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Good morning everyone and welcome to Lowe’s Companies third quarter 2020 earnings conference call. My name is Rob and I’ll be your operator for today’s call. As a reminder, this conference is being recorded.
I will now turn the call over to Kate Pearlman, Vice President of Investor Relations.
Thank you and good morning everyone. Here with me today are Marvin Ellison, our President and Chief Executive Officer; Bill Boltz, our Executive Vice President, Merchandising; Joe McFarland, our Executive Vice President, Stores; and Dave Denton, our Executive Vice President and Chief Financial Officer.
I would like to remind you that our notice regarding forward-looking statements is included in our press release this morning, which can be found on Lowe’s Investor Relations website. During this call, we will be making comments that are forward-looking, including our expectations for fiscal 2020. Actual results may differ materially from those expressed or implied as a result of various risks, uncertainties, and important factors, including those discussed in the Risk Factors, MD&A and other sections of our annual report on Form 10-K and our other SEC filings.
Additionally, we will be discussing certain non-GAAP financial measures. A reconciliation of these items to U.S. GAAP can be found in this morning’s press release and on our Investor Relations website.
Before we discuss our third quarter results, I would like to announce that we will be hosting a virtual investor update on Wednesday, December 9 from 8:00 to 10:00 am Eastern time. Marvin will discuss several growth opportunities that are expected to facilitate further market share gains. Dave will discuss our opportunities to drive operating efficiencies and sustainable shareholder value, and he will also provide an update on our financial targets. After our prepared remarks, we will host a Q&A session. We look forward to speaking with you again soon.
With that, I’ll turn the call over to Marvin.
Good morning everyone. I’d like to start out by taking a moment to extend my thoughts and prayers to all the individuals and communities impacted by the many wildfires, hurricanes and other natural disasters, as well as the COVID-19 pandemic. There is no doubt that this has been a very challenging year for many of us.
Although our Lowe’s associates are dealing with the same challenges facing the rest of the country, I continue to be inspired by their commitment to serve our customers and communities while juggling a multitude of pressures and obstacles at home. Throughout all the uncertainty we’ve faced, we continue to be guided by three key priorities. First, our highest priority as a company will always be protecting the health and safety of our associates and customers through a safe store environment and shopping experience, and we believe that our strict in-store safety and social distancing protocols implemented in a consistent, uniform manner has built trust with our customers. Our second priority remains providing support for our community, including healthcare providers and first responders. Our third priority is financially supporting our associates during this challenging time.
In support of these priorities, we’ve invested an incremental $245 million in the third quarter to support our associates. We’ve now invested more than $1.1 billion in COVID-related support for our associates, store safety initiatives, and communities through the first nine months of this year.
Now turning to our results, for the quarter we delivered total company comparable sales growth of 30.1% over the prior year and 40% growth in adjusted diluted earnings per share to $1.98. At the same time, we’re also making critical investments across our operations to position the company for long term growth.
Our U.S. home improvement comp was 30.4% driven by consistent and strong project demand from both DIY and pro customers throughout the quarter. In a continuation of trends from Q2, growth was broad-based across channels, product categories and geographies. In fact, growth exceeded 15% across all merchandising departments, 20% across all geographic regions, and triple digits on lowes.com.
DIY comps again outpaced pro comps in the quarter, driven by a consumer mindset that remains focused on the redesigning of the functionality of their home. Consistent with this redefinition, in the third quarter customers continued to shop at Lowe’s as they took steps to shift their home to serve three primary purposes: a home school, a home office, and their primary location for recreation and entertainment. We were pleased that customers continue to choose Lowe’s as their retailer of choice for these very important projects.
Our pro business remained strong in the third quarter with comps exceeding 20%. Our investments to improve our product and service offerings and overall customer experience is resonating with the pro customers. We are seeing a significant number of new pro customers rediscover Lowe’s and we’re seeing them come back to buy from us over and over again. We’re well positioned to continue to attract new pro customers while also growing share of wallet with existing pro customers.
We launched a significant merchandising investment in the third quarter to reset the footprint of our U.S. stores, shifting to a project focus versus a product focused store layout. We believe these changes will create a more intuitive shopping experience for our customers, especially the pro, and we redesigned the layout of our stores to improve product adjacencies and bay productivity with the goal of increasing sales per square foot. Bill will provide more detail on this very important reset initiative in a moment.
From a geographic perspective, we had broad-based growth with positive comparable sales growth exceeding 20% across all 15 geographic regions and all three U.S. divisions. Regions that outperformed the total company comps were Atlanta, Houston, Los Angeles and New York. We also continue to see strong sales trends in urban areas; in fact, comp sales in our urban markets outperformed remote or rural markets by over 500 basis points. Our strength in our urban markets reflects the improvements we’ve made to our product and service offerings for the pro customer as well as enhanced omnichannel capabilities to serve customers increasingly shopping online.
