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Good day everyone and welcome Lowe’s Companies third quarter 2019 earnings conference call. This call is being recorded. Please note if you press star, one to enter the question queue prior to the start of today’s call, your signal did not register. You will need to press star, one again to enter the queue. Also, supplemental reference materials 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 materials include information about these measures and a reconciliation to the most directly comparable GAAP financial measures. Statements made during this call will include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Management’s expectations and opinions reflected in those statements are subject to risks, and the company can give no assurance that they will prove to be correct. Those risks are described in the company’s earnings release and in its filings with the Securities and Exchange Commission.
Hosting today’s conference will be Mr. Marvin Ellison, President and Chief Executive Officer; Mr. Bill Boltz, Executive Vice President, Merchandising; Mr. Joe McFarland, Executive Vice President, Stores; and Mr. Dave Denton, Chief Financial Officer.
I will now turn the program over to Mr. Ellison for opening remarks. Please go ahead, sir.
Good morning everyone. For the quarter, total company comp sales grew 2.2%. Our U.S. home improvement comp was 3% despite low single digit online growth and higher than expected lumber deflation. We saw consistent growth across the business with all three U.S. divisions and all 15 U.S. geographic regions generating positive comps for the second consecutive quarter. These results reflect our continued progress on our transformation plan.
Four of our top five performing geographic regions were in the western division, driven by strength in pro, appliances, outdoor project category, improved in-stocks, and customer service. In addition to the west, geographic regions that outperformed the total company comp in the quarter were Nashville, Boston, Tampa and Houston.
Commodity deflation exerted approximately 95 basis points of pressure on comp sales in the quarter; however, unit growth in impacted categories remains strong.
Let me now take a moment and discuss what drove our success in Q3. Let’s start with pro.
Our focus on the pro continues to be a catalyst for our U.S. sales growth, and during the quarter we continued to receive very positive customer feedback from pros experiencing firsthand what is new and different at Lowe’s, and we’re pleased with the pros’ willingness to grow their business with us. Our pro comp significantly outpaced DIY in the third quarter and the pro customer is responding very positively to our investments in job lot quantities, department supervisors, and our improved in-store experience. The result of these investments in pro not only delivered positive sales growth, they are also reflected in a 700 basis point improvement in our pro customer service scores in the third quarter.
Despite this early success, we are focused on the work ahead to better serve this very important customer, and later in the call Joe will detail some of the strategic investments we have planned for the pro customer in Q4 and in 2020.
In addition to the pro, our success focusing on retail fundamentals is also evident as we again drove strong sales performance in merchandising departments that have historically underperformed. In total, eight merchandising departments delivered positive comp performance above the company average, and Bill will add additional color on our merchandising performance shortly.
Turning to Canada, in the third quarter we posted negative comp sales below our expectations which exerted significant pressure on our total company comp. In the third quarter, we initiated a more detailed strategic review of our Canadian business inclusive of leadership changes, with a focus on improving execution and profitability.
As such, we plan to take the following steps beginning in Q4 to improve our long term results in Canada. We’re closing 34 underperforming stores and expect to substantially complete that process in Q4. Given that the Canadian business is operating five banners with multiple legacy systems, we’re undertaking a banner simplification process to reduce operational complexity and drive back office synergies.
As part of simplifying our operations, we plan to rationalize SKUs across the simplified banners to present a more coordinated assortment to our customers. Implementing a simplified banner strategy will allow us to gain efficiencies in marketing, supply chain and merchandising.
We’re also reorganizing our corporate support structure across Canada to more efficiently serve our stores and we plan to migrate Canada to the U.S. IT platform to eliminate inefficiencies and unnecessary technology duplication.
We’re committed to the Canadian market and we’re taking decisive actions to improve Canadian operations and provide a better customer experience while improving profitability through margin improvements and SG&A reduction. Dave will take you through the anticipated financial impacts of these actions in a moment.
Despite pressure from lower than expected comparable sales growth in Canada, we delivered adjusted diluted earnings per share of $1.41 for the quarter, which exceeded our expectations, supported by improved merchandise category management, enhanced process execution, and expense leverage. Later in the call, Dave will outline the steps we took in the third quarter to continue to improve our profitability.
During the third quarter, Lowes.com delivered comp growth of approximately 3% and as we noted last quarter, our ecommerce business is under repair and we are addressing legacy issues with the platform. Our first step in improving our online business is creating stability. To that end, we’re working diligently to improve the foundation of Lowes.com by re-platforming the entire site to Google Cloud from a decade-old platform. This work is critical to improving the stability of our ecosystem and increase our agility. We expect to have the entire Lowes.com site on the cloud in the first half of 2020.
With a modernized, stable architecture in place, we have the ability to provide our customers with basic online functionality and address legacy ecommerce capability gaps. Let me give you four examples of things we’re fixing while we’re temporarily slowing our dot-com growth.
First, we’re taking steps to separate freight from product costs to improve our price perception versus our competition. Second, we are improving our systems and processes to allow us to quickly add SKUs and drop-ship vendors to more rapidly expand our online assortment. These enhancements will reduce on-boarding time from months to days. Third, we’re building capabilities to ship certain SKUs requiring special handling, which will allow us to sell basic home improvement items like lithium ion batteries, cleaning supplies, and fire extinguishers online. Fourth, we’ll improve the customer experience on our website, including a dynamic home page, simplified search and navigation, the ability to schedule a product delivery, and one-click checkout. We know how to repair all of these capability gaps and we have a detailed road map combined with an exceptionally talented team with deep omnichannel experience. It will simply take time and proper sequencing. We expect to see our Lowes.com growth rate start to accelerate in the back half of 2020.
In the meantime, I am very pleased that we can deliver 3% U.S. comp in the third quarter with virtually no benefit from Lowes.com. This only speaks to the upside sales benefit we have in upcoming quarters when the ecommerce business is repaired.
