Lowe's Companies Inc

NYSE:LOW

Earnings Call Transcript 2018-Q3

[Operator]

Good morning, everyone, and welcome to Lowe’s Companies third quarter 2018 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 to be used as a reference document following the call.

During this call, management will be using certain non-GAAP financial measures. The supplemental 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. Bill Boltz, Executive Vice President, Merchandising; and 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, everyone. As reflected in our earnings release earlier today, the strategic reassessment of our business continued in the third quarter.

Our top priority this quarter was taking the necessary steps to build a sustainable foundation to position Lowe’s long-term success, by exiting underperforming stores of non-core businesses. This will allow us to intensify our focus on our core retail business.

As part of the strategic reassessment, we made the decision to close 20 US stores and 27 stores in Canada as well as 4 other Canadian locations. We also intend to exit our retail operations in Mexico and our Alacrity Renovation Services and Iris Smart Home businesses.

These were difficult decisions to make, and we believe we can deliver the greatest return to our shareholders by focusing our attention on running outstanding retail businesses in US and Canada.

These actions send a clear message that we’ll no longer pursue ventures that dilute our return on capital. Instead we’re committed to a more effective capital allocation process that will deliver better returns to our shareholders.

I'm pleased to announce that we have substantially completed our strategic reassessment of the business, and now we can shift our attention to improving execution in our retail stores and online and, of course, we will continue to evaluate all elements of our portfolio annually.

Now, let me comment on our performance in the third quarter. We delivered comparable sales growth of 1.5%, driven by a 2.3% increase in average ticket, partially offset by 1% decline in transactions.

Our US home improvement comp grew at 2%, with positive comps in 11 of 14 geographic regions. And as expected, the Tampa and Houston markets had the weakest comparable sales in the quarter due to tough prior-year comparisons from Hurricanes Harvey and Irma. We also posted 12% comp growth on lowes.com.

Diluted earnings per share were $0.78 for the quarter and adjusted diluted earnings per share were $1.04, a decrease of 1% for the same period a year ago.

Our third quarter results reflect many of the themes we discussed on our second quarter call. First, while we drove strong traffic to our stores and website, out of stocks continued to pressure sales.

Second, our inefficient reset process continued to create disruption in our stores and contributed to out of stocks. In fact, all of our categories with negative comps, millwork, paint, fashion fixtures and flooring were pressured by poorly executed resets.

Third, our store processes are too complex, our labor management system is primitive, and our associates are burdened with too many tasks. These distractions are preventing our associates from spending adequate time with the customer to provide assistance.

And four, our project specialists and installed sales business is too complicated, which prevents us from delivering an outstanding customer experience and it pressures our sales.

The good news is I'm pleased with the strategic initiatives the leadership team designed in Q3 to address these chronic issues. And you'll hear more about these plans later in the call.

As I said earlier, our priority in the third quarter was building the sustainable foundation for long-term success. And part of the foundation for long-term success was identifying a world-class chief information officer.

And earlier this month, we’re pleased to name Seemantini Godbole as our new Chief Information Officer. Seemantini is an accomplished retail executive with more than 25 years of global technology expertise and a proven track record for transforming IT and digital platforms

This is the final addition to our executive leadership team and I'm confident in her ability to help us modernize our IT and omnichannel systems.

Also during the third quarter, our new leadership team assessed our functional areas, upgraded talent, conducted deeper dives in their business areas, and the team was committed to identifying the root causes of our sales per square foot challenges, merchandising reset issues, our chronic out of stock and our low job lot quantity issues.

But rather than implementing quick fixes to address these chronic and long-standing issues in the third quarter, we developed plans to drive sustainable improvement. And this is reflective of our commitment of building a foundation of sustainable long-term success.

In a moment, Bill Boltz, our Executive Vice President, Merchandising, and Joe McFarland, our Executive Vice President of Stores, will walk you through a detailed review of the third quarter results and outline improvements they're making in merchandising and store operations as well as their plans for the fourth quarter.

I'm also pleased to welcome Dave Denton to the call. As we previously announced in August, Dave has been appointed our Chief Financial Officer. And while today is his first official day with the company, he’s spent the past several weeks meeting with our executive leadership team and will share his views on the business as well.

Now, turning to the macroeconomic environment, although interest rates have ticked up and housing turnover has been pressured, the home improvement backdrop remains strong, driven by robust real residential investment, home price appreciation which continues to encourage homeowners to engage in discretionary projects.

The average age of the homes in the US is 40 years, which creates an attractive opportunity for our project categories that support maintenance and repair.

Consumer confidence continues to hover at high levels as consumers remain upbeat about their employment and income prospects, suggesting that we will continue to see solid gains in consumer spending, supported by stronger real disposable personal income growth.

And looking ahead, our future is bright. We operate in a fragmented $900 billion marketplace and we have a unique opportunity to fix some long-standing chronic issues that will improve our performance and increase our market share.

And as we look at our Q3 results, specifically our top line underperformance both in stores and online, we see the issue as poor execution, not a macro concern.

And as I mentioned earlier, we’re not chasing short-term fixes, but we have every expectation that our actions and initiatives will begin to drive improvements in our business as we enter 2019.

I look forward to sharing more details on our long-term strategic plans at our analyst and investor conference on December 12.

Now, before I close, I’d like to thank our associates for their hard work and dedication to serving customers. Our systems and our processes don't make it easy for our associates. Nevertheless, I'm incredibly proud of the way they support customers, each other and the communities in which they live and work.

This is evident in their response to Hurricanes Florence and Michael this quarter. We’ve already hosted 27 hurricane relief events and served 15,000 hot meals. We’ve delivered 18,000 disaster relief buckets for impacted communities.

And this afternoon, our associates will serve 50,000 people Thanksgiving meals in hurricane impacted areas of North Carolina and Florida.

I’d also like to send our thoughts and prayers to all the individuals in the communities being impacted by the California wildfires. We’re using one of our closed Orchard Supply Hardware locations for emergency relief and the warehouse donated supplies from the community. This is the most devastating wildfire in California history and we will do all we can to support our associates and communities impacted by this horrific event.

