates, or didn’t meet our hurdle rate. We are now forecasting cash flows from operations of approximately $7 billion and capital expenditures of approximately $1.2 billion. This is expected to result in estimated free cash flow of approximately $5.8 billion for 2018.
Due to the lower capital expenditure forecast, our guidance now assumes approximately $3 billion in share repurchases for 2018.
Regina, we’re now ready for questions.
Our first question comes from the line of Christopher Horvers with JP Morgan. Please go ahead.
Thanks, good morning. Welcome Marvin, and welcome back to home improvement. I have two questions. First question, you spent a lot of time in the field, and I want to get your thoughts on the opportunity to improve the pro performance as it appears that this is where the strength of the market is, and the pro performance gap has widened. So you’re attacking in-stocks first, but what’s your other early diagnosis points of areas that you can see improvement and try to drive improved comp on the pro side of the business?
Okay, thanks Chris. Pro is a huge opportunity for us. Today, we estimate roughly 30% of our overall sales penetration is from the pro segment. If you think about the pro for a second, they are a very important customer but they have some very simplistic expectations on what it takes to get their business, and really it starts first with service. We’ve heard oftentimes that pros deem time is money, so they want to get in and out quickly, so we’ll invest more emphasis on simple things like loading, staffing the desk, and making sure that we improve our delivery processes.
Secondly, they just want to have a product there, and so I discussed in my prepared comments how we are not only rationalizing inventory, we’re also investing in job lot quantities - that is primarily for our pro customers. Pros need to be able to walk in to see a depth of inventory that they can complete their jobs, and we are very inconsistent in that today.
The next thing that we have to do, and this Bill Boltz, our new EVP of Merchandising is already working on this, is we need the brands. Pros resonate to certain brands, and so we’re working to look at our assortment in our pro building materials area and asking the question, what brand gaps do we have in the assortment that we need to attack, and that is already underway to try to make sure that we are responding to the feedback we received on certain and specific brands that we need to add to the assortment.
The last thing that we feel really good about is credit and our relationship with Synchrony, and how we’ve worked with them to create more of an emphasis around our pro customer. These are really the short term priorities that we’re going after. As you noted, it’s a huge opportunity for us. We can impact this side of the business without distracting or disenfranchising our DIY customers on the garden, on the décor side, and it’s something that we’re going to spend a lot of time on. Joe McFarland, who is our new Executive Vice President of Stores has a deep understanding of this segment and we’re excited about the short and long term potential.
Understood. As a follow-up, you mentioned reviewing non-retail investments. I’m curious as to what they are exactly, and as you think about the long term here, you mentioned a culture of expense discipline. How do you think about the ability to drive operating margin expansion versus the need to invest in things like in-store technology, labor, and supply chain? Thank you.
I think from a non-retail investment--I mean, if you look across some of the decisions we’ve made from a capital perspective over the course of the last three to five years, we’ve dabbled in quite a few investments in non-retail type of formats and non-retail type of synergies and systems and services, so without getting very specific, because it’s still really early, we’re just assessing everything. We’re looking at our entire real estate portfolio and looking at every capital investment where we are spending the shareholders’ money, asking the question, are we getting an appropriate return, and equally as important is it consistent with our strategic long term view of where we think Lowe’s should be as a world class omni channel retailer.
So I’m expecting when we gather for our December investor conference, we’re going to have much more specificity on where we see the future going, where we will invest, and investments we’re going to pare back. I want to just wait until that time frame before I’d be more specific on what opportunities are possibilities that we’re going to shift in from.
Relative to operating income, it really comes down to a couple of fundamental things. We need to generate more sales per square foot productivity in our stores. If you look at where we are in past, we’ve been focused on our end caps. As an example, our end caps have been more leaning toward innovation than driving sales productivity. It’s really not the merchants fault. The merchants have simply been following the company’s strategic plan, but what we’re going to do is shift away from innovation to innovation and drive revenue, so we have to drive more improved sales per square foot productivity. While we’re doing that, we have to be more disciplined on our SG&A and we have to be more disciplined on our investments of expense and capital.