Transforming our supply chain will also support acceleration of our growth as we look to build a true omnichannel ecosystem. We’re investing $1.7 billion to transform our supply chain over the next five years. Part of this transformation can be reflected in our opening of two new bulk distribution centers and three cross-dock terminals this year. This infrastructure improvement will be key to Lowes’ transitioning from a store-based home delivery model to a market-based model.
We believe our future is bright at Lowe’s and as we enter the fourth quarter, we expect to deliver strong top line performance. We plan to capitalize on robust consumer project demand and excitement for the holiday season with strong holiday event execution while driving margin improvement and operational efficiency.
Before I close, I’d like to take a moment to thank our associates for their continued hard work and commitment to the company. The best days of my week are when I’m out visiting stores and during these visits, I continue to be proud of the men and women that represent our company on a daily basis.
With that, I’ll turn the call over to Bill.
Thanks Marvin, and good morning everyone. We posted U.S. comparable sales growth of 3% in the third quarter as we continued to capitalize on robust customer demand which drove strong traffic to our stores, along with improved in-store execution which helped to convert that traffic into sales. We also had terrific execution over Labor Day which drove record sales within our best-in-class appliance offering during the event.
Turning to our merchandising department performance, we delivered above average comps in appliances, décor, hardware, lawn and garden, millwork, paint, rough plumbing and electrical, and tools. Lumber and building materials comps were positive but below the company average.
Paint, which had been a serial underperformer for us, outperformed the company average again this quarter. As we continue to refine our paint business, we will continue to work closely with our suppliers to introduce an improved pro paint offering to better serve the repair remodelers who need paint to complete a larger project, such as a kitchen or bathroom remodel. Previously our décor department had performed below the company average for 12 of the last 13 quarters; however, in Q3 for the second consecutive quarter, décor performed above the company average with mid-single digit comp growth led by strong double-digit comps in blinds and shades.
Millwork is another merchandising department which had historically underperformed. In Q3, for the second consecutive quarter, millwork performed above the company average. Our improved comp performance in these departments is a clear indication that the implementation of our retail fundamentals is gaining traction.
For the quarter, we also continued to drive strong comps in areas of historical strength for Lowe’s. Tools led the merchandising department growth with a continued strong customer response to our Craftsman reset. We are proud to be the exclusive destination in the home center channel for this iconic brand, which continues to drive market share gains within key tool categories. We also continue to drive sales with our key programs, such as DeWalt, the number one power tool brand in the industry. During the quarter, we launched an exclusive line of DeWalt 12-volt compact tools which focus on delivering more power in a smaller and lighter weight tool. In addition, we introduced new and innovative products from Bosch, Spider, and Metabo HPT as we continue to introduce new and innovative products in our exclusive Cobalt line of tools.
In appliances, we delivered solid mid-single digit comps and further increased our market share with record sales during Labor Day, and drove high single-digit comps in refrigerators and freezers with great values and special buys. We also posted above-average comps in hardware with double-digit growth coming from our fastener categories supported by investments in job lot quantities and the full roll-out of GRK, Power Pro One, and FastenMaster, which drove pro demand.
Lastly, we again delivered comps above the company average in lawn and garden with double-digit comps in live goods and landscape products, benefiting from an improved in-stock position and the extended growing season. Within our seasonal and outdoor living business, we are excited about the announcement of our national home center launch with Yeti, a leader in coolers, equipment and drink ware. The Yeti brand along with the expanded product offering highlights our commitment to providing our customers with relevant, innovative best-in-class products.
As part of our ongoing effort to further drive merchandising productivity, we are continuing to implement a category management process and are taking aggressive steps to improve our cross-merchandising efforts and adjacencies in our stores. We are optimizing our store layout to ensure that products typically used together to complete a project are located in the same aisle to make it easier for the customer to efficiently shop their whole project.
Looking ahead to Q4, we are very excited about our plans for the upcoming holiday season, driven by strong Black Friday and Cyber Monday events along with a compelling tool gift center. We will continue to highlight our best-in-class appliance offerings and showcase strong values and special buys and the most sought after brands in home improvement products this holiday season with exciting values such as select buy one, get one deals across DeWalt, Cobalt, Bosch and Craftsman, and the opportunity to receive a Lowe’s gift card when buying two or more select major appliances. We’ll showcase great gift ideas across the store, including great values for both the DIY and pro customer.
We are also excited to be one of the first retailers to introduce the new Weber smoke fire pellet grill on Lowes.com as part of the pre-order product launch on Cyber Monday. Weber’s pellet grill is their initial entry into this fast growing category and is built to let grill users discover what’s possible with pellet grilling. We are proud to partner with Weber to introduce this exciting new product.
This Black Friday, we plan to leverage our NFL partnership, turning holiday shopping into a chance to win the experience of a lifetime at Super Bowl 54. As the official home improvement sponsor of the NFL, this year on Black Friday each U.S. Lowe’s store is offering its first 300 in-store customers the chance to enter to win two tickets to Super Bowl 54 in Miami.
As we look to close out the year strong, we remain focused on retail fundamentals and driving sales and margin productivity by continuing our focus on the pro, leveraging the strong customer response to Craftsman, enhancing our space productivity improvements, and expanding our brand message with our exclusive NFL partnership. Overall, we see significant upside from the initiatives that are underway and we are confident that we are building the foundation to provide home improvement solutions that will continue to drive sales and grow our market share.
Thank you, and now I’ll turn the call over to Joe.
Thanks Bill, and good morning everyone. Our initiatives to improve in-stock levels and provide a better customer service experience, along with our advances in serving the pro customer, contributed to our strong U.S. execution in the quarter. We continue to build upon the actions we’ve taken throughout the year to further improve associate engagement and simplify our store operations and saw compounding benefits from our work to date.
Earlier this year, we deployed new mobile devices for our stores associates, called smartphones. The smartphone empowers our associated by giving them access to real time data without having to step off the sales floor to access a terminal. Throughout the year, we’ve added functionality to the devices such as standard performance scorecards and a store walk application to drive a more efficient strategic store review process. These applications allow our store managers to optimize their store performance by evaluating productivity by department and by associate.
