Lowe's Companies Inc

NYSE:LOW

Earnings Call Transcript 2019-Q2

[Operator]

Good morning, everyone, and welcome to Lowe's Company's Second quarter 2019 Earnings Conference Call. This call is being recorded. [Operator Instructions].

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 it will be used as a reference document following the call.

During this call, management will be using certain non-GAAP financial measures. The supplemental reference materials 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. Bill Boltz, Executive Vice President, Merchandising; Mr. Joe McFarland, Executive Vice President, Stores; and Mr. Dave Denton, Chief Financial Officer.

I will now turn the program over to Mr. Ellison for opening remarks. Please go ahead, sir.

[Marvin Ellison, President and Chief Executive Officer]

Thank you, Regina. Good morning. Total company comp sales grew 2.3% in the second quarter. Our US home improvement comps were positive 3.2%, exceeding expectations despite lumber deflation and unfavorable weather.

In fact, we saw broad-based growth across all 15 geographic regions, generating positive comps. Three of our top four performing regions were in the Western division. In addition to the Western regions, we also had great performance across the following regions that outperformed the total company comps – Atlanta, Boston, Charlotte and Tampa.

Weather was particularly challenging early in the quarter, exerting approximately 195 basis points of top line pressure in the month of May. And as weather improved, we saw broad-based sequential improvement in US comps of positive 0.7% in May, positive 4.2% in June and positive 4.7% in July.

Commodity deflation exerted approximately 110 basis points of pressure to comp sales in the quarter. However, unit growth in impacted departments such as lumber and building materials remain strong.

For the quarter, comparable transactions grew to positive 0.3% and average ticket grew to positive 2%. We executed very well during key holiday events and converted strong foot traffic into sales.

Once again, Pro comps significantly outpaced DIY during the quarter and our strong Pro performance was particularly driven by investments in job lot quantities, coupled with our improved service model. As Joe will detail, we continue to make progress to better serve our Pros and we received very favorable feedback on our improved in-store experience with our customer service scores increasing 900 basis points.

Overall performance in the quarter demonstrated continued momentum executing our retail fundamentals framework. And with the initiatives we've put in place, we continue to make steady, deliberate progress to better serve customers, position our business for long-term success and improve our results in categories that have historically underperformed. Bill will discuss some of those categories in a moment.

On lowes.com, we posted comp growth of approximately 4% in the second quarter. There are a couple of key items that contributed to this [indiscernible] performance.

First, we intentionally slowed the number of new SKUs that we added in the quarter while we addressed systems and process issues that negatively impacted our stores' productivity. These systems and process issues were resolved in early Q3.

Second, we took steps to improve the quality of our online business by eliminating certain programs which were unsustainable from a profit perspective. In taking these steps, we knew that we would stunt our short-term growth. However, we took the necessary actions to position ourselves to grow our online business for long-term sustainable success.

In addition to solving these process and systems issues, we're taking aggressive steps to improve the technology foundation of lowes.com. We're replatforming the entire site to Google Cloud.

At the beginning of this year, our dot-com site was on a decade old platform. So, we expect to have the entire site on the cloud in the first quarter which will improve our agility as we redesign the customer experience from search and navigation to checkout.

Omnichannel is a tremendous growth opportunity for Lowe's and we have a very detailed transformation plan to modernize our platform and dramatically grow lowes.com sales in the future.

Our goal is simple. We want to serve customers in a way they desire to shop and we look forward to updating you on our progress on future calls.

In fact, our commitment to having a world-class technology team is reflected in our announcement to open a new global technology center for 2,000 additional technology professionals in Charlotte. Construction of this new facility began this month with plans to open the center in 2021.

The global technology center underscores our commitment to recruiting world-class talent and becoming a best-in-class omni-channel retailer. But in the meantime, we're utilizing a temporary space in downtown Charlotte for the technology professionals that will ultimately be based in our new global technology center.

In Canada, we posted negative comp sales for the quarter. Our negative comp was driven in large part by our ongoing RONA integration. After a strategic reassessment of the Canadian business, we decided to make adjustments to the original RONA integration strategy.

Although we remain confident in the long-term potential of this business, this shift in strategy has temporarily slowed growth. But once again, we are sacrificing short-term growth to position ourselves for long-term success. And I look forward to providing you with additional updates on future calls.

Diluted earnings per share were $2.14 for the quarter and adjusted diluted earnings per share were $2.15, supported by solid top line growth and expense leverage.

Now, I want to take a moment to provide an update on the progress to deliver gross margin improvement in 2019. The improvement since the first quarter reflects immediate benefits from the actions that we've taken. In fact, we realized compounding benefits as we move through the second quarter, with marked improvement in gross margin for the second half of the quarter as compared to the first half.

Our second quarter performance, coupled with actions still to come, give me confidence that we're on the right path to sequential gross margin improvement in the third and fourth quarters.

Although we're pleased with the progress we made in Q2 to recover gross margin dollars, we have additional work to do to modernize our systems and our pricing tools.

Therefore, over the next 12 months, we'll be focused on two major initiatives to deliver this modernization. Our first initiative is focused on the deployment of our new price management system, which will allow us to better systematically analyze, prioritize and implement retail pricing actions.

This new system will create a single repository of pricing to provide better visibility for the merchants to understand the impact of our pricing decisions. This new pricing management system will be in place by the end of the year and will get us to competitive parity with most retailers.

Our second initiative is focused on fully integrating our acquisition of the Boomerang retail analytics platform. Integrating this platform will allow us to incorporate Boomerang's technology into our core retail business, bolster strategic, data-driven pricing, and also allow us to make better merchandising decisions across the business from an assortment perspective.

This retail analytics platform will be fully integrated with our price management system during the first half of 2020 and will provide us with a best-in-class pricing analytics system.

We're confident in our strategic initiatives as we enter the back half of the year and we expect to continue our strong topline performance while delivering margin improvement. And we'll also begin to manage down our inventory to more sustainable levels.

So, now allow me to take a moment to discuss inventory in more detail. This year, we invested in inventory to support efforts such as earlier seasonal load-ins, Craftsman resets, increased presentation minimums and job lot quantities for Pros.