So, I mentioned in my prepared remarks that we’re going to no longer throw payroll at problems. In the past when we had what we deemed conversion issues in the stores, we indiscriminately just added payroll to try to solve it without really identifying the root cause, and that is not how you run a business this size. Instead, we’re going to be more prudent on getting to root cause, redefining process, and not just thinking every solution is a solution we just kind of throw more headcount at it, because that’s not sustainable.
So improving productivity on our sales per square foot, being more diligent and disciplined around SG&A, making sure that we have more rigor in our capital allocation process is going to improve our EBIT performance, our operating profit, and have more sustainable EPS growth.
Does that mean you think there is an expense reduction opportunity outside of driving the actual productivity in the business?
I would say there is more to come on that. We are spending a lot of time looking at our strategic process around where we invest and where we cut, and how we can drive productivity in our stores. I mean, as a recollection, one of the things that I am significantly focused on is how we can drive improved productivity in our stores while continuing to leverage operating profit, and we can do both. We can improve service, we can improve productivity, and we can also create a more profitable environment, and that is a correlation of understanding more process discipline in addition to making the right investments.
As one specific example, we have very few, if any engineered standards in our stores, and what I mean by that is that typically for a retailer our size, there is very engineered processes on things like how you unload a truck and how you float product from receiving to the sales floor to drive in-stock. We have no standards for that, it’s a very random process where our stores are kind of fending for themselves, trying to make it happen. That is how you destroy productivity, and so if you simply go in and build engineered processes consistent across all types of stores and volumes, you can drive increased productivity without having any kind of a staff reduction action, it’s just more about process efficiency. So we’re going back right now to create engineered standards for everything we do, from unloading a truck to stocking a shelf to every other process, and we know that that’s going to reap significant benefits.
Our next question comes from the line of Simeon Gutman with Morgan Stanley. Please go ahead.
Thanks, good morning. Welcome, Marvin. My first question is given your experience, Marvin, in this segment, and you used to compete a lot against Lowe’s, wondering at that time how you thought about the productivity advantage that Home Depot had over Lowe’s, whether it was real estate driven, whether it was operating execution driven. Any thoughts that you’d share from your time last in the segment of why Lowe’s wasn’t operating at the same level as Home Depot?
Well Simeon, I can remember back in early 2000 where it felt like every quarter, we were getting beat pretty significantly by Lowe’s with those same structural disadvantages that we currently have, so I think for us, it’s less about looking at the competition and it’s more about looking within and asking the question, where can we be better?
Now obviously relative to our largest competitor, we have a disadvantage in real estate locations from a metro area, specifically the northeast and the west coast. However, we believe that if we can find just a better balance between serving our do-it-yourself customer and our pro, that we can start to chip away at any competitive gaps that we have.
Mike McDermott and I both mentioned in our prepared remarks about the challenges we face with our reset execution. That is an example of what I call it a self-inflicted strategic wound that we’ve done to ourselves, because structurally how we execute resets puts our team at a tremendous disadvantage. From a merchandise planning standpoint, that is kind of living in the merchandising side, and the actual reset execution is in-store operations, so you have two teams working on the same process and that just creates inconsistency and communication problems, so there is process improvements that we’ll make to fix areas like resets.
In addition to that, we talked about our dot-com performance and how we delivered roughly 18% comps. Within that number is a significant systems issue where we tried to create better inventory visibility, and by doing that we drove a significant number of order cancellations that had a dramatic impact on the overall sales number of our dot-com business. That’s another self-inflicted issue that created a lack of performance for us during the quarter. I also mentioned the significant number of out-of-stocks that we’re dealing with in our stores that we have to fix, and so as we look within and we ask the question, where can we be better as a company to drive improved productivity, improved sales performance and improved operational leverage, we think that there are a lot of things that we can correct ourselves because there are certain structural disadvantages that we cannot overcome, but what we can overcome is poor execution That is where our focus will be, and we think as we improve within these areas, we’re going to see that gap start to close because we’re going to be focused more within our own company versus looking across the street at our competitor.