In the third quarter, we continue to add new applications to our smart devices. During the quarter, we added a new pricing application that allows associates to update prices in the aisles and standardizes and simplifies the price update process, such that any associate in our store can do it. The pricing application has already driven efficiencies of over 36,000 associate hours per week for the company. We’ll complement this pricing application with new mobile printers which will allow associates to print new price labels in the aisle, creating a complete mobile pricing solution. In this test, the mobile printing process has driven an additional two hours of efficiency per store per day, which will equate to efficiency of over 24,000 associate hours per week for the company. We plan to roll out mobile printing to the company in the first quarter of 2020.
Our smart devices are a significant step towards driving operational productivity in our stores and allowing our associates to spend more time with the customer and less time on tasking. Near the end of the quarter, we completed the national roll-out of our new customer scheduling system which better predicts customer demand by time of day, day of week, and department, allowing us to align our labor hours with peak traffic. Our new labor scheduling system allows us to provide better department coverage and customer service while ensuring that we’re using our labor hours efficiently and reducing payroll expense.
We also expanded our new One Task team to over 1,000 stores in the quarter. This initiative shifts task work from our selling associates to one centralized team that is responsible for completing non-selling tasks during evenings and overnight hours. This centralized team will drive more consistent tasking execution, streamline non-customer facing payroll, and allow for improved cross-training programs.
Our investments in store process and technology paid off in the third quarter. This is evidence by our ability to leverage store payroll expense again this quarter while driving an increase of 500 basis points on our overall customer service scores. We will continue to deliver on our commitment to improve both store efficiency and customer experience, and we are very pleased with the results we are seeing so far. In fact, a recent Newsweek survey measuring customer service in home improvement recognized Lowe’s as number one among big box home improvement retailers. This is one more example of the way our customers are recognizing our improved commitment to customer service in our stores.
Now moving onto our pro business, as Marvin indicated, we were very pleased with our pro performance in Q3 and the customers’ willingness to grow their business with us despite a noticeable increase in competitive promotions. As I have discussed on previous calls this year, our pro strategy has been focused primarily on improving retail fundamentals for this very important customer. We have demonstrated a consistent focus on winning the pro by executing on basic fundamentals like job lot quantities, improved service levels, dedicated loaders, pro department supervisors, and consistent volume pricing. Our commitment to retail fundamentals and continued focus drove significant improvement in the pro customer service scores and pro comps, which significantly outperformed DIY comps. Once again this quarter, we invited customers in to see our improved experience with another successful Pro Appreciation event.
Although we are pleased with pro performance in Q3, we are now transitioning from retail fundamentals to more strategic initiatives. Our goal is simple - we want to deepen our relationship and continue to grow our sales with this very important customer. In keeping with this more strategic approach, this quarter we launched a pilot for our pro loyalty program. Our early results have exceeded our expectations in our test markets. We plan to launch our pro loyalty program nationally in the first half of 2020 integrated with a CRM program which will allow us to deploy more surgical, strategic marketing to the pro and grow our share of wallet through improved account management and suggested selling. I look forward to updating you on our pro loyalty launch on future calls.
In the fourth quarter, we plan to improve the in-store pro experience with the roll-out of dedicated point of sale terminals at the pro desk to allow for more convenient, faster service. Believe it or not, today most of our stores have no way for a pro to purchase product at our pro desk. We’ll solve this problem in Q4.
We’re also very excited for our first dedicated Black November event for the pro with compelling offers to drive pro traffic. All of these pro-related initiatives reinforce the renewed importance of the pro customer at Lowe’s.
Thank you, and I will now turn the call over to Dave.
Thank you Joe, and good morning everyone. Before I review the underlying operating performance of the business, let me briefly discuss the pre-tax charges taken during the quarter and, importantly, our go-forward expectations related to the Canadian business.
As Marvin outlined, we are taking decisive actions to set our Canadian business up for both long-term growth and improved profitability. As part of our strategic review, we evaluated certain assets for impairment which resulted in $53 million of non-cash pre-tax charges in the third quarter. In the fourth quarter, we plan to substantially complete the closing of 34 stores, liquidating the inventory in those locations and rationalizing the inventory in our remaining Canadian locations to support our banner simplification strategy. As a result of these actions, we expect to incur additional pre-tax operating cost and charges of between $175 million to $225 million in Q4 related to the Canadian restructuring. These charges will consist of inventory liquidation, accelerated depreciation and amortization, severance and other costs. These anticipated Q4 financial impacts are reflected in our 2019 GAAP business outlook and are excluded from our 2019 adjusted business outlook.
I’ll now turn to a review of our ongoing capital allocation program. In the first nine months of 2019, we generated approximately $3.2 billion in free cash flow and through a combination of both dividends and share repurchases, we’ve returned over $4.8 billion to our shareholders. In the third quarter alone, we paid $428 million in dividends and our dividend payout ratio currently stands at 36% over the trailing four quarters.
In Q3, we entered into a $397 million accelerated share repurchase agreement, retiring approximately 3.6 million shares. We also repurchased an additional 4.1 million shares in the open market for $438 million. This brings our year-to-date share repurchases to $3.6 billion with a plan to repurchase $4 billion for the year. We have approximately $10.3 billion remaining on our current share repurchase authorization.
We continue to invest in our core business with a focus on developing capabilities designed to drive long-term shareholder value. In Q3, we had capital expenditures of just over $400 million.
Now turning to the income statement, during Q3 we generated GAAP diluted earnings per share of $1.36. My comments from this point forward will be on a comparable non-GAAP basis, where applicable.
In Q3, we delivered adjusted diluted earnings per share of $1.41, an increase of 36% compared to adjusted diluted earnings per share of last year. This solid performance exceeded expectations in large part due to improving gross margin trends, strong expense management, and a favorable tax rate.