Our lowes.com sales grew 106% as we continue to see an increase in both DIY and pro customer demand for contactless shopping options. We have made tremendous progress over the last two years with the right investments to improve our omnichannel retailing capabilities, enabling us to meet the ever increasing expectations of customers to shop whatever way they choose. We continue to invest in our supply chain network as we open new cross-dock delivery terminals, bulk distribution centers, and ecommerce fulfillment centers to expand our fulfillment capabilities.
While we’ve seen exponential online growth this year, we still have tremendous growth runway in front of us as lowes.com business is meaningfully underpenetrated with online representing only 7% of our sales. Supported by our modern cloud-based platform, our talented dot-com and technology team has a detailed road map towards becoming a best-in-class omnichannel retailer.
Turning to Canada, we posted positive comps that exceeded 25%, supported by strong pro and DIY demand as well as early success implementing our retail fundamentals playbook to improve operating efficiency while driving sales. This was a very important quarter for us as we drove strong top line results while continuing to make significant investments across merchandising, lowes.com, store operations and supply chain that will enable us to capitalize on current trends and will position us as a company to drive sustainable growth.
2020 has demonstrated to all of us how quickly shopping behaviors can change, and I’m proud of the agility that we’ve shown to adjust our business model to serve an unprecedented number of customers in store and on lowes.com. We also understand that agility will be important as we hopefully pivot to a post-COVID retail environment later in 2021. However, we understand that creating an efficient and world-class omnichannel experience will determine retail winners and retail losers in the future, therefore we’re pleased with the current development of our omnichannel strategy thus far and remain committed to making the necessary investments to provide our customers with choices to shop any way they choose. Over the near term, our investment thesis will remain laser focused on enhancing the growth and profitability of our core retail business.
Before I close, I’d like to again express my sincere appreciation for the tremendous efforts of our associates to support our customers and communities when they need us most. The country continues to face significant challenges presented by COVID-19 and this is still a very unpredictable business environment; however, our number one priority as an essential business will always be supporting the health and safety of our associates and our customers.
I look forward to speaking with you again at our investor update on December 9 with a discussion focused on the market share growth opportunities that lie ahead of us.
With that, I’ll now turn the call over to Bill.
Thanks Marvin, and good morning everyone.
As Marvin mentioned, we posted U.S. home improvement comparable sales growth of 30.4% in the third quarter. Our continued strong execution combined with elevated brand and product offerings enabled us to effectively serve the sustained increase in customer demand driven by the increased importance that customers are placing on their homes.
Similar to the second quarter, growth was broad-based across both DIY and pro customers, in store and online, and across all merchandising departments. In fact, all 15 merchandising departments generated positive comps exceeding 15%. Lumber led the way, again driven by strong unit demand across pro and DIY customers supported by our continued investments in job lot quantities and the strength of our merchants and our supply chain teams in sourcing these high demand products.
In addition to lumber, we delivered above average comps in décor, lawn and garden, and seasonal and outdoor living. Within décor, our growth was driven largely by the strength in furniture, including accent furniture and accessories, along with the strong results in home organization as customers continued to update and create new spaces for home offices and remote schooling.
In lawn and garden, there was broad-based strength across the business, though most notably within live goods and landscape products as customers actively engaged in outdoor landscaping and other fall exterior projects. Our seasonal and outdoor living team also delivered comps above the company average this quarter driven by customers looking to extend their outdoor entertaining space with fire pits and patio heaters being the accelerated product category for this fall.
We continue to strength our position as the number one destination for outdoor power equipment with the recent addition of EGO, which is the top selling brand in battery powered outdoor power equipment, to our all-star line-up which includes John Deere, Craftsman, Husqvarna, Honda, and the Aaron’s brands, and we continue to leverage our other powerhouse brands like Weber and Charbroil, which continue to be the top two brands in outdoor grilling.
Now turning to our online results, as Marvin mentioned, we delivered sales growth of 106% on lowes.com. With the re-platforming of lowes.com to the cloud, we have been rapidly deploying enhancements to deliver a better customer experience, including enhanced online delivery scheduling so that customers can more efficiently self serve and select the delivery time that is most convenient for them, or easily reschedule as the need arises.
We also made it easier to shop by product collection with over 500 collections and growing, so customers can now purchase a patio set without it involving a time consuming search for each individual item. I’m also excited that we now have the capability to ship products that require special handling, items like lithium ion batteries. This capability now enables us to handle online orders of EGO, Cobalt, and Skil battery powered products along with other products powered by lithium batteries or items that may require care in shipping and handling.