This strategic investment in inventory helped us to deliver improved sales performance in Q1 and Q2. And although our inventory has increased year-over-year, we have very minimal seasonal inventory, which limits our risk of unplanned markdowns.

In the back half of the year, we refined our in-stock expectations and began to reduce inventory in certain categories. One key initiative tied to our supply chain transformation strategy is the rollout of predictable delivery to all stores. This more predictable product flow will enable us to lower safety stock across many SKUs.

In addition, we'll execute a list of strategic initiatives in the back half of the year that will allow us to strategically manage down inventory, while protecting our in-stock position and our margin.

Though we made great strides and we're pleased with our second quarter results, we're not taking victory laps. We have a lot of work to do and we are fully committed to driving topline growth, improving our gross margin, while intensifying our commitment to expense management. We are very excited by the upside potential of our company and we believe we are on the right path to generate long-term profitable growth.

And lastly, I want to take a moment to thank our associates for their hard work, dedication and commitment to each other and commitment to serving customers.

And with that, I'll turn the call over to Bill.

[William Boltz, Executive Vice President, Merchandising]

Thanks, Marvin. And good morning, everyone. We were pleased with our second quarter performance as we capitalized on the continued spring demand and strong event execution. We posted a US comparable sales growth of 3.2%, exceeding our expectation. On a two-year stack, US comp sales accelerated from 4.7% in Q1 to 8.5% in Q2.

During the quarter, we leveraged our successful Memorial Day, Father's Day and July 4 events, taking advantage of the seasonal project demand. And we also drove traffic with our compelling values, relevant assortments and our continued shift into digital marketing channels.

We were well prepared for our holiday events with excellent coordination and alignment between store operations, supply chain and our marketing teams. Our success in driving spring sales was supported by the improved service model in our stores and better in-stock execution. Joe will share more of that in a moment on how well our associates delivered in the aisle.

Our continued focus on retail fundamentals drove strong performance in areas of historical strength and, more importantly, helped deliver improved performance in categories which have historically underperformed. In fact, we had seven departments perform above the company average in the quarter.

For example, we began the implementation of our retail fundamentals framework in the paint department two quarters ago. Prior to that implementation, paint had delivered comps below the company average for 10 consecutive quarters.

This quarter, because of an improved service model, a better in-stock position along with compelling offers, paint led the merchandising department growth with the strength coming from both interior and exterior paint products, all of that being done despite some weather pressure early in the quarter.

This marks the first time in 10 years that paint has led the merchandising department comp growth. We will continue to invest in this important area, given that paint is a traffic driving category and that painting is the number one DIY project.

We are working closely with our suppliers to roll out an improved propane offering and we see a significant opportunity to drive an increased pro penetration in paint, all of this by better serving the repair remodelers who need paint to complete a larger project such as a kitchen or bathroom remodel.

Prior to our implementation of retail fundamentals, our décor department had performed below the company average for 12 of the last 13 quarters. In Q2, we drove mid-single digit comps in décor, with double-digit comps coming in blinds and shades.

The improved performance was largely driven by job lot quantity investments and our improved product offerings in both our private and national brands.

Millwork is another merchandising department that has historically underperformed. In 11 of the past 12 quarters, millwork had posted comps below the company average. This quarter, with the heightened focus on the pro, an improved in-stock position, a refreshed department, an investment in job lot quantities and some new product introductions, millwork delivered comps above the company average.

For the quarter, we also continued to achieve strong comps in areas of historical strength for Lowe's. In tools, we delivered strong mid-single digit comps and continue to see market share gains as a result of our Craftsman resets.

The strength in Craftsman came from categories such as power tools, tool storage and mechanics tools. We're excited to now have completed the Craftsman reset this quarter and we're proud to be the exclusive destination in the home center channel for this iconic brand.

During the quarter, we also leverage key programs such as DeWalt, the number one power tool brand in the industry. Along with the introductions of other new and innovative products from Bosch, Spyder and Metabo HPT, all to help drive strong comps in tools.

Within our clients department, we drove solid mid-single digit comps, building on our leading market share position with our top brands and breadth of assortment. And

In hardware, we posted solid mid-single digit comps, with strength coming from our framing hardware and our fastening categories. The investment we made in job lot quantity and new product introductions helped deliver the results in these two categories to support the pro demand in hardware.

And lastly, we again delivered above-average comps and saw market share gains in seasonal and outdoor living, led by double-digit constant pressure washers as well as riding lawnmowers where we continue to leverage the top three brands in riding equipment, with John Deere, Husqvarna and Craftsman.

We continue to be pleased with the results that we are seeing from our new merchandising service teams, or MST. These teams are supported by our vendors and they're responsible for day-to-day maintenance, the resets in our stores, setting and maintaining our end caps and executing our off-shelf displays.

The MST teams are a critical component to improving our merchandising and reset execution at the store level as they continue to take tasking activities off the shoulders of our selling associates, so that they can be freed up to dedicate more time serving our customers.

The early results of our MST program are positive and these teams have shown a reduction in out-of-stocks, an improved sales productivity and an increase in bay service per hour.

Now, as we look ahead to Q3, we remain focused on our retail fundamentals and driving profitable sales with our upcoming Labor Day and fall harvest events, leveraging additional target events throughout the quarter that will take advantage of the fall micro seasons, continuing to drive the strength of the traffic power of Craftsman, building on the responsibilities of our field merchandising team who will be instrumental in driving the localization in our stores along with executing our seasonal transitions, continuing the focus on the pro categories as we continue to capitalize on our investments and our focus on this important customer segment.

And lastly, we look forward to leveraging our new NFL partnership, including introducing new exclusive products and events that will help drive a strong connection with both the DIY and our pro customer.

As I've shared on previous calls, we're in the process of implementing our category management strategy. This cohesive strategy is going to be critical to driving merchandising productivity by ensuring that we are allocating our resources to the areas of greatest opportunity.

The merchandising team is committed to aggressively driving topline sales, while growing gross margin dollars.

Thank you. And now, I'd like to turn the call over to Joe.

