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Lowe's Companies Inc
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Good morning, everyone, and welcome to Lowe's Companies fourth quarter 2017 earnings conference call. This call is being recorded.
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. Robert Niblock, Chairman, President and Chief Executive Officer; Mr. Richard Maltsbarger, Chief Operating Officer; and Mr. Marshall Croom, Chief Financial Officer. Joining during the Q&A session will be Mr. Mike McDermott, Chief Customer Officer.
I will now turn the program over to Mr. Niblock for opening remarks. Please go ahead, sir.
Good morning and thanks for your interest in Lowe's.
Fiscal 2017 represented the highest sales and net earnings in our company's history. In the fourth quarter, we delivered comparable sales growth of 4.1%, exceeding our expectations, through compelling consumer messaging, strong holiday event performance, and integrated omni-channel customer experiences. Our U.S. home improvement business delivered a 3.7% comp for the quarter, with positive comps in 13 of 14 regions.
From a product view, we posted positive comps in 9 of 11 product categories, while one category was essentially flat. Appliances led product category growth with another quarter of double-digit comps. We achieved above-average comps in tools and hardware, rough plumbing and electrical, and lumber and building materials.
Internationally, we delivered another strong quarter with high single-digit comps in Mexico and mid-single-digit comps in Canada, both in local currency. We've made significant progress integrating RONA, delivering double-digit online sales growth, rolling out appliances to approximately 100 locations, completing five RONA big-box conversions, driving strong growth in our affiliated dealer business, and further optimizing shared supplier partnerships and procurement efforts.
We're pleased with the strong momentum we've built throughout the year, culminating in RONA posting its highest comp in 13 years. We believe that we're well positioned for continued growth and remain on track to double operating profitability in Canada by 2021.
For the quarter, we delivered adjusted diluted earnings per share of $0.74.
Delivering on our commitment to return excess cash to shareholders, in the quarter we repurchased $133 million of stock under our share repurchase program and paid $341 million in dividends. And our board of directors recently authorized an incremental $5 billion of share repurchases, which further underscores our commitment.
Turning now to our progress against our strategic priorities, I'm particularly proud of how we've grown sales with Pro customers by focusing on breadth and depth of inventory, our portfolio of brands, localized assortments, and enhancing LowesForPros.com, as evidenced by our Pro growth rate outpacing DIY for both the fourth quarter and the full year.
The integration of Maintenance Supply Headquarters and Central Wholesalers remains on track and provides a compelling opportunity to improve and expand our ability to serve multi-family property management customers.
On Lowes.com, we saw strong customer response to our enhanced shopping experience and marketing efforts, with comp growth of 28% for the quarter and 34% for the year.
We continue to enhance our in-home selling program, providing customers the ability to now request services online. And we are centralizing our process for providing installation quotes, allowing for greater efficiency and a more consistent customer experience. Our project specialists represent a critical element in our omni-channel offering and a differentiated capability in capturing and serving project demand for the do-it-for-me or DIFM customer.
Though we were pleased with the strategic milestones we achieved this year, we recognize that we still have an opportunity to improve execution to ensure greater success in the future. Richard will speak to our efforts to improve conversion, gross margin, and inventory management in a moment.
Looking ahead, the home improvement industry is expected to see solid growth, supported by job and income gains, which should drive increases in both disposable income and consumer spending. And we expect continued housing tailwinds, including favorable trends in household formation despite near-term pressure on housing availability.
In 2018, we plan to capitalize on this strong macroeconomic environment and see an opportunity to invest much of the incremental cash flow from corporate tax reform to accelerate our strategic priorities, including investments in our people. We are focusing our resources on what is most relevant to engaging customers in the moments that matter and improving the capabilities our employees need to serve customers.
In 2018, we will focus on: leveraging analytics to know the customer better; changing how we engage; expanding our fulfillment options; delivering compelling product experiences; growing sales with the Pro customer; and differentiating with services.
These strategic areas of focus and investment will be instrumental to further strengthening our competitiveness and enhancing our position as the omni-channel project authority. Richard will provide additional details on each of these focus areas in a moment.
And of course, as we look at our results along with the additional investments we're making, it warrants reevaluating our long-term targets. Marshall will address those in a moment. But let me be clear that our entire leadership team and board are focused on working together to continue to analyze our performance and business expectations, and we are moving forward with urgency to improve our results.
Before I close, I would like to express my appreciation to our employees for their dedication to serving customers and living our purpose-driven mission to help people love where they live. We recently announced plans to expand our employee benefits and a one-time bonus of up to $1,000 for our more than 260,000 hourly employees in the U.S. Our employees are the foundation of our success, and we are investing in them to support our bright future and reward them for their unwavering commitment to serving customers in the communities where they live and work. It's their dedication that makes this company great.
Thanks again for your interest and, with that, let me turn the call over to Richard.
Thanks, Robert. Good morning, everyone. As you just heard, we've achieved some important milestones this year and identified actions necessary to drive future success. First, we refined our marketing strategy, successfully launching a new campaign, Start with Lowe's, which has captured mind share and improved measured campaign effectiveness.