Now, with that, I’ll turn the call over to Bill Boltz.

[William Boltz, Executive Vice President, Merchandising]

Thanks, Marvin. And good morning, everyone. Today marks my 99th day with Lowe’s and I'm pleased to be here to discuss the performance of the merchandising team.

As Marvin shared with you, we posted comparable sales growth of 2% in US home improvement this quarter. The favorable macroenvironment, combined with great values and events, drove traffic to our stores and website, but the continued challenges with out of stocks, poor reset execution and assortment issues in certain categories put pressure on our ability to turn those visits into transactions.

Let me take a moment to discuss some of the positives from the third quarter. Seven out of eleven merchandising departments had positive comps in the quarter. Seasonal and outdoor living, appliances, lawn and garden, kitchens and rough plumbing and electrical all delivered comps above the company average.

Seasonal and outdoor living led the way with high single-digit comps, driven by double-digit comps in grills and lawnmowers along with the increased demand driven by the inventory rationalization activity. In addition, we also delivered on the response for hurricane-related products such as generators, air-conditioners and dehumidifiers.

Our lawn and garden comps were the result of capitalizing on the extended growing season, along with our fall preparation activity in our grass seed, fall fertilizer, live goods and watering programs.

For the ninth quarter in a row, we drove above-average comps in appliances as we continue to leverage our omnichannel offering through our leading brands, our breadth of assortment and strong Labor Day and Columbus Day events.

Our kitchen department also posted above-average comps, with strength in organization and shelving as well as cabinets and countertops.

And we also had solid performance in our core pro product groups within rough plumbing and electrical. We continue to be excited about the effectiveness of our new destination brands attracting pro customers, as was evidenced by the double-digit comps in short pipe plumbing fittings and our strong growth in water heaters, driven by the professional brand of A.O. Smith.

Also during the quarter, we completed the rollout of two key programs into our stores, with Zoeller pumps and MAPEI tile setting materials. We also launched new exclusive pro cordless power tools from both Bosch and Metabo HPT that brings the power of a corded tool to the jobsite through the ease and convenience of cordless.

We continue to see robots consumer demand bolstered by a strong home improvement sector.

As Marvin noted, during the third quarter, we took steps to begin to strengthen our merchandising focus on our retail basics. We’ve added industry experts to the team as part of building out a world-class merchandising organization.

In addition, as many of you know, in the third quarter, we also undertook an aggressive inventory clearance process that was focused on eliminating slow-moving or underperforming SKUs and, ultimately, reducing the clutter in our stores.

With that process complete, we have now begun reinvesting those dollars into improving in-stock on our best-selling SKUs and focusing on job lot quantities for the pro customer.

Although the inventory clearance activity and the subsequent reinvestment will allow for strategic benefits in the future, the discounted sales cannibalized other merchandising categories during the quarter.

Within merchandising, we are streamlining our decision-making processes. We're investing in faster moving SKUs and we are shifting the mindset from to an inventory dollar amount to managing to an inventory turnover goal, which, for example, will allow us to have sufficient inventory on hand before the season breaks and have the stores set and ready for our customer.

Now, let me discuss some of the opportunities from the third quarter. Our underperforming categories were largely impacted by out-of-stocks, stemming from poor reset execution, all of which had recovery dates that were pushed back and, therefore, the planned improvements were not realized in the quarter.

Millwork was pressured by supply and reset challenges in categories such as window blinds, resulting from a difficult product transition. Out-of-stocks and limited job lot inventory in core product categories, including both interior and entry doors, also exerted pressure on the comp. We expect to see improvements in these areas in the early part of 2019.

Our paint business was impacted by brand transitions, along with supply disruption, as we transitioned into our exclusive partnership with Sherwin-Williams. Going forward, we’re working with our supplier to improve our inventory position and we expect to see improvement in this area by year-end.

Our fashion fixtures department was negatively impacted by reset challenges in lightbulbs and commercial lighting, where supply availability and a shortage of third-party labor to perform the resets led to out-of-stocks and reset delays.

We expect to make continued progress in our reset completion and in-stock improvements throughout the fourth quarter.

Finally, the underperformance in our flooring business continued and was driven by reset disruption in hard surface, in an assortment that is still overly focused on soft flooring as we continue to see consumers shift to the ease and innovations that are available in vinyl plank flooring.

Going forward, our new assortments will better reflect this trend with the expansion of our exclusive, smart core, vinyl plank products. Our updates to these areas, which are in the early stages, will introduce new lower price points in laminate that will provide great values to both the pro and DIY customer.

These updates will also expand the off-shelf space and will introduce new looks and trends for tile, laminate and vinyl planks that will be assorted to the local market. Given the complexity of these activities, we expect to have solutions implemented in the latter half of 2019.

Although we were not pleased with our execution or results in the third quarter, as Marvin mentioned, we have identified the root causes of the issues that negatively impacted our sales. We are focused on changing our results by enhancing our processes to address these issues and we anticipate that we will see improved execution in 2019.

Now, let me transition to the fourth quarter. We are excited about our continued rollout of Craftsman, including individual mechanics tools, hand tools and power tools.

Throughout the fourth quarter, we will showcase Craftsman on multiple end caps, highlighting exclusive products and offers, including three great values that are featured at $99.

We are proud to be the exclusive destination in the home center channel for this iconic brand, offering some of the best hand tools, storage and outdoor power equipment products in the industry.

We are also excited about our plans for an integrated omni-channel holiday experience that will be driven by strong Black Friday, Cyber Monday and other key holiday events. We will continue to highlight our best-in-class appliances offering and showcase strong values focused around tools, holiday lighting, trees and décor, along with other great gift ideas from across the store.

In conclusion, as part of our refocus on merchandising basics, we have five key priorities. One, we are simplifying our merchandising organization and we are continuing to recruit talented, experienced leaders to enable faster decision-making and to ensure that we’re optimizing our assortments across all channels.

Two, we’re implementing a localized assortment strategy with the development, rollout and support of a field-based merchandising team.

Three, we’re taking steps to rebuild our reset process by reducing our reliance on third-party labor. With that, we are redesigning our internal reset process, with the implementation and rollout of our new merchandising service team, or what we refer to as MST.