[Joseph McFarland III, Executive Vice President, Stores]

Thanks, Bill. And good morning, everyone. Our commitment to improving in-stocks and customer service, along with intensifying our commitment to the pro customer, were integral to our strong event execution and comp growth in the second quarter.

I'm pleased with the accumulating benefits we've seen from actions we took in the first quarter to further improve associate engagement and drive store simplification.

We recently deployed the new mobile devices for our store associates we call SMART phones. The acronym SMART represents our customer service philosophy. Our new SMART phones are designed to reduce tasking hours by providing real-time data without ever stepping off the sales floor.

In the second quarter, we added our standardized performance scorecard to the SMART phones. We also deployed store walk application to allow for a more efficient, strategic store review process.

These applications allow our store managers to drill down and evaluate productivity by department and by associate to manage their store more strategically.

These new mobile devices are an example of how we can leverage modern technology to make significant advancements in the capabilities we make available to our associates.

Putting the new mobile devices in the hands of our managers and supervisors is a significant step towards revolutionizing how we deliver sales and operational productivity in our stores.

Our investment in over 600 assistant store managers and 5,500 department supervisors paid dividends in Q2. On average, we've added 120 customer-facing hours per store per week while still leveraging store payroll.

Because of this investment, we're able to provide better departmental coverage and expertise as well as coaching for our associates in delivering excellent customer service.

With the addition of department supervisors, we ensured that we have proper coverage for strategic areas of focus such as pro and paint. It is no coincidence that both pro and paint were two top-performing areas for the second quarter.

All said, our commitment to improving both store efficiency and customer experience drove 600 basis point increase in overall Q2 customer service scores.

As Marvin indicated, we are very pleased with our pro business performance in Q2, with pro comps significantly outpacing DIY. We're also pleased with the pro customers' willingness to grow their business with us.

We continue to leverage our investments in job lot quantities and product presentation in key areas such as the pro canopy and end caps; improved store level service, including dedicated loaders and preferred parking under the canopy to ensure we can get our pro customers in and out faster and staffing our pro desk with dedicated associates working to consistent schedule; dedicated department supervisors for pro areas; a consistent volume pricing message; and our redesigned field structure with 15 new regional pro directors and experienced leaders to focus our in-store and outside pro sales. We're already seeing great results from this team, with double-digit comps this quarter.

We also continue to leverage key brands to grow our pro business, such as Little Giant Ladder Systems, Lithonia Commercial Lighting, along with Bosch, Metabo HPT and DeWalt. And our merchant teams continue to work to add more key pro items to our assortments, including the new exclusive DeWalt 12-volt Cordless Xtreme brushless platform launching this quarter.

We're proud to be the destination for this platform, offering stream power and a compact lightweight design that allows pros to work more efficiently in tight spaces.

We're seeing positive results from our actions with increased pro customer service scores. Once again, this quarter, we invited the customers in to see our improved environment with another very successful pro appreciation event which allow us to grow our pro accounts. In fact, we opened over 35,000 new pro accounts in the quarter.

Although we're pleased with pro performance in Q2, we're in the early stages of our transformation. Therefore, we're pursuing additional opportunities to deepen our relationship with the pro, including our upcoming pro paint test in select markets focused on improving our staffing and training model to better serve the needs of this key customer. We have additional initiatives on our pro roadmap and I look forward to keeping you updated on future calls.

As we look to the back half of the year, we're working on improved staffing and better leverage our payroll spend, with the national rollout of our new customer-centric labor scheduling system. We've deployed this system in four geographic regions and we'll complete the rollout to our remaining 11 regions by the end of the fiscal year.

This system will better predict customer demand by time of day, day of week and department, allowing us to align our labor hours with peak traffic to provide better coverage and customer service, while ensuring that we're using our labor hours efficiently and reducing payroll expense.

This new system will replace our current staffing system that doesn't effectively capture and predict sales and customer traffic patterns.

We're also deploying the new One Task Team to ship task work from our selling associates to one centralized team that will be responsible for completing non-selling tasks during evenings and overnight hours.

This centralized team will drive more consistent execution of tasking, streamline non-customer-facing payroll and allow for cross training.

Though we're pleased with the changes we've made and excited about the results we're seeing, we're very focused on the hard work ahead to drive further improvements and transform Lowe's into one of the most operationally efficient retailers in the world.

Thank you. And I'll now turn the call over to Dave.

[David Denton]

Thank you, Joe. And good morning, everyone. I'll begin this morning, as I often do, with a brief review of our capital allocation program. In the first six months of 2019, we generated $3.1 billion in free cash flow. And through a combination of both dividends and share purchases, we've returned over $3.5 billion to our shareholders.

In the second quarter alone, we paid $382 million in dividends and our dividend payout ratio currently stands at 37% over the trailing four quarters.

Now, given the dislocation of our stock price coming out of Q1, we ramped up our share repurchase activity and bought back nearly $2 billion of our stock at an average price of approximately $100.

Early in Q2, we entered into a $990 million accelerated share purchase agreement, retiring 9.9 million shares. And additionally, we repurchased 9.7 million shares in the open market for $974 million.

This brings our year-to-date share repurchases to $2.8 billion, with a plan to repurchase $4 billion for the year. We also have approximately $11.2 billion remaining on our current share repurchase authorization.

We continue to invest in our core business with a focus on high return programs designed to drive long-term shareholder value. In Q2, we had capital expenditures of $321 million.

Now, turning to the income statement, generated GAAP diluted earnings per share of $2.14. On a comparable basis, we delivered adjusted diluted earnings per share of $2.15, an increase of 3.9% compared to adjusted diluted earnings per share of last year.

Sales for the second quarter increased 0.5% to $21 billion, supported by total average ticket growth of 3.2% to $77.97. This was partially offset by a 2.7% decline in total transactions.

On our comp sales basis, we were up 2.3%, driven by a comp transaction increase of 0.3% and an average ticket increase of 2%. Our US comp was 3.2% for Q2.

Looking at monthly trends, total comps were negative 0.3% in May, positive 3.4% in June and positive 4% in July. Additionally, monthly comps for our US business were a positive 0.7% in May, positive 4.2% in June and positive 4.7% in July.