As Marvin covered in his opening remarks, we are resetting the footprint of the store so it’s a more intuitive shopping experience for our customers, especially for the pro. For example, the re-flow of our rough plumbing and electrical aisles are two key areas for the pro that needed to reflect how the pro shops. We are now placing all of the relevant products adjacent to each other, such as pipe cement next to pipe and the necessary fittings next to their respective pipe category. We are also eliminating merchandising bays without plan-o-grams - we call these junk bays, thus opening up space for higher velocity, higher demand items in categories that will better reflect the local market.
We are on track to have the reset complete for over 90% of our stores by fiscal year end, and as part of this store reset, there will be two other noticeable changes. First, we are adding a pro flex area, similar to what we did earlier this year in our seasonal areas, making it easier for the pro to grab and go. Second, we are moving the cleaning category to the main or the first aisle of our stores. This is just another example of ways we are working to improve the productivity in this highly visible area of the store.
As we look to close out the year, we are building on our momentum around the holiday season that began with our first-ever drive-through curbside trick or treating event at our stores, where we gave away candy and pumpkins to hundreds of thousands of families who were excited about the holidays but may not have had the same door-to-door trick or treating available in their neighborhoods as in years past.
We feel that this will be a holiday season like no other when our customers will no doubt be spending much more time at home, and because of that, we’re helping our customers invest in the time and memories that they’re creating at home, and we’re planning to deliver a season of savings for the holidays over an extended period to avoid creating congestion in our stores. Consistent with our approach throughout 2020, we continue to expect reduced promotional activity compared to the prior year.
Overall, we’ve delivered outstanding results this year, and I can’t say enough about the unbelievable efforts of our vendor partners and our merchants who have worked extremely hard to keep up with the unprecedented demand.
Thank you, and I’ll now turn the call over to Joe.
Thanks Bill, and good morning everyone.
This year, we faced operational challenges unlike anything I’ve encountered in my career. Whether it’s in response to a hurricane, flood, tornado or global health crisis, Lowe’s associates take pride in the role they play to keep families safe and their homes and businesses running in challenging times. Our associates have also remained steadfast in their commitment to providing a safe shopping experience in our stores so our customers feel comfortable returning for another shopping trip to Lowe’s.
In recognition of the outstanding efforts of our team, we have provided financial support to our hourly associates with two additional $100 million bonuses this quarter. Full time associates received $300 and part time associates received $150 in each payment, while Lowe’s covered the cost of the tax gross-up again. This brings our total COVID-related financial assistance to our associates to over $800 million this year. I’m thrilled to announce that for the third quarter in a row, 100% of our stores have earned their Winning Together profit sharing bonus totaling $104 million. Once again, their efforts exceeded expectations, so this represents an incremental $31 million over the target payment level.
I was also really pleased to see the strong frontline associate morale, reflected in their impressive level of engagement in our recent annual associate survey. Our associates indicated that they feel supported by the company during this challenging year and that they are energized by their work, and we’re supporting our communities through hiring as we’re bringing on 20,000 associates across our U.S. stores and distribution centers this holiday season to support elevated levels of customer demand. This year, we’ve hired over 155,000 associates through our seasonal hiring programs, and many of these seasonal hires have transitioned to a more permanent role within the company.
The pandemic has changed the way we all live, work and shop. This is evident in our increased customer demand for contactless shopping options this year. This quarter, we began adding touchless BOPUS lockers to our stores to complement our curbside pick-up and BOPUS pick-up at checkout. We’re focused on rolling out these lockers to our major metro markets by Thanksgiving and we are standing up dedicated fulfillment teams at our stores who are already improving speed of service and customer satisfaction with their consistent focus on this important function.
We’re also raising our game with the pro as we expand our brand and product offerings to meet their unique needs. We are adding to our Eaton electrical product assortment, which is a go-to solution for the pro working on a home remodeling project, and we are now the largest distribution partner for SharkBite, which provides push to connect plumbing projects that make project fast and easy, a must have for any plumbing project. Combined with the power of Simpson Strong-Tie, DeWalt, Spider and Bosch brands, this broader offering in Eaton and SharkBite builds out our arsenal to ensure that we have a competitive offering that meets the needs of our pros across the variety of projects that they handle.
We’ve kicked off a multi-year national roll-out of our tool rental program to increase our relevance with the pro as over 70% of pros rent tools at least once a year. In August, we celebrated the grand opening of our first tool rental location in Charlotte, where we provide high quality tools for both pros, DIYs, and weekend warriors through a convenient online platform that allows customers to reserve their tools ahead of time. We are encouraged by the early results and the strong feedback from our most frequent pro customers in the Charlotte area.
Looking at our third quarter results, I’m really pleased with the comps exceeding 20% that the pro team delivered. We are consistently meeting the needs of our pro customers with job lot quantities that are available every week, efficient service focused on getting them back on the job site quickly, and the products they’re looking for. We’re winning new pro customers and they’re coming back to our stores again and again.