We've also continued our evolution from analog to digital marketing, delivering more personalized targeted messages. And we've optimized our messaging content, driving critical improvements in value perception. Together with our incremental marketing investments, these improvements have increased awareness, leading to robust traffic growth.
Second, we capitalized on customer excitement for the holiday season. We provided cohesive decorating solutions as well as compelling gift ideas across our product assortment, connecting our in-store display with digital assets such as Pinterest, Facebook, Instagram, and YouTube, and delivered a seamless shopping experience on Lwes.com.
In fact, we drove double-digit comps in appliances, leveraging our investments in customer experience both in-store and online, as well as our best-in-class selection of leading brands and our services advantages of next-day delivery, haul-away, and facilitation of repairs and maintenance.
As cold temperatures and winter storms hit, our never-out strategy ensured that we were in a strong position to serve demand for critical items customers needed. Combined, our strong holiday performance and never-out strategy drove above-average comps in tools and hardware and rough plumbing and electrical.
We also continued to execute on our strategic priorities, driving comp growth of 28% on Lowes.com, the result of strong customer response to our enhanced online shopping experience. We have optimized functionality and display for touch-screen devices to support a better mobile experience, improve product content recommendations, refine search algorithms, improve click-to-chat capabilities, and optimized our assortment, informed by digital line reviews.
And we've re-leveraged our MyLowes platform to drive brand loyalty and build deeper relationships with customers, important because MyLowes members spend approximately 35% more on average than non-members. In 2017, we added more than 4.5 million new MyLowes members, and we used the platform to simplify our military recognition program, allowing active-duty personnel and veterans to register through MyLowes and receive 10% off their purchases every day.
However, not all the actions we took during the year delivered on expectations. While we were pleased with our traffic growth, we are actively working to improve conversion and gross margin while better managing inventory.
Earlier in the year, we recognized the need to improve our sales floor coverage, especially during key weekend and holiday events. We made an investment in Q3 to bolster conversion rates, but did not realize the full value of this investment in the second half of 2017. We ultimately determined that, while necessary, payroll actions alone will not deliver the conversion rates we expect. Therefore, we must accelerate associate readiness and knowledge through our training programs and reengineer key processes in order to better serve customers.
We must also stabilize gross margin by leveraging new pricing and promotion analytics tools to ensure that we are competitive on highly elastic traffic-driving products while driving profitability across less elastic items, and through our continuing value improvement efforts, work closely with our vendors to improve first cost.
Finally, we've made the required inventory investments to support key categories such as appliances, flooring, and tools, as well as depth and breadth in critical Pro categories. Now we must drive greater working capital efficiency. We enter 2018 with a plan to address these challenges and accelerate the investments that will improve our execution and our ability to serve rapidly evolving customer expectations. As Robert outlined, there are six planks to this strategy.
First, we are working to know customers and their homes on an even deeper level, understanding their plans and designing better solutions to help navigate their project journey. We're integrating our analytics capabilities, bringing together terabytes of customer data, connecting many different touch points throughout our omni-channel platform, supplementing that data with third-party information, and leveraging our talented global workforce to translate this information into actionable insights.
Second, we're changing how we engage, connecting with customers and associates through relevant tools and messages. We'll deliver more refined personalized messages to customers through our enhanced marketing management platform that went live in Q4. And we'll better empower associates by deploying more user-friendly interfaces, beginning with our point-of-sale upgrade in Q1, which will allow our associates to better serve customers with a touch of a button. Later in the year, we'll significantly improve our associate connectivity, expanding the functionality of our in-store handheld devices to improve the efficiency of our order staging and management, daily tasking, and inventory processes.
Third, as customers demand an increasingly broad set of fulfillment options, we're transforming our supply chain to better serve their needs and expectations. We're investing in a new direct fulfillment center, which we expect will be operational in the third quarter of 2018, allowing for the expansion of our online product offering and faster parcel shipping. We're also investing in delivery capacity to meet increased demand. And we're advancing our pick-up-in-store experience during Q1 to allow customers and our installation service providers to pick up product within five minutes of arrival.
Fourth, we'll continue to deliver compelling product experiences to provide inspiration and personalized choice through a combination of strategic brands and differentiated in-store experiences. We've previously announced the introduction of Craftsman in-store and online in the second half of 2018.
Today, we're proud to announce our expanded partnership with Sherwin-Williams. Paint continues to be a top home improvement project, and we will partner closely with Sherwin-Williams to deliver a simplified line design to make it easier for customers to select the right product for their painting needs.
Sherwin-Williams will now be the exclusive national supplier to Lowe's U.S. retail outlets for interior and exterior paints, including the Valspar and HGTV Home brands. Sherwin-Williams is one of the most recognized brands in paint, highly respected for quality products by both homeowners and pros.
Under this expanded strategic partnership, Lowe's will become the only U.S. national home center to offer top-selling same brands, Minwax, Cabot, and Thompson's WaterSeal, as well as the top paint brush brand, Purdy. We are excited to bring consumers more of the top brands they trust for their next paint or stain project.