Four, we’re changing our end cap and off-shelf strategy to showcase great values and innovation that drive traffic and that, ultimately, improves the overall sales productivity of this valuable real estate in our stores.

And five, we will continue to strengthen our merchandising presentations by adding key brands to our assortments and by investing in both job lot and presentation quantities within our best-selling SKUs.

All of this is designed to drastically improve the experience for our pro customers. All five of these initiatives were launched at the end of the third quarter and we’ll be laser focused on the rollout plans and execution as we move into 2019.

I look forward to discussing these five priorities in more detail at our December 12 analyst day investor conference.

We're excited about the opportunity ahead of us and we’re working very hard to position Lowe’s for the future and to capitalize on the strong demand in a healthy sector.

Our changes will take time, but we have a detailed plan in place to allow us to make steady progress with near and long-term wins.

Thank you. And now, I’ll turn the call over to Joe.

[Joseph McFarland III, Executive Vice President, Stores]

Thanks, Bill. And good morning, everyone. Like Bill, I too am celebrating my 99th day with Lowe’s, and I'm very excited to share with you the steps we’re taking to improve store operations.

When I joined the company, it struck me that some of the basic and foundational elements of operations were not in place. As an example, there were engineered standards for in-store processes like unloading a truck, flowing product from receiving to the sales floor, or stocking the shelf to drive in-stocks. And labor scheduling systems were antiquated and ineffective leading to payroll inefficiency and detracting from customer service.

Other than cost of goods sold, payroll is the largest expense for the company and we had limited, ineffective tools to track, allocate or monitor coverage.

In addition to payroll inefficiency, stores were inundated with communications and reports with no prioritization. This lack of payroll efficiency, combined with non-existent communications standards, led to process breakdowns like excessive out-of-stocks and a poor customer experience.

Although these process challenges hindered our execution in the third quarter, I've encountered these types of issues before and have put solutions in place to solve them.

Therefore, in the third quarter, we established an operations team with home improvement experts to take initial steps to simply our focus and develop processes and procedures to address all identified issues.

As part of simplifying operations, we’re focusing the teams on key priorities and metrics, while removing distractions and non-value-added tasks.

To improve customer service, we have recently eliminated sales forecasting activities during the busiest hours of the day, so that our associates can focus solely on selling and providing excellent service.

This process eliminates competing demands and provides a clear, concise and consistent approach to deliver repeatable and reliable customer experience across all stores.

Earlier this month, we also significantly reduced the volume of communications and reports going to our stores. Previously, corporate and field associates communicated directly with the stores, bypassing the formal gatekeeping process and leading to information overload, conflicting messages and inconsistent execution.

To focus our teams on the most essential initiatives and allowing them to spend more time with customers, we funneled all store communications through a single portal, established clear weekly priorities and held the stores accountable for executing against these priorities.

To drive efficiency, we've also streamlined the range of reports and metrics sent to our stores, and instead focused the teams on analyzing and improving their customer service scores.

To address the overly complex project specialists in install sales business that Martin mentioned, we recruited an experienced industry leader to the team in the third quarter.

Through his leadership, we’re taking steps to simplify and redesign how we engage customers and grow sales in this very important business.

I look forward to sharing more details with you at our December 12 analyst and investor meeting.

In addition to simplifying our focus in stores, we developed a comprehensive in-stock process, including standardized procedures for efficiently moving product from receiving to the sales floor and rolled it out to US stores in November. We expect that we’ll begin to see measurable improvement in our in-stocks as we head into 2019.

As we work to improve our customer engagement, we continued to invest in our military appreciation program. During the World Series and over Veterans Day weekend, we ran a television spot featuring our veteran associates, thanking all veterans for their service, while building awareness of our 10% up discount for active duty and retired military.

As a Marine veteran who served in both the Gulf War and Desert Storm, I'm proud of the fact that, through our military discount, we’ll provide over $1 billion in savings for our veterans this year. This is unprecedented in retail and I'm proud to work for a company that stands with our veterans.

To recap, as part of our store operations focus on retail fundamentals, we have five key priorities.

One, we have developed and are rolling out engineered standards for all in-store operational activities.

Two, we’re taking steps to simplify communications and reporting sent to our stores.

Three, we’re rolling out a consistent and comprehensive strategy to improve our inventory in-stock execution.

Four, we’re developing a new payroll allocation system to deliver better customer experience, while driving payroll efficiencies.

Finally, we are establishing clear priorities to ensure that customer service is top-of-mind for our associates in the stores. This includes giving our district managers and store managers the autonomy to adjust assortments in their stores to meet the local demands of their customers.

We’re a big believer in the power of entrepreneurial spirit in the home improvement retail.

We know there is still more work ahead to fully capitalize on the healthy demand in our sector and we believe we have the plans and expertise in place to win in today's retail environment.

The good news is I've not encountered any issues or business problems in my last 99 days at Lowe’s that I've not experienced before. Therefore, I'm confident in our ability to develop a world-class operational focus.

Thank you. And I will now turn the call over to Dave Denton.

[David Denton]

Thank you, Joe. Good morning, everyone. I'm excited to be with you today. And while I know many of you from my past, I look forward to working with all of you as we position Lowe's for long-term financial success.

While today is technically my first official day as CFO, over the past several weeks, I spent a great deal of time immersing myself in the business. I’ve been engaged with both the executive leadership team, as well as the finance team here at the company.

I've had the opportunity to both review and participate in the ongoing strategic planning efforts and I strongly believe that the company is taking the necessary actions to be well positioned for success in both the near and long-term grown.

I've grown to appreciate the strong fundamentals of the home improvement market, driven by robust real residential investment and home price appreciation. And yet, I've seen the existing challenges facing the Lowe's business.

I've come away from the past few weeks with tremendous excitement about the future and believe we can create significant long-term value for all stakeholders, including both shareholders, customers and associates.

This morning, I’ll spend a few minutes reviewing the company's financial performance in the third quarter and provide an overview of our expectations for the balance of this year.