We continue to drive efficiency by streamlining our store operations as we leverage technology to improve customer service and alleviate the tasking responsibilities for our red vest associates. This quarter, we leveraged the new intuitive touch screen POS at our registers to easily cross-train other associates on the cashier position. These new touch screen registers not only speed up cashier training from the old green screens, they also provide our customers with a faster checkout experience. This is consistent with our store simplification approach which leverages new technology to make our associates more productive while also improving customer service at the same time.
With all these store technology processes and improvements under our belt, we are well on our way to hit our target of 60% service and 40% tasking by the end of the year, and it’s paying off with high customer satisfaction scores as we acquire new customers who keep coming back to shop at Lowe’s.
Thank you, and I will now turn the call over to Dave.
Thank you Joe, and good morning everyone. I’ll begin this morning outlining the company’s strong capital allocation program.
In the first nine months in 2020, we generated $10.3 billion in free cash flow driven by very strong operating performance. In the third quarter alone, we paid $416 million in dividends. We also announced a dividend of $0.60 per share, a 9% increase that will be paid in the fourth quarter of this year. During the quarter, we reinstated our share repurchase program and repurchased 3.6 million shares in the open market for $621 million. I continue to expect our share repurchase program to be a significant contributor to long term shareholder value creation.
We incurred capital expenditures of $462 million as we invest in the business to support our strategic initiatives, including our omnichannel capabilities. In October, we took advantage of a favorable interest rate environment to reduce our interest expense through a cash tender offer for $3 billion of our higher coupon bonds. As a result, we recognized a loss of $1.1 billion on the extinguishment of debt.
To fund the tender offer, we issued $4 billion of unsecured notes. This issuance consisted of seven, 10 and 30-year notes with a weighted average interest rate of 2.17%, which is a record low in the company’s history. These efforts further strengthen our capital position by lowering our interest expense over the longer term. We now have $8.2 billion of cash and cash equivalents on the balance sheet and combined with $3 billion in undrawn capacity on our revolving credit facilities, we have immediate access to $11.2 billion in funds which we are confident is more than enough liquidity to navigate any uncertainty.
At the end of Q3, our adjusted debt to EBITDA ratio stands at 2.3 times.
Now turning to the income statement, in Q3 we generated GAAP diluted earnings per share of $0.91 compared to $1.36 last year, a decrease of 33%. As I just mentioned, the company incurred a $1.1 billion loss on debt extinguishment this quarter.
My comments from this point forward will include certain non-GAAP comparisons where applicable.
In Q3, we delivered adjusted diluted earnings per share of $1.98 per share, an increase of 40% compared to the prior year. These results were driven by higher than expected sales volume as well as our strong execution to meet elevated customer demand. Q3 sales were $22.3 billion, an increase of 30.1% on a comparable basis versus the prior year. This was driven by transaction growth of 16.4% and comparable sales average ticket growth of 13.7%. We continue to see strong repeat rates from both new and existing customers.
Commodity inflation drove a benefit of approximately 340 basis points to comps in the quarter. U.S. comp sales were up 30.4% in the quarter with continued strength from both DIY and pro customers and broad-based demand across geographies, merchandising departments and selling channels. Our U.S. monthly comps were consistently strong throughout the quarter with 28.9% in August, 31.8% in September, and 30% in October despite a significant reduction in promotional activity versus LY.
Gross margin was 32.7% of sales in the quarter, an increase of 28 basis points compared to the third quarter of ’19. Product gross margin rate improved 65 basis points driven by continued improvements from our pricing, cost management and promotional strategies. Favorable product mix drove approximately 35 basis points of benefit. These benefits were offset by 30 basis points of headwind from lower credit revenue, 25 basis points of pressure from inventory shrink, and 20 basis points of pressure from supply chain costs.
Consistent with our long term strategy, we are investing in our supply chain as we expand our network to stand up market level delivery model for big and bulky products. We further expanded capacity for partial shipments with the opening of a new direct fulfillment center on the west coast.
SG&A was 21.4% of sales in Q3, a 31 basis point improvement compared to LY. As we anticipated, we incurred $290 million of COVID-related expenses. These investments included $230 million in financial assistance for our frontline associates and approximately $55 million related to both cleaning and other safety related programs and approximately $5 million in charitable contributions. These $290 million of COVID-related expenses negatively impacted SG&A leverage by 130 basis points.
We also incurred approximately $100 million in a large scale strategic merchandising reset of our U.S. stores, which negative impacted SG&A leverage by 45 basis points. These incremental costs were partially offset by payroll leverage of 90 basis points related to higher sales volume and improved store operating efficiencies, occupancy leverage of 35 basis points, 35 basis points of leverage in employee benefits, and advertising leverage of 25 basis points.
Adjusted operating income margin increased 55 basis points to 9.81% of sales. The adjusted effective tax rate of 23.9% was in line with the prior. Q3 benefited from a $0.02 timing shift into Q3 at the expense of Q4. At $15.7 billion, inventory was higher compared to the prior year levels as we stocked up on product to meet elevated customer demand throughout the quarter. Also, lumber inflation increased inventory values by approximately $250 million.