We're also investing in our paint service model to improve the associate and customer experience across the entire paint project. We are rolling out a new paint desk experience in select stores beginning in the first quarter, with plans for a nationwide rollout in the second half of 2018. The improved experience will include an updated product selector display as well as a simplified and streamlined service model to make it even easier for customers to work with the associate to find the color, pick a paint or stain, quickly have it mixed, and begin a project.
Fifth, while our Pro penetration has grown over the last five years, we have further opportunity to continue growing sales to Pro customers and expanding our market share. To that end, we're investing to improve the Pro experience. We are building on our strength in the MRO space by optimizing our Maintenance Supply Headquarters business, launching a streamlined product catalog this spring, followed by branch expansion beginning later this year. We're also testing improved Pro job site delivery in select urban markets, with an expectation of rolling out the best concepts nationwide in the second half of the year.
And in order to build a stronger generation of skilled trade professionals, we are launching our Track to the Trades program, a new workforce development initiative that provides innovative career alternatives and financial support for our employees as they pursue a skilled trade.
Finally, as the DIFM opportunity continues to grow, we're providing a differentiated services offering, delivering complete home improvement project solutions through our in-home sales platform, which we are proud to note has grown to over $2 billion in sales annually.
Across all project types, our installation services team completes approximately 60,000 in-home installations each week. And we continue to push forward in this space, where we are currently testing the commercialization of Lowe's Vision Pro with our in-home project specialists, allowing customers to use augmented reality to visualize their kitchen or bathroom model and feel confident proceeding with their project. Through this and other work, we have earned recent recognition by Fast Company as the most innovative company in augmented and virtual reality.
Together, these six planks build upon our strong foundation and further strengthen our competitiveness, positioning us to continue capitalizing on healthy project demand.
Thank you for your interest in Lowe's, and I will now turn the call over to Marshall.
Thanks, Richard, and good morning, everyone. Let me start by reminding you that last year's results included an extra week, which contributed approximately $950 million in sales. That extra week also caused a calendar shift this year, which had no impact on comp sales, but negatively impacted fourth quarter total sales growth by approximately $1 billion or 7%.
Sales for the fourth quarter were $15.5 billion, a decrease of 1.8% compared to last year's fourth quarter. Total transaction count decreased 7%, while total average ticket increased 5.2% to $73.44.
Maintenance Supply Headquarters contributed 40 basis points of growth in the quarter, while new stores contributed 60 basis points. Comp sales were 4.1%, driven by an average ticket increase of 4.9%, partially offset by a transaction decline of 0.8%.
Looking at our monthly trends, comps were 1.1% in November, 7.7% in December, and 3.4% in January. Hurricane recovery efforts in Texas and Florida aided fourth quarter comps, which offset the impact of cold temperatures and winter storms across the country in the latter part of the quarter as well as the comparison to Hurricane Matthew and Louisiana flooding last year. We estimate that the net benefit of weather in the quarter was approximately 65 basis points.
For 2017, total sales were $68.6 billion and comp sales were 4%.
Gross margin for the quarter was 33.73% to sales, a decrease of 68 basis points from the fourth quarter of last year. Two-thirds of the decline was attributable to rate, while the balance was mix and shrink. As we've grown our market share in appliances, gross margin has been impacted from both a mix and rate perspective. We also continue to take competitive actions, which were partially offset by the benefits from value improvement as well as early results from pricing optimization efforts.
SG&A for the quarter was 24.28% to sales, which deleveraged 29 basis points. In last year's fourth quarter, we recorded severance-related costs for organizational changes, which drove 53 basis points of leverage this quarter. In the fourth quarter of 2017, we experienced 21 basis points of leverage related to employee insurance and 32 basis points of leverage related to incentive compensation due to lower attainment levels versus last year.
Offsetting these items were the one-time cash bonus for eligible hourly employees in the U.S, which resulted in 42 basis points of deleverage, as well as 21 basis points of deleverage in delivery costs due to increased demand from continued growth in appliances. We also had 14 basis points of deleverage in advertising, primarily the result of our efforts to amplify our consumer messaging. And lastly, the 53rd week in the fourth quarter of 2016 drove approximately 65 basis points of deleverage this quarter.
Depreciation and amortization for the quarter was $367 million, or 2.37% of sales, flat to last year.
Operating income declined 97 basis points to 7.08% of sales. The 53rd week in the fourth quarter of last year drove approximately 90 basis points of deleverage this quarter.
Interest expense for the quarter was $154 million, which leveraged 3 basis points. The effective tax rate for the quarter was 41.3% compared to 40.3% last year. The higher rate this year was driven by tax reform. The change in our federal statutory rate triggered remeasurement of our deferred tax assets and liabilities, resulting in a charge in the fourth quarter.
Earnings per share was $0.67 for the fourth quarter. Tax reform negatively impacted earnings per share by $0.02, while the one-time cash bonus reduced earnings per share by $0.05. Adjusted earnings per share was $0.74, a 14% decrease compared to last year's adjusted earnings per share of $0.86. Last year's extra week contributed approximately $0.08 to last year's quarter, which negatively impacted adjusted earnings per share growth this year by 9%. For 2017, earnings per share was $4.09, while adjusted earnings per share was $4.39.