As a reminder, in the first quarter of this year, we adopted the new revenue recognition accounting standard. And as a result, we’ve reclassified certain items within operating income, the most significant of which was the classification of the profit-sharing income associated with our proprietary credit program from SG&A to sales.

The adoption of the standard had no meaningful impact on operating income and no impact on comparable sales. Also, it was adopted on a modified retrospective basis, so the prior year has not been adjusted.

Also, before I review the underlying operating performance of the business, let me briefly discuss the pretax charges taken during the quarter. As described in the press release this morning, our strategic reassessment has resulted in $280 million of pretax charges.

These charges were incurred to reposition Lowe’s with the objective of improving the company's financial returns and to allow the organization to focus on the key drivers of long-term value creation.

Specifically, these charges include $123 million associated with our decision to close all Orchard Supply Hardware locations, $121 million related to our decision to close certain underperforming stores in the US and Canada along with a few other Canadian locations, $22 million related to our decision to exit retail operations in Mexico, and $14 million related to our decision to exit Alacrity Renovation Services and the Iris Smart Home business.

The $280 million in pretax charges can be classified into a few major expense categories. These include approximately $130 million of long-lived asset impairments, $15 million in lease obligations, $103 million in accelerated depreciation and amortization, and $32 million in severance obligations.

And given the nature of these expenses, we estimated that the net future cash outflows will be approximately $50 million.

I’ll now turn to a review of our operating performance for the quarter starting with our capital allocation program. In the first nine months of 2018, we generated nearly $6 billion in free cash. And through a combination of both dividends and share purchases, we’ve returned approximately 60% of this cash to shareholders.

In the third quarter alone, we paid $390 million in dividends and our dividend payout ratio currently stands at 35% over the trailing four quarters.

In August of this year, we entered into a $310 million accelerated share repurchase agreement, which settled in the quarter, retiring approximately 2.8 million shares. We also repurchased approximately 2.9 million shares for $310 million in the open market.

So, in total, we’ve repurchased $620 million of our stock in the quarter. This brings our year-to-date share repurchases to $2.5 billion through the end of Q3, with a plan to repurchase $3 billion for the year. We have approximately $4.5 billion remaining on our share repurchase authorization.

And, importantly, we continue to invest in our core business, with capital expenditures of approximately $300 million in the third quarter and nearly $850 million year-to-date.

We are very deliberately managing our capital expenditures, focusing on investing in areas that will stabilize our business and generate healthy long-term returns.

Now, looking at the income statement, we generated GAAP diluted earnings per share of $0.78 compared to $1.05 in the third quarter of LY. On a comparable basis, excluding the $280 million in pretax charges associated with our strategic reassessment, adjusted diluted earnings per share was $1.04, a 1% decrease over last year's earnings per share.

Despite softer sales in the quarter than anticipated, the $1.04 of adjusted earnings per share beat our expectation. The better-than-planned performances was the result of a lower effective tax rate and better margin performance from our inventory rationalization activities.

Sales for the third quarter increased 3.8% to $17.4 billion supported by an average ticket growth of 4.5% to $75.89, partially offset by a roughly 1% decline in total transaction.

Adoption of the new revenue recognition standard provided a 143 basis point benefit to sales growth.

Comp sales were 1.5%, driven by an average ticket increase of 2.3%, partially offset by a transaction decline of about 1%.

And as the team has shared, we continue to see strong traffic growth in the third quarter. However, challenges inventory out-of-stocks, poor reset execution and assortment concerns in certain categories pressured our ability to turn those visits into transactions.

During the quarter, the net effect of cycling the hurricane season was approximately 100 basis point drag on comp sales. Headwinds from Hurricanes Harvey and Irma were partially offset by demands from Florence and Michael.

Our inventory rationalization efforts in the quarter provided an approximately 15 basis points benefit to comp sales.

Looking at monthly trends, comps were 4% in August, 0.7% in September and essentially flat in October. Excluding the estimated net negative impact of hurricanes and adjusted for the estimated pull-forward impact of our inventory rationalization efforts, our monthly comps were 3.7% in August, 1 .9% in September and 1.7% in October.

Gross margin for the third quarter was 32.5% of sales, a decrease of 157 basis points from Q3 of LY. Again, adoption of the new revenue recognition standard provided a 170 basis points benefit to gross margin.

Our efforts to aggressively rationalize inventory and to eliminate slow-moving or underperforming SKUs negatively impacted gross margin by 180 basis points. This effort was an important step in better positioning the company's inventory to foster long-term sales growth and ROIC improvement.

We also experienced 35 basis points of additional pressure from reset-related clearance activity and 25 basis points from clearance activity from the wind down of our Orchard Supply Hardware operation.

Finally, product mix shift had a 10 basis point negative impact on gross margin in the quarter.

SG&A for the quarter was 24.5% of sales, which de-levered 180 basis points. Again, adoption of the new revenue recognition standard resulted in a 118 basis point of SG&A deleverage.

Additionally, pretax charges in the quarter related to our strategic reassessment drove 105 basis points of deleverage as well. These items were partially offset by 20 basis points of leverage due to incentive compensation and 15 basis points of leverage from a favorable employee insurance adjustment.

Depreciation and amortization for the quarter was $433 million, which delivered 36 basis points, again, primarily as a result of the accelerated depreciation related to the exit of Orchard Supply Hardware.

Operating income decreased 373 basis points to 5.5% of sales. Our effective tax rate was 21.8% compared to 37.1% LY. The significant improvement is largely the result of tax reform as well as a few other discrete items that were recorded in the quarter.

Quickly, let me highlight a few items related to the balance sheet. Inventory at $12.4 billion decreased $28 million or 0.2% versus the third quarter of last year, again, primarily the result of our inventory rationalization activity.

Inventory turnover was 3.84 times, a decrease of 10 basis points versus Q3 of LY. And at the end of the third quarter, lease adjusted debt-to-EBITDA was 2.29 times. And our return on invested capital was 19%.

Looking ahead, I’d like to address several updates that we've made to the Lowe’s business outlook. As Marvin shared, the home improvement backdrop remains strong, driven again by robust real residential investment in home price appreciation, which continues to encourage homeowners to engage in discretionary projects.