Sales for the third quarter decreased 0.2% to $17.4 billion as comparable sales growth was offset by the impact of previous store closures and the exit of Orchard Supply Hardware. Total average ticket grew 3.6% to $78.71. This was partially offset by a 3.7% decline in total transactions.
Consolidated comp sales were 2.2% driven by an average ticket increase of 2.4% partially offset by a slight comp transaction decrease of 0.1%. In the U.S., U.S. comp sales growth was 3% driven by an average ticket increase of 2.7% and a comp transaction increase of 0.2%. Now looking at monthly trends, total comps were 2.8% in August, 2% in September, and 2% in October. Additionally, monthly comps for our U.S. business were 3.6% in August, 2.7% in September, and 2.7% in October.
Adjusted gross margin for the third quarter was 32.4% of sales, an increase of 153 basis points from Q3 of last year and 94 basis points better than Q1. The improvement since the first quarter reflects the benefits from the actions we’ve taken, including retail price adjustments that had minimal impact to units, a pivot to more strategic and targeted promotions, greater vendor partnership for key promotional activities, and a continued aggressive product cost management. We’re very pleased with the progress we’ve made to improve our gross margin performance. The actions we’ve implemented are gaining traction, but there is additional work to be done in this important are for the balance of this year.
This quarter, we experienced approximately 90 basis points of rate improvement. The positive impact of cycling our inventory rationalization event from last year was partially offset by 40 basis points of tariff pressure. As expected, we also experienced approximately 20 basis points of pressure from supply chain costs. We’ve added new facilities to the network that are still ramping to full capacity, coupled with ongoing increases in customer delivery costs. Inventory shrink exerted approximately 20 basis points of negative pressure on gross margin for the quarter. Finally, product mix shifts had a 35 basis point positive impact on gross margin in Q3.
Adjusted SG&A for Q3 was 21.4% of sales, which levered 53 basis points. We drove approximately 40 basis points of leverage in payroll in the quarter and approximately 10 basis points of leverage through improved advertising efficiencies.
Adjusted operating income increased 215 basis points to 9.3% of sales. The effective tax rate was 24% compared to 21.8% last year. At $13.7 billion, inventory increased $1.4 billion or 10.9% versus the third quarter of last year but is down $1.3 billion versus Q1. This increase was driven by strategic investments in the first half of the year to drive sales, such as an earlier seasonal load-in, the Craftsman resets, increased presentation minimums, and investment in job lot quantities for the pro. Throughout 2020, we will refine our in-stock expectations and begin to strategically reduce inventories in certain areas while protecting our in-stock position, sales and gross margin.
Now before I close, let me address our 2019 business outlook. As we’ve stated previously and as our analysis supports, the underlying macroeconomic fundamentals in the U.S. remain supportive as the solid pace of job growth, accelerating wage increases, and home price appreciation continue to be tailwinds for our industry. We are maintaining our sales guidance for 2019 and expect a total sales increase of approximately 2% for the year. Comp sales are expected to increase approximately 3%.
Given our strong financial performance in Q3 and our solid outlook for the remainder of this year, we are raising our 2019 adjusted operating margin and adjusted EPS guidance. We now expect adjusted diluted earnings per share of $5.63 to $5.70 per share, and we expect adjusted operating margin to increase 40 to 60 basis points versus last year. This revised outlook includes approximately $20 million to $30 million of incremental investments in our existing store environment. This $0.02 to $0.03 EPS investment will allow us to accelerate key reset projects during the fourth quarter to improve sales and space productivity over the long term without disrupting the stores during the critical spring season.
Our business outlook also includes the impact of both Wave 3 and Wave 4 tariffs. The effective tax rate and adjusted effective tax rates are still expected to be approximately 24%, and we are forecasting operating cash flows of approximately $4.5 billion and capital expenditures of approximately $1.6 billion. This is expected to result in free cash flow of approximately $3 billion for 2019.
Our target leverage ratio remains at 2.75 times and our guidance assumes that we will complete approximately $4 billion in share repurchases for this year.
In closing, we remain excited about the future of the company and its ability to deliver significant shareholder value over the long term.
Operator, we are now ready for questions.
[Operator instructions]
Our first question comes from the line of Christopher Horvers with JPMorgan. Please proceed with your question.
Thanks, good morning guys. Can you talk about the gross margin? Obviously some nice rate upside there. How much did the pricing pressures that you saw earlier in the year impact the third quarter gross margin? It doesn’t seem like it did besides the tariffs. How are you thinking about 4Q for gross margin? I think previously you said flat. I think the big question that we get from investors is, longer term, how do you think about getting back to that high 32, maybe 33% rate especially as you lap through the pricing pressures in ’20?
Hey Chris, this is Marvin. I’ll take the first part of that, then I’ll let Dave and Bill add any additional color to your additional questions.
Look, we feel really good about margin improvement. We talked a lot about the issues that impacted Q1 and we went through a lot of detail after Q1 providing the steps we were taking to recover margin and just to create better visibility and better processes. That’s been a cross-functional effort and we actually are pleased with the results, but there is a lot more work to do.
One of the key things that we’re going to be launching before the end of this year is a new price management system. This will be for the very first time that Lowe’s will have a consolidated depository of one view of all things across retail pricing and the impacts of those changes, and that’s going to be something we’re going to put in place later this year. We feel good about the trajectory, but I’d just remind you as we think about out years and we think about operating income, our real focus is going to be around trying to keep margins relatively flat and creating SG&A benefit in the future, and that’s going to be the driver of our operating income growth in out years.
I’ll let Dave provide more color to that, and Bill, any additional insights as well.
Yes, I think as Marvin indicated, obviously it’s been a team sport here working cross-functionally between finance and merchandising, making sure that, one, we understand the cost complement of the products that we’re buying; two, that we’re analyzing those effectively and, I’ll say, working with our vendors to maximize the performance from either a value engineering perspective or from a cost complement perspective to drive our costs lower over time. Collectively, we’ve also been partnering with our vendors very aggressively to make sure that we develop win-win scenarios that both drive the top line but also improve our margin performance in the near term.