Turning to the balance sheet, cash and cash equivalents at the end of the quarter was $588 million. Inventory at $11.4 billion increased $935 million or 8.9% versus the fourth quarter of last year. This was primarily driven by investments in key categories, as Richard mentioned, such as appliances, flooring, and tools, as well as investments across Pro categories. And part of the increase is also attributable to the acquisition of MSH and new store growth.
Inventory turnover was 3.9 times, a decrease of 15 basis points over last year. The extra week in 2016 negatively impacted inventory turnover by approximately 6 basis points. Asset turnover increased 5 basis points to 1.9 times. Accounts payable of $6.6 billion represented a $61 million or 0.9% decrease over fourth quarter of last year. At the end of the fourth quarter, lease-adjusted debt-to-EBITDAR was 2.33 times. Return on invested capital was 18.8%.
Now looking at the statement of cash flows, we generated strong operating cash flow of nearly $5.1 billion and free cash flow of $3.9 billion. In the fourth quarter, we paid $341 million in dividends and we repurchased approximately 1.7 million shares of stock for $133 million through the open market. For the year, we paid $1.3 billion in dividends and repurchased $3.1 billion of stock for the year.
In January, our board of directors authorized a new $5 billion share repurchase program. The new program has no expiration date. Therefore, our combined purchasing power under the share repurchase program, we have a total authorization of approximately $6.9 billion.
Looking ahead, I'd like to address several of the items detailed in Lowe's business outlook. As Robert and Richard indicated, we've made meaningful progress this year against our strategic priorities. While we are pleased with the strategic milestones, we do recognize that we have an opportunity to improve execution to ensure greater success in the future. We are focused on improving conversion, gross margin, and inventory management.
In addition, customer expectations and the retail landscape are rapidly evolving, and corporate tax reform provides incremental cash flow. As a result, we are accelerating our investments to enhance our ability to serve customers. We'll be taking the necessary actions to transform our supply chain, better empower our associates, and continue to deliver compelling product experiences.
In 2018, we expect a total sales increase of approximately 4%, driven primarily by a comp sales increase of approximately 3.5%. We do anticipate opening approximately 10 stores.
On a GAAP basis, we are expecting operating margin decline of approximately 30 basis points. While we expect flat gross margin for the year as we improve execution, incremental expenses associated with our strategic investments will pressure SG&A.
Factoring in the benefits of tax reform, which are approximately $750 million in 2018, the effective tax rate is expected to be 25.5%.
For the year, on a GAAP basis, we expect earnings per share of approximately $5.40 to $5.50. We are forecasting cash flows from operations of approximately $6.5 billion and capital expenditures of approximately $1.7 billion. This is expected to result in estimated free cash flow of approximately $4.8 billion for 2018. And our guidance assumes approximately $2.5 billion in share repurchases.
As we look at our results along with our decision to accelerate strategic investments, we are reevaluating our long-term targets. We plan to provide a full update on our business strategy and long-term outlook at our analyst and investor conference in December. Until that time, I'd like to share some parameters that we're applying as we reevaluate our long-term targets.
First, the outlook for the home improvement industry over the next few years remains solid. As such, we continue to expect an average annual sales increase of at least 4%. Second, we expect operating margin to improve after 2018, even while we continue to invest in the business. And we are diligently working to improve productivity in order to provide greater confidence in the operating margin targets we plan to communicate in December. Finally, we remain committed to our current shareholder distribution target, returning approximately $14 billion to shareholders through 2019.
Regina, we're now ready for questions.
Our first question will come from the line of Brian Nagel with Oppenheimer. Please go ahead.
Hi, good morning.
Good morning, Brian.
So a couple questions. First off, with respect to the investment plan or the strategic plan you laid out on the call, how should we think about, as we go through 2018, the cadence of investments along those lines and the potential benefits in terms of sales and other metrics? How should those line up?
I'll take the top line first. This is Marshall. Basically, as we think about our sales progression and comps, we would slightly expect sales to be higher in the first half of the year. As you recall, first quarter was our easiest comparison as we headed into 2018, so first half sales will be slightly higher than the second half. As far as capital expenditures and expenses throughout the year, we'll be leaning that throughout the year.
But we do expect, as we manage to stabilize gross margin, that not only the capital investments but the expense associated with some of these initiatives will put pressure on SG&A.
And, Brian, as noted during my comments, this is Richard, a few of the nationwide rollouts that we have such as the paint service experience as well as some of the enhancements to the digital tools in the hands of our associates are back-loaded.
Got it. And then the second question, more as a follow-up, if you look at the cadence of comps in the quarter, so if you exclude – it was weak to start and weak to end, stronger in the middle. Is there something that explains that, that basically what we saw through the quarter?