But as you well know, 2018 continues to be somewhat of a rebalancing year for Lowe’s, as we are refocusing the organization to both enhanced returns and drive shareholder value.

As a result of our strategic reassessment of the business and the ongoing execution challenges, we have updated our expectations for the balance of this year.

We now expect a total sales increase of approximately 4% for the year, driven by comp sales increase of approximately 2.5%. We anticipate opening 8 stores. On a GAAP basis, we expect an operating margin decline of 240 to 255 basis points. This includes charges of 135 to 150 basis points associated with our strategic reassessment of the business.

As a reminder, we incurred $230 million of pretax charges in the second quarter, $280 million in the third quarter and expect an additional $460 million to $580 million in the fourth quarter.

Keep in mind that the amount, the nature and the timing of any additional charges associated with the exit of our retail operations in Mexico will depend on the plan executed and, therefore, have not been reflected in our business outlook.

The effective tax rate is expected to be approximately 24%. And for the year, on a GAAP basis, we now expect diluted earnings per share of $4.08 to $4.24 per share.

Excluding the impact of the charges associated with our strategic reassessment, adjusted diluted earnings per share is now expected to be $5.08 to $5.13 a share.

We are now forecasting cash flows from operations of approximately $6.7 billion and capital expenditures of approximately $1.2 billion. This is expected to result in free cash flow of approximately $5.5 billion for 2018. And our guidance assumes approximately $3 billion in share repurchases for the year.

Again, we remain excited about the future of our business and we’re focused on taking the necessary actions to drive returns and shareholder value.

And with that, we’ll now open it up for questions.

[Operator]

[Operator Instructions]. Our first question comes from the line of Michael Lasser with UBS. Please go ahead.

[Michael Lasser, UBS]

Good morning. Thanks a lot for taking my question. If we look at your performance relative to your large competitor or relative to the category, you clearly took a step back this quarter. Now, I don't think anyone thought it was going to be easy. But, Marvin, when can we expect to see some progress by Lowe’s by narrowing this gap to your competition?

[Marvin Ellison, President and Chief Executive Officer]

Okay. Michael, I think for us – and I stated this in the prepared comments, we were really focused on creating a sustainable foundation in the third quarter, and we made a conscious effort not to chase short-term fixes or short-term results. In any quarter, retailers can make decisions on promotional cadence and special buys and those types of kind of tactical things. We stayed away from all of those types of decisions because I wanted to give the team the appropriate time to really get to the root cause. And that’s why I think it’s appropriate to know that both Bill Boltz and Joe McFarland are celebrating their 99th day with the company today. So, although we made great strides in our kind of reassessment of the business, we have a lot of really new executives.

Having said that, we have an expectation that we’re going to see the business improve going into 2019. But we’re also expecting some short-term improvements in the business just based on all the actions that the team has taken and some of the initiatives put in place in the third quarter. Some very fundamental things that we are looking at that we think will deliver some short-term results will be just simple improvement in customer service. And Joe talked about how removing task and designating service versus task time, those things are important. Bill talked about bringing some level of productivity to our endcaps. Our endcaps in the past have been used for billboards. Not real sales productivity. So, we think just that simple transition will add some value. The improvements we've made in the supply chain and how we now have better coordination between supply chain and stores is we’ll improve our in-stocks, we will see incremental improvement.

So, to answer your question specifically, we were not chasing short-term results in the quarter. And if there’s an expectation that some of these chronic long-standing issues can be fixed in a couple of months, that's really unrealistic. And rather than trying to chase quick fixes, we want to fix it at the root and we think we’re doing that. And that’s why we believe that, going into 2019, you’ll see this company start to have sustainable improvement month over month, quarter over quarter.

[Michael Lasser, UBS]

Marvin, as you head into 2019, what chance that any sort of gains you make with the self-help and addressing some of the execution issues are simply just offset by what will probably be a tougher industry environment next year and how are you preparing for that?

[Marvin Ellison, President and Chief Executive Officer]

I think, for us, the great thing about our business is that we’re in a $900 billion fragmented home improvement marketplace. And if you combine us and our chief competitor, that’s less than $200 billion in revenue. And so, there is a lot of market share up for grabs. We have been very transparent on the issues that we are dealing as a company. Most companies are not going to be as transparent. The reason why that is important is because when we fix these very long-standing chronic issues, poor reset execution, out-of-stocks, assortments not being localized, poor customer service, no real focus on the pro customer, irrespective of what could happen with our competitor or competitors, we have market share opportunity just because we’ve been underperforming as an individual company in a massive marketplace where we have about 10% share. And so, we’re not as concerned with kind of what's happening in other places, not even the macro because we feel really good about the macro environment for home improvement. This is really more about us understanding the steps we need to take to improve execution and the team will lay out some very specific short and long-term initiatives at our December 12 analyst and investor conference.

[Michael Lasser, UBS]

Great, thank you so much.

[Operator]

Your next question comes from the line of Christopher Horvers with JP Morgan. Please go ahead.

[Christopher Horvers, JP Morgan]

Thanks. Good morning. Can you talk a little bit about the 180 basis point headwind for the inventory clearance and reconcile that to the 15 basis point lift to sales from clearance? Is there any assumption in there on ticket cannibalization, sort of stealing a more full-price sale and thereby sort of diminishing the comp from that clearance activity?

[Marvin Ellison, President and Chief Executive Officer]

Chris, the one reason why a retailer never desires to have a massive inventory liquidation process is because it really wreaks havoc on your numbers. But as Dave stated in his prepared comments, we believe we saw some comp benefit early in the quarter from the inventory liquidation because it was being sold at a higher average ticket. But as we got into the month of October, when we started to see the liquidation at its kind of most aggressive cadence, we believe that not only did it hurt average ticket, we think it cannibalized sales.

So, I remember, as an antidote, being in a store and seeing a heater being clearanced in the month of October, and I thought that was very odd. So, after we followed up, I realized that that was a heater from two seasons ago that had been strapped in the overhead because it had never been properly clearanced out.