I’d now like to spend just a few minutes discussing our outlook for the fourth quarter. While the operating environment remains uncertain and we still have limited visibility into the longer term trends, I’d like to share my perspectives about how we are planning the business in Q4.
We expect that our top line growth will moderate from Q3 levels as outperformance in seasonal categories abates in the fourth quarter. This is consistent with natural demand patterns of the home improvement sector. For the quarter, we expect total and comparable sales growth of between 15% and 20%. Consistent with the prior two quarters, we anticipate that we will incur ongoing COVID-related operating expenses of approximately $75 million to support safety and cleanliness in our stores. In Q4, we will continue to evaluate the operating environment and assess any potential incremental associate financial assistance.
We expect to incur approximately $150 million in expenses associated with the merchandising investment in our stores as we expect to complete the reset activity for over 90% of our U.S. stores by the end of the fourth quarter. Additionally, we will continue to invest in expanding our supply chain network. These significant investments coupled with our fourth quarter typically being our smallest revenue quarter should result in adjusted operating margin performance essentially flat to prior year levels.
The effective tax rate is expected to be over 27%.
Continuing our commitment to return capital to shareholders through value enhancing share repurchases, our guidance assumes approximately $3 billion in share repurchases in the fourth quarter. We expect GAAP and adjusted diluted earnings per share of $1.10 to $1.20 a share. For adjusted EPS, this represents 22% growth at the midpoint over the prior year.
We are now planning for approximately $1.7 billion in capital expenditures for the year with a continued focus on our omnichannel investments.
In closing, I’m extremely pleased with our outstanding results for the first nine months of the year. In an unprecedented operating environment, we remain focused on serving our customers and our communities, which led to an opportunity to grow market share earlier than we expected.
I remain confident that we are making the right investments to drive sustainable growth. We have a strong balance sheet and we are committed to a disciplined capital allocation program which will lead to longer term shareholder value creation. I look forward to speaking with you again soon at our investor update meeting on December 9.
With that, I thank you, and we’re now ready for questions.
[Operator instructions]
Your first question comes from the line of Simeon Gutman with Morgan Stanley.
Hey, good morning everyone. I have a question, Marvin. If you step back and look at the transformation so far since you’ve gotten there and your ability to get to 12% margins and beyond, I know the stock’s down a little bit this morning and I think it’s reflecting maybe a mismatch in timing of some investments and flow-through, but it doesn’t look like much has changed with your goals and the path you’re on. But I wanted to ask you if there’s anything that you can be critical of, something that’s not playing out, or is your reaction that things should only be stronger for Lowe’s than what you envisioned when you got to Lowe’s?
Simeon, that’s a very good question. We actually feel great about the transformation. Obviously we don’t have perfect visibility to the future and we had no idea, as no one did, that we’d be dealing with a global pandemic in the year 2020. But when I think about how far we’ve progressed in two years, when you look at the digital platform and our online business, the last two quarters growing 135% last quarter, 106% in the third quarter, we’re at levels that we could not have even imagined just 12 to 16 months ago. Merchandising initiatives, supply chain, I think the key for us is that we’re not really concerned about the short term. We know this is a great brand. We have a strong balance sheet, and we’re trying to make the right investments in the future.
When I look around at the accomplishments of the team, I’m exceptionally proud because we’re a little bit ahead of schedule, as Dave mentioned, and we think that we’re going to start to lean into taking market share. At the December 9 investor update, we’re going to be a lot more specific about where we are in this transformation and how we see the out years and where we believe that we can really start to pick up additional market share.
But overall, I couldn’t be more pleased with the progress of this team.
Okay, and a quick follow-up, I think year to date we have incurred about $1.1 billion of COVID associate benefits and additional costs. How do we think about that into the fourth quarter and into 2021?
I’ll take the first part and see if Dave has any additional context.
Dave mentioned that we’re committed to funding all expenses relative to cleaning and providing a safe environment for our associates and customers in our physical stores, and so that is something that we are committed to continuing to execute. We’re going to just monitor all other aspects of the needs of our associates and determine what, if any, additional investments need to be made in the fourth quarter. We’ve actually followed that philosophy for the last couple of quarters, and the fourth quarter won’t be any different.
I don’t know if Dave has anything to add?
Yes Simeon, this is Dave. The only thing I would add to that is that obviously in November, the associates will receive incremental compensation, and then in December our Winning Together program kicks into play, and just given how the stores are performing, the vast majority, if not almost all the stores are at max payout from that, so we’re leaning into areas to compensate our associates tied to their needs but also tied to performance.
Okay, thanks. Good luck.
The next question comes from the line of Kate McShane with Goldman Sachs.