Yes, it's largely a function of the holiday sales that we experienced. So as we mentioned, we were pleased with appliance sales growth. A majority of our appliance sales are scheduled to be delivered; they're not take-with. As a result, a lot of those sales over Black Friday and that holiday period were delivered in December, and it's not until they're delivered or customer takes possession that we recognize that revenue. So that created some lumpiness of the 1.1% comp in November to the 7.7% in December.
Is there a way with just that one piece, can we quantify it with the shift between those two months?
Yes, Brian, there's another way to think about it. As you look at the comp progression, not including the impact of deferred sales, it was roughly mid-3% comp in November and January and roughly mid-4% comp in December.
Got it. Thanks a lot, good luck.
Thanks, Brian.
Your next question comes from the line of Eric Bosshard with Cleveland Research. Please go ahead.
Thank you.
Good morning, Eric.
Sorry about that – thank you, sorry about that, two questions for you. First of all, the 4Q margin I think was below the guidance you had given 90 days ago. So I was just curious if you could summarize again the moving pieces with the math.
And then secondly, I'm excited to hear about the incremental investments to grow the business in 2018, and you talked about taking advantage of the tax savings, the $750 million, but wondering if you could just quantify the amount of incremental investment that you're making in 2018.
Eric, this is Mike McDermott. I'll touch on the gross margin question. In the fourth quarter, we meaningfully exceeded our expectations in the appliance category, growing significant market share. As a result of that, that had an impact on both our mix and our rate from a margin perspective.
The other thing we did, as you recall, in the second quarter of 2017, we focused on getting more competitive and improving our value perception to make sure that we could take advantage of the available market opportunity. Those actions continued in the fourth quarter, and yet were only partially offset by our value improvement initiatives, working closely with our vendors on first cost and some early price optimization benefits, as we're in the early innings of rolling out analytics tools and capabilities to drive that optimization.
As we look into the new year, I think we're in a solid competitive position. We continue to offset the impact of any competitive pricing actions through the rollout of those tools that I mentioned a moment ago. And we'll continue to work on value improvement with our vendors, ultimately delivering flat gross margin in 2018.
Eric, this is Marshall. Just one other factor for fourth quarter gross margins, as we were going through our integration process with RONA, we did have some accounting harmonization that impacted gross margin in the quarter. So that was just another small factor for the pressure we experienced there.
To your second question, on the incremental capital that we plan to spend in 2018 as a result of tax reform, about 85% of that we will be investing in 2018. So we recognize this as an opportunity. And largely where we're spending that, as you think about our capital expenditures going from roughly $1.1 billion in 2017, $1.7 billion in 2018, 45% of that $1.7 billion will be on strategic initiatives. That's almost triple of what we spent in 2017. So again, the opportunity to lean into the omni-channel capabilities that we need to build to expand customer reach and relevancy and to further drive the six planks that Richard spoke to earlier.
Great, and then just one last question, if I could circle back with Mike McDermott. How do you think about the balance between the incremental promotional spending getting a bit more aggressive on price and effective and then the market share performance? And I know that looking at you relative to Home Depot is just one way to look at it. But how do you look at the incremental spend and the market share performance?
Eric, look, when I take a look at incremental spend, I look at both price as well as traffic. And we had some incredible performance as it relates to our efforts to improve our customer awareness as well as drive traffic and engagement through that awareness through optimizing our marketing spend and better balancing our digital and mass media approach to make sure we're engaging customers at the right time with the right content.
As it relates to both promotional and pricing spend, we simply have to be competitive, and that is our focus. The opportunity to continue to drive optimization is what we see ahead of us in 2018.
Eric, this is Robert. I would just add on that I think we're pleased with the work that Mike and his team have done from a promotions standpoint, the additional traffic it's driven, the consumer awareness, those types of things.
As Richard and I both outlined, our opportunity is to take that traffic and drive greater conversion, and that's what Richard and his team were working on. And some of the strategic investments that he talked about were for focusing on investing in our associates to make sure that they have all the tools, the training, the capability, we have the right coverage for daypart hours, those type of things to ensure that we're then converting that traffic into sales. So that's a big focus area that Richard and his team are focused on as we head into 2018.
Okay, that's helpful. Thank you.
Your next question comes from the line of Christopher Horvers with JPMorgan. Please go ahead.
Thanks and good morning. Can you talk about the appliance category? It sounds like you did extremely well in that category. Any further quantification of what double-digit growth is? Is that closer to the 20% than to 10%?
And somewhat related to that, traffic was down in the fourth quarter. What do you think the drivers of the down traffic were?
I'll just reinforce that we had double-digit comps in appliances and feel good that the combination of our messaging, our assortment, our brand partnerships, and our product offering continue to resonate very, very well with the customer. We are the leader in that space and continuing to drive leverage as a result of that leadership position with fantastic displays and great engaged associates. So I continue to see runway in the appliance space as we lean into that market for the opportunity that exists.
Chris, this is Robert. Just to clarify, it was not traffic that was down. It was transactions that were down. As I just indicated in my follow-up with Eric on an earlier question, we're driving the traffic. It's the conversion of that into transactions. And as we mentioned, as Richard said in his comments, we put the labor there. We realized we've got to put more than just the labor there, so we made the labor investments, and we need to make the incremental investments to ensure that we convert that traffic into transactions.