Gross margin for the second quarter was 32.1% of sales, a decrease of 85 basis points from Q2 of LY, but 65 basis points better than Q1. The improvement since the first quarter reflects immediate benefits from the actions we've taken, including retail price adjustments that had minimal impact to units, a pivot to more strategic and targeted promotions and greater vendor support for key promotional activities.

We're very pleased with the progress we've made to improve our gross margin performance. The actions we've implemented are gaining traction, but there is additional work to be done in this important area for the balance of the year.

This quarter, we experienced approximately 50 basis points of rate pressure. As expected, we experienced approximately 15 basis points of pressure from supply chain costs.

We've added new facilities to the network that are still ramping to full capacity, coupled with ongoing increases in customer delivery costs. Product mix shift and inventory shrink each had approximately 10 basis point negative impact on gross margins during the quarter.

SG&A for Q2 was 19.3% of sales, which levered 170 basis points. It's worth noting that, in last year's second quarter, we recorded a non-cash charge of $230 million related to the strategic reassessment of Orchard Supply Hardware. This resulted in approximately 110 basis points of leverage this year.

We drove approximately 50 basis points of leverage in retail operating salaries in the quarter and approximately 15 basis points of leverage through improved advertising efficiencies.

Operating income increased 98 basis points to 11.34% of sales. The effective tax rate was 24.2% compared to 24.4% to LY.

At $13.7 billion, inventory increased $1.8 billion or 15.5% versus the second quarter of last year, but is down $1.3 billion versus Q1. As Marvin indicated, this increase was driven by strategic investments in the first half of the year to drive sales, such as an earlier seasonal load-in, Craftsman reset, increased presentation minimums and investments in job lot quantities for the pros.

In the back half of the year, we will refine our in-stock expectations and begin strategically reduce inventories in certain areas, while protecting our in-stock position as well as sales and margin.

Before I close, let me address our 2019 business outlook. The underlying macroeconomic fundamentals of the US remain supportive, as demonstrated by the solid pace of job growth.

The home improvement sector should continue to benefit from several factors, including strengthening wage growth, gains in household formation and rising home prices that encourage homeowners to engage in discretionary projects.

Additionally, the aging US housing base is driving ongoing maintenance and repair spending across the nation.

And despite a strong financial performance in Q2, which exceeded our own expectations, and a solid underlying economic outlook for the remainder of 2019, we've elected to maintain our current 2019 business outlook.

We're still recovering from disappointing first quarter margin performance, but we've assembled a very talented management team and we are aggressively implementing initiatives to improve our business.

Therefore, we feel prudent to maintain this intense focus on retail fundamentals throughout the remainder of this year. And as we've said many times, we are in the early days of our transformation.

We expect a total sales increase of approximately 2% for the year, driven by comp sales increase of approximately 3%. We expect an adjusted operating margin increase of 20 business to 50 basis points, the effective tax rate is expected be approximately 24% and we now expect adjusted diluted earnings per share of $5.45 to $5.65.

We shared previously that our business outlook includes the wave of 3B tariffs. We have evaluated wave 4A and have concluded that we can manage through the limited impact in the second quarter of this year within our existing guidance range.

We're forecasting operating cash flows of approximately $4.5 billion and capital expenditures of approximately $1.6 billion. This is expected to result in free cash flow of approximately $3 billion for 2019.

Our target leverage ratio stands at 2.75 times and our guidance assumes that we complete approximately $4 billion in share purchases for this year.

So, in closing, we remain extremely excited about the future of the company and its ability to deliver significant shareholder value over the long term.

So, with that, we're now ready to taking questions.

[Operator]

[Operator Instructions]. Our first question comes from the line of Christopher Horvers with JPMorgan.

[Christopher Horvers, JPMorgan]

Thanks. Good morning. First, a question on – Dave, your comments on the guidance and your decision not to raise it. So, I appreciate your comments on being prudent because there is a lot of uncertainty and the turnaround is in the early stages, but is there anything – any area or any initiative, in particular, that gives you that pause or any area of the P&L and your guidance where you see more risk versus other areas?

[David Denton]

Listen, we're really – extremely pleased with the progress coming out of Q2. We're very confident in our outlook for the balance of the year. Keep in mind, as I said in my prepared remarks, we've committed ourselves to retail fundamentals and improving our financial performance as we cycle into the back half of the year. But as you know, we've launched many broad cross-functional efforts touching almost all areas of our core business. That's creating a little bit of a fluid environment in our business model.

Having said that, we feel very confident in where we stand today and our outlook for the balance of the year. So, there's nothing on that horizon that we see that is a disappointing news coming forward from our perspective.

[Marvin Ellison, President and Chief Executive Officer]

Hey, Chris. This is Marvin. The only additional comment that I will make, Bill outlined in his prepared comments some of the key initiatives for the third quarter and the back half of the year. We have a lot of confidence in our strategy. Q1 was a disappointment and we're still candidly digging out of that. But, as we look forward, we're very confident in our ability to drive the business. We just think it's prudent to just focus on retail fundamental execution, to get this still relatively new team time to continue to get our arms around every aspect of the business and then we'll evaluate guidance as we continue to progress through this quarter and beyond that.

[Christopher Horvers, JPMorgan]

Understood. And then, just a question on the margin front, so SG&A dollars are down in the first half of the year. And if you're looking on a per foot basis, it's up about 0.5% year-to-date with 2Q better than 1Q. So, how are you thinking about SG&A as we proceed through the year and lap the store closures? Should the SG&A dollars be down in 3Q and then up modestly in the fourth quarter on a year-over-year basis as you get through the store closures in 4Q?

[David Denton]

Yeah. Let me just take it first half/second half. I think we continue to make really nice progress from an SG&A perspective. I think the second half, we won't leverage near as much in the second half, driven by the fact that many of our initiatives from a project perspective are continuing to ramp into the back half of the year, and so you'll see those expenses show up back half of the year.

[Christopher Horvers, JPMorgan]

Understood. Thanks much. Best of luck.

[David Denton]

You're welcome.

[Operator]

Your next question comes from the line of Simeon Gutman with Morgan Stanley.