Finally, I think one thing that’s really come to life has been the store. We’ve made some very significant enhancements from a technology perspective at point of sale which have allowed us to be more effective in the promotions that we offer at point of sale, thus improving our margin rate on those items.
I think, Dave, the only thing I would add to that is that in addition to that, I have mentioned in my opening remarks around merchandising adjacencies and putting products together through a cross-merchandising program that Joe and I rolled out at the latter part of Q3 that’s now up and running in all of our stores, and that certainly helps in addition to the promotional planning process that we put in place, starting with Q2, that really puts more focused offers out there in front of the customer and less of these category-wide type offers that we’ve run historically.
So then as a follow-up, do you still expect gross margin rate flattish to 31.5% last year, and can you also talk about on the ecommerce front, is that a transaction growth headwind, because transactions were up in the U.S. but it was sort of an easier compare, so any thoughts there as well. Thanks very much.
Yes, so on the dot-com question, Chris, the short answer is yes, it did have a negative impact on overall transactions. We were very transparent last quarter that we have this business under repair. The good news is we have a very talented, very experienced team that have solved these problems before, it just takes time and sequencing, but in the short run, it did put some pressure on our transactions. We feel really good about our performance in our U.S. stores, and as I noted in my prepared comments, we drove a 3% U.S. comp with no benefit from dot-com. If you just take a 15% to 20% dot-com growth for us, that puts that comp number north of 4% in the U.S. We noted that benefit is coming in the future, but in the short run we’ve got to kind of muscle through it. But we have a really good road map and a good plan in place, and we think that we’ll be able to get this business growing again in the second half of next year.
I’ll let Dave talk about the margin rate question.
Yes Chris, obviously our objective is to recover from our gross margin downdraft in Q1, and I think we’re making really nice progress against that. It was not our expectation that we could fully recover that here in 2019, but it’s our expectation over the longer term to recover that downdraft that we experienced in Q1 and get back to a more stable environment in the long term.
Understood. Have a great holiday.
Thank you.
Thank you. Our next question comes from the line of Simeon Gutman of Morgan Stanley. Please proceed with your questions.
Thanks, good morning everyone. You’re modeling sequential improvement in the comps in the fourth quarter. Can you discuss the puts and takes into that forecast? Then related, the EPS, it’s a little bit below--the implied is a little below the street. Can you clarify, is that the incremental store investment and how does it compare to some of the underlying results of the business for the fourth quarter?
Simeon, this is Marvin. I’ll take the question regarding Q4. As we’ve said, we feel really good about the overall business trends in the U.S. We feel great about our internal execution. Dave talked about the macro backdrop is solid. We look at discretionary purchases, things like average ticket above $500 was over 4% growth for us in the quarter. Consumer project demand is strong, and there is excitement relative to the holiday season.
What I’m going to do is let Bill just provide a couple of key highlights on the merchandising side that gives us confidence in Q4. I’ll let Joe also cover a couple of things in the store that also provides us with a degree of confidence we’re going to be able to achieve our targeted sales number.
Bill?
Yes, I think the piece for us for Q4 is the team has now had a full year to plan for Q4, so we’ve demonstrated throughout the entire year categories that have changed the trajectory from where they were a year ago, being able to plan for trimming tree and to be able to plan for the gift center and to be able to plan for these pro deals that we’ve put out there for Black November are all different from what we did a year ago, and we’re seeing that pay off as it relates to change in direction in some of these key pro-related businesses, as well as DIY.
Right, and then from a store standpoint, we’re really excited about what’s happening inside our pro business. We continue into Q4 in that, we’re excited about the pro loyalty launch we have going, we’re excited that as we continue to invite our pro customers in, we’re enjoying more share of their wallet. Improved store execution, store layout, I think we feel really confident in what we’re doing for Q4.
And then Simeon, just from a guide perspective, let me just kind of step back and just walk you through what we’ve done. We’ve essentially taken the bottom of the range up $0.13 and the midpoint up $0.07 from a year perspective. Keep in mind that that includes $0.02 to $0.03 that we’re investing in Q4 to improve our performance from a long term perspective. I think this is a really constructive investment that we’re making, that we identified late in the quarter, that we’re incrementally investing in our store environment both for the long term but at the same time managing the near term financial objectives that we have as a company.
Okay. My follow-up is for Marvin. You’ve been in the seat now for over a year, some ups, some downs. It seems like the skeletons should be out of the closet by now. You still have a few things executing in stores - labor scheduling, it sounds like there’s new pro systems, so is that a fair statement and does anything in your mind change about the potential margin upside? How do you think about it and the pace of margin over the next few years?
I think when I look back at our initial assessment of the business, I would say the only thing that we probably underestimated the level of complexity was the ecommerce business. When we did our analyst and investor conference last December, we did not have our new online president on board, so although we spent a lot of time dissecting the business across multiple channels, the ecommerce business was still a little bit of a mystery for us, and that mystery unveiled itself during the holiday season when we had all the issues, and we’ve been digging ever since then.
So yes, there’s been ups and downs, but we were very clear that this is a transformation. We didn’t make any bones about the fact that this is a company that had great potential but it had underinvested in supply chain, IT, and also leadership development. If I had to take a snapshot of how I feel about where we are, I think we are right on track, where we hoped to be, and that is taking into account there’s been a lot of uncertainty in the marketplace, like tariffs. That’s one that we did not anticipate, that we’ve been managing as best we can.
Overall, I feel great. I think that we have identified most of the, quote-unquote, surprises because we’ve spent a lot of time really digging deep into the areas of the business that carry the most financial risk and the most financial benefit, and we feel like we’ve got a really good plan heading into the fourth quarter and 2020.
Thanks Marvin.
Thank you. Our next question comes from the line of Karen Short with Barclays. Please proceed with your question.