Understood, that's a great segue. So as you think about the labor model and the changes that you've made, are you thinking about structurally changing how you allocate labor, whether it's full-time versus part-time? The algorithms that you put in place with a new system last year, how does the overall labor strategy shift going forward?
This is Richard. The reality is over the last couple weeks, I've had the opportunity to go into stores across five different states, speak directly with our associates, understand some of the challenges that are happening in our aisles every day. And the emphasis I would put on it are a few areas. First and foremost, it's really the mix of our selling and tasking hours. How do we go about getting the work done in our stores every day to enable our red-vest associates to be in front of the customer when it's time to serve?
The second focus we have on, as Robert noted, is having the labor hours in the stores necessary. Having associates ready through our training and our knowledge programs to be ready to serve is just as necessary, so reinvestments and actions that we are taking right now during spring hiring to bolster that area.
Third, reengineering some of our key processes, as noted during my comments and Robert's, our pick-up-in-store experience, as an example, we have an upgraded experience both in the physical layout as well as in the staffing and training model going out in Q1 as well as, to Robert's comment on centralized quoting, an opportunity to speed up our process by centralization and greater support for our in-store associates to allow them more time to serve the customers that are with them every day, and then finally, upgrading our digital management tools, giving a chance for our associates to get more productive with the hours that we invest in the tasking.
So when you look across those investments, from the midst of tasking to selling, to our associate readiness, to reengineering key processes, to better empowering our associates with the right tools, those are some of the initial focus areas as we move into the year.
Thanks very much.
Your next question comes from the line of Seth Basham with Wedbush Securities. Please go ahead.
Thanks a lot and good morning.
Good morning, Seth.
Good morning.
My question is a follow-up on the conversion issue. If you could, just give us a sense of how conversion trended through 2017 and how much of an improvement you expect in 2018 and what the biggest driver of that is going to be. Is it the training and knowledge programs or something else? Thank you.
Absolutely, as I just noted, the challenges we have had for conversion have steadily been a challenge as we move throughout the year. In fact, it really is an opportunity. As we've grown the traffic, we know that the customer is interested in our offer. There is the demand for what we're bringing to the marketplace. Really, the conversion challenge has grown as the traffic has grown. We have begun to address it in the steps that we had to take necessarily in the payroll action in the back half of the year. And now it is simply a matter of ensuring that our associates are more ready to field that traffic.
And a follow-up on that, in terms of the readiness, is the fact that you had a lot of employees that weren't quite qualified for their jobs or weren't trained for their jobs or were in the wrong places?
The biggest focus that has come from my conversations with our teams in the field right now is greater role clarity and greater understanding of who's going to field what particular aspects of the project cycle and being able to improve the execution of that.
Thank you and good luck.
Thanks, Seth.
Your next question comes from the line of Matt Fassler with Goldman Sachs. Please go ahead.
Thanks a lot, good morning. I want to follow up on gross margin. So gross margin I think was down all four quarters of this year. And I know there have been some mix issues, and Canada coming into the mix earlier on probably impacted that as well. But given the commitment to deliver a comp that's at the level of what you've been putting up in a pretty strong backdrop and given the fact that value improvement has been part of the agenda for quite some time, why the confidence that with mix moving against you and with the desire to continue to hold or gain market share, at this moment the gross margin can stabilize while you achieve everything else you're trying to get done here?
Hey Matt, this is Mike McDermott. Obviously, we have seen gross margin decline throughout 2017. Most of the actions we put in place started in the second quarter of 2017. So we're going to have the ability to lap those activities. We've been working to optimize throughout the year to improve our promotional effectiveness and reduce our spend while continuing to drive traffic. We've seen some pretty good results in the third and the fourth quarter there.
And then we've got some new tools really focused on price and promotional optimization that give us the ability to offset any inflation impacts that we're experiencing, primarily in the lumber and building materials space, while at the same time making sure that we remain competitive and minimize the spend to do so.
Value improvement is an ongoing initiative of us working closely with our vendor partners to make sure that we've got the most efficient and effective way to deliver value to our customers, moving all the way through our supply chain to the prices and promotions that we offer to close the sale. So I think the combination of all of those activities give me confidence that we'll deliver flat gross margin in 2018.
And just a quick follow-up on that, obviously, inventory has the potential to be a factor here. And inventory growing faster than a fairly healthy sales rate I know doesn't make any easier to drive gross margin improvement. So can you talk about your expectations for inventory growth relative to sales growth over the course of the year and whether working that down will require any measures that would impact gross margin as well?
Absolutely, Matt. This is Richard. I'll talk about some of the actions we're taking to manage inventory and then allow Mike if he wants to weigh in further with any estimated impact. But as noted in our guidance, we are going to focus on the improvement of our inventory management. We believe we've made the investments in the inventory in our system to support the strong sales growth we're seeing in categories such as appliances and tools.