[Simeon Gutman, Morgan Stanley]

Thanks. Good morning, everyone. I wanted to ask about gross margin. If we look back, I think the right base on a rebase basis is around 33% for this business before some of the one-time issues occurred. Is there any reason that you shouldn't recoup and get back to those levels? And you mentioned this modernization. Do you need the modernization to recoup what you lost in Q1 or does this enable you to even get past that 33% level over time?

[David Denton]

Yeah, this is Dave. Maybe I'll start. Clearly, if you look at the long-term algorithm of our business model, as we said, to get to our 12% operating margin over time, we would think about gross margin being substantially flat, if you will, over time because I don't think there's anything on the horizon that we see in our business model that would change that expectation.

Clearly, as we go through the years to come, we need to do two things. We need to increase our performance from a sales perspective, thus leveraging SG&A and flowing through at higher profit margins through that algorithm and through that approach. So, I don't think there's anything from a margin perspective that gives us pause at this point.

[Marvin Ellison, President and Chief Executive Officer]

Simeon, the only thing I'd add – this is Marvin – is from technology dependencies, we don't have high dependencies on technology, specifically for the back half of this year. But I talked in a little bit of detail about our price management system and leveraging the retail analytics platform that we acquired from Boomerang. We're going to have a new price management system in position in the fourth quarter. That will get us a competitive parity. And now, candidly, we're quite a bit behind what a modern large retailer would be from the ability to leverage pricing and to have agility pricing in local markets in-store and online.

We're going to give Bill's team better visibility and just a single repository which, believe it or not, this company has never had. But in the first half of next year, we're going to merge the price management tool with the retail analytics platform that we acquired and we think that's going to unlock the ability to meet the expectations that Dave laid out, and that is relatively flat gross margin.

Our operating income story is going to really be about flat gross margin and driving continued SG&A leverage by implementing technology and taking tasks out and putting more labor on the floor to serve customers. And so, that's going to be more of an ongoing year-over-year process.

[Simeon Gutman, Morgan Stanley]

And then, for my follow-up, I'll stay on the same topic. There are some big events you're going to be lapping first in the third quarter with the write-down and then next year's first quarter. Is there any reason today that you see that you couldn't recoup then what was lost in the write-down that should have been a one-time event? Is there any reason we don't get back that amount coming in the third quarter? And then, through the first quarter, a lot of the issues from this prior year's first quarter should be resolved?

[David Denton]

Well, clearly, that's within our plan. So, our guidance assumes that we're going to lap that in the back half of the year. And as you look at the continued performance of our business, both from a sales perspective and a margin perspective, we are actively managing up against that. So, I think there's no doubt that we're going to sequentially continue to make progress from a margin perspective for the balance of the year.

[Simeon Gutman, Morgan Stanley]

Okay, thanks. Good luck.

[David Denton]

You're welcome.

[Operator]

Your next question comes from the line of Zach Fadem with Wells Fargo.

[Zachary Fadem, Wells Fargo]

Hey, good morning. So, Marvin, you called out strong execution on holiday events. Curious if you could talk a little more about what you're doing differently there, both in terms of just the execution and merchandising assortment, but also the traffic driving initiatives like the paint promotions that you ran and how that's impacting your take rate?

[Marvin Ellison, President and Chief Executive Officer]

So, Zach, I'll take the first part and then I'll let Bill add some additional color. When you look at the home improvement business, the one thing that we brought from a strategic standpoint is the importance of event execution. Because you have certain DIY customers that will traditionally shop you about four times a year, so it was very important that you start the year off really effectively.

And in the past, Lowe's has kicked off their spring/Black Friday type events and they've been out of stock, had some degree of service issues. And so, you disappoint customers. And those customers just don't come back for that second, third and fourth shopping occasion later in the year. So, we put an enormous emphasis on great execution, product load-in, in stock, great value for spring/Black Friday understanding that customers who may have been disenfranchised by shopping at Lowe's in the past would come in to shop us because the values were compelling, but the goal was to create such a great service experience that they would come back on that second, third and fourth occasion this year.

And so, what we believe we're seeing in Q2 is we're seeing that second shopping occasion because of the great event execution and spring/Black Friday that led to continual execution on Father's Day and Fourth of July, et cetera, et cetera.

And so, it starts with great product and great value. It starts with a compelling marketing message. And then, the stores have to take it from there to turn their foot traffic into sales. And so, we've done a really nice job of that and it's been a collective team effort.

So, I'll let Bill talk about what some of the values were that drove our success and kind of what we're going to be leaning into as we think about the rest of this quarter.

[William Boltz, Executive Vice President, Merchandising]

Yeah. I think just to add to Marvin's comments, a couple of other things. The investment that we made, propping up our MHP team, as well as our field merchant team certainly started to take hold in Q2 and we were able to pull a lot of this event recovery and event execution off the shoulders of our selling associates and really recover faster inside the stores. And that was a big difference this year versus last year. And then, the marketing teams and the merchant teams did just, I thought, a superb job of coming with just great values that would drive traffic into the store and drive the basket.

And your comments around paint was, we know that that's a traffic driving category, we know it's the number one DIY project. And by being able to strategically look at our overall promotional strategy inside the store, we were able to do something disruptive in paint that drove some unprecedented traffic into that category for Q2. So, we're excited about what's happened. We're excited about the learning we've received. It will help aid certainly as we go into the back half of the year and more importantly into 2020.

[Zachary Fadem, Wells Fargo]

Got it. And then, on some of the merchandising efforts, you're a year removed from the SKU rationalization. Could you talk about the success of that initiative, whether the replacement SKUs have been more productive from a volume or margin perspective? And then, with your inventory up over 15% in Q2, how should we think about the timing potential for further inventory rationalization initiatives ahead?

[Marvin Ellison, President and Chief Executive Officer]

So, Zach, it was less inventory rationalization and more the removal of non-productive inventories. So, it sounds like a nuance, but it's a little different, because the steps we took in the second half of last year was basically just identify all aged inventory that had been sitting and not turning and just take aggressive action to exit it from the business.