Hi, thanks very much. I was actually wondering if you could give a little bit more color on how the dot-com business impacted the U.S. comp, and then looking to 4Q, wondering if you could give a little color on how the total comp will be impacted by Canada, because obviously these closed doors we’ll be left--you won’t have that headwind in the U.S. comp versus the total comp, so any color on both of those would be great.
Karen, I’ll take the dot-com question. I’ll let Dave take Canada. If you think about the impact of dot-com to our business, it was basically a neutral impact. We grew dot-com by 3% for the quarter; we grew U.S. sales by 3%, so there was really no benefit. I would argue that there’s not a brick-and-mortar retail in the U.S. that is our size that had such limited growth in the dot-com business. Most U.S. retailers that announce their comp growth for the quarter typically will have a dot-com number that’s starts with a 20% growth, which is typical in this day and age. We’re not there yet, but we know how to get there, and we’re trying to take the right steps to fix the root cause of the issue.
It’s not difficult to grow dot-com sales, it’s difficult to do it correctly, meaning make money, so rather than having a bunch of non-productive promotions and other coupon-y events, we shut that down and we basically said, how do we structure this business in the right way? We have a really good road map in place and I wanted to be really transparent in my prepared comments just to highlight some of the fundamental things we currently don’t have in place, that we will have in place in the second half of next year.
But I see it as the glass half full. Again, our store productivity is strong. Any time you can deliver a 3% comp off the total benefit of your brick and mortar stores in this day and age is a very positive sign, but getting our dot-com and our omnichannel business going is a huge priority and we think we can get that going as we enter into 2020.
I’ll let Dave talk about Canada.
Karen, as it relates to stores that will be closed in Canada, they will be considered non-comps so they will not affect the comp cadence for Q4 for the company. I also just want to clarify, as you look at Q3, the $53 million non-cash charge that we took was exclusively within SG&A within our GAAP numbers.
Okay. Just a follow-up, in terms of other initiatives as we look to 2020, obviously you talked about the price management system in 4Q, but can you give us an update on some other big initiatives that we should be watching for in early 2020? I think the POS upgrade is still going to be happening, but just so we can track anything that we may need to be on the outlook for if there are any risks on execution.
Yes, so I’ll talk about one and I’ll let Joe give you some thoughts on some really exciting initiatives in pro, and I think Bill has a couple really nice merchandising initiatives we’re excited about.
When we think about our supply chain transformation, I mentioned in my comments that we have a $1.7 billion investment over five years we’re committing to supply chain, and that is to totally transform our supply chain from a distribution network design to get product from suppliers to stores, from suppliers to distribution centers, etc. to being more of an omnichannel center that’s going to allow us to go from store-based delivery to market-based delivery. We’re opening two new bulk distribution centers this year and three cross-dock terminals, which is really the foundational steps to helping us to build out the supply chain transformation. This will be significant for us because it’s going to take enormous pressure off the stores from being the hub for all things delivery, but it’s also going to give us the ability to deliver to customers’ homes and pros’ job sites with the same efficiency that we deliver to a store. That is something that we are going to be constantly rolling out throughout the year and we’re excited about that.
Relative to the price management system, we’ll get that system in place by the end of this year, but then next year in the first half, we’re going to integrate in that system, the boomerang retail analytics will be combined with that price management system. That’s going to give us for the first time the machine learning and AI functionality around pricing and around scraping so that we can be a lot more dynamic.
The only other initiative I’ll mention is that in the first half of next year, we should be fully on Google Cloud with our ecommerce platform, and again we’re moving from a decade-old platform to Cloud, which is something that’s going to give us much more agility.
I’ll let Joe and Bill add any additional color.
Great, so we’ve talked a lot in the past about our pro focus, and really throughout all of 2019. We’ve really focused on the retail fundamentals, which we’ve talked about, things like pro staffing, things like dedicated loaders, job lot quantities, etc., and so we feel in 2019 we have largely made great impact there. As we move forward into next year, we’re really excited, number, one, for the pro loyalty test that we launched in three markets in the third quarter. The pros’ reaction to the pro loyalty has really exceeded all expectations we’ve had for it, and we continue to listen to the pros, we continue to make adjustments, that’s why we’re in test mode, and we’re excited that we’ll fully roll out pro loyalty nationwide in the first half of 2020.
In addition, things like tool rental, we feel really good about testing the waters there. In the pro business, that pro continues to give us more share of their wallet, and so really exciting in the pro space.
I’ll let Bill talk about some of the merchandising.
Just to close on the merchandising side, in addition to the cross-merchandising work that we’re wrapping up, and we wrapped up in Q3, we’ll finish up at the end of Q4 and January-February the wave minding signage roll-out in our stores, which allows the customer to navigate our stores easier. We’ll also finish the refresh work that we started early last year, which will allow us to bring product categories and departments together to make it easier for the customer to shop and to give us the kind of holding power on our end caps and in our departments that we need bringing categories together. So real excited about all the work that the merchants have done to make our stores easier to shop.
Great, thanks very much.
Thank you. Our next question comes from the line of Steve Forbes with Guggenheim Securities. Please proceed with your question.
Good morning. I wanted to focus on payroll leverage, given the commentary around the completion of the labor scheduling system rollout. Maybe just remind us how that phased in throughout the year, how many regions were live in the first half relative to the end of the third quarter, and then maybe discuss the expectations regarding payroll leverage in the fourth quarter and into 2020, because it would seem to appear there’s sort of a chance or a potential for payroll leverage to at least remain at the current run rat as we look out to 2020, so would just like to get your thoughts and updates on that.
Steve, this is Marvin. I’ll kick it off and then I’ll let Joe provide some additional insight. I think as you look at the out years, it’s just a very basic philosophy, and what we’re trying to do is we’re trying to shift payroll from tasks to service in the stores. Our first analysis when Joe arrived and starting looking at the business is that we had a vast majority of our payroll in the store was doing something other than serving customers or driving sales, and so Joe’s team built out a three-year project plan to shift that to be a more service oriented store environment. The way you do that is with technology, and so what you’re going to see in the out years is the investment in technology, a reduction in total hours but in an addition of selling hours, and that’s one of the reasons why Joe gave this really interesting statistic that in third quarter, we leveraged payroll but we improved service across all categories - pro, do-it-yourself customers, and all types of surveys, internal and external. That gives us a really good, comfortable feeling that the technology implementations are working and that we’re putting the payroll in the right location.