Now the onus is on me as I get into the role to continue working with our teams to understand what changes in the flow of our supply chain, what changes in the interactions between our supply chain and our stores, and what changes in specifically having inventory in a shoppable position for customers when they come in to demand the purchase are necessary to continue to manage at roughly a flat to slightly up inventory that is less than our rate of sales growth during 2018.
Much appreciated, guys. Thank you.
Thanks, Matt.
Your next question comes from the line of Mike Baker with Deutsche Bank. Please go ahead.
Hi, guys. Wondering if you could tell us how you measure traffic and conversion and share some trends on that metric over the year.
Absolutely, Mike, this is Richard. We leverage video analytics and the tracking of the movement of customers into our stores and measure that up against the transactions that we are able to execute through our registers and the rest of our activities with customers.
So can you share some metrics on that? So you're saying traffic was up. Frankly, we don't see it in the data that you provide in terms of the number of transactions. So again, if you could help give us confidence in that metric, and then also what that would imply for conversion, how that has changed throughout the year.
Not at this time, Mike.
Okay, then I'll ask just one more quick follow-up. Marshall, you talked about CapEx going from $1.1 billion to $1.7 billion. Then you said 45% of that is on initiatives. Is that 45% of the incremental $600 million or 45% of the total $1.7 billion?
Sure, it's 45% of the total $1.5 billion. The 85% was reference to the proportion of the tax reform benefits that we're going to see in 2018.
Understood. So if it's 45% of the total, and then that's up 3x versus last year, and so the incremental CapEx accounts for most of that 85% of the tax reform...
Correct.
I guess then my question is, is there an SG&A component? Why would SG&A be down 30 basis points on a 3.5% or 4% comp or sales growth number where you'd otherwise expect that to be up with the typical leverage that you get?
With a lot of these programs and our initiatives, there are expense components to deliver some of the strategic initiatives that we do have going on in 2018. So that's just noted pressure that we would expect in SG&A.
Above and beyond the investment in CapEx from the tax reform?
There is a CapEx component and an expense component.
Understood. Okay, thank you.
Your next question comes from the line of Scot Ciccarelli with RBC Capital Markets. Please go ahead.
Good morning, guys. Have you made any changes in your terms with any of your vendors? I guess I'm trying to understand the payable-to-inventory ratio a little bit better.
No significant changes, part of this was just due to timing, comparing this year to last year. We're still looking at terms and where it makes sense to extend terms where we can. But it's all part of the balance that we have with our value improvement process and ongoing vendor negotiations. We do expect to improve that in 2018. But it was just really a matter of timing of some of the seasonal build and buy towards the end of the year.
So one of the things that I know that gets negotiated between vendors and retailers is some kind of pricing or gross margin targets, if you will, coupled with payment terms. Is there any change in the thought process regarding what is a more important aspect or metric to Lowe's?
Not at this point in time, we'll always factor in net-net what we think it's beneficial for us and beneficial for our ongoing relationships with the vendors.
Okay, got it. Thanks, guys.
Your next question comes from the line of Gregory Melich with MoffettNathanson. Please go ahead.
Hi. Thanks, guys. I just had two questions. One was on the reinvestment of the tax savings, just to make sure I got that right. It sounds like there's maybe 30 bps on the income statement, which would be about $200 million. And then a portion of the CapEx, of that increase from $1.1 billion to $1.7 billion, is because the tax reform has given you more money. But CapEx probably would have gone up at least several hundred million anyway. Is that a fair way to think about it?
Yes, first and foremost, as we think about our capital allocation philosophy is to first invest strategically in the business to maintain, run, and improve and enhance the business, so that is always going to be the first pillar. So one is we're reflecting on where we were in the marketplace, the initiatives we need to get underway. This provided a good backdrop to be able to enhance and ramp and accelerate our capital investment as we lean into 2018.
And so it sounds like of that $600 million increase in CapEx this year, a portion of it, maybe half of it, was related to the tax reform, and you would have been doing a lot of these things anyway, you're just accelerating things that were coming. Is that fair?
Correct, accelerating it. Actually, it was about 85% of the tax reform benefit that we're going to see in 2018 that is helping fuel the incremental CapEx. But yes, we would have accelerated the CapEx spend to get after our strategic initiatives.
Regardless, perfect. So then the second question is on RONA. I think, Robert, you had mentioned at the beginning that the integration is going well and doubling the profitability goal over the next four or five years is still there. Could you help us understand how much RONA improved or helped corporate margins last year in 2017, and what is in your guidance for this year in 2018 in terms of RONA improvement?
Like I said, things are going well at RONA. We're pleased with the performance from how it blends in from a margin standpoint, Marshall?
We should be cycling from a gross margin standpoint as we anniversary the acquisition. We did have, again, some minor cleanup that put some pressure in the fourth quarter. But we are on a good trajectory to doubling the profitability of RONA or Canada by 2021.
Got it. And then last, just to make sure I understand...
Greg, this is Richard. Not being too far removed from the old job yet, RONA was not a significant improvement to operating margin in 2017, nor was it planned to be. However, 2018 is when we begin to see more significant movement on the operating margin.