We didn't, in many cases, go back in and replace it with more productive SKUs. We just tried to create better presentation of our most productive SKUs. So, what Bill is in the process of doing now is identifying what we describe as slow turning SKUs. And as we stabilize e-commerce, what really efficient retailers are doing, they're taking the slow-moving SKUs off the shelf in their brick-and-mortar locations and then putting it online. It's easier to have it in a handful of powerful fulfillment centers than have it in 1,700 stores. So, that work is just beginning for us.

But as we think about inventory, and as I said in my prepared comments, we made a strategic decision to invest. If you take a look back at Lowe's historically, Lowe's had one of the worst in-stock positions of any major retailer. And to be quite candid, it was actually worse than what we anticipated when we started to take actions get in-stock.

So, as we think about kind of the timeframe around kind of getting our inventory more, what I'll describe as, rebalanced, we're going to have some supply chain initiatives that are going to be happening right now. I've mentioned predictable delivery. That's really important for us because we were so out of stock and our delivery and supply chain process was so inefficient that we had – except for the amounts of safety stock in stores just to compensate for late and slow deliveries. Now that our supply chain has become much more efficient, this more predictable delivery will allow us to reduce safety stock, so we'll have more frequent flow of product. That doesn't sound like a big deal, but in our environment, it's going to be a big deal and that's going to be one of the most significant initiatives that we are going to take to get our inventory rebalanced.

We think this is going to be a multi-quarter initiative. We'll be updating externally more at the end of this quarter, but we're going to see how our process goes this quarter and then we'll have a better perspective on when we think we'll be in a position that we'll be most comfortable.

And the only caveat to that would be we are committed to staying in-stock, we're committed to driving sales and we're committed to protecting margins. So, we're not going to swing this pendulum from one ditch to the other. And so, it's all about finding balance. But we feel comfortable that the quality of our inventory is really good. We have a small amount of seasonal inventory, so we don't have risk of taking excessive markdowns. So, we feel like we have time on our side to get this in order.

[William Boltz, Executive Vice President, Merchandising]

The only other thing I would add is that the merchant teams, now getting their feet on the ground as they've all come together, along with our planning and replenishment teams on the supply chain side, SKU rationalization is an ongoing effort. Right? It goes on all the time. So, that's part of the rhythm of what they do. Always looking at making sure you've got the most productive stuff inside the store. So…

[Zachary Fadem, Wells Fargo]

Got it. Appreciate the time.

[Marvin Ellison, President and Chief Executive Officer]

Okay, thank you.

[Operator]

Your next question comes from the line of Michael Lasser with UBS.

[Michael Lasser, UBS]

Good morning. Thanks a lot for taking my question. It seems like you went to a deeper level of promotion on the paint category than the industry has seen in the past. So, how does that inform your view on what you might do in other categories? Would you try the same strategy in other products?

[Marvin Ellison, President and Chief Executive Officer]

No. Mike, it's a fair question. So, let me just kind of take a step back and just give you kind of a broad view of the strategic approach that we're taking. One of the first observations that Bill made to me upon arriving is that we have too many category-wide promotional events. So, it is our intent and expectation that we will become less promotional, not more promotional.

What we are trying to do with our promotions is to be more strategic and make them more event based. We want to be less high/low – so, that's something we're going to slowly wind ourselves out of and be more event based.

Having said that, we're going to strategically choose categories that we believe are cart starters, project starters and that drive traffic. But when we lean into something like paint, we're going to be pulling back from other areas, so the net effect will be less promotions, but more effective promotions. And so, paint was the first attempt at that. We are very pleased with the results. Obviously, for competitive purposes, we're not going to telegraph what our next strategic move will be. But, philosophically, I think the message is we're going to lean into certain categories that we think provides a broader strategic gain, we'll pull back from others and we're going to be more SKU focused on promotions than overall category. And that's going to allow us to drive price perception, to drive value perception, but do it while protecting margin more effectively.

And, Bill, I don't know if you have anything to add to that.

[William Boltz, Executive Vice President, Merchandising]

No, I think just – it was also an area where we looked at a lot of disruption a year ago when we came in and we have struggled really through the balance of the second half of last year to try to get paint stabilized. So, really, 2019 gave us an opportunity to try to do something different and that was an opportunity that we had to be able to mix it up a little bit.

[Michael Lasser, UBS]

And I have one follow-up, and two parts on that. So, if you're going to pursue a similar strategy in other categories, do you see the risk or is there a risk of potential ripple effects across the industry as others might be forced to follow suit?

And then, as part of that, are you using some of the pricing actions that you're taking as you described in the first quarter to use that as a source of funding to go out and make some of these investments in promotional activities within certain categories? Thank you so much.

[Marvin Ellison, President and Chief Executive Officer]

Mike, we think – again, the net effect is going to be fewer promotions and more targeted promotions. So, we don't see this as a risk. As a matter of fact, we see it as a benefit because it's going to create an even more rational promotional atmosphere than what we have right now. And we think we have a relatively rational sector from a promotion standpoint.

We're in the process of redefining how we go to market. Anytime you have lost market share and lost relevance over a five to seven-year period, like Lowe's had done prior to 2019, you can't just run the same play over and over again and expect that you're going to get a different result. And so, we believe, one of the reasons why, in Q1 and Q2, we've grown sales and taken share is because we've taken a more strategic approach to how we go to market.

Having said that, we have no intentions on being more promotional, we have no intentions on doing anything that's going to ratchet up the promotional environment. This is an environment that competitors do special buys, all the time. And a special buy is not really described as a promotion. It's described as taking advantage of a specific category during a specific event period. And so, you'll see us do a lot of those different things, but we have no intention of being more promotional. We want be less promotional, less high/low, but a lot more strategic.

[Michael Lasser, UBS]

Thank you.

[Operator]

Your next question will come from the line of Scot Ciccarelli with RBC Capital Markets.

[Scot Ciccarelli, RBC Capital Markets]

Good morning, guys. Thanks for the time. Do you guys have any – we talked about supply chain and inventory and some of the changes happening there, Marvin. Are there any examples of categories where you've been able to pull back on the amount of inventory in a category without it actually adversely impacting your comp growth?