Okay, that’s fair. My follow-up, I respect that it’s early days, but if you’re willing to share your instinct especially given your experience in this segment and now knowing both players, whether there is some type of under-spending that had been taking place at Lowe’s and whether that necessitates some type of big catch-up in order to drive those results that you’re talking about, or if it’s more on process than it is infrastructure.
I don’t think it’s necessarily over-spending as it was the strategic choices we made on what we spent money on. As we announced today, we’re going to be moving away from our Orchard investment, and in retrospect you can argue that that may not have been the most prudent use of capital. I think it’s less about total spending and more about the strategic rationale regarding the spend, so what we’re doing as a team now is we’re taking a really hard look at capital spending and asking the question, where should we invest, and obviously we’re going to invest in supply chain. We have a very clear line of sight of exactly what we want our supply chain to look like. We recruited Don Frieson, who’s spent time at Wal-Mart and Sam’s Club and he brings a wealth of knowledge, and so we’ll make the right investments and we feel very confident that we can create a modern supply chain over the short and long term. It’s an iterative process that you can’t do overnight.
I mentioned we’re looking for a new Chief Information Officer to help us understand how we continue to modernize our in-store technology. We have the capital to spend and we have a pretty good line of sight of what we need to spend it on, and now we’re going to bring a leader in that’s going to build out a multi-year plan. I guess my short answer to the question is it’s not a lack of spending, it’s the prioritization of what we spend it on, and we’re going to get focused on retail fundamentals.
Now, that doesn’t mean that we’re going to think short term. While we’re fixing these fundamental issues like out-of-stocks and reset issues and customer engagement and being more specific around serving the pro, we’re going to be building out our supply chain, improving our IT infrastructure, and also creating this omni channel environment where we can leverage these wonderful stores to be more in tune to serving customers the way they want to be served, both in store and online.
Okay, thanks Marvin.
Your next question comes from the line of Michael Lasser with UBS. Please go ahead.
Good morning. Thanks a lot for taking my question, and welcome Marvin. The first question I have is, Marvin, how are you going to define success, especially in light of the fact that the company has grown earnings over the last few years and benefited from what’s been a fairly healthy home improvement cycle that now looks like it’s in the later stages?
Well, I think for us, like any large public company, we’re going to define success in a couple of ways. First, we’re going to look at are we gaining market share? We’re going to be very purposeful around taking share in key categories. We’re going to look at our financial performance, to look at our sales growth relative to our competitive set. We’re going to look at our bottom line, how are we performing from an EBIT and an EPS perspective, and are we continuing to deliver value for our shareholders.
You know, the thing that we’re going to do, Michael, which is not a surprise, is that we’re going to be really customer focused. We have some very impressive competitors in this space and we’re not denying that, but we understand that we also have to be focused on our customers, and if we can serve our customers at the highest possible level, we think we’re going to take market share. We think that we will see the proper levels of comp sales growth and we’ll drive that sales productivity that I mentioned, and you will see overall bottom line improvement. There are areas that we know we can do a much better job on relative to operating profit, which will be driven through more disciplined SG&A execution, overall operating expense, but keenly focused on driving improved sales productivity in our stores, and we know that we can do that.
So those are kind of the basic fundamental things we’re going to look at, but it’s going to be really more about are we serving our customers at a level that’s driving loyalty and return visits
My follow-up question is can you frame the upside and the downside you’re guiding for the back half of the year? Was there any thought to a new team coming in, let’s provide a downside case or a really conservative outlook to provide breathing room for some of the changes that we’re going to have to make, especially in light of the fact that there’s already been some execution challenges that we’re going to have to confront as we begin this journey?
Michael, I’ll give you a high level of my thoughts. I’ll hand it to Marshall and let him provide you anything more specific. I think the simple answer is that we have a lot of moving pieces, as the earnings release outlined, with our decision to liquidate Orchard and our decision to rationalize inventory, and also we made, I think a very prudent decision to take $500 million in capex and shift it to our share repurchase program. So based on all of that, specifically Orchard and the inventory rationalization, we felt it was prudent to update our guidance, and we feel as though we were conservative but we wanted to also make sure that we did not under-perform what we believe the numbers should be for the second half of the year.