That's great to hear. And then last, gross margins flat this year, and on the sales standpoint, you guys think the first half stronger. It sounds like the SG&A investments won't really build until the second or third quarter.
It's just slightly higher in the first half. But from a capital expense standpoint, again, we are trying to accelerate our investments throughout the year.
And part of the sales is because we think about – we didn't have a strong spring last year. So we'd be cycling against slightly weaker numbers.
Right.
Got it. Thanks. Good luck, guys.
Thanks.
Thank you.
Regina, I think we have time for one more question.
Our final question will come from the line of Michael Lasser with UBS. Please go ahead.
Good morning, thanks a lot for taking my question. So arguably you made some investments over the last several quarters in areas like labor and promotions, and they produced somewhat mixed results. Now you're accelerating investments in different areas. But how do you ensure that you produce a suitable return that will be attractive to your P&L as you accelerate those investments?
I'll start, Michael. Certainly, you mentioned a couple of things, labor and promotions. I think from the promotional aspect, I think we have been pleased with the investments we've made, as I said, driving the traffic, the brand awareness, those type of things. Certainly, as we mentioned, we have challenges from a conversion standpoint that we're working on.
As Richard mentioned and he can further elaborate, we've made the investments in labor. Now it is going in and supplementing those investments that we've made to make sure we have the training, the tools, the other components that are necessary so that we have the associates in front of the customer when they are ready to buy. And, Richard, I'll let you...
Michael, all I would add to that is several of the things that we talked about, investing further in the back half of the year for nationwide rollouts we have had under test over the past several months or weeks to be able to get the early signs of success. And that really is the approach that we're going to take.
A great example is the pickup-in-the-store experience that's currently rolling out in Q1. We've actually had that and a team dedicated to that since last August testing it in a handful of stores, slowly going to a greater level of investment and iterating along the way to ensure that we're getting the maximum value of the investment we're going to make prior to going to a nationwide rollout.
In fact, the iteration that is going to currently roll out is the fourth iteration of that test already in the past six months in order to make sure that we're maximizing the return from all components, the physical space change, the training of the associates, the shift in the processes, the reengineering of how we do that, and the dedicated labor before we decided to take it to a nationwide rollout during the latter part of March and April.
And my follow-up...
I'm going to pile on with more comment. I just want to make it clear that the leadership team is aligned and focused on the areas that we've highlighted on the call. You think about stabilizing gross margin, improving conversion, improving inventory management, along with getting after it from the six strategic planks, so I think that's just something that I do want to reemphasize that we are working with a sense of urgency along all of those fronts.
My follow-up question is that I think we all appreciate your commentary you made around the longer-term guidance, and it was helpful. So if we assume sales remain where they are, flattish gross margin, can you give us a little sense of the operating leverage in the business now with all the different changes that are going on and all the different changes that have taken place over the last few years? It's become harder to understand where the leverage point of the business is, or in a normal run rate environment, how fast your expenses grow relative to the rate of your sales growth.
At this point in time, we're giving a high level of sales growing at least 4%, the total shareholder distributions, sticking to the $14 billion there, and then just really the improvement of operating margin from 2018 levels. We expect those to improve from where we're setting that target in 2018. That being said, we do plan on updating longer-term guidance when we get to our December investor and analyst conference.
And, Michael, I would just add on. As you think about: one, the investments that we're making in the business; two, some of the investments we made last year, as Richard has spoken, him and Michael working together, diving into the investments we've made, trying to figure out how can we get better performance out of those, and then ensuring as we're doing the test and learn before rollout that they're working on as we head into 2018.
Before we go out and commit to additional targets like that, we want to give time for them to be able to continue to dive into the business, understand the opportunities for improvement, and be in a position to really be prepared as we get to December to provide you longer-term guidance that we think we'll have great confidence in. And so at this point, we just don't want to get ahead of ourselves.
That makes sense. And if I could ask maybe more qualitatively, Robert, are you looking at all these investments and then the changes in the six pillars with a lens that you're looking to take the business to be more efficient and maybe produce more leverage over time as you do grow sales?
Absolutely, yes. We know that certainly we've got some investments we've got to make, as we talked about the supply chain investments we're making. We know that as the business has continued to move, consumer expectations have moved.
And so we've got investments we're making in our supply chain. Some of those will pay dividends in 2018. Some of them will be further into the future, but yes, absolutely. That's what we want to do is making sure that we're investing in the business, have the right people in front of the customer at the right time, supporting that with supply chain, supporting it with technology that we're getting greater leverage points to be able to drive improved operating margin in the future. That's what we're after, focused on diving into that in 2018 so that we can be in a good point to provide you exactly how we're going to get after it and how where it's going to be delivered when we get to our analyst conference in December.
Thank you so much.
Great, thanks, Michael. As always, thanks for your continued interest in Lowe's. We look forward to speaking with you again when we report our first quarter 2018 results on Wednesday, May 23. Have a great day.
Ladies and gentlemen, this concludes today's conference. Thank you all for joining, and you may now disconnect.