So, if you think about that for a second, October is a time when we’re really selling heating at a very high rate, but if you can trade down and get a unit that's roughly 60% to 70% off, it’s going to cannibalize regular ticket items. And so, we think it may have benefited us at the beginning of the quarter from a comp standpoint, but as the quarter progressed, specifically October, we think it was a negative impact.

[David Denton]

Chris, it’s Dave. The good news is, while no company likes to liquidate inventory we had about $500 million to liquidate. That’s now largely behind us. So, we’re now positioned going into the back half of the quarter and into 2019, kind of clean from that perspective. So, I think we’re well positioned to put the right inventory in the right locations to begin to improve performance.

[Christopher Horvers, JP Morgan]

Understood. And, I guess, just as a devil’s advocate question, you talked about conversion issues at Lowe's. So, I guess, my question is how do you necessarily know that that sale would've been made if it weren't for that aggressive discount on the product?

[Marvin Ellison, President and Chief Executive Officer]

Chris, our conversion issues were less about the liquidation of inventory and more about just being out of stock. This is a very simple retail analysis. When customers walk into a brick-and-mortar location, they have an intention to either buy or to get some level of consultation on an item they're considering buying. And we’re in the project business, so that happens quite often. But when we talk to our customers and asked the question, what drove a decision not to buy when you physically showed up at a store, it is overwhelmingly that you were not in stock. And so, our conversion issues had nothing to do with the inventory liquidation. It had everything to do with the fact that we had four very problematic resets underway and we still have a significant number of out-of-stocks on our shelves. You can just simply walk our stores and see it with the naked eye.

So, as Joe McFarland mentioned, we put some operational processes in place that's going to help us to improve this, but out-of-stocks is also something you can’t flip a switch on unless you're going to make some aggressive short-term decisions, like air freighting in product or making some bad short-term decisions. We chose not to do that and we’re actually fixing the reset process with an internal team that’s going to own resets. We're having better coordination between supply chain and store operations and we have a consistent in-stock process in the stores. And so, conversion for us was driven almost exclusively by out-of-stocks. And so, we’re going to continue to just execute and improve in-stock and we think our conversion will improve accordingly.

[Christopher Horvers, JP Morgan]

Understood. And then, just one quick one for the model. How should we think about depreciation going forward? Thank you

[David Denton]

If you look at Q3, if you back out the charges that I indicated from my prepared remarks, it should be fairly consistent going forward. It will depend a little bit about what we do with Mexico and the ultimate disposition of that business.

[Christopher Horvers, JP Morgan]

Got it. Thanks.

[Marvin Ellison, President and Chief Executive Officer]

Thank you.

[Operator]

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

[Simeon Gutman, Morgan Stanley]

Thanks. Good morning. Maybe I missed it, but did you quantify how much you think all the reset activity and out-of-stocks hurt your comps in the quarter?

[Marvin Ellison, President and Chief Executive Officer]

We did not.

[Simeon Gutman, Morgan Stanley]

Do you have a guess or is it too difficult to gauge?

[Marvin Ellison, President and Chief Executive Officer]

Simeon, I've learned that guessing is probably not a good thing to do on an earnings call. It is a little too difficult to gauge. We spent most of the time quite candidly trying to get to the root cause of why these issues exist. Bill Boltz and his team spent a lot of time understanding supply issues, supply coordination issues, third-party reset issues, just in-store planning. And so, we feel really good about the fact that we’ve identified root cause. And so, we really focus our time and attention on now trying to put those plans in place to solve those issues.

We’ll have a much more detailed and specific overview of this on our December 12 analyst and investor meeting because we felt it was important to make sure that we communicate externally how we’re solving this because we spent on the last two calls talking about it being a chronic issue. And now we want to spend time about the steps we’re taking to correct it.

[Simeon Gutman, Morgan Stanley]

Okay. I guess, within that question, I think paint, right, this category has been affected, I think, for two quarters in a row. I figure maybe you have some guesstimate around – on that business. And then maybe a way to think about it is can you tell us what the comps were in the categories that weren't affected. And for the answer, I would exclude probably outdoor and seasonal just given that there was probably some hurricane stuff noise in there. So, if we look at traditional categories, you did mention some above-average, some at company average, but maybe you can give a little more color on the categories that didn't have some type of reset activity?

[Marvin Ellison, President and Chief Executive Officer]

Simeon, I think, for me, the best way to answer your question is that we had four negative hopping categories for the quarter. All four had reset interruption issues. And so, that’s probably the most effective way to answer the question. Where we did not have reset issues, we had positive comps. Where we had reset issues, we had negative comps. And so, I think, to me, that’s the best explanation of the impact of poor reset execution on the business. I think anything beyond that would just be data that may not be useful.

[Simeon Gutman, Morgan Stanley]

Fair enough, okay. And my real follow-up is, you mentioned to us, I think it was in September, that there were a couple of pro brands that Lowe's didn't have. And I forget – you didn't name the brands. I don't know if you could share with us what it is. But what’s the visibility on that? Trying to get new brands, does that take a backseat now to you fixing some of the core operations of the business?

[Marvin Ellison, President and Chief Executive Officer]

I will do things. So, first, we’re always going to talk about the brands that we have and the brands we’re very proud to have. And I’ll let Bill talk about some of those programs. And I’ll just say, for the record, the brands that we don't have that we desire to have, we’re actively working to try to get them in our assortment. But we will just take the practice of only talking about the brands we have because those are the companies we want to highlight. And, Bill, just talk a little bit about some of the programs that we feel really good about that performed well in the third quarter.

[William Boltz, Executive Vice President, Merchandising]

Yeah. So, we’re excited about what happened with water heaters and A.O. Smith. We are very excited about what happened with SharkBite. As I mentioned in my prepared remarks around the SharkBite plumbing fittings, we finished the rollout of Zoeller pumps, we finished the rollout of our tile setting material under MAPEI. We introduced new pro cordless products under Bosch and Metabo HPT. So, as good merchants, we’ll continue to evaluate assortments and look at where those opportunities are going forward and try to make sure that we’re doing our best to offer the products and the brands that the customers want.

[Simeon Gutman, Morgan Stanley]

Thanks.

[Marvin Ellison, President and Chief Executive Officer]

Okay, thank you.