Hi, good morning. Thanks for taking my questions.
I wonder if I could ask about pro versus DIY, just if you saw a narrowing of the gap in performance between the two this quarter versus last quarter, and how should we be thinking about the pro penetration in sales next year once you reset the store and leverage some of the initiatives that you’ve put in place the last year or two?
Kate, it’s really difficult for us to give you a very specific forecast on that. Obviously this is the most difficult environment for any kind of a financial forecast, but I think at a high level, we anticipate that you’re going to see that gap continue to close and the pros will start to gain more penetration as we start to have less of the nesting effect when we get to this post-COVID environment.
One of the reasons we’re making all of these investments in the pro, and as Joe and I both mentioned we grew the business over 20% in the third quarter, is because we’re anticipating this post-COVID retail environment, and we know this customer is very important for us, so we expect that gap to continue to close as we get into 2021.
The question is when, and that’s going to be in large part based on COVID and how the nesting effect of the DIY starts to minimize over time.
Kate, this is Dave. I’d just add that if you step back and think about the financial algorithm of this company over the next several years, as we’ve said many times, we have real strength in the DIY customer and you’re seeing that in our numbers today. The opportunity over time is to really penetrate and grow our pro business, and I think the investments we’re making both in Q3 and Q4, and really as we cycle into next year, is really bolstering our business model around the pro.
It’s not going to be like a light switch, that it will just turn on and the pro is going to just elevate significantly, but this is each week and each month and each quarter, kind of continuing to push and grind ourselves out to grow that pro business, and that’s the objective we have here.
Okay, thank you. If I could just ask a quick, unrelated follow-up, just with the news in the MRO space this week, I just wonder if you could remind us how you’re thinking about your competitive positioning within the MRO segment, and does the change this week change anything when you think about supply chain investment for Lowe’s?
Kate, it does not. I made the comment earlier in my prepared comments that we’re committed to the core retail business. When we look at our investment thesis and we evaluate where we can gain the greatest return, it is in our core business.
Now, we’re going to continue to target the MRO segment in our current pro strategy with our outside sales reps, but those reps are connected to the store and connected to our MSH model, and we feel like that that model has the ability to scale; but our investment thesis, our focus is improving our core business, and that core business is defined as our brick and mortar stores, our dot-com platform, our supply chain, and all the other operational components that tie that together, and that’s our omnichannel philosophy.
We feel like we’re in a good position and we’re going to continue to make those investments, and over time that thesis may change but in the short term and near term, we’re just laser focused on our core business.
Thank you.
The next question is coming from the line of Scot Ciccarelli with RBC Capital Markets. Please proceed with your questions.
Good morning everyone. Another expense related question. Looking for some clarity, just in terms of the way to think about the cadence. Pre-pandemic, the Lowe’s story was very heavily centered on productivity improvements, SG&A leverage. Obviously as COVID hit, you’ve incurred a lot of incremental expenses - you know, COVID assistance for your associates, obviously extra labor because of sales growth. How should we think about SG&A growth on, let’s call it a per-store basis, or however you want to frame it for ’21, just in terms of the way we should think about those overall levels? Thanks.
Yes, it’s probably a little early to talk specifically about ’21, but just in general, I think what you’re seeing is we have a very focused effort around store productivity and managing both labor and costs within our stores. Couple that with the investments that we’re making in supply chain, which is ultimately creating market-based delivery model, that will ultimately push pressure a little bit on gross margin as we take delivery out of the stores, move it into the market but relieve the stores with that burden from an SG&A perspective, so you’ll see incremental flow-through as that model gets built out. That’s probably a 12, 18, 24-month process before that happens, but I think we’re well on our way to continuing to make investments both from a technology perspective and an operational improvement perspective to drive productivity, so you should see us continue to get better, absent the effect of COVID.
The one thing that is going to go forward is probably in the neighborhood of $70 million or so per quarter on incremental costs associated with safety and cleanliness. I think that is here to stay for some period of time.
Scot, I’m going to let Joe McFarland talk a little bit about our productivity initiatives. We’re extremely proud of the fact that 18-plus months ago when we did an evaluation of our payroll spend in the stores, roughly 60% of all of our spend was going towards task and non-customer facing activities, and Joe has absolutely flipped that equation with the stores. I’ll let him talk about that for a second.
Yes, thanks Marvin. Scot, we’ve been very pleased with the progress we’re making on our 60/40 transition. As I mentioned in my prepared remarks, we’re well ahead of that schedule. We’ll hit the 60% service, 40% task by the end of this year, but that also allows us to continue to make investments in things like our fulfillment teams and the supervisors that we’ve added to the pro area of the business and the incremental expense that we incurred there. We’re very pleased with the productivity and we’ll continue on that productivity march.
Okay, thanks a lot, guys.
Our next question is coming from the line of Michael Lasser with UBS. Please proceed with your questions.