That’s the out years. I’ll let Joe talk about what we’ve done so far this year.
I’ll give you a quick snapshot just for the third quarter, and I mentioned some of the things in my prepared remarks. As Marvin said, when we first arrived and evaluated the percent of payroll being spent on service versus task, it was completely inverted, so we’ve assembled a terrific team in our store operations group, we’re ahead of schedule as far as moving the needle to more of a balance of customer facing versus tasking. Just in the third quarter alone, we talked about the new scheduling system, so I remind you the first quarter this year we rolled out to one region the customer-centric schedule to make sure we listened to the associates and validated the customers, and to make sure that the changes we were making were beneficial. In the second quarter, we launched that to three additional regions across our northern division, more seasonal, and we wanted to kind of pressure test our spring and our hiring. In the third quarter, we have successfully rolled this out to every region. One hundred percent of the stores in the U.S. are on customer-centric scheduling as of the first day of the fourth quarter.
In addition, in the third quarter we took action on things like our One Task team. We expanded the One Task team centralizing tasks in just over 1,000 stores. In addition, e took action on things like our in-store assembler moving to third party, outsourcing our janitor, our new pricing apps, so there’s a laundry list of initiatives that we continue to execute against, and at the end of the day making sure that we’re doing the things that the customers expect and notice and that the associates appreciate.
Thank you. Maybe just a quick follow-up for Dave for modeling purposes here. If you can, provide a little more detail around the breakdown of that $175 million to $225 million of cost into the various buckets - I don’t know if you can split it between gross margin and SG&A at least, or the three buckets that you mentioned.
Yes, I will come back at the end of the year, the end of the quarter and give a detailed reconciliation of that, so you’ll be able to have that from a modeling perspective. Keep in mind that all of this is non-GAAP. I would look at this, certainly within Q4, I would say over 50% of those costs are due to inventory liquidation and therefore they would fit within the gross margin level versus the remainder at the SG&A level. That’s probably the best way to think about it.
Thank you.
Thank you. Your next question comes from the line of Seth Sigman with Credit Suisse. Please proceed with your question.
Hey guys, good morning. I wanted to follow up on the cadence of the quarter and whether there were any seasonal elements to call out. Obviously you were lapping hurricanes, I don’t know if the extended season was a good guy and offset that. I also think there was a shift in the start of Black Friday, so anything you would call out there and in general how you feel about exiting the quarter?
Yes, this is Dave. We feel very solid about our plans for Q4 from a sales perspective. There was a little bit of weather benefit as we cycled into Q3, probably in the neighborhood of 50 basis points. We also did run Black Friday week one week earlier, so I think that’s very nominal, probably 10 basis point impact on us. As we cycle into Q4, that would give you some confidence that we cycle into Q4 the sales improvement from a comparison perspective looks pretty good.
Okay, thanks for that. Then just in terms of the restructuring in Canada, can you just help us better understand what wasn’t working there, and then if there’s a way to quantify the drag that Canada has had on margins this year or over the course of a 12-month period, just so we could sort of understand the opportunity into next year, I think that would be helpful. Thanks.
Maybe I’ll start. As you can well imagine, just given the performance that we’ve articulated over the first three quarters of this year, the Canadian business from a top line perspective has struggled. It’s important to also understand in the model that it is performing from an operating profit perspective below the company average, so it certainly is dragging us down and certainly dragging us down more if you were to include the charges, so even without the charges the performance is lower than the company average.
With that, I’ll turn it to Marvin.
Yes, look Seth, the only thing I will add is we have great associates in Canada. We just gave them a very complex business model that inhibited their ability to serve customers well. We’re operating five banners all with legacy systems, all with different back end systems, and our initial integration process was wholly complex. It made it very difficult to create synergies from a marketing, merchandising, sourcing perspective, and even in IT systems infrastructure, so part of what we’re doing here in addition to closing underperforming stores is ensure that we are just simplifying the business model so we can give the customers a great experience and give our associates a more simplified operational process to manage. We think the decisions that we announced today are going to put us in a really good position to do just that, so we look forward to coming back in our February call to provide some degree of color around 2020 and our expectations in Canada, and how we think these restructuring actions that we announced today are going to really put us in a position for long term growth.
Okay, thanks guys, appreciate it.
Thank you. Our next question comes from the line of Greg Melich with Evercore ISI. Please proceed with your questions.
Hi, thanks guys. I had two questions. I just wanted to follow up on the progress on gross margin. I understand it’s improved sequentially from the first quarter, but Dave, I want to make sure I get the numbers right. If last year, the baseline gross margin was 32.9% and this year we’re down 40 or 50 BPs on a like-for-like once you add back last year’s inventory charge, are we thinking about that right?
Yes, so maybe I’ll give you a few numbers to help you model this out. If you looked at our gross margin performance, we had improvements of about 150 some-odd basis points We’ve overlapping the clearance event from last year, which gives us kind of a tailwind, if you will, of about 170 basis points. We then have pressure from both tariffs at 40 basis points, supply chain at 20, and shrink at 20, so if think about it, we have 90 basis point improvement just in gross margin rate, then you add on top of that improvements from a product mix perspective.
Got it, that’s super helpful. Then maybe just to follow up on Canada a bit, if we think about the charges in total, the $250 million, what do you guys expect the payback for that to be? Do we get that back in terms of profit in the next 12 months, does it take three years? How quick do these changes really take effect on the business?
Well, obviously these changes are going to take effect pretty quickly, but the way we’ve modeled this is clearly over a multiple year period, of which we looked at the cash flows of the business and net present value of that. Obviously this is a tough decision to make but it’s the right decision to make economically, and we look at that over a multi-year period.