[Operator]

Your next question comes from the line of Steve Forbes with Guggenheim. Please go ahead.

[Steve Forbes, Guggenheim Securities]

Good morning. I wanted to start with the five key priorities you mentioned with the merchandising and store operational functions. Not take too much from the analyst day, but can you briefly address the sort of the anticipated timing of the completion of these initiatives? It is a first half, second half 2019, just some general idea on the timing of the initiatives would be helpful.

[Marvin Ellison, President and Chief Executive Officer]

So, Steve, I’ll hand it over to Bill and let him go first and ask him to keep it high-level because, as you can imagine, we’re still working on some of the really specific details of these. Although these initiatives were launched at the end of the third quarter, there are still some specific details we’re working on. And I’ll ask Joe to kind of appropriately say a little high level on operations as well. So, Bill can talk about those priorities for merchandising.

[William Boltz, Executive Vice President, Merchandising]

Yeah. So, we’re continuing to evaluate talent and to bring in experienced leaders, and so that will continue as we go into the early part of next year. We want to have that done, obviously, as quickly as possible. And as we work through some of the merchandising opportunities, some of those categories I called out in my prepared remarks that will take us longer, some of those will take into the back half of 2019 because of the complexity. The ones we can get done sooner, we’ll obviously implement it as early as we can in the early part of 2019. So, we’ll take them as they come and continue to work through them on an issue by issue basis.

[Marvin Ellison, President and Chief Executive Officer]

Okay. Joe, you want to talk about ops for the quarter?

[Joseph McFarland III, Executive Vice President, Stores]

And so, for store operations, what I would say is we have identified all of the challenges that we have. Certain things like simple process for receiving trucks, customer service, we have already begun implementing those as we think about the new payroll allocation system. We've already taken initial steps. However, that will flow into 2019. And so, I’d say we’re well underway that we have identified all of the root causes and we’re excited to share more as we get together in December.

[Steve Forbes, Guggenheim Securities]

Thank you. And then, just a quick follow-up for Dave. You called out a bunch of the margin dynamics, right, during the quarter for gross margin. What about transportation cost and supply chain cost? Can you quantify that drag this quarter?

[David Denton]

Yeah. We’ve been watching that closely. Like, all industry participants in this sector, transportation cost is a worry. I’d say that, as we look at the forecast for the balance of the year, we've included that in our guidance. I would say it’s not a significant headwind at this point in time, but it’s something we’re watching closely through cycle for the balance of this year and into next year.

[Steve Forbes, Guggenheim Securities]

Thank you.

[Marvin Ellison, President and Chief Executive Officer]

Thank you.

[Operator]

Your next question will come from the line of Zach Fadem with Wells Fargo. Please go ahead.

[Zach Fadem, Wells Fargo]

Hey, good morning. With your strategic review coming to a head, Marvin, could you talk about how your findings compare to your expectations going in? I'm sure you had some ideas around what needed to change. So, I'm curious if you could speak to areas within your business that are maybe functioning better than you expected. And then, for those areas underperforming, how does the magnitude of change needed compare to what you initially thought?

[Marvin Ellison, President and Chief Executive Officer]

Zach, what I've been most pleased with is the people side of the business. As I said in my prepared comments, we don't make it easy on our associates. We spent a lot of capital as a company over the last seven years, but we haven't necessarily spent a lot of capital on making the stores more efficient, making our supply chains modern and just creating an easier work environment for our associates. And so, our associates have been resilient. I've visited all of our geographic markets, including Canada and our MSH operation for pro, and in every case, I just walk away just being encouraged by our associates. I've mentioned the engagement with the community. We’re serving 50,000 meals today for Thanksgiving, for communities affected by the hurricane. This is a kind of thing that I had no real impact on. It was just happening when I got here. So, that’s part of the associates loving the business and the culture.

And I would say the decisions we’ve made rather quickly were around leadership structure and organization. I thought that we needed to bring in some core retail experts. What I've learned in my successes and failures in retail is that when you're solving problems, it is best to go out and find leaders who’ve kind of been there, done it before. And that's why when I look around the table at Don Frieson in supply chain and Bill Boltz in merchandising and Joe McFarland in stores and Seemantini as our new Chief Information Officer, et cetera, et cetera, we've gone out and recruited world-class leaders who’ve kind of been there, done it before, and that's required.

And so, once I was disappointed in what I found, but I felt like the need to bring in experienced leaders, so that we could solve these problems quickly. And also, I just want to make sure that we had a more disciplined capital allocation process. As I mentioned earlier, a lot of the strategic reassessment and closing underperforming stores, exiting non-core businesses, getting out of environments where we can’t really be competitive because we can’t get the scale like Mexico, is all a part of making sure we reallocate capital and invest in creating a great home improvement retail environment. And so, that's kind of where we are and we’ll continue to make the necessary changes.

But we feel great about the future of this company. We can identify obvious shortcomings and what we’re doing on a daily/weekly basis. We can look at where we’re underperforming from a sales perspective and we could point exactly to what's causing it. And to me, that’s very encouraging because we know how to fix it. And so, we’re going to continue to push for it.

[Zach Fadem, Wells Fargo]

Got it, Marvin. Thanks. That’s helpful. And then, quick one for Dave. First of all, welcome aboard. And then, on the store closings and the additional initiatives announced today, curious if you could speak to your approach to some of the cost savings coming out next year and how do you think about just the process of redeploying and reinvesting those savings? And are there any of those savings that you would expect to drop to the bottom line next year?

[David Denton]

Well, obviously, we’re making these investments in these decisions to position the company for long-term financial success. There is no doubt about that. And I think the team is really focused against that very intensely.

I do think that the savings that are going to be generated from these activities are partly going to be invested a little bit as we think about repositioning the company and some of the efforts you heard from both Joe and Bill today. But, importantly, as we think about the future and the future growth and the returns on the business that we have today, this will largely fall to the bottom line and really enhance those returns over the next future periods.

[Zach Fadem, Wells Fargo]

Got it. Thanks so much, guys. I appreciate the time.

[Marvin Ellison, President and Chief Executive Officer]

Thank you.