Good morning, thanks a lot for taking my questions. As you’ve gone through this transformation, you mentioned you’re ahead of schedule and realizing some of the productivity or cost savings that you expected, like the split between tasking and service, and yet now we’re seeing maybe a bit of an acceleration in some of the investments of the business. Are you entering a new phase of this transformation where some of the low-hanging fruit has already been harvested in terms of the cost, and at the same time investments are increasing which could occur at a time where this wallet share shift that is benefiting the home improvement category, all of these come together such that we do see a bit of a retrenchment or some margin degradation in your P&L over the next few quarters? Thank you.
Hey Michael, this is Marvin. As Dave mentioned, we’re going to have a little bit more specificity on the December 9 investor update, but here’s what I will tell you. We don’t believe we’re going to get entrenched and we believe that there’s still a large amount of opportunity in front of us to drive productivity. We have a multi-year timeline where we’ve mapped out initiatives from a merchandising perspective, operational perspective, supply chain, etc. We see productivity gains over the next couple years, to be candid. Obviously those initiatives vary in size and scale, but we believe we still have enormous opportunity.
To put in perspective your comments, we made the decision to accelerate this U.S. store reset initiative because early tests gave us confidence that this would tremendously benefit our pro customers and it would create a much more intuitive shopping experience for our DIY customers, so we took on $100 million of expense in the third quarter and we’re taking on roughly $150 million of expense, and that’s going to get roughly 90% of our stores completed. That is an example of us not running this business quarter to quarter.
We want to make sure that we’re making the right investments that will have long term benefits and create long term productivity gains, and we believe that we’re doing that and that’s going to be our focus. When we update you all in December, we’ll provide some perspective on how we see revenue and operational performance, as well as profitability in 2021, but we feel really good about our progress and we feel good about being in a position now to transition to a market share focus ahead of schedule.
Michael, I’ll just add, Marvin said something very important there. He said, we decided to accelerate the program. This was not an incremental program that we didn’t have on our road map. This was on our road map consistently over the last couple years, since we’ve been here. This is now we’re taking the opportunity to lean into it, so I think the original thesis of all the investments that we put forth, I think are very valid, and we see a lot of runway to continue to fund those investments and drive performance going forward.
Dave, if I could just clarify that and add one unrelated question, does that mean that some of those pull forward of investments will come from next year, such that you get a return on those dollars and you can be in better position to leverage your SG&A, even in a tougher macro environment?
Then my follow-up question is, the big change in the cadence of the P&L this quarter was the discussion around lower credit revenue and shrink. How long are those going to be issues that weigh on the gross margin, and what has caused to pop up suddenly?
Michael, as you think about the investments we are making, yes, we’re making these investments to improve our productivity in the years to come. I won’t speak specifically to ’21, but yes, the things that we’re doing today will benefit us going forward.
Then secondly, I’ll talk a bit about credit revenue and I’ll have Joe McFarland talk about the actions we’re taking from a shrink perspective. On the credit revenue side of the house, yes, we’re having a little bit of pressure there, and it’s really two things that are happening. One, we are seeing a tender shift as the U.S. consumer has pulled back on debt and their saving rate has increased, so we’ve seen a tender shift away from our private label credit a little bit into PIN debit, so that puts pressure on that line. Then secondly, we are forecasting some higher credit risk going forward just given the macro economy in the future, so a little bit of both of those things are driving that pressure.
Then from a shrink perspective, I’ll let Marvin and Joe comment on that.
Michael, I’ll hand it to Joe to talk about two things, give a little bit of an explanation on shrink, our trends and some of the initiatives to reduce it, but also to give another example of a pull forward initiative that we are in the midst of executing.
Joe, you can go ahead and cover those two things.
All right, thanks Marvin. As far as the investments, I’ll give you a quick example. We discussed the rolling out of the Buy Online Pick-Up In Store dedicated lockers, and so this was originally on the road map. This was an approximately $30 million pull-in expense to this year that we had from last year. This will allow us to continue to leverage our payroll expense and continue to drive our omni business. In addition, we have the new dedicated fulfillment team, so we feel very good about the investments we continue to make in the business.
In regards to shrink, we have been experiencing shrink pressures over the last several quarters. We have a good sense of where that lies, we understand the challenges. We have been making significant investments from a loss prevention standpoint, from a safety standpoint, and so we feel good about the trajectory. There were some challenges with being an essential retailer, being some of the only retailers open during the onset of the pandemic. I believe we’re cycling some of that today, but again as we continue to invest in market level intelligence, in loss prevention and safety programs, we’re confident in the payback.
Thank you very much, and have a nice holiday.
The next question is coming from the line of Chris Horvers with JP Morgan. Please proceed with your questions.