Last and just transitioning to the business a bit, I want to make sure I got the guidance right on the comp. Understanding that the Canadian stores come out of the comp, if I use the full-year guide where it is, the fourth quarter comp should accelerate to about 4% or 3.5 or 4 to make up--am I missing something there, or is that the sort of trend that you’re seeing so far into November?
No, your math is correct.
And are we in November running at that kind of rate?
We’re about to approach one of our biggest weeks in the year, quite frankly, as we’re into Black Friday, so it’s probably a little too early to comment on the quarter. I will say that we feel very strongly about the programs we have in place and the things that we’re executing at store level to drive our performance.
That’s great. Good luck, guys, and happy holidays.
Thank you, same to you.
Thank you. Our next question comes from the line of Michael Lasser with UBS. Please proceed with your question.
Good morning, thanks a lot for taking my question. If we triangulate your progress in a couple of ways, one, looking at the U.S.-only stack on a two, three, four-year basis, they did decelerate from the second quarter to the third quarter; and if we look at the spread in your U.S.-only business compared to your biggest competitor, it did reverse this quarter, recognizing that a big piece of that is the performance of the respective dot-com businesses. Why do you think on those measures the business did take a bit of a step back this quarter versus last quarter?
Michael, it’s a fair question. My only answer is that we feel really good about our U.S. business, and to be quite honest, we don’t spend a ton of time thinking about our performance versus our competitor, versus our performance versus our internal expectations. Relative to our expectations, we were where we thought we should be based on the business investments, based on year-over-year overlaps. Remember, Q3 for us last year was a really interesting quarter. We took a lot of actions around store closures, inventory liquidations, and so the year-over-year compares are really tricky. So we appropriately planned the business for Q3 at a certain level, and in the U.S. we feel really good about exactly where we landed, and as we mentioned, we actually exceeded our expectations relative to operating income.
We feel good about the business, we feel good about our trends, and we have a repair plan to fix dot-com. We’re not trying to rush a quick fix. We’re going to fit it foundationally and we think that’s going to give us long term growth potential, and we feel good about the steps we’ve taken to end the year strong as well.
My follow-up, Marvin, is in the prepared remarks, there was a comment that customers will--the pro customers’ willingness to grow their business us despite a noticeable increase in competitive promotion. Can you provide more detail on that? Who and where are you seeing those higher promotions from, and is there a case where as Lowe’s becomes more successful and as Lowe’s makes more progress, the overall environment is just going to become more promotional and more competitive because of that success?
I think we are very well prepared for a more competitive marketplace. The comments were specifically driven based on one of our large competitors getting really aggressive, discounting large projects, going through a bid room process. This is invisible to the general public, but for large customers with purchases over a certain volume threshold, you can submit that for additional discounts from a commodity pricing perspective, and there was more discounting in that area over a consistent period of time than I’ve seen in my 14 years in this business.
It is neither here nor there. We just continue to compete, and we want to just run our strategy, which is something that we’re going to continue to do. But we wanted to highlight that that competitive cadence dramatically changed in Q3 and we’re going to be prepared to see what happens in Q4.
We’ll take one more question, please.
Thank you. Our final question comes from the line of Zach Fadem with Wells Fargo. Please proceed with your question.
Hey, thanks for fitting me in. Could you talk about your Black Friday and Cyber Monday offerings, specifically online, and just given the re-platforming on the site, should we expect a temporary acceleration in dot-com sales for this seasonal uptick and demand around the holiday, or do you expect similar growth versus Q3?
I’ll give you some comments on dot-com. I’ll let Bill give you some of the really exciting deals we have. For dot-com, we had a pretty underwhelming performance last holiday season and so we are expecting to have better performance within that holiday period, but that holiday period does not define the entire quarter, so we don’t have an expectation that we’re going to see dramatic dot-com growth in Q4 relative to what we’ve seen the last two quarters. However, we do expect to have more stability and better performance during the Black Friday period.
The only caveat to that is we gave a lot of product away online last year. We’re not going to give it away this year. We had a lot of site-wide promotions that didn’t make any sense, didn’t provide any value to the customers--well, it gave a lot of value to the customers but no value to the shareholders and to the company from a profit perspective, so we’re going to be appropriately aggressive online but we’re going to be aggressive from the standpoint of running a really good business model, but we’re not expecting robust dot-com growth in Q4, no different than what we’ve seen in the last couple of quarters.
I’ll let Bill highlight some of the exciting things we’re going to be selling in the stores.
We’re super excited about what’s going on for Black Friday, but as you know, it starts with really Black November, so we were able to do a number of deals and special values out there for the pro that ran for Black November. We kicked off the appliance event for Black November, and then with the team having roughly a year to be able to plan this year’s Black Friday, we’ve got just some super door busters for Black Friday day, we’ve got, as I said in my prepared remarks, a chance for lucky customers to win a trip to the Super Bowl, so we’ve got just a lot of excitement that’s going to drive folks to the Lowe’s door on Friday, so we’re excited about where we’re going.
Got it. Then on the repair and remodel overall environment, curious to hear your thoughts on the latest round of data points particularly with existing home sales improving, and curious how you think about just overall category demand and whether you have any expectation of improvement as we enter 2020.
Zach, we feel great about the macro. All of the macro indicators that are important for our business are pointing in the right direction - consumer confidence, unemployment is low, home prices continues to appreciate, wages continue to strengthen, and interest rates continue to be low to moderate. We feel really positive about all the macro indicators. There’s nothing on the horizon that gives us any pause, so that goes to our confidence going into Q4, and we hope that when we provide our guidance for 2020, we’ll have the same confidence looking in that time period as well.
Thanks Marvin, appreciate the time.
Thank you.
Thank you. We have reached the end of our question and answer session and the conclusion of today’s call. Thank you for your participation. You may now disconnect your lines and have a wonderful day.