With that, I’ll hand it to Marshall, and he may provide some more specifics.
Michael, when we started the year, we were guiding to 40 basis points of pressure on our operating margin. We’ve expanded that to 180 basis points, so that’s 140 basis points, again to Marvin’s point, largely driven by Orchard, our decision to exit that business, as well as taking a hard look at our inventory rationalization process that we’re getting underway. Those two items combined drive that, but again it’s the right thing to do so we can redeploy capital to invest it where necessary. It’s those two big pieces that are driving the operating margin pressure.
Marshall, just to confirm, did those two pieces that are what we’re seeing the difference between your old guidance and your new guidance, or was there pressure factored into the operating profit margin above and beyond that, other factors as well?
Those were the two key drivers, and again taking a hard look at the inventory rationalization, felt that we needed to plan for an aggressive approach to that.
Thanks very much.
Your next question comes from the line of Eric Bosshard with Cleveland Research. Please go ahead.
Good morning. Curious Marvin, as you think about--you’re doing a good job of listing out the investments that are needed, the prioritization of what you’re doing, but I’m curious as you think about the resets and customer engagement and the pro service and building out the supply chain and IT, and also identifying the productivity opportunities, is your mindset and discipline to invest first in these areas to strengthen the future, or is your discipline to self-fund these things along the way and measure out and meter out the implementation of these things? Which path are you more apt to go down?
Eric, I think it’s a combination of both. The best way to describe is I think we have to work very aggressively to address what I call a lack of retail fundamentals, just basic things like reset execution, in-stock improvement, sales productivity on end caps, addressing out-of-stocks and job lot quantities, having more engagement with customers and not overriding in tasking versus engaging customers, and understanding how we serve our pro via improved service and brand so they respond. Concurrently, we’ll be investing in a multi-year plan in supply chain, concurrently we’ll be investing in a multi-year plan from an IT infrastructure improvement, and concurrently we’ll be building out our omni channel investments in our stores so that we can continue to leverage our 2,300-plus physical locations with our digital platform. I think it’s a combination of addressing retail fundamentals because we think the short term benefit is there, and again you can’t be a great retailer if you’re not fundamentally sound, while making the strategic investments that will make us viable for the short term and the long term. It’s a combination of all those things
That’s helpful. Secondly, curious in terms of the timing we should be expecting regarding payback on the sales line. You talked about the importance of considering sales growth and sales per square foot and even your market share performance. When is it reasonable to expect the efforts that you’re making to start to change the performance in those areas?
Eric, what I would say to you is as you can imagine, we’re spending a lot of time getting our new leaders assimilated to the company. The good news is both Joe McFarland and Bill Boltz bring a combined 50 years of home improvement experience, which I think is really important for us on the merchandising and the store side, but they have to get assimilated. Dan Frieson brings over 18 years with Wal-Mart and Sam’s Club, but he needs to get assimilated, and we just announced David Denton this morning as our new Chief Financial Officer. When we come together at the investor and analyst conference in December, it’s my expectation that we’re going to have a high degree of specificity around where we see the business going, not only for 2019 but over the course of the next two to three years, and we’ll be able to lay out those strategic investments that we’re going to make that’s going to deliver upon that, and we’re going have probably a degree of detail that hopefully will give confidence to everyone that we’ve thought through this in a very specific fashion.
I would kind of postpone answering that question more directly until we have a chance to get all these leaders assimilated and we can get together and lay out that all-inclusive strategic plan.
Great, thank you.
Your next question comes from the line of Zach Fadem with Wells Fargo. Please go ahead.
Hey, good morning, and welcome Marvin. Congrats on the new role. I’m curious if you could talk a little bit about your initial conversations with vendors and suppliers. Where do you think those relationships are today versus maybe what you expected, and where do you see the opportunities to improve these relationships either via expansion or consolidation of your offerings, where appropriate, and any additional improvement efficiencies? Thanks.