[David Denton]

Thank you.

[Operator]

Our next question will come from the line of Greg Melich with MoffettNathanson. Please go ahead.

[Zach Fadem, Wells Fargo]

Great. A couple of questions. Just want to make sure I piece together the guidance in the inventory adjustments right. If I got it right, there’s $320 million of inventory hit in the third quarter. And I think, Dave, you mentioned around $500 million over the course of the year. If we think about those numbers, sort of 60 to 90 basis points of margin hit this year. Should we be thinking about that as the – if there was 35 to 150 basis points of charges, right, mostly non-cash that really this year EBIT margins are down 90 to 100 bps, but that inventory is 60 to 90 of it and that that’s sort of a clean like-for-like slate into next year? Am I piecing that together right?

[David Denton]

Well, a little bit. Let me just step back a minute. We had roughly $500 million of inventory to clear. We roughly cleared that at a 40% discount. So, I think that’s largely behind us. We recycle into Q4, we’re essentially clean from the inventory rationalization perspective. So, don't think about a hang over into Q4. Think about that being complete in Q3.

[Zach Fadem, Wells Fargo]

Got it. And so, if we took just the third quarter, that’s now behind us, and what we saw in the gross margin, that 320, 330 is when we get to next year – that were clean when we think about it sort of a run rate of margin. Great.

And then, second and sort of bigger picture on just traffic and conversion, I think, Marvin, you mentioned that traffic was still positive, but we basically have transaction counts down. How do you measure what traffic really was versus that conversion? Was it that store traffic was up 1%, but we were down – transaction counts down 1% and that’s the difference in terms of close rates?

[Marvin Ellison, President and Chief Executive Officer]

Well, I think a couple of ways. Measuring traffic online is just pure data-driven. So, that’s something we have 100% visibility to like any other e-com or brick-and-mortar company with an e-commerce platform. So, that’s pretty straightforward.

When we look at traffic in the stores, we have monitoring devices to measure traffic. Our environment is more difficult to measure conversion because we’re a project business. And so, we’re going to shift our discussion from conversion to transactions. I think that is a better way to understand a year-over-year comparison of our business.

So having said that, we still feel very good about traffic, both online and in store base on how we measure it, but we understand that we have challenges in driving transactions and/or conversion based on the traffic.

When you look online, we know we have some issues with functionality that we’re addressing. We also know that we have issue with search and navigation and ease of checkout. If you look at our mobile app, you can see an app that desires to be much more robust. We’re in the process of delivering on that.

As we look in the store, I’ll go back to my previous comments. We don't want to make this overly complicated. When a retailer is not delivering on the traffic that’s walking in your store, there are really a couple of basic reasons why. Either you are pricing incorrectly from what you advertised or you're out of stock. And we feel good about the consistency of our pricing and all of our data tells us that we’re out-of-stock. And that’s why we put such a huge emphasis on addressing this issue.

And so, we understand the root cause. We understand how we got here and now we’re working to create a sustainable solution to fix it.

[Zach Fadem, Wells Fargo]

That's great. Thanks. Good luck, guys. See you in a week.

[David Denton]

Thank you. We’re going to take one more question.

[Operator]

Our final question will come from the line of Scot Ciccarelli with RBC. Please go ahead.

[Scot Ciccarelli, RBC Capital Markets]

Good morning, guys. Thanks for fitting me in here. I guess, this is a bigger picture view for a second as well. When you kind of look at your performance against Home Depot, the bulk of the sales gap on a per store basis, Marvin, as we talked about is really on the pro side. If you were to get the stores right where you want them, the in-stocks where you want them – I know this is an opinion – but over what kind of timeframe do you think you would start to take market share back on the pro side? And related to that, why would a pro change who their incumbent product supplier is? Thank you.

[Marvin Ellison, President and Chief Executive Officer]

Scot, it’s a fair question. So, I’ll speak specifically on the pro customer. The pro customer is a very important customer, but they're a very, very simple customer. And this customer is looking for a couple of fundamental things. First, they're looking for a great price. They're looking for service that saves them time because time is money. And they're looking for the brands that they identify with. That's really it. They're pretty much agnostic on anything else. And so, Lowe’s has proven that you can have a dominant market share in pro and lose it because, at one point, Lowe’s had dominant market share in pro and they didn't maintain it because primarily, of those three things I outlined were no longer competitive advantages. And for us, we’re going to make sure that we are competitively priced. That’s something that Bill and his team are taking the lead on. We’re going to make sure that we have great service because again time is money. And service for the pro is not giving them product knowledge. It’s about having job lot quantity. It’s about giving the ability to buy and stage product. It’s the ability to speak their language and to engage them at the pro desk or engage them online. And now, the third level is to go out and get the brands. And as Bill and I both mentioned, we’re actively engaged in trying to fill our assortments with brands that we currently don't have. When you do those things, the pro is totally agnostic to the channel in which they shop because it's all about those three things for them.

[Scot Ciccarelli, RBC Capital Markets]

And do you think that if you kind of matched apples to apples, the pro would come to Lowe's instead of Home Depot?

[Marvin Ellison, President and Chief Executive Officer]

Well, I think the key is, we spend very little time looking across the street. We are a customer-centric company. And what we believe is, if we take care of the customer, everything else will take care of itself. And I’ll just remind you that we operate in a $900 billion marketplace, and so we don't care a whole lot about what’s happening across the street because between Lowe's and our largest competitors, less than $200 billion in market share, which means there’s more than $700 billion up for grabs in this really fragmented environment. And for us, it’s less about what’s happening with the competitors, more about how we serve customers and how we go out and we take share in this fragmented marketplace that we’re in.

[Scot Ciccarelli, RBC Capital Markets]

Understood. Thanks a lot. And helpful.

[Marvin Ellison, President and Chief Executive Officer]

Okay. Thank you very much. And, look, we appreciate your time and attention on the call. And we look forward to speaking to you again on our fourth-quarter call, which will be Wednesday, February 27. Thanks and have a very blessed Thanksgiving.

[Operator]

Ladies and gentlemen, this concludes today’s conference. Thank you all for joining and you may now disconnect.