Thanks, good morning guys. I’m surprised we’ve gotten this far into the call without the obligatory quarter-to-date question. I’ll phrase it a little bit differently. You talked about seasonal mix being a driver of why you’re expecting 15% to 20% comps in the fourth quarter. You did post a 30% in October. Are you just simply mix adjusting for seasonal mix and that drives you into the 15% to 20%, or are you assuming moderation in other categories?
I’ll take this, Chris, and I’ll let either Bill or Dave jump in if they have additional comments.
To say this is the most difficult environment to forecast in would be an understatement. What I can tell you is we feel great about our early trends in November. We feel very good about our ability to meet demand if it exceeds our 15% to 20% guidance. We’ll have a much better perspective on Q4 when we speak to you and the other investors on December 9, but this is just our way of trying to frame up our best guess of where we think the business is headed in obviously the most difficult and complex forecasting environment any of us has worked in.
Again, I’ll leave it at that, and if we have more context and more detail on December 9, we’ll be more than happy to share it; but the key is we feel really good about the trajectory of our business, but this is our best estimate based on what we know today.
Understood. Then a question on, I guess the medium to long term gross margin outlook. Previously you had talked about mid to high 32% range in the existing algorithm and so forth. Does ’21 revert back down to this prior target, and if so, what are the drivers, because year to date you’re performing very nicely in that regard, so is it supply chain investments that causes some near term pressures? Is it mix, some promotional normalization? Then longer term, how do you think about the opportunity to get into that 33% to 34% range given your largest peer does have a higher gross margin? I understood there’s probably some efficiencies given scale, but at the same time, just trying to think about structurally the differences given all the work that you’re doing in the box and around the supply chain. Thank you.
We feel very strongly the opportunity is ahead of us from a gross margin perspective. We’re not going to give this back specifically. I will say there is some, I’ll say geographies on the P&L. We continue to push very hard at improving what I would consider our product level gross margin performance, and part of this is just being very efficient from a promotional standpoint, being very efficient from a cost management perspective.
At the same time, we are investing in supply chain and that’s going to put pressure on gross margin, but it’s going to relieve operating expense within our stores. The flow through of that is very accretive to op-inc, so I think you’ll see some geography shifts there but there’s nothing that’s going to revert back. It’s not our anticipation that we would revert back to where we were prior to this year.
Understood, thank you. Best of luck.
The next question is coming from the line of Seth Sigman with Credit Suisse. Please proceed with your question.
Thanks, good morning everybody. Thanks for taking the questions. Nice quarter.
I think investors are trying to understand the magnitude and the net impact from the investments you’re talking about and the pull forward, so the question is, and I know it’s been asked a couple different ways today, but if comps are positive, you could sort of manage through next year from a top line perspective. Can you continue to expand margin rate in FY21?
Well Seth, we’re commenting in detail on 2021 at this time. As we’ve mentioned on a couple of different occasions, we’re going to be updating you all on December 9, and we’re going to have a little bit of perspective--we’re going to spend the majority of that presentation talking about the initiatives and actions we’re going to be implementing to improve and take market share. At that time, we’ll have better perspective on ’21 and we’ll be able to provide a lot more context than what we’re doing today.
And Seth, I’ll just add, let’s not get hung up on where we end ’20 and where we end ’21. The reality here is we’ve set a target of 12% operating income flow through. I think we’re very focused on delivering upon that objective. I think we have very good line of sight to getting to that level and using that as just a stopping point to actually potentially go further after that. I think the investments that we’re making, the focus that we have today is really on improving that flow through over time, and we still see a very strong line of sight to that.
Seth, this is Marvin again. The only other comment I will make is we were asked a question earlier about the MRO space and if we are going to make any strategic changes based on the actions in the marketplace. One of the reasons why we’re not is because we see so much upside in our core business and we see an incredible opportunity to drive efficiency and productivity by continuing to make the right investments in merchandising systems, supply chain, operations, and so to Dave’s point, we see the 12% not as a pinnacle but as a milestone that we will hit and then we will continue to drive improved productivity beyond that point.
Again, we’ll be able to provide more context at our investor update in December.
Got it, okay. That makes sense.
We’re going to take one more question, please.
Sure. The next question is from the line of Elizabeth Suzuki from Bank of America.
Great, thank you. I was a little surprised to hear that the product mix was favorable to gross margin, just given that lumber sales growth was strong and this is usually a lower margin category. Can you talk about the categories that helped out from a product mix standpoint in the quarter?
Yes Liz, this is Dave. Actually lumber did put some pressure on gross margin in the quarter, as it typically does in an inflationary environment. Having said that, I’d say the merchandising and the finance team has done a really nice job in managing costs, kind of across all the categories, and I’d say I can’t call out just one category where we’re seeing improvements because we’re seeing improvements more or less up and down the P&L across all merchandising categories, for the most part.
Great, thank you.
Thank you. This concludes today’s teleconference. You may disconnect your lines at this time, and we thank you for your participation.