Well Zach, the first thing is I want to just give Mike McDermott and his team a lot of credit. There are some significant partnerships that they’ve created the last couple years that I think have long term benefits, specifically if you think about being the exclusive big box home center channel for Craftsman - I mean, what an iconic brand, and the brand is exceeding expectations of the team, and we’re just getting started. Also with Sherwin-Williams - I mean, another iconic brand. Having the ability to have their products, whether it’s Thompson’s WaterSeal or Purdy brushes in addition to their paint, this is something that we think we’re just scratching the surface on the potential.
I would say overall, I’ve been very pleased with my engagement with the suppliers I’ve had a chance to spend time with. Obviously with Mike’s transition and Bill Boltz coming on board, we’re going to be spending more time, not only with existing suppliers but we’ll be spending time with suppliers that we currently don’t work with to see if there is a realistic possibility that we can add additional brands to the assortment that will resonate with our DIY and pro customers. I would say overall, it’s been very positive and I think that they have been very encouraged by some of the changes that we’ve made because they now know that we’re getting back, refocused on being a fundamentally sound home improvement retailer, which opens up the opportunity for them to drive more revenue within their own companies.
Got it. Also, just to marry up your current outlook with the plans outlined at the beginning of the year, Marshall, you had called out about $140 million of tax reform reinvestment spending for things like labor, technology, some other items. To what extent are these investments still incorporated in the current outlook today, and is there any planned reallocation in that spend being contemplated?
Zach, again taking a look at the reduction of capital, there are expenses associated with those that’s actually providing a little bit of offset in the back half of the year, but again, net-net the incremental pressure of 140 basis points from our original guidance on operating margin.
Got it. Appreciate the time, guys. Thanks.
Your next question comes from the line of Steve Forbes with Guggenheim Securities. Please go ahead.
Good morning. Maybe to start with the full-year com guidance, are you assuming any flow-through benefit from your inventory rationalization efforts that you mentioned today in the back half or right from the remaining seasonal recapture? I think you mentioned on the call that you got about half of it back in the second quarter.
Then on the top line guide for the back half in general, can you help us quantify what you think the out-of-stock impact is to the business today, sort of like the run rate of it?
Steve, I’ll take the out-of-stock question and I’ll let Marshall take the remaining components of the question. It’s hard for us to determine the upside potential of the out-of-stocks. Having said that, having been in retail for over 30 years, I’m keenly aware that if we have increased traffic and improved in-stock, we should see some level of sales productivity from that. We are optimistic that we’re going to be able to drive sales improvement when we get our in-stock position improved.
Now, the reality is that you just can’t flip a switch and have inventory in your stores on the shelves. We are going to be very prudent in how we exit out and rationalize inventory that we think needs to exit the assortment, but we are going to be equally as prudent on making sure that we are selective and surgical on what we bring in, so it’s really more about timing than anything. Once we get this process completed, we’re very confident we’ll see sales productivity; the question is how quickly can we get it done, and that’s the open question that I have that makes it very difficult to answer your question more precisely.
With that, I’ll let Marshall take the rest of your question.
Steve, just on the inventory rationalization efforts, again in the back half, and primarily that’s being driven in the third quarter and we are anticipating about 55 basis points of operating margin pressure, again just to allow for what we believe will be an aggressive approach to remove some of the clutter of inventory in the store and potentially an effort to reinvest into job lots for the pros and some higher turning SKUs to drive future sales productivity as the company moves forward.
Then just a quick follow-up, I think there was a billion dollar increase in the free cash flow guidance for the year, 2Q over 1Q. Half of that obviously is the $500 million reduction in planned capex for the year. Where is the other half coming from, the other $500 million, and then just touch on where you think inventory ends up being at the end of the year.
To the question on where is the incremental $500 million of operating cash flow coming from, it’s from the liquidation efforts of Orchard and the actions we are anticipating taking in the third quarter with inventory rationalization. That’s really the two drivers to that piece.