[Marvin Ellison, President and Chief Executive Officer]

Well, Scot, I would say that we try to test and learn in everything that we do. And so, I would say that from this whole predictable delivery process that we're rolling out, part of that has been in cooperations with the stores and with supply chain. So, because of that, we have taken a few items – for competitive purposes, we're not going to kind of lay everything out there, but the short answer is, yes, we have. And as we roll predictable delivery out to the entire company, we are evaluating safety stock levels by SKU, by store, so that we can understand what level of safety stock will be required for us to maintain the proper in-stock position, the proper presentation minimums, while driving sales, and then that ties to the frequency required from the supply chain. So, this whole predictable delivery model is, in large part, driven by tests with the operations team on how effective we can do this while still hitting our financial targets.

[Scot Ciccarelli, RBC Capital Markets]

And just to clarify, I mean you've made some, let's call it, adverse comments previously on some of the legacy systems that the current team kind of inherited. Do you have the analytics in-house to be able to make sure you're not adversely impacting your comp growth when you make some of those inventory changes on the delivery side?

[Marvin Ellison, President and Chief Executive Officer]

Yeah. That's why testing and learning, Scot, is the way you do it. And that's just really the environment we put in place. We're not going to roll anything out chain-wide that we're not going to test it first. So, the short answer is we have the analytics, we have the process design. And anytime when we roll something chain-wide, you can be assured that we're pretty confident of what the outcome is going to be.

[Scot Ciccarelli, RBC Capital Markets]

Got it. Thanks a lot, guys.

[Operator]

Your next question comes from the line of Laura Champine with Loop Capital.

[Laura Champine, Loop Capital Markets]

Thanks for taking my question. I'm just wondering if you can help quantify all the comments that you've made on your inventory management and the changes you expect to make? So, by the end of this year, would we still be likely to see inventories up, call it, high-single digits because you need to reset levels to keep your in-stocks in good shape or should we start to see inventories growing in line with sales growth?

[David Denton]

This is Dave. I don't think you're going to see much movement in inventory levels this year. I do think we'll – as we indicated earlier, we're going to strategically rationalize inventory in certain areas, but this is probably a multi-year journey as we make sure that we have the right analytics in place, we have the right supply chain in place, and we've really thought through by category what's the right assortment. And that's a multiple quarter, multiple year journey to get us back to that, I'll say, that optimal level of inventory.

[Marvin Ellison, President and Chief Executive Officer]

And the only thing I'll add to that is to reinforce a point that I've made a couple of times this morning. We have very minimal seasonal inventory, so we don't have markdown risk of excessive inventory that we just have to work out of the system in a certain timeframe. The good news about the home improvement sector is when you load in job lot quantities in pro-related categories, these are year-round SKUs. And when you look at presentation minimums, if you're doing it on core SKUs, you have limited markdown risk.

Having said that, we're still going to be working quarter-over-quarter to make sure that we are getting our inventory more in line with our rate of sales. We will learn a lot in the next two quarters and we'll have a much more efficient and clear point of view as we head into 2020.

[David Denton]

And I think also, as Marvin and I said, listen, it's really important we're going to be focused on our in-stock levels, we're going to make sure that we're supporting our sales plan and we're going to be supporting our margin plan. So, we have all three of those kind of working in tandem and we don't want to harm our business. We've got to make it more efficient over time. But, right now, those three elements are pretty important to us.

[Laura Champine, Loop Capital Markets]

Understood, thank you.

[David Denton]

You're welcome.

[Marvin Ellison, President and Chief Executive Officer]

Thank you.

[Operator]

Your next question comes from the line of Brian Nagel with Oppenheimer.

[Brian Nagel, Oppenheimer]

Hi, good morning. Thanks for taking my questions. Nice quarter. So, the first question, I just want to – I guess, bigger picture. On the pro, you've discussed the success you're having lately with the pro. We talk a lot here about better in-stocks which is, obviously, an effort that would help both pro as well as DIY. But, Marvin, as you look out maybe further to continue to really better serve this professional customer, what are some of the next initiatives we should be thinking about that Lowe's would undertake?

[Marvin Ellison, President and Chief Executive Officer]

Brian, it's a good question. I'll take the first part, then I'll hand it off to Joe. He spent quite a bit of time on this. So, let me first take a step back and give a more strategic overview of why pro is important. I think one of the strategic missteps over the last seven years here is not really understanding what the pro customer does to the overall productivity of the business.

Our stores operate with, in some cases, fixed expenses and variable expenses. And so, as you drive more productivity through those boxes, it just creates and unlocks a lot of value. And so, as we lean into pro, our strategic rationale for this was how you take a box that has a certain amount of expenses allocated to it and exponentially increase volume, which makes it more productive.

And so, we're pretty confident that our sales momentum over the last two quarters, our improvement in transactions and our improvement in sales per square foot in large part is driven by pro. So, the strategic rationale for pro is traffic, transaction, sales per square foot productivity and just unlocking more value in every location.

And so, based on that, we're committed to it. I'll let Joe kind of provide kind of some what's on the horizon that we think will allow us to continue to build on this very important customer.

[Joseph McFarland III, Executive Vice President, Stores]

Brian, thanks for the question. So, the first phase of our journey to win the pro business was setting up the proper retail fundamentals, which we've been discussing and we largely feel we're completed with that in the first half of the year.

As we look out in our pro roadmap, we have a lot of initiatives coming. When you think about having that foundation in place, we can now lean into better pro marketing, focus on things like customer acquisition, driving awareness and what's different at Lowe's, the future focus, key segments, national accounts, our outside sales team, integration of MSH, a better job site delivery. We have a laundry list of improvements that we'll continue to make for the pro customer. And we're very, very encouraged by what we're seeing across the total store from a pro standpoint.

[Brian Nagel, Oppenheimer]

That's helpful. Thank you. Then my follow-up question, shifting gears a bit. I just wanted to discuss again gross margin and maybe more for – I guess for Dave. But Q1, you have the inventory, the systems type issue. You articulated clearly that you isolate that impact on your gross margin. So, what I'm wondering is what was that in Q2. And how should we think about that specific impact as it mitigates through the back half of 2019?