Was there another part to that question?
Just what do you think inventory is at the end of the year as far as the balance sheet line item or on a per-store basis?
Right now, we’re looking at total inventory to be roughly flat for the year.
Thank you very much.
Regina, we have time for one more question.
Our final question will come from the line of Seth Sigman with Credit Suisse. Please go ahead.
Thanks a lot, and good morning. A couple follow-up questions, first just in terms of Orchard Supply. Any more insight into that decision to exit that business and the historical financial contribution for that business? Then I’m just curious your views on Canada and Rona specifically. Do you view that as core to the go-forward strategy? Thanks.
I would say Canada and Rona first has been a very positive benefit for the company. The good news is that the overall integration is happening well. The introduction of unique and different categories to Rona, like appliances, has been met with really strong response from the customers, and we feel very, very good about the Canadian business performance and again that overall acquisition of Rona, and we think that it’s exactly where we want it to be, if not exceeding expectations from the original pro forma.
Relative to Orchard, as the old saying goes, hindsight is 20/20, but I think there were some strategic decisions made that if they had to be done over, would be different. The good news is that 86% of the Orchard stores that are closing are within a ten-mile radius of a Lowe’s store, and so we’re very optimistic that any associate who is an Orchard associate that’s looking for a home at Lowe’s, we should be able to find them a position and we’re going to prioritize those individuals.
But the business was just not running well, and as we started to do the strategic assessment of where we wanted to invest our capital and where we wanted to be focused, it became really clear to me and to the leadership team that we want to be focused on our core retail business, and we could grow Orchard into the most dominant small box specialty home improvement channel in America and it would be very minimal positive impact from an EBIT and from an overall revenue standpoint to the Lowe’s business. So the question is, do you continue to invest financial and intellectual capital in an initiative that will have very small benefit to the shareholder, and we decided that we would not.
So we’re going to take the intellectual and the financial capital that we would have been investing in that business and investing it in the core Lowe’s business, and we think that’s a better return for our shareholders.
Seth, just one other point just as a frame of reference, Orchard for 2017 generated about $600 million in sales, and it was a negative $65 million in EBIT.
Okay, thank you for that. That’s helpful. My last follow-up is just around ecommerce and your assessment of the gap versus the competitors in this space. I guess in general, how are you thinking about investments required to address those gaps? Thank you.
Well, the good news is a lot of the investments are underway and we are building a very, very impressive team of experts that are coming in from a lot of different backgrounds and some of our very impressive competitors. I think our greatest opportunity is fundamentally making sure that our site is a lot more user friendly from a search, from a navigation, from a checkout, and there is a very specific road map that is being built and being executed to deliver on all of those things.
The second big component is how do we more seamlessly connect our digital and our physical footprints together. The great news for us is that we’re in a space of home improvement where customers still like to come to the stores. They enjoy engaging with our associates because they want some level of consultation on a purchase. In addition to that, we have products that are big, bulky and hard to ship, and having the ability to leverage our digital and our physical stores is important.
The good news is if you look at our business today, roughly 60% of our ecommerce transactions were picked up in a store. That’s incredibly powerful, even though we have a significant list of opportunities that we are addressing, so that’s telling me that our customers, they’re already resonating with our omni channel philosophy and being able to connect digital and physical. We just need to make it more seamless, and so the investments required are really already underway, the road map is already built and we’re continuing to tweak it, but we see nothing of positive upside in this space.
Thank you, and best of luck.
Thank you. Just a few closing remarks. I want to make sure that I just take a moment and thank both Marshall Croom and Mike McDermott for their love and commitment to this company, but more importantly these gentlemen have been extremely professional and very, very helpful for me throughout this transition. I’ll be eternally grateful to both of them for their support of me in this transition, their love and support of the associates of this company, and I wish them Godspeed and many blessings in the next chapter of their lives and careers.
Thank you, and we look forward to speaking to you on our November 20 earnings call.
Ladies and gentlemen, this concludes today’s call. Thank you all for joining, and you may now disconnect.