And the second of that, just looking at your results today, it seems as though you're correcting those problems that emerged in Q1 quicker than you initially expected. So, A, is that fair? And then, B, why is that happening?

[David Denton]

Yeah. So, listen, I think we have a fairly comprehensive plan to improve our margin performance. I would say that, if I just kind of tick down some of the things that we've done, you can get a sense for the progress we're making. First and foremost, we kind of really did an evaluation on our price complement across the categories we've adjusted price. At the same time, we've gone through and enhanced our point of sale system such that we're eliminating unnecessary discounting that it's kind of, I'll say, leaking at point of sale.

As the team spoke kind of many times throughout this morning, we've really leaned into kind of more targeted, efficient promotions. And as you can imagine, given coming out of Q1, we couldn't touch all the promotions earlier in the quarter. They were kind of already locked and loaded. So, the changes that we made to adjust the promotional calendar largely happened in the back half of the quarter given the lead time.

And then, finally, we're working with our vendors and making sure that we're managing cost and making sure that we're getting the right support for all the efforts that we're doing within our stores. That's probably the long pole of the tent to get done for the balance of the year.

All of those factors are things that we're managing through the balance of the year. Clearly, when you change price is the quickest to respond from a P&L perspective. So, I think what you've seen is the effect of that happen more rapidly in Q2. We're going to probably lean more aggressively on some of the other actions to improve our performance in the back half of this year. So, that's why you're going to see that progression both in Q3 and Q4 as we cycle into back half.

[Marvin Ellison, President and Chief Executive Officer]

And, Brian, this is Marvin. The only additional comment – it was a lot of work and I just have a ton of admiration for the merchant team, finance team, store operations team that really worked very hard to accelerate the recovery. But as I outlined in my prepared comments, we have two initiatives coming over the next 12 months that are going to be critically important. The rollout of our price management system in Q4, it's going to be just critically important for us to just get to competitive parity. And then, as we integrate this retail analytics platform from Boomerang, it's going to really take us from trailing almost every major retailer to being at a best-in-class level on pricing analytics.

And I think you're very aware that one of the most significant levers that any retailer our size has, the disposal around margin improvement, is strategic pricing actions. And we learn a lot of our strategic pricing in Q2 and we did it kind of the hard way. And as our systems continue to get better, it's going to make this a lot more agile, and so we have a lot of confidence in the future that we can continue to drive more sequential margin improvement from Q1 and just continue to get this whole platform stabilized.

[Brian Nagel, Oppenheimer]

Great. Well, congrats on a…

[Marvin Ellison, President and Chief Executive Officer]

Thank you. We're going to take one more question please.

[Operator]

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

[Eric Bosshard, Cleveland Research]

Thank you. Two things. First of all, the follow-on within gross margin, Dave, I'm curious what we should be expecting in the back half for gross margin. Obviously, 2Q was notably better than you had thought. Is that progress sustainable? Excluding the impact of the markdowns in 3Q, can we get all the way back to flat gross margin on a comparable basis in 3Q? How should we be thinking about that?

[David Denton]

Yeah, I think you should expect a sequential improvement to the second half, jumping off from where we are in Q2. I don't think you're going to have a full recovery by the end of the year. I think, mathematically, that's tough to deliver at this point.

[Eric Bosshard, Cleveland Research]

Okay. And then, secondly, the step down in online, I assume it's more precipitous than you had expected, but if you could characterize that and then also characterize the pace and timing of the road back in growing the online piece of the business?

[Marvin Ellison, President and Chief Executive Officer]

Yeah. Eric, so I think when we look at online, it was definitely below our plan, but as I mentioned, we made a strategic decision that we were going to slow it down primarily by not adding additional SKUs.

But here is a broader point that I'd like for everyone to consider. So, we delivered a 3.2% comparative sales in the US with a 4% online growth. And so, to me, that just screams upside opportunity because we know how to fix the online business. We've hired an outstanding President of Online in Mike Amend and Seemantini, our CIO, has a depth of online experience from her time at Target. So, we have the right people in position to get this fixed and we have a very detailed transformation plan.

So, although we are disappointed with the results, it was part of a strategic decision to slow down short-term to make sure that we could get some issues corrected. We had just some fundamental process issue, i.e. if you added a new SKU online, every store has to go through a manual process as though that SKU is being added to the shelf. And that was a priority project for every store, because if they didn't flag it in the store, print a label and go through the same manual processes, though they would literally add them to the shelf, you couldn't add it online. As rudimentary as that sounds, that was the process and we were able to get that fixed in the early part of Q3.

And there were other just really prehistoric processes like that that really hindered our ability to add additional SKUs. And so, the way we look at online is that we think, for the balance of this year, we're going to have modest growth, but we're going to be working very aggressively on replatforming to Google Cloud and a lot of other foundational functionality to just improved search, checkout, navigation, et cetera. And we believe, as we get into 2020, you're going to start to see this business begin to grow at the rate that we expected to. And we see nothing but upside potential.

Just as a reminder, online is give or take 5% of our total sales and it grew at 4% and we still delivered 3.2% comp. So, we know that we have upside potential for the business by getting our arms around this business and we have the people that can do it.

[William Boltz, Executive Vice President, Merchandising]

And, Eric, this is Bill. The only thing I would add to Marvin's comments is that we're just in the early stages of getting the online merchants integrated with the core merchants. And so, as that starts to gain traction and we get some of these legacy systems issues fixed, then the acceleration in the SKU and the SKU expansion certainly starts to happen and we start to be able to really gain some traction on the online space. So, there's a lot of good things in front of us for dot-com.

[Eric Bosshard, Cleveland Research]

Okay, thank you.

[Marvin Ellison, President and Chief Executive Officer]

Thank you.

[Operator]

I will now turn the conference back over for any closing remarks.

[Marvin Ellison, President and Chief Executive Officer]

No. Well, thank you for your interest in Lowe's. We look forward to updating you on our next quarterly earnings call.

[Operator]

Ladies and gentlemen, this will conclude today's call. Thank you all for joining and you may now disconnect.